Cornerstone Wealth Advisors, LLC

Lessons from 2011 - Part I

Overview: Every year, our investment advisor Larry Swedroe takes a look back at the investing lessons the markets provided in the past year. This year brings us 7 lessons, which we will bring you in three parts. In 2011, the markets offered investors a chance to revisit a few remedial courses by teaching lessons it had introduced in prior years. So, this year’s list includes a few reminders that we are just as likely to lose our discipline in good times as we can in bad times.

Lesson 1: Ignore All Forecasts - All Crystal Balls are Cloudy
Financial analyst Meredith Whitney made a forecast that caused quite a stir in December 2010, when she predicted “50 to 100 sizable defaults” in the municipal bond sector in 2011, totaling “hundreds of billions of dollars’ worth of defaults.” By May 2011, investors had withdrawn money from municipal bond funds for 24 consecutive weeks. Whitney’s prediction might join BusinessWeek’s August 1979 forecast of “The Death of Equities” among the worst of all time.

The massive scale of problems that Whitney had anticipated did not occur because governments have taken actions by cutting spending and raising revenues. Unlike the federal government, all states except one are required to balance their budgets. As a result, budget gaps have been closed by greatly reduced services, renegotiation of contracts with union members regarding wages and benefits, layoffs of public employees, and increased taxes and fees. These actions have gotten results. And intermediate-term municipal bonds were among the best-performing asset classes in 2011.

The following is another example of why all market forecasts should be ignored, no matter how revered the source. In February 2011, Bill Gross (dubbed the “bond king”) announced that the world’s biggest bond fund had reduced its U.S. government-related debt holdings from 22 percent in December 2010 to just 12 percent in January 2011, the lowest in two years. By April, PIMCO had announced it had eliminated government-related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Federal Reserve System ended its quantitative easing program.

In August, Gross admitted he had made a mistake. Interest rates continued to fall, defying the forecasts of the vast majority of professional investors, including those of the 16 primary dealers who make markets in government debt. A corollary lesson is that timing the market is just as much a loser’s game in bond markets as it is in equity markets.

Lesson 2: Make Sure Your Investment Plan Incorporates the Virtual Certainty That Crises Will Occur, and Will Do So With Great Frequency
We cannot know what form crises will take, when they will occur, how deep they will be or how long they will last. However, we do know they will occur. Therefore, you must be sure to avoid taking more risk than you have the ability, willingness and need to take. If you do not, you are likely to allow emotions such as fear and panic and the noise of the markets to cause your plan to end up in the trash heap. Once you sell, there is never a green light that will let you know that it is once again safe to invest.

While bear markets are painful, there is no good alternative to buy and hold except avoiding risk and accepting Treasury bill returns. Few investors can reach their goals by investing solely in Treasury bills. Timing the market is a mug’s game.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2012, Buckingham Family of Financial Services.

 

Implications of Standard & Poor’s Downgrade of U.S. Debt

Another week, another crisis. This time it’s the rating agency Standard & Poor’s (S&P) downgrading the long term outlook of our country’s debt from a AAA rating to a AA+ rating. The S&P is being criticized by many quarters for doing the unthinkable to us and our country, while in fact, the market has already anticipated the potential downgrade and the rating agencies were merely catching up. The yields for AAA vs AA+ U.S. bonds had already been priced in the market. Just compare these rates to comparable U.S. companies with AAA or AA+ ratings.

The downgrade by S&P does not indicate a serious economic problem, rather it indicates a serious political problem - one that we need our elected officials to collaborate on to fix. We have overcommitted our resources and need to cut back. Our promises have become too rich to sustain. There is a political fix, we just don’t know what it is yet. It could be spending decreases or revenue enhancements. However, many times during a crisis, the crisis itself sows the seeds of their own ending.

What should each of us do in light of these events? Consider the following two articles, the first by Larry Swedroe, Director of Research for the Buckingham Family of Financial Services (we partner with the Buckingham Family of Financial Services to bring you our services) and the second by Burton G. Malkiel, Professor Emeritus of Economics at Princeton University and author of “A Random Walk Down Wall Street.” Taken together, these articles present a balanced analysis of the impact of Friday’s ratings downgrade and reasons why not to panic.

