Tax Law and Business Organization Strategy

Fiscal Cliff Avoided

Jack Howell — Wed, 02 Jan 2013 10:11:12 -0600

I saw an editorial cartoon the other day. It was of Wiley Coyote going off the cliff. He seemed to be doing this regularly in the Roadrunner and Coyote cartoons. In this case, he was able to scramble, out of thin air, back to the edge of the precipice.

Early Jan. 1, 2013, the Senate, by a vote of 89-8, passed H.R.8, the “American Taxpayer Relief Act” (the Act). Late on that same day—hours after the government had technically gone over the “fiscal cliff”—the House of Representatives, by a vote of 257 to 167, also passed the bill. The Act, which the President is expected to quickly sign into law, prevents many of the tax hikes that were scheduled to go into effect this year and retains many favorable tax breaks that were scheduled to expire. However, it increases income taxes for some high-income individuals and slightly increase transfer tax rates.

Highlights of the Act include the following:

Tax rates. For tax years beginning after 2012, the income tax rates for individuals will stay at 10%, 15%, 25%, 28%, 33% and 35% (instead of moving to 15%, 28%, 31%, 36% and 39.6% as would have occurred under the EGTRRA sunset). There is now a new rate of 39.6% applying to income above a certain threshold (specifically, income in excess of the “applicable threshold” over the dollar amount at which the 35% bracket begins). The applicable threshold is $450,000 for joint filers and surviving spouses; $425,000 for heads of household; $400,000 for single filers; and $225,000 (one-half of the otherwise applicable amount for joint filers) for married taxpayers filing separately. These dollar amounts are inflation-adjusted for tax years after 2013.

PEP limitations to apply to “high-earners." For tax years beginning after 2012, the Personal Exemption Phaseout (PEP), which had previously been suspended, is reinstated with a starting threshold for those making $300,000 for joint filers and surviving spouses; $275,000 for heads of household; $250,000 for single filers; and $150,000 (one-half of the otherwise applicable amount for joint filers) for married taxpayers filing separately. Under the phaseout, the total amount of exemptions that can be claimed by a taxpayer subject to the limitation is reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer's AGI exceeds the applicable threshold. These dollar amounts are inflation-adjusted for tax years after 2013.

Pease limitations to apply to “high-earners." For tax years beginning after 2012, the “Pease“ limitation on itemized deductions, which had previously been suspended, is reinstated with a starting threshold for those making $300,000 for joint filers and surviving spouses, $275,000 for heads of household, $250,000 for single filers, and $150,000 (one-half of the otherwise applicable amount for joint filers) for married taxpayers filing separately. Thus, for taxpayers subject to the “Pease” limitation, the total amount of their itemized deductions is reduced by 3% of the amount by which the taxpayer's adjusted gross income (AGI) exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions. These dollar amounts are inflation-adjusted for tax years after 2013.

Capital gain and dividend rates rise for higher-income taxpayers. For tax years beginning after 2012, the top rate for capital gains and dividends will permanently rise to 20% (up from 15%) for taxpayers with incomes exceeding $400,000 ($450,000 for married taxpayers). When accounting for Code Sec. 1411's 3.8% surtax on investment-type income and gains for tax years beginning after 2012, the overall rate for higher-income taxpayers will be 23.8%. (Under the EGTRRA/JGTRRA sunset provisions, long-term capital gain was to be taxed at a maximum rate of 20%, with an 18% rate for assets held more than five years, and dividends paid to individuals were to be taxed at the same rates that apply to ordinary income.)

For taxpayers whose ordinary income is generally taxed at a rate below 25%, capital gains and dividends will permanently be subject to a 0% rate. (Under the EGTRRA/JGTRRA sunset provisions, long-term capital gain of lower-income taxpayers was to be taxed at a maximum rate of 10%, with an 8% rate for assets held more than five years, and dividends were to be subject to ordinary income rates.) Taxpayers who are subject to a 25%-or-greater rate on ordinary income, but whose income levels fall below the $400,000/$450,000 thresholds, will continue to be subject to a 15% rate on capital gains and dividends. The rate will be 18.8% for those subject to the surtax.

Transfer tax provisions kept intact with slight rate increase. The Act prevents steep increases in estate, gift and generation-skipping transfer (GST) tax that were slated to occur for individuals dying and gifts made after 2012 by permanently keeping the exemption level at $5,000,000 (as indexed for inflation). However, the Act also permanently increases the top estate, gift and generation skipping rate from 35% to 40%. The Act also continues the portability feature that allows the estate of the first spouse to die to transfer his or her unused exclusion to the surviving spouse. All changes are effective for individuals dying and gifts made after 2012.

Permanent AMT relief. The Act provides permanent alternative minimum tax (AMT) relief. The AMT is the excess, if any, of the tentative minimum tax for the year over the regular tax for the year. In arriving at the tentative minimum tax, an individual begins with taxable income, modifies it with various adjustments and preferences, and then subtracts an exemption amount (which phases out at higher income levels). The result is alternative minimum taxable income (AMTI), which is subject to an AMT rate of 26% or 28%.

Before the Act, the individual AMT exemption amounts for 2012 were to have been $33,750 for unmarried taxpayers, $45,000 for joint filers, and $22,500 for married persons filing separately. Retroactively effective for tax years beginning after 2011, the Act permanently increases these exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers and $39,375 for married persons filing separately. In addition, for tax years beginning after 2012, it indexes these exemption amounts for inflation.

Before the Act, for 2012, nonrefundable personal credits—other than the adoption credit, the child credit, the savers' credit, the residential energy efficient property credit, the non-depreciable property portions of the alternative motor vehicle credit, the qualified plug-in electric vehicle credit, and the new qualified plug-in electric drive motor vehicle credit—were to be allowed only to the extent that the individual's regular income tax liability exceeded his tentative minimum tax, determined without regard to the minimum tax foreign tax credit. Retroactively effective for tax years beginning after 2011, the Act permanently allows an individual to offset his entire regular tax liability and AMT liability by the nonrefundable personal credits.

Recovery Act extenders. The Act extends for five years the following items that were originally enacted as part of the American Recovery and Investment Tax Act of 2009 and that were slated to expired at the end of 2012:

the American Opportunity tax credit, which permits eligible taxpayers to claim a credit equal to 100% of the first $2,000 of qualified tuition and related expenses, and 25% of the next $2,000 of qualified tuition and related expenses (for a maximum tax credit of $2,500 for the first four years of post-secondary education);
eased rules for qualifying for the refundable child credit; and
various earned income tax credit (EITC) changes relating to higher EITC amounts for eligible taxpayers with three or more children, and increases in threshold phaseout amounts for singles, surviving spouses, and heads of households.

Historical individual extenders. The Act extends the following items for the period indicated beyond their prior termination date as shown in the listing:

the deduction for certain expenses of elementary and secondary school teachers, which expired at the end of 2011 and which is now revived for 2012 and continued through 2013;
the exclusion for discharge of qualified principal residence indebtedness, which applied for discharges before Jan. 1, 2013 and which is now continued to apply for discharges before Jan. 1, 2014;
parity for the exclusions for employer-provided mass transit and parking benefits, which applied before 2012 and which is now revived for 2012 and continued through 2013;
the treatment of mortgage insurance premiums as qualified residence interest, which expired at the end of 2011 and which is now revived for 2012 and continued through 2013;
the option to deduct State and local general sales taxes, which expired at the end of 2011 and which is now revived for 2012 and continued through 2013.
the special rule for contributions of capital gain real property made for conservation purposes, which expired at the end of 2011 and which is now revived for 2012 and continued through 2013;
the above-the-line deduction for qualified tuition and related expenses, which expired at the end of 2011 and which is now revived for 2012 and continued through 2013; and
tax-free distributions from individual retirement plans for charitable purposes, which expired at the end of 2011 and which is now revived for 2012 and continued through 2013. Because 2012 has already passed, a special rule permits distributions taken in 2012 to be transferred to charities for a limited period in 2013. Another special rule permits certain distributions made in 2013 as being deemed made on Dec. 31, 2012.

Depreciation provisions modified and extended. The following depreciation provisions are retroactively extended by the Act through 2014:

15-year straight line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements;
7-year recovery period for motorsports entertainment complexes;
accelerated depreciation for business property on an Indian reservation;
increased expensing limitations and treatment of certain real property as Code Sec. 179 property;
special expensing rules for certain film and television productions; and
the election to expense mine safety equipment.

The Act also extends and modifies the bonus depreciation provisions for property placed in service after Dec. 31, 2012, in tax years ending after that date.

Business tax breaks extended. The following business credits and special rules are also extended:

The Code Sec. 41 research credit is modified and retroactively extended for two years through 2013.
The temporary minimum low-income tax credit rate for nonfederally subsidized new buildings under Code Sec. 42(b)(2)(A) is extended to apply to housing credit dollar amount allocations made before Jan. 1, 2014.
The housing allowance exclusion for determining area median gross income for qualified residential rental project exempt facility bonds is extended two years.
The Code Sec. 45A Indian employment tax credit is retroactively extended for two years through 2013.
The Code Sec. 45D new markets tax credits is retroactively extended for two years through 2013.
The Code Sec. 45G railroad track maintenance credit is retroactively extended for two years through 2013.
The Code Sec. 45N mine rescue team training credit is retroactively extended for two years through 2013.
The Code Sec. 45P employer wage credit for employees who are active duty members of the uniformed services is retroactively extended for two years through 2013.
The Code Sec. 51 work opportunity tax credit is retroactively extended for two years through 2013.
Code Sec. 54E qualified zone academy bonds are retroactively extended for two years through 2013.
The enhanced charitable deduction for contributions of food inventory under Code Sec. 174(e) is retroactively extended for two years through 2013.
Allowance of the domestic production activities deduction for activities in Puerto Rico, for the first eight tax years of the taxpayer beginning after Dec. 31, 2005, and before Jan. 1, 2014.
Exclusion from a tax-exempt organization's unrelated business taxable income (UBTI) of interest, rent, royalties, and annuities paid to it from a controlled entity under Code Sec. 512(b)(13)(E)(iv) is extended through Dec. 31, 2013.
Treatment of certain dividends of regulated investment companies (RICs) as “interest-related dividends” is extended through Dec. 31, 2013.
Inclusion of RICs in the definition of a “qualified investment entity” under Code Sec. 897(h)(4) is extended through Dec. 31, 2013.
The exception under subpart F for active financing income (i.e., certain income from the active conduct of a banking, financing, insurance, or similar business) under Code Sec. 953(e)(10) and Code Sec. 954(h)(9) for tax years of a foreign corporation beginning after Dec. 31, '98, and before Jan. 1, 2014, for tax years of foreign corporations beginning after Dec. 31, 2005, and before Jan. 1, 2014.
Look-through treatment for payments between related controlled foreign corporations (CFCs) under the foreign personal holding company rules under Code Sec. 954(c)(6) is extended through Jan. 1, 2014.
Exclusion of 100% of gain on certain small business stock acquired before Jan. 1, 2014.
Basis adjustment to stock of S corporations making charitable contributions of property under Code Sec. 1367(a) in tax years beginning before Dec. 31, 2013.
The reduction in S corporation recognition period for built-in gains tax under Code Sec. 1374(d)(7) is extended through 2013, with a 10-year period instead of a 5-year period.
Various empowerment zone tax incentives, including the designation of an empowerment zone and of additional empowerment zones under Code Sec. 1391(d) (extended through Dec. 31, 2013) and the period for which the percentage exclusion for qualified small business stock (of a corporation which is a qualified business entity) is 60%Code Sec. 1202(a)(2) (extended through Dec. 31, 2018).
Tax-exempt financing for New York Liberty Zone under Code Sec. 1400L(d)(2) is extended for bonds issued before Jan. 1, 2014.
Temporary increase in limit on cover over rum excise taxes to Puerto Rico and the Virgin Islands is extended for spirits brought into the U.S. before Jan. 1, 2014.
American Samoa economic development credit, as modified, is extended through Jan. 1, 2014.

