Category Archives:Newsletter

Jan. 17.

RECENT DEVELOPMENTS THAT MAY AFFECT YOUR TAX SITUATION

RECENT DEVELOPMENTS THAT MAY AFFECT YOUR TAX SITUATION

Business meals…. One of the provisions of the Tax Cuts and Jobs Act (TCJA) disallows a deduction for any item with respect to an activity that is of a type generally considered to constitute entertainment, amusement, or recreation. However, the TCJA did not address the circumstances in which the provision of food and beverages might constitute entertainment.

The new guidance clarifies that, as in the past, taxpayers generally may continue to deduct 50% of otherwise allowable business meal expenses if:
a. The expense is an ordinary and necessary expense paid or incurred during the tax year in carrying on any trade or business;
b. The expense is not lavish or extravagant under the circumstances;
c. The taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages;
d. The food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact; and
e. In the case of food and beverages provided during or at an entertainment activity, the food and beverages are purchased separately from the entertainment, or the cost of the food and beverages is stated separately from the cost of the entertainment on one or more bills, invoices, or receipts.

Convenience of the employer…. IRS provided new guidance under the Code provision allowing for the exclusion of the value of any meals furnished by or on behalf of an individual’s employer if the meals are furnished on the employer’s business premises for the convenience of the employer. IRS determined that the “Kowalski test” — which provides that the exclusion applies to employer-provided meals only if the meals are necessary for the employee to properly perform his or her duties — still applies.

Under this test, the carrying out of the employee’s duties in compliance with employer policies for that employee’s position must require that the employer provide the employee meals for the employee to properly discharge such duties in order to be “for the convenience of the employer”.

While IRS is precluded from substituting its judgment for the business decisions of a taxpayer as to its business needs and concerns and what specific business policies or practices are best suited to addressing such, IRS can determine whether an employer actually follows and enforces its stated business policies and practices, and whether these policies and practices, and the needs and concerns they address, necessitate the provision of meals so that there is a substantial noncompensatory business reason for furnishing meals to employees.

Depreciation and expensing. …IRS provided guidance on deducting expenses under Code Sec. 179(a) and depreciation under the alternate depreciation system (ADS) of Code Sec. 168(g), as amended by the TCJA. The guidance explains how taxpayers can elect to treat qualified real property, as defined under the TCJA, as property eligible for the expense election.

The TCJA amended the definition of qualified real property to mean qualified improvement property and some improvements to nonresidential real property, such as: roofs; heating, ventilation and air-conditioning property; fire protection and alarm systems; and security systems. The guidance also explains how real property trades or businesses or farming businesses, electing out of the TCJA interest deduction limitations, can change to the ADS for property placed in service before 2018, and provides that such is not a change in accounting method. In addition, the guidance provides an optional depreciation table for residential rental property depreciated under the ADS with a 30-year recovery period.

Partnerships… IRS issued final regulations implementing the new centralized partnership audit regime, which is generally effective for tax years beginning after Dec. 31, 2017 (although partnerships could have elected to have its provisions apply earlier). Under the new rules, adjustments to partnership-related items are determined at the partnership level.

The final regulations clarify that items or amounts relating to transactions of the partnership are partnership-related items only if those items or amounts are shown, or required to be shown, on the partnership return or are required to be maintained in the partnership’s books and records. A partner must, on his or her own return, treat a partnership item in a manner that’s consistent with the treatment of that item on the partnership’s return.

The regulations clarify that so long as a partner notifies the IRS of an inconsistent treatment, in the form and manner prescribed by the IRS, by attaching a statement to the partner’s return (including an amended return) on which the partnership-related item is treated inconsistently, this consistency requirement is met, and the effect of inconsistent treatment does not apply to that partnership-related item.

If IRS adjusts any partnership-related items, the partnership, rather than the partners, is subject to the liability for any imputed underpayment and will take any other adjustments into account in the adjustment year. As an alternative to the general rule that the partnership must pay the imputed underpayment, a partnership may elect to “push out” the adjustments, that is, elect to have its reviewed year partners consider the adjustments made by the IRS and pay any tax due as a result of these adjustments.

State & local taxes…. IRS has provided safe harbors allowing a deduction for certain payments made by a C corporation or a “specified pass-through entity” to or for the use of a charitable organization if, in return for such payment, they receive or expect to receive a state or local tax credit that reduces a state or local tax imposed on the entity.

Such payment is treated as meeting the requirements of an ordinary and necessary business expense. For tax years beginning after Dec. 31, 2017, the TCJA limits an individual’s deduction to $10,000 ($5,000 in the case of a married individual filing a separate return) for the aggregate amount of the following state and local taxes paid during the calendar year:
1. Real property taxes;
2. Personal property taxes;
3. Income, war profits, and excess profits taxes, and
4. General sales taxes.

