Pay Now or Pay Later? A Case Against Deferred Compensation

Also: Taxing closed-end fund conversions, Net taxes and more.
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Although we don't tip our hats to Uncle Sam very often in the Tax Forum, this weekend we raise a glass in honor of the 223rd anniversary of our independence.

In addition, we'll try to help you determine when to defer your income and when you should just pay the tax upfront. We've also got a single-dad question and a closed-end fund issue.

Then we'll weigh in on the e-commerce hoopla (here's the skinny: don't sweat the taxes). And would you believe that even tax professionals can't handle a simple thing like entering your Social Security number correctly on your tax return?

Be sure to send any other tax questions to

taxforum@thestreet.com. Please remember to include your full name.

To Defer or Not to Defer

I work for a large metropolitan fire department with a deferred-compensation program. A co-worker made the following argument against deferring now: "My tax rate in 1998 was 11% because I have kids and rental property to deduct. Why not take advantage of my current rate and pay the tax now?" At what point does it pay to bite the bullet upfront vs. investing pretax dollars? -- Mark Corlazzoli

Here's a good rule of thumb: The longer you plan on holding the money, the better off you are deferring it and paying the tax later, says Martin Nissenbaum, national director of personal income-tax planning at

Ernst & Young

.

Granted, if you are in a low tax bracket today and expect to be in a much higher one in the future, it may be worth paying some of that tax today, as your co-worker suggests. Here's why: When you withdraw your deferred income in, say, 30 years, that money will be subject to your ordinary tax rates, assuming the tax rules remain unchanged. (I know, big assumption.) But that could mean a tax rate of up to 39.6%. On the flip side, let's say you paid tax on the money today at your lower rate and invested it for 30 years. When you decide to withdraw the money, you would be hit with the 20% long-term capital gains rate instead.

Still, there are so many variables, there's no way of knowing for sure which move is right. So get out your calculator and your crystal ball and get to work.

Profit from Second Home

How much time do I have to reinvest the profit from a second home without paying capital-gains tax? -- Kathi Sarzynski

Kathi,

I am assuming your second home is not your principal residence. The gain on the sale of a nonprincipal residence is taxed in the year of the sale.

A few years back you did have the option of deferring the gain on the sale of your principal home only, notes Clarence Kehoe, partner and director of employee benefits at

Anchin Block & Anchin

in New York.

But starting in 1998, the deferral option was replaced. Now, assuming you meet a few

requirements, you may be able to exclude up to $250,000 of your gain ($500,000 on a joint return) from your total income. But this exclusion applies only to your principal residence. There's no exclusion for a second home.

"Believe it or not, the new rules are simpler and more taxpayer-friendly," says Kehoe.

Single Dad Claims Son

What filing status is used if an ex-wife allows the father to claim his son as a dependent even though the son does not live with the father? -- Loren Miller

Loren,

Since your son does not live with you, you must file your tax return as a single person with a dependent. (If you are remarried, then you can file as a married person with a dependent.) But you cannot file as head of household.

To be eligible for the head-of-household election, your child must live with you. See the

Internal Revenue Service's

Publication 504

-- Divorced or Separated Individuals

for more on the head-of-household requirements.

Closed-End Fund Opens

I own shares of a closed-end fund that is becoming an open-end fund as of May 1. I was wondering how the exchange is handled for tax purposes. Can I declare a sale on the closed-end fund this year, or is this a tax-free exchange? I would prefer to declare it, as it has a loss that I can use to offset other gains, but do I have a choice? -- Barry Levine

Barry,

You don't really have a choice. Converting a closed-end fund to an open-end fund is a nonevent for tax purposes, says Ravi Singh, mutual-fund tax partner at

Ernst & Young

. It does not affect your year-end tax bill because there's no sale or exchange of shares.

You won't have to worry about paying tax until you decide to sell your shares (unless the fund makes a dividend or capital-gains distribution in the meantime). At that point, the difference between your purchase price and the share price when you sell is the amount on which you will pay capital gains tax.

A quick reminder about closed-end funds: They are baskets of stocks that are grouped according to an investment objective and overseen by a manager.

Unlike open-end funds, which continue to increase their asset base by selling new shares, closed-end funds bring in assets by selling a fixed number of shares through an initial offering. After the initial sale, the closed-end fund's shares trade like stocks on exchanges.

Converting a closed-end fund to an open-end fund means the shares will no longer trade on exchanges and the number of shares is no longer fixed. This is not to be confused with an open-end fund that closes to new investors when the managers don't want any new money coming in.

Taxing E-Commerce

A federal advisory commission has been meeting to discuss how to tax Internet transactions, but don't expect to hear anything until 2001.

State and local governments are screaming about lost revenue. Here's the problem, at least as far as they are concerned: Let's say your state charges sales tax on concert tickets. If you purchase concert tickets on the Net and the seller doesn't charge you sales tax, it is still technically your responsibility to pay that tax. Fat chance, right?

On the flip side, what if you sell things online? Let's say you sold those concert tickets. Are you responsible for collecting those sales taxes? If it's an "isolated and unusual" sale, you are generally excluded from collecting sales tax. You can make up to three sales online before the "isolated and unusual" label doesn't apply. At that point, you have a retail business and you might be obliged to collect sales tax.

The federal advisory commission is trying come up with some clearer guidelines.

An

Ernst & Young

study found that "sales and use taxes not collected in 1998 from Internet sales were less than $170 million. This is only one-tenth of 1% of total state and local government sales and use tax collections." That's not a whole lot of money to be screaming about.

"The government doesn't need to rush into a quick fix. They have time to address the revenue and compliance-burden issue," says Thomas S. Neubig, national director of policy economics at Ernst & Young and a co-author of the study.

So for now, don't worry about all this Internet tax stuff. We'll let you know when the tax man starts to invade your Internet space.

Tax Pros Screw Up Too

The

Internal Revenue Service

has

tallied the top 10 errors made by tax professionals who prepared regular 1040s (as opposed to forms 1040A or 1040EZ). It's bad enough they even have a list, but what's worse is that four of the 10 involved incorrect Social Security numbers.

Pathetic.

Have a safe holiday weekend.

TSC Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.