Vernoia, Enterline + Brewer, CPA LLC

Archive for August, 2014

FAQ: Why use a partnership instead of an S corporation?

Two business partners making a business deal.Taxpayers that plan to operate a business have a variety of choices. A single individual can operate as a C corporation, an S corporation, a limited liability company (LLC), or a sole proprietorship. Two or more individuals can form a partnership, a corporation (C or S), or an LLC.

Nontax considerations

State law and nontax considerations are an important consideration in choosing the form of the business and may play a decisive role. A general partner of a partnership has unlimited liability for the debts of the business. This can be modified by using a limited partnership (LP), which must have at least one general partner and at least one limited partner. The general partner still have unlimited liability, but a limited partner’s liability is limited to its contribution to the partnership. A corporation has limited liability; shareholders generally are not responsible for the liabilities of the corporation beyond their contributions to the entity.

Federal tax considerations

At the same time, it is crucial to consider federal tax requirements and consequences when choosing the form of business entity. A primary federal tax consideration is avoiding a double layer of tax on business income. This can be accomplished by operating as a passthrough entity, such as a partnership or S corporation. Income is not taxed at the entity level. It passes through to partners and shareholders and is taxed at their rates.

In contrast, C corporations are taxable entities. Furthermore, when a C corporation pays a dividend to its shareholders, this generally is taxable to the shareholder. It must be noted that income of a passthrough entity is allocable and taxable to its owners, whether or not the income is actually distributed to the partner or shareholder. Dividends are not taxed unless there is an actual distribution.

While a partnership is organized under state law, an S corporation is a creature of the federal tax system. The S corporation is a regular corporation for state law purposes.

Advantages of partnerships

Unlike an S corporation shareholder, anyone or any entity can be a partner. S corporations are limited to 100 shareholders; only certain individuals, estates and trusts are eligible to be shareholders. C corporations and nonresident aliens cannot be shareholders of an S corporation.

S corporations are limited to a single class of stock; income and losses must be allocated on the same basis to each shareholder. Having only one class of stock may affect the corporation’s ability to raise capital. A partnership can have different classes of partners and has more flexibility for allocating income and losses to different types of partners.

Partnership liabilities can increase a partner’s basis in the partnership, offsetting distributions of cash and reducing their taxation. The increased basis allowed partners to use losses generated by the partnership. Liabilities of an S corporation do not create stock basis; separate bases in stock and debt must be calculated. This lack of basis may limit the use of losses generated by the S corporation.

Contributions of appreciated property by a partner to the partnership generally are not taxable, even if the partner is not part of a group controlling the partnership. Contributions by a shareholder to a corporation are tax-free only if the shareholders are part of a group controlling 80 percent of the corporation after the contribution. However, a partnership must follow special allocation rules for handling built-in gain on contributed property, whereas S corporations do not have special allocation rules in this circumstance.

Conclusion

In general, a partnership offers more flexibility than an S corporation in the treatment of taxes. However, S corporation shareholders do have limited legal liability, while general partners are not insulated from the partnership’s debts and liabilities.

How Do I compute the employer child care expense credit?

Child Care Tax CreditEmployers may be able to claim a tax credit for a portion of their expenses for providing child care to their employees. Code Sec. 45F allows a employer-provided child care credit, which is a part of the general business credit. Businesses calculate the credit using Form 8882, Credit for Employer-Provided Childcare Facilities and Service, and enter any credit amount on Form 3800, General Business Credit, which must be attached to an employer’s tax return.

Amount of the credit

The amount of the credit is the sum of 25 percent of an employer’s “qualified childcare facility expenditures,” plus 10 percent of the employer’s “qualified childcare resource and referral expenditures” for the tax year. The total credit amount is limited to $150,000.

Qualified childcare facility expenditures

Examples of expenses that are qualified child care expenditures include:

  • Expenses paid or incurred to acquire, construct, rehabilitate, or expand a qualified child care facility that (i) is to be used by the taxpayer; (ii) is depreciable property; and (iii) is not the principal residence of the taxpayer or any of the taxpayer’s employees;
  • Expenses for operating costs of a qualified child care facility (i.e. providing childcare training), and
  • Amounts paid or incurred under a contract with a qualified child care facility to provide childcare to the taxpayer’s employees.

Fair market value. Employers should consider the fair market value of childcare expenditures. The IRS may question expenses that exceed the fair market value of the care provided. For example, alarm bells may ring if in a given area, expenses to operate a childcare facility are only half of what the employer claims.

