Planning Opportunities for New 3.8-Percent Medicare Tax Using S Corporations

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Planning Opportunities for New 3.8-Percent Medicare Tax Using S Corporations

The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act implemented Code Sec. 1411, which imposes a new 3.8-percent Medicare tax on unearned income of higher-income individuals. The tax will take effect January 1, 2013, and applies to the net investment income of individuals, estates, and trusts that exceeds specified thresholds. Although the tax does not apply to corporations, it will apply to dividends and other passive income derived from corporations.

Because the tax on net investment income applies to individuals, it may apply to amounts received by individuals from passthrough entities, such as partnerships, limited liability companies, and S corporations. Under general principles, items of income that flow through a partnership, S corporation, or limited liability company (LLC) to partners, shareholders, or members retain their character. Thus, for example, interest income earned by a partnership is still characterized as interest when it passes through to a partner.

Net Investment Income

The tax, known as the Medicare contribution tax, equals 3.8 percent of the lesser of (1) an individual’s net investment income or (2) the excess of the individual’s modified adjusted gross income (AGI) over the threshold amount. The thresholds are $250,000 for married taxpayers filing a joint return; $125,000 for married taxpayers filing a separate return; and $200,000 for all other taxpayers.

Trusts and estates are subject to a much lower threshold. They should strive to distribute their income to their individual beneficiaries to minimize the tax.

The tax does not apply to non-resident aliens, charitable trusts, or corporations.

Net investment income includes gross income from interest, dividends, royalties, and rents, as well as net gain from the disposition of property, unless such income is derived from a passive activity. The tax also applies to other gross income from a trade or business that is a passive activity. Thus, the application of the tax depends on the character of the amounts and the treatment of amounts received from these entities.

Passive Activities

The tax applies to passive income, which is income from a trade or business that is a passive activity under Code Sec. 469. An activity is passive if it involves the conduct of a trade or business in which the taxpayer does not materially participate. Very generally, material participation exists if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis. Accordingly, if the individual materially participates in the entity’s business, the tax on net investment income does not apply to income from the entity. If the individual does not materially participate, the income is characterized as passive and may be subject to the tax under Code Sec. 1411(c)(2).

A sole proprietor by definition manages his or her business. Thus, the sole proprietor materially participates in his or her business and would not have to pay the 3.8-percent tax on income of the proprietorship.

Income from a partnership, S corporation, or LLC is often characterized as passive income if the individual does not materially participate in the business of the entity. In the past, passive income was seen as beneficial, because it could be used to offset passive losses. Thus, in the past, taxpayers have desired passive income and may even have planned for it. Now, because of the net investment income tax, certain taxpayers may prefer not to have income characterized as passive.

Social Security Taxes

Employees generally are subject to Social Security (FICA or SECA) taxes on their wage income, amounting to 7.65 percent contributed by the employee and the employer. This also applies to wages paid to partners. Self-employed individuals pay a similar tax (15.3 percent, which includes both the employee’s and the employer’s shares) on their business income. This income is characterized as net earnings from self employment.

The current payroll tax holiday has reduced an employee’s employment tax share to 5.65 percent (13.3 percent for self-employed). Absent further legislation, the rates will revert to their previous levels in 2013.

Net earnings from self-employment are specifically excluded from being characterized as net investment income (Code Sec. 1411(c)(6)). This eliminates the possibility of an individual being subject to Medicare taxes on both earnings and unearned income.

Partnership Income

Earnings or business income derived from a partnership, which flows through the entity to the general partners, is characterized as net earnings from self-employment. Therefore, it is subject to self-employment tax, and is not subject to the 3.8-percent tax on net investment income.

Income that flows through to the limited partners is not treated as net earnings from self-employment. It will be subject to the 3.8-percent net investment income tax, but not the Social Security tax.

If the same individual is both a general partner and a limited partner, the characterization of the income is not so clear and likely will be subject to greater examination by the IRS.

S Corporation Income

Unlike a partnership, an S corporation’s income that passes through to its owners (its shareholders) is not per se characterized as net earnings from self-employment, because dividends on shares of stock issued by the S corporation are excluded from this characterization. Similarly, normal distributions actually made by an S corporation to its shareholders are not treated as net earnings from self-employment. However, this contrasts with distributions that are payments of wages to shareholder-employees, which are subject to Social Security taxes.