Larry Swedroe: How Markets Have Responded to Past Sovereign Downgrades
Burton Malkeil: Don't Panic About the Stock Market

 

The Debt Ceiling Issue: The "What-If's" Inside the Cloudy Crystal Ball

We have a politically charged issue in Washington with respect to the Debt Ceiling. While it has a lot to do with Economics and Finance, at the present it is the workings of our political system at its worst. If you’re like most of us, whether you’re an investor or not, the potential implications of not reaching a resolution are unthinkable, terribly uncertain and frankly not worth the risk. And so these are the things that are shaping the current market situation – both equity and bond. My intention is to not sugar coat the happenings, but to address them.

This whole issue is causing an immense amount of uncertainty within people and institutions around the world. There is the difference between risk and uncertainty. With risk we can calculate the odds of something or an event. We can then create a strategy to deal the risk presented to us. With uncertainty we have no way of calculating the odds of something or an event. With uncertainty comes an increase in the “risk premium” that is present when we value anything – a company’s stock, a corporate bond, a government bond or any other stream of cash flows or promises to pay into the future. Uncertainty pushes ever higher the return premium an investor needs to take on uncertainty – in whatever form. In many cases, uncertainty can create a “herd” mentality, which if unchecked, could lead to a potentially severe bear market. Keeping this in mind, what are the possibilities?

It’s doubtful the government would not pay the scheduled debt payments, whether interest or principal, as the long-term cost of a default would be extremely high. However, we always say “never treat the improbable as impossible.” A default would likely seize up the market, which would create the most extreme market response and impact on the economy as a whole. The whole system would be shaken. We could have another liquidity event not unlike what happened in 2008 after Lehman Brothers went under. If not dealt with, the debt ceiling limit could cause the government to suspend and defer or reduce payments on other debts, programs, or to other state or local governments, etc. (sort of like the state of California did earlier this year). California simply gave out IOU’s to vendors and taxpayers that were paid later after their budget deal was worked out.

Another implication of a failure to reach a reasonable solution to the debt ceiling issue is that the market and/or ratings agencies would downgrade US Treasury debt. The downgrading of the US Treasury debt could cause the US dollar to trade lower when compared to other countries. The weaker dollar could cause higher commodity prices, higher oil prices and higher gold prices, all of which act as a “tax” on the economy. In addition, interest rates would likely go up with respect to financing of any future debt. Other bonds from other agencies, mortgage backed securities and mortgage rates would all go up, heaping stress onto a weak housing market. Municipal bond pricing could also be affected as it would cost the state and local governments more to borrow for their long-term financing needs. Lastly, the rates for corporate bonds could increase as well as the benchmark US Treasury bond rates have increased, which could cause less earnings at the corporate level, which in turn could depress stock valuations. Then there could be an impact on financial companies that invest in US government obligations, such as banks, savings & loans, etc. when they have to write down their US government bond portfolios. Yet another hit to their capital accounts when these have already been hit by the real estate crisis.

Having explored the negative possibilities, let us reflect on some positive news. Despite all of the crises in the last few years around the world – the markets are still up. Corporate earnings are much stronger than previously expected. The Price/Earnings Ratio is well below its historic average rate of 16. Inflation is not a problem as has been prophesied by some. There is some action now being taken to reduce spending and deal with the large deficit. There is no economic crisis – interest payments on our National Debt are only about 2% of our GDP. What we really have is a political crisis and not an economic crisis. Fix the political crisis and there won’t be an economic crisis.

Bottom line – what to do? It’s best to just wait and see. That may not be what each of us wants to hear or do but it’s probably the best advice. At this stage in the game, the market has priced in uncertainty. The longer we go without a political settlement, the more the market, financial and constituent pressure will bear on the politicians. As Napoleon noted, most battles are won in the preparatory stage and not on the battle field. Warren Buffett has said, “It only takes two things to succeed as an investor – first having a reasonable plan and second sticking to it – it’s the sticking to it part that most investors struggle with.” So it is with your investments: your Investment Policy Statement is a well thought out plan for your investment life.

