Tax Filing Deadline Update….The IRS has extended the deadlines for Employment and Benefit Plans because of the CO-19…(Notice 2020-35)

Be aware that the IRS has issued this week some major changes in tax filing deadline for several tax filings. The new filing dates range from June 30 through August 31, 2020.

Take note of these changes and interest and penalties may accrue if you miss a key filing deadline. Stay tuned for more changes in the coming weeks. Stay safe !

Tax Filing Deadline Update….The IRS has extended the deadlines for Employment and Benefit Plans because of the CO-19 Notice 2020-35

https://www.irs.gov/pub/irs-drop/n-20-35.pdf

Be aware that the Internal Revenue Service this week in Notice 2020-35, 2020-25 IRB has postponed deadlines for specified time-sensitive actions with respect to certain employment taxes, employee benefit plans, exempt organizations, Individual Retirement Accounts (IRAs), Health Savings Accounts (HSAs) and Coverdell education savings accounts due to the ongoing COVID-19 pandemic.

Background. Code Sec. 7508A gives the IRS the authority to postpone the time for performing certain acts under the internal revenue laws for a taxpayer determined by the IRS to be affected by a “federally declared disaster.”

Under Code Sec. 7508A(a), a period of up to one year may be disregarded in determining whether the performance of certain acts is timely under the internal revenue laws.

Code Sec. 7508A(b) provides that, in the case of a pension or other employee benefit plan, or any sponsor, administrator, participant, beneficiary, or other person with respect to such a plan, affected by a federally declared disaster, the IRS may specify a period of up to one year that may be disregarded in determining the date by which any action is required or permitted to be completed.

If the IRS exercises that authority, no plan will be treated as failing to be operated in accordance with its terms solely because the plan disregards any period pursuant to this relief.

On March 13, 2020, the President declared a federal disaster (Emergency Declaration) due to the emerging COVID-19 pandemic. Following the Emergency Declaration, the IRS published guidance utilizing the authority provided under Code Sec. 7508A to postpone certain deadlines in the case of a federally declared disaster.

Tax deadlines extended. The IRS has now postponed deadlines for certain specified time-sensitive actions with respect to certain employment taxes, employee benefit plans, exempt organizations, IRAs, HSAs, and Coverdell education savings accounts on account of the ongoing COVID-19 pandemic.

Deadlines extended to June 30, 2020. With respect to the remedial amendment period and plan amendment rules for section 403(b) plans, actions that were otherwise required to be performed on or before March 31, 2020, with respect to form defects or plan amendments are postponed to June 30, 2020.

Deadlines extended to July 15, 2020. The following tax deadlines have been extended to July 15, 2020:

  • Employers correcting employment tax reporting errors using the interest-free adjustment process.
  • Employers correcting employment tax underpayments or overpayments.
  • Exempt organizations filing Form 990-N, e-Postcard.
  • Exempt organizations commencing a declaratory judgment suit.
  • Single employer defined benefit plans applying for a funding waiver.
  • Multi-employer defined benefit plans:
    1. Certifying funded status and giving notice to interested parties of that certification.
    2. Adopting, and notifying the bargaining parties of the schedules under, a funding improvement or rehabilitation plan; and
    3. Providing the annual update of a funding improvement plan and its contribution schedules, or rehabilitation plan and its contribution schedules, and filing those updates with their annual return.
  • Cooperative and small employer charity (CSEC) plans
    1. Making contributions required to be made for the plan year.
    2. Making required quarterly installments.
    3. Adopting a funding restoration plan; and
    4. Certifying funded status.
  • Employee benefit plans filing Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, and paying the associated excise tax.

In addition, the period beginning on March 30, 2020, and ending on July 15, 2020, will be disregarded in the calculation of any interest or penalty for failure to file the Form 5330 or to pay the excise tax postponed by the notice. Interest and penalties with respect to such postponed filing and payment obligations will begin to accrue on July 16, 2020.

Deadlines extended to July 31, 2020. Defined benefit plans have until July 31, 2020:

  1. To adopt a pre-approved defined benefit plan that was approved based on the 2012 Cumulative List.
  2. To submit a determination letter application under the second six-year remedial amendment cycle; and
  3. To take actions that are otherwise required to be performed regarding disqualifying provisions in a plan during the remedial amendment period that would otherwise have ended on April 30, 2020.

Deadlines extended to August 31, 2020. The due date for filing and furnishing Form 5498, IRA Contribution Information, form 5498-ESA, Coverdell ESA Contribution Information, and the Form 5498-SA, HSA, Archer MSA, or Medicare Advantage MSA Information, is postponed to August 31, 2020.

In addition, the period beginning on the original due date of those forms and ending on August 31, 2020, will be disregarded in the calculation of any penalty for failure to file those forms. Penalties with respect to such a postponed filing will begin to accrue on September 1, 2020.

Waiver of electronic filing requirement. The IRS has also provided a temporary waiver of the requirement that Certified Professional Employer Organizations (CPEOs) file certain employment tax returns, and their accompanying schedules, on magnetic media (including electronic filing). This temporary waiver is extended to all CPEOs; individual requests for waiver do not need to be submitted.

This waiver applies only to Forms 941, Employer’s Quarterly Federal Tax Return, filed for the second, third, and fourth quarter of 2020 and only to Forms 943, Employer’s Annual Federal Tax Return for Agricultural Employees, filed for calendar year 2020, and their accompanying schedules. Accordingly, CPEOs are permitted, but not required, to file a paper Form 941, and its accompanying schedules, in lieu of electronic submission for the second, third, and fourth quarters of calendar year 2020. In addition, CPEOs are permitted, but not required, to file a paper Form 943, and its accompanying schedules, in lieu of electronic submission for calendar year 2020.

References. For extension of tax-related deadlines for taxpayers affected by disasters, see FTC 2d/FIN ¶S-8502; United States Tax Reporter ¶75,08A4.

Accountant-turned-attorney couldn’t deduct law school costs

Here we go again…Watch out when a person qualifies for a new trade or business under the education expense deduction rules!

Santos, TC Memo 2016-100TC Memo 2016-100

The Tax Court has concluded that an accountant could not deduct his law school tuition and fees as ordinary business expenses, finding that such qualified him for a new trade or business and thus were nondeductible under Reg. § 1.162-5(b). The Court also declined to consider the taxpayer’s late-raised arguments challenging the validity of that reg.

Background. Education expenses are deductible under Code Sec. 162(a) if made by a taxpayer either to maintain or improve skills required in his business or employment or to meet the express requirements of his employer, or the requirements of law or regs, if they are imposed as a condition to retaining his salary, status or employment. (Reg. § 1.162-5) The expense is deductible only if the taxpayer is established in the trade or business at the time he pays or incurs the expense. (Jungreis, (1970) 55 TC 58155 TC 581)

Deductions are not allowed if the education:

  • Is needed to meet the minimum requirements for taxpayer’s present or intended employment, trade, business, or profession (Reg. § 1.162-5(b)(2)); or
  • Is undertaken to fulfill general education aspirations or for other personal reasons; or
  • Is part of a program of study that will lead to qualifying the individual in a new trade or business. (Reg. § 1.162-5(b)(3)(i))

Two of the examples in Reg. § 1.162-5(b)(3) illustrating types of nondeductible educational expenses involve individuals who go to law school. In the first example, a self-employed non-lawyer’s law school expenditures are nondeductible because they qualify him for a new trade or business. The second example involves an employee in a nonlegal profession whose employer requires him to get a law degree, and in this example, although the employee intends to continue practicing his nonlegal profession, the expenditures are still nondeductible because the education nonetheless qualifies him to do something new. A number of courts have also held that a law degree qualifies a law student for a new trade or business (i.e., the business of being an attorney) and that, therefore, the cost of a law degree is a nondeductible educational expense under Reg. § 1.162-5(b)(3). (See, e.g., Melnik v. U.S., (CA 9 1975) 36 AFTR 2d 75-566736 AFTR 2d 75-5667)

Facts. Emmanuel Santos began working as a return preparer in ’90. He became an “enrolled agent” authorized to represent taxes before IRS in ’95 and earned a master’s degree in taxation in ’96. He began offering other services to his clients, including financial planning.

