IRS Finally Does the Right Thing: Eases Application of the Tangible Property Regulations for “Small” Taxpayers

On Friday, February 13, 2015, the IRS issued Revenue Procedure 2015-20 to simplify the application of the tangible property regulations (TPRs, sometimes called the “repair regs”) for small taxpayers.  Accountants and industry organizations told the IRS months ago that its implementation rules were too onerous and impractical for small taxpayers to follow.  Now in the middle of tax season the IRS provides relief, but only after tax preparers and taxpayers have already spent many hours of effort trying to make the old rules work.

What is a “small” taxpayer?  A small taxpayer has either less than $10 million of assets on the first day of the 2014 tax year OR has average annual gross receipts of $10 million or less for the three prior tax years.  These tests are applied separately for each separate and distinct trade or business of the taxpayer.  Special rules exist for taxpayers having less than three full prior tax years.  Gross receipts include gross sales less sales returns and allowances, all receipts for services, investment income, but only the gains from the sale of investments and property used in a trade or business (other than inventory). 

The IRS eased two major problems.  First, the TPRs do not have to be retroactively applied to past tax years.  It was ridiculous for the government to require taxpayers to apply today’s tax rules to all previous tax years.  Second, the 8-page Form 3115 (plus attachments) is not required to be completed to tell the IRS that its TPRs are now being complied with.  However, the IRS says this simplification comes at a cost.  The IRS says that there is no audit protection for years earlier than 2014.  Because small taxpayers can use the “cut-off” method and just start complying with the TPRs in 2014, the IRS states that it can still require compliance in past years in the event of an audit.  Most small taxpayers will ignore this threat and avoid the costs and hassles of retroactively applying the rules and filing multiple Forms 3115.

The IRS points out that any tax benefits that would have come from retroactive application of the TPRs won’t be available unless the small taxpayer does in fact retroactively apply the TPRs and file Form 3115.  One example is the “late partial disposition election.”  This “election” is made by filing Form 3115 for prior dispositions of components or structural parts of assets.  For example, for a building, the tax code does not allow for separate depreciation of building components or systems.  Therefore, the building cost is often recorded on the depreciation schedule as a lump-sum number.  The IRS is now permitting the deduction of the undepreciated cost of the portion of the building previously disposed, such as a roof.  When a new roof was put on in the past, the cost of the old roof was not broken out from the building cost and written off.  Now, the IRS is permitting this write-off, and to do so, Form 3115 must be filed with an estimate of the cost of the old roof.  Doing so is an election and not a requirement.  A second example of lost tax benefits if there is no retroactive application of the TPRs deals with prior capitalized repairs that would clearly be deductible under the TPRs.  Filing a Form 3115 allows a current deduction for any remaining undepreciated capitalized cost.  In addition, if the capitalized repairs are not written-off, there is a chance the IRS would deny future depreciation deductions by asserting that the repairs should have been expensed in the prior year and that there is no legitimate asset to depreciate.

Pres. Obama’s Proposed Tax Increases on the “Rich”

In connection with his 2015 State of the Union Address, Pres. Obama proposed to increase taxes again on the “rich” in order to give new tax credits to the “middle class.”  Taxes would increase an estimated $320 billion over 10 years.

Increasing the Top Tax Rate on Qualified Dividends and Long-Term Capital Gains 

·       The current top income tax rate on qualified dividends and long-term capital gains is 20% for taxpayers with income above $413,200 (single) or $464,850 (joint).  In addition, a 3.8% net investment income tax (NIIT) created under Obamacare applies.

·       The President proposes to increase the top tax rate on qualified dividends and long-term capital gains to 28% for couples with income over about $500,000.   The February 2nd budget proposal clarifies that the 28% rate includes the 3.8% net investment income tax.

Treating Transfers of Property by Inheritance and Gifts as Taxable Events 

·       Under current law, most assets receive a new basis at death equal to the date of death value.  This allows heirs to sell inherited assets without a capital gain.  On the other hand, in the case of a gift, the donor generally does not realize any gain, and the donee generally takes a carryover basis, meaning the donee pays the capital gain tax when the asset is sold. 

·       The President describes the current law as “perhaps the largest single loophole in the entire individual income tax code.” 