Lastly, what to do with TV, radio or other media pundits – political or economic? Just be aware that every one of them has an agenda – they are working in their best interests which don’t necessarily match yours. Mostly, it’s about their listenership, ratings, moving the market to cover their financial bet, money, notoriety or ego.

We’re here for you and you alone. If you have any concerns, please contact us. We always have time to meet with you or talk with you to ease your mind during these periods of uncertainty. It’s what we do.

TIPS as Fixed Income Investments

Overview: Many investors may be sensitive to the damaging effects inflation can have on the buying power of their portfolios. One way to address this concern is through Treasury inflation-protected securities (TIPS).

There is an old saying in the investment world that the only returns that matter are the ones investors can spend. Thus, investors should account for the effects inflation can have on their spending power. Inflation poses significant risks to investors over the long term as it may decrease their buying power. One way to account for the effects of inflation is through fixed income investments in Treasury inflation-protected securities (TIPS).

What Are TIPS?
Similar to nominal (non-inflation-adjusted) U.S. Treasury fixed income investments, TIPS are issued with fixed coupon rates and fixed maturity dates (such as five, 10 or 20 years). The key difference between TIPS and nominal bonds is that the coupon rate for TIPS is a guaranteed “real” (inflation-adjusted) return. The principal is adjusted for inflation before the interest payment is calculated.

With TIPS, the coupon payments and face value will maintain purchasing power until maturity. Rates for nominal Treasury fixed income investments are typically higher than the rate for TIPS with comparable maturities because they include a risk premium for future inflation. However, there is no guarantee the coupon payments will retain purchasing power.

How Do TIPS Work?
The principal value of TIPS is adjusted by the Treasury Department according to changes in the Consumer Price Index for All Urban Consumers (CPI-U). The semiannual interest payments vary because the fixed coupon rate is applied to the inflation-adjusted principal, as illustrated below:

Year	Inflation Rate (%)	Amount of Principal Adjustment ($)	Adjusted Principal Value ($)	Total Coupon Payment ($)
1	0	0.00	100,000.00	3,000.00
2	2	2,000.00	102,000.00	3,060.00
3	1	1,020.00	103,020.00	3,090.60
4	3	3,090.60	106,110.60	3,183.32
5	1	1,061.11	107,171.71	3,215.15

Note: Example assumes an individual TIPS with a $100,000 principal value and a 3 percent coupon rate.

Benefits of TIPS
 TIPS work well in diversifying portfolios due to their low correlation to stocks. For the period 1999–2008, the quarterly correlation of the Barclays Capital US TIPS Index to the S&P 500 Index was –0.21.
 When inflation is higher than expected, TIPS typically outperform nominal Treasuries.
 TIPS have no credit risk.
 TIPS have lower volatility than either nominal Treasuries or other investments considered to be hedges against inflation (such as commodities).

Drawbacks of TIPS
 Because nominal Treasuries entail additional risk, TIPS have lower expected returns than nominal Treasuries.
 TIPS are expected to underperform nominal Treasuries during periods when actual inflation is lower than expected inflation. TIPS would also underperform intermediate- and long-term Treasuries during periods of deflation.

Tax Implications
Like all securities issued by the Treasury Department, TIPS are exempt from most local and state taxes (with the most notable exemption being state estate or inheritance taxes). Interest paid on TIPS held outside of tax-deferred accounts is considered ordinary income for federal income tax purposes. Also, increases to the inflation-adjusted principal are considered taxable income in the year they occur, even though TIPS investors do not actually receive these gains until the fixed income investments mature. Because of this tax inefficiency, TIPS should generally be held in tax-deferred accounts unless the investor is in a low tax bracket.

Summary
TIPS have many positive features, which make them valuable fixed income instruments. They provide a guaranteed real rate of return and are good equity diversifiers due to their low correlation to stocks. Investors who are particularly sensitive to the effects of inflation should consider devoting at least some portion of their fixed income assets to TIPS.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2011, Cornerstone Wealth Advisors, LLC.

Protecting Your Portfolio Against Inflation

Overview: Individual investors have some portion of their spending that grows with inflation. For those approaching retirement or in retirement, a crucial component of a well-constructed portfolio is investing in a manner that will help offset the risks of unexpected inflation. In this piece, we review strategies that historically have provided effective protection against inflation and those that have not.

