Death of a Military Servicemember and Other Combat Related Pay Exclusions

Jun 23 2014

Exercise Enhanced Mojave ViperI have been writing about business formations, but in light of recent news of some of my friends having close calls with death, I wanted to write about some of the issues, which might come up, if a servicemember dies in the line of duty. There are only two things in life certain – Death and Taxes. Today, I will discuss both.

Before I go on, I want to discuss timing (the elephant in the room). We are currently in a draw down with the war in Afghanistan and our presence in Iraq is minor, (but increasing due to the resurgence of the ISIS; however, the purpose of this post is not to debate foreign policy). That said, remember the IRS allows amendments of tax returns up to 3 years after the filing date, the due date (normally April 15) or 2 years after the tax is paid, whichever is later,[1] and in some cases even further in the past. If you know someone who has had a family member pass away in a combat zone within the past three years, this article might apply to them and they need to contact their attorney, CPA or EA about their options.

Tax Forgiveness

Society, through the actions of the federal government, attempts to show its gratitude to members of the armed forces, who die in the line of duty in an active combat zone, through forgiveness of taxes owed on the income received by that servicemember:

With respect to the taxable year in which falls the date of his [or her] death, or with respect to any prior taxable year ending on or after the first day he [or she] so served in a combat zone after June 24th, 1950; and (§692(a)(1))

Any tax under this subtitle and under the corresponding provisions of prior revenue laws for taxable years preceding those specified in paragraph (1) which is unpaid at the date of his [or her] death (including interest, additions to the tax, and additional amounts) shall not be assessed, and if assessed the assessment shall be abated, and if collected shall be credited or refunded as an overpayment. (§692(a)(2)

What the above means in English is that under certain conditions, tax paid on military pay to a servicemember who dies in a combat zone (or any terroristic activity) shall not owe taxes! As I read both the section of the law (§692) and the regulation dealing with this section (§1.692-1), the amount of tax forgiveness starts the year in which you arrive in the country, but it is only attributable to the amount paid to the servicemember, and not any additional income (rental properties, partnership income, investment income, etc.)[2] to INCLUDE spousal income.

It is this last line, which needs focus. The income a spouse receives from his or her employment, while the servicemember is stationed in the combat zone, is NOT excludable from income taxes under these rules, nor is the income received in the year of death of the servicemember. In fact, the regulations deal with how the amount of the exclusion is to be calculated;[3] this can get convoluted. It is recommended that you consult with your attorney, CPA or EA, if you think that you may qualify for relief under this condition.

Hospitalization of Servicemembers in a Combat Zone

Many people might know about the exclusion of income while serving in a combat zone, but I remember when I was in the US Navy: Live by the Gouge, Die by the Gouge; therefore, I am going to put some black and white on this. §112 of the tax code deals with combat pay exclusions. It is known, if you serve in a combat zone, you will qualify for a combat exclusion, if you meet the conditions under §112. This is great if you are healthy, but what if you get sick after eating some really bad food and you are sent to Europe for further observation for two months. Did you bust your exclusion?

Section (c) of §1-112 deals with hospitalizations and according to the regulations, “if an individual is hospitalized for wound, disease, or injury while serving in a combat zone, the wound disease or injury will be presumed to have been incurred while serving in a combat zone, unless the contrary clearly appears.” So the answer appears to be “no” you did not bust your exclusion and the pay while in the hospital is excluded.

Six Days Before Retirement

Remember the line in the movies, where the guy gets shot, he says “And only six days before retirement!” and then he died. All of us can sympathize for that, because we all have dealt with Murphy’s Law. Turning to a more serious note, imagine you are on patrol one week before the end of combat operations in Afghanistan and you are injured. The IRS regulations will continue to provide relief under §1.112-1(c).

Agent Orange-like Cases

What happens if a servicemember comes back from the combat zone and experiences symptoms of a disease and is hospitalized (while on active duty). If the disease is determined to be contracted in a combat zone (where the incubation period is showed to put the exposure in the combat zone) and hospitalization occurs, the pay is excludable under §112, but only pay, which is servicemember’s pay and excludable under §112. However, the exclusion is only if the hospitalization for the disease occurs within 2 years of termination of the combat zone status.

