True stories: tax season tales from the TaxTalk listserve.

The TaxTalk listserve has just successfully completed its sixth filing season, proving yet again an invaluable reource for those who take the time to post their queries.

The first two stories here hail from the annals of a longtime CPA.

The first tale confirms the old adage that the only dumb question is the question you don't ask: A married couple was sitting in the CPA's office when the seemingly innocent question "Getting a divorce?" appeared in the tax organizer. The CPA put forth the query.

The wife replied, "Yes." While the stunned husband replied, "What divorce?"

Suddenly the CPA understood why his clients had been speaking to him, but not to each other.

The temperature in the room dropped 20 degrees, and the husband got up and walked out.

The CPA wisely bumped up the fee in anticipation of the barrage of questions that would follow, but those questions never materialized. The fee was paid, but he never saw the woman again. Although he did read about her high-profile wedding to Mr. Megabucks, and subsequent divorce a year later.

Better to Pay the Tax

The second story may illustrate why we wind up with some of the elected officials we get (that's a non-partisan comment).

The client showed up and said he'd made a move to save a large amount on his taxes. When asked what it was, he said that he'd cashed in a bunch of certificates of deposit and taken the penalties for early withdrawal.

When asked, why, he replied that the penalties would lower his taxes.

The next question was what had he done with the money.

The client replied that he'd put the money into a passbook savings account at a lower interest rate, which would lower his taxes even more.

Far too many people have a hard time grasping the fact that taxes in this country aren't 100 percent of income and that one is always better off to have made the money--and pay the tax--than not having made the money in the first place.

Exercising Stock Options After Leaving California

A fairly common situation arises when taxpayers terminate their California employment and move out of California. Then, after the move, they exercise some nonqualified stock options from the prior employer. The question is whether or not the income resulting from the exercise of those options is taxable in California.

An example in Professor Kitty Wright's 2003 Income Tax Manual cites a virtually identical situation. It concluded that the income resulting from the exercise of the taxpayer's non-statutory stock options is taxable by California because the income is compensation for services having a source in California, the state where all of the services were performed.

Income Taxes Aspect of Selling Realty in Another State

Although CPAs know the rules regarding selling realty in another state, most Californians do not, so you should warn clients who mention doing this of the consequences.

The rule is that realty is taxed both in the state where it is located (unless it is in one of the few states that doesn't have a state income tax) and also is taxable to the state of one's residence.

This typically doesn't result in a double tax, because there's usually a credit on one state's tax return for tax paid on the same sale in the other state. However, it does result in more work and a higher fee, because of having to file the tax return for the other state.

The other rule that causes much public confusion is that interest from a non-California bank savings account isn't taxable to that state. Interest and dividend income are taxed to the state of one's residence, not the state where the paying institution is located.

A Break for Taxpayers

California Revenue & Taxation Code Sec. 19116 has a break for taxpayers that is largely unknown, even to CPAs.

Basically, for a timely filed return, if the FTB doesn't change the tax liability for 18 months, interest is suspended from 18 months to the time a notice of proposed assessment is issued. Therefore, delaying audits generally will not result in the additional accrual of interest.

This only applies to individuals.

EDD and LLC Members as "Common Law Employees"

A TaxTalk participant posted a detailed horror story involving an EDD audit on an LLC. The outcome of the audit was that the LLC members who own a minority interest were re-classified as "common law" employees for payroll tax purposes.

When the CPA appealed this result, he was told that it was based on an "in-house" legal interpretation. So he asked for a copy of the interpretation, or the specific authority on which it was based, and the audit supervisor claimed that the interpretation was a "privileged communication."

Clearly, the audit supervisor's answer appears to be off base.

The issue has been forwarded to CalCPA's EDD liaison, who is pursuing this matter. Stay tuned for the results.

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Thanks to the following TaxTalk CPAs for their participation: Joe Abdallah, Dale Bender, Jim Counts, Kip Dellinger, Steve Kramer, Ken Rosen and Tuyet Vu.

By Leonard W. Williams, CPA

Leonard W. Williams, CPA is a Sunnyvale-based sole practitioner. A member of CalCPA's Committee on Taxation, the AICPA Tax Division and a former Peninsula Chapter president, you can reach him at [e-mail].