Michael Gray, CPA's Tax and Business Insight

June 6, 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!

Route to _______   _______   _______   _______   _______

(If you find this information valuable, please pass it on to a friend!)

Table of Contents

• Summer is here!
• The second estimated tax payment is due June 15.
• California changes estimated tax rules for AMT.
• Sorry for any inconvenience.
• Mike Gray and Dawn Siemer attend Renegade Millionaire Boot Camp.
• Arthur Andersen conviction overturned.
• New York taxes out-of-state telecommuter.
• IRS allows election for grace period for cafeteria plans.
• Be careful with "off the shelf" tax preparation software.
• 2006 Lexus RX 400h qualifies for Clean-Fuel Vehicle Deduction.
• Estate value of lottery payments must be valued using IRS tables.
• Certain California family support payments may be deductible as alimony.
• Questions and Answers
  • Should I start a SEP-IRA for my business?
  • Are losses on a home purchase deductible?
  • What's necessary to update a trust?
  • Does my mother need to pay taxes on the sale of her home?
  • Can I make Roth IRA contributions for children under age 3?
  • Will capital gains taxes on residences be rescinded for a year?
• Do you have employee stock options?
• Visit our new articles!
• PS Marché Aux Fleurs
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

Summer is here!

June is a busy month of graduations and the beginning of vacation season. In San Jose, we seem to be finishing our wet spell and beautiful days are ahead. We hope you enjoy a great season for making memories with your families and loved ones.

Remember Father's Day is June 19! My Father's Day gift is an LPG grill that took two days to assemble. That is one expensive grill!

There has been some excitement for our team. Thi Nguyen is planning her wedding in September, and co-hosted a house warming at her fiancée's home. Dawn has been taking a class on backpacking and has been on several trips, most recently to Big Sur. Janet and I are regularly babysitting our grandson.

Return to Table of Contents

The second estimated tax payment is due June 15.

For those of you who make estimated tax payments, remember the second installment is due June 15. If you have had any changes in your tax situation compared to last year, or your estimated tax or withholding isn't based on last year's tax, you should get in touch with your tax advisor. Our clients can call Thi Nguyen at 408-918-3163 to tell us about their changes.

Return to Table of Contents

California changes estimated tax rules for AMT.

Effective January 1, 2005, California requires that estimated tax payments include the alternative minimum tax (AMT). California didn't update its estimated tax forms and instructions to show this. Also, some tax preparation software wasn't updated to include the 2004 AMT when basing estimated tax on last year's tax. Be sure to check your 2005 California estimated tax vouchers to be sure the AMT has been included. (AB 967.)

Return to Table of Contents

Sorry for any inconvenience...

Dawn Siemer, who manages our email and web site, has been "drafted" to be on the Santa Clara County Grand Jury for three months. For a small firm like ours, this is a major inconvenience and means we will be less responsive to email. For a faster response, fax your request to 408-998-2766 or call 408-918-3161. Thanks!

Return to Table of Contents

Mike Gray and Dawn Siemer attend Renegade Millionaire Boot Camp.

Marketing Guru Dan Kennedy hosted a Renegade Millionaire Boot Camp on May 19 through 21. This was a great opportunity to mix with entrepreneurs and discuss money-making and personal management strategies. Then we visited the horse track to see Dan's racehorses and experience his passionate hobby - buggy racing. Dan is scaling back his activities and is planning one more (last ever?) Renegade Millionaire Boot Camp during 2006. Only people who purchase Dan's Renegade Millionaire System may attend the Boot Camp, which is limited to 125 participants. For details, visit www.renegademillionaire.com.

Return to Table of Contents

Arthur Andersen conviction overturned.

On May 31, the United States Supreme Court overturned the conviction of CPA firm Arthur Andersen for obstruction of justice. Arthur Andersen was the auditor for Enron. The action was initiated against Arthur Andersen when the Justice Department learned it was destroying documents when the management at Arthur Andersen knew a federal investigation would be conducted into the collapse of Enron.

The Supreme Court found the instructions to the jury were too vague and broad for the jury to determine correctly whether Arthur Andersen obstructed justice.

Arthur Andersen was destroyed because it lost its license to perform audits of public companies as a result of its conviction. 28,000 employees lost their jobs.

