May, 2002 Newsletter
Note: The items in this newsletter are provided to bring certain information
or opinions to the attention of the reader in capsulized form. The information
is generally not complete and has been oversimplified for the sake of
brevity. Readers should therefore not make decisions based solely upon
the information in these newsletters without first contacting
us or other sources of more complete information.
INCOME TAXES
THE JOB CREATION AND WORKERS ASSISTANCE ACT OF 2002
This latest tax act was enacted chiefly with a view to stimulate the
economy and to reduce unemployment. Some of its provisions that may be
of interest to some broker/dealers are:
Depreciation allowed on some capital assets specified in the tax bill
has been increased by 30% for three years starting September 11, 2001.
Depreciation for alternative minimum tax purposes has also been temporarily
abated. Those finding it beneficial to take advantage of this provision
may need to amend their 2001 tax returns.
Net operating losses may now be carried back 5 years, instead of the
former two year period.
The income realized from the cancellation of debt that is excluded from
the gross income of an insolvent S Corporation no longer increases the
basis of its shareholders.
Receivables of accrual basis companies that are doubtful of collection
may only be excluded from the income of businesses with gross annual receipts
under $5 million or personal service corporations.
OTHER TAX NOTES
The standard mileage rate for business use of automobiles has been increase
to 36½ ¢ from 34½ ¢ per mile for the year 2002.
The standard rates for the use of automobiles for medical and relocation
(moving) purposes have also increased by 1 ¢ to 13 ¢ per mile.
Lifetime minimum distributions from IRA's and other employer-sponsored
deferred compensation plans have now been simplified by new IRS regulations.
The new regulations provide a single table to calculate minimum distribution
amounts. The table assumes that the plan participant has designated a
beneficiary that is more than 10 years younger than the participant. Owners
of IRA's are permitted (but not required) to follow the new regulations
as early as 2001. Participants in other qualified plans are not permitted
to follow the new regulations until their plans have been amended. The
new regulations also contain changes pertaining to: 1) the beginning date
for plan distributions; 2) beneficiary designations; and 3) distributions
after death.
Cash basis accounting rules - In IRS Notices 2001-76
and 2002-14 have proposed procedures allowing companies with gross annual
receipts averaging $10 million or less for a three-year period to change
to the cash basis method of accounting if their business activity does
not fall within certain categories. Currently broker/dealers do not fall
within any of the designated categories. The notices also contain provisions
for companies that have not been in business for three years. However,
taxpayers should be advised that IRC Section 448 still applies, which
states (among its other provisions) that certain C Corporations are subject
to a $5 million gross receipts cap in order to report their taxable income
using cash basis accounting. It is also important to note that the foregoing
proposed procedures are not yet final and therefore some of their provisions
may be modified.
Lump sum severance payments - A recent tax court ruling
has reminded us that lump sum severance payments made to employees may
not be considered wages and, therefore not subject to FICA taxes, if the
payments are deemed to purchase the remaining contractual rights under
an employment contract. This may initiate some tax planning for those
leaving an employment situation, or a business in which they are an owner/shareholder
and in which no written employment contract currently exists.
Contingent fees paid to attorneys - Those currently
involved in litigation which has been accepted by their attorneys on a
contingent fee basis, if successful, will be required to include the amounts
received by their attorneys in the settlement as part of their gross income,
even though this amount may never actually be received by them. The amount
of the fee received by the plaintiff's attorneys is deductible as a miscellaneous
itemized deduction, subject to the 2% floor on these deductions, as well
as the phase-out of itemized deductions for high-income taxpayers. Miscellaneous
itemized deductions are also not deductible for purposes of alternative
minimum tax.
Adoption information website - Those considering adoption
or having recently adopted will find IRS publication 968, entitled "Tax
Benefits for Adoption" at www.irs.gov
under "Forms and Publications". The publication includes information
on the potential exclusion from gross income of amounts received or other
benefits derived from their employer's adoption assistance plan, as well
as information on the available tax credit.
Credit for cost related to setting up a pension plan
- Effective for years beginning after 2001, eligible small employers may
receive a credit of up to $500 for costs incurred to establish or administer
certain employer retirement plans (SEP, SIMPLE and 401(k) plans). One
of the requirements to claim the credit is that the plan must have at
least one employee eligible to participate that is not a highly compensated
employee. For further information see IRC 45E or contact our office.
Deductibility of prepaid expenses for cash basis taxpayers
- We wish to remind our clients that, provided there is a substantial
business purpose, cash basis taxpayers may deduct prepaid expenses. Excesses,
such as the prepayment of rent for three years is not permitted, as stated
in a recent tax court memo.
Late or invalid S Corporation elections - The IRS now
has the authority to grant S Corporation status to prior elections that
for some reason or another were determined to be invalid, or that were
filed late. Previously, taxpayers had until the 15th day of the third
month after the tax year or period began to file an S Corporation election
that would be effective retroactively back to the beginning of the year,
or, in the case of a new corporation, to the time that the corporation
was deemed to have begun doing business. In addition, if the original
election was determined to be invalid, even though it was timely filed,
the IRS had no authority to grant retroactive S Corporation status. Now,
pursuant to IRS Code Sections 1362(f) (for invalid elections) and 1362(b)(5)
(for elections filed late), the IRS may treat the elections as having
been timely filed, if the shareholders filing the election meet the conditions
stated in those code sections.
