Q:

Subject: Interest Income vs. Dividend Income

Kerry (Tax Guru),

My name is … I am currently a Doctoral student studying financial planning at Texas Tech University. I was searching for an answer to a question posed to me by one of my students and I stumbled upon your site. Funny enough I grew up in Harrison, Arkansas. Small world I guess. Anyways… I was talking in class last semester about the current tax cuts and there effect on the financial planning community. More specifically, how clients should diversify their tax retirement vehicles just as they would a portfolio.

One of my students posed the questions, “Why has the government cut rates on capital gains and dividends, yet did not reduced that tax rates on interest income (taxed as ordinary income)?” I suppose it has something to do with double taxation, but I am not an accountant nor an economist.

I was wondering do you have a short answer to this question or at least a sense of direction as to where I might look?

Thanks,

A:

I wasn’t part of the discussions in Congress as to the different taxation on dividends versus interest; but I do have a theory to explain it. It has to do with both the concepts of the tax benefit rule and double taxation on C corporations.

Under the tax benefit rule, when one taxpayer deducts an expense, another taxpayer reports that same amount as income. It’s a kind of balancing act. Interest is an example of this. Banks, businesses, and other payers of interest deduct it on their tax returns, thereby saving taxes at their ordinary income tax rates. The recipients of those interest payments then report them as ordinary income on their tax returns.

Dividends, on the other hand do not currently qualify as deductible expenses on the corporate tax returns. Since dividends are after tax dollars, this results in a second income tax on the same income.

While those of us who believe in capitalism would love to see a complete elimination of the double taxation through either a deduction on the corporate tax return or completely tax free on the stockholders’ tax returns, that has never been politically feasible in this country, where hatred of evil corporations and rich people is stock in trade for politicians.

Over the decades, we have had some very minor offsets to the double taxation, usually designed to only assist the smaller investors. For example, there used to be an annual tax free exclusion of $100 in dividend income per person. This latest change, to tax dividends at the lower long term capital gains rates was explicitly designed as a mid-way compromise between those who believe there should be no double taxation at all and those who still want to stick it to corporations and their shareholders.

I hope this helps you understand some of the history behind the taxation of dividends.

Thanks for writing.

Kerry Kerstetter

Follow-Up:

Thank you so much,

Very Helpful!

Tracts Like $1M Bills Seized By Secret Service – From Texas, where some idiot actually tried to deposit one of the bills.

Proposition 13 Still Has Dangerous Enemies – There are always enemies of anything that helps keep taxes lower.

50-year mortgage gains momentum – This may make more sense than refinancing every few years to pull out equity.

Yeager suit accuses children of diverting money from fund – With all of the news about companies screwing their employees out of their retirement benefits, now it’s your kids you need to watch out for.

Q:

Subject: QuickBooks vs. Quicken

 

Dear Kerry,

 

I just read your article about QB vs. Quicken.  As a sole proprietor I have one question.  Is QuickBooks strictly for business accounting or can it handle personal finances as well?  Should I use QB for my business and Quicken for personal?  I want to do what is simplest and most effective.

 

I would be most appreciative for your response.

 

Thank you sincerely,

A:

You should browse more of the info I have on my website regarding QuickBooks and Quicken.

I addressed your point exactly a few years ago.

Good luck.  I hope this helps.

Kerry Kerstetter

 

Q-1:

Subject: S-Corp single class of stock question

 

An S-Corporation initially issues 1000 shares to its single shareholder for $1/share. Later, it issues 1000 shares for $20/share to another

shareholder. Does the different price per share constitute a second class of stock (assuming all shares receive an equal distribution of profits)? How about if all 2000 shares were issued at initial capitalization (that is, one shareholder paid $1/share and another paid $20/share, all at startup)?

A-1:

What the stock sells for doesn’t determine the class, as long as all ownership rights are the same for both batches.

Here is the description from page D-2 of the Small Business QuickFinder Handbook:

One Class of Stock

An S corporation can have only one class of stock. It is treated as having only one class of stock if all outstanding shares possess identical rights to distribution and liquidation proceeds. Differences in voting rights are allowed as long as the other requirements are met. For example, issuing nonvoting common stock or paying bonuses to key employees does not create a second class of stock. (Letter Rul. 200118046)

Caution: If not properly structured, a shareholder loan to an S corporation can create a second class of stock and disqualify S status. If the debt is convertible to equity, or if terms of the loan are contingent on profits or dependent on the borrower’s discretion, the loan may be considered a purchase of a second class of stock.

 Q-2:

Is the shift in capital immediately taxable (as, I understand, it would be were the company a partnership)? Or do you wait until liquidation, and get a (possibly long-term) capital gain?

 
A-2:

 You really need to be working directly with a professional tax advisor who can explain how corporations work because you seem to be very mistaken on some basic accounting and tax concepts.

If you sell some of your shares to another person, you will have a capital gain to report on your 1040.

If the corp sells new stock to a new person, that isn’t a taxable event and has no tax consequences. 

That new stockholder will need to keep track of his/her basis in the stock for proper tax treatment of corp events, as does the original stockholder.

Kerry Kerstetter

 

Q:

Subject: corp!

 

HI

I would like to know how easy it is to incorp in a

different state than where you live! I came across

your website and found it to be very informing,and

found that I should be asking alot more questions to

someone that really knows what they are talking about

before I incorporate my business.I also believe that

getting any good advice will benefit us ,even if it is

being directed to ask the important questions with

another proffessional.And thats another question what

do you really need to ask ?

