Tuesday, October 28, 2008

Retirement? What retirement?

Eavesdrop on any number of conversations, and you'd think that this country's biggest focus is Friday night. After all, back in the 80's, the band Loverboy sang about how 'everybody's working for the weekend,' and The Kings sang about how 'nothing matters but the weekend...from a Tuesday point of view." But, if you ask most people what they'd do if they won the lottery, they'd respond "retire." For most people, work is a means to an end - with the end being, in a perfect world, retirement at 35. Ok, maybe 40. There's a few things to get done first.

But as this new article in the University of Illinois press points out, retirement itself may become a mere myth for many people. Like the farmer of yesteryear who worked to feed his family right up until the day he died, the modern worker may be faced with a very unhappy choice - no retirement at all.

As Professor Kaplan points out, the original intent was for the 401(k) and similar plans to be one of several retirement funds. With the IRA - and later, the Roth IRA - the government added an additional prong. A person contributing the then-maximum $3,000.00 to an IRA over a 40-year career added at least an additional $120,000.00 to their retirement fund. Combine that with the earnings growth, a company pension, Social Security and a 401(k) plan, and retirement should be an enjoyable respite from a long, productive career.

Not so much anymore. With the market tanking, 401(k) plans and IRAs will be taking hits of up to 40%, possibly more. This should serve as a wake-up call for those of you who have given short shrift to your retirement planning process. If your retirement planning consisted of randomly picking three mutual funds offered by your employer's plan administrator, you may be in for a rude awakening. Social Security can't be relied upon for anything more than a small portion of your retirement, and if you haven't saved anything else, you may find yourself working until 70 or later to fund your retirement. In a worst-case scenario, you may not even have a retirement.

Of course, things can and will change. But this is a good primer on why its important to pay attention to what you're picking - and how it's currently doing, including making changes if needed - and don't just pick a stock or fund because a 'friend' 'recommends' it. That's a terrible idea, but one that happens all too often.

Wednesday, October 22, 2008

When Section 1031 exchanges go bad...

The IRS recently announced proposed changes to the Qualified Intermediary (QI) program to address what happens when a QI goes under.

Among rental property owners, a Section 1031 exchange offers the major tax benefit of deferring capital gain recognition. For the unfamiliar, this type of exchange permits a property owner to use like-kind exchange rules to sell a property they no longer want. It allows a property owner 45 days to identify a replacement property, and 180 days to close on that property.

Obviously, unless the properties are close by (and in these types of cases, that's often not the case), it's difficult to close both transactions on the same day. And, as anyone who's tried to sell a home can attest, you are more likely to find the replacement property than sell your property - especially in this market.

Originally, the IRS had unclear rules regarding like-kind exchanges of property, but that all changed with sStarker v. United States, 35 AFTR 2d 75-1550, 75-1 U.S.T.C. ¶9443 (1975). In that case, the Starkers agreed to sell their entire interest in timberland to a company, in return for the promise of future land within 5 years. The IRS challenged on a number of grounds, but lost - the court found that the deferral was permitted.

In 1984, Section 1031 was amended to allow such exchanges, subject to time limits, and to hopefully cut down on abuses which arose after Starker (it was further amended in 1986 to change the identification period from 44 to 45 days).

Section 1031 exchanges have thus existed for over 30 years, but it was only recently, as the real estate market took off, that they've entered the common lexicon. In recent years, the problem of far-flung properties has been overcome by the use of qualified intermediaries. These parties facilitate 1031 exchanges by taking title to the sale property or presenting replacement properties (there is such a thing as a 'Reverse 1031,' but that's for another day).

The real problem arises when the QI has taken title to the sale property or cash, and subsequently goes out of business. There have been several recent cases where taxpayers have sought relief in the form of extensions on the 180 day requirement. However, the time deadlines are absolute, and neither the IRS nor the courts have been willing to give on this issue, and Congress has failed to act. Obviously this is a big problem (because the dollar amounts are rarely small; in one recent case, the taxpayer lost over $2 million), and a solution is needed.

This weeks announcement attempts to address that issue, by requiring foreign financial institutions who are QIs to notify taxpayers when internal controls have failed. However, the announcement says nothing about independant QIs, nor US financial institutions, so it remains to be seen if this is just a first step in addressing the issue, or just a tease.

