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Archive for July, 2015

FAQ: Can I deduct the cost of sending my child to summer camp?

Now that summer 2015 is officially here and the main filing season is out of the way, tax planning may be far from your mind. However, typical summer traditions can yield tax benefits. For example, when school lets out for the summer, some parents may decide to send their young children to summer camp. Whether parents do this to supplement their children’s education, enhance their athletic skills, provide social opportunities, or simply to get them out of the house, some working parents may be able to deduct certain expenses associated with the cost of sending children to day camp. That’s where the child care and dependent credit under Code Sec. 21, might especially come into play.

Child Care and Dependent Credit Basics

A taxpayer, who incurs expenses to obtain day care for child under age 13 so that the taxpayer and his or her spouse can be gainfully employed (or look for gainful employment), may be able to claim the child care and dependent tax credit on Form 1040, (line 49), Form 1040A (line 31), or Form 1040NR (line 47). Taxpayers may also claim the credit for expenses paid for care for certain other qualifying individuals, such as physically or mentally incapacitated dependents.

Taxpayers who qualify for the child and dependent care tax credit must claim it by completing and filing Form 2441, Child and Dependent Care Expenses, along with their tax returns. Taxpayers may not claim the credit if they file a Form 1040EZ, Income Tax Return for Single and Joint Filers With No Dependents, or Form 1040NR-EZ, U.S. Income Tax Return for Certain Nonresident Aliens With No Dependents.

A taxpayer who qualifies may claim a credit in an amount between 20 to 35 percent of employment-related child care expenses. Such expenses can include the cost of sending a child to day camp, something that can run up a hefty bill of more than $100 or $500 per week!

In general, to claim the child and dependent care credit, the taxpayer must meet the following requirements:

  • The taxpayer must live with the child(ren) or qualifying person(s) for more than half of the tax year;
  • The child and dependent care expenses must be incurred to allow the taxpayer to work or look for work. (If the taxpayer or the spouse is a stay-at-home parent, unfortunately, the child care costs are nondeductible);
  • The taxpayer must have income from work during the year. (The amount of the employment-related expenses taken into account in calculating the child and dependent care credit may not exceed the lesser of the taxpayer’s earned income or the earned income of his spouse if the taxpayer is married at the end of the tax year);
  • The taxpayer must have made payments for child and dependent care to someone the taxpayer or his spouse could not claim as a dependent. If the person to whom payments were made was the taxpayer’s child, the child must have been 19 or over by the end of the year;
  • If married, the taxpayer must file a joint return (unless an exception applies);
  • The taxpayer must include the taxpayer identification number of the qualifying individual on the return;
  • The taxpayer must provide specified information regarding service providers, including the name, address and taxpayer identification number (TIN) of the provider (no TIN is required if the provider is a tax-exempt organization);
  • A taxpayer must substantiate any child and dependent care credit claimed by providing adequate records or other sufficient evidence of work-related expenses, etc.

Summer Camp Costs

Because day camp is comparable to day care, the IRS allows taxpayers to factor in the costs of sending a child to day camp when determining the amount of the child and dependent care credit they may claim. The cost of sending a child to a day camp may be a work-related expense, even if the camp specializes in a particular activity, such as computers, music, football, or soccer. Furthermore, taxpayers are not required to seek out the least expensive day camp option in order to claim the credit. The IRS regulations provide that “the manner of providing care need not be the least expensive alternative available to the taxpayer.”

Reg. §1.21-(1)(d)(6) provides that the cost of sending your child to an overnight camp, however, is not considered a work-related expense. Similarly, summer school and tutoring programs are not considered to be for the care of a qualifying individual and the costs are not employment-related expenses.

The regulations under Code Sec. 21 provide two examples intended to outline the distinction between a summer day camp, for which expenses are deductible, and a tutoring program, for which expenses are nondeductible. They state: To be gainfully employed, N sends her 9-year old child to a summer day camp that offers computer activities and recreational activities such as swimming and arts and crafts. The full cost of the summer day camp may be for deductible care. In contrast, to be gainfully employed, O sends her 9-year old child to a math tutoring program for two hours per day during the summer. The cost of the tutoring program is not for deductible care.

