Tax and Business Alert - October 2002

A new U.S. Securities and Exchange Commission (SEC) requirement is going to make it easier for you to compare mutual fund return rates. When a mutual fund is held in your taxable account, the only investment rate of return that should matter is the fund's after-tax rate of return. Until recently, however, the mutual fund industry was only required to present before-tax rate of return information. This made it difficult to distinguish between mutual funds with similar pre-tax returns but widely different after-tax returns. The new SEC ruling solves that problem by requiring mutual fund companies to disclose both their before-tax and after-tax returns.

HOW THE NEW SEC RULES WORK

In their prospectuses and mutual fund profiles, fund companies must now disclose after-tax rates of return for the preceding:

· One-year period,
· Five-year period (or life of the fund, if shorter), and
· Ten-year period (or life of the fund, if shorter).

This after-tax information must be presented in pre-liquidation and post-liquidation scenarios. For the pre-liquidation scenario, rate of return information is based on the assumption that you still hold your fund shares at the end of the applicable reporting period. In this case, the pre-tax rate of return is simply reduced by the federal income taxes triggered by the fund's capital gain and income distributions during the applicable period.

For the post-liquidation scenario, rate of return information is based on the assumption that you sold your fund shares at the end of each applicable period. In this scenario, the pre-tax rate of return is adjusted for (I) the federal income taxes triggered by the fund's capital gain and income distributions during the applicable period and (2) the impact of federal income taxes for selling your shares for a gain or loss at the end of the applicable period. Gains from sales at the end of the one-year period are considered short-term and taxed at ordinary rates. For losses, the resulting tax benefit is added back using the capital gains rate.

STANDARDIZED CALCULATION PROCEDURE

In calculating after-tax returns, ordinary income and short term capital gains are taxed at the maximum applicable historical federal rate (currently 38.6%). Long-term capital gain distributions and long-term gains from selling fund shares are taxed at the maximum applicable historical federal capital gains rate (currently 20%, in most cases). State and local income taxes are ignored for these calculations and information must be shown net of any fees and charges imposed by the mutual fund company.

TAX CALENDAR

October 15: --Deadline for filing 2001 Form 1040 if an extension was filed in August.
--Forms 5500 that were automatically extended in July are also due today.
--The same is true for calendar-year partnership returns (Form 1065) and trust returns (Form 1041) on an extension.

October 31: --File Form 941 (quarterly payroll tax return) for the third quarter. (Employers who deposited all taxes on time have until November 12.)
--Year-to-date undeposited federal unemployment taxes are due if your undeposited liability was more than $ 100 on September 30.

INTERESTING WEBSITES

Many of you put money into our 401 (k) and other retirement accounts each payday. Just how safe are these funds and what are the options when you want to start making withdrawals? The U.S. Department of Labor's publication "What You Should Know About Your Pension Rights" responds to these questions and addresses many other related issues. You can view this document online at www.dol.gov/pwba/pubs/youknow/knowtoc.htm.

For general information about retirement investing, and fund performance data, try
www.kiplinger.com/investing.

QUOTE OF THE MONTH

"Don't gamble. Take all your savings and buy some good stock and hold it 'til it goes up, then sell it. If it don't go up, don't buy it." - Will Rogers

IRS ISSUES NEW GUIDANCE ON NOL CARRYBACKS

The Job Creation and Worker Assistance Act of 2002 created a five-year carryback period for net operating losses (NOLs) arising in tax years ending during 2001 and 2002. However, it also retained your ability to use the normal two-year carryback period or to elect to forgo one or both carryback periods. Since these changes were made, there has been some confusion regarding exactly how to apply the new rules-especially on returns that have already been filed. Newly released guidance from the IRS helps clear up these questions.

The new guidance says that until October 31, 2002:

1.  Taxpayers that elected to forgo the two-year carryback period with respect to an NOL incurred in the tax year ending in 2001 or 2002 may revoke their elections so they can benefit from the five-year carryback.

2.  These taxpayers, as well as taxpayers who used a two year carryback period for an NOL in a tax year ending during 2001 or 2002 and now want to take advantage of the five-year carryback period, may file an application for a tentative carryback adjustment based on a five-year carryback, even if the 12-month period for filing such an application has expired.

3.  Taxpayers that filed a return for a tax year ending in 2001 or 2002, in which they neither used nor elected to forgo the two-year NOL carryback period, may elect to forgo the five-year carryback period and thereby retain the ability to use the two-year carry back period.

Some taxpayers have already elected to give up their right to carry back an NOL incurred in a tax year ending in 2001 or 2002. If these taxpayers don't want to take advantage of the new five-year carryback period, they don't need to do anything.

The new IRS guidelines create several options regarding the carryback of an NOL from a tax year ending in 2001 and 2002. Depending on your effective tax rate in the carryback years and expected tax rate going forward, significant tax savings may be available by carefully planning what to do with an NOL.

