IRS guidance: Is it a tip or a service charge?

 The IRS recently issued guidance on the difference between a tip and a service charge.

The distinction is important because service charges are considered revenue of the establishment. To the extent that the service charges are, in turn, paid to the employees, that amount is compensation, subject to all payroll taxes and withholdings.

The employer’s calling the payment a “tip” is not conclusive. Customer payments are considered tips when all of the following requirements are met:

1. The amount must not be determined by the employer.

2. The customer has full discretion to determine the amount of the payment.

3. The payment must be freely made.

4. The customer can generally decide who receives the payment.

The IRS believes that the absence of any of these components suggests that the payment is a service charge instead of a tip.

This is an important clarification because the amount of com­pensation paid to employees affects not only the computation of payroll and withholding taxes due but also the calculation of other benefits based on compensation. In addition, service charges are not eligible for the employer tip credit.

In Announcement 2012-25, the IRS advises all businesses to make any needed system or procedure changes to fully conform to these rules by Jan. 1, 2013.

New Medicare investment tax adds layer of taxation

With the Supreme Court’s finding that the 2010 federal healthcare act is constitutional, it’s time to consider one of the revenue-raising provisions of the act and the ways it may affect next year’s tax situation.

As a generalization, the net investment income of taxpayers with total income over a certain threshold is subject to a new Medicare investment tax of 3.8 percent beginning in 2013.

As with almost any tax provision, the devil is in the details, and the details start with the definitions. The additional tax applies only to married couples with modified adjusted gross income over $250,000 (over $125,000 for married couples filing separately). Single filers face a threshold of $200,000.

For this purpose, modified adjusted gross income means total income on page 1 of your Form 1040, plus the foreign earned income exclusion. So, unless you have worked outside the United States and qualify for the exclusion, the threshold is based on the amount at the bottom of page 1 of your Form 1040.

This means that all income is included and only certain deductions apply, such as self-employed retirement contributions and health insurance. Items such as charitable contributions reduce your taxable income on page 2 of your 1040, but they do not reduce the exposure to this investment tax.

Net investment income is income from interest, dividends, royalties, annuities and certain other income. Net rents after expenses are included but not for real estate professionals. Flow-through income from trusts, LLCs, partnerships and S corpora­tions is included if the income is considered passive to the recipient. Gains on the sale of investment assets are generally included in net investment income as well.

Investment income does not include income from tax-exempt municipal bonds, distributions from qualified plans or IRAs, or income or distributions from flow-through entities in which the investor materially participates.

 The tax also applies to trusts and estates if they have income that has not been distributed and the income is in excess of the highest tax bracket in that year. These tax brackets are quite short. For 2012, trusts and estates are generally at the top tax bracket with only $11,650 of income. Charitable trusts are exempt.

Example 1

John, a single filer, has $175,000 of salary and $75,000 of net investment income. His modified adjusted gross income is $250,000, less the $200,000 single-taxpayer threshold, leaving $50,000 of income in excess of the threshold. The lower of net investment income and excess income is $50,000. At a 3.8 percent tax rate, Medicare investment tax of $1,900 is due, in addition to any other tax.

Example 2

Misty and David are married and have $200,000 of combined salary, $50,000 of interest and dividend income, and $100,000 of net rental income from an investment partnership. Their modified adjusted gross income is $350,000, less the $250,000 threshold for a married couple filing jointly, leaving $100,000 of income in excess of the threshold. The lower of net investment income and excess income is $100,000. Medicare investment tax of $3,800 is due.

This investment tax is actually a third income tax system, separate from the regular federal income tax and the alternative minimum tax (AMT). It can be seen as a separate system because you can owe the investment tax without owing either the regular income tax or the AMT.

For example, you could have significant income yet also have large deductions and credits that eliminate your income tax liability. However, you could still owe this Medicare investment tax.

Consider some planning ideas for this new tax:

  • Shift savings and investment strategy to tax-exempt invest­ments and tax-deferred retirement assets.
  • If rents are a major source of your net investment income, a cost segregation study might increase your depreciation expense and reduce your net rental income.
  • If you have significant unrealized capital gains in your portfolio, consider selling those assets in 2012 before the new tax takes effect.
  • Consider using a charitable remainder trust, both to shelter a large gain from net investment income and to prevent a large one-year bulge in your total income subject to the MAGI threshold.
  • Plan for your installment-sale strategy. For sales beginning in 2012, you might consider electing out of the installment method, reporting all of the gain in 2012 and avoiding the tax on the gain from installments collected in future years.
  • If you are considering a Roth IRA conversion, converting a traditional IRA to a Roth IRA this year would be wise in plan­ning for the investment tax. If you wait until 2013, although your IRA income is not considered net investment income, the bump in income from the conversion will increase your modified adjusted gross income subject to the threshold.
  • Shift investment assets to children with lower investment income. The so-called “kiddie tax” will remove much or all of the income tax savings, but the investment tax savings may remain.
  • Trusts should reconsider the amount of distributions paid out to avoid paying this tax at the trust level.

