Highlights - UNC Charlotte Pages
Latest DevelopmentsFederal Tax Update – First Quarter 2010HighlightsTax changes in the Worker, Homeownership, and Business Assistance Act of 2009.First quarter 2010 interest rates on federal tax overpayments and underpayments.IRS announces 2010 standard mileage rates.Federal estate tax is dead for now, but stayed tuned.IRS releases new form for claiming homebuyer credit.Tax Court rules again that MBA expenses can be deducted.Update on tax treatment of gambling activities.Taxpayer failed to qualify for IRS levy exception to 10% premature withdrawal penalty tax.No deductions for Ponzi losses inside IRAs.New regulations provide tax rules for operating employee stock purchase plans (ESPPs).New regulations cover reporting requirements when employer shares are acquired via incentive stock options (ISOs) and employee stock purchase plans (ESPPs).IRS says no year-of-accrual deduction when deferred employee bonuses were subject to continued employment requirement.New regulations on S corporation cancellation of debt (COD) income.Tax Changes in the Worker, Homeownership,and Business Assistance Act of 2009On November 6, 2009, the Worker, Homeownership, and Business Assistance Act of 2009 (the Act) was signed into law. The two tax centerpieces of this legislation are: (1) the extension and expansion of what is now inaccurately called the first-time homebuyer credit and (2) the extension and expansion of the five-year NOL carryback privilege. Other less-important changes are included as well. Here is the story, starting with changes that affect individual taxpayers.Homebuyer Tax Credit Is Extended and ExpandedPurchase Deadline Extended into 2010The so-called first-time homebuyer credit was previously scheduled to expire on November 30, 2009. The Act extends the deal to cover purchases of U.S. principal residences that close by April 30, 2010. However, if a home is under contract on April 30, 2010, the deadline for closing the deal is extended to June 30, 2010. [See IRC Sec. 36(h).]Existing Homeowners Can Qualify for Smaller CreditsThe Act creates a new but less-generous credit for so-called longtime homeowners who buy a replacement U.S. principal residence after November 6, 2009. The new longtime homeowner credit equals the lesser of (1) $6,500, or (2) 10% of the replacement principal residence purchase price, or (3) $3,250 for a buyer who uses married filing separate status.To qualify, the buyer must have owned and used the same home as a principal residence for at least five consecutive years during the eight-year period ending on the purchase date for the replacement principal residence. If the buyer is married, both spouses must pass this test, whether or they file jointly or not. [See IRC Sec. 36(b)(1) and (c)(6).]Key Point. The new longtime homeowner credit is only available for purchases that close after November 6, 2009 and by no later than April 30, 2010 (or by June 30, 2010 if the replacement principal residence is under contract on April 30, 2010).Key Point. The new longtime homeowner credit can be claimed on 2009 returns, for qualifying purchases that close between November 7, 2009 and December 31, 2009. As explained later, it can also be claimed on 2009 returns for qualifying purchases that close in 2010. Larger Credits Still Allowed for First-Time BuyersBefore the Act, the homebuyer credit was only available to so-called first-time homebuyers, which means someone who had not owned a U.S. principal residence during the three-year period ending on the purchase date for the home that will serve as the buyer’s new principal residence. If the buyer is married, both spouses must pass the three-year test, whether or not they file jointly.After the Act, the first-time homebuyer credit still equals the lesser of (1) $8,000, or (2) 10% of the new principal residence purchase price, or (3) $4,000 for a buyer who uses married filing separate status. [See IRC Sec. 36(b)(1) and (c)(1).]Key Point. The familiar first-time homebuyer credit remains available for purchases that close by no later than April 30, 2010 (or by June 30, 2010 if the home is under contract on April 30, 2010).Higher-Income Folks Now QualifyBoth the familiar first-time homebuyer credit and the new longtime homeowner credit are phased out (reduced or completely eliminated) as income goes up. However, the Act significantly raises the phase-out ranges so that many more higher-income buyers will qualify.For purchases after November 6, 2009, the phase-out range for unmarried individuals and married folks who file separately is between modified adjusted gross income (MAGI) of $125,000 and $145,000 (way up from the old-law range of $75,000-$95,000).The phase-out range for married joint filers is between MAGI of $225,000 and $245,000 (way up from the old-law range of $150,000-$170,000).Key Point. Buyers who closed during 2009 before the new liberalized MAGI phase-out ranges kicked in on November 7, 2009 are stuck with the much stricter old-law ranges. Too bad for them!Key Point. As before, MAGI for this purpose means the adjusted gross income figure reported on the last line on page 1 of the client’s Form 1040 increased by income from outside the U.S. that is exempt from taxation under IRC Secs. 911, 931, or 933. These income add-backs only apply to a relatively few folks. [See IRC Sec. 36(b)(2).]New $800,000 Purchase Price LimitFor purchases after November 6, 2009, the homebuyer credit can only be claimed for a principal residence that costs $800,000 or less. So if your client’s new residence costs $800,001, the credit is completely off limits. [See IRC Sec. 36(b)(3).]No More Credits for Kids or DependentsFor purchases after November 6, 2009, the homebuyer must be at least 18 years old on the purchase date to qualify for the credit. Also, no credit is allowed for a buyer who can be claimed as a dependent on someone else’s Form 1040 for the year of the purchase. These new rules are intended to shut down the practice of claiming the credit for youngish buyers who really do not even have incomes of their own (like college students who use money from their parents to buy a pad near the campus). [See IRC Sec. 36(b)(4) and (d)(3).]Anti-Fraud Measures (Finally) and Updated Tax FormAs you may know, a recent TIGTA report said the IRS has already identified about 100,000 returns with potentially fraudulent homebuyer credits. This is not surprising when the government is willing to give away up to $8,000 in free money to anyone who files a return, even when that person reports no income, thanks to the fraud-friendly refundable credit concept. Believe it or not, absolutely no documentation was required to claim the credit before the Act. Now, for credits claimed on returns for tax years ending after November 6, 2009 (meaning calendar-year 2009 and 2010 returns), buyers must attach properly executed real estate settlement sheets (HUD-1 forms) to their returns.Key Point. The updated version of IRS Form 5405 (First-Time Homebuyer Credit) has been revised to reflect this new requirement, and the revised form must be used to claim the credit for (1) any purchases closed after November 6, 2009 and (2) any credits claimed on 2009 Forms 1040, even if the purchase date was before November 7, 2009. The 2008 version of Form 5405 can still be used to claim credits on 2008 returns for 2009 purchases that closed before November 7, 2009. (See IRS Information Release IR 2009-18.)Also, for returns for tax years ending after April 8, 2008 (meaning calendar-year returns for 2008-2010), the IRS can now treat apparent errors in claiming credits and apparent failures to repay credits under the recapture rules (see below) as mathematical or clerical errors and thereby automatically deny credits or assess additional tax without issuing a deficiency notice. [See IRC Secs. 36(d)(4) and 6213(g)(2).]Credits Can Still Be Claimed on Prior-Year ReturnsAs under prior law, a buyer can still claim the credit for a 2009 purchase on his 2008 Form 1040 (although he would usually have to file an amended return to do so at this late date). A buyer can also claim the credit for a 2010 purchase on his 2009 Form 1040. This allows the buyer to cash in on the credit sooner rather than later, and it may also allow him to claim a credit, or a larger credit, if his MAGI is higher in the year of purchase than in the preceding year. [See IRC Sec. 36(g).]Credits Must Still Be Repaid (Recaptured) in Some CasesUnder old-law rules for homes purchased between April 9, 2008 and December 31, 2008, buyers are generally required to repay (recapture) their credits over 15 years, starting in 2010. For post-2008 purchases, this 15-year repayment rule is eliminated in most cases. However under the rules for post-2008 purchasers, your client might still have to repay the credit if she sells the home within three years of the purchase date or stops using it as her principal residence during that period. [See IRC Sec. 36(f).]Looser Rules for Members of the Military, Foreign Service, and Intelligence CommunitiesFor military service members, foreign service members, and employees of the intelligence community on qualified official extended duty service outside the U.S., the Act lengthens the deadline for closing on home purchases for an extra year to April 30, 2011 (or June 30, 2011 for homes under contract on April 30, 2011). The new law also completely waives the credit repayment rules (including the 15-year repayment rule for credits claimed for 2008 purchases) when these individuals are forced to move, after 2008, due to receiving new orders for qualified official extended duty service (including when orders are received by the taxpayer’s spouse). [See IRC Sec. 36(h)(3) and (f)(4)(E).]Tighter Restrictions on Related-Party PurchasesThe homebuyer credit cannot be claimed for a home the buyer purchases from certain related parties. For purchases after November 6, 2009, the Act tightens the related-party restriction by providing that the restriction also applies when a home is purchased from certain parties related to the buyer’s spouse. [See IRC Sec. 36(c)(3)(A)(i).]No DC Homebuyer Credit for Those Eligible for National CreditFor purchases after 2008, the Act disallows the IRC Section 1400C DC homebuyer credit when an individual or an individual’s spouse is eligible for the national homebuyer credit under IRC Sec. 36. [See IRC Sec. 1400C(e)(4).]Tax-Free Treatment for Stimulus Act Military Base Realignment and Closure PaymentsUnder the Department of Defense Homeowner Assistance Program (HAP), eligible military personnel and employees can receive payments intended to reimburse them for home value losses due to base realignments and closures. HAP payments were expanded by the American Recovery and Reinvestment Act of 2009 (better known as the Stimulus Act). The Worker, Homeownership, and Business Assistance Act of 2009 grants tax-free fringe benefit treatment to HAP payments that were authorized by the Stimulus Act, effective for payments made after February 17, 2009. [See IRC Sec. 132(n).]Five-Year NOL Carryback Deal Is Extended and ExpandedBackground on Earlier Five-Year Carryback Deal for Small Business NOLs Generated in 2008 Tax YearsAs you recall, the American Recovery and Reinvestment Act of 2009, which we will call the Stimulus Act, allows an eligible taxpayer to elect to carry back an applicable 2008 net operating loss (NOL) for either three, four, or five years in order to claim refunds of federal income taxes paid for those years. This is a beneficial exception the two-year carryback rule that usually applies to NOLs. [See IRC Sec. 172(b)(1)(A)(i) and IRC Sec. 172(b)(1)(H) before all the amendments included in the Worker, Homeownership, and Business Assistance Act of 2009.]For a calendar-year taxpayer, the applicable 2008 net operating loss is one that was generated in calendar year 2008.For a fiscal-year taxpayer, the applicable 2008 net operating loss is one that was generated in either (1) the tax year that began in 2008 or (2) the tax year that ended in 2008 (some such years just ended late in 2009). The expanded NOL carryback election can be made for one year or the other, but not both.Eligible TaxpayersThe expanded NOL carryback election allowed by the Stimulus Act, which we will call the old-law election, is only available to an eligible small business (ESB), as defined by IRC Sec. 170(b)(1)(H)(iv). An ESB can be a C corporation, a partnership (including a multi-member LLC treated as a partnership for federal income tax purposes), an S corporation, or a sole proprietorship (including a single-member LLC treated as a sole proprietorship for federal income tax purposes). An ESB must have average annual gross receipts of no more than $15 million for the applicable three-year period, which means the three-year period that ends with the NOL year for which the election is made.Again, the old-law election can only be made for calendar year 2008 or for a fiscal tax year that begins or ends in 2008. In determining if an entity (including an S corporation or partnership) is an ESB, the aggregation rules found in IRC Sec. 448(c)(2) must be followed. (See Rev. Proc. 2009-26.)Losses from S Corps, Partnerships, and Sole ProprietorshipsIn the case of an ESB that is a partnership an S corporation, or a sole proprietorship, the old-law election allowed under the Stimulus Act is made at the owner level. The election can be made for the owner’s applicable 2008 net operating loss, including passed-through items of income, gain, loss, and deduction from an ESB that are allowed in calculating the owner’s NOL. The owner’s applicable 2008 net operating loss equals the lesser of (1) the owner’s entire NOL for that year or (2) the portion of the owner’s NOL for that year that is attributable to one or more ESB S corporations, partnerships, or sole proprietorships. (See Rev. Proc. 2009-26.)NOL Calculations for IndividualsAn individual taxpayer’s NOL does not simply equal the negative taxable income amount shown on the return for that year. Certain add-backs and adjustments must be made. These include (among other things): (1) adding back personal exemption deductions, (2) adding back the excess of non-business deductions over non-business income, (3) adding back the excess of non-business capital losses over non-business capital gains, (4) adding back gains excluded under IRC Sec. 1202 (the qualified small business corporation stock rules), (5) adding back the domestic producer deduction under IRC Sec. 199, and (6) adding back any NOL carried into the year in question. (See IRC Sec. 172.) See Schedule A of Form 1045 for a worksheet that can be used to calculate an individual’s NOL.NOL Calculations for C CorporationsSimilarly, a C corporation’s NOL does not simply equal the negative taxable income amount shown on that year’s Form 1120. Certain adjustments must be made here too. Specifically, any NOL carried into the year must be added back, and the dividends received deduction (if any) may have to be recomputed. (See IRC Sec. 172.)Election and Carryback ProceduresThe old-law election allowed under the Stimulus Act generally must be made by the due date (including any extension) of the return for the loss year for which the election is made. As mentioned earlier, the old-law election for a calendar-year taxpayer can only be made for the 2008 tax year. The election deadline for that year has long since passed. If the taxpayer has a fiscal tax year, however, the old-law election can be made for the tax year that begins or ends in 2008. The election deadline may not have yet passed for some fiscal tax years that began in 2008. For example, the deadline has not yet passed for a tax year that began on November 1, 2008 and ended on October 31, 2009 if the return for that year was extended.The claim for a tax refund from carrying back an NOL for which the election is made generally must be filed – typically using Form 1045 for individuals, estates, and trusts and Form 1139 for corporations – by no later than 12 months after the end of the loss year for which the election is made. The instructions to Forms 1045 and 1139 have been revised to accommodate the old-law expanded NOL carryback election privilege.Key Point. Rev. Proc. 2009-26 provides specific instructions on how to make the old-law election for an applicable 2008 net operating loss.New Law Gives Similar Deal to Almost All Businesses for NOLs Generated in Tax Years Ending after 2007 and before 2010Thanks to the new Worker, Homeownership, and Business Assistance Act of 2009 (the Act), businesses of any size can generally elect to carry back NOLs for either three, four, or five years. This is a beneficial exception to the two-year carryback rule that usually applies to NOLs.This new expanded NOL carryback election is allowed for NOLs that arise in tax years that end after 2007 and begin before 2010. However, the taxpayer in question can only make the election for one such year. [See IRC Sec. 172(b)(1)(H)(ii) and (iii).]For purposes of this discussion, we will call the extended and expanded NOL carryback election allowed by the Act, the new election.Key Point. A calendar-year taxpayer can make the new election for either 2008 or 2009. A fiscal-year taxpayer can make the new election for the tax year beginning in 2007, or the tax year beginning in 2008, or the tax year beginning in 2009.Key Point. The taxpayer’s status as an ESB (or not) does not affect eligibility for the new election.New Law Also Gives Small Businesses Second Bite of the Five-Year NOL Carryback Privilege AppleIf the taxpayer properly made an old-law for an NOL attributable to ESBs for a 2008 tax year, the taxpayer can now make the new election for an NOL arising in different tax year that ends after 2007 and begins before 2010. [See IRC Sec. 172(b)(1)(H)(v)(I).]Therefore, a small business taxpayer can potentially benefit twice from the expanded carryback privilege: first for an NOL attributable to ESBs for a 2008 tax year (under the old-law election) and again for an NOL from a different tax year that ends after 2007 and begins before 2010 (under the new election).Key Point. Once again, the taxpayer’s status as an ESB (or not) does not affect eligibility for the new election.Example 1Danny Corp (DC) is a calendar-year C corporation ESB that made the old-law election for the NOL from its 2008 tax year. Assume DC generates another NOL in 2009. DC can make the new election for 2009. Note that DC’s status as an ESB is not relevant for the new election.Example 2Florida Corp (FC) is a fiscal-year C corporation ESB that made the old-law election for the NOL from its tax year ending in 2008. FC continues to generate NOLs. FC can make the new election for its tax year ending in 2009 or for its tax year beginning in 2009 (but not for both years). Note that FC’s status as an ESB is not relevant for the new election.Limitation on NOL Carried Back to Fifth Preceding YearWhen the taxpayer chooses under the new election to carry back an NOL to the fifth preceding tax year, the amount carried back to that year is limited to 50% of the taxable income for that year. The remaining NOL amount (if any) can then be used to offset income in more-recent carryback years without any such restriction. Note that this 50%-of-taxable-income limitation applies whether the taxpayer is an ESB or not, because ESB status (or lack thereof) is irrelevant for purposes of the new election. [See IRC Sec. 172(b)(1)(H)(iv)(I).]Example 3Georgia Corp (GC) is a calendar-year C corporation and is not an ESB. GC had taxable income of $50 million for each year in 2004-2008. In 2009, GC runs up a whopping $90 million NOL. Under the new election privilege, GC can carry back the 2009 NOL to 2004 (the fifth preceding tax year). However, only 50% of the 2004 taxable income ($25 million) can be offset with the carryback. The remaining $65 million of the 2009 NOL ($90 million – $25 million utilized in 2004) can be used to offset all of GC’s 2005 taxable income and $15 million of GC’s 2006 taxable income. At that point, the 2009 NOL will be all used up.Deadline for Making the New ElectionThe new expanded NOL carryback election must be made by the due date (including any extension) of the return for the taxpayer’s last tax year that begins in 2009. There will only be one such year except in the unusual case where the taxpayer has two short years that begin in 2009. Once made, the election is irrevocable. [See IRC Sec. 172(b)(1)(H)(iii)(II).]AMT Limitation on NOL Carrybacks Is Suspended for NOLs for Which Old-Law and New Elections Are MadeFor NOLs for which either the old-law election or the new election is made, the Act suspends the AMT rule that limits the carryback of a alternative tax NOLs (ATNOLs) to 90% of the alternative minimum taxable income (AMTI) for the year to which the ATNOL is carried back. This change is effective for tax years ending after 2002. [See IRC Sec. 56(d)(1)(A)(ii)(I).]Special New Election for Life Insurance CompaniesThe Act allows life insurance companies to elect a four or five-year NOL carryback (instead of the usual three-year carryback) for an NOL that arises in a tax year that ends after 2007 and begins before 2010. The election can only be made for one such year. Also, the NOL carried back to the fifth preceding tax