Tax and Business Alert - June 2004

Stock Dividends and Stock Splits - Taxable or Not?

A corporate shareholder can benefit from nontaxable stock dividends if they are structured properly.  Stock dividends are distributions of stock made to shareholders from a corporation's surplus account using its own stock. Generally, stock dividends are tax free.  However, they can be taxable in certain circumstances.  For example, stock dividends are taxable if the shareholder has the option of receiving those dividends in cash or stock.

Stock splits merely represent divisions of outstanding shares into a greater number of shares with a lower per-share value. Companies that want to make their shares more attractive and affordable may authorize a stock split to create more shares selling at a lower price.  For example, a 2-for-1 stock split doubles the number of existing shares and halves the price.  Let's say you own 1,000 shares of a stock selling at $20 a share, for a total value of $20,000.  If the company's directors authorize a 2-for-1 split, you would own 2,000 shares priced at $10 a share (subject to market fluctuation), with the same total value of $20,000. Your holding period (which determines whether long-term or short-term capital gain rates will apply) in the shares does not change, nor does your total basis in the stock. However, your per-share basis will be reduced in the same percentage as the stock split. For instance, if your basis in the aforementioned shares was $6 per share ($6,000 invested) before the 2-for-1 split, your per-share basis after the split is $3 per share (still the same $6,000 invested).

Taxable Stock Dividends. A stock dividend is taxable if you are given the choice between cash or stock as a dividend. Stock dividends may be taxable in other rare cases, as well. If your stock dividend is taxable, the basis of the new stock is its fair market value on the date of distribution. The holding period (long-term or short-term) begins on that date as well. Your basis and holding period in the old stock does not change.

Nontaxable Stock Dividends and Stock Splits. Calling stock splits and certain stock dividends "nontaxable" may be a misnomer. Rather than a permanent exclusion of income, they actually result in a deferral of income. While cash dividends may be taxed currently, any gain resulting from a stock dividend or stock split is realized when the shares are eventually sold. The holding period (long-term or short-term) for the new stock is the same as for the old stock.

2004 Vehicle Depreciation Limits

The IRS recently announced the depreciation limit for passenger autos placed in service during 2004 is $2,960 for the first year. For passenger autos eligible for the 50% bonus depreciation deduction the first-year limit is $10,610. Separate limits are provided for trucks and vans placed in service during 2004 - the regular first-year depreciation limit is $3,260. For trucks and vans eligible for the 50% bonus depreciation deduction the first-year limit is $10,910.
An employee's personal use of an employer provided auto must be treated as a fringe benefit. The vehicle cents-per-mile valuation (37.5 cents per mile in 2004) can be used to place a value on the personal use if the fair market value of the passenger auto on the date first made available to the employee for personal use in 2004 does not exceed $14,800.

SBA Certified Development Company Loan Program

A Certified Development Company (CDC) is a nonprofit corporation set up to contribute to the economic development of its community. CDCs work with the Small Business Administration (SBA) and private sector lenders to provide financing to small businesses. There are about 270 CDCs nationwide, each covering a specific geographic area. The CDC 504 loan program provides long-term financing for economic development within a designated community. Information on this program can be located at www.sba.gov/financing/sbaloan/cdcS04.html. The CDC 504 program provides growing businesses with long-term, fixed rate financing for major fixed assets such as land and buildings.

A typical 504 project loan is secured up to 50% with senior lien financing provided by a private sector lender. Secondary financing, of up to 40%, is provided by the CDC (backed by a 100% SBA-guaranteed debenture). Loan maturities of 10 and 20 years are available. The small business must contribute 10% as equity in the project being financed.

IRS Updates "Dirty Dozen"

In an update of its annual consumer alert, the IRS urged taxpayers to avoid falling victim to one of the "Dirty Dozen" tax scams and a variety of other schemes. In the 2004 ranking, several new scams have reached the top of the consumer watch list, including abusive trusts and the "claim of right" doctrine. The IRS has issued new guidance to consumers and tax practitioners that debunks the schemes.

The "Dirty Dozen" list for 2004 includes (1) the misuse of trusts, (2) the claim of right doctrine (deducting the entire amount of earnings), (3) Corporation Sole (involving a one-person, phony religious organization), (4) offshore transactions, (5) employment tax evasion, (6) return preparer fraud, (7) Americans with Disabilities Act schemes, (8) African-Americans get a special tax refund, (9) improper home-based business, (10) frivolous arguments, (11) identity theft, and (12) sharing or borrowing dependents.