Energy-related tax breaks extended. Various energy credits are extended. These include:

The nonbusiness energy property credit under Code Sec. 25C for energy-efficient existing homes is retroactively extended for two years through 2013. A taxpayer can claim a 10% credit on the cost of: (1) qualified energy efficiency improvements, and (2) residential energy property expenditures, with a lifetime credit limit of $500 ($200 for windows and skylights).
The alternative fuel vehicle refueling property credit under Code Sec. 30C is retroactively extended for two years through 2013 so that taxpayers can claim a 30% credit for qualified alternative fuel vehicle refueling property placed in service through Dec. 31, 2013, subject to the $30,000 and $1,000 thresholds.
The credit for 2- or 3-wheeled plug-in electric vehicles under Code Sec. 30D is modified and retroactively extended for two years through 2013.
The cellulosic biofuel producer credit under Code Sec. 40(b) is modified and extended one year through 2013.
The credit for biodiesel and renewable diesel under Code Sec. 40A is retroactively extended for two years through 2013.
The production credit for Indian coal facilities placed in service before 2009 under Code Sec. 45(e)(10) is extended one year. The credit applied to coal produced by the taxpayer at an Indian coal production facility during the 8-year period beginning on Jan. 1, 2006, and sold by the taxpayer to an unrelated person during such 8-year period and the tax year.
The credits with respect to facilities producing energy from certain renewable resources under Code Sec. 45 is modified and extended one year. A facility using wind to produce electricity will be a qualified facility if it is placed in service before 2014.
The credit for energy-efficient new homes under Code Sec. 45L is retroactively extended for two years through 2013.
The credit for energy-efficient appliances under Code Sec. 45M is retroactively extended for two years through 2013.
The additional depreciation deduction allowance for cellulosic biofuel plant property under Code Sec. 168(l)(2) is modified and extended one year.
The special rule for sales or dispositions to implement Federal Energy Regulatory Commission (FERC) or State electric restructuring policy for qualified electric utilities is retroactively extended for two years through 2013.
The alternative fuels excise tax credits under Code Sec. 6426(d )Code Sec. (5) and Code Sec. 6426(e)(3) for sales or use of alternative fuels or alternative fuel mixtures is retroactively extended for two years through 2013.

Pension provisions. For transfers after Dec. 31, 2012, in tax years ending after that date, plan provisions in an applicable retirement plan (which includes a qualified Roth contribution program) can allow participants to elect to transfer amounts to designated Roth accounts with the transfer being treated as a taxable qualified rollover contribution under Code Sec. 408A(e).

"Now that's a fine mess you've gotten us into!"

Jack Howell — Thu, 08 Nov 2012 15:12:02 -0600

Suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.
- Mark Twain, a Biography

The so-called “fiscal cliff” is looming, and I don’t see how we can avoid going over the edge. The election is now over, but nothing has really changed. Before the election we had Obama as President, a Democratic majority in the Senate, and a Republican majority in the House. Today, we still have the same thing.

The day after the election, Democratic and Republican leaders claimed to be willing to work towards a bi-partisan solution, but it sounds more like posturing than substance, and I don’t think there is enough time left before January 1, 2013 to avoid the tax calamity that will automatically happen on that date.

Though both sides agreed not to draw lines in the sand, congressional leaders did just that, staking out unchanged bargaining positions. Harry Reid, Senate Democratic leader, said he wanted to avoid the tax increases except for the wealthy and he would like to see substantial measures enacted during the lame-duck session of Congress that starts next week. Speaker John Boehner, Republican leader of the House, said that while he was open to tax reform, and saw considerable common ground on that, he continued to find tax increases unacceptable. Boehner repeated his previous objections to moving forward during the lame-duck session, except with temporary, stop-gap legislation to avoid the cliff. Vice President Joe Biden, saying the administration would like to move "right now," claimed "a clear, clear sort of mandate" on the tax issue, citing in particular doing "something on corporate taxes sooner than later".

It is thus apparent on the day after the election that the clarity it was supposed to have brought has yet to arrive.

Fiscal Cliff

So what is the “fiscal cliff”?

The fiscal cliff refers to the numerous tax increases and spending decreases that are scheduled to automatically occur on or before January 1, 2013. They include:

The 2001/2003 tax relief (the “Bush tax cuts) expires on 12/31/12.
There is currently no alternative minimum tax (AMT) patch in effect for 2012.
There are numerous tax provisions that have been extended annually for the last several years and they have not been extended yet for 2012.
Payroll tax relief expires on 12/31/12.
New Medicare taxes take effect in 2013.
Expanded unemployment benefits expire on 12/31/12.
Medicare physician payment rate falls on 12/31/12.
Sequestration under Budget Control Act of 2011 (BCA) in 2013.

The expiration of the 2001 / 2003 tax relief will have the following consequences:

Highest marginal income tax rates will rise to 36% and 39.6% from 33% and 35%
10% rate bracket will be eliminated
Maximum rate on qualified dividends will rise from 15% to 39.6% (plus 3.8% Medicare tax for taxpayers with income above $250,000)
Maximum rate on long-term capital gains will rise from 15% to 20% (plus 3.8% Medicare tax for taxpayers with income above $250,000)
Phase-out’s of itemized deductions and personal exemptions will be reinstated for high-income individuals
Marriage penalty relief will expire
Child tax credit will decline from $1,000 to $500
Maximum estate tax rate will rise from 35% to 55%, and exemption will fall from $5 million to $1 million
Individuals with income over $250,000 (joint) or $200,000 (individual) face Medicare tax increases of: 0.9% on wages (on amounts exceeding threshold) and 3.8% on the lesser of: net investment income (e.g., interest, dividends, capital gains) or excess of modified AGI on amounts over the $250,000/$200,000 threshold.

Without Congressional action, the alternative minimum tax will affect an additional 27 million taxpayers in tax year 2012. AMT was originally designed to prevent high-income taxpayers from using exclusions, deductions and credits to minimize tax liability. AMT is not indexed for inflation, but it needed to be for it to be imposed only on the intended target. The "fix" has been a series of legislative patches, which have prevented its expansion to middle-income taxpayers. The most recent AMT patch expired December 31, 2011, and a new one has not been adopted for 2012 or beyond.

More than 60 business and individual tax extenders expired December 31, 2011. In prior years, tax extenders were generally passed as a package or, if allowed to expire, retroactively reinstated. The political and economic environment dims the prospects for extending these provisions. It is difficult to pass revenue losing tax provisions without identified revenue offsets. So, it may be that these extenders will only be “extended” as part of fundamental tax reform. It will be almost impossible to find a legislative vehicle for the extenders before the year-end. So, any extenders that get addressed may be in a piecemeal fashion. And it certainly looks now as if no extenders will pass or be retroactively reinstated this year.

Due to the 2011 failure of the Joint Select Committee on Deficit Reduction to agree on a deficit reduction plan, the BCA mandated $1.2 trillion of scheduled savings through an automatic spending cut process (sequestration). The BCA resulted in an initial $917 billion in deficit reduction from discretionary spending caps for FY 2012—2021. Sequestration is scheduled to begin in January 2013. Sequestration will be divided evenly between defense and non- defense spending. House of Representatives recently passed a bill to replace the sequester and generally protect defense spending. The Senate and Administration are opposed to the House bill. If Congress cannot agree on an alternative $1.2 trillion in spending cuts or added revenue over the next 10 years, sequestration will go into effect.

Likely Scenario

What happens if Congress cannot act before the end of the year?

Even if some sort of tax agreement or "tax reform" gets adopted retroactively, the IRS must administer the tax law as it exists. So, unless something happens before the due date (or the date returns actually get filed), everyone will have to pay their 2012 taxes based on the law then currently in effect. This could very likely mean that you have to file your 2012 return without any AMT relief and without any of the "extender" tax provisions. So, it is likely that you already have a tax increase on your 2012 income, and you might not even know it. If you end up owing the AMT, you may not have withheld or made quarterly deposits of enough to satisfy your 2012 tax liability. So, be prepared to write a check for your 2012 taxes.

Everyone will also owe a higher rate of tax in 2013. The withholding tables will reflect those higher rates. Even if tax reform occurs in 2013 and it is retroactive, the withholding tables will not reflect the "reformed" rates until the reform bill passes. So, you will have a reduced cash flow as if taxes were higher for 2013 even if the rates turn out to be lower by the end of the year.

Strategy

What should I do right now?

If nothing happens rates are going up:

Dividends: 15% to 43.4%
Capital Gains: 15% to 23.8%
Ordinary income: from 35% or 37.9% to 43.4%

I don’t think anything will happen before the year end. And, while any actual reform adopted in 2013 can be made retroactive, I don’t think that reform will touch the new Medicare tax increases. I also don’t see capital gains taxes going below 20% or dividends getting taxed at anything other than ordinary income rates. In other words, tax rates on individuals for dividends are probably at an historical low -- significantly so. Taxes on capital gains are also at a low that we may not see again, although the difference in the current and likely future rates is less drastic.

Usually, I would be encouraging my clients to defer income into later years and accelerate deductions into this year. This year, however, it may be wise to take the opposite course of action.

In particular, if you do business through a corporation and can pay taxable dividends, now may be the best time you will ever have to do that. Only if you have other plans in place to avoid any taxable dividends from ever being paid by the corporation might paying dividends now be a bad strategy. It’s simply hard to write that tax check when you could avoid it by not paying the dividend. You’re paying the "second" corporate tax, and you can’t take it back later.

Likewise, you should consider whether to trigger capital gains. The difference in rates is less drastic, but I don’t think you will ever see rates at less than 20% again. But with the smaller rate differential, it becomes a closer call as the time value of the deferral may still outweigh paying the lower tax now.

These are tough decisions. But the longer you delay, the less likely you'll be able to act when you make a decision to act.

Real Estate Transferred to FLP Escapes Inclusion in Estate

Jack Howell — Tue, 20 Mar 2012 14:38:17 -0600

In a case involving an asserted estate tax deficiency of over $2.5 million, the Tax Court has held that real estate transferred to a family limited partnership (FLP) did not have to be included in the transferor's gross estate under Code Sec. 2036 because the transfer was a bona fide sale for an adequate and full consideration in money or money's worth. Estate of Joanne Harrison Stone, TC Memo 2012-48.

Background.

A decedent's gross estate includes transfers under which she retained the possession or enjoyment of, or the right to the income from, the transferred property. (Code Sec. 2036(a)) The decedent need not have a legally enforceable right, but there must be an agreement, either expressed or implied, that the decedent will retain the benefit. Inclusion is not required if the transfer was a bona fide sale for full and adequate consideration. (Code Sec. 2036(a))

Facts.

The decedent, Joanne Harrison Stone (Mrs. Stone) was married to Roy A. Stone (Mr. Stone). They had six adult children and numerous grandchildren at the time of her death in 2005.

The Stones were a prominent family in their hometown of Crossville, Tennessee. They held significant amount of real estate in the area for several generations including 740 acres of undeveloped woodlands. One son acquired real estate near these parcels and collaborated with the local authorities in forming a lake near them.

