401(k) plan restrictions

Nov. 1, 2004
I have a successful dental practice with four full-time employees and no part-timers. My wife began working for me last year in a part-time capacity, providing accounting, bookkeeping, payroll, and marketing functions.

John K. McGill, MBA, CPA, JD

I have a successful dental practice with four full-time employees and no part-timers. My wife began working for me last year in a part-time capacity, providing accounting, bookkeeping, payroll, and marketing functions. I would like to include her in my practice's 401(k) profit-sharing plan, but my CPA says that I can't, since she does not work the required 1,000 hours. Is he correct?

The correct answer to your question depends upon the wording of your retirement plan document. Under the tax law, practices can require employees to be at least 21, complete at least one year of service, and work at least 1,000 hours a year to be eligible to participate. If your plan contains these limitations, your accountant is correct.

However, you should note that these typical plan provisions are the maximum restrictions the IRS will allow to maintain your plan in a qualified status. If you wish to include part-time employees, such as your spouse, you could simply amend the plan document to eliminate these requirements. In fact, your plan could be established and maintained with no age, years of service, or 1,000-hour requirement. However, if you do amend your plan, all future part-time employees must be eligible to participate in it on the same basis as your wife.

Several years ago, I invested $50,000 in a new-venture software company, started by my former college roommate. Unfortunately, the venture failed and went out of business at the end of last year, and I lost my entire investment.

I also had $60,000 of capital gains from the sale of a real estate lot which I had owned for several years. I assume that only the $10,000 difference between the real estate gain and the software company loss would be subject to tax at the 15 percent maximum rate. Is this correct?

There's another approach that could save you some real money. Section 1244 of the tax law allows losses from qualified small business stock to be deducted against your ordinary income. To qualify, the software company's total equity could not have exceeded $1,000,000, and most of its revenue must have come from its operations. If you meet these and the other Section 1244 tax requirements, you will be able to deduct the entire $50,000 loss against ordinary income, for a tax savings of up to $17,500 ($50,000 x 35 percent tax rate).

This would allow the full $60,000 of gain from the sale of your lot to be taxed at the maximum 15 percent rate, for federal income taxes of $9,000 ($60,000 x 15 percent).

Assuming the software company stock qualifies for Section 1244 treatment, reporting it in this manner will actually reduce your income taxes paid for the year by $8,500 ($17,500 tax savings from Section 1244 loss minus $9,000 taxes owed on capital gain). This compares to the $1,500 taxes owed if you had netted the loss against the gain. Thus, by utilizing Section 1244 tax treatment, you would save a total of $10,000.

I set up custodial accounts for my three children several years ago, and invested the proceeds in stock mutual funds. My children are 18, 16, and 14. Last year, each of them received approximately $3,000 in dividend and capital gain income, along with approximately $6,000 of other income. Is their dividend and capital gain income subject to the same 15 percent maximum tax rate as on my return?

As a general rule, the maximum tax rate on long-term capital gains and dividends is 15 percent. However, for taxpayers whose income from all sources does not exceed $28,400, the maximum tax rate drops to a paltry 5 percent. Accordingly, since each of your children are age 14 or older — and their income is below this level — it will be subject to tax at only a 5 percent rate for federal income tax purposes.

Several years ago, I purchased $40,000 in corporate bonds at a discounted price of $35,000. The bonds recently matured and I received the full $40,000 face value, as well as my final interest payment, in a lump sum. How is the final payment that I received taxed?

Assuming that you purchased these bonds at a discount in the secondary market (not at the original issue price), the $5,000 difference between the original purchase price and the $40,000 value at maturity represents a long-term capital gain, taxed at a maximum rate of 15 percent. The final interest payment you received represents interest income, taxed at ordinary rates.

John K. McGill is a tax attorney, CPA, and MBA, and is the editor of The McGill Advisory, a monthly newsletter helping dentists to maximize profitability, slash taxes, and protect assets. The newsletter ($199 a year) and consulting information are available from Blair/McGill and Company, 2810 Coliseum Centre Drive, Suite 360, Charlotte, NC 28217. Call (704) 424-9780 or visit the Web site at www.bmhgroup.com.

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