This limitation does not apply to certain taxes that are paid and incurred in carrying on a trade or business or a for-profit activity. An entity will be considered a specified pass-through entity only if:
1. The entity is a business entity other than a C corporation that is regarded for all federal income tax purposes as separate from its owners;
2. The entity operates a trade or business;
3. The entity is subject to a state or local tax incurred in carrying on its trade or business that is imposed directly on the entity; and
4. In return for a payment to a charitable organization, the entity receives or expects to receive a state or local tax credit that the entity applies or expects to apply to offset a state or local tax described in (3), above, other than a state or local income tax.
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Personal exemption suspension…. IRS provided guidance clarifying how the suspension of the personal exemption deduction from 2018 through 2025 under the TCJA applies to certain rules that referenced that provision and were not also suspended. These include rules dealing with the premium tax credit and, for 2018, the individual shared responsibility provision (also known as the individual mandate).

Under the TCJA, for purposes of any other provision, the suspension of the personal exemption (by reducing the exemption amount to zero) is not be considered in determining whether a deduction is allowed or allowable, or whether a taxpayer is entitled to a deduction.

Obamacare hardship exemptions…. IRS guidance identified additional hardship exemptions from the individual shared responsibility payment (also known as the individual mandate) which a taxpayer may claim on a Federal income tax return without obtaining a hardship exemption certification from the Health Insurance Marketplace (Marketplace).

Under the Affordable Care Act (ACA, or Obamacare), if a taxpayer or an individual for whom the taxpayer is liable isn’t covered under minimum essential coverage for one or more months before 2019, then, unless an exemption applies, the taxpayer is liable for the individual shared responsibility payment.

Under the guidance, a person is eligible for a hardship exemption if the Marketplace determines that:
i. He or she experienced financial or domestic circumstances, including an unexpected natural or human-caused event, such that he or she had a significant, unexpected increase in essential expenses that prevented him or her from obtaining coverage under a qualified health plan;
ii. The expense of purchasing a qualified health plan would have caused him or her to experience serious deprivation of food, shelter, clothing, or other necessities; or
iii. He or she has experienced other circumstances that prevented him or her from obtaining coverage under a qualified health plan.
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Certain Obamacare due dates extended…. IRS has extended one of the due dates for the 2018 information reporting requirements under the ACA for insurers, self-insuring employers, and certain other providers of minimum essential coverage, and the information reporting requirements for applicable large employers (ALEs).

Specifically, the due date for furnishing to individuals the 2018 Form 1095-B (Health Coverage) and the 2018 Form 1095-C (Employer-Provided Health Insurance Offer and Coverage) is extended to Mar. 4, 2019. Good-faith transition relief from certain penalties for 2018 information reporting requirements is also extended.

Limitation on deducting business interest expense… IRS has provided a safe harbor that allows taxpayers to treat certain infrastructure trades or businesses (such as airports, ports, mass commuting facilities, and sewage and waste disposal facilities) as real property trades or businesses solely for purposes of qualifying as an electing real property trade or business.

For tax years beginning after Dec. 31, 2017, the TCJA provides that a deduction allowed for business interest for any tax year can’t exceed the sum of:
1. The taxpayer’s business interest income for the tax year;
2. 30% of the taxpayer’s adjusted taxable income for the tax year; plus
3. The taxpayer’s floor plan financing interest (certain interest paid by vehicle dealers) for the tax year.

The term “business interest” generally means any interest properly allocable to a trade or business, but for purposes of the limitation on the deduction for business interest, it doesn’t include interest properly allocable to an “electing real property trade or business”. Thus, interest expense that is properly allocable to an electing real property trade or business is not properly allocable to a trade or business and is not business interest expense that is subject to the interest limitation.
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Avoiding penalties… IRS has identified the circumstances under which the disclosure on a taxpayer’s income tax return with respect to an item or position is adequate for the purpose of reducing the understatement of income tax under the substantial understatement accuracy-related penalty for 2018 income tax returns.

The guidance provides specific descriptions of the information that must be provided for itemized deductions on Form 1040 (Schedule A); certain trade or business expenses; differences in book and income tax reporting; and certain foreign tax and other items.

The guidance notes that money amounts entered on a form must be verifiable, and the information on the return must be disclosed in the manner set out in the guidance. An amount is verifiable if, on audit, the taxpayer can prove the origin of the amount (even if that number is not ultimately accepted by the IRS) and the taxpayer can show good faith in entering that number on the applicable form.

If the amount of an item is shown on a line of a return that does not have a preprinted description identifying that item (such as on an unnamed line under an “Other Expense” category), the taxpayer must clearly identify the item by including the description on that line. If an item is not covered by this guidance, disclosure is adequate with respect to that item only if made on a properly completed Form 8275 (Disclosure Statement) or 8275-R (Regulation Disclosure Statement), as appropriate, attached to the return for the year or to a qualified amended return.

Nov. 02.

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.

 

Oct. 19.

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.

 

Jul. 11.

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)

Jul. 11.

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.

Feb. 06.

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 !!

Jan. 17.

What the House tax bill holds for individuals…. A New “Game”

What the House tax bill holds for individuals

 

H.R. 1, known as the Tax Cuts and Jobs Act, which both houses of Congress passed on Dec. 20, contains a large number of provisions that affect individual taxpayers. However, to keep the cost of the bill within Senate budget rules, all of the changes affecting individuals expire after 2025. At that time, if no future Congress acts to extend H.R. 1’s provision, the individual tax provisions would sunset, and the tax law would revert to its current state.