According to the IRS, the question of whether or not an expense qualifies for the dependent care credit depends on the nature and primary purpose of the services provided and is primarily a question of fact. In order for an expense to qualify in full for the dependent care credit, any portion of the expense for purposes other than care must be minimal or insignificant and inseparable from the portion of the expense for care. If a significant portion of the expense is for purposes other than care, an allocation must be made as to which portion of the costs are for deductible care and which portion of the costs are for other purposes. An expense that is primarily for a purpose that is not care, such as education, does not qualify for the dependent care credit.

Amounts paid for clothing, schooling and entertainment are not considered qualified expenses for purposes of calculating the child care and dependent credit. However, if these amounts are incidental to and cannot be separated from the cost of caring for the qualifying person, the regulations provide that these expenses can be counted toward the credit for qualified dependent care. This means that costs to purchase clothing, horseback riding chaps, soccer cleats, football padding, violin strings, or other gear that may be used by the child while at the day camp are nondeductible because they are technically personal in nature and not for the well-being of the child. However, if the day camp provides a lunch and snacks to the children attending the day camp, the regulations provide that the cost of this lunch and the snacks may be included in the cost of care for the child if they are incidental to and inseparably a part of the care.

The cost of transporting a qualifying individual to a place where care is provided is not generally a qualifying expense unless it is provided by a dependent care provider. If a day camp takes a child or qualifying person to or from the day camp location, that transportation is for the care of the child. This includes transportation by bus, subway, taxi, or private car.

Forfeited amounts

A taxpayer may include the cost of fees paid to an agency to get the services of a day camp provider, including deposits and application fees. However, if the taxpayer changes his or her mind and either does not send the child to day camp or selects another program, any forfeited deposit will not be considered “for the care of a qualifying person” and will therefore become nondeductible.

Credit Amount

The amount of the child care and dependent credit is subject to a cap calculated as a percentage of the taxpayer’s employment-related expenses, as well as a dollar limit. A maximum credit of 35 percent of employment-related expenses is available to taxpayers with adjusted gross income (AGI) of $15,000 or less. The credit percentage is reduced by one percentage point for each $2,000 of adjusted gross income, or fraction thereof, above $15,000. The minimum credit percentage is 20 percent, and it applies to a taxpayer with AGI in excess of $43,000.

In addition, the maximum amount of eligible expenses that may be used to calculate the final credit amount is $3,000 for taxpayers with one qualifying individual and $6,000 for taxpayers with two or more qualifying individuals. Therefore, the maximum credit amount is $1,050 for taxpayers claiming expenses for one child and $2,100 for taxpayers claiming expenses related to two or more children.

Any child care benefits provided by an employer will reduce dollar-for-dollar the amount of expenses a taxpayer may use to calculate the credit.

The child care and dependent credit is nonrefundable, meaning that if the taxpayer already has no tax liability for the year in which he or she incurred qualified expenses for purposes of the credit, he or she will receive no tax benefit from claiming the credit.

How Do I? Determine when “at risk” rules apply to my business

Taxpayers that invest in a trade or business or an activity for the production of income can only deduct losses from the activity or business if the taxpayer is at risk for the investment. A taxpayer is at risk for the amount of cash and the basis of property contributed to the activity. Taxpayers are also at risk for amounts borrowed if the taxpayer is personally liable to pay the liability, or if the taxpayer has pledged property as security for the loan (other than property already used in the business).

At-risk or not?

A taxpayer is not at risk for a nonrecourse loan, since there is no personal liability. However, amounts at risk include “qualified nonrecourse financing” used in connection with the holding of real estate. A taxpayer also is not at risk for contributions that are protected against loss by a guarantee, stop loss arrangement, or other similar arrangement. For certain activities, such as farming, oil and gas exploration, motion pictures, and the leasing of Code Sec. 1245 property, a taxpayer is not at risk for amounts borrowed from related persons or from persons who have an interest in the activity (other than as a creditor).

