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Taxing Questions
Three local
experts navigate the treacherous waters of tax-law changes
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Business New Haven
9/22/1997
By: Mitchell Young
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To survive and thrive, business people must learn to cope with a myriad of tax issues - from local and state to federal, and from personal to business. New federal tax laws compound the potential confusion, so BNH asked two area CPAs and a tax lawyer to help decipher the often cryptic tax codes and explain the ins and outs of the new law.
That'll Be $1.99, Plus Tax
Michael D'Addio is a principal at Bailey, Moore, Glazer, Schaefer, Proto, a Woodbridge accounting firm, and an attorney. D'Addio focuses on tax issues including representing taxpayers before the state's Department of Revenue Service.
Give us some background on what you find in your sales tax practice?
We normally deal with sales-tax issues on four fronts: audits, cases, letter rulings or technical advice, and answering everyday tax questions of clients. Sales tax is a very complex area of Connecticut law. The Department of Revenue Service [DRS] devotes considerable time and personnel toward doing sales-tax [audits]. In a typical three-year examination, the dollars are very substantial.
Why is something that seems
as simple as sales tax so
complicated?
Sales tax is not a simple area because it applies to more than just tax on the sales of types of property; it also includes services. These services are enumerated in a statute, and if you fall into a given service, you're covered. If you don't, you're not. But you might be doing something that isn't clearly stated as subject to tax, and the DRS may interpret it in a way that you fall into a related service, and that makes you subject to the tax.
The statutes name things that are taxable, meaning other things shouldn't be, and then there is a list of exceptions. For a typical businessperson, it is very difficult to keep all that information together. Also, until 1990 or 1991, there wasn't a cohesive body of law that you could go to for advice. Connecticut had a sales- and use-tax manual, and that was kind of outdated - even the DRS didn't follow it. To some degree, if you were examined by different examiners, you might get different results on the same issue.
Is it still that ambiguous?
It was very much that way until the early '90s. There was also the perception that if you were going into a Connecticut court to fight an issue, you probably weren't going to win. At the beginning of 1990, the Connecticut Supreme Court started handing down decisions that gave the DRS real losses. Law firms began developing divisions concentrating in the sales-tax area, and a lot of litigation has gone on since then. The DRS, to its credit, began an effort to get information out to taxpayers and to handle problems in their legal division on a more technical basis.
If a company is found not
to have collected taxes, who
is liable?
The seller has the responsibility to collect and remit [taxes] and is liable with interest and penalty. The seller may have a right to reimbursement from his buyer. It becomes a collection issue.
What occurs if the buyer never pays the debt?
[The seller is] liable for the collection of the sales tax when the service is provided, even if he wasn't paid. The tax accrues upon rendering the bill for the service. If you never receive payment, there are some provisions for you to take a bad debt [credit], but that may be in a later period.
What's the role of use taxes
in an audit?
Use tax is a big item. If I sell something to you, I should charge you sales tax. If I get examined, the state is going to say I should have collected and remitted the tax. If you get audited first, the state will look for evidence that you paid sales tax. If they determine you haven't, they are going to charge you this use tax on your purchase.
Six, seven years ago, the typical approach was for taxpayers to say to the DRS, 'That's a sales tax issue, you go to the seller first.' And only if the DRS couldn't get satisfaction from the seller did it become a use tax issue. The DRS' position, and there are court decisions that support it, says it can go to the buyer first.
They're doing what a seller would have to do in court?
From the perspective of the seller, if you're being examined, you can't say, 'Why don't you go to the buyer?' They also won't accept the argument from the buyer - 'Go to the seller.'
If both companies are being audited, what then?
It gives the state the potential to collect the tax twice. They can get it twice if the companies aren't aware of what is happening. The state doesn't necessarily coordinate the sales and use tax. They're not entitled to it twice. If you're being examined, you could call the seller [or buyer] and ask, 'Have you been examined and did they pick up these items?'
Do you have any recent
examples of how an audit worked out?
We just came in on a case where the assessment was $150,000. We argued with the state, and we've knocked it down to $15,000.
That almost defies common sense.
In most circumstances, if you know what the law is and the facts of the transaction, the situation can be presented in a way that makes it clear that it is not subject to sales tax. If you don't know, you might describe the item wrong and not be aware of the consequence of that description. Or you may not have the proper documentation to bring to the examiner.
What generates the most
problems for taxpayers?
Buying an item or service from someone outside of the state. Sellers located outside the state normally will not charge sales tax. Therefore, the item becomes subject to a use tax if it is taxable. Unless someone examining the invoice is aware of it, often this will go by the boards.