Talk with your tax adviser about how the Medicare investment tax will affect your tax situation in 2013. But remember, in the end, this is only an additional 3.8 percent tax. While that amount may be sub­stantial in certain circumstances, the cost of this tax may not offer a sufficient reason to make dramatic changes in your affairs.

Project the expected effect of this tax on your tax picture first, determine how much of it can be avoided with certain changes, and then consider whether the net savings truly justifies the changes.

Small employers not claiming health care credit, IRS says

The volume of claims for the Small Business Health Care Tax Credit has been lower than expected, according to a Treasury Inspector General for Tax Administration audit released Nov. 7, 2011.

As of mid-May 2011, only 228,000 taxpayers out of an estimated potential pool of 4.4 million taxpayers have made claims for the credit. Less than 15 percent of the expected $2 billion of credit for tax year 2010 was claimed.

The credit is generally available only to small employers who pay at least half the cost of health insurance coverage for their employees. The credit is refundable to tax-exempt organizations but only to the extent it does not exceed the total amount of income tax and Medicare tax withholding from employees’ wages and the employer share of Medicare tax.

To qualify for the credit, an employer must have fewer than 25 full-time equivalents for the taxable year and have average annual wages for its employees for the year of less than $50,000 per FTE.

Employers with more than 10 but fewer than 25 FTEs or average wages of more than $25,000 but less than $50,000 may qualify for a reduced credit amount.

Tax credit for hiring qualified veterans extended, expanded

A new act extends the work opportunity tax credit for one year but only for qualified veterans who begin work before Jan. 1, 2013. The act also makes a number of changes for hiring qualified veterans.

The Three Percent Withholding Repeal and Job Creation Act was signed by President Obama on Nov. 21, 2011.

Effective for individuals who begin work after Nov. 21, 2011, a qualified veteran is a veteran who is certified by the designated local agency as falling within one of the following categories:

1. The individual is a member of a family receiving assistance under a food stamp program for at least three months, all or part of which is during the 12-month period ending on the hiring date.

2. The individual is entitled to compensation for a service-connected disability and either:

  • Has a hiring date that is no more than one year after having been discharged or released from active duty in the U.S. Armed Forces
  • Has aggregate periods of unemployment during the one-year period ending on the hiring date that equal or exceed six months

3. The individual has aggregate periods of unemployment during the one-year period ending on the hiring date that equal or exceed four weeks (but less than six months).

4. The individual has aggregate periods of unemployment during the one-year period ending on the hiring date that equal or exceed six months.

The last two categories of qualified veterans are new under the act.

Effective for individuals who begin work after Nov. 21, 2011, the maximum amount of qualifying first-year wages against which the credit may be claimed is:

  • $12,000 for an individual who is a qualified veteran entitled to compensation for a service-connected disability and has a hiring date that is no more than one year after having been discharged or released from active duty. The maximum credit is $4,800 (40 percent of $12,000).
  • $24,000 for an individual who is a qualified veteran entitled to compensation for a service-connected disability and has aggregate periods of unemployment during the one-year period ending on the hiring date that equal or exceed six months. The maximum credit is $9,600 (40 percent of $24,000).
  • $14,000 for an individual who is a qualified veteran having aggregate periods of unemployment during the one-year period ending on the hiring date that equal or exceed six months. The maximum credit is $5,600 (40 percent of $14,000).

A tax-exempt employer may claim a credit for hiring qualified veterans as if it were not tax-exempt. The credit is allowed against the Social Security tax that the exempt employer would otherwise have to pay on the wages of all its employees during the one-year period beginning with the day the veteran goes to work for the tax-exempt organization.

IRS ruling allows bonus accrual deduction

An employer using an accrual method of accounting may take a deduction in the current year for a fixed amount of bonuses, according to a new IRS ruling.

The deadline covers bonuses payable to a group of employees even though the employer does not know which of the employees will receive a bonus or the amount of any particular bonus until after the end of the taxable year.

