Complex Regulations on Deducting or Capitalizing Repairs Now in Effect

As if constantly changing tax laws weren't complex enough, the IRS has also been issuing new forms, rulings, and regulations.  On December 23, 2011, temporary regulations were issued changing the tax rules (effective for tax years beginning on or after January 1, 2012) regarding whether costs incurred for tangible property must be capitalized as an asset or may be expensed as a repair.  Since all businesses own or lease tangible property, all businesses are affected by these regulations.  In some cases, businesses will need to change their method of tax accounting to comply with the new regulations.  Changing a tax accounting method is complex and often involves a cumulative adjustment to taxable income to change from the effects of the prior method.

The length and complexity of the regulations prohibit a full analysis.  Some of the highlights are:

1. New rules are set forth for deducting or capitalizing materials and supplies.
2. Several methods of accounting are provided for rotable and temporary spare parts.
3. Rules are provided for moving and reinstalling property.
4. To determine whether a cost incurred for property is an "improvement" requiring capitalization, it is necessary to refer to what is called a "unit of property."  A "unit of property" is somewhat subjective as demonstrated by numerous examples in the regulations.  Generally, the larger the unit of property the more likely the cost can be deducted as a repair.
5. For buildings, the IRS has identified eight component systems as "units of property" making improvements to these components (e.g., HVAC, plumbing, electricity, elevators, etc.) more likely to be capital expenditures (requiring lengthy depreciation) rather than repairs (permitting current deductions).
6. Leasehold improvements are a separate unit of property.
7. For machinery and equipment, a unit of property is one that performs a discrete and major function or operation.
8. While a "unit of property" is considered in accounting for repairs or improvements, the concept is not used for purposes of determining the property's depreciation period.
9. Improvements are required to be capitalized.  An improvement means that a unit of property has been bettered.  For example, a material defect prior to acquisition has been fixed, a material addition has been added, capacity has been increased, the unit of property has been restored, or the unit of property has been adapted to a new or different use.
10. Routine maintenance such as cleaning, testing, and reasonable replacement of parts is not considered an improvement and may be deducted as a repair.
11. The retirement of a structural component of a building may now be treated as a disposition separate from the overall building and a loss claimed for the adjusted tax basis.

The complexity and cost of complying with these regulations just to determine whether an expenditure is a repair or is a capital asset certainly won't make American business any more competitive in the global marketplace.  Taxpayers have been making these decisions for decades, and now the IRS comes along with new rules changing long-held accounting practices.  The increased intrusion of government regulators into normal business accounting practices drives up the cost of business.  These rules are currently in effect and must be dealt with in your accounting systems.

Proposal Would Dramatically Change Rules for Inherited IRAs

On February 7th, Max Baucus, the Senate Finance Committee Chairman, proposed dramatic changes to the distribution rules for beneficiaries of inherited IRAs, 401(k)'s, and other qualified plan accounts (all termed "IRAs" in this post), for deaths after 2012.  The proposal raises $4.6 billion over 10 years and is part of a highway funding bill.  The change would require beneficiaries to completely distribute the inherited accounts within five years.  Exceptions would be provided for certain beneficiaries:  disabled or chronically ill individuals, surviving spouses, children who had not attained the age of majority, and beneficiaries who are not more than 10 years younger than the deceased account owner.  Once these beneficiaries die, the five-year rule applies to their beneficiaries.  Furthermore, when a beneficiary-child reaches the age of majority, the five-year rule commences.  Senator Baucus justifies his proposal by stating that IRAs are intended for retirement, but some taxpayers are using them to give tax-free benefits to second, third, and maybe fourth generations.  He further stated that if this proposal doesn't pass now, perhaps it will as part of tax reform.

Current rules permit beneficiaries to stretch-out distributions from inherited IRAs over their life expectancies.  The younger the beneficiary, the longer the stretch-out period.  In the early years, the IRA can continue to grow in value as the required distribution amounts will generally be less than the IRA earnings.  Distributions from traditional IRAs are subject to income tax.  A 50% penalty applies to any shortfall in the required minimum distribution amount.  Accelerating the required distribution amounts eliminates the financial benefits of compounding IRA earnings on a tax-deferred basis.  The proposed change will have a major detrimental financial impact upon families that have used retirement accounts to save for the future.  Larger required distributions will likely cause the beneficiary to pay income tax on the benefits at a higher tax rate, and will tempt beneficiaries to spend their inheritances instead of preserving the IRA benefits for their own retirements.  Furthermore, once the assets are outside of the IRA, the beneficiary loses whatever asset protection benefits were afforded by the IRA.

The proposed change goes even further and can apply to IRA accounts of owners who have died or will die before 2013.  Once the primary IRA beneficiary (who may use the current stretch-out rules) dies, those who succeed to the primary beneficiary's benefits will be subject to the new five-year payout rule!

Many commentators do not believe this proposal will become law at this time.  If it does become law, proactive planning will be necessary to reduce the resulting financial loss on families.  This proposal will upend the financial planning of many families, and seems to be a short-sighted grab for tax revenue to fund one-time government expenditures.

Voluntary Offshore Disclosure Program, Round Three

The IRS has had a major focus on finding and penalizing taxpayers who have foreign financial accounts and who have not made proper disclosure of those accounts and have not paid U.S. income tax on earnings in those accounts.  Two temporary, voluntary disclosure programs in 2009 and 2011 were established to encourage delinquent taxpayers to come forward and clear up the matter.  About 33,000 disclosures were made and $4.4 billion was collected.  The new program started in January 2012 and has no end date.  However, the IRS cautions that it could end or modify the program at any time, and so taxpayers should come forward expeditiously.  The IRS also warns of severe civil (criminal penalties are also a possibility) penalties if they find a taxpayer with delinquent foreign accounts before such taxpayer makes a voluntary disclosure.  The IRS also states that "quiet disclosures," whereby taxpayers amend past tax returns to disclose foreign financial accounts and pay back taxes, will not avoid the full extent of penalties that the IRS will assert if the quiet disclosure is discovered.  Taxpayers must come under the new voluntary disclosure program to reduce penalties.

The new program is not inexpensive.  The program requires up to eight years of corrected back tax returns, with added taxes, interest, and the addition of the accuracy-related and/or delinquency penalty.  In addition, the taxpayer must pay a penalty of 27.5% of the highest aggregate balance in foreign financial accounts during the eight full years prior to the date of disclosure.  This is an increase from the 25% penalty under the 2011 program.  The penalty might be reduced to 12.5% if foreign accounts and assets total $75,000 or less.  There is also a penalty reduction to 5% for certain restrictive situations.

Taxpayers who have yet to make full disclosure of their foreign accounts and to pay U.S. income tax on foreign earnings should use this program to come clean.  The risks of coming clean with quiet disclosure in order to avoid the settlement penalties are too high.  More information about the program can be found on the IRS website at http://www.irs.gov/newsroom/article/0,,id=252162,00.html.

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.