At some point, Santos enrolled in law school. He was attending law school in 2010 and, during that year, paid tuition, and fees of $20,275. He later started a law firm with his father that also provides tax and financial planning services.

Santos attached a Schedule C (Profit or Loss from Business) to his 2010 Form 1040 for the “business or profession” of tax and financial planning. On his Schedule C, Santos deducted a variety of expenses, including $20,275 for law school tuition and fees. After concessions from both parties, the remaining issue was whether Santos could deduct the law school tuition and fees.

No deduction. The Tax Court easily concluded, looking at the applicable regs and caselaw, that the law school tuition and fees paid by Santos were not deductible.

Santos also challenged the validity of Reg. § 1.162-5. The Court noted that the reg was challenged shortly after its promulgation and was upheld both by the Tax Court (Weiszmann, (1969) 52 TC 110652 TC 1106) and by the Ninth Circuit Court of Appeals (the relevant Court to which an appeal of this case would lie), which affirmed the Tax Court. (Weiszmann v. Comm., (CA 9 1971) 27 AFTR 2d 71-97027 AFTR 2d 71-970) Specifically, the Tax Court found in Weiszmann that the challenged reg was consistent with statutory law and not arbitrary.

In this case, the Tax Court found that Weiszmann was binding precedent and thus declined to reconsider the validity of the reg. The Court noted that, while the tests for evaluating a reg’s validity are different now than they were when Weiszmann was decided, and while “precedent may lose its force when the underlying law upon which the precedent was based has changed,” it didn’t see any such change warranting a departure from Weiszmann.

The Court also rejected the argument that it should hold the reg invalid under other tests. Santos cited Altera, (2015) 145 TC No. 3145 TC No. 3, in which the Tax Court struck down certain cost-sharing regs for, among other reasons, failure to address “numerous relevant and significant comments.” However, the Tax Court distinguished the regs at issue in Altera as requiring empirical analysis, whereas the education expense regs in the instant case are purely a matter of statutory interpretation. And further, the Court found that Santos failed to challenge the validity of the reg until after trial—so the trial record and court papers have no information regarding public comment on the education expense reg, leaving the Court unable to determine the adequacy of Treasury’s response.

References: For when a person qualifies for a new trade or business under the education expense deduction rules, see FTC 2d/FIN ¶ L-3715; United States Tax Reporter ¶ 1624.185; Tax Desk ¶ 302,013; TG ¶ 16197.

IRS ADDS FAQS ABOUT “GET MY PAYMENT” ECONOMIC IMPACT PAYMENT STATUS

IRS website – Get My Payment Frequently Asked Questions (updated May 20, 2020)

On its website, IRS has added to its FAQs regarding its “Get My Payment” website, which provides information about economic impact payments (EIPs) made under the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

Background. As part of the CARES Act (PL 116-136, 3/27/2020), IRS is making EIPs to certain taxpayers.
Tax filers with adjusted gross income up to $75,000 for individuals and up to $150,000 for married couples filing joint returns receive the full payment. For filers with income above those amounts, the payment amount is reduced by $5 for each $100 above the $75,000/$150,000 thresholds.

Eligible taxpayers who filed tax returns for either 2019 or 2018 automatically receive an EIP of up to $1,200 for individuals or $2,400 for married couples. Parents also receive $500 for each qualifying child under the age of 17 as of the end of 2020.

IRS has set up the Get My Payment website/tool that:
a. Shows taxpayers either their EIP amount and the scheduled delivery date of the EIP by direct deposit or paper check, or that a payment has not been scheduled; and
b. Allows taxpayers who did not use direct deposit on their last filed tax return to provide their direct deposit information which will speed their receipt of their EIP. (Get My Payment tool)

The IRS also has an online “non-filer tool,” that taxpayers who do not file tax returns can use to register to receive their EIPs. See IRS launches new on-line tool to help non-filer register for Economic Impact Payments (4/13/2020) .

The IRS previously updated its FAQs about the Get My Payment website on May 4. See IRS adds FAQs about “Get My Payment” economic impact payment website/tool (05/06/2020) .

Added FAQ. The IRS added FAQs, including:
Q. I am not required to file a tax return. Can I still use Get My Payment to check my payment status?
A. Depending on your specific circumstances, it may not be possible for you to access Get My Payment.
If you used the non-filer tool, then Get My Payment will display your Payment Status and details within two weeks. Until your payment is scheduled, you will receive a “Payment Status Not Available” message.

If you receive Supplementary Security Income (SSI), Survivor or Disability benefits (SSDI), Railroad Retirement benefits or Department of Veterans Affairs beneficiaries and did not file a return or use the non-filer tool, then:
• Get My Payment will display your Payment Status and details once it has been scheduled for delivery. Until then, you will receive a “Payment Status Not Available” message.

• You will not be able to use Get My Payment to provide your bank account information. The IRS will use the information from SSA or VA to generate your payment.

• You will receive your payment as a direct deposit or by mail, just as you would normally receive your benefits. For example, if your benefits are currently deposited to a Direct Express card (a debit card used to receive federal benefits), your EIP will also be deposited to that card. If your benefits are currently deposited to your bank account, your EIP will also be deposited to that account.

If a Direct Express account holder used the non-filer tool to add a spouse or qualifying child, the account holder cannot receive the EIP payment on the Direct Express card. The account holder must select a bank account for direct deposit or leave bank information blank and receive the EIP by mail.

If you did not file a return, did not use the non-filer tool, or are not a recipient of SSA, SSI, RRB or VA benefits, then the IRS may not have enough information on file for you to send you an EIP. In that case, Get My Payment will display a “Payment Status Not Available” message.

Q. I filed jointly with my spouse. Does it matter whose information I use for Get My Payment?
A. Either spouse can use Get My Payment by providing their own information for the security questions used to verify their identity. Once verified, the same payment status will be shown for both spouses. If you receive “Need More Information” and proceed to enter your direct deposit information, you should enter the Adjusted Gross Income (AGI) and Refund Amount or Amount You Owed exactly as it appears on your joint tax return.

The AGI can be found on Line 8b on your 2019 Form 1040 or 1040-SR, or Line 7 on your 2018 Form 1040.
The refund amount can be found on Line 21a on your 2019 Form 1040 or 1040-SR, or line 20a on your 2018 Form 1040.
The amount you owed can be found on Line 23 on your 2019 Form 1040 or 1040-SR, or Line 22 on your 2018 Form 1040.
Your EIP can only be directed to one bank account if you filed jointly.

Q. I requested a direct deposit of my payment. Why are you mailing it to me?
A.There are several reasons why your payment may have been sent by mail, including:
• If the payment was already in process before the bank information was entered, or
• If the bank rejects the deposit because the bank information is invalid or the bank account has been closed.
The IRS will mail your payment to the address IRS has on file for you. Get My Payment will be updated to reflect the date your payment will be mailed. Typically, it will take up to 14 days to receive the payment, standard mailing time.

The IRS notes that it is not possible to change your bank information online once your payment has been processed. Don’t contact the IRS as phone assistors won’t be able to change your bank information either.

Q. My bank account information has changed since I filed. Can I update it using the Get My Payment tool?
A. No. To help protect against potential fraud, the tool does not allow people to change direct deposit information already on file with the IRS.
If the IRS issues a direct deposit and the bank information is invalid or the bank account has been closed, the bank will reject the deposit. The IRS will then mail your EIP as soon as possible to the address it has on file for you, and will update Get My Payment to reflect the date your payment will be mailed.

