New Utah Sales Factor Weighted Taxpayer Apportionment Rule Begins with 2011 Tax Returns

A business that has nexus in Utah and in other states must divide its business income among the states through a process called apportionment.  Nexus means that the business has enough physical or economic attachment to a state to require the filing of income tax returns and the payment of tax.  Apportionment has traditionally used a three-factor formula to divide business income:  an average of (1) the percentage of property owned or rented in the state, (2) the percentage of employee wages paid in the state, and (3) the percentage of sales to customers in the state.

States have become much more aggressive in seeking business development from multistate businesses.  Many states have changed from the equal weighting of the traditional three-factor formula to over-weighting the sales factor, or even adopting a single sales factor.  Increasing the sales factor portion of the apportionment percentage tends to favor businesses who use a large amount of property, plant, and equipment and/or who employ a lot of labor in the state in relation to the amount of sales to customers in the state.  Utah has made changes to its sales factor in response to the evolving apportionment landscape.

For tax years beginning after 2010, every multistate taxpayer must determine if they are a "Sales Factor Weighted Taxpayer (SFWT)."  A SFWT is a taxpayer having greater than 50 percent of total sales (everywhere, not just in Utah) generated by economic activities classified in the 2002 or 2007 North American Industry Classification System (NAICS) code from activities other than:

1. Section 21, Mining;
2. Sections 31-33, Manufacturing;
3. Sections 48-49, Transportation and Warehousing;
4. Section 51, Information (except for Subsector 519, Other Information Services); or
5. Section 52, Finance and Insurance.

A taxpayer who is a partner in a partnership must include their pro-rata share of the partnership's sales in determining whether it meets the 50 percent of total sales everywhere requirement.  The NAICS can be found at http://www.naics.com/.

Utah is increasing the sales factor weighting over a period of years for SFWTs.  For tax years beginning in 2011, the sales factor receives a four times weighting in the traditional three-factor formula.  For tax years beginning in 2012, the sales factor receives a 10 times weighting.  For tax years beginning in 2013 and later, the apportionment formula for SFWTs will change from three-factors to a single-sales factor apportionment formula.  Multistate taxpayers that are not SFWTs continue using the traditional, equal-weighted three-factor formula, or they may make an election to double weight the sales factor in the traditional apportionment calculation.

Understanding the Real Estate Professional Exception to the Passive Activity Loss Rules

The 1986 Tax Reform Act introduced the concept of passive activity loss (PAL) limitations.  Prior to the PAL rules, taxpayers could invest in businesses in which they did not work and deduct tax losses against their earnings and investment income.  While the passive activity rules generally restrict the deduction of PALs to passive activity income, certain exceptions apply.  A passive activity includes any rental activity.  It also includes any business in which an individual does not materially participate.  Material participation in a business can be met under one of seven tests set forth in tax regulations.  The general standard is that an owner must work at least 500 hours during a year in the business in order to deduct a loss against nonpassive income.

As a general rule, losses from rental real estate activities are always passive.  A special rule, known as the "real estate professional" exception, permits real estate losses to be reclassified as nonpassive.  Nonpassive losses are deductible against any category of income.  However, the requirements for meeting the real estate professional exception are often misunderstood.  Each real estate rental property is considered to be a separate activity unless an election is made to group the properties as a single activity.  This grouping election is an important factor in meeting the requirements of the real estate professional exception.

A real estate professional must first meet a two-prong test.  Then the individual must materially participate in his or her real estate rental activities.  The two-prong test requires that an individual spend more than 50% of his or her working time in "real property trades or businesses" in which the individual materially participates, and that the amount of this time exceeds 750 hours during the year.  Time worked as an employee does not count unless the individual owns more than 5% of the company with whom he or she is employed.  Real property trades or businesses include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.  The misunderstanding is that meeting these two prongs is enough to change passive real estate rental losses into a nonpassive losses.

After qualifying as a "real estate professional," the individual must also materially participate in each real estate rental activity.  Material participation will be impossible if the taxpayer does not elect to group separate real estate rental activities into one activity, because it isn't possible to work 500 hours or more in each separate activity when several properties are involved.  The grouping election is made in the income tax return and is effective for future tax years.  In the event of an audit, the IRS insists that detailed time logs be produced to prove that both the two-prong test and the material participation test are met.

