DISABILITY INSURANCE - YOU DON'T WANT TO LIVE WITHOUT IT!

Despite the terrible death toll from the recent national tragedy, individuals in the workforce are roughly four times more likely to become disabled during a year than to die.   And if that's not enough, a permanently disabled breadwinner can have a greater financial impact on a family than a premature death. Both remove a source of family income; but with a disability, family expenses may actually increase. The disabled person must be fed, clothed, and sheltered, plus there may be large, ongoing medical expenses and other special needs. Thus, most people should be more concerned about having adequate disability insurance than life insurance, even though both are critical.

GROUP VERSUS INDIVIDUAL POLICIES

Many group disability polices have an "any occupation" definition of disability which can severely restrict their usefulness (because benefits generally cease after a disability if you're able to perform any type of work, even if it's not your chosen occupation). In addition, a group policy with employer-paid premiums or with premiums you pay with pretax dollars is easier on your current cash flow--but any benefits you receive from such a policy are taxable. In contrast, disability benefits are tax-free if paid by either an individual policy or group policy on which you've paid the premiums with after-tax dollars.

If you have the choice, the best option may be a blend of both types of policies; an inexpensive group policy for basic coverage and an individual policy for more comprehensive coverage. It's worth noting that an employer can provide disability coverage to selected employees without violating IRS antidiscrimination rules, as long as the coverage is provided through a third-party insurance company rather than by way of self-insurance.

HOW MUCH DO YOU NEED?

It's unlikely you'll want to provide coverage for 100% of your current earnings. The premiums would be too high and besides, most insurance companies won't provide such coverage because it might encourage abuse. Thus, the general goal is to maintain coverage equal to about 60% to 70% of current earnings. If the benefits are received tax-free, this amount of coverage should just about equal your current take-home pay.

When determining how much coverage you need, don't forget you probably already have some coverage through the Social Security system.  However, it's generally unwise to depend solely on the Social Security coverage because it contains an "any occupation" definition of disability and the waiting period is five months.  In addition, the disability must have lasted or be expected to last for at least 12 months.

CONCLUSION

No one likes to think about the possibility of becoming disabled. However, if you're a family breadwinner, you owe it to yourself and your family to maintain adequate disability coverage.

DIVIDENDS VS. SALARY

In a recent Tax Court decision involving a personal service corporation (PSC) that rendered medical services, the corporation's gross receipts for each of the two years in question exceeded $2 million. The company reported taxable income of approximately $29,000 for one year and $49,000 for the other. These amounts represented what was left after year-end shareholder-employee bonuses that essentially paid out all available cash less reserves for anticipated near-term expenses.

The problem was that in addition to the shareholder-employees, the corporation also employed two non-shareholder doctors.  So, the IRS contended that part of the money paid to shareholder-employees was actually a dividend derived from net profits generated by the two nonshareholder doctors.  Ultimately, the Tax Court agreed.  And, to add insult to injury, the Tax Court also upheld an IRS assessment of the 20% accuracy-related penalty for negligence noting that "the shareholder surgeons could not reasonably conclude that all predistribution profits were solely attributable to services performed by them and, therefore, available for bonus payments to them."

The message for PSCs seems pretty clear--when meaningful amounts of corporate net revenue are generated from activities other than the delivery of services by shareholder-employees, distributions of this profit to the shareholders is going to have to come out as something other than deductible compensation.  If your corporation fits in this situation, we'd be glad to discuss with you some alternate forms of distributions. O

INTERESTING WEBSITES

Going global. Are you looking to expand your sales by reaching new markets outside the U.S. but aren't sure where to begin?  Numerous resources are available to help.  For example, try out the Department of Commerce site at usatrade.gov.  Dedicated to helping small and medium-sized businesses export their goods and services, the Commerce Department's U.S. Commercial Service division offers export counseling and a team of overseas experts that can help you determine the best markets for your products, develop an effective export strategy, comply with regulatory issues, locate export financing, and learn about cultural issues and business protocol.  You might also want to try export.gov and tradenet.gov.

