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Table of Contents

• Where have we been?
• Happy Halloween!
• Should you be looking at refinancing your home mortgage now?
• Standard mileage allowance reduced for 2003.
• IRS changes audit focus.
• IRS rules on deductions for enterprise resource planning software.
• Regulations issues on self-charged interest for PALs.
• IRS responds to abusive split-dollar arrangements.
• Change of accounting method procedure modified.
• Taxpayers affected by 9/11 attacks eligible for partial homesale exclusion.
• Deduction allowed for cost of removing and replacing roof on rental property.
• California budget legislation includes tax provisions.
• Limit increased to omit detail of dividends and interest for 2002.
• Market Basics.
• Questions and Answers

  What is the federal capital gains rate for selling a business?

  Where can I find more information about you?

  What is the maximum contribution to a SEP?

  Can I claim mileage on my tax return?

  Will I have to pay luxury tax even if I don't register my new car right away?

  Can I conceal my earnings from my parents at age 18?

  What is the tax basis for stock from life insurance and disability plans?

  Are we responsible for withholding when we issue a Form 1099-MISC?

• Do you have employee stock options?
• PS Marché Aux Fleurs
• Visit our new articles
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight.

Where have we been?

Usually we try to get our newsletter out at the end of the month. Dawn (my daughter, administrative assistant and webmaster) has just returned from a three-week trip to Eastern Europe. Since Dawn processes the distribution of the newsletter, I didn't send it before her return.

I needed the additional time anyway. The books I chose to review for this month, Napoleon Hill's The Law of Success series, is a monster to read. I hope you'll find my review of interest and become inspired to check this two volume series of lessons out.

Janet and I will soon be taking some vacation time. We will be on a cruise from October 20 to 27 and on a tour of Ireland from November 16 to 24. Dawn and I will also be going to Dan Kennedy's Copywriting Boot Camp on November 7 and 8.

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Happy Halloween!

Does it feel like autumn where you are? (It might be spring for some of our readers in the Southern Hemisphere.) Halloween is a very popular holiday in many places, so I hope you enjoy it and that it is a safe one for you.

With children returning to school, now Halloween and the Holiday season approaching, we know the end of the year is near. Are you ready? Be sure to reserve your year-end planning appointment now, because the times available are limited.

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Should you be looking at refinancing your home mortgage now?

A side effect of the sagging stock market is low interest rates. Some of our clients were able to take advantage of an opportunity to refinance their mortgage just a month after a previous refinancing. You can no longer get a new mortgage that will allow refinancing in such a short time, but many of the mortgage companies allow refinancing after three payments are made.

Remember we offer home mortgages as a service to our clients and newsletter subscribers located in California through our strategic partner, Wymac Capital. We specialize in financing with no points and no costs, if certain conditions are met.

To find out if we can reduce your home mortgage costs or help provide financing for education, a vacation, or a new home, please call Michael Gray at 408-918-3161. There is no fee or obligation for this service.

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Standard mileage allowance reduced for 2003.

The optional standard mileage allowance for business use of an auto will be reduced from 36.5¢ per mile for 2002 to 36¢ per mile for 2003. The allowance for using an auto for medical reasons or relating to moving will be reduced from 13¢ per mile for 2002 to 12¢ per mile for 2003. (IR 2002-100, 9/18/02.)

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IRS changes audit focus.

The Internal Revenue Service says it will be focusing more of its audit resources to "high-risk" areas of non-compliance. Here are the key areas of concern: (1) offshore credit cards; (2) high-risk, high-income taxpayers; (3) Abusive schemes and promoter investigations; (4) high-income non-filers and (5) unreported income. (IRS Fact Sheet (FS-2002-12.)

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IRS rules on deductions for enterprise resource planning (ERP) software.

A taxpayer asked for guidance for deducting costs relating to implementing an ERP system. According to the IRS, the original software cost must be depreciated over 36 months. The costs for functional costs and maintenance costs are deductible for the periods in which they are incurred. Prepaid training is deductible in the periods in which it is incurred.

Relating to Technical Consulting Costs, the risk for assuring that the software was functional was with the taxpayer. Therefore, the technical consulting costs related to self-developed software, and were generally currently deductible. Technical consulting costs for option selection and implementation of imbedded templates, including any allocable portion for the modeling and design of additional software activity is part of enterprise-specific installation costs of the ERP software necessary to make it compatible with the taxpayer's business. These costs must be added to the software cost and amortized over 36 months. Separately-stated computer hardware costs must be capitalized and depreciated over 5-years using MACRS. (Letter Ruling 200236028.)

