Vernoia, Enterline + Brewer, CPA LLC

Archive for August, 2011

Tax Court finds individual drag racing a hobby; no profit motive

hobby - no tax write-offA drag racing enthusiast has failed to persuade the Tax Court that his sport was a business and not a hobby. The Tax Court acknowledged the taxpayer’s long experience in drag racing but found that experience did not equate to business expertise. This and other factors indicated that the taxpayer lacked a genuine profit objective in drag racing.

Drag racing

In 1970, the taxpayer began participating in drag racing. At first, he volunteered as a crew member and mechanic for various drag racing teams.  The taxpayer purchased a drag racing car in 1988 and entered races. In subsequent years, he purchased additional cars and entered more races.

During race seasons, the taxpayer typically would spend about 30 hours per week preparing the race cars. This time was in addition to the time spent participating in weekend races. The taxpayer also worked a full-time job unrelated to drag racing.

On his 2005, 2006 and 2007 federal income tax, the taxpayer reported more than $100,000 in losses related to drag racing on Schedule C.  The IRS disallowed the losses; determining that the taxpayer’s drag racing was not an activity engaged in for profit.

Factors

The IRS and the courts use a number of factors to determine if an activity is for profit or is a hobby. Some of the factors are (not an exhaustive list):

  • Does the time and effort put into the activity indicate an intention to make a profit?
  • Does the taxpayer depend on income from the activity?
  • If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
  • Has the taxpayer changed methods of operation to improve profitability?
  • Does the taxpayer have the knowledge needed to carry on the activity as a successful business?
  • Does the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

Hobby not business

In this case, the court found that the taxpayer drew substantial enjoyment from drag racing.  The taxpayer enjoyed traveling to weekend race events, watching his team participate in events, and developing friendships with individuals involved in drag racing.

The court also found that the taxpayer did not maintain books or written records, had no formal business plan, and did not create annual budget and expense forecasts relating to drag racing. Although a taxpayer is not required to maintain a sophisticated system of accounting, a taxpayer should keep documents that allow the taxpayer to make informed business decisions, the court noted.

The court further found that the taxpayer’s drag racing generated minimal income.  The losses the taxpayer incurred in connection with his drag racing activity were over 54 times the amount of income earned.

The court concluded that the taxpayer lacked good faith intent to make a profit from his drag racing activities. The court upheld the IRS’s disallowance of his drag racing losses.

IRS posts individual income data by zip code

Ever wonder how other residents in your area are doing, either in terms of income or deductions, or other tax information?  You may be able to get some indication through IRS-provided online tables for Individual Income Tax Zip Code Data.

The IRS’s Statistics of Income (SOI) Division regularly extrapolates return data for U.S. zip codes where 250 or more individual returns were filed.  The IRS reports the number of returns filed, joint returns, income levels, capital gains and dividends, various amounts taken as deductions, IRA distributions, and additional statistical information for a particular tax year. The IRS recently posted preliminary data about returns filed by individuals for tax year (TY) 2008 on its web site.

The latest data was available on the irs.gov web site (http://www.irs.gov/taxstats/indtaxstats/article/0,,id=242739,00.html) for several days after it was posted in late-July.  However, at this time, the IRS has removed the data pending a review.  It stated that it is reviewing its methodology for preparing the annual zip code file to safeguard the confidentiality of taxpayer information. The agency nevertheless indicated it may update the TY 2008 preliminary data that had been originally posted, depending on the results of its review.

IRS abandons two-year limitations period for equitable innocent spouse relief

The IRS has abandoned its controversial regulations that imposed a two-year statute of limitations period for taxpayers to request equitable innocent spouse relief under Code Sec. 6015(f).  Instead, taxpayers can request relief within the applicable statute of limitations period:

  • For the IRS to collect the tax — 10 years after assessment, or
  • For taxpayers to request a credit or refund of tax — the later of three years after the return was filed or two years after the tax was paid.

While the statute imposed a two-year statute of limitations requirement for taxpayers to request innocent spouse relief under Code Sec. 6015(b) or (c), the statute had no statute of limitations period for requesting equitable relief under Code Sec. 6015(f).  The IRS by regulation imposed a two-year statute, from the time of the first collection activity.

The Tax Court struck down the regulation as an improper denial of equitable relief; but U.S. Courts of Appeal reversed the Tax Court and upheld the regulation.  In May 2011, more than 50 Congressmen wrote to the IRS that the regulation was contrary to Congressional intent.  IRS Commissioner Douglas Shulman promised to review the regulation.

