Michael Gray, CPA's Tax and Business Insight

April 1, 2005

© 2005 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

• Only two weeks to go to April 15.
• Extensions - and when you don't have the money to pay.
• First individual estimated tax payment is due April 15.
• Tax reporting shortfall estimated by IRS.
• Sales tax deduction explained.
• Questions and Answers
  • How can I get the fair market value of 4 years ago?
  • How are trustee's fees determined?
  • What's wrong with Rich Dad, Poor Dad?
  • What is the automobile luxury tax?
  • How do I buy real estate under a corporation?
  • What are the rules for capital gains on primary residence sales?
  • How long do I have to wait to collect my inheritance?
  • Can my boyfriend claim me as a dependent?
  • Can I claim my sister as a dependent?
  • Is there a one-time capital gains exemption for real estate sales in CA?
  • How do I calculate W4 exemptions?
• Do you have employee stock options?
• PS Marché Aux Fleurs
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

Only two weeks to go to April 15.

If you want our help and we haven't received your information yet, please send it to us immediately so that we can prepare extensions and estimated tax vouchers for you. If we don't have your information yet and you want an appointment to bring it to us, please call 408-918-3162 to make an appointment now.

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Extensions - and when you don't have the money to pay the tax.

(This is a reprint from past newsletters.)

What do you do when you don't have the money to pay the tax?

My first recommendation is to file your income tax returns, certified mail, by the initial filing date. One of the nastiest penalties in the IRS's arsenal is for late filing - 5% per month to a maximum of 25%. Some people who owe money don't file their returns because they are afraid. THIS IS A HUGE MISTAKE! The best approach is to be honest about your situation and work with the tax authorities to resolve it.

When you file an extension, any balance of tax due when the tax return is filed represents an exposure for the late filing penalty.

Please don't misunderstand me. I regularly use extensions for my clients and myself as a workload "safety valve". We often don't have the information to complete a return by the due date. They just aren't appropriate when there will be a significant balance due that won't be paid by the original filing due date.

According to the Treasury regulations for the requirements to file a valid automatic extension request, "an application for extension must show the full amount properly estimated as tax for the taxable year." (Reg. § 1.6081-4(a)(4).) The regulations relating to reasonable cause for failure to file a tax return state that if a taxpayer satisfies the requirement of showing the full amount estimated as tax, the taxpayer has a reasonable cause for failure to file during the extension period provided (1) the excess of the amount of tax shown on the return over the amount of tax paid by the original filing date (including the amount paid with the extension form) is no greater than 10 percent of the amount shown on the return (restated - 90% of the tax is paid by the due date), and (2) any balance due shown on the return is paid with the return. (Reg. § 301.6651-1(c)(3).)

(For California taxpayers, the extension is paperless so the amount of the tax need not be stated. You are still required to pay at least 90% of the tax by the original due date to avoid the late filing penalty.)

If you have filed an income tax return for 2003, you can process your federal extension electronically or by telephone - call 888-796-1074 by April 15. Better call early to beat the rush! Mailing a paper form is still acceptable and is the only way a person who didn't file a 2003 income tax return can request an automatic extension.

A taxpayer can still avoid the late filing penalty by demonstrating a "reasonable cause," but this can be a hassle and the taxpayer is at the mercy of the subjective judgment of a representative of the tax authority.

Remember, you may now pay income taxes using a credit card. Call 800-272-9829, or try the web site, www.officialpayments.com. The extension for California is 1555. You can also call 888-729-1040. Maybe you can find a card offering a low interest rate promotion that will work for your situation.

Should you borrow using a margin account? In most cases, this is not a good choice because of the exposure to margin calls if the market declines.

Should you use an equity advance loan, secured by your principal residence? In some cases it might be to your advantage, if you can get a favorable interest rate. Remember that interest for an equity loan not used for a home improvement is only deductible on a loan amount up to $100,000. This interest is not deductible when computing the alternative minimum tax.