Here is a look at many of the provisions in the bill affecting individuals.

Tax rates

For tax years 2018 through 2025, the following rates apply to individual taxpayers:

Single taxpayers

Taxable income over But not over Is taxed at
$0 $9,525 10%
$9,525 $38,700 12%
$38,700 $82,500 22%
$82,500 $157,500 24%
$157,500 $200,000 32%
$200,000 $500,000 35%
$500,000   37%

Heads of households

Taxable income over But not over Is taxed at
$0 $13,600 10%
$13,600 $51,800 12%
$51,800 $82,500 22%
$82,500 $157,500 24%
$157,500 $200,000 32%
$200,000 $500,000 35%
$500,000   37%

Married taxpayers filing joint returns and surviving spouses

Taxable income over But not over Is taxed at
$0 $19,050 10%
$19,050 $77,400 12%
$77,400 $165,000 22%
$165,000 $315,000 24%
$315,000 $400,000 32%
$400,000 $600,000 35%
$600,000   37%

Married taxpayers filing separately

Taxable income over But not over Is taxed at
$0 $9,525 10%
$9,525 $38,700 12%
$38,700 $82,500 22%
$82,500 $157,500 24%
$157,500 $200,000 32%
$200,000 $300,000 35%
$300,000   37%

Estates and trusts

Taxable income over But not over Is taxed at
$0 $2,550 10%
$2,550 $9,150 24%
$9,150 $12,500 35%
$12,500   37%

Special brackets will apply for certain children with unearned income.

 

The system for taxing capital gains and qualified dividends did not change under the act, except that the income levels at which the 15% and 20% rates apply were altered (and will be adjusted for inflation after 2018). For 2018, the 15% rate will start at $77,200 for married taxpayers filing jointly, $51,700 for heads of household, and $38,600 for other individuals. The 20% rate will start at $479,000 for married taxpayers filing jointly, $452,400 for heads of household, and $425,800 for other individuals.

Standard deduction: The act increased the standard deduction through 2025 for individual taxpayers to $24,000 for married taxpayers filing jointly, $18,000 for heads of household, and $12,000 for all other individuals. The additional standard deduction for elderly and blind taxpayers was not changed by the act.

Personal exemptions: The act repealed all personal exemptions through 2025. The withholding rules will be modified to reflect the fact that individuals can no longer claim personal exemptions.

Passthrough income deduction

For tax years after 2017 and before 2026, individuals will be allowed to deduct 20% of “qualified business income” from a partnership, S corporation, or sole proprietorship, as well as 20% of qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income. (Special rules would apply to specified agricultural or horticultural cooperatives.)

A limitation on the deduction is phased in based on W-2 wages above a threshold amount of taxable income. The deduction is disallowed for specified service trades or businesses with income above a threshold.

For these purposes, “qualified business income” means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. These items must be effectively connected with the conduct of a trade or business within the United States. They do not include specified investment-related income, deductions, or losses.

“Qualified business income” does not include an S corporation shareholder’s reasonable compensation, guaranteed payments, or — to the extent provided in regulations — payments to a partner who is acting in a capacity other than his or her capacity as a partner.

“Specified service trades or businesses” include any trade or business in the fields of accounting, health, law, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of one or more of its employees.

The exclusion from the definition of a qualified business for specified service trades or businesses phases out for a taxpayer with taxable income in excess of $157,500, or $315,000 in the case of a joint return.

 

For each qualified trade or business, the taxpayer is allowed to deduct 20% of the qualified business income for that trade or business. Generally, the deduction is limited to 50% of the W-2 wages paid with respect to the business. Alternatively, capital-intensive businesses may get a higher benefit under a rule that takes into consideration 25% of wages paid plus a portion of the business’s basis in its tangible assets. However, if the taxpayer’s income is below the threshold amount, the deductible amount for each qualified trade or business is equal to 20% of the qualified business income for each respective trade or business.

Child tax credit

The act increased the amount of the child tax credit to $2,000 per qualifying child. The maximum refundable amount of the credit is $1,400. The act also created a new nonrefundable $500 credit for qualifying dependents who are not qualifying children. The threshold at which the credit begins to phase out was increased to $400,000 for married taxpayers filing a joint return and $200,000 for other taxpayers.

Other credits for individuals

The House version of the bill would have repealed several credits that are retained in the final version of the act. These include:

  • The Sec. 22 credit for the elderly and permanently disabled;
  • The Sec. 30D credit for plug-in electric drive motor vehicles; and
  • The Sec. 25 credit for interest on certain home mortgages.

The House bill’s proposed modifications to the American opportunity tax credit and lifetime learning credit also did not make it into the final act.

Education provisions

The act modifies Sec. 529 plans to allow them to distribute no more than $10,000 in expenses for tuition incurred during the tax year at an elementary or secondary school. This limitation applies on a per-student basis, rather than on a per-account basis.

The act modified the exclusion of student loan discharges from gross income by including within the exclusion certain discharges on account of death or disability.

The House bill’s provisions repealing the student loan interest deduction and the deduction for qualified tuition and related expenses were not retained in the final act.