What other problems arise?
Manufacturers are subject to certain exemptions. Some manufacturers think their exemptions cover everything they buy. Certain items are subject to complete exemptions, some to partial exemption and some are taxed in full. Connecticut recently issued some tax booklets; the one for manufacturing is 100 pages long.
This doesn't seem to fit in well with the era user-friendly government?
I tend not to see sales and use taxes and the sales-tax department as user-friendly. The rules aren't simple, and that makes the possibility of error greater. Many of the changes that caused a reduction of rates were done to make tax law more business-friendly, because you're charging lower rates. The problem is, it made the law more complex and increased the opportunity for error.
Do business people understand the various potential exemptions?
When the rules for manufacturers first came out, many companies said, 'That doesn't apply to us, because we're not manufacturers.' But you may be a company that sells to manufacturers. Some people know the law, and they take full advantage. Others take too much advantage because of errors. And others who don't know the law throw their arms up and say, 'This is too complex for me.'
Feeling Your Pain: Taking the Tax Relief Act Personally
Paul Caiafa is a partner and co-founder of Solakian, Caiafa & Co. in Branford, a firm mostly serving the needs of closely held companies and high-wealth individuals.
What's your basic reaction to the Taxpayer Relief Act of 1997, or as some call it the 'Accountant Full Employment Act'?
My basic reaction is that it is a good bill and does help a fairly broad base of middle-income and lower-income individuals. Some of the provisions do benefit high-wealth individuals with changes relating to the capital gains and some of the estate tax benefits in the new law.
What do you see as the most important ramifications for an executive or business owner?
The most significant changes are in the capital-gains area. Those changes would effect their investment portfolio because of the reduction of the long-term rate from 28 percent to 20 percent. Portfolios in the last couple of years, and for many people for a lot longer than that, have increased appreciably.
What about selling a home?
There are two basic provisions that have been in the law for a number of years. If you sold your home and reinvested the proceeds into another home that was more expensive than the first, you got to defer the gain on the sale to a future date, and that was unlimited. If over the last 25 years you have bought and sold homes and have appreciation building up in them, then you were allowed to continue to defer it as long as you kept reinvesting those proceeds into a more expensive home. Coupled with that, there was a $125,000 once-in-a-lifetime gain exclusion [if the home was sold after age 55]. That number never kept up with inflation. Congress has put into place a new provision that completely excludes gains of up to $500,000 for a married couple - whenever it happens.
But you can only make $500,000 once?
No, as long as it doesn't happen in a two-year period. It's $500,000 per transaction.
What is the current IRA law and how has it changed?
Current law has been confusing; it has left a lot of people unable to do any IRA contributions. Basically, the rules say that if you are not covered by a retirement plan at work, then it doesn't matter what your income level is - you are allowed to put $2,000 in a deductible IRA for yourself or for your spouse, as long as your spouse has earned income.
Congress has changed the deductible IRAs in a number of ways. They've increased the phase-out range for taxpayers who are covered by a retirement plan at work. In the past, if you were covered by a retirement plan, then you determined whether you could take a deductible IRA by what your income range was. If your adjusted gross income was less than $40,000, then it didn't matter if you were covered by a retirement plan at work - you were allowed to take a deductible IRA. If your gross income went over $50,000, you got no deduction for the IRA. Between $40,000 to $50,000, it was phased out. The new act raises the phase-out range to $50,000 to $60,000, and after the year 2007 will raise it to $80,000 to $100,000. [Also] it no longer matters what your spouse is doing at work. If your spouse is covered by a retirement plan, that does not affect your own ability to [contribute] to a deductible IRA. As of 1998, the spouse not covered by a retirement plan at work can deduct $2,000 as long as the couple's adjusted gross income is $150,000 or less.
What about non-deductible IRAs?
Congress came out with what they call a Roth IRA. It is also referred to as a back-loaded IRA or IRA Plus. Contributions are not going to be deductible, but the earnings will build up tax-free. You can't take your money before 59 1/2 without penalties, but you can take it out after that age completely tax-free.
What if you have money going into a Keogh?
No problem.
What about the credits for higher education?
Starting in 1998, you get to take a tax credit of up to $1,500 per student per year for tuition and fees. There is also a lifetime learning credit that is a non-refundable tax credit up to 20 percent of up to $5,000 of tuition fees for a maximum credit of $1,000 (lifetime) beginning with expenses paid after June 1998.
What's happening with home office deductions?
