Q:

Hello,

I have found your information to be very helpful and was wondering if you can point me in the right direction. All along I thought our corporation was set up as an S corp., I have been filing 1120 returns since 1999 and the
income of the corp. has been low to min up until our 2004 tax year. If I send the form to elect an S status with the IRS, can I use this S status for our 2004 return? Any response would be helpful. I am sure you get many requests…Thanks again…

Thank You,

A:

First thing, you should be working with a tax pro.  If you have been trying to handle corporate taxes on your own, you have been asking for trouble.

If you have seen the S corp election form 2553 and its instructions, you should know that it’s too late to file an election now and make it effective for 2004.  You need to file the 2553 by March 15, 2005 if you want to make it effective for 2005.

IRS does have provisions for late S elections for special circumstances.  However this is usually only allowed for new corporations where no tax returns have been filed.  I seriously doubt whether your case will qualify for the IRS’s permission on this.   

If you do try for the special late election, you should be working with a tax pro and you need to get your story straight.  You claim to have been under the impression that you were already an S corp; yet you were filing 1120 forms, which are used for C corps.  That doesn’t make sense to me and it won’t for IRS.

Sorry to be so hard on you; but this is either a classic example of the dangers of not using a tax pro; or if you were using one, the repercussions of using an incompetent one.

Good luck.

Kerry Kerstetter

Overstating Of Assets Is Seen To Cost U.S. Billions In Taxes –  This claim that most people overstate the cost basis of their assets in order to reduce their capital gains is a load of crap; but is consistent with the Left’s propaganda that everyone cheats on their taxes. News stories like this are used to justify more IRS power. 

As I’ve constantly said, rather than underpay their taxes, most people overpay through either ignorance, incompetence (their own and their tax pros’), or a desire to just keep IRS away from them (fear).  What I have seen too many times to count are large understatements of the proper cost basis of assets, leading people to report too much taxable profit.  In fact, when I was traveling all over the place teaching my seminars to Realtors on real estate tax issues, my very first topic was the proper determination of cost basis because it has so often been done incorrectly by so many people.

Common mistakes I see all of the time include

Assuming that the cost basis of an item received as a gift is zero because the recipient didn’t pay anything for it.  The truth is that the cost basis for the recipient is the same as it was for the previous owner.

Forgetting to step up the cost basis of assets that were inherited to its fair market value as of the date of death.  I have prepared dozens of amended returns for this very reason, where the clients’ previous tax preparer used the original cost of an asset when reporting a capital gain, although there had been a death since then.  This is even more critical with surviving spouses in community property states, where the entire property’s cost basis is stepped up; not just the inherited half, as it is in non-community property states.  

I know I am a lone voice compared to the big media machine of the Left; but stories claiming that everyone cheats on their taxes and that we need a tougher more powerful IRS are completely wrong. Of course, my claim is only based on working with thousands of real people over the past 30 years.  How can that compare with ivory tower theory and distrust of the commoners by our superiors? 

As I’ve mentioned previously, one of the most indispensable programs I have used for probably the last 20 years has been Tax Tools from CFS Software in California. I have also been buying their Small Business Tools program for as long as it’s been offered. A few years back, I bought their Financial Planning Tools program; but I didn’t renew it after two years because it was their most expensive program and the only parts of it that I used were already included in the Tax Tools and Small Business programs. 

I had noticed their Tax Corresponder program, but had never seen a need to buy it because I was under the impression that it only covered letters to IRS and FTB, and I already have my own decades old files with the letters I have written to them.  When I was preparing my renewal order for the 2005 programs, I noticed that the Corresponder program also includes a lot of letters to be sent to clients on a huge variety of topics.  I figured if it saved me time on just one explanatory letter to a client, it would have more than covered its $39 cost.  After receiving the 2005 CD last week, and scrolling through the list of 319 master letters it contained, I noticed several right off the bat that would come in very handy around here, including an excellent CYA letter to send to the clients that we are letting go.

