Michael Gray, CPA's Tax and Business Insight

July 2, 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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Happy July 4!

It’s time again to reflect on the blessings of liberty in our country. Despite our faults, we remain the envy of the world. There is a reason so many people are still making the United States their destination when seeking a better life for themselves and their families.

The price of liberty is vigilance, particularly for government abuse of power. Our government was designed with checks and balances to protect the citizens from despotism. That was a very big concern of our Founding Fathers.

Abraham Lincoln said that we should be more concerned about weakness from within our country than threats from outside. Of course, the world has grown much smaller through improved transportation (and long-distance weapons) and communications since Mr. Lincoln said that.

Our strengths include the resourceful, independent spirit of our people and tolerance and appreciation for the differences of others that contribute to the prosperity of us all.

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Grandparents on the move.

Grandma Janet is having a ball looking after her little granddaughter Kara weekday afternoons while Mommy Dawn is working. She has also been running up to babysit Kyan extra weekday nights while his regular babysitter is on vacation. Janet and I have also been looking after Kyan on Friday and Saturday nights during June, except a trip last weekend for a family wedding in Washington state.

We’re having a great time, but we’re also looking forward to getting back to a more normal schedule in July.

Mom Holly said it’s nice to have parents (including parents-in-law) who say they "get to" babysit their grandchild.

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July family birthday celebrations.

On July 16, my dad, Aubrey Gray, will be celebrating his 89th birthday. We feel extremely blessed to still have him with us, with a sound mind and reasonably good health.

My son, James, will be celebrating his 27th birthday on July 28. He has passed his graduation exams for a masters degree in philosophy at San Jose State University and should be graduating December, 2007.

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Report of Foreign Bank and Financial Accounts is due July 2.

Form TD F 90-22.1, the Report of Foreign Bank and Financial Accounts for 2006 is due July 2. The form is required when a U.S. person has a financial interest in, or signature or other authority over any financial accounts in a foreign country when the aggregate value of these financial accounts exceeds $10,000 at any time during the calendar year. Taxpayers who have filed an extension for their 2006 income tax returns should be especially mindful of this deadline.

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The year’s half over. How’s it going?

If you’re like me, the first six months of this year have been a blur. Some of my plans had to be put on the back burner with tax season, Dawn’s maternity leave, Kara’s arrival, and moving our office.

How have your plans been working out? Consider scheduling an appointment for a mid-year tax planning "check up". Call Dawn Siemer weekday afternoons at 408-918-3166 to make your appointment.

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Pre-release offer for Secrets of Tax Planning for Employee Stock Options.

I will soon be releasing the second edition of Secrets of Tax Planning for Employee Stock Options. If you would like information about the book, including a half-price pre-release offer, please email a request to Dawn Siemer at dawn@taxtrimmers.com, or call Dawn at 408-918-3166 by July 15, 2007.

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Subscribe to our Real Estate Tax Newsletter.

I have decided to write a separate newsletter devoted to real estate tax developments and questions. The newsletter will be sent by email at no charge or obligation. To subscribe, call Dawn Siemer at 408-918-3166 or send an email to dawn@taxtrimmers.com with your email address.

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Michael Gray speaks on non-qualified deferred compensation plans.

Michael Gray, CPA and attorney Michael Brayton will discuss the final regulations under Internal Revenue Code Section 409A, Non-Qualified Deferred Compensation Plans, at two presentations. One will be a breakfast meeting for the Silicon Valley San Jose Chapter, California Society of CPAs on July 18 from 8:30 a.m. to 11:30 a.m. at the Los Gatos Lodge. For details, call Stephanie Stewart at 408-983-1122. The second will be a lunch meeting for the Santa Clara County Bar Association on July 25 from noon to 2 p.m. at the Bar office 31 N 2nd Street, 4th floor in San Jose. For details, call Cindy Gartner at 408-975-2113.