The House bill’s proposed repeal of the exclusion for interest on Series EE savings bonds used for qualified higher education expenses and repeal of the exclusion for educational assistance programs also did not appear in the final act.

 

Itemized deductions

The act repealed the overall limitation on itemized deductions, through 2025.

Mortgage interest: The home mortgage interest deduction was modified to reduce the limit on acquisition indebtedness to $750,000 (from the prior-law limit of $1 million).

A taxpayer who entered into a binding written contract before Dec. 15, 2017, to close on the purchase of a principal residence before Jan. 1, 2018, and who purchases that residence before April 1, 2018, will be considered to have incurred acquisition indebtedness prior to Dec. 15, 2017, under this provision, meaning that he or she will be allowed the prior-law $1 million limit.

Home-equity loans: The home-equity loan interest deduction was repealed through 2025.

State and local taxes: Under the act, individuals are allowed to deduct up to $10,000 ($5,000 for married taxpayers filing separately) in state and local income or property taxes.

The conference report on the bill specifies that taxpayers cannot take a deduction in 2017 for prepaid 2018 state income taxes.

Casualty losses: Under the act, taxpayers can take a deduction for casualty losses only if the loss is attributable to a presidentially declared disaster.

Gambling losses: The act clarified that the term “losses from wagering transactions” in Sec. 165(d) includes any otherwise allowable deduction incurred in carrying on a wagering transaction. This is intended, according to the conference report, to clarify that the limitation of losses from wagering transactions applies not only to the actual costs of wagers, but also to other expenses the taxpayer incurred  in connection with his or her gambling activity.

Charitable contributions: The act increased the income-based percentage limit for charitable contributions of cash to public charities to 60%. It also denies a charitable deduction for payments made for college athletic event seating rights. Finally, it repealed the statutory provision that provides an exception to the contemporaneous written acknowledgment requirement for certain contributions that are reported on the donee organization’s return — a prior-law provision that had never been put in effect because regulations were never issued.

Miscellaneous itemized deductions: All miscellaneous itemized deductions subject to the 2% floor under current law are repealed through 2025 by the act.

Medical expenses: The act reduced the threshold for deduction of medical expenses to 7.5% of adjusted gross income for 2017 and 2018.

 

 

Other provisions for individuals

Alimony: For any divorce or separation agreement executed after Dec. 31, 2018, the act provides that alimony and separate maintenance payments are not deductible by the payer spouse. It repealed the provisions that provided that those payments were includible in income by the payee spouse.

Moving expenses: The moving expense deduction is repealed through 2025, except for members of the armed forces on active duty who move pursuant to a military order and incident to a permanent change of station.

Archer MSAs: The House bill would have eliminated the deduction for contributions to Archer medical savings accounts (MSAs); the final act did not include this provision.

Educator’s classroom expenses: The final act did not change the allowance of an above-the-line $250 deduction for educators’ expenses incurred for professional development or to purchase classroom materials.

Exclusion for bicycle commuting reimbursements: The act repealed through 2025 the exclusion from gross income or wages of qualified bicycle commuting expenses.

Sale of a principal residence: The act did not change the current rules regarding exclusion of gain from the sale of a principal residence.

Moving expense reimbursements: The act repealed through 2025 the exclusion from gross income and wages for qualified moving expense reimbursements, except in the case of a member of the armed forces on active duty who moves pursuant to a military order.

IRA recharacterizations: The act excludes conversion contributions to Roth IRAs from the rule that allows IRA contributions to one type of IRA to be recharacterized as a contribution to the other type of IRA. This is designed to prevent taxpayers from using recharacterization to unwind a Roth conversion.

Estate, gift, and generation-skipping transfer taxes

The act doubles the estate and gift tax exemption for estates of decedents dying and gifts made after Dec. 31, 2017, and before Jan. 1, 2026. The basic exclusion amount provided in Sec. 2010(c)(3) increased from $5 million to $10 million and will be indexed for inflation occurring after 2011.

 

 

Individual AMT

While the House version of the bill would have repealed the alternative minimum tax (AMT) for individuals, the final act kept the tax, but increased the exemption.

For tax years beginning after Dec. 31, 2017, and beginning before Jan. 1, 2026, the AMT exemption amount increases to $109,400 for married taxpayers filing a joint return (half this amount for married taxpayers filing a separate return) and $70,300 for all other taxpayers (other than estates and trusts). The phaseout thresholds are increased to $1 million for married taxpayers filing a joint return and $500,000 for all other taxpayers (other than estates and trusts). The exemption and threshold amounts will be indexed for inflation.

Individual mandate

The act reduces to zero the amount of the penalty under Sec. 5000A, imposed on taxpayers who do not obtain health insurance that provides at least minimum essential coverage, effective after 2018.

Alistair M. Nevius (Alistair.Nevius@aicpa-cima.com) is The Tax Adviser’s editor-in-chief, tax.

 

Mar. 27.

President Trump’s first executive order targets Obamacare… How do we proceed ?

