RBK

How to lower federal tax on business stock sales

With an increased capital gain tax rate of 20 percent for tax years 2013 and after, small-business owners should be aware of a provision that eliminates one-half or more of capital gains recognized on the sale of their C corporation stock.

Enacted in the early ’90s, Internal Revenue Code Section 1202 excludes 50 percent of the corporate stock gain, provided that the stock has been held for more than five years before the sale. This provision applies to original issue stock issued to noncorporate stockholders after August 10, 1993.

The total assets of the issuing corporation must not exceed $50 million on the date of issue and sale.

For stock issued after Feb 17, 2009, and before Sept. 28, 2010, the exclusion is 75 percent of qualified small-business gain. The exclusion is 100 percent for stock issued after Sept. 27, 2010, and before Jan. 1, 2014.

Corporation stock issued in an empowerment zone after Dec. 21, 2000, has an exclusion rate of 60 percent for empowerment zone stock sold before Jan. 1, 2019. Empowerment zones are certain geographic areas with enhanced tax benefits that terminated after Dec. 31, 2013.

How does this provision affect an existing business?

Does your company need capital?

Instead of lending the corpo­ration money, the business owner may issue new stock. If the stock is issued more than five years before the business is sold, one-half of the gain from this newly issued stock is tax-free.

If the company grants stock options to employees, it should consider funding the executed stock option with new small-business corporation stock. Not only does the employee receive an equity position, but if the company performs favorably in the future, the employee’s sale of stock is 50 percent or more tax-free.

A company may convert its debt to stock and give the newly issued stock to the former debt holder. If the debt holder sells the small-business stock more than five years later, the gain is only 50 percent taxable.

Small-business stock converted to preferred stock is treated as qualified small-business stock. Some employers may pay bonuses with original issue stock, which saves the company�s cash and potentially reduces the capital gains tax that the employee may pay when the company is sold.

Some wealthy employees may choose to make charitable contributions with their fully tax­able stock and keep qualified small-business stock to sell if the company is seeking a future buyer.

The gain exclusion also reduces the net investment income tax of 3.8 percent on excluded gains. Net investment income is gross income from interest, dividends, annuities, royalties, rents and substitute interest and dividend payments, but not to the extent this income is derived from a trade or business. Net gains are net investment income if recognized as attributable to property disposition, but not to the extent the property is held by a trade or business.

The net investment income tax applies to:

  • Single taxpayers if their adjusted gross income is over $200,000
  • Married taxpayers if their adjusted gross income is over $250,000
  • Married taxpayers filing separately if their adjusted gross income is over $125,000

The tax is computed by taking 3.8 percent of the lesser of:

  • Taxpayer net investment income for the tax year, or
  • Adjusted gross income in excess of the threshold amounts of $200,000 (single taxpayer), $250,000 (married taxpayer) or $125,000 (married filing separately).

One CPA client’s 2013 business stock sale saved over $485,000 in income and net investment taxes. This savings resulted because, during the past decade, the client’s corporation issued original stock to its employees after they had executed their stock options.

Can a sale of stock result in zero tax on qualified business stock gain? Yes, paying no tax is achievable.

A noncorporate stockholder is allowed under IRC Section 1045 to exclude capital gain from the sale of qualified business stock if it has been held more than six months – and if similar small-business stock is acquired within a 60-day period beginning on the date of the stock sale. Gain is recognized only to the extent that equal dollars are not reinvested in qualified small-business stock within 60 days of the previous stock sale.

In future years, noncorporate stockholders may exclude 50 percent, 60 percent, 75 percent or 100 percent of the gains realized from the sale of their corporate business. This opportunity should enable families to keep more of their career’s wealth invested for future retirement or new investments.

Passive Activity: Trust can be a “real estate professional”

In a highly anticipated decision that could save substantial taxes for trusts that manage real estate investments, the Tax Court recently ruled in favor of a Michigan real estate developer’s estate that an estate can be treated as a “real estate professional.”

The Tax Court ruled in favor of the taxpayer – the Frank Aragona Trust – that a trust that owned real estate properties and engaged in other real estate activities qualified for the exception to the passive activity loss rules for real estate professionals.

A passive activity is any activity conducted by a trade or business in which a person does not materially participate. Material participation is a key issue with real estate investors, more so today with the new Medicare tax, which imposes a 3.8 percent tax on net investment income.

In general, any rental activity is considered a passive activity, even if the person materially participates in the activity. However, there are exceptions.

For example, the rule for rental activities does not apply to a qualifying real estate professional if:

  • More than half of the personal services the real estate professional performs during the year are performed in real property trades or businesses in which the professional materially participates; and
  • The real estate professional performs more than 750 hours of services during that tax year in real property trades or businesses in which the professional materially participates.

In this case, the Frank Aragona Trust owns rental real estate properties and is involved in other real estate business activities, such as holding and developing real estate. Frank Aragona created the trust in 1979, with him as trustee and his five children as beneficiaries.

Frank Aragona died in 1981. He was succeeded as trustee by six trustees – one independent trustee and Aragona’s five children, one of whom acted as executive trustee.

