The IRS has finally released regulations for the IRC §199A deduction for qualified business income, also known as “pass-through deduction.”

What is Section 199A and Who Does it Apply To?

Section 199A allows business owners to deduct up to 20% of their Qualified Business Income (QBI) from sole proprietorships, partnerships, trusts and S corporations. Individuals, estates and trusts can also deduct 20% of their qualified REIT dividends and Qualified Income from a Publicly Traded Partnership (PTP). The deduction was one of the most high-profile pieces of the Tax Cuts and Jobs Act.

What’s included?

The Good:

  • Individuals can aggregate businesses and treat them as a single business, which can effectively increase the wage limits and capital limits on the deduction
  • A qualified business can get up to 10% of its gross receipts from services
  • A qualified business can include a related rental activity

The Bad:

  • Broadens the “service-business” category to include some non-service businesses that are incidental or related to a service business. This can limit the effectiveness of “crack and pack” strategies that try to create a qualified business by spinning off part of a service business

Mixed:

  • A rebuttable presumption that a former employee who continues to perform the same services for the employer is still an employee. I.e. the worker’s compensation is not qualified business income.

Neutral:

  • Defines terms such as:
    • Trade or Business
    • Unadjusted basis immediately after acquisition
  • Explains how to calculate the deduction
  • Detailed rules for determining the wage limits and capital limits
  • More clearly illustrates the three components of the deduction:
    • Qualified Business Income
    • REIT dividends
    • PTP income
  • Better explanations of:
    • Service business categories
    • Reporting requirements for pass-through entities (S corps and partnerships)
    • How an estate or trust can qualify for the deduction.

These changes and clarifications open up great opportunities for tax planning. Please contact us to discuss these new regulations will apply to your specific situation. Our team can review your current tax structure to ensure that you are receiving the maximum benefit of these new rules.

Summary:

Businesses can enhance their cash flow by optimizing their tax accounting methods.

The Tax Cuts and Jobs Act expanded the number of small business taxpayers eligible to use the cash method of accounting by raising the cap on gross receipts to $25 million averaged over the prior three years.

A change in accounting method can benefit any company, of any size, in any industry.

Before changing an accounting method, the IRS requires that a taxpayer obtain the IRS’s consent.

Businesses can enhance their cash flow by optimizing their tax accounting methods. This is especially important in times of tight money and inadequate revenues. More and more companies are putting their taxes under a microscope and taking a hard look at whether they can improve their cash flow by changing the accounting methods that they have elected either on past returns or during the current year. A taxpayer who is not on the optimal accounting method is effectively prepaying taxes, an undesirable and unnecessary result.

Every business must adopt a method of accounting to determine when it recognizes items of income and deduction. An accounting method determines timing (when an item is taken into account for taxes), not whether the item is taken into account. The choice of an appropriate method (or methods) is crucial because it determines the timing of overall income or loss.

The two most common overall accounting methods are the cash method, in which income and deductions are taken into account when payments are received or made, and the accrual method, in which income and deductions are taken into account when amounts are earned and expenses are incurred. Other accounting methods can apply to specific “material” items, such as the valuation of inventory or the treatment of an installment sale. For many businesses, there are scores of these “other accounting methods” to consider.

The Tax Cuts and Jobs Act expanded the number of small business taxpayers including startups eligible to use the cash method of accounting by raising the cap on gross receipts to $25 million averaged over the prior three years. Taxpayers who meet this revenue test are also eligible to use several simplified methods of accounting that exempt them from the requirements to capitalize costs in many situations, including the cash method of accounting and certain exceptions that may apply to accounting for capitalized costs, inventory, and long-term contracts. The IRS recently announced that it would automatically consent to these changes for taxpayers who meet specific eligibility requirements.

A change in accounting method can benefit any company—of any size, in any industry. Before changing an accounting method, the IRS requires that a taxpayer obtain the IRS’s consent. For some changes, the taxpayer must apply to the IRS for advance consent and pay a user fee. The application procedures are spelled out in IRS Revenue Procedure 2015-13. For these changes, the taxpayer cannot switch methods until the IRS agrees.

For other methods, the IRS has streamlined the process and will approve changes automatically. For these changes, the taxpayer can switch to another method by merely filing the proper information with the IRS, without having to wait for the IRS to grant its consent. “Automatic consent” significantly lowers the compliance costs needs to switch to a more advantageous method, enabling many more businesses to realize net savings by identifying yet unclaimed opportunities.

If you would like to know whether a change of accounting method can benefit your business and increase your cash flow, please contact us. If you have already filed a request to make one of these changes using non-automatic consent procedures, you may be able to have the user fee for that request returned if you act quickly.

As a Certified Public Accountant who regularly works with early-stage technology companies, I have come to accept that accounting usually is not a favorite topic among entrepreneurs. In fact, given all the other things an entrepreneur has to think about, conforming to generally accepted accounting principles and practices can end up fairly far down on the priority list.

I am a big believer that you don’t let accounting and tax rules tell you how to run your business. I also believe that a fuller understanding of the accounting considerations for equity and revenue recognition can help investors, entrepreneurs, and board members ask the right questions and know when to seek outside expertise to avoid unpleasant surprises, unanticipated adverse affects on the P&L, delays in due diligence, or renegotiated valuations.

I. Accounting for Equity

In today’s world, accounting for equity is more complex than ever before. Depending on the choices a company makes with equity awards, there are both financial reporting and tax issues. These issues are not always the same.

Entrepreneurs and their boards need to understand both the profit and loss impact and the tax ramifications of granting equity before any granting occurs. Whether the business is a Limited Liability Company (LLC), C-Corporation, or S-Corporation, the issues are generally the same.

Determining Fair Market Value is at the Core

When a company issues an equity security or option as compensation, both the Financial Accounting Standards Board (FAS 123R) and the Internal Revenue Service (IRC Sec. 409A) require the company to establish a fair market value for those securities as of the date the stock is issued or the options are granted.

The intent of FAS 123R is to make sure that the company’s financial statements accurately reflect current fair market value expenses of the grant. The IRS wants to make sure that any stock or options granted as compensation are not valued too cheaply.

The IRS and FASB requirements for setting the fair market value are similar, but not exactly the same. The consequences of being out of compliance include additional tax, interest, and penalties from the IRS’s standpoint and potential restatement of financial statements as the result of an audit, due diligence, or Initial Public Offering (IPO) filing to satisfy FASB requirements.

The following is a review of the accounting and to a lesser extent tax considerations of the various forms of equity that an early stage company is likely to use as compensation.

Stock Options

Prior to 2006 and FAS 123R, generally accepted accounting principles (GAAP) did not require privately held companies to report stock options as an expense as long they were granted at market value following the intrinsic value methodology. The intrinsic method was a theory that did not require the company to expense compensation as long as the options were issued at the fair market value. Since FASB 123R, all stock options must be recorded at their fair market value as expenses when they are granted, even if issued at the fair market value price of the stock.

To calculate the fair market value of the options (and therefore the expense), companies are required to use an option pricing model which satisfies minimum FAS 123R requirements (e.g., Black Scholes-Merton or binomial-lattice).

While a detailed discussion of these option models is well beyond the scope of this article, it is important to know that each requires the company to make assumptions about volatility, interest rates, and the dividend rate and life of the options.

