Michael Gray, CPA's Tax and Business Insight

August 8, 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

• August happenings.
• August 15 individual extended deadline is approaching.
• September 15 is extended corporate deadline.
• September 15 estimated tax payment.
• Congress passes Energy Bill.
• IRS launches S corporation audit initiative.
• Fifth Circuit affirms inclusion of FLP interest in estate.
• AMT repeal proposed.
• Taxing partner's share of LIFO reserve with S election.
• State disaster payments to businesses are taxable.
• IRA distributions didn't qualify for early withdrawal.
• Questions and Answers
  • Sale of principal residence questions.
  • Can I claim a dependent exemption for my stepson?
  • Should brokers report tax basis on 1099s?
  • Can I apply all my capital losses to capital gains?
  • Can I apply time rented to the capital gains exemption for selling a principal residence?
  • Can I get a capital gains exemption for selling a principal residence even if I'm not a US citizen or permanent resident?
  • What happens if I sell my residence after 5 months?
• Do you have employee stock options?
• Read our new articles!
• PS Marché Aux Fleurs
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

August happenings.

Thi Nguyen has passed the CPA exam and she has submitted her application for her CPA license. Congratulations, Thi! We are very proud of you.

Dawn has returned safely from her Peru vacation, including a cruise on the Amazon and visiting Machu Piccu. Janet and I will be leaving for our tour of Scotland on August 19 and return September 5. Hope you enjoy a vacation this summer.

We have been attending a rash of weddings! Be careful, this marriage stuff is contagious!

Janet and I celebrated our 34th wedding anniversary on August 7.

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August 15 individual extended deadline is approaching.

August 15 is the initial extended deadline for individual income tax returns. If you're tax return isn't completed by that date, apply for a second extension to October 15 using Form 2688. Remember to include a reason for the additional extension.

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September 15 is extended corporate deadline.

September 15 is the extended due date for calendar year corporations. If your corporate income tax return is on extension, be sure to get your information to your tax return preparer now so you will have the tax returns before the due date.

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September 15 estimated tax payment.

The due date for the third estimated tax payment for calendar-year taxpayers (including individuals) is September 15. If your income and deductions are much different from last year's, you should have your estimated tax payment amount reviewed by your tax return preparer.

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Congress passes Energy Bill.

The Energy Policy Act of 2005, H.R. 6, has been passed by Congress. Most of the tax provisions will be effective on January 1, 2006. There are tax credits for residential solar water heating, photovoltaic equipment and fuel cell property and for hybrid vehicles. The hybrid vehicle credit will only be available for 60,000 vehicles per manufacturer from 2006 through 2010. More details later.

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IRS launches S corporation audit initiative.

The number of S corporations has grown from 724,749 in 1985 to 3,154,377 in 2002. The number of S corporations with more than $10 million in assets has grown from 2,305 in 1985 to 26,096 in 2002. S corporations have become popular to avoid double-tax concerns for regular corporations adopted in the Tax Reform Act of 1986. Congress has also generally made the S corporation tax laws more "taxpayer friendly" since 1985.

The IRS has decided to assess reporting compliance for S corporations by auditing 5,000 randomly-selected S corporation returns for tax years 2003 and 2004. The information from this study will be used to determine which S corporation returns have greater compliance risk, making them more productive audit candidates.

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Fifth Circuit affirms inclusion of FLP interest in estate.

Albert Strangi formed a family limited partnership and transferred assets, including securities, real estate, insurance policies, annuities and partnership interests to the FLP in exchange for a 99% limited partnership interest. Strangi's children owned the corporate general partner of the FLP. Before and after his death, the FLP made payments for Albert's needs and expenses, including $40,000 to pay funeral expenses, estate administration expenses and debts. Pro-rata distributions were made to the corporate general partner at the same time.

Albert also continued to live in one of two houses he transferred to the FLP. He was charged rent for the use of the house, but it wasn't paid until more than two years after his death.