The IRS announced transition rules for taxpayers seeking equitable innocent spouse relief, while it modifies the regulations.  Subject to the applicable statutes of limitation on collections and refunds, the IRS will do the following:

  • Future requests – Taxpayers may request equitable innocent spouse relief after July 25, 2011, the date of the IRS announcement, without regard to the first collection activity.
  • Pending requests – The IRS will consider a pending request without regard to the first collection activity.
  • Denied requests – Taxpayers should reapply for relief.  The IRS will accept the application if the initial request was timely for requesting a refund.
  • Requests in litigation – The IRS will take appropriate action where it previously denied a request as untimely.

Completed litigation – The IRS generally will take no further collection action.

FinCEN announces e-file option for FBAR

Effective immediately, filers of Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (known as the “FBAR”) may opt to file the FBAR electronically. The Treasury Department’s Financial Crimes Enforcement Network (FinCEN) announced the long-awaited e-file option for the FBAR.

FBARs

United States persons are required to file an FBAR if they had a financial interest in or signature authority over at least one financial account located outside of the United States; and the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the calendar year to be reported.

Filers do not file the FBAR with their federal income tax return. The FBAR must be received by the IRS on or before June 30 of the year following the calendar year being reported. Previously, the only option for filers was to file the FBAR on paper.  Electronic filing was not an option until now.

Electronic filing

To electronically file the FBAR, filers must apply and obtain a user ID. FinCEN reported it will review the application for accuracy and issue a user ID. Additionally, filers must download a free forms viewer, which allows for the preparation of electronic returns and their transmittal. The e-filing platform also has certain operational system specifications.

FinCEN noted that its current capability only allows for one digital signature on an e-filed FBAR. Therefore, each spouse must file a separate FBAR if they choose to file electronically, FinCEN explained.  Additionally, FinCen reported that tax preparation software cannot, at this time, be used to create and file the FBAR. FinCEN added it is working to create that capability.

Paper option retained

Filers may continue to file the FBAR on paper if they choose. Any change in that policy will be announced by FinCEN.

(FinCEN News Release, July 18, 2011)

NJ enacted budget increases tax credit and homestead benefits

On June 30, 2011, New Jersey Gov. Chris Christie approved a budget that does not raise taxes, eliminates the cap on the corporation business tax research credit, decreases the minimum corporation business tax on S corporations by 25%, doubles the homestead property tax benefit, and phases out the transitional energy facility assessment (TEFA) imposed on utilities over the next three years.

The governor also vetoed legislation that would have done the following: raised taxes on individuals and businesses with taxable gross income exceeding $1 million; increased the exclusion from annual gross income of certain benefits (i.e., pension, annuity, endowment, life insurance contract, disability, and retirement income) received by senior and disabled taxpayers; and increased the amount of the state earned income tax credit to 25% of the federal earned income tax credit (EITC).

Minimum corporation business tax on S corporations: S.B. 2981, Laws 2011, provides that for tax periods beginning on and after January 1, 2012, the minimum corporation business tax on S corporations is decreased by 25%, as follows:

  • if New Jersey gross receipts are less than $100,000, the minimum tax is $375;
  • if New Jersey gross receipts are $100,000 or more but less than $250,000, the minimum tax is $562.50;
  • if New Jersey gross receipts are $250,000 or more but less than $500,000, the minimum tax is $750;
  • if New Jersey gross receipts are $500,000 or more but less than $1 million, the minimum tax is $1,125; and
  • if New Jersey gross receipts are $1 million or more, the minimum tax is $1,500.

The minimum tax of New Jersey S corporations that are members of affiliated or controlled groups with total payrolls of $5 million or more will remain at $2,000 annually.

Corporate business tax research credit: S.B. 2980, Laws 2011, eliminates the limit on the application of the corporation business tax research expense credit for tax periods beginning on and after January 1, 2012. Currently, the research expense credit is equal to 10% of the increase in “qualified research expenses” (research performed by or for the taxpayer) in a tax year over a base amount, plus 10% of the “basic research payments” (university research funded by the taxpayer) in a tax period. The credit is limited to expenditures made in New Jersey. This bill does not affect the allowance of the credit, but removes a restriction on its application. Currently, the amount of research credit applied in any tax period may not exceed 50% of the tax otherwise due and may not reduce the tax liability to less than the statutory minimum (currently $500 to $2,000 annually, depending on the gross receipts of the taxpayer). This bill eliminates the restriction that the amount of credit may not exceed 50% of the tax otherwise due for tax periods beginning on or after January 1, 2012. This bill retains the restriction that the credit may not reduce the tax liability to less than the statutory minimum.

