Tax and Business Alert - May 2002

CONGRESS PROVIDES MORE TAX BREAKS

As you've probably heard, Congress passed an economic stimulus bill earlier this year and President Bush quickly signed it. Despite all the political wrangling that preceded this development, the new law includes a number of favorable tax changes that will benefit many individuals ~and small businesses. We certainly welcome that news and are happy to spread the good word. This article explains what we think are the most important tax changes.

GENEROUS NEW WRITE-OFF FOR NEW BUSINESS ASSETS

By far the most important change is a very favorable new write-off that applies to many newly acquired business assets, including purchased software and leasehold improvements. Even better, the new rule is retroactive. It generally applies to qualified property acquired and placed in service during a three-year period beginning September 11, 2001. Because of the timing of this law change, some 2001 returns will need to be amended to take advantage of the new rule. Of course, this is an inconvenience, but the tax savings could be considerable.

Specifically, the law change allows taxpayers to immediately deduct 30% of the cost of qualifying new assets. (Purchasing a used asset doesn't get you the extra 30% deduction.) The remaining 70% is then depreciated or amortized over a number of years according to the normal tax rules or, if eligible, claimed as a Section 179 (current year) expense.

When an asset qualifies for the 30% immediate write-off, the same treatment will apply for alternative minimum tax purposes. So this new break won't have any negative impact on taxpayers' alternative minimum tax situations.

ADDITIONAL DEPRECIATION FOR NEW VEHICLES USED FOR BUSINESS

Depreciation write-offs for most cars and light trucks, vans, and minivans are subject to very strict limits.  Under prior law, the maximum first-year deduction for such vehicles placed in service last year or this year was a meager $3,060. However, the new law includes a big improvement in this area. The maximum first-year write-off is increased by $4,600, to $7,660 ($3,060 + $4,600 = $7,660) for new vehicles purchased and placed in service during the three-year period beginning September 11, 2001. Of course, if your vehicle is used less than 100% for business, the $7,660 maximum depreciation figure must be reduced accordingly.

Once again, 2001 returns may need to be amended for new vehicles acquired and placed in service last year after the trigger date.  If you bought or will buy a new vehicle in 2002, you can look forward to the tax savings for this year.

LONGER CARRYBACK PERIOD FOR NET OPERATING LOSSES

Congress recognizes that lots of businesses have really been struggling to make profits.    In fact, many successful outfits have incurred net operating losses (NOLs). If this is the case for your business, you would certainly like to be able to carry back all your tax losses and obtain refunds of at least some of the taxes paid in earlier, more-profitable years. However, prior law generally allowed NOLs to be carried back only as far as the two previous tax years. The new law now permits a five-year NOL carryback period. This favorable change can result in greatly increased tax refund opportunities. However, it has a very short shelf life. Specifically, the new five-year NOL carryback privilege is only available for NOLs incurred in tax years ending in 2001 or 2002.

FIX FOR GLITCH IN SEP CONTRIBUTION LIMIT

Last summer's tax bill made many favorable changes to the rules governing tax-advantaged retirement plans and accounts. These changes are generally effective starting this year. As part of the overall retirement plan improvement package, Congress intended to allow more generous deductible contributions for simplified employee pensions (SEPs), consistent with the liberalized contribution limits for defined contribution plans. However, a technical glitch in last year's law changes prevented this. Now the glitch has been fixed. As a result, the deductible contribution to a SEP account is generally limited to the lesser of: (I) 25% of your compensation for a corporate plan (20% of your self-employment income if you are self-employed), or (2) $40,000. This change is effective for the 2002 tax year.

