Tax and Business Alert -

 JUNE 2003

The "Fully Insured" Retirement Plan

Few people would disagree that three years of negative returns has caused numerous investors to change their retirement outlook. Many of us who, after years of very positive investment results, were making early retirement plans in December of 1999 are still working and will be for some time to come. In addition, the events of and related to September 11, 2001, have caused many business owners and employees to invest their retirement assets much more conservatively.

An insurance-based, and somewhat conservative, retirement idea that fell from favor during years of double digit investment returns is currently receiving renewed interest. The Section 412(i) plan, named for the applicable IRS code section, is a defined benefit retirement plan where benefits are provided through life insurance or annuity contracts, which are fully insured and guaranteed by a life insurance company. (Defined benefit plans, sponsored by employers, promise to pay participating employees a specific amount each year during retirement.) The insurance differentiates Section 412 (i) plans from the other defined benefit plans where employers invest plan contributions in a variety of investment instruments.

To qualify under Section 412(i), e defined benefit plan must, among other requirements, meet the following six specific guidelines:

- The plan must be funded exclusively by the purchase of individual insurance contracts.
- The insurance contracts must provide for level annual premium payments to be paid commencing with the date of plan participation or with an increase in plan benefits, and extending not later than the retirement age for each individual participating in the plan.
- Plan and contract benefits must be equal at retirement age and contract benefits must be guaranteed by an insurance carrier (licensed under the laws of a state to do business with the plan) to the extent premiums have been paid.
- Premiums payable for the plan year, and all prior plan years, under such contracts have been paid before lapse of there is reinstatement of the policy.
- No rights under such contracts have been subject to a security interest at any time during the plan year
- No policy loans can be outstanding at any time during the plan year.

The Section 412(i) plan has become popular with small business owners recently because it allows for high tax-deductible contributions, especially when the business owner is older. Deductions can be large because the required premium is based on the relatively low guaranteed interest rates of the insurance contracts. In addition, plan assets are typically exempt from creditors of the business and its employee participants and the contract may provide for a death benefit to protect the participant's heirs.

There are many important items to consider when establishing, amending, or discontinuing a retirement plan. Please call us to discuss how we can assist you with retirement planning, key employee retention and related issues.

Selecting a Guardian for Your Minor Children

A guardian is a person you designate to be responsible for the care and well-being of your minor children; the guardian is not necessarily responsible for managing the assets owned by your children. If you have minor children, your will should contain a clause appointing a guardian for them. The surviving parent will automatically be the natural, although not necessarily the legal, guardian for any minor children. You should be sure that the prospective guardian is willing to serve in such a capacity and he or she is provided with the financial resources with which to raise and educate your minor children.

When selecting a guardian, consider his or her age and the existing relationship with the children. Also think about whether a married couple or a specific individual shall serve. If you appoint a couple, you should indicate whether the surviving member of that couple is intended to serve.

You may want to consider appointing a person with children of similar ages. If a family member is chosen, you need to take into account the possible premature death of that family member, who might be survived by a spouse.

Some questions to ask when considering the care of your minor children in the event of your untimely death include:

- Does my will or another instrument provide a guardian for my children?
- Does the instrument designate a successor guardian?
- Can the guardian serve without bond?
- Has the prospective guardian indicated a willingness to serve?
- Is the guardian to be compensated?

Please contact us if you would like more information.

What are Your Chances of Being Examined by the IRS?

A total of 743,881 individual income tax returns were audited during fiscal 2002 out of 129,1444,947 returns that were files in calendar year 2001. That's less than a 1% chance of being audited. Acting IRS Commissioner Bob Wenzel recently indicated the IRS is realigning its resources to focus on the following key areas in the future:

- The promotion of abusive tax shelters
- The misuse of off-shore accounts
- Abusive corporate tax avoidance
- The underreporting of income by higher-income individuals
- Nonfiling by higher-income individuals
- Individuals improperly claiming the earned income credit
- The National Research Program to redefine audit selection criteria

Interesting Website

In an effort to help high school and other students better understand the U.S. tax system, the IRS has launched a website at www.irs.gov/app/understandingTaxes/index.jsp called "Understanding Taxes." This Internet-based interactive program about taxation replaces print materials previously provided to teachers each year by the IRS. The new program offers teachers more flexibility in a modern format.

"Understanding Taxes" is divided into a student section and an educator section. Tutorials guide students through the basics of tax preparation and introduce them to the concept of filing their tax return. The student home page offers links to student lessons, word puzzles, tax trivia questions, story problems and examples of how and why taxes affect and influence our daily lives. Tax filing simulations deliver real-life applications for today's students.

The teacher home page includes detailed lesson plans along with numerous interactive student activities, student assessments, and presentations.

The site can be used for traditional classroom, self-study, or home-schooling use. Students without computer access can even use it as long as the teacher has computer access.

Retaining Key Employees

Unless you have capable successors and employees, your closely held business may not survive your departure if key employees leave instead of adapting to the new owners and management. Therefore, a business succession plan should be in place and contain strategies to identify, retain, and reward key employees.

