S Corporation Shareholder Loans and Tax Basis

For income tax purposes, the definition of the word “basis” generally means the amount of after-tax investment in an asset.  Basis is a dollar amount that is used in various ways in the tax law, including the following examples:

1.     Basis is subtracted from the selling price of an asset to determine gain or loss.

2.     Basis is the amount that can be depreciated or amortized.

3.     Basis is the tax-free portion of retirement account or annuity distributions.

4.     Basis is the limitation on the amount of tax losses that can be deducted by a partner of a partnership, a member of a limited liability company, or a shareholder of a Subchapter S corporation.  These entities are called “pass-through” entities, meaning that the owner’s allocable share of the entity’s taxable income or loss (as shown on Schedule K-1) is reported on the owner’s income tax return.

Basis generally starts out as the after-tax cost of an asset or investment.  Then adjustments are made to basis depending upon the tax rules that apply.  For example, depreciation deductions reduce the original basis so that a double tax benefit isn’t received when the asset is sold:  once for the depreciation deduction and again in calculating gain or loss if basis isn’t reduced for the depreciation deduction.  When the asset is sold, “adjusted basis” is used in calculating the gain or loss.

For an S corporation shareholder, the original basis in the shares acquired is adjusted upward for allocated income and is adjusted downward for allocated losses and deductions and for distributions.  In addition, a special rule permits a shareholder to increase basis for the amount of loans made by the shareholder to the S corporation.  Unlike for a partnership or an LLC, third-party debt incurred by the S corporation does not increase basis for the shareholder.  Only bona fide shareholder loans to the S corporation create basis.  Loan basis permits the deduction of losses in excess of the shareholder’s basis in the S corporation’s stock.  Loan basis has been a source of controversy between the IRS and taxpayers over the years.  The IRS recently released final regulations governing shareholder loan basis.

The regulations permit loan basis only for bona fide, direct shareholder loans to the S corporation.  Personal guarantees of loans to the corporation made by third parties do not create basis, except when and only to the extent the shareholder actually makes payments under the guarantee.  Taxpayers run into trouble establishing basis when attempting to get around the third party debt limitation on basis if they engage in “circular loans” with a related party or if they do not properly structure “back-to-back” loans with an unrelated third party.  Generally a back-to-back loan will create basis if an independent third party loans money to the shareholder and the shareholder loans that amount to the S corporation in exchange for a promissory note secured with corporate assets.  This promissory note plus collateral of the shareholder is assigned to the third-party lender as security on the loan to the shareholder.  It is critical that the shareholder be directly liable on the third-party loan and not the corporation in order for the back-to-back loan structure to create basis.

How the Health Insurance Premium Assistance Tax Credit Impacts the Self-Employed Health Insurance Income Tax Deduction

Starting in 2014, taxpayers having household income below 400% of the Federal poverty line will receive a premium assistance tax credit if they purchase health insurance on a government health insurance exchange or marketplace.  Currently there is a legal challenge as to whether this credit is permitted if the purchase is made on the Federal exchange instead of on a State exchange (see my previous blog article for a brief description of the challenge).

Generally, self-employed individuals may deduct the cost of health insurance premiums as an adjustment for Adjusted Gross Income.  How is this deduction calculated if a premium assistance tax credit is received?  Surprisingly, the calculation is extremely complicated!  The deduction is limited to the lesser of:  1) the amount of the premiums paid less the premium credit claimed on the tax return, or 2) the sum of the premiums paid as reduced by an advance of the premium credit plus any required repayment of excess premium credits advanced once the income tax return is completed.  Many people ask for the premium assistance tax credit to be advanced in order to reduce their monthly premium cash expense.  Since the amount of the premium credit is based upon an estimate of AGI, a portion of the advance may be required to be repaid on the income tax return if the estimate of household income was too low.  Because household income is based upon modified AGI, and because AGI is reduced by the amount of the self-employed health insurance deduction, the amount of the premium tax credit changes based upon the amount of the deduction, and the deduction changes based upon the amount of the credit!  This is a circular calculation.

