“All progress is based upon a universal innate desire on the part of every organism to live beyond its income.”
More Leaky Tax Shelters
You will recall all the troubles that befell the national CPA firm of KPMG, for very aggressively designing and selling “tax shelters” that the IRS later ruled were fraudulent. After paying a fine of well over $400 million, KPMG is still in business. Related to such organizations, were the law firms that gave legal opinions that these tax shelters (“more likely than not”) would be approved by the IRS. WRONG!
Among the more prominent was the 600-lawyer national law firm of Jenkins & Gilchrist. They paid a $76 million penalty for promotion of “abusive and fraudulent tax shelters and violation of the tax law concerning tax shelter registration and maintenance and turnover to the IRS of tax shelter investor lists.” That law firm discontinued operations and is now liquidated.
The very prestigious law firm of Sidley Austin LLP has paid a civil tax promoter penalty of $39.4 million — for the firm’s “promotion of abusive tax shelters and a failure to comply with tax shelter registration requirements.”
Recently four employees of the national CPA firm Ernst & Young were indicted on charges of designing and selling abusive tax shelters etc.…and so it goes….
A Big Change in the Kiddie-Tax Rules
Many people do not realize the broad significance of these recent changes in the law. The so called Kiddie Tax imposes the parents’ top tax rate on investment income of children who have not reached age 19 before the end of the tax year (beginning in 2008) — instead of the previous ages of first 14 and then 18. Investment income includes interest, dividends, capital gains, rents, and other unearned income. This tax applies if the child’s total investment income exceeds $1,700 (2007 amount, inflation adjusted each year).
This change completely destroyed smart and legitimate investment strategies that previously involved just over age 14 children, with a remaining four-years before they went to college. During that old four-year window, it was very smart for parents to shift substantial income-producing investment property to their over 14 — who only paid taxes at their own low tax rate — and built up significant funds to be used for their college education. That opportunity is now gone and investment strategies for college funding need to be re-evaluated.
Rather than incur the parents’ high tax rate, it now makes sense to shift the children’s investments to growth equities that pay little or no dividends. Also tax-exempt municipal bonds, or qualified tuition/Section 529 plans (probably most-recommended in the future), and possibly IRAs (if the child also has earned income) may also make sense now (at least until age 19). See your tax advisor if you will be caught by these changes (taxwise).
EXAMPLE: Assume a 17-year old teen has $3,700 of investment income — which after the $1,700 threshold leaves $2,000 that is now taxed at the parents’ top tax rate. Under the old law, the child’s tax rate on that income (if at age 15) would typically be 10%, while the parents’ rate generally runs from 28% to 35%. Assuming their rate is 33% versus their child’s 10% rate, the Kiddie Tax will now causes an additional 23% in federal tax — or in this example an extra $460 in taxes.
CAUTION: A recent and still further change (probably final) in this part of the tax law can cause the Kiddie Tax to apply to some dependent children until they reach 24 years of age. In simplified terms it will now apply to dependent full-time students under age 24 (rather than under age 19 — who don’t have earned income that exceeds half of his or her support. Confusing? Yes!
“The latest revisions in the kiddie tax represent “the final nail in the coffin for families trying to shift income from parents in a high tax bracket to children in a lower one.” (Wall Street Journal — from J.P. Morgan Private Bank.)
A Financial Rule to Live By
Among the many to guide your financial life by, this may be among the most important. No matter how or where or in what form you invest your money — the higher the return you are promised — the higher your risk. (Every investor should memorize and repeat this rule daily.)
Why would someone offer you 5% or 10% a month — with “no risk”? If it’s really that kind of deal — why do they need to pay you such promised returns? Why can’t they just go to the bank with their “no risk” deal — and just pay about 8% a year? Why should they share such a wonderful deal with you, instead of just keeping it for themselves, or just with their own family? Why you? The higher your promised return — the higher your risk, no matter what they claim. Always!