Qualified childcare facility

It should go without saying that child care expenses are only qualified for purposes of claiming the credit if the expenses were paid or incurred with respect to a qualified child care facility. This is defined as a facility whose principal use—unless it is the principal residence of the operator—is to provide child care assistance. A qualified childcare facility must also meet the requirements of all applicable state and local laws and regulations, including licensing requirements. Furthermore:

  • A facility must have enrollment open to employees of the taxpayer during the tax year; and
  • The facility may not discriminate in favor of highly compensated employees.
  • Finally, if the facility itself is the principal trade or business of the taxpayer, at least 30 percent of the children enrolled must be dependents of employees of the taxpayer.

Qualified childcare resource/referral expenditures

An expense qualifies as a qualified child care resource and referral expenditure if it is paid or incurred under a contract to provide child care resource and referral services to an employee of the taxpayer.

No double benefit

Taxpayers are not entitled to double benefits from the same expenditures. For example, if an employer claims a credit for expenses of constructing, rehabilitating, or expanding a qualified childcare facility, the employer must reduce its basis of the property by the amount of the credit. If the credit is subsequently recaptured, however, the employer may increase the basis of the property by the amount of the credit recaptured.

Recapture provisions

If a recapture event occurs during the first ten years after a qualified childcare facility is placed into service, the employer must pay back all or a portion of any amount of the employer-provided child care credit taken for qualified child care expenditures with respect to that qualified child care facility. The amount of the credit that must be recaptured decreases over the ten-year period. In addition, recapture applies only to the portion of the credit attributable to qualified child care expenditures, not to qualified child care resource and referral expenditures.

One example of an event that would trigger recapture is if the facility ceases to be operated as a qualified child care facility or if there is a change of ownership in the facility within the ten-year period.

If you have any questions about how to compute the employer-provided childcare credit, please contact our offices.

Appeals courts split on tax credits for ACA Marketplaces

On July 22, two federal appeals courts roughly 100 miles apart reached very different conclusions about one of the most widely-used provisions of the Affordable Care Act: the Code Sec. 36B premium assistance tax credit. The U.S. Court of Appeals for the District of Columbia Circuit found that the IRS had overreached when it issued regulations providing that individuals who obtain health coverage through a federally-facilitated Affordable Care Act Marketplace are eligible for the tax credit. In contrast, the Fourth Circuit Court of Appeals, sitting in Richmond, Virginia, upheld the IRS regulations as a valid exercise of the agency’s authority. The contradictory decisions create a split among the Circuits, which could prompt the U.S. Supreme Court to review the IRS regulations.

Tax Credit

To help offset the cost of health insurance coverage obtained through Marketplaces, the Affordable Care Act created the Code Sec. 36B credit. The credit is linked to an individual’s income in relation to the federal poverty line (FPL). Generally, individuals and families whose household income is between 100 percent and 400 percent of the FPL for their family size may be eligible for the credit. The credit is refundable and may be paid in advance to the insurer.

In 2012, the IRS issued regulations about the Code Sec. 36B credit. Opponents of the Affordable Care Act challenged the regulations in a number of cases, including the cases that made their way to the D.C. Circuit (Halbig et al. v. Burwell) and the Fourth Circuit (King et al. v. Burwell). Generally, they argued that the language of the Affordable Care Act only made the Code Sec. 36B credit available to individuals who obtained their coverage through a state-run Marketplace. Individuals who obtained coverage through a federally-facilitated Marketplace were ineligible for the credit. Two federal district courts ruled in favor of the IRS and the D.C. Circuit and the Fourth Circuit agreed to hear appeals.

D.C. Circuit Decision

In a 2-1 decision, a panel of the D.C. Circuit found that the IRS regulations were inconsistent with the Affordable Care Act. The majority looked to the language of the Affordable Care Act and found it was clear. “Applying the statute’s plain meaning, we find that Code Sec. 36B unambiguously forecloses the interpretation embodied in the IRS rule and instead limits the availability of premium tax credits to state-established (Marketplaces),” the court found.

The dissent would have upheld the IRS regulations. The dissent argued that the words of the Affordable Care Act had to be read with a view to their place in the overall statute. The tax credits, the dissent explained, are an essential component of the Affordable Care Act, and the IRS regulations were entitled to deference.

Fourth Circuit Decision

The Fourth Circuit decision was also made by a panel of three judges. Unlike the D.C. Circuit, the Fourth Circuit found that the language of the Affordable Care Act was unclear and looked to the policy goals of the Affordable Care Act. “Widely-available tax credits are essential to fulfilling the Affordable Care Act’s primary goals. The IRS rule advances this understanding by ensuring that this essential component exists on a sufficiently large scale, the court held. The court concluded that the IRS regulations were a permissible construction of the Affordable Care Act and upheld the regulations.