2017 Health Care Reform: President Trump’s first executive order targets Obamacare

President Trump’s first executive order, signed hours after taking office, stated his intent to seek prompt repeal of the Affordable Care Act (ACA) and, pending repeal, directed agency and department heads to exercise all authority and discretion available to them to minimize the ACA’s impact.

Although the executive order does not itself undo or repeal the ACA, it nonetheless delivers a strong statement on the direction that Trump wants to go and his ideal timeframe.

Specifically, the executive order directed the Secretary of Health and Human Services  Tom Price,  and other department and agency heads to exercise all available authority and discretion to “waive, defer, grant exemptions from, or delay the implementation of any provision or requirement of the Act that would impose a fiscal burden on any State or a cost, fee, tax, penalty, or regulatory burden on individuals, families, healthcare providers, health insurers, patients, recipients of healthcare services, purchasers of health insurance, or makers of medical devices, products, or medications”.

The order also directed the HHS Secretary and other department heads to provide flexibility to the States and “encourage the development of a free and open market in interstate commerce for the offering of healthcare services and health insurance”.

Although Trump did not specify which parts of the program would be affected by his order, Kellyanne Conway, counselor to the president, said on ABC’s “This Week” program that President Trump “may stop enforcing the individual mandate”.

According to Reuters, healthcare experts have been speculating that President Trump could do this by expanding the exemptions to the mandate.

Although the Trump Administration, and HHS can’t simply repeal the individual mandate—which is law passed by Congress and signed by President Obama—they could make the regulatory exemptions from it so broad that the mandate (which is a critical component of the ACA) is weakened, if not completely ineffective.

Trump’s administration could also decide to delay or not enforce the employer mandate, experts said, or it could alter, or fail to enforce, requirements that insurers cover a basic set of health benefits in all of their plans, from maternity and newborn care to mental health services.

 Back in 2013, the Obama Administration used its executive authority to delay the employer mandate…

Make sure your clients understand that the Affordable care Act is still an enforceable statue.  The IRS can and will take action in the future to enforce its provisions.

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Over the weekend… David Morgan and Richard Cowan of Reuters expressed the following observations about the events in the U. S. House of Representatives that recently happened on March 24, 2017…

“President Donald Trump failed on Thursday to convince enough skeptical members of his own Republican Party to begin dismantling Obamacare, forcing the House of Representatives to delay a vote on the healthcare legislation.

The day was designed to be a big symbolic win for conservatives, with Trump and House Republican leaders planning the vote on the seventh anniversary of former Democratic President Barack Obama signing his namesake healthcare law, formally known as the Affordable Care Act, which became a favored target of Republicans.

Instead, the vote was postponed indefinitely, dealing a setback to Trump in what he hoped would be his first legislative victory. His staff and allies had billed him as “the closer” for high-stakes negotiations with lawmakers.

The House replacement plan, formally called the American Health Care Act, would rescind the taxes created by Obamacare, repeal a penalty against people who do not buy coverage, slash funding for the Medicaid program for the poor and disabled, and modify tax subsidies that help individuals buy plans.

Conservative Republicans objected to the bill because they thought it did not go far enough, and was too similar to Obamacare. Moderate Republicans thought it was too hard on their constituents.

Groups of lawmakers from both camps have met with Trump, and a gathering of moderates known as the “Tuesday Group” was still set to meet with him at the White House on Thursday.

The Republicans have a majority in the House but because of united Democratic opposition, can afford to lose only 21 Republican votes. As of Thursday morning, NBC News said that 30 Republicans had planned to vote “no” or were leaning that way.

With this delay, House of Representatives Speaker Paul Ryan and his Republican leadership team will continue to search for ways to alter the legislation and bring it to a vote.

Even if it does get approval from the House, the legislation faces a potentially tough fight in the Republican-controlled Senate.

The House and Senate had hoped to deliver a new healthcare bill to Trump by April 8, when Congress is scheduled to begin a two-week spring break.

The delay in the house vote is likely to contribute to the ups and downs that have marked hospitals and some insurers for the past month. Most Wall Street analysts are expecting hospital and insurer stocks to be volatile as the likelihood of new healthcare legislation rises and falls.

The nonpartisan Congressional Budget Office estimated 14 million people would lose medical coverage under the Republican plan by next year. It also said 24 million fewer people would be insured by 2026. “…

######

The take away from both occurrences for our clients is to make sure they are aware of the potential penalties of not carrying health insurance and the need to adhere to the ACA rules and regulations.

We may hear additional direction from Secretary of Health and Human Services Tom Price in the near future…so stay alert as to what changes may affect our tax planning form 2017.

Mar. 10.

2017 Health Care Reform: Draft Republican bill …off we go !!

2017 Health Care Reform: Draft Republican bill would replace Obamacare and include age-based health insurance credit

Draft budget reconciliation bill for 2017 fiscal year (Feb. 10, 2017)..” We have to start somewhere..”

A draft reconciliation bill that was recently leaked to the press provides significant insight into the Republican strategy to repeal and replace the Affordable Care Act (ACA, or Obamacare). The bill would repeal the individual and employer mandates and the premium tax credit and enact a new health insurance coverage credit that varies depending on the age, rather than the income, of the individual. It would also repeal the 3.8% net investment income tax and the 0.9% additional Medicare surtax.

