Michael Gray, CPA's Tax and Business Insight

September 1, 2004

© 2004 by Michael C. Gray

ISSN 1539-395X

A monthly report to help you prepare for your financial future, keep more of what you earn by minimizing your taxes, and build an extraordinary business!

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Table of Contents

• It's almost grandbaby time!
• 2004 is two thirds over.
• Third quarter estimated tax payments are due.
• California use tax break to be tightened.
• Multiple state employee headaches.
• Telecommuters (and their employers) beware - the states are out to get you.
• Final regulations issued for sale of a residence.
• Disaster relief announced for Florida counties hit by Tropical Storm Bonnie and Hurricane Charlie.
• New regulations require lookthrough for LIFO inventory recapture.
• Tax return preparers have more ways to sign tax returns.
• Guidance issued for Health Savings Accounts.
• Questions and Answers
  • Can we exclude gain on our home sale for job relocation?
  • How and when should I apply for a business license?
  • Can I claim my parents as dependents if they aren't permanent residents of the US?
  • Is interest tax deductible on margin loans for personal expenses?
  • If you are close enough to 2 years, can you prorate the exemption on a home sale?
• Do you have employee stock options?
• Visit our new article.
• PS Marché Aux Fleurs
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

It's almost grandbaby time!

Our daughter, Holly Baker, and her husband Dan are expecting their first child (our first grandchild) at the end of September. Since Holly's birthday is September 16 and "Grandma" Janet's birthday is October 4, there is a chance one of them might share a birthday with the baby. Time will tell, but our family is getting excited! When we ask Holly the baby's name, she says, "I call him Sweet Pea."

Holly and Dan feel that it doesn't make sense for them to continue offering lunch at their restaurant, Marché Aux Fleurs, when there will be a child to care for. They are no longer serving lunches to the public, but may for private parties. Janet, Dawn and my father-in-law, Wally Bowers, visited for a final lunch on August 26 and the place was packed!

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2004 is two thirds over.

The kids are or soon will be back in school. Summer's almost over. How is your year shaping up? What needs to be done to move you closer to your goals for this year? Before we know it, the holidays will be here. Scary, isn't it?

It's about time for me to plan my vacation. Hope you had a good one.

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Third quarter estimated tax payments are due.

The third quarterly estimated tax payment for 2004 for calendar year taxpayers is due September 15, 2004. Your payments may be based on last year's income taxes or what happened this year. This is a good time to touch base with your tax advisor for estimated tax adjustments and to start preparing for the end of the year.

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California use tax break to be tightened. Take action now!

When California residents bring a vehicle, vessel or aircraft into the state, they are required to pay the California use tax. (Replacement for the sales tax.) Under the current law, the asset isn't subject to the use tax provided the taxpayer owned the asset outside of California for more than 90 days after purchase. Under the state's 2004-5 budget agreement, the period required to avoid the use tax is extended from 90 days to 12 months.

Purchases or binding contracts made before October 2, 2004 are not subject to the new law. If you want to use the 90-day exemption, buy that yacht or airplane by October 1st!

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Multiple state employee headaches.

People who work in multiple states can have real tax headaches. Just ask Sammy Sosa. Sammy claims that he is a resident of the Dominican Republic, but he works for the Chicago Cubs. Since the Cubs baseball team is located in Chicago, Illinois says Sammy's income has an Illinois source and is taxable in Illinois. Also, since Sammy is a nonresident, he is not eligible for a state tax credit in Illinois. Sammy also has to report taxable income in each state where he plays in a baseball game, so a lot of his income is taxed by more than one state.

Sammy asked for relief in the Circuit Court for Cook County, Illinois, but the court ruled against him. (Samuel and Sonya Sosa v. Glenn L. Bower as Director of the Illinois Department of Revenue (Cook County Cir. Ct. 2003).)

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Telecommuters (and their employers) beware - the states are out to get you.