The entire amount of the bonus pool will be paid to members of the group of employees in the following year, but at the end of the current year, the employer does not yet know which particular employees will receive any bonus or how much each will receive.

To secure the deduction in the year of accrual, the bonus must actually be paid within the first two and one-half months of the subsequent tax year.

How IRS examiners will handle uncertain tax positions

The IRS Large Business and International Division has issued guidance to examination teams on the procedures and requirements they are to follow when reviewing and using Schedule UTP, Uncertain Tax Position Statement, in conjunction with their examinations.

Schedule UTP requires certain corporations to report each federal income tax position taken on their returns for which two conditions are satisfied:

  1. The corporation took a tax position on its federal income tax return for the current or prior year; and
  2. The corporation or a related party has:
  • Recorded a reserve for that position for federal income tax in audited financial statements, or
  • Did not record a reserve for that position because the corporation expects to litigate the position. Tax positions taken in years before 2010 need not be reported.

Public or privately held corporations that issue, or are included in, audited financial statements and file a Form 1120, Form 1120-F, Form 1120-L or Form 1120-PC must report their uncertain tax positions on Schedule UTP if they satisfy the total asset threshold.

Under a five-year phase-in, corporations that have total assets of at least $100 million must file Schedule UTP starting with 2010 tax years. The total asset threshold will be reduced to $50 million starting with 2012 tax years and to $10 million starting with 2014 tax years.

The division has issued guidance on how its examiners should use Schedule UTP when examining corporate returns. The guidance includes the following:

  • The presence of the Schedule UTP should not, by itself, be the sole factor used to determine whether to proceed with an examination.
  • Examiners may ask for information about the relevant facts affecting the tax treatment of positions disclosed on Schedule UTP. However, they cannot ask for an explanation of the rationale for determining that the issue was uncertain or for an analysis of support for or against the tax position.
  • Examiners may not ask for copies of workpapers used to prepare Schedule UTP.

If the corporation’s financial statements reflect an increase in reserves, but the filed return did not include a Schedule UTP, examiners are told they cannot ask about the makeup of the reserves. They may only ask the taxpayer to confirm that there are no issues to be disclosed according to the Schedule UTP reporting requirements.

Depreciation incentives reduced for 2012

To help a struggling economy, Congress has encouraged business investment in capital equipment using two incentives.

Through 2011, new equipment – not used equipment recently purchased – qualified for a 100 percent bonus depreciation deduction. But for calendar year 2012, the first-year bonus percentage drops to 50 percent, and for 2013 there is no bonus percentage. The 100 percent incentive for 2011 required the asset to have been legally acquired and placed in service by Dec. 31, 2011.

The Internal Revenue Code Section 179 (first-year depreciation) deduction was $500,000 for tax years beginning in 2011. The tax year beginning in 2012 sees this deduction reduced to $139,000. The first-year incentive deduction applies to new and used assets. It’s claimed before applying the 50 percent bonus for 2012.

Example: A small-business owner purchases $339,000 of both new and used machinery and equipment during 2012. The owner can claim up to $139,000 of the Section 179 deduction and apply it to used items, leaving $200,000 of cost.

The 50 percent bonus is applied to another $100,000 deduction – assuming the remaining $200,000 is for new equipment eligible for the bonus. The final $100,000 is subject to the normal seven-year depreciation schedule.

In this example, the first-year depreciation deduction is $239,000 on total machinery and equipment cost of $339,000.

The bonus depreciation provision applies to new acquisitions of assets that have a 20-year or shorter depreciation period. If machinery and equipment are placed in service in 2012, bonus depreciation applies to 50 percent of the cost with the remaining 50 percent depreciated over the 20-year or shorter depreciation period, using a half-year convention for the first year.

2011 Overview: End-of-year tax legislation

In the closing days of 2011, Congress passed tax legislation that temporarily extended a payroll tax cut, but did not extend two important depreciation incentives – a lack of action that will be important as taxpayers plan their income and deductions for 2012.

For 2011, Congress reduced by 2 percent the employee share of the Social Security tax and the self-employment tax rates, hoping to stimulate consumer spending.

However, when it came time to extend this cut for 2012, Congress could not agree on how to pay for a one-year extension. So, the 2 percent waiver of Social Security tax was effective through Feb. 29, 2012.

In February 2012, Congress finally agreed to extend the payroll tax cut through the rest of the year, and President Obama signed this extension into law on Feb. 22, 2012.

Grouping? Investors may want to take a second look

Taxpayers involved with passive activities should make sure they understand the ins and outs of the rules – especially in view of recent developments.