Scope of at-risk rules

The at-risk rules apply to all trade or business activities and to activities for the production of income. The rules apply to individuals, partners, S corporation shareholders, estates, trusts, and certain closely-held corporations. The at-risk rules generally do not apply to widely-held C corporations, whether public or private. There also is an exception for equipment leasing activities of closely-held corporations.

Deduction of losses

The taxpayer’s amount at risk limits the allowable loss from the activity.  The loss subject to the at-risk limitation is the excess of allowable deductions over the income received from the activity for that year. Under proposed regulations under Code Sec. 465, losses that are allowed as deductions for the tax year reduce the taxpayer’s at-risk amount for the activity for the succeeding year. Losses that are denied under the at-risk rules can be carried over to subsequent years and deducted against amounts at risk in the subsequent years.

Adjustment of amount at risk

The amount at risk must be adjusted each year. At the close of the tax year, the following procedures are used to determine the amount at risk:

  • As stated above, amounts at risk at the end of the prior year must be reduced by the amount of loss allowed in that prior year;
  • Amounts at risk are increased by items, such as contributions of money or property, that add to the amount at risk; and
  • Amounts at risk are decreased by items, such as withdrawals of money or property, which reduce the amount at risk.

Treasury, IRS get moving on ABLE accounts

Late in 2014, Congress passed and President Obama signed into the law the Achieving a Better Life Experience (ABLE) Act. The new law, which enjoyed strong bipartisan support, authorizes the creation of tax-favored accounts for qualified individuals challenged by disabilities. Congress instructed Treasury and the IRS to quickly issue guidance and the agency did so in June. The new guidance covers how to establish ABLE accounts, funding for these accounts, qualified distributions, and various reporting requirements.

ABLE accounts

ABLE accounts are intended to encourage individuals and families to establish a tax-favored savings account to assist and support individuals with disabilities. Contributions to an ABLE account are not deductible, but qualified distributions for certain expenses are excluded from taxation.

Creation

ABLE accounts must be created under a state program. Currently, many states are in the process of setting up an ABLE program. If a state does not establish and maintain an ABLE program, the law allows it to contract with another state to provide an ABLE program for its residents.

Eligibility

Generally, an individual is an eligible individual for a tax year if, during that year, either the individual is entitled to benefits based on blindness or disability under Title II or XVI of the Social Security Act and the blindness or disability occurred before the date on which the individual attained age 26, or a disability certification meeting specified requirements is filed with the IRS. In some cases, the IRS explained that individuals may be unable to establish an account themselves. If the eligible individual cannot establish the account, the eligible individual’s agent under a power of attorney or, if none, his or her parent or legal guardian may establish the ABLE account for that eligible individual.

Contributions and distributions

Total contributions to an ABLE account per calendar year cannot exceed the annual gift tax exclusion (which is $14,000 for 2015). Additionally, state must provide adequate safeguards to ensure that total contributions to an ABLE account do not exceed the state’s limit for aggregate contributions under its qualified tuition program.  The ABLE Act allows for direct and indirect investment of contributions to the program or earnings no more than two times in any calendar year. If distributions from an ABLE account do not exceed the designated beneficiary’s qualified disability expenses, no amount is included in the designated beneficiary’s gross income. Otherwise, the distribution may be subject to income tax and an additional tax.

Qualified expenses

For ABLE accounts, qualified expenses are expenses that relate to the designated beneficiary’s blindness or disability, and are for the benefit of that designated beneficiary in maintaining or improving his or her health, independence, or quality of life. These include expenses for education, housing, transportation, employment training, and personal support services. The IRS requested comments from interested parties about what types of expenses should be considered qualified disability expenses and under what circumstances. For example, a smartphone could be considered a qualified disability expense if it is an effective and safe communication or navigation aid for an individual with autism.

Reporting and means-testing

The guidance includes various reporting rules. For example, information regarding distributions will be reported on new Form 1099-QA: Distributions from ABLE Accounts. Generally an ABLE account is not to be counted in determining the designated beneficiary’s eligibility for many federal means-testing programs. Special rules may apply to some federal programs.

The new guidance covers many aspects and requirements of ABLE accounts, beyond this high-level review. If you have any questions about ABLE accounts and the IRS’s new guidance, please contact our office.

