Tax and Business Alert - April 2003

IRS Liberalizes Home Sale Gain Recognition Rules

The IRS recently issued new regulations that affect home owners in a number of ways. You can generally exclude from taxable income up to $250,000 ($500,000 for qualifying joint filers) of gain from the sale of a home you owned and used as your principal residence for at least two of the five years before the sale. The new regulations liberalize the rules for taxpayers who use a portion of their home for business purposes, sell their home earlier than allowed (the two of five year requirement), or sell vacant land adjacent to their home in a separate transaction. The new regulations apply generally to sales or exchanges after December 23, 2002, but the benefits of the new regulations can extend back as far as May 7, 1997 (see Tax saving opportunity below).

Selling residential property used partially for business (mixed-use property)

Previously, you could not exclude from taxable income any gain on the sale of your residence attributable to that portion used for a business purpose.

The new regulations adopt a more liberal stance on the disposition of mixed-use property. Where the residential and nonresidential portions of the property are within the same dwelling unit, you are no longer required to allocate any portion of the gain on sale to the nonresidential portion. However, gain to the extent of depreciation claimed after May 6, 1997, is not excludable from taxable income and is subject to taxation.

Partial home sale exclusion

The new regulations may allow you to exclude a portion of your residential sale gain from income even if you (a) fail to meet the two out of five year ownership and use rule or (b) if you previously sold another home within the two-year period ending on the sale date of the current home in a transaction to which the exclusion applied. Simply stated, if you sell your principal residence due to employment or health reasons or other unforeseen circumstances (recognized or allowed by the IRS) and fail to meet the two out of five year ownership and use rule, you may still qualify for a portion of the $250,000 ($500,000 for qualifying joint filers) home sale exclusion. An IRS-prescribed formula is used to determine the portion of your gain that is excludable from taxable income.

Selling vacant land

Previously, a sale of vacant land that did not include a dwelling unit would not qualify as the sale of a residence. Under the new regulations, any gain from the sale or exchange of vacant land that you owned and used as part of your principal residence and where the sale or exchange of the dwelling unit occurs within two years before or after the sale or exchange of the vacant land may be excluded from taxable income (subject to the limitations). To qualify, the vacant land must be adjacent to the land containing the dwelling unit and the sale or exchange of the vacant land must satisfy all other IRS requirements.

Tax saving opportunity

The new regulations are generally effective for sales or exchanges after December 23, 2002. However, if you would otherwise qualify under the new regulations to retroactively exclude the gain on the sale or exchange of your principal residence you may elect to apply the new regulations. The transactions must have occurred between May 6, 1997, and December 24, 2002. You may apply for the exclusion in any open year (generally 2000, 2001, and 2002) and apply for a refund by filing an amended tax return.

Tax Calendar

April 15
-- Besides being the last day to file (or extend) your 2002 return and pay any tax that is due, 2003 first quarter estimated tax payments for individuals, trusts, and calendar-year corporations are also due today, So are 2002 returns for trusts and calendar-year partnerships and LLCs, plus any final contribution you plan to make to a traditional or Roth IRA or Education Savings Account for 2002. (SEP and Keogh contributions are also due today if your return is not being extended.)
-- If you need to file a 2002 gift tax return, it also must be filed or extended by this date.
April 30
-- For those with employees, a federal unemployment tax deposit is due if the liability through March 31 exceeds $ 100.
-- The first quarter Form 941 (Employer's Quarterly Federal Tax Return) is also due today (except that you have until May 12 to file if you deposited all taxes for the quarter when they were due).
June 16
-- The second quarter estimated tax payments for individuals, trusts, and calendar-year corporations are due today.

What's New in Retirement Planning for 2003?

Elective deferral limits. The elective deferral limits for 401(k), 403(b), and 457 plans increase to $12,000 in 2003 from $ 11,000 in 2002. If you are at least age 50 by year end, the catch-up contribution increases to $2,000 in 2003 from $1,000 in 2002. So, if you will be age 50 or more by year-end, you can elect to defer up to $14,000.

SIMPLE plan deferrals

The deferral limit for your SIMPLE plan has also increased in 2003 to $8,000 from $7000 in 2002. An additional $1,000 can be deferred in 2003 if you are at least age 50 by year-end, up from $500 in 2002.

Roth IRA earnings

Roth IRA earnings can be withdrawn tax- and penalty-free for the first time in 2003. Your first opportunity to make a Roth IRA contribution was in 1998 and tax-free withdrawals of earnings were restricted for five years and until you reached age 59. Therefore, if you made a contribution to a Roth IRA in 1998 and you are now 59 or older, you can make a tax- and penalty-free withdrawal of earnings from any of your Roth IRAs.

Interesting Websites

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You can refer your teenage children and grandchildren to www.teenshealth.org for honest, accurate information and advice about health, relationships, and growing up. Created by the Nemours Foundation's Center for Children's Health Media, Teens Health and Kids Health provide teens and families with accurate, up-to-date, and jargon-free health information they can use.

