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Tax Cuts and Jobs Act of 2017

Posted by Admin Posted on Mar 11 2018

 

Tax cuts and Jobs act of 2017 (TCJA)

 

 

 

On Friday, December 22, 2017, President Trump signed the Tax Cuts and Jobs Act of 2017 (TCJA). This guide provides an in-depth explanation of the sweeping tax overhaul that will affect virtually every individual and business taxpayer in the United States.  

 

Where the guide makes references to the “House Bill” and the “Senate Bill”, it’s referring to the earlier versions of TCJA that passed the House and the Senate on November 16, 2017, and December 2, 2017, respectively. 

 

With respect to individuals, TCJA’s more significant changes include:   the provision of seven tax brackets, with a top rate of 37 percent (the top rate under present law is 39.6 percent);   a repeal of the personal exemption deductions and an increase in the standard deduction amounts to $24,000 for joint filers and surviving spouses, $18,000 for heads of household, and $12,000 for unmarried taxpayers and married taxpayers filing separately (additional amounts for the elderly and blind are retained);   a $10,000 limit on the deduction for state and local taxes, which can be used for both property taxes and income taxes (or sales taxes in lieu of income taxes);   a $750,000 limit on the loan amount for which a mortgage interest deduction can be claimed by individuals, with existing loans grandfathered, and the repeal of interest deductions on home equity indebtedness;   a repeal of miscellaneous itemized deductions subject to the 2 percent of adjusted gross income floor;   a repeal of the personal deduction for casualty and theft losses, except for losses incurred in presidentially declared disaster areas;  an increase in the child tax credit to $2,000 ($1,400 is refundable) and an increase in the phaseout threshold amounts to $400,000 for joint filers and $200,000 for all others (the credit is $1,000 under present law and is fully refundable);  an increase in the alternative minimum tax (AMT) exemption amounts and the adjusted gross income thresholds at which the exemption amount begins to phase out;  a repeal of the deduction for alimony paid and corresponding inclusion in income by the recipient, effective for tax years beginning in 2019 (alimony paid under a separation agreement entered into prior to the effective date is generally grandfathered);  permanent repeal of the individual shared responsibility payment (individual healthcare mandate) enacted as part of the Affordable Care Act (ACA); and  the expiration of most of the TCJA’s individual tax provision changes after December 31, 2025.

 

TCJA also provides a 20 percent deduction against qualified business income from passthrough business entities. The provision includes relatively relaxed rules for calculating qualified 

business income for individuals with taxable income below certain thresholds ($315,000 for joint filers, $157,500 for all others), and stricter ones that are phased in for individuals with taxable income above the thresholds.

 

TCJA reduces the corporate tax rate to 21 percent and fully repeals the corporate alternative minimum tax. Both changes are effective for tax years beginning after December 31, 2017.

 

Other important business-related changes include (1) 100% bonus depreciation for qualified property placed in service before January 1, 2023; (2) a permanent increase in the Section 179 expensing limit to $1,000,000 (up from $500,000 under present law) and a permanent increase in the phase-out threshold amount to $2,500,000 (up from $2,000,000 under present law); (3) a change in the law that will allow more businesses to qualify for the cash method of accounting; and (4) an exemption from the requirement to use inventories for certain taxpayers.

 

TCJA also makes changes to certain partnership rules, including (1) the repeal of the technical termination rule in Code Sec. 708(b); (2) the recharacterization of certain gains in the case of partnership profits interests held in connection with the performance of investment services; (3) the modification of the definition of substantial built-in loss in the case of the transfer of a partnership interest; and (4) a modification of the basis limitation on partner losses to account for a partner’s distributive share of partnership charitable contributions and foreign taxes.     

 

I. Changes Affecting Individuals

 

2018 Tax Rates and Brackets

 

Individual Tax Rates and Brackets For 2018 through 2025, TCJA replaces the current set of seven individual tax rates with a different set of seven individual tax rates. Under TCJA, the highest marginal tax rate is 37%, as compared to the top tax rate of 39.6% under present law. The current tax rates of 10%, 15%, 25%, 28%, 33%, 35%, 39.6% rates are replaced with tax rates of 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

 

Observation: While applicable rates at any given level of income generally go down by two to three points, some go up. For example, the rate for single taxpayers with taxable income between $200,000 and $400,000 goes from 33 percent to 35 percent (head of household filers face a similar jump, but at slightly different breakpoint).

 

The income tax bracket thresholds are all adjusted for inflation after December 31, 2018, and then rounded to the next lowest multiple of $100 in future years. Unlike present law (which uses a measure of the consumer price index for all-urban consumers), the new inflation adjustment uses the chained consumer price index for all-urban consumers.

 

For 2018, the tax rate for schedules are as follows:

 

Married Filing Jointly and Surviving Spouses

 

If Taxable Income Is:  Over ($) But Not Over ($) The Tax Is: 0 19,050 10% of the taxable income 19,050 77,400 $1,905.00 plus 12% of the excess over $19,050 77,400 165,000 $8,907.00 plus 22% of the excess over $77,400 165,000 315,000 $28,179.00 plus 24% of the excess over $165,000 315,000 400,000 $64,179.00 plus 32% of the excess over $315,500 400,000 600,000 $91,379.00 plus 35% of the excess over $400,000 600,000 --- $161,379.00 plus 37% of the excess over $600,000

 

Single Individuals Who Are Not Heads of Household or Surviving Spouses

 

If Taxable Income Is:  Over ($) But Not Over ($) The Tax Is: 0 9,325 10% of the taxable income 9,325 38,700 $952.50 plus 12% of the excess over $9,525 38,700 82,500 $4,453.50 plus 22% of the excess over $38,700 82,500 157,500 $14,089.50 plus 24% of the excess over $82,500

 

If Taxable Income Is:  Over ($) But Not Over ($) The Tax Is: 157,500 200,000 $32,089.50 plus 32% of the excess over $157,500 200,000 500,000 $45,689.50 plus 35% of the excess over $200,000 500,000 --- $150,689.50 plus 37% of the excess over $500,000

 

Heads of Household

 

If Taxable Income Is:  Over ($) But Not Over ($) The Tax Is: 0 9,325 10% of the taxable income 9,325 38,700 $952.50 plus 12% of the excess over $9,525 38,700 82,500 $4,453.50 plus 22% of the excess over $38,700 82,500 157,500 $14,089.50 plus 24% of the excess over $82,500 157,500 200,000 $32,089.50 plus 32% of the excess over $157,500 200,000 300,000 $45,689.50 plus 35% of the excess over $200,000 300,000 --- $80,689.50 plus 37% of the excess over $300,000

 

Married Filing Separately

 

If Taxable Income Is:  Over ($) But Not Over ($) The Tax Is: 0 9,325 10% of the taxable income 9,325 38,700 $952.50 plus 12% of the excess over $9,525 38,700 82,500 $4,453.50 plus 22% of the excess over $38,700 82,500 157,500 $14,089.50 plus 24% of the excess over $82,500 157,500 200,000 $32,089.50 plus 32% of the excess over $157,500 200,000 300,000 $45,689.50 plus 35% of the excess over $200,000 300,000 --- $80,689.50 plus 37% of the excess over $300,000

 

 

 

Estate and Trust Tax Rates and Brackets For 2018 through 2025, under TCJA, the tax rate for estates and trusts are 10% of taxable income up to $2,550, 24% of the excess over $2,550 but not over $9,150; 35% of the excess over $9,150 but not over $12,500; and 37% of the excess over $12,500.

 

Simplification of Tax on Unearned Income of Children TCJA simplifies the “kiddie tax” by effectively applying ordinary and capital gains rates applicable to trusts and estates to the net unearned income of a child. Thus, taxable income attributable to earned income is taxed according to an unmarried taxpayer’s brackets and rates. Taxable income attributable to net unearned income is taxed according to the brackets applicable to trusts and estates, with respect to both ordinary income and income taxed at  

 

preferential rates. The child’s tax is no longer affected by the tax situation of the child’s parent or the unearned income of any siblings.

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Maximum Rates on Capital Gains and Qualified Dividends TCJA generally retains the present-law maximum rates on net capital gain and qualified dividends. The breakpoints between the zero- and 15-percent rates (“15-percent breakpoint”) and the 15- and 20-percent rates (“20-percent breakpoint”) are the same amounts as the breakpoints under current law, except the breakpoints are indexed using the Consumer Price Index for all Urban Consumers (C-CPI-U) in tax years beginning after 2017. Thus, for 2018, the 15-percent breakpoint is $77,200 for joint returns and surviving spouses (one-half of this amount for married taxpayers filing separately), $51,700 for heads of household, $2,600 for estates and trusts, and $38,600 for other unmarried individuals. The 20-percent breakpoint is $479,000 for joint returns and surviving spouses (one-half of this amount for married taxpayers filing separately), $452,400 for heads of household, $12,700 for estates and trusts, and $425,800 for other unmarried individuals.

 

Observation: Therefore, in the case of an individual (including an estate or trust) with adjusted net capital gain, to the extent the gain would not result in taxable income exceeding the 15-percent breakpoint, such gain is not taxed. Any adjusted net capital gain which would result in taxable income exceeding the 15-percent breakpoint but not exceeding the 20-percent breakpoint is taxed at 15 percent. The remaining adjusted net capital gain is taxed at 20 percent. 

 

As under current law, unrecaptured Code Sec. 1250 gain generally is taxed at a maximum rate of 25 percent, and 28-percent rate gain is taxed at a maximum rate of 28 percent. 

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Personal Exemptions, Standard Deduction, and Family Tax Credits

 

Increase in Standard Deduction TCJA increases the basic standard deduction for individuals across all filing statuses. Under the provision, the amount of the standard deduction is increased to $24,000 for married individuals filing a joint return, $18,000 for head-of-household filers, and $12,000 for all other taxpayers. The amount of the standard deduction is indexed for inflation using the chained consumer price index for all-urban consumers for tax years beginning after December 31, 2018. The additional standard deduction for the elderly and the blind is not changed by the provision.

 

Observation: The fact that the standard deduction has nearly doubled may create the misleading impression that taxpayers will reap a large tax benefit from the change. But, because the increase in the standard deduction was coupled with the repeal of the deduction for personal exemption ($4,150, per exemption in 2018), the actual benefit is fairly modest. For example, the overall amount of income that is exempt from tax will increase by $2,700 for joint filers – a nice increase, but nowhere near double the $13,000 standard deduction under prior law.

 

 

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.  

 

Repeal of the Deduction for Personal Exemptions TCJA repeals the deduction for personal exemptions. 

 

In addition, the provision modifies the requirements for those who are required to file a tax return. In the case of an individual who is not married, such individual is required to file a tax return if the taxpayer’s gross income for the tax year exceeds the applicable standard deduction. Married individuals are required to file a return if that individual’s gross income, when combined with the individual’s spouse’s gross income for the tax year, is more than the standard deduction applicable to a joint return, provided that: (1) such individual and his spouse, at the close of the tax year, had the same household as their home; (2) the individual’s spouse does not make a separate return; and (3) neither the individual nor his spouse is a dependent of another taxpayer who has income (other than earned income) in excess of $500 (indexed for inflation).

 

 This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Observation: Withholding rules under present law are based partly on the number of personal exemptions claimed by a taxpayer. Form W-4 and withholding tables will need to be changed to reflect the repeal of personal exemptions. TCJA provides that the Secretary may, at his discretion, administer wage withholding in 2018 without regard to the repeal of the deduction for personal exemptions.

 

Reform of Child Tax Credit

 

TCJA increases the child tax credit to $2,000 per qualifying child under the age of 17.

 

Observation: The Senate Bill would have increased the maximum age of a qualifying child to 17. TCJA retains the current law maximum age of 16 (i.e., “under the age of 17”).

 

The credit is further modified to provide for a $500 nonrefundable credit for qualifying dependents other than qualifying children. The provision generally retains the present-law definition of dependent.

 

Under TCJA, the modified adjusted gross income threshold at which the credit begins to phase out is increased to $400,000 for joint filers and $200,000 for all other taxpayers. These amounts are not indexed for inflation.

 

The provision lowers the earned income threshold for the refundable child tax credit to $2,500. The maximum amount refundable may not exceed $1,400 per qualifying child (up from $1,000 under present law). Under the provision, the maximum refundable amount is indexed for inflation with a base year of 2017, rounding up to the nearest $100. In order to receive the refundable portion of the child tax credit, a taxpayer must include a social security number for each qualifying child for whom the credit is claimed on the tax return.

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Paid Preparer Due Diligence Requirement for Head of Household Status TCJA directs the Secretary of the Treasury to issue due diligence requirements for paid preparers in determining eligibility for a taxpayer to file as head of household. A penalty of $500 will be imposed for each failure to meet these requirements.  

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Deductions

 

Limitation on Deduction for State and Local Taxes TCJA limits the deduction for state and local property, income, war profits, and excess profits taxes to $10,000 ($5,000 in the case of a married individual filing a separate return), unless such taxes are paid or accrued in carrying on a trade or business or an activity described in Code Sec. 212 (relating to expenses for the production of income). TCJA also repeals the deduction for foreign property taxes. As under current law, taxpayers may elect to deduct state and local sales taxes in lieu of state and local income taxes.

 

Observation: An earlier version of this provision that was included in both the House and Senate Bills, would have permitted only the deduction of state, local, and foreign property taxes within the $10,000 limit. TCJA expanded the scope of the deduction to include state and local income taxes (or sales taxes in lieu thereof), as under current law, but eliminated the deduction for foreign property taxes.

 

Caution: TCJA includes a provision blocking taxpayers from prepaying state and local income taxes relating to the 2018 tax year in 2017 in order to circumvent the new limitation on the deduction. Specifically, in the case of an amount paid in a tax year beginning before January 1, 2018, with respect to a state or local income tax imposed for a tax year beginning after December 31, 2017, the payment will be treated as paid on the last day of the tax year for which such tax is imposed for purposes of applying the provision limiting the dollar amount of the deduction.

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

 Limitation on Mortgage Interest Deduction TCJA provides that a taxpayer may treat no more than $750,000 as acquisition indebtedness ($375,000 in the case of married taxpayers filing separately) for purposes of the mortgage interest deduction. In the case of acquisition indebtedness incurred before December 15, 2017, the limitation is the same as it is under current law: $1,000,000 ($500,000 in the case of married taxpayers filing separately).

 

Observation: A provision in the House Bill, that was omitted from TCJA, would have disallowed an interest deduction for debt used to acquire a second home. Thus, interest on such debt remains deductible within the overall limits that apply to the deductibility of acquisition indebtedness.

 

TCJA repeals the deduction for home equity indebtedness.

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Modification to Deduction for Charitable Contributions TCJA make the following modifications to the deduction for charitable contributions –  

 

(1) increases in the income-based percentage limit described in Code Sec. 170(b)(1)(A) for certain charitable contributions by an individual taxpayer of cash to public charities and certain other organizations from 50 percent to 60 percent; 

 

(2) denies a charitable deduction for payments made in exchange for college athletic event seating rights; and 

 

(3) repeals the substantiation exception in Code Sec. 170(f)(8)(D) for certain contributions reported by the donee organization. 

 

The provisions that increase the charitable contribution percentage limit and deny a deduction for stadium seating payments are effective for contributions made in tax years beginning after December 31, 2017. The provision that repeals the substantiation exception for certain contributions reported by the donee organization is effective for contributions made in tax years beginning after December 31, 2016.

 

Deduction for Student Loan Interest and the Exclusion for Graduate Student Tuition Waivers Retained

 

TCJA omits provisions from the House Bill that would have repealed the above-the-line deduction for student loan interest and the exclusion from income of tuition waivers for graduate students, thereby retaining current rules for both provisions. 

 

Deduction for Certain Educator Expenses Retained

 

The House Bill would have repealed the for the deduction of up to $250 for certain expenses of eligible educators. The Senate Bill would have doubled the current law deduction to $500. TCJA adopted neither the House nor Senate Bill and instead keeps the current law $250 deduction.

 

Repeal of Deduction for Alimony Paid TCJA repeals the deduction for alimony paid and the corresponding inclusion of alimony in income by the recipient. The provision is effective for any divorce or separation instrument executed after December 31, 2018, or for any divorce or separation instrument executed on or before December 31, 2018, and modified after that date, if the modification expressly provides that the amendments made by this provision apply to such modification. Thus, alimony paid under a separation agreement entered into prior to the effective date is generally grandfathered.

 

Temporary Reduction in Medical Expense Deduction Floor TCJA provides special rules for medical expense deductions for years 2017 and 2018. For those years, the adjusted-gross-income floor above which a medical expense is deductible is reduced from 10 percent to 7.5 percent. 

 

Observation: The medical expense deduction is one of a few areas where the Senate and House Bills went in opposite directions. Whereas the Senate Bill retained the deduction and enhanced it for certain tax years, the House Bill would have repealed it altogether.  

 

Partial Repeal of Deduction for Casualty and Theft Losses TCJA temporarily modifies the deduction for personal casualty and theft losses. Under the provision, a taxpayer may claim a personal casualty loss, subject to the applicable limitations in Code Sec. 165(h), only if such loss was attributable to a disaster declared by the President under Section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act.

 

The above-described limitation does not apply with respect to losses incurred after December 31, 2025.

 

Repeal of Miscellaneous Itemized Deductions Subject to the 2-Percent Floor TCJA repeals all miscellaneous itemized deductions that are subject to the two-percent of adjusted-gross-income floor. 

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Repeal of Overall Limitation on Itemized Deductions TCJA repeals the overall limitation on itemized deductions. 

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Modification to Gambling Losses

 

TCJA clarifies the scope of “losses from wagering transactions” as that term is used in Code Sec. 165(d). The provision provides that this term includes any deduction otherwise allowable incurred in carrying on any wagering transaction.

 

The provision is intended to clarify that the limitation on losses from wagering transactions applies not only to the actual costs of wagers incurred by an individual, but to other expenses incurred by the individual in connection with the conduct of that individual’s gambling activity. The provision clarifies, for instance, an individual’s otherwise deductible expenses in traveling to or from a casino are subject to the limitation under Code Sec. 165(d).

 

Observation: This provision will reverse the result reached by the Tax Court in Mayo v. Comm’r, 136 T.C. 81 (2011). In that case, the court held that a taxpayer’s expenses incurred in the conduct of the trade or business of gambling, other than the cost of wagers, were not limited by Code Sec. 165(d), and were thus deductible under Code Sec. 162(a) as trade or business expenses.

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Repeal of Deduction for Moving Expenses

 

TCJA repeals the deduction for moving expenses. However, under the provision, rules providing for exclusions of amounts attributable to in-kind moving and storage expenses (and reimbursements or allowances for these expenses) for members of the Armed Forces of the United States (or their spouse or dependents) are not repealed. For a discussion of the repeal of the exclusion for qualified moving expense reimbursements, see “Other Income Tax Provisions Affecting Individuals”, below.

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.  

 

Repeal of Deductions for Living Expenses of Members of Congress

 

TCJA repeals a provision which allows members of Congress to deduct up to $3,000 annually for certain living expenses, effective for tax years beginning after December 22, 2017.

 

Other Income Tax Provisions Affecting Individuals Rules for Exclusion of Gain from the Sale of a Principal Residence Unchanged

 

Both the House and Senate Bills included similar provisions tightening the rules for the exclusion of gain from the sale of a principal residence. Both bills would have made the exclusion available only if the taxpayer had owned and used the residence as a principal residence for at least five of the eight years (as opposed to two out of five years under current law) prior to selling it, and both would have allowed a taxpayer to benefit from the exclusion only once every five years (as opposed to once every two years under current law).

 

These provisions were not included in TCJA. Thus, the rules for exclusion of gain from the sale of a principal residence under current law will remain in effect.

 

Increase in Individual AMT Exemption and Phaseout Amounts TCJA provides for increased AMT exemptions. For 2018, the exemptions are $109,400 (up from $84,500 in 2017) in the case of a joint return or the return of a surviving spouse; $70,300 (up from $54,300 in 2017) in the case of an individual who is unmarried and not a surviving spouse; $54,700 (up from $39,375 in 2017) in the case of a married individual filing a separate return. Additionally, TCJA increases the alternative minimum taxable income limit where the exemptions begin to phase out. Under TCJA, the exemption amount of any taxpayer is reduced by an amount equal to 25 percent of the amount by which the alternative minimum taxable income of the taxpayer exceeds $1,000,000 (up from $160,900 in 2017) in the case of a joint returns; and $500,000 for all others (up from amounts ranging from $80,450 to $120,700 in 2017). This provision is effective for tax years beginning after December 31, 2017.

 

Net Investment Income Tax TJCA retains the 3.8 percent net investment income tax (NIIT) without changes.

 

Business Loss Limitation Rules Applicable to Individuals

 

Under TCJA, for tax years beginning after December 31, 2017, and before January 1, 2026, excess business losses of a taxpayer other than a corporation are not allowed for the tax year. Such losses are carried forward and treated as part of the taxpayer’s net operating loss (“NOL”) carryforward in subsequent tax years. Under this provision, NOL carryovers generally are allowed for a tax year up to the lesser of the carryover amount or 80 percent of taxable income determined without regard to the deduction for NOLs.

 

An excess business loss for the tax year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $250,000 (or twice the otherwise  

 

applicable threshold amount in the case of a joint return). The threshold amount is indexed for inflation after 2018.

 

In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the tax year of the partner or S corporation shareholder. Regulatory authority is provided to apply the provision to any other passthrough entity to the extent necessary to carry out the provision. Regulatory authority is also provided to require any additional reporting as the Secretary determines is appropriate to carry out the purposes of the provision.

