Tax and Business Alert - December 2003

Save Taxes by Employing Family Members

Employing family members (usually children or grandchildren) who are in a lower tax bracket than the business owner can shift taxable income to those individuals, thus reducing the family's overall tax burden. Not only is income shifted from the parent to the child, if the child is a minor, payroll taxes can quite often be avoided. In addition, the child's compensation is earned income, which allows the child to contribute to an IRA.

When a family member is employed, the business owner should handle all transactions with the family member in the same businesslike way as with an unrelated employee. The IRS is inclined to look unfavorably on arrangements that are structured merely to obtain tax advantages.

When a business owner (i.e., sole proprietor, or partner or shareholder in a closely held entity) pays wages to his or her child, the wages are deducted by the business. Although the child is taxed on the wage income, a child's tax rate is often lower than the rate imposed on the business income. Also, a child has the benefit of a standard deduction and, if not a parent's dependent, a personal exemption ($3,050 in 2003) to offset some or all of the wage income.

The 2003 standard deduction for a child who can be claimed as a dependent on another return is the greater of $750 or $250 plus earned income, but not more than the $4,750 amount otherwise allowed a single taxpayer. Thus, for 2003, the standard deduction will shelter up to $4,750 of the child's earned income from tax. The kiddie tax [which taxes unearned income (e.g., interest income) of children under age 14 at their parent's rates] does not apply to earned income.

For younger children, a realistic goal may be to earn $3,000 to fund an annual IRA contribution. Sweeping floors, dusting, entering data into a computer, and filing are examples of tasks that could reasonably be performed. These children might be expected to work an hour or two after school and a few hours on the weekend. A rate much higher than minimum wage would probably be subject to challenge, since that is probably the rate a nonfamily member would be paid for such tasks.

For an older child, the work may be more complex and command a higher wage. Also, an older child can be expected to work longer hours. However, the rate paid must be comparable to what a nonfamily member would be paid for the same work. But, if the child is in college, or entering college soon, and financial aid is a factor in the child's college attendance, having too much earned income can have a detrimental impact on the amount of aid the child might be eligible to receive. Please call us to discuss this and other tax-saving techniques.

Recognizing Losses on Worthless Securities

As a taxpayer, you are allowed to take a capital loss for securities that have become worthless. However, this loss can only be taken when the security becomes totally worthless-- losses for partial worthlessness cannot be claimed. To claim a capital loss, you must first correctly identify the year during which the security becomes completely worthless.

Generally, a security is considered worthless at the time it first has no liquidation value and no reasonable hope or expectation exists that the security will become valuable at some future date. To avoid the "when a security becomes wholly worthless" issue, you should consider selling the security to an unrelated third party. A bona fide sales transaction in which you transfer ownership of the security at a loss should allow you to take the capital loss in the year of the transfer. If you do not or cannot sell the security (a good sign the security is worthless) your decision to claim the loss must be supported by available information.

To provide some relief from the difficulties of determining when a security becomes worthless, the IRS allows a seven-year statute of limitations (instead of the normal three-year period) to file an amended return for refund claims due to losses from worthless securities.

You can offset capital gains with capital losses (including losses from worthless securities), and to the extent there are excess capital losses, up to $3,000 ($1,500 for married filing separate returns) can be deducted against your ordinary income. Remaining capital losses can be carried forward indefinitely, retaining their character as
either short-term or long-term. ·

2004 Toyota Prius Certified for Deduction

The IRS has certified the 2004 Toyota Prius as being eligible for the clean-burning fuel deduction. The certification means individuals who purchase the hybrid vehicle in 2003 may claim a tax deduction of up to $2,000 on their 2003 Form 1040.

Under current law, the clean-burning fuel deduction will be reduced incrementally until it expires beginning in 2007. Purchasers of IRS certified cars can claim a deduction of $2,000 if the vehicle is placed in service on or before December 31, 2003. The $2,000 maximum deduction will be reduced by 25 percent for vehicles placed in service in 2004, by 50 percent in 2005, and by 75 percent in 2006. No deduction will be allowed for vehicles placed in service after 2006.

The one-time deduction must be taken in the year the vehicle is originally used and is only allowed to the original owner. You do not have to itemize deductions to claim the clean burning fuel deduction and both personal-use and business-use vehicles qualify.

The IRS previously certified the Toyota Prius for model years 2001, 2002, and 2003. The IRS also certified the Honda Insight for model years 2000, 2001, and 2002 and the Honda Civic Hybrid for model year 2003.

Interesting Website

Many retirees struggle financially to pay for prescription medications. Although a solution for this growing problem will be difficult to find, help is available. The Pharmaceutical Research and Manufacturers of America (PhRMA) representing 48 member companies (includes many of the leading drug manufacturers) at http://www.helpingpatients.org provides prescription drugs free of charge to patients of all ages who may not have access to necessary medicines. In 2002, PhRMA members provided free prescription medicines to more than 5.5 million patients in the U.S. This online service is free and completely confidential.