Q. The Get My Payment website indicates my EIP went to my bank, but I’ve learned it was sent to them in error and has been returned to the IRS for reprocessing. How can I see the status of this payment and where it will be sent?
A. Once reprocessed, these payments will be automatically mailed to the most current address on file. This could be the address identified on a 2019 or 2018 tax return, or the address on file with the U.S Postal Service. Get My Payment tool will update accordingly. However, until the IRS processes the returned payment, there may be a short period where Get My Payment may still indicate the original payment date and direct deposit status.

In mid-April, some taxpayers may have seen an erroneous message when checking Get My Payment, which indicated the EIP was being deposited to the same taxpayer account a second time.

The IRS corrected this reporting error as of Tuesday, April 21 to reflect that the taxpayer’s payment was actually mailed and not rerouted.

Coronavirus Aid, Relief, and Economic Security (CARES) Act tax provisions.

Right now, your highest priority continues to be the health of those you love and yourself.

You may have read an article that I recently published that summarized the Coronavirus Aid, Relief, and Economic Security (CARES) Act tax provisions.

That article included a brief discussion of the CARES Act’s deferral of and changes to the limit on excess business losses.

Here is more about the deferral and changes.

Deferral of the excess business loss limits.

The Tax Cuts and Jobs Act (the 2017 Tax Law) provided that net tax losses from active businesses in excess of an inflation-adjusted $500,000 for joint filers, or an inflation-adjusted $250,000 for other covered taxpayers, are to be treated as net operating loss carryforwards in the following tax year.
The covered taxpayers are individuals (or estates or trusts) that own businesses directly or as partners in a partnership or shareholders in an S corporation.

The $500,000 and $250,000 limits, which are adjusted for inflation for tax years beginning after calendar year 2018, were scheduled under the 2017 Tax Law to apply to tax years beginning in calendar years 2018 through 2025.

But the CARES Act retroactively postponed the limits so that they now apply to tax years beginning in calendar years 2021 through 2025.

The postponement means that you can amend your prior years returns.

Here is what to look for on your individual tax returns.
1. Any filed 2018 returns that reflected a disallowed excess business loss (to allow the loss in 2018) and
2. Any filed 2019 returns that reflect a disallowed 2019 loss and/or a carryover of a disallowed 2018 loss (to allow the 2019 loss and/or eliminate the carryover).

If you filed any such return(s), you need to consider filing an amended tax return as soon as possible.
Note also that the excess business loss limits don’t apply to tax years that begin in 2020.

Thus, such a 2020 year can be a window to start a business with large up-front-deductible items (for example capital items that can be 100% deducted under bonus depreciation or other provisions) and be able to offset the resulting net losses from the business against investment income or income from employment (see below).

Changes to the excess business loss limits.

The CARES Act made several retroactive corrections to the excess business loss rules as they were originally stated in the 2017 Tax Law.

Most importantly, the CARES Act clarified that deductions, gross income or gain attributable to performing services as an employee are not considered in calculating an excess business loss.

This means that excess business losses cannot shelter either net taxable investment income or net taxable employment income.
Be aware of that if you are planning a start-up that will begin to generate, or will still be generating, excess business losses in 2021.

Another change provides that an excess business loss is considered in determining any net operating loss (NOL) carryover but is not automatically carried forward to the next year.

And a generally beneficial change states that excess business losses do not include any deduction under Code Sec. 172 (NOL deduction) or Code Sec. 199A (the qualified business income deduction that effectively reduces income taxes on many businesses).

And because capital losses of non-corporations cannot offset ordinary income under the NOL rules,
1. Capital loss deductions are not considered in computing the excess business loss, and
2. The amount of capital gain considered in computing the loss cannot exceed the lesser of capital gain net income from a trade or business or capital gain net income.

I will be pleased to answer any questions you might have about the above information or any other matters, related to COVID-19 or not.

I continue to wish all of you the absolute best in a difficult time.

Stay safe…!

Before we get too festive..all of us need to understand how the “Qualified Business Income (QBI) Deduction (Sec. 199A)” will effect our clients..

The American Institute of CPA’s tax section recently published a “Q&A” on  Qualified Business Income (QBI) Deduction (Sec. 199A)….

All tax professionals need to spend some time understanding its implementation and use.

So lets get started….

Qualified Business Income (QBI) Deduction (Sec. 199A)

What are some general rules of thumb of Sec. 199A?

The qualified business income (QBI) deduction of Sec. 199A is limited to 20% of the excess of taxable income over net capital gain. For example, suppose a taxpayer has $100,000 of QBI, $120,000 of capital gain, and $40,000 of deductions. Taxable income in this example is $180,000, and the excess of taxable income of net capital gain is $60,000. Thus, the tentative tax deduction of $20,000 ($100,000 QBI x 20%) is limited to $12,000 ($60,000 x 20%).

If taxable income is less than $157,500 (single) or $315,000 (married), then the QBI deduction is simply 20% of the lesser of QBI or taxable income other than captial gain (subject to the taxable income limitation), regardless of whether the business is a specified service trade or business (SSTB) or whether the business pays W-2 wages.

If taxable income is greater than $207,500 (single) or $415,000 (married), and the QBI is from an SSTB, the QBI deduction is $0. However, if the taxpayer has QBI from other sources, a deduction is still allowed for the non-SSTB businesses. If the QBI is from a non-SSTB, the deduction is allowed, but is limited to the greater of:

  1. 50% of the taxpayer’s allocable share of the W-2 wages paid by the business, or
  2. 20% of the taxpayer’s allocable share of the W-2 wages paid by the business plus 2.5% of the taxpayer’s allocable share of the unadjusted basis of qualified property.

If the taxable income is between $157,500 and $207,500 (single) or $315,000 and $415,000 (married), both the prohibition on SSTBs and the W-2 and property limitations partially apply. See our Sec. 199A flowchart and listen to our podcast: Sec. 199A: What is it and whom does it apply.

What types of businesses are treated as specified service trades or businesses that are generally prohibited from generating QBI?

SSTBs include “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners; or any trade or business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests or commodities.” Engineering and architectural businesses are specifically removed from the definition of an SSTB.

The recently released proposed regulations provide a de minimis exception that will allow a business that both sells product and performs services to avoid being treated as an SSTB. Proposed Regs. Sec. 1.199A-5(c) states that if a trade or business has gross receipts of $25 million or less for the tax year, it will not be treated as an SSTB as long as less than 10% of the gross receipts of the business are attributable to the performance of services in one of the disqualified fields. If a business has gross receipts of more than $25 million, a similar de minimis rule exists, but 10% is replaced by 5%.[MG1]

Listen to the podcast: Sec. 199A: Application to non-specified service businesses.

What guidance has the IRS issued regarding Sec. 199A?

The IRS recently issued proposed regulations regarding the qualified trade or business income deduction under Sec. 199A (REG-107892-18). The IRS also issued Notice 2018-64, which provides guidance on how to compute W-2 wages for purposes of the deduction, along with FAQs. The proposed rules include a way that taxpayers can aggregate separate trades or businesses. The proposed regulations also add an anti-abuse rule designed to prevent taxpayers from separating out parts of an otherwise disqualified business in an attempt by the taxpayer to qualify those separated parts for the Sec. 199A deduction.

Does the AICPA have a flowchart on Sec. 199A?

The AICPA Tax Section has developed a flowchart exclusively for Tax Section members to help them with the QBI deduction. Download it now.

If a U.S. partnership has disregarded foreign manufacturing entities, does the QBI deduction only apply to the U.S. manufacturing?

Yes, the QBI deduction only applies to activities within the U.S.

How are wages calculated for purposes of the 50% limitation (i.e., what number is used)?

W-2 wages are total wages before any elective deferrals such as Sec. 401(k) or Sec. 457 deferrals. As such, a general rule of thumb is to use the Medicare wages reported on the W-2. Section 199A(b)(4) references Sec. 6051(a)(3) and (8). There are exceptions.