 

The provision applies after the application of the passive loss rules.

 

For tax years beginning after December 31, 2017, and before January 1, 2026, the present-law limitation relating to excess farm losses does not apply.

 

The provision is effective for tax years beginning after December 31, 2017.

 

Treatment of Student Loans Discharged on Account of Death or Disability

 

TCJA modifies the exclusion of student loan discharges from gross income, by including within the exclusion certain discharges on account of death or total and permanent disability of the student.  Loans eligible for the exclusion under the provision are loans made by (1) the United States (or an instrumentality or agency thereof), (2) a state (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a state, county, or municipal hospital and whose employees have been deemed to be public employees under state law, (4) an educational organization that originally received the funds from which the loan was made from the United States, a State, or a tax-exempt public benefit corporation, or (5) private education loans (for this purpose, private education loan is defined in Section 140(7) of the Consumer Protection Act). 

 

The provision applies to discharges of loans after December 31, 2017, and before January 1, 2026.

 

Repeal of Exclusion for Qualified Bicycle Commuting Reimbursement

 

TCJA repeals the exclusion from gross income and wages for qualified bicycle commuting reimbursements.

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Repeal of Exclusion for Qualified Moving Expense Reimbursements

 

TCJA repeals the exclusion from gross income and wages for qualified moving expense reimbursements except in the case of a member of the Armed Forces of the United States on active duty who moves pursuant to a military order. 

 

This provision is effective after December 31, 2017, and expires after December 31, 2025.

 

Increased Contributions to ABLE Accounts and Allowance of Contributions to be Eligible for Saver’s Credit  

 

TCJA increases the contribution limitation to ABLE accounts under certain circumstances.  While the general overall limitation on contributions (the per-donee annual gift tax exclusion ($14,000 for 2017)) remains the same, the limitation is increased with respect to contributions made by the designated beneficiary of the ABLE account.  Under the provision, after the overall limitation on contributions is reached, an ABLE account’s designated beneficiary can contribute an additional amount, up to the lesser of (1) the federal poverty line for a one-person household; or (2) the individual’s compensation for the tax year. Additionally, the provision allows a designated beneficiary of an ABLE account to claim the saver’s credit for contributions made to his or her ABLE account. 

 

The provision is effective for tax years beginning after December 22, 2017 and will sunset after December 31, 2025.

 

Use of 529 Plan Distributions for Elementary or Secondary Schools

 

TCJA modifies Section 529 plans to allow such plans to distribute not more than $10,000 in expenses for tuition incurred during the tax year in connection with the enrollment or attendance of the designated beneficiary at a public, private or religious elementary or secondary school. This limitation applies on a per-student basis, rather than a per-account basis. Thus, under the provision, although an individual may be the designated beneficiary of multiple accounts, that individual may receive a maximum of $10,000 in distributions free of tax, regardless of whether the funds are distributed from multiple accounts. Any excess distributions received by the individual will be treated as a distribution subject to tax under the general rules of Code Sec. 529.

 

The provision applies to distributions made after December 31, 2017.

 

Rollovers Between 529 Plans and Qualified ABLE Programs

 

TCJA allows for amounts from qualified tuition programs (also known as Section 529 accounts) to be rolled over to an ABLE account without penalty, provided that the ABLE account is owned by the designated beneficiary of that Section 529 account, or a member of such designated beneficiary's family.  Such rolled-over amounts count towards the overall limitation on amounts that can be contributed to an ABLE account within a tax year.  Any amount rolled over that is in excess of this limitation will be includible in the gross income of the distributee in a manner provided by Code Sec. 72. 

 

The provision applies to distributions after December 31, 2017, and will sunset after December 31, 2025.

 

Extension of Time Limit to Contest IRS Levy

 

TCJA extends from nine months to two years the period for returning the monetary proceeds from the sale of property that has been wrongfully levied upon. The provision also extends from nine months to two years the period for bringing a civil action for wrongful levy. 

 

The provision is effective with respect to: (1) levies made after December 22, 2017; and (2) levies made on or before December 22, 2017 provided that the nine-month period has not expired as of December 22, 2017.

 

Treatment of Certain Individuals Performing Services in the Sinai Peninsula of Egypt  

 

TCJA grants combat zone tax benefits to the Sinai Peninsula of Egypt, if as of December 22, 2017 of the provision any member of the Armed Forces of the United States is entitled to special pay under Section 310 of title 37, United States Code (relating to special pay; duty subject to hostile fire or imminent danger), for services performed in such location.  This benefit lasts only during the period such entitlement is in effect. 

 

The provision is generally effective beginning June 9, 2015.  The portion of the provision related to wage withholding applies to remuneration paid after December 22, 2017.

 

Relief for 2016 Disaster Areas TCJA provides tax relief relating to a “2016 disaster area,” which is defined as any area with respect to which a major disaster was declared by the President under Section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act during calendar year 2016. In the case of a personal casualty loss which arose after December 31, 2015, and before January 1, 2018, and was attributable to the events giving rise to the Presidential disaster declaration, such losses are deductible without regard to whether aggregate net losses exceed ten percent of a taxpayer’s adjusted gross income. Under the provision, in order to be deductible, the losses must exceed $500 per casualty. Additionally, such losses may be claimed in addition to the standard deduction.

 

TCJA also provides special rules for using retirement funds and taking a casualty loss deduction with respect to a “2016 disaster area.” The term "2016 disaster area" means any area with respect to which a major disaster has been declared by the President under Section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act during calendar year 2016. The term "qualified 2016 disaster distribution" means any distribution from an eligible retirement plan made on or after January 1, 2016, and before January 1, 2018, to an individual whose principal place of abode at any time during calendar year 2016 was located in a 2016 disaster area and who has sustained an economic loss by reason of the events giving rise to the Presidential declaration which was applicable to such area.

 

Under the provision, the early withdrawal penalties under Code Sec. 72(t) do not apply to a qualified 2016 disaster distribution to the extent the amount withdrawn does not exceed $100,000 over the aggregate amounts treated as qualified 2016 disaster distributions received by such individual for all prior years. Amounts required to be included in income as a result of such distributions may be included ratably over a three-tax year period. The provision also allows a casualty loss deduction with respect to a loss relating to a 2016 disaster area. 

 

Observation: Although TCJA’s relaxation of retirement plan distribution rules only applies to disasters occurring in 2016 (for which qualified retirement plan distributions can be made in either 2016 or 2017), victims of several major 2017 disasters were granted similar disaster relief by Pub. L. 115-63. See Parker Tax ¶ 79,330, “Hurricane Harvey, Irma, and Maria Relief” for an explanation of those relief provisions.

 

Healthcare Taxes

 

Affordable Care Act (ACA) Individual Healthcare Mandate  Under TCJA, the amount of the individual shared responsibility payment (aka, the “individual healthcare mandate”) enacted as part of the ACA is reduced to zero, effective with respect to health coverage status for months beginning after December 31, 2018.  

 

II. Estate and Gift Tax Changes

 

Increase in Estate and Gift Tax Exemption TCJA doubles the estate and gift tax exemption amount. This is accomplished by increasing the basic exclusion amount provided in Code Sec. 2010(c)(3) from $5 million to $10 million. The $10 million amount is indexed for inflation occurring after 2011. 

 

The provision is effective for decedents dying, generation-skipping transfers, and gifts made after December 31, 2017, and expires for years beginning after December 31, 2025.

 

TCJA omits a provision from the House Bill that would have repealed the estate and generationskipping transfer tax beginning in 2025.    

 

III. Deduction for Qualified Business Income of an Individual (Passthrough Break)

 

Overview of the Deduction TCJA adds new Code Sec. 199A, which provides that individuals who are sole proprietors, partners in partnerships, members in LLCs taxed as partnerships (hereafter, “partners”), and shareholders in S corporations may qualify for a new deduction for qualified business income for tax years beginning after December 31, 2017, and before January 1, 2026. Trusts and estates are also eligible for this deduction.

 

The amount of the deduction is generally 20 percent of the taxpayer’s qualifying business income (QBI).

 

Example: In 2018, Joe receives a salary of $100,000 from his job at XYZ Corporation and $50,000 of qualified business income from a side business that he runs as a sole proprietorship. Joe’s deduction for qualified business income in 2018 is $10,000 (20 percent of $50,000). 

 

Observation: The effective marginal tax rate on qualified business income for individuals in the top 37-percent tax bracket who are able to fully apply the new deduction will be 29.6 percent – fully 10 points lower than the top rate under pre-TCJA law. 

 

The deduction for qualified business income (QBI deduction) is claimed by individual taxpayers on their personal tax returns. The deduction reduces taxable income. The deduction is not used in computing adjusted gross income. Thus, it does not affect limitations based on adjusted gross income. Observation: The deduction is available to both nonitemizers and itemizers. The deduction for qualified business income is subject to several restrictions and limitations, discussed below.

 

Different Rules Apply at Different Levels of Taxable Income The rules that apply to individuals with taxable income below certain thresholds (discussed below) in a given tax year, are simpler and more permissive than the ones that apply above those thresholds. 

 

The rules that are waived for taxpayers with income below the thresholds are: (1) a rule that disqualifies income from specified service trade or businesses from the QBI deduction; and (2) a rule that limits the QBI deduction to a percentage of W-2 wages paid by a business. Both are discussed below.

 

Other rules, such as one preventing individuals from claiming the QBI deduction for employment income, apply to all taxpayers, regardless of their level of taxable income.  

 

Qualified Trade or Business TCJA provides that qualified business income is determined for each qualified trade or business of the taxpayer. The term “qualified trade or business” means any trade or business other than: 

 

(1) a specified service trade or business (defined below); and 

 

(2) the trade or business of performing services as an employee. 

 

There are no exceptions to the rule prohibiting employees from claiming the QBI deduction for their employment income is without exception. By contrast, the rule prohibiting taxpayers from claiming the deduction for income from a specified service trade or business does not apply to individuals with taxable income below certain threshold amounts (see below) and is phased in for those with taxable income above the thresholds.

 

Trade or Business Requirement; Rental Real Estate Activities In order to be a qualified trade or business, an activity must rise to the level of being a trade or business. TCJA does not define the term “trade or business” and it is not defined elsewhere in the Code. Because the IRS has interpreted the term differently in different contexts, the definition for purposes of the QBI deduction will remain unknown until the IRS provides guidance.

 

Observation: Under Code Sec. 162, an activity must be regular, continuous, and substantial to be considered a trade or business. The IRS has adopted these criteria in several areas, most recently for the net investment income tax (NIIT). While it’s reasonable to speculate that the IRS will take the same approach for the QBI deduction as it did with NIIT, it is by no means certain that it will do so.

 

The definition of “trade or business” for purposes of the QBI deduction is of particular importance to rental real estate activities. The status of such activities became a prominent question in 2013, when the 3.8 percent net investment income tax (NIIT) went into effect, because trades and businesses are exempt from NIIT. With the 20 percent QBI deduction being contingent on an activity having trade or business status, the question will take on renewed prominence.

 

Gray Area: The early consensus among practitioners and expert commentators is that most rental real estate activities other than those involving triple net (NNN) rentals will qualify as trades or businesses for purposes of the QBI deduction, because such rental activities typically involve the regular provision of substantial services to tenants. So, even if the IRS adopts the relatively strict Code Sec. 162 definition of trade or business (as it did for NIIT), most non-NNN rental activities will meet the criteria. Until the IRS issue guidance, however, this will remain a gray area.

 

Specified Service Trade or Business Certain types of businesses defined as “specified service business” are not considered qualified businesses for individuals whose taxable income exceeds certain thresholds (discussed below). A specified service trade or business means any trade or business involving the performance of services in the fields of –

 

 health,   law,   accounting,  consulting,  financial services,  brokerage services,  actuarial science,  athletics, or  performing arts.

 

Specified service trades or businesses also include any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.

 

Observation: While some of the items listed above are reasonably clear in their meaning, others are open to interpretation. For example, determining whether an individual is engaged in consulting will be difficult in many cases; identifying businesses where the principal asset is the reputation or skill of employees or owners, even more so (see additional discussion, below). Many questions in this area will not be resolved until the IRS provides guidance.

 

Practice Tip: Before digging into the often-difficult question of whether a given client’s business is a specified service trade or business, practitioners should determine what the client’s taxable income will be for the year. If it’s below the applicable threshold (discussed below), it won’t matter if the taxpayer’s activity is a specified trade or business.

 

Specified service trades or businesses also include trades or businesses which involve the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. For this purpose, the terms “security” and “commodity” have the same meanings as those provided in the rules for the mark-to-market accounting method for dealers in securities under Code Sec. 475(c)(2) and Code Sec. 475(e)(2), respectively.

 

Engineering and Architecture Are Not Specified Service Trade or Businesses. Engineering and architecture services are specifically exempted from the definition of a specified service trade or business. 

 

Gray Area: The exemption for engineering and architecture services was added to Code Sec. 199A at Conference Committee in order to preserve an exemption found in repealed Code Sec. 199 (which was effectively replaced by Code Sec. 199A). Unlike Code Sec. 199, which specifically limited the exemption for engineering and architecture to services performed with respect to the construction of real property, Code Sec. 199A includes no such limitation. For engineering, the absence of restrictive language would appear to extend the exemption to engineers who provide services with respect to personal and possibly intangible property (e.g., software engineering). But until the IRS weighs in, the scope of the engineering and architecture exemption will be a gray area.

 

Trades or Businesses Where the Reputation or Skill of Owners or Employees Is the Principal Asset. One of the biggest challenges for tax practitioners will be determining if a taxpayer’s business falls under the heading of a specified trade or business because “the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners” (hereafter, “reputation and skill clause”). This is because there is no guidance or relevant case law to guide practitioners under either new Code Sec. 199A or Code Sec. 1202 (the obscure  

 

Code section from which Code Sec. 199A incorporates the reputation and skill clause by reference).

 

Observation: Based on just the language in the Code, it would be difficult to conclude with certainty that the reputation and skill clause applies to any particular business. There are many businesses for which the reputation and skill of employees and owners are important. But what does it mean for reputation and skill to be the principal asset of a business? In what situations is such an “asset” more important than a business’s customer list, or the collection of tangible and intangible property that enables its skilled and unskilled workers to create value? Until the IRS provides guidance, this will continue be a gray area.

 

Special Rule Where Taxpayer’s Income Is Below a Specified Threshold The rule disqualifying specified service trades or businesses from being considered a qualified trade or business does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the restriction is phased in over a range of $50,000 in taxable income ($100,000 for joint filers).

 

The threshold amount is indexed for inflation. The exclusion from the definition of a qualified business for specified service trades or businesses is fully phased in for a taxpayer with taxable income in excess of the threshold amount plus $50,000 ($100,000 in the case of a joint return). For a taxpayer with taxable income within the phase-in range, the exclusion applies as follows.

 

Phase-in of Specified Service Business Limitation Once an individual’s taxable income reaches the specified threshold amount, in computing his or her QBI deduction with respect to a specified service trade or business, the taxpayer takes into account only the applicable percentage of items considered in determining qualified business income and the W-2 wage limitation (discussed below). The applicable percentage with respect to any tax year is 100 percent reduced by the percentage equal to the ratio of the taxable income of the taxpayer for the tax year in excess of the threshold amount bears to $50,000 ($100,000 in the case of a joint return).

 

Example: Tom, an unmarried taxpayer, has taxable income of $187,500, of which $150,000 is attributable to an accounting sole proprietorship that is a specified service trade or business. Assume that the sole proprietorship’s W-2 wages are high enough that the W-2 wage limitation will not affect Tom’s deduction. Tom has an applicable percentage of 40 percent [$187,500 - $157,500 (Tom’s threshold amount) = $30,000 / $50,000 (phaseout range) = 60 percent; 100 percent – 60 percent = 40 percent]. In determining qualified business income, Tom takes into account 40 percent of $150,000, or $60,000. Since the W-2 wage limitation doesn’t apply, Tom’s QBI deduction is $12,000 (20% of $60,000).

 

Trade or Business of Performing Services as an Employee The trade or business of performing services as an employee is not a qualified trade or business. Thus, employees cannot claim the QBI deduction against their employment income. There are no exceptions to his rule, which applies to taxpayers at all levels of taxable income (i.e., it isn’t phased in like the rule disqualifying specified service trades or businesses).

 

Although the disqualification of employees is one of Code Sec. 199A’s clearer provisions, it can nonetheless be expected to give rise to a great deal of controversy between taxpayers and the IRS. Such conflicts will result from the fact that while employees are ineligible for the QBI  

 

deductions, independent contractors are not. The IRS has a long history of challenging worker classifications (i.e., employee vs independent contractor) in the context of employment taxes. Such disputes are resolved by applying a set of factors used to determine the degree of control that the payer has over the worker. For a discussion of worker classification, see Parker Tax ¶360,970.

 

Observation: In determining worker classifications, courts give little or no weight to designations made by workers or those paying them, focusing instead on substance of the work relationship. As a result, workers and employers who attempt to change a worker’s classification from employee to independent contractor without a substantive change in the work relationship are unlikely to prevail if challenged by the IRS.

 

Practice Tip: Because a 20 percent deduction sounds alluring, some clients may have an exaggerated sense of the tax benefits of being reclassified as an independent contractor, absent a large pay increase. Helping a client understand that switching from paying payroll taxes to paying self-employment tax would erase most of the tax benefit of the QBI deduction will put them in a better position to weigh the pros and cons of such a change, and to negotiate an appropriate deal with their employer if they decide to pursue it.

 

Qualified Business Income Qualified business income (QBI) means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. 

 

QBI does not include any qualified REIT dividends, qualified cooperative dividends, or qualified publicly traded partnership income, which are eligible for a separately calculated 20 percent deduction, but are not included in the definition of QBI (discussed below).

 

Reasonable Compensation and Guaranteed Payments Are Not QBI QBI does not include reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business. Similarly, QBI does not include any guaranteed payment for services rendered with respect to the trade or business, and to the extent provided in regulations, does not include any amount paid or incurred by a partnership to a partner who is acting other than in his or her capacity as a partner for services.

 

Example: Charlotte is a partner in, and sales manager for, the XYZ partnership, a domestic business that is not a specified service trade or business. During the tax year, she receives guaranteed payments of $250,000 from XYZ for her services to the partnership as its sales manager. In addition, her distributive share of XYZ’s ordinary income (it’s only item of income or loss) was $175,000. Charlotte’s qualified business income from XYZ is $175,000.

 

Reasonable Compensation. S corporations have long had an incentive to classify payments made to shareholder-employees as dividends rather than wages, because the latter are subject to employment taxes and the former are not. The IRS, however, can recharacterize "dividends" that are paid lieu of reasonable compensation for services performed for the S corporation (Rev. Rul. 74-44). So, “reasonable compensation” of an S corporation shareholder refers to any amounts paid by the S corporation to the shareholder, up to the amount that would constitute reasonable compensation.

 

Example: Robert is the sole shareholder and CEO of ABC, Inc., an S corporation that is a qualified trade or business. ABC has net income in 2018 of $250,000 after deducting Robert’s  

 

$100,000 salary. ABC makes payments of $350,000 to Robert in 2018, of which it classifies $100,000 as wages and $250,000 as dividends. Assume that reasonable compensation for someone with Robert’s experience and responsibilities is $200,000. Robert’s qualified business income from ABC in 2018 is $150,000, which is its net income of $250,000, minus the $100,000 of “dividends” that are actually reasonable compensation ($200,000 reasonable compensation - $100,000 of payments classified as wages by ABC). The $200,000 treated as reasonable compensation is not QBI.

 

Guaranteed Payments. Guaranteed payments include payments made by a partnership, without regard to its income, to a partner, for services provided to the partnership. Partnerships are not required by federal tax law to make guaranteed payments to partners who provide services to the partnership, and are not constrained by a reasonableness standard if they choose to do so. To the extent a partnership makes such payments to a partner, the partnership’s ordinary income (and qualified business income) is reduced by the amount of the payment because guaranteed payments are deductible to the partnership. To the partner receiving the guaranteed payment, the payment is ordinary income but is not qualified business income.

 

Example: Marie and Joan are the equal owners of Acme, a partnership that is a qualifying trade or business. In 2018, Acme had $1,050,000 of ordinary income before deducting $250,000 in guaranteed payments made to Marie and Joan for their services to Acme ($125,000 each), and $800,000 of ordinary income after deducting the guaranteed payments ($1,050,000 - $250,000). Marie and Joan’s qualified business income for 2018 is $800,000, or $400,000 each. The guaranteed payments Marie and Joan receive are not QBI. If, instead, Acme had $550,000 in ordinary income after paying a total of $500,000 in guaranteed payments to Marie and Joan for their services ($1,050,000 - $500,000 = $550,000), Marie and Joan would each have QBI for 2018 of $275,000. 

 

Observation: Guaranteed payments can be paid not only for services rendered, but also for the use of capital. TCJA excludes only guaranteed payments for services from QBI.

 

QBI Includes Only Items Included in Determining Taxable Income The determination of qualified items of income, gain, deduction, and loss, only takes into account such items to the extent they are included or allowed in the determination of taxable income for the tax year. 

 

Example: During the tax year, a qualified business has $100,000 of ordinary income from inventory sales, and makes an expenditure of $25,000 that is required to be capitalized and amortized over five years under applicable tax rules. Qualified business income is $100,000 minus $5,000 (current-year ordinary amortization deduction), or $95,000. The qualified business income is not reduced by the entire amount of the capital expenditure. It is only reduced by the amount deductible in determining taxable income for the year. 