Once the lake had been constructed, Mr. and Mrs. Stone concluded that they wanted the woodland parcels to become a family asset. To that end they sought the advice of an attorney. They informed the attorney that they wanted to give gifts of real estate to various family members and were seeking the best way of doing so. The attorney told them that a limited partnership would simplify the gift-giving process by not requiring execution and recording of new deeds every year. He also said it would help guard against partition suits, which could cause the land to be divided into smaller tracts.

The Stones took his advice and formed Stone Family Limited Partnership of Cumberland County (SFLP). The SFLP agreement provided that its purpose was to hold and manage property for the family members. It listed various ways in which SFLP could be terminated, including by written agreement of partners owning 67% of SFLP or upon sale of all SFLP property and distribution of proceeds. The agreement placed various restrictions on a partner's ability to transfer their partnership interest and allowed SFLP to purchase the interest of any partner upon his or her death.

Upon its formation, Mr. Stone and Mrs. Stone each obtained 1% general partnership interests and 49% limited partnership interests in SFLP. On Dec. 30, '97, they quitclaimed the woodland parcels to SFLP and the parcels became SFLP's only assets. Shortly before that, the combined parcels were appraised at a value of $1,575,600. On Dec. 31, '97, they gave portions of their limited interests in SFLP as gifts to their 21 children, children's spouses, and grandchildren. They valued each 1% interest in SFLP at $15,756 for gift tax purposes or, in other words, at 1% of the combined value of $1,575,600.

Dispute over applicability of Code Sec. 2036.

The Tax Court said that Code Sec. 2036 is applicable when three conditions are met: (1) the decedent made an inter vivos transfer of property; (2) the decedent's transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right enumerated in Code Sec. 2036 in the transferred property which the decedent did not relinquish before his death.

IRS argued that the three conditions were satisfied by Mrs. Stone's transfer of the woodland parcels to SFLP, while the estate argued that the latter two conditions were not satisfied. The parties agreed that she made an inter vivos transfer of property.

Transfer was bona fide sale.

The Tax Court observed that, in the context of family limited partnerships, the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant nontax reason for creating the family limited partnership and the transferors received partnership interests proportional to the value of the property transferred.

The estate argued that Mrs. Stone had two nontax motives for transferring the woodland parcels to SFLP: (1) to create a family asset which later may be developed and sold by the family; and (2) to protect the woodland parcels from division as a result of partition actions. IRS countered that she was motivated only by a desire to simplify the gift-giving process by not having to execute deeds each time a gift of a portion of the woodland parcels was made.

The Tax Court disagreed that gift giving was her only motive. Testimony at trial established that a significant purpose of the transfer was to create a family asset managed by Mrs. Stone's family. She and Mr. Stone desired that their children, their children's spouses, and their grandchildren work together to develop and sell homes near the lake. The Tax Court found that desire to have the woodland parcels held and managed as a family asset constituted a legitimate nontax motive for her transfer of the woodland parcels to SFLP.

IRS also argued that because Mrs. Smith stood on both sides of the transaction, as both transferor of the woodland parcels and general manager of SFLP, there was no arm's length bargaining and thus the bona fide transfer exception did not apply. The Tax Court rejected this argument because it had already found a legitimate nontax motive for the transaction In addition, the Court found that this factor did not weigh against the estate because Mrs. Stone received interests in SFLP proportional to the property she contributed.

IRS further argued that partners of SFLP failed to respect partnership formalities because: (1) in divorce proceedings, divorcing spouses of two Stone children quitclaimed their interests in the woodland parcels to their former spouses but did not transfer actual SFLP interests; (2) some inadequate documentation was kept for the partnership, such as using bills of sale to make gifts of SFLP interests; and (3) the Stones paid SFLP property taxes out of their personal funds.

The Tax Court agreed with IRS that the partners of SFLP failed to respect some partnership formalities. The Court found, however, that other factors supported the estate's argument that a bona fide sale occurred. First, the Stones did not depend on distributions from SFLP as no distributions were ever made. Second, they actually did transfer the woodland parcels to SFLP. Third, there was no commingling of partners' personal and partnership funds, as SFLP had no partnership funds. Fourth, no discounting of SFLP interests for gift tax purposes occurred. Also, the Stones were in good health at the time the transfer of the woodland parcels was made to SFLP.

Accordingly, the Tax Court found that Mrs. Stone had a legitimate and actual nontax motive in transferring the woodland parcels to SFLP. It therefore find that the bona fide sale prong was satisfied.

Full and adequate consideration received.

The Tax Court noted that a taxpayer's receipt of a partnership interest is not part of a bona fide sale for full and adequate consideration where an intrafamily transaction merely attempts to change the form in which the decedent holds property. The Tax Court stressed that it had already found that Mrs. Stone had a legitimate and actual nontax purpose in transferring the woodland parcels to SFLP. It therefore found that the transaction was not merely an attempt to change the form in which she held the woodland parcels and that the full and adequate consideration prong was satisfied.

Bottom line.

Mrs. Stone's transfer of the woodland parcels to SFLP was a bona fide transfer for which she received full and adequate consideration from SFLP. Therefore,Code Sec. 2036(a) did not apply to the transfer and did not operate to include the values of the woodland parcels in the value of Mrs. Stone's gross estate.

Tax Court Rejects Cost Segregation Study of Apartment Complex

Jack Howell — Tue, 20 Mar 2012 14:03:34 -0600

A new Tax Court case deals with a taxpayer's claims that numerous assets in a rental apartment complex were depreciable as short-lived personal property rather than as residential rental property written off over 27.5 years. Amerisouth, TC Memo 2012-67. The Court disallowed most of the deductions, which were based on an overaggressive cost segregation study.

Background.

Residential rental property (a building or structure for which 80% or more of the gross rental income is from dwelling units), is depreciated over 27.5 years via straight line. (Code Sec. 168(c)) Code Sec. 1250 property that is a non-residential building generally is depreciated over a 39-year recovery period using the straight-line method. Under MACRS, taxpayers cannot depreciate a building via component depreciation—that is, for depreciation purposes, they can't break up a building into components and write off each separately. (Code Sec. 168(i)(6)) Some types of land improvements are, however, recoverable over a 15-year MACRS period. Additionally, most types of Code Sec. 1245 property are eligible for fast depreciation (e.g., over 5 or 7 years).

In the depreciation context, there is no stand-alone definition of “personal property.” Instead, the regs say the term is defined the same way as “tangible personal property” is defined under Reg. § 1.48-1(c), which deals with property eligible for the repealed investment tax credit (ITC). (Reg. § 1.1245-3(b)(1))

In recent years, taxpayers have hired firms to conduct what are called cost segregation studies. Capitalizing on some taxpayer-favorable court decisions, these studies make detailed inventories of individual assets in order to distinguish items of short-recovery-period Code Sec. 1245 from long-recovery-period realty (buildings and their structural components). The leading case on the issue is Hospital Corp of America & Subsidiaries, (1997) 109 TC 21, in which the Tax Court held that realty-related property is rapidly depreciable tangible personal property for MACRS purposes (rather than slowly recoverable commercial realty) if it would have been classified by the courts as tangible property for purposes of the repealed investment tax credit (ITC).

Hospital Corp. of America generally stands for the following propositions:

If property would have qualified as tangible personal property for ITC purposes under pre-'81 case law, it will also qualify as tangible personal property for MACRS purposes.
The following factors must be tested to determine whether an asset is an inherently permanent structural component or personal property (i.e., section 1245 property): Can the property be moved, and has it in fact been moved? Is the property designed or constructed to remain permanently in place? Are there circumstances which tend to show the expected or intended length of affixation, i.e., are there circumstances which show that the property may or will have to be moved? How substantial a job is removal of the property and how time-consuming is it? Is it “readily removable” and how much damage would it sustain if moved? How is the property affixed to the land?
An item may be section 1245 property if it does not relate to the operation and maintenance of the building.

The Tax Court concluded that the taxpayer in Hospital Corp. could depreciate over five years that percentage of the electrical systems, measured by electrical load, allocable to hospital equipment as opposed to building operation or maintenance. Also eligible for a quick writeoff were branch electrical wiring, connections, and special electrical equipment relating to special items of hospital equipment, to the extent they furnished electrical power for a function or equipment that did not relate to the operation or maintenance of the building (e.g., branch systems relating to operating rooms, kitchen, computer-room air conditioners). The fact that the equipment was permanently installed did not matter. The Tax Court OK'd quick writeoffs for a wide variety of other assets, such as certain carpeting, vinyl wall coverings, and accordion-style room partitions.

IRS acquiesced in the Hospital Corp. holding that the tests developed under the ITC are applicable in determining whether an asset is a structural component for purposes of ACRS and MACRS depreciation. IRS nonacquiesced, however, to the way in which the Tax Court applied this principle to specific items. (Acq and nonacq 1999-35 IRB 314, as corrected by Ann. 99-116, 1999-52 IRB 763) In recent years, IRS has bought into the concept of clearly documented cost segregation studies to identify section 1245 assets in buildings.

Facts.

In 2003, AmeriSouth, LLC, bought and renovated a large apartment complex with numerous 2-story apartment buildings, a storehouse for mechanical equipment, and a leased office building. A consultant hired by AmeriSouth did a cost segregation study that broke down the cost of the complex into over 1,000 parts, including items such as sinks, outlets, paint, and electrical wiring connected to garbage disposal units. AmeriSouth claimed depreciation deductions for 2003 through 2005 based on the consultant's recommendations, but IRS denied a substantial portion of the deductions.

Tax Court.

The Tax Court was highly critical of AmeriSouth's aggressive application of the cost segregation principle and sided with IRS on most of the contested items. Following is a sample of the numerous items discussed in the case:

AmeriSouth submitted an exhibit that claimed $65,381 of depreciable basis related to “land improvements for excavating, grading, stone bases and compaction needed to construct sidewalks,” but could provide no allocation to these assets, so its claim was denied.
AmeriSouth claimed the water distribution system was tangible personal property with a recovery period of 15 years, but the Tax Court said it was clear that the system was an integral part of the building's plumbing and air-conditioning systems and also served the building by providing potable water. As a result, the water system's components had to be depreciated over the life of the apartment buildings.
AmeriSouth's property had units with washer and dryer connections for tenant use and seven common laundry rooms. The venting connected to clothes dryers in the apartments, and the venting connected to stove hoods in the units, were called “special HVAC” by AmeriSouth and depreciated over a short recovery period (the decision doesn't explain what the claimed recovery period was). The Tax Court held that the clothes-dryer vents serve specific equipment—the dryers. They expelled hot air and carbon monoxide, reduced humidity, extended directly from the dryers to the outside of the building, and had no connection to the apartments' general ventilation system. As a result, the Tax Court agreed the cost allocated to the venting was entitled to a shorter writeoff period than the building. However, the Tax Court was not convinced that the vent hoods above stoves in the units were tangible personal property. Although they served equipment—the kitchen ovens-–the Court was not convinced that they served only the stoves. AmeriSouth did little to rebut IRS's contention that the vents remove both heat and smells that can come from beyond the stovetop, so the Court held that the hoods were structural components of the buildings and had to be depreciated over 27.5 years.
AmeriSouth argued that its sinks (in apartment units and the office building) were personal property because they were easy to remove, using its 2003 renovation effort as an example. However, the Tax Court pointed out that under the ITC regs (Reg. § 1.48-1(e)(2)), structural components include plumbing fixtures such as sinks and bathtubs, and denied AmeriSouth's claim.
The Court agreed with IRS that kitchen countertop outlets and the outlets that a treadmill, copier, and cycle might plug into are structural components. The fact alone that a copier, treadmill, toaster, or other item of personal property happens to be plugged into a specific outlet in no way indicated that the outlet is for that specific use rather than the general operation or maintenance of the building. By contrast, the Court found that duplex outlets in rental units that are four feet above the ground in kitchen areas clearly accommodated refrigerators, which are personal property. The same was true for the 220-volt outlets in kitchen areas that were used solely for powering stoves and the outlets in laundry areas for washers and dryers. Thus, the duplex outlets for refrigerators and the 220-volt outlets could be depreciated as personal property.