The Tax Court found that Albert retained a lifetime interest in the assets transferred to the FLP, so the entire value of those assets and 47% of the corporate general partner was taxable on his federal estate tax return. The Tax Court also found the transfer did not qualify for the exception to the inclusion rules for a bona fide sale for adequate and full consideration in money or money's worth.

The Fifth Circuit Court of Appeals affirmed the Tax Court's decision. The benefits retained by Albert, including periodic payments made before his death, the continued use of the transferred house, and the payment of expenses after death indicated he retained the enjoyment of the assets. The court also found that the transfer did not serve a substantial business or non-tax purpose, so it was not a bona-fide sale. (Gulig v. Commissioner, 5th Circuit, 7/15/05.)

The Gulig/Strangi case illustrates the importance of properly structuring an FLP transfer, including separating the financial affairs of the transferor from the FLP.

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AMT repeal proposed.

Several bills have been introduced in the House of Representatives and the Senate to repeal the AMT. Senators Charles Grassley, R-Iowa, and Max Baucus, D-Montana, of the Senate Finance Committee have introduced a bill to repeal the AMT effective January 1, 2006. The problem is that the AMT is producing a lot of revenue. Some commenters have said there would be a smaller revenue loss from repealing the regular tax than the AMT. A proposal to help offset the loss - repeal the deduction for state and local income taxes. Maybe a president from Texas (where there is no individual income tax) thinks this is a great idea, but a lot of voters from New York and California have a different opinion.

Stand by on this one.

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IRS issues regulations taxing corporate partner's share of LIFO reserve with S election.

The IRS has issued regulations to counter an Eleventh Circuit court decision , Coggins v. Commissioner, against the IRS. Coggins transferred subsidiary auto dealerships to partnerships and then made an S election. Normally LIFO reserves (the excess of the cost of the inventory over the LIFO carrying amount) is taxed when a former C corporation makes an S election. The court noted the IRS didn't indicate that LIFO reserves of partnerships were also taxable, so the IRS fixed the regulations. (T.D. 9210.)

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State disaster payments to businesses are taxable.

The IRS has ruled that a grant received by a business under a state program to reimburse businesses for losses from damage or destruction of real or personal property on account of a disaster are taxable income. On the other hand, these payments may qualify for tax deferral as an involuntary conversion when they are reinvested in similar assets and a taxpayer makes the election under Internal Revenue Code Section 1033. (Revenue Ruling 2005-46.)

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IRA distributions for education expenses didn't qualify for early withdrawal.

The Tax Court ruled that distributions from a taxpayer's IRA used to pay education expenses were subject to the penalty for early withdrawal because the distributions weren't made in the year the qualified higher education expenses were incurred. (Beckert v. Commissioner, T.C. Memo 2005-162.)

Distributions to an individual from an IRA to the extent the distributions do not exceed the qualified higher education expenses for the taxable year are exempted from the penalty tax. Linda Beckert paid current-year expenses plus her credit card bill for two previous years' expenses.

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Questions and Answers

Dear readers:

Many of your questions relate to the sale of a principal residence. We have an article at our web site, "Could your residence be the ultimate tax shelter?" (www.taxtrimmers.com/residence.shtml) where you should be able to find the answers to most of your questions.

Question

I may be able to be a stay at home mom. My fiancée and I were wondering if he would be able to claim a dependency exemption for my son as a stepfather? As the custodial parent, I have always claimed his exemption; his real father does not.

Answer

The federal rules for claiming a dependent exemption have changed, starting January 1, 2005 under the American Jobs Creation Act of 2004. The support test (except for self-supporting children) has been replaced by a residency test. The child is the dependent of the parent with which the child lives for more than one-half of the year. If the child resides with more than one parent for the same period of time, the child is the dependent of the parent with the highest adjusted gross income. A step-parent counts.

If you and your new husband file a joint income tax return, it will eliminate any confusion about the dependency exemption.