year cannot exceed 50% of the taxable income for that year. [See IRC Sec. 810(b)(4).]Some Businesses Are Ineligible for New ElectionThe new expanded NOL carryback election privilege is not allowed for taxpayers that receive certain financial assistance from the federal government under the Emergency Economic Stabilization Act of 2008 (better known as the Bailout Bill). [See Section 13(f)(1) of the Act.]Rev. Proc. 2009-52 Supplies New Election SpecificsIn Rev. Proc. 2009-52, the IRS provided guidance on how to make the new expanded NOL carryback election and how to claim the resulting federal income tax refunds. Here are the three most important things to know.Under Rev. Proc. 2009-52, there are two ways to make the new election. First, it can be made with the original or amended federal income tax return for the loss year (the year the applicable NOL was generated). As a second and simpler alternative, the new election can also be made with the NOL carryback refund claim (using Form 1045 for individuals, estates, and trusts or Form 1139 for corporations) or with the amended return for the year to which the NOL is being carried back. Regardless of which way the new election is made, it must be done by no later than the due date (including any extension) of the return for the last tax year that began in 2009 (even if the new election is being made for an NOL generated in some other tax year). Similarly, the refund claim from carrying back the NOL for which the new election is made must be filed (using Form 1045 for individuals, estates, and trusts or Form 1139 for corporations or via an amended return for the year to which the NOL is being carried back) by no later than the due date (including any extension) of the return for the last tax year that began in 2009.Rev. Proc. 2009-52 also explains how to revoke an earlier election to forgo carrying back an NOL in order to allow the taxpayer to make the new expanded NOL carryback election for that NOL. The revocation must be made by no later than the due date (including any extension) of the return for the last tax year that began in 2009.Rev. Proc. 2009-52 also explains what to do if the taxpayer has already filed a carryback claim or amended return to carry back an NOL for which the new election is now being made.Extension of FUTA Tax SurchargeThrough 2009, the Federal Unemployment Tax Act (FUTA) imposes a maximum tax rate of 6.2% on the first $7,000 of an employee’s annual wages. The 6.2% rate is comprised of a permanent 6% rate and a .2% temporary surtax. The Act extends the .2% surtax for another 18 months, through June 30, 2011. (See IRC Sec. 3301.)Higher Failure-to-File Penalties for Partnerships and S CorpsThe Act increases the monthly penalty for failing to file a partnership return (on Form 1065) or failing to provide required information on a return from $89 per partner to $195 per partner. The penalty can be assessed for a maximum of 12 months. For example, the maximum penalty for a partnership with five partners is $11,700 (5 × $195 × 12 = $11,700). Ouch! The increased penalty applies to Forms 1065 required for tax years beginning after December 31, 2009. (See IRC Sec. 6698.)Key Point. It seems like the partnership penalty could be a pretty big deal if the Feds really get serious about trying to identify unfiled partnership returns. Taxpayers often enter into arrangements that can be classified as partnerships for federal income tax purposes without even realizing it.The Act also increases the monthly penalty for failing to file an S corporation return (on Form 1120S) or failing to provide required information on a return from $89 per shareholder to $195 per shareholder. The penalty can be assessed for a maximum of 12 months. For example, the maximum penalty for an S corporation with four shareholders is $9,360 (4 × $195 × 12 = $9,360). The increased penalty applies to Forms 1120S required for tax years beginning after December 31, 2009. (See IRC Sec. 6699.)Estimated Tax Bump for Large CorporationsThe Act jacks up by another 33% the 2014 corporate estimated tax payments that were already jacked up by the little-noticed Corporate Estimated Tax Shift Act of 2009. This change only affects corporations with assets over $1 billion. (See Section 18 of the Act and IRC Sec. 6655.)Key Point. This budget accounting gimmick has been used so often that it has become a bad habit.Beneficial Worldwide Interest Allocation Rules DelayedThe Act postpones the pro-taxpayer worldwide interest allocation rules, which would benefit consolidated groups that own foreign corporations and some financial institutions. The rules now will not take effect until tax years beginning after 2017. Frankly, our beloved Congress may never actually allow these rules to kick in. [See Section 15 of the Act and IRC Sec. 864(f).]More Preparers Must File Electronic Returns (in Theory)Why this is considered a revenue raiser is a mystery, but the Act stipulates that the IRS will require electronic filing by all preparers except those who reasonably expect to prepare a total of less than ten income tax returns for individuals, trusts, and estates in a calendar year. However, there is no penalty for failing to comply with this requirement, which is scheduled to take effect in 2011. [See Section 17 of the Act and IRC Sec. 6011(e).]Key Developments AffectingVarious Types of TaxpayersFirst Quarter 2010 Interest Rates on Federal Tax Overpayments and Underpayments Are UnchangedThe interest rates that apply to federal tax overpayments and underpayments for the first quarter of 2010 are the same as for the previous three quarters. (See Rev. Rul. 2009-37 and IRC Sec. 6621.) The first quarter 2010 rates are as follows: 4% for overpayments and underpayments by unincorporated taxpayers and most corporate underpayments.3% for most corporate overpayments.1.5% for the portion of corporate overpayments that exceed $10,000.6% for large corporate underpayments (generally underpayments by C corporations in excess of $100,000).IRS Announces 2010 Standard Mileage RatesIn Rev. Proc. 2009-54, the IRS announced that the standard mileage deduction allowances listed below will apply for 2010.50 cents per mile for business driving (down from 55 cents per mile for 2009). The 50 cents per mile allowance for 2010 includes 23 cents per mile for depreciation.16.5 cents per mile for driving for medical or moving purposes (down from 24 cents per mile for 2009).14 cents per mile for charitable driving (this amount is fixed by statute and does not change from year to year).Key Developments Affecting Individual TaxpayersFederal Estate Is Dead (for Now)Washington, we have a problem. You just let the federal estate tax die, and we lowly citizens out here are confused about what it means. No wonder, because nobody saw this coming. Here is a brief discussion of how we arrived at this strange destination along with some common-sense advice for clients.The Federal Estate Tax Was Programmed to Die in 2010 (and It Did Die) but the Story Is Not OverEver since the Economic Growth and Tax Relief Reconciliation Act of 2001 became law, the federal estate tax has always been scheduled to be repealed this year. But it has also always been a two-part story. In part two, the tax is scheduled to come roaring back in 2011 and beyond. In those years, estates worth as little as $1 million are lined up for a tax whipping (versus only estates worth over $3.5 million last year), and the maximum federal estate tax rate is poised to rise to the confiscatory percentage of 55% (versus “only” 45% last year). No informed person ever thought our beloved Congress would allow this two-part story to be played out because, taken together, the two parts make no sense. Duh!So we all sleepily assumed Congress would step in and continue the relatively generous (by historical standards) $3.5 million federal estate tax exemption that we had last year with a maximum tax rate of no more than 45% (same as last year). More optimistic observers were hopeful the exemption would be bumped up to $5 million or so with a maximum rate well below 45%.No such luck! Our pals in Congress did absolutely nothing about the estate tax last year, and it could be months before they get around to tackling it this year. By then, the issue may be so contentious that all previous predictions about what might happen get tossed out the window. Meanwhile, the tax will stay repealed for 2010 until something changes.So to sum it up so far, we are in a very weird place where there is no federal estate tax on those who happen to die right now, but there is a harsh federal estate tax looming over those who happen to die next year. This bizarre situation will continue until the law gets changed, which it undoubtedly will. Until then, however, clients want advice about what to do (or not do) today. Fair enough. Here goes.Observation. The author still believes Congress will resurrect the federal estate tax sometime in 2010 and that the effective date of the new rules (whatever they turn out to be) will be sometime in 2010. Some commentators believe that making the new rules retroactively effective all the way back to January 1, 2010, would be unconstitutional. It remains to be seen whether Congress shares that concern. Client Is Married with Joint Estate Worth Over $3.5 MillionIf your client falls into this category, we hope she already has a tax-saving estate plan in place. If so, she should probably leave it alone unless she has one of the two problems explained below.Problem No. 1: Too Much Goes to the KidsYour client’s existing estate plan may be fatally flawed (so to speak) if it calls for giving as much money as possible (as opposed to a specific dollar amount) to the kids and/or grandkids without triggering a federal estate tax bill, with the rest then going to the surviving spouse.Last year, this plan would have directed $3.5 million to the kids. That $3.5 million bequest would have been federal-estate-tax-free because it matched last year’s federal estate tax exemption.But with the federal estate tax now missing in action, the current exemption is infinity. Therefore, dying today would mean all the client’s assets go to the kids with absolutely nothing left for the surviving spouse. If this is not what your client intends (and it probably is not), his estate planning documents need to be fixed ASAP.One simple-and-easy fix is to amend the documents to provide that the surviving spouse gets a specific dollar amount or percentage of the client’s estate with the rest going to the youngsters. The plan may have to be retooled later on when Congress finally does whatever it does. Oh well. We will cross that bridge when we come to it.Problem No. 2: Not Enough Goes to the KidsThe second potential problem is less serious, and some folks might decide it is even not worth worrying about. Say the client’s current estate plan calls for leaving the specific amount of $3.5 million to the kids and/or grandkids (last year’s federal estate tax exemption amount), with the rest then going to the surviving spouse. In 2009, this was a good plan. It would have avoided any federal estate tax hit by taking full advantage of last year’s $3.5 million exemption.As of today, however, the client can leave as much as she wants to the youngsters with no federal estate tax due. So if her existing plan gives her spouse more than he really needs, the client can change the deal and leave more to the youngsters and less to the spouse. Once again, the client may very well have to retool her plan yet again when Congress finally takes action. Sorry about that!Client Is Married with Joint Estate Worth Less Than $3.5 MillionThere will not be any federal estate tax hit if this client dies today, and there would not have been one if he had died last year. We can only hope the same will be true if he dies next year. In any case, this client does not need any tax-saving estate plan right now. But if the plan was set up several years ago, it is still a good idea to revisit it to make sure it reflects the client’s current wishes.Client Is Single with Estate Worth Over $3.5 MillionLast year, this client could not have left more than $3.5 million to loved ones without triggering a federal estate tax liability. The existing plan might still call for the estate to make enough charitable donations to whittle its net worth down to $3.5 million, before giving that $3.5 million to the client’s loved ones.Since the client can now leave an unlimited amount to loved ones with no federal estate tax due, she might want to make a change to leave more to loved ones and less to charities. Of course, another fix might be necessary after Congress finally makes its move.Client Is Single with Estate Worth Less Than $3.5 MillionThere will not be any federal estate tax hit if this client dies today, and there would not have been one if he had died last year. We can only hope the same will be true if he dies next year. This client does not need any tax-saving estate plan right now. But if the plan was set up several years ago, it is still a good idea to revisit it.New Modified Carryover Basis Rule Replaces (for Now) Old Stepped-Up Basis Rule for Inherited AssetsIn conjunction with the 2010 repeal of the federal estate tax, we also get a new rule for determining the federal income tax bases of inherited assets. Under the old rule, the bases of inherited assets were generally stepped up (or stepped down) to equal their date-of-death FMVs. However, there was no basis step-up for an amount attributable to income in respect of a decedent (IRD). Basically, IRD is ordinary income that was accrued as of the decedent’s death but that had not yet been included in the decedent’s gross income for federal income tax purposes. The two most common examples of IRD assets are tax-deferred retirement accounts and CDs and taxable bonds with accrued interest that had not been paid as of the decedent’s death.Under the new basis rule that exists today, the federal income tax bases of inherited assets can still be stepped to reflect their date-of-death FMVs, but there is a limit on this tax-saving benefit. In a nutshell, the new rule says the bases of inherited assets start off equal to the decedent’s carryover basis amounts (generally equal to cost). Then those carryover basis amounts can be stepped up by as much as $1.3 million to reflect date-of-death FMVs, or by as much as $4.3 million for assets inherited by a surviving spouse. As under prior law, there is no basis step up for an amount attributable to IRD. To sum up, the new modified carryover basis rule for inherited assets is complicated, and very few tax pros have bothered to learn exactly how it works. [See IRC Sec. 1014(a)(1) and (f) for the old stepped-up basis rule and IRC Sec. 1022 for the new modified carryover basis rule.]Key Point. When Congress gets around to resurrecting the federal estate tax, the author expects the old stepped-up basis rule for inherited assets will also be resurrected as part of the deal. Fingers crossed!Generation-Skipping Transfer Tax Is Gone Too (for Now) but Gift Tax Lives OnAs part and parcel of the one-year repeal of the federal estate tax, the dreaded generation- skipping transfer tax (GSTT) was also repealed for 2010. We do not miss it! The GSST is a super-confiscatory extra tax that is added on top of the “regular” gift or estate tax liability when generation-skipping transfers in excess of the GSTT exemption amount are made. Generation-skipping transfers are those made via gifts while alive or via bequests after death to individuals who are deemed to be two or more generations below the giver. For 2009, the GSTT exemption was a relatively generous $3.5 million, and the maximum tax rate was “only” 45%. Next year, the GSTT is scheduled to come roaring back with an exemption of only $1 million, and the maximum tax rate is scheduled to balloon to the confiscatory percentage of 55%.Despite the one-year death of the federal estate tax and GSTT, the federal gift tax lives on in 2010 with the familiar $1 million lifetime exemption still in place. However, the maximum gift tax rate drops to 35% in 2010 (versus 45% in 2009). That is the end of the good news. For 2011 and beyond, the maximum gift tax rate is scheduled to soar to the confiscatory percentage of 55%. The exemption is scheduled to stay at $1 million.Observation. Just because the GSTT is currently missing in action is no reason to make big generation-skipping gifts. Our beloved Congress will probably resurrect the GSTT, along with the federal estate tax, sometime in 2010. Congress may try to make both taxes retroactive to January 1, 2010.New Form for Homebuyer CreditTo claim the IRC Section 36 homebuyer credit on a return for a tax year ending after November 6, 2009 (meaning a calendar-year 2009 or 2010 return), the buyer must attach a properly executed real estate settlement sheet (HUD-1 form) to her return. The updated version of IRS Form 5405 (First-Time Homebuyer Credit) has been revised to reflect this new requirement. The revised form must be used to claim the credit for (1) any purchase closed after November 6, 2009 and (2) any credit claimed on a 2009 Form 1040, even if the purchase date was before November 7, 2009. The 2008 version of Form 5405 can still be used to claim the credit on a 2008 return for a 2009 purchase that closed before November 7, 2009. (See IRS Information Release IR 2009-18.)Tax Court Rules Again That MBA Expenses Can Be DeductedIndividual taxpayers can deduct what we will call, for purposes of this discussion, qualified education expenses. The taxpayer has qualified education expenses if (1) the education is expressly required by his employer or by applicable law or regulations in order for him to retain his current employment relationship, status, or compensation level or (2) the education maintains or improves skills needed in the taxpayer’s current employment or business. [See IRC Sec. 162(a) and Reg. 1.162-5(a).]In contrast, the taxpayer does not have qualified expenses if the education (1) prepares her for a new profession or business or (2) occurs before the taxpayer’s employment or shortly thereafter in order to meet pre-existing minimum educational requirements for his employment, profession, or business. [See Reg. 1.162-5(b).]The IRS says an undergraduate degree automatically prepares you for a new profession, so costs to obtain a BA or BS are not qualified education expenses, and you cannot deduct them. Unfortunately, the Tax Court has repeatedly agreed with the IRS on this score. [See for example Malek, Theresa (TC Memo 1985-428, 1985); Meredith, Judith (TC Memo 1993-250, 1993); and Fields, Edward M. (TC Summary Opinion 2001-35, 2001).]The IRS has made the same argument about MBAs. Thankfully, the Tax Court has repeatedly disagreed by concluding that MBA costs are qualified education expenses in the common situation where the MBA program improves the taxpayer’s general business knowledge and skills and thereby improves knowledge and skills needed in the taxpayer’s current job. For the latest decision along this line, see Singleton-Clarke, Lori (TC Summary Opinion 2009-182, 2009).Key Point. The Tax Court reached the same conclusion in three earlier cases. See Allemeier, Daniel Jr. (TC Memo 2005-207, 2007); Beatty, Robert C. (TC Memo 1980-196, 1980); and Blair, Frank S. III (TC Memo 1980-488, 1980). So you would think the Tax Court must be getting a little cranky that IRS keeps bringing up the same losing argument.Update on Tax Treatment of Gambling ActivitiesGambling is always popular. Perversely enough, it may be even more popular when the economy stinks. Here is the updated story on the tax implications of gambling.Tax Basics for GamblersLoss Deductions Are Limited to WinningsThe most important thing to know is you can only deduct gambling losses for the year (from all types of gambling) to the extent of gambling winnings for the year (from all types of gambling). If you have excess gambling losses for the year, they go up in smoke without delivering any tax benefit. [See IRC Sec. 165(d).]After applying this losses-cannot-exceed-winnings limitation, the allowable loss amount for a client who is not a professional gambler is then claimed as a Schedule A itemized deduction (on line 28 of the 2009 version of Schedule A). So if the client does not itemize, he is out of luck in the gambling loss deduction game.Now for some good news. Allowable itemized gambling losses are not subject to the 2%-of-AGI floor that applies to most other types of miscellaneous itemized deductions. Also, allowable itemized gambling losses are not subject to the phase-out rule that applies to certain other itemized deductions (this phase-out rule disappears for 2010 before reappearing with a vengeance in 2011). Finally, allowable itemized gambling losses are fully allowed for AMT purposes too, unlike some other itemized deductions. [See IRC Secs. 56(b)(1)(A)(i), 67(b)(3), and 68(c)(3).]Key Point. When a married couple files jointly, the winnings of both spouses are combined for purposes of determining the deductible losses incurred by both spouses. (See Reg. 1.165-10.) No Deductions for Amateur’s Out-of-Pocket ExpensesThe IRS and the Tax Court agree that only the cost of an amateur gambler’s actual wagering transactions are