Moore Colson :: News & Resource Center

Tax Tips

No complaints about new lodging rules

Previously, lodging expenses were deductible only if incurred when traveling away from home. But the IRS has announced a change in its policy and plans to amend its regulations accordingly. Under interim guidance published last year, local lodging expenses are deductible and not included in employee income if:

What’s the use?

There’s a common misperception that when you buy products from an out-of-state vendor, either on the Internet or by mail order, the purchase is tax free. Sellers aren’t required to collect sales tax unless they have a physical presence in your state. But that doesn’t mean you’re off the hook.

If a seller isn’t required to collect sales tax, you’re required to file a use tax return and pay the tax — sales and use taxes are usually imposed at the same rate. As the name suggests, use tax applies when you buy a tax-free item out of state for use in your state. Some states allow you to make a small amount of tax-free purchases each year.

Collection actions against individuals and businesses are becoming more prevalent, so you should exercise caution, especially if you make a significant amount of purchases each year without paying sales or use taxes or buy items outside the United States.

Random thoughts

The IRS is reviving its random audit program, and the number of taxpayers expected to be audited represents a tiny fraction of total filers. Unfortunately, if you’re one of the few who are audited, you may have to pay hundreds or even thousands of dollars to defend yourself. The best way to protect yourself is to maintain thorough, well-organized supporting documentation for your returns.

Don’t be afraid to ask

If you receive a letter from the IRS or a state taxing authority informing you of a discrepancy or mistake in your tax return that increases your tax liability, don’t assume the government is right. Before you make a payment, talk to your tax advisor. There have been a number of recent cases in which IRS notices contained errors, particularly when complex areas of the tax code, such as the alternative minimum tax, are involved.

Other mistakes include assessing late-filing penalties against taxpayers who received automatic extensions and assessing estimated tax underpayment penalties against taxpayers who met the requirements for one of the safe harbors.

Some taxpayers receive notices that information reported on their W-2s or 1099s do not match the information on their returns. But often that’s because income items were reported on a different part of the return — not because they were omitted — or there was a data-entry error.

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5 post-year-end tax strategies to reduce your 2007 tax bill

Now that you’ve closed the books on the 2007 tax year, you may think you’re finished tax planning for it. But there’s still time for you to implement these five post-year-end strategies that can reduce your 2007 tax bill.

1. Contribute to your IRA

You have until April 15, 2008, to contribute to an IRA and deduct that amount on your 2007 return. You can even open a new IRA by April 15 and still make contributions for 2007.

2. Check your receipts

An examination of your bank records, credit card statements, receipts and other documents may reveal valuable tax-saving opportunities. For example, you can deduct sales taxes in lieu of state and local income taxes on your 2007 return, so look for any large purchases that would make the sales tax deduction a more beneficial tax strategy.

3. Simplify your retirement plan

If you’re self-employed, you can contribute up to the lesser of $45,000 or 20% of self-employment income adjusted for half of self-employment tax to a Simplified Employee Pension (SEP) plan. Even better, you can set up and fund a SEP plan as late as your extended tax return due date (Oct. 15, 2008) and still deduct the contribution on your 2007 return.

4. Don’t cut your losses

If you’re a shareholder in an S corporation, your ability to deduct corporate losses in 2007 may be limited by your tax basis in your stock. If the corporation has accumulated earnings and profits left over from its days as a C corporation, you may be able to increase your basis by having the corporation file a deemed dividend election on its tax return. Keep in mind that the other shareholders must approve.

Provided you meet the requirements, a deemed dividend election assumes that the corporation made a pro-rata distribution of some or all of its accumulated earnings and profits to its shareholders on the last day of 2007. It also assumes that the shareholders immediately transferred the funds back to the corporation as a capital contribution. As a result, you and the other shareholders owe capital gains taxes on the deemed dividend. But your basis is increased by the fictitious capital contribution, allowing you to deduct a greater portion of corporate losses from ordinary income.

5. Spare no expense

If you’re self-employed or own a small business and acquired any equipment or other fixed assets during 2007, take advantage of Internal Revenue Code Section 179 to write off the expense. You can elect on your 2007 return to expense up to $125,000 worth of qualified property instead of depreciating it over the property’s useful life. The expensing election is reduced to the extent the cost of qualified property placed in service during 2007 exceeds $500,000.

