Tax and Business Alert - 

April 2005

Why Develop a Business Succession Plan?

Like most people, business owners are usually concerned about their own financial security, providing for their loved ones, and keeping their family happy. However, closely held business owners may have the additional concern of keeping the business successful after they are no longer running it, since they (or their family members) could depend on the business to provide continuing financial resources.

A closely held business often represents the business owner's most significant asset. In addition, many business owners have strong loyalties to employees and customers with whom they have worked for many years. Planning for the transfer of ownership and management control can ensure that (a) the value of the business is preserved for the owner's dependents; (b) loyal employees maintain their jobs; and (c) established customers are well-served.

The amount of financial resources available to the owner (or the owner's family) when he or she is no longer working may be limited by the business's value. Planning for ownership and management succession actually enhances value because planning minimizes potentially costly disruptions and disagreements that can take place when the transition happens without preparation.

Without planning, it is very likely that the value of the business will decline because the management successor is inexperienced, unprepared, or not well-received by key employees, customers, suppliers, or other important third parties. Also, a sound succession plan can help minimize estate taxes on the business and provide liquidity to the owner's estate. In addition, the succession plan can be structured to minimize income taxes on business income or the eventual sale of the business. Both measures preserve cash resources and enhance the security of the owner and his or her dependents.

Some business owners anticipate and plan for their retirement. Others cannot envision life without the business and have no intention of retiring. Even those who have no intention of retiring must realistically acknowledge that circumstances beyond their control may force them to stop working at some point. An exit strategy can help to ensure that the owner and his or her family will be able to withdraw adequate financial resources from the business at the owner's retirement, whether voluntary or not.

Tax Calendar

April 15 -
Besides being the last day to file (or extend) your 2004 personal return and pay any tax that is due, 2005 first quarter estimated tax payments for individuals, trusts, and calendar year corporations are also due today. So are 2004 returns for trusts and calendar-year estates, partnerships and LLCs, plus any final contribution you plan to make to a traditional or Roth IRA or Education Savings Account for 2004. (SEP and Keogh contributions are also due today if your return is not being extended.)

If you need to file a 2004 gift tax return, it also must be filed or extended by this date.

May 2 -
For those with employees, a federal unemployment tax (FUTA) deposit is due if the FUTA liability through March 31 exceeds $500.

The first quarter Form 941 (Employer's Quarterly Federal Tax Return) is also due today (except that you have until May 10 to file if you deposited all taxes for the quarter when they were due).

June 15 -
The second quarter estimated tax payments for individuals, trusts, and calendar-year corporations are due today.

Teacher's $250 Tax Break Still Available

Elementary and secondary school teachers often find themselves paying school-related expenses out of their own pockets. While this unfortunate situation may not change any time soon, a tax break enacted in 2002 and extended by recent legislation provides a bit of relief. Teachers can still deduct up to $250 of unreimbursed expenditures for books, most supplies, computer hardware, other equipment, and supplementary materials used in the classroom.

Generally, those eligible for the deduction include a K-12 teacher, instructor, counselor, principal or aide working in a school for at least 900 hours during the school year Teachers incurring school-related expenses in excess of the $250 limit may be entitled to write-off the remainder as a Schedule A miscellaneous itemized deduction.

We recommend that teachers eligible for this deduction note on each receipt the date, amount, and purpose for the school-related expense. That way, they will have the necessary documentation on hand at tax return time.

Health Savings Accounts

Health Savings Accounts (HSAs) were created by federal legislation in 2003 as a tax-favored framework to provide health care benefits. HSAs are targeted mainly at the self-employed, small business owners, and employees of small to medium sized companies. These folks often don't have access to health insurance and are receptive to having only bare-bones coverage because it costs less.

Since HSAs are relatively new, many eligible participants have questions concerning their applicability and suitability. HSA Insider at www.hsainsider.com is an excellent resource for information about HSAs, available qualifying high-deductible health insurance coverage by state, and available HSA trustees and custodians (including their fees and investment options).

Using QDRO's to Divide Qualified Plan Assets in Divorce

When a couple divorces, it is often necessary to divide assets held in qualified retirement plan accounts [e.g., Section 401(k), profit sharing or pension plan accounts] to equitably divide the marital property. When your qualified plan assets are divided in divorce, a qualified domestic relations order (QDRO) is critical. A QDRO is any judgment, decree or order that (a) creates or recognizes the existence of an alternate payee's (e.g., your former spouse's) right to some, or all, of the participant's (your) qualified plan benefits; (b) is made pursuant to a state domestic relations order; and (c) relates to providing child support, alimony, or marital property rights of a spouse, former spouse, child, or other dependent of the plan participant. IRAs are not qualified plans and, therefore, are not subject to the QDRO rules.