Ranch Owner Didn't Materially Participate in Ranch Activities

Jack Howell — Mon, 30 Jan 2012 15:10:08 -0600

The Tax Court in Iverson, TC Memo 2012-19, has disallowed losses incurred in a cattle ranch owned by Mr. Iverson. The taxpayer was the founder and an executive with a company based in Minnesota and appeared to use the ranch to entertain clients of his Minnesota company. So, the decision is not surprising in that regard. The decision could nonetheless spell trouble for other ranch owners. The court seemed to focus on the fact that the taxpayer did not live at the ranch, did not keep detailed records on participation in ranch activities, and had a full-time paid ranch manager who ran the day to day activities of the ranch. Many owners of ranches in Texas do not live and work full-time at their ranch and have paid employees who handle the day to day activities. Where the taxpayers do not keep extensive files, to-do lists, home and mobile phone records, business plans, project descriptions and instructions to employees documenting and establishing their active involvement in the regular, continuous, and substantial management and day-to-day activities of ranch, they may have difficultly persuading the fact finder that they have the necessary involvement in the ranch activities to avoid passive activity classification. This would particularly be true of taxpayers who do not live at the ranch or actually “work” the ranch when they are at the ranch.

Highlights of Tax Changes Becoming Effective in 2013

Jack Howell — Thu, 05 Jan 2012 11:27:29 -0600

There are many important tax changes taking effect in 2013, as well as some that took effect late last year and thus are “new.” They are the result of tax legislation enacted in prior years, or are triggered by effective dates in regs, rulings and other guidance, or will occur by default in 2013 absent Congressional action. The following is a list derived from Checkpoint of the key non-inflation-indexed tax changes, categorized by those affecting businesses and individuals. In addition, a list of provisions that expired at the end of last year is provided.

Business and retirement plan changes taking effect in 2012 and late 2011. Business changes effective in 2012 (or went into effect in December of 2011 and are thus “new”), include the following:

New guidance on deduction vs. capitalization of tangible property costs. IRS has issued temporary regs, generally effective in tax years beginning after 2011, on the application of Code Sec. 162(a) and Code Sec. 263(a) to amounts paid to acquire, produce, or improve tangible property. Among other things, these new regs clarify and expand the standards in the current regs; provide certain new bright-line tests for applying these standards; provide guidance under Code Sec. 168 regarding the accounting for, and dispositions of, property subject to that section; and amend the general asset account regs.
Basis reporting requirements. The complex stock basis and character reporting rules under Code Sec. 6045(g) apply to shares in a regulated investment company (RIC, i.e., a mutual fund), or stock acquired in connection with a dividend reinvestment plan (DRP), if acquired after 2011.
Estimated taxes for large corporations. For a corporation with assets of at least $1,000,000,000 (determined as of the end of the previous tax year), the amount of any required installment of corporate estimated tax which is otherwise due in July, Aug. or Sept. of 2012 is 100.5% of that amount, and the amount of the next required installment after the installment due in July, Aug. or Sept. of 2012 is appropriately reduced to reflect the amount of the 0.5% increase.
Use of smartcards or other electronic media to provide qualified transportation fringes. Beginning in 2012, after numerous postponements, the rules under which employers can provide their employees with qualified mass transit fringe benefits through the use of employer-provided credit cards, debit cards, smartcards, or other electronic media officially go into effect (although employers could rely on the guidance before 2012).
Lump-sum payouts from defined benefit plans. Some defined benefit plans offer participants the option of receiving a lump-sum distribution (e.g., at age 65) instead of an annuity. For plan years beginning after 2007, the Pension Protection Act of 2006 (PPA, P.L. 109-280) amended Code Sec. 417(e)(3) to require defined benefit plans to compute the minimum lump-sum value of an annuity using blended corporate bond rates instead of 30-year Treasury bond rates, which were the benchmark under prior law. Because corporate bond rates generally are higher than long-term Treasury bond rates, the change had the overall effect of reducing lump-sum distributions. Under Code Sec. 417(e)(3), this new rule was phased in over 2008 through 2011 and will be fully in effect for plan years beginning after 2011.
Hybrid defined benefit plan regs. Regs that set forth the exclusive list of interest crediting rates and combinations of interest crediting rates that satisfy the market rate of return requirement for hybrid plans, apply to plan years that begin on or after Jan. 1, 2012. For plan years that begin before Jan. 1, 2012, statutory hybrid plans could use a rate that is permissible under the final regs, or the 2010 proposed regs.
“Readily tradable” employer securities. For purposes of meeting Code Sec. 401(a)(35)'s diversification requirements for defined benefit contribution plans, generally effective for plan years beginning on or after Jan. 1, 2012, employer securities that are “readily tradable on an established securities market” and “readily tradable on an established market” mean employer securities that are readily tradable on an established securities market under Reg. § 1.401(a)(35)-1(f)(5).
Community health needs assessment mandatory. To qualify as tax-exempt, for tax years after Mar. 23, 2012, under Code Sec. 501(r)(3), charitable hospital organizations will need to (i) conduct a community health needs assessment during the tax year or in either of the two tax years immediately preceding the tax year, and (ii) adopt an implementation strategy to meet the community health needs identified therein.
Work opportunity tax credit (WOTC) not available except for hiring qualified veterans. The WOTC under Code Sec. 51 generally can't be claimed for an individual who begins work for the employer after Dec. 31, 2011. However, the WOTC continues to be available for employers that hire qualified veterans who began work for the employer before Jan. 1, 2013.
Disregarded entities included in rules for conduit financing arrangements. Effective for payments made after Dec. 8, 2011, transactions that a disregarded entity enters into are taken into account in determining whether a financing arrangement exists and should be recharacterized under Code Sec. 7701(l) and Reg. § 1.881-3.
Longer writeoff period for certain property. For specialized realty assets (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) placed in service after 2011, a 39-year (up from 15-year) writeoff period generally applies.
Reduced bonus depreciation allowance for qualified property. For qualified property acquired and placed in service after 2011 and before 2013 (after 2012 and before 2014 for aircraft and certain long-production period property), a 50% (down from 100%) bonus first-year depreciation allowance applies under Code Sec. 168(k).
Reduced expensing. For a tax year beginning in 2012, the Code Sec. 179 expensing election is reduced to $139,000, with a $560,000 investment-based ceiling (down from $500,000/$2 million). For tax years beginning after 2012, it will be further reduced to $25,000 with a $200,000 investment-based ceiling. Additionally for a tax year beginning after 2011, expensing can no longer be claimed for qualified real property.

Individual changes taking effect in 2012. Individual changes that apply in 2012 include the following. Note that Congress may retroactively amend one or more of these rules:

Reduced alternative minimum tax (AMT) exemption amounts. Absent another AMT “patch,” the AMT exemption amounts for tax years beginning after 2011 revert to the significantly lower “permanent” amounts of $33,750 for unmarried taxpayers, $45,000 for joint filers, and $22,500 for marrieds filing separately.
Reduced adoption credit. For 2012, the total expenses that may be taken as a credit for all tax years with respect to the adoption of a child by the taxpayer will be limited to $12,650 (down from $13,360 for 2011), and the credit for the adoption of a special-needs child will also be $12,650 (down from $13,360 for 2011). Furthermore, the adoption credit will no longer be refundable.
No parity for exclusion from income for employer-provided mass transit and parking benefits. For 2012, unless Congress changes the rules, the exclusion for qualified parking rises from $230 to $240 due to an inflation adjustment, but falls from $230 to $125 for employer-provided transit and vanpooling benefits.
Protective claims for estate tax refunds. For estates of decedents dying after 2011, a Code Sec. 2053 protective claim for refund of estate tax must be filed by either: (i) attaching one or more completed Schedules PC to the estate's Form 706 at the time the return is filed; or (ii) filing a Form 843 with the IRS office where the Form 706 for the decedent's estate was previously filed, with the notation “Protective Claim for Refund under Section 2053” entered across the top of page 1 of the Form 843.
Reporting foreign assets. Beginning in 2012, U.S. taxpayers who have an interest in certain specified foreign financial assets with an aggregate value exceeding $50,000 must report those assets to IRS on Form 8938, Statement of Specified Foreign Financial Assets, with their tax return.

Provisions that expired on Dec. 31, 2011. The following business and individual provisions expired at the end of last year. Note that Congress may retroactively reinstate some or all of these rules:

7-year straight line cost recovery period for motorsports entertainment complexes under Code Sec. 168(i)(15)(D)
Accelerated depreciation for qualified Indian reservation property under Code Sec. 168(j)
Election to expense 50% of the cost of advanced mine safety equipment under Code Sec. 179E(g)
Election to expense production costs of qualified film and television products in the U.S. under Code Sec. 181(f)
Election to expense environmental remediation costs under Code Sec. 198(h)
Research credit under Code Sec. 41(h)(1)(B)
Income tax credits for biodiesel and renewable diesel under Code Sec. 40A
Alternative fuel and fuel mixture tax credits under Code Sec. 6426(d)(5) and Code Sec. 6426(e)(3)
Indian employment credit under Code Sec. 45A(f)
New markets tax credit under Code Sec. 45D
Railroad track maintenance credit under Code Sec. 45G(f)
Credit for construction of new energy efficient homes under Code Sec. 45L
Energy efficient appliance credit under Code Sec. 45M)
Mine rescue team training credit under Code Sec. 45N(e)
Enhanced charitable deduction for contributions of food inventory under Code Sec. 170(e)(3)(C)
Enhanced charitable deduction for contributions of book inventories to public schools under Code Sec. 170(e)(3)(D)
Enhanced deduction for corporate contributions of computer equipment for educational purposes under Code Sec. 170(e)(6)(G)
Empowerment Zone tax breaks under Code Sec. 1391, Code Sec. 1394, Code Sec. 1396, Code Sec. 179, and Code Sec. 1397B
District of Columbia Enterprise Zone (DC Zone) tax breaks under Code Sec. 1400(f), Code Sec. 1400A(b), and Code Sec. 1400B(b)(2)(A)(i)
The inclusion of Puerto Rico as “within the U.S.” for purposes of determining a taxpayer's domestic production gross receipts (DPGR) under Code Sec. 199(d)(8)(C)
The election to defer gain on sales of qualifying electric transmission property under Code Sec. 451(i)
The exclusion from a tax-exempt organization's unrelated business taxable income (UBTI) of interest, rent, royalties, and annuities paid to it from a controlled entity under Code Sec. 512(b)(13)(E)(iv)
The suspension of income limitations on percentage depletion for marginal wells under Code Sec. 613A(c)(6)(H)(ii)
The ability of a RIC to designate all or a portion of a dividend as an “interest-related dividend” under Code Sec. 871(k)(1)(C) and Code Sec. 871(k)(2)(C)
Inclusion of a RIC in the definition of a “qualified investment entity” under Code Sec. 897(h)(4)
Lower shareholder basis adjustments for charitable contributions by S corporations under Code Sec. 1367(a)
Reduced S corporation recognition period for built-in gains tax under Code Sec. 1374(d)(7)
Exception under subpart F for certain income from the active conduct of a banking or similar business under Code Sec. 953(e)(10) and Code Sec. 954(h)(9)
Look-through treatment for payments between related controlled foreign corporations (CFCs) under the foreign personal holding company rules under Code Sec. 954(c)(6)
The increased limit on cover over of rum excise taxes to Puerto Rico and the Virgin Islands under Code Sec. 7652(f)
Election for itemizers to deduct State and local general sales taxes under Code Sec. 164(b)(5) in lieu of a state and local income taxes
Above-the-line deduction for qualified tuition and related expenses under Code Sec. 222
Treatment of mortgage insurance premiums as qualified residence interest under Code Sec. 163(h)(3)(E)
Above-the-line deduction for up to $250 of certain expenses of elementary and secondary school teachers under Code Sec. 62
Nonbusiness energy property credit under Code Sec. 25C
Tax credit for first-time District of Columbia homebuyers under Code Sec. 1400C(i)
Adoption assistance programs under Code Sec. 137
Allowance of personal tax credits against regular tax and AMT under Code Sec. 26(a)(2)
Exclusion of 100% of gain on certain small business stock under Code Sec. 1202(a)(4)
Tax-free distributions (up to $100,000 annually for taxpayers 70- 1/2 and older) from individual retirement plans for charitable purposes under Code Sec. 408(d)(8)
Special rules to encourage contributions of capital gain real property for conservation purposes under Code Sec. 170(b)(1)(E) and Code Sec. 170(b)(2)(B)
Look-through treatment of certain RIC stock in determining nonresidents' gross estates under Code Sec. 2105(d)