IR-2015-91, NPRM REG-102837-15

Same-sex marriage affects federal, state taxation

The Supreme Court’s decision in Obergefell v. Hodges (2015-1 ustc ¶50,357) on June 26, 2015 continues what was set in motion in 2013: the expansion of tax benefits to same-sex married couples. In Obergefell, the Court ruled 5 to 4 that the Fourteenth Amendment requires a state to license a marriage between two people of the same sex. The Court further held that states must recognize a marriage between two people of the same sex when a marriage was lawfully licensed and performed out of state.

Background

In 2013, the Supreme Court decided Windsor v. U.S (2013-2 ustc ¶50,400). Windsor was an estate tax case, which challenged Section 3 of the federal Defense of Marriage Act (DOMA). Section 3 defined marriage as a man-woman relationship for federal purposes. The Court in Windsor struck down Section 3 as unconstitutional.

After Windsor, the IRS issued Rev. Rul. 2013-17. The IRS announced that it would take a place of celebration approach to same-sex marriage. The IRS would recognize, for federal tax purposes, a marriage of same-sex individuals that was validly entered into even if the married couple is domiciled in a state that did not recognize the validity of same-sex marriages. In Notice 2014-19, the IRS issued guidance for retirement plans, reflecting Windsor.

Since Windsor, a number of cases challenging state bans on same-sex marriage moved through the federal courts, including Obergefell. The Supreme Court agreed to hear Obergefell.

Obergefell decision

Justice Anthony Kennedy delivered the Court’s opinion in Obergefell. Kennedy wrote that the “the Fourteenth Amendment requires a State to license a marriage between two people of the same sex and to recognize a marriage between two people of the same sex when their marriage was lawfully licensed and performed out-of-State.”

State prohibitions on same-sex marriage, Kennedy added, “abridge central precepts of equality. Same-sex couples are denied all the benefits afforded to opposite-sex couples and are barred from exercising a fundamental right. The Equal Protection Clause, like the Due Process Clause, prohibits this unjustified infringement of the fundamental right to marry.”

However, four justices dissented. The dissenting judges would have held that the fundamental right to marry does not include a right to make a State change its definition of marriage. “The people of a State are free to expand marriage to include same-sex couples, or to retain the historic definition.”

Going forward

For federal tax purposes, the treatment of same-sex couples as on par with opposite-sex couples since the Windsor decision will continue unchanged. The IRS is likely to issue more guidance to reflect the Court’s decision in Obergefell. Many other federal agencies, such as the Social Security Administration, also are expected to issue guidance reflectingObergefell. The Obergefell decision also impacts retirement, pension and health care benefits of many same-sex married couples.

For state tax purposes, same-sex married couples in states that did not recognize their marriages have had to file as single individuals for state tax purposes. Under the Obergefell decision, these couples have a Constitutional right to file amended returns as married at the state level. Whether the normal three-year limitations period for filing these amended returns will apply remains to be tested. Also uncertain may be whether same-sex married couples must now retroactively file jointly or whether re-filing will be made optional, either state-by-state or nationwide.

If you have any questions about the Supreme Court’s decision in Obergefell and its impact on taxes, please contact our office.

Supreme Court upholds ACA premium tax credit

After months of waiting, the U.S. Supreme Court announced its decision on the fate of the Code Sec. 36B premium assistance tax credit on June 25 in King v. Burwell, 2015-1 ustc ¶50,356. In a 6 to 3 decision, the Court held that enrollees in both federally-facilitated Marketplaces and state-run Marketplaces can claim the credit, which helps offset the cost of health insurance. The decision leaves in place the current IRS regulations on the credit and the regime for administering and claiming the credit.

Code Sec. 36B credit

The Affordable Care Act (ACA) created both the Marketplaces (previously called Exchanges) and the Code Sec. 36B credit. The Marketplaces connect eligible individuals with health insurance issuers. Some states have set up their own Marketplaces. In other states, the Marketplaces are operated by the federal government. Qualified enrollees may take advantage of the Code Sec. 36B credit if their incomes are within certain guidelines and they satisfy other requirements. When the IRS issued regulations on the Code Sec. 36B credit, the agency made the credit available to enrollees in state-run Marketplaces and federally-facilitated Marketplaces.