In Revenue Procedure 2014-41, the Internal Revenue Service provides instructions on how to compute the self-employed health insurance deduction as impacted by the premium tax credit.  The revenue procedure provides an iterative and an alternative calculation method in an attempt to resolve the circular computation.  Either method may be used.  Based upon the examples provided in the revenue procedure, the amount of the deduction and the amount of the premium credit may both be larger in many cases if the more complex iterative calculation method is used.  These complex calculations will require the use of a computer!  Thus, self-employed taxpayers who qualify for both the deduction and the premium tax credit will need good tax software and/or the services of a tax advisor in order to calculate the deduction and the credit.

Some Updates Regarding the Affordable Care Act

Several interesting developments regarding Obamacare occurred during July 2014.

Premium Tax Credit for Federal Exchanges

One of the primary features of the ACA is the establishment of so-called health insurance exchanges, now termed “marketplaces.”  The law contemplated that the marketplaces would be established by most of the States with a Federal backup for those States that did not establish their own marketplaces.  The reality is that 36 States chose not to establish their own exchanges requiring their citizens to purchase needed health insurance through the Federal exchange.  The ACA provides for substantial premium assistance tax credits to help make health insurance premiums affordable to lower income and middle class individuals and families.  These credits apply to taxpayers “enrolled through an Exchange established by the State” according to the statutory language.  The IRS interpreted this language to include Federal exchanges.  This interpretation was challenged in court and could affect an estimated 5 million people who are receiving the premium tax credit on the Federal exchange.

Two Federal Appeals Courts ruled on this challenge on July 22, 2014.  A three-judge panel of the District of Columbia Circuit Court ruled the IRS interpretation invalid with the consequence that the credits should not be available to those who enrolled through the Federal exchange.  The Fourth Circuit held that the IRS interpretation was consistent with congressional intent.  The conflicting opinions will need to be resolved by the U.S. Supreme Court.  The credit will remain in place for the Federal exchange until final resolution.  On August 1^st, the U.S. Justice Department asked the full District of Columbia Circuit Court to reconsider its opinion, which if it does, could delay the time that this matter will be heard by the U.S. Supreme Court.

Update:  the District of Columbia Circuit Court agreed on September 3, 2014, to rehear the case before the full court and vacated the earlier decision that would deny credits for those enrolling through a Federal exchange.

Second Update:  the U.S. Supreme Court agreed on November 7, 2014, to hear this matter.  If it rules that credits are not permitted for Federal exchanges, the decision could be the death knell for the ACA as health insurance would no longer be affordable by millions of people relying on the credits.

Draft Information Reporting Forms Released

On July 24, 2014, the IRS released drafts of the following information forms to report health insurance coverage:

·       Form 1095-B:  used by health insurance providers (including self-insured employers) to report monthly coverage of individuals.

·       Form 1095-C:  used by employers subject to the mandate to report the offering of health insurance to employees and to list the covered individuals.

·       Form 1094-B:  the transmittal form for submitting Forms 1095-B to the IRS.

·       Form 1094-C:  the transmittal form for submitting Forms 1095-C to the IRS; but this form also requires additional information pertaining to the aggregation of related employers and for indicating whether transition relief for 2015 applies (mid-sized employers having 50 to 99 full-time employee equivalents).

In addition, the IRS released a draft of Form 8965 that is to be used by individuals to report a marketplace-granted coverage exemption (e.g. premiums exceed 8% of household income) or a coverage exemption (e.g. a religious objection) from the individual mandate.  This form informs the IRS why the individual claims exemption from the penalty for not having minimum essential coverage health insurance.

2014 National Bronze-Level Premium Set for Individual Mandate Penalty

Unless an exemption applies, individuals and members of the individual’s tax household must be covered by minimum essential health insurance each month during 2014 or else pay a tax penalty for each month of non-coverage.  An exception is granted once each year for short periods of non-coverage that does not exceed three months.  The penalty is the greater of a flat dollar amount or a percentage of household income, not to exceed the national bronze-level premium amount.  Revenue Procedure 2014-46 sets the bronze-level national premium amount for 2014.  The annual penalty amount is calculated as follows.  Note, the amounts shown below are annual amounts; they should be converted to monthly amounts for purposes of computing the monthly penalty.