How do wages paid to the owner(s) of an S corporation factor into the QBI calculations?

Wages paid to S corporation owner(s) are factored into the calculation two ways:

  • Section 199A(c)(4) says that QBI does not include reasonable compensation paid to the S corporation shareholder. The reasonable wages paid to an S corporation shareholder reduces the pass-through QBI allocated among the shareholders. The wage income of the shareholder is not QBI.
  • Section 199(b)(2) says the QBI deduction is the lesser of 20% of QBI, or 50% of wages. Section 199(b)(2) doesn’t say anything about excluding wages paid to an S corporation shareholder; wages paid to shareholders are included in the 50% calculation.

Is it safe to say that an S corporation with a single employee, the sole owner, does not qualify for the QBI deduction?

No. If the lesser of QBI or taxable income is less than $157,500 (single) or $315,000 married, the QBI deduction is simply 20% of the lesser of QBI or taxable income (subject to limitations) regardless of the wages paid. If the taxable income of the shareholder is greater than these amounts, the shareholder’s Sec. 199A deduction might be limited based upon the W-2 wages limitation or the limitation based upon wages and investment in qualified property.

How are wages paid to an S corporation shareholder’s spouse or children treated?

All wages paid by the S corporation qualify in the computation of the W-2 wages expense limitation. If the 20% deduction is otherwise limited (e.g., the shareholder is above the income thresholds), the payment of reasonable wages for services rendered by the spouse and children may increase the Sec. 199A deduction.

Under what conditions will a QBI deduction be allowable for rental real estate?

Proposed Regs. Sec. 1.199A-1(b)(13) provide that a trade or business is defined under a Sec. 162 judicial definition. As a result, the trade or business status of a real estate rental activity is uncertain and may lead to inconsistent treatment amongst taxpayers attempting to claim the Sec. 199A QBI deduction. The AICPA has recommended that the Department of the Treasury and the IRS provide assurance that rental real estate activities are generally considered a trade or business. Further, guidance is needed on whether there are specific circumstances in which rental real estate activities would not generate qualified trade or business income under the adopted Sec. 162 trade or business standard.

What if I rent my real estate to my SSTB?

Real estate rented to a business which is commonly owned with the real estate owner is automatically treated as a qualified trade or business. The net rental income will have the same character (SSTB or non-SSTB) as the operating business. “Commonly owned” is at least 50% common ownership. Ownership by the spouse, children, grandchildren and parents is attributed to the owner.

 

Would a royalty interest in an oil and gas well qualify for the QBI deduction?

Unlikely, because a royalty interest will not likely be considered a trade or business. On the other hand, a working interest should qualify.

If a taxpayer has an interest in a profitable passive partnership, will he or she qualify for the QBI deduction?

Yes, nothing in Sec. 199A requires active or material participation. The limitations apply.

How is QBI treated if a taxpayer has an interest in an unprofitable passive partnership where none of the loss is allowed under Sec. 469?

Since the passive loss is disallowed and suspended for regular income tax purposes, the loss will not yet enter into the QBI computations. The reduction in QBI will occur in the year in which the suspended passive activity loss carryover is allowed.

 

Careful Planning of Year-end transactions is Essential to maximizing tax savings !!!

Although plenty of people have made money on the stock market this year, there are many others who have recognized losses on securities, or may be thinking of bailing out of other holdings that show paper losses.

It is critical to plan  the most appropriate year-end planning strategy for an individual’s capital gains and losses will depend on a series of factors, including the amount of regular taxable income, the tax rate that applies to the individual’s “adjusted net capital gain”, whether recognized capital gains are long- or short-term, and whether there are unrealized capital losses.

Capital gain and loss basics. As explained in more detail below, an individual’s “adjusted net capital gain” is taxed at maximum rates of 0%, 15%, or 20%. “Adjusted net capital gain” is net capital gain plus qualified dividend income, minus specified types of long-term capital gain that are taxed at a maximum rate of 28% (gain on the sale of most collectibles and the unexcluded part of gain on Code Sec. 1202 small business stock) or 25% (“unrecaptured section 1250 gain”—i.e., gain attributable to real estate depreciation). “Net capital gain” is the excess of net long-term capital gains (from sales or exchanges of capital assets held for over one year) over net short-term capital losses for a tax year. Net short term capital gains (i.e., from the sales of capital assets held for one year or less before being sold) are taxed as ordinary income.

Long-term capital losses are used to offset long-term capital gains before they are used to offset short-term capital gains. Similarly, short-term capital losses must be used to offset short-term capital gains before they are used to offset long-term capital gains. Noncorporate taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income (AGI).

Capital gain tax rates. As a result of the Tax Cuts and Jobs Act (TCJA; P.L. 1115-97, 12/22/2017), for 2018 through 2025, the taxpayer’s ordinary income tax rates are not factors in determining how adjusted net capital gain is taxed. Instead, the rates that apply to such gain are determined with reference to dollar amounts set forth in the Code (subject to inflation adjustment after 2018). (Code Sec. 1(j)(5))

For 2018:

 

  • The 0% tax rate applies to adjusted net capital gain to the extent that it, when added to regular taxable income, is not more than the “maximum zero rate amount” ($77,200 for joint filers and surviving spouses, $51,700 for heads of household, $38,600 for single filers, $38,600 for married taxpayers filing separately, and $2,600 for estates and trusts);
  • The 15% tax rate applies to adjusted net capital gain to the extent that it, when added to regular taxable income, is over the amount subject to the 0% rate, but is not more than the “maximum 15% rate amount” ($479,000 for joint filers and surviving spouses, $452,400 for heads of household, $425,800 for single filers, $239,500 for married taxpayers filing separately, and $12,700 for estates and trusts); and
  • The 20% tax rate applies to adjusted net capital gain to the extent that it, when added to regular taxable income, is over $479,000 for joint filers and surviving spouses, $452,400 for heads of household, $425,800 for single filers, $239,500 for married taxpayers filing separately, and $12,700 for estates and trusts. (Code Sec. 1(h)(1); Code Sec. 1(j)(5)(A))

Illustration (1): For 2018, Mr. and Mrs. Smith have $75,000 of taxable income exclusive of capital gains, plus $8,000 of long-term capital gains from the sale of stock. They have no other capital gains and losses for the year.

  • A zero (0%) tax rate applies to $2,200 of their long-term capital gain ($77,200 – $75,000); and
  • A 15% rate applies to $5,800 of their long-term capital gain ($8,000 – the $2,200 that is subject to the 0% tax rate).

Thus, the tax on the Smiths’ $8,000 of long-term capital gain is $870 (15% of $5,800).

Under Code Sec. 1411, there is a 3.8% surtax on net investment income (including capital gains) of noncorporate taxpayers whose modified adjusted gross income exceeds $250,000 for joint filers and surviving spouses, $125,000 for separate filers, and $200,000 in all other cases. If this surtax applies, it will result in a maximum tax rate of either 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%) on adjusted net capital gain, depending on taxable income.

Year-end strategies for capital gains and losses. Keeping in mind that investment factors are paramount when deciding to sell or hold capital assets, here are year-end strategies that can produce significant tax savings.

 

  1. Taxpayers whose 2018 taxable income from long-term capital gains and other sources is below the zero rate amount should try to avoid recognizing long-term capital losses before year end as they may receive no benefit from those losses.

Illustration (2): For 2018, if marrieds filing jointly have $70,000 of taxable income exclusive of capital gains, plus $5,000 of long-term capital gain from the sale of stock earlier this year, none of that gain will be taxed. If they unload mutual fund shares showing a $5,000 long-term paper loss, they will receive not a tax benefit from that loss.