How Today's Low Interest Rates Affect Tax and Estate Planning

Jack Howell — Thu, 13 Oct 2011 15:21:34 -0600

Interest rates have dropped significantly in recent months and may remain low given the state of the economy. Sagging rates can have a significant impact on many tax and estate planning strategies. Lower interest rates affect the income, estate, and gift tax values of many types of transfers. In many cases, the drop in rates produces more favorable results for persons engaging in certain types of transactions. In other cases, however, the lower rates result in higher tax costs. This post examines how low interest rates affect key tax and estate planning transactions and strategies.

IRS valuation tables.

The value of annuities (other than commercial annuities), life estates, term interests, remainders, and reversions for estate, gift, and income tax purposes is determined using tables issued by IRS under Code Sec. 7520. The value in a given month under the tables may be higher or lower than the value in an earlier or later month because the interest factor under the tables changes monthly. For charitable transfers, the interest rate for the month of the transfer or for either of the two preceding months may be used. (Code Sec. 7520(a))

The Code Sec. 7520 interest rate for October 2011 is 1.4%. (Rev Rul 2011-22, 2011-41 IRB) The 1.4% interest rate is an all-time low. The all-time high was 11.6%.

How low rates affect various noncharitable planning strategies.

The discussion that follows explains various noncharitable financial and estate planning strategies and shows how they stack up under current falling rates.

Grantor retained annuity trust (GRAT). An individual can save transfer tax by setting up a GRAT. The individual retains an annuity interest for a specified term at the expiration of which the trust property goes to a child or other individual named at the outset. Gift tax is payable but only on the present value of the remainder interest, which is the value of the property transferred to the trust less the value of the retained annuity interest. A lower interest rate increases the value of the annuity retained by the grantor and thus reduces the value of the gift of the remainder in a GRAT.

The post-transfer appreciation in the value of the trust assets will escape transfer tax. However, this is so only if the grantor survives the trust term. If the grantor dies during the trust term, at least a portion of the trust property will be included in his gross estate under Code Sec. 2036(a), which provides that property transferred by an individual during his lifetime is includible in his estate if he retains an interest for any period that does not in fact end before his death. In 2008, IRS issued regs for determining the extent to which the trust property would be included in a situation like this and in 2009, issued proposed regs that would fine-tune the rules in the final regs. In any event, an individual who sets up a GRAT and dies before the end of the term would be no worse off than if he had not entered into the transaction except that he will have incurred the costs of setting up and administering the trust.

Illustration: When the Code Sec. 7520 interest factor is 1.4%, Smith transfers $1 million to a trust, which is to pay him an annual annuity of $80,000 for 10 years. At the end of the 10 years, the trust property is to go to Smith's daughter. The value of Smith's retained annuity is $741,696. This figure is determined by multiplying $80,000 by 9.2712, which is the annuity factor for a 10-year term and an interest rate of 1.4%. The value of the gift of the remainder to Smith's daughter is $258,304.

By way of comparison, if the interest factor were 5.0%, the value of the retained annuity would be $617,736 ($80,000 times 7.7217) and the value of the gift would be $382,264.

Grantor retained income trust (GRIT). A GRIT is like a GRAT, except that the grantor retains an income interest instead of an annuity interest. Code Sec. 2702 generally treats the grantor as making a gift of the full value of the property. However, the value of the gift of the remainder is determined under the valuation tables where the trust is funded with a personal residence of the grantor or the remainder goes to someone falling outside of the definition of a family member, such as a nephew or niece. A lower interest rate results in a lower value for the retained interest and a higher value for the gift of the remainder interest in a residence GRIT or other GRIT excepted from the Code Sec. 2702 rules.

Illustration: When the Code Sec. 7520 interest factor is 1.4%, Bailey establishes a personal residence GRIT, retaining a 10-year term interest. At the end of the 10-year period, the residence is to go to his son. The value of the residence at the time of the initial transfer to the trust is $400,000. The remainder factor is .870203, making the value of the gift $348,081.

By way of comparison, if the interest factor were 5.0%, the value of the gift would be $245,565 ($400,000 times .613913).

A higher rate produces a better result for this strategy. Accordingly, a person may want to wait until interest rates rise before engaging in this type of transaction.

Grantor retained unitrust (GRUT). The interest factor does not affect the value of a gift of a remainder interest in a GRUT because the retained unitrust interest is the right to receive a fixed percentage of the trust's assets, and changes in rates inure uniformly to the benefit of the unitrust holder and the remainderperson.

Private annuity. Historically, private annuities have offered a number of income, gift, and estate tax advantages. They also can save estate administration expenses and offer other nontax advantages as well. In the typical private annuity transaction, a parent transfers property to his child in return for that child's unsecured promise to pay the parent a fixed, periodic income for life. If the fair market value of the property transferred equals the present value of the annuity under the Code Sec. 7520 valuation tables, there is no gift tax due.

Historically, one huge advantage of a private annuity has been the opportunity to transfer highly appreciated property and defer the gain over several years as annuity payments are received. Additionally, there was the possibility of being taxed on less than the entire gain if the annuitant died before the expiration of his tabular life expectancy. However, in 2006, IRS issued proposed regs that would knock out the income tax advantages of selling appreciated property in exchange for a private annuity. It would do this by causing the property seller's gain to be recognized in the year the transaction is effected rather than as payments are received. The regs generally would apply for transactions entered into after Oct. 18, 2006. However, certain transactions effected before Apr. 19, 2007 would continue to be subject to the historical rules.

Entering into a private annuity when interest rates are lower results in a lower annual payment amount that the younger family member will have to make to the older family member to prevent a gift from arising on the transfer.

Illustration: In October 2011, when the Code Sec. 7520 interest factor is 1.4%, Jones, age 70, transfers property worth $1 million to his daughter in exchange for a private annuity. She must make an annual payment of $79,879.22 to prevent a gift from arising on the transfer. This figure is determined by dividing $1 million by 12.5189, which is the annuity factor from Table S for a 70-year old and an interest rate of 1.4%.

By way of comparison, if the interest factor were 5.0%, the annual payment to prevent a gift would be $107,319.16 ($1 million divided by 9.3180).

A private annuity may be a good strategy for an individual with a short life expectancy who is not expected to survive for too many years. However, the mortality component of the valuation tables cannot be used to determine the present value of an annuity if the person with the measuring life is terminally ill when the gift is completed. Under Reg. § 25.7520-3(b)(3), an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50% probability that he will die within one year.

Someone who is considering setting up a private annuity may want to fund it with stock valued near its original purchase price. Such stock may be a good candidate for funding a private annuity because there would be little or no gain to report in the year of the transfer under the proposed regs, if they take effect. Also, if the stock takes off, the transaction could achieve considerable transfer tax savings. That's because the child will end up with a sizeable amount of property with no gift or estate tax cost imposed on the post-transfer appreciation in its value.

How low rates affect various charitable planning strategies.

The discussion that follows explains various charitable planning strategies and shows how they stack up under current declining rates.

Charitable remainder annuity trust (CRAT). With a CRAT, the donor retains an annuity interest for himself or someone else such as a family member and names a charity to receive the remainder at the end of the annuity term. The donor gets a current income tax deduction for the present value of the charity's remainder interest. Now may not be a good time to establish a CRAT. That's because a lower interest rate produces smaller income, gift and estate tax charitable deductions and a higher gift tax value for a gifted annuity interest.

Charitable remainder unitrust (CRUT). A change in the rate does not affect income tax deductions for CRUTs or gift tax costs in connection with them.

Charitable lead unitrust (CLUT). Estate and gift tax factors are essentially unaffected by changes in the rates.

Charitable lead annuity trust (CLAT). A lower interest rate results in a larger gift or estate tax deduction for the annuity interest going to the charity and a smaller value for any gift of the remainder interest going to a private beneficiary. Thus, it may be a good time to establish a CLAT if the grantor is going to give the remainder interest to a family member.

Charitable transfer of remainder interest in residence or farm. A lower interest rate provides higher income, estate and gift tax deductions for a transfer of a remainder interest in a residence or farm. Conversely, a higher interest rate provides lower income, estate and gift tax deductions for a transfer of a remainder interest in a residence or farm.

Pooled income funds in existence for more than 3 years. Charitable income, gift and estate tax deductions for transfers to pooled income funds that have been in existence for more than three years are not affected by changes in interest rates because values of respective interests are determined with reference to the funds' own rates of return. Any personal gift arising from the transfer also is not affected.

Convert Your Limited Partnership into a Limited Liability Limited Partnership

Jack Howell — Mon, 29 Aug 2011 13:28:59 -0600

The Texas Legislature made several changes to the Texas Business Organizations Code (BOC) that become effective September 1, 2011. Several of these changes deal with limited liability partnerships. I have, until now, not advised my clients to make use of the limited liability partnership provisions in the BOC because of their administrative difficulties and questionable liability protections. Those impediments have been removed. So, I am now advising my limited partnership and general partnership clients to take advantage of the limited liability partnership provisions unless the annual filing fees prove to outweigh the liability protections offered to LLPs and LLLPs.

Details of Law Changes

Before September 1, 2011, the Texas Business Organizations Code (BOC) required limited liability partnerships, as a condition to their registration, to provide evidence of $100,000 of liability insurance or a $100,000 cash deposit, bank letter of credit or insurance company bond. No other states with limited liability partnership statutes have a similar requirement nor are there
similar insurance requirements in the Uniform Partnership Act (1997) or the current limited liability partnership statutes of most jurisdictions. The BOC does not require any other type of business entity or professional entity (i.e., professional corporation, professional association or
professional limited liability company) to satisfy a similar insurance requirement. The insurance requirement under the BOC cause limited liability partnerships in Texas to suffer a disadvantage compared to limited liability partnerships formed in other states and other types of business entities formed in Texas. For the foregoing reasons, the Texas legislature repealed the insurance requirement imposed on LLPs and LLLPs by the BOC.