SUPREME COURT TIPS SCALES AGAINST RESTAURANTS

After a long battle and much to the dismay of the restaurant industry, the Supreme Court has now said it's okay for the IRS to use the aggregate estimation method to assess employer FICA tax on unreported tips. This method allows the IRS to figure and assess the employer's share (not the employee's portion) of FICA taxes on unreported tips without determining the actual amount underreported by the tipped employees. This Supreme Court decision is likely to increase tip audits.

With the aggregate estimation method, the IRS uses the restaurant's records of charged gross receipts and the related charged tips to project an overall-tipping pattern. This overall-tipping pattern includes cash tips for which records may not exist. This estimate is used to determine a business's unreported tips. The IRS then assesses the restaurant with its share of FICA tax on this unreported tip amount without crediting the employees for additional FICA wages or trying to collect any taxes due from the tipped employees. Why? Because it's easier to go after the restaurant than to find the employees.

TIP REPORTING REQUIREMENTS

Both employers and employees must pay FICA tax on tips. Employees who receive tips of $20 or more in a month must report the tip income to their employers by the 10th day of the following month. Employers use these reported amounts to determine how much FICA tax is owed on [he employee's tips. While employers can't force employees to report all tip income, they are responsible for the employer's share of FICA tax on unreported tip income.

In addition to collecting tip information from employees on a monthly basis, employers may also have to test and adjust the reported tips on an annual basis. The IRS requires "large food or beverage establishments'' to file Form 8027 (Employer's Annual Information Return of Tip Income and Allocated Tips) to report cash and charged sales as well as cash and charged tips. A business is a large food or beverage establishment if (I) it's a food or beverage operation, (2) tipping food or beverage employees is customary, and (3) it normally employed more than 10 people on a typical business day during the preceding calendar year. The IRS may initiate a tip audit if information on Form 8027 doesn't appear reasonable.

While giving the IRS a victory, the Supreme Court did give restaurants some hope by acknowledging that, although the aggregate estimation method isn't unlawful, the IRS's calculations can be challenged if no previous agreement not to challenge exists.

PROTECTING AC~INST TIP AUDITS

If you own a restaurant and want to avoid a tip audit, the IRS has a Tip Rate Determination and Education Program that offers protection from audit through several voluntary tip reporting compliance agreements. These agreements might be especially useful if your Form 8027 reveals substantial allocable tips and a wide disparity between the charged tip rate and cash tip rate, elevating the risk of an IRS tip audit.

The IRS developed these agreements after realizing that, despite the amounts collected from employers during tip audits, there was still a substantial amount that could be collected from the employees for their income and FICA tax on the unreported tips. However, instead of trying to collect the taxes from the individual employees, the IRS decided it would be more cost-effective if they could find a way to decrease the amount of unreported tips. With that in mind, they developed agreements designed to increase employees' tip reporting. If a restaurant properly executes one of these agreements, the IRS will not audit the restaurant's tips during the period the agreement is in effect and will only assess additional employer FICA taxes on unreported tips discovered during an IRS audit of an employee. These agreements are voluntary and the IRS may not use the threat of a tip examination to induce an employer to enter into one.

Restaurant owners should evaluate their tip reporting practices to determine if reported tip rates appear reasonable based on both the business's charged and cash tip rate. If you own a restaurant or are thinking about investing in one, please call us to discuss tip agreements and related issues

The Job Creation and Worker Assistance Act of 2002 included a retroactive change,~at basically equates the contribution limits for Simplified
Employee Pension plans (SEPs) with the higher limits for defined contribution qualified retirement plans. Thanks to this favorable tax law change, generous amounts can now be contributed to SEPs set up for the benefit of small business owners. The icing on the cake, however, is that a SEP is also (I) incredibly easy to establish and (2) a powerful retroactive tax planning tool (unlike other types of retirement plans). SEPs are a great choice for many high-income small business owners who do not currently have tax-advantaged retirement plans set up for themselves.

A SEP can be established as late as the extended due date of the self-employed person's or employer's tax return for the taxable year for which the SEP is to first apply. You can establish a SEP as late as that date, make the initial contribution, and claim a potentially hefty deduction on your prioryear's return. (In general, other types of retirement plans must be in existence by the end of the year for which the plan is to first apply.) In addition, there's no requirement to file Form 5500 series reports for a SEP.

PARTICIPATION AND FUNDING REQUIREMENTS

An eligible participant is defined for SEP participation purposes as an employee who has (I) attained age 21, (2) performed any services for the employer during at least three of the preceding five years, and (3) received at least $450 in compensation (this is the inflation adjusted amount for both 2001 and 2002). The employer is free to establish less-restrictive eligibility requirements. The self-employed individual or employer then makes contributions directly to each participant's IRA.

All eligible employees must participate in the plan, including those who die or quit during the year. Contributions to employee accounts are immediately 100% vested and nondiscrimination rules apply.

ANNUAL CONTRIBUTION LIMITS

For 2001, the maximum contribution to a SEP account set up for an employee (including a sole share holder employee of the sponsoring corporation) is 15% of compensation of up to $170,000. This effectively translates into a maximum contribution of $25,500. For 2002, the maximum contribution rises dramatically to 25% of compensation of up to $200,000, subject to a $40,000 maximum.