The models also call for the company to establish a fair market value of the underlying stock, and this is where things can get very complicated.

It is one thing to be able to go to The Wall Street Journal or the Internet to get a price for a stock, or to establish the underlying value as a result of an investment round where the valuation of the company has been agreed. It is another thing entirely to come up with the underlying stock price when a company is just starting out and there is no valuation or current street price to base the stock price on.

A company cannot simply assign a price for the stock that seems reasonable. It is possible to establish a fair market value internally for tax purposes under IRC Sec. 409A as long the person setting the value is qualified and knowledgeable about valuation and has significant experience.

However, the calculations and considerations in a comprehensive report are so complex that many companies obtain an independent valuation report from a reputable outside appraiser to set an independent value to the common stock. These external assessments are usually a more effective way to meet the requirements that can make an accountant or auditor comfortable that the fair market value is credible.

An independent appraisal costs between $5,000 to $15,000. Very early stage companies that are pre-revenue may delay having an independent valuation to avoid these costs, but once a company has employees, transactions, revenue, and a board of directors, most accountants and CPAs—especially if they are auditing the company—will require an outside appraisal.

The fair market value of the underlying stock and the other assumptions (i.e., volatility, interest and dividend rates, life of the stock) are fed into the chosen algorithm (Black Scholes-Merton or binomial-lattice). From that calculation, the fair market value of the option is determined. This expense is then generally recognized over the vesting or earning period of the recipient of the option(s). As long as the grant of the option is issued at least at the fair market value, there will be no federal tax implication at the grant date to the company or the option recipients.

Options have a value that is set as of the date of the grant under FAS 123R. As those options vest, a corresponding expense must be charged against the profit of the company. The amount of this expense correlates to the value set at the date of the grant, no matter how the fair market value for the options may change. Even if the options are underwater, the company cannot subsequently adjust the expense downward.

Common and Preferred Stock Grants

Granting stock is an effective way to attract key employees early in the company’s life cycle. When a company grants actual stock (not options) to employees as a form of compensation or as payment for outside services, the fair market value of the stock must be recorded on the company’s books as an expense and reported to the IRS as taxable income to the person who receives the stock.

When granting shares of stock, a company’s first concern is satisfying the fair market value requirements of IRC Sec. 409A. The IRS will allow an independent appraisal, a nonlapse repurchase formula, or an illiquid startup valuation.

Management will want to seek the advice of someone with financial acumen who understands the IRS guidelines for the “reasonableness” of the valuation method used.

By following these valuation methodologies with sign-off from the board of directors, the company will at least be able to demonstrate that it followed the mechanics of IRC Section 409A if the IRS raises an issue with the resulting stock valuation.

If the company is seeking a fair market value that will stand the tests of both IRC 409A and FASB 123R, it is best to engage a Certified Public Accountant (CPA) well versed in equity accounting to verify that the methodology used for IRS purposes meets the minimum requirements of FAS 123R.

Stock appreciation rights are also subject to the IRC 409A rules. Keep in mind that board members or officers may find themselves on the hook for potential payroll taxes that are considered trustee taxes if issues with the IRS occur. In these situations, seek legal counsel.

With the economic downturn, many companies are finding their current option plan holders “under water” as the stock price is below the option price. Modifications to existing plans or changes in exercise prices most likely will have an accounting consequence to the company’s books so before making modifications a company should seek professional advice.

Restricted Stock Grants

Assuming that retention as well as attraction is also a goal of any stock compensation plan, granting restricted stock early in the company’s life cycle can be a superior strategy.

Under a restricted stock plan as compensation, management may put restrictions on the shares themselves or the grants of shares that permit the stock to vest over time. Examples of restrictions could be calendar events (a portion of the stock vests annually as long as the employee remains with the company) or milestone accomplishments (e.g., profitability, product releases, or sales goals).

For accounting purposes, if the restrictions create a “substantial risk of forfeiture to the recipient,” the company may not need to book the fair market value of the stock as expense, but rather may disclose it in the notes of their financial statements. When the event becomes probable, the company records the expense.

As the restrictions on the stock lapse and the stock vests, the employee pays federal tax on the vested stock at ordinary income rates based on the fair market value of the stock on the day it vests and the company recognizes the expense.

However, under a special IRS provision (IRC, SEC 83B), an employee can elect to pay the tax on restricted stock immediately by sending a letter to the IRS within thirty days of the grant stating their election to pay the tax today on the current fair market value of the stock. The employee will be taxed at ordinary income rates. As with all stock grants as compensation, the company reports the difference between the fair market value of the stock and any price the recipient pays as an expense.

This provision makes restricted stock a powerful tool for founders and early key employees. At the beginning of the company, the fair market value of the stock will typically be low. Under current IRS provisions, as long as the stock is held for a year and a day, any appreciation will be treated as long-term capital gain.

Warrants and Convertible Debt

A warrant is similar to an option except that it is usually issued with debt. A warrant provides the right (but not the obligation) to buy shares of stock at a certain price. Warrants, like options, must be valued at fair market value and are usually expensed over the life of the associated debt.

Convertible debt is a note that typically converts to equity at the option of the note-holder (lender) or when certain events, such as a subsequent investment round, occur. New accounting rules now require issuers to account separately for the liability and equity components of the convertible debt if the settlement can be settled at least partially or wholly in cash.

Market Capitalization Table: Keep it Simple, Accurate, and Up-To-Date

If a company ever expects to go through due diligence, whether as a candidate for private equity or in advance of an IPO, acquisition, or merger, the way they have valued their options and stock and the complexity and the currency of their market capitalization table become very important.

Keep the capital structure current, straightforward and clean. Limit the number of initial shareholders and the types of rights. We strongly advise our clients against giving different rights to different shareholders. Record each group of shareholders and option holders separately; list their names and document the terms and expectations of each category as the option or shares are granted.

The cap table is one of the most important items of due diligence. I have seen small companies with as many as 75 or 100 shareholders, with different terms and valuation, and a cap table that hasn’t been updated in months. Those conditions become a nightmare and derail the process, if not the deal, when it is time to raise angel or venture capital.

II. Revenue Recognition

In the early years of most companies, cash is the primary concern. It is likely and understandable that very aggressive deals and discounts will be offered to close sales and build a base of early adopters for the new company’s products and services.

Often these deals are structured as one-offs and are frequently a necessary part of moving the business forward. With sales people making creative proposals to customers to capture early contracts, companies must be aware that the way these proposals are structured can significantly impact the amount and timing of revenue that can be recognized.

Principles and Criteria for Revenue Recognition

The two basic principles of revenue recognition are:

  • Revenue must be earned.
  • Revenue must be realized.

Four criteria are generally required in order to meet the two principles of revenue recognition:

  • Persuasive evidence of an arrangement exists (i.e., a contract)
  • The arrangement is fixed and determinable (i.e., stated prices and rights of return are firm)
  • Delivery or performance has occurred (no more services or obligations are due)
  • Collectability is reasonable assured (the purchaser is deemed a good credit risk)

For most products—equipment, devices, hardware, or consumer goods—revenue recognition is reasonably straightforward as long as a company satisfies these criteria. With software, it is a different story.