Electronic filing of income tax returns - Since all
1040 forms and related schedules may now be processed electronically,
the IRS is now encouraging the electronic submission of all individual
income tax returns in order to reduce the amount of paper being handled
by the service and to avoid delays caused by the precautionary measures
taken following the September 11, 2001 crisis.
ACCOUNTING AND FINANCIAL REPORTING ISSUES
GUIDE FOR NON-REGISTERED INVESTMENT COMPANIES
For those that have established trading partnerships and other investments
that function in a manner similar to companies registered under the Investment
Company Act of 1940, but are not registered under that act, the American
Institute of Certified Public Accountants (AICPA) has developed, in a
question and answer format, guidance pertaining to accounting, disclosure
and financial statement issues for this type of investment vehicle. More
specifically, these questions and answers provide guidance to non-registered
investment companies as to the applicability of accounting and financial
reporting practices utilized by those companies that are registered under
the Investment Company Act of 1940 and contained in the AICPA's audit
guide entitled "Audits of Investment Companies". The guidance
is available at:
www.aicpa.org/members/div/acctstd/general/othitem.htm.
SECURITIES REGULATORY NOTES
AMENDMENTS TO RECORD PREPARATION AND PRESERVATION REQUIREMENTS
The Securities and Exchange Commission (SEC) has amended SEC Rules 17a3
and 17a4, which pertain to the preparation and retention of the books
and records of broker/dealers. The amendment becomes effective on May
2, 2003. The changes were necessitated in order to facilitate the reasonable
compliance of various states with the National Securities Market Act of
1996, which prohibited states from establishing books and records that
differed from or proved to be more cumbersome than those established by
the SEC. Specific areas addressed in the amendment pertain to: 1) the
definition of "office"; 2) the records required to be prepared
and maintained at each office; 3) circumstances in which records need
not be retained at a specific office, but produced promptly upon request;
4) customer records and the customer information required to be retained;
and 5) information and records required to be prepared and maintained
regarding associated persons. More detailed information may be obtained
from NASD Notice to Members 01-80, which also contains the SEC's final
rule release published in the Federal Register. Select the "Notices
to Members" option at www.nasdr.com.
AUDITOR INDEPENDENCE
Since the independence criteria mandated by the SEC for independent auditors
is more restrictive than the independence requirements of the American
Institute of Certified Public Accountants, confusion often occurs in this
area, especially when new broker/dealers first select an independent auditor.
In addition, more concern has been given to the area of auditor independence,
in the wake of the "Enron" affair. NASD Notice to Members 02-19
contains information on auditor
independence for those that wish to determine whether their relationship
with their auditor meets SEC independence requirements. That publication
may be obtained by selecting the "Notices to Members" option
at www.nasdr.com.
CLEARING AGREEMENTS WITH EARLY TERMINATION PENALTIES
The Spring 2000 NASD Regulation, Inc. Regulatory & Compliance Alert
(pages 12 and 13) stated, in response to an inquiry, that penalties for
early terminations of clearing agreements are charges to an introducing
broker/dealer's net capital. In other words, if a clearing agreement states
that the introducing broker/dealer (IB) will be charged an early termination
fee of $10,000 if the IB terminates its clearing agreement at any time
during the first 2 years of the agreement, the introducing broker/dealer
must deduct the $10,000 as a charge to its net capital. When we called
the NASD to determine their source for this response, we were told that
the Securities and Exchange Commission had given them (the NASD) this
information. When we asked for a copy of the particular interpretation,
we were told that the determination was provided verbally.
According to Generally Accepted Accounting Principles, the aforementioned
$10,000 early termination penalty is a contingency and, although disclosure
of this potential loss contingency would be appropriate if the amount
was material, no adjustment to the financial statements would ordinarily
be necessary, unless the early termination of the clearing agreement became
probable. Broker/dealers, as well as all other businesses, enter into
agreements or other commitments with the intention of fulfilling the terms
of those agreements. Sometimes things don't quite work out for a particular
broker/dealer and agreements must be either terminated or amended prior
to their expiration. When such is the case and penalties are to be paid,
then these penalties must be appropriately accrued as liabilities in the
financial statements of the broker/dealer. However, we believe that charging
a broker/dealer's net capital with a contingent charge, when the conditions
of the contingency have not occurred, is merely placing an unnecessary
and unjust burden on the broker/dealer community.
We sent an inquiry to the SEC requesting that they please inform us if
there might be any situations in which a clearing agreement containing
an early termination penalty might not result in a charge or deduction
to net capital. We then received a telephone call from the SEC, stating
that, although they were not yet able to put into writing any definitive
statement regarding the charge, their concern was for customer funds.
When we asked how the issue of customer funds was applicable to an introducing
broker/dealer, the response somehow had to do with introducing broker/dealers
becoming insolvent and the potential claims of customers upon that broker/dealer.
We were told that a deduction from net capital would not be necessary
if the clearing agreement were to contain a provision that in the event
of an early termination of the agreement, the penalty due to a clearing
broker/dealer was subordinated to the rights of any customers of the introducing
broker/dealer. So far that's the best we were able to accomplish. Those
entering into new clearing agreements with significant early termination
penalties should determine if their clearing broker/dealer will consider
entering this subordination provision into the agreement.
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