Estate Tax Returns Required for Portability of Unused Exemption

Significant estate tax changes were enacted at the end of 2010.  See my blog post of December 27, 2010 for more information.  One of the changes concerns "portability."  Portability enables the surviving spouse to add to his or her $5 million ($5.12 million in 2012) lifetime exemption from estate tax the amount of unused lifetime exemption belonging to his or her deceased spouse.  As enacted, portability only applies to deaths in 2011 and 2012.  For example, if the husband died in 2011 with a gross estate of $2 million, the husband's unused lifetime exemption amount would be $3 million (assuming no prior taxable gifts).  Thus, if portability is elected by the personal representative, the wife's exemption from estate tax increases from $5 million to $8 million.  If no election is made, the unused $3 million exemption is wasted.  Note that portability does not apply for generation-skipping transfer tax purposes and does not apply for deaths after 2012.

Portability must be "elected" by filing a regular estate tax return for the deceased spouse by the nine-month due date of the estate tax return.  A six month extension is available if the extension form is timely filed.  According to IRS instructions, the estate return must be completed with all required calculations, appraisals, and attachments.  Normally, an estate tax return is not required to be filed for a decedent having a gross estate under the exemption amount.  Therefore the estate's personal representative must be aware of the requirement to timely file the estate tax return (when it otherwise is not required) in order to preserve any unused lifetime exemption for the surviving spouse under the portability provisions.

New Reporting of Specified Foreign Financial Assets

New Form 8938, Statement of Specified Foreign Financial Assets, is required to be completed for 2011 and future income tax returns.  This is the federal government's attempt to increase tax compliance by gathering more information about taxpayers' foreign assets.  Significant civil and criminal penalties apply if the form is not filed as required.  The statue of limitations is also suspended if Form 8938 is not filed when required.  Currently only individuals must file Form 8938.  The IRS plans to issue regulations that will require entities to file the form if the entity is formed or availed of to hold specified foreign financial assets and the value of the assets exceeds the filing threshold.  See more information at www.irs.gov/formspubs/article/0,,id=248113,00.html.

Different thresholds apply to require the filing of Form 8938 depending upon whether you are married and whether you live in or outside of the United States.  See the Form 8938 instructions.  Generally, you should be concerned about whether Form 8938 is required to be completed if the aggregate value of your foreign assets and accounts exceeds $50,000 ($100,000 if married) on the last day of the year or exceeded $75,000 ($150,000 if married) at any time during the year.  The specified foreign financial assets that must be reported include:

• Depository or custodial accounts maintained at foreign financial institutions,
• Foreign retirement accounts,
• Direct ownership of stock, security, other form of ownership interest in a foreign entity; and any direct ownership of a financial instrument or contract with a foreign person or entity (outside of an account at a foreign financial institution),
• Foreign life insurance products,
• Foreign partnership interests, such as foreign hedge funds and foreign private equity funds,
• Foreign deferred compensation arrangements, and
• Beneficial interests in foreign trusts or estates.

Form 8938 not only requires disclosure of your specified foreign financial assets, the form also requires that you disclose the specific tax form or schedule on which you have reported the income and deductions attributable to the foreign asset.  This is a complex form and it will require a significant amount of time to understand and to complete.

Filing Form 8938 does not relieve you of the requirement to also file Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR) that is due each June 30th and is filed with the U.S. Treasury Department, separate from your income tax return.

New Form 1099 Compliance Question on 2011 Tax Return Forms

Over the years, Congress has dramatically increased the penalties for not filing Forms 1099 (or filing incorrect 1099 forms) when required.  At the same time, Congress and the IRS have increased the complexities of completing these forms.  Now, as a "coup de grace," the IRS has added a question to each of the business entity tax returns, and also to individual sole proprietor business forms (e.g. Schedules C and F), where you must respond to whether you made payments during 2011 for which Forms 1099 were required to be completed, and if so, did you file ALL of the required forms?  Since tax returns must be signed under penalties of perjury, the IRS has "gotcha" if you answer favorably but didn't fully comply.