Remember that IRA accounts and even other retirement accounts can be temporary sources of funds. Distributions from IRAs that aren't minimum required distributions can be rolled over to another IRA or returned to the same IRA within 60 days after a withdrawal. This exception only applies to one rollover per year. (You must wait more than one year after a rollover is completed before making another one.)¹

Certain distributions from other qualified plans can also be rolled over within a 60-day period to an IRA or another qualified plan.² Using IRAs or qualified plans as a temporary source of funds to pay taxes can be useful if the funds to complete the rollover will soon be available, such as when there is a lockout "window" that will soon be open. The cost of an error can be high, because if the rollover isn't completed before 60 days have expired, the distribution may be subject to tax as ordinary income plus a 10% early distribution penalty.³

The IRS has a form for installment agreements, Form 9465. They would prefer that you submit the form with your income tax return. You can take up to five years to pay off your tax liability. An advantage of arranging an installment agreement is the penalty for late payment of tax is reduced from 1/2% per month to 1/4% per month. In addition to penalties, interest is charged for late tax payments. The interest rate is adjusted quarterly. Recently, the rate has been five percent.

Another alternative is to make an Offer in Compromise, Form 656. With this procedure, the IRS actually can reduce your tax based on your ability to pay. You don't have to wait until you have owed the tax a long time to use this procedure. I think it's best to work with an attorney, CPA or enrolled agent when making an Offer in Compromise. If the amount is large, an attorney is probably the best choice.

Although it may provide relief from your other creditors, bankruptcy doesn't offer much help for recent debts for income taxes. When you make payments on your tax bill, be sure to specify to apply the payments to taxes due. Penalties and interest are dischargeable in bankruptcy, but income taxes aren't.

It may be to your advantage to plan how to use regular tax or alternative minimum tax capital loss carryovers or minimum tax credit carryovers. You might need to generate capital gains, which can be difficult when you're in financial distress.

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First individual estimated tax payment is due April 15.

(This is a reprint from past newsletters.)

Remember to review your estimated tax situation for 2005.

There is no estimated tax penalty provided the taxpayer pays at least 90% of the tax (including AMT) on the current year's tax return through withholding and/or equal quarterly estimated tax payments.

For taxpayers who have no more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁴ For taxpayers who have more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least, for 2003, 110% of the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁵

Taxpayers who have uneven income and deductions may also compute their estimated tax on an "annualized" basis. You multiply the year to date income and deductions to arrive at amounts for a year, compute the tax for that amount, then pay amounts to cumulatively pay in 1/4, 1/2, 3/4 and 100% of those amounts. You should probably get help from a professional tax return preparer to do this.

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Tax reporting shortfall estimated by IRS.

IRS has conducted the National Research Program since 2001, and has released the results. The IRS compiled the information from examinations of a cross section of income tax returns. In the report, the IRS estimates that taxpayers underreport about $300 billion in income taxes each year. About 80% of the shortfall results from underreporting income, not overreporting deductions.

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Sales tax deduction explained.

The IRS has issued guidance about the sales tax deduction, which can be claimed instead of the state income tax deduction for 2004 and 2005. Notably, the IRS says that both spouses must report consistently (either the state income tax deduction or the state sales tax deduction) when they file separate income tax returns. Also, remember to use the state tax tables for the state of actual residence, which may be different from the address on the income tax return. If you move, you should prorate the table amounts for each location. Remember to adjust the table amount to include local sales taxes. (Notice 2005-31.)

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Questions and Answers

Question

In one of your answers, you stated the cost basis for inherited property was based on the fair market value at the time of death. My grandmother passed away four years ago and left me a piece of land that I want to sell. No appraisal was done at that time. How can I get the fair market value at the date of death?

Answer

A real estate appraiser located close to the property location should be able to give you a report of the fair market value as of the date of death that you can rely on for income tax reporting.

Question

Can you tell me how a trustee's fees are determined?

Answer

I suggest that you consult with an attorney. Unlike estates, there are generally no statutory fee schedules for trustees. When writing trust provisions, it can be helpful to spell out how the trustee should be compensated. It helps avoid arguments later.