Thus, shareholder-employees can avoid Social Security taxes by withdrawing funds from the S corporation as a distribution, rather than as wages. However, if the employee takes no salary or an unreasonably low salary, the courts generally have supported the IRS in recharacterizing at least a portion of the distributions as wages subject to Social Security taxes.

Income that passes through to S corporation shareholders, as well as distributions, will be subject to the 3.8-percent Medicare tax unless the shareholder materially participates in the business (i.e., the S corporation’s business is not a passive activity with respect to the shareholder). In the latter case, however, the income may successfully avoid both Social Security taxes and Medicare taxes. Furthermore, gain on the sale or redemption of the S corporation interest likewise should not be net investment income under this interpretation if the shareholder materially participates in the business.

Planning Strategies

With these consequences in mind, taxpayers may now be more inclined to establish an S corporation to run their business as long as they are materially involved in the operation of the business and pay reasonable salaries to shareholder-employees. This can be accomplished with a variety of structures.

The basic structure is to operate the business through an S corporation or through an LLC that elects to be taxed as an S corporation. The shareholder-owners must be materially involved in the business. Wages paid to shareholder-employees will be subject to Social Security taxes, but distributions, passthrough income, and net gains from the sale or redemption of the shareholder’s interest in the S corporation will not be subject to the net investment income tax.

If a shareholder does not materially participate in the business operations, the net investment income tax will apply to income items paid or distributed to the shareholder (other than wages).

Variations of this basic structure can be used, and the tax consequences should be the same. S corporations can only have one class of stock. An LLC with one class of interests and no preferred income allocations or distributions may elect S corporation treatment for tax purposes and secure this same treatment. Another variation can be used if there are varying interests. An S corporation owned by the business’s operators can become a member of an LLC with other investors who are not eligible to hold S corporation stock (e.g. foreign investors) becoming members of the LLC.

Another possible structure uses a corporation as the manager of an LLC. The corporate manager in this case would have the authority to bind the LLC. A member investing in the LLC as a limited partner would not be subject to self-employment taxes. If involved in the business, the limited partner would not be subject to the net investment income tax. It may not be so clear, however, how to treat an LLC member who is involved in the business for self-employment tax purposes. Finally, a limited partnership with an S corporation as the sole general partner could also obtain these benefits. Income would pass through and the limited partners would qualify for the limited partner exception to self-employment taxes.

The IRS has argued that LLCs should be treated as limited partnerships, but the courts generally have not accepted this analysis.

Under current law, it appears that investors may be able to use the S corporation structure to avoid most Social Security self-employment taxes and the net investment income tax. However, the IRS has yet to issue regulations on the 3.8-percent net investment income tax, and it remains to be seen whether potential IRS guidance on material participation in a business, or other interrelationships between the self-employment tax and net investment income tax provisions under the Code, will affect the use of these structures.

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California Income Tax Update

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An estimated tax underpayment penalty will not be imposed against taxpayers who underpay their estimated California personal income taxes to the extent that the underpayment was created or increased as a result of the personal income tax rate increases just approved by the voters with the passage of Proposition 30. California law contains a safe-harbor provision for underpayments resulting from any provision of law that is chaptered during and operative for the taxable year of the underpayment. Taxpayers will not be required to make any catch-up payments.

Taxpayers should also be aware that the additional mental health tax imposed on taxpayers with taxable incomes above $1 million is not affected by Proposition 30, and taxpayers will still be liable for the additional 1% tax on taxable income above $1 million.

Finally, taxpayers should be aware that the tax imposed on nonresident individuals participating in composite returns filed by corporations and pass-through entities is imposed at the highest marginal tax rate, which is now 12.3% for the 2012—2018 tax years.

Sellers of California real property should note the impact of the increased tax rates on the alternative withholding rate, under which sellers may choose to compute the amount of withholding based on the reportable gain from the sale rather than on a percentage of the total sales price.

Individuals and non-California partnerships making the election must compute the withholding on the reportable gain using the highest marginal personal income tax rate, which has increased to 12.3%. Withholding on amounts paid by a partnership to its foreign partners, which is at the maximum personal income tax rate, is likewise affected.

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Year-End Tax Planning for Business and the Fiscal Cliff

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As a taxpayer, you are facing what is perhaps an unprecedented set of circumstances – the expiration of the tax rates enacted in 2001, the expiration of more than 150 tax provisions and a tax increase of more than $500 billion overall – that could result in a much higher tax liability when you file your next return.