Sunday, October 12, 2008

When volunteering can cause tax liability

As a lawyer, I am often reminded by the bar associations I belong to how important it is to pro bono work. "Equal access to the law" is the catchphrase, and in Illinois (though not yet in California) you have to report the number of hours you spend doing such work (or, in lieu of pro bono work, how much money you donated to legal aid groups). Although the information collected is not shared with the general public (Illinois does publish whether or not you have malpractice insurance, for example), it's clear that the state is making a concerted effort to convince lawyers to take on non-paying or low-paying work to benefit society as a whole.

Altruistic as that is, it's not always as simple as it seems. And sometimes, volunteer work can be downright expensive, especially if you're the 'take charge' type. Take the case of Jefferson v. U.S., a recent Seventh Circuit case.

In Jefferson, a taxpayer worked on a volunteer basis for a day care center that received at least some funding from the United Way. The day care center hit a rough patch, and failed to pay payroll taxes. Long story short (you can read the details if you're so inclined by following the above link), Jefferson did a number of significant things that worked against him in the long run: he helped the organization secure a loan, he hired an accountant to help manage finances, he had check-writing authority (he claimed to have written only two checks out of over 900, but both were to the IRS), he directed policy and he sat on the board.

The 7th Circuit decided that Jefferson's involvement was enough to make him a 'responsible person' under Section 6672 (Specifically 26 U.S.C. Section 6672(a)). Jefferson argued that he was 'an honorary and voluntary board member' exempt from personal liability under Section 6672(e). That section was quoted by the Court, and reads as follows:

No penalty shall be imposed by subsection (a) on any unpaid, volunteer member of any board of trustees or directors of an organization exempt from tax under Subtitle A if such member—
(1) is solely serving in an honorary capacity,
(2) does not participate in the day-to-day or financial operations of the organizations, and
(3) does not have actual knowledge of the failure on which such penalty is imposed.

Of course, Jefferson's biggest problem was paragraphs (b) and (c). He did, by virtue of getting the loans, hiring the accountant, and so on, participate in both the day-to-day and financial operations. Moreover, the court found that he was aware of the charity's failure to pay payroll taxes. In shooting down Jefferson's argument, the court cited to Bowlen v. United States, 956 F.2d 723, 728 (7th Cir. 1992) and found that, in order to be exempt under 6672(e), one could not, by definition, be a 'responsible person'. As the Court noted, "[t]he term “honorary” suggests a lack of power, a lack of responsibility, and a corresponding lack of ability to do harm—factors that do not apply to the instant case."

In the end, Jefferson was tagged with over $40,000.00 in payroll taxes. The message here is clear: if you are asked, or for professional reasons decide, to join the board of a non-profit group, be sure to check your 'can do' attitude at the door lest you, too, find yourself in a pickle. The more involved you get in the day-to-day, or financial, operations of the non-profit, the more likely you are to expose yourself to tax liability should that organization fail to pay their taxes when due.

Monday, September 29, 2008

Is my stock worthless? Part I

Stock which is worthless results in a capital loss. However, the devil lies in the details, and in this instance, the details are important

Say a long-time client comes to your office, with a stack of yellowed papers and tells you that he ‘found these while cleaning out some boxes in the attic over the summer,’ and his ‘co-worker/neighbor/friend told him that he could write these off as a loss’. He also tells you that the papers are the ‘buys’, that he has never received dividends on these stocks, and that he has no other records. Does the client have a deductible capital loss?

It’s up to the tax preparer at this point to do some hard research. Find out if the stock was ever acquired by another company (depending on the industry, this very well may be what happened). Usually, the acquiring company will have traded their stock for stock in the old company (such as Chase trading its stock for that of Bear Stearns and WaMu), and such a trade can still be affected via a broker or the acquiring company. If for some reason, the opportunity to trade in the stock has passed, then your client does not have worthless stock, but potentially a capital gain or loss based on the value of the stock on the date of the trade. A well-organized client can assist greatly in this research (they may remember getting some kind of letter, but not understanding the contents, merely filed it without action), but more likely than not the client’s records (and memory) will be spotty at best.