UNFAVORABLE S CORPORATION CHANGE

This is one of the few pieces of bad news included in the new law. But it only affects shareholders of insolvent or bankrupt S corporations that negotiate away some of their debts or have them discharged in bankruptcy. Generally, for debt discharge transactions occurring after October 11, 2001, the new law says any debt discharge income that is excluded from taxation does not increase the tax basis of stock held by the S corporation's shareholders. However, for debt discharge transactions occurring pursuant to bankruptcy reorganization plans filed on or before October 11, 2001, the effective date is for discharges occurring on or after March I, 2002. This change is intended to override a controversial 2001 Supreme Court decision (Gitlitz v. Commissioner) that allowed S corporation shareholders to claim increased stock basis from excluded debt discharge income. Note that 2001 returns can potentially be affected by debt discharges that occurred last year after the magic date.

"EXTENDERS" GET EXTENDED ONE MORE TIME

Congress has once again followed its time-honored tradition of extending a host of tax breaks that were scheduled to expire or begin phasing out by certain dates. These breaks have come to be known as the "extenders." Among others, the following provisions have now been extended by the new legislation.

    ·     The right for individual taxpayers to use certain personal tax credits to reduce both               regular tax and alternative minimum tax liabilities has been extended through 2003.

    ·     The work opportunity and welfare-to-work tax credits are now extended through 2003.

    ·     The suspension of the net income limitation for percentage depletion from marginal oil               and gas properties is extended through tax years beginning in 2003.

NEW BREAK FOR TEACHERS

Elementary and secondary school teachers and personnel often find themselves having to pay some school expenses out of their own pockets. While this situation may not change anytime soon, the new law at least authorizes a deduction for up to $250 of eligible out-of-pocket expenses paid in tax years beginning in 2002 and 2003. The new break will expire after next year, unless Congress takes further action. This is destined to become yet another "extender."

The new write-off is an "above-the-line" deduction, which means you need not itemize to benefit. Eligible expenses include books; most supplies; computer hardware, software, and services; and other equipment and supplementary materials used in the classroom. Eligible taxpayers include K-12 teachers, instructors, counselors, and principals who log at least 900 hours at school during the school year.

AND THERE'S MORE

Because we don't want you to have to read a whole book, this article only covers what we think are the most widely applicable tax changes included in the new law. Of course, there are many others. They can be very important when they affect you, your family, or your business. Please give us a call if you'd like to know more about new provisions that we did not have room to explain here, or if you want to know more about the changes we did cover. Our goal is to help you plan ahead so you can take advantage of as many new breaks as possible. For that, we're always at your service.

THE IMPORTANCE OF MILEAGE RECORDS HASN'T DIMINISHED

Although the rules on keeping detailed records of the business use of vehicles have been with us since the mid-'80s, taxpayers still have trouble complying with them. The rules stop just short of requiring that you keep a contemporaneous log of your mileage, but still generally say that you must maintain an account book, diary, log, statement of expense, trip sheets, or similar record, along with other appropriate documentary evidence to support your business usage. Thus, it's no small wonder that when you're out in the real world trying to earn a living, sometimes all of these documentation requirements get lost in the shuffle.

However, as a recent Tax Court case reminds us, if you want the tax deduction, the documentation rules can't be ignored.  In Olsen v. Commissioner, the taxpayers claimed several thousand dollars of car and truck expenses and depreciation, but failed to keep adequate records of their business usage of the vehicles.  At the trial, they offered, as evidence, a summary showing mileage based on figures in a computer atlas database rather than actual odometer readings. They also offered summaries of the repairs and maintenance on a truck used in their business.

Unfortunately for the Olsens, the Court wasn't impressed. The mileage records were insufficient because they weren't prepared at the time the vehicles were used and were based on estimates rather than actual odometer readings. In addition, the repair and maintenance records for the truck were no help because the taxpayers failed to produce the underlying receipts and because they couldn't document the percentage of business versus personal use of the truck. Thus, the Olsens lost their entire deduction.

NO TAX ON FREQUENT FLYER MILES

Given how hard many people work to earn them, few would dispute that frequent flier miles are worth something. Thus, if taxpayers earn miles on trips paid for by their employers or clients and use them for personal purposes, should they be taxed on the value of the miles?