Three of the children also worked full time for, and received wages from, Holiday Enterprises, LLC, which is wholly owned by the trust and a disregarded entity for federal income tax purposes. Holiday managed most of the trust’s rental real estate properties and had a number of other employees in addition to the three children.

The trust conducted some of its rental real estate activities directly, some through wholly owned entities and the rest through entities in which it owned majority interests. It conducted its real estate holding and real estate development operations through entities in which it owned majority or minority interests.

The issue presented in the case was whether the Frank Aragona trust can qualify as a real estate professional. The IRS asserted that it cannot because “personal services” means work performed by an individual in connection with a trade or business. As support, the IRS cited certain legislative history stating that the exception applies to individuals and closely held C corporations.

The Tax Court concluded that, if the trustees are individuals and they work in a trade or business as part of their trustee duties, their work can be considered “work performed by an individual in connection with a trade or business.” Accordingly, it concluded that a trust is capable of performing personal services and therefore can be considered a real estate professional.

The court then determined that the trust materially participated in its real estate operations and thus qualifies for the exception. The court concluded that the activities of the trustees, including their activities performed as employees of Holiday, should be considered in determining whether the trust materially participated (Frank Aragona Trust v. Commissioner, 142 TC No. 9, March 27, 2014).

The determination of whether a particular trade or business is subject to the 3.8 percent surtax on investment income is based in part on whether the trade or business is considered a passive activity. The holding in this case could potentially result in fewer trusts being liable for the surtax.

Home builders get big win in Tax Court case

Home builders won a significant victory in a recent Tax Court case, allowing them to defer income recognition until the entire development is complete, not on a house-by-house basis under the completed contract method of accounting.

The U.S. Tax Court concluded in the case of California-based Shea Homes (Shea Homes, Inc. v. Commissioner, 142 TC No. 3, Feb. 12, 2014) that Shea did not have to recognize income under the completed contract method until the year the development has been completed.

Developers are warned to take caution because the case was based on specific facts that may not be present in all situations.

The amenities of the development were a crucial aspect of the developer’s sales effort, the attainment of governmental approval of the development and the buyers’ purchase decision. Accordingly, the amenities were an essential element of the home purchase and sale contract.

Shea Homes and its related entities developed large planned residential communities ranging in size from 100 homes to more than 1,000. They sold more than 114 developments across three states: California, Arizona and Colorado.

Shea contended that final completion and acceptance under the completed contract method of accounting did not occur until the last road was paved and the final performance bond required by state and municipal law was released.

The IRS contended that the subject matter of Shea’s contracts consisted only of the houses and the lots upon which the houses were built. Under its interpretation, the contract for each home met the final completion and acceptance test upon the close of escrow for the sale of each home.

The IRS also contended that contracts entered into and closed within the same tax year were not long-term contracts eligible for the completed contract method of accounting.

The Tax Court called the IRS analysis “simplistic and short sighted; it does not acknowledge the complex relationships created by the purchase and sales agreement, especially obligations that continue long after the first home is built.”

The court determined that Shea was permitted to use the completed contract method of accounting and that the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements.

The court reasoned that the primary subject matter of the contracts included the house, the lot, improvements to the lot and common improvements to the development.

New safe harbor for structuring historic tax credit partnerships

Are you an investor or a developer with questions about historic tax credits?

You should be aware that the IRS issued new safe-harbor rules in Revenue Procedure 2014-12 on Dec. 30, 2013, in direct response to the holding in Historic Boardwalk Hall, LLC v. Commissioner 694 F.3rd 425 (3rd Cir 2012).

In the Historic Boardwalk Hall case, the 3rd U.S. Circuit Court of Appeals denied the taxpayer the right to claim historic tax credits on the basis that it was not a true partner in the partnership through which historic tax credits pass. The court found that the investor partner lacked both a meaningful downside risk and a meaningful upside potential.

The IRS, reacting to the impact of the case on the historic tax credit industry, issued Rev. Proc. 2014-12 to provide a safe harbor to give investors and developers comfort in structuring historic tax credit partnerships. The safe-harbor rules apply equally to project-level partnerships and master-lease partnerships, in which the developer has elected to pass the historic tax credits through to a master tenant.

Rev. Proc. 2014-12 is effective for allocations of historic tax credits made on or after Dec. 30, 2013 – that is, with a placed-in-service date of on or after Dec. 30, 2013.

The four key partnership structural provisions required to take advantage of the safe harbor are as follows:

1. Partnership Interests: The minimum requirements are a developer interest of 1 percent and an investor interest of 5 percent. Most deals are structured with 1 percent/99 percent interests, which may “flip” at the end of the five-year compliance period to as low as 5 percent of the investor’s initial 99 percent interest, or to 4.95 percent.

2. Guarantees: The developer may guarantee the investor against recapture of historic tax credits for direct acts or omissions to act that cause the partnership to fail to qualify for historic tax credit. However, a guarantee against recapture based on an IRS challenge of the transaction structure of the partnership is impermissible.