·       The proposal treats bequests and gifts other than to charitable organizations as realization events.  A realization event means the property is treated as if it had been sold for its fair market value at the date of death or at the date of gift.  Treating death as a realization event is harsher than prior proposals to deny an increase in basis at death (carryover basis).  Under a carryover basis regime, the beneficiaries can defer the tax until they sell the appreciated assets.  It is unclear who would pay the capital gain tax upon a gift, but it would probably be the person making the gift.

·       Administration officials indicate that the capital gains tax paid at death may be deducted for estate tax purposes.  The combined estate, capital gain, and Utah taxes on appreciated property would amount to as much as 60%.

·       A spouse could inherit from a deceased spouse without immediate tax.  The tax would not be due until the death of the surviving spouse. 

·       There would be an exemption from capital gains tax at death of up to $100,000 per individual ($200,000 per couple).  Note that these figures are “gains” and not the fair market value of the asset.  Any unused exemption of one spouse would “port” to the surviving spouse.

·       In addition, capital gains of up to $250,000 per individual ($500,000 per couple) for a personal residence would be exempt.  This additional exemption would also be portable between spouses. 

·       Tangible personal property other than expensive art and similar collectibles would be exempt. 

·       No tax would be due on inherited small family-owned and operated business unless and until the business was sold.  A small family-owned business was not defined.

·       Any closely-held business would have the option to pay the tax over 15 years on gains.  A closely-held business was not defined.

Limiting Retirement Plan Contributions

·       The President proposes to prohibit contributions to and accrual of additional benefits to IRAs, 401(k)s, and pension plans when balances are sufficient to produce an annual distribution of $210,000 in retirement.

·       Under current assumptions, the permitted balance would be about $3.4 million.

Withdrawn:  Treating Section 529 College Savings Plan Distributions as Taxable.

·       Under current law, earnings on Section 529 college savings plans withdrawn to pay for qualifying college expenses are not taxable.

·       Last week Pres. Obama proposed to tax the earnings on new contributions even when spent on qualifying college expenses.  This proposal received a lot of push back, including from members of his political party.  Administration officials indicated on January 27, 2015 that this proposal is withdrawn.

The New Utah Unitrust Act Can Help Trust Beneficiaries in a Period of Low Investment Yield

With historically low interest rates, income beneficiaries of traditional trusts have been suffering low distributions.  A trust often has different classes of beneficiaries, those who receive income distributions as the trust earns income, and those who receive the remaining principal of the trust after some event has occurred or some time period has elapsed.  A trustee is in a difficult position where investment decisions must be made to benefit the two classes of beneficiaries who have opposing interests.  The income beneficiaries will want a high allocation to income generating investments at the expense of capital growth investments favored by the remainder beneficiaries.  An example of such a situation is a trust established by a deceased husband for his second wife who is to receive the trust income, with the children of his first wife waiting to receive the principal until after the second wife passes away.

The Utah Unitrust Act became effective July 1, 2013.  The Act permits a trustee, or a beneficiary who petitions the trustee, to convert the traditional income trust into a Total Return Unitrust.  The word “unitrust” means a distributable amount computed as a fixed percentage of the fair market value (FMV) of trust assets as determined annually.  The Act permits a unitrust of at least 3% but not more than 5% of FMV.  The trustee can then invest the trust assets for total return as a prudent investor would do, without worrying whether the investment selection will disadvantage one class of beneficiaries in favor of the other.  There are important variables that must be agreed to by all of the parties when converting to a unitrust such as:

·       Setting the unitrust percentage

·       Determining how much capital gain is to be taxed to the income beneficiaries as part of the unitrust

·       The method for determining FMV

·       How expenses are to be accounted for between the beneficiaries

Converting a traditional income trust to a Unitrust may very well benefit both classes of beneficiaries as the trustee then can invest to grow the trust assets as a whole which will both increase the unitrust payout to the income beneficiaries and provide capital appreciation for the remainder beneficiaries.

Utah Partnerships with Resident Individual Partners May Have a Utah Tax Return Filing Requirement

In the past, partnerships owned 100% by Utah resident individual partners have not been required to file a Utah partnership tax return.  Beginning with the 2011 form instructions, the Tax Commission clarified that a partnership that is a pass-through entity taxpayer is required to file a Utah partnership tax return, even if all its partners are Utah resident individuals.

