More 1099 fun for California businesses

If you’re a business owner in California, you might feel a bit overwhelmed with all the tax returns and documents you file. There’s income tax returns, sales tax returns (or use tax returns, if you’re a service provider with over $100,000.00 in gross receipts), business property tax returns, e-waste returns….

And, of course, the ubiquitous 1099. Not that there’s anything wrong with that, except when you have a bunch of small-dollar forms to complete at year end, and poor records to draw from.

In California, as opposed to other states, any nonresident who receives income is subject to backup withholding on income over $1,500.00. What is backup withholding? Well, if you refuse to provide a Taxpayer Identification Number (TIN – essentially your Social Security or Employer ID number) when asked, or try to be clever and give a false/incorrect one, the IRS requires the payor to withhold tax on any payment to you. Normally, that’s it. But for a while now, nonresidents of California have also faced the possibility of losing an additional 7% in withholding to California (the IRS rate is 28%).

Effective January 1 of this year, the rules in California have changed to include residents in the mix. So now it doesn’t matter where you live, if you get California-sourced income, you WILL pay tax, one way or another, on it. There really just isn’t any way to avoid it – however, 7% is still lower than the state’s actual rate of 9%, so….you be the judge.

This just in....

From the IRS newsroom....
Those of you who enjoy the 'fake bake' may soon be paying more for the privilege:
IR-2010-73, June 11, 2010
WASHINGTON — The Internal Revenue Service today issued regulations outlining the administration of a 10-percent excise tax on indoor tanning services that goes into effect on July 1.
The regulations were published today in the Federal Register.
In general, providers of indoor tanning services will collect the tax at the time the purchaser pays for the tanning services. The provider then pays over these amounts to the government, quarterly, along with IRS Form 720, Quarterly Federal Excise Tax Return.
The tax does not apply to phototherapy services performed by a licensed medical professional on his or her premises. The regulations also provide an exception for certain physical fitness facilities that offer tanning as an incidental service to members without a separately identifiable fee.
The IRS and Treasury Department invite comments - provided, of course, that you can wade through the 121 pages of regs...

We're married! Uh, no we're not....

Riddle: When does a divorce not follow a marriage ceremony?

Answer: When the marriage is a common law marriage.


Seem weird? Or maybe you didn't know that 10 states still allow you to form a common law marriage?

It's true: in Alabama, Colorado, DC, Iowa, Kansas, Montana, Rhode Island, SouthCarolina, Texas and Utah, it's still possible to form a common law marriage. Oklahoma's tried to ban them after 1998, but there's a question of whether that ban is valid. And Ohio (1991), Idaho (1996), Georgia (1997) and Pennsylvania (2005) allowed them up until recently (the year indicates the latest year that the requirements could have been satisfied for a valid marriage). New Hampshire will recognize a common law marriage for probate purposes only.

There's a catch: even though you never had a marriage ceremony of any type, if you have a common law marriage, you MUST get divorced for any subsequent marriage to be valid. And even though you cannot form a valid common law marriage in other states, the principle of comity would cause the marriage to be valid if it was formed in a state that did. This makes sense, since couples united in common law marriage have the same rights as those married by a JOP or in a religious ceremony.

Interestingly, the standards for such a marriage are not set in stone. For example, every state requires cohabitation for a common law marriage to be valid, but none specifies how long. When I was in law school, the rumor was 20 years, but in fact the standard seems only to be a 'substantial' period of time, without definition.

The other problem is that many people believe that common law marriage is recognized everywhere (it is, subject to the constraint that it was formed legally) and that it can be legally formed everywhere (it can't). And therein lies the rub - your client tells you he's married, but IS he? You have no affirmative duty to verify (imagine asking your client for a marriage certificate!), so you take him at his word. Then it turns out he wasn't actually married - he thought he was, because he bought into the common law myth - and now your client is forced to revise his return, with negative consequences.

Then there's the flip side - people who WERE common law spouses, who never got a legal divorce, then subsequently 'married' another. Imagine their surprise when you tell them that they aren't married to their new spouse!

Truth is, you'll never really be able to catch these before its too late. Some idle banter ("how'd you guys meet?" and the like) might give you clues to inquire further about the validity of one's marriage, but often this stuff rears its ugly head long after you've prepared the return and generally for an out-of-the blue reason. The best you can do is document, document, document, and keep in mind that all may not be as it seems.

Oh, and lest you think this is just an oddity - I've had two such situations in the last 4 months. Seriously. Fortunately, I've been the guy called in to fix things, but it makes me think every time I prepare a married couple's tax return...

Allowed vs. Allowable

For some odd reason, this tax season I've run across a number of tax returns which fail to calculate depreciation (and it's only February!).

My suspicion is that the prior preparer (not in my office) thought that they'd be clever and not claim depreciation, knowing that it's recaptured when the property is sold. You can't recapture what you haven't taken, right?

Wrong.

The IRS has a principle called 'allowed or allowable'. Here's their take on it:

"You must reduce the basis of property by the depreciation allowed or allowable, whichever is greater. Depreciation allowed is depreciation which you actually deducted (from which you received a tax benefit). Depreciation allowable is depreciation you are entitled to deduct.

If you do not claim depreciation you are entitled to deduct, you must still reduce the basis of the property by the full amount of depreciation allowable.

If you deduct more depreciation than you should, you must reduce your basis by any amount deducted from which you received a tax benefit (the depreciation allowed)."

In short, you're paying tax on the depreciation recapture, whether or not you actually claimed it (and if you claim too much, on the excess, too). So those people who think they're being clever are in for a rude awakening when they sell the property. Sadly, because of depreciation, it is possible to sell a property for less than what you paid for it and still have a gain! Not good news for landlords.

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.

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.

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.