Tax and Business Alert - February 2002

A New Twist on Charitable Giving

In the aftermath of last September's tragedy, a number of employers set up leave-based donation programs. These programs generally allow employees to forgo part or all of their vacation, sick, or personal leave in exchange for their employer contributing the value of that leave to charity.

To facilitate these donation programs, the IRS released favorable guidance late last year explaining the tax consequences of such a program to both the employee and employer for donations made through the end of this year.  In addition, although the purpose of this guidance was to assist people in donating to various terrorist attack relief funds, it applies to donations to any qualified charity.

Here's a summary of what the IRS had to say.

From the employee's perspective--Employees aren't subiect to income or payroll taxes on any portion of their vacation, sick, or personal leave that they forgo in favor of having their employer donate an amount equal to the value of the unused leave to a charity.  For employees who were going to make a donation anyway, forgoing the cash for the unused vacation days or leave and instead having the employer make the donation converts what would have been an itemized deduction into a direct reduction of the employees' gross income. This can have the positive effect of increasing the amount of other deductions allowed on the employees' returns (to the extent some of an employee's deductions are subject to what's known as the adjusted gross income phase-out rules).   It's also a benefit for employees who don't itemize their deductions because it allows them to indirectly claim a charitable deduction.  One potential disadvantage is that forgoing pay can affect certain fringe benefits [such as 401(k) deferrals or matching contributions] that are tied to compensation.

From the employer's perspective--To  the extent unused leave would have otherwise been paid to the employee if a donation hadn't been made, the employer saves payroll taxes by donating an amount equal to the value of this leave to charity.   In addition, the IRS says the employer's contributions to charity under a leave-based donations program can be deducted by the employer as ordinary business expenses rather than as charitable contributions. This is favorable news because charitable contributions are subject to special deduction limits not applicable to ordinary business expenses.

Although this IRS guidance about leave-based donations can be beneficial to any employer and its employees who are interested in making charitable donations, it seems particularly well-suited for closely held corporations with charitably inclined owners.  In this situation, the employee-owners may find such a program an attractive alternative to their normal approach to making charitable contributions.

Call us if you'd like more details about leave-based donation programs.

Disability Insurance

In three private letter rulings from the IRS, the employers involved provided their employees with long-term disability coverage through group insurance plans.  As is typical in such situations, these plans provided employees with basic wage continuation payments if they became disabled from certain accidental bodily injury, sickness, or pregnancy.

At the time of the ruling requests, the employers' plans covered the entire premium for the basic coverage.  The cost of this coverage was nontaxable to the employees. However, any disability payments the employees received from the plans would be taxable.

The purpose of the ruling requests was that the employers wanted to know the tax effect of amending their plans to allow employees, prior to the start of each year, the option of paying the full cost of the long-term disability coverage on an after-tax basis (through payroll deduction).  A separate election would be available for each year, but the election for a particular year became irrevocable once the year began.

Based on the above amendments to the plans, the IRS concluded that long-term disability benefits paid to an employee who had elected to pay the premiums on an after-tax basis for the plan year in which he or she becomes disabled will be excludable from such employee's gross income. In other words, in return for paying the premiums themselves with after-tax dollars, the employees could receive tax-free benefits if they became disabled.

What's interesting about this is that in earlier rulings, the IRS concluded that if the employer had paid any of the premiums in the three years prior to the disability, a portion of any benefits paid by the plan were taxable to the employee. It appears this three-year look-back rule no longer applies.

Interesting Websites

Is there a new computer in your life (and an old one gathering dust)? As you outgrow a computer at home or the office, sometimes it's hard to decide what to do with it. If it's not but a few years old, you may find a local school or nonprofit that would love to have it. However, if the PC has really outlived its usefulness, another option for getting it out of your way without cluttering up a landfill is to recycle it.  The Consumer Education Initiative website (www.elae.org) includes links to recycling centers around the country. Or, for around $40, IBM will take back any brand of computer for recycling (call 1-877-999-7115, option 4).

Free software. The price of hardware has fallen significantly in the last several years, even as what you get has improved.  However, the cost of name brand software generally hasn't followed suit. One alternative is to download free or Iow-priced software (such as shareware) from the net.  Several sites specialize in rating the quality of such software and providing downloads.  For example, try Download.com, PCWorld.com, or tucows.com.

Selling a Principle Residence with Acreage

Most taxpayers who sell their principal residences are at least vaguely familiar with the rule that normally allows them to exclude up to $250,000 of gain from the sale (or up to $500,000 on certain joint returns).  However, how does this exclusion work if the home that's sold also includes some acreage (or perhaps only the acreage is sold and the home and the land immediately around it are retained)?

Based on a series of court cases and an old IRS regulation, gain from the sale of acreage and a principal residence is likely to qualify for the $250,000/ $500,000 gain exclusion as long as the land is used for personal purposes in connection with the residence.   In contrast, gain from the sale of a portion of a taxpayer's residential property without selling the house is normally not excludible.

Nonetheless, based on an IRS information letter issued late in 2001, even gain from the sale of vacant land used as part of a taxpayer's principal residence property may be excludible. The key appears to be a matter of timing. If the land sale is one of a series of separate transactions that include the sale of the house and the sales all occur at different times and to different buyers but during the same tax year, it appears the gain exclusion (assuming it otherwise applies) may be available for all of the sales together.

Because of the limited guidance available in this area, taxpayers who want certainty always have the option of requesting a private letter ruling from the IRS if they feel the added assurance is worth the expense. Call us if you'd like more information.