If the stock has not been acquired, and research turns up no quotes on the major markets, then you likely have a worthless stock – provided three hurdles can be met. The first hurdle is determining whether the stock is truly worthless. It’s not enough that the stock was delisted from the NYSE or NASDAQ, since both exchanges have minimum capitalization amounts and other rules (such as annual listing fees) which impact whether or not a stock remains listed, and since other viable trading alternatives remain. For example, if a stock has been delisted, investors can still trade the stocks over the counter, in the so-called ‘pink sheet’ market. One might also be able to sell the stock to a broker or other party who specializes in such trades. If any or all of these options exist, a market for the stock exists, and therefore it is not worthless. Although delisting can be an indicator of poor financial health, in order to be truly worthless, no market must exist for the stock, and there must be no likelihood that investors will ever recover their investment (or such recovery must be highly unlikely). A prime example of such an instance is Enron, whose stock was cancelled and whose website states: “it is not believed that the value of Enron Corp.’s assets will exceed the amount of its allowed claims. Therefore, we do not expect the Enron Bankruptcy Estate to ever make distributions to the former holders of Enron Corp. stock.”[fn.1]

If no one – not even your aunt Mabel – is willing to take a risk on your stock, then you’ve cleared the first hurdle to meeting the ‘worthless’ definition. You still need to clear two more hurdles.

The second hurdle is the ‘no likelihood of recovery’ hurdle. Generally speaking, if the company has filed for bankruptcy protection, this hurdle is easy to clear – secured investors will get something, common stockholders won’t. If the company ceased operations without a bankruptcy filing, then further investigation is warranted (if possible) into whether the company was in receivership or some other avenue was made to repay investors some or all of their investment. If so, the client’s recourse is to claim that repayment, and possibly deduct any shortage which results in a capital loss.

Unfortunately, one hurdle still remains, and it’s the one most likely to disappoint your client. Section 165(g)(1) requires the recognition of the capital loss as of the end of the year in which the security became worthless (exactly when during the year that the security became worthless is irrelevant; on a tax return, it is reported as of the last day of the tax year) . And that’s usually the rocks upon which the client’s ship runs aground. Unless you can point to a date within the previous year (or a date during a prior year which can still be amended)[fn. 2], you’re likely to have an unrecognizable loss. Generally speaking, you’ll be able to determine that no market exists because you’ll look at an online listing in Yahoo! or similar source and see no current trading on any market, but that source will only tell you when trading on the shares ceased (and in some instances, will only give a date, not a year!). It won’t tell you whether investors have any hope of recovery of funds (hurdle two) or when that determination was made (hurdle three). Unless you can reasonably determine when those two events occurred, the client cannot recognize the capital loss.

Thus the lesson to be learned: Clients who do not keep good records, or closely track the myriad of small holdings that they may have, run the risk of missing out on an important deduction, or finding themselves subject to an unpleasant surprise down the road. It’s important for tax preparers to ask a new client – and even existing clients – when they purchased their home, as well as reviewing a client’s financial holdings on a regular basis. If a client owns a dividend-paying stock which stops paying dividends, don’t let the stock slip through the cracks – it may be in a downward spiral, and should be monitored. (The same goes for stocks which are still paying dividends, but the dividend is less than $1.00.) It’s also a good idea to avoid the temptation to go ‘completely electronic’ and maintain at least some client records in an accessible ‘permanent file’ in the event the client forgets, or loses, their copies. Although this won’t catch every problem, it may trigger the client’s memory before it’s too late.


[1] See: http://www.enron.com/index.php?option=com_content&task=view&id=17&Itemid=27#41. Last accessed September 29, 2008.

[2] In this instance, the period to amend the return is extended to seven years, instead of the general three year limit. See Publication 550.

