Tax and Business Alert - 

August 2005

New IRS Guidelines for Vehicle Deductions

Following changes made by the 2004 American Jobs Creation Act (2004 Act), the allowable charitable contribution deduction for a vehicle valued at more than $500 depends on the charity's use of the vehicle. If the charity sells the vehicle without significantly using it in the intervening period or prior to making material improvements to it, the charitable deduction is limited to the proceeds received from the vehicle's sale. In either case, the actual fair market value (FMV) of the vehicle is irrelevant.
However, if the charity significantly uses the vehicle in the intervening period before its sale or makes material improvements to it prior to the sale, the donor's deduction is not limited to the gross sales proceeds. Instead, it can be valued using any reasonable method, including the use of an established used car pricing guide.

The IRS recently released additional guidance on these new rules to help taxpayers gain a better understanding of terms like "intervening use" and "material improvement." As noted, the 2004 Act provides some exceptions under which a donor can claim a FMV deduction. If the charity makes a significant intervening use of a vehicle, the donor can deduct the full FMV. The new guidance explains that a significant intervening use can include, for example, driving a vehicle a total of 10,000 miles over a one-year period to deliver Meals on Wheels®. The new guidance also indicates that a material improvement means major repairs that significantly increase the value of a vehicle, but not the mere painting or cleaning of the vehicle.

The IRS has also authorized an additional exception to the sale price limitation that was not included in the 2004 Act. A donor can claim a deduction for the full FMV of a donated vehicle if the charity gives or sells the vehicle at a significantly below-market price to a needy individual, as long as the transfer furthers the charitable purpose of helping a poor person in need of transportation.

The new guidance also explains how to determine the vehicle's FMV if one of these three exceptions applies. Generally, vehicle pricing guidelines and publications differentiate between trade-in, private-party, and dealer retail prices. According to the new IRS guidance, the FMV for vehicle donation purposes will be no higher than the private-party price.

Flexible Spending Account Use It or Lose It Rule Relaxed

With a Health Care Flexible Spending Account (FSA), an employee elects annually to have a specified dollar amount of salary withheld from his or her paycheck and contributed to a personal FSA. The funds contained in the FSA account are then used to pay or reimburse qualified expenses, including the employee's uninsured medical costs, using pretax dollars. However, if the employee fails to completely drain the account by the end of the year, any leftover dollars revert to the employer--the so-called "use it or lose it" rule.

The IRS recently released a new provision that will allow (but not require) employers to modify FSAs to extend the deadline for reimbursing health and dependent care expenses. Employers can extend the deadline by up to 2 ½ months after the end of the plan year Note that during the new optional grace period, the FSA can't permit unused benefits or contributions to be cashed-out or converted to any other taxable or nontaxable benefit.

If there are still unused benefits after the 2 ½ month grace period, they are forfeited. Employers can, but are not required to, adopt this 2 ½ -month grace period for the current and future plan years by amending the cafeteria plan document containing the provision for FSAs before the end of the current plan year.

Tax Freedom Day®

According to information posted on www.taxfoundation.org, Tax Freedom Day® falls on April 17 for 2005, two days later than it did last year. The Tax Foundation states that: "Tax Freedom Day® is the day when Americans will finally have earned enough money to pay off their total tax bill for the year. Every dollar that's officially called income by the government is counted, and every payment to the government that is officially considered a tax is counted. Taxes at all levels of government are included, whether levied by Uncle Sam or state and local governments."

What Your Beneficiaries Should Know about Your Traditional IRA's

Not many of us like to face the fact that the day will eventually come when our beneficiary or beneficiaries will inherit at least a portion of our traditional IRA accounts. These accounts maintain some beneficial tax-saving attributes while we live and some very firm distribution guidelines that take effect after we die. An informative letter to your beneficiaries indicating the location of your IRA beneficiary forms, the decisions required of beneficiaries within nine months of your death, distribution information, and how to initiate distributions during the year of your death will help ease this transition and could help your beneficiaries save on taxes and penalties as well.

Benefits of a QTIP Trust

As you are probably aware, most assets transferred to a surviving spouse are free from estate tax due to the unlimited marital deduction. But, quite often, individuals want to transfer specific income-generating assets to their surviving spouse on an interim basis, allowing the earnings from those assets to provide lifetime support for him or her, and subsequently have those same assets, or the residue thereof, transferred to their children or other beneficiaries upon the death of their spouse. However, in many situations, transferring outright ownership of significant assets to one's spouse may be undesirable.

