Michael Gray, CPA's Tax and Business Insight

April 3, 2006

© 2006 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

• 14 days to April 17. Have you made your tax appointment yet?
• Congratulations, Dawn!
• Pacific Science Center honors Todd Johnston.
• Extensions – and when you don’t have the money to pay the tax.
• First individual estimated tax payment is due April 15.
• First calendar corporation estimated tax payment is due April 17.
• IRS warns against email "phishing" scam.
• IRS shares audit statistics.
• Questions and Answers
  • Can I claim a dependent exemption for my adult daughter?
  • Do I have to pay taxes on an inheritance?
  • Can my wife change a return that’s already been filed?
  • Can I pay taxes on my Roth IRA conversion in installments?
  • Can I claim a business expense for my commute?
  • Can I be reimbursed for rental expenses due to an accident?
  • Can I claim head of household in years I don’t claim my daughter?
• Do you have employee stock options?
• Do you have real estate tax issues?
• Read our new article!
• PS Marché Aux Fleurs
• Subscribe/Unsubscribe from Michael Gray, CPA's Tax & Business Insight

14 days until April 17. Have you made your tax appointment yet?

We’re on the "home stretch."

We can still squeeze in the completion of a few income tax returns and extension forms for new clients. If you haven’t received partnership information or a couple of 1099 forms, send us the information you have to get in the system.

To make an appointment, call Dawn on weekday afternoons at 408-918-3162.

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Congratulations, Dawn!

My daughter and the web master and administrative manager for our firm, Dawn Gray is engaged to be married to John Siemer! The happy couple hasn’t decided on a date yet, but believe it will be in late August 2006. We are thrilled!

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Pacific Science Center honors Todd Johnston.

Todd Johnston’s co-workers at the Pacific Science Center in Seattle hosted a beautiful Celebration of Life for him. (My nephew, Todd, passed away unexpectedly about February 26 at age 33.) A perpetual memorial plaque for Todd is on display in the Butterfly Room at the Pacific Science Center, where Todd was the manager for traveling exhibitions. If you would like to help carry on Todd’s work, you can make a donation to the Todd Johnston Memorial Fund, Pacific Science Center, 200 2nd Ave. N., Seattle, WA 98109.

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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.

Remember the automatic extension of time to file for 2005 income tax returns is for six months to October 16, 2006.

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 2004, you can process your federal extension electronically (using tax return preparation software or through a tax return preparer). If you make a tax payment using a credit card, you can extend your income tax return by calling 888-729-1040 or 800-272-9829 by April 17. (For California extension payments, the extension is 1555.) 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 2004 income tax return can request an automatic extension.

You can also make a credit card payment online at www.pay1040.com or www.officialpayments.com.

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.

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 2006.

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 2006, 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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First calendar corporation estimated tax payment is due April 17.

Calendar-year Corporations almost always have to pay the minimum California tax payment of $800 by April 17, 2006. In addition, regular corporations have federal and California estimated tax payments due on that date. The estimated tax payments may be based on the income tax on last year’s income tax returns, provided there was a tax on the return. If there was no tax, the estimated tax must be computed based on the current year’s income. Corporations that had taxable income exceeding $1 million in any of the last three years may only base their first estimated tax payment on last year’s income tax returns; the rest must be based on the current year’s income.

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IRS warns against email "phishing" scam.

Taxpayers have been receiving emails claiming to be from the IRS requesting information for processing a refund. The IRS says it does not issue emails requesting this information. If you receive such an email, forward it to phishing@irs.gov. Due to the volume of submissions, the IRS will not acknowledge receiving the forwarded message.

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IRS shares audit statistics.

The IRS has published its annual data book, which includes information about the tax audits conducted during 2005. The overall total of returns audited increased to 1,215,308 from 1,007,874 during 2004. The percentage audited of total returns filed increased to .93% from .77%, so the number of audits increased about 21%. 42.9% of the returns were selected based on an earned income tax credit.

The audit rates for corporate income tax returns increased by 75% to 1.24% of returns filed from .71% for 2004.

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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?" where you should be able to find the answers to most of these questions.

Question

My adult daughter lived with me for most of 2005 due to a severe automobile accident. I did not pay for her medical expenses, but I did support her. Can I claim a dependent exemption for her on my income tax return?

Answer

If your daughter had gross taxable income of less than $3,200 and did not provide more than one-half of her own support, you should be able to claim a dependent exemption for her. See IRS Publication 501 at www.siliconvalleycpas.com.

Question

I am the beneficiary to an escrow account of over $2 million. Do I have to pay taxes for it? Will the IRS ask where the money came from? What rules and laws apply?

Answer

I am assuming this a trust account that you will be inheriting. The trustee or creator of the account may be responsible for paying estate, gift or generation-skipping taxes for these funds. They should be working with a tax advisor about this. You may be responsible for paying income taxes on income earned in the account. The estate or trust would issue a Schedule K-1 for items you are required to report. I suggest that you discuss these matters with the executor or trustee.

The IRS won’t automatically ask where you got these funds, but you will want to keep documentation about how you received them.

Question

My wife and I filed 2005 individual income tax returns married, filing jointly. I filed for divorce during February 2006. Now she wants to refile her return as married, filing a separate return. Can she change her filing status after the income tax returns were filed?

Answer

It appears to me she can refile her income tax returns as married, filing separately provided the "corrected" income tax return is submitted by April 17, 2006. (Treasury Regulations Section 1.6013-1(a).) This will invalidate the joint return election, requiring you to also file a separate return. If you live in a community property state, community income and deductions should be split between the two income tax returns, which could have a similar income tax result to filing a joint return, with a few exceptions.

People who are getting divorced often choose to file separate income tax returns to avoid joint and several income tax liability. See your attorney.

Question

I converted nearly all of my retirement savings into a Roth IRA in 2005.

May I pay my taxes in four annual installments, or was that rule only for conversions in 1998?

Answer

The ability to pay income taxes on a Roth conversion in four installments is no longer available. It only applied for conversions made during 1998.

Question

I commute about 40 miles to and from work 5 days a week. Can I claim an employee business expense for this mileage?

Answer

No.

Question

If you had an accident and had to rent a car to get to work, is any part of the expense that isn’t reimbursed from insurance deductible?

Answer

Probably not.

Casualty losses are usually determined based on the decrease in the value of the property. Incidental expenses aren’t generally deductible.

Also, you deduct $100 from an individual casualty loss and 10% of your adjusted gross income from your total casualty losses for the year. This "floor" makes it hard to deduct casualty losses except for damage to real estate.

Also, employee commuting expenses are non-deductible personal expenses.

Question

My ex-wife and I alternate years to claim the dependent exemption for my five-year-old daughter.

Can I claim head of household status for the years that I do not claim her as a dependent?

Answer

First, understand that you and your wife can’t both claim head of household status based on your daughter as a "qualifying child" for the same tax year.

These rules are tricky because of recent tax law changes.

In order to qualify, you must provide more than one-half of your daughter’s support for the taxable year, and she must have lived with you for more than one-half of the tax year. (Given – she must not have provided more than one-half of her own support for the year.)

See IRS Publication 501 at www.siliconvalleycpas.com.

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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 Michael Gray, CPA's Option Alert?

To subscribe or review past issues, go to www.stockoptionadvisors.com/subscribe.shtml.

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We are starting a newsletter devoted to real estate tax issues.

Like this newsletter, we will talk about new developments, have reports on special tax concerns, and answer questions and answers. The subscription rate is $19.95 per month. For a sample issue, visit www.realestatetaxletter.com.

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Visit our new article!

• The Soul of Money book review

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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)

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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.

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.

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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.