This decision by the IRS sparked controversy. A number of law suits were filed challenging the IRS’s regulations. According to the challengers, the ACA limited the availability of the tax credits to enrollees in state-run Marketplaces. Enrollees in federally-facilitated Marketplaces could not claim the credit. In the King case, both a federal district court and the Fourth Circuit Court of Appeals ruled against the challengers. The Supreme Court agreed to take up the case and heard oral arguments in March of this year.

Note. Not all of the challenges to the Code Sec. 36B regulations were unsuccessful in the lower courts. In a case very similar to King, the Court of Appeals for the District of Columbia Circuit struck down the IRS regulations as contrary to the plain language of the ACA. The split among the circuits left the outcome of the controversy far from certain.

Supreme Court’s decision

Chief Justice John Roberts delivered the Court’s decision in King. “Congress based the Affordable Care Act on three major reforms: first, the guaranteed issue and community rating requirements; second, a requirement that individuals maintain health insurance coverage or make a payment to the IRS; and third, the tax credits for individuals with household incomes between 100 percent and 400 percent of the federal poverty line. In a State that establishes its own Exchange, these three reforms work together to expand insurance coverage. Under petitioners’ reading, however, the Act would operate quite differently in a State with a Federal Exchange. As they see it, one of the Act’s three major re-forms – the tax credits – would not apply,” Roberts wrote. This outcome, the Court found, was not what Congress intended.

“The combination of no tax credits and an ineffective coverage requirement could well push a State’s individual insurance market into a death spiral. It is implausible that Congress meant the Act to operate in this manner,” Roberts added.

Three justices dissented in King. They would have found in favor of the challengers. “The Congress that wrote the Affordable Care Act knew how to equate two different types of Exchanges when it wanted to do so,” the dissent wrote. According to the dissent, the government did not show why the Court should have departed from the language of the ACA.

Impact

Since enactment of the ACA, the IRS and the U.S. Department of Health and Human Services (HHS) have issued instructions and guidance for enrollees in Marketplace coverage. The Marketplaces make initial determinations of eligibility for the credit. The IRS administers how enrollees claim the credit when they file their federal income tax returns. According to HHS, nearly 80 percent of all enrollees in Marketplace coverage have been eligible and have used the Code Sec. 36B credit to offset the cost of health insurance. The decision by the Supreme Court in King leaves the IRS regulations on Code Sec. 36B undisturbed. Going forward, nothing is expected to change for enrollees.

If you have any questions about the Code Sec. 36B credit and/or the Supreme Court’s decision in King, please contact our office.

More than 100,000 tax transcripts stolen from IRS

More than 100,000 tax transcripts stolen from IRS’s online “Get Transcript” application

More than 104,000 taxpayers are victims of a new identity theft scheme through which criminals used information previously stolen from outside sources to obtain unauthorized access to the IRS’s online “Get Transcript” application. After discovering the scheme in mid-May, the IRS disabled the online application and is taking steps to alert affected taxpayers and to further investigate the perpetrators. The IRS estimated in the meantime that these criminal downloads might result in only 15,000 false tax return filings.

The Get Transcript application enables taxpayers to obtain line-by-line tax return information going back five or more tax years. Criminals could use this specific tax return information to file false tax returns that appear similar to taxpayers’ legitimately filed past-year returns. The false returns could then bypass the IRS’s filters that flag suspicious returns by looking for anomalies in tax information.

According to recently released IRS FAQs, the Get Transcript application uses a multi-step process to check identities. First taxpayers must submit personal information including Social Security number, birth date, filing status and address. The second step poses certain “out of wallet” questions based on information that only the taxpayer should know.

The IRS detected the breach of the application in May while investigating a suspected denial-of-service attack on the application. After recognizing a large number of suspicious domains used to access an unexpectedly high volume of tax transcripts, the IRS determined that criminal organizations had attempted to access tax transcripts of approximately 200,000 taxpayers, and had been successful in an estimated 104,000 cases. The core tax filing system used by 150 million taxpayers was unaffected, the IRS said.