A developer may provide completion, operating deficit, financial covenant breach (but not minimum net worth covenant) and/or environmental guarantees, as long as these guarantees are unfunded. However, cash reserves are allowed as long as they total no more than reasonably projected 12-month operating expenses.

3. Exit Structure: At the end of the five-year compliance period, the developer may not have a call option (an option to buy at a specified price from the investor). Rather, the investor may have a put option, as long as the sales price is less than the fair market value of the investor’s partnership interest at the time of exercise.

4. Bona Fide Investment: This factor has four separate terms:

  • Equity timing: An investor must contribute at least 20 percent of its total expected equity prior to the placed-in-service date, and at least 75 percent of the investor’s equity must be fixed prior to the placed-in-service date. Note that typical equity adjusters based on milestones are allowed but cannot adjust the investor”s commitment by more than 25 percent.
  • Bona fide investment: The investor�s interest must be a bona fide equity investment with a reasonable anticipated value that is commensurate with the investor�s overall percentage interest in the partnership, separate from tax attributes (deductions, credits, allowances) allocated by the partnership to the investor, and that is not substantially fixed in amount.
  • Commensurate value: To have a commensurate value requires that the investor receive the cash and other economic benefits – other than historic tax credits – on a basis equal to its percentage interest. This requirement continues to allow an investor’s interest in the partnership to be determined principally by the amount of anticipated historic tax credits to be allocated.
  • Value impacts: An investor’s interest may not be depressed through the use of developer fees, disproportionate distributions, lease or other business terms that are not reasonable (and a sublease with a term not shorter than the master lease is deemed unreasonable) relative to arm’s-length development transactions not using historic tax credits. This is really the key requirement in Rev. Proc. 2014-12.

    While preferred returns, developer, management and/or incentive fees are allowed, they must be comparable to non-historic-tax-credit development partnerships. This may likely require third-party verification from accountants or appraisers as a condition to a tax opinion from legal counsel.

Rev. Proc. 2014-12 establishes a number of safe-harbor requirements that differ significantly in material ways from customary terms in most historic tax credit transactions closed over the years. These requirements play out most significantly in the value impact requirements, requiring negotiation of business terms (fees, preferred returns and lease arrangements) that previously were fairly well settled.

Because counsel will likely require independent verification of the reasonableness of such business terms as a condition to providing a tax opinion, you should seek the advice of your CPA, who may enlist the expertise of an appraiser, in connection with historic tax credit transactions.

Facing college expenses? What you should know

The U.S. tax code provides multiple tax-saving opportunities
related to higher education costs for yourself and your dependents. To take advantage of these breaks, you must first know what is available and which may apply to you.

While the tax code has a marvelous way of complicating even the simplest concepts, making every situation unique, you and your school-aged child may find a crash course in the basics helpful.

American Opportunity Credit

The American Opportunity Credit would have expired at the end of 2012, but the passage of the American Taxpayer Relief Act extended the credit until 2017. An improved version of the Hope Credit, the American Opportunity Credit is calculated as 100 percent of the first $2,000 of qualified expenses plus 25 percent of the next $2,000, for a maximum benefit of $2,500.

The credit is allowed for the first four years of postsecondary education and is phased out between a modified adjusted gross income (MAGI) of $80,000 and $90,000, for single taxpayers, and $160,000 and $180,000, for married taxpayers filing jointly in 2013 and 2014.

The biggest advantage of the American Opportunity Credit is that 40 percent of the unused amount is refundable. This means that a taxpayer who qualifies for the full $2,500 of credit but has no tax liability can request a cash refund of up to $1,000 (40 percent of $2,500).

Tuition and fees are qualified expenses, and required supplies and books are now included as qualified expenses. This is an improvement over the credit’s predecessor, the Hope Credit. To be eligible, a student must be considered enrolled at least half the time. Room and board are never considered qualified.

Lifetime Learning Credit

The Lifetime Learning Credit has a maximum value of $2,000 per year, calculated as 20 percent of the first $10,000 of qualified expenses. Unlike the American Opportunity Credit, which can be taken only for the first four years of postsecondary education, the Lifetime Learning Credit can be used during any year.

And the student does not have to be enrolled half time or be in the process of earning a degree or educational credential. This makes the credit particularly valuable to graduate students.

The Lifetime Learning Credit is not refundable, meaning it can be used only to offset a tax liability. Any amount not used in the current year is lost. The costs of books and supplies are considered qualified expenses only if they are purchased directly from the eligible institution. This requirement differs from the American Opportunity Credit, which allows them to be purchased anywhere.

For 2013 tax returns, the credit phases out between MAGI of $53,000 and $63,000, for single taxpayers, and $107,000 and $127,000, for married taxpayers filing jointly. For 2014 returns, the credit phases out between MAGI of $54,000 and $64,000 for single taxpayers and $108,000 and $128,000 for married taxpayers filing jointly.

One important item to note is that the Lifetime Learning Credit is available up to a maximum of $2,000 per return. Even if there are three students included on one tax return and all have education expenses, the maximum credit remains $2,000. It is a per-return limitation, not a per-student limitation.

In contrast, the American Opportunity Credit, including the refundable portion, is available on a per-student basis.