·       Flat dollar amount per adult age 18 and older: $95.00.  Flat dollar amount per child under age 18: $47.50.

o   The total flat dollar amount can’t exceed three times the per-adult penalty, so for 2014 the upper limit on the flat dollar amount is $285.

·       The percentage of household income (assessed on the amount in excess of the income tax return filing threshold amount) is 1%.

·       The national bronze coverage premium for each individual to be covered is $2,448 with the premium capped at $12,240 for a family with five or more members.

Deducting Out-of-Pocket Partnership & S Corporation Expenses

Many businesses are operated as tax partnerships and S corporations, including limited liability companies treated as one or the other.  These entities are known as “flow-through” or “pass-through” entities, meaning that the entity’s items of income and deduction are reported on the owners’ personal tax returns via Schedules K-1.  A tax advantage of pass-through entities is the ability for the owner to deduct losses (depending upon tax basis and participation levels) and to avoid double taxation on income and gains.  Sometimes owners will incur unreimbursed expenses relating to their work in the business.  Since the business is operated as a pass-through entity, may the owners claim their unreimbursed expenses as deductions in addition to the amounts reported from Schedule K-1?

Partnerships

In order to deduct an out-of-pocket expense, the regular deduction rules must first be met:  the expense must be incurred in a trade or business and the expense must be ordinary and necessary in nature.  Next, the partnership agreement must be examined.  If the agreement provides for the reimbursement of business expenses incurred directly by the owner, then the owner may not deduct the unreimbursed expense.  In this case, the owner should seek reimbursement so that the partnership may deduct the expense.  If the expenses are of a nature that the owner is expected to pay without reimbursement, then the unreimbursed expenses may be deducted.  It is best that the partnership agreement state that the partners are expected to bear their own expenses without reimbursement such as, for example, expenses incurred to develop or market their business.  Tax form instructions require that deductible unreimbursed expenses be reported on a separate line from the K-1 information.  Note that as a partner, these expenses will be deducted on Schedule E instead of Schedule A.  Schedule A is used by employees and a partner is not considered to be an employee for tax purposes.  A Schedule E business deduction is much more favorable tax-wise than a Schedule A itemized deduction.  In addition to reducing taxable income, such expenses may also reduce self-employment income tax.

S Corporations

Unlike for a partnership, an owner working in an S corporation is considered to be an employee.  Therefore, unreimbursed expenses that are not reimbursable by the corporation may not be deducted on Schedule E even though that is where the K-1 information is reported.  Instead, the expenses must be reported on Schedule A as a miscellaneous itemized deduction.  The Schedule A deduction does not result in income tax savings until total miscellaneous itemized deductions exceed 2% of adjusted gross income.  Furthermore, miscellaneous itemized deductions will not save any income taxes if the owner is subject to the alternative minimum tax.  For these reasons an owner-employee should seek reimbursement from the S corporation so that the business expenses can be deducted by the corporation against business income, thereby avoiding the tax limitations on unreimbursed business expenses.

What is Longevity Insurance?

Longevity insurance, also known as a longevity annuity or a deferred income annuity, is a risk-shifting tool to insure against the risk of outliving your retirement assets.  The risk of outliving retirement assets has become a very real possibility given increasing life expectancies and the decline of employer-provided defined benefit retirement plans.  With longevity insurance, you invest a lump-sum of money now with the objective of waiting for many years (e.g. until age 85) before receiving a stream of payments for the rest of your life.  If you die before the starting date, your heirs receive nothing.  Requesting a payback guarantee so your heirs receive back your investment if you die early will significantly reduce the annuity payment, defeating some of the benefit of the longevity policy.  The objective is to provide an enhanced income stream in your old age when much of your retirement assets may have been depleted.  So in a sense, longevity insurance is like any other insurance policy that pays when some event occurs, such as a car wreck, a fire in your home, etc.  But with longevity insurance, the event is living to a certain age.

The fact that not everyone lives to old age enables the insurance company to pay a fairly high amount in relation to the premium.  The longer you wait to receive the annuity the higher the payout.  However, you must remember that the stated benefit is in future dollars, meaning that the real purchasing power of the annuity will have been reduced by inflation.  For example, assuming a 3% inflation rate, today’s dollar will only buy 55 cents worth of goods and services in 20 years.  Some policies provide an inflation adjustment for an additional premium payment.

