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Tax Planning & Controversy

Emilie K Elliott square2
The Dangers of Misclassifying Your Workers

Employers are often confused about what makes a worker an employee rather than an independent contractor. The distinction is of great importance, as misclassification can lead to litigation by, and damages owed to, a number of different players, including the employee, the IRS, the FTB and the Division of Workers Compensation.

What makes a worker an employee? It really comes down to the degree of control exerted by the employer over the employee in terms of the manner and means of accomplishing the work. The more control exerted by the employer, the more likely the worker, regardless of how he or she is classified, is actually an employee. This is a fact-intensive inquiry, and there are very few “bright line” rules – which is part of the reason the correct characterization is so important and lends itself to litigation.

Other important and relevant factors are the degree of integration of the worker into the employer’s business, whether the worker uses his or her own tools (computer, desk, telephone, etc.) or whether such tools are supplied by the employer, whether the work performed is part of the regular business of the employer, where the individual performs the work, whether the services he or she provides require a special skill, the worker’s opportunity to profit or lose depending on his or her managerial skills, the length of time and degree of permanence of the working relationship and whether payment is by the amount of time spent or by the job. All of these factors bear on whether a worker appears to be running his or her own business (i.e., like an independent contractor) or, alternatively, whether the worker is actually a part of the employer’s business (i.e., like an employee).

Often, employers and workers think that, because they memorialize in an agreement that they are in a certain kind of relationship (independent contractor or employee), they are “in the clear,” but this not necessarily true. Although the parties’ intention (and their relative negotiating power) has some bearing, the relationship still has to be bona fide, and the actual effect of the agreement must look and act in accordance with what the parties say it is. Otherwise, a court or other interested entity may seek to void your stated characterization, and a number of consequences could flow from this.

Speaking of interested entities, a number of government agencies are interested in whether a worker is misclassified. These entities include, but may not be limited to, the IRS, the Division of Labor Standards Enforcement (DLSE), the Employment Development Division (EDD), the Division of Workers’ Compensation (DWC) and the Franchise Tax Board (FTB). Adding to the confusion and uncertainty, one entity’s determination that a worker is not misclassified is not binding on the other entities. Thus, although an employer may escape penalties with the DLSE, the same employer may be required to back pay payroll taxes with the FTB or IRS if a worker is later determined (by those agencies) to be an employee rather than an independent contractor.

Other consequences of misclassification by an employer include, but are not limited to, having to pay the worker for unpaid and unknown overtime and the associated penalties plus interest, meal and rest break penalties, waiting time penalties (for not paying all amounts due within 72 hours of termination, even though, at the time, the employer did not know the employee was misclassified), wage statement penalties, workers’ compensation fines, IRS and FTB fines and penalties, and, potentially, class action exposure.

Employers can’t afford to get this wrong! Misclassification can lead to severe consequences for an employer. If you have questions about the proper classification of your employees, or any other labor and employment law questions, please contact Emilie Elliott at eelliott@carnaclaw.com, or at 805-546-8785. The attorneys at Carmel & Naccasha have extensive experience in handling matters related to labor and employment law on behalf of employers and public agencies and are happy to assist you.

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Tax and Business Alert Newsletter

As a resource to our clients, friends, and colleagues, Carmel & Naccasha, LLP is very pleased to distribute the most recent Tax and Business Alert Newsletter. This quarterly Newsletter provides up-to-date federal tax law changes, inside information, business legal and tax developments, and a host of practice aids that we hope will be helpful.

Tax Action Bulletin April 2011

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Great time to Review Your Current Estate Plan

As most people have heard, Congress cobbled together new rules regarding the estate and gift tax that will be in place for a whopping two years. Despite the obvious tenuousness associated with laws in place for only two years, the general consensus is that congress is unable to take away that which it has bestowed.

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Update on the Estate Tax

It appears there may be some light at the end of the tunnel for the estate tax. After being bogged down by Congress’s inaction regarding the estate tax law sunset, practitioners are now getting clearer pictures of what they can expect.