The law in recent years has prohibited some taxpayers [from taking deductions] who have no other office outside their home and who do not perform services related to their employment in their home. For example, contractors or tradesman - they've been prohibited. Now if your only office is in your home and you're doing bookkeeping, customer filing and telephone solicitation, etc., work that typically happens in a home office, you can deduct home office expenses.
Is there any impact on inheritance taxes?
There are changes in increasing the $600,000 for lifetime transfer, and transfer upon death. Starting in 1998, it will gradually increase until the year 2006, when it goes up to $1 million. Also, the state of Connecticut is gradually phasing out its inheritance tax.
How the New Tax Law Affects Businesses
Ronald Larrow is principal with Simione, Scillia, Larrow & Dowling of New Haven, an accounting firm serving primarily privately held companies.
What's your overview on the impact of recent tax changes to businesses?
Net balance, it's a positive change for businesses. They've done some simplification. There were many complicated rules for alternative tax for corporations, for example. They exempted corporations [not subchapter S or limited liability] with less than $5 million worth of revenue - and in 1998 it will be $7.5 million in revenue - from the Alternative Minimum Tax [AMT]. It's an average of the last three years. Currently, if a business has certain preference items, such as for depreciation, they have to pay the greater of the Alternative Minimum Tax or the regular tax. The computations that these taxpayers have to go through cause a lot of record keeping. They'll no longer have to do the record keeping.
Subchapter S corporations, partnerships or LLCs will still have their owners paying AMT and having to keep track of the computations.
Did you see a lot of businesses that had to pay the tax?
There's not a large percentage that had to pay the tax, but the work had to be done for all of them. Typically it's difficult to manage and expect, because you can't always predict.
What is the overall sense your clients have about tax fairness, prior to any changes?
When they increased the tax rates for individuals, and many of our clients pay tax at the individual level because they're S corporations or Limited Liability Companies, most business people felt they paid an unfair amount.
How did they change the research credit?
It was scheduled to expire at the end of May, and they extended it for 13 more months.
What constitutes 'research,' and how is it computed?
It has to be in the development of a new product, a new method of making a product or a significant improvement of an existing product. Connecticut also has 20-percent credit on the increase in the research expenditures from year to year. On the federal level, it is also receive a credit when the company has its current research and development higher than its historical base. They don't have to increase their expenditures every year; they simply have to have expenditures that are greater than their historical base.
What about hiring credits?
There is a Work Opportunity Credit. That credit allows for certain employees who previously have been on special assistance programs. They refer to it as Supplemental Security Income (SSI). If you employ those individuals, you can get a credit on their wages - 25 percent of the first 400 hours of employment and 40 percent of the next 400 hours.
Have you found companies taking advantage of Welfare to Work tax credits?
It's fair to say that we don't have many clients actually motivated by this. I don't think this is going to be a widely sought-after credit.
What about the environment?
Certain expenditures for environmental remediation won't have to be depreciated. In the past, if a company was cleaning up a site and not adding to the value of the site, those expenditures were deductible. There was controversy with taxpayers over what was an improvement and what was not. Congress has made it clear that for certain environmental remediation expenses, even if it will improve the value of the property, the expenses can be immediately depreciated.
Previously the IRS ruled that if you were cleaning up a site and you purchased the site with those contaminants in it, those expenses would have to be capitalized. Many manufacturing clients and landowners are being asked to clean up and it wasn't entirely clear before when they could deduct the expense.
Any items of special interest?
In Connecticut, there is a new machinery-and-equipment credit for increased expenditures. That will be sought out. It was part of older legislation, but it was deferred and will start applying beginning in 1997. If you have up to 250 employees, you can have a credit of up to ten percent of your incremental expenditures. If a company has more than 250 employees it will be five percent.
You don't have to be a
manufacturer?
No, you simply have to be a business that is increasing expenditures in machinery and equipment. You do have to be subject to tax. You have to be profitable.
What about credits for computer equipment?
Any industry that pays property taxes on its computers or data-processing equipment can receive a state tax credit equal to the tax that is being paid. Unfortunately, that is only for corporations; partnerships, LLCs or sole proprietorships cannot take that credit. I don't think that this approach is targeting the business population in a fair and equitable way.
How do the capital-gains changes affect businesses?
Unfortunately for corporations, there is no preference for capital gains. However, corporations that elect S status or partnerships or LLCs do benefit from the capital-gains cuts because their owners benefit from them. Many of our clients will benefit when their companies sell appreciated assets or when the company itself is sold, which is a tremendous benefit.
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