Medicare surtax in 2013. Under the 2010 healthcare act, a surtax on higher-income individuals’ net investment income becomes effective in 2013. The surtax is 3.8 percent of the lesser of net investment income or the excess of the taxpayer’s Form 1040 modified adjusted gross income over $200,000 ($250,000 if married filing jointly).

The definition of “net investment income” includes income from a business in which the taxpayer personally does not materially participate within the meaning of passive activity loss (PAL) rules. Exceptions to the definition include active business income, interest income and other working capital income attributable to an active business.

A passive activity is defined as any rental activity and any activity involving the conduct of a trade or business in which the taxpayer does not materially participate. Any passive losses not used in a current tax year are suspended and carried forward to future tax years.

Suspended losses may offset future passive income. Or, they may be recognized upon complete disposition of the taxpayer’s interest in the passive activity.

Taxpayers should be concerned with the proper grouping of activities and should review every opportunity to group a passive activity with a materially participating business. Passive business income and rental income will be subject to the Medicare surtax, but active business income will not.

The proper grouping of activities could reduce or eliminate the surtax, beginning in calendar year 2013.

Grouping of activities. Treasury regulations permit one or more trade or business activities or rental activities to be treated as a single activity if the activities are an economic unit for measurement of gain or loss under PAL rules. The definition of an activity and the determination of whether a group of activities can be treated as a single activity depend on facts and circumstances.

The taxpayer can use any reasonable method to determine whether trade or business activities constitute an appropriate economic unit for measuring gain or loss and thus can be treated as a single activity.

The regulations identify the following factors to consider in determining an appropriate economic unit:

  • Similarities and differences in types of trades or businesses
  • Extent of common control and ownership
  • Geographic location
  • Interdependencies between the activities (e.g., the extent to which activities purchase or sell goods among themselves, involve products or services normally provided together, have the same customers or employees, or are accounted for with a single set of books)

Defining an activity is important. It’s the unit of measurement for determinations under PAL rules. Material participation is determined at the activity level.

If two activities are grouped together as a single activity, material participation must be shown in the activity as a whole. But if the activities are grouped separately, material participation must be shown in each activity.

Disclosure requirements. Once taxpayers have grouped activities, they must remain consistent in the grouping, unless the original grouping election was clearly inappropriate or facts and circumstances have changed.

In January 2010, the IRS issued Revenue Procedure 2010-13 on reporting activity groupings. It’s applicable only to tax years begin­ning on or after Jan. 25, 2010 – essentially beginning with the 2011 Form 1040.

A written tax return statement is required for new groupings, the addition of a new activity to an existing grouping and regroupings for reasons such as an error or change in facts.

No written statement is required for:

  • Activity groupings prior to the effective date unless an activity is added
  • The disposition of an activity from a grouping
  • Pass-through entities like S corporations and partnerships

If a taxpayer is engaged in two or more business activities or rental activities and fails to report whether they are grouped as a single activity, each business or rental activity is treated as a separate activity.

Although prior grouping elections are grandfathered in under Rev. Proc. 2010-13, the regulations require tax consistency. Therefore, documenting a grouping position on an annual basis with a written tax return statement may assist in the preparation of future tax returns.

Mortgage interest deduction limited per residence

The Tax Court has rendered a decision that could affect unmarried individuals who share a residence, same-sex married couples and multiple families who pool their resources to purchase a vacation home.

Charles Sophy and Bruce Voss bought two houses as joint tenants. They financed the purchases by obtaining a mortgage secured by each house.

Sophy and Voss also obtained a home equity line of credit for one of the houses. They were jointly and severally liable on the mortgage and home equity debt.

On audit, the IRS determined that Sophy and Voss were together limited in deducting interest on $1 million of acquisition indebtedness and $100,000 of home equity indebtedness. The IRS contended that the limitations applied on a per-residence basis, regardless of how many owners were involved and whether the co-owners were married to each other.

In the IRS view, co-owners are collectively limited to a deduction for interest paid on a maximum of $1.1 million of acquisition and home equity indebtedness ($1 million + $100,000).

Sophy and Voss argued that the limitations on indebtedness should be applied on a per-taxpayer basis for co-owners who are not married to each other. In their view, each co-owner should be allowed a deduction for interest paid on up to $1.1 million of acquisition and home equity indebtedness.

The court sided with the IRS. The court found nothing in the legislative history suggesting that Congress had any intention other than a per-residence limitation. (Charles J. Sophy, et al. v. Commissioner, 138 T.C. No. 8, March 5, 2012)