Question

I am interested in your opinion as to the magnitude and lack of compliance regarding reporting of basis for the sale of stocks and bonds, since it is not reported by dealers and brokers in the 1099s. It would seem logical that investors would benefit from reporting of tax basis on their 1099s. What is your opinion?

Answer

I don't have any statistics for non-compliance of reporting basis information on Schedule D. We try to be conscientious in this area for the tax returns that we prepare.

Although it is helpful for brokers and investment managers to track tax basis for their investor clients, there can be basis adjustments that they are unaware of. For example, securities may be transferred between brokerage firms and the previous history may not be readily available. When a taxpayer dies, different basis adjustments can apply, depending on how the title is held and whether the alternate valuation date is elected on the estate tax return. A taxpayer may hold a stock certificate, receive return of capital dividends (which reduce tax basis) and later deposit the certificate in a brokerage account. In other words, basis can be an accounting nightmare that it is unrealistic to require the broker to report on Form 1099.

Mutual funds are now required to report an "average cost" basis to their investors when shares are sold. This may not be the most tax-advantageous way to account for the tax basis of the securities sold, but can be a real timesaver when only a small value of securities or the entire account is sold.

Taxpayers need to recognize their responsibilities for accounting for the tax basis (cost to determine taxable gain or loss) and keep good records, including copies of their trade confirmation slips. This will be critical if the estate tax is repealed (now scheduled for one year for 2010), because some of the ability to receive a "fresh start" basis will be lost. Discuss this with your tax advisor.

Question

I have a large capital loss being carried forward since 2002. Can I apply all this loss to any capital gains this year if I am subject to the alternative minimum tax? Does the AMT restrict me from subtracting capital losses from capital gains? All of my gains are long term and I have no incentive stock option shares.

Answer

In the situation you describe, the Schedule D should be identical for regular and AMT reporting, and the current gains can be reduced by the capital loss carryover.

Be aware that tax basis can sometimes be different for regular tax and AMT reporting. As you pointed out, a common difference is for ISO shares, for which the tax basis is the fair market value on which any AMT adjustment is based (generally at date of exercise or the vesting date). Another example is the tax basis of a partnership or S corporation interest for which there are depreciation adjustments for AMT reporting.

Question

I have lived in my home over six years. I rented it the first 4 1/2 years, then purchased it on 12/15/03. Must I defer the closing of the sale of the house until two years have passed - 12/15/2005, in order to be exempt from capital gains taxes?

Answer

Yes (but hold the house until at least 12/16/2005), unless you meet one of the "reasonable cause" exceptions for a prorated exclusion. The house must have been owned and used as a principal residence for more than two years during the five years before the sale.

Question

I bought my house in January, 2004. I have to sell it because I have to re-locate to Taiwan for job reasons. I assume I can apply for a partial $250,000 exclusion. Is that true? I am not a U.S. citizen nor a permanent resident.

I need someone to write a letter to help me avoid California tax withholding for the sale. Who should I turn to, a CPA or an attorney?

Answer

Although you don't have the legal immigration status as a permanent resident, it appears to me you may be taxable as a resident. I suggest that you consult with a CPA who is familiar with the taxation of aliens in the U.S.

I am not aware of any restriction where nonresident aliens aren't eligible for the exclusion from the sale of a principal residence.

Either a CPA or tax attorney can write the letter that you need.

Question

If I sell my home, which I bought 5 months ago, do I owe capital gains tax? This is my primary residence. I been living in the home since I bought it in February, 2005. The gain is less than $250,000.

I just want to move to a nicer place.

Answer

Since you haven't owned the home and used it as your principal residence for more than two years, and there is no "reasonable cause" exception that applies in your situation, any gain will be taxable income. If you don't own the home for more than one year at the time the sale closes, any gain will be taxable as a short-term capital gain at your highest marginal tax rates.

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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.

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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.