  1. Taxpayers whose 2018 taxable income will be below the zero rate amount should consider recognizing enough long-term capital gains before year-end to take advantage of the 0% rate. For example, joint filers who anticipate having $67,000 of taxable income for this year, exclusive of capital gains, could recognize up to $10,200 of long-term capital gains before year end, and none of the gain would be subject to tax ($77,200 zero rate amount – $67,000).
  2. Taxpayers who have no capital gains should consider selling enough loss securities to yield a $3,000 capital loss, which can be used to offset ordinary income.
  3. Taxpayers should consider selling capital assets showing a long-term gain this year rather than next if their gains would be subject to a higher capital gain tax rate next year. Conversely, taxpayers should put off recognizing long-term capital gains if next year’s capital gain tax rate is likely to be lower.
  4. Time long-term capital losses for maximum effect. A taxpayer should try to avoid having long-term capital losses offset long-term capital gains since those losses will be more valuable if they are used to offset short-term capital gains. To do this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains are taken. However, this is not just a tax issue. As is the case with most planning involving capital gains and losses, investment factors need to be considered. A taxpayer won’t want to defer recognizing gain until the following year if there’s too much risk that the value of the property will decline before it can be sold. Similarly, a taxpayer won’t want to risk increasing the loss on property that he expects will continue to decline in value by deferring the sale of that property until the following year.

To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, the taxpayer should take steps to prevent those losses from offsetting those gains.

Additionally, it may pay for taxpayers who have already realized short- and long-term capital gains for 2018 to accelerate the sale of depreciated-in-value capital assets so that they yield a short-term rather than a long-term capital loss.

Illustration (3): Jennifer invested $10,000 in Crypto stock on Nov. 4, 2017. In September 2018, the value of the stock has dropped to $2,000. Jennifer thinks the chances of the stock increasing in value are slim so she plans to sell it. Jennifer is in the top 37% income tax bracket and also will be subject to the 3.8% surtax on net investment income. Earlier in 2018, she recognized short-term capital gains of $15,000 facing a tax of 40.8% (37% + 3.8%), and long-term capital gains of $20,000 facing a tax of 23.8% (20% + 3.8%). She does not anticipate any other trades for the year.

If Jennifer sells the Crypto stock before Nov. 5, 2018, she will recognize a short-term capital loss of $8,000 (assuming no change in value). This loss will offset $8,000 of her short-term capital gains for the year, thus producing a $3,264 ($8,000 × 40.8%) tax savings.

If, on the other hand, Jennifer waits and sells the stock after Nov. 4 but before Jan. 1, 2019, she will recognize an $8,000 long-term loss (assuming no change in value occurs). This loss will offset $8,000 of her long-term capital gains in the year of the sale, thus producing a $1,904 ($8,000 × 23.8%) tax savings.

By selling the Crypto stock before Nov. 5, 2018, and generating a short-term capital loss, Jennifer saves an additional $1,360 ($3,264 – $1,904) in taxes because of the difference in the tax rates applied to her short-term (40.8%) and long-term (23.8%) capital gains.

Preserve investment position after recognizing gain or loss on stock. For the reasons outlined above, paper losses or gains on stocks may be worth recognizing this year in some situations. But suppose the stock is also an attractive investment worth holding onto for the long term. There is no way to precisely preserve a stock investment position while at the same time gaining the benefit of the tax loss, because the so-called “wash sale” rule precludes recognition of loss where substantially identical securities are bought and sold within a 61-day period (30 days before or 30 days after the date of sale). Thus, a taxpayer can’t sell the stock to establish a tax loss and simply buy it back the next day. However, a taxpayer can substantially preserve an investment position while realizing a tax loss by using one of these techniques:

 

  • Double up. Buy more of the same stocks or bonds, then sell the original holding at least 31 days later. The risk here is of further downward price movement.
  • Sell the original holding and then buy the same securities at least 31 days later.
  • Sell the original holding and buy similar securities in different companies in the same line of business. This approach trades on the prospects of the industry as a whole, rather than the particular stock held.
  • In the case of mutual fund shares, sell the original holding and buy shares in another mutual fund that uses a similar investment strategy. A similar strategy can be used with Exchange Traded Funds.

Planning Idea….. The wash sale rule applies only when securities are sold at a loss. As a result, a taxpayer may recognize a paper gain on stock in 2018 for year-end planning purposes and then buy it back at any time without having to worry about the wash sale rule.

 

Money received by client due to attorney malpractice wasn’t gross income!!

In a private letter ruling, IRS has held that where a taxpayer lost a nonbusiness wrongful death lawsuit, then sued his insurance company and law firm for malpractice with respect to their handling of the wrongful death case, the amount he received from winning the malpractice suit was deemed a return of capital to compensate for a loss and thus was not gross income.

Background. Gross income includes all income, from whatever source derived. (Code Sec. 61(a)) This broad definition is generally interpreted to include all accessions to wealth, and exclusions from income are narrowly construed. (Schleier, (S Ct 1995) 75 AFTR 2d 95-2675)

Payments are excludable from gross income as a return of capital if they are to compensate for the loss or destruction of capital. A taxpayer bears the burden of showing entitlement to this exclusion. (Milenbach, (CA 9 2003) 91 AFTR 2d 2003-818, affg on this issue Milenbach, (1996) 106 TC 184)

Facts. Taxpayer is a bankruptcy estate. Taxpayer was created in response to an unfavorable judgment against Insured, who fatally injured a party with his automobile. Insured was covered by an automobile insurance policy.

A wrongful death law suit was instituted by the fatally-injured party’s family (“victim’s family”) against Insured and Insured’s automobile insurance company (“Insurer”). Insured was represented by Insurer’s law firm (“Law Firm”) in defending the wrongful death law suit. Law Firm failed to settle the lawsuit within the policy limits of the automobile policy.

The victim’s family went to trial against Insured and Insurer. After trial, a significant judgment was granted against Insured. Insured then filed for bankruptcy.

The only asset of significance Taxpayer obtained from Insured was a legal claim against Insurer and Law Firm. The legal claim was that Insurer and Law Firm failed to settle within the policy limits, exposing Insured to the large personal judgment. Taxpayer instituted a lawsuit against Law Firm and Insurer, alleging various errors, including professional negligence by Law Firm (“malpractice lawsuit”).

The parties to the malpractice lawsuit executed a settlement under which Taxpayer would receive a substantial payment from Law Firm’s malpractice insurer (“Settlement Payment”). There were no punitive damages. The settlement was approved by the bankruptcy court.

At issue in the PLR is whether Taxpayer can exclude the Settlement Payment from its income.

Settlement payment isn’t gross income. The PLR concluded that the Settlement Payment stemming from the malpractice lawsuit is a return of capital to compensate for a loss or destruction of the capital of Insured.

The PLR looked to several cases and a revenue ruling involving amounts received by taxpayers in settlement of suits against tax return preparers, where the taxpayer alleged that the tax preparer’s mistakes caused the taxpayer to pay additional amounts of tax.

For example, in Clark, (1939) 40 B.T.A. 333, the tax counsel had prepared a joint return for the taxpayers, a husband and wife, and advised them to file it. It later turned out the joint return brought them a less favorable tax outcome than separate returns would have. The Clark court concluded that the payment that the taxpayers received from their tax counsel was compensation for the taxpayers’ loss which impaired their capital, or a return of the lost capital, and was not income since it was not “derived from capital, from labor or from both combined”.

No economic gain benefited Insured personally; rather, the Settlement Payment restored some of Insured’s impaired capital. Consistent with the holding of Clark, the recovery of impaired capital is excluded from Insured’s gross income as a restoration of lost capital.

And, as successor to Insured’s claim against Law Firm and in its capacity as Insured’s bankruptcy estate, the Settlement Payment in the hands of Taxpayer is also deemed as a return of capital to compensate for a loss or destruction of capital. Accordingly, the Settlement Payment is excludable from gross income of Taxpayer as successor.

