Partial Annuity Exchange

Variable annuity contract distributions generally contain two components, taxable income and nontaxable return of basis (investment). However, distributions received before the annuity starting date (nonannuity distributions) are likely to be less taxpayer-friendly. Initially, these nonannuity payments generally consist entirely of taxable income until all of the annuity contract’s earnings have been distributed. Subsequent payments are considered to be a nontaxable return of basis. Because of this issue, when an annuity owner must take a nonannuity distribution, the tax impact can be onerous.

Internal Revenue Code Section 1035 has traditionally provided a federal tax-free mechanism to exchange one annuity contract for another annuity contract. This Section 1035 exchange, without recognition of gain or loss, is limited to cases where the person who is the insured or annuitant is the same in both contracts. Recent regulatory guidance offers a way to lessen the tax impact on nonannuity distributions using the Section 1035 exchange mechanism.
A person holding a highly appreciated annuity (one containing a large amount of built-up earnings) can lessen the tax bite using a two-step process. First, he or she makes a partial withdrawal from the original annuity by completing a partial exchange into another annuity. Next, he or she surrenders either annuity contract more than 12 months later to minimize the tax impact (see the following example).

Example: Partial Annuity Exchange. Pat originally invested $50,000 in an annuity, which has now grown to a fair market value of $200,000. If she withdraws $100,000 from this annuity, it is considered to be composed entirely of income and will be taxed as ordinary income. But, if Pat makes a Section 1035 exchange with half of the original annuity into a second annuity worth $100,000, there will be no immediate tax cost. Her basis in each annuity is split proportionally. Accordingly, she has a $25,000 tax cost (basis) in each $100,000 annuity after the partial Section 1035 exchange. If Pat surrenders one of the annuities in full more than 12 months after the date of the Section 1035 exchange, she receives a $100,000 distribution that is considered to be $25,000 return of basis and $75,000 of ordinary income. This is a better result than receiving $100,000 of ordinary income without the partial Section 1035 exchange.

Please contact us if you have questions about the tax aspects of annuity distributions or any other tax compliance or planning issue.

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Bankruptcy—Advantages and Disadvantages

If bankruptcy is the only viable business solution, a business generally can use two types of bankruptcy proceedings. Under one, the business is liquidated, so that at the conclusion of the process the business no longer exists. Under the other, the business is reorganized and, hopefully, comes out of the bankruptcy as a viable business structure. Each type of bankruptcy has its unique set of advantages and disadvantages.

Chapter 7—Liquidating Bankruptcy. The biggest advantage to filing bankruptcy to liquidate is that the debtor gets a fresh start. All dischargeable debts are eliminated, and the creditors are absolutely prohibited from going back to the debtor to try and collect the debt. In addition, the liquidation is orderly when under the supervision of a single, independent third party. The debtor’s assets are marshaled, the creditor’s claims verified and accepted, the property sold, and the proceeds distributed based on the priority of the claims. Creditors cannot increase their take by taking preemptive collection action. In fact, under the preference rules, payments made to a creditor within 90 days of filing the petition can be recovered from the creditor.The court will also ensure that a reasonable price is obtained for the assets, thus maximizing the value received. This can be particularly important when there are co-debtors or other guarantors that have an obligation to pay the debt if the debtor cannot. The debtor is spared the costs of responding to multiple collection actions, including lawsuits, since the bankruptcy court has jurisdiction over the entire case. But Chapter 7 has disadvantages as well. Perhaps the biggest disadvantage is the cost. Bankruptcy is an expensive process, and the monies paid in professional fees, filing fees, and other costs could arguably have been better spent in reducing the debtor’s liabilities. This may be particularly true when there are few creditors or when related parties have agreed to guarantee the debtor’s liabilities. Another disadvantage is the time and effort of the bankruptcy process. Since the court will direct the liquidation, it is the court, not the debtor, that sets the schedule. If the creditors are also arguing over various issues, the time it takes to liquidate can be increased. This can prove to be inconvenient and frustrating, particularly if the debtor is trying to operate a new business.

Chapter 11—Reorganization. The biggest advantage to using Chapter 11 to reorganize a business is the ability of the court to control the process. The debtor is given breathing room and is normally left in charge of the business. The debtor is also given the opportunity to develop the reorganization plan free of creditor pressure, although the creditors must ultimately approve it. Furthermore, the automatic stay provisions prevent creditors from taking legal action outside the bankruptcy reorganization that could harm the debtor or jeopardize a successful reorganization. Unfortunately, many reorganizations simply do not work and end up converting to liquidating bankruptcies. The main disadvantage of Chapter 11 is the cost of the proceedings and the oversight that will be provided by the court and creditors. The debtor is under a duty to the court and the creditors to operate the business and must seek approval for any action outside the course of business. The debtor effectively operates in a fishbowl, which can be an unpleasant experience since most business owners are not used to having every decision scrutinized and second-guessed.