It remains to be seen whether the Justice Department will re-try the Andersen case.

Many people are relieved with the Supreme Court's decision, because the ruling against Andersen makes a real headache of determining when documents can be destroyed without being guilty of a criminal act. It was impractical from a business point of view.

The shareholders of Enron and Worldcom might benefit from the Supreme Court's decision because Arthur Andersen could have some of its losses reimbursed by malpractice insurance if the losses weren't attributable to criminal acts.

Return to Table of Contents

New York taxes out-of-state telecommuter.

Thomas Huckaby was a Tennessee resident. He worked as a computer programmer for the National Organization of Industrial Trade Unions, based in Jamaica, New York. 75% of the time, he worked at his home in Tennessee. 25% of the time, he worked at the corporate office in Jamaica, New York.

The New York Court of Appeals has ruled that since Huckaby worked at his home for his own convenience, and not the convenience of his employer, 100% of his compensation is taxable in New York.

This case shows that state income tax laws haven't caught up to our new social norms. Telecommuting should be encouraged to improve our environment, reduce waste, and improve relationships in our families.

An employee could live in a state with no income tax, like Florida, work for a company headquartered in a high tax state, like New York, and have a dramatic increase in tax liability compared to working for a local company.

If you are a telecommuter, you should discuss this issue with your representatives in Congress and request federal legislation to eliminate this injustice. The states appear to have a conflict of interest (to get the most revenue they can) and can't agree on a way of taxing income of telecommuters that is equitable for taxpayers.

(Huckaby v. New York State Division of Tax Appeals, New York Court of Appeals, Mar. 29, 2005)

Return to Table of Contents

IRS allows election for grace period for cafeteria plans.

The IRS has announced it will accept a 2 1/2 month grace period for cafeteria plans, also known as flexible benefit plans or flexible benefit arrangements. Since amounts contributed to these plans that aren't spent by the end of the year are lost, employees will be relieved to learn they have an additional 2 1/2 months after the year end to use the amount that otherwise wouldn't be carried over. In order to take advantage of this election, employers will have to amend their plans by the end of the current plan year. (Notice 2005-42.)

Return to Table of Contents

Be careful with "off the shelf" tax return preparation software.

One of our new clients brought us a preliminary income tax return he used to prepare his 2004 extension requests. He used "off the shelf" tax return preparation software to prepare the returns.

There were some significant errors. For example, he had paid about $56,000 in state income taxes, but the state income tax deduction on federal Schedule A was over $400,000. A $54,000 extension payment was erroneously entered on the California income tax return. The withholding for sales of securities that was included on his W-2 form was evidently entered again from the sale of securities confirmations, resulting in a $67,000 overstatement of federal withholding.

Needless to say, he substantially underpaid the tax with his extension requests and could be penalized for late filing.

We are not "blaming" the software. Users need to be aware they can't rely on the "interview mode" to automatically generate correct income tax returns. You have to "sanity check" the output.

In this particular case, we think it was well worth the fee to have us prepare his income tax returns.

Return to Table of Contents

2006 Lexus RX 400h qualifies for Clean-Fuel Vehicle Deduction.

The IRS has certified the 2006 Lexus RX 400h as eligible for the clean-burning fuel deduction. The "above the line" deduction for qualifying vehicles purchased during 2005 is $2,000. Other cars that have previously been certified are the 2005 Toyota Prius, Honda Insight, Honda Civic Hybrid, Honda Accord Hybrid, and Ford Escape Hybrid.

Return to Table of Contents

Estate value of lottery payments must be valued using IRS tables.

The estate of a lottery winner claimed the value of future lottery payments determined using the IRS IRC Section 7520 annuity tables was too high. The federal district court in Massachusetts ruled the value using the IRS tables was reasonable and the tables must be used. (Donovan Estate, D.C. Mass., April 26, 2005.)

The Fifth Circuit has previously ruled the annuity tables must be used, but the Second and Ninth (California) Circuits have allowed special discounts.

Return to Table of Contents

Certain California family support payments may be deductible as alimony.

