T.W. Lewis & Co., LLC Summer 2006 PUBLICATION

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1 T.W. Lewis & Co., LLC Summer 2006 PUBLICATION fyi: Roth IRA Conversions Taxpayers with six-figure incomes who like to plan ahead should be aware of a new provision in the recently enacted Tax Increase Prevention and Reconciliation Act. Currently, a taxpayer with more than $100,000 in income cannot convert a regular individual retirement account (IRA) into a Roth IRA. Beginning in 2010, that limitation will be eliminated. Contributions to an IRA are generally deductible, and earnings are not subject to federal income tax as they are earned. However, distributions are generally taxed as ordinary income. Significant restrictions on distributions before the age of 59 1/2 also apply. For a Roth IRA, there is no up-front deduction for contributions, but federal income tax generally does not apply to either earnings or distributions. There are also more exceptions that allow distributions from a Roth IRA before the age of 59 1/2. Under current law, only taxpayers with $100,000 or less in modified adjusted gross income can convert a regular IRA into a Roth IRA. If you make the conversion, you generally must pay tax on the amount that is converted (transferred to the Roth IRA). Future earnings and distributions from the Roth IRA are generally not subject to federal income tax. A Roth conversion may be appropriate for you if you either expect your income tax rate to increase in retirement; believe that the value of your account will rise significantly; or desire to avoid taking required minimum distributions from a traditional IRA once the you reach the age of 70 1/2. In that case, the tax savings in later years may exceed the cost of making the up front tax payment at the time of conversion. The new law eliminates the modified adjusted gross income limit beginning in It also provides that taxation of amounts converted to a Roth IRA in 2010 can be deferred so that one-half of the converted amount is subject to tax in 2011 and the other half is subject to tax in Creating a Limited Liability Company If you own or are considering acquiring either a business or an investment property, it may be desirable to form a limited liability company (LLC) to operate the business or hold the property. An LLC is somewhat of a hybrid entity in that it can be structured to resemble a corporation for owner liability purposes and a partnership (continued on page 4) Inside This Issue Converting Your Home... 2 into a Rental Property Partnership Tax: The Disconnect... 2 Between Cash Flow and Taxable Income Trusts and Estates... 3 Basics: Probate New York State Tax Credits... 3 for Remediated Brownfields Real Eastate and Taxes, Part II... 4 Private Foundations There are two principal classifications of charitable organizations under the Internal Revenue Code: public charities and private foundations. The main advantages of public charity status are the higher annual deductibility limits for contributions and avoiding the application of the restrictive private foundation rules and the associated compliance costs. The two principal ways of qualifying as a public charity are based on either the type of organization (school, church, hospital, etc.) or the organization's sources of support. If the organization derives at least onethird of its support from contributions from the general public, as opposed to a limited group of donors, then it will meet the support test and qualify as a public charity. (continued on page 5)

2 Converting Your Home into a Rental Property If you decide to move to another residence, you may want to retain ownership of your present home to avoid taxes on the sale, to earn rental income, to retain an interest in its potential future appreciation, or for other reasons. If you are thinking of taking this step, you no doubt are fully aware of the economic risks and rewards. However, you also should be aware that renting out your former personal residence carries potential tax benefits and pitfalls. You generally are treated like a regular real estate landlord once you begin renting your home to others. That means you must report rental income on your tax returns, but also are entitled to offsetting deductions for your expenses such as utilities, repairs, mortgage interest, condominium common charges, real estate taxes and property maintenance. Additionally, you can claim depreciation deductions based on the value of the building and personal property components of your home's value. There are potential tax pitfalls that may arise from the rental of your residence. For example, the passive activity loss rules may prevent you from currently deducting losses incurred with respect to a rental property unless an exception applies. You may also lose part or all of an important tax benefit if you finally sell the home at a profit. In general, you can exclude from your income up to $250,000 ($500,000 for certain married couples filing joint returns) of gain on the sale of your home. However, this tax-free treatment is conditioned on your having used the residence as your principal residence for at least two years during the five-year period preceding the sale. You also may not be able to deduct all or part of a loss that you incur if you sell the residence that has declined in value. The question of whether to turn a principal residence into rental property is not always easy to resolve. Contact us to discuss the specifics of your situation so that you can make a more informed decision. Partnership Tax: The Disconnect Between Cash Flow and Taxable Income The taxation of partnerships and partners is one of the most complex areas of the tax law. An issue that partners (and members of LLC's) frequently encounter is that, for a variety of reasons, a partner may be subject to tax on a greater or lesser amount of income than the amount of cash distributions received by partner during the year. In that case, the partner must obtain funds from another source to pay tax currently on the undistributed income. For this reason, partnership agreements often provide for mandatory cash distributions to cover the partners' expected federal, state and local income tax liabilities as they arise. The explanation lies in the way in which partnerships and partners are taxed. Unlike a regular corporation, a partnership is not subject to income tax. Rather, each partner is taxed on his or her share of the partnership's income, whether or not distributed. Similarly, any loss incurred by a partnership is passed through to the partners. Although a partnership is not subject to income tax, it is treated as a separate entity for purposes of determining its income, gains, losses, deductions and credits. After the aggregate amounts of those items are determined at the partnership level, the partnership then passes through a share of each item to each of its partners. A partnership must file an information return (Form 1065), on which it separately identifies many items of income, deduction and credits for the year. Examples of such items include the partnership's ordinary rental or business income, capital gains and losses, charitable contributions and expenses eligible for tax credits. The partnership provides to each partner a Schedule K-1, which states the partner's share of each of those partnership items. Basis and distribution rules ensure that partners are not taxed twice on the same income. A partner's initial basis in his partnership interest, the determination of which varies depending on how the interest was acquired, increases by the partner's share of partnership taxable income. When that income is distributed, the partners are not taxed on the distribution if they have sufficient basis in their partnership (continued on page 6)