Tuition and Fees Deduction

For 2013 returns, the deduction for tuition and fees can be taken dollar for dollar up to a maximum of $4,000 of qualified expenses. The good news: This deduction is considered an “above-the-line deduction,” which means it is available whether you itemize or take the standard deduction.

There are MAGI phaseout issues to consider. The 2013 limits are:

  • $65,000-$80,000 for singles
  • $130,000-$160,000 for married couples filing jointly

The deduction is not allowed for married taxpayers filing separately.

Like the Lifetime Learning Credit, the costs of books and fees paid directly to the college or university are considered qualified, but personal expenses such as room and board are not.

The tuition and fees deduction was set to expire after 2011 but was extended through 2013 by the American Taxpayer Relief Act. The deduction expired at the end of 2013.

The tuition and fees deduction cannot work in conjunction with education credits. You must choose one or the other for each student.

If you paid qualified expenses for more than one student, you can claim a credit for one and the deduction for the other – but never both for the same student. However, you can choose between the credit and the deduction based on which produces the largest benefit to you.

You can’t claim both the American Opportunity Credit and the Lifetime Learning Credit for the same student. You must choose one or the other.

Remember: A credit is more valuable than an equivalent amount of deduction. If you’re eligible for both, the American Opportunity Credit has a larger benefit than the Lifetime Learning Credit.

Student Loan Interest Deduction

If you have a loan to pay for qualified higher education expenses for yourself or a dependent, you may be able to deduct the interest paid on the loan. A deduction is available for the lesser of $2,500 or the amount of interest paid.

Like the tuition and fees deduction, the student loan interest deduction is considered an above-the-line deduction, making it available to taxpayers who do not itemize their deductions.

For 2013 returns, the benefit is available only at certain income levels. It phases out between MAGI of $125,000 and $155,000 for married couples filing jointly and $60,000 and $75,000 for single filers. For 2014, the phaseout ranges are $130,000-$160,000 for married couples filing jointly and $65,000-$80,000 for single filers. No benefit is available for a married person filing separately.

Savings Plans

The IRS has allowed for certain savings plans that can provide tax benefits if the proceeds are used for qualified education expenses upon distribution. But the same qualifying expenses can’t be used for both an education credit and an education savings plan.

Contributions to a 529 plan, also known as a QTP (qualified tuition plan), are not deductible. However, the principal and earnings are allowed to grow tax free. The distributions aren’t taxable if they’re used for qualified education expenses. This offers a tremendous tax-planning opportunity since there are no income limits for either the contributor or the beneficiary.

Qualified education expenses include postsecondary tuition, books and supplies. Room and board is also qualified if the student is enrolled at least half time in postsecondary education. There are no limitations on the amount that can be contributed, but any amounts not used for education will be taxable upon distribution.

It’s important to note that contributions to a 529 plan for someone other than yourself or your spouse are considered gifts. Therefore, the contributions may have gift tax implications if the amount is more than $14,000, which is the annual per-person gift tax exclusion for both 2013 and 2014.

Another savings plan available is the Coverdell Education Savings Account. Like the 529 plan, contributions to a Coverdell are not deductible, and the distributions, including growth in the account, are tax free if used for qualified education expenses.

This plan differs from a 529 plan in that the proceeds can be used to pay expenses for K-12th grade education as well as graduate level education. In return for this amazing benefit, the Coverdell plan is substantially more restricted. Contributions are limited to $2,000 per beneficiary and generally can’t be made once the beneficiary reaches age 18.

There are also income limitations to be considered. The ability to contribute is phased out when the contributor’s MAGI reaches amounts between $95,000 and $110,000 for singles and $190,000 and $220,000 for married taxpayers filing jointly.

IRA Distribution

Typically, distributions made from an IRA account before the account owner reaches age 59 1/2 are subject to income tax and a 10 percent early withdrawal penalty. However, an exception to the early withdrawal penalty exists if the proceeds are used for qualified education expenses. Since this option subjects the distributions to income taxation, it would likely be the least favorable method of funding education from an income tax perspective.

These tax savings opportunities have been summarized for simplicity. These options can be subject to further restrictions based on every taxpayer’s unique situation.

What final repair regulations say about materials and supplies

It is no secret that business owners generally – with some exceptions – prefer to deduct as much as possible up front rather than capitalize and then depreciate over time.

For this reason, it has become increasingly important for business owners to be aware of the tax laws associated with materials and supplies. These laws can be found among various other equally important topics in the seemingly endless final repair regulations, released Sept. 19, 2013, which become effective Jan. 1, 2014.

Proposed regulations were issued in August 2006, followed by temporary regulations in December 2011, with which your business may or may not be in compliance. Unfortunately, determining deductible materials and supplies isn’t as simple as choosing an arbitrary dollar threshold to expense smaller items used in your business operations.

Materials and supplies defined

The following information attempts to outline the basics of what constitutes materials and supplies as well as the various tax treatments of those expenses.

