Avoiding Tax Problems with Shareholder—Corporation Loans

Owners of closely-held corporations will often either borrow money from the corporation or lend money to it.  Many times these arrangements are informal and not carefully documented.  In such cases it can appear as though the corporation’s bank account is functioning as if it were another personal account of the shareholder or vice versa.  These loose arrangements are problematic from an income tax point of view because the corporation and the shareholder are treated as distinct persons for tax purposes.

Poorly documented amounts borrowed from a corporation may be deemed instead by the IRS as a distribution.  For a C corporation, a deemed distribution is a dividend taxable to the shareholder and not deductible to the corporation.  For an S corporation, a deemed distribution may give rise to a potential second class of stock problem that could invalidate the S election, or perhaps the IRS might treat the deemed distribution as compensation subject to payroll taxes normally avoided by true S corporation distributions.

On the other hand, poorly documented amounts loaned to the corporation may be deemed instead by the IRS as a contribution to shareholder capital.  A contribution of capital cannot be repaid to the shareholder like a loan can be.  Instead repayments are treated as distributions to the shareholder with the applicable treatment depending upon the classification of the corporation.

In order to avoid these kinds of problems with shareholder—corporation loans, be sure to observe the following factors that have been considered by the courts when ruling on disputes between taxpayers and the IRS.  The main factor in determining whether the transaction is a loan for tax purposes is whether the parties intend for the money to be repaid.  Such intention should be contemporaneously evidenced as follows.

1.       Is there a promissory note or other written obligation promising repayment?

2.       Is adequate interest being charged?

3.       Has a fixed schedule for repayment and maturity date been established?

4.       Has collateral been given to secure repayment?

5.       Have repayments actually been made?

6.       Is there a reasonable prospect that the borrower can repay the loan?

Another factor to consider is this:  if the shareholder does not respect the separate existence and legal form of the corporation, will the corporate “veil” of limited liability be pierced if there is a third-party lawsuit, putting the shareholder’s personal assets at risk?

New “Simplified” Option for Deducting Home Office Expenses

Certain home office deductions are permitted for businesses run out of an individual’s home.  However, to be eligible for home office deductions, two basic requirements must be met:

1.     Regular and Exclusive Use:  You must regularly use part of your home exclusively for conducting business.  This test can be difficult to meet if the business part of your home isn’t separated from the personal part of your home such as by a door or by a separate structure.

2.     Principal Place of Your Business:  If business is conducted outside of your home, you can still qualify if you can show that you also use your home substantially and regularly to conduct business.  For example, you might have in-person meetings with clients or customers in the home.

The business home office deduction cannot exceed gross business income less other business expenses.  Any excess home office deduction can be carried over to the next year.

If you are not the business owner, but are an employee, then in addition to the above two tests, you must also meet the following two tests:

3.     Your business use must be for the convenience of your employer.  If the use of the home office is merely appropriate and helpful, you cannot deduct expenses for the business use of your home.

4.     You may not rent any part of your home to your employer and use the rented portion as the employee.

Starting with 2013 tax returns a new simplified option is available.  Instead of keeping track of actual expenses and prorating by the percentage of the square feet of your home used for business, a flat rate prescribed by the IRS multiplied by the business square footage can be used.  The simplified option does not change the above rules for qualifying for the home office deduction.  Rather, the method is like a standard deduction:  a $5.00 rate times up to 300 square feet (roughly 17 by 17 feet), or $1,500 is permitted.  You can choose each year to use either the regular or the simplified method.  Once selected, the method cannot be changed for that tax year.

Benefits of the simplified option include:

1.     Mortgage interest and real estate taxes can be deducted in full as itemized deductions.  They are not considered part of the $5.00 rate.

2.     The $5.00 rate is not considered to include home depreciation (and none may be claimed under the simplified option), so there is no depreciation recapture if you later sell your home.

3.     The $5.00 rate does not reduce other business deductions that are unrelated to the home.

Disadvantages of the simplified option include:

1.     The business square footage is limited to 300 square feet.

2.     Any excess home office deduction above business net income may not be carried over to the next tax year.

3.     No home depreciation deduction can be claimed.  If actual expenses are used in a later year, depreciation is computed using the optional depreciation table as if there had been no interruption in depreciation years.