The Tax Court has ruled that Michael Berry was allowed to deduct California family support payments to his ex-wife, Carmen, as alimony. "Family support" is an agreement between the parents, or an order of judgment, that combines child support and spousal support without designating the amount to be paid for child support and the amount to be paid for spousal support. The California Family Code doesn't state the effect of the payee spouse's death on a family support obligation. In this case, the divorce documents also didn't say what the effect of Carmen's death would be.

The Tax Court ruled that the provisions enacted by the California legislature show that it intended that family support payments should qualify as deductible alimony under federal income tax law. The Tax Court examined other California decisions and concluded that a California court would reject an attempt by Carmen's successor in interest to enforce Michael's family support obligation for any period after her death. Therefore, Michael's family support obligation should meet the termination at death requirement for spousal support.

The court refused to apply a worst-case scenario to assume someone other than Michael would have custody of the children in the event of Carmen's death for the child support portion of the payments.

(Berry v. Commissioner, T.C. Memo 2005-91 (4/26/2005).)

Return to Table of Contents

---

Questions and Answers

Question

I am considering setting up a SEP-IRA. Our business is incorporated and there only two employees - myself and my mother. She is 73 years young and I am 53. We both earn paychecks. She is starting to withdraw her retirement due to her age.

Can we establish a SEP-IRA? I read the IRS publication about SEPs and I see the limitation for a person under age 21 but don't see a limitation for someone who still works and is over 70.

Answer

I can't see any prohibition for a person over age 70 from participating in a SEP.

Although you generally can't contribute to a "regular" IRA after age 70 1/2, a SEP is a replacement for a regular retirement account, so I believe that prohibition doesn't apply for a SEP. (The prohibition appears to apply to contributions by an individual on his or her own behalf, but not to contributions by the employer. IRC Section 219(d)(1).)

The minimum required distribution rules do apply, so your mother will be required to take distributions from her IRAs.

Before you go ahead, check with the plan administrator you are planning to use whether they are aware of a prohibition. Let me know if they have a different answer.

Question

My husband and I are in the middle of mediating a lawsuit over a home purchase. The home was fraudulently misrepresented and has many structural defects. We are suing for compensatory damages for the amount of $110,000.

Will we be taxed on this amount, since it represents a loss we have suffered on our investment? The lawsuit also calls for recission of the contract, or a buy back of the home.

Answer

Amounts paid for legal judgments other than for physical personal injuries are taxable income.

Expenses for a personal residence are not deductible. A loss for the sale of a personal residence is not deductible.

Question

What is necessary to update a trust? If you want to change an executor of a will, do you have to do it with an attorney?

Answer

Because of the necessity of having these documents done properly, I recommend that you retain an attorney to handle these matters for you.

Question

My mother sold a house in California and moved to Georgia and bought another house. Does she need to pay estimated taxes for the sale of residence?

Answer

Assuming this is a qualified sale of residence, your mother should be able to exclude $250,000 of gain from her taxable income. She will have to file a California income tax return to report the transaction if there is any taxable gain.

She can pay her 2005 estimated taxes based on her 2004 income tax returns, and pay the balance of the tax on April 15, 2006. The next installment is due June 15, 2005. See the instructions for Form 1040ES at www.irs.gov and Form 540ES at www.ftb.ca.gov.

Question

I read your suggestion of making Roth contributions for children. How can this be done for children under age 3?

Answer

The children have to earn the income, so this strategy becomes more practical as they become older.

Sometimes there are opportunities in family businesses for small children to be compensated for participating in advertising, like television commercials for auto dealerships. There is also the "child talent" situation for other commercial advertisements, movies and television shows.

Question

I heard in the very near future, for one particular year only, home owners who sell their principal residences will not have to pay any capital gains tax. Which year will it be?

Answer

I'm not aware of any such tax law being passed.

---

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

Return to Table of Contents

If you have employee stock options, have you subscribed to Michael Gray, CPA's Option Alert?

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

Return to Table of Contents

Visit our new articles!

• Secrets of Direct Mail Book Review
• It's OK to not be normal!

Return to Table of Contents

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.

Return to Table of Contents

P.P.S.

To receive the next issue of Michael Gray, CPA's Tax & Business Insight with more tax developments, another book review, and upcoming deadlines automatically via email, subscribe by filling out the form below.

Return to Table of Contents

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.