In fact, the most difficult area of revenue recognition may well be in software, which generally falls under the American Institute of Certified Public Accountants rules entitled, SOP 97-2 “Software Revenue Recognition.” The guidance in this statute outlines a rule-based approach to complicated accounting issues. These provisions were instituted in 1997 as a result of companies trying to manipulate their earnings.

Since software companies and businesses that produce high technology products of which software is a significant component make up such a significant portion of angel investors’ portfolios, understanding some of the challenges of software revenue recognition will be useful.

Software Revenue Recognition

Companies follow several models when selling software. The software may be licensed as a stand-alone canned product, bundled with hardware, other software, or with post-contract support (PCS), or may be sold as a service (SaaS). Software may be plug-and-play or may require hours of contracted consulting to make it appropriately usable in the customer’s environment.

SOP 97-2 rules apply to companies selling software under any of these models and potentially to firms selling products of which software is one of multiple components. If embedded software is “more than incidental” to a system, hardware component, or other type of box, these accounting rules may apply.

Not every product that operates with software falls into this category, however. For example, there is a lot of software in a car or truck, but the automakers don’t have to use software recognition rules to account for their vehicles. On the other hand, a telecommunications company that sells a mobile device with cutting edge software may need to go under those rules.

Contracts

As salespeople make different deals, a company can find that they have millions of dollars in deferred revenue. That is why we recommend that new companies establish standard contractual terms that anticipate revenue recognition issues.

We also recommend that a process be established that requires the accountant in charge of revenue or the company’s chief financial officer to review the terms of every deal before the proposals are submitted to the customer, so that the salesperson and the company both understand how the revenue will be booked and give the parameters and discounts of the deal. Tying the salesperson’s commission to revenue recognition is another tool to help the company manage these issues.

Stated Prices and Rights of Return

When software, post-contract support (PCS), or other services, such as help-line support or feature upgrades, are bundled together, the individual components of the bundled software contracts must have readily definable fair-market values that have vendor-specific objective evidence (VSOE) for the revenue generated by each component to be recognized.

Generally VSOE means a history of transactions with customers that demonstrates the fair market value of the various components and a pattern of customer acceptance. If the bundled components have been sold separately, the standalone price is the best evidence of VSOE.

Many products don’t have a separate sales history, especially in a young company. In these cases, VSOE can be set by “management having relevant authority.” In setting VSOE, some of the factors are type of customer, geography and distribution channels.

If a company cannot convince its auditors that it is conforming to the strict guidelines of VSOE, some portion of the revenue for bundled software transactions will most likely be deferred until VSOE is satisfactorily established.

A new company may need to have separate transactions paid for in the second year of the contract before it can establish a fair market value for non-software components of the original bundle.

Consider this example: An early stage company with a fiscal year that ends December 31 sells a piece of software for $100,000 in September and charges the customer an additional $10,000 for the first twelve months of software support. The company sends the customer an invoice for $110,000, and the customer promptly pays it.

Assuming the company has not previously established VSOE for its support at $10,000, the company will only be able to recognize $27,500 (3/12 of $110,000 fee for the software) by December 31 as the entire amount must be prorated over the twelve months specified for software support.

In year two, if the company has obtained VSOE and has sold another software package with the same pricing and terms, the $100,000 for the software license can be recognized in the month it is sold and accepted. However, the $10,000 for the software support will be recognized 1/12 per month for a year.

The amount of recognizable revenue cannot be based solely on list prices or the prices on a customer invoice. After a couple of years of selling the same components, a company that keeps good records will collect enough data to support the VSOE of each of the software components, but until that is the case, a good practice is to express all discounts as a consistent percentage of the license fee, the post contract support, and any other elements that are bundled together.

If a term license includes post-contract support, revenue recognition for the portion of the fee appropriately allocated to the support will be prorated over the term of the license.

The accounting treatment of bundled software sales must be handled properly and consistently, otherwise companies may find that they have corrupted their VSOE and this could result in deferred revenue and reduced profits.

Delivery and Acceptance

It used to be that when a client sold a piece of software, proof of delivery was easily determined by looking at the Federal Express or UPS paperwork. Today most software is delivered via automatic downloads over the Internet, subscription services or shared licenses activated by keys. Proof of the delivery is impossible unless the company retains electronic records or paperwork that verifies delivery.

We recommend that each of our clients establish a clearly written, company-wide revenue recognition policy that requires customer verification (paper or electronic) that the software was received, accepted, and it has been activated before revenue can be recognized.

It is also good practice to specify in the contract an end-date for any approval, installation or service period, otherwise the contract is so open-ended that recognizing the revenue will be deferred, potentially indefinitely. In one situation we saw recently, a 24/7 support arrangement had no expiration date on use. As a result, our client found it difficult to recognize any revenue at all on this element since contractually a customer could use it indefinitely. As a basis for revenue recognition in this situation, the company would need to prove that over time a percentage of their customers no longer used the 24/7 support, even though it was available indefinitely.

Sometimes the customer can’t use the software to their specifications until significant implementation efforts occur. Months and months of consulting may be required. Depending on the way the contract is written, revenue may be recognized on a percentage of completion basis or may have to be deferred on all elements until the customer indicates acceptance of the software.

For companies that follow a typical SaaS model, revenue recognition requires clear documentation of when the customer’s subscription begins. There are too many situations where the only way the accountants could determine that a user had subscribed to the service was when transactions actually started happening. Assuming there is documentation, it is easy to recognize revenue on a monthly basis for the most simple SaaS models.

If the company grants the client the ability to buy the software product today and commits to provide the next version for free, the company cannot book the revenue because they haven’t delivered the product that the customer is buying. This treatment can apply to products other than software, but most commonly comes up with software upgrades and new product releases.

Other Terms and Nuances Can Affect Revenue Recognition

There are specific accounting regulations for extended payment terms whether for a product or service, especially when a contract contains terms that are outside the company’s typical credit policy or different from other contracts in force.

Delivering a product and allowing the customer to pay over two or three years raises questions about collection and likely will delay the full revenue recognition of the contract. The auditor’s decision often comes down to whether or not the company can demonstrate a history of payment in general and from specific customers. Usually early stage companies cannot.

Granting customers specific rights of return or acceptance periods outside of the normal practice for the company can also delay revenue recognition. Issuing significant volume discounts to customers can also pollute recognition of revenue if not handled properly.

Conclusion

Entrepreneurs and their boards should not become so focused on accounting considerations that they let the accounting rules dictate how the business is run. By establishing a process that includes reasonable record keeping and review and by anticipating the basic rules and principles of equity accounting and revenue recognition, company management and boards of directors can avoid surprises. They will understand the implications of the operating decisions they need to make to cause the business to gain traction and grow and will hopefully avoid having to make major accounting adjustments when the auditors or due diligence teams come in.

Any change in Presidential Administration brings the possibility, indeed the likelihood, of tax law changes and the election of Donald Trump as the 45th President of the United States is no exception. During the campaign, President-elect Trump outlined a number of tax proposals for individuals and businesses. This letter highlights some of the President-elect’s tax proposals. Keep in mind that a candidate’s proposals can, and often do, change over the course of a campaign and also after taking office. This letter is based on general tax proposals made by the President-elect during the campaign and is intended to give a broad-brush snapshot of those proposals.