 

 

Ninth Circuit affirms the Tax Court -Payments by one spouse to another were Alimony!!

Ninth Circuit finds payments were alimony and not property settlement

Leslie v. Comm., (CA 9 6/6/2018) 121 AFTR 2d ¶2018-828

The Court of Appeals for the Ninth Circuit, affirming the Tax Court, has concluded that payments by one spouse to another were alimony, deductible by the payor and includible in the recipient’s income.

observation: Under the Tax Cuts and Jobs Act (TCJA, P.L. 115-97, 12/22/2017), for any divorce or separation agreement executed after Dec. 31, 2018, or executed before that date but modified after it (if the modification expressly provides that the new rules apply), alimony and separate maintenance payments are not deductible by the payor spouse and are not included in the income of the payee spouse.

Background on alimony. Generally, property settlements (or transfers of property between spouses) incident to a divorce do not give rise to deductions or recognizable income. (Code Sec. 1041) On the other hand, for any divorce or separation agreement executed before 2019 (i.e., for the years at issue here), amounts received as alimony or separate maintenance payments are included in gross income and taxable to the recipient (Code Sec. 71(a), before repealed by TCJA) and deductible by the payor in the year paid. (Code Sec. 215(a), before repealed by TCJA)

An alimony or separate maintenance payment is one that meets the following four requirements:

  1. The payment must be made under a “divorce or separation instrument”;
  2. The instrument must not designate the payment as not includible in the recipient spouse’s gross income under Code Sec. 71 and not deductible by the payor spouse under Code Sec. 215;
  3. The payor and payee spouses must not be members of the same household at the time the payments are made; and
  4. The payor’s obligation to make the payment must end at the death of the payee spouse. (Code Sec. 71(b)(1))

Background on constructive receipt. Income not actually received is constructively received and reportable if it’s within the recipient’s control. Cash basis taxpayers must report money unconditionally subject to their demand as income, even if they haven’t received it. However, there’s no constructive receipt if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it. (Reg § 1.451-2(a))

Facts. After Maria Leslie’s marriage to Byron Georgiou came to an end, marital separation negotiations began in 2003 and continued for three or four years. A major reason for their length was the division of fees that Georgiou, an attorney,hoped to get from certain litigation (the Enron litigation) in which he would receive a substantial referral fee.

Under the marital separation agreement (MSA), Leslie received $7,000 per month in spousal support which would end with either party’s death. Under a separate section of the MSA entitled “Division of Community and Co-owned Property”, Leslie was awarded nine rental properties. She was also awarded 10% of whatever fee Georgiou received as a result of the Enron litigation as spousal support taxable to her; the MSA did not say whether this payment would terminate in the event of either party’s death. In addition, under the same section of the MSA, Georgiou was to pay, contingent on his receiving his split of the Enron fees, an additional $355,000 lump sum to Leslie as spousal support. The MSA expressly specified that the obligation to make the $335,000 payment would terminate upon Leslie’s death.

Georgiou received a referral fee of $55 million from the Enron litigation spread out from 2008 to 2010. He paid the $355,000 to Leslie in 16 separate payments from 2006 to 2007. He deposited the 2009 Enron payment to Leslie into a bank account that had both his name and Leslie’s on it. But Leslie credibly testified that she had no control over the account: she wasn’t given any checks to sign from the account, and her impression of the payment was that it wasn’t yet legally hers. In January of 2010, she filed a petition in state court to gain control of the account, which Georgiou opposed, and the state court at first refused to grant. The Tax Court noted that it was not clear from the record when or if Leslie ever gained control over the account containing the 2009 payment.

On her 2009 tax return, Leslie excluded from taxable income the 2009 Enron litigation payment from Georgiou.

Parties’ positions. Leslie argued that the 2009 Enron litigation payment she received (which didn’t expressly terminate on her death under the MSA) didn’t qualify as alimony and was therefore a nontaxable property settlement. As a fallback position, she argued that even if the amount was taxable, she didn’t receive it in 2009: she did not have control over the bank account; she did not have access to it; and did not even know it existed.

On the other hand, IRS argued that the 2009 payment qualified as alimony under Code Sec. 71 and was thus taxable to Leslie. And, even if Leslie didn’t have knowledge or control over the trust, Georgiou should be considered Leslie’s agent, thus giving her constructive receipt over the funds.

Tax Court decision. The Tax Court held that the 2009 payment qualified as alimony under Code Sec. 71. While nowhere in the MSA was there a condition that terminated Georgiou’s obligation to pay the contingent referral fee upon Leslie’s death, state law could supply the missing termination-on-death-of-payee condition for alimony under Code Sec. 71(b)(1)(D).

Under then-applicable California law, except as otherwise agreed by the parties in writing, the obligation of a party under an order for the support of the other party terminates upon the death of either party or the remarriage of the other party. The mere failure to include language terminating support upon death was not enough to constitute a waiver. (Cal. Fam Code §4337 (West 2013)) Accordingly, the Tax Court found that by operation of California law, the payments from the Enron settlement would have terminated upon Leslie’s death. (Leslie, TC Memo 2016-171, see “Tax Court rules on alimony and theft loss deduction”)

However, the Tax Court also concluded that there was no constructive receipt and that Leslie did not receive the 2009 Enron payment in the 2009 tax year. The Tax Court noted that it has held that knowledge of funds (something Leslie didn’t have) was necessary for constructive receipt. (Furstenberg, (1984) 83 TC 755) And the fact of her unsuccessful petition to state court to gain control indicated that, even after Leslie became aware that the funds were in an account, she still had no power to get them. Further, there was no evidence suggesting that Georgiou had any authority to act as Leslie’s agent; Georgiou’s interest was adverse to Leslie’s, as shown by his opposition to her state court petition to gain access to the account.

Appellate decision. The Ninth Circuit, affirming the Tax Court, rejected Leslie’s contention that the payments should have been treated as a lump-sum payment not subject to federal income tax under Code Sec. 1041(a).

The Ninth Circuit found that Code Sec. 71(b) plainly applied to the payments at issue:

  • The payments were received “under a …separation instrument”. (Code Sec. 71(b)(1)(A))
  • The separation instrument designated the payments as “taxable to Ms. Leslie and deductible to Mr. Georgiou as spousal support”. (Code Sec. 71(b)(1)(B))
  • Leslie and Georgiou were “not members of the same household at the time such payment[s][were] made”. (Code Sec 71(b)(1)(C))
  • By operation of California law, the liability to make the payments would have ended upon Georgiou’s death. (Code Sec. 71(b)(1)(D); Cal. Fam. Code §4337)

The Ninth Circuit noted that Leslie conceded that Code Sec. 71(b) provided the applicable definition of alimony and that the payments in question met the statutory definition of Code Sec. 71(b).

The Court declined Leslie’s invitation to reject the statute’s plain meaning, stating that when a statute has a plain meaning, it is that meaning that the Court applies. (Hughes Aircraft Co. v. Jacobson (S Ct 1999) 525 U.S. 432) Further, the Ninth Circuit stated that courts “do not resort to legislative history to cloud a statutory text that is clear”. (Ratzlaf v. U.S., (S Ct 1994) 510 U.S. 135)

SUPREME COURT ABANDONS PHYSICAL PRESENCE STANDARD…It is a new day !!!