Edward Zelinsky is a professor at the Cardozo School of Law in New York City. His residence is in Connecticut. He worked from his home in Connecticut two days a week and commuted to New York three days a week. Professor Zelinsky claimed that only three-fifths of his wages should be taxable in New York. The New York Court of Appeals upheld the New York State Department of Taxation and Finance, finding the Professor worked at home for his own convenience, not as a condition of employment. All of his wages were subject to New York income tax. (Edward A. Zelinsky v. Tax Appeals Tribunal (NY Court of Appeals 2003).)

The Zelinsky case opens a discussion of potential issues relating to telecommuters. Employers located in one state, such as California, with employees telecommuting in another state, such as Colorado, may find they have established sufficient business connection with the second state to be subject to that state's income tax, requiring those businesses to file multiple state income tax returns. (There is an exception when employees are out of state just to solicit sales.)

Telecommuters who work from their homes for their own convenience may find they are subject to income tax in their employer's home state.

This is a very messy, complex area. I am just raising the issue as an alert. You should discuss your situation with your tax advisor.

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Final regulations issued for sale of a residence.

The IRS has issued final regulations for the exclusion of gain from the sale of a principal residence. The final regulations replace temporary regulations that were previously issued. The regulations fine-tune the partial exclusion rules that apply for taxpayers who sell their principal residences before holding them for more than two years because of unforeseen circumstances and include special rules for military personnel enacted in the Military Family Tax Relief Act of 2003. The final regulations are effective for sales and exchanges after August 12, 2004. (TD 9152.)

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Disaster relief announced for Florida counties hit by Tropical Storm Bonnie and Hurricane Charlie.

Twenty-five Florida counties have been declared Presidential disaster areas. Affected taxpayers qualify for special tax relief. Affected taxpayers include individuals and businesses located in the designated counties, those whose tax records are located there, and relief workers.

Affected taxpayers whose federal tax returns were due on or after August 11, 2004 and before October 15, 2004 have an automatic extension of time to file until October 15, 2004. Those with a tax payment due between those dates have until October 15, 2004 to make the payments.

The extension to file and pay doesn't apply to information returns or to employment and excise tax deposits.

Affected taxpayers may claim their casualty losses on either their 2003 or 2004 income tax returns. Those who claim the disaster loss on their 2003 income tax returns should write "Bonnie/Charley" in red ink at the top of the form to expedite processing the return. (IR 2004-108.)

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New regulations require lookthrough for LIFO inventory recapture.

The IRS has issued proposed regulations that would require a C corporation that holds LIFO inventory indirectly through a partnership to recognize recapture of the lookthrough LIFO reserve if it elects to be an S corporation or transfers its partnership interest to an S corporation in a nonrecognition transaction. The proposed regulations would apply to S elections and transfers after August 12, 2004.

These regulations are intended to overturn the result of Coggin Automotive Corp. (CA 11 6/6/2002 89 AFTR 2d 2002-2826.)

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Tax return preparers have more ways to sign tax returns.

The IRS has announced that tax return preparers can now sign original returns, amended returns, or requests for extensions by (1) rubber stamp, (2) mechanical device, or (3) computer software program. This announcement will give more flexibility to tax return preparers who are moving to "paperless" record retention.

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Guidance issued for Health Savings Accounts.

The IRS has issued comprehensive guidance on the requirements for high-deductible health insurance plans (HDHPs) and health savings accounts (HSAs). The guidance should provide more certainty to employers, insurance companies and other parties, encouraging offerings of more of these plans by January 1, 2005.

Families covered with HDHPs can make tax deductible contributions to an HSA, somewhat like an IRA. The earnings in the HSA are tax-deferred, and may escape tax entirely if used to pay for qualifying medical expenses. The annual contribution limits are $2,600 for individuals and $5,150 for families, based on the deductible for the HDHP. (Notice 2004-50.)

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Questions and Answers

Question

We purchased a home in California last October, 2003, but now our company wants to relocate us to Virginia. We have sold our home and will have a capital gain. Will we be able to exclude this gain for California income taxes as well as our federal taxes?

Answer

First, remember you can only use the exclusion once every two years. Considering how long you've owned the home, your gain may be minimal and not worth eliminating the ability to claim the exclusion again in the near future. With the deduction of the cost of your residence plus selling expenses, you might have a very small gain or a (non-deductible) loss. You might also have claimed the exclusion for your last residence, which would knock this one out.

