Vernoia, Enterline + Brewer, CPA LLC

Archive for May, 2011

Tax Court highlights strict rules for conservation easement contributions

The Tax Court recently ruled on a series of three conservation contribution cases, with mixed results for the IRS and taxpayer. A common thread running through all of them is the necessity of taxpayers to adhere closely to the strict rules that are required to win such charitable deductions.  Also apparent, however, is the win-win result – for the taxpayer and for the community that benefits from a conservation contribution—that these donations can promote.

Comment.  The IRS has had improper deductions for conservation easements on its radar for a number of years, dating back at least since 2004. Congress has also expressed concern; under the Pension Protection Act of 2006 (PPA), it especially tightened the rules for façade easements on personal residences.

In Kaufman, 136 T.C. No. 13, the Tax Court confirmed that the transfer of a façade easement to a preservation trust did not qualify for a charitable deduction because the property contributed was subject to a bank mortgage.  The court upheld this denial of a charitable deduction despite the fact that foreclo sure was only a very remote possibility, with the taxpayer’s personal finances in strong financial shape.

Next, in Boltar, L.L.C., 136 T.C. No. 14, the Tax Court held that an expert’s valuation of a charitable conservation easement may be subject to a high level of scrutiny.  Hiring an expert and relying on the expert’s valuation did not automatically make the contribution impervious to IRS attack.  The Tax Court, in taking its own look, found that the expert’s report was not the product of reliable methods, and it assumed scenarios that were unrealistic in view of the facts of the case. As a result, the size of the taxpayer’s charitable deduction was substantially decreased.

Finally, in Tempel, 136 T.C. No. 15, the Tax Court handed the donor a partial victory by finding that the sale of transferable state conservation easement income tax credits received as a result of an easement donation gave rise to short-term capital gain as opposed to ordinary income. The court found over IRS’s protests that the state tax credits sold did not represent a right to income and therefore the “substitute for ordinary income doctrine” did not apply. However, the court agreed with the IRS that taxpayer did not have any basis in the credits or a long-term holding period, which began when the credits were granted and ended when the taxpayer sold them.

Bottom line:  A conservation or historic preservation easement can allow you to continue to enjoy property you own while receiving a tax deduction in return for helping preserve the unique value of your property for future generations. The rules for qualifying an easement as a charitable donation, however, are strict and must be planned for carefully. Please consult our offices for further details.

IRS adds to rules on reporting and withholding on foreign accounts

The IRS has issued additional guidance under the Foreign Account Tax Compliance Act (FATCA) provisions in the Hiring Incentives To Restore Employment (HIRE) Act of 2010, which impose reporting requirements on foreign financial institutions (FFIs) that hold accounts on behalf of U.S. persons worth more than $50,000. The guidance focuses on reporting of “preexisting” individual accounts and withholding on “passthru payments.”

Comment: The FATCA reporting requirements, imposed on financial institutions starting in 2013, should not be confused with the related FBAR (foreign bank account reporting) requirement, imposed on the U.S. person (individual or entity) that owns the foreign account. The FBAR requirements are already in force and impose up to a 50 percent penalty for noncompliance.  Also in play is the Offshore Voluntary Disclosure Initiative (OVDI), announced earlier this year and ending in August 2011.  The OVDI offers individuals reduced penalties if they come forward with disclosures about their unreported foreign holdings before the deadline.

The new guidance revises the procedures that FFIs should follow to identify U.S. accounts among their preexisting accounts.  A preexisting individual account for this purpose is an account held by an individual on the date that an FFI agreement takes effect. A participating FFI is required to determine whether its preexisting accounts are U.S. accounts, recalcitrant accounts, or non-U.S. accounts.

The latest guidance details the steps that FFIs must take to make this determination, including the sifting of documentary evidence and electronically searchable information that it collects or maintains in an account holder’s file and that may establish a person’s identity and status as a non-U.S. person.

The new guidance also clarifies the requirement that FFIs deduct and withhold a 30 percent tax on any passthru payment to a recalcitrant account holder or nonparticipating FFI. It defines passthru payments as a withholdable payment (certain U.S. payments) plus the passthru payment percentage of a non-withholdable payment.