This question has bothered the IRS for years because the tax rules say all income is taxable unless otherwise exempt or excluded. In fact, in 1995, the IRS released a Technical Advice Memorandum (TAM) in which the company's situation was probably typical of most. The company paid its employees' job-related travel costs but allowed the employees to keep any miles they earned on airline tickets or other travel expenses. The IRS concluded in the TAM that the value of these miles should be treated as wage income to the employees (and therefore subject to payroll tax and income tax withholding).

Because of the controversy the TAM generated, less than 48 hours after being released the IRS said it was reconsidering the TAM's conclusions. Now, seven years later, the IRS has announced that at least for the time being it's no longer going to try to come up with a way to tax in-kind personal use of frequent flyer miles earned through business or official government travel. That's great news for what is essentially a middle-class tax perk.

INTERESTING WEBSITES

Investing in Bonds. A lot of investors have substantially less experience investing in bonds or bond mutual funds than they do buying stocks or equity-based mutual funds.  If you're new to the bond world, or just want a handy place to calculate the tax equivalent yields of municipal bonds, check out www.investinginbonds.com/investing.shtml.

Temporary Health Insurance. Whether you're between jobs, waiting for a new employer's coverage to kick-in, or have a child who is graduating from college or over    age 19 and no longer a full-time student, there may be times when you or a family member isn't covered by a health insurance plan.  Sometimes COBRA coverage from a current or former employer can help fill in the gap.  But, not every business is required to offer such coverage or it may not be available in your situation for various reasons. Rather than doing without coverage in a situation like this and exposing yourself to a potentially huge liability if something unexpected happens, short-term medical insurance may be just what you need.  For example, check out www.temporaryinsurance.com or www.allhealthnet.com/Insurance/Temporary/.


FEE-BASED BROKERAGE ACCOUNTS

While lots of individual investors do their own search these days, others prefer some hand holding even if they want to do some things for themselves. One potential answer for this latter group of investors is to sign up for a "fee-based" deal with a brokerage firm.

Under a fee-based arrangement, the customer is charged an annual amount based on a formula. This is usually a percentage of assets with a designated minimum fee. In return, the customer can make a certain number (or, sometimes an unlimited amount) of transactions and receive investment research, advice, and so forth. The theory is these fee-based deals align the firm's and customer's interests because the firm's fee gets bigger as the customer's account grows larger, whether or not there's a lot of activity in the account.

Because these fee-based arrangements have become quite popular during the last few years, you'd think the tax treatment of the fees paid would be well settled. Surprisingly, it's not.

THE ITEMIZED DEDUCTION APPROACH

Assuming you use a fee-based account strictly for taxable investments, the entire annual brokerage company charge can probably be classified as tax deductible investment expenses without fear of IRS challenge. Unfortunately, such expenses must be lumped together with other miscellaneous itemized deductions and then reduced by an amount equal to 2% of your adjusted gross income (that number at the bottom of page one of your return).

Even if part of your deduction clears the 2% hurdle, there's still the dreaded itemized deduction phase-out rule to consider. It can delete up to 80% of the most common types of itemized write-offs, including the one for miscellaneous itemized deductions. (For 2002, itemized deductions generally are reduced by 3% of AGI in excess of $137,300.) Finally, any miscellaneous itemized deduction amount that (amazingly) survives both the 2% floor and the itemized deduction phase-out rule will be completely disallowed for alternative minimum tax (AMT) purposes--which, of course, is a problem if you're hit by the AMT.

For all the above reasons, classifying an annual brokerage firm fee as an investment expense may not do much good and often does no good at all. So far, so bad.

ANOTHER ALTERNATIVE

To the extent part of the annual brokerage fee can be counted as additional cost basis of investments held in taxable accounts; you should receive a tax benefit. Higher basis means smaller taxable gains or larger capital losses upon disposition of said investments.

But how much of the fee can you allocate to individual assets? Good question. Although there's no official guidance that we're aware of in this area, some portion of the annual fee (say $250) should be deducted as an investment expense (under the unfavorable miscellaneous itemized deductions explained above) while the balance should generally be allocable to stocks or bonds acquired or sold during the year.