Tuesday, June 29, 2010

Summertime for ROTH

To the tune of George Gershwin, lyrics of Dubose Heyward:

Summertime
And the livin' is easy
Fish are jumpin',
And the cotton is high.
Oh, your daddy's rich,
And your ma is good lookin',
So hush, little baby,
Don' yo' cry.

When I sing these lyrics, and I am a big fan of the classic American song book, I think of ROTH IRA conversions. Really, I do!

2010 is the time to think about converting the regular IRA to a ROTH IRA. You do pay tax, but you get to spread the tax out over the next two years, and there is no longer any AGI restriction. The Wall Street Journal had a recent article where they mentioned that some notable people will be doing the conversion, including Michael Graetz, the brilliant tax professor.

Should you convert? It depends. And therein lies the genius of the lyrics of Porgy and Bess. To determine whether the conversion makes sense, you must run the figures for your client. And during the summer doldrums is a wonderful time to crunch numbers.

And the conversions seem to make sense if your daddy's rich, especially given that future tax brackets might be higher than they are presently. If your clients are in the roughly 50% of the population that do not pay income tax, conversion is not advised. And, as for the little baby, remember that ROTH distributions are tax free and there is no RMD, so conversions are great for that little baby.

But do the calculations carefully. Or else you'll be singing Ira Gershwin's words, “Oh, I got plenty 'o nuthin'.”

The Face Behind the Blog

Editor Winford Paschall with a quick behind-the-scenes look at the CPE & Training Blog—a great way to stay current and share your opinion on tax and A&A issues.

video

Father's Day and Taxation

Father's Day, 2010. My wife and daughter cooked up a delicious breakfast of buttermilk waffles. The key is: buttermilk. It makes everything better. Turns ordinary waffles into extraordinary waffles. Combine buttermilk with love and, well, you've got it made.

My wife is is out running chores, my daughter is out running, jogging, I took a brief bike ride, came home, and sat down to read Chapter Five, Choice and Happiness from The Paradox of Choice by Barry Schwartz. In it, he speaks about a psychology experiment which is pertinent to all tax practitioners. The chief experimenter, Martin Seligman, ran an experiment teaching a group of animals to jump over a hurdle to avoid an electric shock (which is similar to a tax audit, but less painful). One group of animals had previously learned a different way to avoid the shock, but that method would no longer work. Another group had never learned to avoid shocks. The result of the experiment was that the animals who had previously learned how to avoid shocks learned the new method more quickly than the group which had never learned any technique to avoid a shock.

So, Abe, what has this to do with tax practitioners? Easy. We are like those animals. We have learned tax law and we have learned tax planning approaches that serve our clients well. Congress continues to change the law but, because we have prior experience, we can more easily learn the new law than someone entirely new to the profession. Or, think of it this way, we are the experienced animals and our clients are the animals who have never learned any technique. That's why they continue to come to us for help.

The law continues to change. The end is not in sight. What we used to know no longer applies. But we have learned how to learn. We have learned how Congress thinks, or doesn't think. We have learned about dealing with the IRS. Maybe it is true, maybe there is nothing new under the sun. Maybe what Congress passes is just a variation of what came before. But even if they come up with something entirely novel, we can adapt more easily because of what we have learned previously.

This is why continuing professional education is so important. In Los Angeles, where I live, the victory of the Lakers is being celebrated. And they won because, well, because they are good and they stay in shape. They have new competitors, but they stay in practice. And continuing education keeps us in practice, keeps us in shape.

When, on my bicycle ride, I went by cars with Laker flags waving, I picture all of us, as experienced tax practitioners, with our winning pennant in the race. The route may change, but the footwork basics always apply.

Your thoughts?

Best,

Abe Carnow

Thursday, June 10, 2010

Free Debt or is it Debt Free?