The best case for the above exclusion, which I can think of, would be exposure to Agent Orange, where the onset of the disease was years after exposure. It would be likely symptoms would appear after returning home. An interesting point on this is the Vietnam War was specially excluded under §1.112-1(a)(2) and the two year limit, as listed above, does not apply. But as there are likely no active duty people who served in Vietnam in the military at this time, this use of this code for Vietnam serving active duty servicemembers might be limited.


[1] §6511(a)
[2] (S)1.692-1
[3] §1.692-1

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Sole Proprietorship

Jun 04 2014

man_with_briefcaseIn previous blogs, I discussed the benefits of a partnership and how in some cases, they are a good way to start a business. Partnerships require there are two or more owners, [1] but what if you don’t want the sidekick, in other words you want no Robin for Batman, no Paul Shaffer for David Letterman, no Barney for Fred Flintstone (or Andy Griffith), no Dr. Watson to Sherlock, Ed McMahan to Johnny Carson. (I think that I covered every generation here…) You want to go it alone: enter the Sole Proprietorship.


There are many advantages to going it alone. First of all and best of all, there is no argument to when you decide something. This especially appeals to prior military officers, who are used to being in charge and having a single reportable chain of command. With partners or boards of directors, there is the constant justification of what you are doing and in some cases, others can usurp your authority, meetings can slow down a process to a painful crawl (remember all of those meetings you had with command staff to make a decision as to what the definition of the problem was?)

Another advantage is the ease of creation. In many cases, there is no registration process REQUIRED. That said, there are many things you SHOULD do. First of all, you SHOULD register or an Employer Identification Number, or EIN (so you don’t have to use your Social Security Number) with the IRS and you should also register you Trade Name (So you don’t accidently use someone else’s nor someone doesn’t try to use yours).

While there is no registration process required, you will still have to file your taxes for your business and this is another advantage, you will file your taxes on your return, eliminating the need for a separate business return (which can save money on processing fees). Another benefit of this is that the income tax rates for a sole proprietorship are the same as yours on your 1040, which can be significantly lower than corporate tax rates (particularly for service corporations). You will file your taxes for your Sole Proprietorship on a Schedule C, which only requires that you report your income statement and no balance sheet is required to be reported to the IRS (as with Partnerships and Corporations, under certain conditions). That stated, the accounting requirement should not change. A well maintained accounting system should be maintained, including a balance sheet, income statement and statement of cash flows (more on these in a future blog) for banks and potential investors.


There a many disadvantages to Sole Proprietorships and I will only cover some of the basic ones. First is the unlimited liability. Imagine this: on your company premises a customer slips and falls. You did not get insurance, because you are a services company and did think that there was any danger. The customer breaks his leg and as a result of the breakage loses full use of the leg permanently. (The customer was a just retired individual). The insurance company for your client decides to sue you to recover the damages they had to pay out. Your company is only worth 250K, but civil court determines that the liability is $1,000,000. Where does the other $750K come from? Your home, your 401k (TSP, SEP IRA, etc.) college saving for your children… in other words, the liability is LIMITLESS!

Another disadvantage is flexibility as compared to corporations is lower. If you are a sole proprietorship it is easy to go to a partnership, but to move towards a corporation is a little more complicated. Worse yet, undoing any of these moves can also be very challenging depending on the circumstances.

A final issue, which might not be as important, is credibility. When someone says that they work for Bright Lights, Inc. or Bright Lights, LLC, verses Bright Lights Company, people who work in the financial industry might be concerned due to the above concerns. LLCs often times can be searched online as well as corporations. Sole Proprietorships are harder to find online, unless you have an online presence, but even that can be misleading.