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Regulations issued on self-charged interest for PALs.

The IRS has issued final regulations on the self-charged interest rule for passive activity losses. The final regulations make the rule available for more taxpayers, but don't extend the rule to other self-charged items. The regulations are effective for tax years beginning after 1986. For tax years beginning before June 4, 1991, a taxpayer that owns an interest in a passthrough entity may use any reasonable method to offset items of interest income and interest expense from lending transactions between the passthrough entity and its owners or identically-owned passthrough entities. (TD 9013)

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IRS responds to abusive split-dollar arrangments.

The IRS responded to an article in the July 28, 2002 New York Times about using private split-dollar life insurance to transfer large sums to family members at little gift tax cost. The IRS says it will not respect any arrangement using split-dollar life insurance, including reverse split-dollar, in which the parties attempt to avoid taxes by using inappropriately high current term insurance rates, prepayment of premiums, or other techniques to understate the value of policy benefits. (Notice 2002-59.)

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Change of accounting method procedure modified.

In Revenue Procedure 2002-19, the IRS allowed a negative Section 481(a) adjustment for many accounting method changes to be deducted in one year (the year of change). Under a new Revenue Procedure, companies with applications or ruling requests filed under Revenue Procedure 97-27 for a year of change ending before December 31, 2001 and pending on March 14, 2002, may modify the application to defer the year of change to the first tax year ending after December 30, 2001 to take advantage of the one-year adjustment period. The company must notify the IRS National Office of its intent to defer the change before the later of December 13, 2002 or the issuance of the letter ruling granting or denying the requested change.

Companies that have received consent agreements may elect to apply the one-year adjustment period if (1) the consent agreement is for a change in method of accounting for a year of change ending after December 30, 2001; and (2) the agreement does not reflect a one-year adjustment period. If the company has already signed and returned the consent agreement, it must write "Election to Apply 1-year Adjustment Period" at the top and attach the copy to either its timely-filed original federal income tax return or an amended federal income tax return that includes the adjustment period. If the company hasn't signed and returned the consent agreement, it should contact the National Office and request a correction agreement reflecting the one-year adjustment period. (Revenue Procedure 2002-54.)

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Taxpayers affected by 9/11 attacks eligible for partial homesale exclusion.

Taxpayers affected by the 9/11 terrorist attacks are eligible to exclude part or all of the gain from the sale of their principal residence, even though they don't meet the conditions to qualify for the full exclusion under § 121. The attacks qualify as an "unforseen circumstance" under § 121(c)(2).

Taxpayers who are eligible for the exclusion and didn't claim it may file amended returns.

The Notice also includes a preview of how forthcoming regulations will define an "unforseen circumstance." (Notice 2002-60.)

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Deduction allowed for cost of removing and replacing roof on rental property.

The taxpayer repaired a leaking roof for a rental property by removing the existing top layers of the roof and replacing them with fiberglass sheets and hot asphalt. She deducted the cost of the repair, together with costs to repair water damages in the house. The IRS claimed the cost of the roof should be capitalized and depreciated.

The Tax Court ruled the taxpayer could currently deduct the expenses as costs of incidental repairs because they didn't materially add to the value of the property, nor appreciably prolong the life of the property. The court followed the reasoning in a previous ruling, Oberman Manufacturing Co. v. Commissioner, 47 T.C. 471 (1967).

(Campbell v. Commissioner, T.C. Summary 2002-117 (9/6/02).)

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California budget legislation includes tax provisions.

Governor Davis approved the California budget legislation on September 11, 2002. Here are a few highlights.

• Certain taxpayers will receive an offer of amnesty for interest, penalties and fees. The amnesty applies to any unpaid tax liability that the California State Board of Equalization or the California Franchise Tax Board has determined to be a high-risk collection account and for which all payments of unpaid tax are received by a due date determined by the SBE or FTB, not later than June 30, 2004. Eligible taxpayers will receive a notification of the waiver from October 1, 2002 to June 30, 2003.
  
  
• The NOL deduction is suspended for tax years 2002 and 2003. The NOL carryover period is extended by one year for losses incurred during 2002, and two years for losses incurred before January 1, 2002. 100% of NOLs incurred in taxable years beginning after 2003 are allowed as a carryforward deduction.
  
  
• The credit for credentialed teachers is suspended for taxable years beginning in 2002.
  
  
• California tax law relating to Bad Debt deductions for banks is conformed to the federal tax law (§ 585) effective for taxable years beginning after 2001, including related AMT changes.
  