At the same time, the end of the year may bring some tax law changes before President Obama leaves office. This letter also highlights some of those possible changes with an eye on how late tax legislation could impact your year-end tax planning.

Campaign proposals

During the campaign, President-elect Trump called for reducing the number of individual income tax rates, lowering the individual income tax rates for most taxpayers, lowering the corporate tax rate, creating new tax incentives, and repealing the Affordable Care Act (ACA) (including presumably the ACA’s tax-related provisions). The President-elect, in his campaign materials, highlighted several goals of tax reform:

  • Tax relief for middle class Americans
  • Simplify the Tax Code
  • Grow the American economy
  • Do not add to the debt or deficit

President-elect Trump also identified during the campaign a number of tax-related proposals that he intends to pursue during his first 100 days in office:

  • The Middle Class Tax Relief and Simplification Act: According to Trump, the legislation would provide middle class families with two children a 35 percent tax cut and lower the “business tax rate” from 35 percent to 15 percent.
  • Affordable Childcare and Eldercare Act: A proposal described by Trump during the campaign that would allow individuals to deduct childcare and elder care from their taxes, incentivize employers to provide on-site childcare and create tax-free savings accounts for children and elderly dependents.
  • Repeal and Replace Obamacare Act: A proposal made by Trump during the campaign to fully repeal the ACA.
  • American Energy & Infrastructure Act: A proposal described by Trump during the campaign that “leverages public-private partnerships, and private investments through tax incentives, to spur $1 trillion in infrastructure investment over 10 years.”

Individual income taxes

The last change to the individual income tax rates was in the American Taxpayer Relief Act of 2012 (ATRA), which raised the top individual income tax rate. Under ATRA, the current individual income tax rates are 10, 15, 25, 28, 33, 35, and 39.6 percent. During the campaign, President-elect Trump proposed a new rate structure of 12, 25 and 33 percent:

  • Current rates of 10% and 15% = 12% under new rate structure.
  • Current rates of 25% and 28% = 25% under new rate structure.
  • Current rates of 33%, 35% and 39.6% = 33% under new rate structure.

This rate structure mirrors one proposed by House Republicans earlier this year. During the campaign, President-elect Trump did not detail the precise income levels within which each bracket percentage would fall, instead generally estimating for joint returns a 12% rate on income up to $75,000; a 25% rate for income between $75,000 and $225,000; and 33% on income more than $225,000 (brackets for single filers will be half those dollar amounts) and “low-income Americans” would have a 0% rate. As further details emerge, our office will keep you posted.

Closely-related to the individual income tax rates are the capital gains and dividend tax rates. The current capital gains rate structure, imposed based upon income tax brackets, would presumably be re-aligned to fit within President-elect Trump’s proposed percent income tax bracket levels.

AMT and more

President-elect Trump proposed during the campaign to repeal the alternative minimum tax (AMT). The last time that Congress visited the AMT lawmakers voted to retain the tax but to provide for inflation-adjusted exemption amounts

During the campaign, Trump proposed to repeal the federal estate and gift tax. The unified federal estate and gift tax currently starts for estates valued at $5.49 million for 2017 (essentially double at $10.98 million for married individuals), Trump, however, also proposed a “carryover basis” rule for inherited stock and other assets from estates of more than $10 million. This additional proposal has already been criticized by some Republican members of Congress, while some Democrats have raised repeal of the federal estate tax as a non-starter.

Other proposals made by President-elect Trump during the campaign would limit itemized deductions, eliminate the head-of-household filing status and eliminate all personal exemptions. President-elect Trump also has called for increasing the standard deduction. Under Trump’s plan, the standard deduction would increase to $15,000 for single individuals and to $30,000 for married couples filing jointly. In contrast, the 2017 standard deduction amounts under current law are $6,350 and $12,700, respectively, as adjusted for inflation

Possible new family-oriented tax breaks were discussed by President-elect Trump during the campaign. These include the creation of dependent care savings accounts, changes to earned income tax credit and enhanced deductions for child care and eldercare.

Health care

The Affordable care Act (ACA) created a number of new taxes that impact individuals and businesses. These taxes range from an excise tax on medical devices to taxes on high-dollar health insurance plans. The ACA also created the net investment income (NII) tax and the Additional Medicare Tax, both of which generally impact higher income taxpayers. The ACA also made significant changes to the medical expense deduction and other rules that affect individuals. For individuals and employers, the ACA created new mandates to carry or offer insurance, or otherwise pay a penalty.

President-elect Trump made repeal of the ACA one of the centerpieces of his campaign. During the campaign, the President-elect said he would call a special session of Congress to repeal the ACA. At this time, how repeal may move through Congress remains to be seen. Lawmakers could vote to repeal the entire ACA or just parts. Our office will keep you posted of developments as they unfold.

Business tax proposals

On the business front, President-elect Trump highlighted small businesses, the corporate tax rate, and some international proposals during his campaign. Along with simplification, and the reduction, of taxes for small business.

Particularly for small businesses, Trump has proposed a doubling of the Code Sec. 179 small business expensing election to $1 million. Trump has also proposed the immediate deduction of all new investments in a business, which has also been endorsed by Congressional tax reform/simplification advocates.

The current corporate tax rate is 35 percent. President-elect Trump called during the campaign for a reduction in the corporate tax rate to 15 percent. He also proposed sharing that rate with owners of “pass through” entities (sole proprietorships, partnerships and S corporations), but only for profits that are put back into the business.

Based on campaign materials, a one-time reduced rate would also be available to encourage companies to repatriate earnings of foreign subsidiaries that are held offshore. Many more details about these corporate and international tax proposals are expected.

Year-end 2016

More immediately, the calendar is quickly turning to 2017. Congress will meet for a “lame duck” session and is expected to take up tax legislation. Exactly what tax legislation Congress will consider before year-end remains to be seen. Every lawmaker has his or her “key” legislation to advance before the year-end. They include:

  • Legislation to renew some expiring tax extenders, especially energy extenders.
  • Legislation to fund the federal government, including the IRS, through the end of the 2017 fiscal year.
  • Legislation to enhance retirement savings for individuals.
  • Legislation to help citrus farmers, small businesses and more.

Some of these bills, if passed and signed into law, could impact year-end tax planning. The expiring extenders include the popular higher tuition and fees deduction along with some targeted business incentives. If these extenders are renewed, or made permanent, our office can assist you in maximizing their potential value in year-end tax planning.

Another facet of year-end tax planning is looking ahead. President-elect Trump has proposed some significant changes to the Tax Code for individuals and businesses. If these proposals become law, especially any reduction in income tax rates, and are made retroactive to January 1, 2017, your tax planning definitely needs to be reviewed. Our office will work with you to maximize any potential tax savings.

Working with Congress

When the 115th Congress convenes in January 2017, it will find the GOP in control of both the House and Senate, therefore allowing Trump to move forward on his proposals more easily. It remains to be seen, however, what compromises will be necessary between Congress and the Trump Administration to find common ground. In particular, too, compromise will likely be needed to bring onboard both GOP fiscal conservatives who will want revenue offsets to pay for tax reduction, and Senate Democrats who have the filibuster rule to prevent passage of tax bills with fewer than 60 votes. Beyond considering tax proposals one tax bill at a time, it remains to be seen whether proposals can be packaged within a broader mandate for “tax reform” and “tax simplification.”