Before September 1, 2011, the BOC detailed the circumstances when a partner in a limited liability partnership is liable for an error, omission, negligence, incompetence, or malfeasance of another partner or representative of the partnership. Those provisions specified that a partner could be liable if the partner

was supervising or directing the responsible partner or representative or was directly involved in the specific activity in which the error, omission, negligence, incompetence or malfeasance was committed or
had notice or knowledge of such error, omission, negligence, incompetence or malfeasance by the responsible partner or representative and failed to take reasonable action to prevent or cure the error, omission, negligence, incompetence or malfeasance.

As a result, these Code provisions more closely conform to the approach taken in the Uniform Partnership Act (1997) and the trend in other jurisdictions. The legislature determined that the specified provisions are not found in the uniform law or the statutes of most other jurisdictions and are not considered necessary in view of the principle that a partner is usually liable for the partner’s own tortious conduct.

Impact of Law Changes

From a practical standpoint, these changes are significant. Let’s take the example of a “typical” limited partnership. That limited partnership will have a single general partner that is itself some type of limited liability entity, such as a limited liability company or a corporation. The general partner will have a small interest in the limited partnership (maybe even no interest after other recent changes to the BOC regarding “zero percent” general partners). That general partner will also probably have little or no assets other than whatever interest it may own in the limited partnership. But the general partner, by law, has unlimited liability for limited partnership liabilities that exceed the assets of the limited partnership. It is for this very reason that the entity to serve as a general partner was formed in order to protect the management and ownership of the general partner for the liabilities that the limited partnership might generate.

I am, therefore, advising my clients to form limited liability limited partnerships (LLLPs) instead of simply limited partnerships (LPs) in the circumstances that I would have before advised forming an LP. I also think that existing LPs should change into LLLPs. $200 per year in filing fees seems a small price to pay to get the added layer of protection for their general partner and to head off claims asserting the piercing of the liability veil of the general partner.

What to do

If you are interested in changing your LP into an LLLP, contact me and I will explain in more detail the process involved and its cost.

Make Sure Your Compensation Plans Are in Order and Documented

Jack Howell — Mon, 08 Aug 2011 13:52:30 -0600

I recently finished resolving a dispute between a client and the IRS regarding the amount of compensation for the founder and owner of a corporation. While the amount of compensation during one of the years at issues was probably unjustifiably high if viewed by itself, the person's compensation over the years (and including the year in dispute) was readily justifiable when viewed over the entire period that the person worked for the business. We ended up resolving the dispute and the resolution was within $50,000 in compensation from my initial evaluation of the case. But it was an expensive "victory" for the client.

The strongest point for the IRS, and the reason it took as much time and expense to resolve, was the client’s lack of documentation of a consistently applied compensation plan. The client had annual minutes (which many clients do not), but those minutes did not address how the owner’s compensation was determined. The client also did not have a written employment agreement, nor did they have any written (or “understood”) basis for calculating the client’s incentive compensation each year. This lack of a consciously determined pattern to the compensation ended up costing the client several thousand dollars in attorneys fees, and a like amount in additional taxes.

The moral of the story: properly pay and report compensation to employee/owners as such; have a written employment agreement or at least some sort of documentation in your minutes of the oral arrangements for compensation; make sure you have a documented or easily proved method for determining incentive compensation that is reasonable in amount.

IRS Instructs Examiners How to Seek Approval to Apply Economic Substance Doctrine

Jack Howell — Mon, 08 Aug 2011 13:39:56 -0600

In a July 15th directive from IRS's Large Business & International (LB&I) Division, the IRS issued guidance to managers and examiners on when to seek the approval of the Director of Field Operations (DFO) for asserting the economic substance doctrine. The directive lays out a multi-step analysis for examiners to complete before submitting their requests to the DFO.

Background on Economic Substance.

For transactions entered into after Mar. 30, 2010, and for underpayments, understatements, and refunds and credits attributable to transactions entered into after Mar. 30, 2010, a transaction to which the economic substance doctrine is relevant is treated as having economic substance under a conjunctive two-prong test only if—apart from Federal income tax effects—both:

the transaction changes in a meaningful way the taxpayer's economic position (Code Sec. 7701(o)(1)(A)); and
the taxpayer has a substantial purpose for entering into the transaction. (Code Sec. 7701(o)(1)(B)) -- that is, the taxpayer's non-Federal-income-tax purpose for entering into a transaction must be “substantial.”

Background on Penalties.

For underpayments attributable to transactions entered into after Mar. 30, 2010, a 20% strict liability penalty applies to an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (as defined in Code Sec. 7701(o)), or failing to meet the requirements of any similar rule of law. (Code Sec. 6662(b)(6)) The penalty rate is increased to 40% if the taxpayer doesn't adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return. (Code Sec. 6662(i)(1)) Code Sec. 6664 's reasonable cause exception doesn't apply to the Code Sec. 6662(b)(6) penalty. (Code Sec. 6664(c)(2)) Additionally, a maximum 20% strict liability penalty under Code Sec. 6676 also applies to refund claims based on any transaction described in Code Sec. 6662(b)(6).

IRS’ Guidance.

The new LB&I directive provides instructions to examiners and their managers on determining when to seek the approval of the DFO in order to raise the economic substance doctrine. This approval was mandated by a prior LB&I directive designed to ensure consistent application of the associated strict liability penalty.

Once an examiner determines that raising the doctrine might be warranted, the directive sets out a series of four steps that the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

1. The examiner must determine whether the facts and circumstances of a transaction are similar to those listed in the directive that tend to show that application of the economic substance transaction is likely not appropriate. Among the factors indicating that the doctrine is inappropriate are that the transaction is not promoted by a tax department or outside advisors, is not highly structured, is at arm's length with unrelated third parties, and carries a significant risk of loss.

2. The examiner must determine whether the facts and circumstances of a transaction are similar to those listed in the directive that tend to show that application of the economic substance transaction is likely appropriate. These factors include that the transaction includes unnecessary steps, accelerates a loss or duplicates a deduction, has no credible business purpose apart from federal tax benefits, and is outside the taxpayer's ordinary business operations.

3. The examiner must answer each of the following inquiries before seeking the approval of the appropriate DFO to apply the doctrine. If the answer to (i) through (iv) is affirmative, then application of the doctrine should not be pursued without specific approval of the examiner's manager in consultation with local counsel. In answering (v) and (vi), the examiner should seek the advice of his manager in consultation with local counsel.

Is the transaction a statutory or regulatory election?

Is the transaction subject to a detailed statutory or regulatory scheme and, if so, does it comply with this scheme?

Does judicial or administrative precedent exist that either rejects the application of the economic substance doctrine to the type of transaction or a substantially similar transaction, or upholds the transaction without reference to the doctrine?

Does the transaction involve tax credits (e.g., for low-income housing or alternative energy) that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits?

Does another judicial doctrine more appropriately address the noncompliance that is being examined?

Does recharacterizing a transaction more appropriately address the noncompliance that is being examined?

In considering all the arguments available to challenge a claimed tax result, is the application of the doctrine among the strongest arguments available? If not, it shouldn't be pursued without specific approval of the examiner's manager in consultation with local counsel.

4. If an examiner completes the above inquiries and concludes that it is appropriate to seek approval to apply the doctrine, the examiner, in consultation with his manager and territory manager, should describe for the appropriate DFO in writing how the analysis was completed. The DFO should then review the written material provided and consult with counsel. If the DFO believes it is appropriate to approve the request, the DFO should provide the taxpayer an opportunity to explain their position. The DFO should convey the final decision to the examiner in writing.

Individual Steps of Multi-step Transactions.

The directive provides that when a transaction involves a series of interconnected steps with a common objective, the steps are generally viewed together in applying the above guidance. However, in certain circumstances, it may be appropriate to apply this guidance separately to one or more steps that are included within a series of arguably interconnected steps, such as when an integrated transaction includes one or more tax-motivated steps that bear only a minor or incidental relationship to a single common business or financial transaction. If an examiner wants to apply this guidance separately to one or more steps with a common objective, the examiner must first seek guidance from their manager and consult with their local counsel.

Taxpayer Notification.

An examiner should notify a taxpayer that he is considering whether to apply the economic substance doctrine to a particular transaction as soon as possible, but not later than when the examiner begins the four-step analysis.

Penalties Limited to Economic substance Doctrine.

The directive also clarifies that, until further guidance is provided, the penalties under Code Sec. 6662(b)(6) and Code Sec. 6676 are limited solely to the application of the economic substance doctrine. They may not be imposed due to the application of any other similar “rule of law” or judicial doctrine, like the step transaction doctrine or substance over form.

The text of LB&I-4-0711-015 “Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties” can be viewed on the IRS website at http://www.irs.gov/businesses/article/0,,id=242253,00.html.

Form 990: Could yours be front page news?

Mindi Bozeman Zanowiak — Fri, 05 Aug 2011 14:18:09 -0600

One major difference between Form 990 and the tax forms filed by individuals and businesses has to do with privacy and confidentiality. On Form 990, almost nothing (except the list of donors' names) is private or confidential. The financial data of exempt organizations is out there for the world to see—and now that many Web sites carry copies of Forms 990, "the world" is probably not an exaggeration.

Form 990 is prepared for review by the IRS as well as state attorneys general, to whom copies are sent. Others can also be expected to read an organization's Form 990, including:

(1.) Congress, if it is studying an issue to which the organization's Form 990 relates.

(2.) State officials and agencies that perform charitable or regulatory oversight, or enforce state income tax filing requirements.

(3.) Prospective donors and their legal and financial advisors. The $50 donor might not seek out a Form 990, but there is a high probability that the largest donors will.

(4.) Members of the general public who are interested in the programs and accomplishments of an organization, and the efficiency with which it operates.

(5.) News media and researchers seeking information about an organization.

(6.) Self-appointed "watchdog" organizations and others who may be checking up on an organization. These may include competing charities, organizations with opposing policy views, or taxable organizations checking to see whether a tax-exempt organization is providing unfair competition.

(7.) Employees and former employees of the organization.

When completing Form 990, the answers should be prepared as if they may appear on the front page of the local newspaper…they just might!

"Gang of Six" tax proposals

Jack Howell — Wed, 20 Jul 2011 09:18:45 -0600

I don't know about any of you, but I didn't see any specifics mentioned in the news reports yesterday about the tax proposals that are part of the newest compromise proposal to fix the debt ceiling. But I am happy to report that RIA included them this morning in their daily update. Here they are:

A single corporate tax rate between 23% and 29% and shift to a competitive territorial tax system.
Tax simplification that involves reducing the number of tax expenditures (i.e., tax breaks) and reducing individual tax rates. There would be three tax brackets with rates in the range of 8%–12%, 14–22%, and 23%–29%. To the extent future Congresses find that the dynamic effects of tax reform result in additional revenue beyond initial targets, this revenue would go to additional rate reductions and deficit reduction, not to new spending.
Permanent repeal of the alternative minimum tax (AMT).
Reform, rather than elimination, of tax breaks for health, charitable giving, homeownership, and retirement.
Retention of the earned income tax credit and child tax credit, or creation of an alternative that would provide at least the same level of support for qualified beneficiaries.

The bipartisan plan calls for the Senate Finance Committee within six months to report a comprehensive tax reform package using the listed items to deliver “real deficit savings by broadening the tax base, lowering tax rates, and generating economic growth.”

