WASHINGTON TAX UPDATE

Transcription

1 WASHINGTON TAX UPDATE FEBRUARY 8, 2012 Welcome to Washington Tax Update, where you will find useful information about taxes, including current events in our nation s capital, as well as informed opinions and predictions about what is expected to happen. Tax Look Inside Tax Planning Tip of the Week IRS Courts What s New from the IRS What s New from the Courts It Bears Repeating Tax Laughs Congress

2 tax planning tip of the week A losing proposition: Letting the IRS hold your money It s that time of year again when some tax preparers fill your television with commercials touting big refunds. While a large tax refund may sound like a good deal, keep in mind that a refund is your money. The only reason you get a refund is that you paid more taxes to the government than you actually owed. The larger the refund you receive when you file your tax return, the more of your money you have placed in the hands of the government throughout the year. The government doesn t pay interest on your refund. If you reduce your withholdings during the year and invest the savings, you ll come out ahead.

3 Some people view over-withholding as a form of forced savings. They don t believe they have the discipline to save if they receive a larger paycheck every pay period. If your employer offers a 401(k) plan or other contributory retirement plan, consider having the difference deposited directly into your retirement account rather than letting the government hold your money. If you re expecting a large refund this year, consider paying a visit to your employer s payroll department and provide a new Form W-4, Employee s Withholding Allowance Certificate, reducing the amount of taxes to withhold during Then put that extra take-home pay to work for you in a productive investment vehicle.

4 Proposed rules give retirees more options what s new from the IRS The Departments of Treasury and Labor have unveiled two executive actions to expand the transparency of 401(k) fees and broaden the availability of retirement plan payout options. The purpose of these actions is to encourage the use of annuities to provide lifetime income. The annuity rules are designed to help retirees who are worried about outliving their retirement savings. Historically, the most comprehensive solution to the challenge of retirement security has been to replace the paycheck retirees received when they were working with a guaranteed and predictable stream of lifetime income, such as a defined benefit pension or life annuity. Over time, the use of annuities and other lifetime income in retirement plans has been diminishing as the number of traditional pension plans has declined. Today s more common defined contribution plans, such as 401(k) plans, typically offer a lump-sum payout option. The new package of proposed regulations is designed to make it easier for retirement plans to offer workers a wider range of choices for receiving their benefits. The proposals include rules to: Make it easier for retirement plans to offer combination options that avoid an all-or-nothing choice. For example, plans could provide the option to take a portion of your plan benefit as a stream of regular monthly income payable for life, while taking the remainder in a single lump-sum cash payment.

5 Remove a key obstacle to longevity annuities. A proposed regulation would give special relief from the minimum distribution requirement. As long as the annuity costs no more than 25 percent of the account balance or up to $100,000, whichever is less, and will begin payouts by age 85, it would not be subject to required minimum distributions before the annuity begins. Clarify rules for plan rollovers to purchase annuities. Employees receiving lump-sum cash payout from their employer s 401(k) plan can transfer some or all of the amount to the employer s defined benefit pension plan if the employer has one and is willing to allow the transfer. Resolve uncertainty about how the 401(k) plan spousal protection rule applies when employees choose deferred annuities, including longevity annuities, from their plans. This ruling describes various arrangements permitting employees who are not yet ready to retire to invest their account balances in lifetime income benefits either on a one-time basis or incrementally over a period of years under deferred annuity contracts that will begin payments at retirement or later. The guidance identifies plan and annuity terms that will automatically protect spousal rights without requiring spousal consent before the annuity begins. Click here to read more in the government s fact sheet.

6 what s new from the courts Capital gain treatment may depend on active business Owners of qualified small business stock, other than shareholders who are corporations, may elect to roll over capital gain from the sale of the stock. To qualify for rollover treatment, replacement small business stock must be purchased within 60 days of the date of sale, and both corporations must be engaged in active businesses. A recent Tax Court case (John P. Owen, et ux., et al. v. Commissioner, TC Memo , Jan. 19, 2012) involved a transaction in which John Owen sold his stock in FFAEP, a corporation actively engaged in the business of selling prepaid legal service policies and estate planning services. Owen received about $2 million for his shares, resulting in a gain of almost $1.9 million. Within 60 days of the sale, Owen formed J&L Gems, Inc., as a retail jewelry business and deposited the proceeds from the FFAEP sale in J&L s account. During its first six months of operation, J&L purchased 16 pieces of jewelry at a total cost of less than $150,000. For its first year of operation, the company reported six sales grossing about $12,000, and three of those sales were to friends or parties related to Owen.