Question

Your review of Rich Dad, Poor Dad (at www.profitadvisors.com/dads.shtml) is favorable, but I read another review that was very critical of the book. What do you think of it?

Answer

The review that referred me to by John T. Reed is almost as long as Kiyosaki's book. Frankly, I don't have time to read it right now. I don't think of Rich Dad, Poor Dad as the Bible. There are many details that I disagree with that I don't care to list here. However, the book is thought-provoking and I think many of his basic concepts are valuable. Becoming wealthy requires a change in mindset, and I think Kiyosaki's educational approach helps with that process.

Question

I want to buy a BMW Z4 for about $40,000. What is the luxury tax?

Answer

The federal luxury tax for automobiles has expired for sales after 2002, so there is no luxury tax unless a local one applies. Ask your BMW dealer.

Question

Can you guide me about how to buy real estate under a corporation?

Answer

Very rarely would I recommend buying real estate and holding it in a corporation. There are other ways of holding real estate, including limited liability companies, that preserve the tax benefits of holding real estate and provide limited liability protection. If you have a corporation conducting an active trade or business, it's generally better to have the corporation lease the real estate from you or an entity owned by you and your family than for the corporation to own the property.

Question

I sold a home for $330,000 and bought another home for $520,000 shortly before the sale. My CPA says I have to pay capital gains tax on the sale, because I didn't own the first home for more than two years. Is that right?

Answer

Probably. The old rules allowing the deferral of gain from the sale of a principal residence when it is replaced with a more expensive residence were repealed back in 1997. We have an article on our web site that explains the new rules.

Question

My dad left a living trust with my brother as the successor trustee. Dad left a sizable estate and the tax returns due are numerous. He died six months ago and my brother says that he will distribute the estate "when he is ready". If he has already sold the stock and the cash is sitting in an account, what rate is the interest taxed at and where is this interest reported? If the house isn't sold until next year, must we wait until it is sold to collect any of the estate?

Answer

I'm sorry, but you need to be more patient. If you really believe your brother isn't acting correctly, get an attorney to represent you.

The interest income will be reported on a fiduciary income tax return for the trust. Trusts have a condensed tax rate schedule for which a 35% federal income tax rate applies for taxable income over $9,750.

Your brother is also responsible for filing a federal estate tax return. The estate tax is a "transfer tax" roughly based on the net value of the estate. That tax return is due nine months after death, and is often extended for an additional six months.

Trustees typically won't make principal distributions until the estate tax return is filed.

Preliminary distributions are sometimes made. This is something your attorney can discuss with your brother's attorney.

Question

Can my boyfriend claim me as a dependent on his income tax returns? We are living together, but my ex-spouse pays me spousal support.

Answer

Since you probably have gross income from spousal support exceeding the $3,100 limit, your boyfriend can't claim you as a dependent.

Question

Can I claim my little sister as a dependent? I don't live with her and she is on welfare. I received a letter saying I have to meet a test.

Answer

Why don't you read the requirements to claim a dependent? (See our FAQ at www.taxtrimmers.com/taxfaq/nopension.shtml.) There are conditions to claim a dependent that the IRS and state tax authorities may inquire about to disallow them. Further, your claiming your sister as a dependent could possibly make her ineligible for welfare. Check these matters out carefully before claiming the deduction.

Question

Is there still a one-time capital gains exemption for a real estate sale in California? Do I have to reach age 55 to claim it?

Answer

No. The old senior citizen exemption for a sale of a principal residence was repealed back in 1997.

Question

How do I figure the additional exemptions to claim for interest expense and property taxes for my principal residence?

Answer

There is a worksheet included with Form W-4 that you can use to make the computation. Alternatively, hire someone like me to do it for you.

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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 http://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 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.

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1 Internal Revenue Code § 408(c)(3)
2 Internal Revenue Code § 402(c)
3 Internal Revenue Code § 72(t)
4 Internal Revenue Code § 6654(d)(1)
5 Internal Revenue Code § 6654(d)(1)(C)