 

Investment Income Excluded from QBI Qualified items of income, gain, deduction, and loss do not include specified investment-related income, deductions, or loss. Specifically, qualified items of income, gain, deduction and loss do not include –

 

(1) any item taken into account in determining net long-term capital gain or net long-term capital loss;  

 

(2) dividends, income equivalent to a dividend, or payments in lieu of dividends; 

 

(3) interest income other than that which is properly allocable to a trade or business; 

 

4) the excess of gain over loss from commodities transactions, other than those entered into in the normal course of the trade or business or with respect to stock in trade or property held primarily for sale to customers in the ordinary course of the trade or business, property used in the trade or business, or supplies regularly used or consumed in the trade or business; 

 

(5) the excess of foreign currency gains over foreign currency losses from Code Sec. 988 transactions, other than transactions directly related to the business needs of the business activity; 

 

(6) net income from notional principal contracts, other than clearly identified hedging transactions that are treated as ordinary (i.e., not treated as capital assets); and 

 

(7) any amount received from an annuity that is not used in the trade or business of the business activity. 

 

Qualified items under this provision do not include any item of deduction or loss properly allocable to such income.

 

Qualified Items Must Be Domestic Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States. In the case of a taxpayer who is an individual with otherwise qualified business income from sources within the commonwealth of Puerto Rico, if all the income is taxable under Code Sec. 1 (income tax rates for individuals) for the tax year, the “United States” is considered to include Puerto Rico for purposes of determining the individual’s qualified business income.

 

Carryover Losses TCJA provides that if the net amount of qualified business income from all qualified trades or businesses during the tax year is a loss, it is carried forward as a loss from a qualified trade or business in the next tax year. Similar to a qualified trade or business that has a qualified business loss for the current tax year, any deduction allowed in a subsequent year is reduced (but not below zero) by 20 percent of any carryover qualified business loss. 

 

Example: Sean has qualified business income of $20,000 from qualified business A and a qualified business loss of $50,000 from qualified business B in Year 1. Sean is not permitted a deduction for Year 1 and has a carryover qualified business loss of $30,000 to Year 2. In Year 2, Sean has qualified business income of $20,000 from qualified business A and qualified business income of $50,000 from qualified business B. The QBI deduction amounts from the business are $4,000 (20% of $20,000) and $10,000 (20% of $50,000), respectively, for a total of $14,000. This amount is reduced by $6,000 (20% of the $30,000 carryover loss), for a QBI deduction of $8,000.

 

Calculating the QBI Deduction for Each Trade or Business TCJA provides the QBI deduction must be calculated separately for each trade or business. The deductible amount for each qualified trade or business is the lesser of -

 

(1) 20 percent of the taxpayer's qualified business income with respect to the trade or business; or   

 

(2) the greater of –

 

(a) 50 percent of the W-2 wages (defined below) with respect to the trade or business; or

 

(b) the sum of 25 percent of the W-2 wages with respect to the trade or business and 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property. 

 

The amount in “(2)”, referred to hereafter as “the W-2 wage limitation,” is discussed in detail below.

 

After calculating the QBI deduction amount for each trade or business, the taxpayer totals the amounts. TCJA’s requirement that the deductible amount be calculated separately for each trade or business may reduce the overall deduction by preventing W-2 wages from one business from being used to increase the deductible amount from another.

 

Example: Marty owns stock in two S corporations, Company A and Company B, which are both qualified businesses. Marty’s share of Company A’s qualified business income and W-2 wages are $0 and $100,000 respectively. His share of the corresponding items for Company B are $250,000 and $0. Assume that neither company has any qualified property, so the W-2 wages limitation will be based on 50% of W-2 wages. Marty’s QBI deduction for Company A is $0 (the lesser of 20% of $0 and 50% of $100,000). Marty’s QBI deduction for Company B is also $0 (the lesser of 20% of $250,000 and 50% of $0). 

 

If Marty had instead been able to combine the qualified business income and W-2 wages for his two business and then calculate his deduction, his QBI deduction would have been $50,000 (the lesser of 20% of $250,000 (total qualified business income) or 50% of $100,000 (total W-2 wages)). Because TCJA requires that the deduction be calculated separately for each business and then totaled, Company A’s W-2 wages cannot be used to ease the limitation on Marty’s QBI deduction for company B.

 

Observation: The taxpayer in the example would have had a better result had he been able to group the two companies before calculating the deduction in a manner akin to the grouping of activities for the passive activity loss rules. TCJA does not provide a grouping option, but it does grant the Treasury Secretary broad power to prescribe regulations to carry out the purposes of the section. Although the section takes a different approach than the one used for the passive activity loss rules - focusing on “trades or businesses” instead of “activities” - there doesn’t appear to be anything in the section that would preclude the Secretary from implementing an elective grouping regime.

 

For most taxpayers, the total of their QBI deduction amounts for all qualified businesses will be their QBI deduction for the year. But before the final QBI deduction is determined, TCJA requires taxpayers to perform a series of additional calculations, discussed below under the heading “Determining the Final Amount of the QBI Deduction.” These additional calculations will only change the QBI deduction in two situations: (1) the taxpayer has qualified REIT dividends, qualified cooperative dividends, or qualified publicly traded partnership income, or (2) the taxpayer’s taxable income (reduced by any net capital gain) is less than his or her qualified business income.

 

W-2 Wage Limitation on QBI Deduction TCJA provides a limitation on the QBI deduction based on either W-2 wages paid or W-2 wages paid plus a capital element. This limitation is phased in above a threshold amount of taxable income.   

 

The W-2 Wage Limitation Amount Specifically, the W-2 wage limitation is the greater of - 

 

(1) 50 percent of the W-2 wages paid with respect to the qualified trade or business; or 

 

(2) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.

 

Example: Susan owns and operates a sole proprietorship that sells cupcakes. The business is not a specified service business and Susan’s filing status for Form 1040 is single. The cupcake business pays $100,000 in W-2 wages and has $350,000 in qualified business income. For the sake of simplicity, assume the business had no qualified property, and that Susan has no other items of income or loss (putting her taxable income at a level where she’s fully subject to the W2 wage limitation). Susan’s QBI deduction is $50,000, which is the lesser of (a) 20 percent of $350,000 in qualified business income ($70,000), or (b) the greater of (i) 50 percent of W-2 wages ($50,000) or (ii) 25 percent of W-2 wages plus 2.5 percent of qualified property ($25,000) ($25,000 ($100,000 x 25 percent) + $0 (2.5 percent x $0)).

 

The first of the two alternatives for calculating the W-2 wage limitation (50 percent of W-2 wages) is the one that will apply to the great majority of businesses that have employees. The second approach (25 percent of W-2 wages plus 2.5 percent of qualified property) will mainly apply to real estate businesses and other businesses that have high ratio of qualified property to W-2 wages.

 

TCJA provides that the IRS must provide rules for applying the limitation in cases of a short tax year in which the taxpayer acquires, or disposes of, the major portion of a trade or business or the major portion of a separate unit of a trade or business during the year. 

 

W-2 Wages Defined W-2 wages are the total wages subject to wage withholding under Code Sec. 3401(a), elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the tax year of the taxpayer. 

 

Practice Tip: “Total wages subject to wage withholding” will generally correspond with the amount on Form W-2, Box 1. “Elective deferrals” and “deferred compensation” correspond with the amount in Box 12. 

 

As practitioners await IRS guidance on the QBI deduction, they may find Rev. Proc. 2006-47 helpful. Rev. Proc. 2006-47 provides guidance on determining W-2 wages under now-repealed Code Sec. 199, which included the same definition of W-2 wages as Code Sec. 199A, and a similar W-2 wage limitation.

 

For purposes of the QBI deduction, W-2 wages do not include –

 

(1) any amount which is not properly allocable to the qualified business income as a qualified item of deduction; and  

 

(2) any amount which was not properly included in a return filed with the Social Security Administration (SSA) on or before the 60th day after the due date (including extensions) for such return.

 

Observation: Under these rules, reasonable compensation paid to an S corporation shareholder falls within the definition of W-2 wages for purposes of applying the W-2 wage limitation. Guaranteed payments to a partner, by contrast, would not be considered W-2 wages for this purpose. See discussion below on the impact of entity type on the determination of W-2 wages.

 

In the case of a taxpayer who is an individual with otherwise qualified business income from sources within the Commonwealth of Puerto Rico, if all the income is taxable under Code Sec. 1 (income tax rates for individuals) for the tax year, the determination of W-2 wages with respect to the taxpayer’s trade or business conducted in Puerto Rico is made without regard to any exclusion under the wage withholding rules for remuneration paid for services in Puerto Rico.

 

Impact of Entity Type on the Determination of W-2 Wages As discussed above, W-2 wages include wages subject to wage withholding under Code Sec. 3401(a), that are properly included in a return filed with the SSA.

 

Reasonable compensation paid to an S corporation shareholder - which is subject to withholding and is reported to the SSA on Form W-3 - meets these criteria and therefore falls within the definition of W-2 wages for the purposes of the W-2 wage limitation (assuming that the compensation is properly allocable as a deduction in determining qualified business income). 

 

Example 1: Joseph owns and operates an art gallery as a single owner S corporation of which he is the sole employee. Assume that the gallery is qualified trade or business, and that it has no qualified property. Joseph pays himself a reasonable salary of $250,000 which is timely reported to the SSA, and the S corporation has $600,000 in qualified business income, after deducting Joseph’s salary. Joseph’s QBI deduction is $120,000 (20% of $600,000 of QBI). The W-2 wage limitation doesn’t reduce the deduction because 50% of corporation’s $250,000 in W2 wages is $125,000, an amount greater than 20% of QBI.

 

Guaranteed payments to a partner in a partnership, by contrast, do not meet the definition of W2 wages. Such payments are not subject to withholding (partners pay estimated taxes, instead), and are reported to the IRS, not the SSA. Thus, guaranteed payments fail two of the tests for W-2 wages. Because they don’t count as W-2 wages, such payments are of no help to partners constrained by the W-2 wage limitation.

 

Example 2: Assume the same facts as Example 1, except that Joseph and his wife, Jeanine, are equal partners in a partnership which owns the art gallery. Joseph receives compensation in the form of a guaranteed payment of $250,000. The partnership has $600,000 in qualified business income, after deducting Joseph’s guaranteed payment. In this scenario, because the partnership has no W-2 wages, the W-2 wage limitation amount is $0. Accordingly, Joseph and Jeanine’s QBI deduction on their joint return is $0, which is the lesser of $120,000 (20% of $600,000 of QBI) and $0 (50% of W-2 wages).

 

The result in Example 2 would be the same if the taxpayer’s business was a sole proprietorship, as the Code does not provide sole proprietors with any means to pay themselves W-2 wages.   

 

Example 3: Assume the same facts as Example 1, except that the art gallery is a sole proprietorship. Because a sole proprietor’s salary paid to himself doesn’t meet the definition of W-2 wage and is not deductible, the business has no W-2 wages, and its qualified business income is $850,000 (after adding back Joseph’s non-deductible salary). Accordingly, Joseph’s QBI deduction is $0, which is the lesser of $170,000 (20% of $850,000 of QBI) and $0 (50% of W-2 wages). The only difference with the partnership scenario in Example 2 is that the amount of the forfeited QBI deduction is greater, because QBI is greater.

 

As the examples show, S corporations with shareholder-employees have an advantage over the other entity types in situations where a potential QBI deduction may be limited or zeroed out by the W-2 wage limitation.

 

Caution: There’s no indication that the sharply divergent tax results discussed above were intended by Congress. By enacting Code Sec. 199A, Congress clearly chose to favor business owners over employees on the theory that doing so would promote job creation. But did it also intend to favor S corporation shareholders over partners and sole proprietors? Probably not. So, there’s a pretty good chance that the provisions for determining W-2 wages will eventually be changed (or interpreted by the IRS) in a way that puts the different types of entities on more equal footing.

 

Qualified Property Defined For purposes of the QBI deduction, TCJA defines “qualified property” to mean tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the tax year, and which is used in the production of qualified business income, and for which the depreciable period has not ended before the close of the tax year. The depreciable period with respect to qualified property of a taxpayer means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (1) the date 10 years after that date, or (2) the last day of the last full year in the applicable recovery period that would apply to the property under Code Sec. 168 (without regard to Code Sec. 168(g)).

 

Example: Walter is a sole proprietor of a widget-making company that is a qualified trade or business. The company buys a widget-making machine for $300,000 and places it in service in 2020. The business has no employees in 2020. The W-2 limitation in 2020 is the greater of (a) 50 percent of W-2 wages, or $0, or (b) the sum of 25 percent of W-2 wages ($0) plus 2.5 percent of the unadjusted basis of the machine immediately after its acquisition: $300,000 x .025 = $7,500. The amount of the limitation on any QBI deduction Walter may claim for the business is $7,500.

 

In the case of property that is sold, for example, the property is no longer available for use in the trade or business and is not taken into account in determining the limitation. 

 

The IRS is required to provide guidance applying rules similar to the rules of Code Sec. 179(d)(2) to address acquisitions of property from a related party, as well as in a sale-leaseback or other transaction as needed to carry out the purposes of the provision and to provide antiabuse rules, including under the limitation based on W-2 wages and capital. Similarly, the IRS must provide guidance prescribing rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W-2 wages and capital.  

 

Phase-in of W-2 Wage Limitation The application of the W-2 wage limitation phases in for a taxpayer with taxable income in excess of the following threshold amounts: $315,000 for joint filers and $157,500 for all other taxpayers, indexed for inflation. Thus, for a taxpayer with taxable income below these thresholds, the W-2 limitation does not apply. For purposes of phasing in the wage limit, taxable income is computed without regard to the 20 percent deduction. 

 

The W-2 wage limitation applies fully for a taxpayer with taxable income in excess of the threshold amount plus $50,000 ($100,000 in the case of a joint return). For a taxpayer with taxable income within the phase-in range, the wage limit applies as follows. With respect to any qualified trade or business, the taxpayer compares – 

 

(1) the tentative QBI deduction amount (20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business); with 

 

(2) the W-2 wage limitation amount with respect to the qualified trade or business. 

 

If the amount determined under (2) is less than the amount determined under (1), (that is, if the wage limit is binding), the taxpayer’s deductible amount is the amount determined under (1), reduced by the same proportion of the difference between the two amounts as the excess of the taxable income of the taxpayer over the threshold amount bears to $50,000 ($100,000 in the case of a joint return).

 

Example: Christine, a married taxpayer who files a joint return, has taxable income of $345,000, of which $200,000 is qualified business income from the JKL partnership. Assume that Christine’s allocable share of JKL’s W-2 wages is $60,000, and that the partnership had no qualified property. The tentative QBI deduction amount is $40,000 (20% of $200,000). The W-2 wage limitation amount is $30,000 (50% of $60,000). The difference between the two amounts is $10,000. The proportion of the excess of taxable income over the threshold amount is 30% (($345,000 taxable income - $315,000 threshold amount for a joint filer) / $100,000 phase-in range for a joint filer). So, to determine Christine’s QBI deduction, $3,000 ($10,000 x 30%) is subtracted from the $40,000 tentative QBI deduction, to get $37,000.

 

Special Rules for Partnerships and S Corporations TCJA provides that, in the case of a partnership or S corporation, the business income deduction applies at the partner or shareholder level.

 

Each shareholder of an S corporation takes into account the shareholder’s pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the tax year equal to the shareholder’s pro rata share of W-2 wages of the S corporation, and a pro rata share of qualified property equal to the shareholder’s allocable share of pro rata share depreciation.

 

Similar rules apply to a partner in a partnership, who takes into account his or her allocable share of all of same items mentioned in the preceding paragraph. The partner’s allocable share of W-2 wages is required to be determined in the same manner as the partner’s allocable share of wage expense (which is typically the same as the partner’s allocable share of ordinary income). The partner’s allocable share of qualified property is equal to the shareholder’s allocable share of depreciation. If the partnership agreement does not provide for special  

 

allocations of depreciation, the partner’s allocable share of qualified property will be the same as the partner’s allocable share of ordinary income.

 

Special Rules for Trusts and Estates TCJA provides that trusts and estates are eligible for the 20-percent deduction. The section further provides that rules similar to the ones under now-repealed Code Sec. 199 (as in effect on December 1, 2017) apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital.

 

REIT Dividends, Cooperative Dividends, and Publicly Traded Partnership Income  A deduction is allowed under the provision for 20 percent of the taxpayer’s aggregate amount of qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income for the tax year. 

 

Qualified REIT Dividends  Qualified REIT dividends do not include any portion of a dividend received from a REIT that is a capital gain dividend or a qualified dividend. 

 

Qualified Cooperative Dividend A qualified cooperative dividend means a patronage dividend, per-unit retain allocation, qualified written notice of allocation, or any similar amount, provided it is includible in gross income and is received from either (1) a tax-exempt benevolent life insurance association, mutual ditch or irrigation company, cooperative telephone company, like cooperative organization, or a taxable or tax-exempt cooperative that is described in Code Sec. 1381(a), or (2) a taxable cooperative governed by tax rules applicable to cooperatives before the enactment of subchapter T of the Code in 1962. 

 

Qualified Publicly Traded Partnership Income  Qualified publicly traded partnership income means (with respect to any qualified trade or business of the taxpayer), the sum of the (1) the net amount of the taxpayer’s allocable share of each qualified item of income, gain, deduction, and loss (that are effectively connected with a U.S. trade or business and are included or allowed in determining taxable income for the tax year and do not constitute excepted enumerated investment-type income, and not including the taxpayer’s reasonable compensation, guaranteed payments for services, or (to the extent provided in regulations) Code Sec. 707(a) payments for services) from a publicly traded partnership not treated as a corporation, and (2) gain recognized by the taxpayer on disposition of its interest in the partnership that is treated as ordinary income (for example, by reason of Code Sec. 751).  

 

Determining the Final Amount of the Deduction TCJA provides a complex set of calculations for determining a taxpayer’s final QBI deduction, which are used after the QBI deduction for each of the taxpayer’s trades or businesses have been determined. 

 

Most of the complexity in determining the final deduction results from the way Code Sec. 199A handles qualified cooperative dividends, and qualified publicly traded partnership income. Imbedded within the complex set of calculations, however, is a simpler calculation (“standard calculation”) that applies to taxpayers who do not have any income of the aforementioned types. For such taxpayers, the basic calculation will provide the same result as the more complex calculations.

 

The more complex set of calculations (“complex calculation”), must be used for taxpayers who have qualified REIT dividends, qualified cooperative dividends, or qualified publicly traded partnership income.

 

Determining the Final QBI Deduction – Standard Calculation For a taxpayer eligible for the QBI deduction who does not have any qualified REIT dividends, qualified cooperative dividends, or qualified publicly traded partnership income, the QBI deduction amount is the lesser of –

 

(1) the sum of the taxpayer’s QBI deduction for all qualified trades or businesses (reduced, but not below zero, by 20 percent of any carryover qualified business loss); or 

 

(2) an amount equal to 20 percent of the taxpayer’s taxable income (reduced by any net capital gain).

 

The effect of reducing taxable income by any net capital gain is to ensure that the QBI deduction does not exceed 20 percent of income taxed at regular rates. The amount in (2), above (hereafter referred to as the “taxable income limitation”), will only apply in situations where taxable income is less than the taxpayer’s total QBI from all qualified trades or businesses (reduced by any QBI loss carryover). 

 

Example 1: Cynthia has a part-time job at BigCo, a company in which she has no ownership interest. In addition, she owns and operates LittleCo, a sole proprietorship that is a qualified trade or business. Cynthia is paid wages of $40,000 by BigCo, and has $100,000 in qualified business income from LittleCo. She has no other items of income or loss. She has a total of $25,000 in above-the-line and itemized deductions (“individual deductions”). Her taxable income, prior to applying any QBI deduction, is $115,000 ($40,000 in wages from BigCo + $100,000 income from LittleCo - $25,000 in deductions). Cynthia’s QBI deduction is $20,000, which is the lesser of the sum of the QBI deductions for all of her qualified businesses ($20,000 = 20% x $100,000 QBI from LittleCo) or an amount equal to 20 percent of her taxable income (reduced by any net capital gain) ($23,000 = 20% x ($115,000 taxable income - $0 net capital gain)). 

 

Example 2: Assume the same facts as Example 1, except that Cynthia doesn’t have a job at BigCo. In this scenario, her taxable income, prior to applying any QBI deduction, is $75,000 ($100,000 income from LittleCo - $25,000 in individual deductions). Cynthia’s QBI deduction is $15,000, which is the lesser of the sum of the QBI deductions for all of her qualified businesses ($20,000 = 20% x $100,000 QBI from LittleCo) or an amount equal to 20 percent of her taxable  

 

income (reduced by any net capital gain) ($15,000 = 20% x ($75,000 taxable income - $0 net capital gain)).

 

Observation: Cynthia’s QBI deduction is $5,000 lower in Example 2 than it was in Example 1, because the taxable income limitation applied. The limitation was triggered because Cynthia didn’t have any non-QBI income, such as wages from employment, to offset her individual deductions (which reduced her taxable income below the amount of her qualified business income). In Example 2, if Cynthia had $25,000 of non-QBI income of any type other than a net capital gain (e.g., taxable interest income, spousal wages, gambling winnings, etc.) to offset her individual deductions, the taxable income limitation would not have applied, and she would have been able to claim a full QBI deduction equal to 20% of her QBI.