Act now

Time is running out to act on these tax tips. Talk to your tax advisor about these and other strategies you can implement now to soften the blow of your 2007 tax bill.

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Bulletproofing your FLP

During the last decade, family limited partnerships (FLPs) have come under fire from the IRS. That doesn’t mean an FLP has lost any of its muscle as an estate and succession planning tool. What it does mean is that the IRS may attempt to shoot down an FLP it believes is nothing more than a tax-avoidance scheme.

Fortunately, with careful planning, you can create an FLP that’s bulletproof — or at least bullet resistant. There are no guarantees when it comes to tax law, but designing and operating an FLP as a legitimate business rather than merely a tax-saving vehicle can help deflect an IRS challenge.

A high-caliber planning tool

FLPs offer several benefits, including the ability to:

Consolidate ownership and management of securities, real estate or other investments,
Transfer large amounts of wealth to children or other family members without giving up management control,
Keep a business or other assets in the family,
Ensure a smooth transition of business ownership from one generation to the next,
Provide a mechanism for resolving disputes over the disposition of assets,
Shield assets against personal creditors’ claims, and
Reduce gift and estate taxes through valuation discounts available to limited partnership interests (typically between 30% and 40%).

The key to preserving an FLP’s tax benefits is to ensure that the partnership is designed to also meet one or more nontax objectives.

The IRS’s target

If you’ve followed recent court cases involving FLPs, you might think that the string of IRS victories signals the death of the FLP as a viable planning strategy. But most of these cases involved taxpayers who failed to follow partnership formalities and were unable to demonstrate a legitimate, nontax purpose for forming the FLP.

Fortunately, the courts’ opinions provide a roadmap for helping you structure and operate an FLP that will likely survive an IRS challenge. (See “FLP red flags” on page 5.)

Consider the Tax Court’s decision in Erickson v. Commissioner in 2007. The decedent, Hilda Erickson — who was suffering from advanced Alzheimer’s disease — formed an FLP on the advice of counsel and largely through the efforts of her daughter, Karen. The partnership was designed to hold several million dollars worth of real estate, marketable securities and other assets. Karen and her younger sister, Sigrid, were general as well as limited partners, and Karen’s husband was a limited partner.

Contrary to the partnership agreement’s terms, the FLP wasn’t fully funded until Mrs. Erickson was on her deathbed. Two days before she died, Karen, acting as her mother’s attorney-in-fact, transferred more than $2 million in assets to the FLP. Karen also gifted substantial limited partnership interests to Mrs. Erickson’s grandchildren. After Mrs. Erickson’s death, the FLP purchased her home and gave her estate more than $100,000 to help pay estate taxes.

Ammunition

The IRS successfully challenged the FLP under Internal Revenue Code Section 2036(a), which allows the IRS to disregard an FLP under certain circumstances and treat assets contributed during the person’s lifetime as part of his or her estate. Sec. 2036(a) applies if, by express or implied agreement, the transferor retains “possession or enjoyment of, or the right to the income from, the property,” or the right to determine who can do so. There’s an exception for assets transferred as part of a “bona fide sale for adequate and full consideration.”

The Tax Court pointed to several factors indicating that Mrs. Erickson retained the right to possess or enjoy the assets she contributed to the FLP:

The delay in funding the FLP until two days before Mrs. Erickson died suggested that the parties did not respect partnership formalities.
The FLP provided the estate with funds to meet its liabilities — the court wasn’t convinced by the estate’s argument that this was merely a redemption of Mrs. Erickson’s partnership units.
The FLP had little practical effect during Mrs. Erickson’s life — the court said it was “mainly an alternate method through which Mrs. Erickson could provide for her heirs.”

According to the court, the transaction represented the daughters’ “last-minute efforts to reduce their mother’s estate’s tax liability while retaining for decedent the ability to use the assets if she needed them.”

The court also found that the FLP transactions didn’t fall within the bona fide sale exception. That exception applies when an FLP is formed for a legitimate and significant nontax reason and each partner receives a partnership interest that’s proportionate to the fair market value of the property he or she contributes.

