Tax Guru – Ker$tetter Letter

Wealth tax initiative signature deadline looming – People who wonder why I refer to my former home state as the People’s Republic of California need no better example than this attempt to confiscate $200 billion of wealth from the evil rich.  This is exactly what communists do, as former property owners in Cuba are well aware of.

New Steps Taken By IRS to Improve Questionable Refund Program

The IRS established the Questionable Refund Program to deal with the serious problem of refund fraud, which has increased significantly in recent years. The IRS estimates that fraudulent refund claims now exceed a half-billion dollars a year.

Avoid An Audit: Don’t File Electronically – I’ve always refused to use e-filing because of the inability to add additional explanatory information to assist in avoiding IRS problems.  This writer’s less realistic theory is that not all paper tax returns have their data entered into the IRS computer and are thus out of the loop for selection for audits.  The comments section of this blog post also has some misguided debate on the wisdom of e-filing based on whether it costs more or less than the postage to mail in paper returns.   

Q-1:

Subject: C CORP TO S CORP

 

HI

I HAVE A SIMPLE QUESTION REGARDING CHANGING C CORP TO AN S CORP THAT HAS REAL ESTATE PROPERTY ALREADY DEPRECIATED OVER THE YEARS.

THIS C CORP HAS 6 STOCKHOLDERS RETIRED AND WISH TO DO WHAT IS RIGHT FOR THEIR CHILDREN

THIS C CORP HAS SEVERAL PROPERTIES VALUED AT  4,000,000 (estimated, not appraised)

IF THE CORP. IS CHANGED FROM A C TO AN S DO THE STOCKHOLDRES, OR THE CORP. HAVE TO PAY TAXES NOW  ON THE CURRENT MARKET VALUE OF THE PROPERTIES EVEN IF THE PROPERTIES ARE NOT SOLD NOW.

IF THERE ARE TAX IMPLICATIONS, HOW MUCH TAX WILL BE DUE

THANKS FOR YOUR HELP

A-1:

You definitely need to be working with a tax pro on matters such as this.  In fact, you should have been working with one from before you even set up your C corp.

You are obviously referring to the 35% Built-In Gains (BIG) Tax that comes into play with appreciated assets in C corps that are converted to S status.  That tax isn’t payable at the date of the conversion.  It’s payable when the asset is sold, if that happens within 10 years after the date of the S election .

Planning for this can be tricky, especially depending on any future sale plans for the property.  You all, along with your professional tax advisors, need to take a serious look at the wisdom of converting the existing C corp to an S instead of just starting up a new S corp and leaving the existing C corp as is.  You didn’t mention any rationale for doing the conversion, so I have no idea what is behind that plan.  Too many people jump into S corps just because they’ve heard it’s the “cool thing” to do or because they heard of someone else doing it, without fully investigating all of the related ramifications.  This is why I posted the comparison of C and S corps on my website several years ago.

Another strategy that is often applied is to have the C corp sell the property before converting to S status so as not to have any potential BIG tax.

You may also be interested in this article I came across recently, explaining that S corps provide less lawsuit protection for assets than do C corps or LLCs.

I hope this helps.  A tax pro can better apply these concepts to your unique circumstances.

Good luck.

Kerry Kerstetter

Q-2:

 DEAR KERRY

THANK SO MUCH FOR YOUR PROMPT REPLY

IF I MAY TROUBLE YOU JUST ONE MORE TIME

MY FATHER-IN IN LAW AND HIS PARTNERS ARE ALL OVER 80 YEARS YOUNG AND I AM THE ONE THEY TRUST TO GIVE THEM A LOGICAL AND ACCURATE ANSWER ON THIS MATTER.

SINCE WE ARE TALKING ABOUT 6 partners and THE CHILDREN (HEIRS ARE 11 + SPOUSES)

IT IS VERY PROBABLE THIS INCOME PRODUCING COMMERCIAL PROPERTY WILL NOT BE MANAGED IN THE FUTURE WITH SO MANY PEOPLE HAVING THEIR OWN IDEAS.

THEREFORE, I WILL LIKE TO NARROW THE POSSIBILITIES AS FOLLOWS AND PRESENT THE SCENARIO THE THE STOCKHOLDERS AND THEN GO ABOUT GETTING A TAX PRO AS YOU SUGGESTED TO GET THIS TASK DONE.(if you can, you can refer us to a pro?)