 

 

 

Determining the Final QBI Deduction – Complex Calculation The set of calculations for determining a taxpayer’s final QBI deduction discussed in this section can be used for any taxpayer eligible for the deduction. Taxpayers who do not have any qualified REIT dividends, qualified cooperative dividends, or qualified publicly traded partnership income, however, can use a simplified version of the calculation (standard calculation) discussed above. For taxpayers who have such items, the calculations for determining the deduction are as follows:

 

The QBI deduction is an amount equal to the sum of –

 

(1) the lesser of –

 

(a) the sum of the taxpayer’s QBI deduction for all qualified businesses (including any carryover loss from a prior tax year) plus 20 percent of the aggregate amount of the taxpayer’s qualified REIT dividends and qualified publicly traded partnership income; or 

 

(b) an amount equal to 20 percent of the excess (if any) of taxpayer’s taxable income for the tax year over the sum of any net capital gain and qualified cooperative dividends, plus

 

(2) the lesser of –

 

(a) 20 percent of qualified cooperative dividends for the tax year; or 

 

(b) taxable income (reduced by net capital gain). 

 

The amount determined under (2), above, may not exceed the taxpayer's taxable income for the tax year.

 

Treatment of Agricultural and Horticultural Cooperatives TCJA provides that, for tax years beginning after December 31, 2017, but not after December 31, 2025, a deduction is allowed to any specified agricultural or horticultural cooperative equal to the lesser of –

 

(1) 20 percent of the cooperative’s taxable income for the tax year; or   

 

(2) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative.

 

A specified agricultural or horticultural cooperative is an organization to which subchapter T applies that is engaged in (1) the manufacturing, production, growth, or extraction in whole or significant part of any agricultural or horticultural product, (2) the marketing of agricultural or horticultural products that its patrons have so manufactured, produced, grown, or extracted, or (3) the provision of supplies, equipment, or services to farmers or organizations described in the foregoing.   

 

IV. Business-Related Changes

 

 

 

Corporate Taxation 

 

Reduction in Corporate Tax Rate TCJA eliminates the graduated corporate rate structure and instead taxes corporate taxable income at 21 percent. It also eliminates the special tax rate for personal service corporations and repeals the maximum corporate tax rate on net capital gain as obsolete. For taxpayers subject to the normalization method of accounting (e.g., regulated public utilities), TCJA provides for the normalization of excess deferred tax reserves resulting from the reduction of corporate income tax rates (with respect to prior depreciation or recovery allowances taken on assets placed in service before January 1, 2018).

 

The provision is effective for tax years beginning after December 31, 2017.

 

Reduction of Dividends Received Deductions to Reflect Lower Corporate Tax Rate TCJA reduces the 70 percent dividends received deduction available to corporations who receive a dividend from another taxable domestic corporation to 50 percent. It also reduces the 80 percent dividends received deduction for dividends received from a 20-percent owned corporation to 65 percent.

 

The provision is effective for tax years beginning after December 31, 2018.

 

Corporate Alternative Minimum Tax  TCJA repeals the corporate alternative minimum tax (AMT). 

 

In the case of a corporation, TCJA allows the AMT credit to offset the regular tax liability for any tax year. In addition, the AMT credit is refundable for any tax year beginning after 2017 and before 2022 in an amount equal to 50 percent (100 percent in the case of tax years beginning in 2021) of the excess of the minimum tax credit for the tax year over the amount of the credit allowable for the year against regular tax liability. Thus, the full amount of the minimum tax credit will be allowed in tax years beginning before 2022.

 

The provision is effective for tax years beginning after December 31, 2017.

 

Modification of Net Operating Loss (NOL) Deduction TCJA limits the NOL deduction to 80 percent of taxable income (determined without regard to the deduction). Carryovers to other years are adjusted to take account of this limitation, and may be carried forward indefinitely.

 

The provision repeals the two-year carryback and the special carryback provisions in current law, but provides a two-year carryback in the case of certain losses incurred in the trade or business of farming. In addition, TCJA provides a two-year carryback and 20-year carryforward for NOLs of a property and casualty insurance company.

 

The provision applies to losses arising in tax years beginning after December 31, 2017.  

 

Modification of Limitation on Excessive Employee Remuneration TCJA revises the definition of covered employee to include both the principal executive officer and the principal financial officer. Further, an individual is a covered employee if the individual holds one of these positions at any time during the tax year. The provision also defines as a covered employee the three (rather than four) most highly compensated officers for the tax year (other than the principal executive officer or principal financial officer) who are required to be reported on the company’s proxy statement for the tax year (or who would be required to be reported on such a statement for a company not required to make such a report to shareholders). The provision applies to tax years beginning after December 31, 2017. However, there is a transition rule which provides that the proposed changes do not apply to any remuneration under a written binding contract which was in effect on November 2, 2017, and which was not modified after this date in any material respect, and to which the right of the covered employee was no longer subject to a substantial risk of forfeiture on or before December 31, 2016.

 

Treatment of Qualified Equity Grants Under TCJA, a qualified employee can elect to defer, for income tax purposes, the inclusion in income of the amount of income attributable to qualified stock transferred to the employee by the employer. An election to defer income inclusion (inclusion deferral election) with respect to qualified stock must be made no later than 30 days after the first time the employee’s right to the stock is substantially vested or is transferable, whichever occurs earlier. If an employee elects to defer income inclusion under the provision, the income must be included in the employee’s income for the tax year that includes the earliest of (1) the first date the qualified stock becomes transferable, including, solely for this purpose, transferable to the employer; (2) the date the employee first becomes an excluded employee (as described below); (3) the first date on which any stock of the employer becomes readily tradable on an established securities market; (4) the date five years after the first date the employee’s right to the stock becomes substantially vested; or (5) the date on which the employee revokes her inclusion deferral election. Deferred income inclusion applies also for purposes of the employer’s deduction of the amount of income attributable to the qualified stock. The provision generally applies with respect to stock attributable to options exercised or RSUs settled after December 31, 2017. 

 

Contributions to Capital While TCJA retains Code Sec. 118, a provision the House Bill had sought to repeal, it provides that the term “contributions to capital” does not include -

 

(1) any contribution in aid of construction or any other contribution as a customer or potential customer, and 

 

(2) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such). 

 

The Conference Report states that the conferees intended that, as modified, Code Sec. 118, which under current law provides that the gross income of a corporation does not include any contributions to capital, will continue to apply only to corporations.  

 

The provision applies to contributions made after December 22, 2017. However, the provision will not apply to any contribution made after December 22, 2017, by a governmental entity pursuant to a master development plan that has been approved prior to such date by a governmental entity.

 

Bonus Depreciation TCJA extends and modifies the additional first-year (i.e., “bonus”) depreciation deduction through 2026 (through 2027 for longer production period property and certain aircraft). Under TCJA, the 50-percent additional depreciation allowance is increased to 100 percent for property placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for longer production period property and certain aircraft), as well as for specified plants planted or grafted after September 27, 2017, and before January 1, 2023. 

 

Phase-Down of Bonus Percentage for Tax Years Beginning After 2022  The 100-percent allowance is phased down by 20 percent per calendar year for property placed in service, and specified plants planted or grafted, in tax years beginning after 2022 (after 2023 for longer production period property and certain aircraft). Thus, for property placed in service after December 31, 2022, and before January 1, 2024 (January 1, 2025, for longer production period property and certain aircraft), the bonus percentage is 80 percent; for property placed in service after December 31, 2023, and before January 1, 2025 (January 1, 2026, for longer production period property and certain aircraft), the bonus percentage is 60 percent; for property placed in service after December 31, 2024, and before January 1, 2026 (January 1, 2027, for longer production period property and certain aircraft), the bonus percentage is 40 percent; for property placed in service after December 31, 2025, and before January 1, 2027 (January 1, 2028, for longer production period property and certain aircraft), the bonus percentage is 20 percent. The general bonus depreciation percentages also apply to certain specified plants bearing fruits or nuts. 

 

Observation: Under current law, the bonus depreciation is scheduled to end for qualified property acquired and placed in service before January 1, 2020 (January 1, 2021, for longer production period property and certain aircraft) and the 50-percent bonus depreciation amount is scheduled to be phased down for property placed in service after December 31, 2017, including certain specified plants bearing fruits or nuts planted or grafted after such date. Thus, TCJA repeals the current-law phase-down of the additional first-year depreciation deduction for property placed in service after December 31, 2017, as well as the phase down also scheduled for certain specified plants bearing fruits or nuts planted or grafted after such date. 

 

Phase-Down of Bonus Percentage for Certain Property Acquired before September 28, 2017 TCJA also provides that the present-law phase-down of bonus depreciation is maintained for property acquired before September 28, 2017, and placed in service after September 27, 2017. Under the provision, in the case of property acquired and adjusted basis incurred before September 28, 2017, the bonus depreciation rates are as follows: 50 percent if placed in service in 2017 (2018 for longer production period property and certain aircraft), 40 percent if placed in service in 2018 (2019 for longer production period property and certain aircraft), 30 percent if  

 

placed in service in 2019 (2020 for longer production period property and certain aircraft), and zero percent if placed in service in 2020 (2021 for longer production period property and certain aircraft). 

 

Luxury Passenger Automobiles  TCJA maintains the bonus depreciation increase amount of $8,000 for luxury passenger automobiles placed in service after December 31, 2017. 

 

Observation: Under current law, the $8,000 increase in depreciation for luxury passenger automobiles (as defined in Code Sec. 280F(d)(5)) was scheduled to be phased down to $6,400 and $4,800 for property placed in service in 2018 and 2019, respectively. 

 

Computer Equipment  TCJA removes computer equipment from the category of listed property (as defined in Code Sec. 280F(b)(2)), thus eliminating the depreciation limitation on such property.

 

Original Use Requirement Removed TCJA removes the requirement that, in order to qualify for bonus depreciation, the original use of qualified property must begin with the taxpayer. Thus, the provision applies to purchases of used as well as new items. 

 

To prevent abuses, the additional first-year depreciation deduction applies only to property purchased in an arm’s-length transaction. It does not apply to property –

 

(1) received as a gift or from a decedent;

 

(2) acquired in a nontaxable exchange such as a reorganization;

 

(3) acquired from a member of the taxpayer’s family, including a spouse, ancestors, and lineal descendants, or from another related entity as defined in Code Sec. 267; or

 

(4) acquired from a person who controls, is controlled by, or is under common control with, the taxpayer. 

 

For example, the additional first-year depreciation deduction does not apply if one member of an affiliated group of corporations purchases property from another member, or if an individual who controls a corporation purchases property from that corporation. 

 

In the case of trade-ins, like-kind exchanges, or involuntary conversions, it applies only to any money paid in addition to the traded-in property or in excess of the adjusted basis of the replaced property.

 

Certain Film, Television and Live Theatrical Productions are Qualified Property TCJA also expands the definition of qualified property eligible for the additional first-year depreciation allowance to include qualified film, television and live theatrical productions, effective for productions placed in service after September 27, 2017, and before January 1, 2023. For this purpose, a production is considered placed in service at the time of initial release, passive staged performance (i.e., at the time of the first commercial exhibition, broadcast, or live staged performance of a production to an audience).

 

Other Changes to Definition of Qualified Property TCJA excludes from the definition of qualified property certain public utility property, i.e., property used predominantly in the trade or business of the furnishing or sale of:

 

(1) electrical energy, water, or sewage disposal services;

 

(2) gas or steam through a local distribution system; or 

 

(3) transportation of gas or steam by pipeline, if the rates for such furnishing or sale, as the case may be, have been established or approved by a state or political subdivision thereof, by any agency or instrumentality of the United States, or by a public service or public utility commission or other similar body of any state or political subdivision thereof.

 

TCJA also excludes from the definition of qualified property any property used in a trade or business that has had floor plan financing indebtedness, unless the taxpayer which has such trade or business is not a tax shelter prohibited from using the cash method and is exempt from the interest limitation rules by meeting the small business gross receipts test of Code Sec. 448(c).

 

Conforming Changes As a conforming amendment to the repeal of the corporate AMT, TCJA repeals the election to accelerate corporate AMT credits in lieu of bonus depreciation.

 

TCJA extends the special rule under the percentage-of-completion method for the allocation of bonus depreciation to a long-term contract for property placed in service before January 1, 2027 (January 1, 2028, in the case of longer production period property).

 

Effective Date and Transition Rule The provision generally applies to property placed in service after September 27, 2017, in tax years ending after such date, and to specified plants planted or grafted after such date. A transition rule provides that, for a taxpayer’s first tax year ending after September 27, 2017, the taxpayer may elect to apply a 50-percent allowance.

 

Section 179 Expensing

 

Increased the Maximum Amount and Phase-Out Threshold TCJA increases the maximum amount a taxpayer may expense under Code Sec. 179 to $1,000,000, and increases the phase-out threshold amount to $2,500,000. Thus, the provision provides that the maximum amount a taxpayer may expense, for tax years beginning after 2017, is $1,000,000 of the cost of qualifying property placed in service for the tax year. The $1,000,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the tax year exceeds $2,500,000. The $1,000,000 and $2,500,000 amounts, as well as the $25,000 sport utility vehicle limitation, are indexed for inflation for tax years beginning after 2018.  

 

Qualified Real Property Definition Expanded TCJA also expands the definition of qualified real property eligible for Code Sec. 179 expensing to include any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service: roofs; heating, ventilation, and airconditioning property; fire protection and alarm systems; and security systems.

 

Property Used in Connection with Furnishing Lodging TCJA expands the definition of Code Sec. 179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging.

 

Observation: Property used predominantly to furnish lodging or in connection with furnishing lodging generally includes, for example, beds and other furniture, refrigerators, ranges, and other equipment used in the living quarters of a lodging facility such as an apartment house, dormitory, or any other facility (or part of a facility) where sleeping accommodations are provided. 

 

Effective Date and Transition Rule The provision applies to property placed in service in tax years beginning after December 31, 2017.

 

Other Provisions Relating to Cost Recovery

 

Modifications to Depreciation Limitations on Luxury Automobiles and Personal Use Property TCJA increases the depreciation limitations under Code Sec. 280F that apply to listed property. For passenger automobiles that qualify as luxury automobiles (i.e., gross unloaded weight of 6,000 lbs or more) placed in service after December 31, 2017, and for which the additional firstyear depreciation deduction is not claimed, the maximum amount of allowable depreciation is $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period. The limitations are indexed for inflation for luxury passenger automobiles placed in service after 2018.

 

TCJA removes computer or peripheral equipment from the definition of listed property. Such property is therefore not subject to the heightened substantiation requirements that apply to listed property.

 

The provision is effective for property placed in service after December 31, 2017.

 

Elimination of Separate Definitions Relating to Qualified Leasehold Improvements, Qualified Restaurant, and Qualified Retail Improvement Property TCJA eliminates the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property, and provides a general 15-year recovery period for qualified improvement property, and a 20-year ADS recovery period for such property. Thus, for example, qualified improvement property placed in service after December 31, 2017, is generally depreciable over 15 years using the straight line method and half-year convention,  

 

without regard to whether the improvements are property subject to a lease, placed in service more than three years after the date the building was first placed in service, or made to a restaurant building. Restaurant building property placed in service after December 31, 2017, that does not meet the definition of qualified improvement property is depreciable over 39 years as nonresidential real property, using the straight line method and the mid-month convention.

 

As a conforming amendment, TCJA replaces the references in Code Sec. 179(f) to qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property with a reference to qualified improvement property. 

 

TCJA also requires a real property trade or business electing out of the limitation on the deduction for interest to use ADS to depreciate any of its nonresidential real property, residential rental property, and qualified improvement property.

 

The provision is effective for property placed in service after December 31, 2017.

 

Modifications of Treatment of Certain Farm Property TCJA shortens the recovery period from 7 to 5 years for any machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business, the original use of which begins with the taxpayer and is placed in service after December 31, 2017.

 

TCJA also repeals the required use of the 150-percent declining balance method for property used in a farming business (i.e., for 3-, 5-, 7-, and 10-year property). The 150-percent declining balance method will continue to apply to any 15-year or 20-year property used in the farming business to which the straight line method does not apply, or to property for which the taxpayer elects the use of the 150-percent declining balance method.

 

The provision is effective for property placed in service after December 31, 2017.

 

Modification of Alternative Depreciation System Recovery Period for Residential Rental Property TCJA shortens the alternative depreciation system (ADS) recovery period for residential rental property from 40 to 30 years. It also allows an electing real property trade or business to use the ADS recovery period in depreciating real and qualified improvement property.

 

Observation: The Senate Bill had shortened the recovery period for determining the depreciation deduction with respect to nonresidential real property from 39 years to 25 years and for residential rental property from 27.5 years to 25 years. Under the Senate Bill, such property placed in service before 2018 would have been treated as having a new placed-in-service date of January 1, 2018, if it resulted in more advantageous deductions. However, this provision was eliminated in TCJA.

 

Expensing of Certain Costs of Replanting Citrus Plants Lost by Reason of Casualty TCJA modifies the special rule for costs incurred by persons other than the taxpayer in connection with replanting an edible crop for human consumption following loss or damage due to casualty. Under the provision, with respect to replanting costs paid or incurred after December 22, 2017, but no later than a date which is ten years after such date of enactment, for 

 

citrus plants lost or damaged due to casualty, such costs may also be deducted by a person other than the taxpayer if (1) the taxpayer has an equity interest of not less than 50 percent in the replanted citrus plants at all times during the tax year in which the replanting costs are paid or incurred and such other person holds any part of the remaining equity interest, or (2) such other person acquires all of the taxpayer’s equity interest in the land on which the lost or damaged citrus plants were located at the time of such loss or damage, and the replanting is on such land.

 

Entertainment, Meals, and Fringe Benefit Deductions TCJA provides that no deduction is allowed with respect to –

 

(1) an activity generally considered to be entertainment, amusement or recreation; 

 

(2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes; or 

 

(3) a facility or portion thereof used in connection with any of the above items. 

 

Thus, the provision repeals the present-law exception to the deduction disallowance for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer’s trade or business (and the related rule applying a 50 percent limit to such deductions). TCJA also disallows a deduction for expenses associated with providing any qualified transportation fringe to employees of the taxpayer, and except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment.

 

Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel). For amounts incurred and paid after December 31, 2017, and until December 31, 2025, the provision expands this 50 percent limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer. Such amounts incurred and paid after December 31, 2025, are not deductible.

 

The provision generally applies to amounts paid or incurred after December 31, 2017. However, for expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer, amounts paid or incurred after December 31, 2025, are not deductible.

 

Interest Deduction Rules

 

Changes to Interest Deduction Rules Under TCJA, in the case of any taxpayer for any tax year, the deduction for business interest is limited to the sum of business interest income plus 30 percent of the adjusted taxable income of the taxpayer for the tax year. There is an exception to this limitation, however, for floor plan  

 

financing, which is a specialized type of financing used by car dealerships and certain regulated utilities. 

 

TCJA also exempts from the limitation taxpayers with average annual gross receipts for the three-tax year period ending with the prior tax year that do not exceed $25 million. In addition, for purposes of defining floor plan financing, TCJA modifies the definition of motor vehicle by deleting the specific references to an automobile, a truck, a recreational vehicle, and a motorcycle because those terms are encompassed in the phrase, “any self-propelled vehicle designed for transporting persons or property on a public street, highway, or road.”

 

At the taxpayer’s election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business is not treated as a trade or business for purposes of the limitation, and therefore the limitation does not apply to such trades or businesses. The limitation also does not apply to certain regulated public utilities. Specifically, the trade or business of the furnishing or sale of (1) electrical energy, water, or sewage disposal services, (2) gas or steam through a local distribution system, or (3) transportation of gas or steam by pipeline, if the rates for such furnishing or sale, as the case may be, have been established or approved by a State or political subdivision thereof, by any agency or instrumentality of the United States, or by a public service or public utility commission or other similar body of any State or political subdivision thereof is not treated as a trade or business for purposes of the limitation.

 

The amount of any interest not allowed as a deduction for any tax year may be carried forward indefinitely. The limitation applies at the taxpayer level. In the case of a group of affiliated corporations that file a consolidated return, it applies at the consolidated tax return filing level. A farming business, including agricultural and horticultural cooperatives, may elect not to be subject to this limitation if the business uses the alternative depreciation system to depreciate any property used in the farming business with a recovery period of 10 years or more. An electing real property trade or business may also elect out of the interest deduction limitation if the business also uses the alternative depreciation system to depreciate its property.

 

Business interest means any interest paid or accrued on indebtedness properly allocable to a trade or business. Any amount treated as interest for purposes of the Internal Revenue Code is interest for purposes of the provision. Business interest income means the amount of interest includible in the gross income of the taxpayer for the tax year which is properly allocable to a trade or business. Business interest does not include investment interest, and business interest income does not include investment income, within the meaning of Code Sec. 163(d).

 

By including business interest income in the limitation, the rule operates to limit the deduction for net interest expense to 30 percent of adjusted taxable income. That is, a deduction for business interest is permitted to the full extent of business interest income. To the extent that business interest expense exceeds business interest income, the deduction for the net interest expense is limited to 30 percent of adjusted taxable income.

 

Generally, adjusted taxable income means the taxable income of the taxpayer computed without regard to: 

 

(1) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business (but see below for special rules for tax years beginning after 2017 and before 2022);   

 

(2) any business interest or business interest income; 

 

(3) the 20 percent deduction for certain pass-through income; and 

 

(4) the amount of any net operating loss deduction. 