Now, the above problems can be fixed with the use of the Limited Liability Company (LLC). LLCs are entities formed by filing Articles of Organization with the state (some states differ, consult your CPA, EA or attorney for more information) The best part of the flexibility of LLCs in that if formed by a single-member will file taxes just as a sole proprietorship (Schedule C on the owner’s return). Have a second person join? Now your LLC is a partnership[2]. Lose your partner and you are back to one? Now you are a sole proprietorship, again.[3] Are you growing and want to take advantage of some of the corporate tax rules? Check the box and now you are a corporation.[4] Want to elect S? File From 2553 and the IRS will process the request. While each of these is easy to accomplish, there can be significant tax ramifications, as a result consult with a tax professional (CPA, EA or attorney)


[1] §301.7701-3(a); Rev Rul 95-55
[2] Rev Rul 99-5
[3] Rev Rul 99-6
[4] §701.7701-3(c)(1)(i)

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Taxation of a Sole Proprietorship

Jun 04 2014

As discussed above, tax compliance with sole proprietorships are simpler as the owner files a Schedule C attached to their 1040. A schedule C looks like an income sheet of a company, with some additional questions (1099s, cash/accrual basis, etc) There may be some additional forms that will need to be filed though:

  • Form 4562 – Depreciation and Amortization: When a business buys property to be used in a trade or business, it may have to be capitalized and depreciated. What does this mean? It means if you spend $7,000 buying an espresso machine to use in your business, you are going to receive benefit from that machine for more than one year (we hope at least), so you will take the cost of the machine over the expected life of the machine. In order to prevent shenanigans, the IRS prescribes those amounts. An example of his is say you bought your espresso machine and it has a seven year life, your deduction would be $1,000 per year ($7,000/7 years), so you income on your tax return would be reduced by $1000 per year for the seven years. There are special rules about depreciation, where you could take a full[1] or half[2] deduction. Conditions apply and again, contact your CPA, EA or attorney for more information.
  • Form 3800 – General Business Credit: There are a whole host of business credits, which businesses can take to reduce tax liability. A small list of some of the credits available are:
    • Work Opportunity Credit
    • Disabled Access Credit
    • Biodiesel and Renewable Diesel Fuels Credit
    • Credit for Small Employer Health Insurance Premium

CPA_WEBEach of the above credits requires additional forms, but could be a good source for tax credits, which benefit small businesses.

  • Form 6198 – At-Risk Limitations: Most businesses make money, but some don’t. When your business does not make money, you will generally get to take a loss on your tax return, which can go against your active income (spouses wages, other businesses, etc.) That loss however, has to be tested to be allowed. The first test is the “at-risk test.”[3] The amount at risk is equal to your investment plus any loans that you have taken for the business, for which you are personally liable.[4]
  • Form 8582 – Passive Activity Loss Limitations: This is the second test for loses allowed as a deduction. Without getting into great detail, passive income is income derived from a trade or business,[5] “which the taxpayer does not materially participate.”[6] Good examples are real estate activities. If you rent property for money, you will have your losses limited under the law (more to follow in a future blog). Remember Good ‘ole Uncle Ed from the last set of posts? Uncle Ed gives you money to set up a partnership and takes a limited partnership interest. Because Uncle Ed is limited, his income is passive income. In that case, a Form 8582 will have to be filed.

Sounds like a lot, right? Well, I have barely scratched the surface. This is what makes tax compliance difficult for the average person starting out, but for the most part, your CPA, EA or attorney will be able to handle these forms and all of your questions with ease and allow for what you need the most: peace of mind and sleep at night.


[1] §179
[2] §168
[3] §465(a)(1)
[4] §465(b)(1) and §465(b)(2)
[5] §469(c)(1)(A)
[6] §469(c)(1)(B)

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Investing Doesn’t Have to be That Complicated

May 28 2014

9677861633_cc1d703f56I wish I had a dollar every time someone told me about their cosmic investment strategy. Maybe it works for them; maybe not. Investor psychology indicates we tend to remember our gains and forget our losses—remember that fishing trip when we caught the big fish? We don’t tend to remember the hours or days before we bagged the big fish. Plus there are trading costs to consider. Put the gains, losses and costs together and what’s their net performance?

Surveys and analyses from investment firms are not encouraging about individual investors’ trading successes. Even professionals pick numerous stocks hoping a small number of selections will carry the load for the majority of picks that won’t work out. The majority of mutual fund managers can’t beat the free flowing markets we pay them to beat.

The average investors I meet who are saving for a dream retirement tend to think investing is naturally complicated. Can you blame them? Look how investing is portrayed in publications, TV, radio, and the web. It’s a process heavily laden with detailed numbers, analysis, and market sensitive, time critical trades. “The pros can’t get it right, how can I!?” is what I hear.