considered gambling losses. Other out-of-pocket expenses such as transportation, meals, and lodging do not count as gambling losses and therefore cannot be written off at all. Such outlays are considered nondeductible personal expenses, under IRC Sec. 262. Note that Section 262 treatment also negates any possibility of deducting out-of-pocket expenses under the IRC Section 183 hobby loss rules or as IRC Section 212 expenses for the production of income. [See Whitten, Stanley, TC Memo 1995-508 (1995) and PLR 9808002.]All Winnings Must Be Reported (in Theory)Technically speaking, an amateur gambler must report the full amount of each and every win on the miscellaneous income line on page 1 of Form 1040 (line 21 on the 2009 version of Form 1040). So in a profitable year, you cannot simply subtract losses from winnings and report the net amount of winnings on page 1 of Form 1040.The fact that clients are technically required to report the sum total of each and every win as gross income on page 1 of Form 1040 results in higher AGI, which may cause all sorts of nasty phase-out rules to come into play. But let us be realistic: even clients who attempt to keep good records will probably only record their daily net winnings and daily net losses. Reporting an amount of gross income on page 1 of Form 1040 equal to the sum total of the net winnings from all days with net winnings will probably not get the client into trouble with the IRS, as long as the amount reported as income equals or exceeds the sum total of any amounts reported as income on Forms W-2G (more on Form W-2G later).Key Point. Along the lines suggested in the immediately preceding paragraph, IRS Chief Counsel Advice (CCA) EMISC 2008-011 (dated December 12, 2008) says a casual slot player can simply keep a record of his net win or net loss for each gambling session. If the casual slot player then reports the sum total of all his net winnings from all winning sessions as gross income on page 1 of Form 1040 and keeps track of the sum total of all his net losses from all losing sessions for purposes of applying the losses-cannot-exceed-winnings limitation to his Schedule A itemized deduction, the IRS will consider that close enough to the theoretically required recording of each win or loss from each spin of the slot machine. Thank you IRS! Presumably this procedure of recording all net wins and losses from all gambling sessions would also be considered adequate recordkeeping for other forms of casual gambling. (See the following example.)Example 4Floyd likes occasional casino action. Assume he is not a professional gambler. Early in 2009, Floyd had a gambling session where he won $20,000 playing poker. Later in 2009, he had a gambling session where he lost $30,000 playing roulette. On Floyd’s 2009 Form 1040, the $20,000 of net winnings from the winning poker session should be reported on page 1 on the other income line (line 21). His $20,000 deductible loss amount from the losing roulette session (equal to his reported winnings for the year) should be reported as an itemized deduction on Schedule A (line 28). Floyd’s $20,000 deduction is unaffected by the 2%-of-AGI floor. It is also exempt from the itemized deduction phase-out rule, and it is fully allowed for AMT purposes. However, Floyd’s $10,000 excess loss ($30,000 of losses – $20,000 of winnings) simply vanishes. It cannot be deducted in 2009, nor can it be carried forward to future years. Bad luck! Professional GamblersAlthough it is relatively rare, a taxpayer can sometimes rightly claim to be a professional gambler for income tax purposes. In this case, his winnings should be reported as business income on Schedule C, and his losses should be reported as business expenses on Schedule C of Form 1040, just like for any other business activity. [See Rusnak, Charles (TC Memo 1987-249, 1987).] Schedule C deductions equate to above-the-line treatment for the taxpayer’s allowable gambling losses, which is beneficial because the allowable losses will reduce AGI dollar for dollar.Key Point. As you can see, it is really only necessary to keep track of annual nets wins and losses in some reasonable fashion (like on a daily basis) to arrive at the correct bottom line amount on a professional gambler’s Schedule C.In a number of cases, the courts have considered what it takes to be a professional gambler. To summarize the decisions, the taxpayer must devote substantial time to gambling on a regular basis and must depend on winnings as a meaningful source of income. [See for example Panages, Pansy (TC Summary Opinion 2005-3, 2005) and Pias, Thomas (TC Summary Opinion 2005-138, 2005).] It also helps when the taxpayer conducts gambling activities in a businesslike fashion by keeping detailed records and developing and evaluating strategies. [See for example Castagnetta, James (TC Summary Opinion 2006-24, 2006) and Groetzinger, Robert (87-1 USTC 9191, 1987).]Loss Limitation Rule Still AppliesUnfortunately, several court decisions have also concluded that IRC Section 165(d) limits a professional gambler’s wagering losses to the amount of his winnings. In other words, the dreaded losses-cannot-exceed-winnings limitation applies equally to professional gamblers and amateurs alike. This may not seem very fair, but it is true. [See for example Kent, John (83 AFTR 2d 99-2850, 9th Cir., 1999) and Valenti, Pete (TC Memo 1994-483, 1994).]In a more-recent decision, the Tax Court confirmed that a professional tournament poker player’s wagering losses are subject to the losses-cannot-exceed-winnings limitation. The taxpayer argued that playing poker in tournaments was not a “wagering activity” and that her losses were therefore not subject to the gambling loss limitation rule. No dice said the Tax Court. [See Tschetschot, George E (TC Memo 2007-38, 2007).]Example 5Assume the same basic facts as Example 4, except this time assume Floyd is a professional gambler. Despite his professional status, the dreaded losses-cannot-exceed-winnings limitation still applies to Floyd. Therefore, the $20,000 allowable loss amount is the same as in Example 4. The difference is the $20,000 allowable loss in this example is reported on Schedule C.Watch Out for SE Tax TooSo far, so bad. An additional negative consideration is the fact that a professional gambler’s net Schedule C income in profitable years is subject to the dreaded self-employment (SE) tax. (See IRC Sec. 1402.) Therefore, in some cases, exposure to the SE tax may actually make claiming professional gambler status more expensive than not.IRS Says Out-of-Pocket Expenses Get Favorable TreatmentA professional gambler can deduct out-of-pocket non-wagering expenses under the normal rules that apply to Schedule C business expenses (including the 50% disallowance rule for meal costs). However, several court decisions concluded that a professional gambler’s out-of-pocket expenses must be combined with his wagering losses and then subjected to the dreaded losses-cannot-exceed-winnings limitation under IRC Sec. 165(d). [See for example Kozma, Michael (TC Memo 1986-177, 1986); Valenti, Pete (TC Memo 1994-483, 1994); and Praytor, William (TC Memo 2000-282, 2002).]Despite these anti-taxpayer decisions, the IRS has decided that a professional gambler’s out-of-pocket expenses should not be combined with wagering losses for purposes of applying the Section 165(d) losses-cannot-exceed-winnings limitation. Instead, the Service now says the limitation only applies to wagering losses. In other words, a professional gambler’s deductions for wagering losses are indeed limited to her wagering winnings under the limitation. But a professional gambler’s out-of-pocket non-wagering expenses can be deducted as garden-variety Schedule C business expenses without regard to the limitation. (See IRS Office of Chief Counsel Memorandum EMISC 2008-013, dated December 19, 2008.) This is good news in years when the client’s gambling losses exceed gambling winnings, because her out-of-pocket expenses will result in a Schedule C loss that can be used to offset income from other sources.Forms W-2G Help Keep Winning Taxpayers HonestFor most types of gambling at a legitimate gaming facility, your client will be issued a Form W-2G (Certain Gambling Winnings) if she wins $600 or more and that amount is also more than 300 times the amount wagered. Of course, the IRS gets a copy too! However a $1,200 tax reporting threshold applies to winnings from slots and bingo, and a $1,500 tax reporting threshold applies to winnings from keno. Since the IRS gets a copy of Form W-2G, the client better make darn sure to report an amount of gross gambling winnings on page 1 of Form 1040 (or on Schedule C if the client is a professional gambler) that at least equals the winnings reported on Forms W-2G. When winnings exceed $5,000, federal income tax withholding is generally required (but not for winnings from slots, bingo, or keno). [See the Form W-2G instructions and IRC Sec. 3402(q).]Recordkeeping IssuesWhether the taxpayer is an amateur or a professional gambler, she must adequately document the amount of her gambling losses in order to claim her rightful deductions. According to Rev. Proc. 77-29, taxpayers must compile the following information in a log or similar record:The date and type of each specific wager or wagering activity.The name and address or location of the gambling establishment.The names of other persons (if any) present with the taxpayer at the gambling establishment (obviously this requirement cannot be met at a public venue such as a casino or race track).The amount won or lost. Substantiation of winnings and losses from wagering on table games can done by recording the number of the table played and keeping statements showing casino credit issued to the player. See also IRS Publication 529 (Miscellaneous Deductions).Per-Session Recordkeeping Is Apparently OKTo reiterate what was said earlier, the IRS in Chief Counsel Advice (CCA) EMISC 2008-011 (dated December 12, 2008) indicated that it is permissible for a casual slot player to simply keep a record of his net win or net loss amount for each gambling session. In other words, the determination of the net win or loss amount can be made when the gambler redeems his tokens at the end of each session or determines that he lost all the tokens he started off with at the beginning of that session. If the casual slot player then reports the sum total of all the net winnings from all winning sessions as gross income on page 1 of Form 1040 and keeps track of the sum total of the net losses from all losing sessions for purposes of applying the losses-cannot-exceed-winnings limitation to his Schedule A itemized deduction, the IRS will consider that close enough to the theoretically required recording of each win or loss from each spin of the slot machine. Thank you IRS! Presumably this concept of recording all net wins and losses from all gambling sessions would also be considered sufficient recordkeeping for other forms of casual gambling.In Dire Circumstances No Recordkeeping May Be RequiredIn a 2009 Summary Opinion, the Tax Court allowed a taxpayer to use a common-sense approach to establish that his gambling losses, for which he had no records, were more than enough to offset gambling winnings reported on Forms W-2G. The evidence showed the taxpayer was a compulsive gambler who lost so habitually that he did not own a car and had to depend on relatives to help pay his living expenses. Therefore, the Tax Court concluded that all his reported gambling winnings (more than $70,000) had obviously been gambled away, even though he had no records to prove it. [See Caro, Jose D. (TC Summary Opinion 2009-184, 2009).]Taxpayer Failed to Qualify for IRS Levy Exception to 10% Premature Withdrawal Penalty TaxWithdrawals before age 59? from a tax-deferred retirement account (including an IRA) are subject to the dreaded 10% premature withdrawal penalty tax unless an exception applies. [See IRC Sec. 72(t).] One such exception applies to premature withdrawals taken to satisfy IRS levies against the account. [See IRC Secs. 72(t)(2)(A)(vii) and 6331.] Unfortunately, the Tax Court says this exception is not available when the IRS levies against the account owner or participant, as opposed to the account itself, or when the IRS has merely issued a Notice of Intent to Levy against an account but has not yet put the levy in place. In these scenarios, the 10% penalty tax still applies to premature retirement account withdrawals even when the withdrawn funds are used to pay amounts owed to the IRS. [See Willhite, James (TC Memo 2009-263, 2009).]No Deductions for Ponzi Losses Inside IRAsIn information letter INFO 2009-0154, the IRS pointed out that when IRA funds are lost in Ponzi investment schemes, the losses do not in and of themselves give rise to deductible losses. Instead, the following rules apply.Losses from Traditional IRAsLosses from traditional IRAs can only be claimed when both of the following conditions are met:The taxpayer liquidates all traditional IRAs set up in her name.The taxpayer’s total tax basis in those accounts exceeds the total proceeds from liquidating those accounts. The excess equals the tax loss amount. [See IRS Publication 590 (Individual Retirement Arrangements) and IRS Notice 89-25, Q&A-7.]Even when there is a tax loss, another hurdle must be cleared. The IRS says the loss is classified as a miscellaneous itemized deduction. (See IRS Publication 590.) As such, the loss gets thrown in the pot with other miscellaneous itemized deduction expenses (e.g., unreimbursed employee business expenses, investment expenses, and fees for tax advice and preparation). Only the excess of total miscellaneous itemized deductions over 2% of AGI can be claimed as a write-off on Schedule A of Form 1040. (See IRC Sec. 67.) If the account owner clears the 2%-of-AGI hurdle, she is still not home free. She may lose part of his miscellaneous itemized deduction write-off due to the deduction phase-out rule for higher-income individuals. (See IRC Sec. 68.) Finally, miscellaneous itemized deduction write-offs are completely disallowed for AMT purposes. So if the account owner is an AMT victim, some or all of the anticipated tax savings from IRA losses will go up in smoke. [See IRC Sec. 56(b)(1)(A)(i).] Losses from Roth IRAsFor tax loss determination purposes, taxpayers must treat Roth IRAs separately from traditional IRAs. Losses from Roth IRAs can only be claimed when both of the following conditions are met:The taxpayer liquidates all Roth IRAs set up in his name.The taxpayer’s total tax basis in those accounts exceeds the total proceeds from liquidating those accounts. The excess equals the tax loss amount. [See IRS Publication 590 (Individual Retirement Arrangements); IRS Notice 89-25, Q&A-7; and IRC Sec. 408A(d)(4)(A).]Unfortunately, the other hurdles mentioned above in the context of traditional IRA tax losses apply equally to Roth IRA tax losses, because the IRS says Roth losses must also be treated as miscellaneous itemized deductions. (See IRS Publication 590.)Key Developments Affecting Business TaxpayersNew Regulations Provide Tax Rules for Operating Employee Stock Purchase Plans (ESPPs)In newly released final Regs. 1.423-1 and 1.423-2 (in TD 9471), the IRS explains the federal income tax rules applicable to ESPPs. The rules are quite similar to those that apply to incentive stock option (ISO) programs. The new final regulations apply to ESPP options granted after 2009, but they can also be relied upon for options granted earlier.New Regulations Cover Information Reporting Rules When Employer Shares Are Acquired via Incentive Stock Options (ISOs) and Employee Stock Purchase Plans (ESPPs)In newly released final Regs. 1.6039-1 and 1.6039-2 (in TD 9470), the IRS explains how employers must file information returns and supply information to employees when company shares are acquired by exercising ISOs or participating in ESPPs. Returns must be filed using new Form 3921 for ISO shares and new Form 3922 for ESPP shares. The return-filing requirement does not apply to shares that were acquired in 2007-2009. For those years, however, employees must still be given certain information including (among other things) the option exercise date, the exercise price, and the FMV of the shares on the exercise date.No Year-of-Accrual Deduction for Deferred Bonuses Subject to Continued Employment RequirementIn Chief Counsel Advice (CCA) 200949040, the IRS opined that an accrual-method corporation could not claim a Year 1 deduction for deferred employee bonuses that were accrued in Year 1 and paid in the first 2? months of Year 2. In this case, the employees could only collect their bonuses if they were still employed on the Year 2 bonus payment date. Therefore, the IRS concluded the employer’s deferred bonus liability was subject to a contingency as of the end of Year 1, and the liability did not become fixed until the bonus payment date in Year 2. The IRS also concluded that economic performance with respect to the deferred bonus liability had not occurred as of the end of Year 1, because the deferred bonus plan required employees to continue to provide services until the Year 2 bonus payment date. Therefore, the employer could not deduct the deferred bonus liability until Year 2, when the contingency was removed and economic performance had occurred.New Regulations on S Corporation Cancellation of Debt (COD) IncomeIn newly released final amendments to Reg. 1.108-7 (in TD 9469), the IRS explains how to reduce certain S corporation shareholder tax attributes (such as NOL carryovers) when an S corporation has COD income that is excluded from gross income under IRC Sec. 108(a)(1).Federal Tax Update – Second Quarter 2010HighlightsTax changes in the healthcare legislationTax changes in the Hiring Incentives to Restore Employment ActTax Freedom Day is April 9th this yearSecond quarter 2010 interest rates on federal tax overpayments and underpaymentsCOBRA subsidy extended againWhether severance payments will be exempt from FICA tax or notIRS says golf cart tax credit is not for golf cartsNew Form 3115 for requests to change accounting methodsEmployers get postcards from IRS about new health insurance tax creditIRS announces 2010 luxury auto depreciation limitsPAL groupings must be disclosed on tax returns (but not yet)Yet another court decision says LLC members are general partners for PAL purposesCertain 2010 Haiti relief donations can be deducted on 2009 returnsTax Changes in the Healthcare LegislationFor purposes of this analysis, the Patient Protection and Affordable Care Act and the related Health Care and Education Reconciliation Act will be collectively referred to as the healthcare legislation. The two pieces were signed into law on March 23, 2010, and April 30, 2010, respectively, and they include lots of tax changes, some of which have nothing to do with healthcare.This section summarizes what we think are the most important new tax provisions. Frankly, it will take time to make much sense out of some of them, because we have two different laws going on here, plus poorly drafted language to boot. What is included is what we can say right now.Retroactive Changes Taking Effect Before 2010New Exclusion for Certain Forgiven Student LoansThe healthcare legislation creates a new and retroactive federal income tax exclusion for student loan amounts paid off or forgiven under certain state loan repayment and forgiveness programs that are intended to increase the availability of healthcare in underserved areas.Effective Date: Amounts received or forgiven in tax years beginning after 2008. [See IRC Sec. 108(f)(4).]New Credit for Therapeutic Discovery ProjectsThe healthcare legislation creates a new and retroactive tax credit for qualified investments in therapeutic discovery projects, as defined. The credit is only available to taxpayers with 250 or fewer employees.Effective Date: For eligible expenses paid or incurred in 2009 and 2010, subject to a $1 billion limit on total allowable credits. (See IRC Sec. 48D.)Changes Taking Effect in 2010New Health Insurance Tax Credit for Small EmployersQualifying small employers can claim a new tax credit to help cover the cost of providing employee health coverage. A qualifying small employer is one that (1) has no more than 25 full-time-equivalent (FTE) workers, (2) pays an average FTE wage of no more than $50,000, and (3) pays on a uniform basis at least 50% of the cost of employee health coverage (meaning the employer must pay the same percentage of the cost for all employees). For 2010 only, the IRS intends to issue transition rules that will allow the credit, even if the employer does not pay for coverage on a uniform basis.Health premiums paid under a Section 125 cafeteria benefit plan salary-reduction arrangement do not count as employer-paid premiums for purposes of the credit.The maximum credit equals 35% of the lesser of (1) the actual cost of providing qualifying health coverage, or (2) the cost of “benchmark” coverage as determined on a state-by-state basis by the Department of Health and Human Services. For tax-exempt employers, the maximum credit percentage is reduced to 25%.The maximum credit percentage (35% or 25%) is only allowed to qualifying small employers