 

However, under TCJA, for tax years beginning after December 31, 2017, and before January 1, 2022, adjusted taxable income is computed without regard to deductions allowable for depreciation, amortization, or depletion. Additionally, because TCJA repeals Code Sec. 199 effective December 31, 2017 (see discussion below), adjusted taxable income is computed without regard to such deduction. 

 

TCJA authorizes the IRS to provide other adjustments to the computation of adjusted taxable income.

 

Application to Pass-Through Entities In the case of any partnership, the limitation is applied at the partnership level. Any deduction for business interest is taken into account in determining the nonseparately stated taxable income or loss of the partnership. To prevent double counting, special rules are provided for the determination of the adjusted taxable income of each partner of the partnership. Similarly, to allow for additional interest deduction by a partner in the case of an excess amount of unused adjusted taxable income limitation of the partnership, special rules apply. Similar rules apply with respect to any S corporation and its shareholders.

 

Double Counting Rule The adjusted taxable income of each partner (or shareholder, as the case may be) is determined without regard to such partner’s distributive share of the nonseparately stated income or loss of such partnership. In the absence of such a rule, the same dollars of adjusted taxable income of a partnership could generate additional interest deductions as the income is passed through to the partners.

 

Additional Deduction Limit The limit on the amount allowed as a deduction for business interest is increased by a partner’s distributive share of the partnership’s excess taxable income. The excess taxable income with respect to any partnership is the amount which bears the same ratio to the partnership’s adjusted taxable income as the excess (if any) of 30 percent of the adjusted taxable income of the partnership over the amount (if any) by which the business interest of the partnership exceeds the business interest income of the partnership bears to 30 percent of the adjusted taxable income of the partnership. This allows a partner of a partnership to deduct additional interest expense the partner may have paid or incurred to the extent the partnership could have deducted more business interest. TCJA requires that excess taxable income be allocated in the same manner as nonseparately stated income and loss.

 

Treatment of Wages Received  The trade or business of performing services as an employee is not treated as a trade or business for purposes of the limitation. As a result, for example, the wages of an employee are  

 

not counted in the adjusted taxable income of the taxpayer for purposes of determining the limitation.

 

Carryforward of Disallowed Business Interest The amount of any business interest not allowed as a deduction for any tax year is treated as business interest paid or accrued in the succeeding tax year. Business interest may be carried forward indefinitely. With respect to the limitation on deduction of interest by domestic corporations which are United States shareholders that are members of worldwide affiliated groups with excess domestic indebtedness, whichever rule imposes the lower limitation on the deduction of interest with respect to the tax year (and therefore the greatest amount of interest to be carried forward) governs.

 

Effective Date The provision applies to tax years beginning after December 31, 2017.

 

Other Deductions 

 

Repeal of Domestic Activities Production Deduction Under TCJA, the deduction in Code Sec. 199 for domestic production activities is repealed.

 

The provision applies to tax years beginning after December 31, 2017.

 

Amortization of Research and Experimental Expenditures Under TCJA, amounts defined as specified research or experimental expenditures are required to be capitalized and amortized ratably over a five-year period, beginning with the midpoint of the tax year in which the specified research or experimental expenditures were paid or incurred. Specified research or experimental expenditures which are attributable to research that is conducted outside of the United States are required to be capitalized and amortized ratably over a period of 15 years, beginning with the midpoint of the tax year in which such expenditures were paid or incurred. Specified research or experimental expenditures subject to capitalization include expenditures for software development. Specified research or experimental expenditures do not include expenditures for land or for depreciable or depletable property used in connection with the research or experimentation, but do include the depreciation and depletion allowances of such property. Also excluded are exploration expenditures incurred for ore or other minerals (including oil and gas). 

 

This rule will be applied on a cutoff basis to research or experimental expenditures paid or incurred in tax years beginning after December 31, 2025 (hence there is no adjustment under Code Sec. 481(a) for research or experimental expenditures paid or incurred in tax years beginning before January 1, 2026).

 

The provision applies to amounts paid or incurred in tax years beginning after December 31, 2025.  

 

Deductibility of Penalties and Fines for Federal Income Tax Purposes TCJA denies deductibility for any otherwise deductible amount paid or incurred (whether by suit, agreement, or otherwise) to or at the direction of a government or specified nongovernmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law. An exception applies to payments that the taxpayer establishes are either restitution (including remediation of property) or amounts required to come into compliance with any law that was violated or involved in the investigation or inquiry, that are identified in the court order or settlement agreement as restitution, remediation, or required to come into compliance. In the case of any amount of restitution for failure to pay any tax and assessed as restitution under the Code, such restitution is deductible only to the extent it would have been allowed as a deduction if it had been timely paid. Restitution or included remediation of property does not include reimbursement of government investigative or litigation costs.

 

The provision applies only where a government (or other entity treated in a manner similar to a government under the provision) is a complainant or investigator with respect to the violation or potential violation of any law. An exception also applies to any amount paid or incurred as taxes due. 

 

The provision is effective for amounts paid or incurred after December 22, 2017, except that it does not apply to amounts paid or incurred under any binding order or agreement entered into before such date. Such exception does not apply to an order or agreement requiring court approval unless the approval was obtained before such date.

 

Repeal of Certain Deductions Relating to Employee Achievement Awards TCJA prohibits a deduction for cash, gift cards, and other non-tangible personal property given to an employee as an achievement award, effective for amounts paid or incurred after December 31, 2017.

 

Repeal of Deduction for Local Lobbying Expenses TCJA disallows deductions for lobbying expenses with respect to legislation before local government bodies (including Indian tribal governments), effective for amounts paid or incurred on or after December 22, 2017.

 

Denial of Deduction for Settlements Subject to a Nondisclosure Agreement Paid in Connection with Sexual Harassment or Sexual Abuse Under TCJA, no deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement. The provision is effective for amounts paid or incurred after December 22, 2017.

 

Limitation on Deduction Relating to FDIC Premiums Under TCJA, no deduction is allowed for the applicable percentage of any FDIC premium paid or incurred by certain large financial institutions. For taxpayers with total consolidated assets of $50 billion or more, the applicable percentage is 100 percent. Otherwise, the applicable percentage is the ratio of the excess of total consolidated assets over $10 billion to $40 billion. The provision does not apply to taxpayers with total consolidated assets (as of the close of the  

 

tax year) that do not exceed $10 billion. The provision applies to tax years beginning after December 31, 2017.

 

Property Transactions 

 

Modification of Like-Kind Exchange Rules TCJA modifies the provision providing for nonrecognition of gain in the case of like-kind exchanges by limiting its application to real property that is not held primarily for sale. 

 

The provision generally applies to exchanges completed after December 31, 2017. However, an exception is provided for any exchange if the property disposed of by the taxpayer in the exchange is disposed of on or before December 31, 2017, or the property received by the taxpayer in the exchange is received on or before such date.

 

Certain Self-Created Property Not Treated as a Capital Asset TCJA amends Code Sec. 1221(a)(3), resulting in the exclusion of a patent, invention, model or design (whether or not patented), and a secret formula or process which is held either by the taxpayer who created the property or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created) from the definition of a “capital asset.” Thus, gains or losses from the sale or exchange of a patent, invention, model or design (whether or not patented), or a secret formula or process which is held either by the taxpayer who created the property or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created) will not receive capital gain treatment.

 

The provision applies to dispositions after December 31, 2017. 

 

Repeal of Rollover of Publicly Traded Securities Gain into Specialized Small Business Investment Companies TCJA repeals the election that could be made by a corporation or individual to roll over tax-free any capital gain realized on the sale of publicly-traded securities to the extent of the taxpayer’s cost of purchasing common stock or a partnership interest in a specialized small business investment company within 60 days of the sale. The amount of gain that an individual could elect to roll over under this provision for a tax year was limited to (1) $50,000 or (2) $500,000 reduced by the gain previously excluded under this provision. For corporations, these limits were $250,000 and $1 million, respectively.

 

The provision applies to sales after December 31, 2017.

 

 

 

Accounting Methods

 

Small Business Cash Accounting Method Reform and Simplification TCJA expands the universe of taxpayers that may use the cash method of accounting. Under the provision, the cash method of accounting may be used by taxpayers, other than tax shelters,  

 

that satisfy a gross receipts test, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. The gross receipts test allows taxpayers with annual average gross receipts that do not exceed $25 million for the three prior taxable-year period (the “$25 million gross receipts test”) to use the cash method. The $25 million amount is indexed for inflation for tax years beginning after 2018.

 

The provision expands the universe of farming C corporations (and farming partnerships with a C corporation partner) that may use the cash method to include any farming C corporation (or farming partnership with a C corporation partner) that meets the $25 million gross receipts test.

 

TCJA retains the exceptions from the required use of the accrual method for qualified personal service corporations and taxpayers other than C corporations. Thus, qualified personal service corporations, partnerships without C corporation partners, S corporations, and other passthrough entities are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of such method clearly reflects income.

 

The provisions to expand the universe of taxpayers eligible to use the cash method apply to tax years beginning after December 31, 2017. The change to the cash method is a change in the taxpayer’s method of accounting for purposes of Code Sec. 481

 

Modification of Inventory Classification Rules for Small Businesses TCJA exempts certain taxpayers from the requirement to keep inventories. Specifically, taxpayers that meet the $25 million gross receipts test are not required to account for inventories under Code Sec. 471, but rather may use a method of accounting for inventories that either (1) treats inventories as non-incidental materials and supplies, or (2) conforms to the taxpayer’s financial accounting treatment of inventories.

 

TCJA expands the exception for small taxpayers from the uniform capitalization rules. Under the provision, any producer or reseller that meets the $25 million gross receipts test is exempted from the application of Code Sec. 263A. The provision retains the exemptions from the uniform capitalization rules that are not based on a taxpayer’s gross receipts. Finally, the provision expands the exception for small construction contracts from the requirement to use the percentage-of-completion method. Under the provision, contracts within this exception are those contracts for the construction or improvement of real property if the contract: (1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract, and (2) is performed by a taxpayer that (for the tax year in which the contract was entered into) meets the $25 million gross receipts test.

 

Under TCJA, a taxpayer who fails the $25 million gross receipts test is not eligible for any of the aforementioned exceptions (i.e., from the accrual method, from keeping inventories, from applying the uniform capitalization rules, or from using the percentage-of completion method) for such tax year.

 

The provisions to exempt certain taxpayers from the requirement to keep inventories, and expand the exception from the uniform capitalization rules are changes in the taxpayer’s method of accounting for purposes of Code Sec. 481. Application of the exception for small construction contracts from the requirement to use the percentage-of-completion method is applied on a cutoff basis for all similarly classified contracts (hence there is no adjustment under Code Sec. 481(a) for contracts entered into before January 1, 2018). 

 

The provisions to expand the universe of taxpayers eligible to use the cash method, exempt certain taxpayers from the requirement to keep inventories, and expand the exception from the uniform capitalization rules apply to tax years beginning after December 31, 2017. The provision to expand the exception for small construction contracts from the requirement to use the percentage-of-completion method applies to contracts entered into after December 31, 2017, in tax years ending after such date.

 

Exceptions to Using Uniform Capitalization Rules Expanded TCJA expands the exception for small taxpayers being subject to the uniform capitalization accounting method rules. Under the provision, any producer or reseller that meets a $25 million gross receipts test is exempted from the application of Code Sec. 263A. In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership. The provision retains the exemptions from the uniform capitalization rules that are not based on a taxpayer’s gross receipts.

 

If a taxpayer changes its method of accounting because it is either no longer required or is required to apply Code Sec. 263A by reason of this provision, such change is treated as initiated by the taxpayer and made with the consent of the Secretary.

 

The provision apples to tax years beginning after December 31, 2017. Application of these rules would be a change in the taxpayer’s method of accounting for purposes of Code Sec. 481.

 

Increase in Gross Receipts Test for Construction Contract Exception to Percentage of Completion Accounting Method TCJA expands the exception for small construction contracts from the requirement to use the percentage-of-completion accounting method. Under the provision, contracts within this exception are those contracts for the construction or improvement of real property if the contract: 

 

(1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract; and 

 

(2) is performed by a taxpayer that (for the tax year in which the contract was entered into) meets the $25 million gross receipts test.

 

In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership. The provision applies to contracts entered into after December 31, 2017, in tax years ending after such date. Application of this rule would be a change in the taxpayer’s method of accounting for purposes of Code Sec. 481, but is applied on a cutoff basis for all similarly classified contracts (hence there is no adjustment under Code Sec. 481(a) for contracts entered into before January 1, 2018).

 

Modification of Accounting Method Rules Relating to Income Recognition TCJA revises the rules associated with the recognition of income. Specifically, the provision requires a taxpayer to recognize income no later than the tax year in which such income is taken into account as income on an applicable financial statement or another financial statement under rules specified by the Secretary, but provides an exception for long-term contract income to which Code Sec. 460 applies.  

 

The provision also codifies the current deferral method of accounting for advance payments for goods and services provided by the IRS under Rev. Proc. 2004-34. That is, the provision allows taxpayers to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income also is deferred for financial statement purposes.

 

In addition, the provision directs taxpayers to apply the revenue recognition rules under Code Sec. 451 before applying the OID rules under Code Sec.1272. 

 

Observation: Thus, for example, to the extent amounts are included in income for financial statement purposes when received (e.g., late payment fees, cash-advance fees, or interchange fees), such amounts generally are includable in income at such time in accordance with the general recognition principles under Code Sec. 451.

 

In the case of any taxpayer required by this provision to change its method of accounting for its first tax year beginning after December 31, 2017, such change is treated as initiated by the taxpayer and made with the consent of the Secretary.

 

The provision applies to tax years beginning after December 31, 2017, and application of these rules would be a change in the taxpayer’s method of accounting for purposes of Code Sec. 481.

 

 

 

Passthrough Entities and ESBTs

 

Tax Gain on the Sale of a Partnership Interest on a Look-through Basis Under TCJA, gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. The provision requires that any gain or loss from the hypothetical asset sale by the partnership be allocated to interests in the partnership in the same manner as nonseparately stated income and loss.

 

TCJA also requires the transferee of a partnership interest to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation. If the transferee fails to withhold the correct amount, the partnership is required to deduct and withhold from distributions to the transferee partner an amount equal to the amount the transferee failed to withhold.

 

The provision treating gain or loss on sale of a partnership interest as effectively connected income is effective for sales, exchanges, and dispositions on or after November 27, 2017. The portion of the provision requiring withholding on sales or exchanges of partnership interests is effective for sales, exchanges, and dispositions after December 31, 2017.

 

Modification of the Definition of Substantial Built-in Loss on Transfers of a Partnership Interest TCJA modifies the definition of a substantial built-in loss for purposes of Code Sec. 743(d), affecting transfers of partnership interests. Under the provision, in addition to the present-law 

 

definition, a substantial built-in loss also exists if the transferee would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all partnership’s assets in a fully taxable transaction for cash equal to the assets’ fair market value, immediately after the transfer of the partnership interest.

 

Example: ABC Partnership has three taxable partners (partners A, B, and C). ABC has not made an election pursuant to Code Sec. 754. The partnership has two assets, one of which, Asset X, has a built-in gain of $1 million, while the other asset, Asset Y, has a built-in loss of $900,000. Pursuant to the ABC partnership agreement, any gain on the sale or exchange of Asset X is specially allocated to partner A. The three partners share equally in all other partnership items, including in the built-in loss in Asset Y. In this case, partner B and partner C each have a net built-in loss of $300,000 (one third of the loss attributable to asset Y) allocable to his partnership interest. Nevertheless, the partnership does not have an overall built-in loss, but a net built-in gain of $100,000 ($1 million minus $900,000). Partner C sells his partnership interest to another person, D, for $33,333. Under the provision, the test for a substantial built-in loss applies both at the partnership level and at the transferee partner level. If the partnership were to sell all its assets for cash at their fair market value immediately after the transfer to D, D would be allocated a loss of $300,000 (one third of the built-in loss of $900,000 in Asset Y). The partnership does not have a substantial built-in loss, but a substantial built-in loss exists under the partner-level test, and the partnership adjusts the basis of its assets accordingly with respect to D.

 

The provision applies to transfers of partnership interests after December 31, 2017.

 

Charitable Contributions and Foreign Taxes Taken into Account in Determining Limitation on Allowance of Partner’s Share of Loss TCJA modifies the basis limitation on partner losses to provide that a partner’s distributive share of items that are not deductible in computing the partnership’s taxable income, and not properly chargeable to capital account, are allowed only to the extent of the partner’s adjusted basis in its partnership interest at the end of the partnership tax year in which the expenditure occurs. Thus, the basis limitation on partner losses applies to a partner’s distributive share of charitable contributions and foreign taxes. A partner’s distributive share of loss takes into account the partner’s distributive share of charitable contributions and foreign taxes for purposes of the basis limitation on partner losses. In the case of a charitable contribution of property whose fair market value exceeds its adjusted basis, the basis limitation on partner losses does not apply to the extent of the partner’s distributive share of such excess.

 

The provision applies to partnership tax years beginning after December 31, 2017.

 

Modification of Treatment of S Corporation Conversions to C Corporations TCJA provides that any Code Sec. 481(a) adjustment of an eligible terminated S corporation attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) is taken into account ratably during the six-taxable-year period beginning with the year of change. An eligible terminated S corporation is any C corporation which (1) is an S corporation the day before the enactment of TCJA, (2) during the two-year period beginning on the date of such enactment revokes its S corporation election under Code Sec.  

 

1362(a), and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment.

 

Under the provision, in the case of a distribution of money by an eligible terminated S corporation, the accumulated adjustments account shall be allocated to such distribution, and the distribution shall be chargeable to accumulated earnings and profits, in the same ratio as the amount of the accumulated adjustments account bears to the amount the accumulated earnings and profits.

 

The provision is effective upon enactment.

 

Repeal of Technical Termination of Partnerships TCJA repeals the Code Sec. 708(b)(1)(B) rule providing for technical terminations of partnerships in certain situations. The provision does not change the present-law rule of Code Sec. 708(b)(1)(A) that a partnership is considered as terminated if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.

 

The provision applies to partnership tax years beginning after December 31, 2017

 

Expansion of Qualifying Beneficiaries of an Electing Small Business Trust (ESBT) TCJA allows a nonresident alien individual to be a potential current beneficiary of an ESBT. The provision takes effect on January 1, 2018.

 

Charitable Contribution Deduction for ESBTs TCJA provides that the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but rather by the rules applicable to individuals. Thus, the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock. 

 

The provision applies to tax years beginning after December 31, 2017.

 

Tax Credits

 

Modification of Orphan Drug Credit TCJA reduces the Orphan Drug Credit rate to 25 percent (instead of current law’s 50 percent rate) of qualified clinical testing expenses. The new law also has reporting requirements similar to those required in Code Sec. 48C and Code Sec. 48D. In addition, TCJA strikes any base amount calculation and also the limitation regarding qualified clinical testing expenses to the extent such testing relates to a drug which has previously been approved under Section 505 of the Federal Food, Drug, and Cosmetic Act.

 

The provision applies to amounts paid or incurred in tax years beginning after December 31, 2017.

 

Modification of Rehabilitation Credit TCJA modifies the rehabilitation credit in Code Sec. 47.  

 

Employer Credit for Paid Family and Medical Leave For 2018 and 2019, TCJA allows eligible employers to claim a general business credit equal to 12.5 percent of the amount of wages paid to qualifying employees during any period in which such employees are on family and medical leave if the rate of payment under the program is 50 percent of the wages normally paid to an employee. The credit is increased by 0.25 percentage points (but not above 25 percent) for each percentage point by which the rate of payment exceeds 50 percent.

 

Observation: An employer must have a written policy in place that provides family and medical leave to all employees on a non-discriminatory basis in order to qualify for the credit. Given the cost of implementing such a policy and complying with yet-to-be-announced reporting requirements, the credit may be impractical for many employers to pursue during the short period it’s available. For companies that already have a qualifying family and medical leave plan in place, however, the credit may provide a nice windfall.

 

Certain Unused Business Credits While both the House Bill and the Senate Bill would have repealed the deduction in Code Sec. 196 for certain unused business credits, the repeal of that provision did not make it into TCJA.

 

Repeal of Tax Credit Bonds TCJA prospectively repeals the authority to issue tax-credit bonds and direct-pay bonds. The provision applies to bonds issued after December 31, 2017.

 

Miscellaneous Provisions 

 

Modification of Limitation on Excessive Employee Remuneration TCJA revises the definition of covered employee to include both the principal executive officer and the principal financial officer. Further, an individual is a covered employee if the individual holds one of these positions at any time during the tax year. The provision also defines as a covered employee the three (rather than four) most highly compensated officers for the tax year (other than the principal executive officer or principal financial officer) who are required to be reported on the company’s proxy statement for the tax year (or who would be required to be reported on such a statement for a company not required to make such a report to shareholders). The provision applies to tax years beginning after December 31, 2017. However, there is a transition rule which provides that the proposed changes do not apply to any remuneration under a written binding contract which was in effect on November 2, 2017, and which was not modified after this date in any material respect, and to which the right of the covered employee was no longer subject to a substantial risk of forfeiture on or before December 31, 2016.

 

Change in Determination of Cost Basis of Specified Securities TCJA does not include a controversial provision in the Senate Bill which would have required that the cost of any specified security sold, exchanged, or otherwise disposed of on or after January 1, 2018, generally be determined on a first-in first-out basis except to the extent the average basis method is otherwise allowed (as in the case of stock of a regulated investment company). The Senate’s proposal had included several conforming amendments, including a  

 

rule restricting a broker’s basis reporting method to the first-in first-out method in the case of the sale of any stock for which the average basis method was not permitted.