The basic definition of materials and supplies is tangible property used or consumed in your business operations that is not inventory and that meets one or more of five possibilities:

  • It was acquired to maintain, repair or improve a unit of property owned, leased or serviced by the taxpayer and was not acquired as any single unit of property.
  • It consists of fuel, lubricants, water and other similar items that are reasonably expected to be consumed within 12 months or less.
  • It is considered a unit of property with an economic useful life of 12 months or less, beginning when the unit is first used in the business operations.
  • It is a unit of property with an acquisition or production cost of $200 or less.
  • It is specifically identified in the Federal Register or Internal Revenue Bulletin.

Taxpayers that were previously in compliance with the temporary regulations may notice that they were given a slight break with the increase in the previous $100-or-less limitation to $200. During the discussion phase, some consideration was given to increasing the limit to $500, which the IRS felt was too high. But keep an eye on this threshold in the future because the IRS still has the power to amend the amount.

Treatment of material and supply types

A distinction between various types of materials and supplies dictates their particular treatments. These types are:

  • Nonincidental materials and supplies
  • Incidental materials and supplies
  • Rotable spare parts
  • Temporary spare parts
  • Emergency spare parts

Both nonincidental and incidental materials and supplies are those that are kept on hand for the maintenance, repair or improvement of a unit of property.

However, a record of consumption is kept of nonincidental materials and supplies, and a deduction is allowed in the first year that the material or supply is used or consumed. Incidental materials and supplies differ in that there is no record of consumption, and the deduction is allowed only in the year when the business pays for the materials or supplies.

Rotable and temporary spare parts are generally deductible in the year they are disposed of, unless an optional accounting method (described below) is elected allowing for a deduction upon initial installation.

A rotable spare part is a part that is acquired for a unit of property, is removable and can be repaired or improved before being reinstalled on either the same unit of property or a different unit or stored for later use. A temporary spare part is a part that can be installed on a temporary basis until a new or repaired part becomes available, at which point the temporary part may be stored for future installation.

Emergency spare parts are also deductible in the year they are disposed of, as are rotable and temporary spare parts. However, the optional accounting method is not available to them.

In short, an emergency spare part would be considered either rotable or temporary, except that it is normally very specific to a particular unit of property. It isn’t interchangeable, tends to be very expensive and difficult to obtain, and isn’t repaired or reused.

Optional accounting method

As mentioned above, the optional method of accounting allows for immediate expensing when installed. However, this method imposes additional tracking and administrative responsibilities that a taxpayer may or may not be willing to perform.

Basically, upon each removal from the unit of property on which the part had been installed, the taxpayer must recognize the part’s fair value in gross income and subsequently include this amount, as well as any removal costs, in the basis of the part. Any amounts paid to maintain, repair or improve the part must be included in the basis but not deducted currently. When the part is reinstalled on a different unit of property, the basis is deducted along with any reinstallation costs.

Capitalizing election

Sometimes deducting everything at once is not the best option. When this is the case, there is the option to capitalize rotable, temporary and emergency spare parts. This election may lessen the business’s administrative burden by aligning the company’s book capitalization policy with its tax policy, effectively eliminating book to tax differences.

To capitalize the allowable supplies and materials, the taxpayer must elect on its tax return for each item to be capitalized in the year the item is placed in service. This election may not be revoked unless the taxpayer files a request for a private letter ruling. Regulations dictate that the Commissioner of Internal Revenue will grant this letter ruling if it is deemed that the taxpayer acted reasonably and in good faith and if the revocation will not prejudice the government’s interests.

Keep in mind that a letter ruling’s authority is specific to individual items. In addition, a letter ruling is usually quite expensive to obtain. Do not try to revoke this election by filing an application for a change in accounting method or filing an amended return.

Safe harbor

There are many more intricacies of the finalized repair regulations. In fact, the materials and supplies topic is really only one component with which other components within the repair regulations may become intertwined.

For example, there is a safe harbor, found in the section of regulations dealing with capital expenditures, that allows for items that would otherwise require capitalization to be treated essentially as material or supplies and expensed up front. It’s allowed provided that the item’s cost on a per invoice basis is at or below either $5,000, with audited financials, or $500, without audited financial statements.

As demonstrated, it can’t be stressed enough how numerous and complicated the rules get. This is why consulting with your tax professional is highly recommended.

Although materials and supplies may seem immaterial by themselves, cumulatively, they can have a huge effect on taxable income – either positive or negative – depending on how they are managed.

Understand the issues involved with business use of vehicles

The business use of vehicles seems to be an inexhaustible topic with a new twist or wrinkle every year.

A review of the basics, specifically for automobiles, SUVs and pickup trucks, can serve as a foundation for a proper understanding of how vehicle expenses relate to tax deductions. Ownership, risk management and business-use percentages are good areas to review, in addition to the usual “How much can I write off on my taxes?” items.

Ownership

Ownership is an area that is often taken for granted.

First, let’s look at purchased vehicles. Whose name appears on the title to the vehicle? Is it the corporation or LLC, or is it the name of the officer or owner of the business?

More often than not, vehicles intended for business use are purchased in an individual’s name. But then they find their way onto the books of a corporation or LLC, along with the loan if there is one.