The IRS is trying to close the "tax gap" by catching people who don't pay income tax on all of their earnings.  Using IRS computers to match income reported by payers to the tax returns of payees is an efficient way for the IRS to audit income.  However, the burdens on business have been greatly increased by forcing businesses to report the amount of money paid to other businesses and people.  I counted 30 different types of information reporting forms in the 2011 Form 1099 instructions!  There are even more information reporting forms not included in the 1099 family, such as Schedule K-1's, Form 8594 for business asset purchases, and Form 8937 for corporate distributions affecting stock basis.  Companies must install adequate software systems to keep track of the information that must be reported in order to avoid significant penalties that in some cases could put them out of business.

Forms 1099 must generally be provided to payees by January 31, 2012.  A 30-day extension may be requested by sending a letter to the IRS.

Forms 1099 must generally be provided to the IRS by February 28, 2012.  Electronic filing is required if 250 or more copies of Form 1099 must be completed.  The 250 test applies separately to each type of Form 1099.  The due date for sending electronic information to the IRS is April 2, 2012.  However, advance approval to file electronically must first be received by filing Form 4419 at least 30 days before the April 2nd due date.  An automatic 30-day extension can be received by filing Form 8809.  In addition, a one-year waiver from filing electronically can be requested on Form 8508 at least 45 days before the due date.

Refer to the IRS instructions for when Forms 1099 are required and the type of information that must be reported.  The penalties for not filing Forms 1099 with correct information when required are shown below.  The amount of the penalty varies upon the timeliness of correcting mistakes and whether your business qualifies as a small business.  A small business is one whose average annual gross receipts for the three most recent prior tax years (or period of existence if shorter) are $5 million or less.  Note that the penalties shown must be doubled because the penalties apply separately, once for not timely providing correct information to payees and again for not timely reporting correct information to the IRS.

1. $30 per 1099 if you correctly file within 30 days of the due date.  Maximum penalty is $250,000 ($75,000 for a small business).
2. $60 per 1099 if you correctly file after 30 days of the due date but by August 1st.  Maximum penalty is $500,000 ($200,000 for a small business).
3. $100 per 1099 if you correctly file after August 1st.  Maximum penalty is $1,500,000 ($500,000 for a small business).
4. Failure to file electronically when required is another $100 per 1099 above 250.
5. Intentionally disregarding the duty to file Forms 1099 when required is $250 per 1099 with no maximum penalty.

Penalties can be waived for reasonable cause, not for willful neglect.  Also, an inconsequential error or omission is not considered a failure to report correct information.  A special de minimis rule applies for corrections made by August 1st; see the instructions.

New Corporate Stock Basis Transaction Reporting Form Due January 17, 2012

The IRS has been developing many new information reporting tax forms to assist them in conducting "behind the scenes" audits of taxpayers.  My blog of January 4, 2012 discusses the new capital gains reporting form, and the fact that brokers must track the tax basis of their customers' stock purchases after 2010.  New Form 8937 applies to corporations that undertake an "organizational action" after 2010 that affects the tax basis of its stock held by its shareholders.  This new form not only assists stockbrokers in tracking stock basis, but also provides information to the IRS for its purposes.  Form 8937 is required to be filed with the IRS by the 45th day following the organizational action (or by January 15th of the following year if that date is earlier than the 45th day).  A transition rule permits the filing of this form for 2011 actions by January 17, 2012.  A late filing penalty of $100 is assessed for each failure to file with the IRS, up to an annual maximum of $1.5 million.  A like penalty also applies for failure to furnish the information to a shareholder.  Information must also be furnished to the shareholders by January 15th of the year following the calendar year of the organizational action.  So the total penalty can be $200 per shareholder up to $3.0 million!

Examples of "organizational actions" that must be reported include the following:

• A non-dividend cash distribution to shareholders (meaning the distribution exceeds "earnings and profits"),
• A stock dividend to shareholders,
• A tax-free stock split,
• A tax-free spin-off,
• A tax-free acquisition,
• A redemption of stock by the corporation, and
• A leveraged recapitalization.

Exceptions from reporting include initial public offerings, the issuance of stock to someone exercising a right to purchase stock, and distributions that will be reported as taxable dividends reported on Form 1099-DIV.  No exception is provided for privately-owned corporations.  In lieu of using Form 8937, corporations can post the information to their primary public website that remains accessible to the public for 10 years.  In addition, an S corporation can avoid using Form 8937 if it reports the effect of the organizational action on a timely filed Schedule K-1 for each shareholder and timely gives a copy to all proper parties.