Supreme Court Abandons Physical Presence Standard: An In-Depth Look at South Dakota v. Wayfair

By Sarah Horn (J.D., Editor, Checkpoint Catalyst), Jill McNally (J.D., Editor, Checkpoint), Rebecca Newton-Clarke (J.D., Senior Editor, Checkpoint Catalyst), and Melissa Oaks (J.D., LL.M., Managing Editor, Checkpoint Catalyst)

South Dakota v. Wayfair, Inc., (S Ct 6/21/2018) No. 17-494

On June 21, 2018, the U.S. Supreme Court issued a decision in South Dakota v. Wayfair, overturning the physical presence standard espoused in Quill v. North Dakota, (Sup Ct 1992) 504 U.S. 298, and National Bellas Hess v. Department of Revenue of State of Ill., (Sup Ct 1967) 386 U.S. 753. In a strongly worded opinion, the Court held that the physical presence rule in Quill is an “unsound and incorrect” interpretation of the Commerce Clause that has created unfair and unjust marketplace distortions favoring remote sellers and causing states to lose out on enormous amounts of tax revenue. The Court ruled that the correct standard in determining the constitutionality of a state tax law is whether the tax applies to an activity that has “substantial nexus” with the taxing state. The case involves South Dakota’s economic nexus law, which imposes tax collection and remittance duties on out-of-state sellers meeting gross sales and transaction volume thresholds. In overturning its prior precedents the Court determined that physical presence is not required to meet the “substantial nexus” requirement laid out in Complete Auto Transit, Inc. v. Brady, (Sup Ct 1977) 430 U.S. 274. The Court held that the respondents had established substantial nexus in this case through “extensive virtual presence”.

Since the U.S. Supreme Court’s 1992 decision in Quill v. North Dakota, the standard for whether a state can require an out-of-state retailer to collect and remit sales tax has been physical presence. In Quill, the Court affirmed and elaborated upon its prior decision in National Bellas Hess. A seller had to have property, people, or some other physical connection with a state to be required to collect and remit sales tax. As a complement to the sales tax, states impose use taxes that require the in-state purchaser to pay tax on taxable items on which no sales tax was paid. Very few consumers comply with use tax requirements. With the rise of the digital economy, states began to lose out on significant sales tax revenues because they were unable to tax online/internet sales under physical presence nexus standards.

Following Quill, states have engaged in various nexus expansion gambits. Over the past decade, assertions of click-through nexus (pioneered by New York) and affiliate nexus have become commonplace. When the U.S. Supreme Court denied certiorari in the appeal of the New York high court’s ruling in Overstock.com, Inc. v. New York State Dept. of Taxation and Finance, (2013 NY) 20 N.Y.3d 586, upholding click-through nexus, the states became emboldened. They grew bolder still following dicta by Justice Kennedy in Direct Marking Assn. V. Brohl, (Sup Ct 2015) 135 S Ct 124, suggesting that “There is a powerful case to be made that a retailer doing extensive business within a State has a sufficiently ‘substantial nexus’ to justify imposing some minor tax-collection duty, even if that business is done through mail or the Internet”. He urged the Court to revisit the physical presence standard, contending that “[T]he Internet has caused far-reaching systematic and structural changes in the economy, and…. it is unwise to delay any longer a reconsideration of the Court’s holding in Quill“. At the time, Justice Gorsuch sat on the 10th Circuit, which ultimately decided that case and upheld Colorado’s remote seller notice and reporting requirements irrespective of physical presence. He characterized the physical presence rule as an “analytical oddity” that “seems deliberately designed” to be overturned.

The Wayfair case examines the constitutionality of a 2016 South Dakota economic nexus law (the law) that imposes sales tax collection and remittance requirements on out-of-state sellers delivering more than $100,000 of goods or services into South Dakota or engaging in 200 or more separate transactions for the delivery of goods or services into South Dakota. The law was enacted by the South Dakota legislature as part of an emergency declaration to prevent erosion of the state’s sales tax base. It followed the release of a suggested model economic nexus law from the National Conference of State Legislatures, though it did not conform to the model law entirely. South Dakota does not impose an income tax and therefore relies on sales and use tax revenue to fund essential state services. South Dakota enforced the law by filing a declaratory judgment action against three major online retailers with no physical presence in the state: Wayfair, Newegg, and Overstock. Following state court decisions in favor of the retailers, South Dakota appealed to the U.S. Supreme Court.

Noting that the issue of sales and use tax nexus turns on the interpretation of the Commerce Clause, the Court began its analysis with a lengthy review of its Commerce Clause jurisprudence, going back as far as the early nineteenth century. The Commerce Clause grants Congress the authority to regulate interstate commerce. A negative corollary, often called the Dormant or Negative Commerce Clause, prohibits the states from passing laws that either facially discriminate against or place undue burdens on interstate commerce. In the context of state taxation, the Court endorsed the four-prong test in Complete Auto Transit, which builds upon Commerce Clause principles, as the correct analytical framework. Complete Auto Transit provides that a state tax will be upheld if it

  1. Applies to an activity with substantial nexus with the taxing state,
  2. Is fairly apportioned,
  3. Does not discriminate against interstate commerce, and
  4. Is fairly related to the services the state provides”.

The question, then, is whether an activity must meet Quill’s physical presence standard to have substantial nexus with a taxing state. The Court ruled that it does not. Substantial nexus exists when a taxpayer “avails itself of the substantial privilege of carrying on a business in that jurisdiction”. It can be established on the basis of both “economic and virtual contacts” with a state. In the case of South Dakota’s economic nexus law, the law’s sales volume and dollar amount thresholds were high enough for the Court to find that a seller meeting those thresholds would have clearly availed itself of the privilege of doing business in South Dakota. Further, the Court noted that the specific respondents (Wayfair, Newegg, and Overstock) are large companies that “undoubtedly maintain an extensive virtual presence”. The Court also observed that targeted advertising and electronic sales may allow a business to have substantial virtual connections to a state without traditional physical presence. Interestingly, the Court noted that other functions of e-commerce, such as websites leaving cookies on customer hard drives and apps that can be downloaded on customer phones, may be considered to create almost a physical presence in a taxing state. The court noted the Ohio law and Massachusetts regulation that assert cookie nexus; Iowa recently enacted a law asserting cookie nexus as well. These are discussed in a bit more detail below.

The Court not only overruled the physical presence standards of both Quill and Bellas Hess, but eviscerated the rule that physical presence is required for sales tax nexus. Writing for the majority, Justice Kennedy’s biting commentary on Quill likened the physical presence requirement to a “judicially created tax shelter” that has created marketplace distortions and unfair and unjust incentives to avoid physical presence in various states. Local businesses are put at a significant disadvantage compared to remote vendors. Justice Kennedy noted that the physical presence rule is “artificial in its entirety” and goes against modern Commerce Clause jurisprudence’s emphasis on marketplace dynamics, not “anachronistic formalisms”. Specifically discussing Wayfair, Justice Kennedy described the company’s business model of advertising that it did not have to charge sales tax as a “subtle offer to assist in tax evasion”. Justice Kennedy further mused that Wayfair’s image of selling items for beautifully decorated dream homes would not be possible without solvent local and state governments.

According to Justice Kennedy, although the law passes the Complete Auto Transit test, the question remains “whether some other principle in the Court’s Commerce Clause doctrine might invalidate the it. Because the Quill physical presence rule was an obvious barrier to the law’s validity, these issues have not yet been litigated or briefed, and so the Court need not resolve them here. That said, South Dakota’s tax system includes several features that appear designed to prevent discrimination against or undue burdens upon interstate commerce”.

Practical Effects

The Quill standard has never been easy to implement. In the years since the Court’s 1992 decision, companies have structured companies in creative ways and taken other steps to try to avoid setting a toe into more than one or two jurisdictions.

While Wayfair clearly overturns the physical presence requirement, it does not provide states carte blanche to enact or enforce all forms of economic nexus laws. South Dakota’s law has several features that prevented it from running afoul of Commerce Clause protections:

  1. The law has a safe harbor provision for transacting limited business in the state that does not meet the specific thresholds,
  2. The law is not retroactive, and
  3. South Dakota is a member of the Streamlined Sales and Use Tax Agreement, which reduces administrative and compliance costs for taxpayers and even provides state-funded sales tax administration software.

Other states with economic nexus provisions will need to apply the same test in determining whether those provisions pass constitutional muster.