IRS Provides Relief for Missed IRA and Pension Rollover Deadlines

You have 60 days to make a tax-free rollover transaction after funds are withdrawn from your IRA or other tax-advantaged retirement account. For this purpose, the 60-day period starts on the day after the distributed funds are received. There apparently is no extension when the 60-day period ends on a weekend or holiday.

Failure to meet the 60-day deadline results in the withdrawal being treated as a taxable distribution. To add insult to injury, the 10% premature withdrawal tax will generally apply if you are under age 59½ . Historically, the IRS has shown little inclination to grant relief from this unpleasant tax outcome, even when missing the deadline was clearly due to circumstances beyond your control.

However, the Economic Growth and Tax Relief Reconciliation Act of 2001 included a little-noticed provision giving the IRS statutory authority to waive the 60-day rule when: (a) the taxpayer is affected by a casualty, disaster, or other event beyond his or her reasonable control; and (b) not waiving the 60-day rule would be "against equity or good conscience".

The IRS recently delivered specific guidance on circumstances where the 60-day rule will be waived. In a nutshell, the IRS will grant automatic waivers for failed rollovers caused by financial institution errors. Otherwise, you must use the private letter ruling process to request waivers on the grounds of hardship.

Note: Only distributions occurring after 12/31/01 are eligible for relief under the new rules.

Failed rollovers caused by financial institution errors

The IRS will automatically waive the 60-day rollover rule when an error committed by a financial institution causes the taxpayer to miss the deadline. However, such automatic waivers are only available when all of the following requirements are satisfied:

1. The financial institution received the funds before the 60-day rollover period expired.

2. The taxpayer gave instructions to deposit the funds into an eligible retirement plan.

3. The taxpayer followed all the financial institution's procedures for depositing the funds into and eligible retirement plan within the 60day period.

4. The failure to deposit the funds into an eligible retirement plan within the 60-day rollover period was solely due to the financial institution's error.

5. A valid rollover would have resulted had the financial institution deposited the funds as instructed.

6. The funds were actually deposited into an eligible retirement plan within one year from the beginning of the 60-day rollover period.

Applicable financial institution errors apparently include bookkeeping mistakes that result in an account not being credited with the funds the taxpayer intended to roll over until after the end of the 60-day deadline and deposits placed into the wrong account.

"Hardship waivers" can be obtained by private letter ruling

Taxpayers ineligible for automatic waivers may still be able to obtain relief on hardship grounds by requesting waivers via the private letter ruling process. In this · scenario, after considering all relevant facts and circumstances, the IRS will agree to waive the 60-day rule when not doing so would be against equity or good conscience, including situations involving casualty, disaster, or other events beyond the reasonable control of the taxpayer.

Recommendation

The best way to avoid failed rollover transactions is to closely monitor the situation to make sure the 60-day rule isn't violated in the first place. Failing that, quickly gather documentation that shows what went wrong and why it wasn't your fault.

Use Donor-advised Funds for Controlled Charitable Giving

Donor-advised funds, also known as charitable gift or philanthropic funds, allow you to make a charitable contribution (usually in the form of stock or mutual fund shares) to a specific public charity or community foundation that uses these assets to establish a separate fund. The public charity or community foundation typically receives grant requests from charities seeking distributions from the advised fund, and you (as donor) suggest which grant requests should be honored. You retain the right, generally during your lifetime, to make recommendations for using the separate fund's income and principal. However, you can only make recommendations; you cannot make a binding directive. In effect, you, as the donor, advise rather than direct the fund. Also, the fund is limited to supporting the public charity's exempt purpose.

Donor-advised funds are themselves tax-qualified charities. Contributions are therefore tax deductible under the standard rules for public charities. Donor-advised funds offer the following tax advantages:

· The contributions to the fund are tax-deductible immediately even though the fund may not disburse them to your recommended charity right away. Thus, you may claim a tax deduction when you are subject to a higher marginal tax rate while actual payouts from the account can be deferred until later, allowing the account to grow in the meantime.

· If appreciated securities (stock or mutual fund shares) that you have held for more than a year are contributed to a donor-advised fund, the full current fair market value can be deducted (subject to the 30% of adjusted gross income limitation). Also, capital gains tax on the appreciation can be avoided.

· The contribution reduces the value of your estate for potential estate tax savings.

In addition to the tax benefits described above, donor-advised funds offer a number of nontax benefits:

· You have more control over how your contributions are invested and distributed when compared with a contribution to most charities.

· Expert advice on grant making and administrative services may be provided.

· Fund operating expenses are usually low.

· You have the convenience of being able to defer to your donor-advised funds when solicited for charitable contributions.

Some donor-advised funds allow donors to name successor advisers for the account. Successor advisors can then continue to recommend how donations are spent long after the original donor is gone. Preferably, the successor adviser can name yet another successor adviser to follow in his or her footsteps. In this way, control over how contributions are spent can continue indefinitely.

Major mutual fund companies have established donor-advised funds. Typically, minimum initial contributions are in the range of $10,000 to $50,000, depending on the fund. Later contributions can be made in smaller amounts. The fund generally handles all of the administrative aspects.