Michael Gray, CPA's Tax and Business Insight

Table of Contents

• Happy Fourth of July!
• New tax law has a surprise "Cinderella" ending.
• Santa visits retirement plans... for a while.
• Clarification about sale of decedent's residence.
• Ninth Circuit criticizes Tax Court valuation rulings.
• LIFO must be used for all inventory components.
• Covenant not to compete requires 15-year amortization.
• Finance company must capitalize salaries and benefits.
• Deathbed gifts under power of attorney fail to reduce estate tax.
• Texas counties get disaster relief.
• QTIP election can be undone.
• If you have employee stock options...
• PS Marché Aux Fleurs
• Visit our new articles.
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax and Business Insight.

Happy Fourth of July!

This is a great time to count the "blessings of liberty" and to be greatful to our Founding Fathers for taking a chance and creating a new nation "dedicated to the proposition that all men are created equal" (in potential).

Now we must remain vigilant in protecting our rights as free people while protecting the earth for which we are the custodians and beneficiaries.

I once asked my grandmother if she ever wanted to return to the old country. "Why would I want to go back there? I have everything I want here! I love my toilet! I love my washing machine! I love my stove! (And there are no vampires or werewolves here.) God Bless America!"

Well, the year is half over. How are you doing with that list of resolutions and goals you made for this year? We have worked our way through most of the extended tax returns and the second wave of estimate reviews. This is an excellent time to better define your financial goals and discuss how to meet them. The new tax law gives us many tools to work with. Sort of. See below.

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New tax law has a surprise "Cinderella" ending.

You remember the old saying, "If something appears to be too good to be true, it probably isn't." That maxim certainly applies to the tax cut legislation recently passed by Congress and approved by President Bush. There are many provisions to study and great tax benefits, but after each one, we should say, "Maybe."

The last provision of the law is that it does not apply after December 31, 2010. In other words, at midnight on December 31, 2010, the spell will be over and - POOF!! - the "coach and horses" will become a "pumpkin and mice"!

The repeal of the estate tax and generation skipping tax is a bad joke - it's only effective for one year! Many states have estate taxes that dovetail with the Federal estate tax. What are they supposed to do?

Yes, Congress will revisit these issues and probably extend many of these provisions, but how do we make long-term plans based on an optimistic hope about what Congress will do in the future?

Also, many of the provisions of the law will not become effective until President Bush is out of office. We have already had a change in controlling party for the Senate, and the House could follow in a few years.

Somehow, we need to establish more consistent and practical tax laws that we can all live with, and with less favoritism to special interests.

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Santa visits retirement plans . . . for a while.

There are many generous provisions relating to qualified retirement plans in the new tax law. Here are some examples.

• The maximum contribution for individual retirement accounts will be increased from $2,000 to $3,000 for 2002, 2003 and 2004; $4,000 for 2005, 2006 and 2007; and $5,000 for 2008. After 2008, the limit will be indexed for inflation.
  
  
• Individuals who are age 50 by the end of the taxable year will be able to contribute an additional $500 to an IRA for 2002 through 2005, and an additional $1,000 for 2006 and thereafter.
  
  
• The 25% of compensation limit for defined contribution plans will be increased to 100% of compensation, effective for years beginning after December 31, 2001.
  
  
• The $35,000 contribution limit for 2001 for defined contribution plans will be increased to $40,000, effective for years beginning after December 31, 2001.
  
  
• The maximum compensation limit for computing contributions to defined contribution plans will be increased from $170,000 for 2001 to $200,000, indexed for inflation for 2002 and thereafter.
  
  
• The maximum percentage of compensation limit for contributions to a profit sharing plan or a simplified employee pension plan (SEP) will be increased from 15% to 25%, effective for years after 2001. (With these increased limits, some employers will elect to terminate their money-purchase pension plans.)
  
  
• The maximum contribution for 401(k) plans will increase to $11,000 for 2002, $12,000 for 2003, $13,000 for 2004, $14,000 for 2005, and $15,000 for 2006 and thereafter, indexed for inflation.
  
  
• Effective for years after 2001, deferred employee contributions to a 401(k) plan, SARSEP, SIMPLE or a Section 403(b) deferred annuity will be disregarded when computing the maximum contribution to other retirement plans.
  
  
• The maximum contribution to SIMPLE plans will increase to $7,000 for 2002, $8,000 for 2003, $9,000 for 2004 and $10,000 for 2005 and thereafter, indexed for inflation.
  
  
• The maximum compensation limit for defined benefit plans will increase from $140,000 for 2001 to $160,000 for years after 2001, indexed for inflation.
  
  
• Effective for tax years beginning after 2005, employers may enable employees to designate contributions to 401(k) plans and 403(b) plans as non-deductible Roth contributions, subject to the same limitations as contributions to Roth IRA accounts.

(This list is not complete. You should consult with a professional who specializes in qualified retirement plans when determining how these rules apply to you.)

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Clarification about sale of decedent's residence.

A reader asked for some details about the availability of the $250,000 of gain exclusion for the principal residence of a decedent under the new tax law. This provision is effective in 2010. Like estate tax repeal, it is currently only effective for one year. Act Sections 543(c) and (f)(1) added new Internal Revenue Code Section 121(d)(9). There is a good chance this provision will be repealed and never become effective.

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Ninth Circuit criticizes Tax Court valuation rulings.