4.     A carryover of unused home office deduction from an earlier tax year may not be claimed.

Despite the limitations imposed on the simplified option, some taxpayers may benefit from it.  More information can be obtained by referring to RevenueProcedure 2013-13, IRS Publication 587, or Form 8829.

Employer Health Insurance Mandate and Reporting Delayed

In a post on the White House blog on July 2, 2013, the Obama administration unexpectedly delayed the mandate for “large” employers to provide minimum essential, affordable health insurance to full-time employees.  According to the law, the mandate begins after 2013 with a noncompliance penalty assessed on a monthly basis.  How the executive branch can unilaterally change the effective date of enacted law is a question many commentators are asking.  Nevertheless, affected employers may appreciate the one-year enforcement delay to 2015.  The Deseret News (7/3/2013) reported that in Utah, 93% of large employers already provide health insurance to their employees, so the delay will have minimal impact in Utah.  The Administration cited the complexity of the law for the delay, but some commentators smell political motivations in light of the coming 2014 election when the mandate was originally to begin.  The delay of the employer mandate does not delay the individual mandate, the establishment of health insurance exchanges, or other provisions of the Affordable Care Act.

Also delayed to 2015 is the employer’s annual insurance information return.  This return was to identify each full-time employee and the number of months each employee was covered by an employer-sponsored health insurance plan and whether the employee’s share of premiums was “affordable.”  Not only would the information assist the IRS in penalizing employers that fail to meet the mandate’s requirements, the information is critical to the insurance exchanges.  The exchanges need the information to determine who qualifies for premium support tax credits.  On July 5, 2013, the Administration released new rules that also postpone to 2015 the requirement for exchanges to verify an applicant’s income and health insurance status before granting tax credits.  So for 2014, applicants are on the “honor system” in providing truthful information to the exchanges for purposes of calculating the amount of the tax credits.  Given these postponements and previous adjustments, we are beginning to see evidence of the oncoming “train wreck” described by Obamacare supporter and retiring Montana Democrat, Max Baucus, several months ago.

U.S. Supreme Court Rules Section 3 of DOMA Unconstitutional

The U.S. Supreme Court released the Edith Schlain Windsor case decision on June 26, 2013.  In a 5 to 4 decision, it held Section 3 of the Defense of Marriage Act (DOMA) unconstitutional under the Fifth Amendment to the U.S. Constitution providing for equal protection of persons.  DOMA was enacted in 1996 and Section 3 provided that Federal tax benefits for married persons were conditioned upon a legal marriage between one man and one woman.  The consequences of the decision will have far reaching implications for same-sex married couples.  The IRS announced on June 27, 2013 that it would act swiftly to provide guidance.

The Windsor case concerned the use of the unlimited marital estate tax deduction for the survivor of a same-sex married couple.  Ms. Windsor, as the widow, was denied the estate marital deduction.  She paid $363,053 of estate tax and sued for a refund and declaration that Section 3 of DOMA was unconstitutional.  A federal district court and the Court of Appeals (Second District) found in favor of the taxpayer.  Justice Kennedy wrote that while marriage law is within the province of the States, DOMA created unequal treatment of married couples within a state recognizing same-sex marriages.  For example, prior to this decision, a same-sex couple living in a state recognizing same-sex marriage was entitled to a joint state income tax return but had to file as two single persons for Federal tax purposes; whereas an opposite-sex married couple could file a joint Federal tax return.  Now it appears that a Federal joint income tax return is permitted, so both kinds of marriages would be entitled to have the same filing statuses apply.  Questions arise as to how to handle past tax returns, some of which may be closed by the three-year statute of limitations.  Some same-sex taxpayers may have filed protective refund claims to hold open the statute of limitations pending the outcome of this case.