Who should consider a longevity annuity?  A person in their 50’s or 60’s who is in good health.  A person having family members who lived to an old age.  Those who have sufficient retirement assets and Social Security or other pension benefits and can afford to make the lump-sum premium payment and wait until the annuity begins.  On the other hand, longevity insurance doesn’t make financial sense for those persons with sufficient money that the risk of outliving their retirement funds is remote.

Generally no more than 10% to 25% of retirement assets would be placed in longevity insurance.  The money paid in is generally not accessible to you during the time period before payout.  The payout amount depends upon your age and upon interest rates at the time of purchase.  The younger you are when purchasing the policy, the higher the future payout.  The higher interest rates are at the time of purchase, the greater the future payout.

Only financially sound and historically stable insurance companies should be considered for this type of policy.  If the insurance company were to fail before you receive your benefits, you would receive nothing or only some amount from the state insurance guaranty fund.  For this reason, it makes sense to use more than one insurance company in order to reduce the risk of loss if an insurance company goes bankrupt.  Longevity insurance policies are relatively new to the financial landscape, and it is anticipated that the policies will improve once more competition arrives.

In the past, purchasing a longevity annuity in an IRA or 401(k) plan has been problematic because of the start of the required minimum distribution (RMD) rules at age 70 ½.  If the RMD isn’t distributed on time, a 50% penalty applies.  Since the longevity annuity doesn’t typically start paying until well after the age of 70 ½, this financial product didn’t fit well within these plans.  However, the government just issued new regulations permitting IRA owners and 401(k) plan participants to invest in qualifying longevity annuity contracts (QLAC) inside their retirement accounts without having to worry about the RMD rules.  In essence, the value of the QLAC is removed from the year-end account value used each year in calculating RMDs.  However, the regulations limit the amount that may be invested in a QLAC to 25% of the account balance or $125,000 whichever is less.  The QLAC must be a fixed annuity but may be adjusted for inflation.  The $125,000 ceiling will be adjusted for inflation in $10,000 increments.  The 25% limit for IRAs is applied by aggregating the account values of all traditional IRAs as of December 31^st of the year before the year the premium is paid.  The QLAC must begin payout no later than age 85.  Each spouse can have his or her own QLAC without impacting the limitations on the other spouse’s IRA or 401(k).  Because Roth IRAs are not subject to the RMD rules during the account owner’s lifetime, there appears to be no limitation on the amount or percentage of a Roth IRA that can be used to purchase a longevity annuity.

IRS Again Revises its Offshore Voluntary Disclosure Program

The Federal government is continuing to use its power to catch taxpayers who did not report their foreign financial accounts and/or pay income tax on the income derived in those accounts.  The U.S. taxes worldwide income of its citizens and residents and requires the disclosure of certain foreign financial accounts and assets.  The rules for determining who must report and what must be reported are exceedingly complex.  Many taxpayers have been blissfully ignorant of the rules.  The government is using the threat of large penalties to encourage taxpayers to catch up on accounts that haven’t been reported in the past.  In the past these threats have not distinguished between taxpayers who ignorantly omitted their foreign disclosures and taxpayers who have willfully concealed their accounts.  Responding to some criticism of their approach, the IRS has revised some of the rules pertaining to the offshore voluntary compliance program.  See their statement dated June 18, 2014.  There appear to be four programs currently in place as described on the IRS website.  Various financial penalties apply.

1.     The Offshore Voluntary Disclosure Program (OVDP) is a voluntary disclosure program specifically designed for taxpayers with exposure to potential criminal liability and/or substantial civil penalties due to a willful failure to report foreign financial assets and pay all tax due in respect of those assets.  OVDP is designed to provide to taxpayers with such exposure (1) protection from criminal liability and (2) terms for resolving their civil tax and penalty obligations.  A special rule under this program requires taxpayers to comply with an August 3, 2014 deadline.  This is the date that FBAR non-filers  who have foreign bank accounts with a foreign financial institution that has been publicly identified as being under investigation, or is cooperating with a government investigation.  See the list here.  If such individuals voluntarily come forward by the deadline, their penalty is reduced to 27.5% of the account balance instead of the 50% penalty that will be imposed if they voluntarily come forward after this date.