The information generally available now about President-elect Trump’s tax proposals is based largely on statements by him during the campaign and campaign materials. President-elect Trump will take office January 20, 2017. Between now and then, more details about his tax proposals may be available.

IRS shutdown

On October 1, IRS offices across the country emptied as most of the agency’s employees were furloughed following a lapse in appropriations. Nearly 90 percent of the IRS’s 90,000 employees were furloughed on October 1 after Congress failed to pass legislation to keep the IRS and other federal agencies operating after the end of the government’s fiscal year (FY) 2013. The IRS explained that some functions would continue during the government shutdown, including the processing of tax payments, criminal investigations and some litigation. The IRS reminded taxpayers that the underlying tax law remains in effect, as do their tax obligations during the shutdown.

Employer mandate

In July, the White House announced a one-year delay in the employer shared responsibility payment and employer/insurer reporting under the Patient Protection and Affordable Care Act (Affordable Care Act). The Affordable Care Act generally requires applicable large employers to pay an assessable payment if, among other circumstances, the employer fails to offer full-time employers and their dependents the opportunity to enroll in minimum essential coverage. The Affordable Care Act also requires large employers and many insurers to file annual returns reporting minimum essential coverage. After the White House’s announcement, the IRS issued transition relief and proposed regulations. The IRS reported that it is exploring simplification of employer/insurer reporting.

Individual mandate

The IRS issued final regulations on the Affordable Care Act’s individual shared responsibility requirements in August. The individual mandate generally requires individuals to carry minimum essential health coverage after 2013 unless they qualify for an exemption. An individual who does not carry minimum essential coverage and does not qualify for an exception must pay a penalty.

Repair regulations

In September, the IRS issued long-awaited final regulations on the treatment of costs to acquire, produce or improve tangible property. The final regulations impact any industry that uses tangible property, real or personal, the IRS explained. In the final regulations, the IRS added many taxpayer-friendly provisions, including a revised de minimis safe harbor, a routine maintenance safe harbor for buildings and new safe harbors for small taxpayers. Taxpayers will apply the final regulations to determine whether they can deduct costs as repairs or if they must capitalize the costs and recover them over a period of years.

Same-sex marriage/domestic partners

Following the U.S. Supreme Court’s decision to strike down Section 3 of the Defense of Marriage Act (DOMA) ( E.S. Windsor, June 28, 2013), the IRS issued guidance for taxpayers and tax professionals in August. The IRS announced a general rule recognizing same-sex marriage nationwide. Same-sex married couples are treated as married for all federal tax purposes, including income and estate taxes, the IRS explained.

However, the IRS’s treatment of married same-sex couples does not extend to domestic partners. The IRS explained that domestic partners are not considered married for federal tax purposes because they are not married under state law.

Net investment income tax

The Affordable Care Act imposes a 3.8 percent surtax on qualified net investment income under new Code Sec. 1411, generally effective for tax years beginning after December 31, 2012. In August, the IRS released a draft version of Form 8960, Net Investment Income Tax. The IRS is expected to finalize Form 8960 before the start of the 2014 filing season. The IRS is also expected to issue final regulations about the net investment income surtax before year-end to clarify many questions about the scope of the surtax.

Tax reform

The leaders of the House and Senate tax writing committee launched a nationwide tax reform tour during the summer of 2013. Rep. Dave Camp, R-Mich. and Sen. Max Baucus, D-Mont., visited several cities to promote comprehensive tax reform. At the same time, President Obama proposed to eliminate some business tax preferences in exchange for a reduction in the corporate tax rate. President Obama also proposed to tax carried interest as ordinary income.

Tax extenders

After 2013, many popular but temporary tax incentives (known as extenders) are scheduled to expire. They include the state and local sales tax deduction, the teacher’s classroom expense deduction, the research tax credit, transit benefits parity, and many more. Some lawmakers in Congress have proposed to include the extenders in year-end comprehensive tax reform legislation, but leaders in the House and Senate have been cool to this idea. More likely, these incentives will be extended for one or two years in a year-end stand-alone bill or linked to other legislation. Our office will keep you posted of developments on the fate of these valuable tax incentives.

S corps

In August, the IRS announced exclusive simplified methods for taxpayers to request late S corporation elections. The IRS consolidated and expanded earlier guidance for taxpayers requesting late S corporation elections, late Electing Small Business Trust elections, late Qualified Subchapter S Trust Elections, Qualified Subchapter S Subsidiary elections, and certain late corporate classification elections.

Small employer health insurance tax credit

Qualified small employers may be eligible for the Code Sec. 45R tax credit that is designed to help offset the cost of providing health insurance to their employees. In August, the IRS issued proposed reliance regulations on the credit. In tax years beginning after 2013, a qualified small employer must participate in the Small Business Health Options Program (SHOP) to take advantage of the credit. In September, the White House announced a delay in the start of SHOP.

Per diem rates

The IRS announced in September that the simplified per diem rates that taxpayers can use to reimburse employees for expenses incurred during travel after September 30, 2013. The high-cost area per diem increases from $242 to $251 and the low-cost area increases from $163 to $170. In 2012, the IRS did not increase the per diem rates, reflecting a directive from the White House to federal agencies to curb rising travel costs.

Innocent spouse

The IRS updated its equitable innocent spouse relief procedures in September. The IRS explained that the updated procedures are intended to give greater deference to the presence of abuse in a relationship. Some of the factors that the IRS uses to weigh a request for equitable innocent spouse relief were also made more taxpayer-friendly.

Worker classification

The Tax Court held in August that it lacks jurisdiction to review an IRS determination of worker status. The case arose from a request for the IRS to determine a worker’s status. The Tax Court found there was no audit or examination as the IRS was simply responding to the taxpayer’s request.

Collection due process cases

Taxpayers subject to IRS levy are generally entitled to a pre-levy hearing (a collection due process (CDP) hearing or an equivalent hearing). The Treasury Inspector General for Tax Administration (TIGTA) reported in September that it had discovered some concerns about the handling of CDP cases by the IRS. TIGTA discovered delays in the initial processing of requests for CDP hearings.

LILO/SILO transactions

In a case of first impression, the Tax Court applied the substance-over-form doctrine and found that an insurance company’s lease-in, lease-out (LILO) and sale-in, sale-out (SILO) transactions were not leases ( John Hancock Life Insurance Co. (USA), 141 TC No. 1). The Tax Court held that the taxpayer could not deduct depreciation, rental expenses, interest expenses, and transactional costs connected with the transactions.

Domestic production activities deduction

Code Sec. 199 provides a deduction for qualified domestic production activities. In August, the IRS determined that a taxpayer could claim the Code Sec. 199 deduction for in-store photo production activities. However, the taxpayer could not claim the deduction where it only transferred a customer’s photos onto DVDs because those activities were a service and not the manufacturing of a product.

IRS administration

President Obama has proposed John Koskinen to serve as the next Commissioner of Internal Revenue. If confirmed by the Senate, Koskinen would replace IRS Principal Deputy Commissioner Daniel Werfel. Koskinen previously served in leadership roles with the Federal Home Loan Mortgage Corporation (Fannie Mae).