In recent years, a growing number of states have followed South Dakota and enacted economic nexus laws that intentionally flout the physical presence requirement by asserting nexus based on the number and/or dollar amount of sales into the state. Connecticut, the most recent state to enact an economic nexus law, targets out-of-state sellers making $250,000 in gross receipts and engaging in 200 or more retail sales into Connecticut during a 12-month period. The new nexus standard, which goes into effect on December 1, 2018, also redefines retailers to include marketplace facilitators. Some states, such as Iowa, Ohio, and (through regulations adopted by its taxing agency) Massachusetts, assert the kind of cookie or app nexus discussed by the Court in Wayfair. Each of these states will need to apply the Wayfair test in determining whether its standard is constitutional.

A number of states have also enacted detailed notice and reporting laws for out-of-state sellers. Often these are tied to a dollar threshold of taxable sales into the state. Many are cumbersome and impose stiff penalties for noncompliance. Colorado pioneered this approach, and its law was upheld in Direct Marketing. A handful of states (Georgia, Oklahoma, Pennsylvania, Rhode Island, and Washington) have notice and reporting requirements that are explicitly the default alternative to registering to collect and remit the tax under elective economic nexus provisions.

With the vast majority of states urging the Court to overturn the physical presence rule, the states’ appetite for asserting nexus against out-of-state retailers is not in question. It is important to bear in mind that many states have laws on the books that by their plain language exceed the physical presence standard and assert nexus based on remote solicitation and resulting in-state sales. Traditionally, taxing agencies in those states tended to accept the physical presence standard and have adopted regulations or issued guidance to that effect, but with the physical presence rule eradicated, those are likely to be repealed or rescinded in short order. A number of states have laws asserting nexus to the greatest extent permitted by the U.S. Constitution and federal law.

For example, Florida law broadly defines dealers having nexus with the state to include, among other things, every person who “solicits business either by direct representatives, indirect representatives, or manufacturer’s agents; by distribution of catalogs or other advertising matter; or by any other means whatsoever”, and because of these solicitations receives orders for tangible personal property from consumers for use, consumption, distribution, and storage for use or consumption in the state. (Fla. Stat. § 212.06(2)) A ruling of Florida’s high court limited the law, establishing that the substantial nexus requirements of the Commerce Clause require a dealer to have some type of physical presence in Florida, and more than insubstantial solicitation activities in the state, for the state to assert nexus against the dealer. (Department of Revenue v. Share Intern., Inc. (FN: 676 So.2d 1362 (Fla. 1996))

New York’s nexus law defines an out-of-state vendor having nexus with the state to include a person who solicits business “by distribution of catalogs or other advertising matter, without regard to whether such distribution is the result of regular or systematic solicitation”, if the person has some additional connection with the state that satisfies the nexus requirements of the U.S. Constitution and if because of the solicitation the person makes taxable sales into New York. (N.Y. Tax Law § 1101(b)(8)(i)(E))

Businesses can expect to see rapid expansion of nexus assertions in light of the Wayfair standard. As discussed above, however, the Wayfair decision still places constraints on nexus. Although states like New York and Florida have laws the plain language of which might allow them to make broad assertions of nexus, those states are not members of the Streamlined Sales and Use Tax Agreement (SSUTA). Barring legislative action, taxing agencies in states like these will undoubtedly face challenges if they expand their assertions of nexus to include contacts that do not meet the physical presence rule. Out-of-state retailers lacking physical contacts could successfully argue, under the new Wayfair standard, that the burden of compliance is too high in states that do not conform to the SSUTA. Whether those challenges would succeed is uncertain but far from unlikely.

Given the Court’s conclusion that “physical presence is not necessary to create substantial nexus”, this decision will impact other state taxes, such as corporate income taxes, which could apply to the income of an entity conducting significant business activities in a state without having a physical presence there. Economic nexus laws in the sales and use tax environment are an import from the corporate income tax realm. Most state and federal courts have taken the position that the physical presence standard does not apply in the corporate income tax environment, and many states have been emboldened to enact “factor presence” laws tied to sales, property or payroll in the state. The U.S. Supreme Court has consistently declined to hear challenges to those laws, and with the test announced in Wayfair more states may follow suit. Changes are likely to be especially pronounced in the handful of states that have taken the position that physical presence is necessary for the state to assert corporate income tax nexus against a corporation.

Dissent

In overturning National Bellas Hess and Quill, the Court has effectively overturned half a century of precedent. Dissenting Chief Justice Roberts, joined by Justices Breyer, Sotomayor, and Kagan, took particular note of this fact, observing that departing from the doctrine of stare decisis is “an ‘exceptional action'” requiring a “‘special justification,'” even moreso when the Court is ruling in matters where Congress has “‘primary authority'”. The dissenting Justices pointed out this is the third time the Court has addressed the physical presence standard and state that “[w]hatever salience the adage ‘third time’s a charm’ has in daily life, it a poor guide to Supreme Court decisionmaking”.

Although critical of the Majority’s overruling of those cases, Justice Roberts acknowledged that “Bellas Hess s was wrongly decided”. The dissent expressed concern, however, that discarding the physical-presence rule at a time when e-commerce is flourishing could be disruptive, and contend that any change to the established rules should come from Congress as was stated in Quill.

In response to the majority’s “inexplicable sense of urgency” in overturning established jurisprudence, Chief Justice Roberts also pointed out that many of the “behemoth” online retailers, such as Amazon, have already begun collecting and remitting the tax (regardless of whether they have a physical presence in a state) and that the revenue loss to states is “receding with time”. (p.5) As was the case in Quill, the dissent is concerned with the effect of the ruling on small businesses who will feel the full weight of the Court’s decision.

New Rules to remember.. for deducting Qualified Residential Interest

During the review of your clients 2017 tax return …please remember to let your clients know about certain changes in the rules for deducting qualified residential interest, i.e., interest on your home mortgage, under the Tax Cuts and Jobs Act (the Act).

Under the pre-Act rules, you could deduct interest on up to a total of $1 million of mortgage debt used to acquire your principal residence and a second home, i.e., acquisition debt. For a married taxpayer filing separately, the limit was $500,000. You could also deduct interest on home equity debt, i.e., other debt secured by the qualifying homes. Qualifying home equity debt was limited to the lesser of $100,000 ($50,000 for a married taxpayer filing separately), or the taxpayer’s equity in the home or homes (the excess of the value of the home over the acquisition debt). The funds obtained via a home equity loan did not have to be used to acquire or improve the homes. So you could use home equity debt to pay for education, travel, health care, etc.

Under the Act, starting in 2018, the limit on qualifying acquisition debt is reduced to $750,000 ($375,000 for a married taxpayer filing separately). However, for acquisition debt incurred before Dec. 15, 2017, the higher pre-Act limit applies.

The higher pre-Act limit also applies to debt arising from refinancing pre-Dec. 15, 2017 acquisition debt, to the extent the debt resulting from the refinancing does not exceed the original debt amount. This means your  client  can refinance up to $1 million of pre-Dec. 15, 2017 acquisition debt in the future and not be subject to the reduced limitation.

Please remember …starting in 2018, there is no longer a deduction for interest on home equity debt. This applies regardless of when the home equity debt was incurred. Accordingly, if your client  is  considering incurring home equity debt in the future, they should take this factor into consideration. And if your client  currently has an outstanding home equity debt, please inform them that they will  lose the interest deduction for it, starting in 2018. (They  still will  be able to deduct it on your 2017 tax return, filed in 2018.)

Lastly, both of these changes last for eight years, through 2025.

In 2026, the pre-Act rules are scheduled to come back into effect. So beginning in 2026, interest on home equity loans will be deductible again, and the limit on qualifying acquisition debt will be raised back to $1 million ($500,000 for married separate filers).

My suggestion is to have an in-depth conversation with your client NOW ..as to their debt limited and the net effect to future asset purchases using leverage.

God Luck !!