CONVERSION PROPERTY MAY HAVE LIMITED SECTION 121 EXCLUSION

Code Section 121 allows taxpayers to exclude up to $250,000 of gain from sale of a principal residence from federal income taxation ($500,000 for married couples). To qualify for the exclusion, the sold residence must have been used as the taxpayer's principal residence for at least 2 years in the 5 years preceding sale.

The Housing Assistance Tax Act of 2008 has enacted a new limitation on the exclusion. Code Section 121(b)(4) now provides that if a residence was at any time NOT used as a principal residence of the taxpayer, the portion of the gain allocated to periods of "nonqualified use" will not be available for exclusion. Thus, if a taxpayer rented out a residence or used it only as a vacation home for a period, but still otherwise used the residence as a principal residence for the requisite 2 years out of the preceding 5, the full exclusion may not be available.

The available portion of the gain available for exclusion is determined by multiplying the gain on sale by a fraction. The numerator is the period that the residence was used as a principal residence by the taxpayer, and the denominator is the entire period of ownership of the taxpayer. The resulting amount of gain is eligible for exclusion (up to the maximum $250,000/$500,000 exclusion limits), and the remaining gain is not excluded.

There are some finer details to the new rules, including:

a. In applying the above "nonqualified use" fraction, the period of "nonqualified use" in the numerator does not include periods before 1/1/09 (but such periods before 1/1/09 are not excluded from the denominator);

b. The numerator also does not include any time period of "nonqualified use" arising in the prior 5 years before sale that occur AFTER use a principal residence;

c. The numerator also does not include periods of "nonqualified use" (up to 10 years) due to service as a member of the uniformed services or the Foreign Service, or as an employee of the intelligence community; and

d. The numerator also does not include periods of "nonqualified use" (up to 2 years) due to change of employment, health conditions, or any other unforeseen circumstances as may be specified by IRS.

Note that the formula determines how much of the GAIN is eligible (and not eligible) to be subject to the exclusion - it does not adjust the statutory amount of the exclusion. Thus, in some circumstances, if the gain amount is high enough and a small enough portion is treated as allocable to nonqualified use, the remaining gain may still be excluded by the full applicable statutory exclusion amount. For example, if the taxpayer has $1 million of gain, and 1/5 of the gain is treated as allocable to periods of nonqualified use, $800,000 is still eligible for the statutory exclusion (up the available $250,000/$500,000 maximum). Thus, the full statutory exclusion amount may at times still be available even with periods of nonqualified use, given enough gain.

APPLICABLE FEDERAL RATES - SEPTEMBER 2008

FRINGE BENEFITS AND 2% SHAREHOLDERS OF S CORPORATIONS

S corporations may pay fringe benefits for the benefit of its shareholders, as well as its other employees. However, special rules apply as to whether these benefits will be taxable to shareholders who receive them if those shareholders own 2% or more of the stock of the corporation.

Not all fringe benefits will be taxable to the shareholders. For a quick review of what expenses can and cannot be received free of income tax, click here to see a summary chart.

DAY TRADER IS ONLY AN INVESTOR

Successful stock market day traders like to be characterized as mere investors for federal income tax purposes - this allows them to pay taxes on their trading gains at preferential capital gains rates. Unsuccessful stock market day traders want to avoid the "investor" label, and instead they want to be characterized as engaged in the trade or business of trading. This is because they don't want capital loss treatment for their trading losses - capital losses can only be used to offset capital gains (except as to $3,000 per year which can be used to offset ordinary income). Further, their trading expenses can only be deducted to the extent they and any other miscellaneous itemized expenses exceed 2% of adjusted gross income.

William Holsinger fell into the unsuccessful category, losing over $180,000 in trading activities in 2001. William claimed he was in the trade or business of trading, and sought ordinary loss treatment for his trading (even though, in 2000, when he had trading profits, he reported those as investment capital gains). He also sought ordinary loss treatment for losses incurred in 2002. The IRS disallowed the ordinary loss treatment, indicating that Mr. Holsinger's trading activities were insufficient to give rise to trade or business status.

To determine whether a trade or business exists for trading activities, the courts look at the taxpayer's investment intent and the frequency, extent, and regularity of the taxpayer's securities transactions. More particularly as to stock market trading activities, a taxpayer's stock market activities constitute a trade or business if the trading is substantial, and the taxpayer seeks to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holding of investments.

Mr. Holsinger's trading activities were somewhat substantial - in 2001, Mr. Holsinger conducted 289 trades. In 2002 he conducted 372 trades.

However, in neither year did he trade on more than 45% of the available trading days. Further, Mr. Holsinger rarely bought and sold the same securities on the same day, and held many stocks for more than 31 days at a time. As such, it was difficult to show that he was seeking to capture "daily" market movements, as opposed to seeking to capture profits from more long-term market movements.

Ultimately, the Tax Court held that his trading activities were not sufficient to get out of investor status, in large part due to the extended holding period of many of his purchases (i.e., more than one day).

Holsinger v. Comm., TC Memo 2008 –191

MORE ON PROTECTION OF ASSETS AT BANK AND BROKERAGES

We recently addressed the FDIC insurance limits on various types of bank accounts. Not all accounts with banks are FDIC insured. Many don't need it - that is, some assets are effectively owned by the client so they are not impacted by a failure of the institution itself.