Short story long, as I was setting up one such letter this morning, I again noticed two letters for advising clients on the proper procedures for documenting the donations of vehicles to charities.  One is for donations prior to the new 2005 change, and the other is for the new rules.  Since I had just covered this topic in a posting last night, I though it would be interesting to show how CFS explains the differences.

For Donations Prior to 2005:

Donating a vehicle to charity has real tax advantages if you itemize your deductions, but you need to follow a few simple rules to take the deduction.  How much you may deduct depends on whether you used the vehicle in a trade or business.  If you did use the car in your business, the allowable deduction is the fair market value reduced by the amount that would be ordinary income if the car had been sold (this is generally the adjusted basis of the vehicle).  If you used the vehicle for personal use only and you owned it for more than one year, the amount of the charitable deduction is the fair market value of the vehicle at the time of the donation.

If the value is $5,000 or more, the IRS requires an appraisal of the vehicle.  If the value is less than $5,000, to determine the value, start with the used car ads or a price guide such as Kelly Blue Book.  You should then adjust the value according to the vehicle’s condition.  If the vehicle’s condition is excellent, you may be able to deduct more than book value.  A beat-up car is worth less.  Take pictures of the vehicle for substantiation of your deduction.

I have one word of caution for donations of $250 or more.  A written receipt from the charity is required, and this receipt must be in your hands by the time you file your tax return (including extensions).  The receipt must include the organization’s name, date, location of the donation, a description of the vehicle, and the value of the vehicle.  If the value of the vehicle was greater than $500, you must also provide the IRS with information as to how the vehicle was acquired (e.g. purchase or gift), the date it was acquired, and what you paid for the vehicle.

As you can see, you may be able to take a sizeable deduction.  Because of current scrutiny by the IRS of this particular deduction and the potential abuse by taxpayers, it is imperative that you follow the rules to avoid an audit.  I hope this explanation is helpful and that you will feel free to call me if you have any questions.

For Donations After 2004:

Even though the law changed for the donations of vehicles valued at more than $500 as of January 1, 2005, if you itemize your deductions, donating a vehicle to a charity will benefit you.  How much you may deduct depends on the use of the vehicle by the charity. 

I have a word of caution for donations valued at $500 or more: you must follow the new IRS rules.  A written receipt from the charity is required, and this receipt must be in your hands within 30 days of the charity’s sale of your vehicle or 30 days of your contribution.  The charity’s written receipt must include your name and tax identification number and the vehicle identification number.  If the charity sells the vehicle without significantly using it or materially improving it, your deduction is limited to the gross proceeds of the sale.  The charity is required to certify in writing to you whether your vehicle was sold or if they intend to sell it (limiting your deduction to the gross sales price) or whether the charity intends to use the vehicle and will not transfer it in exchange for money, other property, or services. 

As you can see, you may be able to take a deduction if you follow the new rules.  Because of current scrutiny by the IRS of this particular deduction, it is imperative that you follow the rules to avoid an audit.  I hope this explanation is helpful and that you will feel free to call me if you have any questions.

 

Tax change drives away donations of vehicles – This is really a misleading description of the change in the law. It doesn’t eliminate the ability to claim the market value of vehicles. It just tightens up on what can be used to determine what exactly that market value is. As I’ve discussed on several occasions, people were claiming completely bogus values for their donated vehicles when they knew full well that they could never have sold them for those prices. This new law just makes it mandatory that the actual sales prices be used.

I offend professional appraisers every time I get into this area; but it is a fact that appraisals are no more than guesses of an asset’s value. A real bona fide sale on the open market is a much more reliable number to use. If the Kelly Blue Book says that a car is worth $5,000 in tip top condition, and the car can only be sold for $1,000, the only number I would trust as accurate would be the actual sales price.