with 10 or fewer FTE employees and an average FTE wage of no more than $25,000. For qualifying small employers with more employees and/or higher wages, the credit percentage is effectively reduced under complicated phase-out rules.Finally, the credit for the year cannot exceed the sum of (1) federal income tax and 1.45% Medicare tax withheld from employee wages, plus (2) the employer’s 1.45% Medicare tax on wages.See the IRS website at for some helpful information and examples of how to calculate the credit.The credit is apparently allowed to all types of employers, including C and S corporations, partnerships, LLCs, and sole proprietorships. However, the credit cannot be claimed for healthcare expenditures to cover sole proprietors, partners, more-than-2% shareholder-employees of S corporations, more-than-5% owners of businesses, and certain related employees. For credit calculation purposes, these excluded individuals are not counted in determining how many FTE employees a business has or the average FTE wage.The credit is classified as a general business credit. Therefore, it can be used to offset both regular federal income tax and any AMT. Unused credits can be carried back for one year (but not to any pre-2010 year) and ahead for 20 years.Finally, the employer’s deduction for health insurance premium costs is reduced by the amount of the credit.Observation. In this economy, it is exceedingly doubtful that the new credit will induce many small businesses to suddenly start providing employee health coverage. The fact that the credit rules are too complicated to be easily explained does not help matters. Presumably, a fair number of small businesses that already provide health coverage will qualify for the credit, but that remains to be seen.Effective Date: Tax years beginning in 2010-2013. Note that eligible costs incurred in 2010 before the healthcare legislation was enacted can still qualify for the credit. [See IRC Secs. 45R and 280C(h) and Section 1421 of the healthcare legislation.]Healthcare-Related Tax Breaks Granted to Adult ChildrenEffective for plan years beginning after September 23, 2010, health plans that cover dependent children must continue to cover adult children until they turn 26.In conjunction with the new coverage requirement, employer-provided health coverage for an employee’s adult child is now treated as a tax-free fringe benefit, as long as the child has not reached age 27 by the end of the year. It does not matter if the adult child is the employee’s dependent or not.Key Point. In Notice 2010-38, the IRS concluded that tax-free treatment also applies to reimbursements from a cafeteria plan, healthcare FSA, or HRA to cover an under-age 27 adult child’s qualified medical expenses.If you are self-employed and pay for your own health coverage, the cost of covering an adult child is eligible for the above-the-line deduction for self-employed health insurance premiums, as long as the adult child has not reached age 27 by the end of the year. It does not matter if the adult child is your dependent or not.The discrepancy between the until-age-26 coverage requirement and the until-age-27 tax breaks is apparently an unintended glitch.Effective Date: March 30, 2010. [See IRC Secs. 105(b) and 162(l).]Liberalized Adoption Tax BreaksStrangely enough, the healthcare legislation also increases the annual cap on tax-free employer adoption assistance payments by $1,000 and extends the new deal through 2011. For 2010, this change increases the cap to $13,170 (up from $12,170).Similarly, the healthcare legislation increases the maximum annual adoption credit by $1,000 and extends the new deal through 2011. For 2010, this increases the maximum credit to $13,170 (up from $12,170). Finally, for 2010 and 2011, the adoption credit is transformed into a refundable credit that can be collected in full, even if you do not owe any federal income tax.Effective Date: Tax years beginning in 2010 and 2011. (See IRC Secs. 36C and 137.)Economic Substance Doctrine Is CodifiedIn what is sure to open up a giant can of worms, the healthcare legislation attempts to provide a home within our beloved Internal Revenue Code for the so-called economic substance doctrine. Economic substance will be deemed to exist only if the transaction in question (1) changes the taxpayer’s economic position in a meaningful way without regard to tax consequences, and (2) is entered into for a substantial non-tax purpose. A 20% penalty can be assessed on tax underpayments attributable to transactions that are disallowed because they lack of economic substance. The penalty rises to 40% for “undisclosed economic substance transactions.” Other penalties may also apply.Effective Date: For transactions entered into after March 30, 2010, and tax underpayments, understatements, refunds, and credits attributable to transactions entered into after that date. [See IRC Secs. 7701(o), 6662(i), and 6676(c).]New Rules for Nonprofit HospitalsThe healthcare legislation establishes new rules for hospitals to qualify for tax-exempt nonprofit status.Effective Date: Tax years beginning after March 23, 2010. [See IRC Secs. 501(r) and 6033(b).]No More Biofuel Tax Credit for Black LiquorThe healthcare legislation disallows the cellulosic biofuel producer credit for so-called black liquor fuels.Effective Date: For fuels sold or used after 2009. [See IRC Sec. 40(b)(6)(E).]New Loss Ratio Rule for Health OrganizationsThe healthcare legislation requires a medical loss ratio of at least 85% for health organizations to qualify for certain insurance company tax breaks.Effective Date: Tax years beginning after 2009. [See IRC Sec. 833.]New Tanning Excise TaxThe healthcare legislation imposes a new 10% excise tax on indoor tanning services.Effective Date: For services performed after June 30, 2010. (See IRC Sec. 5000B.)Changes Taking Effect in 2011Employer Costs to Provide Health Insurance Must Be Reported on Forms W-2The healthcare legislation requires employers to report to employees on their annual Forms W-2 the value of employer-provided health insurance coverage (not including salary-reduction amounts contributed to healthcare FSAs).Effective Date: Tax years beginning after 2010. [See IRC Sec. 6051(a)(14).]No More Tax-Free Reimbursements for Non-Prescription DrugsIf you participate in an employer-sponsored healthcare FSA or HRA, or have your own HSA or MSA, current rules allow you to take tax-free withdrawals to pay for non-prescription drugs such as pain and allergy relief medications. Starting next year, this tax-favored treatment will only be available for prescription drugs, insulin, and doctor-prescribed over-the-counter medications.Effective Date: For expenses incurred in tax years beginning after 2010. [See IRC Secs. 106(f), 220(d), and 223(d).]Stiffer Penalty on Nonqualified HSA and MSA WithdrawalsIf you take money out of your HSA or MSA for any reason other than to cover qualified medical expenses, you usually owe federal income tax, plus a 10% penalty tax on HSA account earnings included in the payout, or a 15% penalty tax for an MSA. The healthcare legislation increases the penalty tax rate to 20% for nonqualified withdrawals of earnings.Effective Date: Withdrawals in tax years beginning after 2010. [See IRC Secs. 220(f) and 223(f).]New Simple Cafeteria Plans for Small EmployersThe healthcare legislation establishes a new and simpler type of Section 125 cafeteria benefit plan for employers with 100 or fewer employees. These simplified plans will be deemed to automatically satisfy all applicable cafeteria benefit plan nondiscrimination rules if they satisfy certain minimum standards for eligibility, participation, and contributions.Effective Date: Tax years beginning after 2010. [See IRC Sec. 125(j).]New Tax on Drug CompaniesThe healthcare legislation imposes a new nondeductible fee (we will call it a tax) on manufacturers and importers of branded prescription drugs. Each targeted company must pay an allocable portion of the total annual fee, which is $2.5 billion for 2011. The fee is apportioned among targeted companies, based on each company’s share of sales in the preceding year.Effective Date: Calendar year 2011. (See Section 9008 of the Patient Protection and Affordable Care Act.)Changes Taking Effect in 2012New Form 1099 Reporting Requirement for Business Payments to Corporate Providers of Property and ServicesBusinesses that pay over $600 a year to a corporate provider of property or services must supply the provider with a Form 1099 and file a copy with the IRS.Effective Date: For payments made after 2011. [See IRC Sec. 6041(h).]New Tax on Health Insurance PoliciesHealth insurers and sponsors of applicable self-insured health plans will have to pay an annual fee of $2 per covered life ($1 per life for affected policy or plan years that end by September 30, 2013). Effective Date: Policy years ending after September 30, 2012. (See IRC Secs. 4375, 4376, and 4377.)Changes Taking Effect in 2013Additional 0.9% Medicare Tax on Salaries and Self-Employment Income Earned by “Rich” FolksRight now, the Medicare tax on salary and/or self-employment (SE) income is 2.9%. If you are an employee, 1.45% is withheld from your paychecks, and the other 1.45% is paid by your employer. If you are self-employed, you get to pay the whole 2.9% yourself.Starting in 2013, an extra .9% Medicare tax will be charged on (1) salary and/or SE income above $200,000 for an unmarried individual, (2) combined salary and/or SE income above $250,000 for a married joint-filing couple, and (3) salary and/or SE income above $125,000 for those who use married filing separate status. More good news: these thresholds will not be adjusted for inflation.For self-employed individuals, the additional .9% Medicare tax hit will come in the form of a higher SE bill. However, the additional .9% Medicare tax will not qualify for the above-the-line deduction for 50% of SE tax.The additional .9% Medicare tax must be taken into account for estimated tax payment purposes.Effective Date: Tax years beginning after 2012. [See IRC Secs. 164(f), 1401(b), 3101(b), 3102, and 6654.]Additional 3.8% Medicare Tax on Net Investment Income Collected by “Rich” Folks and TrustsRight now, the maximum federal income tax rate on long-term capital gains and dividends is 15%. Starting in 2011, the maximum rate is scheduled to go up as the so-called Bush tax cuts expire. The president repeatedly promised that 20% would be the maximum rate for 2011 and beyond, but he changed his mind. Starting in 2013, all or part of the net investment income, including long-term capital gains and dividends, collected by higher-income folks can get socked with a 3.8% “Medicare contribution tax.” Therefore, the maximum federal rate on long-term gains and dividends for 2013 and beyond will actually be 23.8% (assuming it is not increased yet again) instead of the promised 20%.The additional 3.8% Medicare tax will not apply unless modified adjusted gross income (MAGI) exceeds (1) $200,000 for an unmarried individual, (2) $250,000 for a married joint-filing couple, or (3) $125,000 for those who use married filing separate status. These MAGI thresholds will not be adjusted for inflation.MAGI means regular AGI plus the excess of the amount excluded from gross income under the IRC Section 911(a)(1) foreign earned income exclusion over any deductions or exclusions that are disallowed under IRC Sec. 911(b)(6) with respect to such excluded foreign earned income.The additional 3.8% Medicare tax will apply to the lesser of (1) net investment income or (2) the amount of MAGI in excess of the applicable threshold. For instance, a married joint-filing couple with MAGI of $265,000 and $60,000 of net investment income would pay the 3.8% tax on $15,000 (the amount of excess MAGI). If the same couple has MAGI of $350,000, they would pay the 3.8% tax on $60,000 (the entire amount of net investment income).Net investment income includes interest, dividends, royalties, annuities, rents, gross income from passive business activities, gross income from trading in financial instruments or commodities, and net gain from property held for investment (but not property held for business purposes) reduced by deductions allocable to such income.The additional 3.8% Medicare tax must be taken into account for estimated tax payment purposes.Key Point. For a trust, the additional 3.8% Medicare tax will apply to the lesser of (1) undistributed net investment income, or (2) the amount of AGI in excess of the threshold for the top trust federal income tax bracket.Effective Date: Tax years beginning after 2012. [See IRC Secs. 1411 and 6654.]New $2,500 Cap on Healthcare FSA ContributionsRight now, there is no tax-law limit on salary-reduction contributions to an employer’s healthcare FSA arrangement. Starting in 2013, the maximum annual FSA contribution by an employee will be capped at $2,500. For post-2013 years, the cap will be indexed for inflation.Effective Date: Tax years beginning after 2012. [See IRC Sec. 125(i).]Higher Threshold for Itemized Medical Expense DeductionsRight now, you can claim an itemized deduction for medical expenses paid for you, your spouse, and your dependents, to the extent the expenses exceed 7.5% of AGI. Starting in 2013, the hurdle is raised to 10% of AGI. However, if you or your spouse is age 65 or older at year-end, the new 10%-of-AGI threshold will not take effect until 2017. The medical expense deduction threshold for AMT purposes remains at 10% of AGI.Effective Date: Tax years beginning after 2012 (tax years beginning after 2016, if taxpayer or spouse is 65 or older at year-end). [See IRC Sec. 213(a) and (f).]No More Deductions for Retiree Drug Plan SubsidiesEmployers that sponsor qualified retiree prescription drug plans are entitled to collect tax-free federal subsidies for a portion of the cost. Employers are currently allowed to deduct the full cost of retiree drug plans without any reduction for the tax-free federal subsidies. In effect, deductions are allowed for amounts that are actually paid by the government. The healthcare legislation reduces deductions by the amount of tax-free federal subsidies. Effective Date: Tax years beginning after 2012. (See IRC Sec. 139A.)New Excise Tax on Medical Device ManufacturersManufacturers will have to pay a 2.3% excise tax on taxable sales of medical devices intended for humans. However, devices commonly retailed to the general public will be exempt. The tax will not apply to eyeglasses, contact lenses, hearing aids, and the like. Effective Date: Sales after 2012. (See IRC Sec. 4191.)New Deductible Compensation Limit for Health InsurersAffected health insurance providers will face a $500,000 per-person deduction limit on compensation paid to “applicable individuals,” which can include officers, employees, directors, and certain other service providers, such as consultants. Effective Date: Tax years beginning after 2012. [See IRC Sec. 162(m)(6)(A).]Changes Taking Effect in 2014New Penalties on Individuals without “Adequate” CoverageIn general, U.S. citizens and legal residents of this country will be required to pay penalties if they do not obtain (one way or the other) “adequate” health insurance coverage.The tentative penalty amount will equal the greater of (1) the applicable percentage of household income above the income threshold that requires the filing of a federal income tax return, or (2) the applicable dollar amount, times the number of uninsured individuals in the household.The applicable percentage of income is 1% for 2104, 2% for 2015, and 2.5% for 2016 and beyond.The applicable dollar amount is $95 for 2104, $325 for 2015, and $695 for 2016. For post-2016 years, the applicable dollar amount will be $695, adjusted for inflation. For an under-age-18 household member, the applicable dollar amounts will be 50% of the aforementioned amounts.The final penalty amount for each household will be limited to 300% of the applicable dollar amount. For example, the maximum penalty for 2016 will be $2,085 (3 × $695). However, if the national average cost of “bronze coverage” (a new term of art) for the household is less, the maximum penalty will be limited to the cost of bronze coverage.If an affected individual is uninsured for only part of the year, the penalty amount will be calculated on a monthly basis using pro-rated annual figures. We can hardly wait to see how that calculation will work.Observation. Although the penalty is supposed to be reported on your federal income tax return, there is apparently no enforcement mechanism other than subtracting the penalty from your federal income tax refund (if any). Therefore, it is hard to see how the penalty will scare very many scofflaws into buying “adequate” health insurance.Effective Date: Tax years beginning in 2014. (See IRC Sec. 5000A.)New Penalties on EmployersEmployers with at least 50 full-time employees who do not provide all employees with affordable health coverage that meets certain minimum standards of generosity will be charged a penalty if even one employee purchases his own government-subsidized coverage through a state-run ernment-subsidized coverage means coverage for which a federal cost-sharing subsidy (explained above) is available.The penalty will be $167 per month ($2,000 per year) for each employee who is not provided with “adequate” coverage for that month (whether or not that particular employee purchases subsidized coverage from a state-run exchange). However, no penalty is charged for the first 30 employees.Alarmingly enough, an employer can be charged a penalty even when employees are offered the opportunity to enroll in a plan that provides minimum essential coverage, but one or more employees choose to buy subsidized coverage through a state-run exchange. In this case, the penalty is $250 per month for each applicable employee, but the total penalty cannot exceed the penalty that would be charged for outright failure to offer “adequate” coverage. Good grief!Employers cannot deduct these penalties as a business expense.Effective Date: Coverage months beginning in 2014. (See IRC Sec. 4980H.)New “Cost-Sharing Subsidies” for Eligible IndividualsGovernment paid “cost-sharing subsidies” will be provided to help individuals who are ineligible for Medicaid, employer-provided coverage, or other “adequate” coverage. This deal has been advertised as a benefit for low-income folks, but you can be eligible with income up to 400% of the federal poverty level. For 2009, 400% of the poverty level was $43,320 for one person or $88,200 for a family of four, so middle-income folks will be able to cash in.Key Point. The cost-sharing subsidy is sometimes called a “premium assistance tax credit,” mainly because the enabling language is found in the Internal Revenue Code. In most cases, however, the cost-sharing subsidy will simply be paid in advance directly to the insurer. If that does not happen, the amount of the subsidy can be claimed as a refundable tax credit on the eligible individual’s federal income tax return.Effective Date: Tax years beginning in 2014. (See IRC Sec. 36B.)More Generous Health Insurance Tax Credit for Small EmployersAs explained in the 2010 changes, qualifying small employers can claim a new tax credit to help cover the cost of providing employee health coverage. For 2010-2013, the maximum credit percentage is 35% or 25% for tax-exempt employers. Starting in 2014, the maximum credit percentage increases to 50% or 35% for tax-exempt employers. However, employers must purchase qualifying health coverage from state-run insurance exchanges to be eligible for the higher credit percentages. Also, the FTE wage caps for credit qualification and calculation purchases are indexed for inflation, starting in 2014.Effective Date: Tax years beginning in 2014. (See IRC Sec. 45R and Section 1421 of the healthcare legislation.)Some Employers Must Give Employees “Free Choice Vouchers”The gist of this change is that an affected employer must give a so-called free choice voucher to any eligible employee who chooses to buy her own coverage instead of participating in the company plan. The amount of the voucher equals the amount the employer would have contributed to the company plan on behalf of the employee if she had participated. As long as the employee spends at least the amount of the voucher on qualified health coverage, the voucher is tax-free to the employee. However, an employee who takes advantage of the free choice voucher deal is ineligible to receive any cost-sharing subsidy for buying coverage from a state-run exchange.Effective Date: 2014. (This change was supposed to be set forth in IRC Sec. 139D, but that section was already devoted to something else. See Section 10108 of the healthcare legislation.)New Excise Tax on Health Insurance ProvidersThe healthcare legislation imposes a new fee (we will call it a tax) on health insurance providers. Each targeted company must pay an allocable portion of the total annual fee, which is $8 billion for 2014. The fee is apportioned among targeted companies based on each company’s share of applicable net premiums.Effective Date: Calendar year 2014. (See Section 9010 of the Patient Protection and Affordable Care Act.)Change Taking Effect in 2018New Excise Tax on “Cadillac Health