Converting from Accrual to Cash Accounting

In 2000, the IRS made a lot of business people happy by releasing new rules that permitted taxpayers with average annual gross receipts of no more than $1 million to use the cash method of accounting even if they would otherwise be required to use the accrual method. This was good news for at least a couple of reasons.

Taxpayers using the cash method generally have more flexibility in the area of tax planning than similar taxpayers using the accrual method. Secondly, one of the effects of this policy change was that taxpayers who made the switch to the cash method were permitted to treat their inventory as a supplies inventory. This meant you still had to count the inventory and not expense it until used, but the IRS specifically said such an inventory wasn't subject to the dreaded uniform capitalization rules.

NEW HIGHER LIMIT

After hearing from a lot of taxpayers that the $ I million ceiling was too Iow, the IRS has now raised it to $10 million. But, the new limit isn't available for every business. Unlike the up to $1 million exception that potentially allows any business to use the cash method, the latest rules only apply to qualifying taxpayers who fit within the $1 to $10 million range.

A qualifying taxpayer is any taxpayer that reasonably determines that the activity from which it derived its largest percentage of gross receipts in its prior tax year is something other than mining; oil and gas extraction; manufacturing; wholesale trades; retail trades; newspaper, periodical, book, or database publishers; or the sound recording industry. In addition, the latest rules don't apply to farming businesses (which have their own rules for using the cash method). Nor do the new rules apply to most C corporations that have more than $5 million of gross receipts (unless the corporation's main activity is rendering personal or professional services) or to partnerships with such C corporation partners.

So, who does that leave? In other words, which businesses that would otherwise have to use the accrual method stand to benefit from having the cash method ceiling raised to $10 million? The types of industries that can potentially benefit include construction; finance and insurance; professional, scientific, and technical services; administrative and support services; lodging and food services; and educational services. In addition, in the following situations, a business may also potentially use the cash method:

When a business' principal business activity (i.e., the activity generating the largest percentage of its gross receipts) is not one of the prohibited industries (listed earlier), even if part of its activities do fit within a prohibited industry.

When a business' principal business activity is the provision of services, including the
provision of property incident to those services, even if its principal business activity is in an ineligible industry. Thus, for example, a publisher whose principal business activity is selling advertising space in its publications may use the cash method (assuming it meets the gross receipt test) even though publishing is one of the prohibited industries.

When its principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specification. For this purpose, merely allowing the customer to choose among pre-defined options (such as size, color, or materials) or having to make only minor modifications to a basic design to meet customer specifications doesn't count as fabrication or modification.

And finally, an otherwise qualifying business may use the cash method for separate and distinct trades or businesses (for which a complete and separate set of books and records is kept), if such trade or business' principal business activity is not in one of the prohibited industries. This is true even if the taxpayer's principal business activity does fit within an ineligible industry.

CONCLUSION

Although the cash method is generally the preferred method to use for tax purposes, it isn't right for every business, including some that will qualify to use it under this latest IRS guidance. Thus, if your business is using the accrual method now and you think you might qualify for the cash method, call us and we'll help you determine if you do (and if that's the method that makes the most sense for you).


Turning Lemons into Lemonade

Suppose your company still owes a significant federal income tax bill for its just-ended tax year, but you're already expecting a net operating loss (NOL) for the just started current year because things are getting off to a really slow start.  Ordinarily, the current-year NOL won't do you a bit of good until the return for this year has been filed and the NOL carried back to prior years.

Fortunately, a little-known rule allows C corporations to effectively carry back the estimated current-year NOL to prior years and thereby obtain an extension of time to pay what is still owed for last year's tax bill (although interest will be owed on any amount for which the due date is extended). The tax payment extension generally expires at the end of the month that the return for the current year (the NOL year) is required to be filed (including extensions).

The extension request is made by filing a form with the IRS Service Center where the corporation files its return. The request applies to tax payments (including estimated payments) due after the form is filed. Thus, this procedure doesn't offer any relief for payments already made or already due. (However, a separate procedure, called a Quick Refund, potentially allows a corporation to receive a refund before filing its return if it has overpaid its estimated tax payments.)

The form related to the expected NOL must be filed after the beginning of the tax year for which the NOL is expected but before the due date for paying the previous year's federal income tax bill. So for calendar-year corporations, the deadline is March 15, 2002. The form can also be filed with an application to extend the deadline for filing the 2001 return. When the two forms are filed together, the effect is to reduce or eliminate the amount of federal income tax otherwise required to be deposited with the return extension application.

Example:  Martin, Inc. (MI) is a calendar-year C corporation. The company expects to file its 2001 federal income tax return on March 15, 2002. That return will show a tax liability of $100,000 with a balance due of $60,000. (Ml's 2001 estimated tax payments were based on 100% of its 2000 tax liability, which was only $40,000.)

MI anticipates incurring a $500,000 NOL in 2002, which will then be carried back, resulting in a refund of the entire $ I00,000 federal income tax liability for 2001. MI can file a request on or before March 15, 2002, for an extension of time to pay the $60,000 still owed for the 2001 tax year. Assuming the NOL turns out as expected, MI will never need to pay the $60,000, but will owe interest on that amount from March 15, 2002, to the following March 15 (the unextended due date of the return for the year with the NOL).

Because estimates of the current-year NOL can obviously change as the year unfolds (resulting in an increase or decrease in the expected NOL), corporations can file more than one form as the current year progresses. This can result in extending the time for payment of a greater or lesser amount of tax than was indicated on previously filed forms.