I /we have a development company -Construction in

California

and we are starting a consaulting company >which would

consault our clients in working with all general

contractors ,interior designers etc!

This was our idea to relieve our personal tax burdens.

We would hire our own development company along with

other needed companies through our corporation trying

of course to keep the main funds in the corp,and not

into our personal .Our development company is a sole

prop.

So if you have a better suggestion I would love to

here it! I just dont want to make the wrong choices

and end up over my head ,or in trouble. I was told to

open up an s corp.Simply because you can use funds

from your s corp and your personal ,or sole prop

buisness as long as you keep your papers in very good

order. This is easier because you can move thing

around to meet your needs. What do you think about

that! I have been told so many different things I

really dont know what to believe.

A:

This is the exact kind of issue that you should be discussing directly with an experienced professional tax advisor.

Anyone can set up a corporation in any state.  You just need to have someone residing in that state who can act as your corp’s registered representative.  There are dozens of companies that provide such services, especially in states with no income tax, such as Nevada.

The really tricky issue will have to do with where the corp earns its money and conducts its operations.  If any business activity happens inside the California borders, regardless of where the corp is chartered, you will have to file a Calif. corp income tax return and pay at least the $800 minimum corp tax each year. 

If, on the other hand, all business activity happens outside of the Calif. borders, no Calif corp tax return would be required.

Proper sourcing of income in various sates is a tricky thing to handle, and an area where you most definitely need to be working with an experienced tax pro.  The California Franchise Tax Board is the most aggressive tax agency in the country at tracking down and nailing anyone they suspect of failing to pay every last bit of required taxes.  

Even if all of your business activities are conducted inside Calif, there are still plenty of tax savings opportunities by setting up a corp.  Any good tax pro should be able to help you develop the best strategy for your unique circumstances.

Good luck.

Kerry Kerstetter

 

Q:

Subject: Roth IRA Question / New Home Exclusion

Kerry, thanks for your help on a # of subjects I have found on your website. 

 

Quick question about using Roth IRA contributions towards a purchase of a new home.  I believe I have read that an individual can w/draw (tax free) money contributed towards a Roth IRA, capped at $10K/ea, used towards the purchase of a 1st home.

I’ve also read that a 1st time homebuyer isnt really a 1st timer, just the 1st time in the last two years.  How do you define 2 years?  From closing date to closing date, or tax years?  What if the 2nd purchase is being built and you have a construction loan and a mortgage?

 

Any idea why there is this “loophole” for the not really 1st time home buyer?

My wife and I will have rented for just over 1.5 yrs when we think our home will be built and ready to close and the extra $20K would be a nice addition to the downpmt.

 

Any ideas?

 

Thanks again for your help.

A:

This is the exact kind of issue that you should be discussing with your own personal professional tax advisor because it seems that you are very unclear on how Roth IRAs function. 

In most cases, because it was not deductible from your 1040 at the time you deposited it, the money you contributed to the Roth can be withdrawn at any time without any income tax or early withdrawal penalties being applicable. 

The taxes and penalties for early withdrawal are applicable on the earnings that have been generated by the Roth IRA account, if those are taken out prematurely.  There is a five year minimum holding period for Roth IRAs that affects their taxation.

The first time home-buyer exception to the early withdrawal penalty is often misunderstood in regard to several factors.  First is the fact that the withdrawal from conventional IRAs is still subject to normal income taxes, even if it qualifies for the exception to the early withdrawal penalty.  This is also the case for withdrawals from Roth IRAs made in less than five years after the Roth was opened.  Withdrawals of earnings after five years that are used for a new home purchase by a qualifying first time home-buyer are tax and penalty free, up to $10,000 per person. 

The $10,000 per person exclusion is for an entire lifetime.  

The time frame for qualifying as a “first time home-buyer” is very specific.  You must have had no ownership interest in a residence within 24 months prior to the actual withdrawal.  So, if you sold your previous home less than two years prior to the withdrawal, the exception does not apply.

The other requirement that confuses many people is the fact that the withdrawn money must be actually spent on the home purchase within 120 days after it was removed from the IRA account.  This means that you don’t want to take it out too soon prior to the actual purchase.

These are some of the specific points that you should review with your own personal professional tax advisor.  From the way you worded your questions, it could very well turn out that, even though you won’t qualify as a first time home-buyer by purchasing in 1.5 years after your previous home was sold, you may be able to withdraw enough of your actual Roth IRA contributions tax free to make a dent in your down payment, since it sounded as if you were under the impression tat those withdrawals would be taxable.

Good luck.

Kerry Kerstetter

 

Q:

Subject: FISCAL

What exactly does “FISCAL” stand for?  =)  I know it is an acronym for something, but no one I ask seems to know.  Do YOU?

A:

I had never heard that theory or ever considered that word to be an acronym of anything.  It always meant money or financial to me.

In fact, the dictionary shows that it is a variation of a Latin word:

            Etymology: Latin fiscalis, from fiscus basket, treasury 

Kerry Kerstetter

Follow-Up:

The reason I was asking is because someone once told me that is stood for Federal-Income-something-something-Annual Liabilities (ish) and I was just curious.  If you ever do hear of that again you should let me know. =)  Thanks Again!

 What you are probably thinking about is the acronym used for withholding of Social Security & Medicare taxes, FICA.

That stands for Federal Insurance Contributions Act.

Kerry Kerstetter

 

QuickFinders has its summary of the recently signed 2006 tax law available for free, much more reasonable than the $30 plus versions various companies are selling.