As we edge nearer to the “fiscal cliff,” as it’s being called, several changes are looming, including (but not limited to) a possible increase on long-term capital gains, restrictions on  itemized deductions, reinstatement of the full payroll tax, and an increase in both the estate tax rate and the number of estates that will be subject to the estate tax. In addition, a new 3.8% surtax on some investment income will become effective Jan. 1, 2013.

Many of these changes will have an impact on small businesses and call for tax planning and possible actions now to soften the potential burden [particularly if you operate as a pass-through entity as many tax increases will affect individuals]. For example, if you are planning to sell appreciated business assets, doing so before the end of 2012 may help avoid the higher capital gains tax. Please come in at your earliest convenience so we can discuss your tax situation and develop a strategy that makes sense for you.

Deductible Business Expenses – How Will You be Affected?

Under Section 179 of the tax code, small businesses can deduct the total cost of some qualifying property in the year it is placed in service, within certain limits, rather than depreciating it over time. The limit on the cost of property (including real property) that can be expensed is now $139,000. The total value of the equipment purchased cannot be higher than $560,000.

As of Jan. 1, 2013, the expensing limit is set to drop and real property, some of which is allowed now, will no longer be included. As a result, businesses may want to consider making equipment or property purchases before year-end to take advantage of the higher expense amount. What may be critical to taking advantage of section 179 election is whether the equipment can be put into service before Jan. 1, 2013.

Also, with the expiration of current 50% first-year bonus depreciation allowance, businesses will have to revert to the modified accelerated cost recovery system to calculate depreciation, meaning that more costs will have to be deducted over time rather than immediately.

Pass-Through Entities

As a pass-through entity, there are several other issues to consider since you pay your business taxes as an individual, including:

  • The return of the phase-out for itemized deductions for a taxpayer who has adjusted gross income over roughly $175,000 as well as a phase-out of personal exemptions for taxpayers with income over a certain level. Each one would limit the amount of allowable deductions and raise the taxpayer’s net taxable income.
  • The lowest individual income tax rate will rise from 10% to 15% and all other individual rates will also edge up.
  • Due to an expiring Bush-era tax cut, a broader marriage penalty will mean higher tax bills for married couples. Instead of the current 200%, the standard deduction for married couples filing jointly will fall to 167% of the standard deduction for single taxpayers.
  • The alternative minimum tax (AMT) will apply to 2012 income for many more Americans if not indexed for inflation. At the end of 2011, the AMT exemption was $74,450 for married taxpayers and $48,450 for singles. It is set to fall to $45,000 for joint filers and $33,750 for single filers. Taxpayers are also set to lose the ability to offset their AMT bite with personal tax credits.
  • The credit for Research and Experimentation Expenses, worth up to 20% of qualified costs, expired at the end of 2011 and has not been extended.

We also want to remind you that business owners and self-employed individuals need to:

  • Obtain tax identification numbers for all the individuals to whom they send Forms 1099-Misc
  • Closely review their estimated tax calculations in light of any tax changes that occur

Azran Financial can help you review those calculations to understand the effect these possible increases could have on your tax situation. Please contact us today at (310) 691-5040 or (818) 691-1234, or e-mail us at info@azran.mycloudserver.online to schedule an appointment to develop strategies to minimize the impact of this uncertain tax climate on your business.

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Arrangements that Recharacterize Taxable Wages as Nontaxable Reimbursements or Allowances

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The IRS has provided guidance which clarifies that an arrangement that recharacterizes taxable wages as nontaxable reimbursements or allowances does not satisfy the business connection requirement for accountable expense reimbursement plans.

In general, employee business expense reimbursements that are paid through an employer’s accountable expense reimbursement plan are excluded from the employee’s adjusted gross income. An accountable plan basically requires employees to submit receipts for expenses and repay any advances that exceed substantiated expenses. Amounts paid to employees through an accountable plan are not taxable compensation. Thus, they are not subject to federal or state income taxes or Social Security taxes, or employer payroll taxes and withholding.

On the other hand, business expense reimbursements paid through a system that does not meet the specific requirements for accountable plans are considered paid under a nonaccountable plan, and are treated as taxable compensation. An employer can have a reimbursement plan that is considered accountable in part and nonaccountable in part.