Now legally married same-sex couples who are recognized as married for Federal tax purposes will enjoy the same tax benefits and suffer the same “marriage tax penalties” as opposite-sex married couples.  Each couple’s situation will differ and tax planning should be tailored to individual circumstances and personal goals.

There will also be implications to employee benefits.  These include:

1.     Spousal coverage under employer-provided health insurance.

2.     COBRA continuation of health insurance.

3.     Spousal right to pension plan joint and survivor annuities.

4.     Spousal consent to name a non-spouse beneficiary of a defined contribution retirement plan.

5.     Retirement plan and IRA minimum required distribution and rollover provisions.

6.     Qualified domestic relations orders (QDRO) for dividing retirement benefits in a divorce.

7.     Qualifying for exchange premium support credits under Obamacare.

How will this decision impact legally married same-sex couples who move to a state that does not recognize the marriage?  Will they be able to file joint Federal tax returns even though required to file single person state income tax returns?  Section 2 of DOMA was not before the Supreme Court.  Section 2 provides that states do not have to recognize same-sex marriages performed in other states.  Democrats have introduced the Respect of Marriage Act in the U.S. House of Representatives.  The Act is designed to repeal Section 2 and to require states that do not permit same-sex marriages to recognize same-sex marriages legally performed in other states.

SEC Proposes Reforms for Money Market Mutual Funds

On June 5, 2013, the U.S. Securities and Exchange Commission proposed major changes to certain “prime” money market mutual funds (MMF).  The changes could dramatically alter investors’ perceptions and use of MMFs.  There is a 90-day public comment period after which these proposals could be imposed. 

One of the most desirable features of MMFs is a stable $1 per share Net Asset Value (NAV).  MMF interest rates float in order to preserve a constant $1 per share value.  During the recent financial crisis, in September 2008, the Reserve Primary Fund MMF “broke the buck” because of the fund’s investment in Lehman Brothers securities that became essentially worthless.  The NAV only dropped from $1.00/share to $0.97/share but that elicited a run on the fund and called into question whether other MMFs would also break the buck.  The Federal government had to quickly step in to guarantee the value of MMF shares owned prior to September 19, 2008 to prevent a potential collapse of the MMF industry.  This guarantee expired September 18, 2009 with no losses and the government has been struggling for years to come up with some solutions to avoid the need to make such a guarantee again. 

One of the SEC’s proposals is to require the NAV of institutional MMFs to float to the nearest 1/100^th of 1% ($1.0000 per share instead of $1.00 per share) in response to market conditions.  Exempted from this proposal are prime retail MMFs that limit redemptions to $1 million per day and government MMFs that are at least 80% invested in government securities.  This is a major change and could very well cause the run on MMFs that the government is trying to prevent. 

An alternative SEC proposal is to allow MMFs to impose a 2% redemption fee on investors or suspend redemptions for up to 30 days during periods of “market stress” in order to reduce the likelihood of a run on the MMF.  Government MMFs are exempt (unless they voluntarily opt in) but institutional and retail MMFs are subject to this proposal.  Most people think of MMFs as safe-havens for their cash, even though there is no FDIC insurance for MMFs.  This proposal changes the liquid nature of MMFs that investors find appealing.  If adopted, this proposal could prevent investors from accessing their money during times of financial turmoil.  Part of the concept of “safety” means that investors can access their money when they need to, and charging redemption fees or preventing access will be unpalatable to many investors.  Such investors should instead consider bank money market accounts if this alternative proposal is adopted.

Update
The IRS issued Notice 2013-48 in which it said that the wash sale rule wouldn't be applied to losses recognized from a floating NAV for MMFs as long as the loss did not exceed 0.5% of the tax basis in the shares redeemed.  The wash sale rule disallows a loss on the sale of securities if substantially identical securities are purchased in the period beginning 30 days before and 30 days after the date of sale.

2012 FBAR due by June 30, 2013

U.S. persons having interests in or signature authority over a foreign financial account must file an annual report with the U.S. government if the maximum account value exceeds US$10,000 on any day during the calendar year.  A foreign exchange rate is used for conversion purposes.  The IRS provides conversion rates here. 