The American Bankers Association has issued a memo that addresses deposit accounts, fiduciary accounts, and custody accounts, and the general operation of such accounts in the event of a financial institution failure. The memorandum provides:

Assets held in deposit accounts become liabilities of the bank. As such, deposits create a debtor-creditor relationship between the bank and the depositor. In exchange for the money deposited, a liability of the bank is created which is the bank’s contractual promise to repay the amount on deposit plus, where applicable, interest. Deposit accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000 per individual per bank.

Assets held in trust and fiduciary accounts do not become assets or liabilities of the bank and are, indeed, segregated from the bank’s assets. The bank acts as trustee or fiduciary to the account and, in this connection, provides investment management, investment advice and other services to the account. Account ownership remains vested in the individuals or entities for whose benefit the bank is acting as trustee or fiduciary and the assets are not subject to the claims of creditors.

Assets held in custodial accounts in the trust department of a bank do not become assets or liabilities of the bank and are segregated from the bank’s assets. The bank’s role as custodian is to hold the assets for safekeeping, to collect dividends and interest and provide other similar services. Account ownership in the assets remains vested in the individuals or entities for whose benefit the bank is acting as custodian and the assets are not subject to the
claims of creditors.

What happens if a bank fails?

Since deposit accounts become liabilities of the bank, it follows that the depositor would become a creditor in the event a bank failed. However, the FDIC insures depositors for up to $100,000 per individual per bank.

Since assets held in trust, fiduciary and custodial accounts do not become assets or liabilities of the bank (title is held by the account’s owner(s)), it follows that none of this property is subject to the claims of the bank’s creditors. As a result, a failure of a bank will have no adverse effect on trust, fiduciary or custodial accounts: they remain the property of the account’s owner(s).

In the event that a bank with trust, fiduciary or custodial powers fails, the FDIC will seek to transfer responsibility for administration of the accounts to a successor trust institution as quickly as possible. Provided this effort is successful, the account beneficiaries would need to either accept this new arrangement or make provisions with the successor bank for alternative arrangements. Should the search for a successor trustee to the failed bank be unsuccessful, the FDIC will then promptly notify all affected beneficiaries to either personally reclaim their property or designate an alternate institution to which the trust, fiduciary or custodial property may be conveyed.

Therefore, the safety of trust, fiduciary and custodial assets is not dependent upon whether the bank has assets greater than its liabilities. Property held in these accounts belongs to the owner(s) of the accounts and would be unaffected by a bank failure.

One area of failure that has not been widely explored is what happens to securities in a brokerage account held in street name, if the brokerage house goes under. As many readers are already aware, securities held in a brokerage account these days is typically held in "street name," and not registered with the issuer in the name of the client. There are some questions as to who is the legal owner of such securities (the client or the brokerage house) and whether the client will always receive back all of such securities.

Thanks to Tim Peters at Key Private Bank in North Palm Beach, Florida for providing the materials which this post was based upon.

IS THERE LIFE LEFT IN THE COHAN RULE?

For income tax purposes, taxpayers are required to maintain permanent books of account and records sufficient to sufficient to establish the amount of gross income, deductions, credits, or other matters reported to the IRS (Treas.Regs. §1.6001-1(a)). Some taxpayers are less fastidious than others in maintaining adequate books and records, so the question often comes up whether a given level of record and bookkeeping will be sufficient to uphold a deduction.

In 1930, it was held that a famous actor, playwright and producer could deduct entertainment expenses based on estimated expenses, rather than having to produce detailed records of each expenditure. The holding in this case became known as the "Cohan Rule" - that is, that if a taxpayer can substantiate that a legitimate deduction was incurred, courts will be willing to use the documentation available to estimate the deductible amount.

In opposition to the Cohan Rule, Congress by statute does require more detailed receipts and records for certain types of expenses before a deduction will be allowed. These expenses include travel and entertainment expenses, business gifts, deductions relating to listed property (certain types of property that are prone to taxpayer abuse, such as autos, computers, cell phones, and property used for entertainment), and charitable contributions.

In a recent article in Practical Tax Strategies, Paul G. Schloemer conducted a survey of tax cases where the Cohan Rule was invoked, to see if the rule still has viability today. Happily, he reports that the rule is alive and well.

Of course, all invocations of the Cohan Rule will not result in deductibility. Mr. Schloemer notes that there are two key variables that courts will look for in allowing a taxpayer to rely on the Cohan Rule. The first is that SOME documentation will be needed - oral testimony alone probably will not cut it. The second variable is the veracity of the taxpayer's testimony, since the court will need to have some level of trust in the taxpayer's assertions before it will allow deductions under the rule.

Schloemer, Paul G., Cohen Rule Still Secures Some Deductions Despite Statutory Limits, Practical Tax Strategies (WG&L)

FDIC DEPOSIT INSURANCE LIMITATIONS

Over the past several weeks, several banks have failed, and their depositors paid out by the FDIC. While the FDIC may pay out more than the insured amount, the actual amount of deposit insurance per account at a given bank is $100,000 (or $250,000 for certain IRA's and other similar deferred accounts).

However, depositors can have different types of accounts at the same bank, and their interest in each can each be insured separately up to $100,000. Since the various types of accounts and applicable rules are lengthy, I have prepared a useful summary which can be accessed here.

The FDIC also provides a calculator that can assist in determining amounts insured at a given bank.