Tax and Business Alert - October 2004

Deducting Business Bad Debts

A bona fide debt is one arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable amount of money. For debt creation, the business must be able to show that it was the intent of the parties at the time of the transfer to create a debtor-creditor relationship. In other words, the business must be able to show that at the time of the transaction, there was a real expectation of repayment, and there was intent to enforce the indebtedness.

For most commercial businesses, it is not uncommon to hold uncollectible or worthless debts. Two types of bad debt deductions are allowed by the IRS: business bad debts and nonbusiness bad debts. Business bad debts give rise to ordinary losses which can generally offset taxable income on a dollar-for-dollar basis. Nonbusiness bad debts are considered to be short-term capital losses. Because of the limitation on capital losses, distinguishing business and nonbusiness bad debts is critical.

Business bed debts generally originate as credit sales to customers for goods delivered or services provided. If a business sells goods or services on credit and the account receivable subsequently becomes worthless, a business bad debt deduction is permitted, but only if the income arising from the receivable was previously included in income.

The fact that the debtor is a related party does not preclude a business bad debt deduction by the business. If owner or related party loans made for legitimate business purposes become worthless, they are treated no differently than debts to an unrelated party.

Business bad debts can also take the form of loans to suppliers, clients, employees, and distributors. Additionally, a guarantor is allowed a business bad debt deduction for any payments made in the capacity as guarantor if the reason for guaranteeing the debt was business related. Here, the guarantor's payment results in a loan to the debtor, and the taxpayer is allowed a bad debt deduction once the loan (including any right of subrogation against the debtor) becomes partially or totally worthless.

Worthlessness can be established when the business sues the debtor, and then shows the judgment is uncollectible. However, when the surrounding circumstances indicate a debt is worthless and uncollectible, and that legal action to collect the debt would in all probability not result in collection, proof of these facts is sufficient to justify the deduction.

Tax Calendar

November 1

- For those with employees, a federal unemployment tax (FUTA) deposit is due if your  employment taxes (FICA and withheld income taxes) liability is $2500 or more and the FUTA liability through September 30 exceeds $100.
- The third quarter Form 941 (Employer's Quarterly Federal Tax Return) is also due today (except that you have until November 10 to file if you deposited all taxes for the quarter when they were due).

October 15

-Personal returns extended in August need to be filed by today.

The IRS recently unveiled a new multiyear strategic plan that focuses on improved taxpayer service, enhanced enforcement of the tax laws, and modernized business processes and technology.

The new strategic plan supports the agency's key enforcement priorities to:

- Discourage and deter noncompliance, with emphasis on corrosive activity by

   corporations,   high-income individual taxpayers, and other contributors to the tax gap.
- Ensure attorneys, accountants, and other tax practitioners adhere to professional

   standards and follow the law.
- Detect and deter domestic and off-shore-based tax and financial criminal activity.
- Discourage and deter noncompliance within tax-exempt and government entities by third

   parties for tax avoidance and other unintended purposes.

The plan was reviewed and approved by the IRS Oversight Board, which was created by the IRS Restructuring and Reform Act of 1998 to oversee the tax agency. A majority of the Board members are from the private sector.

Increased FDIC Insurance Coverage for Revocable Living Trusts

The Federal Deposit Insurance Corporation (FDIC) at www.fdic.gov recently increased the deposit insurance coverage for revocable trusts. The new coverage increases the trust owner's insurance coverage to $100,000 for each of the trust's beneficiaries if the following specific requirements are met:

- The beneficiary must be the owner's spouse, child, grandchild, parent, or sibling.
- The beneficiary must become entitled to his or her interest in the trust when the owner

  dies.
- The account title at the bank is held by a trust.

 

Previously, many living trusts did not qualify for per-beneficiary coverage and were limited to just $100,000 in coverage because of certain prohibited trust provisions that are now approved by the FDIC. For living trusts with more than one owner, the coverage of up to $100,000 extends to each qualifying beneficiary of each owner.

529 or ESA? Choosing a College Saving Vehicle

If you have young children, you probably realize you ought to start saving for their college education. And you should start saving as soon as possible to give that money time to grow.