These regulations have a surprisingly broad application, and the penalties for violating these rules are severe. Some items we’ll be talking about include pricing employee stock options, waiver of salary for small business owners, split dollar life insurance and expense reimbursement arrangements, in addition to structuring traditional non-qualified deferred compensation arrangements.

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Do you have a summer remodeling project to finance?

Remember that we can help with setting up equity lines of credit or refinancing a first mortgage to get the cash you need to finance your new kitchen, bathroom or workshop. Call Mike Gray at 408-918-3161 for details.

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Is your interest-only mortgage going to start amortizing?

Yes, mortgage interest rates have increased from a few years ago. But you can have often have a lower mortgage payment by refinancing with a new interest-only mortgage. We can help. Call Mike Gray at 408-918-3161 for details.

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Be alert for this identity theft scam.

James Kinsey at the IRS has issued an alert for an identity theft scam. A caller claims to be a jury coordinator and says he or she is following up about a failure to appear for a jury summons. If you protest that you haven’t received a summons, the caller asks for your social security number and date of birth to verify the information and cancel an arrest warrant. If you provide the information, your identity is stolen.

Moral – don’t give your identifying information to anyone who calls you on the telephone.

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"Kiddie tax" change means more capital gains and dividends will be taxable.

As I reported in the last newsletter, effective for tax years beginning after May 25, 2007, the "kiddie tax" has been extended to children over age 18, but under age 24 who are full-time students, provided the earned income of the child doesn’t exceed one-half of his or her support. (These are full-time students who qualify to be claimed as dependents on their parents’ federal income tax return.)

The purpose of this change is to close a "tax loophole". For 2008 through 2010, the tax rate that applies to long-term capital gains and qualified dividends for individuals in the 10% and 15% tax brackets will be 0%. Parents were transferring assets to their adult children who would qualify for the 0% tax rate. With this change, the long-term capital gains and qualified dividends will probably be taxed at 15%.

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IRS postpones enforcement of a new tax return preparer penalty.

The IRS has announced transitional relief for a new preparer penalty enacted in the Iraq funding act. A penalty of the greater of $1,000 or one-half the tax return preparation fee would be imposed on a tax return preparer of a tax return for which there is an understatement of tax attributable to a tax position that the tax return preparer did not believe would more likely than not be sustained if litigated, unless the position was adequately disclosed on the return (using Form 8275 or Form 8275-R).

The new law extends preparer penalties to all tax returns, instead of income tax returns only.

The penalty was to apply for tax returns prepared after May 25, 2007.

The IRS has announced that it will not impose the penalty provided the position has a realistic possibility of being sustained on its merits, which was the previous standard. The transitional relief applies for all tax returns, amended returns, employment tax returns and excise tax returns and refund claims due on or before December 31, 2007; to 2007 estimated tax returns due on or before January 15, 2008; and to 2007 employment and excise tax returns due on or before January 31, 2008.

Another new penalty applies when an understatement results from willful or reckless conduct.

This temporarily relief will certainly be appreciated, and hopefully will buy some time for Congress to moderate the new standard, including establishing an understatement level before the penalty applies. (Notice 2007-54, June 11, 2007.)

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Musician’s home office deductions upheld.

Bruce Millard was a professional musician. He worked as an employee for the Brookline Music School. He also was self-employed giving music lessons and performed in clubs and at music festivals. His self-employed music lessons were given at a music studio or at a room in his home.

He claimed deductions for the room in his home that was devoted to giving music lessons and to rehearsing for performances on Schedule C. He also claimed employee business expenses on Schedule A. The IRS attempted to disallow many of these deductions.

The Tax Court ruled that Millard was entitled to most of the disputed deductions, including the home office deduction for the room in his home devoted to music lessons and rehearsal. (Millard v. Commissioner, T.C. Summary 2007-86 (5/29/07).) (This case may not be cited as a precedent.)

Under Internal Revenue Code Section 280A, a qualifying use of the home office is "exclusively used on a regular basis … as a place of business which is used by patients, clients or customers in meeting or dealing with the taxpayer in the normal course of his trade or business."