Choosing a Fiduciary-Part II of II

Mindi Bozeman Zanowiak — Fri, 17 Jun 2011 14:10:00 -0600

As you are choosing a fiduciary, it is also important to name successor fiduciaries. What if the executor or trustee you choose is unable or unwilling to serve when the time comes? What if that person is sick, deceased or incapacitated when it comes time for them to serve? What if they move far away, making it difficult to perform important duties?

Because of the issues identified above, it can make sense to consider an institutional fiduciary, like a bank or trust company. Theoretically, a bank or trust company will be around when you need it. Additionally, the bank or trust company should have the resources to redress any errors they make. Most importantly, however, is that they have the infrastructure and processes already in place to perform their duties. Yes, they charge a fee for serving as a fiduciary, but it is often worth the price.

There are no “rules” to follow in making fiduciary appointments. The important thing is to think long and hard about these issues and then make the best decision you can based on the information you have.

Choosing a Fiduciary-Part I of II

Mindi Bozeman Zanowiak — Fri, 10 Jun 2011 08:00:00 -0600

Good estate planning requires serious thought when making "fiduciary" (e.g., power of attorney, executor, and trustee) appointments. Black's Law Dictionary describes a fiduciary relationship as "one founded on trust or confidence reposed by one person in the integrity and fidelity of another." These appointments will dictate who controls, manages and distributes your assets when you are incapacitated or have passed away.

At first glance, it may seem that choosing a fiduciary is a simple decision. Married couples often name each other to serve as agents under powers of attorney, as executor and as trustee. It is also common to appoint the eldest child, a family member, or a close friend to the position. Contrary to what many people think, however, it's not just an "honor" to serve as someone's fiduciary- it's actually a lot of hard work. Additionally, executors and trustees have "fiduciary duties" (the highest duties imposed by law) and can be held legally liable for failing to properly carry them out. Accordingly, it is important that you choose these fiduciaries wisely because they usually have very broad powers which can be easily abused.

Before appointing a fiduciary, consider the following:

Do you trust them completely?
Can they be objective?
Are they financially competent, well organized, and detail-oriented?
Do they have the time?
If you own a business or farm and ranching operation, do they have the time and talent to oversee and operate it?
Are they willing to serve?
Will they mind having their actions scrutinized by the beneficiaries?
Do they have the financial resources to pay for any damages they cause?

The IRS is on the hunt. Are you a target?

Mindi Bozeman Zanowiak — Fri, 03 Jun 2011 08:00:00 -0600

If one thinks the IRS has nothing to do at the estate and gift tax division (because of the increased estate and gift tax exemptions to $5.0 million), think again.

The IRS has begun a hunt for recorded transactions that indicate a gift or gifts by a taxpayer that exceed the annual $13,000 gift tax exclusion. Arden Dale in the Wall Street Journal reported on the IRS’s efforts. A court filing in California described efforts by the IRS estate and gift tax division to find people who have not filed gift and generation-skipping tax returns and reported the taxable transfers. Obvious targets include transfers that may have exceeded the $1.0 million gift tax exemption in calendar year 2010 and prior. States are cooperating with the information requests, including TEXAS, Connecticut, Florida, Hawaii, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, Washington and Wisconsin. The court filing notes that Josephine Bonaffini, the coordinator of an IRS state and federal gift-and-estate tax program, examined a sampling of data from these states and it showed an extremely high failure-to-report rate.

New tax rules have made big gifts to family members popular this year, as Congress raised the limit on how much a person can give in a lifetime to $5 million without having to pay gift tax. Still, any time a gift to one person exceeds $13,000, the giver is supposed to let the IRS know by reporting such gifts on Form 709.

Turning Startup Profits into 100% Tax-free Gains under the Qualified Small Business Stock Rules

Jack Howell — Mon, 23 May 2011 12:34:37 -0600

Venture capitalists and private equity groups are reportedly taking an interest in structuring startups to qualify under the qualified small business stock (QSBS) provisions of Code Sec. 1202. It's not hard to see why — this often-overlooked Code provision can turn much or all of the profit on a successful investment in a startup into tax-free gain. But time may be of the essence: Under current law, the 100% exclusion won't apply for QSBS acquired after 2011.

Noncorporate taxpayers may exclude from gross income 100% of any gain realized on the sale or exchange of QSBS held for more than five years if the QSBS is acquired after Sept. 27, 2010 and before Jan. 1, 2012. The exclusion is 75% of gain realized on the sale or exchange of QSBS acquired after Feb. 17, 2009 and before Sept. 28, 2010, and 50% of gain realized on the sale or exchange of QSBS acquired either before Feb. 18, 2009, or after Dec. 31, 2011 (but 60% instead of 50% for certain gain attributable to QSBS in a qualified business entity). Excluded gain is subject to a cumulative and annual dollar limitation.

Additionally, the alternative minimum tax (AMT) preference for a portion of gain from the sale or exchange of QSBS that is excluded from gross income for regular tax purposes under Code Sec. 1202 doesn't apply to QSBS acquired after Sept. 27, 2010 and before Jan. 1, 2012.

A noncorporate taxpayer's net capital gain that is adjusted net capital gain is taxed at a maximum rate of 15%. If the adjusted net capital gain would otherwise be taxed at a rate below 25% if it were ordinary income, it is taxed at a zero percent rate. Under current law, these rates are in effect through 2012. Net capital gain attributable to section 1202 gain (as well as collectibles gain) is taxed at a maximum rate of 28%. Section 1202 gain is the excess of (1) the gain that would be excluded from gross income on the sale of certain QSBS under Code Sec. 1202, if the percentage limitations of Code Sec. 1202(a) didn't apply, over (2) the gain actually excluded under Code Sec. 1202.

Qualifying as QSBS. Stock qualifies as QSBS only if it meets all of the following tests.

It must be stock in a C corporation (that is, not S corporation stock) originally issued after Aug. 10, '93.
As of the date the stock was issued, the corporation was a domestic C corporation with total gross assets of $50 million or less (a) at all times after Aug. 9, '93, and before the stock was issued, and (b) immediately after the stock was issued. Gross assets include those of any predecessor of the corporation, and all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.
In general, the taxpayer must have acquired the stock at its original issue (either directly or through an underwriter), either in exchange for money or other property or as pay for services (other than as an underwriter) to the corporation.
During substantially all the time the taxpayer held the stock:

The corporation was a C corporation;
At least 80% of the value of the corporation's assets were used in the active conduct of one or more qualified businesses; and
The corporation was not a foreign corporation, domestic international sales corporation (DISC), former DISC, regulated investment company (RIC), real estate investment trust (REIT), real estate mortgage investment conduit (REMIC), financial asset securitization investment trust (FASIT), cooperative, or a corporation that has made (or that has a subsidiary that has made) a Code Sec. 936 election.

Active conduct of a qualified business. For purposes of the rule requiring 80% of the value of assets to be used in the conduct of a qualified business, all of the following are treated as used in the active conduct of a qualified business:

Assets used in certain activities with respect to future qualified businesses, without regard to whether the corporation has any gross income from these activities at the time this rule is applied. Those activities are (a) Code Sec. 195(c)(1)(A) startup activities, (b) activities that result in the payment or incurrence of qualifying research and experimental expenditures under Code Sec. 174, and (c) activities with respect to in-house research expenses.
Assets held to meet the reasonably required working capital needs of a qualifying business, and assets held for investment that are reasonably expected to be used within two years to finance research and experimentation in a qualified business or to finance increases in working capital needs of such a business. But, after the corporation has been in existence for at least two years, no more than 50% of its assets may qualify as being used in the active conduct of a qualified business by reason of these rules.
The rights to computer software which produces active business computer software royalties as defined in Code Sec. 543(d)(1)

A corporation will be treated as failing to meet the active business requirement for any period during which: (1) more than 10% of the value of its assets in excess of its liabilities consists of stock or securities in other corporations which are not subsidiaries of the corporation, other than working capital assets; or (2) more than 10% of the total value of its assets consists of real property which is not used in the active conduct of a qualified business (for this purpose, owning, dealing in, or renting real property is not considered to be the active conduct of a qualified business).

Note that a corporation will be treated as meeting the active business requirement for any period during which it is a specialized small business investment company (SSBIC).

Qualified business. For QSBS purposes, a qualified business is one that isn't:

A business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
A banking, insurance, financing, leasing, investing, or similar business.
A farming business (including the raising or harvesting of trees).
A business involving the production of products for which percentage depletion can be claimed.
A business of operating a hotel, motel, restaurant, or similar business.

Dollar limit on eligible gain. For each tax year, for each corporation in which the taxpayer sells or exchanges QSBS, the amount of gain eligible for the exclusion can't exceed the greater of:

$10 million ($5 million for married persons filing separately), less the total amount of eligible gain (i.e., gain on the sale or exchange of QSBS held for more than five years) taken into account under the Code Sec. 1202(a) rules by the taxpayer with respect to dispositions of stock issued by the corporation in all earlier tax years, or
ten times the taxpayer's total adjusted basis in QSBS of the corporation disposed of by the taxpayer in the tax year.

IRS tool makes it easier for employers to keep track of important tax deadlines

Jack Howell — Wed, 16 Mar 2011 08:53:37 -0600

The IRS has a new online tool to make it easier to remember important tax return and deposit deadlines. It's called the “IRS Calendar Connector” and it doesn't cost anything to download it to a computer desktop. The calendar includes deadlines for all types of taxes, including income, employment, and excise taxes. However, employers may customize the calendar to only include deadlines for certain types of taxes. For example, a calendar that was customized to only show employment tax deadlines would display semiweekly and monthly payroll tax deposit due dates and the deadlines for filing employment tax returns. Employers may choose whether they want to see a list of deadlines by day, week, or month. The “settings” option allows users to check for updates, which will refresh in real time. The settings may also be adjusted to have the calendar start up at the time a user logs onto his or her computer.

The “Calendar Connector” may be downloaded at http://www.tax.gov/irscalendarconnector/. In addition, the IRS also has a monthly online calendar on its website at http://www.tax.gov/calendar/, and Publication 509 (http://www.irs.gov/pub/irs-pdf/p509.pdf) that provides tax calendars and deadline dates for 2011.

Obama Wants to Change How All Businesses Are Taxed?

Jack Howell — Mon, 28 Feb 2011 14:22:40 -0600

According to Bloomberg News, Geithner Says Tax Overhaul Must Address Businesses Filing as Individuals. It is not clear from the article exactly what this means. It could mean that the administration wants to impose the same type of taxes on all businesses, whether they are incorporated or not. Or it could be something less sinister. But, in either event, it does look like tax changes will be proposed by the administration to all business taxes, whether they are earned by C corporations or pass-through entities. We'll continue to monitor the situation to find out exactly what the administration has in mind.

Highlights of New Items on 2010 Form 1040

Jack Howell — Wed, 09 Feb 2011 14:18:23 -0600

Politicians say they want to simplify the tax laws; yet they continue to make the law more complicated. This year is no different. The 2010 Form 1040 reflects a number of new tax breaks. Some are straightforward. Others are complex. Some present choices. But they all provide an opportunity to save money.

Here is a list of the key changes for this filing season:

• Roth IRA rollovers no longer restricted. You can now make a qualified rollover contribution to a Roth IRA, regardless of the amount of your modified adjusted gross income.

• Income from Roth rollover can be spread out. Half of any income that results from a rollover or conversion to a Roth IRA from another retirement plan in 2010 is included in income in 2011, and the other half in 2012, unless you elect to include all of it in 2010.

• Self-employed health insurance deduction. Effective March 30, 2010, a self-employed person who paid for health insurance may be able to include in his self-employed health insurance deduction any premiums he paid to cover his child who was under age 27 at the end of 2010, even if the child was not his dependent. Also, health insurance costs for a taxpayer and his family are deductible in computing 2010 self-employment tax.