The Ninth Circuit Court of Appeals (which covers the states along the Pacific Coast and Arizona) rejected the Tax Court's findings of estate tax valuation for corporate stock in three cases. In Estate of Simplot v. Commissioner, the Ninth Circuit said the Tax Court was speculating about the motivations of particular potential purchasers of the stock in valuing a minority interest at a premium, instead of at fair market value. In Estate of Mitchell, the Tax Court should have shifted the burden of proof to the IRS when its proposed value was found to be unreasonable. The Tax Court didn't adequately explain why its value conclusion was higher than the value findings of the taxpayer's experts. In Morrissey v. Commissioner, the Tax Court disregarded two contemporaneous arm's-length sales of stock in the same corporation in determining the value of the stock.

Valuation is "where the action is" for estate planning involving business interests. These cases demonstrate that, when the estate is in the Ninth Circuit, it can be worthwhile to appeal an unfavorable Tax Court valuation decision.

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LIFO must be used for all inventory components.

Using the Last-In, First-Out (LIFO) method of valuing inventory can result in significant tax savings when inventory prices are rising. Consolidated Manufacturing used the First-In, First-Out (FIFO) method to price replacement "cores", but used the LIFO method for labor, overhead and new parts in remanufacturing the items. The Tenth Circuit affirmed the Tax Court's decision that, as a condition of using the LIFO method, it must be used for all components of an item of inventory. (Consolidated Manufacturing, Inc. v. Commissioner.)

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Covenant not to compete with partial redemption of stock requires 15-year amortization.

Frontier Chevrolet, Co. redeemed 75% of its common stock, held by ABC Automotive Group. At the same time, it entered a five-year non-competition agreement with ABC Automotive Group and its former executive manager. Frontier Chevrolet claimed the covenant not to compete did not relate to the acquisition of an interest in a trade or business, because it was merely continuing its existing trade or business. Therefore, it amortized the covenant not to compete over the five-year period. The Tax Court ruled the redemption was an acquisition of a trade or business under Internal Revenue Code Section 197. Therefore, the covenant not to compete was amortizable over 15 years. (Frontier Chevrolet Co. v. Commissioner, 116 TC No. 23.)

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Finance company must capitalize salaries and benefits.

Automotive Credit Corporation was in the business of providing alternative financing for purchasers of used automobiles and light trucks. About 70% to 75% of its contracts had terms exceeding 12 months. The Tax Court held that salaries and benefits attributable to acquiring and servicing the contracts must be capitalized and amortized over the terms of the contracts. Overhead expenses could be currently deducted, because it didn't relate to the acquisitions. In addition, expenses related to an anticipated public offering were required to be capitalized, but were deductible when the offering was abandoned. (Lychuk v. Commisioner, 116 T.C. No. 27)

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Deathbed gifts under power of attorney fail to reduce estate tax.

Dean Stubblefield was given a durable general power of attorney by his aunt, Sylvia Swanson. The power of attorney did not specify that Dean was given the power to make gifts for Sylvia. When Sylvia was on her deathbed, Dean made gifts on Sylvia's behalf of $10,000 to 38 individuals. She died shortly after the gifts were made. The Court of Federal Claims found the gifts were void under California law because the power of attorney didn't specifically authorize Dean to make gifts on Sylvia's behalf. (Estate of Swanson, 87 AFTR 2d ¶ 2001-873.)

Moral - If you want to enable a person to make gifts on your behalf, you must specifically authorize it in your power of attorney.

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Texas counties get disaster relief.

28 Texas counties affected by tropical storm Allison have been granted relief from IRS tax filing and payment deadlines. Taxpayers whose federal tax returns were due on or after June 5, 2001 and before August 15, 2001 have an automatic extension to file until August 15, 2001. Estimated tax payments that were due on June 15, 2001 will be timely if paid by August 15, 2001. Taxpayers should write on the top margin of the form "Texas Tropical Storm Allison Disaster" in large red letters.

Although the due dates haven't been extended for payroll tax deposits, the IRS may abate penalties for late deposits for reasonable cause during the extension period.

In addition, the counties have been declared "Presidential Disaster Areas", so taxpayers who suffered deductible casualty losses during 2001 may deduct them on an amended tax return for 2000.

The affected counties are Anderson, Angelina, Brazoria, Cherokee, Chambers, Fort Bend, Galveston, Hardin, Harris, Houston, Jasper, Jefferson, Leon, Liberty, Madison, Montgomery, Nacogdoches, Newton, Orange, Polk, Sabine, San Augustine, San Jacinto, Shelby, Smith, Trinity, Tyler, and Walker.

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QTIP election can be undone.

In some cases, it may develop after an estate tax return is filed that a QTIP election made for some assets may not be necessary. For example, the values finally determined in a tax examination may result in no tax without a QTIP election. The IRS has issued a procedure to reverse the election in these circumstances. (Revenue Procedure 2001-38.)

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If you have employee stock options, have you subscribed to the ESOAA Option Alert?

To subscribe, go to http://www.stockoptionadvisors.com. You can review past issues at http://www.stockoptionadvisors.com/optionalert/.

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P.S. Marché Aux Fleurs

My daughter and her husband, Holly and Dan Baker, have opened a Southern French Restaurant at 23 Ross Common, Ross, California, about 15 minutes north of the Golden Gate Bridge. The name of the restaurant is Marché Aux Fleurs. For the best meal of your life, call 415-925-9200 for a reservation and give them a try soon! For directions, visit our directions page.

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IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.