Plans”Starting in 2018, health insurance companies that service the group market and administrators of employer-sponsored health plans (if any are left by then) will get socked with a 40% excise tax on premiums that exceed the applicable threshold of $10,200 for self-only coverage, or $27,500 for family coverage. For retired individuals and plans that cover employees in high-risk professions, the thresholds will be $11,850 and $30,950, respectively. All these thresholds may be increased to reflect higher than expected inflation in health premiums. Plans sold in the individual market will be exempt, except for coverage that is eligible for the above-the-line deduction for self-employed health premiums.Effective Date: Tax years beginning in 2018. (See IRC Sec. 4980I.)Tax Changes in the Hiring Incentivesto Restore Employment ActThe Hiring Incentives to Restore Employment Act (the HIRE Act) was signed into law on March 18, 2010. It received relatively little notice because the healthcare reform soap opera was still dominating the nation’s attention at that time.Despite the lack of fanfare, the HIRE Act is significant. It includes three meaningful business tax breaks, and a daunting array of changes intended to clamp down on taxpayer attempts to avoid or evade U.S. taxes by taking assets and transactions offshore. The HIRE Act also makes a few changes that fall into the miscellaneous category.This section summarizes the new provisions, starting with the taxpayer-friendly changes for business.Favorable Business Tax ChangesGenerous Section 179 Deduction Limits Extended Through 2010The HIRE Act extended the $250,000 maximum Section 179 deduction allowance by one year, to cover tax years beginning in 2010. Without this retroactive change, the 2010 maximum deduction would have been only $134,000.Key Point. For tax years beginning in 2011, the maximum Section 179 deduction will take a drastic fall to only $25,000, unless our beloved Congress takes further action (which it probably will). The HIRE Act also extended the $800,000 threshold for the Section 179 deduction phase-out rule by one year, to cover tax years beginning in 2010. Without this retroactive change, the 2010 phase-out threshold would have been only $530,000.Key Point. For tax years beginning in 2011, the phase-out threshold will plummet drastically, to only $200,000 unless Congress takes further action (which it probably will).Temporary Social Security Tax Exemption for Wages Paid to New HiresAnother HIRE Act provision exempts wages paid by a qualified employer to a qualified new employee for work performed between March 19, 2010, and December 31, 2010, from the 6.2% employer’s portion of the Social Security tax. [See IRC Sec. 3111(d).]The maximum amount of Social Security tax savings for an employer is $6,621.60 for each qualified new employee (6.2% × the $106,800 Social Security tax ceiling for 2010). Savings are less if the qualified new employee’s wages during the exemption period are below the Social Security tax ceiling (which will almost always be the case).Key Point. There is no exemption for the employee’s 6.2% portion of the Social Security tax, and there is no change in the Medicare tax component of the FICA tax. Finally, there is no exemption for self-employed folks who pay Social Security tax (and Medicare tax) via the self-employment tax. Sorry! Definition of Qualified EmployerQualified employers are defined as private sector employers, tax-exempt not-for-profit outfits, and eligible public higher education institutions. Other public sector employers do not meet the definition. [See IRC Sec. 3111(d)(2).]Definition of Qualified New EmployeeQualified new employees are defined as full-time or part-time workers who begin work after February 3, 2010, and by no later than December 31, 2010, and who were not employed for more than 40 hours during the 60-day period ending on the start date.To be a qualified new employee, a newly hired worker cannot replace another worker, unless that other person exited voluntarily or was discharged for cause.Key Point. The new worker must certify to the employer that she was not employed for more than 40 hours during the 60-day period ending on her start date. [See IRC Sec. 3111(d)(3).] This is done by having the new worker sign new IRS Form W-11 (HIRE Act Employee Affidavit). The signed Form W-11 is not filed with the IRS, but it should be kept with the employer’s tax records. No Exemption for Wages Paid to Certain Related PartiesThe Social Security tax exemption is disallowed for wages paid to new employees who are related to employers under the same related party disallowance rules that apply to the IRC Section 51 Work Opportunity Tax Credit (WOTC). [See IRC Sec. 51(i)(1).] For example, say the employer is a closely held corporation. Wages paid to a new hire who would otherwise be a qualified new employee, but who is a brother or sister of a more-than-50% owner of the corporation, are ineligible for the exemption. [See IRC Sec. 3111(d)(3)(D).]Implementation RulesThe benefit of the Social Security tax exemption for any eligible wages paid during March of 2010 (for work performed between March 19, 2010, and March 31, 2010) will show up as a credit on the employer’s second quarter Form 941, Employer’s Quarterly Federal Tax Return, which has been revised to reflect this change. The first quarter Form 941 is completely unaffected. The benefit of the exemption for any eligible wages paid during the last three quarters of 2010 will show up as reduced employer Social Security tax obligations on the employer’s Forms 941 for those quarters. [See IRC Sec. 3111(d)(5).]Employers Can Elect Out of Exemption and Claim WOTC InsteadEmployers have the option of electing out of the Social Security tax exemption. Then, they can use wages paid during the one-year period beginning on the qualified new employee’s hiring date to claim the Work Opportunity Tax Credit (WOTC), assuming the qualified new employee’s wages are also eligible for the WOTC. Without the election out, wages paid to the qualified new employee are automatically ineligible for the WOTC.Key Point. When a lower-paid qualified new employee’s wages could be used to claim either break, electing out of the Social Security tax exemption will often be beneficial, because the value of the WOTC will often exceed the value of the exemption. [See IRC Secs. 3111(d)(4) and 51(c)(5).]Temporary Tax Credit for Retaining New HiresIn addition to the Social Security tax exemption explained above, the HIRE Act also gives employers a temporary new tax credit of up to $1,000 to help offset wages paid to each qualified new employee, using the same definition as for the Social Security tax exemption.The new credit comes in the form of an increase in the employer’s general business credit [under IRC Sec. 32(b)]. Interestingly enough, the provisions for the new credit are found in Section 102 of the HIRE Act rather than in the Internal Revenue Code itself (more government transparency in action).Eligibility Rules and Credit AmountIn order to claim the credit, the qualified new employee must be kept on the payroll for at least 52 consecutive weeks. In addition, wages paid to the new employee during the second 26 weeks of the 52-week period must equal at least 80% of wages paid during the first 26 weeks of that period. Otherwise, no credit is allowed.The credit equals the lesser of 6.2% of wages paid to the qualified new employee during the 52-consecutive-week period or $1,000. To claim the maximum $1,000 credit, the worker must be paid at least $16,130 during the 52-week period (6.2% × $16,130 = $1,000). The credit can only be claimed for the tax year during which the 52-week requirement is first met for the qualified new employee in question.Key Point. Understand this: the credit is a one-time break for each qualified new employee based on wages paid to him during the 52-week period that starts with his employment date.No Instant Gratification for EmployersUnfortunately, the credit can only be claimed for the tax year ending after March 18, 2010, during which the 52-week requirement is first met for the qualified new employee. As you can see, the 52-week requirement cannot be met until February of 2011 at the earliest – for a worker who started on the earliest possible date of February 4, 2010. Therefore, a calendar-year employer can claim the credit on the 2011 federal income tax return, but there is no way to claim it on the 2010 return. Rats!If the qualified new employee begins work on the latest possible date of December 31, 2010, the 52-week requirement cannot be met until the bitter end of 2011. Once again, this translates into having to wait until the calendar-year 2011 return to claim the credit.Another provision prevents employers from carrying back any portion of an unused Section 38(b) credit attributable to the qualified new employee credit to any tax year beginning before March 18, 2010. For a calendar-year taxpayer, this provision prevents carrying the credit back to the 2010 tax year. The bottom line is that calendar-year taxpayers cannot possibly benefit from the credit until they file their 2011 returns. Sorry! The timing rules are even more complicated when the employer uses a fiscal tax year. In such case, the credit cannot be claimed any sooner than on a return for a fiscal tax year that began on March 1, 2010. Key Point. Despite the preceding unfavorable timing rules, hiring a qualified new employee as soon as possible and retaining that person for at least 52 weeks will indeed generate a credit that will eventually cut the employer’s federal income tax bill by up to $1,000. Clients just need to understand that the tax savings will not show up anytime soon. Unfavorable Changes Affecting Taxpayers with Offshore Assets and TransactionsIf you have clients with foreign assets and transactions, watch out, because those clients are now in the government’s crosshairs more than ever before, thanks to changes in the HIRE Act. Here is a quick summary of the new provisions.New Disclosures Required for Foreign Financial Assets Owned by IndividualsThe HIRE Act added new IRC Section 6038D which requires new tax return disclosures from individuals with interests in “specified foreign financial assets,” if the aggregate value of such assets exceeds $50,000. Future regulations or IRS guidance may add more disclosure rules to cover domestic entities used to hold (directly or indirectly) specified foreign financial assets in the same manner as if the entities were individuals.Affected AssetsSpecified financial assets are defined to include depository and custodial accounts at foreign financial institutions; stocks and securities issued by foreign persons that are not held in such accounts; certain other financial instruments and contracts that are held for investment but that are not held in such accounts; and interests in foreign entities that are not held in such accounts.Stiff Penalties for NoncomplianceFailure to provide required tax return disclosures can trigger a $10,000 penalty for each applicable tax year. Failure to provide disclosures for more than 90 days after the IRS notifies the taxpayer of a failure can result in additional penalties of $10,000 per 30-day period, or any part of a 30-day period. If the IRS discovers a failure to make disclosures, the $50,000 threshold is presumed to be exceeded, and penalties will be assessed accordingly. (Note that the statutory language appears to allow total Section 6038D penalties of up to $60,000 for each applicable tax year, but the legislative history seems to indicate that total penalties for a tax year were not meant to exceed $50,000.)Effective Date: Tax years beginning after March 18, 2010. (See IRC Sec. 6038D.)New 40% Accuracy-Related Penalty on Tax Understatements from Undisclosed Foreign Financial AssetsThe HIRE Act establishes a new 40% accuracy-related penalty on any tax understatement that is attributable to an undisclosed foreign financial asset. Ouch!Affected AssetsThe new 40% penalty covers assets for which taxpayer disclosures are required under IRC Sec. 6038 (dealing with U.S. persons that control foreign corporations or partnerships); IRC Sec. 6038B (dealing with U.S. persons that make certain outbound transfers to foreign entities); IRC Sec. 6038D (new rules for individuals with interests in specified foreign financial assets, as explained immediately above); IRC Sec. 6046A (dealing with U.S. persons with interests in foreign partnerships); and IRC Sec. 6048 (dealing with U.S. persons that have interests in foreign trusts or make certain transactions with them).Broad Definition of Tax UnderstatementAlarmingly enough, a tax understatement is deemed to be attributable to an undisclosed foreign financial asset if it is attributable to any transaction involving such an asset. Yikes!Effective Date: Tax years beginning after March 18, 2010. [See IRC Sec. 6662(b)(7) and (j)(1).]New Six-Year Statute of Limitations Period for Tax Understatements from Foreign Financial AssetsThe HIRE Act amends IRC Section 6501 to establish a new six-year assessment period (statute of limitations period) for tax understatements attributable to certain understated income from foreign financial assets. This is bad news for affected taxpayers, because the “normal” statute of limitations period is only three years. For the much harsher six-year statute of limitations rule to apply, the understated income attributable to foreign financial assets must exceed $5,000.Effective Date: For returns filed after March 18, 2010, and earlier returns for which the IRC Section 6501 assessment period had not expired as of March 18, 2010. [See IRC Secs. 6501(e)(1) and 6629(c)(2).]New Tax Withholding Requirements for Payments to Foreign Financial Institutions and Other Foreign EntitiesThe HIRE Act adds new IRC Sections 1471-1474. Together, the new provisions require 30% tax withholding on affected payments from U.S. sources to foreign financial institutions (such as interest paid on loans from such institutions) and on “withholdable payments” (as defined) to certain other foreign entities. Affected foreign financial institutions and withholding agents can avoid the new 30% withholding requirement by following applicable IRS disclosure, reporting, and compliance rules.Effective Date: The new 30% withholding rules generally apply to payments made after December 31, 2012, but they do not apply to payments on obligations that are already outstanding as of March 18, 2012. (See IRC Sec. 1471-1474.)Passive Foreign Investment Company (PFIC) Shareholders Must File Information ReturnsThe HIRE Act requires U.S. persons that are shareholders in PFICs to file annual returns to report whatever information the IRS requires.Effective Date: March 18, 2010. [See IRC Sec. 1298(f).]Statute of Limitations Is Suspended by Failures to File Passive Foreign Investment Company (PFIC) Information Returns or Make Required Disclosures of Foreign Financial AssetsAnother provision in the HIRE Act suspends the IRC Section 6501 assessment period (the statute of limitations period) for as long as the taxpayer fails to make (1) timely filings of information returns required for a PFIC pursuant to IRC Secs. 1295(b) or 1298(f) (see immediately above), or (2) required tax return disclosures of specified foreign financial assets pursuant to the new IRC Section 6038D rules (explained earlier). This is bad news for affected taxpayers because the statute of limitations normally runs out after only three years.Effective Date: For returns filed after March 18, 2010, and earlier returns for which the IRC Section 6501 assessment period had not expired as of March 18, 2010. [See IRC Sec. 6501(c)(8).]Dividend Equivalents Treated as Dividends for Tax WithholdingThe HIRE Act mandates that U.S. source “dividend equivalents” (as defined) which are paid to foreign recipients are treated the same as garden-variety U.S. source dividends, for purposes of dividend tax withholding rules.Effective Date: For payments made on or after September 19, 2010. [See IRC Sec. 871(l).]Unfavorable New Provisions for Unregistered Foreign Targeted ObligationsUnder provisions that pre-date the HIRE Act, “registration-required obligations” (as defined) must be issued in registered form (as opposed to unregistered “bearer bond” form), in order for bond issuers to deduct interest payments and in order for interest paid on state and local municipal bonds to be classified as tax-exempt interest. Certain unfavorable provisions (including an excise tax) can also apply to issuers when registration-required obligations are not registered. Under pre-HIRE Act law, “foreign targeted obligations” were exempt from the aforementioned rules. In a nutshell, foreign targeted obligations are unregistered obligations (bearer bonds) that satisfy tax-law requirements intended to discourage them from being sold to U.S persons who might be sorely tempted to use them to evade taxes on the interest payments. The HIRE Act generally repeals an exemption that previously allowed interest to be deducted by an issuer of an unregistered foreign targeted obligation. However, the repeal does not apply to an obligation issued by a natural person that matures in one year or less and is not of a type offered to the public. Effective Date: For obligations issued after March 18, 2012. [See IRC Secs. 149(a), 163(f), and 4701(b).]Another change in the HIRE Act generally repeals a provision that previously allowed tax-exempt treatment for interest paid on unregistered foreign targeted municipal bonds (certain bearer bonds that satisfy tax-law requirements intended to discourage them from being sold to U.S persons). However, the repeal does not apply to bonds that mature in one year or less and that are not of a type offered to the public.Effective Date: For bonds issued after March 18, 2012. [See IRC Secs. 149(a), 163(f), and 4701(b).]Note. The HIRE Act also includes some other technical changes to the rules for foreign targeted obligations. [See IRC Secs. 149(a), 163(f), and 4701(b).]New Withholding Tax Requirement for Unregistered Foreign Targeted ObligationsUnder pre-HIRE Act law, an exception to the general 30% withholding tax requirement for interest paid to foreign persons was allowed for unregistered foreign targeted obligations (bearer bonds) that satisfied certain requirements intended to discourage them from being sold to U.S persons who might have been sorely tempted to use them to evade taxes. The HIRE Act generally repeals the exemption from the 30% withholding requirement for unregistered foreign targeted obligations.Effective Date: For bonds issued after March 18, 2012. [See IRC Sec. 871(b), (c), and (h).] New 180-Day No-Interest Rule for Tax Refunds from Over-Withholding on Certain Offshore PaymentsNormally, the government is required to pay interest on tax overpayments that are not refunded within 45 days after the tax return due date (without regard to any extensions) or the tax return filing date, whichever is later. The HIRE Act increases the no-interest period on certain refunds of tax overpayments to 180 days. Ouch! This unfavorable change applies to overpayments that are attributable to taxes withheld under Chapter 3 of the Internal Revenue Code (dealing with withholding on nonresident aliens and foreign corporations) and Chapter 4 (new withholding rules for payments to foreign financial institutions and certain other foreign entities, pursuant to new IRC Secs. 1471-1474, as explained earlier in this analysis).Effective Date: For overpayments shown on returns due after March 18, 2010, without regard to any extensions and refund claims filed after March 18, 2010. [See IRC Sec. 6611(e)(4).]New Electronic Filing Requirement for Foreign Financial InstitutionsThe HIRE Act allows the IRS to require a foreign financial institution to file electronic returns to report taxes withheld by the institution pursuant to IRC Sec. 1461 (which deals with withholding by withholding agents) or IRC Sec. 1474(a) (which deals with withholding on foreign accounts). The IRS can assess the IRC Section 6721 penalty for failure to file information returns if an institution fails to comply.Effective Date: For returns due after March 18, 2010, without regard to any extensions. [See IRC Secs. 6011(e)(4) and 6724(c).]Unfavorable Changes Affecting Foreign Trusts and Beneficiaries We are not done yet. If you have clients that are involved with foreign trusts, you too have to watch out, because those clients are also targeted by unfavorable changes in the HIRE Act. Here is a quick summary of the new provisions. Broader Definition of U.S. Beneficiary of Foreign TrustThe HIRE Act establishes a broader definition of what constitutes a beneficiary for purposes of determining when a foreign trust is treated as a grantor trust that is owned by a U.S. beneficiary. This is a significant change, because said U.S. beneficiary must then report its share of income from the foreign trust.Effective Date: March 18, 2010. [See IRC Sec. 679(c).]Transfer to Foreign Trust Creates Presumption of U.S. BeneficiaryThe HIRE Act establishes a rebuttable presumption that a foreign trust is a grantor trust owned by a U.S. beneficiary (under the IRC Section 679 grantor trust rules), when property is transferred to the