Obviously, tax and legal advice should be sought when contemplating bankruptcy. Please contact us for further guidance on this topic.

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Better plan ahead for Self-employment

If you are considering self-employment because of a pending layoff, job uncertainty, or just because it is the right time, you have a lot to plan for. So, please consider the following issues while making this important, life-changing decision.

Check for Noncompete Agreements:

If you plan to continue in the same business as your present employer, make sure you have not signed anything that prevents you from dealing with the customers or clients you are counting on.

Continue Your Employee Health Insurance Coverage:

It often takes time to find private health insurance at a price you are willing to pay. Unless your spouse can provide coverage through his or her employment, you can continue your existing coverage under your former employer’s group plan by making a COBRA election. Generally, coverage is continued for up to 18 months at a cost not to exceed 102% of what it costs your former employer. Make sure you check ahead of time to find out what the COBRA cost will be so you can accurately budget your expenses.

Make Other Insurance Arrangements:

Contact your insurance agent to discuss property and casualty, personal and business liability, disability, and term insurance needs. Some professional associations offer relatively inexpensive umbrella liability policies that insure against some things not covered by your other basic liability policies. These umbrella policies are generally worth investigating.

Arrange for Credit before You Quit:

Even though you may have excellent credit, the change in your status from employee to self-employed can make borrowing much more difficult until you have a track record from being in business for yourself. If you have a definite need to buy a new house or car or make other purchases that involve significant borrowing, do it before you quit your job. If you are considering refinancing your home, do it now.Even if you do not think you will need the money, it is also a good idea to consider taking out a home equity loan or line of credit now. The extra cash on hand can provide some cushion if your self-employment expenses turn out to be higher than expected or if the money does not come in quite as fast as you thought it would.

Conserve Cash:

Before you actually quit your job, and for the first few months after you go into business for yourself, minimize your cash outlays so you can build up a margin for error. In the early months of a new business, revenues are often less than expected because you have to spend time in start-up activities and because at least some of the revenue you anticipated does not materialize. In addition, clients or customers do not always pay as quickly as you would like. You may also have underestimated your expenses. Two ways to deal with this are to (1) postpone spending money on things that are not strictly necessary (such as vacations or upgraded computer equipment) and (2) use your credit judiciously.

Make Sure Your Planned Home Office Is OK:

Many people starting a new business plan to use an office in the home—at least in the beginning. However, do not automatically assume you can do this without any problems. A little-known fact is that quite a few cities have surprisingly strict limits on home-operated businesses. Similarly, many residential insurance policies have exceptions and exclusions if a business is operated within the residence.

Avoid Cabin Fever:

If you are used to lots of interaction with people in your job, it may be a shock to go out on your own. If you have no employees, there can be little or no face-to-face contact for days at a time. Consider joining or becoming active in professional organizations or local groups. In addition to providing potentially valuable networking opportunities, such involvement will help provide the activity level that you are accustomed to and some needed diversions from your new business.
There is a lot to consider before making the plunge into self-employment. Please contact us to discuss ideas and methods to minimize the tax bill from your new endeavor.

Cash Method vs. Accural Method - Selecting an Accounting Method for Your Business

Cash Method vs. Accrual Method - Selecting an Accounting Method for your Business

When setting up a bookkeeping system for your company, it is important to understand the definition of the cash method and the accrual method of accounting. Under the cash method, revenue and expenses are recorded according to the flow of cash in and out of the business. Under the accrual method, revenue and expenses are recorded when incurred, usually in the absence of a cash transaction. The cash basis is an easier concept to work with but does not always give you a true picture of business operations. The accrual basis will give you a more accurate picture of your company’s results of operations, but requires a bit more work.

Characteristics of the Cash Basis:

a. Deduct your business expenses when paid. ( Ex: Record expenses on the books only when cash goes out the door)

b. Record Income when you receive payments from your customers. (Ex: Recognize income on the books only when cash comes in the door)

c. At year end, only expenses paid during the year and income received during the current year will be recorded on the tax return. (Ex: If customers were invoiced a total of $75,000 late in December and payments on those invoices have not been received by December 31st, that income does not show up on the tax return. Likewise, if invoices from your supplier totaling $75,000 are being held but not paid by December 31st, those expenses are not deducted on the tax return)

Characteristics of the Accrual Basis:

a. Business expenses are deducted when you receive goods or services usually before they are paid. (Ex: Record expenses on the books when goods/invoices are received from your suppliers, before you send your payment.)

b. Revenue is recognized when you provide goods or services to your customers, even if payment has not been received. (Ex: Record income on the books when services are rendered to customers or goods are sold, prior to receiving payment)

c. At year end, unpaid invoices/receivables to customers could be sitting on the books which create taxable revenue for the current year, even though payment has not been received from the customer.

d. Likewise, at year end, unpaid bills to vendors/payables could be recorded on the books for expenses that have not yet been paid. These expenses will reduce taxable income.