 

Recharacterization of Certain Gains in the Case of Partnership Profits Interests Held in Connection with Performance of Investment Services TCJA provides for a three-year holding period in the case of certain net long-term capital gain generated as the result of the receipt of a profits interest in a partnership (sometimes referred to as a carried interest).  TCJA clarifies the interaction of Code Sec. 83 with the provision’s threeyear holding requirement, which applies notwithstanding the rules of Code Sec. 83 or any election in effect under Code Sec. 83(b). Under the provision, the fact that an individual may have included an amount in income upon acquisition of the applicable partnership interest, or that an individual may have made a Code Sec. 83(b) election with respect to an applicable partnership interest, does not change the three-year holding period requirement for long-term capital gain treatment with respect to the applicable partnership interest. Thus, the provision treats as short-term capital gain taxed at ordinary income rates the amount of the taxpayer’s net long-term capital gain with respect to an applicable partnership interest for the tax year that exceeds the amount of such gain calculated as if a three-year (not one-year) holding period applies. In making this calculation, the provision takes account of long-term capital losses calculated as if a three-year holding period applies.

 

The provision applies to tax years beginning after December 31, 2017.

 

Modify Tax Treatment of Alaska Native Corporations and Settlement Trusts TCJA addresses the tax treatment of Alaska Native Corporations and settlement trusts in three separate but related sections. The first section allows a Native Corporation to assign certain payments described in the Alaska Native Claims Settlement Act (ANCSA) to a Settlement Trust without having to recognize gross income from those payments, provided the assignment is in writing and the Native Corporation has not received the payment prior to assignment. The Settlement Trust is required to include the assigned payment in gross income when received. The second section allows a Native Corporation to elect annually to deduct contributions made to a Settlement Trust. The third section of the provision requires any Native Corporation which has made an election to deduct contributions to a Settlement Trust as described above to furnish a statement to the Settlement Trust containing: (1) the total amount of contributions; (2) whether such contribution was in cash; (3) for non-cash contributions, the date that such property was acquired by the Native Corporation and the adjusted basis of such property on the contribution date; (4) the date on which each contribution was made to the Settlement Trust; and (5) such information as the Secretary determines is necessary for the accurate reporting of income relating to such contributions. 

 

The provision relating to the exclusion for ANCSA payments assigned to Settlement Trusts is effective to tax years beginning after December 31, 2016. The provision relating to the reporting requirement applies to tax years beginning after December 31, 2016.

 

Aircraft Management Services TCJA exempts certain payments related to the management of private aircraft from the excise taxes imposed on taxable transportation by air, effective for amounts paid after December 22, 2017.  

 

Qualified Opportunity Zones TCJA provides for the temporary deferral of inclusion in gross income for capital gains reinvested in a qualified opportunity fund and the permanent exclusion of capital gains from the sale or exchange of an investment in the qualified opportunity fund. The provision allows for the designation of certain low-income community population census tracts as qualified opportunity zones, where low-income communities are defined in Code Sec. 45D(e). The designation of a population census tract as a qualified opportunity zone remains in effect for the period beginning on the date of the designation and ending at the close of the tenth calendar year beginning on or after the date of designation. The provision is effective on December 22, 2017.

 

Excise Tax on Stock Compensation in an Inversion Transaction TCJA increases the excise tax on stock compensation in an inversion transaction from 15 percent to 20 percent. The provision applies to corporations first becoming expatriated corporations after December 22, 2017.   

 

V. Foreign-Related Changes

 

 

Deduction for Foreign-Source Portion of Dividends Received by Domestic Corporations from Specified 10-Percent Owned Foreign Corporations  TCJA enacts new Code Sec. 245A, which provides for an exemption for certain foreign income. This exemption is provided for by means of a 100-percent deduction for the foreign-source portion of dividends received from specified 10-percent owned foreign corporations by domestic corporations that are United States shareholders of those foreign corporations within the meaning of Code Sec. 951(b) (referred to as “DRD”). The provision is effective for distributions made (and, for purposes of determining a taxpayer’s foreign tax credit limitation under Code Sec. 904, deductions in tax years beginning) after December 31, 2017.

 

Special Rules Relating to Sales or Transfers Involving Specified 10Percent Owned Foreign Corporations  TCJA provides that, in the case of the sale or exchange by a domestic corporation of stock in a foreign corporation held for one year or more, any amount received by the domestic corporation which is treated as a dividend for purposes of Code Sec. 1248, is treated as a dividend for purposes of applying the provision.

 

Solely for the purpose of determining a loss, TCJA provides that a domestic corporate shareholder’s adjusted basis in the stock of a specified 10-percent owned foreign corporation (as defined in this provision) is reduced by an amount equal to the portion of any dividend received with respect to such stock from such foreign corporation that was not taxed by reason of a dividends received deduction allowable under Code Sec. 245A in any tax year of such domestic corporation. This rule applies in coordination with Code Sec. 1059, such that any reduction in basis required pursuant to this provision will be disregarded, to the extent the basis in the specified 10-percent owned foreign corporation’s stock has already been reduced pursuant to Code Sec. 1059.

 

TCJA also provides that, if for any tax year of a controlled foreign corporation (CFC) beginning after December 31, 2017, an amount is treated as a dividend under Code Sec. 964(e)(1) because of a sale or exchange by the CFC of stock in another foreign corporation held for a year or more, then: (1) the foreign-source portion of the dividend is treated as subpart F income of the selling CFC for purposes of Code Sec. 951(a)(1)(A), (2) a United States shareholder with respect to the selling CFC includes in gross income for the tax year of the shareholder with or within the tax year of the CFC ends, an amount equal to the shareholder’s pro rata share (determined in the same manner as under Code Sec. 951(a)(2)) of the amount treated as subpart F income under (1), and (3) the deduction under Code Sec. 245A(a) is allowable to the U.S. shareholder with respect to the subpart F income included in gross income under (2) in the same manner as if the subpart F income were a dividend received by the shareholder from the selling CFC.  

 

In the case of a sale or exchange by a CFC of stock in another corporation in a tax year of the selling CFC beginning after December 31, 2017, to which this provision applies if gain were recognized, rules similar to Code Sec. 961(d) apply.

 

Code Sec. 367 is amended to provide that in connection with any exchange described in Code Secs. 332, 351, 354, 356, or 361, if a U.S. person transfers property used in the active conduct of a trade or business to a foreign corporation, such foreign corporation is not, for purposes of determining the extent to which gain is recognized on such transfer, be considered to be a corporation.

 

Under TCJA, if a domestic corporation transfers substantially all of the assets of a foreign branch (within the meaning of Code Sec. 367(a)(3)(C), as in effect before the date of enactment of TCJA) to a specified 10-percent owned foreign corporation with respect to which it is a U.S. shareholder after the transfer, the domestic corporation includes in gross income an amount equal to the transferred loss amount, subject to certain limitations.

 

The provisions relating to sales or exchanges of stock apply to sales or exchanges after December 31, 2017. The provision relating to reduction of basis in certain foreign stock for the purposes of determining a loss is effective for distributions made after December 31, 2017. The provisions relating to transfer of loss amounts from foreign branches to certain foreign corporations and to the repeal of the active trade or business is effective for transfers after December 31, 2017.

 

Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation TCJA generally requires that, for the last tax year beginning before January 1, 2018, any U.S. shareholder of a controlled foreign corporation, as well as all foreign corporations (other than PFICs) in which a U.S. person owns a 10-percent voting interest, must include in income its pro rata share of the undistributed, non-previously-taxed post-1986 foreign earnings of the corporation (“mandatory inclusion”). A special rule permits deferral of the transition net tax liability for shareholders of a U.S. shareholder that are an S corporation. The provision is effective for the last tax year of a foreign corporation that begins before January 1, 2018, and with respect to U.S. shareholders, for the tax years in which or with which such tax years of the foreign corporations end.

 

Current Year Inclusion of Global Intangible Low-Taxed Income by U.S. Shareholders  Under TCJA, a U.S. shareholder of any CFC must include in gross income for a tax year its global intangible low-taxed income (GILTI) in a manner generally similar to inclusions of subpart F income. GILTI, which is defined in new Code Sec. 951A, means, with respect to any U.S. shareholder for the shareholder’s tax year, the excess (if any) of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return. The shareholder’s net deemed tangible income return is an amount equal to 10 percent of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (QBAI) of each CFC with respect to which it is a U.S. shareholder. The provision is effective for tax years of foreign  

 

corporations beginning after December 31, 2017, and for tax years of U.S. shareholders in which or with which such tax years of foreign corporations end.

 

Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income TCJA provides domestic corporations with reduced rates of U.S. tax on their foreign-derived intangible income (“FDII”) and GILTI (defined above). A domestic corporation’s FDII is the portion of its intangible income, determined on a formulaic basis that is derived from serving foreign markets. For tax years beginning after December 31, 2017, and before January 1, 2019, the effective tax rate on FDII is 21.875 percent and the effective U.S. tax rate on GILTI is 17.5 percent. For tax years beginning after December 31, 2018, and before January 1, 2026, the effective tax rate on FDII is 12.5 percent and the effective U.S. tax rate on GILTI is 10 percent. For tax years beginning after December 31, 2025, the effective tax rate on FDII is 15.625 percent and the effective U.S. tax rate on GILTI is 12.5 percent. The provision is effective for tax years beginning after December 31, 2017.

 

Modifications of Subpart F Provisions TCJA makes the following modifications –   eliminates the inclusion of foreign base company oil related income as a category of foreign base company income;   repeals Code Sec. 955;   amends the ownership attribution rules of Code Sec. 958(b);   modifies the definition of U.S. shareholder;   eliminates the requirement that a corporation must be controlled for 30 days before subpart F inclusions apply;   makes permanent the exclusion from foreign personal holding company income for certain dividends, interest (including factoring income that is treated as equivalent to interest under Code Sec. 954(c)(1)(E)), rents, and royalties received or accrued by one CFC from a related CFC; and  amends the requirement in subpart F that U.S. shareholders recognize income when earnings are repatriated in the form of increases in investment by a CFC in U.S. property to provide an exception for domestic corporations that are U.S. shareholders in the CFC either directly or through a domestic partnership.

 

 

 

Prevention of Base Erosion TCJA makes the following modifications –   places limitations on income shifting through intangible property transfers;   denies a deduction for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity;   provides rules that surrogate foreign corporations are not eligible for reduced rate on dividends; and 

 

 modifies the tax rate on base erosion payments of taxpayers with substantial gross receipts.

 

Modifications Related to Foreign Tax Credit System TCJA makes the following modifications: (1) repeals the Code Sec. 902 indirect foreign tax credits and provide for the determination of Code Sec. 960 credit on current year basis; (2) requires foreign branch income to be allocated to a specific foreign tax credit basket; (3) accelerates the effective date of the worldwide interest allocation rules to apply to tax years beginning after December 31, 2017, rather than to tax years beginning after December 31, 2020; and (4) allocates and apportion gains, profits, and income from the sale or exchange of inventory property produced partly in, and partly outside, the United States on the basis of the location of production with respect to the property.

 

Inbound Provisions Under TCJA, an applicable taxpayer is required to pay a tax equal to the base erosion minimum tax amount for the tax year. The base erosion minimum tax amount means, with respect to an applicable taxpayer for any tax year, the excess of 10-percent of the modified taxable income of the taxpayer for the tax year over an amount equal to the regular tax liability of the taxpayer for the tax year reduced (but not below zero) by the excess (if any) of credits allowed under Chapter 1 against such regular tax liability over the sum of: (1) the credit allowed under Code Sec. 38 for the tax year which is properly allocable to the research credit determined under Code Sec. 41(a), plus (2) the portion of the applicable Code Sec. 38 credits not in excess of 80 percent of the lesser of the amount of such credits or the base erosion minimum tax amount (determined without regard to this clause (2)). 

 

For tax years beginning after December 31, 2025, two changes have been made, (i) the 10percent provided for above is changed to 12.5-percent, and (ii) the regular tax liability is reduced by the aggregate amount of the credits allowed under Chapter 1 (and no other adjustment made). 

 

Modification of Insurance Exception to the Passive Foreign Investment Company Rules TCJA modifies the requirements for a corporation the income of which is not included in passive income for purposes of the PFIC rules. The provision replaces the test based on whether a corporation is predominantly engaged in an insurance business with a test based on the corporation's insurance liabilities. The requirement that the foreign corporation is subject to tax under subchapter L if it were a domestic corporation is retained.

 

Repeal of Fair Market Value of Interest Expense Apportionment TCJA prohibits members of a U.S. affiliated group from allocating interest expense on the basis of the fair market value of assets for purposes of Code Sec. 864(e). Instead, the members must allocate interest expense based on the adjusted tax basis of assets. The provision is effective for tax years beginning after December 31, 2017.  

 

VI. Retirement Plan-Related Changes

 

 

 

Partial Repeal of Special Rule Permitting Recharacterization of IRA Contributions Under TCJA, the special rule that allows a contribution to one type of IRA to be recharacterized as a contribution to the other type of IRA does not apply to a conversion contribution to a Roth IRA. Thus, recharacterization cannot be used to unwind a Roth conversion. However, recharacterization is still permitted with respect to other contributions. For example, an individual may make a contribution for a year to a Roth IRA and, before the due date for the individual’s income tax return for that year, recharacterize it as a contribution to a traditional IRA

 

The provision is effective for tax years beginning after December 31, 2017.

 

Extended Rollover Period for the Rollover of Plan Loan Offset Amounts in Certain Cases Under TCJA, the period during which a qualified plan loan offset amount may be contributed to an eligible retirement plan as a rollover contribution is extended from 60 days after the date of the offset to the due date (including extensions) for filing the federal income tax return for the tax year in which the plan loan offset occurs, that is, the tax year in which the amount is treated as distributed from the plan. Under the provision, a qualified plan loan offset amount is a plan loan offset amount that is treated as distributed from a qualified retirement plan, a Code Sec. 403(b) plan or a governmental Code Sec. 457(b) plan solely by reason of the termination of the plan or the failure to meet the repayment terms of the loan because of the employee’s separation from service, whether due to layoff, cessation of business, termination of employment, or otherwise. As under present law, a loan offset amount under the provision is the amount by which an employee’s account balance under the plan is reduced to repay a loan from the plan. The provision applies to tax years beginning after December 31, 2017.

 

Length of Service Award Programs for Bona Fide Public Safety Volunteers TCJA increases the aggregate amount of length of service awards that may accrue for a bona fide volunteer with respect to any year of service to $6,000 and adjusts that amount to reflect changes in cost-of-living for years after the first year the provision is effective. In addition, under the provision, if the plan is a defined benefit plan, the limit applies to the actuarial present value of the aggregate amount of length of service awards accruing with respect to any year of service. Actuarial present value is to be calculated using reasonable actuarial assumptions and methods, assuming payment will be made under the most valuable form of payment under the plan with payment commencing at the later of the earliest age at which unreduced benefits are payable under the plan or the participant’s age at the time of the calculation. The provision is effective for tax years beginning after December 31, 2017.

 

2013 Tax Year-in-review

Posted by Admin Posted on Feb 04 2014

2013 Tax Developments Break New Ground; Build On Past

2013 was an eventful year for federal tax developments, notable from its onset by passage of the American Taxpayer Relief Act of 2012 (ATRA), which permanently extended the Bush-era tax cuts for all but higher-income taxpayers as well as numerous other important, but previously temporary, provisions. The year also saw an ample release of important guidance relating to the Affordable Care Act, the new Net Investment Income tax and Additional Medicare Tax, capitalization and repairs, the tax treatment of married same-sex couples and much more. In international taxation, the IRS won several important victories in the federal courts relating to international financial transactions used as tax shelters. The IRS also stepped up investigations of U.S. persons who may be hiding funds in undisclosed offshore accounts and continued to implement the Foreign Account Tax Compliance Act (FATCA) by releasing rules and regulations, draft forms and signing intergovernmental agreements. With all these factors in mind, this Tax Briefing reviews the key federal tax developments from 2013.

IMPACT.

2013 was bracketed by tax legislation: the year started with the successful passage of ATRA and ended with no movement on the tax extenders. There remains uncertainty over the fate of the many popular extenders, such as enhanced Code Sec. 179 expensing and bonus depreciation, not permanently extended by ATRA. The extenders may be affected by continued discussion of comprehensive tax reform. However, the momentum toward tax reform has been slowed by other issues in Congress. It is also far from clear if the White House and the GOP can reach an agreement that covers both individual and business tax reform. The two sides remain divided over the question of whether tax reform should be revenue neutral or include revenue-raising measures.

COMMENT 

For 16 days in October, the IRS ceased nearly all day-to-day operations, including most enforcement, collection, return and refund processing, and most computer system programming. Some online functions remained available. As a result, taxpayers and practitioners enter 2014 to find a delayed start to the filing season and, consequently, delayed refunds. However, the threat of a shutdown during the 2014 filing season has been averted with passage of the Bipartisan Budget Act of 2013, which effectively provides funding for the IRS for two years.

TAX LEGISLATION AND REFORM

In January 2013, President Obama signed ATRA into law, which resolved the tax side of the so-called fiscal cliff. ATRA made permanent some temporary tax incentives but only extended others through 2013. At year-end, those provisions had not been extended again.

ATRA. Under ATRA, the Bush-era tax cuts were made permanent for lower and moderate income taxpayers. ATRA also permanently patched the alternative minimum tax (AMT) to prevent its encroachment on middle income taxpayers, provided a maximum estate tax rate of 40 percent with a $5 million exclusion (indexed for inflation), and made several other changes.

IMPACT.

Effective for 2013, higher income individuals are subject to increased taxes. Income above $400,000 (indexed for inflation) and $450,000 for married couples filing a joint return (also indexed for inflation) is taxed at a 39.6 percent rate. Additionally, ATRA raised the top rate for capital gains and dividends to 20 percent where a taxpayer's income exceeds the thresholds set for the 39.6 percent tax bracket. ATRA also revived the "Pease" itemized-deduction limitation and the personal exemption phaseout (PEP) for higher income taxpayers.

Extenders. While ATRA extended many of the extenders, it did so only through 2013. These included the state and local sales tax deduction, higher education tuition deduction, teachers' classroom expense deduction, research tax credit, transit benefits parity, a mortgage debt forgiveness exclusion, and more. Consequently, 2014 has started with the extenders—at last count, up to 55 of them—having expired.

IMPACT.

The days of Congress routinely extending the extenders may be over. An eleventh-hour push by Democrats in the Senate in December to extend the extenders by unanimous consent failed. The GOP-controlled House did not even take up the extenders in 2013.

President Obama's proposals. President Obama unveiled early in 2013 a proposed $3.77 trillion fiscal year (FY) 2014 budget, his fifth since taking office, which included new revenue raisers, impacting taxpayers of all types. They included limiting contributions and accruals on tax-favored retirement benefits; reducing the value to 28 percent of certain deductions and exclusions that would otherwise reduce taxable income in the 33, 35 or 39.6 percent tax brackets; creating 20 "Promise Zones" (14 urban and six rural) to offer tax incentives for job creation; repealing the last-in, first-out (LIFO) method of accounting; and eliminating many fossil fuel tax incentives.

President Obama also renewed his call for business tax simplification in exchange for using the "one-time revenues" to encourage job creation. The President's plan would eliminate unspecified tax preferences to achieve a 28 percent corporate tax rate (25 percent for manufacturers), allow businesses to expense up to $1 million in investments, impose a minimum tax on foreign earnings, and provide new incentives for clean energy.

SFC tax reform proposals. Sen. Max Baucus, D-Mont., chair of the Senate Finance Committee (SFC), unveiled a series of tax reform proposals (including legislative language) in 2013. The proposals reflect hearings the SFC held over the past three years on tax reform. Baucus proposed a simplified depreciation system, international tax reforms, and improvements in tax administration.

COMMENT 

Baucus emphasized that the proposals should be considered as a package and not as stand-alone proposals. However, it is unclear if the Senate leadership agrees. Baucus has won some support for tax reform from his House counterpart, Ways and Means Chair Dave Camp, R-Mich., whose committee also explored tax reform in 2013.

COMMENT 

President Obama has nominated Baucus to serve as U.S. ambassador to China. It is unclear if Baucus' successor as SFC chair will share his enthusiasm for tax reform.

NEW MEDICARE TAXES

Effective January 1, 2013, the Affordable Care Act imposed two new Medicare taxes on qualified taxpayers: a 3.8 percent net investment income (NII) tax and a 0.9 percent Additional Medicare Tax. Throughout much of 2013 …and despite proposed reliance regulations issued in 2012, many taxpayers and their advisors continued to have questions regarding the application of these new taxes. Finally, on November 26, 2013 -a full 330 days into the first year in which the two new taxes applied, the IRS released much-anticipated final regulations.

IMPACT.

The final NII tax regulations are intended to clarify many issues, largely in favor of taxpayers, but also defer complete resolution of other questions to guidance promised in 2014. They arrived late enough in the year to foreclose consistent or aggressive strategies for the 2013 tax year.

Net Investment Income Tax. The NII tax on taxpayers (individuals and trusts and estates) equals 3.8 percent of the lesser of: (1) net investment income for the tax year, or (2) the excess, if any of: (a) an individual's modified adjusted gross income (MAGI) for the tax year, over (b) the threshold amount.

COMMENT 

The threshold amount is $250,000 in the case of a taxpayer making a joint return or a surviving spouse, $125,000 in the case of a married taxpayer filing a separate return, and $200,000 in any other case (these amounts are not indexed for inflation). The threshold amount for trusts and estates is the start of their 39.6 percent tax bracket, which, for 2013 was $11,950 ($12,150 for 2014).