I was watching a TV news program the other evening where a reporter was interviewing a man in California about the home mortgage crisis. The man explained to the reporter that the home he and his wife had purchased about three years ago for $800,000, was now only worth about $375,000. As a result they had decided to simply walk away from the home and stop making loan payments even though they could afford to continue to pay the monthly installments. I wondered why the reporter never mentioned anything about a potential tax liability related to debt forgiveness. I was remembering back several years ago when one of my clients faced a debt forgiveness issue with a totally different outcome. The client was struggling to make a go of it in a retail business. When the client finally gave up and closed the business, the suppliers were kind enough to forgive the debts they were owed for inventory purchased and sold by my client. Needless to say you can imagine how shocked my client was when I told them that they owed some $25,000 in income taxes. Their response was a predictable, how can we owe income taxes when we have no assets, no cash and our business is a total loss? I explained to them that if you owe a debt to someone else and they cancel or forgive that debt, the canceled amount is usually considered taxable income and you will have to pay income taxes on the dollar amount of the debt forgiven.

So why wasn’t the reporter mentioning this possibility to the California couple? Well, the answer is the Mortgage Forgiveness Debt Relief Act of 2007. This act generally allows taxpayer to exclude income from the discharge of debt on their principal residence so long as the debt is secured by the home. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. Bankruptcy and insolvency of the taxpayer also qualify for the exclusion.

The provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

So why did my client owe taxes on their forgiven debt? The reason is that their debt was business debt and not personal debt related to their principal residence. For more information about cancelled debts see the IRS Publication 4681 and IRS news release IR-2008-17.

So what do you think about debt forgiveness? Should taxpayers like the couple in California be allowed to simply walk away from their mortgage? If they walk away from their mortgage, won’t you and I ultimately end up paying for it through our taxes?

Friday, June 4, 2010

CP2000 letters by the dozen

The letters usually begin with ominous words: “there is an error on your tax return.”

I’m speaking of course of the CP2000 forms that have been flooding my mail box since right around April 15; it’s almost like the IRS was told to wait until tax season is over and then to let them rip.

The CP2000 is used by the IRS to notify taxpayers of items which do not appear on the 1040 but which have been reported by third parties--usually on a 1099. The IRS’s choice of words can be quite frustrating. They assume that there is an error on the return. They assume that they are right and that the taxpayer is wrong. Therefore included in the form is a computation of tax deficiency, interest and sometimes penalties.

In my experience the IRS is usually wrong in their assumptions. Frequently one receives such a form because the IRS has not been able to match their information with that properly reported on the tax return. Fortunately all it takes to get the matter resolved is a letter of explanation. Still it is frustrating that my clients are being told that I made an error on their return. An unexpected letter from the taxing authorities can be stressful enough; I do not need them being informed erroneously that their accountant is making mistakes! Furthermore, I wonder how many taxpayers do not understand the nature of a CP2000. They might simply pay the amount requested rather than take the time to find out what the form means.

Am I the only one receiving what seems like an inordinate number of CP2000 forms from the IRS this year? Feel free to leave a comment if you have received a CP2000 form recently, especially if it is for something really bizarre.

Is Getting it Right More Important than Getting it Back?

The other day I read about a recent Grant Thornton, LLC, survey of some 496 top U.S. financial executives. The survey asked what was the top priority of their tax departments. They concluded that the number one priority was not how much tax they can save the company, but rather providing timely and accurate tax return preparation and compliance. I agree that any self-respecting tax department is going to be focused on providing timely and accurate return preparation and compliance. However, it is hard to imagine that they are not just as interested in saving the company the most they legally can on their taxes. Now don’t get me wrong--I agree with the survey that accuracy and compliance is the number one priority of most tax departments; however, I would bet that tax avoidance is probably number 1A. Maybe they haven’t heard about “Transfer Pricing.”

It is estimated that U.S. companies legally avoid paying about $60 billion in federal income taxes each year through the use of transfer pricing. (Transfer pricing is the practice of pricing contributions transferred within an organization, which affects the amount of taxes owed.) The article mentioned a company that had sold $2 billion worth of a particular drug. All of these sales were made in the U.S. to U.S. customers, but by using transfer pricing to transfer the profits from the sales of this drug to its Bermuda subsidiary, the company paid no U.S. income taxes on the profits. (Bermuda does not have a corporate income tax.) So is getting the tax return and compliance right really the top priority of corporate tax departments or is it actually how much of a refund they can get back for their employers--or, better yet, avoid paying in the first place? I think that accuracy and compliance are probably the top priority but I would wager that tax avoidance is a very close second. What do you think?