Property tax provisions: S.B. 4000, Laws 2011, provides that for purposes of the Homestead Benefit Program, residents who are 65 years of age or older at the close of the tax year, or residents who are allowed to claim a personal deduction as a blind or disabled taxpayer, with gross income in excess of $100,000 but not in excess of $150,000 for tax year 2010 are eligible for a benefit in the amount of 5% of the first $10,000 of property tax paid. Those with gross income not in excess of $100,000 for tax year 2010 are eligible for a benefit in the amount of 10% of the first $10,000 of property taxes paid. Those with gross income in excess of $150,000 for tax year 2010 are excluded from the program.

Residents who are not 65 years of age or older at the close of the tax year, or residents who are not allowed to claim a personal deduction as a blind or disabled taxpayer, with gross income in excess of $50,000 but not in excess of $75,000 for tax year 2010 are eligible for a benefit in the amount of 6.67% of the first $10,000 of property taxes paid. Those with gross income not in excess of $50,000 for tax year 2010 are eligible for a benefit in the amount of 10% of the first $10,000 of property taxes paid. Those with gross income in excess of $75,000 for tax year 2010 are excluded from the program. The benefits are calculated based on the 2006 property tax amounts assessed or as would have been assessed on the October 1, 2010 principal residence of eligible applicants.

For purposes of the senior and disabled citizens’ property tax freeze, citizens with annual income of more than $70,000 are not eligible for property tax reimbursements in fiscal year 2012. S.B. 2980, Laws 2011, effective June 30, 2011, applicable as noted; S.B. 2981, Laws 2011, effective June 30, 2011, applicable as noted; S.B. 4000, Laws 2011, effective July 1, 2011; S.B. 4001, Laws 2011, effective June 30, 2011; Press Release, Office of New Jersey Gov. Chris Christie, June 30, 2011.

FUTA surtax expires; retroactive reinstatement possible

The Federal Unemployment Tax Act (FUTA) surtax expired effective July 1, 2011. The 0.2 percent surtax, originally enacted in 1976, had been last extended by the Worker, Homeownership and Business Assistance Act of 2009 (2009 Worker Act) through 2010 and the first six months of 2011. It has been extended for one or two year increments since its 1976 enactment.

Prior to July 1, 2011, FUTA was made up of the permanent 6.0 percent rate and the 0.2 percent surtax for a combined tax rate of 6.2 percent. Employers in states with programs approved by the federal government and with no delinquent federal loans may credit 5.4 percentage points against the 6.2 percent tax rate.

The extension of the FUTA surtax under the 2009 Worker Act expired after June 30, 2011. As a result of the expiration of the surtax, the FUTA tax rate falls to 6 percent before any state unemployment tax credits are taken into account. However, since the FUTA tax is imposed on employers for annual wage amounts paid to employees only up to the $7,000 FUTA wage base, employers with a stable workforce likely will have already capped out on the maximum $7,000 wage base on each employee before the July 1, 2011 expiration.

Comment.  President Obama has called on Congress to make the surtax permanent. GOP leaders in the House have indicated they are not likely to bring legislation to the floor to make the surtax permanent. However, a retroactive extension of the FUTA surtax to July 1, 2011 could be part of any number of bills that may clear Congress before year end.

Federal debt limit talks move major tax proposals up for consideration

The federal debt limit negotiations that preoccupied Washington for most of July did not result in immediate tax legislation. However, the general debate did succeed in helping to jumpstart a serious discussion over taxes that now has the momentum to continue. Tax increases, rate hikes, rate reductions and general tax reform are now all on the table.

Whether tax legislation will be recommended and passed at year-end 2011 as the result of an immediate directive to start trimming the deficit is but one possible outcome of the debt-limit debates. Another increasingly persuasive catalyst for tax legislation will result from the many Congressional hearings on tax reform now being held on Capitol Hill. Those hearings are using as springboards initial proposals that have been introduced recently by the White House Deficit Commission Report, the Republican Study Committee, and the so-called Gang of Six, a bi-partisan group of Senators suggesting ways to cut trillions from the deficit over the next 10 years. Finally, the need for Congress to act on the Bush-era tax cuts set to expire after December 31, 2012, will all but force Congress to deal with tax reform in an era in which careful budgeting is essential to economic growth.

Administration’s Proposals

At the center of President Obama’s plan to trim the deficit is an extension of the Bush-era tax cuts for lower and middle income taxpayers after 2012, but not for some higher income taxpayers now in the top two rate brackets. Under the president’s plan, taxes would increase for higher income individuals (which the White House defines as individuals with incomes above $200,000 and families with incomes above $250,000). The White House has also called for the elimination of certain oil and gas tax preferences, a permanent research tax credit and an extension of the 2011 payroll tax cut.

Gang of Six Tax Proposals

In early 2011, six members of the Senate (the Gang of Six) began negotiations on a comprehensive deficit reduction plan. On July 19, 2011, the senators released a bipartisan blueprint to reduce the budget deficit by $3.7 trillion over 10 years through a combination of spending cuts and revenue raisers.