3 Trusts and Estates Basics: Probate An article in the Spring 2006 edition of this newsletter discussed basic estate and personal planning documents, including the importance of a last will and testament. When a person with a will dies, the executor named in the will obtains the original will and presents it to the appropriate court (in New York, the Surrogate's Court) along with additional information about the deceased and his or her family and assets to initiate probate of the will. The probate of a will is often referred to as proving the will, because the word probate is derived from the Latin word probare, which means to prove. The court examines the will to determine if it was properly executed, and then the court issues a citation to each interested party. The citation gives each interested party the opportunity to appear in the court to object to the probate of the will. As an alternative to issuing a citation, the executor can request that an interested party sign a waiver and consent, which waives the issuance of a citation to that party and consents to the probate of the will. Interested parties include certain of the decedent's relatives (and their guardians if they are minors) who would be entitled to a share under state law if the will were invalid; the public administrator or the attorney general in some cases; and any parties who would be entitled to a greater share of the estate under a former will that is superseded by the will presented to the court for probate. If there are no valid objections, the court grants probate of the will and the executor is authorized to gather the decedent's assets and administer the estate. New York State Tax Credits for Remediated Brownfields A recently enacted tax credit program for developers of environmentally contaminated ( brownfield ) sites in New York State establishes cleanup and development incentives in the form of three types of refundable New York State income tax credits. The credits are available to taxpayers that have fulfilled certain requirements with respect to a brownfield site and received a Certificate of Completion from the State stating that applicable environmental remediation requirements have been met for their site. The three credits for expenses related to a brownfield site are: Brownfield Redevelopment Tax Credit: a one-time credit for 10-22% of costs incurred for site preparation, groundwater remediation and qualified tangible property constructed on the site. A rental apartment building would be qualified tangible property. Owner-occupied housing generally does not constitute qualified tangible property. Remediated Brownfield Credit for Real Property Taxes: an annual credit of up to 25% of real property taxes paid, depending on the number of persons employed at the site (or $10,000 per employee, if lower) for a 7-year period; and Environmental Remediation Insurance Credit: 50% of environmental insurance premiums paid, limited to a maximum credit of $30,000. Credits can be claimed beginning in 2006 against New York State corporate, personal income and franchise taxes. Partnerships and limited liability companies pass through eligible expenses to their partners or members, who claim the credits on their respective returns. If the amount of allowable credits exceeds a taxpayer's tax liability for the year, the taxpayer will receive a refund from New York State in the amount of the excess. These credits are a significant incentive for cleanup and Ron Senatore redevelopment of brownfield sites in New York State. For Sales Manager example, Member, if an Advisory individual Board developer acquires a contaminated property, spends $500,000 to remediate the contamination and prepare Office: 917 the site and then 1251 constructs Avenue of the a Americas, multi-unit Suite 2300 rental Fax: New York, NY apartment Mobile: 914 building on the site at a cost of $2,500,000, the individual would be eligible for redevelopment tax credits of $300,000 to $600,000 the year of completion plus any applicable credits for real property taxes or environmental insurance premiums paid. Insurance Services Mirko D. Carrea 555 Westchester Avenue Rye Brook, New York Telephone: (914) Fax: (914)