Notice 2011-34

NJ – Information provided on changes to UEZ exemption, refund procedure

The New Jersey Division of Taxation has issued a notice regarding recently enacted legislation which provided that all qualified Urban Enterprise Zone (UEZ) businesses will be eligible to receive a sales tax exemption at the point of purchase regardless of annual gross receipts generated in the prior annual tax period, effective April 1, 2011. The new changes permit any duly certified qualified UEZ business to claim a sales tax exemption at the point of purchase for eligible exempt purchases of tangible personal property and services that are used or consumed exclusively at the UEZ business location when an Urban Enterprise Zone Exempt Purchase Certificate (Form UZ-5-SB or Form UZ-5) is issued to its sellers.

Application process: As all UEZ businesses will be eligible for the exemption, there will no longer be a need to complete Form UZ-5-SB-A as part of the UEZ certification application or renewal procedures. Also, the division will no longer need to verify a business’s gross annual receipts from the previous calendar year. However, the division will continue to check an entity’s tax compliance status on an annual basis for the application and recertification approval process.

Certificates: UEZ businesses that were formerly classified as “small qualified businesses” may continue to issue valid UZ-5-SB certificates to their suppliers, until such certificates expire. As the UZ-5-SB certificates expire, they will be replaced with UZ-5s. Large certified UEZ businesses that did not previously qualify for the exemption certificates and newly certified UEZ businesses will receive UZ-5 certificates with effective dates beginning April 1, 2011. The point-of-purchase exemption cannot be applied retroactively. Therefore, the UZ-5 exemption certificates can only be used for purchases for which the invoice date is on or after April 1, 2011.

Extension of refund procedure for large businesses: The refund procedure for those businesses not considered “small qualified businesses” will be eliminated effective April 1, 2011. However, UEZ refund requests may still be filed for purchases having an invoice date up through March 31, 2011. Refund claims may be filed one year following the invoice date or invoice payment date, whichever is later.

Refund process for pre-certification purchases: The law also allows a qualified UEZ business to apply for refunds of sales and use taxes paid on exempt property or services purchased and used in the initial building or equipping of a business in a zone prior to the business becoming certified. A qualified business may file a claim for refund of sales or use tax associated with eligible purchases made during the UEZ application process, only after the business has become certified as a qualified business. Under the law, claims for refunds associated with eligible purchases must be made and filed with the Division of Taxation after the business is certified as a qualified business, but within one year of the date that the purchase is made.

Businesses making such a claim will be required to file Form A-3730-UEZ within one year of the date of purchase as indicated by the invoice date or invoice payment date, whichever is later.

Refund process when exemption certificate is not received: As of April 1, 2011, if a UEZ business does not have its exemption certificate and is charged tax on an eligible exempt purchase, the business may file a regular refund claim using Form A-3730 within four years of payment of the tax.

Use tax: As of April 1, 2011, qualified UEZ businesses will no longer have to self-assess use tax for UEZ-eligible exempt purchases that were from out-of-state sellers where tax was not collected or was collected at a lesser tax rate than New Jersey’s, or for items removed from inventory. Notice, New Jersey Division of Taxation, March 22, 2011

Tax reform debate heats up as deficit grows

The growing U.S. deficit and the increasing attention being paid to it by financial markets is creating what many see as the “perfect storm” that will drive the debate over tax reform.  Whether “tax reform” will include tax increases –and whether “tax simplification” will include a flattening of existing tax rates through cutting back on deductions and credits to which many individuals and businesses have grown accustomed– are questions that will soon be raised as Congress starts a tough fight over the FY 2012 federal budget.

Consensus had been that nothing would get done on taxes until after the 2012 presidential elections and that tax changes would not take effect until 2013. Now, with inflation looming, if Congress does not show quickly that it can control the deficit, the timetable may be getting pushed up.  While tax changes may still not take place until 2013, decisions over what those changes will be may be made earlier. The compromise on taxes made between Republicans and Democrats late in 2010 extended the so-called “Bush tax cuts” for two years, through 2012. The temporary nature of that delay makes a decision on what to do about taxes for 2013 pivotal to the current tax reform debate.

