Taxation - FAQ

1. I DID NOT FILE TAX RETURNS FOR THE PAST SEVERAL YEARS, WHEN I WAS REQUIRED TO DO SO. WHAT SHOULD I DO?

Failure to file required tax returns can be a crime. Also, you may be responsible for tax due. Don't wait to be contacted by the IRS. You may lose strategic advantage if you do. In many cases, the best advice is to file outstanding returns and try to work out payment problems with the IRS. To protect yourself, particularly from criminal exposure, seek the advice of a knowledgeable tax professional.

2. INHERITED SOME MONEY FROM MY MOTHER, WHO RECENTLY PASSED AWAY. DO I HAVE TO PAY INCOME TAX ON THIS?

As a general rule, inheritances are not subject to federal or Connecticut income tax. Exceptions do exist, however. For example, if you received money from your mother's Individual Retirement Account ("IRA"), there most likely will be income tax due on the proceeds.

3. MY MOTHER GAVE ME HER HOUSE. DO I HAVE TO PAY INCOME TAX ON THE GIFT?

Generally, gifts are tax free to the recipient. However, the donor (your mother) may owe a tax, which if not paid, you, the recipient, must pay. Also, if and when the gifted property is sold, there may be income tax due. This is known as a capital gains tax. Pre-gift tax planning can result in substantial future tax savings to the recipient.

4. I WANT TO GIVE $50,000.00 TO MY SON TO BUY A HOUSE. AM I SUBJECT TO GIFT TAX?

Both the federal government and the State of Connecticut have a gift tax, which is imposed on the person who makes the gift. There are exceptions. For example, tax-free gifts of up to $12,000.00 per person may be made each year under the annual exclusion amount. Gifts to your spouse are exempt. There are also exceptions for certain medical and education expense-related gifts. If the gift is over the annual exclusion amount, returns are required to be filed on or before April 15th following the year in which the gift was made, even if a gift tax is not due at that time.

5. CAN I WITHDRAW FUNDS PENALTY FREE FROM MY 401(k) PLAN TO PURCHASE MY FIRST HOME?

If you are under the age of 59-1/2, you cannot withdraw funds from your 401(k) plan to purchase your first home without being subject to a ten percent additional tax on early distributions from qualified retirement plans. However, depending on the rules for your 401(k) plan, you may be able to borrow money from your 401(k) plan to purchase your first home. Your plan administrator should have written information about your particular plan that explains when you can borrow funds from your 401(k) plan as well as other plan rules.

6. WHAT ARE THE BENEFITS OF A LIKE-KIND EXCHANGE UNDER INTERNAL REVENUE CODE SECTION 1031?

In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a like-kind exchange, the tax on the gain is deferred until some future date. Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction. The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

7. WHAT IS THE PRINCIPAL RESIDENCE EXCLUSION AND HOW DO I KNOW WHETHER I QUALIFY?

Taxpayers who sell or exchange a principal residence after May 6, 1997 can exclude up to $250,000.00 on a single return or up to $500,000.00 on a joint return of unrealized gain. A residence includes houseboats, trailers, condos, and co-ops. Gain is computed by subtracting from the gross sales price the selling expenses, cost of improvements, and adjusted basis or original cost which is reduced by any previously deferred gain.

Taxpayers must meet three tests to qualify:

(i) The taxpayer(s) must have owned the residence for at least two of the last five years ending on the date of sale. In the case of a couple living in the residence, only one taxpayer/owner needs to meet the test.

(ii) The taxpayer(s) must have used the residence for at least two of the last five years ending on the date of sale. Both occupants must meet this test, but the time does not have to be consecutive.

(iii)The taxpayer(s) must not have used the $250,000.00/$500,000.00 exclusion for any residence sold or exchanged during a two year period ending on the date of the current sale or exchange. This test does not apply if the first sale or exchange occurred before May 6, 1997.

8. I RECENTLY LEFT MY JOB. WHEN I DID, I RECEIVED A DISTRIBUTION FROM MY EMPLOYER'S RETIREMENT PLAN FOR MY VESTED SHARE. IS THIS TAXABLE?

Yes, but you can defer paying the tax on any portion of the distribution that you had your previous employer roll-over directly into your IRA within 60 days. If you do not roll-over, but receive the distribution, and if certain other exceptions do not apply, you will have to pay regular income tax, plus a ten percent penalty, on the distribution. The penalty does not apply in all instances. For example, the penalty is not imposed if you are over a certain age or if you use the proceeds to purchase health insurance during an unemployment period. Chances are your employer withheld 20 percent of your distribution for taxes. The withheld amount is only an estimate of tax due. You may owe additional tax. For some taxpayers, the withholding makes it difficult to roll-over the entire distribution, because of lack of funds. The withholding tax can be avoided if you arrange to have the distribution made directly to an IRA.

9. I HAVE INVESTMENTS IN ANOTHER COUNTRY. I DO NOT RECEIVE ANY U. S. TAX REPORTING DOCUMENTS, SUCH AS A FORM 1099, FOR THE INCOME EARNED. DO I HAVE TO PAY U. S. INCOME TAX ON THIS INCOME?

As a general rule, U. S. citizens are taxed by the United States on all income earned, regardless of source. If you pay foreign tax on the income, you may be eligible for a tax credit or deduction on your U. S. return.

10. MY FORMER HUSBAND AND I FILED JOINT TAX RETURNS FOR AS LONG AS WE WERE MARRIED. LAST YEAR WE DIVORCED. HE HAS SINCE DISAPPEARED TO PARTS UNKNOWN. I WAS RECENTLY CONTACTED BY THE INTERNAL REVENUE SERVICE AND INFORMED THAT I OWE A SUBSTANTIAL AMOUNT OF TAX AS A RESULT OF AN AUDIT. APPARENTLY, MY EX-HUSBAND WAS INVOLVED IN A SHADY BUSINESS DEAL. I KNEW NOTHING ABOUT HIS BUSINESS AFFAIRS. I JUST TOOK HIS WORD AT THE TIME THAT THE TAX RETURN WAS OKAY, AND I SIGNED IT. AM I RESPONSIBLE FOR THE TAX?

When spouses file a joint tax return, each spouse is responsible for the entire tax obligation, regardless of who earned the income. However, you may qualify under a relief provision in the tax laws for Innocent Spouse Relief. To the extent that you so qualify, you will not be responsible for the tax.

11. I HAVE A "JUMBO IRA" ACCOUNT THAT I HAVE BEEN CONTRIBUTING TO FOR MANY YEARS. WHAT IS THE BEST WAY TO TAKE MONEY OUT OF THE PLAN?

Retirement plan distribution planning is very complex. It involves property law, beneficiary designation, estate taxes, income taxes, and investment analysis. There are substantial penalties for taking distributions too soon, taking too much money out in a year, not taking enough money out in a year, and dying with too much money in a plan. Congress has granted a three-year amnesty period wherein certain persons with jumbo IRAs can remove excess funds there from without incurring penalties. This amnesty ends in 1999. Persons with substantial retirement savings should take the time to consult with a tax advisor as to how to structure a plan that fits his or her needs without paying excessive taxes and penalties.