A reimbursement plan must meet three requirements in order to be considered an accountable expense allowance arrangement

  1. reimbursements must have a business connection;
  2. reimbursements must be substantiated; and
  3. employees must return reimbursements in excess of expenses incurred.

An arrangement satisfies the business connection requirement if it provides advances, allowances, or reimbursements only for business expenses that are allowable as deductions, and that are paid or incurred by the employee in connection with the performance of services as an employee of the employer. Therefore, not only must an employee actually pay or incur a deductible business expense, but the expense must arise in connection with the employment for that employer.

The business connection requirement will not be satisfied if a payor pays an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur deductible business expenses. Failure to meet this reimbursement requirement of business connection is referred to as wage recharacterization because the amount being paid is not an expense reimbursement but rather a substitute for an amount that would otherwise be paid as wages.

The business connection requirement will not be satisfied if a payor pays an amount to an employee regardless of whether the employee incurs or is reasonably expected to incur deductible business expenses. Failure to meet this reimbursement requirement of business connection is referred to as wage recharacterization because the amount being paid is not an expense reimbursement but rather a substitute for an amount that would otherwise be paid as wages.

The IRS guidance includes four situations, three of which illustrate arrangements that impermissibly recharacterize wages such that the arrangements are not accountable plans. A fourth situation illustrates an arrangement that does not impermissibly recharacterize wages. In this arrangement, an employer prospectively altered its compensation structure to include a reimbursement arrangement.

Because of the difference in tax treatment of reimbursements under an accountable plan versus a nonaccountable plan, it is important to review your reimbursement policies. Please call our office for an appointment to discuss your options under this IRS guidance.

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2012 Planning: Tax Solutions for S-Corporations

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An S-corporation, such as yours, is a pass-through entity that is treated very much like a partnership for federal income tax purposes. As a result, all income is passed through to your shareholders and taxed at their individual tax rates. However, unlike a C corporation, an S corporation’s income is taxable to the shareholders when it is earned whether or not the corporation distributes the income. Because an S corporation has a unique tax structure that directly impacts shareholders, it is important for you to understand the S corporation distribution and loss limitations, as well as how and when items of income and expense are taxed, before developing your overall tax plan.

In addition, some S corporation income and expense items are subject to special rules and separate identification for tax purposes. Examples of separately stated items that could affect a shareholder’s tax liability include charitable contributions, capital gains, Sec. 179 expense deductions, foreign taxes, and net income or loss related to rental real estate activities.

These items, as well as income and losses, are passed through to the shareholder on a pro rata basis, which means that the amount passed through to each shareholder is dependent upon that shareholder’s stock ownership percentage. However, a shareholder’s portion of the losses and deductions may only be used to offset income from other sources to the extent that the total does not exceed the basis of the shareholder’s stock and the basis of any debt owed to the shareholder by the corporation. The S corporation losses and deductions are also subject to the passive-activity rules.

Other key points to consider when developing your comprehensive tax strategy include:

the availability of the Code Sec. 179 deduction at the corporate and shareholder level;

  1. reporting requirements for the domestic production activities deduction;
  2. the tax treatment of fringe benefits;
  3. below-market loans between shareholders and S corporations; and
  4. IRS scrutiny of distributions to shareholders who have not received compensation.

We can assist you in identifying and maximizing the potential tax savings. Please call our office at (310) 691-5040 or (818) 691-1234 or e-mail us at info@azran.mycloudserver.online to arrange an appointment.

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2012 Year-End Tax Planning For Businesses

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In recent years, end-of-the-year tax planning for businesses has been complicated by uncertainty over the future availability of many tax incentives. This year is no different.  In 2010, Congress extended many business tax incentives for one or two years. Now, those incentives have expired or are scheduled to expire. Whether they will be extended beyond 2012 is unclear as Congress debates with the fate of the fate of the Bush-era tax cuts and across-the-board spending cuts scheduled to take effect in 2013. In the meantime, you need to be aware of the expiring provisions and explore developing a multiyear tax strategy that takes into account various scenarios for the future of these incentives.

Code Sec. 179 expensing.  Code Sec. 179 gives businesses the option of claiming a deduction for the cost of qualified property all in its first year of use rather than claiming depreciation over a period of years. For 2010 and 2011, the Code Sec. 179 dollar limitation was $500,000 with a $2 million investment ceiling. For 2012, the amounts are less generous. The dollar limitation for 2012 is $139,000 with a $560,000 investment ceiling. Under current law, the Code Sec. 179 dollar limit is scheduled to drop to $25,000 for 2013 with a $200,000 investment ceiling.