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As we discuss below, there are only a handful of asset classes that closely track inflation. Further, several strategies that are commonly thought of as being effective ways to protect against the risk of inflation have actually been ineffective, in particular over relatively short time periods.

The Good
Historically, the two most effective ways to protect against the risk of unexpected high inflation have been allocating a portion of your portfolio to Treasury inflation-protected securities (TIPS) and commodities. TIPS are bonds that are issued by the U.S. Treasury that have principal and interest payments that are directly linked to the U.S. Consumer Price Index (CPI). All else equal, this means that when inflation goes up, the value of the bond and the level of future interest payments will go up as well. From a held-to-maturity point of view, TIPS are virtually guaranteed to provide you with a return of realized inflation over the period that you held the TIPS plus an amount above the level of inflation (or minus an amount, as has unfortunately been the case for short-term TIPS over the past couple of years).

The two most well-known commodities indexes are the Dow Jones-UBS Commodity Index and the S&P GSCI Commodity Index. The Dow Jones-UBS Commodity Index had a correlation of about 0.50 with inflation over quarterly periods covering early 1991 through late 2010, and the S&P GSCI Commodity Index had a correlation of about 0.60 over the same time. What these numbers mean is that when inflation has been above its average, the returns of these diversified commodities indexes have tended to be above their averages as well. And while these numbers may not sound high, they are relative to all other broadly diversified asset classes that we have analyzed. For example, over this same period, the correlation of the S&P 500 Index with inflation was only 0.10.

Another strategy that has provided notable protection against expected inflation (but not unexpected inflation) is short-term fixed income such as Treasury bills or short-term government agency bonds.1 While this is helpful, the fact that short-term fixed income provides very limited protection against unexpected inflation makes it less attractive than either TIPS or commodities.

The Bad
Historically, two asset classes that are frequently viewed as providing protection against inflation that in practice have been ineffective are equities and gold. As mentioned, the S&P 500 Index, which is a diversified portfolio of U.S. large-cap stocks, has had a weak historical relationship with inflation, as has gold. The correlation of the returns of gold with unexpected inflation has been close to zero for the period 1978–2010.2

However, the asset class that offers the worst protection against inflation risk is long-term bonds. The returns of long-term bonds tend to be below average when inflation is above average. There is a simple explanation for this: Because the interest and principal payments on most long-term bonds are fixed amounts, when inflation goes up, those payments are worth less and the market value of the bonds tend to go down.

Summary
Inflation protection should be an important consideration in the construction of your investment portfolio. Inflation increases the costs of goods and services, and most traditional asset classes tend to do poorly when inflation is unexpectedly high. There are no perfect ways to protect against inflation, but historically the two most effective strategies have been to allocate a portion of your portfolio to TIPS and a diversified commodities fund. Most other asset classes including equities and gold have either provided ineffective protection against inflation or, in the case of long-term bonds, have actually been detrimental in terms of providing inflation protection.

1 Geetesh Bhardwaj, Dean J. Hamilton and John Ameriks, Hedging Inflation: The Role of Expectations. Vanguard Research, April 2011.
2 Ibid.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2011, Cornerstone Wealth Advisors, LLC.

The Current Market Aftershock

Using an illustrated timeline, David Booth of Dimensional Funds Advisors chronicles US stock market performance in four periods since World War II. His review suggests prevailing market sentiment is often wrong and that investors must stay disciplined through all market environments to pursue their long-term goals.

 

2010 Review: Investment Overview, Part Three

After a slow start and a tough second quarter, most markets in the world ended the year with positive results. The US market indices accounted for most of the top performance, with the Russell 2000 Growth Index delivering a 29.09% return for the year.  US small cap and small value also were among the top performers.  (All returns are in US dollars.)

Most developed markets around the world logged positive returns, with thirty-seven of the forty-five countries that MSCI tracks gaining ground in both local currency and US dollar terms.  Scandinavia and Asia had particularly high returns.  Overall, the MSCI World ex USA index gained 9%, and the MSCI Emerging Markets Index gained 19% for the year.