But maybe you haven't begun because you're not sure where to put those funds. A Savings account? U.S. savings bonds? A mutual fund? A trust account? Or one of the tax-advantaged vehicles provided by recent legislation - a 529 plan or education savings account (ESA)?

All of those choices have advantages and disadvantages. But if you've narrowed your list down to a 529 plan and an ESA, consider the following in your analysis.

An ESA allows you to save up to $2000 a year for your child's education. The investment is self-directed (as with an IRA). A 529 plan allows you to either purchase tuition credits at today's prices (a pre-paid plan) or invest among certain mutual funds [as with a 401(k) plan] that will (hopefully) grow into a large enough sum to pay for college (a savings plan).

Since prepaid 529 plans have limited appeal (and because some have closed to new investors because of poor performance), we'll limit our comparison to 529 savings plans and ESA's. Both are considered tax-advantaged for two reasons. First, they allow your money to grow tax-deferred. Second, you won't pay taxes on the money that is spent on 'qualified education expenses.' (Note that there is no federal income tax deduction for contributions as with a qualifying traditional IRA.)

So what's the difference and how do you decides? Here are some questions to ask?

1. Am I eligible? Almost everyone can open up a 529 account, but ESAs have income limitations. The ESA annual contribution limit of $2000 is phased out for joint filers whose modified adjusted gross income is between $190,000 and $220,000. If your income exceeds that range, an ESA is not an option for you. Enjoy your 529 account!

2. What if my children incur precollege education expenses? A significant advantage for ESAs is that some primary and secondary school costs are considered qualified education expenses. Thus, tuition at a private school and the cost of a computer may qualify.

3. Am I comfortable making my own investment choices? Choices with 529 plans are limited and some provide age-based tracks that automatically move your money into 'appropriate' funds as your children get older. ESAs are completely self-directed. You choose the investments.

Here are some additional items to keep in mind. If you are concerned about financial aid implications, don't worry. An ESA is no longer treated as an asset of the student/beneficiary and so it is no longer assessed at the student rate. Now, ESAs and 529 plans owned by the parent (with the child/student as the beneficiary) are both assessed at the lower parental rate for federal financial aid computations. That said, if you have enough available money, you can contribute to both. You can put up to $2000 in an ESA for your child, and then stash more money in a 529 account. Most 529 plans allow account balances to exceed $200,000. (Just be aware of gift tax implications.)

Call us. We can help you make a good decision about college planning.

Are Your Bank Deposits Fully Insured?

The Federal Deposit Insurance Corporation's (FDIC's) reserves stand behind insured deposits that also have the full faith and credit backing of the US Government. The FDIC protects deposits that are payable in the U.S., but not in other countries. Securities and mutual funds, even if purchased at a bank, are not covered by deposit insurance. All types of deposits received by a financial institution in its usual course of business are insured. For example, savings, checking, NOW accounts, certificates of deposit, cashier's checks, money orders, officer's checks, and outstanding bank drafts are all insured.

An individual depositor is insured up to $100,000 in each financial institution. Accrued interest is included when calculating insurance coverage. Deposits maintained in different categories of legal ownership are separately insured. Accordingly, you can have more than $100,000 of insurance coverage in a single institution provided the funds are owned and deposited in different ownership categories. However, the account of a sole proprietorship is not considered a different category of legal ownership (i.e., it is an individual account). Funds deposited by a corporation, partnership, or unincorporated associations are insured up to a maximum of $100,000 and are insured separately from personal accounts of shareholders, partners, or members.

Federal deposit insurance is not determined on a per-account basis, but on an ownership basis. The type of account has no bearing on the amount of insurance coverage, and the social security or tax identification numbers do not determine coverage.

Separate insurance is available for funds held for retirement (e.g., IRAs, Keoghs, and pension or profit sharing plans). IRA and Keogh funds are separately insured from your nonretirement deposits. However, IRA and self-directed retirement Keogh funds, other self-directed retirement funds, and those belonging to 457 Plan accounts (if the deposits are eligible for pass-through insurance) will be insured up to $100,000. Pass-through insurance means that each beneficiary of a pension or profit sharing plan's ascertainable interest in a deposit, as opposed to the deposit as a whole, is insured up to $100,000.

See the article above about increased FDIC insurance coverage limits on revocable living trust accounts.