Individual tax rates. The Gang of Six would replace the current individual marginal income tax rate schedule with three new tax brackets, ranging from: 8-12 percent; 14-22 percent; and 23-29 percent. The alternative minimum tax (AMT) would be repealed as well.

Tax expenditures. In return for lower tax rates and no AMT, the Gang of Six would reduce a yet unspecified number of “tax expenditures,” aka deductions and credits. Possible tax expenditures up for reform, but not repeal, could include the home mortgage interest deduction, the deduction for charitable contributions and the deduction for certain medical expenses.

Corporate tax. The Gang of Six would establish a single, lower corporate tax rate of somewhere between 23 percent and 29 percent while promising to raise as much revenue as under the current corporate tax system by eliminating many yet-to-be specified business deductions, credits and other preferences. The Gang of Six would also move to a territorial tax system under which profits would be taxed only by the country where the income is earned.

House Republican Study Committee

The Republican Study Committee (RSC) is made up of 175 conservative members of the House. The RSC drafted the deficit reduction proposal which passed the House on July 19, 2011 as the Cut, Cap and Balance Act. The Cut, Cap and Balance Act, ultimately rejected by the Senate, did not include any tax increases.

Tax reform. The RSC has called for a “smarter” Tax Code that would lower rates while broadening the tax base. The RSC to date has not offered any further specifics on how it would lower rates and broaden the tax base. The RSC has previously indicated its opposition to any scaling back of the Bush-era tax cuts.

White House Deficit Commission

The bipartisan National Commission on Fiscal Responsibility and Reform issued its final report, “The Moment of Truth,” in December 2010. The Commission developed a six-part plan designed to reduce the federal deficit by almost $4 trillion by 2020. The 18-member commission approved the report by a vote of 11-7, with Democrats and Republicans on both sides of the vote.

Tax reform. Tax reform as envisioned by the Deficit Commission would achieve at least 20 percent of the $4 trillion reduction. The Deficit Commission plan aims to reduce, if not eliminate, $1.1 trillion in tax expenditures in the current Tax Code for individuals and businesses. Under current law, the largest tax expenditure is the tax-free treatment of contributions to health care plans at approximately $144 billion per year.

Other substantial tax expenditures include:

  •    $79 billion by disallowing portions of the home mortgage interest deduction,
  •    $57 billion by curtailing accelerated depreciation,
  •    $53 billion by raising capital gains rates, and
  •    $49 billion by tightening the availability of the earned income credit.

At the same time, the plan would reduce tax rates, the amount depending on the amount of tax expenditures eliminated.

Individual income tax rates. Under one scenario, the Deficit Commission’s plan would provide three ordinary income tax rates as low as 8, 14, and 23 percent. The plan would treat capital gains and dividends as ordinary income, but, of course, ordinary income rates would be lower. The plan would eliminate the alternative minimum tax (AMT).

More “reforms. Other targeted reforms proposed by the Deficit Commission include:

  •    Limiting the charitable deduction for individuals to amounts over two percent of adjusted gross income;
  •    Repealing the state and local tax deduction for individuals;
  •    Repealing all miscellaneous itemized deductions for individuals;
  •    Capping the income tax exclusion for employer-provided health insurance; and
  •    Raising the federal gasoline tax by 15 cents per gallon.

Corporate tax. The Deficit Commission plan would provide a single corporate tax rate of 26 percent, compared to the current maximum rate of 35 percent. Additional business-related reforms include eliminating the Code Sec. 199 domestic manufacturing deduction, the LIFO (last-in, first-out) method of accounting, and oil and gas production incentives.

TAX WRITING COMMITTEES

In tandem with deficit reduction proposals, the tax writing committees in Congress are exploring possible reforms to the Tax Code. The Senate Finance Committee, controlled by Democrats, and the House Ways and Means Committee, controlled by Republicans, have looked at a variety of issues related to individual and business taxation.

The Senate Finance Committee (SFC), under the leadership of Sen. Max Baucus, D-Mont., has held a series of hearings in recent months on tax reform. The SFC has examined, among other issues, oil and gas tax preferences, the tax treatment of business and household debt, strategies to increase the voluntary compliance rate to 90 percent, and efforts to close the tax gap.

The House Ways and Means Committee has also held a series of hearings on tax reform in recent months. The Ways and Means Committee has examined, among other issues, the advantages and disadvantages of a value added tax (VAT), tax incentives to encourage foreign investment in the U.S., and the corporate tax rate.

Please contact this office if you have any questions over how momentum toward deficit reduction and tax reform may impact your bottom line tax liability in the future.