  
• The California withholding rate for stock options and bonus payments that are considered wages, paid after 2002, is specified to be 9.3%, instead of the 6% rate that applies for supplemental wages.
  
  
• Penalties for underpayment of estimated tax will be waived for 2002 if the penalty resulted from a change enacted as part of the budget legislation.
  
  
• The income tax withholding requirements are extended to certain transfers of real estate by individuals for tax years beginning after 2002. However, the withholding will be waived if the seller certifies under penalties of perjury that the California real property transfer (1) is or will be exchanged for like kind property, to the extent of the unrecognized gain; (2) was compulsorily or involuntarily converted and the seller intends to acquire property that is similar or related in use; or (3) will result in a loss.

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Limit increased to omit detail of dividends and interest o individual income tax returns for 2002.

The amount of dividends or interest that can be reported on an individual income tax return for 2002 without including the details by payor will be increased from $400 (for 2001) to $1,500 (for 2002). (IR 2002-102, 9/26/02.)

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Market Basics.

As investors are sitting on the sidelines, here is a reminder of a few market basics, as I understand them.

• The market is the barometer of the emotional state of the country.
  
  
• Traditional wisdom is "buy low, sell high". Unfortunately, we don't know how high the top is or how low the bottom is. Emotionally, the tendency is to buy when the market is high and to sell when the market is low. (But remember, there is a buyer for every seller and a seller for every buyer. Volume of transactions decreases in a bear market - a symptom of fear. Volume of transactions increases in a bull market - a symptom of greed. Greed and fear are the two dominant emotions that drive the market.)
  
  
• Most people agree that an investor reduces risk through diversification. But diversification involves owning investments in different asset classes. Investments in one asset class (such as technology stocks) will tend to move together, frustrating an attempt of diversification by buying several different stocks in the same class.
  
  
• The stock market and the bond market tend to move in opposite directions. The current recession has been following this classic pattern. There was an exception in the "stagflation" of the late 1970's - a recession with high inflation and high interest rates.

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Questions and Answers

Question

I sold a business in 2001 which I owned for over 5 years. I have no basis as the business was inherited. Could you tell me what my capital gains federal rate would be? Also, would the value of the business at the time ownership was transferred to me be considered help in reducing the capital gains tax?

Answer

You haven’t provided enough information for me to answer your question. I highly recommend that you seek help from a professional tax return preparer. The answer can vary for a proprietorship, a partnership interest, an S corporation or a C corporation.

Generally, the tax basis of inherited property is equal to the fair market value at the date of death or alternate valuation date. Inherited property is generally treated as held more than one year when sold after a death. Accounts receivable for a trade or business does not receive a new tax basis. You also may have basis adjustments for depreciation allowed or allowable after the date of death.

The maximum federal tax rate for long-term capital gains is generally 20%. Most people will not qualify for the new 18% rate for capital assets held for more than five years until after 2005. Taxpayers in the 10% or 15% brackets may qualify for the 8% capital gains rate for 2001. There is a worksheet on page 8 of the Schedule D instructions showing whether you qualify.

The same maximum capital gains rate (20%) applies for computing the regular tax and the alternative minimum tax (AMT). Taxpayers with large long-term capital gains are often subject to the AMT because state income taxes aren’t allowed as a deduction when computing the AMT.

When you sell a business, part of the income can be for depreciation recapture, taxed as ordinary income (38.6% maximum rate for 2002), or capital gain attributable to accumulated depreciation for real estate, subject to a 25% maximum rate.

State income taxes can also be significant. For example, California has a maximum income tax rate of 9.3% with no break for capital gains. If a sale results in only a long-term capital gain subject to the 20% maximum federal AMT rate plus the 9.3% maximum California rate, the total would be 29.3% (not considering the tax benefits lost for other deductions that are disallowed for AMT.)

Other special rules can apply, depending on the details. That’s why you need to have someone help you with your particular facts. Since the tax rules for the sale of a business are complex, it’s a good idea to get tax advice when structuring an agreement for the sale.

Question

Hello! I like your writing very much! Could you give me some suggestions on how to read more of your recent books? How to understand more about yourself?

Alex Wang from China

Answer

Thank you for the compliment. The only books that I have written that are available are about employee stock options. Otherwise, my written material is available at our web sites, www.taxtrimmers.com and www.profitadvisors.com. Eventually, I may be publishing some more books.

You have seen the books I have written reviews for at the profitadvisors site. I hope you can find some of them at a public library. Understanding one's self is a lifelong project, and I certainly haven't "arrived."