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Anti-Deficiency Rules and Senate Bill 1178

People often cite to California’s anti-deficiency rules as a consumer’s best friend. See California Code of Civil Procedure 580b. While it is true that precluding a deficiency judgment on any purchase money mortgage pursuant to a foreclosure is a great benefit to California home buyers, the reality of home ownership tends to negate the benefits associated with the anti-deficiency rules.

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I Loaned Money to my Sister and All I Got was This Stupid 1099!

We are going to take a side trip from our recent discussions surrounding the wonderful world of ILITs in order to address one of the more insidious bamboozles the IRS pulls, imputed interest.

As we all know, family members mooch. I have been on both the giving and the receiving end of the less than enthusiastic family loan. What nobody told me was that in addition to lending money, the IRS might very well force me to recognize interest income on that loan regardless of whether I receive it or not.

Under Internal Revenue Code 7872, the IRS requires any lender to recognize interest on a “below market” or “gift” loan. Basically, if you lend someone money and do not charge adequate interest, the IRS is going to impute adequate interest to you as income.

There are de minimus exceptions that have other exceptions within exceptions, and all of those can be perused at your leisure in your tax code. We are in the business of pointing simply to the inherent unfairness (not really) of the tax code, and not the minor exceptions the IRS sparingly parses out.

Now, there are two types of loans, the both aptly named term loan and demand loan. Each has its own unique set of rules regarding imputed interest. This week’s blog will divulge the secrets of the demand loan.

A demand loan is a loan with no fixed term for repayment. When no fixed term for repayment exists, foregone interest must be calculated annually. For example:

Assume A lends 100,000 to B interest free, with the balance payable upon demand. At the end of year one, the IRS would impute interest income to A. Absent a stated interest rate, the IRS imputes the applicable federal rate to any gift or demand loans in order to determine income required to be recognized.

What is the Applicable Federal Rate? Basically, it is the current market interest rate as determined by a statutory formula that analyzes interest rates on Federal obligations of appropriate maturity. Each month, the IRS publishes AFRs for short-term, mid-term and long-term loans. Imputed interest computations for a demand loan under Sec. 7872(f)(2) are based on the blended short-term rate in effect for the period for which the amount of forgone interest is being determined. The blended short-term rate is basically an average determined by taking ½ * January’s published short-term AFR + ½ * July’s published short-term AFR.

Given the current economic climate and the Feds attempts at curtailing inflation, short term AFRs are at historic lows. However, blended short term AFRs have been as high as 9% and are historically around 3-5%, which means in our example above, A could have imputed interest income of $5,000.00. Let’s assume that A is in the highest federal tax bracket. This means that A has to come out of pocket with $1,750.00 to pay taxes on income he never received.

Brian J. Baker

bbaker@carnaclaw.com

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ILIT Part II

How shocking of a revelation would it be to set up an ILIT thinking you have successfully removed life insurance death benefits from your estate, only to find out, upon dying (talk about insult to injury), that because of three little sentences, that entire death benefit is pulled back into your estate and subject to estate tax (it is coming back).

Some generalizations are necessary for understanding. As with anything tax related, all generalizations mask excessively more complex specifics. However, blogging about Treasury Regulation 20.2036-1 and  whether there is, in fact, a difference between a time period not ascertainable without reference to someone's death and a time period which does not in fact end before someone's death, is not really helpful. FYI, there is a difference and only we tax attorneys care.

First generalization: The IRS frowns upon donors gifting property with strings attached. Accordingly, it enacted IRC Sections 2036 – 2038. Essentially, these code sections describe retained "powers" that result in estate tax inclusion of property thought to have been gifted away. In the parlance of our times, the powers retained are referred to as a life estate, reversionary interest, or retained power to revoke.

Today we discuss IRC 2036:

2036 – The most common example is Donor gifts property into a trust but retains the right to recieve the income. Although the donor has no right to the trust principal, the entire date of death value of the trust is included in the estate. Why is this particularly egregious in the ILIT context? As a general matter the date of death value is 30-40 times greater than the value of the original gift into the trust, which likely consisted of the cash surrender value of an existing life insurance policy.

A retained income interest can come in many different shapes and sizes; however, the general pitfalls associated with an ILIT will be the following:

1. Jointly owned second to die policy that provides an income interest to the surviving spouse.

This would result in inclusion in the surviving spouse's estate of 50% of the death benefit.