People tend to think investing is a direct relationship with their account value since they understand their account statement and value. For many, if the stock market goes down, it’s a bad thing. After all, have you heard the news reports during a down market? “And look at my account value going down!” This compels people to think they have to act to protect their account value by dumping the stock funds that are bringing down their retirement account value. After being burned by the down market, they are reluctant to re-enter the stock market until it has gone up for years thereby proving it’s safe to return to water, so to speak. This whole mindset couldn’t be more wrong.

Truth is it doesn’t have to be complicated. Don’t believe the talking heads and marketing hype. Investing can be simple for the great majority who are building wealth over the course of their working lives. The ingredients for wealth creation to retire comfortably are pretty simple:

  • Contribute to your retirement account regularly; every pay period.
  • Invest 10% or more per pay check.
  • Have a portfolio heavier in stocks than bonds/cash.**
  • Don’t take loans or withdrawals from retirement accounts.
  • Re-balance your portfolio annually to maintain the appropriate stock/bond/cash mixture.
  • Increase your contributions after raises, promotions, and job changes—max it out.

**The proportion of stocks typically decreases as you close in on retirement but will normally remain at least 30-50% of your portfolio to maintain some growth potential in your assets in retirement. I’m talking about the mutual funds you can purchase in your retirement accounts.

The above ingredients ensure that as the stock market rises and falls over the years (which it will), your steady contributions buy more stock ownership shares in depressed market periods. It is a key wealth building strategy that lower stock markets are necessary for us to build wealth. Down stock markets are normal occurrences that are historically short-lived. We never know what the stock markets will do in advance, so regular contributions ensure you are buying stocks on the cheap when stock prices fall. As the stock markets return, you’ll be happy with the results.

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Take a Chill Pill by Simplifying Your Life

May 21 2014

balancingfinances_WEBIn my previous post on ‘8 Boring Rules to Live By’, I hit on an important financial issue that I need to expound upon. That is the need to keep things simple.

Why is this so important? Because when families have financial difficulties, an overly complicated financial situation can be the cause. They have too many accounts, loans or credit cards. The more accounts, the more complicated their situation. And the more complicated, the more out of control the management and oversight slowing sucking you into a whirlpool of trouble.

Here are some examples:

If a family has five credit cards, it can be easy to add a sixth credit card when a perceived need arises. First off, five credit cards are probably a red flag—what’s going on in the family that requires five cards? Having numerous cards numbs a family to think, “What’s one more?” Plus, debt spread out over five accounts looks different than one big debt. The act of juggling five credit accounts and the associated payments in conjunction with all the other family financial issues is complex and tiring.

Another scenario I’ve seen is a person who has changed jobs numerous times. At each job, the person contributed to the companies’ 401k/TSP accounts. With each job change, the person left his money in the ex-employers’ 401k accounts. “Where are your retirement assets?” “Well, I have some at company A and some at company B and C…” You get the picture.

A person starts an Individual Retirement Account (IRA) with a company. Over time, other opportunities pop up or to satisfy a curiosity, the person opens another IRA somewhere else. Eventually, the person has collected three or four IRAs.

One more. A person fully retires at age 65 or over. She’s faced with a health care decision; the employer’s retiree plan, Medicare-Tricare for Life (TFL), add a Medicare supplement plan, a combination, or all of them? She chooses them all. The employer plan, TFL and the Medicare supplement. Better to be safe than sorry, right?

Stop the madness. Take an inventory of all your financial situations:

  • savings, checking, investment, retirement accounts
  • loans
  • credit cards
  • college savings plans
  • life insurances
  • medical-health plans

With an eye toward simplicity, how many accounts do you really need? How many of the accounts can be consolidated?

There are valid reasons for multiple accounts in many scenarios. There are questionable reasons for others. Pull things together and simplify to regain the control over your life.

Make it your objective to maintain a small “financial footprint.” Your financial footprint equals all the financial issues in your life. Keep this footprint to a minimum and feel the power you have over your life.

A small footprint going into retirement means you will require less retirement income to support your living standard or you’ll have more income for the fun things in life. Win-win!

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