Initial Steps When Forming a Nonprofit Entity

You may have an opportunity to become involved in the formation of a nonprofit entity, either individually or within a dedicated group. Nonprofits range in size from small local clubs to large national and international organizations. Their scope covers almost every activity imaginable---health and welfare, religion, research, social entities, and'' professional associations. It is estimated that there are more than one million nonprofit entities in the United States.

Most nonprofit entities must apply for and receive recognition of tax-exempt status from the IRS. Churches, however, do not need to apply for tax-exempt status, but automatically qualify. Often, the only attribute shared by nonprofit entities is their tax-exempt status; their missions and primary activities may be very diverse. Other distinguishing characteristics of nonprofit entities include a lack of profit motive in providing services or goods; their activities relate to religious, charitable, scientific, literary, or educational purposes; and there is an absence of defined ownership interests that may be sold, transferred, redeemed, or liquidated.

Similar to the formation of a for-profit entity, care and due diligence must be exercised when forming a nonprofit entity to avoid future tax and legal problems. Where necessary, professional guidance should be requested. Initial steps when forming a nonprofit entity include:

Filing a Corporate Charter Application

Depending upon its nature and purpose, the nonprofit entity will generally be required to obtain a corporate charter before it can officially begin to operate. A corporate charter application should be filed with the appropriate state government agency (e.g., Secretary of State) or other charter-granting authority. Documentation submitted with the charter application should include, at a minimum, articles of incorporation and bylaws. It is recommended that a licensed attorney be used for preparing and filing the entity's charter application and supporting documentation. The IRS will subsequently examine the articles of incorporation and bylaws when reviewing the entity's application for tax-exempt status.

Obtaining an Employer Identification Number (EIN).
When sufficient information is available, the newly organized nonprofit entity should apply for a federal Employer Identification Number (EIN) from the IRS. The nonprofit entity must obtain an EIN before it can open a bank account or file required federal and state tax and informational returns. Therefore, an EIN should be obtained even though the entity may never hire a single employee.

Open a Financial Institution Checking Account.

Avoiding Unexpected Taxes and Penalties from 401(k) Plan Loans

Many 401(k) plan participants borrow against their vested plan benefits, but are unaware that there can be adverse tax consequences. If the loan amount, terms, and repayment schedule meet specific guidelines and limits, the loan is not considered a taxable distribution by the IRS. In contrast, a loan offset (i.e., where the loan is actually considered repaid by applying a portion of the participant's account against it) is an eligible rollover distribution.

Loan offsets can occur only when distributions are otherwise allowed by the plan, such as when an employee separates from employment. Loan offsets not properly rolled over to another tax-deferred account must be included in the participant's income and are subject to taxation. In addition, the loan offset amount may be subjected to a 10% penalty for early distribution (if the participant is under age 59~ and does not qualify for an exception) and 20% federal income tax (FIT) withholding. When taking a loan from their 401(k) account, eligible participants should plan for the possibility that the loan may have to be repaid early if there is a separation of employment. The following example typifies a situation of which many 401(k) participants may be unaware.

Example: Lisa, age 53, is planning early retirement and wants to rollover her entire 401(k) plan proceeds to a traditional IRA in a tax-free lump sum distribution. Her 401(k) balance is $60,000 and she has a $20,000 plan loan. Lisa has two options.

The preferable way to facilitate the rollover is to repay the $20,000 loan before the distribution. Lisa can then request a direct rollover of the entire $60,000 to an IRA. Here, no taxes will be due and she will avoid the 10% early withdrawal penalty. However, this option does require that Lisa have $20,000 available from a source other than her 401(k) plan to repay her loan.

Lisa can also accomplish a tax-deferred rollover without first repaying the loan, but this procedure is more cumbersome. Here, her employer will offset the $20,000 loan against her $60,000 vested account balance leaving $40,000 in her account. That was relatively simple, but now the process becomes much more complicated. Because the $20,000 loan offset is considered an eligible rollover distribution, it is subject to 20% FIT withholding. Lisa's employer will take the required withholding of $4,000 ($20,000 x 20%) from the $40,000 remaining in her account after the loan offset. This will leave $36,000 in the account, which Lisa can have directly rolled over to an IRA. If this ($36,000) is all that Lisa rolls over, she will have to include $24,000 ($20,000 loan and $4,000 FIT withholding) in her taxable gross income. In addition, she will be assessed a 10% early withdrawal penalty of $2,400 ($24,000 x 10%) since she is under age 59½ (unless an exception applies).

To accomplish a totally tax-free rollover in the second scenario, Lisa must transfer $60,000 (her total vested balance) to her IRA. Therefore, she will have to obtain $24,000 ($60,000 - $36,000) from a source other than her 401(k) plan. The transfer will be totally tax-free if Lisa transfers the additional $24,000 to her IRA within 60 days of the original transfer to the account. But, Lisa will still have to wait until she files her tax return to get back the $4,000 in FIT withholding taxes.