There is a partial exclusion available when you have to move because of "unforeseen circumstances", like an employment-related move. The exclusion is a fraction of the total exclusion ($500,000 married joint or $250,000 other). The fraction is the number of months you owned and used the home as your principal residence divided by 24 months.

If you decide to claim the exemption, I recommend that you consult with a tax return preparer.

Question

I opened a new business back in December, 2003. I am doing laundry and dry cleaning out of my home. I have a contract with a cleaner for use of machinery until I build my own. My customers drop-off and pick up at my home. Since I've been open, I've made about $1,200 from the laundry business.

Do I need to pay any taxes now?

How do I apply for a business license?

Do I wait until I move the business out of my home before applying for a business license and Sales and Use Tax permit?

Answer

Please consider getting a tax consultant and a business attorney to help you. The problem will be being able to pay the fees.

The income level you are talking about probably doesn't warrant concern about paying estimated taxes. Your tax problem will be the federal self employment tax, for which there is no personal exemption or standard deduction. Go to the IRS web site at www.irs.gov and find Form 1040-ES and the related instructions. Also find Form 1040, Schedule SE for the self-employment tax.

You should not wait until moving to a commercial business location before applying for a business license or sales and use tax permit. Look in the white pages under your city for business license (or call information for your city business office). Also look up your state sales tax agency. In California, look under California, State Board of Equalization.

There may be classes offered for new business owners at a community college near you. Also look for classes and seminars in the calendar of the business section of your local newspaper.

Good luck!

Question

My parents visited me in 2002 for 3 months and now again in 2004 for almost 6 months and therefore they qualify for the "substantial presence test". They are neither U.S. citizens nor permanent residents and they come on visitor visa.

They do not have any U.S. income to report. I am a U.S. resident and have been supporting them fully.

1. Can I claim them as my dependents for 2004?
   
   
2. Do I need to get ITIN numbers for them?

Answer

1. It appears your parents may qualify as resident aliens and therefore may qualify as your dependents. Remember in computing their income to see if they qualify as dependents, all of their worldwide income is taxable in the U.S. (as is yours). (See Internal Revenue Code Sections 152(b)(3) and 7701(b)(2).
   
   Your parents may not qualify under the substantial presence test if they are present in the U.S. less than one-half of 2004 and it is established that for 2004 they have a tax home in a foreign country and have a closer connection to the foreign country than to the United States. (§7701(b)(3)(B) and §911(d)(3).)
   
   
2. To claim your parents as dependents, they must have ITINs so you can list that information on your income tax return.

By the way, questions relating to dependents, residence and aliens are extremely complex. I don't claim to be an expert about them.

Question

We used a margin loan for personal living expenses while getting a business established. Is the interest tax deductible?

Answer

Interest paid to any source (other than certain home equity loans) where the loan was used to pay personal living expenses is not tax deductible. However, the tracing rules are fairly liberal, so you might be able to "trace" the loan proceeds to business expenditures. Consult with a tax advisor.

Question

I bought my home in California on January 30, 2003 and am considering selling it. I know that it is better to wait the full 2 years before selling for tax reasons.

I heard that if you are close enough to the 2 years that they will prorate the exemption. Is that correct? I would like to sell soon but with the market cooling off here and homes now sitting on the market, I don't want to wait, but I don't want to get slammed with taxes.

We owe $264,000 on our house and we will market it for $470,000.

Answer

Unless you qualify for the "unforeseen circumstances" exception, there is no prorata of the exemption.

You haven't given me enough information to determine what the tax might be for selling your home. Your gain is probably the sales price minus the cost minus selling expenses. You have to "guess" whether the market value of the home will decrease more than the tax you would have to pay.

Where are you going to live after you sell the home? Aren't you going to be playing the same game with the replacement residence?

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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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P.S.

My daughter and her husband, Holly and Dan Baker, have 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 and their website address is www.marcheauxfleursrestaurant.com. For the best meal of your life, call 415-925-9200 for a reservation and give them a try! For directions, visit our website at 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.