Businesses should consider accelerating purchases into 2012 to take advantage of the still generous Code Sec. 179 expensing. Qualified property must be tangible personal property, which you actively use in your business, and for which a depreciation deduction would be allowed. Qualified property must be newly purchased new or used property, rather than property you previously owned but recently converted to business use. Examples of types of property that would qualify for Code Sec. 179 expensing are office equipment or equipment used in the manufacturing process. Additionally, Code Sec. 179 expensing is allowed for off-the-shelf computer software placed in service in tax years beginning before 2013.

If your equipment purchases for the year exceed the expensing dollar limit, you can decide to split your expensing election among the new assets any way you choose. If you have a choice, it may be more valuable to expense assets with the longest depreciation periods. As long as you start using your newly purchased business equipment before the end of the tax year, you get the entire expensing deduction for that year. The amount that can be expensed depends upon the date the qualified property is placed in service; not when the qualified property is purchased or paid for.

Congress could raise the Code Sec. 179 dollar limit and investment ceiling for 2013. In July 2012, the Senate voted to increase the Code Sec. 179 dollar amount to $250,000 with an $800,000 investment limitation for tax years beginning after December 31, 2012. The House voted to increase the Code Sec. 179 dollar amount to $100,000 with a $400,000 investment limitation for tax years beginning after December 31, 2012.

Bonus depreciation.  The 50 percent bonus first-year depreciation deduction is scheduled to expire after 2012 (2013 in the case of certain longer-production period property and certain transportation property). Unlike the Section 179 expense deduction, the bonus depreciation deduction is not limited to smaller companies or capped at a certain dollar level. To be eligible for bonus depreciation, qualified property must be depreciable under Modified Accelerated Cost Recovery System (MACRS) and have a recovery period of 20 years or less. The property must be new and placed in service before January 1, 2013 (January 1, 2014 for certain longer-production period property and certain transportation property).

Businesses also need to keep in mind the relationship of bonus depreciation and the vehicle depreciation dollar limits.  Code Sec. 280F(a) imposes dollar limitations on the depreciation deduction for the year a taxpayer places a passenger automobile in service within a business, and for each succeeding year. Code Sec. 168(k)(2)(F)(i) increases the first-year depreciation allowed for vehicles subject to the Code Sec. 280F luxury-vehicle limits, unless the taxpayer elects out, by $8,000, to which the additional first-year depreciation deduction applies.  The maximum depreciation limits under Code Sec. 280F for passenger automobiles first placed in service by the taxpayer during the 2012 calendar year are: $11,160 for the first tax year ($3,160 if bonus depreciation is not taken); $5,100 for the second tax year; $3,050 for the third tax year; and $1,875 for each tax year thereafter. The maximum depreciation limits under Code Sec. 280F for trucks and vans first placed in service during the 2012 calendar year are $11,360 for the first tax year ($3,360 if bonus depreciation is not taken); $5,300 for the second tax year; $3,150 for the third tax year; and $1,875 for each tax year thereafter. Sport utility vehicles and pickup trucks with a gross vehicle weight rating in excess of 6,000 pounds are exempt from the luxury vehicle depreciation caps.

New de minimis rule in repair regulations.  Comprehensive repair and capitalization regulations issued by the IRS in late 2011 open up a new planning opportunity. A new de minimis expensing rule allows a taxpayer to deduct certain amounts paid or incurred to acquire or produce a unit of tangible property if the taxpayer has an Applicable Financial Statement (AFS), written accounting procedures for expensing amounts paid or incurred for such property under certain dollar amounts, and treats the amounts as expenses on its AFS in accordance with its written accounting procedures. An overall ceiling limits the total expenses that a taxpayer may deduct under the de minimis rule. The de minimis expensing rule applies to amounts paid or incurred (to acquire or produce property) in tax years beginning on or after January 1, 2012.