trust by a U.S beneficiary. This is a significant change, because said U.S. beneficiary must then report its share of income from the foreign trust. This unfavorable presumption can be rebutted by submitting such information as the IRS may require proof that none of the trust’s income or corpus has accrued to the benefit of a U.S. person.Effective Date: For property transfers after March 18, 2010. [See IRC Sec. 679(d).]New Reporting Requirement for Foreign Trust GrantorsThe HIRE Act dictates that U.S. persons treated as grantors (owners) of foreign trusts under the grantor trust rules (IRC Sections 671 through 679) must report such information as the IRS may specify.Key Point. This new requirement is over and above the pre-existing requirement that U.S. grantors must ensure that their foreign trusts comply with return filing and information reporting rules. Effective Date: Tax years beginning after March 18, 2010. [See IRC Sec. 6048(b)(1).]Increased Minimum Penalty for Failure to Meet Foreign Trust Reporting RulesThe HIRE Act imposes a new $10,000 minimum penalty for failures to file required foreign trust returns and notices pursuant to the IRC Section 6048 rules. Previously, the minimum penalty was based on percentages of amounts that were required to be reported. The new $10,000 minimum penalty can be imposed even when amounts required to be reported are not known by the IRS. Effective Date: For failures to file returns and notices due after December 31, 2009. [See IRC 6677(a).]Below-Market Deals with Foreign Trusts Treated as DistributionsThe HIRE Act treats uncompensated use of foreign trust property by a U.S. grantor, a U.S. beneficiary, or a U.S. person related to such a grantor or beneficiary as a distribution by the trust to the grantor or beneficiary. In addition, below-market loans made by foreign trusts to U.S. persons and discounted uses of foreign trust property by U.S. persons are treated as distributions that cause the trusts to be considered grantor trusts owned by U.S. persons under the IRC Section 679 rules.Key Point. The new rules are aimed at discouraging foreign trusts from providing interest-free loans, and other freebies and discounted goodies, to U.S. persons without any U.S. tax consequences for those persons.Effective Date: For uses of property and loan transactions after March 18, 2010. [See IRC Sec. 643(i).] Miscellaneous ChangesWorldwide Interest Allocation Rules Postponed AgainThe HIRE Act postpones the effective date for beneficial rules that would allow interest expense to be allocated among domestic and foreign corporations on a worldwide basis. The rules are delayed for another three years, until tax years beginning in 2020. [See IRC Sec. 864(f).] More Estimated Tax Increases for Large CorporationsFor large corporations (those with assets over $1 billion), the HIRE Act increases estimated tax payments due in July, August, or September of 2014 to 157.5% of the amounts that would otherwise be required to avoid the IRC Section 6655 interest charge penalty. Estimated payments due in July, August, or September of 2015 are increased to 121.5% of the amounts that would otherwise be required. Estimated payment due in July, August, or September of 2019 are increased to 106.5% of the amounts that would otherwise be required. For an affected corporation, the next estimated tax payment due after these dates is reduced accordingly. (See IRC Sec. 6655 and Section 561 of the HIRE Act.)Issuers of Certain Tax-Credit Bonds Can Elect to Receive Federal SubsidyState and local governmental entities have the option of issuing tax-credit bonds instead of traditional tax-exempt interest bonds. Flipping the coin to the other side, the HIRE Act allows issuers of certain tax-credit bonds to elect to receive direct payments from the IRS. Bondholders are then paid taxable interest instead of receiving allocations of tax credits. To clarify, a bond issuer that makes the new election is given a direct federal subsidy that covers part of the interest paid to bondholders. The election must be made by no later than the bond issue date.Effective Date: For new clean renewable energy bonds (new CREBs), qualified energy conservation bonds (QECBs), qualified zone academy bonds (QZABs), and qualified school construction bonds (QSCBs) issued after March 18, 2010. [See IRC Sec. 6431(f).]Key Developments AffectingVarious Types of TaxpayersTax Freedom Day Is April 9th This YearThe Tax Foundation announced that Tax Freedom Day for 2010 fell on April 9th. As you know, Tax Freedom Day is the estimated day when the average taxpayer’s income finally equals her total tax obligations for the year to federal, state, and local government. Put another way, it is the day the taxpayer starts working for herself, instead of working to pay the government. With that thought in mind, it would be very interesting to know what the Tax Freedom Day over/under bet is in Las Vegas right now for 2011 and beyond.Second Quarter 2010 Interest Rates on Federal Tax Overpayments and Underpayments Are UnchangedThe interest rates that apply to federal tax overpayments and underpayments for the second quarter of 2010 are the same as for the previous four quarters. (See Rev. Rul. 2010-9 and IRC Sec. 6621.) The second quarter 2010 rates are as follows:4% for overpayments and underpayments by unincorporated taxpayers and most corporate underpayments3% for most corporate overpayments1.5% for the portion of corporate overpayments that exceed $10,0006% for large corporate underpayments (generally, underpayments by C corporations in excess of $100,000)COBRA Subsidy Extended AgainThe Continuing Extension Act of 2010 extended the 65% subsidy for COBRA health insurance premiums to cover workers who are involuntarily terminated though May 31, 2010. As a result, the subsidy now covers terminations that occur during the 21-month period extending from September 1, 2008, and May 31, 2010. The period during which the subsidy can available for a terminated worker can now be as long as 15 months. (See IRS News Release IR-2010-52 and the COBRA guidance available at .)Severance Payments Exempt from FICA Tax?According to a Michigan District Court, severance payments to terminated employees are not subject to the FICA tax, because they meet the IRC Section 3402(o)(2) definition of supplemental unemployment compensation benefits. Therefore, they are not wages for FICA tax purposes. [See U.S. v. Quality Stores, Inc., 105 AFTR 2d 2010-1110 (DC MI).]IRS Says Golf Cart Tax Credit Is Not for Golf CartsLast year’s stimulus legislation included a new business and personal tax credit of up to $2,500 for buying a four-wheeled, plug-in electric vehicle that weighs no more than 3,000 pounds when fully loaded and has a top speed of 20-25 MPH. Although the vehicle must be “primarily for use on public streets,” the only thing that seems to meet the description is an electric golf cart with a little bumper sticker that says “intended for street use.” The statutory language for this credit is buried in a heaping pile of zany tax incentives that were supposed to create all those “green jobs” that nobody can find. When this goofy break got some press and became a public embarrassment, the IRS quickly issued a requirement that qualifying vehicles must come with certifications saying they are not mainly intended for golf course transportation. Fair enough, but we are still trying to figure out what the credit is meant to cover, if not golf carts. However that turns out, you will be happy to know the credit is scheduled to remain on the books through 2011. [See IRC Sec. 30(d)(1) and (d)(2) and IRS Notice 2009-58.]Key Developments Affecting Business TaxpayersNew Form 3115 for Accounting Change RequestsThe IRS has released an updated version of Form 3115, Application for Change in Accounting Method. The new form shows a December 2009 revision date. In general, the new form must be used for requests to change tax accounting methods that are filed after May 31, 2010. (See IRS Announcement 2010-32.) Employers Get Postcards from IRS about New Health Insurance Tax CreditAs explained at the beginning of this chapter, the healthcare legislation created a new tax credit intended to encourage small employers to provide health insurance coverage to employees. The credit is one of a relatively few changes that are effective this year. The IRS is publicizing the credit by issuing postcards to about four million potentially eligible small businesses and tax-exempt employers.IRS Announces 2010 Luxury Auto Depreciation LimitationsFor vehicles that fall under the dreaded luxury auto depreciation limitation rules, the expiration of the 50% first-year bonus depreciation break has translated into a $7,900 decrease in maximum first-year depreciation deductions for new vehicles placed in service in 2010 compared to those placed in service last year (assuming 100% business use). For affected vehicles placed in service during 2010, the maximum depreciation deductions for 100% business use are listed below. (See Rev. Proc. 2010-18.) New and Used CarsYear 1$3,060Year 24,900Year 32,950Year 4 and thereafter until cost is recovered1,775New and Used Light Trucks and Light VansYear 1$3,160Year 25,100Year 33,050Year 4 and thereafter until cost is recovered1,875Key Point. When vehicles are not used 100% for business, the numbers shown above must be proportionately reduced to account for the non-business usage. Also, the numbers shown above only apply when business use exceeds 50%.Key Point. If 50% first-year bonus depreciation is retroactively reinstated for new vehicles placed in service in 2010, the first-year amounts shown above will be approximately $8,000 higher.PAL Groupings Must Be Disclosed on Tax Returns (but Not Yet)For purposes of applying the dreaded passive activity loss (PAL) rules, Rev. Proc. 2010-13 requires taxpayers to make tax return disclosures of (1) activity groupings and regroupings that occur during the tax year, and (2) additions of new activities to existing groupings that occur during the tax year. The new disclosure requirements are effective for tax years beginning on or after January 25, 2010. Therefore, they will not impact calendar-year 2009 or 2010 returns. However, calendar-year 2011 returns will be impacted. Key Developments Affecting Individual TaxpayersYet Another Court Decision Says LLC Members Are General Partners for PAL PurposesIn Newell, the Tax Court concluded that a member of a California multi-member LLC was allowed to use all seven of the passive activity loss (PAL) material participation tests that are available to general partners, rather than just the three stricter tests that are available to limited partners. [See Lee Newell, 132 TC Memo 2010-23 (2010).]The Tax Court and Court of Federal Claims already came to the same conclusion in three earlier decisions. [See Paul Garnett, 132 TC No. 19 (2009); James Thompson, 104 AFTR 2d 2009-5381, Court of Federal Claims (2009); and Sean Hegarty, TC Summary Opinion 2009-153 (2009).]In effect, these decisions all say that interests in multi-member LLCs that are treated as partnerships for tax purposes are general partner interests, rather than limited partner interests for purposes of applying the PAL material participation tests. The common thread is the fact that LLC members are allowed to be heavily involved in LLC activities, under applicable state LLC laws. In contrast, when a limited partner becomes too involved in a partnership’s affairs, his limited partner status may be lost under applicable state partnership laws. According to the courts, this important distinction makes it impossible to conclude that LLC interests are equivalent to limited partner interests for PAL purposes.Bottom Line. The courts say LLC members are general partners for PAL purposes, even though LLC members have limited liability similar to what limited partners have. Period! While some tax advisers may have adopted this position long ago, it is reassuring to know that the courts agree. In particular, the Tax Court’s agreement is very reassuring, because it is the law of the land on this subject, until further notice. In Action on Decision (AOD) 2010-001, the IRS acquiesced to the outcome in Garnett, but has not yet thrown in the towel, altogether. It should!Certain 2010 Haiti Relief Donations Can Be Deducted on 2009 ReturnsThe so-called Haiti Relief Act (Public Law 111-126) allows calendar-year 2009 tax return deductions for certain 2010 cash donations to assist Haiti relief efforts. Individuals must itemize deductions to benefit. Specifically, 2009 tax return deductions can be claimed for Haiti relief donations made between January 12, 2010, and February 28, 2010, to help victims in areas affected by the January 12th earthquake. For this purpose, cash donations include contributions made via check, money order, credit card, charge card, debit card, or phone. For donations under $250, the taxpayer needs either a bank record (like a cancelled check or credit card statement) or a receipt from the charity to support the deductible amount. For donations of $250 or more, the taxpayer must have a receipt from the charity. For donations made by phone or text message, the IRS says that a service provider bill showing the name of the charity, the donation date, and the amount is sufficient proof. Beyond that, the normal rules for charitable donation deductions apply. (See IRS News Releases 2010-12 and 2010-21 and IRC Sec. 170.)Federal Tax Update – Third Quarter 2010HighlightsThird quarter 2010 interest rates on federal tax overpayments and underpayments2011 inflation-adjusted amounts for HSAs (same as for 2010)Guidance on new requirement for health plans to cover adult children Guidance on new healthcare-related tax breaks for adult childrenHomebuyer credit fraud runs rampantFederal tax consequences for California Registered Domestic PartnersInstructions for tip credit form revised to reflect temporary employer Social Security tax exemptionGuidance on small business healthcare credit Detailed explanation of new small business healthcare creditSmall business alert: detailed explanation of temporary payroll tax breaks for hiring relatives of business ownersDetailed explanation of burdensome new Form 1099 reporting requirements starting in 2012Key Developments AffectingVarious Types of TaxpayersThird Quarter 2010 Interest Rates on Federal Tax Overpayments and Underpayments Are UnchangedThe interest rates that apply to federal tax overpayments and underpayments for the third quarter of 2010 are the same as for the previous five quarters. (See Rev. Rul. 2010-14 and IRC Sec. 6621.) The third quarter 2010 rates are as follows: 4% for overpayments and underpayments by unincorporated taxpayers and most corporate underpayments3% for most corporate overpayments1.5% for the portion of corporate overpayments that exceed $10,0006% for large corporate underpayments (generally underpayments by C corporations in excess of $100,000)2011 Inflation-Adjusted Amounts for HSAs Unchanged from 2010 Deductions for HSA contributions can cut your client’s federal income tax bill starting with the year he obtains coverage under a qualifying high-deductible health plan (HDHP). For tax years beginning in 2011, an HDHP must have a deductible of at least (1) $1,200 for self-only coverage or (2) $2,400 for family coverage (same as for 2010).For tax years beginning in 2011, an HDHP cannot have an annual limit on total out-of-pocket costs for covered benefits in excess of (1) $5,950 for self-only coverage or (2) $11,900 for family coverage (same as for 2010). Key Point. Having HDHP coverage is the initial hurdle that must be cleared for an individual to be eligible for HSA contributions. For tax years beginning in 2011, the maximum HSA contribution amounts are generally (1) $3,050 for self-only coverage or (2) $6,150 for family coverage (same as for 2010). If an account owner will be age 55 or older as of 12/31/11, an additional $1,000 can be contributed (same as for 2010).These 2011 amounts were announced in Rev. Proc. 2010-22. Guidance on New Requirement for Health Plans to Cover Adult Children Pursuant to this year’s healthcare legislation, health plans must cover a participant’s adult child until he reaches age 26 if the participant is signed up for dependent child coverage. This new coverage requirement is effective for plan years or policy years that begin after 9/22/10. (See IRC Sec. 9815.) The IRS has now issued temporary regulations on the new requirement. (See Temp. Reg. 54.9815-2714T.) Among other things, the guidance clarifies that health plans cannot condition eligibility for coverage of an under-age-26 child on anything other than the relationship between the participant and the child. For example, eligibility cannot be conditioned on the child’s financial dependency, place of residence, income, employment status, or status as a student. Enrollment of under-age 26 children for which coverage previously ended or was previously denied (before such things were illegal) must be opened up for at least 30 days on the first day of the first plan year or policy year that begins after 9/22/10. Guidance on New Healthcare-Related Tax Breaks for Adult ChildrenIn conjunction with the aforementioned health plan coverage requirement for under-age-26 adult children, the healthcare legislation also stipulates that employer-provided health coverage for an employee’s adult child is now treated as a tax-free fringe benefit as long as the child has not reached age 27 by the end of the year. It does not matter if the adult child is the employee’s dependent or not. When a self-employed person pays for her own health insurance, the cost of covering an adult child is eligible for the above-the-line deduction for self-employed health insurance premiums, as long as the adult child has not reached age 27 by the end of the year. It does not matter if the adult child is a dependent or not. These changes are effective as of 3/30/10. [See IRC Secs. 105(b) and 162(l).] In Notice 2010-38, the IRS concludes (among other things) that tax-free treatment also applies to reimbursements from an employer-provided cafeteria plan, healthcare flexible spending account (FSA) plan, or health reimbursement arrangement (HRA) to cover an under-age 27 adult child’s qualified medical expenses. Key Point. The discrepancy between the until-age-26 coverage requirement and the until-age-27 tax breaks is apparently intended to allow tax breaks for adult children who are covered by health plans all the way through the end of the plan year or policy year during which they turn age 26 (at which point they could be as little as one day short of hitting age 27). Key Developments Affecting Individual TaxpayersHomebuyer Tax Credit Fraud Runs Rampant (No Big Surprise)Before the Worker, Homeownership, and Business Assistance Act of 2009 became law, absolutely no documentation was required to claim the homebuyer tax credit, which can be up to $8,000 (the credit has now expired except for certain buyers who are in the military). Since it is a “refundable” credit, the homebuyer credit can be collected in cash even when the “taxpayer” has no federal income tax liability. So you can get up to $8,000 in free money just for filling out some forms. Not surprisingly, tons of fraudulent homebuyer credit claims have already been filed with many, many more sure to follow. A recent Treasury Inspector General for Tax Administration (TIGTA) report on IRS efforts to monitor credits claimed on 2008 returns is illuminating. The IRS discovered that over 10,000 “taxpayers” had received credits for allegedly purchasing the same homes that other “taxpayers” had also claimed credits for. In one case, 67 different “taxpayers” claimed credits for the same home. But that is not all. Over $9 million in credits went to prisoners who were incarcerated when they allegedly made qualifying home purchases. Now for the good news, if you can call it that. The IRS has supposedly blocked nearly 400,000 bogus claims. The question is, how many bogus claims sailed right through, and how much did they cost the public? As this publication went to press, there was talk in some quarters of Congress about resurrecting the credit because it was such a great idea. Good grief!IRS Addresses Federal Tax Consequences for California Registered Domestic PartnersIn Private Letter Ruling (PLR) 201021048 and related Chief Counsel Advice (CCA) 201021050, the IRS addressed the federal income and gift tax consequences of a 2007 California state law change that mandates community property treatment for income earned by California Registered Domestic Partners (RDPs). As of 1/1/07, said community property treatment applies for both California property law purposes and California state income tax purposes. Accordingly, in PLR 201021048, the IRS concluded that each member of a California RDP couple must report on his or her separate federal income tax return 50% of the couple’s combined income from the performance of personal services and 50% of the couple’s combined income from community property assets. The IRS also concluded that each member is entitled to 50% of the credit for the combined amount of federal income taxes withheld from the couple’s wages. Finally, the IRS concluded that there are no federal