Appeals Expected

Shortly after the D.C. Circuit announced its decision, a White House spokesperson said that the Obama administration will appeal the ruling to the entire D.C. Circuit. All 11 judges of the D.C. Circuit are expected to hear the appeal (an “en banc” hearing). The full D.C. Circuit could uphold the panel’s decision or reverse it. If the full D.C. Circuit agrees with the panel, the Obama administration would very likely appeal the decision to the U.S. Supreme Court. The taxpayers in the King case could also petition the Supreme Court to review the Fourth Circuit’s decision. At the same time, two other challenges to the Code Sec. 36B regulations are making their way through the federal district courts: one in Indiana and another in Oklahoma.

Looking Ahead

The conflicting decisions certainly contribute to uncertainty over eligibility for the Code Sec. 36B tax credit. Both individuals and employers need to keep track of developments. The Code Sec. 36B credit is part of the calculation under the Affordable Care Act to determine if an applicable large employer must make an employer shared responsibility payment (the “employer mandate.”).

The Obama administration is treating the decision by the D.C. Circuit as having no impact on the availability of the Code Sec. 36B tax credit. The U.S. Justice Department reported that qualified individuals in both state-run Marketplaces and federally-facilitated Marketplaces will continue to be eligible for the credit. IRS Commissioner John Koskinen made the same comments to Congress on July 23.

If you have any questions about these decisions or the Code Sec. 36B premium assistance tax credit, please contact our office.

New look to TINs/EINs to prevent identity theft/refund fraud

The IRS continues to ramp-up its work to fight identity theft/refund fraud and recently announced new rules allowing the use of abbreviated (truncated) personal identification numbers and employer identification numbers. Instead of showing a taxpayer’s full Social Security number (SSN) or other identification number on certain forms, asterisks or Xs replace the first five digits and only the last four digits appear. The final rules, however, do impose some important limits on the use of truncated taxpayer identification numbers (known as “TTINs”).

Note. A TTIN typically appears as XXX-XX-1234 or ***-**-1234.

Identity theft/refund fraud

The IRS has more than 3,000 employees working identity-theft related issues. They are investigating refund fraud and assisting taxpayers – both individuals and businesses – that have been victims of identity theft. The IRS has also upgraded its filters that screen tax returns for indications of refund fraud. Between 2011 and 2014, the IRS reported that it prevented more than $50 billion in fraudulent refunds.

Protecting personal information from disclosure is one important tool in the IRS’s toolshed to fight identity theft. IRS data systems contain personal information, such as SSNs, EINs, individual taxpayer identification numbers (ITINs) and adoption taxpayer identification numbers (ATINs) on millions of taxpayers. To thwart potential identity thieves, the agency launched a pilot program in 2009 to allow the use of TTINs. The goal of the pilot program was to reduce the risk of identity theft that could result from the inclusion of a taxpayer’s entire identifying number on a payee statement or other document.

Proposed regulations

The IRS viewed the pilot program as a success and issued proposed regulations in 2013. Under the proposed regulations, TTINs would be available as an alternative to using a taxpayer’s SSN, ITIN, or ATIN. The proposed regulations also permitted the use of TTINs to electronic payee statements as well as paper payee statements.

Expanded use

In July, the IRS announced that it was finalizing the proposed TTIN rules. The final rules also expand the use of TTINs to:

  • Employer identification numbers. The final rules allow the use of abbreviated employer identification numbers (EINs) in certain cases.
  • More documents. The final regulations permit the use of TTINs on any federal tax-related payee statement or other document required to be furnished to another person unless specifically prohibited.

Voluntary

The IRS encourages the use of TTINs but did not make use of TTINs mandatory. The IRS also explained that use of a TTIN will not result in any penalty for failure to include a correct taxpayer identifying number on any payee statement or other document.

Limitations

The final regulations (officially known as TD 9765) place some limits on TTINs. A TTIN may not be used on a return filed with the IRS. This includes Form 1040, U.S. Individual Income Tax Return. A TTIN also may not be used if a statute or regulation specifically requires use of an SSN, ITIN, ATIN, or EIN. Additionally, employers cannot use a TTIN on an employee’s Form W-2, Wage and Tax Statement.

If you have any questions about TTINs or identity theft/refund fraud, please contact our office.

IRS final rules encourage longevity annuity purchases

grannyLife expectancies for many Americans have increased to such an extent that most taxpayers who retire at age 65 expect to live for another 20 years or more. Several years ago, a number of insurance companies began to offer a new financial product, often called the longevity annuity or deferred income annuity, which requires upfront payment of a premium in exchange for a guarantee of a certain amount of fixed income starting after the purchaser reaches age 80 or 85. Despite the wisdom behind the longevity annuity, this new type of product did not sell especially well, principally for tax reasons. These roadblocks, however, have largely been removed by new regulations.