Final regulations. The November 2013 final regulations retained most provisions from the 2012 proposed reliance regulations, but nevertheless changed several key portions to accommodate what it conceded was legitimate criticism (TD 9644). The final regulations addressed dozens of requests for changes to the 2012 proposed regulations. Some recommendations were adopted, some were tweaked, and some were rejected by the IRS.

Some of the more significant pro-taxpayer changes in the final regulations include:

  • ? Allowing Code Sec. 465 net disposition losses to offset other categories of investment income and treating as properly allocable deductions net operating losses allocable to investment income;

  • ? Concluding generally that income treated as nonpassive under the Code Sec. 469 passive activity limitations also may qualify as nonpassive under Code Sec. 1411;

  • ? Classifying income from self-rented property more favorably;

  • ? Providing safe harbors under which some real estate professionals will avoid the NII tax;

  • ? Acknowledging that renting out even a single item of property may qualify as a trade or business, depending on facts and circumstances; and

  • ? Providing regrouping opportunities on passive activities that apply to Code Sec. 469 in addition to Code Sec. 1411.

New proposed regulations. In response to taxpayer feedback, the IRS issued new proposed reliance regulations at the same time as the final regulations. The proposed reliance regulations are intended to provide, among other things, simplified methods to compute NII vulnerable gain or loss on the sale of pass through entities (NPRM REG130843-13). The proposed reliance regulations address areas that either were not covered in the 2012 proposed regulations, or that the IRS subsequently revised.

Additional Medicare Tax. Final regulations on the Additional Medicare Tax were also released by the IRS in November (TD 9645). The Additional Medicare Tax applies to employee compensation/self-employment income in any tax year beginning after December 31, 2012. The final regulations generally track proposed regulations issued in 2012, with some clarifications.

The IRS acknowledged that the Additional Medicare Tax requires new recordkeeping and withholding procedures for employers. However, the agency declined to give employers additional time to correct errors, allow corrections for a certain period without penalty, or exempt de minimis errors from penalties. The IRS also described correction of overpayments and underpayments by employers in the final regulations.

IMPACT.

Employers should be aware of the requirement that they withhold additional income tax from employees whose wages exceed the threshold for the tax (generally, $200,000). Employers that did not properly withhold for 2013 compensation may expect to be assessed penalties since corrections under the regulations are generally only allowed if made within the same tax year.

AFFORDABLE CARE ACT

When Congress passed the Affordable Care Act in 2010 it delayed the effective dates of many key provisions. Effective January 1, 2014, the individual mandate took effect; however, the Obama administration mitigated the requirements for some individuals as the deadline approached. And the Obama administration delayed the effective date of the employer mandate entirely.

Employer mandate. The IRS issued proposed regulations on the employer mandate in January (NPRM REG-138006-12). The proposed regulations describe an applicable large employer (ALE) for purposes of Code Sec. 4980H, the number of hours of service in a calendar month treated as fulltime, how the requirement would apply to a new employer that is an applicable large employer, and more.

IMPACT.

Under the Affordable Care Act, an ALE with respect to a calendar year is an employer that employed an average of at least 50 full-time equivalent employees on business days during the preceding calendar year. The proposed regulations would treat 130 hours of service in a calendar month as the monthly equivalent of 30 hours of service per week.

Delay. In July, the Obama administration announced that the employer mandate would not apply until 2015. The administration explained that it took this action to give employers additional time to implement reporting requirements under Code Sec. 6056. The IRS subsequently issued transition relief providing that information reporting under Code Sec. 6056 (and Code Sec. 6055 for insurers) is optional for 2014.

Individual mandate. The IRS issued proposed regulations on the individual shared responsibility payment requirement (individual mandate) in January (NPRM REG-148500-12). Under the proposed regulations, minimum essential coverage for purposes of the individual mandate includes (not an exhaustive list) qualified employer-sponsored coverage, Medicare, Medicaid, and coverage for veterans and children. Certain individuals are exempt from the requirement to carry minimum essential coverage, such as individuals who experience a short gap in coverage, individuals who are unlawfully present in the U.S., and individuals who are incarcerated. The Obama Administration also grandfathered for 2014 certain additional plans that were being cancelled.

COMMENT 

Unlike the employer mandate, the individual mandate in general is not delayed and took effect January 1, 2014. However, individuals will not report any liability for failing to carry minimum essential coverage until they file their 2014 returns in 2015.

Code Sec. 36B credit. Individuals who obtain health insurance coverage through an Affordable Care Act Marketplace after 2013 may be eligible for the Code Sec. 36B credit to offset the cost of coverage. In January, the IRS released final regulations on the Code Sec. 36B premium assistance tax credit (TD 9611). In May, the IRS issued proposed regulations to clarify the meaning of "minimum value" (MV) for purposes of claiming the Code Sec. 36B credit (NPRM REG-125398-12).

The IRS also issued proposed reliance regulations on reporting the Code Sec. 36B credit (NPRM REG-140789-12). Marketplaces will report the level of coverage, advance payments of the credit and more to the IRS.

COMMENT 

Marketplaces will provide qualified taxpayers with a written statement that includes this same information on or before January 31 of the year following the calendar year of coverage.

COMMENT 

The Code Sec. 36B credit has been challenged in litigation. In October, a federal district court declined to dismiss a suit claiming that Congress intended for the Code Sec. 36B credit to be available only when individuals purchase health insurance through a state-established Marketplace (Halbig v. Sebelius, D-D. C., No. 13-00623).

Health insurance fees. In November, the IRS issued final regulations on the application of annual fees to health insurance providers under the Affordable Care Act. The annual fee on covered entities is effective after 2013. The IRS intends to notify each covered entity of the preliminary fee calculation by June 15 of each fee year and the final fee calculation on or before August 31. The fee must be paid by September 30 of each fee year (TD 9643).

Branded prescription drug fee. The IRS issued guidance on the branded prescription drug fee for the 2014 fee year in August (Notice 2013-51). The IRS explained it will mail each covered entity a paper notice of its preliminary fee calculation for the 2014 fee year by March 3, 2014. The IRS will notify each covered entity of its final fee calculation for 2014 by August 29, 2014.

90-day waiting period. The IRS and the U.S. Departments of Health and Human Services (HHS) and Labor (DOL) issued proposed reliance regulations in March to describe the 90-day limitation for group health insurance under the Affordable Care Act (NPRM REG-122706-12). Insured and self-insured group health plans are generally precluded from imposing a waiting period that exceeds 90-days before coverage can begin for eligible group members.

Compensation. The IRS issued proposed reliance regulations on the $500,000 deduction limitation on compensation provided by health insurance providers under the Affordable Care Act in April (NPRM REG106796-12). The deduction limit applies to a covered health insurance provider in a tax year beginning after December 31, 2012.

Charitable hospitals. In April, the IRS released proposed reliance regulations on the Code Sec. 501(r)(3) requirement that charitable hospitals perform a community health needs assessment (CHNA) every three years or risk losing their tax-exempt status (NPRM REG-106499-12). The IRS issued temporary and proposed regulations in August for charitable hospital organizations on how to report excise taxes and file any excise tax return for failing to meet the CHNA requirements (TD 9629, NPRM REG-115300-13).

Indoor tanning tax. In June, the IRS issued final regulations on the Affordable Care Act's indoor tanning tax when services are bundled (TD 9621). This excise tax generally took effect in 2010.

PCORI. The Affordable Care Act established the Patient-Centered Outcomes Research Institute (PCORI), which is funded by the Patient-Centered Outcomes Research Trust Fund. The trust fund is funded—in part—by fees paid by issuers of certain health insurance policies and sponsors of certain selfinsured health plans. In July, the IRS posted frequently asked questions (FAQs) on its website about the PCORI fees that apply to specified health insurance policies with policy years ending after September 30, 2012, and before October 1, 2019.

COMMENT 

IRS Chief Counsel determined in 2013 that the Patient-Centered Outcomes Research Trust Fund fee is deductible under Code Sec. 162(a) (AM 2013-002).

Preventative services. In July, the IRS issued final regulations on the coverage of certain preventative services under the Affordable Care Act (TD 9624). The final regulations generally provide that the requirement to offer coverage for certain preventive services without cost sharing is subject to the religious employer exemption and eligible organization accommodations.

TOP 10 TAX DEVELOPMENTS FOR 2013

The start of a New Year presents a time to reflect on the past 12 months and, based on that history, predict what may happen next. Here is a list of the top 10 developments from 2013 that may prove particularly important as we move forward into the New Year.

  • ? American Taxpayer Relief Act (ATRA)

  • ? Unaddressed Tax Extenders

  • ? Repair and Capitalization Regulations

  • ? NII/Additional Medicare Tax Final Regs

  • ? Supreme Court Decision/IRS Guidance on Same-Sex Marriage

  • ? Affordable Care Act Implementation

  • ? Foreign Compliance Measures

  • ? Code Sec. 501(c)(4) Organizations

  • ? IRS Return Preparer Oversight

  • ? Comprehensive Tax Reform Proposals

HEALTH BENEFITS

In the area of health benefits, the IRS announced a number of important developments affecting employee benefits, individual benefits and more. Some of the projects reflected changes made by the Affordable Care Act but others were independent developments.

Health FSA "use-or-lose" rule. In November, the IRS announced relief from the "useor-lose" rule for health flexible spending arrangements (health FSAs) by allowing a new up-to-$500 carryover option for year-end balances (Notice 2013-71, TDNR JL-2202). Effective for plan years starting in 2013, employers may amend their cafeteria plan documents to provide for this new option. Any unused amount above $500 will be forfeited.

IMPACT.

The move is intended to mitigate the harsh impact of the "use-or-lose" rule and to encourage greater participation in health FSAs.

COMMENT 

Generally, an employer that offers FSAs can allow each year's remaining account balance to be used for expenses incurred up until 2½ months into the next year (March 15 for calendar year plans). Account balances that remain unused at the end of the plan year (or beyond the 2½ month grace period, if applicable) are automatically forfeited.

COMMENT 

Starting in 2013, the Affordable Care Act limited each employee's salary reduction contributions to a health FSA to no more than $2,500 each year (adjusted for inflation for plan years beginning after 2013).

COMMENT 

The up-to-$500 carryover amount will not count toward the following year's $2,500 inflation-adjusted salary-reduction limit.

IMPACT.

Incorporation of the carryover is optional; however, employers cannot offer both the grace period and the carryover at the same time.

Health savings accounts (HSAs). Adjusted for inflation, the annual limitation on deductible contributions under Code Sec. 223(b)(2)(A) for an individual with self-only coverage under a high-deductible health plan (HDHP) is $3,300 or $6,550 for an individual with family coverage for 2014, up from $3,250 and $6,450, respectively, for calendar year 2013 (Rev. Proc. 2013-25).

COMMENT 

For calendar year 2014, an HDHP is defined as a health plan with an annual deductible that is not less than $1,250 for self-only coverage and $2,500 for family coverage, the same as in 2013.

Wellness programs. The IRS, DOL and HHS issued final regulations in June to clarify the design of wellness programs for group health plans (both insured and selfinsured) and group health insurance issuers, for plan years beginning on or after January 1, 2014 (TD 9620). The regulations describe the standards for participatory wellness programs and health contingent wellness programs.

IMPACT.

Wellness programs are growing in popularity. The final regulations explain that wellness programs generally must satisfy certain criteria, including the requirement that the program must be available to all similarly-situated individuals. A reasonable alternative standard (or waiver) must be available to any individual for whom it is unreasonably difficult, due to a medical condition, to satisfy the standard.

Mental health benefits. The IRS, DOL and HHS issued final regulations requiring group and individual health insurance plans to provide parity in their mental health and substance use disorder (MH/SUD) benefits, with medical/surgical (M/S) benefits offered by the same plans (TD 9640, TDNR JL-2213). The final regulations implement the Mental Health Parity and Addiction Equity Act of 2008, as amended by the Affordable Care Act.

COMMENT 

The final regulations are intended to ensure that health plan features like copays and deductibles are not more restrictive for mental health benefits than for medical benefits.

INDIVIDUALS: SAME-SEX MARRIAGE

On June 26, 2013, the U.S. Supreme Court struck down Section 3 of the Defense of Marriage Act (DOMA) in a 5 to 4 decision (E.S. Windsor, SCt., 2013-2 USTC ¶50,400). The Windsor decision set in motion a wave of new guidance from the IRS and other federal agencies impacting married same-sex couples.

Windsor decision. In Windsor, the Supreme Court held that Section 3 of DOMA is unconstitutional as deprivation of the equal protection of persons that is protected by the Fifth Amendment. Writing for the majority, Justice Kennedy said that DOMA created two contradictory marriage regimes: married same-sex couples lived as married for purposes of state law (in states that recognized same-sex marriage) but as unmarried for purposes of federal law.

IMPACT.

Immediately after the decision was announced, President Obama directed all federal agencies to quickly revise their rules and regulations to reflect Windsor. The question arose if the IRS would take a place of celebration approach or a place of domicile approach to same-sex marriage. The IRS ultimately took a place of celebration approach (discussed below).

IRS guidance. The IRS issued the first batch of guidance in August (Rev. Rul. 2013-17 and FAQs). The IRS explained that it would treat all legally married same-sex couples as married for all federal tax purposes, including income and gift and estate taxes, regardless of whether a couple resides in a jurisdiction that recognizes same-sex marriage or in a jurisdiction that does not recognize same-sex marriage. The IRS also announced that for tax year 2013 and going forward, same-sex spouses generally must file using a married filing separately or jointly filing status. Additionally, the IRS provided that individuals who were in a same-sex marriage may, but are not required to, file original or amended returns—for federal tax purposes for one or more prior tax years still open under the statute of limitations—choosing to be treated as married.

IMPACT.

As long as a couple is married in a jurisdiction that recognizes same-sex marriage, the IRS will recognize their marriage even if the couple later relocates to a jurisdiction that does not recognize same-sex marriage.

IMPACT.

The IRS reiterated in its guidance on same-sex marriage that it does not treat registered domestic partners, individuals in a civil union, or similar relationships as married for federal tax purposes because these individuals are not married under the laws of any jurisdiction.

Employers. Because of Section 3 of DOMA, employers that allowed an employee to add his or her same-sex spouse to their health plan needed to impute income to the employee for federal income tax purposes equal to the fair market value of health coverage provided to the same-sex spouse. However, this did not apply if the same-sex spouse qualified as a dependent. The IRS issued Notice 2013-61, describing two administrative procedures for employers to correct overpayment of employment taxes.

COMMENT 

In updated FAQs posted on its website in December, the IRS explained an employee should seek a refund of Social Security and Medicare taxes from his or her employer first. However, if the employer indicates an intention not to file a claim or adjust the overpaid Social Security and Medicare taxes, the employee may claim a refund of any overpayment of employee Social Security and Medicare taxes.

COMMENT 

Section 2 of DOMA (which provides that states do not have to recognize same-sex marriages performed in other states) was not before the Supreme Court. At the time this Briefing was prepared, 18 states and the District of Columbia recognize same-sex marriage.

INDIVIDUALS: INCOME/EXPENSES

During 2013, developments affecting the taxation of individual income taxation fell across a broad range of sectors. In addition to the 3.8 percent Net Investment Income tax and the 0.9 Additional Medicare Tax (discussed, above, in this Briefing), 2013 developments touched upon such diverse areas as marriage and divorce, gambling losses, charitable contributions, investment transactions, and more.

Equitable innocent spouse relief. The IRS issued proposed regulations in August that would remove a two-year deadline for requesting Code Sec. 6015(f) equitable innocent spouse relief (NPRM REG132251-11). The IRS also updated its equitable innocent spouse relief procedures in September (Rev. Proc. 2013-34). At the same time, the IRS described procedures for streamlined equitable innocent spouse relief determinations.

IMPACT.

In regulations issued in 2002, the IRS set a two-year deadline for requesting relief under Code Sec. 6015(f). The proposed regulations replace the two-year requirement with a requirement that a request for equitable innocent spouse relief must be filed with the IRS within the period of limitation in Code Sec. 6502 for collection of tax or the period of limitation in Code Sec. 6511 for a credit or refund of tax, as applicable to the specific request.

COMMENT 

IRS Chief Counsel announced acquiescence in the Ninth Circuit ruling, Wilson, 2013-1 USTC ¶50,147 (AOD-2012-07). The IRS will no longer argue that the Tax Court should review Code Sec. 6015(f) equitable innocent spouse claims only for an abuse of discretion or that the court should limit its review to the administrative record.

IMPACT.

The revised procedures reflect the elimination of the two-year deadline to request equitable innocent spouse relief The revised procedures also give greater deference to the presence of abuse in a relationship.

Broker reporting. The IRS issued final, temporary and proposed regulations on the requirement that brokers report the basis of debt instruments and options that they sell on behalf of customers (TD 9616, NPRM REG-154563-12). The IRS provided phased-in effective dates and other measures intended to relieve the burden on brokers.

IMPACT.

The IRS provided a January 1, 2014 start date for less complex debt instruments, options and securities future contracts. For certain complex instruments with a fixed yield and maturity date, and for more complex debt without a fixed yield and maturity date, the IRS does not require basis reporting until January 1, 2016. The final regulations generally except short-term debt from basis reporting.

COMMENT 

The IRS decided to give affected entities more time to develop compliance systems, rather than provide penalty relief. The IRS previously provided penalty relief for the reporting of stock basis, which took effect in 2011.

Gambling losses. In July, the Court of Appeals for the District of Columbia Circuit reversed the Tax Court and applied the IRS's per-session rule for U.S. citizens to a nonresident alien's gambling losses(Park, CA-D.C., 2013-2 USTC ¶50,423). The DC Circuit found that the nonresident alien could subtract gambling losses from his wins within a gambling session to arrive at per-session wins or losses.

Conservation easements. In 2013, the Tax Court denied several deductions claimed for the donation of real property associated with charitable conservation easements. In Belk, CCH Dec. 59,401, 140 TC No. 1, the taxpayer had contributed land to a Code Sec. 501(c)(3) organization. The conservation easement agreement permitted the parties to substitute what property would be subject to the conservation easement. The Tax Court found that the conservation easement must relate to specific property or it cannot be a qualified conservation easement. The use restriction was not granted in perpetuity, the court found.

In July, the Tax Court declined to reconsider its 2012 ruling in Carpenter, CCH Dec. 58,902(M), where it found that language providing for extinguishment of an easement by mutual consent does not guarantee that the conservation purpose of the donated property will continue to be protected in perpetuity (Carpenter II, CCH Dec. 59,591(M)).

Casualty/theft loss. The Tax Court found in March that a married couple was entitled to a theft loss deduction resulting from home repair fraud (Urtis, CCH Dec. 59,470(M)). The contractor had used a significant amount of the taxpayer's progress payments for unrelated expenses. According to the court, the taxpayers were victims of a theft under Code Sec. 165 stemming from the violation of their state home repair law.

COMMENT 

The Tax Court emphasized that a conviction was not necessary for the theft to qualify for purposes of Code Sec. 165.

IRS Chief Counsel approved a casualty loss deduction under Code Sec. 165(c) for two homes that were destroyed by fire, even though the homes had been constructed without the proper building permits (CCA 201346009). Chief Counsel concluded that there were not sufficient grounds for denying a casualty loss deduction based on public policy considerations.

Mortgage insurance premiums. The IRS issued final rules in November on the Code Sec. 6050H information reporting requirements for those who receive an aggregate amount of $600 or more in mortgage insurance premiums during any calendar year (TD 9642). Effective for mortgage insurance premiums received on or after January 1, 2013 (but not before), these premiums must be reported on Form 1098, Mortgage Insurance Statement.

INDIVIDUALS: RETIREMENT BENEFITS

In 2013, IRS developments focused on facilitating the transfer of assets between certain qualified plans and plan sponsor compliance. In addition, the IRS updated several key contribution amounts and income limits for 2014 to account for annual inflation figures.

2014 COLA limits. The IRS announced the 2014 cost-of-living adjustments (COLAs) for qualified plans in October (IR-2013-86). Many retirement plan contribution and benefit limits increase slightly in 2014.

COMMENT 

The limitation for defined contribution (DC) plans increases from $51,000 for 2013 to $52,000 for 2014. The annual benefit limit under a Code Sec. 415(b)(1)(A) defined benefit plan (the maximum amount a plan may pay a participant each year) increases from $205,000 for 2013 to $210,000 for 2014. The limits on elective deferrals for employees who participate in 401(k), 403(b), certain 457 plans, and the federal government's Thrift Savings Plan, remain $17,500 for 2014, unchanged from 2013.

In-plan Roth rollovers. The IRS issued guidance in December in question-and-answer format on in-plan Roth rollovers (Notice 2013-74) to reflect the expansion of the in-plan rollover provisions under ATRA.

Generally, a Code Sec. 401(k) plan, 403(b), or governmental 457(b) plan can permit a rollover of an amount that is ineligible for distribution at the time of the rollover.

IMPACT.

The following contributions (and earnings thereon) may be rolled over to a designated Roth account in the same plan, without regard to whether the amounts satisfy the conditions for distribution: elective deferrals in Code Sec. 401(k) and 403(b) plans; matching contributions and nonelective contributions, including qualified matching contributions and qualified nonelective contributions described in Reg. §1.401(k)-6; and annual deferrals made to governmental 457(b) plans.