==============THE PROPERTY IS DEPRECIATED TO $0.00================

EX#1 THE C CORP IS NOT CONVERTED TO S

          THE PROPERTY WORTH TODAY 4,000,000 IS SOLD NOW—HOW MUCH DOES THE CORP PAY IN TAXES AND HOW MUCH DO THE STOCKHOLDERS PAY IN TAXES

EX#2 THE C CORP IS CONVERTED NOW TO AN S CORP AND THE PROPERTY IS SOLD IN THE NEXT TWO YEARS FOR 4,000,000 — HOW MUCH DOES THE CORP PAY IN TAXES AND HOW MUCH DO THE STOCKHOLDERS PAY IN TAXES

EX#3 THE C CORP IS CONVERTED NOW TO AN S CORP AND THE PROPERTY IS SOLD 12 YEARS FROM NOW (over the 10 yr clause)  FOR 4,000,000– HOW MUCH DOES THE CORP PAY IN TAXES AND HOW MUCH DO THE STOCKHOLDERS PAY IN TAXES.

THANKS A GAIN FOR ALL YOU HELP

SINCERELY

A-2:

There is no way to accurately answer any of those questions without analyzing all of the details, including the owners’ personal tax situations.  Taxes are based on several factors, including what other income and losses they may have.

To work out the best solution for everyone’s particular circumstances, you all really need to work with a tax pro who can help you set up a strategy that will work for all of you.

I wish I could help you; but I already have too many clients to take care of; so we are not accepting any new ones at this time.

Unfortunately, we don’t have anyone else to whom we could refer you. If you haven’t already done so, you should check out my tips on how to select the right tax preparer for you.

Good luck.

Kerry Kerstetter
 

Follow-Up:

thank you very much 

Q:

Subject: Question–blog topic?

Kerry,

 

Thanks for taking the time to help so many people understand tax matters.  I have gotten better information on your blog than I have in meeting face-to-face with my tax preparer.  Since you seem to be “plugged in” to such matters, I wanted to ask you about my situation…

 

I’m a full time grad student, married since 2003.  In December 2003 I started buying government surplus equipment and reselling it on Ebay, usually selling about 2 items a week.  This is to supplement my wife’s wage income and help pay for tuition.  In 2003 I only sold a few things and had a small loss, which I did not list on my return for that year.  In 2004, I made a stupid mistake on a spreadsheet, which led me to believe that I had no net profit for 2004 either.  While this didn’t seem quite right, I was in a hurry to finish the 2004 return, and again did not list my business on it.  The 2004 return showed (correctly) $9K in wages for my wife and I, $35K in capital gains from sale of a rental house, and about $5K in expenses relating to that house, for an AGI of $39K.

 

Well, in 2005 my little Ebay trade did make a profit of over $15K.  When I started getting everything together for the 2005 return, which I’ve not yet filed, I found the error on my spreadsheet and realized that I actually made a profit in 2004, of about $5K.  So now I have to file an amended return for 2004.  I’ve had many sleepless nights lately and would be glad to hear your opinion on:

 

1.  Do you think my amended return will trigger an audit?  The error was due to my own carelessness, but I would imagine the sudden appearance of $5000 in previously unreported Schedule C income would look somewhat unusual.  There will be a check for the full amount due attached to my amended return, of course.  How would you phrase the explanation for this error?

 

2.  I use the cash accounting system since my gross receipts are (way) under $1 million.  This means what would otherwise be the “cost of goods sold” is instead treated as an expense, pushing my expense ratio to about 80%.  I have read on other tax sites that this ratio should be kept under 60% or an audit can be expected.  Is this something to worry about?

 

3.  Is there any truth to the persistent rumor that the IRS is targeting Ebay sellers this year, and that they have obtained a list of “powersellers” – those grossing over $1000 monthly on Ebay – and are systematically auditing them?  I heard this from a fellow “powerseller” who was audited recently, who said his auditor was the source of the info.  If so, they may already be investigating me…. fantastic.

 

Sorry for the long-windedness.  I am so busy with school – and our financial margins are so tight – that I want to do everything I can to avoid future trouble.  I’ve even taken the time to go back and account for every penny deposited into our bank account for the past two years, just in case.  I’ve read and heard so many horror stories about the IRS that I live in perpetual dread of an audit.

 

Thanks again-

A:

In regard to filing amended tax returns with IRS, the highest risk of triggering an audit seems to be with those claiming  refunds.  I haven’t heard of any such risk with 1040Xs where the people have “volunteered” to pay additional taxes.

Interest will be due on those tax payments; but IRS generally doesn’t charge late penalties on voluntarily disclosed  additional taxes.  That is not the case if you fail to file a 1040X on your own and then IRS later discovers your unreported income.  Penalties will be assessed in that case.

If you  live in a state with an income tax, you will have to file an amended State return as well.

You claim to have had a net loss for 2004.  In the old days, I would have advised filing a 1040X for that year; but that is not advisable now because of IRS’s policy of auditing refund claims.  You should work with a professional tax advisor to see if some of your 2004 costs can be set up as start-up expenses and carried over and amortized on your  2004 and subsequent years’ returns.