gift tax consequences for any transfers of wealth from one RDP member to the other that could be construed to occur as a result of the state-law community property treatment of the couple’s income. In CCA 201021050, the IRS indirectly states that the aforementioned 50/50 federal income tax treatment for an RDP couple’s income is mandatory for tax years beginning after 5/31/10. For tax years that began before 6/1/10, the 50/50 treatment is not mandatory because California RDP couples were expected to follow contrary guidance in CCA 200608038. The earlier CCA concluded that each RDP member should report 100% of his or her income from the performance of personal services on his or her separate federal income tax return. For open tax years that began after 12/31/06 and before 6/1/10, RDPs also have the option of filing amended federal income tax returns (using Form 1040X) to reflect the new 50/50 treatment deal.Key Point. Although the IRS does not explicitly say so, California RDPs should apparently file their separate federal income tax returns as unmarried taxpayers rather than using the less-favorable married filing separate status. Key Developments Affecting Business TaxpayersInstructions for Tip Credit Form Revised to Reflect Temporary Social Security Tax Exemption for EmployersThe IRS has issued revised instructions for Form 8846 (Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips) to reflect the new temporary employer Social Security tax exemption for wages paid between 3/19/10 and 12/31/10 to eligible new hires who were previously unemployed. Key Point. See the discussion on claiming the Social Security tax exemption for newly-hired relatives of small business owners later in this chapter. Guidance on New Small Business Healthcare Tax Credit In Notice 2010-44, the IRS issued guidance on the new tax credit for small employers that provide health insurance coverage for their employees.In Rev. Rul. 2010-13, the IRS announced the state-by-state benchmark premium amounts that must be used for credit calculation purposes. Key Point. Later in this chapter, we cover how the healthcare credit works in detail, including some of what is discussed in Notice 2010-44 and Rev. Rul. 2010-13.Detailed Explanation of New SmallEmployer Health Insurance Tax CreditThe healthcare legislation enacted in March of 2010 includes a new tax credit for qualifying small employers. The credit can cover up to 35% of employee health insurance costs. It is available for tax years beginning in 2010, and it can be claimed for eligible costs that were incurred before the healthcare legislation became law.Key Point. The rules explained in this analysis apply to tax years beginning in 2010-2013. Different rules are scheduled to take effect in 2014. Basics on How the Credit WorksA qualifying small employer is one that (1) has no more than 25 full-time-equivalent (FTE) employees, (2) pays an average FTE wage of no more than $50,000, and (3) has a qualifying healthcare arrangement in place. (See IRC Sec. 45R.)The credit is quickly phased out when the number of FTE employees exceeds 10 and when the average FTE wage exceeds $25,000. Phase-out is complete when the number of FTE employees hits 25 or when the average FTE wage hits $50,000. Therefore, it is inaccurate to imply (as the statute does) that an employer can have 25 FTE employees or an average wage of $50,000 and still qualify for the credit. Anyway, a qualifying healthcare arrangement is one that requires the employer to (1) pay at least 50% of the cost of each enrolled employee’s qualifying health insurance coverage and (2) pay same cost percentage for all enrolled employees. However for tax years beginning in 2010, this uniform cost percentage requirement does not apply. Instead, a favorable transition rule published in IRS Notice 2010-44 allows the employer to pay an amount equal to at least 50% of the cost of single coverage for all enrolled employees (including those with more-expensive family or self-plus-one coverage). To be eligible for the credit in later years, however, the employer must pay the same cost percentage for all enrolled employees, including those with more expensive coverage.According to IRS Notice 2010-44, qualifying health insurance coverage includes (1) major medical coverage; (2) limited scope coverage for dental care, vision care, long-term care, nursing home care, home health care, community-based care, or any combination of these; (3) hospital indemnity coverage (such as so-called daily hospital insurance) or other fixed indemnity coverage; and (4) Medicare supplemental health insurance and certain other types of supplemental coverage. In the usual situation where the employer pays less than 100% of the cost of coverage (with employees picking up the balance), the credit can only be claimed for the percentage of the cost that is paid by the employer. Healthcare premiums paid under a section 125 cafeteria benefit plan salary-reduction arrangement do not count as an employer-paid cost. The credit is allowed for all types of qualifying small employers including C and S corporations, partnerships, LLCs, and sole proprietorships. However, certain workers who are also owners of the employer are classified as excluded workers, and costs to cover them are ineligible for the credit. Specifically, sole proprietors, partners, more-than-2% S corporation shareholder-employees, and more-than-5% C corporation shareholder-employees are excluded workers. Most employees who are members of such an owner’s family, including in-laws and dependents, are also classified as excluded workers, and costs to cover them are also ineligible for the credit. [See IRC Sec. 45R(e)(1)(A).]Key Point. It is clear that an employee who is married to a more-than-2% S corporation shareholder or a more-than-5% C corporation shareholder is an excluded worker. However, it appears that an employee who is married to a sole proprietor or a partner is not an excluded worker. We await IRS guidance on this issue, but we may not get any.Calculating FTE Employees and FTE WagesAs you will see, a complicated phase-out rule quickly reduces the credit if the business in question has over 10 FTE employees or an average FTE wage above $25,000. Phase-out is complete when the number of FTE employees hits 25 or when the average FTE wage hits $50,000. Therefore, the FTE employee and FTE wage calculations are super-important. Here is the drill.The number of FTE employees for the year is calculated by dividing total paid employee hours for the year by 2,080. However, if a worker is paid for more than 2,080 hours, the excess hours are excluded from the calculation. Hours worked by seasonal employees who work 120 days or less during the year (counting all days that any hours are worked) are also excluded from the calculation. The calculated number of FTE employees is then rounded down to the next whole number. The average FTE wage for the year is calculated by dividing total employee wages for the year by the number of FTE employees for the year. Wages paid to seasonal employees who work 120 days or less (counting all days that any hours are worked) are excluded from the calculation. The calculated FTE wage amount is then rounded down to the next multiple of $1,000. Because the credit cannot be claimed for costs to cover excluded workers (certain owners and their relatives, as explained earlier), their hours and wages are not counted in determining the number of FTE employees or the average FTE wage.See Notice 2010-44 for additional details on how to calculate the number of FTE employees and the average FTE wage. Key Point. A business can have more than 25 workers and still be eligible for the credit when some of the workers are part-time employees, seasonal employees, or excluded workers. Calculating the Tentative Credit before the Phase-Out RuleThe maximum possible credit, which we will call the tentative credit, equals 35% of the lesser of (1) the employer’s real-world cost of providing employee health coverage under its qualifying arrangement or (2) the imaginary government-world cost to obtain “benchmark” coverage in the small-group market as determined on a state-by-state basis by the Department of Health and Human Services (HHS). In the usual situation where the employer pays less than 100% of the real-world cost of coverage under its qualifying arrangement, the tentative credit is calculated by multiplying the real-world cost or the imaginary benchmark cost (whichever is less) by the percentage of real-world cost paid by the employer.ExampleEpsilon Corporation is a qualifying small employer. The real-world cost of Epsilon’s qualifying healthcare arrangement is $150,000, and the company pays 60% of the cost. Assume the imaginary benchmark cost in Epsilon’s state is $175,000. Epsilon’s tentative credit is $31,500 (60% × $150,000 × 35%). ExampleFriendly LLC is a qualifying small employer. The real-world cost of Friendly’s qualifying healthcare arrangement is $150,000, and the company pays 75% of the cost. Assume the imaginary benchmark cost in Friendly’s state is $130,000. Friendly’s tentative credit is $34,125 (75% × $130,000 × 35%). The initial stab at providing imaginary benchmark costs for tax years beginning in 2010 was published in Rev. Rul. 2010-13. The benchmark cost for single coverage ranges from a high of $6,204 (Alaska) to a low of $4,215 (Idaho). The benchmark cost for family coverage ranges from a high of $14,138 (Massachusetts) to a low of $9,365 (Idaho). For higher-cost areas within certain states, HHS may provide additional 2010 imaginary benchmark amounts later on. Calculating the Allowable Credit after the Phase-Out RuleAn employer’s allowable credit (the amount that can actually be claimed on the employer’s federal income tax return) equals the tentative credit (based on 35% of the applicable healthcare cost figure) only when the employer has (1) 10 or fewer FTE employees and (2) an average FTE wage of $25,000 or less. If the employer has more employees and/or a higher average wage, the allowable credit is quickly reduced under a complicated two-tiered phase-out rule. Here is the drill. Tier 1 Phase-Out FactorThe tentative credit amount is reduced by a phase-out factor that depends on the number of FTE employees in excess of 10. Specifically, the tentative credit is reduced by 6.667% for each excess employee. For instance, say your client’s business has 15 FTE employees. It has five excess employees, and the tier 1 phase-out factor is therefore 33.335% (5 × 6.667%). Once a business hits 25 FTE employees, the allowable credit is reduced to zero because the tier 1 phase-out factor is 100%. However, if the business has 10 or fewer FTE employees, the tier 1 phase-out factor is inapplicable. Tier 2 Phase-Out FactorThe tentative credit amount is also reduced by a second phase-out factor that depends on the average FTE wage in excess of $25,000. Specifically, the tentative credit is reduced by 4% for each $1,000 of excess wage. For instance, say your client’s business has an average FTE wage of $35,000. The excess wage is $10,000, and the tier 2 phase-out factor is therefore 40% (10 × 4%). Once the business hits an average FTE wage of $50,000, the allowable credit is reduced to zero because the tier 2 phase-out factor is 100%. However, if the average FTE wage is $25,000 or less, the tier 2 phase-out factor is inapplicable. ExampleGentle Partnership is a qualifying small employer with 15 FTE employees and an average FTE wage of $35,000. Assume Gentle’s tentative credit is $37,800 (35% × $108,000 of real-world healthcare costs). Since Gentle has five excess employees, the tier 1 phase-out factor reduces the tentative credit by 33.335%, or $12,600 (33.335% × $37,800). Since Gentle has $10,000 of excess FTE wage, the tier 2 phase-out factor reduces the tentative credit by another 40%, or $15,120 (40% × 37,800). Therefore, Gentle’s allowable credit is only $10,080 ($37,800 - $12,600 - $15,120). This amounts to an effective credit rate of only 9.33% (credit of $10,080 for $108,000 of healthcare costs) versus the maximum rate of 35%. When all is said and done, the credit will only provide truly meaningful benefits to truly small employers that pay truly modest wages. In the real world, however, such employers are the least likely to have any interest in providing company-paid health coverage.Impact of Offering Several Types of Healthcare CoverageSome small employers may offer several different types of qualifying health insurance coverage such as major medical coverage, dental coverage, and vision care coverage. Each type of coverage must be tested separately for purposes of meeting the requirement to pay at least 50% of the cost. For instance, say the employer pays 50% of the cost for major medical coverage and 25% of the cost of dental and vision care coverage. Only the cost of the major medical coverage can be taken into account for purposes of calculating the credit. In addition, offering several types of coverage has no impact on the imaginary benchmark cost limitation rule. For instance, say an especially generous employer pays 50% of the cost for major medical, dental, and vision care coverage. Costs for dental and vision care coverage are not included in the state-by-state imaginary benchmark cost figures. If 50% of the applicable imaginary benchmark cost is less than the employer’s real-world cost to provide the more-generous coverage, the credit calculation will be based on 50% of the applicable imaginary benchmark cost. Sorry about that! Special Rules for Tax-Exempt Small EmployersFor qualified small employers that happen to be tax-exempt not-for-profit organizations, the maximum credit percentage is 25%, and the phase-out rule explained above applies to them too. In addition, the allowable credit amount for the year cannot exceed the sum of (1) federal income tax and 1.45% Medicare tax withheld from employee wages for that year plus (2) the employer’s 1.45% Medicare tax on wages for that year. Since there is no federal income tax liability to offset, the allowable credit amount for a tax-exempt employer is refunded to the employer in cash. Other ConsiderationsAs we said earlier, the credit can be claimed for eligible healthcare costs incurred in tax years beginning in 2010 before the healthcare legislation was enacted. (See Notice 2010-44.)An employer’s federal income tax deduction for employee healthcare costs is reduced by the amount of the credit. [See IRC Sec. 280C(h).]The credit is classified as a specified general business credit, under IRC Sec. 38(b) and (c). As such, the credit can be used to offset both regular federal income tax and any AMT. It cannot be used to offset federal employment tax liabilities. Any unused credit amount can be carried back for one year (but not to any pre-2010 year) and ahead for 20 years. Therefore, unused credits for tax years beginning in 2010 can only be carried forward. (See Notice 2010-44.)See Notice 2010-44 for guidance on how state health insurance credits and subsidies impact the credit. Last but not least, we make the observation that in this economy, it is exceedingly doubtful that the credit will induce many small businesses to suddenly start providing employee health coverage. The fact that the credit rules are too complicated to be easily explained does not help matters. Presumably, a fair number of small businesses that already provide health coverage will qualify for the credit, and we hope some of your clients fit into that category.Small Business Alert: TemporaryPayroll Tax Breaks for Hiring Relatives In a weak economy, keeping more money within the family unit is a worthy goal. For small business clients, one way to accomplish that goal is to hire family members instead of outsiders when additional workers are needed. Great idea! As a bonus, your client might qualify for two temporary payroll tax breaks. As you will see, the odds of collecting these breaks are much better if the newly hired relative happens to be the business owner’s spouse rather than some other relative. Here is the story. Temporary Social Security Tax Break for Wages Paid to New Hires The Hiring Incentives to Restore Employment (HIRE) Act, which became law in March of 2010, grants a temporary employer Social Security tax exemption for wages paid by a qualified employer to a qualified new employee between 3/19/10 and 12/31/10. Specifically, such wages are exempt from the 6.2% employer portion of the Social Security tax. [See IRC Sec. 3111(d).] We will call this new break the Social Security tax exemption. Key Point. There is no change in the 6.2% employee portion of the Social Security tax on wages that are collected via FICA tax withholding from employee paychecks. There is also no change in the 2.9% Medicare tax on wages (1.45% is paid in via FICA tax withholding from employee paychecks, with the other 1.45% paid by the employer). For each qualified new employee, the employer’s 2010 Social Security tax bill can be cut by a maximum of $6,621.60 (6.2% × $106,800 Social Security tax ceiling = $6,621.60). The tax savings will be less if the qualified new employee’s wages paid during the exemption period (3/19/10 through 12/31/10) are below the $106,800 Social Security tax ceiling (which will usually be the case). Hiring a qualified new employee sooner rather than later will usually result in more tax savings.Key Point. According to FAQs About Claiming the Payroll Exemption on the IRS website, the Social Security tax exemption applies to wages paid between 3/19/10 and 12/31/10 as opposed to wages paid for work performed between those dates. (See PE7.) Qualified Employers Include All Private-Sector Businesses Qualified employers include private-sector businesses as well as tax-exempt not-for-profit organizations and certain public higher-education institutions (other public employers are ineligible). [See IRC Sec. 3111(d)(2).] Qualified New Employees Can Include Owner’s Spouse (Maybe Other Relatives Too) A qualified new employee is a worker who begins employment between 2/4/10 and 12/31/10 and who was not employed for more than 40 hours during the 60-day period ending on the start date. Both part-time and full-time workers can meet this description. However, the Social Security tax exemption is not allowed for wages paid to a worker who is hired to replace another worker, unless that person quit voluntarily or was discharged for cause. According to updated instructions to Forms W-2 and W-3, being discharged in a downsizing counts as being discharged for cause.The new worker must certify with a signed affidavit that he or she was not employed for more than 40 hours during the 60-day period ending on the start date. [See IRC Sec. 3111(d)(3).] The certification can be made by completing and signing new IRS Form W-11 (Hiring Incentives to Restore Employment (HIRE) Act Employee Affidavit). The Form W-11 is not turned in to the IRS, but it should be kept with the employer’s tax records. Mind the Related-Party Disallowance Rules Here is where it gets interesting for small employers. The Social Security tax exemption is disallowed for wages paid to any person who fits the general description of a qualified new employee but who has a prohibited relationship to the employer under the same related-party disallowance rules that apply for purposes of the Work Opportunity Tax Credit (WOTC). [See IRC Secs. 3111(d)(3)(D) and 51(i)(1).] We will call such workers ineligible employees. Related-Party Rule for Employers Treated as Individuals When the employer is a sole proprietorship or (presumably) a single-member LLC that is treated as a sole proprietorship for tax purposes, the employer is considered to be an individual taxpayer for purposes of the Social Security tax exemption. In this case, ineligible employees are defined by reference to the list of persons who can potentially be qualifying relatives of the taxpayer (employer) for purposes of claiming dependent exemption deductions. These persons include (1) the taxpayer’s (employer’s) child, including a stepchild, adopted child, eligible foster child, or descendant of the taxpayer’s child (most often a grandchild); (2) the taxpayer’s (employer’s) brother, stepbrother, half brother, sister, stepsister, half sister, or a descendent of one of these individuals (most often a niece or nephew); (3) the taxpayer’s (employer’s) son-in-law, daughter-in-law, father, stepfather, father-in-law, mother, stepmother, mother-in-law, brother-in-law, sister-in-law, aunt, or uncle; and (4) any non-relative who is classified as the taxpayer’s (employer’s) dependent because the person lives in the same household. [See IRC Sec. 51(i)(1) and IRC Sec 152(d)(2)(A) through (H).] Somewhat surprisingly, the taxpayer’s (employer’s) spouse does not appear on the list of ineligible employees. This means that wages paid to a newly hired spouse are eligible for the Social Security tax exemption if the spouse fits the general description of a qualified new employee (previously unemployed, hired between the magic dates, and so on). Key Point. Most other new hires who are related to the taxpayer (including in-laws) will be on the list of ineligible employees. ExampleHank operates his business as a sole proprietorship. Therefore, he is treated as the employer if the