When a home sale could result in capital gain

Given the current economic situation, a taxpayer selling their home may not be a frequent occurrence, but tax preparers should still be vigilant. It’s all too easy to look a the current mortgage rules – exempting the first $250,000.00 to $500,000.00 of capital gain – and forget that these rules have only been in force since May, 2007. Prior to May 2007, the old rules – allowing a deferral of gain, provided reinvestment of the funds within two years – were in effect.
Let’s see how forgetting that fact can have an impact:
X, a single homeowner, buys her home in May, 1986 for $100,000.00. In October, 1996 X sells her home for $200,000.00, and files form 2119 to defer the $100,000.00 capital gain. At the same time, X buys her new home, for $225,000.00.
In 2008, X sells her home for $460,000.00, and heads down to Harry’s Tax Service to have her taxes prepared. Harry dutifully notes that the cost basis of the home was $225,000.00, the sales price is $460,000.00 and the capital gain is $460,000 less $225,000.00, or $235,000.00. Since the $235,000.00 capital gain is less than the $250,000.00 exemption, Harry claims no capital gains tax.
Sadly, Harry’s wrong, because X’s house was purchased under the old rules, and under the old rules, the basis of the new home must be reduced by any capital gain deferred. Thus, X’s basis in her home isn’t $225,000.00, but $225,000.00 less the deferred gain of $100,000.00, or $125,000.00.
Revisiting the earlier transaction, X’s capital gain is now $335,000.00, or $85,000.00 over the $250,000.00 exemption amount. X might not be happy to hear that she owes capital gain tax, but it’s better you tell her while preparing her return, then having her show up in your office with a CP2000 letter telling her she has a balance due of not only the capital gain tax amount, but the refund that she received!

Tuesday, April 29, 2008

This just in....

Yesterday, the Federal Government announced that rebate payments would be going out as soon as today.

Predictably, I got this email today (including spelling and grammar errors):

Over 130 million Americans will receive refunds as
part of President Bush program to jumpstart the economy.

Our records indicate that you are qualified to receive the
2008 Economic Stimulus Refund.

The fastest and easiest way to receive your refund is by
direct deposit to your checking/savings account.

Please click on the link and fill out the form and submit
before May 01th, 2008 to ensure that your refund will be
processed as soon as possible.

Submitting your form on May 01th, 2008 or later means that
your refund will be delayed due to the volume of requests we
anticipate for the Economic Stimulus Refund.

To access Economic Stimulus Refund, please click here.

And here I thought that the payment would be made in the same manner as my tax refund. Foolish me.

Monday, April 28, 2008

The siren call of the Home Office Deduction...

As tax season approaches, prognosticators start to write on 'hidden' or 'secret' (or some other descriptive term) tax deductions, telling taxpayers not to 'miss out' on these 'tax saving' devices. One deduction which almost always seems to make the list is the infamous Home Office deduction.

In fact the myth of the missing home office deduction has become so prevelant that the House Committee on Small Business recently jumped on the bandwagon. But is it really a good idea? And does it deserve the hype it continually gets?


Now that's a daring comment, because most tax writers, and many tax practitioners would disagree with me. But hear me out.

First, The Rules:

In order to deduct a home office, you must observe some rules, which the House Committee recently called 'inordinately complex'. Here they are, courtesy of IRS Publication 587 and their 'tax tips':
  1. The 'office' area must be exclusively used as a home office. This is the sticking point for a lot of people. Frequently, people will convert a portion of a larger room (say, a den) to an 'office' area, and wonder if they can claim a home office. The quick answer? No. The key here is the phrase 'separately identifiable space'. If all you've done is stick a desk in the corner, it's not enough to qualify for a home office deduction.
  2. The area must be the principal place of business for your business. Ok, so it sounds wordy. But it's actually pretty straightforward, because all you have to do is answer one simple question: When someone at a cocktail party asks you where your office is, what do you say? If you say "I have an office at my home," then your home office is most likely your 'principal place of business'. But if you say "I'm in the Smith-Jones building" and never mention the home office, then your home office fails this test. It's that simple.
  3. The area must be the place in your home where you regularly meet with or deal with patients, clients, or customers only. Again, pretty straightforward if you think about it. Say Suzie Client comes over. You show her into the office in the back. So far so good. But then Bill Buddy comes over, and he stops there as well. Now you might have a problem. If Bill comes there because you're there, and the two of you immediately repair to the den, it's not as much of a problem as if you and Bill hang out drinking for a few hours. At that point, you've probably blown the deduction (though a one-time event isn't as bad as doing that every Saturday).
  4. The area must be used for a trade or business. This one almost seems to belong in the 'huh?' category - as in 'can it be more obvious?' After all, this is a home office we're talking about. But realize that this little provision means that you can't claim a home office for using that third bedroom to do your stock trades unless you are a legitimate trader.
That's it. Sure, you have to calculate just how much of your home is an office, but by comparison, that's pretty straightforward. If you can meet the requirements above, you're eligible to claim a home office deduction, which means deducting part of your mortgage/rent, utilities and other expenses. Even better, it means that you just might be able to write off more of the mileage on your new Hummer.

But the real question here is: Do you want to?