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Part of sale of partnership interest not qualified for installment sale.

Part of the gain from the sale of a partnership interest was ordinary income relating to unrealized receivables as payment for services rendered. The ordinary income was not eligible for installment sale reporting, which must therefore be reported as taxable income for the year of sale. (CCM 200722027.)

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Supreme Court to review deduction of investment fees by trusts.

A controversial issue for trusts is whether fees paid to an investment manager are subject to reduction by 2% of the trust’s adjusted gross income. The Courts of Appeal have had different conclusions.

The U.S. Supreme Court has agreed to review a Second Circuit decision on this issue, William L. Rudkin Testamentary Trust.

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House energy bill would eliminate tax break for heavy SUVs.

The House version of H.R. 2776, the Renewable Energy and Energy Conservation Tax Act of 2007, includes a provision that would subject all SUVs with a gross vehicle weight of over 6,000 pounds to 14,000 to the annual luxury auto depreciation and expensing limits. The bill would also repeal the $25,000 heavy SUV expensing limit. SUVs would be taxed the same as other vehicles. The change would be effective for property placed in service after December 31, 2007.

The Senate version of the energy bill does not include this provision.

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Proposal introduced to tax certain publicly-traded partnerships as corporations.

Senators Max Baucus and Chuck Grassley have introduced legisltation that would tax all publicly-traded partnerships that directly or indirectly derive income from investment adviser or asset management services. Private equity firms would be subject to the change. A five-year transition period applies for partnerships whose interests were traded, or readily tradable on June 14, 2007. Similar legislation, with no transitional period, has been introduced in the House of Representatives by Representative Peter Welch.

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Congress considers taxing "carried interest" as ordinary income.

Private equity funds often provide general partners with a "carried interest" or share in the fund’s profits. Currently, this income may be taxable as long-term capital gain. On June 22, Representative Sander Levine introduced a bill to tax carried interest as ordinary income.

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Questions and Answers

Question

Since I wasn’t able to find a job in my city of residence, Portland, Oregon, I took a job in the San Francisco Bay Area, California. My wife, who is a tenured college professor in Oregon, continues to live in Portland with our two young children. Are my unreimbursed expenses to travel to and from Portland to be with my family on the weekends tax deductible?

Answer

No. Based on the facts you gave me, these are non-deductible personal expenses.

I highly recommend that you seek professional help immediately to determine your state tax status and to prepare your state income tax returns. Sometimes you can be taxable in two states with a scenario like you describe.

Question

If you win a house and your income is $50,000 per year with no bills and the standard deduction, what would the tax be?

Answer

You haven’t given me enough information to answer your question. The fair market value of the house is taxable as ordinary income. You should ask whoever is awarding you that house what the taxable amount is. You could have a big tax bill.

Question

Is my 18-year-old former stepson considered my dependent? He lived with me for the first 13 years of his life, before I was divorced from his father. His father passed away two years ago, when my former stepson was 16.

The boy lives with me full time. I will support him through his last year of high school and through college. I am also adding him to my health and dental insurance.

Answer

The answer is more difficult than you might think.

Since he is no longer your stepson, he is no longer a "qualifying child".

You can claim him as a dependent while he is living in your home and you are providing more than half of his support, providing he does not have gross income exceeding $3,400 for 2007.

Has he applied for social security benefits as an orphan of his father?

Consider legally adopting him to get the benefits of being able to continue claiming a dependent exemption when he is a full-time student through age 23, despite his income level. You should get legal advice about your responsibilities and update your will before taking this step.

Question

How long do you have to be employed by a company before you qualify to participate in a SEP (Simplified Employee Pension Plan?)

Answer

It depends on the terms of the plan. You could optionally be immediately covered.

An employee must be covered who (1) has reached age 21; (2) performed services for the employer during at least three of the five immediately preceding years; and (3) received at least a specific dollar amount of compensation from the employer for the year – $500 for 2007.


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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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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