7 Based on the facts presented, the Tax Court determined that J&L did not meet the active business requirement set forth in the tax law. The law requires at least 80 percent of the corporation s assets to be invested in the active conduct of one or more qualified trades or businesses. Only 8 percent of the amount invested was in inventory with the balance in cash. As a result, Owen was taxable on his capital gain from the sale of the FFAEP stock. It was not enough for Owen to form and capitalize a new corporation during the 60-day rollover period. He also had to demonstrate that the new corporation was engaged in an active business. According to the court, having 92 percent of the corporation s assets in cash did not meet the active business requirement. Owen was also assessed the substantial understatement of tax penalty of 20 percent. The Tax Court concluded that Owen failed to follow his tax adviser s advice.

8 it bears repeating Remember: Forgiven loans are taxable Some employers who are seeking to snare top talent offer deferred signing bonuses often in the form of loans to key employees. The loans are scheduled to be forgiven later, after the employees prove their commitment to the new organization. A recent Tax Court case (Robert J. Brooks, et ux. v. Commissioner, TC Memo , Jan. 26, 2012) deals with just such a loan and serves as a reminder that employer loans that are later forgiven usually result in taxable income to the employee. In this case, Robert Brooks received a loan of more than $500,000 from his employer. The employer promised to forgive the entire loan including interest if Brooks stayed employed for the full five-year loan term. He stayed and the employer forgave the loan. Brooks included the forgiven loan principal and accrued interest as income on his tax return. But later, Brooks had second thoughts and claimed that, although the forgiven principal was income, the forgiven interest was not. The entire amount forgiven was $650,342, including $506,300 of principal and $144,042 of accrued interest.

9 The tax law generally treats the discharge, or forgiveness, of debt as income, but there are exceptions. One is that a debtor does not realize income from forgiveness of debt to the extent that payment of the liability would have provided a deduction. Under this rule, a cash-method taxpayer will not realize income upon the cancellation of the accrued interest that would have been deductible if it had been paid. Brooks argued that the interest his employer forgave would have been deductible under Code Section 212, which allows individuals to deduct all the ordinary and necessary expenses paid or incurred for the production of income. Brooks said the loan s purpose was to give him a stake to showcase his skills as a stockbroker to produce income for himself and his wife. The Tax Court acknowledged that Brooks engaged in a large number of stock trades, which Brooks pointed to as proof that he used the loan to buy a portfolio of stocks. He argued that his actions proved that the forgiven interest would have been deductible as an expense for the production of income. The IRS countered that Brooks did not trace the flow of money from the loan to his investments. Without evidence showing use of the loan proceeds to buy stocks or securities, the IRS contended that Brooks didn t prove he would have been entitled to a deduction. The Tax Court agreed with the IRS. Interest expense generally is allocated to the associated debt. The court said it had to look at how Brooks used the loan proceeds to determine whether the interest related to the debt would have been deductible. Brooks did not give the court enough information to make the determination.

10 tax laughs Eighteenth century England took its hat tax seriously Most Americans are well aware that our founding fathers were not too keen on the taxing policies of the British government. One draconian measure passed by Parliament in 1784 during the reign of George III was the Hat Tax. The tax was designed to be a simple way of raising revenue for the government in rough accordance with each person s relative wealth. The assumption was made that the rich had a large number of expensive hats, while the poor might have had one cheap hat or none at all. To be a bona fide hat seller, an individual had to obtain a license to sell hats. The license cost two pounds in London, and five shillings outside London. In addition, sellers had to have the words Dealer in hats by retail over the door of their premises.

11 Special stamps had to be affixed to the lining or inside the crown of the hats to make them legal. The cost of the duty depended on the cost of the hat. For hats with a retail cost under four shillings, the duty was threepence. For hats costing between four and seven shillings, sixpence was levied. A shilling was charged for those between seven and twelve shillings. For really expensive hats over twelve shillings, the duty was two shillings. There were penalties for both the seller and the buyer of hats without stamps, and the removal and reuse of stamps was a punishable offense. The penalty for forgery of hat stamps was particularly severe. In 1798, an unlucky Brit named John Collins was caught with a forged printing plate, ready inked, and a dampened linen ready to receive its impression. Ink he had just wiped from the surface of the plate was on his hands. Unbelievably, Collins was sentenced to death. Apparently, Americans won their independence in the nick of time. Who knows how much the tax would have been on coonskin caps? I object and take exception to everyone saying that Congress [is] spending money like a drunken sailor. As a former drunken sailor, I quit when I ran out of money. Bruce L. Hargraves, U.S. Navy, retired

12 Courts Tax IRS Congress The technical information in this newsletter is necessarily brief. No final conclusion on these topics should be drawn without further review and consultation. Please be advised that, based on current IRS rules and standards, the information contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty assessed by the IRS CPAmerica International