Tomorrow: Why taking the home office deduction is a bad idea.

Saturday, April 19, 2008

The Myth of 'But my buddy told me...' PART I

All too frequently, I find myself having to explain to a client that the deduction they want to claim is, in fact, not a deduction at all. Often, this explanation is prefaced by the client telling me "my buddy/friend/co-worker/cousin/neighbor/trusted-adviser told me that I could write off..."

Case in point: the lovely Unreimbursed Employee Business Expense (or UEBE, for short).

The purpose of the UEBE is to allow employees to deduct job-related expenses that are not reimbursed by their employer. The actual result is that all too often employees try to deduct expenses that don't qualify. Legitimate expenses here include Union Dues, Trade Publications, Education Expenses and Meal and Entertainment Expenses. There's also the ability in most tax software to add 'other' expenses.

The problem is that people liberally define terms. Take 'business and trade publications'. It's one thing to subscribe to the Journal of Accountancy if you're a CPA - after all, it's not exactly a person's first choice (or even their eighth choice) in the doctor's office. It's quite another to - as one client of mine tried - deduct your People subscription because, as she put it "I need to be informed when I talk to my customers". She was a hairdresser. I've seen people try to justify deductions of Newsweek, Time, the local newspaper, US, and numerous other publications as 'business' or 'trade' related (one actor claimed that his deduction for Entertainment Weekly was a necessary expense, because he had to know what was going on in his business). Even your subscription to Money doesn't fall here (at best, it's a deduction under investment expenses).

And then there are the 'grey-area' things. Take flight attendants, for example. They love to deduct everything even remotely related to their job, because they feel they make so little money anyway. Some of their expenses - such as uniforms and union dues - are explicitly permitted, while others - such as luggage, the cost of trip trades, tips to drivers who pick them up at the hotel - fall under the 'ordinary and necessary' guide lines. Some, such as wristwatches, are explicitly prohibited. But others - such as nylons/support hose, shoes, makeup, manicures/pedicures, and the cost of hairstyles/cuts - fall into that 'grey area'. Sure, you can make an argument that they are ' common and accepted in your trade, business, or profession' and 'appropriate and helpful to your business,' both of which must be met to have a deductible expense. In fact, I've had several flight attendants tell me that they are required to wear makeup on the job. But...does it make the make up a deductible expense?

Sadly, no. What makes this difficult to comprehend for most people is that the IRS gives little comprehensive guidance as to what can and cannot be deducted by profession, so most people are left to interpret on their own what is a true expense. Hence the myth of 'my buddy told me...'

The IRS disallows as a deduction work clothing that is 1) not required by the employer and 2) suitable for everyday wear. As a result, an attorney cannot deduct the cost of a suit, even though it's foolish to show up in court with anything less (pro se litigants excepted). And since makeup, manicures/pedicures, and hairstyles and cuts are definitely 'suitable for everyday wear' (and since the impact of the mani/pedi and haircut last more than a day) they are non-deductible. The tougher argument is for nylons or shoes - flight attendants argue over these items as well, claiming that they don't wear the nylons/shoes elsewhere. However, this is a loser too, since the IRS specifically says that '[t]he clothing must not be suitable for taking the place of your regular clothing.' So even though you only wear those shoes on the plane, if there's any way they could be worn off the plane, you can't deduct them. Just because you choose not to wear them elsewhere is irrelevant. You could, so it's not a deduction.

So is the UEBE ever useful? And when? That's Part II.

Friday, April 18, 2008

Recovering from Tax Season

As the post-tax-season recovery begins, it bears taking some time to review the last 10 weeks....
  1. This was easily my busiest tax season: 270 tax returns, and counting, as a few are still outstanding via extension. Most should be wrapped up in the next two weeks, though some will take longer.
  2. Considering that tax season is roughly 10 weeks long, that translates to 27 returns a week, or about 4.5 returns a day. The busiest days were February 18th and April 14th when I saw 8 clients. Most days averaged 5-6.
  3. Typically, the early part of the season was slow; surprisingly, so was the late part. I actually had time open on April 15th.
  4. 17 years in, I'm still amazed to see how seriously people take the advice of a friend on tax issues, and discount what I'm telling them as true.
In the coming weeks, I'll discuss some of the more interesting myths of this tax season, and what kind of deductions are available to certain professions. Stay tuned.