If you have any questions about these or other federal tax developments that may impact you or your business, please contact our office.

April 15 has come and gone but it’s not time to stop thinking about taxes and strategic tax planning opportunities. Since the start of 2013, there have been many new federal tax developments, which will impact tax planning for this year and beyond. As 2013 unfolds, many changes made to the Tax Code by the American Taxpayer Relief Act of 2012 (ATRA) take effect. Additionally, there are new taxes to take into account because of the health care reform package, along with enhancements to many tax credits and deductions. Now is a good time to revisit these developments and explore how they will affect your strategic tax plans. Planning today can help maximize your tax savings going forward. As always, please give our office a call or email if you have any questions.

Tax planning and ATRA

Returns just filed (or that will be filed under extension by October 15, 2013) reflect the tax laws as they existed in 2012 (with some expired provisions renewed retroactively for 2012 by ATRA). Looking ahead, your 2013 return to be filed in 2014 will reflect the many changes to the Tax Code made by ATRA. Because the new law was passed at the beginning of the year, it was overshadowed by the filing season. However, its provisions impact every taxpayer and it’s vital to take time to gauge how they will affect you. The list of changes made by ATRA is long: many generous tax incentives, such as the $1,000 child tax credit, enhanced adoption credit, and enhanced earned income credit, are made permanent. ATRA also permanently “patches” the alternative minimum tax (AMT), which definitely will impact planning for taxpayers liable for the AMT. The new law also extends permanently the Bush-era tax rate cuts for individuals except taxpayers with taxable income above $400,000 ($450,000 for married couples filing a joint return). Income above these levels is taxed at 39.6 percent effective January 1, 2013. ATRA also increased the tax rates on qualified capital gains and dividends for higher income taxpayers. All these changes and more are set in motion by ATRA.January 10, 2013.

New proposals to consider

Looking ahead, some new proposals could impact tax planning in 2013 and beyond. President Obama has proposed to reduce the value to 28 percent of certain deductions and exclusions that would otherwise reduce taxable income in the 33, 35 or 39.6 percent tax brackets. The President also re-proposed the so-called Buffett Rule, now referred to as the “Fair Share Tax” for taxpayers with incomes above $1 million (with full phase-in above $2 million). Moreover, the President has proposed to limit contributions and accruals on tax-favored retirement benefits, including IRAs, qualified plans, tax-sheltered annuities, and deferred compensation plans. The limit generally would apply when a taxpayer accumulates total retirement amounts that exceed the amount necessary to provide the maximum annuity permitted for a defined benefit plan. The President’s proposals are expected to be debated in Congress as lawmakers and the White House try to reach an agreement on tax reform and deficit deduction. President Obama has said he wants an agreement before August, which could significantly change your tax planning for 2013 and beyond. Our office will keep you posted of developments.

NII surtax takes effect

The 3.8 percent Medicare surtax on net investment income (NII) became effective January 1, 2013. The NII surtax on individuals equals 3.8 percent of the lesser of: Net investment income for the tax year, or the excess, if any of the individual’s modified adjusted gross income (MAGI) for the tax year, over the threshold amount. The threshold amount in turn is equal to $250,000 in the case of a taxpayer making a joint return or a surviving spouse, $125,000 in the case of a married taxpayer filing a separate return, and $200,000 in any other case.

The IRS issued proposed regulations in 2012 intending them to be “reliance regulations.” Nonetheless, taxpayers continue to be confused over certain sections. Although final regulations are promised “within 2013” so they would be available for the 2013 tax year and 2014 filing season, current misinterpretation of the proposed regulations can impact on tax strategies now being put into motion in 2013. Any misinterpretation can also bear on 2013 estimated tax that may be due to cover any 3.8 percent NII surtax liability. Our office will keep you posted of developments.

Vehicle depreciation limits increase for 2013

Tax planning for 2013 is helped by the IRS’s release of inflation-adjusted limitations on depreciation deductions for business-use of passenger automobiles, light trucks, and vans first placed in service during calendar year 2013. Some of the depreciation limits are identical to the limits for 2012; other ceilings have increased by $100. The 2013 dollar limits reflect the inflation adjustments both with the extension of bonus depreciation by ATRA and without. If bonus depreciation is allowed to lapse after 2013, as President Obama has proposed, the dollar limits for 2014 would be lower but would still be adjusted for inflation. The maximum depreciation limits under Code Sec. 280F for passenger automobiles first placed in service during the 2013 calendar year are: $11,160 for the first tax year ($3,160 if bonus depreciation does not apply); $5,100 for the second tax year; $3,050 for the third tax year; and $1,875 for each succeeding tax year. The maximum depreciation limits under Code Sec. 280F for trucks and vans first placed in service during the 2013 calendar year are slightly higher. Keep in mind that SUVs and pickup trucks with a gross vehicle weight rating (GVWR) in excess of 6,000 pounds continue to be exempt from the luxury vehicle depreciation caps based on a loophole in the operative definition.

IRS audits of business property write-offs on “stand-down”

The IRS announced in March that it had updated its 2012 directive that generally instructs employees to discontinue audits of costs to maintain, replace or improve tangible property. The updated directive tells employees not to begin examining those issues for tax years beginning on or after January 1, 2012 and before January 1, 2014. The directive retains the “stand-down” of audit activity in this area beginning in 2012. The IRS also advised that it intends to make changes to temporary regulations regarding certain de minimis rules, routine maintenance and more.

Prepare for employer and individual mandates under PPACA

The IRS issued long-awaited proposed reliance regulations on the employer mandate under the Patient Protection and Affordable Care Act (PPACA). An applicable large employer is an employer that employed an average of at least 50 full-time employees during the preceding calendar year, including full-time equivalent (FTE) employees. The statute defines a full-time employee as an employee who on average was employed for at least 30 hours of service per week.

The PPACA also generally requires individuals, unless exempt, to carry minimum essential health insurance coverage after 2013 or make a shared responsibility payment. The IRS has issued proposed regulations on the individual mandate. The proposed regulations, the IRS explained, are intended to mitigate the affordability test for related individuals.

IRS ramps up oversight of foreign accounts

The Foreign Account Tax Compliance Act (FATCA) gives the agency new tools to discover tax evasion. In January, Treasury and the IRS issued final regulations under FATCA that describe the requirements for foreign financial institutions (FFIs), nonfinancial foreign entities (NFFEs), and other taxpayers to comply with FATCA’s reporting and withholding regimes on U.S. and foreign account holders. The 544-page regulation package seeks to harmonize the United States’ regulatory requirements with the use of intergovernmental agreements (IGAs) to implement FATCA.

Simplified safe harbor for claiming home office deduction

The home office deduction is one of the most complex in the Tax Code. In response, the IRS announced a simplified safe harbor method for claiming the home office deduction for tax years beginning on or after January 1, 2013. Under the safe harbor, taxpayers determine the amount of deductible expenses for qualified business use of the home for the tax year by multiplying the allowable square footage by the prescribed rate. The allowable square footage cannot exceed 300 square feet and the prescribed rate is $5.00, which provides a maximum deduction under the safe harbor of $1,500. The IRS indicated it may revisit the prescribed rate amount in the future.

To conclude “Since the start of 2013, there have been many new federal tax developments, which will impact tax planning for this year and beyond.”