4 Creating a Limited Liability Company (continued from page 1) for tax purposes. In appropriate circumstances, this can provide the owners with the best of both worlds. Like the shareholders of a corporation, the owners of an LLC (called members rather than shareholders or partners) are generally not liable for the debts of the business except to the extent of their investment. Thus, the owners can operate the business with the security of knowing that their personal assets are generally protected from the entity's creditors. This protection is far greater than that afforded by a partnership. In a partnership, the general partners are personally liable for the debts of the business. Even limited partners can have personal liability in some cases. From a tax perspective, the earnings of a corporation operating a business in New York City are generally subject federal (up to 35%), state (up to 7.5%) and city (8.85%) corporate income taxes. The remaining earnings are then subject to personal income tax when distributed to shareholders as dividends. A corporation can generally avoid federal and state corporate income taxes by making an S election, but the City corporate income tax applies to all corporations. An LLC can be structured to be treated as a partnership for federal, state and local income tax purposes. This can provide a number of important benefits to the owners. If treated as a partnership, the LLC is not subject to federal or state income tax; instead, the LLC's income flows through to its members in proportion to their respective interests in profits. Each member then reports his or her share of the income on his or her individual income tax return. Ron Senatore Sales Manager Member, Advisory Board Office: Fax: Mobile: Avenue of the Americas, Suite 2300 New York, NY As discussed in an article in the Spring 2006 newsletter, if an LLC conducts business in NYC, it would be also subject to the NYC unincorporated business tax (UBT) of up to 4%. Partial relief from UBT is available to members who are NYC residents in the form of a partial credit against their NYC personal income tax for their share of the UBT paid by the LLC. Thus, a large portion of the double tax burden imposed on corporations is eliminated by the use of an LLC. If certain requirements are met, a member of an LLC can also deduct his or her share of losses incurred by the LLC against his or her other income. The ability of a corporate shareholder to do that is extremely limited. An LLC that is taxable as a partnership can provide special allocations of tax benefits to specific members. This can be an important reason for using an LLC over an S corporation, which requires that all tax items be allocated in accordance with the percentage of stock owned by each shareholder. S corporations are also subject to the restrictions regarding the number of owners and the types of ownership interests that may be issued. In addition, a single-member LLC can be disregarded for tax purposes, which allows for the owner to report all of the LLC's activities on his or her personal income tax return without filing any additional tax returns for the LLC, except a UBT return if required. In summary, an LLC can provide corporate-like protection from creditors and the favorable tax treatment of a partnership. Please contact us to discuss the suitability of an LLC for your particular business or investment situation. Real Estate and Taxes, Part II: Section 1031 Like-Kind Exchanges with a Related Party As described in the Spring 2006 edition of this newsletter, federal tax law generally provides for non-recognition treatment (i.e. no taxable income is currently created), subject to certain exceptions, when property held for investment purposes or used in a trade or business is exchanged for likekind property. Gain must be recognized, however, to the extent that cash (or other non-like-kind property) is received as part of the exchange. If an exchange occurs between related parties, special restrictions apply. Related parties include brothers; sisters; parents; grandparents; spouses; children and grandchildren. Insurance Services