Without a QDRO, distributions from your qualified retirement plan to another person are treated as paid to that person on your behalf. Thus, you are taxed on the distribution as if you had received it and then given the cash to the other person (e.g., your former spouse). In this situation, you receive no deduction for the deemed transfer to, for example, your former spouse, and the entire distribution is taxable to you in the year received. Clearly, this is the worst possible result you might expect. However, distributions under a QDRO are taxed to the recipient (e.g., your former spouse) when received by that person. The 10% early distribution penalty tax does not apply to any distribution to an alternate payee pursuant to a QDRO, regardless of the alternate payee's age when he or she receives it.

Generally, the alternate payee is assigned the participant's tax attributes under the plan. If the alternate payee is your spouse or former spouse, any distribution received by that person will qualify for rollover treatment to an IRA. A properly rolled over distribution is not taxed until it is subsequently withdrawn from the IRA. To qualify for tax deferral the distribution must be rolled into the IRA within 60 days of receipt. The funds should be transferred directly from the distributing plan to the receiving IRA (a trustee-to-trustee transfer) to avoid the 20% withholding that is imposed if a distribution is made directly to the recipient. However, the QDRO exception to the 10% early distribution penalty tax does not apply to distributions from IRAs.

A rollover to an IRA allows the alternate payee to control the account's investment. It may also be attractive when the alternate payee wants to sever ties that connect him or her to the former spouse.

If the alternate payee is under age 59¼, rolling over a plan distribution made under a QDRO to an IRA may not be advisable. Subsequent IRA distributions before age 59¼ would generally be subject to the 10% early distribution penalty tax. If the plan allows, a better solution may be to leave the funds in a segregated account with the plan trustee. Future distributions from the segregated account pursuant to the QDRO would not be subject to the early distribution penalty tax even if made before age 59¼.

Caution: Although qualified plan assets can be divided between spouses using a QDRO, the beneficiary form (not the QDRO or divorce decree) determines who gets the participant's share of the assets (the non-QDRO assets) at the participant's death. It is, therefore, very important for the participant whose spouse has been listed as beneficiary to execute new beneficiary forms, preferably at the same time the divorce decree is signed. Otherwise, the ex-spouse may receive the participant's share of the funds, as well as the QDRO assets, a costly oversight.

Overview of Exchange-Traded Funds

Like mutual funds, exchange-traded funds (ETFs) offer investors a simple method of investing in portfolios of stocks. Index ETFs closely track the performance and dividend yield of specific market indexes such as the S&P 500® Index. ETFs give investors the opportunity to buy or sell an entire portfolio of stocks in a single security, as easily as buying or selling a share of stock.

ETFs are similar to traditional mutual funds in that they are an investment structure that pools the assets of its investors and uses professional managers to invest the money to meet clearly identified objectives, such as current income or capital appreciation. Unlike a mutual fund, ETFs are traded like other listed stocks.

All of the buying and selling methods and strategies associated with stocks (e.g., market orders, limit orders, stop orders, and buying on margin) can be used when buying or selling ETFs.

Some benefits of investing in ETFs include:

No sales loads. However, brokerage commissions still apply to the same extent they would to the purchase or sale of any other stock.

Ability to buy or sell at any time during the trading day. Unlike open-end mutual funds that can only be redeemed at the end of the day, ETFs are priced throughout the day and can be bought or sold just like a stock.

Ability to buy on margin. This cannot be done with mutual funds.

Ability to sell short. This cannot be done with mutual funds.

Instant exposure to a diversified portfolio of stocks. There are ETFs representing broad-based market indexes and specific industry sectors.

Relatively low management fees. Expense ratios usually range from 0.15% to 1.0%.

Diversification. By owning an ETF containing the stocks in an entire market index or industry sector, an investor owns a large, diversified number of companies, which gives a degree of protection in case the price of one company in the index goes lower.

Tax efficiency. ETFs provide tax advantages not available with mutual funds.

Additional information on ETFs is available from the American Stock Exchange at www.amex.com.