Two versions of tax reform

The House approved a FY 2012 budget resolution ( HConRes 34) on April 15 along a party-line vote (235 to 193). The resolution proposes to reduce federal spending by more than $6.2 trillion over 10 years. HConRes 34 proposes to replace the current marginal rate structure ranging from a low of 10 percent to a high of 35 percent with just two rates: 10 percent and 25 percent. The 10 percent rate would apply to single individuals with taxable income under $50,000 and to married couples filing jointly with taxable income under $100,000. The 25 percent rate would apply to single individuals with incomes over $50,000 and married couples filing jointly with incomes over $100,000. The budget resolution also proposes to reduce the corporate tax rate to 25 percent.

Meanwhile, President Obama described his vision for reducing the federal budget deficit and tax reform on April 13. The president is opposed to renewing the Bush-era individual income tax cuts for higher-income individuals, which the White House defines as single individuals with incomes over $200,000 and families with incomes over $250,000. The president also proposed more than $3 trillion in cuts to federal spending over 10 years.

This office will continue to monitor events in Washington and how the outcome of the current debate on tax reform will impact our clients.

Scope of information reporting continues to expand

Information reporting continues to expand as Congress seeks to close the tax gap: the estimated $350 billion difference between what taxpayers owe and what they pay. Despite the recent rollback of expanded information reporting for business payments and rental property expense payments, the trend is for more – not less – information reporting of various transactions to the IRS.

Transactions

A large number of transactions are required to be reported to the IRS on an information return. The most common transaction is the payment of wages to employees. Every year, tens of millions of Forms W-2 are issued to employees. A copy of every Form W-2 is also provided to the IRS. Besides wages, information reporting touches many other transactions. For example, certain agricultural payments are reported on Form 1099-G, certain dividends are reported on Form 1099-DIV, certain IRA distributions are reported on Form 1099-R, certain gambling winnings are reported on Form W-2G, and so on. The IRS receives more than two billion information returns every year.

Valuable to IRS

Information reporting is valuable to the IRS because the agency can match the information reported by the employer, seller or other taxpayer with the information reported by the employee, purchaser or other taxpayer. When information does not match, this raises a red flag at the IRS. Let’s look at an example:

Silvio borrowed funds to pay for college. Silvio’s lender agreed to forgive a percentage of the debt if Silvio agreed to direct debit of his monthly repayments. This forgiveness of debt was reported by the lender to Silvio and the IRS. However, when Silvio filed his federal income tax return, he forgot, in good faith, to report the forgiveness of debt. The IRS was aware of the transaction because the lender filed an information return with the IRS.

Expansion

In recent years, Congress has enacted new information reporting requirements. Among the new requirements are ones for reporting the cost of employer-provided health insurance to employees, broker reporting of certain stock transactions and payment card reporting (all discussed below).

Employer-provided health insurance. The Patient Protection and Affordable Care Act requires employers to advise employees of the cost of employer-provided health insurance. This information will be provided to employees on Form W-2.

This reporting requirement is optional for all employers in 2011, the IRS has explained. There is additional relief for small employers. Employers filing fewer than 250 W-2 forms with the IRS are not required to report this information for 2011and 2012. The IRS may extend this relief beyond 2012. Our office will keep you posted of developments.

Reporting of employer-provided health insurance is for informational purposes only, the IRS has explained. It is intended to show employees the value of their health care benefits so they can be more informed consumers.

Broker reporting. Reporting is required for most stock purchased in 2011 and all stock purchased in 2012 and later years, the IRS has explained. The IRS has expanded Form 1099-B to include the cost or other basis of stock and mutual fund shares sold or exchanged during the year. Stock brokers and mutual fund companies will use this form to make these expanded year-end reports. The expanded form will also be used to report whether gain or loss realized on these transactions is long-term (held more than one year) or short-term (held one year or less), a key factor affecting the tax treatment of gain or loss.

Payment card reporting. Various payment card transactions after 2010 must be reported to the IRS. This reporting does not affect individuals using a credit or debit card to make a purchase, the IRS has explained. Reporting will be made by the payment settlement entities, such as banks. Payment settlement entities are required to report payments made to merchants for goods and services in settlement of payment card and third-party payment network transactions.