 Background…Back on January 13, Congress approved a budget reconciliation resolution that instructed the relevant committees—i.e., the House Committee on Ways and Means, the House Energy and Commerce Committee, the Senate Finance Committee, and the Senate Committee on Health, Education, Labor, and Pensions—to come up with legislation by Jan. 27 to repeal the ACA. The effect of this measure was to reduce the necessary Senate votes from 60 to 51 to approve the repeal legislation. This draft bill may well have originated from one of these committees, but there is no indication at this point which committee(s) or politician(s) wrote it or how much support it has. In addition, as the draft is dated February 10th, it may not represent the most recent Republican consensus and any final version, if issued, may contain changes.

ACA repeal. The draft legislation (cited as “Bill Sec.” throughout) would repeal virtually all of the ACA, including the following tax provisions:

  • The individual mandate under Code Sec. 5000A-by making the penalty amounts zero, effective for months beginning after Dec. 31, 2015. (Bill Sec. 205)
  • The employer mandate under Code Sec. 4980H-by reducing the penalty amounts to zero, effective for months beginning after Dec. 31, 2015. (Bill Sec. 206)
  • The premium tax credit under Code Sec. 36B would be repealed for tax years beginning after Dec. 31, 2019, and would be modified for prior years by, among other things, removing the repayment limits for excess advance payments, and modifying the applicable percentage tables in Code Sec. 36B(b)(3) (which essentially determine a taxpayer’s eligibility for the premium tax credit based on the percentage of income that the cost of health insurance premiums represents, for taxpayers with household incomes of 100% to 400% of the federal poverty line) to also take into account the taxpayer’s age. (Bill Secs. 201 – 203)
  • The 3.8% net investment income tax (NIIT) under Code Sec. 1411, effective for tax years beginning after Dec. 31, 2016. (Bill Sec. 218)
  • The 0.9% additional Medicare tax under Code Sec. 3101(b)(2), effective with respect to remuneration received after, and tax years beginning after Dec. 31, 2016. (The draft has a notation stating “[confirm this date]” at the end of the effective date provision.) (Bill Sec. 216)
  • The higher floor for medical expense deductions under Code Sec. 213(a), effective for tax years beginning after Dec. 31, 2016. The 7.5% floor that was previously in place would be restored. (Bill Sec. 215)
  • The small employer health insurance credit under Code Sec. 45R, effective for amounts paid or incurred in tax years after Dec. 31, 2019. (Bill Sec. 204)
  • The limitation on health FSA contributions, for tax years beginning after Dec. 31, 2016. (Bill Sec. 210)
  • The so-called “Cadillac” tax on high cost employer-sponsored health plans under Code Sec. 4980I, effective for tax years beginning after Dec. 31, 2019. (Bill Sec. 207)
  • The exclusion from “qualified medical expenses” of over-the-counter medications, for Health Savings Account (HSA), Archer Medical Savings Account (MSA), Health Flexible Spending Arrangement (FSA), and Health Reimbursement Arrangement (HRA) purposes, effective for amounts paid, and expenses incurred, with respect to tax years beginning after Dec. 31, 2016. (Bill Sec. 208)
  • The increased additional tax on HSAs and Archer MSAs for distributions not used for qualified medical expenses, effective for distributions made after Dec. 31, 2016. (Bill Sec. 209) The percentages would be reduced from 20% to 10% and 15%, respectively.
  • The annual fee imposed on branded prescription drug sales, for calendar years beginning after Dec. 31, 2016 (Bill Sec. 211)
  • The medical device excise tax under Code Sec. 4191, for sales after Dec. 31, 2017. (Bill Sec. 212)
  • The annual fee on health insurance providers, for sales after Dec. 31, 2016. (Bill Sec. 213)
  •  Update…This fee is currently suspended for the 2017 calendar year.
  • The elimination of a deduction for expenses allocable to Medicare Part D subsidy under Code Sec. 139A, effective for tax years beginning after Dec. 31, 2016. (Bill Sec. 214)
  • The 10% tanning tax under Code Sec. 5000B, effective for services performed after Dec. 31, 2016. (Bill Sec. 217)
  • The disallowance under Code Sec. 162(m)(6) of any deduction for “applicable individual remuneration” in excess of $500,000 paid to an applicable individual by certain health insurers, for tax years beginning after Dec. 31, 2016. (Bill Sec. 219)
  • A number of provisions relating to the economic substance rules, effective for transactions entered into, and to underpayments, understatements, or refunds and credits attributable to transactions entered into, after Dec. 31, 2016, including:
    1. The codification of the economic substance doctrine under Code Sec. 7701(o),
    2. The Code Sec. 6662(b)(6) penalty for transactions lacking economic substance,
    3. The Code Sec. 6662(i) increased penalty for nondisclosed noneconomic substance transactions, and
    4. The Code Sec. 6664(c)(2) and Code Sec. 6664(d)(2) exclusions from the reasonable cause and good faith exceptions to the accuracy-related and fraud penalties for transactions lacking economic substance. (Bill Sec. 220)

Replacement. The bill would create a new Code Sec. 36C refundable tax credit for health insurance coverage. The credit would generally equal the lesser of the sum of the applicable monthly credit amounts (below) or the amount paid by the taxpayer for “eligible health insurance” for the taxpayer and qualifying family members. It would be subject to a $14,000 aggregate annual dollar limitation with respect to the taxpayer and the taxpayer’s qualifying family members. Monthly credit amounts would be taken into account only with respect to the five oldest qualifying individuals of the family.