There are numerous methods for rewarding a key employee's commitment, loyalty, and hard work. The most effective incentives are usually monetary. Generally, they are offered in the form of nonqualified plans so the incentive can be tailored to a particular person's situation. Nonqualified plans are much more flexible when compared to qualified plans concerning benefits, contributions, and participation requirements. Nonqualified plans also provide the opportunity to "tie" the employees to the business by incorporating conditions that cause the forfeiture of benefits if the employee leaves or the business does not reach certain performance targets. Listed below are several methods to reward and retain valuable employees.

Restricted Stock Plan

A restricted stock plan transfers stock to an employee subject to certain restrictions. Often, the shares are transferred to the employee at little or no cost, but are subject to forfeiture if the employee fails to fulfill the terms of the plan. A common restriction requires employees to forfeit the shares if they terminate employment within a certain number of years. Restricted stock is particularly useful when you, as the business owner, want to reward a key employee with equity ownership in recognition of past efforts or in anticipation of future service, but are unwilling to give immediate unrestricted ownership. The arrangement can be structured so the employee earns ownership of the stock over time, yet obtains the economic benefits and voting rights of the shares immediately.

Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs) can provide key employees additional compensation through the opportunity to share in the appreciation of the company's stock value. ISOs are usually granted to the employee at no cost with an exercise price at or above the stock's current market price. Therefore, the employee is not required to invest any capital at the date of grant and thus has no significant downside risk if the company stock declines in value before the option is exercised.

Nonqualified Stock Options (NQSOs)

A nonqualified stock option (NQSO) is an option that specifically states it is an NQSO or one that does not meet the requirements of an incentive stock option (ISO). Like an ISO, you can use an NQSO to provide key employees additional compensation through the opportunity to share in the appreciation of the company's stock value. NQSOs generally require the employee to use cash to exercise them. Although the tax treatment of an NQSO is less favorable to your employee than an ISO, the employee may view the NQSO more favorably because it can establish an option price that is below the stock's current value, allowing the employee to obtain an immediate compensation benefit if the option is exercised. In addition, your company receives a deduction for the compensation realized by the employee.

Stock Appreciation Rights (SARs)

A stock appreciation right (SAR) is the right to receive compensation based on the increase in value of a specified number of the employer's shares of stock. When a SAR is exercised, the company usually pays the employee cash equal to the stock's appreciation, although payment can be made in shares equal in value to the appreciation. Because the employee does not have to spend any cash to benefit from the plan, he or she may prefer a SAR to a stock option, which often requires cash to exercise. However, the employee does not receive any dividends paid on the company's outstanding shares with a SAR.

Phantom Stock Plans

A phantom stock plan replicates the benefits of a restricted stock arrangement without transferring actual shares. Under a typical phantom stock plan, each participant's account is credited with a stated number of stock units as of a certain date. Each unit is equal in value to a share of employer stock. (Many closely held businesses use current book value to measure stock value.) A phantom stock award is outstanding for the period specified in the plan. At the end of that period, the key employee receives compensation equal to the value of either the stock units or the stock units' appreciation, measured by the difference between the value of the stock units at the end of the arrangement and their value on the date of the agreement.

A Reverse Mortgage Can Generate Cash Flow

If a homeowner has significant equity in his or her residence and needs funds but lacks the resources to make monthly payments on a conventional home equity loan, a reverse mortgage might provide the solution. A reverse mortgage is so called because the mortgage balance normally increases over the term of the loan, rather than decreasing as the balance of a conventional mortgage does. A reverse mortgage allows the homeowner to receive loan proceeds over a certain period (by borrowing against the equity in the home) while continuing to live in the house. In the typical case, the house will be sold at some point (normally after the borrower dies) to pay off the mortgage. Since the loan typically defers all repayment until the house is sold or the borrower dies, lending decisions may be based primarily on the home's value rather than the borrower's credit-worthiness and ability to make monthly payments as in the typical loan underwriting process. An older homeowner may be motivated to obtain a reverse mortgage for many reasons, including one or more of the following:

 Paying off current or delinquent mortgage or other debts
 Paying property taxes
 Paying for medical care
 Covering financial emergencies
 Supplementing monthly income
 Paying for home nursing or household help
 Setting funds aside for future use

A reverse mortgage is obtained from a private lending institution, but it may be guaranteed by the Department of Housing and Urban Development (HUD) through the Federal Housing Administration (FHA) under the Home Equity Conversion Mortgage Insurance Demonstration Act of 1988. These FHA-guaranteed reverse mortgages are known as home equity conversion mortgages (HECM).

Home lenders who make reverse mortgages that fit certain criteria set out by the Home Keeper® mortgage program of the Federal National Mortgage Association (Fannie Mae) can sell the reverse mortgages to Fannie Mae (which in turn sells them to investors). However, reverse mortgages purchased by Fannie Mae are not federally guaranteed.

The amount the lender will advance depends on the borrower's age, the equity in the home, and the loan's interest rate. The homeowner must be at least age 62 to qualify for the HECM or Home Keeper® reverse mortgage programs. Under a reverse mortgage, the lending institution advances funds to the homeowner in a lump sum or on a periodic basis (such as monthly). The loan principal, including accrued interest, is secured by the equity in the home. The amount of the advances, plus interest, is payable when the homeowner permanently moves from the residence, the property is refinanced, the home is sold, or the homeowner dies. The homeowner will normally be allowed to repay the loan without penalty before tile due date.