Financing Sources. Cash flow is a concern for nearly every business and is frequently the number one issue for small businesses-especially in the start-up stage. But if you've struck out at the bank, where do you turn? Here are a couple of options.   For loans of up to $35,000, the Small Business Administration's Microloan program may be the answer (check out www.sba.gov/financing/frmicro.html). For larger loans of up to $5 million, try www.sba.gov/INV and www.business.gov. And remember, if you're in the market for additional financing, a strong business plan is normally a must. Call us if you need help putting one together.

DIALING FOR DOLLARS

In a recent case, the Tax Court agreed with the IRS' disallowance of a self-employed individual's disputed expense deductions for, among other things, use of a cell phone for business purposes.  Although the case doesn't break new legal ground, it does serve as a useful reminder of the strict substantiation requirements imposed upon what the tax rules refer to as listed property (including automobiles, cell phones, and most computers and related equipment used for business purposes in the owner's home).

In this case, the taxpayer claimed he paid $715 during the year at issue for cell phone service. At trial, he admitted there was some personal use but insisted that such use was minimal. Unfortunately, he was unable to produce any evidence to support his business use.   After noting that a cell phone is classified as listed property, the Tax Court stated that "no deduction is allowable with respect to a cellular telephone on the basis of any approximation or the unsupported testimony of the taxpayer.   "What's required is an adequate record or sufficient evidence of the amount of the expenditure, the time and place of use, and the business purpose.  In the case of a cell phone, this presumably requires an itemized list of calls, which generally is available only if you request it and pay an additional fee.

Fortunately, IRS regulations appear to offer a partial solution. The regulations indicate that a log or other record maintained for part of a year may suffice to establish a taxpayer's pattern of business use. In other words, if an itemized list of calls for several months out of the year indicates that you fairly consistently use your cell phone 80% of the time for business, it might be okay to assume this same business usage for the remainder of the year.

MAKING SENSE OUT OF QUALIFIED TUITION PROGRAMS

Qualified tuition programs (sometimes called Section 529 plans) have received a lot of attention recently because the 2001 Tax Act generally makes distributions from such plans tax free starting in 2002. The idea behind these plans is that people will have an easier time saving for their children's (or grandchildren's) college education if the funds they set aside for this purpose grow on a tax free basis. Currently, each qualified tuition program (QTP) is sponsored by a state. However, beginning next year, private colleges will be able to set up their own plans.

While QTPs aren't for everyone (and we'll be glad to help you determine if they're right in your situation), many people have already decided they want to put at least some of their college savings in such a plan. If you're in that group, your next task is selecting the best plan. This can be a difficult decision since there are currently more than 40 state plans--most of which accept funds from out-of-state residents.  Our purpose is to walk you through some of the issues you might want to consider as you make that decision.

Prepaid or saving plan? One place to start when comparing plans is to decide which is best--a prepaid tuition plan (that guarantees some portion up to 100% of a student's college costs will be covered) or a savings plan (that simply provides a tax efficient way to save for college but doesn't guarantee the funds will be enough). The choice normally depends on (I) the time period until the student enters college and (2) your tolerance for risk. In most cases, savings plans will be preferred;  however, when college is imminent or you want assurance that a certain amount of tuition will be paid for regardless of how the financial markets do, the prepaid plan might be appropriate. Because QTP savings plan are the most popular, we're going to focus on selecting that type of plan.

Should you go with the home team? With nearly every state offering a plan, some people will be tempted to pick their state's plan without any comparison shopping.  Sometimes that will be a good (or perhaps even great) choice, other times people can do better looking elsewhere. Many state plans allow residents to deduct all or part of their contributions to the state's QTP and exclude the account earnings for state income tax purposes.  However, this is not automatic, so it's important to look at each state's specific provisions.

What kind of returns can you expect?  Like any investment, it's important that the investment options and fund manager(s) be consistent with your risk tolerance and investment style. Until recently, account owners could not change the investment strategy once a plan was selected.