The 2012 Report of Foreign Bank and Financial Account (Form TD F 90-22.1, termed the “FBAR”) must be received by the U.S. Treasury Department in Detroit, Michigan on or before June 30, 2013.  The normal postmark rule for the timely mailing of tax returns is not applicable.  In addition, no extension of time is permitted.  This year June 30^th falls on a Sunday.  This means that you should ensure that the FBAR is received by June 28^th as the government’s offices are generally closed on weekends.  Significant penalties exist for late or non-filing.

An alternative to using a paper Form TD F 90-22.1 is to submit the FBAR electronically through the Bank Security Act e-filing system.

Owners of entities that are required to file an FBAR must also file an FBAR at the owner level if they have more than a 50% direct or indirect ownership interest. 

Be sure to also check the appropriate boxes at the bottom of Schedule B, Form 1040, and to include any account earnings in your U.S. income tax return.

Estate and Gift Tax Provisions of Pres. Obama’s Fiscal Year 2014 Budget Proposal

On April 10, 2013, Pres. Obama released his budget proposal for the Federal government’s fiscal year running from October 1, 2013 through September 30, 2014.  The budget proposal includes many individual and business income tax provisions, projected to increase taxes by $1.1 trillion over 10 years according to the Tax Policy Center.  This post concerns estate and gift taxes.  Previous blog posts covered the proposals dealing with individual and business income taxes. 

1.     Beginning in 2018, the estate and generation skipping transfer tax exemptions would decrease to $3.5 million and the gift tax exemption to $1.0 million, and the tax rate would increase to 45%.  These are the exemptions and tax rate that existed in 2009.  In addition, the exemption amounts would no longer be indexed for inflation.  Portability of unused estate and gift tax exclusions between spouses would be retained.  These changes are being proposed only three months after the American Taxpayer Relief Act of 2012 had “permanently” increased the exemptions to $5.25 million (as indexed for inflation) and had “permanently” set the tax rate at 40%!  The proposal does not claw back any tax benefits for gifts above the proposed $1 million gift exemption made before 2018.

2.     Effective for transfers on or after the date of enactment, the income tax basis of inherited property could be no greater than the value of property for estate or gift tax purposes.  A new information reporting requirement will cause the estate executor or the donor to provide the necessary valuation and basis information to both the property recipient and the IRS.

3.     For grantor-retained annuity trusts (GRATs) created after the date of enactment, the GRAT term must be no shorter than 10 years or longer than the life expectancy of the annuitant plus ten years.  The remainder interest must have a value greater than zero when the GRAT is established.  In addition, the GRAT annuity may not decrease during the term of the GRAT.  These proposals eliminate the benefits of the so-called short-term, zeroed-out GRAT.

4.     For trusts created after the date of enactment, and for additions made to pre-existing trusts after that date, eliminate any generation skipping transfer tax (GST) exclusion allocated to the trust on the 90^th anniversary of the trust’s creation.  It is unclear how the 90-year limitation applies to an addition to a grandfathered trust.  This proposal effectively eliminates the future use of the dynasty trust strategy.

5.     For property sold to an intentionally defective grantor trust on or after the date of enactment, the portion of the trust attributable to such property (including all retained income, appreciation, and reinvestment) will be included in the gross estate, less any payments received.  In addition, if the trust ceases to be classified as a grantor trust during the grantor’s life, then the amount will be treated as a gift with the gift tax being paid by the trust.  Any distributions out of the trust in excess of the prior taxable gift amount will be treated as additional gifts.

6.     The exclusion from GST tax will be eliminated for health and education exclusion trusts (HEETs) created after the date of introduction of the bill proposing this change, and for transfers to existing HEETs after that date.  A HEET is used to pay providers of medical care and to pay schools for tuition costs of trust beneficiaries, which can include multiple generations.  Direct payments to providers by an individual for another person's medical or tuition costs are gifts that are excludable from GST tax.  The purpose of a HEET is to permit the GST exclusion to apply to such payments made for future trust beneficiaries, even after the death of the trustor.  This proposal eliminates the HEET GST exclusion tax benefit.