A pass-through entity is an entity whose items of income, deductions, and credits flow through to the tax returns of its owners via Schedule K-1 (partnerships, limited liability companies taxed as partnerships, S corporations, trusts, and estates).  A pass-through entity taxpayer is an entity that is an owner in another pass-through entity.  For example, Partnership B is a partner in Partnership A.  Partnership B is referred to as a “second tier partnership” and is classified as a pass-through entity taxpayer.  Partnership B is now required to file a partnership tax return even though all its partners may be Utah resident individuals.  This is true regardless of whether Partnership A withheld any Utah tax on the income allocated to Partnership B.

Last Minute 2014 Personal Tax Planning

Consider implementing the following strategies by December 31^st to save income taxes.  The income tax laws are now so complex that it is difficult to know whether any of these general recommendations will actually save you tax without undertaking a computerized tax projection.  You should consult your tax advisor before implementing these ideas.

·       If you are in the upper tax brackets, harvest capital losses as necessary to reduce capital gains tax, and to lower the Obamacare tax on net investment income.  Generally, short-term losses are preferred over long-term losses because short-term gains bear a higher tax rate than long-term gains.  Be sure to specifically identify the block of securities you are selling to your broker.  Don’t trigger capital losses if you are in a low tax bracket.  Be sure to avoid the “wash sale” rule that applies if you purchase substantially identical replacement securities within 30 days before or 30 days after the date of sale.  See my prior blog post for more details.

·       If you are in the lower tax brackets, harvest long-term capital gains as necessary to fill in the lower tax brackets.  For example, a zero percent long-term capital gain tax rate applies through $73,800 of taxable income!  However, ordinary income fills up the low brackets first, so some coordination is necessary to achieve a zero percent tax rate.

·       Be sure that any year-end charitable donations are either delivered or mailed and postmarked by December 31^st.  Be sure that you obtain the required tax-qualified receipt early next year so that documentation is available when preparation of your income tax return begins.  If you want a charitable deduction but are not prepared to actually give the funds to a charity at this time, consider using a donor advised fund (DAF) to claim the deduction now.  You can select the charity later and “advise” the DAF to contribute to the charity then.

·       For those at least age 70 ½, consider using your traditional IRA to make a direct charitable donation of up to $100,000 to a public charity (but not a DAF).  This provision had expired at the end of 2013 but was just retroactively reinstated for 2014 donations.  It expires again after 2014!  The charitable IRA donation is also considered a distribution for purposes of your 2014 minimum required distribution.  Coupled with the phase out of itemized deductions, personal exemptions, and the net investment income tax, the charitable IRA donation can be effective in lowering your overall income tax.

·       Consider donating any long-term appreciated securities to charity.  You can claim a tax deduction equal to the fair market value of the securities without triggering tax on the capital gain.

·       For those at least age 70 ½, and for those who have inherited an IRA, don’t forget to take your minimum required distribution by December 31^st to avoid a 50% penalty.

·       Prepay state income tax unless you are subject to the alternative minimum tax (AMT) because taxes are not deductible for the AMT.

·       Consider accelerating ordinary income into 2014 if you are subject to the AMT and may not be in 2015.  The top AMT tax rate is lower than the top ordinary tax rate.

·       If you exercised incentive stock options (ISOs) in 2014 and the value of the stock has dropped, consider selling the ISO stock by year-end in order to purge the AMT ISO adjustment so that you don’t pay tax on value that has disappeared.

·       Consider making a Roth IRA conversion if you are in a low tax bracket this year.

·       Keep a focus on your adjusted gross income (AGI).  Many deductions and credits are lost, and additional taxes can apply, depending on the size of your AGI.  These include the deduction of personal exemptions, itemized deductions, some IRA deductions, the ability to contribute to a Roth IRA, educational credits, taxation of Social Security benefits, and Obamacare taxes.  Therefore, it generally makes sense to keep your AGI as low as possible.

·       For purposes of gift and estate tax planning, don’t forget to use the $14,000 annual exclusion.  Giving cashier checks is advisable when cash gifts are made at year end to be sure that the gift is completed in the 2014 calendar year.

Last Minute 2014 Business Tax Planning

Now that the Senate has passed the Tax Prevention Act of 2014, and with the expected signature of the President, taxpayers have less than two weeks until December 31, 2014, to implement any “last minute” income tax planning strategies.  The Act basically extends for one-year the various tax items that had expired at the end of 2013.  Here is a checklist of several strategies applicable to businesses:

·       50% first-year bonus depreciation has been extended to include qualified property acquired and placed in service by December 31, 2014 (previously expired after 2013 and expiring once more after 2014).  The property’s original use must begin with the taxpayer (new property).