This decision may have several reasons. Perhaps the transaction at the dealership is easier for an individual, or a manufacturer’s incentive isn’t offered to a business purchaser. Perhaps the purchase in the name of the business would make the insurance more expensive than if it were in the individual’s name.

Something as simple as this could expose the person or business to unfore­seen risks. It’s a good idea to discuss with your insurance agent how you will take title to the vehicle and what insurance coverage is appropriate.

Consider a contractor who does business as a corporation – primarily for liability protection – but purchases a pickup truck in his individual name. He obtains insurance under an individual policy. The contractor may or may not tell his agent that there will be business use of the truck.

The truck is recorded on the books of the corporation as an asset and is depreciated. All ownership costs are borne by the corporation.

Perhaps an employee takes the truck to run an errand and is involved in an accident that inflicts serious injury to another party. The truck is owned and insured by an individual.

How does that sound to the injured party’s legal counsel? Is this clear-cut and worry-free for the truck owner? Does it seem as if the corporate liability protection is firmly in place with no threat to the truck owner’s personally owned assets?

Most rational folks conclude that the more expensive but correct way to own and insure business vehicles is in the business name. By the way, the same general theme applies to leased vehicles.

Business-Use Percentages

Many business owners purchase or lease a vehicle and automatically assume that 100 percent of the costs are business related. In reality, the business use is often well below 100 percent. Mixed-use – that is, business and personal – vehicles are more the norm.

Beyond the initial purchase invoice or lease agreement, other records must be kept to support business deductions. Do you maintain a mileage log for your business vehicles?

This is an often mentioned and more often ignored area. The requirement to maintain contemporaneous mileage records shouldn’t be ignored. The log should contain enough information to tell someone reviewing it what happened.

It isn’t enough to have beginning and ending odometer readings of the vehicle. You need dates and business-purpose notations regarding the mileage. Any personal use of the vehicle also should be reflected.

The service records for the vehicle should tie into and corroborate entries in your logbook. Are you rolling your eyes? The thought of reconstructing such records when called for under IRS audit should be enough to motivate you to start doing it currently.

Depreciation

To make a discussion of depreciation easier, assume 100 percent business use of the automobile (however unlikely that is!). If your percentage is less than that, reduce the amounts accordingly. Beware if your business use drops below 50 percent because you will be subject to further reductions.

Any passenger car that costs more than $15,800 is considered a luxury auto and is subject to depreciation restrictions. When was the last time you noticed prices like that when automobile shopping?

SUVs and pickup trucks with a gross vehicle weight rating (GVWR) of over 6,000 pounds are exempt from the luxury auto depreciation limits. For federal tax purposes, large expensing deductions under Code Section 179 are currently available for these types of vehicles. Be sure to check whether your state goes along with the federal expensing rules.

The luxury automobile depreciation limits are as follows:

  • First tax year maximum – $3,160
  • Second tax year maximum – $5,100
  • Third tax year maximum – $3,050
  • Maximum for subsequent tax years – $1,875

Trucks and vans subject to these rules (GVWR 6,000 or less) are allowed only slightly higher amounts than these. Search online for Revenue Procedure 2013-21 for tables that spell this out.

Leased Vehicles

Assuming 100 percent business use, lease payments are deductible. However, lessees must add back a certain amount to income each year to partially offset the difference between the fully deducted lease payments and the luxury auto depreciation limits that would apply if they owned the vehicle.

How to handle 2 percent shareholders’ health insurance

As the 2013 year-end closes in, it’s a good time to revisit the proper treatment of health insurance premiums and S corporation “2 percent shareholders.”

If you own more than 2 percent of the outstanding stock of an S corporation (or stock giving you more than 2 percent of the total voting power), a good chance may exist that your health insurance premiums are not being handled properly at the corporate level. As a result, you could be at risk from a personal tax standpoint.

Health insurance premiums paid by an S corporation on behalf of its 2 percent shareholders should be reported as wages on shareholder W-2 forms. Too often, these payments are not included in wages because the premiums are paid along with those for rank-and-file employees.

From the corporation’s perspective, premiums are different than payroll. Unfortunately, in the eyes of the IRS, they belong on the W-2.

Excluding these amounts from wages jeopardizes the 2 percent shareholders’ ability to deduct these premiums on their personal tax return as self-employed health insurance in arriving at adjusted gross income (AGI). Based on the cost of health insurance, the value of this tax deduction is not something to take lightly.

If there are family members employed by the corporation and covered under the health plan, premium payments made on their behalf may also be required to be included in their wages. Generally, this applies to a spouse, sons, daughters, parents and other direct relatives of 2 percent shareholders.

As wages, these amounts are subject to withholding. But what about Social Security and Medicare tax?

If the 2 percent shareholders are participating in a corporate plan established for the benefit of employees and their dependents, these amounts are not subject to Social Security and Medicare. But they are subject if there is no such plan for the employees.

As far as premium payments and the personal deduction for AGI, it’s important that the corporation make the premium payment or reimburse the 2 percent shareholder making the payment. The 2 percent shareholder cannot make the payment personally and claim the deduction unless the corporation provides reimbursement.