The IRS and other federal agencies are aggressively pursuing and prosecuting promoters of these schemes and many of their clients for fraud and tax evasion.

Lower Your Taxes with Section 179 Deduction

Internal Revenue Code Section 179 allows a taxpayer to expense up to $102,000 of qualifying property placed in service during 2004 and 2005 (adjusted for inflation in 2005). After 2005, the annual limit will be reduced to $25,000. The $102,000 limit is reduced dollar-for-dollar (but not below zero) to the extent the taxpayer purchases more than $410,000 of qualifying property in 2004 and 2005 (adjusted for inflation in 2005). Accordingly, no Section 179 deduction is available for 2004 if the total investment in qualifying property is $512,000 or more.

Qualifying property means tangible personal property that is subject to depreciation, amortization, or other reasonable allowance for wear and tear In addition, qualifying property must be acquired from an unrelated party and used more than 50% in an active trade or business. Purchased computer software placed into service in years 2003-2005 is eligible for expensing under Section 179.  No proration is made to reflect when during the tax year the property was acquired. So, property acquired on the last day of the tax year is eligible for the Section 179 deduction.

The Section 179 deduction is also limited to the taxpayer's aggregate taxable income derived from the active conduct of any trade or business. In addition to a taxpayer's wages, salaries and other compensation, active business income includes the taxpayer's share of (1) ordinary proprietorship, partnership or S corporation income; (2) gains (or losses) from a trade or business; (3) depreciation recapture from a trade or business; and (4) interest earned from working capital related to a trade or business. A partner or S corporation shareholder's taxable income includes all his or her pass-through of equity taxable income from the active conduct of any of the entity's trades or businesses, provided he or she is engaged in the active conduct of at least one of the entity's trades or businesses. Taxable income is not reduced by any net operating loss (NOL) carryover or carryback to the tax year or by the deduction for half of self-employment taxes. If a joint return is filed, the taxable incomes of both spouses are aggregated, even though the Section 179 deduction may be related to the activities of only one spouse.

The determination of active conduct of a trade or business by the taxpayer is based on facts and circumstances and requires meaningful participation in the management or operations of a trade or business. Taxable income from investments or hobbies clearly does not count as income from an active trade or business.

Example: Aggregating business income to support a Section 179 deduction.

Any Section 179 deduction limited by taxable income is carried forward indefinitely to succeeding tax years. The deduction is claimed when the taxpayer generates sufficient trade or business income. However, the allowable deduction may not exceed the annual Section 179 dollar limitation for any given tax year

Retirement Plan Loan Interest

Individuals who participate in qualified retirement plans [401(k), corporate profit sharing plans, and the like] sometimes borrow from those plans and pay interest on their loans. In essence, the participants pay interest to themselves when they take out plan loans. Plan loans provide participants with access (within limits) to their retirement plan money without incurring the income and penalty taxes that generally apply, to retirement account withdrawals before age 59½.

401(k) and 403(b) Plan Loan Interest: Interest paid on a loan secured by the participant's (borrower's) 401(k) or 403(b) account is nondeductible if any of the account balance used to secure the loan is attributable to elective deferrals (i.e., elective salary reduction contributions the employee signed up for). This is true regardless of how the loan proceeds are used and regardless of the existence of other security for the loan, such as the participant's home. Since the participant's account will almost always be required as security for a plan loan and 401(k) and 403(b) account balances will almost always include at least some elective deferral dollars, interest from such plan loans will rarely be deductible. In the unusual case where the participant's account balance has been funded entirely by non-elective employer contributions and related earnings (or the loan is secured solely by these amounts), the tax treatment of the interest expense is determined by following the general rules for individuals, as summarized below. Bottom line, interest on 401(k) and 403(b) plan loans will almost always be nondeductible.

Other Plan Loan Interest: Under general federal income tax rules, the participant's (borrower's) use of the loan proceeds determines whether and to what extent the related interest expense can be deducted. Specifically, interest paid on a plan loan, other than a 401(k) and 403(b) plan loan (see above), traced to a personal, business, or investment use is classified accordingly. In a nutshell, personal interest expense that is not qualified residence interest is generally nondeductible. Business interest expense is generally deductible and investment interest expense is generally deductible to the extent of the participant's net investment income. However, for any period beginning when the participant becomes a key employee (based on compensation and stock ownership guidelines), the interest paid on the plan loan is completely nondeductible.