Let’s look at an example. A taxpayer purchases 10 VoIP phones for its business at $200 each for a total cost of $2,000. Each phone is a unit of property and is not a material or supply. The taxpayer has an applicable financial statement and a written policy at the beginning of the tax year to expense amounts paid for property costing less than $500. The taxpayer treats the amounts paid for the phones as an expense on its applicable financial statement. Assume further that the total aggregate amount treated as de minimis and not capitalized, including the amounts paid for the phones, are less than or equal to the greater of 0.1 percent of total gross receipts or 2 percent of the taxpayer’s  total financial statement depreciation. The result: the de minimis rule applies and the taxpayer is not required to capitalize any portion of the $2,000 paid for the 10 phones.

Dividends.  Under current law, tax-favorable dividends tax rates are scheduled to expire after 2012. Qualified dividends are eligible for a maximum 20 percent tax rate for taxpayers in the 25 percent and higher brackets; zero percent for taxpayers in the 10 and 15 percent brackets. In July, the House voted to extend the current dividend tax treatment through 2013. The Senate, however, voted to extend the tax favorable rates only for individuals with incomes below $200,000 (families with incomes below $250,000). For income in excess of $200,000/$250,000 the tax rate on capital gains and dividends would be 20 percent.

If Congress taxes no action, qualified dividends will taxed at the ordinary income tax rates after 2012 (with the highest rate scheduled to be 39.6 percent not taking into account the 3.8 percent Medicare contribution tax for higher income individuals). Qualified corporations may want to explore declaring a special dividend to shareholders before January 1, 2013

Expired business tax incentives.  Many temporary business tax incentives expired at the end of 2011. In past years, Congress has routinely extended these incentives, often retroactively, but this year may be different. Confronted with the federal budget deficit and across-the-board spending cuts scheduled to take effect in 2013, lawmakers allow some of the business tax extenders to expire permanently. Certain extenders, however, have bipartisan support, and are likely to be extended.  They include the Code Sec. 41 research tax credit, the Work Opportunity Tax Credit (WOTC), and 15-year recovery period for leasehold, restaurant and retail improvement property.

Small employer health insurance credit.  A potentially valuable tax incentive has often been overlooked by small businesses, according to reports. Employers with 10 or fewer full-time employees (FTEs) paying average annual wages of not more than $25,000 may be eligible for a maximum tax credit of 35 percent on premiums paid for tax years beginning in 2010 through 2013. Tax-exempt employers may be eligible for a maximum tax credit of 25 percent for tax years beginning in 2010 through 2013.

The Code Sec. 45R credit is subject to phase-out rules. The credit is reduced by 6.667 percent for each FTE in excess of 10 employees. The credit is also reduced by four percent for each $1,000 that average annual compensation paid to the employees exceeds $25,000. This means that the credit completely phases out if an employer has 25 or more FTEs and pays $50,000 or more in average annual wages.

Let’s look at an example. A for-profit employer has 10 FTEs and pays average annual wages of $250,000 in tax year 2012. The employer’s qualified employee health care costs for tax year 2012 are $70,000. The employer’s Code Sec. 45R credit is $24,500 ($70,000 x 35 percent).

The credit is scheduled to climb to 50 percent of qualified premium costs paid by for-profit employers (35 percent for tax-exempt employers) for tax years beginning in 2014 and 2015. However, an employer may claim the tax credit after 2013 only if it offers one or more qualified health plans through a state insurance exchange.

Today’s uncertainty makes doing nothing or adopting a wait and see attitude very tempting. Instead, multi-year tax planning, which takes into account a variety of possible scenarios and outcomes, should be built into your approach. Please contact our office at (310) 691-5040 or (818) 691-1234 or at info@azran.mycloudserver.online for more details on developing a tax strategy in uncertain times that includes consideration of certain tax-advantaged step that may be taken before year-end 2012.

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Repairs Versus Improvements: New Rules for Deductibility

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The IRS and Treasury have issued long-awaited, comprehensive regulations on the capitalization of amounts paid to acquire, produce or improve tangible property. The regulations, released at the end of 2011 and effective immediately for most taxpayers, provide the standards that businesses must now apply to determine whether expenditures can be deducted as repairs or must be capitalized and then recovered over a period of years.

The regulations are broad and far-reaching – they apply to every business taxpayer that uses tangible property, whether owned or leased, regardless of the form of entity that operates the business, and regardless of the entity’s foreign or domestic status. They apply to manufacturers, wholesalers, distributors, and retailers.