Situations where the Accrual Method is required:There are some situations where the accrual method of accounting is required. However, for most small businesses, these situations probably do not apply. If you have a corporation that has annual gross revenue of $5million or more, you must use the accrual method. Additional if you carry inventory on the books or if your business is engaged in farming operations, you might be required to use the accrual basis.

Change in Method of Accounting:

Once a method of accounting is adopted, this method needs to be followed year after year for tax purposes. However, if there are specific reasons to change methods that might prove to be more advantageous to your business, you might consider changing methods. To change to a different method of accounting used in reporting taxable income on your business tax return, the corporation must file a Form 3115 – Application for Change of Accounting Method to receive approval from the IRS.

Small business accounting software will usually allow the presentation of the financial statements on either a cash or accrual basis. However, for tax purposes, arbitrarily switching back and forth between the two methods is not allowed.

In Conclusion, for most small business with revenue under $5 million, it is probably best to use the Cash method, especially if those businesses carry large receivable balances on the books. By carrying receivables, this means that you have invoiced customers, but not actually received payment from these customers. At tax time, those invoices are disregarded and will Not result in taxable income. Because, under the Cash method, only cash actually received during your tax year has to be reported as income on the tax return. For businesses that do not carry large receivable balances, it might be more beneficial to use the Accrual basis of accounting. This would allow deductions for business expenses that have been incurred but not yet paid. Some businesses plan on accelerated spending at year end for this purpose.

Conversion to Roth IRA

Restricted from a Roth IRA? Not Anymore

Starting 2010, more people can convert to a Roth IRA. That's because income limits and tax-filing restrictions go away!

Roth Conversion Details

• Who: All taxpayers, regardless of income or tax-filing status

• What: Conversions from a traditional, SEP or SIMPLE IRA – or qualified rollover contributions from an employer plan (401(k), 403(b), etc.) – to a Roth IRA

• When: Starting January 1, 2010

• Why: Take advantage of tax-deferred growth and tax-free withdrawals.1 No required minimum distributions.2
  

Act Now
Converting to a Roth IRA has many potential benefits. But there are important things to consider, such as your retirement goals, account status and potential tax implications. Taxpayers who convert to a Roth IRA in 2010 have the option to report 50% of the taxable conversion in 2011 and 50% in 2012. In subsequent years, taxpayers will have to pay all taxes in the year they convert.

Consult our offices and ask your tax advisor, as not all states have adopted the federal rules, and there may be differences in federal and state taxation of a Roth IRA conversion.

1 Must be qualified Roth IRA distributions.

2 Applies to the original account owner only. Beneficiaries would be required to withdraw required minimum distributions.
State tax treatment may vary.


Are You Conversion Bound?

Talk to someone at Tahim and Associates about the Roth IRA conversion and whether it's right for you.

Ready to talk to someone now? Call Tahim and Associates at:

714-772-4744

2010 Tax Calendar

2010 Tax Calendar

January 15 — Individual taxpayer’s final 2009 estimated tax payment is due unless Form 1040 is filed by February 1, 2010, and any tax due is paid with the return.

February 1 — Most employers must file Form 941 (Employer’s Quarterly Federal Tax Return) to report Medicare, social security, and income taxes withheld in the fourth quarter of 2009. (If your tax liability is less than $2,500, you can pay it in full with a timely filed return.) If you deposited the tax for the quarter in full and on time, you have until February 10 to file the return. Employers who have an estimated annual employment tax liability of $1,000 or less may be eligible to file Form 944 (Employer’s Annual Federal Tax Return).

— Give your employees their copies of Form W-2 for 2009. If an employee agreed to receive Form W-2 electronically, have it posted on the website and notify the employee.

— Generally, give annual information statements to recipients of certain payments you made during 2009. You can use the appropriate version of Form 1099 or other information return. Form 1099 can be filed electronically with the consent of the recipient.

— File Form 940 [Employer’s Annual Federal Unemployment (FUTA) Tax Return] for 2009. If your undeposited tax is $500 or less, you can either pay it with your return or deposit it. If it is more than $500, you must deposit it. However, if you deposited the tax for the year in full and on time, you have until February 10 to file the return.

— File Form 945 (Annual Return of Withheld Federal Income Tax) for 2009 to report income tax withheld on all nonpayroll items, including backup withholding and withholding on pensions, annuities, IRAs, etc. If your tax liability is less than $2,500, you can pay it in full with a timely filed return. If you deposited the tax for the year in full and on time, you have until February 10 to file the return.

March 1 — The government’s copy of Form 1099 and Form W-2 series returns (along with the appropriate transmittal form) should be sent in by today. However, if these forms will be filed electronically, the due date is March 31.

March 15 — 2009 income tax returns must be filed or extended for calendar-year corporations. If the return is not extended, this is also the last day for calendar-year corporations to make 2009 contributions to pension and profit-sharing plans.