The very tight reporting deadline means that you may not have all of the information necessary to accurately complete the form.  The IRS instructions state, "To report the quantitative effect on basis by the due date, you may make reasonable assumptions about facts that cannot be determined before the due date.  You must file a corrected return within 45 days of determining facts that result in a different quantitative effect on basis from what was previously reported."  An acquiring or successor entity must satisfy the reporting obligations if the acquired corporation has not done so, as both entities are jointly and severally liable for any penalties.  This new form obviously creates a burdensome obligation upon affected corporations!

New California Law Regarding Worker Misclassification

A new California law (SB 459) became effective January 1, 2012, to make it unlawful to voluntarily and willfully misclassify a worker as an independent contractor instead of an employee in the state.  The new law also states that businesses may not deduct from a misclassified independent contractor any fee or charge for work-related expenses where such amounts are not permitted to be charged against a regular employee's pay.  State civil penalties from $5,000 to $25,000 for each violation may be assessed.  In addition, licensed contractors can lose their state license to operate.  Advisors (other than employees or attorneys) who knowingly advise a business to misclassify a worker as an independent contractor may be jointly and severally liable for these penalties.

Businesses may try and save money by misclassifying their workers as independent contractors.  However, federal and state governments are cracking down on this abuse.  A misclassified worker not only loses out on potential unemployment and workers' compensation benefits, they may also lose out on benefits provided by the business to regular employees.  Furthermore, the government believes it is missing some employment tax revenue when a worker is misclassified because there is no withholding by the employer on the worker's compensation. 

Any mistakes in misclassifying workers should be corrected as soon as possible.  The IRS currently has a Voluntary Classification Settlement Program in effect that permits employers to correct past mistakes in misclassifying workers.  See my blog post dated October 3, 2011.

New Rules for Reporting Capital Gains

The 2011 tax return reporting of capital gain transactions has been substantially modified.  The new procedures are implemented in accordance with the Emergency Economic Stabilization Act of 2008.  The change is expected to increase tax revenues by $6.7 billion over 10 years by increasing the amount of information brokers must report to the IRS on Form 1099-B (or substitute statement) upon the sale of investments.  For publicly traded securities, brokers must now report in addition to the sales date and price, the tax basis and whether the sale is a short-term or long-term capital gain or loss.  The additional information will be used by IRS computers to monitor compliance by taxpayers who might otherwise under-report their capital gains.  The basis information is reported on "covered securities."  Covered securities are defined as follows:

1. Stocks purchased after 2010,
2. Mutual funds and exchange-traded funds (ETFs) purchased after 2011, and
3. Options and bonds purchased after 2012.

In determining the tax basis of covered securities sold, brokers will use either a "first-in, first-out (FIFO)" or "average cost" method.  You have the right to elect to use the "specific identification" method wherein you tell the broker in writing which shares are to be sold.  Most brokers request that you communicate your method to them prior to the sale.  Significant differences in the basis amount can result, depending upon the method used.

Details of capital gains and losses are no longer reported on Schedule D or D-1.  Instead, use new Form 8949, Sales and Other Dispositions of Capital Assets.  Summary amounts are carried from Form 8949 to Schedule D.  The new form requires transactions be sorted into three separate categories using a separate Form 8949 for each category.  If you have both short-term and long-term sales, you could have six separate Forms 8949!  The segregation into categories facilitates IRS computer auditing of your capital gains and losses.  The three categories are:

1. Transactions reported on Form 1099-B with the tax basis reported to the IRS,
2. Transactions reported on Form 1099-B but the tax basis is not reported to the IRS, and
3. Transactions not reported on Form 1099-B.

Brokers may mistakenly report incorrect tax basis to the IRS.  Form 8949 requires any corrections to the tax basis reported to be separately disclosed along with designating a pre-determined code as set forth in the instructions to explain the reason for the correction.

These new reporting rules will increase the cost and burden of compliance.  The rules essentially require taxpayers to do the work normally associated with preparing for an IRS tax audit.