One of the latest ways to suck you in is to tell you that (in some form or another) the deal involves US Government guarantees, or US securities, or something similar that makes the whole deal risk-free. Of course these are usually blatant lies, but it sure sounds great that the whole US government is standing behind you to make sure you can’t lose your money. Don’t hold your breath!
We often hear about the so-called “Ponzi” schemes when they explode. They indeed pay the initial group of investors that 5% or 10% a month — by simply using the funds that come in from the later group of investors. Then, the word spreads from the initial investors that you really can get that 5%-10% no-risk monthly return — and more and more suckers stand in line to invest bigger and bigger money. When the group gets so big they can no longer pay everyone the promised returns — they just grab the $100 million or $500 million that’s still left — and take off for Costa Rica or Brazil. Then, the Wall Street Journal reports another Ponzi scheme that just blew up — and almost all of their financially sophisticated readers say, “How could those so-called “investors” be so stupid? The higher the return — the higher the risk — every idiot knows that….” (I guess a lot of people still don’t.)
(For those of you not familiar with the name, many years ago a Mr. Ponzi was the first one on a large scale, to pull this scam of using Peter’s money to pay Paul, so he permanently got the fame.)
Converting a Corporation to a Limited Liability Company (LLC)
With all the favorable talk about the advantages of an LLC, many now operating as corporations are interested in becoming an LLC. It’s not easy….
- A corporation must be formally liquidated before its assets can be put into an LLC.
- If it’s a C corporation with significant assets, there is potentially a double tax to pay. (1) The liquidation is treated as a sale of the corporation’s assets and any profits are taxed to the corporation. (2) Then the funds from the sale are deemed distributed to the shareholders, who may be taxed again. (3) Whatever is left after taxes can go into the LLC.
- If it’s an S corporation, there is no double taxation, as any taxes on liquidation are only placed on the shareholders (with the possible exception of any corporate “built-in gains tax.”)
- A new corporation, or one without past successes or minimal assets, may be able to convert to an LLC without tax cost.
- If you want to go forward with the conversion, see a good tax attorney and expect some nice-sized legal bills.
- Interestingly, converting a partnership to an LLC is rather easy.
IRS Notices
In May and June 2007, the IRS sent out their annual “CP” letters to a few million individuals, regarding so-called discrepancies in their 2005 (not 2006) personal income tax returns. While our clients have received relatively few, there was an obvious pattern that developed. When taxpayers do a tax-free rollover of their retirement account from one financial institution to another, they usually receive a form 1099-R that reports the total amount of the distribution, while the taxable amount box is left blank.
To clear the IRS computers (which record a copy of every such form), we report the total 1099-R, and then indicate that it is a tax-free rollover, and, of course, show no taxable income. A number of our clients looked at such forms and did not bother to send them to us, since they were not taxable. And a number of our clients now received these IRS letters that assumed, since no amounts were reported, that the total distributions were taxable. Since many of these rollovers were in the millions, there were some very large, albeit incorrect tax bills, included in these letters. MORAL OF THE STORY: Give your tax preparer all Forms: 1099-R, 1099, W-2, etc., etc.!
Another Independent Contractor Case
We have often seen where companies have their lawyers draw up (apparently) ironclad and elaborate contracts that state that the workers are independent contractors and not employees. After both parties sign those contracts, the company proceeds to pay them accordingly. The Tax Court has ruled that such contracts are not binding in cases where the firm has enough control over them. Remember, it’s always “direction and control” that is the primary determination of a worker’s classification.