·       The higher Section 179 business expensing limits have been extended to include property (new or used) acquired and placed in service in tax years beginning in 2014 (previously expired for tax years beginning after 2013 and expiring once more for tax years beginning after 2014).  The expensing limit is restored to $500,000; phasing out dollar for dollar as purchases exceed $2,000,000.  Previously these limits would have been $25,000 and $200,000 respectively.

·       Adopt a qualified retirement plan, such as a profit sharing plan, a 401(k) plan, or a defined benefit plan by December 31^st.  Alternatively, a simplified employee pension (SEP) plan can be adopted by the due date of the tax return (with extensions).

·       Estimate the business’ marginal income tax rate for 2014 and 2015 and shift income and deductions as appropriate to allow more income to be taxed at lower tax rates, or to allow more deductions to be claimed at higher tax rates.

·       Cash basis taxpayers should pay and mail all outstanding bills and payroll by December 31^st.

·       Accrual basis corporations should declare and accrue bonuses by December 31^st as long as actual payment occurs no later than March 15, 2015.  Special rules apply to shareholders owning directly or indirectly more than 50% of the corporation’s stock.  Bonuses to such shareholder-employees must be paid by December 31^st to be deductible in 2014.

·       If you own an interest in a partnership or an S corporation, you may need to increase your tax basis in the entity in order to deduct a loss from it for this year.

·       If you do not already have an existing policy, be sure that a written capitalization policy is in place by December 31, 2014 for the 2015 tax year.  This policy permits low-cost asset purchases ($500 or up to $5,000 for audited financial statements) to be expensed in the income statement instead of capitalized on to the balance sheet and depreciated.  Your financial accounting records must also treat these low-cost asset purchases as expenses.  While an annual election in the income tax return must be made each year to claim the deduction, it does not appear that a new capitalization policy must be adopted each year.  Rather, a written capitalization policy simply must be in place before the start of the tax year for which you are making the tax return election.

Employer Reimbursement of Employee Health Insurance Premiums

Historically, many small employers haven’t directly offered group health insurance policies, but instead have reimbursed or directly paid some or all of the premium expense of policies purchased by their employees.  Beginning in 2014, the Affordable Care Act (ACA) presents at least two large problems with these arrangements.

1.     First, if more than one current employee is involved in the expense reimbursement plan, the government says the employer has established a group health plan.  The ACA prohibits group health plans from limiting the amount of medical benefits provided under the plan.  By design, reimbursement arrangements are limited to the cost of the premium.  Now, under the ACA, the reimbursement plan exposes the employer to potentially unlimited liability for employee medical costs.

2.     Second, if the employee purchases his or her policy on the health insurance marketplace or exchange, the employer’s reimbursement or payment of the premium is a violation of the ACA.  It does not matter whether or not the reimbursement or payment is treated as taxable wages or as a non-taxable, pre-tax reimbursement to the employee.  Plans that violate the ACA are subject to a $100 per day per employee penalty under IRC §4980D.

Another pitfall deals with more-than-2% S corporation shareholder employees.  IRS Notice 2008-1 permits the shareholder-employee to purchase an individual policy and to either be reimbursed by the S corporation or to have the S corporation directly pay the premium.  If the premium is included as income taxable wages on the W-2 (it isn’t subject to FICA or Medicare tax), the shareholder-employee may deduct the premium cost as self-employed health insurance.  However, this Notice 2008-1 pre-dates the ACA.  So if more than one employee is involved, the problems listed above apply.

What can be done to avoid these problems?  The employer should offer an ACA-compliant group health insurance policy for the employees instead of reimbursing the costs of individual policies.  The employer could also consider the small business health options program (SHOP), known as Avenue H in Utah.  Avenue H permits an employer to provide a sum of money for an employee to use to purchase a policy on that exchange.  Alternatively, the employer could simply increase their employees’ wages and let the employees purchase their own health insurance.  The wage increase should not refer to health insurance premiums.  As a small employer, there is no requirement to offer health insurance, so there is no penalty for increasing employee wages and letting them purchase their own insurance.  The downside, of course, is that increasing wages is not a tax efficient way for the employee to purchase insurance.  A better approach for tax purposes would be to use Avenue H which permits pre-tax money to be used to purchase health insurance.

For further guidance on these issues, see IRS Notice 2013-54 and a DOL FAQ on the subject.