There is a better approach. Transferring qualified terminable interest property (QTIP) to a trust (known as a QTIP trust), allows the decedent to transfer assets, which will be held for the surviving spouse's benefit, free of estate tax. A valid QTIP trust must meet the following requirements: (1) all trust income must be payable to the surviving spouse, at least annually for life; (2) trust assets cannot be appointed or distributed during the surviving spouse's life to any person other than the surviving spouse; (3) the trust may hold assets that do not generate income only if the trust document requires or permits the surviving spouse to require the trustee to either make the property productive or convert it to productive property; and (4) the decedent's executor must elect on a timely filed estate tax return to have some or all of the trust property qualify for the marital deduction.

The surviving spouse gets an income stream from the QTIP trust, but the decedent controls (through his or her will) the property's ultimate disposition when the survivor dies. The QTIP trust can allow the trustee to make discretionary principal distributions to the surviving spouse (but no one else). The property owner (decedent) usually names the person or organization that will receive any remaining trust property at the survivor's death. Individuals with children from a previous marriage (or other beneficiaries) often want to provide an income stream for their spouse, but also want assurance that their children (or other beneficiaries) will receive the assets at the spouse's death. An outright property transfer to the surviving spouse will not provide that assurance.

Surviving spouses often remarry and any property they own outright could be subject to an ownership claim by the new spouse. Although this could be avoided with a well-drafted prenuptial agreement, there is no guarantee that the survivor will enter into such an agreement. Property held in a QTIP trust for the surviving spouse's benefit generally will not be subject to claims by that person's future spouse. Finally, some organizations prey upon individuals who have lost a spouse, sometimes convincing them to assign a large portion of their assets to the organization. Assets in a QTIP trust cannot be assigned.

A QTIP trust guards against anyone other than the person named by the decedent from gaining ownership of the property while providing income to the surviving spouse. Also, this property is removed from the taxable estate of the first to die. But, if not consumed or gifted away during the survivor's life, it is subject to estate tax when the surviving spouse dies.

A will can be drafted to reduce the estate tax at the first death to the lowest possible amount by transferring all assets that would otherwise be taxed to the QTIP trust and electing to claim the marital deduction. Or, the will can give the executor flexibility to decide the amount of property for which the QTIP election is made based on the couple's circumstances when the first spouse dies. Using a QTIP trust is an important consideration for meeting both tax and non-tax goals for your estate.

Maximizing Tax Deductions for Inventory

For many business owners, inventory represents a significant cost and is one of their biggest business concerns. A business generally must maintain inventories for income tax reporting if producing, purchasing, or selling merchandise is material to its income. However, taxpayers may choose their method for valuing the cost of ending inventory, which gives them some control over their cost of goods sold and taxable income. (The lower the ending inventory, the higher the cost of goods sold deduction.)

The IRS allows a deduction for inventory shrinkage (i.e., undetected losses due to theft, breakage, bookkeeping errors, and similar occurrences) based on estimated shrinkage each year. Since many businesses do not take a physical inventory on the last day of the tax year, this accelerates their deduction into the year the shrinkage occurs, rather than waiting until the year the inventory is counted.

For retailers, a safe harbor method for estimating shrinkage is available. The business's actual shrinkage for the most recent three years (as a percentage of sales for those years) is multiplied by current sales to compute the shrinkage deduction. Taxpayers that are not retailers (as well as retailers who choose not to use the safe harbor method) can use any other accounting method to estimate shrinkage, as long as it clearly reflects income. The advantage of using the safe harbor method is that the IRS will not challenge it.

Another way to minimize taxable income is to establish effective procedures for identifying inventory that cannot be sold at normal prices (e.g., damaged or obsolete items). Taxpayers can write these so-called subnormal goods down to the price at which they are offered to the public, even if the goods are not actually sold. The key is to identify the goods and offer them for sale within 30 days after the inventory date (generally, year-end).

Finally, the lower of cost or market (LCM) method of inventory accounting is a rare exception to the general rule that tax losses are not deducted until realized. Under the LCM method, the taxpayer deducts the amount by which the inventory's market value declines below cost. If the inventory's value is stable, or the inventory turns quickly, the additional work required under the LCM method may not be warranted. But, in some situations, adopting the LCM method for inventory accounting may be beneficial.