The Tax Court summed it up beautifully, as a guide for all you readers: “The company and drivers entered into written agreements which expressly provided the drivers were independent contractors. However, our findings with respect to the degree of control exercised by (the company), (the company’s) investment in trucks, the driver’ lack of assumption of risk, the ability to discharge, the integration of the drivers into the business, and the permanency of the relationship override any contrary characterization contained in the agreement.” (Peno Trucking, Tax Court Memo 2007-66)
Day Camp and a Tax Break
Many working parents must arrange for care of their children under 13 years of age during the school vacation period. A tax-advantaged solution is a day camp program. The cost of day camp can count as an expense toward the child and dependent care credit. (Expenses for overnight camps do not qualify.) If your childcare provider is a sitter in your home, you’ll get some tax benefit if you qualify for the credit (and the sitter can then report the income, pay into a Roth IRA, and be rich at age 65 — as I have often suggested).
The credit is generally 20% to 35% of non-reimbursed expenses; up to $3,000 in expenses for one child and up to $6,000 for two or more children. The actual credit is also based on your income and gradually phases out as your income level increases. The 35% rate applies if your income is under $15,000; the 20% rate, if your income is over $43,000.
For more information, see IRS Publication 503, Child and Dependent Care Expenses. Available at website IRS.gov or by calling 800-829-3676, for a free copy of any IRS publication.
“Pump and Dump”
Our firm gets an average of five to twenty unsolicited faxes a week, each one touting a different 1¢, 10¢, 50¢ or $1 stock that positively, absolutely will be selling for $2, $5, or $10 within a the next week or so. So you can triple, quintuple, sextuple your money or more — in no time at all. And you simply cannot lose….
This is a scheme in which the promoters artificially push up the price of a thinly traded stock, by virtue of these faxes sent by the millions, unsolicited phone calls, and any other means available. They sell the stocks to all the fools that fall for these (very persuasive) arguments at what is really the very high for the stock — and then the bottom drops out, leaving you (the fools) with worthless stock. Of course the promoters bought their shares at about 1/10th or 1/100th of a cent per share — and laugh all the way to the bank. So first the pump up the price of the stock — then they gladly dump their shares on you!
A variation on this scheme is when you get a voice mail about a “hot” stock that appears to be left by someone who was calling a friend, but mistakenly dialed your number. How tempting to act on that accidental tip — that was really left by the pump and dumpers on thousands of phones. As Texas Guinan (remember her you old folks?) used to say, ”Hello Suckers.”
Small Tax-Exempt Organizations
These are classified as those with gross receipts that are normally an annual $25,000 or less. In the past they were not required to file annual reports with the IRS. With the enactment of the Pension Protection Act of 2006, they are now required to annually file electronically Form 990-N, also known as the “e-Postcard.” Any such organizations that do not file the e-Postcard will automatically lose their tax-exempt status as of the filing date of the third year.
Heartbreak Hotel
I previously wrote about the case of Walter Anderson, in what the IRS called the biggest tax prosecution case ever. This telecommunications entrepreneur admitted to hiding hundreds of millions of dollars from the IRS and was sentenced to nine years in jail. However, the judge in the case ruled that his hands were tied, and that he could not order Andersen to repay the government $100 to $175 million — because the Justice Department’s binding plea agreement with Anderson listed the wrong statute!
Financial Independence
Not from the IRS, but valuable advice for all:
- Separate wants from needs. Concentrate on needs.
- Never take a risk you cannot afford to lose. Never purchase an item you cannot afford to buy.
- Personal purchases really cost you about 50% more, since they are paid for with after-tax dollars.
- Don’t forget taxes. Immediately set aside the funds to pay the taxes.
- Windfalls are capital — not income to be spent. Capital is for wealth investment.
- Debt is poison. It is negative. First is interest and charges. Second debt prevents investing and reaching financial independence. Finally, it creates insecurity in your life and judgment.
- Small savings over big time are the better way to create wealth — than big risks.
- The pleasure of luxury is short. Anxiety lasts until you discharge debt.
- Get gratification from personal relationships — not from material things.
- Credit is for emergencies. Pay cash until you reach your goal.
- Fight impulse purchases, resist gratification, and invest instead.
- Buy what pays you, not what decreases in value or costs money to carry.
- Put your own oxygen mask on first.