In the last few months of the year, the highest returns were generally experienced by countries whose economies are dominated by oil and commodity exports—for example, Canada, Norway, Russia, and South Africa.  Other emerging markets, such as Thailand, Philippines, Chile, and Peru had strong returns.  China, despite its continued high profile and news of economic growth, was one of the lowest-performing emerging markets.
The US dollar lost ground against the Canadian dollar and most Pacific Rim currencies, which helped dollar-denominated equity returns from those countries.  The US dollar gained against the euro and British pound.

Along the market capitalization dimension, small caps outperformed large caps by substantial margins in the US, developed, and emerging markets.  Value stocks underperformed growth stocks across all market capitalization segments in the US and had more mixed results in international developed and emerging markets.

Fixed income performed generally well, especially for investors who took term and credit risk, with long-term, high-yield bonds returning more than 20%.  Real estate securities had excellent returns, performing comparably to the equity asset classes.

Lessons from 2010
• Major headlines (of any sort – even if you know them in advance) can’t make you a better investor.
• Diversification still matters.  And always will.
• Active management is a Loser’s Game.
• You can’t pick the winners – consistently, over the long-term.
• Staying in the market – Always a Winner – long-term.
• Invest by taking into account your Willingness, Ability and Need to take investment risks.

2010 Review: Economy & Markets, Part Two

Themes in 2010

In retrospect, it was a good year for globally diversified investors.  But if investors had shaped their market expectations and decisions according to economic news, they likely would not have expected positive returns. The following are a few dominant themes during the year. 

Mixed Economic Signals
Although investors in the US and Europe awaited signs of a rebound, economic news was mixed, with some measures showing gradual improvement and others offering evidence that the economy remains vulnerable. Favorable news included moderate economic expansion in the US, the Euro zone, and Australia, as well as rising factory orders and manufacturing activity, rebounding auto sales and automaker profits, slowing growth in US bankruptcies, declining home foreclosures, and an improving financial services sector.  In late Q3, US corporate cash levels reached $1.9 trillion, which, as a percentage of total corporate assets, is the highest since 1959.  In late Q4, initial claims for unemployment fell to the lowest level in two years.
Negative news included continuing high jobless rates in the US and other developed markets. US unemployment began the year at 9.7%, dipped to 9.5% in July, but climbed to 9.8% in November.  Personal bankruptcies in the US increased 9%, reaching their highest level since 2005.  Also, bank failures in 2010 were the worst since 1992, during the savings and loan crisis.

Housing and Real Estate
The global property decline that helped trigger the 2008 financial crisis began to ease in 2010.  Home prices improved in the UK but remained weak in the US, with monthly sales of new homes falling at one point to the lowest level since tracking was initiated in 1963.  Foreclosures increased dramatically in the first half of 2010 before improving in Q4.  However, 2010 proved to be another successful year for REITs, despite recurring predictions of a brewing commercial real estate collapse that would trigger a financial crisis.

Quantitative Easing and Fiscal Stimulus
Governments and central banks took additional actions to stimulate economies and shore up financial markets. The most direct support came as central banks supported government bond markets in the US and Europe.  The Federal Reserve’s November announcement of a second round of quantitative easing (known as “QE2”) sparked concern that additional monetary stimulus would stoke inflation and debase the dollar. According to some, the actions helped lift stocks and corporate bond markets.  In December, the extension of the Bush-era tax cuts and a 2% reduction in Social Security payroll taxes in 2011 improved economic expectations.

Sovereign Debt Worries
During the year, the weakening finances of some European states, including Portugal, Ireland, Italy, Greece, Spain, and Belgium, raised concern that the financial crisis had moved from private-sector banks to public-sector balance sheets.  These concerns led to the downgrading of certain government debt and widening of bond yield spreads.  The Euro zone countries and International Monetary Fund responded with loans that were conditional on some sovereign borrowers taking drastic austerity measures.

Inflation vs. Deflation
Despite moderate inflation in most economies during 2010, economists warned that continued government budget deficits and monetary expansion would drive up prices.  Conversely, the US central bank was concerned that inflation was so low that the economy might slip into a deflationary cycle.  In fact, potential deflation was one of the main reasons the Fed implemented QE2 and pumped $600 billion into the banking system.  By year end, the Fed indicated that the deflation threat was easing.