The new regulations have taken effect and steps must be taken to comply with them. They generally apply to amounts paid or incurred in tax years beginning on or after January 1, 2012. Thus, for calendar year taxpayers, the rules already apply. Some of the rules build upon rules already in place; other requirements, however, are completely new. The IRS will take comments and consider further changes, so any plans set forth to respond to these new regulations must themselves be ready for fine tuning. In the meantime, however, the new regulations must be followed precisely or the loss of tax benefits and imposition of penalties can ensue.

The regulations are generally beneficial to most businesses, but they also add complexity. They provide a more defined framework for determining capital expenditures, along with some clarifications of the law and some simplifying conventions. The regulations make significant and substantial changes to previous regulations issued by the government in 2008. In many cases, the tax treatment of an expenditure will vary from its treatment for book purposes, putting an additional burden on taxpayers to apply new tax accounting systems to track and collect data.

The regulations will require many decisions by taxpayers in determining the appropriate tax treatment. In some cases, taxpayers are given an explicit election to decide what type of tax treatment to follow, creating new opportunities as well as challenges. In other cases, taxpayers must make a de facto election. In either case, once the taxpayer adopts a particular method of accounting for particular assets, that business must continue to follow that method of accounting, and will not be able to change it without the IRS’s permission.

There will be more guidance from the IRS. Most taxpayers must now change their method of accounting for certain covered items to comply with the new regulations. The IRS has issued revenue procedures that provide transition rules for taxpayers changing their method of accounting. When changing accounting methods, however, the regulations require that taxpayers make so-called Code Section 481(a) adjustments to prevent duplicated or omitted tax benefits. Because of this requirement, taxpayers will in effect have to apply the new rules to costs incurred prior to the effective date of the regulations. As a result, some taxpayers may have to capitalize amounts they previously deducted, and recognize income based on the difference in treatment. Conversely, other taxpayers may be able to deduct amounts previously capitalized, and take a deduction for the difference. The retroactive impact of these changes can be significant for many businesses.

Our firm is here to help you determine how the regulations affect your business, what you must do to comply, what changes are necessary, what decisions must be made, and what opportunities are available.

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Q2 2012 Update on Federal Tax Law Developments

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During the Second Quarter of 2012, there were many important federal tax developments.

Health care legislation

In a 5-4 decision, the U.S. Supreme Court upheld the Patient Protection and Affordable Care Act (PPACA) and its companion law, the Health Care and Education Reconciliation Act (HCERA) on June 28, 2012 (National Federation of Independent Business et al. v. Sebelius). Chief Justice John Roberts, writing for the majority, held that the law’s individual mandate is a valid exercise of Congress’ taxing power. Four justices dissented and would have overturned the law.

Since 2010, the IRS has issued extensive guidance on the tax provisions in the health care legislation. Many of the tax provisions were effective in 2010, 2011 and 2012; but others are scheduled to take effect after 2012 and in subsequent years. These include an additional 0.9 percent Medicare tax for higher income individuals (tax years beginning after December 31, 2012), a Medicare tax of 3.8 percent on investment income for higher income individuals, trusts and estates (tax years beginning after December 31, 2012), and a higher threshold to claim an itemized deduction for unreimbursed medical expenses (tax years beginning after December 31, 2012 with a temporary waiver for individuals age 65 and older). Our office will keep you posted of developments.

Foreign accounts

The IRS announced in June streamlined procedures for U.S. citizens who are nonresidents, including dual citizens, who have failed to file U.S. income tax and information returns, such as Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR). The IRS also reported it has collected more than $5 billion from its 2009 and 2011 offshore voluntary disclosure initiatives (OVDI). The IRS reopened the 2011 OVDI in January 2012 but with less generous terms.

Corporations

In June, the IRS issued new temporary and proposed regulations on corporate inversions. The regulations remove the facts and circumstances test from regulations issued in 2009 and replace it with a bright-line rule describing the threshold of activities required for an expanded affiliated group (EAG) to have substantial business activities in the relevant foreign country. The regulations apply to transactions completed on or after June 7, 2012, the IRS explained.

Partnerships

The IRS unveiled in June a safe harbor under which it will not challenge a determination by a publicly traded partnership that income from discharge of indebtedness (cancellation of debt “COD” income) is qualifying income (passive-type income) under Code Sec. 7704(d). To benefit from the safe harbor, the COD income must result from debt incurred in activities that produce qualifying income.