The monthly credit amount with respect to any individual for any “eligible coverage month” (in general, a month when the individual is covered by eligible health insurance and is not eligible for “other specified coverage”, such as coverage under a group health plan or under certain governmental programs, like Medicare and Medicaid) during any tax year would be 1/12 of:

  1. $2,000 for an individual who has not attained age 30 as of the beginning of the tax year;
  2. $2,500 for an individual age 30 – 39;
  3. $3,000 for an individual age 40 – 49;
  4. $3,500 for an individual age 50 – 59; and
  5. $4,000 for an individual age 60 and older.

The above amounts, which are available to qualified individuals regardless of their income levels, would be subject to annual inflation adjustments.

The bill also provided special rules for, among other things, coordinating the credit with the medical expense deduction under Code Sec. 213, and calculating the credit where the taxpayer (or any qualifying family member) has a “qualified small employer health reimbursement arrangement” under Code Sec. 9831(d)(2) (see Weekly Alert ¶ 14 12/15/2016 and ¶ 22 for more details on small employer HRAs). (Bill Sec. 221(a)

The bill would also create a new Code Sec. 7529, which would direct a number of Agency heads to consult and establish a program for making payments to providers of eligible health insurance for taxpayers eligible for the new Code Sec. 36C credit. It would also create a new Code Sec. 7530, which would provide a mechanism under which “excess” credit amounts (generally, the amount, if any, by which the credit amount exceeds the amount paid for coverage) can, at the taxpayer’s request, be contributed to a designated HSA of the taxpayer. (Bill Sec. 221(b)) Reporting requirements relating to the health insurance coverage credit would be provided by new Code Sec. 6050X, and penalties for failure to meet the requirements would be added to Code Sec. 6724(d). (Bill Sec. 221(c))

The above provisions pertaining to the new health insurance coverage credit would apply to tax years beginning after Dec. 31, 2019.

In addition, the bill would add a new subsection, Code Sec. 106(h), which would require the inclusion in income of “excess coverage” under employer-provided health coverage. Essentially, a taxpayer would be required to include in gross income the amount for any month by which his or her “specified employer-provided health coverage” for that month exceeds 1/12 of the “annual limitation”, which is an amount determined by IRS to be equal to the 90th percentile of annual premiums for self-only, or other-than-self-only, coverage in 2019 (and adjusted for inflation thereafter). (Bill Sec. 222) Specific rules for computing the total amount of coverage, such as the treatment of health FSAs, as well as exceptions, are provided.

A similar provision would be added to limit the deduction of health insurance costs by self-employed individuals to the 90th percentile amount. (Code Sec. 162(l)(2)) (Bill Sec. 222)

The above provisions would be effective for tax years beginning after Dec. 31, 2019.

The bill would also:

  • Increase the maximum HSA contribution limit to the sum of the amount of the deductible and out-of-pocket limitation, effective for tax years beginning after Dec. 31, 2017; (Bill Sec. 223)
  • Allow both spouses to make “catch-up contributions” to the same HSA, effective for tax years beginning after Dec. 31, 2017; (Bill Sec. 225)
  • Provide a special rule under which, if an HSA is established within 60 days of the date that certain medical expenses are incurred, it will be treated as having been in place for purposes of determining if the expense is a “qualifying medical expense”. (Bill Sec. 226)

Observations…As you can see this bill will take a lot of twists and turns before we get a FINAL  Health care bill.

At first blush..it is a start! Not a final product..

STAY TUNED…!!!

. . . . . . . . . .

Oct. 29.

Tax Court concludes shareholder intended his advances to be loans…. NOT compensation. !

What are the factors that an owner of a closely held “S corporation “must recognize to avoid repayments of personal expenses as ‘compensation’…REALLY !

Scott Singer Installations, Inc., TC Memo 2016-161TC Memo 2016-161

The Tax Court has concluded that an S corporation’s payment of personal expenses on behalf of its sole shareholder/officer should not be characterized as wages subject to federal employment taxes. Instead, the Court found that they were repayments of loans made to the S corporation.