IRS actions

One of the IRS’s highest priorities is to inform the taxpayers whose transcripts were downloaded (or nearly downloaded) that identity theft criminals have uncovered a large volume of their personal information. In addition to sending letters to these taxpayers, the IRS will provide free credit monitoring services to the taxpayers whose accounts were actually accessed. In addition, on June 1, Sen. Kelly Ayotte, R-N.H., announced that the IRS has agreed to change its policy and will provide victims of identity theft with redacted copies of fraudulent returns filed in their names.

On June 2, IRS Commissioner John Koskinen appeared before the Senate Finance Committee to answer questions about the security breach of the IRS Get Transcript application. During the hearing Koskinen said that the IRS is continuing its in-depth analysis of what happened and stressed that for the time being, the Get Transcript program has been discontinued.

IRS rules on corporate inversions maintain tight standards

Final IRS rules on corporate inversions maintain tight standards for “substantial business activities”

The IRS has issued final regulations on corporation inversions, which are a type of transaction by which a U.S. corporation reincorporates in a foreign jurisdiction by replacing the U.S. parent with a foreign parent. Inversions have proved controversial, with many lawmakers and policy makers criticizing them as vehicles for large businesses to evade U.S. taxes.

In some cases the inversion transaction can be legitimate if, for example, it has substantial business activities in the foreign country. The IRS’s newly finalized guidance affirms the government’s tight standards for determining whether a corporate group has substantial business activities in a foreign country. In general, the final regulations adopt without substantial changes the 2012 temporary regulations that require 25 percent of the corporate group’s employees, assets, and income to be connected to the country of the group’s foreign parent. The final regulations apply to acquisitions completed on or after June 3, 2015.

Background

According to the Obama administration and other lawmakers, some U.S. corporations have escaped U.S. taxes by incorporating a foreign parent to head a multinational group. By having a foreign parent, foreign subsidiaries would avoid U.S. taxes, and the group could claim certain tax benefits (such as interest deductions and “earnings stripping”) to reduce taxes on U.S.-source income, the administration reported.

Criticism has increased in recent years after a number of large U.S. pharmaceutical companies announced inversions or attempted to plan one. As such, the government has taken an active role in attempting to curb the practice. Recently, for example, the IRS issued administrative guidance (Notice 2014-52) intended to reduce some of the benefits of inversions.

Substantial business activities

Temporary regulations adopted in 2006 provided a facts and circumstances test for determining substantial business activities. Temporary regulations adopted in 2009 retained the facts and circumstances test, but eliminated examples and a 10-percent safe harbor that were in the 2006 regulations. The government then issued temporary regulations in 2012 that removed the facts and circumstances test and replaced it with a 25-percent bright-line test for the employees, assets and income of the expanded affiliated group (EAG) (the group that includes the foreign parent and the U.S. subsidiary).

Changes in final regulations

The IRS has clarified that an entity is not a member of the EAG unless it is an EAG member on the “acquisition date” of the inversion. However, members of an EAG are determined by considering all transactions related to the acquisition, including transactions that occur after the acquisition date.

Under the deemed corporation rule in the 2012 regulations, a partnership is treated as a corporation and a member of the EAG if more than 50 percent of its interests are owned by members of the EAG. In the final regulations, the IRS adopted a look-through rule that, to determine the corporations in the EAG, treats each partner of a partnership as holding its proportionate share of stock held by the partnership.

In applying the 25-percent tests under the existing anti-abuse rules, certain assets, employees or income are excluded from the numerator, but included in the denominator, where the transfer of these items is associated with a plan that has a principal purpose of avoiding Code Sec. 7874. The IRS modified the test to exclude items associated with a transfer of property to the EAG from both the numerator and the denominator. Otherwise, the IRS affirmed the anti-abuse rules.

The test for a group’s assets requires that the asset be physically present in the particular foreign country on the date of the inversion, and that the asset be physically present in that country for more time than in any other country during the prior year. The IRS modified the test so that assets used in transportation do not have to be physically present on the inversion date.