2. SIngle life policy ILIT on Husband's life that grants an income interest to the surviving spouse.

Must be sure the Surviving Spouse avoids any further gifts to the ILIT (given an ILIT is an irrevocable trust already in existence, and generally provides crummey withdrawal rights, it offers the perfect vehicle for lifetime gifts in trust that qualify for the annual exclusion). Once the spouse gifts to the trust while retaining the income interest she now falls within the grips of IRC 2036, and will be subject to  estate tax.

One very notable exception to IRC 2036 is split gifts from a husband and wife when the non-grantor spouse has an income interest. Letter Rulings have indicated that split gifts by the grantor spouse who does not have a retained income interest will not trigger 2036 for the non-grantor spouse.

The above really only scratches the surface of the 2036 retained interest issues that could be associated with ILITs. It is imparative that an ongoing relationship with an estate planning attorney is maintained, and that any future transactions are vetted through such attorney prior to their completion. The adverse consequences that can result from the simplest of transfers are devastating and should and can be avoided with appropriate planning and ongoing professional oversight.

Our ILIT series will continue with pitfalls associated with other retained interests, and one of the more cunning issues, 2041 general poiwers of appointment. In the meantime, if you have any questions, please do not hesitate to contact our office.

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Irrevocable Life Insurance Trusts

Over the next few weeks, I will provide an overview of Irrevocable Life Insurance Trusts (ILIT's) and how they are utilized to maximize "free money" to the next generation while also providing a pool of funds from which to pay any estate tax liability (trust me, it will be back).

An ILIT is generally an Intentionally Defective Grantor Trust (IDGT) that owns life insurance on the lives of the grantors. An IDGT, for our purposes, is simply a trust that is considered irrevocable for all purposes except income tax. Once a life insurance policy is transferred to an ILIT (please note, an ILIT can purchase new life insurance, but the cost tends to negate this option), and the grantors have survived for three years subsequent to such transfer, the policy's death benefit has been successfully removed from the grantors' estate. Moreover, a pool of money has been created from which all estate liabilities, including estate taxes (trust me, they are coming back) can be satisfied.

This seems like a relatively simple estate planning technique that can be utilized by everyone. Obviously, however, complications do arise, especially when the grantors own single life policies. Estate tax inclusion issues, income that is taxed that can never be received. All this scary stuff and more will be addressed in the next blog. In the meantime, should you have any quesitons regarding ILIT's, please feel free to contact our office.

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I Have to Pay Taxes On Forgiven Loan Proceeds?

I Have to Pay Taxes On Forgiven Loan Proceeds?

One of the harsh realities of our beloved taxing system is that it will tax you on any benefit received. With the housing market still crawling out from the depths of its collapse, many taxpayers are still saddled with mortgages so disproportionate to the value of the underlying real property that simply walking away from the debt seems the only option. What are the consequences associated with foreclosure/short sale/debt forgiveness, and why are you lucky if you live in California?

 

In general, if you owe a debt to someone else and they cancel or forgive that debt, the canceled amount is income subject to tax. This comes up most often in the context of home mortgages and other loans secured by real property. If a mortgagor forecloses/agrees to a short sale/ or somehow modifies the debt, any deficiency or amount of the debt forgiven could be income. Assume a loan for $500,000.00 secured by real property. Assume further that the owner simply walks away from the property and the lender forecloses realizing only $300,000.00 on the foreclosure sale. Assuming no deficiency judgment, in many instances, the lender will actually send the borrower a 1099 indicating $200,000.00 of ordinary income. Not a great result.

 

What to look for in California:

  1. Is my home loan recourse or non-recourse. Non-recourse loans do not result in Cancellation of Debt (COD) income, the policy being that since the lender never had recourse beyond the underlying real property securing the loan, foreclosure on that underlying real property fully satisfies the loan resulting in no COD income.

     

    1. One lucky aspect of living in California is that it is a non-recourse state. Basically, this means that most loans procured in anticipation of purchasing a residence are non-recourse meaning that foreclosure on these loans will usually not result in COD income to the borrower. (There are multiple nuances to this, not the least of which is the fact that refinancing usually converts a non-recourse loan to a recourse loan in California. A borrower should have his or her loan document thoroughly reviewed by counsel prior to making any final determinations on whether to walk away from a loan and simply allow foreclosure.)