Background. The proper characterization of transfers by shareholders to corporations, as either loans or capital contributions, is made by reference to all the evidence, and the burden of proving that a transfer is a loan falls on the taxpayer. (Dixie Dairies Corp., (1980) 74 TC 47674 TC 476)

Courts have established a nonexclusive list of factors to consider when evaluating the nature of transfers of funds to closely held corporations. Such factors include:

  1. The names given to the documents that would be evidence of the purported loans;
  2. The presence or absence of a fixed maturity date;
  3. The likely source of repayment;
  4. The right to enforce payments;
  5. Participation in management as a result of the advances;
  6. Subordination of the purported loans to the loans of the corporation’s creditors;
  7. The intent of the parties;
  8. The capitalization of the corporation;
  9. The ability of the corporation to obtain financing from outside sources;
  10. Thinness of capital structure in relation to debt;
  11. Use to which the funds were put;
  12. The failure of the corporation to repay; and
  13. The risk involved in making the transfers. (Calumet Indus., Inc., (1990) 95 TC 25795 TC 257)

That is, the inquiry before a court is “whether the transfer… constitutes risk capital entirely subject to the fortunes of the corporate venture or a strict debtor-creditor relationship”. ( Dixie Dairies Corp. ) Transfers to closely-held corporations by controlling shareholders are generally subject to heightened scrutiny.

Facts. Richard Scott Singer was the sole shareholder and president of an S corporation called Scott Singer Installations, Inc. (the corporation), and served as its sole corporate officer. The corporation was primarily engaged in servicing, repairing, and modifying recreational vehicles; it also sold cabinets used in the construction of homes. Mr. Singer worked full time for the corporation and occasionally employed a service technician, two laborers, and an individual to help with the corporation’s Internet sales.

Between 2006 and 2008, Mr. Singer advanced a total of $646,443 to the corporation to fund business growth. The corporation struggled from 2009 to 2011 and Mr. Singer borrowed another $513,099, which he advanced to the corporation. Mr. Singer also began charging business expenses to personal credit cards. The corporation reported operating losses of $103,305 for 2010 and $235,542 for 2011. During these years, the corporation paid $181,872 of Mr. Singer’s personal expenses by making payments from its bank account to Mr. Singer’s creditors.

All of the advances were reported as shareholder loans on the corporation’s general ledgers and Form 1120S (U.S. Income Tax Return for an S Corporation), but there were no promissory notes between Mr. Singer and the corporation, there was no interest charged, and there were no maturity dates imposed. The corporation did not deduct the payment of Mr. Singer’s personal expenses on Form 1120S.

The corporation filed Form 940 (Employer’s Annual Federal Unemployment (FUTA) Tax Return) and Forms 941 (Employer’s Quarterly Federal Tax Return) and paid employment taxes on wages paid to each employee except Mr. Singer (the corporation did not report paying wages to Mr. Singer during 2010 or 2011).

On audit, IRS determined that Mr.  Singer was an employee of the corporation for 2010 and 2011 and that the $181,872 in payments the corporation made on his behalf constituted wages that should have been subject to employment taxes. Mr. Singer did not object to being classified as an employee of the corporation, but contended that the advances that he made to the corporation were loans and that the payments the corporation made on his behalf represented repayments of those loans. IRS, on the other hand, argued that the funds advanced to the corporation were contributions to capital.

Tax Court’s decision. , that his intention was reasonable for a substantial portion of the advances, and that the corporation’s repayments of those loans were valid and should not be characterized as wages subject to employment taxes.

The Court said that there were a number of factors involved when evaluating the nature of transfers of funds to closely held corporations. It believed that the ultimate question was whether there was a genuine intention to create a debt, with a reasonable expectation of repayment, and whether that intention comported with the economic reality of creating a debtor-creditor relationship. If there was a genuine intention to create a debt, the corporation’s payment of Mr. Singer’s personal expenses could be considered as partial repayment of Mr. Singer’s loans rather than as wage income.

The Court noted that the corporation consistently reported the advances as loans on its general ledgers and on Forms 1120S. The corporation also consistently reported the expenses it was paying on behalf of Mr. Singer as a repayment of shareholder loans rather than reporting the payments as deductible business expenses. The Court said this indicated that Mr. Singer and the corporation intended to form a debtor-creditor relationship and that the corporation conformed to that intention. In addition, the Court pointed out that the corporation’s payments on behalf of Mr. Singer were consistent regardless of the value of the services Mr. Singer provided to the corporation.

Many of the payments the corporation made were for Mr. Singer’s recurring monthly expenses, including home mortgage and personal vehicle loan payments. The consistency of these payments, both in time and in amount, was characteristic of a debt repayment. Furthermore, the fact that the corporation made payments when it was operating at a loss strongly suggested that a debtor-creditor relationship existed: a creditor expects repayment of principal and compensation for the use of money, while an investor understands that any return of his investment depend on the success of the business.

The Court also said that Mr. Singer had a reasonable expectation of repayment of the advances when he first advanced funds to the corporation between 2006-2008. At that time, the business was well-established and successful. The Court believed that because the corporation was operating profitably and showed signs of growth, Mr. Singer was reasonable in assuming his loans would be repaid and that such intention comported with the economic reality of creating a debtor-creditor relationship.

The Court, however, did not believe Mr. that Singer had a reasonable expectation that the loans he made after 2008 would be repaid as the corporation’s business had dropped off sharply. It therefore concluded that the advances made in 2008 and earlier were bona fide loans and that advances made after 2008 were capital contributions.

Take away ..This is just another case in which the IRS has focused on the factors that a closely held corporation must follow to avoid  officers compensation on personal expenses and loans incurred by the corporation shareholders.   

Be careful to document all your actions and confirm your expectations as to the treatment of these items in your corporation  minutes.