If you are an employee/2 percent shareholder in an S corporation, and you think your company-paid health insurance hasn’t been handled appropriately, you may want to make a correction for 2013 year-end payroll reporting and get on track for the future.

Tax issues involved with repeal of marriage defense act

The recent Supreme Court decision to invalidate a section of the Defense of Marriage Act has far-reaching tax implications.

Section 3 of the Defense of Marriage Act (DOMA) defines marriage for federal law purposes as the “legal union between one man and one woman as husband and wife.” The Supreme Court case reviewed a surviving same-sex spouse’s claim seeking an estate tax refund based on the disallowance of the marital deduction. The Internal Revenue Service’s position was that a marital deduction was not available because the federal government does not recognize the couple’s marriage under DOMA.

The Supreme Court ruled that DOMA violates the right to equal protection under the Fifth Amendment of the U.S. Constitution. While this case was based on estate tax matters, the ripple effect is significant for other federal tax laws relating to income taxes, compensation and benefits afforded to married couples.

Registered domestic partners are not married for federal purposes. Civil unions are also not recognized. The only way to qualify for these federal tax benefits is to enter into a lawful marriage.

For federal purposes, same-sex married couples will now be treated the same as a heterosexual married couple. Their filing options will be married filing jointly or married filing separately. They will not be able to file two single returns.

Federal rules currently stipulate that an income tax return that was originally filed under the status of married filing separately may be amended to married filing jointly. However, the filing status of an original return filed under the status of married filing jointly cannot be changed to married filing separately by amending the return. As decisions are made on how to file both amended returns and future returns, this will need to be considered.

Another important item to remember: When using the married filing separately status, if one spouse itemizes deductions, both must itemize. The standard deduction would be zero to a non-itemizing spouse. Same-sex spouses will now be able to deduct alimony and pursue innocent spouse protection if they meet all the legal requirements of deductibility.

Both Congress and the IRS will need to clarify a number of items:

  • Are married same-sex couples who filed federal tax returns as single individuals prior to the ruling required to amend those returns? Will this be optional?
  • Will the IRS accept married filing jointly returns on a going-forward basis? Will it be retroactive to Jan. 1, 2013, or will the couple have to amend prior years’ returns?
  • If they are required to amend returns, will they have to amend only those within the three-year statute of limitations?

Those who don’t have the luxury of waiting until the issues are clarified should file protective refund claims for open tax years as soon as possible.

Ultimately, some couples will benefit from a joint return while others will be subject to additional taxation. Married same-sex couples could now be impacted by the marriage penalty as well as the phaseout of deductions and exemptions.

The exclusion of gain from the sale of a principal residence at the $500,000 level is now available for same-sex spouses. And now that joint filing is allowable, couples should consider amending a return if one spouse previously had capital gains that could have been offset by the other spouse’s capital losses.

How will same-sex married couples file their taxes if the state they reside in does not recognize their marriage? If the state doesn’t recognize same-sex marriages, the couple may need to file a joint federal return and potentially two single state returns.

How will the federal government treat a same-sex couple who married in a state that allows same-sex marriage but moved to a state that doesn’t recognize the out-of-state marriage?

The IRS provided additional guidance in late August. Click here for the IRS News Release, Revenue Ruling 2013-17, FAQs for Domestic Partners and FAQs for Same-Sex Spouses.

In states that do not recognize same-sex marriage, couples may not enjoy all of the benefits available to residents of states that do recognize these marriages. This could change a couple’s decision-making process when considering which state they want to live in. Although same-sex couples have won a major victory, until the states they reside in recognize their marriage, they will have additional hurdles to navigate.

Estate tax benefits will include the unlimited marital deduction and portability of the deceased spouse’s unused exclusion deduction. For gift tax purposes, they will benefit from the spousal exemption and the ability to split gifts made to non-spouses. We will have to wait and see the effect on property transactions in community property law states.

Wills, trusts and any other planning that has been done in the past will have to be reviewed to make sure it is still valid. Planning related to state issues, depending on where the couple resides, will need to be considered.

Same-sex married couples should review their beneficiary designation forms to make sure they are including the spouse on their retirement accounts. If they aren’t, they will need to obtain the correct signatures. Spousal rollovers of retirement accounts will be available.

From a benefits perspective, same-sex couples will be eligible to collect Social Security based on their spouse’s earning record and receive survivorship benefits on retirement plans. If a spouse served in the military, spousal benefits will now apply.

Same-sex couples will be eligible to receive health benefits tax free. In the past, the premium that was deducted from an employee’s paycheck for same-sex spouse coverage was not considered a pretax deduction and was therefore subject to tax. The same coverage for a heterosexual spouse has always been treated as a tax-free benefit.

Other results of the Supreme Court’s DOMA decision include the following:

  • Same-sex couples will benefit from the Family and Medical Leave Act if necessary to care for their spouse.
  • The couples will have the same immigration benefits available to heterosexual couples.
  • If a state-maintained plan for qualified long-term care coverage provides for coverage of a spouse, same-sex spouses will also be eligible to receive this benefit.