2.     “Streamlined” filing compliance procedures are available to taxpayers certifying that their failure to report foreign financial assets and pay all tax due in respect of those assets did not result from willful conduct on their part.  The streamlined procedures are designed to provide to taxpayers in such situations (1) a streamlined procedure for filing amended or delinquent returns and (2) terms for resolving their tax and penalty obligations.  These procedures will be available for an indefinite period until otherwise announced.  The IRS definition of “streamlined” does not mean that a lot of work isn’t necessary to comply with the requirements.

3.     Delinquent FBAR Submission Procedures.  Taxpayers who do not need to use either the OVDP or the Streamlined Filing Compliance Procedures to file delinquent or amended tax returns to report and pay additional tax, but who:  (1) have not filed a required Report of Foreign Bank and Financial Accounts (FBAR) (FinCEN Form 114, previously Form TD F 90-22.1), (2) are not under a civil examination or a criminal investigation by the IRS, and (3) have not already been contacted by the IRS about the delinquent FBARs should file the delinquent FBARs according to the FBAR instructions and include a statement explaining why the FBARs are filed late.

4.     Delinquent International Information Return Submission Procedures.  This program pertains to foreign reporting for forms other than the FBAR.  Taxpayers who do not need to use the OVDP or the Streamlined Filing Compliance Procedures to file delinquent or amended tax returns to report and pay additional tax, but who:  (1) have not filed one or more required international information returns, (2) have reasonable cause for not timely filing the information returns, (3) are not under a civil examination or a criminal investigation by the IRS, and (4) have not already been contacted by the IRS about the delinquent information returns should file the delinquent information returns with a statement of all facts establishing reasonable cause for the failure to file.  As part of the reasonable cause statement, taxpayers must also certify that any entity for which the information returns are being filed was not engaged in tax evasion.

The IRS states that simply filing amended tax returns to correct past problems won’t protect taxpayers from penalties and possible criminal prosecution.  The IRS wants taxpayers to come in under one of the above programs and pay the financial penalty associated with the program.  This type of threat is not normally associated with amended tax returns filed to correct mistakes, and it shows the attitude of the government towards taxpayers who have not timely reported foreign financial accounts.

U.S. Supreme Court Rules that Inherited IRAs are not Protected from the Claims of Creditors

On June 12, 2014, the U.S. Supreme Court unanimously held in Clark v. Rameker that the protection afforded individual retirement accounts under the Bankruptcy Code is lost once such accounts are inherited.  The reason given is that the account loses its traditional character as “retirement funds.”  While it seems clear that an IRA inherited by a non-spouse is now no longer protected, it is unclear whether the protection is also lost if a spouse inherits the IRA.

The Court concluded that an inherited IRA did not constitute “retirement funds” in the hands of the beneficiary by citing the following limitations imposed on inherited IRAs.  Such limitations do not exist for IRAs that are owned and not inherited.

1.     The beneficiary cannot contribute money into the inherited IRA.

2.     The beneficiary must begin minimum required distributions from the inherited IRA and cannot wait until the beneficiary’s own retirement.

3.     The beneficiary may withdraw the entire inherited IRA balance without an early withdrawal penalty if under age 59 ½.

A spouse beneficiary has the ability to roll over the inherited IRA to his or her own personal IRA, whereas non-spouse beneficiaries are unable to do so.  This fact brings up a few important questions: Will this rollover allow the inherited funds to be protected under the Bankruptcy Act?  Or, will the protection not be permitted because the spouse did not set aside such money him or herself?  We may not know the answer to these questions without future litigation.

IRA owners should now consider naming a discretionary trust as beneficiary.  Giving the trustee discretion on how and when to make distributions to beneficiaries may enhance creditor protection.  The trust must be properly drafted to qualify as a designated beneficiary to avoid unfavorable income tax results upon the IRA owner’s death.

This case deals with Federal bankruptcy law.  State law may nevertheless provide some protection to an inherited IRA.  Individuals with large IRA balances who are concerned about asset protection should consult with their attorney.