You seem to be misunderstanding the concept of cost of goods sold for a cash basis business.  You do still need to keep track of inventory cost in the CoGS section of your Schedule C.  Any experienced professional tax advisor should be able to instruct you on this.

I have heard that IRS is aware that many online businesses, such as eBay sellers, are not reporting their income.  IRS can get eBay records with no problem and go after the biggest sellers.

Besides the peace of mind, there are tons of benefits to reporting all of your business income and expenses.  Any experienced professional tax advisor should be able to help you stay legit. 

Good luck.

Kerry Kerstetter

Follow-Up:

Kerry,

 

Thanks so much for your help.  I will do as you recommend and hope for the best.

 

Regards,

 

 

For quite some time now, this whole Richard Hatch tax evasion scheme has seemed as if he wanted to be sent to prison. Nobody in his right mind could possible expect him not to be caught for leaving off over a million dollars of income that most of the country saw him win.

For a gay man who likes parading around naked in front of strangers, it must be some kind of paradise to be locked up with hundreds of other men.

Q:

Subject: 1041 software

Hello,
I am individual who is trustee for my three adult children’s trusts of $250,000 each inherited from my father. I just ran into your Web site and hope that your software would be what I need to prepare their tax forms. All the money is invested with a broker and I plan to distribute the income to them. Please let me know if your product would be good for me and put me on a mailing list to let me know when it is available.
Thanks.

A:

I’m confused by your inquiry.  We don’t sell software.

If you are referring to the QuickBooks programs, which you can buy via some referral links on our websites, that is the best program for keeping the books for trusts, as well as anything where there is money involved.  Most of my clients who have trusts use it and then send me their data discs to use in preparing the 1041s.

QuickBooks can prepare basic 1099 and W-2 forms; but not the 1041 or other income tax forms.  While I use the very expensive top of the line Lacerte programs to prepare all kinds of income tax returns, including 1041s, there are other less expensive products out there, if you plan to prepare them yourself.  A web search should locate those programs.

Kerry Kerstetter

 

Q:

Subject: Gift Tax Question

 

Thank you for the important information. 

 

If I am giving a child a loan between them and ourselves, expecting them to pay us back in a timely fashion, and if I have already given them the max of $11,000, that is not considered gift tax is it?  Does this amount, maybe around $5,000, need to be reported on our income tax as something?  Thank you for your input. 

A:

Loans and gifts are two completely different things.  A gift has no requirement to be repaid. 

A loan has no dollar limit and the repayment terms are negotiable between you and your child.  Loans are not taxable deductible by you or taxable income to the borrower.  The only thing you will need to report on your tax return is the interest income you receive.

A loan can be reclassified as a gift if you forgive all or part of the balance. 

Your personal professional tax advisor should be able to give you more useful information based on your unique situation.

Good luck.

Kerry Kerstetter

 

Q:

Subject: Tax Advice

 

Kerry,

I do taxes for individuals, but not for businesses.  A friend of the family approached me about doing taxes for his business but I am referring him on to someone who can help him.  For my own personal knowledge and because he is a family friend, I have a couple questions on his situation.  He has not filed his business taxes for several years.  In addition, he paid his employees as contractors (but did not issue 1099’s) even though I believe they would be considered employees under the IRS’s 20 step test.  As this goes back several years, it is difficult to rectify the situation just by issuing 1099’s and hoping the IRS doesn’t audit.  Will he have difficulty finding a preparer (i.e. does the preparer have liability if he prepares the taxes for those years knowing the workers should have been classified as employees)?  Any suggestions on how he should proceed?

Thank you for your help.

A:

While every tax pro has his/her own approach to handling cases such as your friend’s, there shouldn’t be a problem finding one to take this on.  Over the past 30 years, I have worked on several cases just like this.  Most tax pros who are looking to expand their practice would be glad to have a big multi-year project.  The most critical issue is to bring the income tax returns up to date. 

In those cases, we decided the best approach was to keep the worker classifications as they were for the past-due returns.  Going back and filing very late 1099s or worse, changing the status to W-2, has far too much potential for opening a very messy and expensive can of worms with IRS and the State tax agencies.  I always warned the clients that they were on shaky ground with the status, and that IRS and/or the state could try to change it.  Luckily, they never did.  They were just glad to receive the delinquent income tax returns.

For future payments to workers, we made sure the clients were treating their workers properly in accordance with the rules.  This sometimes meant setting them up as W-2 employees or having them sign independent contractor agreements.  In some cases, the client insisted that any workers themselves be incorporated in order to prevent any possibility of being classified as a W-2 employee.

I hope this helps. 

Kerry Kerstetter