When you consider these issues, take into account the current state of our economy and the current status of our Social Security system. The question of retroactive treatment and its impact will be huge. This law change will have implications that probably haven’t even been considered yet.

Foreign reporting doesn’t have to be a dirty word … if you learn the rules

Offshore reporting is filled with sinkholes that can entrap the unwary taxpayer. With some of the largest civil penalties found anywhere, it’s an area where even the smallest mistake can be costly.

The Report of Foreign Bank and Financial Accounts, or FBAR, is one of the most common offshore reporting forms (Form TD F 90-22.1). But it’s often overlooked.

Schedule B of the U.S. Individual Income Tax Return, Form 1040, requires taxpayers to disclose whether they own or have signatory authority in foreign accounts. If the answer is “yes,” a taxpayer may be required to file an FBAR.

Many taxpayers incorrectly fail to check the appropriate box on Schedule B. That’s critical because the IRS views a box that is checked “no” as an affirmative or “willful” misstatement.

A willful misstatement can subject a taxpayer to enhanced civil penalties. Those penalties can include prison, a $500,000 fine and civil penalties of 50 percent of the highest account balance for each year the taxpayer did not report the account properly.

It’s important for taxpayers to tell their accountants whether they have offshore accounts. Often a CPA will have an affirmative representation in the engagement letter stating that a client doesn’t have any interests in foreign accounts.

Many taxpayers think that the offshore reporting requirements affect only foreign bank accounts. But FBAR may also require the following to be reported:

  • Foreign brokerage accounts
  • Custodial precious metal accounts
  • Foreign hedge funds
  • Real estate investments
  • Life insurance policies with some type of annuity or savings component

If taxpayers have ownership or signature authority in a foreign investment or account, they should share answers to the following questions with their CPA:

  • When was the account opened?
  • What is the approximate value of the account?
  • What is the source of funds?
  • What is the account used for?
  • Does the account generate income?
  • Is the account related to any business activity?
  • Is anyone else related to the account?

Answers to these questions will determine whether a taxpayer has an FBAR reporting requirement.

The instructions give the following guidance: “A United States person that has a financial interest in or signature authority over foreign financial accounts must file an FBAR if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year.”

That may be a good starting point. But a few important clarifications may affect a CPA’s final decision.

First, some taxpayers have the false impression that, as long as no individual account exceeds the threshold of $10,000, they aren’t required to file an FBAR report for any of their accounts. This is a common error.

Actually, the aggregate of the accounts is determinative. If two accounts hold $8,000 each, both accounts must be reported.

Another big hurdle in FBAR reporting is the definition of “U.S. person.” It is not uncommon for taxpayers to be dual nationals, foreign-born naturalized citizens, ex-pats living overseas and resident aliens (green card holders).

Are green card holders who never lived here residents? What if they moved here late in the calendar year? If taxpayers are unsure of how the answers apply to them, they should consult with an immigration attorney or ask their CPA to review the residency tests.

A taxpayer’s CPA should carefully note the definition of “resident alien” and the Substantial Presence Test. First- and last-year residency may complicate things but can be important for tax purposes.

Another issue is whether a taxpayer has a financial interest or signature authority over a foreign account. Estate planning maneuvers and cultural norms can play havoc. The Tax Code often says that interests are reportable even though taxpayers do not consider the accounts to be “theirs.”

Common reporting scenarios include elderly parents who add their children to accounts to help with money management and children who open accounts “back home” to provide for elderly parents or siblings who have not emigrated. As a general rule, a taxpayer should report the account if the taxpayer’s name is on it.

Indirect interest through more than 50 percent ownership of an entity is another area of complication. Many countries do not allow foreigners to own land directly, so Americans wishing to own property must set up LLCs or trusts to buy property. Then they own 100 percent of that LLC.

Other similar situations are comparable to condominium ownership or timeshares but through a foreign entity. Depending on the ownership and entity, this type of ownership may be reportable.

The definition of “foreign financial account” is not as black and white as one might think. For the average taxpayer, only checking, savings, investment and retirement accounts come to mind. As noted above, the definition encompasses many other financial instruments, such as:

  • Certificates of deposit
  • Foreign stock and securities
  • Hedge funds
  • Mutual funds
  • Commodities and precious metals accounts
  • Indirect interests in foreign financial assets through an entity if ownership exceeds 50 percent
  • Life insurance and annuities with cash value 

With so many financial products and derivatives invented every year, it’s important to remember that the definition of “account” is quite broad.

The definition of “foreign financial institution” is also important. An account at the local UBS branch is not a foreign financial account. However, an account at the London branch of the Bank of America is.

For people who hold gold bullion or silver bars, the definitions of these accounts are also important. Reporting may be required, depending on what type of institution holds the metal and whether the taxpayer can purchase and sell through that account.

The purpose of this information isn’t to frighten people away from having offshore accounts. The number of taxpayers who do is growing. They need to know when to seek outside help and be aware of the potential pitfalls. Addressing these issues with their CPAs is wise.

Simply hoping that they won’t need to disclose offshore accounts or even to understand what the IRS considers reportable is a recipe for disaster for taxpayers.