• Small business health insurance credit. There's a new tax credit for an eligible small employer who makes qualifying contributions to buy health insurance for his employees. This credit is very complex but it can yield substantial tax savings. In general, the credit is 35% of premiums paid and can be taken against regular and alternative minimum tax.

• Limits on personal exemptions and itemized deductions ended. You no longer lose part of your deduction for personal exemptions and itemized deductions, regardless of the amount of your adjusted gross income.

• Personal casualty and theft loss limit reduced. Each personal casualty or theft loss is limited to the excess of the loss over $100 (instead of the $500 limit that applied for 2009). This yields larger deductions and thus greater tax savings for affected individuals.

• Corrosive drywall damage. A taxpayer who paid for repairs to his personal residence or household appliances because of corrosive drywall that was installed between 2001 and 2008 may be able to deduct those amounts as casualty losses under a special safe harbor crafted by the IRS.

• Homebuyer credit. An eligible first-time homebuyer (and a long-term resident treated as a first-time homebuyer) may be able to claim a first-time homebuyer credit for a home that was purchased in 2010. To qualify, the home must have cost $800,000 or less. You generally cannot claim the credit for a home you bought after April 30, 2010. However, you may be able to claim the credit if you entered into a written binding contract before May 1, 2010, to buy the home before July 1, 2010, and actually bought the home before October 1, 2010.

• Adoption credit. The maximum adoption credit is $13,170 per eligible child for both non-special needs adoptions and special needs adoptions. In addition, the adoption credit is refundable, i.e., you get the credit even if it exceeds your taxes.

• Gifts to charity. The provision that excludes up to $100,000 of qualified charitable distributions (distributions to a charity from an Individual Retirement Account) has been extended. If you elect, a qualified charitable distribution made in January of 2011, will be treated as made in 2010.

• Enhanced small business expensing (Section 179 expensing). To help small businesses quickly recover the cost of capital outlays, small business taxpayers can elect to write off these expenditures in the year they are made instead of recovering them through depreciation. For 2010, you generally may expense up to $500,000 of qualifying property placed in service during the tax year. This annual limit is reduced by the amount by which the cost of property placed in service exceeds $2,000,000. \

• Special depreciation allowance. Businesses that acquire and place qualified property into service after September 8, 2010 can now claim a depreciation allowance in the placed-in-service year equal to 100% of the cost of the property. Businesses that acquired qualified property from January 1, 2010 through September 8, 2010 can claim a bonus first-year depreciation allowance of 50% of the cost of the property.

• Cellular telephones. Cellular telephones (cell phones) and other similar telecommunications equipment have been removed from the categories of “listed property.” This means that cell phones can be deducted or depreciated like other business property, without onerous record keeping requirements.

• Carryback of general business credits. Generally, a business's unused general business credits can be carried back to offset taxes paid in the previous year, and the remaining amount can be carried forward for 20 years to offset future tax liabilities. However, for 2010, eligible small businesses can carry back unused general business credits for five years instead of just one.

• Luxury auto limits. First-year luxury auto limits for vehicles first placed in service in 2010 are $11,060 for autos and $11,160 for light trucks or vans (for vehicles ineligible for bonus depreciation, or if the taxpayer elects out, $3,060 and $3,160, respectively).

Brief Summary of Recent Income Tax Changes

Jack Howell — Mon, 24 Jan 2011 09:48:55 -0600

The tax laws enacted in the last couple of years contain important income tax and information reporting provisions that are effective for the first time in 2011. Here's a summary of the key tax changes for 2011, broken down into three categories: Personal Income Taxes, Retirement Plan Changes, and Tax Changes for Businesses and Investors.

Personal Income Taxes

Payroll tax holiday in place. Employees will pay only 4.2% (instead of the usual 6.2%) OASDI (Social Security) tax on compensation received during 2011 up to $106,800 (the wage base for 2011). Similarly, for tax years beginning in 2011, self-employed persons will pay only 10.4% Social Security self-employment taxes on self-employment income up to $106,800. In either case, the maximum savings for 2011 will be $2,136 (2% of $106,800) per taxpayer. If both spouses earn at least as much as the wage base, the maximum savings will be $4,272.

Stricter rules apply to energy saving home improvements. You can claim a tax credit for energy saving home improvements you make this year, but stricter rules apply for 2011 than for 2010. You can only claim a 10% credit for qualified energy property placed in service in 2011 up to a $500 lifetime limit (with no more than $200 from windows and skylights). What's more, the credit you claim for any year can't exceed $500 less the total of the credits you claimed for all earlier tax years ending after Dec. 31, 2005. The amount you claim for windows and skylights in a year can't exceed $200 less the total of the credits you claimed for these items in all earlier tax years ending after Dec. 31, 2005. The credit is equal to the sum of: (1) 10% of the amount you pay or incur for qualified energy efficient improvements (such as insulation, exterior windows or doors that meet certain energy efficient standards) installed during the year, and (2) the amount of the residential energy property expenses you paid or incurred during the year.

The credit for residential energy property expenses can't exceed: (A) $50 for an advanced main circulating fan; (B) $150 for any qualified natural gas, propane, or hot water boiler; and (C) $300 for any item of energy efficient property (advanced types of energy saving equipment, such as electric heat pumps, meeting specific energy efficient standards).

Partial annuitization of annuity contracts. When you receive non-retirement-plan annuity payments from an annuity contract, part of each payment is a tax-free recovery of your basis (cost of the annuity contract for tax purposes), and part is a taxable distribution of earnings. For amounts received in tax years beginning after Dec. 31, 2010, taxpayers may partially annuitize such an annuity (or endowment, or life insurance) contract. If you receive an annuity for a period of 10 years or more, or over one or more lives, under any portion of an annuity, endowment, or life insurance contract, then that portion is treated as a separate contract for annuity taxation purposes. The net effect is that the annuitized portion is treated as a separate contract, and each annuity payment from that portion is partially a tax-free recovery of basis and partially a taxable distribution of earnings. Absent this rule, the payments might have been treated as coming out of income before recovery of any basis. The portion of the contract that is not annuitized is also treated as a separate contract and will continue to earn income on a tax-deferred basis.

Restricted definition of medicine for health plan reimbursements. Beginning this year, the cost of over-the-counter medicines can't be reimbursed with excludible income through a health flexible spending arrangement (FSA), health reimbursement account (HRA), health savings account (HSA), or Archer MSA (medical savings account), unless the medicine is prescribed by a doctor or is insulin. This new rule applies to amounts paid after 2010. However, it does not apply to amounts paid in 2011 for medicines or drugs bought before Jan. 1, 2011. Also, for distributions after 2010, the additional tax on distributions from an HSA that are not used for qualified medical expenses increases from 10% to 20% of the disbursed amount, and the additional tax on distributions from an Archer MSA that are not used for qualified medical expenses increases from 15% to 20% of the disbursed amount.

Retirement Plan Changes

Small employers may establish “simple cafeteria plans.” For years beginning after Dec. 31, 2010, small employers (those having an average of 100 or fewer employees on business days during either of the two preceding years) may provide employees with a “simple cafeteria plan.” An employer that uses this type of plan gets a safe harbor from the nondiscrimination requirements for cafeteria plans as well as from the nondiscrimination requirements for certain types of qualified benefits offered under a cafeteria plan, including group term life insurance, benefits under a self-insured medical expense reimbursement plan, and benefits under a dependent care assistance program.

Election to treat January 2011 charitable distributions as made in 2010. If you are age 70 1/2 or older, you can make tax-free distributions to a charity from an Individual Retirement Account (IRA) of up to $100,000. This applies for charitable IRA transfers made in tax years beginning before Jan. 1, 2012. In addition, if you make such a distribution in January of 2011, you can treat it for income tax purposes as if it were made on Dec. 31, 2010. Thus, a qualified charitable distribution made in January of 2011 may be treated as made in your 2010 tax year and count against the $100,000 exclusion for 2010. It is also may be used to satisfy your IRA required minimum distribution for 2010.

Tax Changes for Businesses and Investors

Electronic filing rules now in place. Beginning Jan. 1, 2011, employers must use electronic funds transfer (EFT) to make all federal tax deposits (such as deposits of employment tax, excise tax, and corporate income tax). Forms 8109 and 8109-B, Federal Tax Deposit Coupon, cannot be used after Dec. 31, 2010.

Up-to-$1,000 credit for “retained workers” in 2011. Employers may claim a “retention credit” for retaining qualifying new employees (certain formerly unemployed workers meeting specific requirements). The amount of the credit is the lesser of $1,000 or 6.2% of wages you pay to the retained qualified employee during a 52 consecutive week period. The qualified employee's wages for such employment during the last 26 weeks must equal at least 80% of wages for the first 26 weeks. The credit may be claimed for a retained worker for the first tax year ending after Mar. 18, 2010, for which the retained worker satisfies the 52 consecutive week requirement. However, the credit applies only for qualifying employees hired after Feb. 3, 2010, and before Jan. 1, 2011.

New basis and character reporting rules. Generally effective on Jan. 1, 2011, every broker required to file an information return reporting the gross proceeds of a “covered security” such as corporate stock must include in the return the customer's adjusted basis in the security and whether any gain or loss with respect to the security is short-term or long-term. The reporting is generally done on Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions.” A covered security includes all stock acquired beginning in 2011, except stock in certain regulated investment companies (i.e, mutual funds) and stock acquired in connection with a dividend reinvestment plan (both of which are covered securities if acquired beginning in 2012).

Corporate actions that affect stock basis must be reported. Effective Jan. 1, 2011, issuers of “specified securities” must file a return describing any organizational action (e.g., stock split, merger, or acquisition) that affects the basis of the specified security, the quantitative effect on the basis of that specified security, and any other information required by IRS. The issuer's return (and information to nominees or certificate holders) must be filed within 45 days after the date of the organizational action or, if earlier, by January 15th of the year following the calendar year during which the action occurred. Nominees or certificate holders must (unless the IRS waives this requirement) be given a written statement showing (1) the name, address, and telephone number of the information contact of the person required to file the return, (2) the information required to be included on the return for the security, and (3) any other information required by the IRS. In general, a specified security is any share of stock in an entity organized as, or treated for federal tax purposes as, a foreign or domestic corporation.

Reporting requirement for payment card and third-party payment transactions. After 2010, banks generally must file an information return with the IRS reporting the gross amount of credit and debit card payments a merchant receives during the year, along with the merchant's name, address, and TIN. Similar reporting is also required for third party network transactions (e.g., those facilitating online sales).

Information reporting for real estate. For payments made after Dec. 31, 2010, for information reporting purposes, a person receiving rental income from real estate is treated as engaged in the trade or business of renting property. As a result, recipients of rental income from real estate generally are subject to the same information reporting requirements as taxpayers engaged in a trade or business. In particular, rental income recipients making payments of $600 or more during the tax year to a service provider (such as a plumber, painter, or accountant) in the course of earning rental income must provide an information return (typically Form 1099-MISC) to the IRS and to the service provider.

The rental property expense payment reporting requirement doesn't apply to: (1) an individual who receives rental income of not more than a minimal amount (to be determined by the IRS); (2) any individual (including one who is an active member of the uniformed services or an employee of the intelligence community) if substantially all of his or her rental income is derived from renting the individual's principal residence (main home) on a temporary basis; or (3) any other individual for whom the information reporting requirement would cause hardship (to be defined by the IRS).