Mortgage interest deduction

In May, the U.S. Tax Court found that a taxpayer who filed as married filing separately was limited to a deduction for interest paid on $500,000 of home acquisition indebtedness plus interest paid on $50,000 of home equity indebtedness (Bronstein, 138 TC No. 21). The court found that the plain language of the statute mandated this result, which is half the $1 million/$100,000 limit imposed on other taxpayers.

Deferred compensation

The IRS issued proposed regulations intended to tighten the definition of substantial risk of forfeiture (SRF) that applies to compensatory transfers of property in connection with the performance of services under Code Sec. 83 in June. As a result, fewer restrictions would qualify as an SRF.

Statute of limitations

On April 25, 2012, the U.S. Supreme Court resolved a split among the circuit courts of appeal by concluding that an overstatement of basis does not result in an omission of income for statute of limitations (SOL) purposes (Home Concrete & Supply, LLC). As a result the IRS has three years, rather than six years, to act against taxpayers who overstate basis except where fraud can be proved. The issue has arisen in a number of tax shelter cases where a taxpayer overstates basis in a partnership interest, resulting in an understatement of income.

Income

In April, a taxpayer successfully persuaded the Tax Court that her documentary film work was for-profit and not a hobby (Storey, TC Memo. 2012-115). The IRS had determined that the taxpayer, who had a full-time job as an attorney, had engaged in filmmaking without the intent to make a profit. The Tax Court found that the taxpayer had become skilled in film-making by attending classes, spent many hours outside of her full-time job on film-making and concluded that the taxpayer had a for-profit motive.

Estate tax

The IRS issued temporary and proposed regulations in June on temporary portability election for qualified estates. The portability election generally allows the estate of a deceased spouse dying after December 31, 2010 and before January 1, 2013 to transfer the decedent’s unused estate tax exclusion amount, if any, to the surviving spouse.

Local lodging expenses

In May, the IRS issued proposed reliance regulations outlining when an employee may treat local lodging expenses as working condition fringe benefits or accountable plan reimbursements; and when employers may treat qualified expenditures as deductible business expenses. The proposed regulations also provide a safe harbor for an employee to deduct local lodging expenses if certain requirements are satisfied.

Deposit interest

The IRS issued final regulations in April requiring U.S. banks and other financial institutions to report interest on deposits paid to a nonresident alien (NRA). The requirement applies to residents of any country having a tax information exchange agreement (TIEA) with the U.S. The reporting requirement applies to interest payments made on or after January 1, 2013, the IRS explained.

Health savings accounts

The IRS announced in May inflation-adjusted amounts for health savings accounts (HSAs) in 2013. For 2013, the annual contribution limit for an individual with self-only coverage under a high deductible health plan (HDHP) is $3,250 compared to $3,100 for 2012. For 2013, the annual contribution limit for an individual with family coverage under a HDHP is $6,450, compared to $6,240 for 2012. A HDHP is defined as a health plan with an annual deductible that is not less than $1,250 for self-only coverage and $2,500 for family coverage for 2013.

Fresh start initiative

The IRS announced in May an expansion of its Fresh Start initiative, designed to help taxpayers struggling financially. The IRS provided more flexible terms to its offer in compromise (OIC) program. The IRS also instructed its examiners on taxpayers’ ability to pay when student loans or state/local taxes are outstanding.

Economic substance

The Health Care and Education Reconciliation Act (HCERA) codified the economic substance doctrine. In April, IRS Chief Counsel released instructions to its personnel on when they may raise the codified economic substance doctrine.

Telephone tax refunds

In April, the IRS reminded taxpayers of the July 27, 2012 deadline to request refunds of federal excise taxes paid on long-distance telephone communications billed after February 23, 2003 and before August 1, 2006. In 2006, the IRS had announced that would stop collecting the three percent excise tax on long-distance telephone communications. Individuals who filed a 2006 return but who did not request a telephone excise tax refund should file an amended return or Form 1040-EZT (if not required to file a 2006 return).

Bankruptcy

The Supreme Court held in May that tax on a bankrupt debtor’s post-petition farm sale was not dischargeable in bankruptcy (Hall). The Supreme Court found that federal income tax liability resulting from a debtor farmer’s post-petition farm sale was not “incurred by the estate” under Bankruptcy Code Sec. 503(b).

If you have any questions about these or any federal tax developments, please contact our office.

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