Higher Commodity Prices
Commodities climbed during 2010, with many sectors reaching price levels not seen in decades.  Copper prices, which are considered a bellwether of economic activity, rose 33%, and oil gained 15% to finish 2010 over $91 a barrel.  Agricultural commodities, a traditionally volatile sector, saw even more extreme price swings.  Concern about a weakening dollar drove up precious metals, with gold exceeding $1,400 per ounce and silver up 81% for the year.

Investor Confidence
In the wake of the financial crisis, investors who have become more risk averse or accepted the tenets of a “new normal” in the economy and markets chose to remain in fixed income assets.  Bond funds in the US received a massive net inflow of money in the past two years, suggesting that many investors who fled stocks may have missed out on much of the rebound in equities.  Throughout most of 2010, investment flows were leaving the US stock market and moving to emerging markets.  In December, flows turned sharply positive in the US, with an estimated $22 billion directed to US stock funds.

2010 Review: Economy & Markets, Part One

The past year offered an interesting mix of positive and negative news as investors around the world eagerly anticipated signs of economic recovery and financial stabilization.  While most financial markets logged positive returns for a second straight year, investors had to endure a whole host of troubling news and pessimistic market predictions.  Even eight months into the year, the S&P 500 Index was down 5.9%.  But diversified, long-term investors were rewarded with attractive market returns, as the S&P 500 closed the year up 15.06%, with 10.76% of the gain coming in the fourth quarter.  (Returns are in US dollars throughout this report.)

Stocks performed well in the US and most developed countries, and across size and value risk factors, despite ongoing concerns over a possible double-dip recession, rising government indebtedness, and inflation.  Thirty-seven out of forty-five countries tracked by MSCI achieved positive returns in both local currency and US dollar terms.

Fixed income returns were positive, thus thwarting assertions that bond prices were in dangerous “bubble” territory.  Despite continued weakness in residential housing and commercial property, real estate securities around the world outperformed the broad equity market.  Diversification across the size and value risk dimensions proved rewarding in both US and non-US markets, particularly among small company stocks.
 
 As shown in the US Stock Market Performance chart, the broad US stock market logged strong performance, returning 16.93% for the calendar year.  The chart features some of the year’s most highly publicized events. These events are not offered as an explanation of market performance, but simply to illustrate that long-term investors faced a major challenge to stay disciplined in a volatile news environment.  Although investors must deal with uncertainty in all markets, 2010 may have presented a more intense challenge as markets watched for signs of economic recovery from the global financial crisis.

Throughout the year, investors could find a host of reasons to avoid stocks and wait for more positive news before returning to the market.  As these select headlines suggest, determining the right time to invest is a difficult task since the market anticipates news and quickly factors in new information.  Stay tuned for part two of this discussion.

Recent Tax Law Changes

While the new law tax changes in the bipartisan legislation that was enacted in late 2010 were the most significant developments in the fourth quarter of 2010, many other tax developments may affect you, your family, and your livelihood. These other key developments in the fourth quarter of 2010 are summarized below. Please call us for more information about any of these developments.

Final Regulations on Stock Reporting Rules
The IRS has issued final regulations explaining the complex basis and character reporting requirements that apply for most stock acquired after 2010, for shares in a regulated investment company (i.e., a mutual fund) or stock acquired in connection with a dividend reinvestment plan after 2011, and for other specified securities acquired after 2012. In brief, brokers will have to report to the IRS the customer's adjusted basis (cost for tax purposes) in the security and whether any gain or loss is short- or long-term. When these rules are fully implemented, the IRS will be in a much better position to monitor whether taxpayers are properly reporting investment gains and losses.

Small Business Health Care Credit 
The IRS issued a second wave of detailed guidance on the small employer health insurance credit created by last year's health reform legislation. For tax years beginning after Dec. 31, 2009, an eligible small employer (ESE) may claim a tax credit for nonelective contributions to purchase health insurance for its employees. An ESE is an employer with no more than 25 full-time equivalent employees (FTEs) employed during its tax year, and whose employees have annual full-time equivalent wages that average no more than $50,000. However, the full credit is available only to an employer with 10 or fewer FTEs and whose employees have average annual full-time equivalent wages from the employer of not more than $25,000. And, in general, the ESE must pay not less than 50% of the premium cost of the employee health plan. The new guidance examines which employers qualify for the credit and which employees may be counted for credit purposes. It includes new rules for satisfying the complex uniform contribution requirement with special transition rules for 2010. The IRS also issued the final version of Form 8941 (Credit for Small Employer Health Insurance Premiums), which is used to claim the credit.