If you have any questions about these or any other federal tax developments and their impact on tax planning, please contact our office at (310) 691-5040 or (818) 691-1234 or via e-mail at [email protected]

How would you like to squeeze more time out of your busy week, cut down on record-keeping duties, and reduce piles of paperwork and old receipts? The optional standard mileage rates for business vehicles can help you do just that. Businesses that operate up to four vehicles at the same time can deduct this standard mileage rate rather than keeping track of depreciation, gas, and repairs.

The business standard mileage rate for 2013 is 56.5 cents-per-mile. The business rate reflects, among other things, gasoline, depreciation and maintenance costs each year. The business standard mileage rate for 2012 has been 55.5 cents-per-mile (the same as for the second half of 2011 and up from 51 cents-per-mile for the first half of 2011).

Four or more vehicles

Businesses using no more than four vehicles for business purposes can use the business standard mileage rate. Generally, the IRS prohibits taxpayers from using the business standard mileage rate to compute the deductible expenses of five or more vehicles the taxpayer owns or leases and uses simultaneously, such as in a fleet operation.

Depreciation

The depreciation component of the business standard mileage rate is 23 cents-per-mile for 2013, the same as for 2012. In 2011 the rate was 22 cents-per-mile. Businesses that use the standard mileage rate are not allowed to take actual depreciation deduction amounts, even if they are higher than the depreciation component. Before deciding to use the standard mileage rate, a look at whether you will do better under the actual expense method, which includes actual depreciation, should be considered. Especially for circumstances in which Code Section 179 expensing and/or bonus depreciation is available; taking actual expenses, including actual depreciation, may be worth the effort.

Luxury vehicle caps. If actual depreciation is taken on a business vehicle, Congress wanted to be sure that vehicles selling above a certain price point did not enable their owners to take a larger write-off because of that premium cost. The “luxury vehicle” limits are designed to do just that, although taxpayers may debate the price points above which Congress set the “luxury” level. For example, using the standard mileage rate to value an employee’s personal use of a business vehicle is not allowed if the vehicle is valued at more than $15,900 for 2012 (projected to rise to $16,000 in 2013); Light trucks or vans are governed by a slightly higher level of $16,700 for 2012 (and $17,000 for 2013). This value also translates into the cap allowed on depreciation taken each year on the vehicle. For example, the maximum depreciation deduction for passenger automobiles first placed in service by the taxpayer in the 2012 calendar year is $3,160 for the first year (in addition to $8,000 for bonus depreciation, if applicable). For light trucks and vans, the first year cap is slightly higher: $3,360 (but with the same additional $8,000 deduction for bonus depreciation).

Special rules for heavy SUVs. For many years, SUV owners enjoyed a special tax break, often referred to as the “SUV loophole.” As explained, the “luxury car” rules place strict limits on the maximum amount of depreciation that may be claimed on passenger automobiles, including trucks and vans, during each year of a vehicle’s recovery (depreciation) period. Generally, however, the luxury vehicle limits only apply to vehicles primarily used on public streets with an unloaded gross weight of 6,000 pounds or less. A truck or van, including an SUV built on a truck chassis, is not subject to the annual vehicle depreciation limitations if its gross vehicle weight rating (maximum loaded weight) is in excess of 6,000 pounds. This “loophole” treatment had allowed many taxpayers who purchased an SUV with a gross weight in excess of 6,000 pounds to write off the entire cost in the year of purchase under the Code Sec. 179 expensing deduction.

Congress started to crack down on the so-called “SUV loophole” when, in the American Jobs Creation Act of 2004, it put the brakes on the cost of any SUV that may be expensed under Code Sec. 179 to $25,000, in addition to being counted toward the total caps on deductions for Code Sec. 179 property of all types. For example, a $139,000/$560,000 overall Section 179 expensing limits apply for 2012 (this is scheduled to drop to $25,000 for 2013, with a $200,000 investment ceiling, unless Congress takes further action). If the SUV is not built on a truck chassis or if it does not have a gross vehicle weight of more than 6,000 pounds, however, the “luxury vehicle” limit puts an even lower cap on those deductions. Nevertheless, heavy SUVs continue to benefit from a “bonus depreciation” loophole in the law in which a deduction for bonus depreciation is not capped for those vehicles not falling under the luxury-vehicle depreciation caps (that is, heavy SUVs). Although bonus depreciation applies to 2012, Congress may not extend it into 2013, or it may do so but without retaining what some have termed an unintended benefit for heavy SUV owners.

Bonus depreciation. Bonus depreciation for 2012 may be added to the available first-year deductions allowed on the purchase of a vehicle used for business if certain criteria are met. For most vehicles (those that are not fully depreciated in their first-year after applying the cap), business taxpayers claiming 50 percent bonus depreciation in 2012 are allowed an additional $8,000 in first year depreciation over and above the $3,160 first-year limit, for a total of $11,160 in the first tax year. Bonus depreciation, however, is for new vehicles only, and only if placed in service within the tax year. The section 179 expensing deduction, on the other hand, is available for both used and new vehicles.

Personal and business use

If you use your business vehicle for personal trips (including commuting back and forth from home and your principle business location) you must pro-rate your deduction to exclude the percentage of personal use. The magic number here is 50 percent. As long as you use your vehicle more than 50 percent for business during the year, you can pro-rate your deduction. You also have the option of using the standard mileage rate, based on miles of business use for the year times the prescribed rate.

After weeks, indeed months of proposals and counter-proposals, seemingly endless negotiations and down-to-the-wire drama, Congress has passed legislation to avert the tax side of the so-called “fiscal cliff.” The American Taxpayer Relief Act permanently extends the Bush-era tax cuts for lower and moderate income taxpayers, permanently “patches” the alternative minimum tax (AMT), provides for a permanent 40 percent federal estate tax rate, renews many individual, business and energy tax extenders, and more. In one immediately noticeable effect, the American Taxpayer Relief Act does not extend the 2012 employee-side payroll tax holiday.

The American Taxpayer Relief Act is intended to bring some certainty to the Tax Code. At the same time, it sets stage for comprehensive tax reform, possibly in 2013. Moreover, it creates important planning opportunities for taxpayers, which we can discuss in detail.

Individuals:

Unlike the two-year extension of the Bush-era tax cuts enacted in 2010, the debate in 2012 took place in a very different political and economic climate. If Congress did nothing, tax rates were scheduled to increase for all taxpayers at all income levels after 2012.  President Obama made it clear that he would veto any bill that extended the Bush-era tax cuts for higher income individuals. The President’s veto threat gained weight after his re-election.  Both the White House and the GOP realized that going over the fiscal cliff would jeopardize the economic recovery, and the American Taxpayer Relief Act is, for the moment, their best compromise.

Tax rates.  The American Taxpayer Relief Act extends permanently the Bush-era income tax rates for all taxpayers except for taxpayers with taxable income above certain thresholds:

$400,000 for single individuals, $450,000 for married couples filing joint returns, and $425,000 for heads of households.  For 2013 and beyond, the federal income tax rates are 10, 15, 25, 28, 33, 35, and 39.6 percent.  In comparison, the top rate before 2013 was 35 percent.  The IRS is expected to issue revised income tax withholding tables to reflect the 2013 rates as quickly as possible and provide guidance to employers and self-employed individuals.