Roll back

In 2010, Congress expanded information reporting but this time there was a backlash. The PPACA required businesses and certain other taxpayers to file an information return when they make annual purchases aggregating $600 or more to a single vendor (other than a tax-exempt vendor) for payments made after December 31, 2011. The PPACA also repealed the long-standing reporting exception for payments made to corporations. The Small Business Jobs Act of 2010 required information reporting by landlords of certain rental property expense payments of $600 or more to a service provider made after December 31, 2011.

Many businesses, especially small businesses, warned that compliance would be costly. After several failed attempts, Congress passed legislation in April 2011 (H.R. 4, the Comprehensive 1099 Taxpayer Protection Act) to repeal both expanded business information reporting and rental property expense reporting.

The future

In April 2011, IRS Commissioner Douglas Shulman described his vision for tax collection in the future in a speech in Washington, D.C. Information reporting is at the center of Shulman’s vision.

Shulman explained that the IRS would get all information returns from third parties before taxpayers filed their returns. Taxpayers or their professional return preparers would then access that information, online, and download it into their returns. Taxpayers would then add any self-reported and supplemental information to their returns, and file their returns with the IRS. The IRS would embed this core third-party information into its pre-screening filters, and would immediately reject any return that did not match up with its records.

Shulman acknowledged that this system would take time and resources to develop. But the trend is in favor of more, not less, information reporting.

What is a limited liability company?

A limited liability company (LLC) is a business entity created under state law. Every state and the District of Columbia have LLC statutes that govern the formation and operation of LLCs.

The main advantage of an LLC is that in general its members are not personally liable for the debts of the business. Members of LLCs enjoy similar protections from personal liability for business obligations as shareholders in a corporation or limited partners in a limited partnership. Unlike the limited partnership form, which requires that there must be at least one general partner who is personally liable for all the debts of the business, no such requirement exists in an LLC.

A second significant advantage is the flexibility of an LLC to choose its federal tax treatment. Under IRS’s “check-the-box rules, an LLC can be taxed as a partnership, C corporation or S corporation for federal income tax purposes. A single-member LLC may elect to be disregarded for federal income tax purposes or taxed as an association (corporation).

LLCs are typically used for entrepreneurial enterprises with small numbers of active participants, family and other closely held businesses, real estate investments, joint ventures, and investment partnerships. However, almost any business that is not contemplating an initial public offering (IPO) in the near future might consider using an LLC as its entity of choice.

Deciding to convert an LLC to a corporation later generally has no federal tax consequences. This is rarely the case when converting a corporation to an LLC. Therefore, when in doubt between forming an LLC or a corporation at the time a business in starting up, it is often wise to opt to form an LLC. As always, exceptions apply. Another alternative from the tax side of planning is electing “S Corporation” tax status under the Internal Revenue Code.

How Do I Write Off Bad Business Debts?

A business with a significant amount of receivables should evaluate whether some of them may be written off as business bad debts. A business taxpayer may deduct business bad debts if the receivable becomes partially or completely worthless during the tax year.

In general, most business taxpayers must use the specific charge-off method to account for bad debts. The deduction in any case is limited to the taxpayer’s adjusted basis in the receivable.

The deduction allowed for bad debts is an ordinary deduction, which can serve to offset regular business income dollar for dollar. If the taxpayer holds a security, which is a capital asset, and the security becomes worthless during the tax year, the tax law only allows a deduction for a capital loss. However, notes receivable obtained in the ordinary course of business are not capital assets. Therefore, if such notes become partially or completely worthless during the tax year, the taxpayer may claim an ordinary deduction for bad debts.

For a taxpayer to sustain a bad debt deduction, the debt must be bona fide. The IRS looks carefully at a bad debt of a family member.

To be entitled to a business debt write off, the taxpayer must also make a reasonable attempt to collect the debt. However, in a nod to reality, the IRS does not request the taxpayer to turn the debt over to a collection agency or file a lawsuit in an attempt to collect the debt if doing so has little probability of success.

Deadlines for claiming a write off for any past business bad debt must be watched. Taxpayers have until the later of (1) seven years from the date they timely filed their tax return or (2) two years from the time they paid the tax, to claim a refund for a deduction for a wholly worthless debt not deducted on the original return.