As I’ve said many times before, this is not technically a new change in the law. It is just tightening up the valuation method because of the widespread abuse by so many people, as well as the various services that had popped up to receive donated vehicles and give part of the sales proceeds to actual charities by promising much larger deductions for people than they could get from actually selling the vehicles themselves. If these services go out of business, so what?

As I’ve long told clients, highly appreciated assets are good candidates for donation to charities. With depreciated assets, such as vehicles, it’s most efficient financially to just sell them and donate the cash. You then don’t have the issue of appraisals and follow-up sales prices to even worry about.

Tax Protester Is Convicted on 13 U.S. Charges – Another of ex-IRS agent turned tax protesting leader Joe Banister’s disciples bites the dust for following Banister’s insane advice to not file tax returns or even withhold taxes from employees.

Politicians Flouting ‘No Work, No Pay’ Rule, Taxpayer Group Says – As I’ve long noted, the main reason we don’t have many outsiders running for public office is that we have to actually do some work in order to earn a living.  Professional politicians are paid whether or not they actually do anything and can easily spend most of their time campaigning.  This perpetuates the cycle of control by professional career politicians.   

How Much Do You Want to Pay? Your answer on a postcard, please. – Freedom to Choose Flat Tax.

Catching Up Pays Off – Gail Buckner on the catch-up contributions that can be made to retirement accounts by people over 50.

Q:

Subject: Taxes on Dividend Reinvestment

Kerry, have reinvested dividends for the 1st time, and had a few questions.  If you received, say $100, in dividends in 04 which all were reinvested (in a DRIP program), do you load $100 to line 9 of the 1040?  What if you sold your stock (a long-tern capital gain) including these dividends in 04?  Is the $100 of dividends taxed a 2nd time as a capital gain, with a $0 cost basis?

 

Thanks for your time.  Glad to see you over at the new SS blog.

A:

As you know, reinvested dividends are reported on Schedule B and subject to the same income tax as are dividends paid in cash.

The reinvested amounts won’t be subjected to two taxes if you or your stockbroker do a proper accounting.  The offset to the dividend income is an increase in your cost basis of the stocks.  When you sell the stock, you need to show its cost basis as the accumulation of the original purchase price plus the reinvested dividends that were reported on Sch. B.  This is most efficiently accounted for if you use QuickBooks.  You credit dividend income and debit the stock asset account.

This is relatively easy to account for if you sell all of the stock at the same time.  However, if you sell shares in multiple transactions, you will need to either specifically identify the cost of the individual shares you are selling, or recalculate the average cost per share of your total holdings each time you make a new purchase, such as through a reinvested dividend.

If your stocks are managed by a stockbroker, I have found that most of them are very good at providing their clients with good year-end reports showing the sales and the cost basis of the shares sold.  This is especially true with mutual funds.

I hope this helps.  Your personal tax advisor should be able to help you set up and operate your accounting system to keep track of the reinvested dividends.

Kerry Kerstetter

Q:

Subject: S Corp problem

Two shareholders own a 66% share of a Tennessee S Corp. The other 33% shareholder left disgruntled and formed a C Corp that bought his 33% share of the S Corp stock. The sale takes effect as of January 1, 2005. I am an Enrolled Agent with the IRS but do not understand the legal ramifications. Also this is not my area of expertise for tax consequences either. I understand that this terminates the S status but how else does it affect the corp and its shareholders? Can you share your expertise?

A:

Actually, because this change is effective precisely at the end of the previous tax year, this should be relatively easy to deal with.  The 2004 1120S will be marked as final and then you will report 2005 on an 1120.

It would have been messier if the change were mid-year and you had to file two short-year returns.

There are some other statements that will need to be attached to the returns and you will need to do some calculations of the retained earnings to prevent previously taxed income from being taxed again. 

I strongly encourage you to buy a copy of the Small Business Quickfinder book.  It covers this in much more detail than I can right now.  It’s my number one reference tool for questions about all non-1040 tax returns. You can order it from www.quickfinders.com

Good luck.

Kerry Kerstetter