business has any employees. Assume Hank hires his unemployed wife, Helen, who meets the description of a qualified new employee. Hank can take advantage of the Social Security tax exemption for wages paid to Helen between 3/19/10 and 12/31/10. However, if Hank also hires his unemployed son, Harry, he is an ineligible employee because of his prohibited relationship (son) with the employer (Hank). Related-Party Rule for Corporate Employers When the employer is a corporation, ineligible employees include (1) any relatives (as defined earlier) of an individual who owns [directly or indirectly under IRC Sec. 267(c)] more than 50% of the employer’s stock and (2) any dependents of any relatives (as defined earlier) of a more-than 50%-shareholder. [See IRC Sec. 51(i)(1).] Under this rule, the spouse of a majority shareholder will not be an ineligible employee except in highly unusual circumstances. This means that wages paid to a majority shareholder’s spouse will almost always be eligible for the Social Security tax exemption if the spouse fits the general description of a qualified new employee (previously unemployed, hired between the magic dates, and so on). Most other new hires who are related to a majority shareholder (including in-laws) will be ineligible employees. However, new hires who are only related to minority shareholders (taking into account both direct and indirect stock ownership) can be eligible if they fit the description of a qualified new employee. This can include relatives who are students hired to work over the summer. ExampleDonald, Enid, and Floyd each own one-third of the shares in DEF, Inc. They are not related. Assume DEF hires Enid’s unemployed husband, Edward, who meets the description of a qualified new employee. DEF can take advantage of the Social Security tax exemption for wages paid to Edward between 3/19/10 and 12/31/10. Assume DEF also hires Donald’s unemployed son, Dale, and Floyd’s unemployed daughter, Fern. They both meet the qualified new employee description. DEF can take advantage of the Social Security tax exemption for wages paid to Dale and Fern between 3/19/10 and 12/31/10, because being related to minority shareholders does not disqualify them. Warning. With family corporations, the related-party rule can be tricky, as the following example illustrates. ExampleJoe owns 60% of the shares in Joeco, Inc. Assume Joeco hires Joe’s unemployed wife, Jill, who meets the description of a qualified new employee. Joeco can take advantage of the Social Security tax exemption for wages paid to Jill between 3/19/10 and 12/31/10. Assume Joe’s daughter June owns the other 40% of Joeco’s stock. If Joeco hires June’s unemployed husband, Jeff, he is an ineligible employee because he has a prohibited relationship (son-in-law) with Joe, who is the employer’s majority shareholder. However, if June was unrelated to Joe, her husband Jeff could meet the description of a qualified new employee because being related to a minority shareholder (June) would not disqualify him. Related-Party Rule for Partnership Employers When the employer is a partnership or (presumably) a multi-member LLC that is treated as a partnership for tax purposes, ineligible employees are any relatives (as defined earlier) of an individual who owns [directly or indirectly under IRC Sec. 267(c)] more than a 50% interest in the partnership’s capital and profits. [See IRC Sec. 51(i)(1).] Under this rule, the spouse of a majority partner will not be an ineligible employee. This means that wages paid to a majority partner’s spouse will be eligible for the Social Security tax exemption if the spouse fits the general description of a qualified new employee (previously unemployed, hired between the magic dates, and so on). Most other new hires who are related to a majority partner (including in-laws) will be ineligible employees. However, new hires who are only related to minority partners (taking into account both direct and indirect ownership) can be eligible if they fit the description of a qualified new employee. This can include relatives who are students hired to work over the summer. ExampleGlenda, Hank, and Ingrid are equal one-third partners in the GHI Partnership. They are not related. Assume GHI hires Glenda’s unemployed husband, Glen, who meets the description of a qualified new employee. GHI can take advantage of the Social Security tax exemption for wages paid to Glen between 3/19/10 and 12/31/10. Assume GHI also hires Hank’s unemployed daughter, Helen, and Ingrid’s unemployed son, Irving. They both meet the qualified new employee description. GHI can take advantage of the Social Security tax exemption for wages paid to Helen and Irving between 3/19/10 and 12/31/10, because being related to minority partners does not disqualify them. Warning. With family partnerships, the related-party rule can be tricky, as the following example illustrates. ExampleRich is a 51% partner in the RS Partnership. Assume RS hires Rich’s unemployed wife, Rowena, who meets the description of a qualified new employee. RS can take advantage of the Social Security tax exemption for wages paid to Rowena between 3/19/10 and 12/31/10. Assume Rich’s daughter Rylee owns the other 49% of RS. If RS hires Rylee’s unemployed husband, Ron, he is an ineligible employee because he has a prohibited relationship (son-in-law) with Rich, who is the employer’s majority partner. However, if Rylee was unrelated to Rich, her husband Ron could meet the description of a qualified new employee because being related to a minority shareholder (Rylee) would not disqualify him. Temporary Tax Credit for Retaining New Hires In addition to the temporary Social Security tax exemption, the HIRE Act also grants a temporary tax credit of up to $1,000 for wages paid to each qualified new employee, using the same definition as for the Social Security tax exemption (the worker must begin employment between 2/4/10 and 12/31/10, have been unemployed during the 60-day period ending on the start date, and so on). However, the employer must meet two additional requirements to claim the credit: (1) the new hire must be retained for at least 52 consecutive weeks, and (2) wages paid during the second 26 weeks of the 52-week period must equal at least 80% of wages paid during the first 26 weeks of that period. (See Section 102 of the HIRE Act.) We will call this new break the employee retention credit. To be clear, the employer can claim the Social Security tax exemption for wages paid to a qualified new employee between 3/19/10 and 12/31/10, and the employer can also claim the employee retention credit if the two additional requirements are met for the worker in question. Claiming one break does not prevent claiming the other. Calculating and Claiming the Credit The employee retention credit amount equals the lesser of (1) 6.2% of wages paid to the qualified new employee during the 52-consecutive-week period or (2) $1,000. To claim the maximum $1,000 credit, the new hire must be paid at least $16,130 during the 52-week period (6.2% × $16,130 = $1,000). In contrast to the Social Security tax exemption, hiring an eligible worker any sooner than 12/31/10 will not result in a larger tax benefit for the employer. That is because the full $1,000 employee retention credit can potentially be claimed for a new hire who starts work any time between 2/4/10 and 12/31/10. Key Point. To summarize so far, the credit is a one-time tax benefit for each eligible worker, and the credit amount is based on wages paid during the 52-week period that begins with that worker’s employment date. The credit is allowed for the tax year during which the 52-week requirement is first met for the worker in question. Since that requirement cannot possibly be met any sooner than February of 2011, the credit cannot be claimed for tax years that end in 2010 (for calendar-year employers, the credit can be claimed on calendar-year 2011 returns). The credit is implemented via an increase in the general business credit under IRC Sec. 38(b). No portion of any unused Section 38(b) credit that is attributable to the retained employee credit can be carried back to any tax year that begins before 3/18/10. Taken together, these timing rules ensure that the credit will not result in any immediate tax-saving gratification for employers. Qualified New Employees Can Include Owner’s Spouse (Maybe Other Relatives Too) When a business owner’s newly-hired spouse or relative fits the description of a qualified new employee for purposes of the Social Security tax exemption, that person is also a qualified new employee for purposes of the employee retention credit, assuming the two additional requirements for the credit are satisfied. See the earlier discussion and examples regarding when spouses and other relatives can be qualified new employees for purposes of the Social Security tax exemption. The exact same considerations apply for purposes of the employee retention credit (assuming the two additional requirements for the credit are met for the person in question). Work Opportunity Tax Credit (WOTC) Considerations When wages paid to a qualified new employee are eligible for both the Social Security tax exemption and the WOTC, the employer can “elect out” of the Social Security tax exemption and instead claim the WOTC. For lower-paid workers, the WOTC will often be more lucrative. Without an election out, however, the WOTC cannot be claimed for wages paid during the one-year period beginning on the qualified new employee’s hiring date. [See IRC Secs. 3111(d)(4) and 51(c)(5).] The election out can be made on an employee-by-employee basis by simply not claiming the Social Security tax exemption for the employee in question. (See PE8 and PE9 in FAQs About Claiming the Payroll Exemption on the IRS website.) When wages paid to a qualified new employee are eligible for both the employee retention credit and the WOTC, both breaks can be claimed. In other words, claiming one does not prevent claiming the other. (See PE11 in FAQs About Claiming the Payroll Exemption on the IRS website.) Key Point. The WOTC can only be claimed for wages paid to newly hired members of targeted groups (such as qualified veterans, qualified felons, qualified summer youth employees, long-term family assistance recipients, and so on). Spouses and other relatives of small business owners are not terribly likely to be members of targeted groups, so the WOTC coordination issue may be irrelevant in most real-life situations. The Bottom LineThe availability of the two temporary tax breaks explained in this section do not make the case for hiring a spouse or relative. That said, these breaks can be meaningful for small business owners who were going hire spouses or relatives anyway. If so, great! But watch out for the related-party loss disallowance rules. They are tricky, especially in situations where businesses are owned by several related individuals. Healthcare Legislation Imposes Burdensome New Form 1099 Reporting Requirements (Starting in 2012)Businesses have grown accustomed to existing requirements to report certain types of payments on annual Form 1099 information returns. However, the healthcare legislation enacted in March of 2010 adds new Form 1099 reporting requirements. Complying with them may add significantly to your small business clients’ paperwork burdens. While the new rules do not apply to payments made before 2012, it may not be too soon to start helping clients gear up to deal with them. This section gives you a quick summary of what you need to know right now. Key Point. The healthcare legislation does not require Form 1099 reporting of payments that are made for non-business reasons. Current Form 1099 Reporting Rules in a NutshellFor many years, businesses have been required to report various types of payments on various versions of Form 1099. For instance, when a business pays $600 or more during a calendar year to an independent contractor for services, the business must issue the contractor a Form 1099-MISC that reports the total amount paid in that year. The business must also furnish a copy of the Form 1099-MISC to the IRS. This reporting procedure helps the contractor remember to include the payments as income on his tax return, and it helps the IRS to make sure that happens. Fair enough. Under the current rules, other types of payments that businesses must report on Forms 1099 include (1) commissions, fees, and other forms of compensation paid to a single recipient when the total amount paid in a calendar year is $600 or more; and (2) interest, rents, royalties, annuities, and other income items paid to a single recipient when the total amount paid in a calendar year is $600 or more. When a Form 1099 is required, it must show the total amount of payments in the calendar year, the name and address of the payee, the tax ID number (TIN) of the payee (for privacy reasons, it is okay to show a truncated TIN on a 1099 issued to an individual payee), contact information for the payer, and the payer’s TIN.If the business does not have a payee’s TIN, it may be required to institute backup federal income tax withholding at a 28% rate on payments to that payee. (See IRC Sec. 3406.) In most cases, the rules summarized above apply equally to payments made by non-profit organizations, because they are generally considered to be businesses for Form 1099 reporting purposes. If a payer inadvertently fails to issue a proper Form 1099, the IRS can assess a $50 penalty. The penalty for each intentional failure can be $100 or more. (See IRC Secs. 6721, 6722, and 6723.) Most Payments to Corporations Need Not Be Reported under Current Rules Under the rules that apply right now, most payments to corporations are exempt from any Form 1099 reporting requirements. Naturally, there are a few exceptions. For instance, payments of $600 or more in a calendar year to a corporate law firm must be reported on a Form 1099-MISC for that year.ExampleBillco, LLC makes monthly payments to rent office space from a corporate lessor. Under the current rules that apply through the end of 2011, there is no Form 1099 reporting requirement for the payments, because they are made to a corporation. Payments for Property Need Not Be Reported under Current Rules Under the rules that apply right now, there is generally no requirement to issue Forms 1099 to report payments for property (merchandise, raw materials, equipment, and just about anything else you can put your hands on).ExampleRetail Associates, LLC buys a delivery van, display shelving, and computer equipment. Under the current rules that apply through the end of 2011, there is no Form 1099 reporting requirement for these payments, because they are for property. Healthcare Legislation Changes the Deal for 2012 and BeyondThe healthcare legislation makes two big changes to the existing Form 1099 reporting rules and a third change that is hard to assess without further guidance. [See IRC Sec. 6041(a), (i), and (h).] Change No. 1: Payments to Corporations Must Be Reported Starting in 2012, if a business pays a corporation $600 or more in a calendar year, it must report the total amount of the payments on an information return for that year. Presumably, Form 1099-MISC will be used for this purpose, or a new type of Form 1099 will be developed. (Payments to corporations that are tax-exempt organizations will be exempt from this new requirement.) ExampleBizco, Inc. pays $30,000 to rent office space from a corporate lessor. Under the new rule that will take effect in 2012, the $30,000 must be reported on a Form 1099. Before 2012, most payments to corporations are exempt from any Form 1099 reporting requirements. In 2012, Bizco pays $2,000 for four employees to attend a seminar put on by a corporation in the seminar business. Under the new rule that will take effect in 2012, the $2,000 must be reported on a Form 1099. In 2012, several of Bizco’s employees go on a business trip, and Bizco pays $1,500 to a hotel operated by a corporation. Under the new rule that will take effect in 2012, the $1,500 must be reported on a Form 1099. In 2012, Bizco spends $1,000 at a local restaurant for a modest holiday gathering for employees. The restaurant is operated by a corporation. Under the new rule that will take effect in 2012, the $1,000 must be reported on a Form 1099. As you can see, the new requirement to report payments to corporations will undoubtedly result in the issuance of many millions of additional Forms 1099 each year. (Presumably, payments between related corporations will not be exempted.) Also, businesses must obtain a TIN from each corporate payee to avoid the requirement for backup withholding of federal income tax. On the other side of the coin, if your client runs a corporate business, it will have to supply customers with the company’s TIN to avoid backup withholding on payments to it. Change No. 2: Payments for Property Must Be ReportedStarting in 2012, if a business pays $600 or more in a calendar year to any payee (including an individual) as “amounts in consideration for property,” the total amount of such payments must be reported on an information return for that year. Once again, the term “property” means equipment, merchandise, raw materials, and just about anything else you can put your hands on. Presumably, Form 1099-MISC will be used to reported affected payments, or a new type of Form 1099 will be developed for this purpose. ExampleFargo, Inc. buys equipment from a supplier for $25,000. Under the new rule that will take effect in 2012, the $25,000 must be reported on a Form 1099. Before 2012, payments for property are exempt from any Form 1099 reporting requirements. In 2012, Fargo buys inventory from a supplier for $20,000. The $20,000 must be reported on a Form 1099.In 2012, Fargo buys an old pickup truck from an individual for $1,500. The $1,500 must be reported on a Form 1099. In 2012, Fargo spends $1,000 at a specialty food and liquor store to buy food and beverages for a company party. The $1,000 must be reported on a Form 1099. In 2012, Fargo spends $750 at an office supply store for supplies. The $750 must be reported on a Form 1099. As you can see, the new requirement to report payments for property will undoubtedly result in the issuance of many millions of additional Forms 1099 each year. For each payee that must be issued a Form 1099, the payer must obtain a TIN in order to avoid the requirement to institute backup withholding of federal income tax. On the other side of the coin, if your client’s business sells property, it will have to supply customers with its TIN to avoid backup withholding on payments to it.Change No. 3: Payments of “Gross Proceeds” Must Be Reported In general, the current Form 1099 reporting rules do not attempt to cover payments where the payer cannot determine the payee’s taxable profit or gain. One exception is for payments to a non-corporate service provider, such as an independent contractor. Under the current rules, when the gross amount of payments to a non-corporate service provider in a calendar year add up to $600 or more, the total must be reported as non-employee compensation on a Form 1099 for that year. We understand that. Now it gets a little confusing. Under a third new rule that will take effect in 2012, payments of $600 or more in “gross proceeds” to a payee in a calendar year must be reported on an information return for that year. Perhaps this new gross proceeds rule is intended to force businesses to issue 1099s for payments to non-corporate payees such as restaurants, motels, gas stations, repair shops, and seminar providers. We await IRS clarification on this issue. Action PlanDealing with the new Form 1099 reporting rules is not going to be any fun. The more you think about it, the more this truth becomes self-evident. Your client’s business may have to modify its accounting procedures to capture payee information that will be needed to comply with the new rules. One key point to remember is that TINs must be obtained from vendors to avoid having to institute backup federal income tax withholding on payments made to them. By the same token, your client’s business will have to make sure that its customers have its TIN to avoid backup withholding on payments made to it. And if backup withholding does occur on payments made to your client’s business, it must be prepared to track the withheld amounts so credit can be claimed for them at tax return time. [See IRC Sec. 31(c).] If your client’s business winds up on either side of the backup withholding rules, it can be a real mess. And with lots more 1099s flying around, the odds rise proportionately for TIN screw-ups that will result in backup withholding messes. Fortunately, the new Form 1099 reporting rules (including any backup withholding implications) do not cover payments made before 2012. So there is still plenty of time to help clients plan for what may be a daunting compliance task. Do not waste that time!Key Point. The IRS Commissioner has informally stated that businesses will not have to issue 1099s for payments made with credit or debit cards, because those payments are already covered by existing information reporting requirements. ................
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