     

  2. Is the loan on my personal residence as that term is defined under the Internal Revenue Code? If a foreclosure/short sale or loan modification does ultimately lead to COD income, there may be some exemptions allowing the borrower to avoid paying income tax.

The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Both debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

Under the new law, a discharge of "qualified principal residence indebtedness" is excluded from taxable income. "Qualified principal residence indebtedness" is acquisition indebtedness secured by the principal residence of a taxpayer as defined for the deduction of residential mortgage interest, but the limit is $2,000,000 for the exclusion ($1,000,000 for the mortgage interest deduction) and $1,000,000 for married persons filing a separate return ($500,000 for the mortgage interest deduction). Also, the exclusion only applies to a mortgage secured by the principal residence of the taxpayer.

If, however, the taxpayer continues to own the home after the debt cancellation, generally occurring upon a loan modification agreement, the tax basis of the residence (cost used to determine taxable gain or loss upon a subsequent sale) is reduced by any amount of discharge of indebtedness excluded from taxable income, but not below zero.

 

As you can see, the Federal Government is at least trying to alleviate some of the destructive force of the housing bubble burst. Although these exemptions/exclusions, loan nuances are well known, understanding how they apply to any borrower’s specific situation can and is tricky. If you have any questions regarding your loan, or any inquiries in general, please do not hesitate to contact us.

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Estate Planning with Retirement Benefits

As a general matter, retirement benefits are pretax dollars that have been invested on behalf of an employee. Accordingly, when the employee, or his designated beneficiary, ultimately receive the funds, they will be subject to ordinary income tax.

There is little that can be done to minimize taxes once mandatory distributions have begun, that is April of the year following the employee attaining the age of seventy and one-half. Basically, the employee must take mandatory distributions calculated to exhaust the entire balance of the retirment plan by the end of the employee's life expectancy. However, there are many occasions when an employee dies with a balance remaining in his or her retirement account. This is the circumstance where simple steps can result in large tax savings and deferral.

Once an employee receiving retirement benefits passes away, the employee's beneficiary designation controls the ultimate tax consequences. Generally, the designated beneficiary is either a spouse, child/children, or the decedent's trust or estate. There are three available transfers with the following resulting tax consequences:

1. If the beneficiary is employee's spouse, the spouse can always roll over the Plan assets into a new IRA, giving the spouse the ability to use his or her own life expectancy, achieving further tax deferral. This ability to roll over Plan assets is limited to employee's spouse, and only if the beneficiary is the spouse individually, not a trust for his or her benefit unless the spouse has the right to withdraw the Plan assets from the trust. Although the spouse has other options, rolling over Plan assets will almost always be the best choice.

2. If the beneficiary is not employee's spouse and if employee dies prior to attaining seventy and one-half, there are two options.

        a.  If the beneficiary is a named designated beneficiary under the retirement benefit plan, then the beneficiary can withdraw Plan assets over his or her life expectancy.

        b. If, on the other hand, the beneficiary is not a designated beneficiary under the retirement benefit plan but instead receives the plan funds pursuant to a trust or estate bequest, then the beneficiary must withdraw the entire balance of the retirement account (and pay income taxes on the withdrawal) within 5 years of employee's death.

3. Finally, if employee dies after the turning seventy and one-half and beginning his mandatory distributions, then a designated beneficiary named in the retirement plan has the option of  withdrawing Plan assets over the longer of the the beneficiary's life expectancy or employee's remaining life expectancy. If there is no designated beneficiary named in the retirement plan documents, then the ultimate beneficiary, who generally takes pursuant to a trust or estate bequest, is required to withdraw the funds over employee's remaining life expectancy.

    The difference between being required to withdraw an entire retirement account over five years versus a younger beneficiary's life expectancy could be very significant. Simple math illustrates that removing 1/5 of something is far greater than removing 1/30.

    All taxpayers should review their retirement plans to ensure they are maximizing the available tax benefits. Often times, people name their trusts or estates as the beneficiary which automatically precludes the use of a beneficiary's longer life expectancy.

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