However, QTPs that choose to can now allow account owners to change investment strategies once per calendar year or, if earlier, when an account's beneficiary changes.

Many state plans have engaged well-known mutual fund companies or brokerage firms to manage the investment options.  Most state plans also include age-based investment options whereby the investment strategy goes from a more aggressive style (higher percentage of equities) to a more conservative style (higher percentage of cash and bonds) as the child nears college age. In addition, some states offer other options, including some weighted heavily in equities as well as fixed income accounts. Thus, there are a lot of options available but it's important to find the one that's right for you.

Another important factor to consider is fees and expenses because they will have a direct impact on your overall investment return. These can vary in type as well as amounts or rates. QTPs typically charge either a fixed or asset-based annual maintenance fee in addition to the fee charged by the investment manager.  Some charge an enrollment fee as well.

And lastly, are there other catches?  Some QTPs include unusual or unique features that could be a factor in your decision. For example, one state's program is somewhat unusual in that it shifts many of the ownership rights from the contributor to the beneficiary.  Another state's program has a 36-month waiting period before qualified withdrawals can be made and when it was recently amended to take into account the 2001 Tax Act provisions, it surprisingly retained its own 10% penalty on nonqualified withdrawals in addition to the 10% penalty imposed by the IRS beginning in 2002.

CONCLUSION

As we mentioned earlier, qualified tuition programs aren't for everyone.  However, for most people saving for college expenses they are at least worth a look.  We'd be glad to help answer any questions you have about such plans. Just give us a call.

"NEW COMPARABILITY" RETIREMENT PLANS  


Several good reasons exist for setting up a retirement plan for a small business. However, the bottom-line question for many small business owners is, "How much is it going to cost me versus what kind of benefits am I personally going to receive from the plan?"

Against this backdrop, developments regarding defined contribution plans in the last year or so have attracted a lot of attention. Using a so-called "new comparability'' defined contribution plan, a company's highly compensated employees (a group that generally includes the owners and tends to be older than a majority of the nonhighly compensated employees) can receive high allocation rates (say, 20%+ of covered compensation) while nonhighly compensated employees, regardless of their age or years of service, receive comparatively low allocation rates (say, 5% of compensation). Such a plan passes the tax law's nondiscrimination rules by using something called cross-testing. Newly issued final regulations help explain how all of this is supposed to work and bring some certainty to a retirement planning area that has suffered from a lack of guidance and a cloud of controversy because of concerns raised by the IRS about 18 months ago.

WHY CROSS-TESTING CAN BE A BENEFIT

A qualified retirement plan can satisfy the nondiscrimination rules by demonstrating that either plan contributions or plan benefits are nondiscriminatory in amount.  Using one of several safe harbors, defined contribution plans (such as profit-sharing plans) generally satisfy this requirement by showing that contributions to the plan are nondiscriminatory. However, passing the nondiscrimination rule based on contributions can be frustrating for small business owners because it frequently means the owner (and perhaps other highly paid management members) either can't receive the maximum annual contribution to a defined contribution plan (currently $35,000, but scheduled to rise to $40,000 next year) or the cost to cover the other employees is prohibitive.

That's where cross-testing can be appealing. Under the cross-testing method of determining whether the nondiscrimination rules are met, contributions to a defined contribution plan are converted to and tested as equivalent benefits payable at normal retirement age. The conversion is done by making an actuarial projection of the benefits payable at normal retirement age that are attributable to such contributions.

In the typical case where cross-testing works as intended, there are enough young nonhighly compensated employees to enable an employer to demonstrate compliance with the nondiscrimination standards by comparing the actuarially projected value of the small allocations for those employees (which grow to a much larger number in the future because of the time value of money and the long time period before these employees retire) with the actuarially projected value of the substantially larger allocations for the older highly compensated employees (who obviously are much closer to retirement age and thus have less time for earnings to increase their balances in the plan).

The testing and administration of new comparability plans is complex compared to basic profit-sharing plans. However, they are worth serious consideration for any small business owner who is interested in maximizing personal retirement benefits while minimizing the overall costs to the company.