In this case, several factors belied the existence of a legitimate and significant nontax purpose:

The parties stood on both sides of the transaction — Karen, for the most part, acted unilaterally and the other parties were not represented by independent counsel, nor did they appear to understand the transaction.
Mrs. Erickson and her estate were financially dependent on distributions from the FLP.
The partners commingled partnership funds with their own.
The parties didn’t transfer assets to the FLP until Mrs. Erickson was on her deathbed.

The court found that the FLP was nothing more than an “asset container.” It didn’t serve to centralize management of family assets, as the estate claimed, because there was virtually no change in management responsibilities or investment strategies after the FLP was formed.

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Seal your exit strategy with an ESOP

If you own a successful business, chances are a substantial portion of your net worth is tied up in it. Even if you plan to stay actively involved in the company for many years, it’s important to have an exit strategy that addresses when to convert your business interest into cash so you can use it to diversify your investments.

Designing an exit strategy that meets your objectives can be challenging, especially if your business is closely held or the company’s stock is thinly traded. How do you cash out without selling the business to an outsider or giving up control? One solution to consider is an Employee Stock Ownership Plan (ESOP). In addition to creating a market for your stock, an ESOP offers extraordinary tax savings and other benefits to your company and its owners and employees.

Plotting your exit route

An ESOP is a qualified retirement plan, similar to a profit sharing or 401(k) plan. The main difference between an ESOP and these other types of retirement plans is that, instead of investing in a variety of stocks, bonds and mutual funds, an ESOP invests primarily in the employer’s own stock.

Here’s how it works. Often using borrowed funds, the employer makes tax-deductible contributions to the ESOP, which the plan uses to acquire stock from the company or its owners. Essentially, by establishing an ESOP, you create a buyer for your shares. At the same time, you provide a powerful incentive for employees, who now have an opportunity to share in the company’s growth on a tax-deferred basis. When employees retire or otherwise qualify for distributions from the plan, they can receive benefits in the form of stock or cash.

Like other qualified plans, ESOPs are strictly regulated. They must cover all full-time employees who meet certain age and service requirements, and they’re subject to annual contribution limits (generally 25% of covered compensation), among other conditions.

ESOPs are also subject to rules that don’t apply to other types of plans. For example, an ESOP must obtain an independent appraisal of the company’s stock when the plan is established and at least annually thereafter. Also, participants who receive distributions in stock must be given the right to sell their shares back to the company for fair market value. This requirement creates a substantial “repurchase liability” that the company must prepare for.

Leveraging the tax benefits

An ESOP provides a company and its owners with several tax benefits. If the ESOP acquires at least 30% of a closely held C corporation, the selling owners can defer their gain indefinitely by reinvesting the proceeds in qualified replacement property within one year after the sale — an advantage over an outright sale. Qualified replacement property includes most securities issued by domestic operating companies.

ESOPs are unique among qualified retirement plans because they permit a company to finance the buyout with borrowed funds. A “leveraged” ESOP essentially permits the company to deduct the interest and the principal on loans used to make ESOP contributions — a tax benefit that can do wonders for a company’s cash flow. If the company is a C corporation, it can also deduct certain dividends paid on ESOP shares. Interest and dividend payments don’t count against contribution limits.

S corporations with multiple shareholders are now permitted to have ESOPs, but limited tax incentives make them less effective as an exit strategy. Gain deferral and dividend deductions are unavailable, and interest payments on leveraged ESOP loans apply toward the contribution limit.

Staying in control

Another advantage of ESOPs over sales or other exit strategies is that they allow you to cash out without giving up control over the business. Even if you transfer a controlling interest in a closely held company to an ESOP, most day-to-day decisions will be made by the plan’s trustee, who can be an officer of the company.

However, ESOP participants may have the right to vote their shares on certain major decisions, such as a merger, dissolution or sale of substantially all of the company’s assets.

Determining whether an ESOP is right for you

Of course, ESOPs do have some disadvantages: Annual appraisals, repurchase obligations and other requirements make them expensive to administer, and investing in the company’s stock involves some risk. But for owners looking to cash out in a tax-advantaged manner while providing benefits to the company and its employees, an ESOP is definitely a strategy to consider.

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