5 Partnerships and corporations in which a person or group of related persons hold more than a 50% interest are also related parties for these purposes. For example, if you desire to diversify your real estate holdings while maintaining an economic stake in a particular parcel of real estate, you might consider exchanging your real estate for other real estate owned by a partnership in which you are a 50% partner. That way, through the partnership you still have an indirect 50% interest in the property that you exchanged, but you would not recognize gain on the other 50% of the property that you no longer own. The other 50% of the property is now indirectly owned by the other partners of your partnership. Two-year holding period. If related parties enter into a qualifying like-kind exchange, non-recognition treatment will be lost if either of the exchanged properties is disposed of within two years of the exchange. This is how the rule would apply to a typical exchange involving related parties: Max and Tom are brothers. Max owns a rental apartment unit with a basis of $40,000 and a value of $100,000. Tom has an office building that is worth $100,000 and his basis in it is also $100,000. If Max sells the apartment to a third party for cash, he would be currently taxed on his $60,000 gain. Instead, therefore, he and Tom trade properties. Max thus disposes of the apartment but does not recognize his gain under the like-kind exchange rules. As you may recall, these rules also provide that the basis of the property you receive in the exchange will be equal to the basis you had in the property you gave up. Tom's basis in his newly-acquired apartment is thus $100,000, the basis he had in the office building. Tom now (instead of Max) would sell the apartment to an unrelated party for its $100,000 value. Since Tom's basis in the apartment is $100,000, he would have no gain or loss on the sale. Under the two-year rule, if Tom's sale takes place within two years of his like-kind exchange with Max, Max would lose the benefits of non-recognition treatment from the original exchange. In that case, Max would not have to go back and amend his tax return for the year of the like-kind exchange. Instead, he would report his gain ($60,000 in this example) in the year in which Tom sells the apartment. He would also increase his basis in the office building by the amount of gain that he recognizes in the year of the sale. If Tom waits two years before selling the apartment, the sale by Tom does not cause Max to recognize any of his $60,000 deferred gain under the related party exchange rules. Filing requirements. If you enter into a like-kind exchange with a related party, you must file the like-kind exchange Form 8824 along with your federal income tax return not only for the year of the exchange but also for the following two years, to keep the IRS apprised of the situation. Before entering into a like-kind exchange with a related party, contact us to ensure that you will receive the desired tax treatment in your particular circumstances. Private Foundations Ron Senatore Sales Manager (continued from page 1) Member, Advisory Board In many cases, a donor or a small group of donors desire to form Office: an 917 organization to 1251 receive Avenue current of the Americas, charitable Suite 2300 contributions that will be used, Fax: New either York, NY currently or in a future Mobile: year, to fund one or more presently undetermined future charitable projects or to make grants to one or more presently undetermined charitable organizations. For example, if a donor has a high-income year because of a bonus, lottery winnings or exercise of stock options, the donor may want to fund several future years of charitable giving by making a contribution to a foundation during the high-income year. Alternatively, a donor may want to support one or more non-u.s. charitable organizations or a group of individuals, Insurance Services neither of which are eligible to receive deductible contributions directly from an individual. Mirko D. Carrea If your contemplated activities and sources of support will not meet either of the public charity qualification requirements described Telephone: above, (914) a private foundation Fax: (914) may be an 555 Westchester Avenue Rye Brook, New York appropriate vehicle to achieve one more of your goals. The application of the private foundation rules can be quite complex. If you would like to form a charitable organization for one or more of those purposes, contact us to discuss the benefits of a private foundation in your situation.

6 Partnership Tax: The Disconnect Between Cash Flow and Taxable Income (continued from page 2) interests. Rather, partners merely reduce their basis in their partnership interest by the amount of the distribution. If a cash distribution exceeds a partner's basis in his or her partnership interest, then the excess is taxed to the partner as a gain, which often is a capital gain. Example: At the beginning of 2005, Smith and Jones each contribute $10,000 to form an equal partnership. The partnership earned $80,000 of taxable income in 2005, during which it made no cash distributions to Smith or Jones. Smith and Jones must each report on their 2005 Forms 1040 their $40,000 share of the partnership's taxable income as shown on their Schedule K-1s. Since no distributions were made to them in 2005 by the partnership, they must each come up with funds to pay their 2005 income tax on that $40,000 of income from another source. Both Smith and Jones have a starting basis in their partnership interest of $10,000. Their basis is increased by $40,000 to $50,000 at the end of In 2006, the partnership breaks even (has zero taxable income) and distributes $40,000 to both Smith and Jones. The cash distributed to them is not subject to tax. Each of them, however, must reduce their basis in their partnership interest from $50,000 back to $10,000 to account for the distribution. This discussion is a summary and does not discuss many other applicable partnership tax rules. Please contact us if you wish to discuss any aspect of how you are taxed as a partner. Copyright 2006 T.W. Lewis & Co., LLC Disclaimer and IRS Circular 230 Disclosure: The content of this newsletter is intended to be a general overview of particular legal topics and does not constitute legal advice or create an attorney-client relationship. Please contact us to obtain legal advice for your particular situation. As required by U.S. Treasury Regulations governing tax practice, you are hereby advised that any written tax advice contained herein 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. Contact Us AREAS OF PRACTICE T.W. Lewis & Co., LLC 30 Broad Street, 15th Floor New York, New York (212) Fax (212) Timothy Lewis, admitted to practice in NY and MA Taxation -Tax planning -Tax returns for individuals & businesses -Partnership and joint venture tax issues -Tax controversies -Tax collection defense -State and local tax matters -Section 1031 like-kind exchanges Real Estate -Purchase and sale of co-ops, condos, and other real estate -Co-op and condo conversions Trusts and Estates -Wills and health care documents -Trusts -Issues involving minor children and disabled beneficiaries -Planning for business interests -Charitable gifts and trusts -Estate, gift and inheritance taxes Tax Exempt Organizations -Formation and operation -Tax exemption -Private foundations -Regulatory matters and filings Other -Commercial transactions and contracts -Setting up corporations and limited liability companies -Partnership agreements Advertise with us Call (212)

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