Michael Gray, CPA's Tax and Business Insight

March 30, 2007

© 2007 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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Baby watch update.

Dawn Siemer, who is expecting her first child (my second grandchild) in May, has been prescribed bedrest by her doctor, so her last day of work was March 16. She recently had a sonogram and the technician said the baby is definitely a beautiful girl.

Meanwhile, Donna Jeffries is covering Dawn’s administrative duties here, including answering Dawn’s telephone at 408-918-3166.

Dawn is still helping me to get this newsletter out, but her internet duties will be very limited.

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18 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 Donna at 408-918-3166.

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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 2006 income tax returns is for six months to October 15, 2007.

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 2005, 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 2005 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 eight 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 17.

(This is a reprint from past newsletters.)

Remember to review your estimated tax situation for 2007.

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, 2007. 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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Last chance to make an IRA or Roth contribution for 2006.

Remember the final due date for IRA and Roth contributions for 2006 is April 17, 2007. We don’t think making an election to have a tax overpayment deposited to an IRA or Roth account is a good idea for income tax returns filed during the last two weeks of tax season. It’s too easy for a refund to be delayed past the due date.

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Remember second California real estate tax payment is due April 10.

With the income tax deadline, most of us are focused on April 17, but the second California real estate tax payment is due April 10, and there is a nasty penalty for a late payment. Consider yourself reminded!

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AVA reviewed in San Francisco Magazine.

AVA restaurant in San Anselmo, California (owned by Dan Baker and Holly (Gray) Baker) was reviewed in the March 11, 2007 issue of San Francisco Magazine, which was part of the Sunday San Francisco Chronicle. Holly reported the restaurant was mobbed during the next weekend, and she’s not in any hurry to get more publicity. Congratulations, Dan and Holly! (For reservations, call 415-453-3407.)

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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?" (realestateinvestingtax.com/residence.shtml) where you should be able to find the answers to most of these questions.

Question

Suppose I sell an apartment building and exchange into land to build a spec home for profit. Then the market gets weaker over the year that it took to build the home, so it can’t be sold at a profit, and I can’t rent it for a reasonable cash flow.

  1. Can one exchange into property to be sold for a profit and not rented?
  2. Can a property received in a tax-free exchange be converted to a principal residence because of a change in circumstances?

Answer

  1. No.
  2. Yes, assuming the exchange qualified in the first place. However, this type of scenario can create some real headaches in the event of an IRS audit. You have to carefully document the entire situation.

Question

A friend pays his children’s private school tuition by transferring appreciated stock to the school. He does not take a charitable deduction but does not pay tax on the gain. Is this a taxable transfer?

Answer

Yes. The school should be issuing Form 1099-B to your friend, because he has exchanged his shares for the fair market value of education services received.

Question

I have a business in California. Am I responsible for withholding taxes from independent contractors to whom I issue Form 1099-MISC? If so, is there a way that they can opt out and take care of their own taxes?

Answer

Currently you are not required to withhold income taxes from payments made to independent contractors who are California residents. This could change in the future. Payments to independent contractors who are not California residents for services rendered in California are subject to California income tax withholding. If you need help with this, see your tax advisor. (You do have one for your business, don’t you?)


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/optionalert/.

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We also have a newsletter devoted to real estate tax issues.

Like this newsletter, we talk about new developments, have reports on special tax concerns, and answer questions and answers. To subscribe and read a sample issue, visit realestatetaxletter.com.

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Visit our new article!

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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 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.

They also have a second restaurant, AVA, at 636 San Anselmo Ave., San Anselmo, California. AVA serves food and drinks produced in California. For reservations, call 415-453-3407. The web site is avamarin.com.

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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.


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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Michael Gray, CPA
2190 Stokes St. Ste. 102
San Jose, CA 95128
(408) 918-3162
FAX: (408) 998-2766
Hours: 8am - 5pm PDT Monday - Friday

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