Medical Residents Do Not Qualify for FICA Student Exemption
Under the so-called student exception, FICA doesn't apply to students' work for a college if they are regularly enrolled in and attending classes at the college. The Supreme Court has upheld the validity of IRS regulations that generally prevent medical residents from qualifying for the FICA student exception. Under these regulations, an employee for FICA purposes includes a medical resident who works 40 hours or more per week for a school, college or university. This decision has important ramifications for the many teaching hospitals and their residents.
 
Electronic Funds Transfer (EFT) Rules Now in Place
Beginning Jan. 1, 2011, employers must use EFT to make all federal tax deposits (such as deposits of employment tax, excise tax, and corporate income tax). Forms 8109 and 8109-B, Federal Tax Deposit Coupon, cannot be used after Dec. 31, 2010.

Standard Mileage Rates Up
The optional mileage allowance for owned or leased autos (including vans, pickups or panel trucks) is 51¢ per each business mile traveled after 2010. That's 1¢ more than the 50¢ allowance for business mileage during 2010. Further, the 2011 rate for using a car to get medical care or in connection with a move that qualifies for the moving expense deduction is 19¢ per mile, 2.5¢ more per mile than the 16.5¢ for 2010.

More Interest Deductions for Debt on the Purchase of an Expensive Home
In new guidance on rules for deducting qualified residence interest, the IRS has determined that acquisition debt incurred by a taxpayer to buy, build, or substantially improve a qualified residence can also qualify as home equity debt to the extent it exceeds $1 million. As a result, a taxpayer can deduct up to $1.1 million of the debt securing the purchase of his principal residence.

Basis Overstatement Can Trigger 6-Year Limitations Period Under New Regulations
The IRS has issued final regulations under which an understated amount of gross income reported on a return resulting from an overstatement of unrecovered cost or other basis is an omission of gross income for purposes of the 6-year period for assessing tax and the minimum period for assessment of tax attributable to partnership items. The 6-year limitations period applies when a taxpayer omits from gross income an amount that's greater than 25% of the amount of gross income stated in the return. Several courts had held that a basis overstatement is not an omission of gross income for this purpose. In response to these decisions, the IRS issued the new regulations to clarify that an omission can arise in that fashion. After it initially issued these regulations as temporary ones, the Tax Court found them to be invalid. How other courts will react to the clarification remains to be seen.

New Law Delays Start of Filing Season for Some Taxpayers
Some taxpayers planning to file their 2010 tax returns early have been advised by the IRS to wait until mid- to late-February, 2011. Affected taxpayers are those planning to file Schedule A or claim above-the-line deductions for higher-education tuition and fees or educator expenses. The culprit is Congress's late passage of the 2010 Tax Relief Act. The IRS needs time to reprogram its computers to reflect the changes.

Extended Due Date this Year
Because of the Emancipation Day holiday in the District of Columbia, the due date of Form 1040 for 2010 is Apr. 18, 2011, instead of Apr. 15, 2011. The Apr. 18 due date applies even for taxpayers who do not live in the District of Columbia.

S-Corp Shareholder-Employee Wages
A district court has concluded that an S Corporation shareholder-employee's salary was unreasonably low and allowed the IRS to reclassify a large portion of the dividend payments as wages and the corporation owes employment taxes on the reclassified dividend payments (Watson, P.C. v. U.S. (DC IA 12/23/10) 107 AFTR 2d 2011-305).  This has been a long standing compliance issue with the IRS, which feels many service professionals try to minimize Medicare and Social Security taxes by routing what would otherwise be self-employment income through the S-Corp and then pay themselves a nominal salary.  In 2010, the House, but not the Senate, passed legislation that included a crackdown on service professionals who try to minimize employment taxes.  We will keep you updated on any developments.