Enjoy the ride!

Question

You have a FAQ about the maximum contribution to a SEP that I don't understand. From what I read in Publication 560, employers can contribute up to 25%, while employees can defer up to 15% or $11,000 per year. Please comment about this.

Answer

Page 7 of Publication 560 says the same thing as the FAQ. The percentage of compensation for 2001 is 15%, and for 2002 is 25%.

I didn't discuss employee contributions to SEPs in the FAQ because employees generally can't make contributions to a SEP. There is another arrangement called a SARSEP for which employees can make a salary reduction contribution, like a 401(k) plan. A new SARSEP can not be adopted after 1996. The limitations for SARSEPs are explained at page 8 of Publication 560. For 2001, the maximum contribution was the lesser of (1) 15% of compensation up to $170,000 or (2) $10,500. For 2002, the maximum contribution is the lesser of (1) 15% of compensation up to $200,000 or (2) $11,000. For 2002, participants who are age 50 or over can make a catch-up contribution of $1,000.

There is an overall limit on SEP contributions. The total of nonelective and elective contributions to a SEP-IRA cannot exceed the lesser of 15% of the employee’s compensation or $35,000 for 2001, 25% of the employee’s compensation or $40,000 for 2002.

Remember that state income tax laws can further limit contributions to retirement plans. California has enacted legislation conforming to the federal rules, but the conformity legislation is being challenged as unconstitutional.

For new plans after 1996, SARSEPs were replaced by SIMPLE retirement plans. Unlike SARSEPS, an employer can't have both a SIMPLE and a SEP.

Question

My employer reimburses me for automobile expenses at 20¢ per mile, but I know the maximum allowance is 36.5¢. Can I claim the difference on my federal income tax return?

Answer

Yes. The expense information and reimbursement are reported on Form 2106, Employee Business Expenses. The net expense is reported on Schedule A as a miscellaneous itemized deduction. Since 2% of adjusted gross income is subtracted from most miscellaneous itemized deductions, including employee business expenses, it's hard to qualify for a deduction for the unreimbursed amount.

Question

I'm thinking of buying a car in Alabama. I live in New York, which is where I will register the car. If I buy the car now, but don't register it until January, 2003, will I still have to pay the luxury tax? Is a dealer in Alabama required to collect the luxury tax from out-of-state residents?

Answer

The luxury tax is imposed "on the first retail sale" of a vehicle. Postponing registering the vehicle will not avoid the tax. A dealer in Alabama is required to collect the tax from out-of-state residents. (It's a federal excise tax.)

Question

I'm a college student, age 18. Can I put my earnings in my own bank account and not tell my parents about it?

Answer

It may depend on which state you live in. In California, you are an adult at age 18 and don't have to tell your parents about your finances. If you are living at home, the bank will probably send you statements to your residence and your parents can find out about it. You could open a post office box to keep your mail confidential.

If you have to be this secretive about your finances with your parents, you have a problem for which you should seek counseling.

Question

My wife has a life insurance policy issued by a large US mutual life insurance company, and she received stock when that company recently converted to stock ownership. I am employed by that company, and I also received stock due to my participation in my employer's group life insurance and disability plans. I don't believe my stock grant is considered compensation and taxable as income but can you clarify that? Also, what is the tax basis for the stock my wife and I received if we decide to sell it? Neither of us paid anything for the stock, other than the normal premiums on the policies.

Answer

You should have received information packets from the company about the tax results of these transactions. Generally, the tax basis of the stock you received is zero. Selling the stock will result in realization of a capital gain. The IRS has been issuing letter rulings for a number of these reorganizations, including Letter Ruling 200021002.

Good luck!

Question

If we have a non-employee to whom we issue a Form 1099-MISC, are we responsible for withholding or do we just supply the taxable income information?

Answer

You just supply the information report, unless the service provider is a non-resident of the United States or is subject to backup withholding. Some states also require withholding when a service provider is providing services within the state but is a resident of another state. See your tax advisor about how the rules work in your state.

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Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter.

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

To subscribe or review past issues, visit stockoptionadvisors.com/optionalert/.

Advisors may find information about joining the Employee Stock Option Advisors Association, LLC and training materials about tax planning for employee stock options at stockoptionadvisors.com/seminar.shtml.

Employee option holders may find information about self-study materials relating to planning for employee stock options at stockoptionadvisors.com/seminar.shtml.

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Visit our new articles!

• The Law of Success Book Review

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P.S.

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 at http://www.taxtrimmers.com/directions.shtml.

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P.P.S.

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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.