Treasury and the IRS recently released final regulations (TD 9673) to encourage taxpayers to purchase “qualified longevity annuity contracts” (QLACs) with a portion of their retirement savings held in IRAs or in retirement accounts held under a 401(k), 403(b) or other defined contribution plans that are subject to the rules for required minimum distributions (RMDs). The final regulations are meant to remove or mitigate some of the tax concerns new retirees may face when deciding whether or not to purchase a deferred income annuity.

Longevity Annuities—Generally

Purchase of a longevity annuity provides for a deferred income stream. Although the terms of specific longevity annuity contracts differ from plan to plan, the arrangement generally requires the purchaser to pay the premium as a lump sum to the insurer. The purchaser could be 65 years of age, 55, 50 or some other age, and the insurer would not begin to make payments under the longevity annuity contract until the purchaser had reached the specified age (of no more than 85 years for the tax benefits contained in the final regulations). The amount of the annuity depends on a number of factors, among them: the age at which the contract is purchased; the amount of the premium paid; the contractual interest rate; and the age at which payments begin.

RMDs

Not every individual who reaches retirement age possesses enough spare cash outside of his or her IRAs or other retirement accounts to purchase an income annuity, let alone a longevity annuity that does not begin to pay out for many years. In such cases individuals can purchase an annuity from within an IRA or defined contribution plan account. Prior to the final regulations, however, the RMD rules requiring taxpayers who reach age 70 ½ to begin taking distributions from these accounts would have forced taxpayers to factor the premium amounts into the calculation of their annual taxable distribution. This would have depleted the account funds more quickly than the actual balance, without premium payment, warranted.

QLACs

The final regulations provide that only qualified longevity annuity contracts (QLACs) are eligible for account balance exclusion from the RMD calculation. The regulations define a QLAC as:

  • A longevity annuity whose premium payment does not exceed the lesser of $125,000 or 25 percent of the employee’s account balance;
  • A contract that provides for payouts to begin no later than the first day of the month following the purchaser’s 85th birthday;
  • A contract that does not provide any commutation benefit, cash surrender right, or other similar feature;
  • A contract under which any death benefit offered meets the requirements of paragraph A-17(c) of Reg. §1.401(a)(9)-6 (see below for more details);
  • A contract that states when issued that it is intended to be a QLAC; and
  • A contract that is not a variable contract under Code Sec. 817, an indexed contract, or a similar contract.

The total value of all QLACs held by one person cannot exceed the lesser of $125,000 (indexed for inflation) or 25 percent of all qualified retirement accounts put together. This limitation does not extend to funds held in non-retirement accounts or to funds held in Roth IRAs.

In addition, the amount used to pay the QLAC premium is not taxable when the QLAC is purchased. This means the account holder has a zero basis in the QLAC. Distributions from the QLAC are fully taxable.

Death Benefit

Most longevity annuities do not provide any death benefit for the purchaser’s beneficiaries. While some longevity annuity plans do offer a death benefit for the beneficiaries of annuity purchasers who die prematurely, plans that maximize the annuity payment generally provide that the insurer keeps the entire premium amount, plus interest, if the purchaser dies before payouts begin or the contract basis is exhausted.

Return of premium. The final regulations attempt to mitigate some of the risk retirees face when deciding to purchase a QLAC by allowing a QLAC to provide certain death benefits in limited circumstances. Notably, the final regulations add a feature missing from the proposed regulations: return of premium. Under the final rules, a QLAC is authorized to guarantee the return of a purchaser’s premium if the purchaser dies before receiving benefits equal to the premium paid.

Surviving spouse. The final regulations provide that, where the purchaser’s sole beneficiary under the QLAC is his or her surviving spouse, generally the only benefit permitted to be paid after the purchaser’s death is a life annuity that does not exceed 100 percent of the annuity that would have been paid to the employee. The final regulations also allow QLACs to provide the return of premium feature if a surviving spouse who receives a life annuity under the contract dies before the payments equal the premium.

Non-spouse beneficiary/beneficiaries. QLACs may also provide a lifetime annuity to designated non-spouse beneficiaries, but the annuity would likely be reduced. Calculation of an annuity payable to a non-spouse beneficiary would be calculated based on the applicable percentage provided in one of the tables in the final regulations. However, if the QLAC provides a return of premium feature, the applicable percentage that the beneficiary would receive is zero.

Please contact this office if you have any questions on how a qualified longevity annuity might fit into your retirement plans now that the IRS has relaxed some of the rules.