IRS Offers Tips to Avoid Taxing Situations

In Business Las Vegas, December 22nd, 2006

As we move into 2007, it might not be a bad idea to learn from others’ tax mistakes from 2006.

Tax Courts and the Internal Revenue Service clarified a number of tax regulations this year that could help small businesses be more careful. Some of the top cases include helping land owners save their beneficiaries. Others serve as stark reminders to go beyond due diligence when considering a business deal.

“These rulings react to very technical ituations but they’re important because they remind people of common problems and things they need to be aware of,” said Simon Johnson, a tax attorney with the Hale Lane law firm who (very patiently) discussed with me some of the most significant rulings for small businesses in 2006.

Sure it’s worth that much

Don’t get greedy with your charitable giving this season.

That is the message the IRS is sending to people this year after increasing problems with people convincing appraisers to increase the estimated worth of charitable donations for purposes of tax deductions.

In one prominent case, a man donated to an auction shares in a submersible bar for divers.

The IRS found it was worth about a third the amount estimated by the appraiser. It is typical of the kind of tax deduction that led the IRS to require appraisals be performed by approved appraisers and which prompted Congress to pass legislation penalizing those who file returns with infl ated appraisals.

“The IRS is paying a lot of attention to appraisals to make sure they refl ect reality and if there’s any basis to challenge it, they do,” Johnson said.

Estate Tax Reprieve

One ruling could have significant implications for Southern Nevada property owners, or their children.

Under IRS guidelines, if 35 percent of more of a decedent’s estate value is tied up in business ventures, its beneficiaries can pay the unpopular estate or “death” tax over a ten year period instead of all at once. Not having to worry about paying out a huge chunk of cash could be of great benefit to inheritors, especially if that land is the estate’s only major asset.

“People who have owned real estate in Las Vegas for a long time, it tends to make them very wealthy, but the value tends to be locked up in the value of the land itself,” Johnson said. “This allows their estate to pay those taxes over a longer period of time.”

But just because a piece of property brings in cash, does not mean it qualifies as a business venture.

In order to qualify, the land must be an active trader business. That means you have to do more with the property than sit back and watch the equity rise. Essentially, you’ve got to be a property manager as well as an owner.

Of particular importance when evaluating it is the time and the amount of staff devoted to the business, whether the owner kept regular business hours and an office to conduct business, if the employees were active in finding lessees, and the extent to which the decedent provided services beyond just leasing the property such as cleaning, management services or maintenance.

Loan or Equity?

A family-owned corporation got into hot water with the IRS this year when it failed to pay taxes on what the IRS considered transfers of equity.

The family shareholders made periodic transfers of money or property to the corporation, but due to poor record keeping, it was unclear whether those transfers were loans or gifts.

The transfers would only be tax free if they were loans.

In this case, the corporation only occasionally made payments to the shareholders on those transactions, usually when the shareholders needed money. The IRS said that indicated theriginal transfers were equity, not debt.

The tax court agreed with the IRS, but on appeal, a higher court sided with the corporation, saying that in the larger picture, it looked like debt, despite the initial poor record keeping.

“The bottom line in this issue is that under all the circumstances whether you have debt or equity, something as simple as `oh we’ll do the paperwork and write the note next week’ could have big implications for you,” Johnson said. “It turned out in the taxpayers favor this time but there’s no guarantee that it will always work out that way. You need to respect the formalities of debt. You need to treat yourself as a debt holder and not a shareholder for those purposes.

People often forget it and the IRS is always watching for it.”

Debt and Taxes

Another interesting case that popped up in 2006 had to do with loans. A man got a loan using his interest in stock as collateral. The note came due and the man didn’t have the cash to pay it back so he told the bank to take the stock. Unfortunately, the company whose stock he had pledged went bankrupt and the stock was basically worthless.

The IRS said that this counted as a cancellation of indebtedness and that the man owed money on the amount of money he received for the loan. The debtor argued that this was not the case because the bank had taken the property — the stock — in lieu of payment and thus there was no cancellation of the debt because it had been paid.

The court sided with the debtor, but Johnson said it is a good warning to companies taking out loans. If that loan is ever cancelled or forgiven, the debtor will have to pay taxes on the amount of the loan.

“It’s a reminder to people that debt forgiveness is a source of income,” he said. “There are special rules that can help avoid an immediate tax on that, but the source of the debt can be very important to the outcome.”

Not So Passive Now

In order to retain their small business status, corporations with earnings cannot have passive income that exceeds 25 percent of its income for more than 2 years in a row. That passive income could include royalties, rent from property the corporation or its interests lease out or deposits from tenants if the corporation is not active in managing the properties. Why is that such a bad thing? Because then you’ll be taxed on two levels instead if one.

In one case, a corporation asked the IRS to evaluate its income to ensure the money it received from rents did not constitute passive income. The IRS found the corporation was active enough in managing the properties to keep the money from being classified as passive, but it is indicative of how such holdings often sneak up on corporations if they are not careful, Johnson said.

“If you have an S Corporation (designated small business), you need to watch carefully what type of entities you’re acquiring and what type of business they’re doing. Because it could be a tax disaster,” Johnson said. “The good news is if you’ve slid into a more passive form of income, you usually have time to act on it and do more active things to keep the eligibility.”

The most important thing to do if you are considering a business transaction of any kind is to consult a qualified tax expert beforehand. You never know what trouble — and money — you might save yourself.