Additionally, the new law revives the Pease limitation on itemized deductions and personal exemption phaseout (PEP) after 2012 for higher income individuals but at revised thresholds. The new thresholds for being subject to both the Pease limitation and PEP after 2012 are $300,000 for married couples and surviving spouses, $275,000 for heads of households, $250,000 for unmarried taxpayers; and $150,000 for married couples filing separate returns.

Capital gains.  The taxpayer-friendly Bush-era capital gains and dividend tax rates are modified by the American Taxpayer Relief Act. Generally, the new law increases the top rate for qualified capital gains and dividends to 20 percent (the Bush-era top rate was 15 percent). The 20 percent rate will apply to the extent that a taxpayer’s income exceeds the $400,000/$425,000/$450,000 thresholds discussed above. The 15 percent Bush-era tax rate will continue to apply to all other taxpayers (in some cases zero percent for qualified taxpayers within the 15-percent-or-lower income tax bracket).

Payroll tax cut.  The employee-side payroll tax holiday is not extended. Before 2013, the employee-share of OASDI taxes was reduced by two percentage points from 6.2 percent to 4.2 percent up the Social Security wage base (with a similar tax break for self-employed individuals).  For 2013, two percent reduction is no longer available and the employee-share of OASDI taxes reverts to 6.2 percent. The employer-share of OASDI taxes remains at 6.2 percent. In 2012, the payroll tax holiday could save a taxpayer up to $2,202 (taxpayers earning at or above the Social Security wage base for 2012).  As a result of the expiration of the payroll tax holiday, everyone who receives a paycheck or self-employment income will see an increase in taxes in 2013.

AMT. In recent years, Congress routinely “patched” the AMT to prevent its encroachment on middle income taxpayers. The American Taxpayer Relief Act patches permanently the AMT by giving taxpayers higher exemption amounts and other targeted relief. This relief is available beginning in 2012 and going forward. The permanent patch is expected to provide some certainty to planning for the AMT. No single factor automatically triggers AMT liability but some common factors are itemized deductions for state and local income taxes; itemized deductions for miscellaneous expenditures, itemized deductions on home equity loan interest (not including interest on a loan to build, buy or improve a residence); and changes in income from installment sales. Our office can help you gauge if you may be liable for the AMT in 2013 or future years.

Child tax credit and related incentives.  The popular $1,000 child tax credit was scheduled to revert to $500 per qualifying child after 2012.  Additional enhancements to the child tax credit also were scheduled to expire after 2012.  The American Taxpayer Relief Act makes permanent the $1,000 child tax credit. Most of the Bush-era enhancements are also made permanent or extended. Along with the child tax credit, the new law makes permanent the enhanced adoption credit/and income exclusion; the enhanced child and dependent care credit and the Bush-era credit for employer-provided child care facilities and services.

Education incentives.  A number of popular education tax incentives are extended or made permanent by the American Taxpayer Relief Act.  The American Opportunity Tax Credit (an enhanced version of the Hope education credit) is extended through 2017.  Enhancements to Coverdell education savings accounts, such as the $2,000 maximum contribution, are made permanent.  The student loan interest deduction is made more attractive by the permanent suspension of its 60-month rules (which had been scheduled to return after 2012). The new law also extends permanently the exclusion from income and employment taxes of employer-provided education assistance up to $5,250 and the exclusion from income for certain military scholarship programs.  Additionally, the above-the-line higher education tuition deduction is extended through 2013 as is the teachers’ classroom expense deduction.

Charitable giving.  Congress has long used the tax laws to encourage charitable giving.  The American Taxpayer Relief Act extends a popular charitable giving incentive through 2013:  tax-free IRA distributions to charity by individuals age 70 ½ and older up to maximum of $100,000 for qualified taxpayer per year.  A special transition rule allows individuals to recharacterize distributions made in January 2013 as made on December 31, 2012.  The new law also extends for businesses the enhanced deduction for charitable contributions of food inventory.

Federal estate tax.  Few issues have complicated family wealth planning in recent years as has the federal estate tax.  Recent laws have changed the maximum estate tax rate multiple times. Most recently, the 2010 Taxpayer Relief Act set the maximum estate tax rate at 35 percent with an inflation-adjusted exclusion of $5 million for estates of decedents dying before 2013. Effective January 1, 2013, the maximum federal estate tax will rise to 40 percent, but will continue to apply an inflation-adjusted exclusion of $5 million. The new law also makes permanent portability between spouses and some Bush-era technical enhancements to the estate tax.

Businesses:

The business tax incentives in the new law, while not receiving as much press as the individual tax provisions, are valuable. Two very popular incentives, bonus depreciation and small business expensing, are extended as are many business tax “extenders.”

Bonus depreciation/small business expensing.  The new law renews 50 percent bonus depreciation through 2013 (2014 in the case of certain longer period production property and transportation property). Code Sec. 179 small business expensing is also extended through 2013 with a generous $500,000 expensing allowance and a $2 million investment limit.  Without the new law, the expensing allowance was scheduled to plummet to $25,000 with a $200,000 investment limit.

Small business stock.  To encourage investment in small businesses, the tax laws in recent years have allowed noncorporate taxpayers to exclude a percentage of the gain realized from the sale or exchange of small business stock held for more than five years.  The American Taxpayer Relief Act extends the 100 percent exclusion from the sale or exchange of small business stock through 2013.

Tax extenders.  A host of business tax incentives are extended through 2013.  These include:

  • Research tax credit or R&D credit
  • Work Opportunity Tax Credit (WOTC)
  • New Markets Tax Credit
  • Employer wage credit for military reservists
  • Tax incentives for empowerment zones
  • Indian employment credit
  • Railroad track maintenance credit
  • Subpart F exceptions for active financing income
  • Look through rules for related controlled foreign corporation payments

Energy:

For individuals and businesses, the new law extends some energy tax incentives.  The Code Sec. 25C, which rewards homeowners who make energy efficient improvements, with a tax credit is extended through 2013.  Businesses benefit from the extension of the Code Sec. 45 production tax credit for wind energy, credits for biofuels, credits for energy-efficient appliances, and many more.

Looking ahead

The negotiations and passage of the new law are likely a dress rehearsal for comprehensive tax reform during President Obama’s second term.  Both the President and the GOP have called for making the Tax Code more simple and fair for individuals and businesses.  The many proposals for tax reform include consolidation of the current individual income tax brackets, repeal of the AMT, moving the U.S. from a worldwide to territorial system of taxation, and a reduction in the corporate tax rate. Congress and the Obama administration also must tackle sequestration, which the American Taxpayer Relief Act delayed for two months. All this and more is expected to keep federal tax policy in the news in 2013. Our office will keep you posted of developments.

If you have any questions about the American Taxpayer Relief Act, please contact Azran Financial at (310) 691-5040 or (818) 691-1234 or via e-mail at [email protected]  We can schedule an appointment to discuss how the changes in the new law may be able to maximize your tax savings.

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

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

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

Net Investment Income

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

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

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

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

Passive Activities

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

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

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

Social Security Taxes

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

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

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

Partnership Income

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

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

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

S Corporation Income

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

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

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

Planning Strategies

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

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

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

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

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

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

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