COMMENT 

The IRS also clarified the extended deadline for a calendar year plan sponsor wanting to allow in-plan Roth rollovers for the 2013 tax year. The sponsor has until December 31, 2014 to amend the plan.

Safe harbor for struggling 401(k) plan sponsors. The IRS issued final regulations allowing employers facing economic difficulties to reduce or suspend nonelective contributions to safe harborCode Sec. 401(k) plans in November (TD 9641). The employer generally must be operating at an economic loss as described in Code Sec. 412(c)(2)(A) to qualify, the IRS explained.

Reporting hard-to-value assets. The IRS announced that for 2014 the new information reporting requirements imposed on financial institutions with respect to certain hard-tovalue assets invested in an IRA are optional (2013ARD 222-5). In other words, for 2014 financial institutions may or may not report on the value of IRA assets that have no readily available fair market value, such as investments in non-publicly traded stock, ownership interests in a partnership, trust, or LLC, real estate, or option contracts.

IMPACT.

In December the IRS released instructions for 2014 Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., and 2014 Form 5498, IRA Contribution Information. The instructions indicate that financial institutions must indicate when IRA assets have no readily available fair market value by using Code K on Form 1099-R. In addition, on the as-of-yet unreleased 2014 Form 5498, financial institutions must report the fair market value of the IRA asset in the new box 15a and indicate the type of asset in box 15b by using the appropriate category code. However, these reporting requirements are optional for 2014, to provide financial institutions reasonable time to fully implement them, the IRS announced.

2013 AND 2014 DOLLAR LIMITS


IRAs

2013

2014


IRA Contribution Limit

$5,500

$5,500


IRA Catch-Up Contributions

1,000

1,000


Traditional IRA AGI Deduction Phase-out Starting at


Joint Return

95,000

96,000


Single or Head of Household

59,000

60,000


401(k), 403(b), Profit-Sharing Plans, etc.


Annual Compensation - 401(a)(17)/404(l)

255,000

260,000


Elective Deferrals - 402(g)(1)

17,500

17,500


Defined Contribution Limits - 415(c)(1)(A)

51,000

52,000


Social Security Taxable Wage Base

113,700

117,000


BUSINESS DEDUCTIONS/CREDITS

The treatment of business expenditures obviously has a major impact on the determination of the business's profits and losses. While companies seek to make a profit (especially on their financial accounting statements), they also want the tax treatment of their expenditures to reduce their taxable profits. In 2013, the IRS continued to issue important guidance on a business' deduction of "repair"expenditures for tangible personal property.

Final "repair" regulations. The IRS issued much-anticipated final regulations (the so-called "repair" regs) on the treatment of costs to acquire, produce or improve tangible property in September (TD 9636). The guidance is intended to instruct taxpayers how to determine whether to capitalize the costs under Code Sec. 263 or deduct them under Code Sec. 162. The IRS also issued new proposed regulations on dispositions of property under Code Sec. 168 (NPRM REG-110732-13).

IMPACT.

The final regulations retain many aspects of the temporary regulations issued in December 2011 but make some helpful and taxpayer-friendly changes. Significant changes affect:

  • ? materials and supplies,

  • ? the de minimis safe harbor,

  • ? improvements,

  • ? routine maintenance,

  • ? new safe harbors for small taxpayers, and

  • ? a capitalization election.

The final regulations raised the threshold for deductible materials and supplies from $100 to $200; eliminated a controversial ceiling on the use of the de minimis deduction; eased the rules for writing off building systems that are replaced; and prescribed a 10-year period over which companies must perform recurring maintenance, to deduct these expenses.

IMPACT.

The final regulations affect any industry that uses tangible property, real or personal. The final regulations are generally effective January 1, 2014, but taxpayers may elect to apply the regulations to 2012 or 2013.

IMPACT.

The new proposed regulations make significant changes to the rules for determining the asset disposed of, the use of a general asset account, and partial dispositions of assets.

COMMENT 

The final regulations aim to reduce controversy by allowing companies to follow their book or financial policies. The regulations provide additional clarity and flexibility to all taxpayers, and helpful, simplified rules for smaller taxpayers.

LB&I directive. The IRS Large Business & International Division (LB&I) updated its 2012 directive that generally instructed employees to discontinue audits of costs to maintain, replace or improve tangible property for the 2012 and 2013 tax years (LB&I-04-0313-001). LB&I instructed examiners and managers to cease audits and not begin any new audits for tax years beginning before January 1, 2012.

Travel and entertainment expenses. During 2013, the IRS issued the usual annual adjustments to various amounts relating to travel and entertainment expenses. These included the standard mileage rates, the depreciation vehicle limits, and the fair market value amounts for fringe benefit usage of company cars. Several of these rates bucked the trend and decreased slightly for 2013, owing mainly to lower gas prices.

COMMENT 

At the time this Briefing was prepared, the IRS has not yet finalized guidance issued in 2012 on the local lodging expenses deduction and meal and travel expense reimbursements (NPRM REG-137589-07). However, the IRS instructed that taxpayers may apply the proposed regulations to expenses paid or incurred in taxable years for which the period of limitation on credit or refund under Code Sec. 6511 has not expired.

Standard mileage rates. The optional business standard mileage rate for 2014 is 56 cents-per-mile, the IRS announced in December (IR-2013-95, Notice 2013-80). This reflects a decrease from the 2013 rate of 56.5 cents-per-mile. The optional standard mileage rate for qualified medical and moving expenses will also decrease from 24 cents-per-mile for 2013 to 23.5 cents-per-mile for 2014. The 14 cents-per-mile rate for charitable miles driven is set by statute, however, and it remains unchanged for 2014.

For 2014, the depreciation component of the business standard mileage rate will be 22 cents-per mile. This represents a one-cent decrease from the depreciation component for the 2013 business standard mileage rate.

IMPACT.

Gas prices are one factor affecting the optional business standard mileage rates.

Vehicle depreciation dollar limits. The IRS released inflation-adjustments on depreciation deductions for business-use passenger automobiles, light trucks, and vans first placed in service during calendar year 2013 (Rev. Proc. 2013-21).

IMPACT.

The maximum depreciation limits under Code Sec. 280F for passenger automobiles first placed in service during calendar year 2013 are $11,160 for the first tax year ($3,160 if bonus depreciation does not apply); $5,100 for the second tax year; $3,050 for the third tax year; and $1,875 for each succeeding tax year. The maximum depreciation limits under Code Sec. 280F for trucks and vans first placed in service during the 2013 calendar year are $11,360 for the first tax year ($3,360 if bonus depreciation does not apply); $5,400 for the second tax year; $3,250 for the third tax year; and $1,975 for each succeeding tax year.

Fringe benefit income/FMV limits. The IRS issued the maximum fair market value (FMV) amounts for purposes of determining which is the proper valuation rule for employees calculating fringe benefit income from employer-provided automobiles, trucks, and vans that were first made available for personal use in 2013 (Notice 2013-17). Taxpayers with employer-provided vehicles within the designated FMV amounts may apply either the vehicle cents-per-mile rule or fleet average valuation rule.

The maximum 2013 FMV amounts for purposes of applying the cents-per-mile valuation rule are $16,000 for a passenger automobile and $17,000 for a truck or van, including passenger automobiles such as minivans and sport utility vehicles, which are built on a truck chassis.

COMMENT 

For 2014, the projected amounts for purposes of applying the cents-per-mile valuation rule will be $16,000 for a passenger automobile (same as for 2013); and $17,300 for a truck or van, which includes minivans and SUVs built on a truck chassis (up from $17,000 in 2013).

Per diem rates. The IRS announced the simplified per diem rates that taxpayers can use to reimburse employees for expenses incurred during travel after September 30, 2013 (Notice 2013-65). The high-cost area per diem increases from $242 to $251 and the low-cost area per diem increases from $163 to $170.

50-percent meal deduction limit. The IRS issued final regulations in August to clarify who is subject to the 50-percent limit on meal expense deductions under Code Sec. 274 in multi-party arrangements—the employer or employee leasing company, the employee, or a third-party client (TD 9625). The final regulations generally permit the parties to determine who is subject to the 50-percent limit. If there is no agreement, the 50-percent limit applies to the party who pays the expenses under a reimbursement arrangement, the IRS explained.

COMMENT 

The exception is only available to one party to the reimbursement arrangement; therefore, the deduction limitation will still apply to the other party to the arrangement.

Code Sec. 199 deduction. The IRS and the Tax Court issued rulings and guidance on the Code Sec. 199 domestic production activities deduction in 2013. In general, these 2013 developments broadened the scope and flexibility of the Code Sec. 199 deduction beyond exclusive use by those who would traditionally be classified as manufacturers, looking more toward the process and contractual obligations involved when applying this tax benefit.

  • ? Claiming the deduction. In ADVO, Inc., CCH Dec. 59,670, the Tax Court added a new factor to the eight-factor test from Grodt & McKay, CCH Dec. 38,472, for determining which party in a contract manufacturing arrangement held the benefits and burdens of ownership and was therefore entitled to the deduction. The Tax Court in ADVO asked whether the taxpayer had actively and extensively participated in the management and operations of the contract manufacturer's activity.

  • ? Billboards. IRS Chief Counsel determined that mobile billboards qualified for the Code Sec. 199 domestic production activities deduction (CCA 201302017). Chief Counsel determined that the mobile billboards were intended to be moved frequently and, therefore, were not inherently permanent structures.

  • ? Photo processing. IRS Chief Counsel issued field attorney advice stating that a retail drug store and pharmacy chain could claim the Code Sec. 199 deduction for its photo processing activities (FAA 20133302F). Chief Counsel pointed out that the drug store employees created the photo products from raw materials, including paper, ink and blank computer disks, using sophisticated machinery and equipment. Thus, the taxpayer transforms raw materials into finished photo products, which qualified as products "manufactured, produced, grown or extracted" in the U.S.

  • ? IRS directives. The IRS issued two directives in 2013, LB&I-04-0713006, in July and LB&I-04-1013008, in October. The directives allow the contracting parties themselves to determine who will claim the deduction, in situations where each of the parties can demonstrate some indicia of the benefits and burdens of ownership. If the taxpayer does not follow the directive, examiners are instructed to apply regular audit procedures to determine benefits and burdens. If the directives do not apply, the taxpayer and the examiner must apply all the facts and circumstances. In such cases it is possible the IRS analysis would take into account the nine factors expounded upon in the ADVO decision.

IMPACT.

LB&I instructed examiners not to challenge the taxpayer's ownership claim under Code Sec. 199 if the taxpayer provides all three of the following documents: a statement explaining the taxpayer's basis for determining that it has the benefits and burdens of ownership; a certification signed by the taxpayer that it is claiming the benefits and burdens of ownership; and a certification signed by the counterparty to the contract manufacturing arrangement that it is not claiming the Code Sec. 199 deduction.

Home office deduction. The IRS announced a new optional safe harbor method for individuals to determine the amount of their deductible home office expenses (IR-2013-5, Rev. Proc. 2013-13). The safe harbor is effective for tax years beginning on or after January 1, 2013.

IMPACT.

The maximum deduction under the safe harbor—under current regulations—is $1,500. The allowable square footage of a home used for a qualified business purpose is 300 square feet. The IRS indicated that the $1,500 amount, which is not indexed for inflation, may be revisited in future years.

COMMENT 

The Tax Court held that a motor home used as the base for a taxpayer's consulting business did not qualify for the home office exception (Dunford, CCH Dec. 59,609(M)). The taxpayer and his wife could not show that an identifiable area of their motor home was used exclusively for business purposes.

Production tax credit. The IRS issued guidance on the production tax credit (PTC) and the investment tax credit (ITC) that may be claimed in lieu of the PTC (Notice 2013-60). The guidance clarifies Notice 2013-29 on when a taxpayer has begun construction of a qualifying facility.

IMPACT.

To qualify for the credit, the statute provides a safe harbor if construction of a facility began before January 1, 2014, and the taxpayer makes continuous progress toward completing the facility so that it is placed in service before January 1, 2016. Whether a taxpayer makes continuous progress is determined by the facts and circumstances.

Whistleblower litigation expenses. A federal district court found that a taxpayer was engaged in a trade or business under Code Sec. 162(a) when litigating a lawsuit under the Federal Claims Act (FCA) against his former employer (Bagley, DC-Calif., 2013-2 USTC ¶50,462). The taxpayer's litigation expenses in pursuing an FCA lawsuit as a qui tam relator could be deducted as ordinary and necessary expenses incurred for a trade or business.

IMPACT.

The decision allows the whistleblower to deduct all of his litigation expenses against his income. Treating the expenses as miscellaneous itemized deductions would have substantially increased the whistleblower's tax liability.

Research expenditures. The IRS issued proposed regulations (NPRM REG-12414805) in September 2013 to allow taxpayers to deduct currently or amortize (over 60 months) research and experimentation expenses incurred for prototypes and other tangible property "in the experimental or laboratory sense." The ultimate success, failure or use of the property does not affect eligibility to write off the expenses. However, costs for producing a product after uncertainty is eliminated do not qualify for the write-off.

IMPACT.

The regulations aim to clarify the treatment of certain expenses for prototypes and pilot models.

Expensing real property. After ATRA extended Code Sec. 179 expensing of qualified real property through 2013, the IRS issued guidance on the income limitation (Notice 2013-59). Qualified real property includes leasehold improvement property, restaurant property, and retail improvement property.

IMPACT.

According to the IRS, taxpayers were confused about how to treat their disallowed deductions. Since the deduction for qualified real property expired at the end of 2013, the guidance explains that disallowed deductions from qualified real property must be taken as depreciation after 2013. Disallowed deductions from other Code Sec. 179 property can still be carried forward and deducted in a later year.

PARTNERSHIPS

The use of partnerships for doing business continues to increase exponentially, with more partners, more complex structures, and more challenges to tax compliance. This increasing complexity, the IRS has discovered, sometimes results in partners and partnerships pushing the envelope to obtain large tax benefits.

Noncompensatory stock options. The IRS issued final regulations in February 2013 with a characterization rule that treats the holder of a noncompensatory stock option as a partner in certain circumstances (TD 9612, NPRM REG-106918-08). Under the final regulations, the exercise of a non-compensatory option does not trigger the recognition of gain or loss to either the issuing partnership or the option holder, unless the partnership is satisfying a debt.

IMPACT.

A noncompensatory option is an option issued by a partnership, other than an option issued in connection with the performance of services. The characterization rule is designed to prevent partnerships from allocating income to a partner in a low tax bracket when the option holder will get the benefit and is in a higher bracket.

Recourse liabilities. The IRS issued proposed regulations (NPRM REG-13984-12) to determine a partner's share of the partnership's recourse liabilities. The regulations would apply to multiple partners liable for the same liability (overlapping risk of loss), tiered partnerships, and related partners. Generally, the partners will each include a portion of the liability in their basis.

IMPACT.

A partner's basis is increased for his share of partnership liabilities. Basis can affect whether the partner must recognize a gain on a partnership distribution or can recognize a loss on a distributive share of partnership losses. The proposed regs are intended to eliminate confusion stemming from a 2004 Tax Court case (IPO II, CCH Dec. 55,622), and bring clarity to the rules for allocating debt, the IRS explained.

Employee's undistributed partnership profits. In a case of first impression, the Tax Court found in December that an employee who held a nonvested partnership interest was not taxable on partnership profits allocated to the interest, because the partnership did not actually distribute any amounts to the employee (Crescent Holdings, LLC, CCH Dec. 59,705). The court found that since the partnership interest was subject to a substantial risk of forfeiture, the employee's right to receive a distribution of profits was subject to the same risk of forfeiture and should not be recognized as income.

IMPACT.

The regulations under Code Sec. 83 are clear that a distribution of profits on a nonvested partnership interest is taxable as compensation under Code Sec. 61. However, the regulations do not address the treatment of undistributed profits allocated to a nonvested interest.

Unamortized partnership expenses. The IRS issued proposed regulations in 2013 that would require a partnership undergoing a technical termination (a transfer of 50 percent or more of the partnership interests) to continue amortizing start-up and organizational expenses over a 15-year period (NPRM REG-126285-12). While some deductible expenses can be completely written off when a trade or business is completely disposed of, a partnership undergoing a technical termination is deemed to contribute its assets and liabilities to a new partnership and to continue its operations.

IMPACT.

The proposed regs would provide that a technical termination is not a disposal of the partnership's trade or business, and would not allow the partners to accelerate the deduction of the expenses.

Historic rehabilitation tax credits. The U.S. Supreme Court announced in May that it would not review the Third Circuit Court of Appeals' decision in Historic Boardwalk Hall, LLC, 2012-2 USTC ¶50,538. Reversing the Tax Court, the Third Circuit had found that the investor was not a bona fide partner of a limited liability company (LLC) and therefore was not entitled to an allocation of historic rehabilitation tax credits (HRTCs) as a partner. The Third Circuit found that the partnership was set up merely to transfer credits to the investor and was more akin to a sale.

IMPACT.

Lawmakers had requested IRS guidance, expressing concern that the Third Circuit's decision would discourage investments in historic properties that are designed to claim the credit. At the end of 2013, the IRS issued guidance that provided a safe harbor to allow a partnership to allocate its HRTCs to its investment partners (Rev. Proc. 2014-12).

CORPORATIONS

Corporate transactions and reorganizations are an important part of the economy and the tax world. The IRS strives to facilitate business-related transactions by corporations while discouraging transactions that lack a business purpose other than reducing taxes. The IRS issued several sets of regulations in the corporate area in 2013.

Rulings under Code Sec. 355. The IRS announced in 2013 that it would no longer rule on whether a transaction qualifies for nonrecognition treatment under Code Sec. 355 as a spinoff (Rev. Proc. 2013-32). Instead, the IRS will only rule on significant issues under related Tax Code sections (such as nonrecognition and basis) that result from the application of Code Sec. 355. A significant issue is a legal issue (as opposed to a factual issue) that is not essentially free from doubt.

IMPACT.

This is a significant change by the IRS because spinoffs are common transactions. These "comfort rulings" reduced the tax risk associated with spinoffs that may not pass Code Sec. 355rules for tax-free treatment. Smaller, family owned businesses in particular had benefitted from the assurance of a letter ruling.

COMMENT 

This announcement continues an IRS trend of not ruling on standard reorganizations. Code Sec. 355 was one of the few remaining corporate areas where the IRS would rule on the overall transaction.

S corporations. The IRS announced in August exclusive simplified methods for use by taxpayers requesting late S corporation elections, ESBT elections, QSST elections, QSub elections, and certain late corporate classification elections (Rev. Proc. 2013-30). Additionally, the IRS provided transition relief for pending letter ruling requests.

IMPACT.

The revenue procedure, the IRS explained, is intended to consolidate various pre-existing relief procedures into a single document.

Qualified stock dispositions. The IRS issued final regulations in May under Code Sec. 336(e) allowing taxpayers to elect to treat the sale, exchange, or distribution of at least 80 percent (by vote and value) of a corporation's stock (a qualified stock disposition or QSD) as a deemed disposition of the corporation's underlying assets (TD 9619). The final regulations generally track proposed regulations issued in 2008 (NPRM REG-143544-04), with some modifications.

COMMENT 

Code Sec. 336(e) provides relief from potential multiple taxation of the same economic gain, which can result by taxing a transfer of appreciated corporate stock without providing a corresponding step-up in the basis of the corporation's assets.

Duplicated losses - regulations. Final regulations (TD 9633) were released by the IRS to prevent duplicated losses where a taxpayer transfers property with a built-in loss to a corporation in a Code Sec. 351 transaction. However, the regulations provide a taxpayer-favorable election to prevent the duplicated loss by reducing basis in the taxpayer's stock, rather than the basis of the property transferred to the corporation.

IMPACT.

The election allows taxpayers to preserve a higher basis for the property transferred, which enables the corporation to take more depreciation and reduce its taxes. An election may also avoid the recognition of additional income stemming from taxable dividends paid by a controlled foreign corporation to the transferor.

Duplicated losses — Tax Court decision. The Tax Court disallowed a parent corporation's deductions for losses from the sale of a subsidiary's assets that duplicated losses the parent had already claimed from selling the same subsidiary's stock (Duquesne Light Holdings, CCH Dec. 59,639(M)). The claimed deductions represented the same economic loss as a second deduction, and there was no evidence that Congress intended to authorize the double deduction, the court found.

Built-in losses. The IRS issued proposed regulations in 2013 that would clarify that taxpayers receiving an asset with a built-in loss must reduce the basis of the asset to fair market value (NPRM REG-16194805). The reduction would be required if the transferor's gain would not have been subject to U.S. taxes, but the transferee's loss would be subject to U.S. taxes.

IMPACT.

The IRS explained that the primary goal of the regulations is to prevent taxpayers from importing a net built-in loss in certain nonrecognition transactions, including a Code Sec. 332liquidation, a Code Sec. 351 transfer of property, or a Code Sec. 368 reorganization.

Transfers to RICs and REITs. The IRS adopted final regulations that provide exceptions to the built-in gain rules that apply to transfers of property by a C corporation to regulated investment companies (RICs) and real estate investment trusts (REITs) (TD 9626). The exceptions apply to tax-exempt gain, gain from Code Sec. 1031 exchanges, and gain from Code Sec. 1033 exchanges.

IMPACT.

Corporations could avoid corporate level taxes on appreciated property by converting to a RIC or REIT. The built-in gain rule would normally require a RIC or REIT to recognize gain at the corporate level if it sold property received from a C corporation. Here, the IRS recognized that certain transactions were not abusive and should not trigger tax.

Mexican Land Trusts. The IRS determined in June 2013 that a Mexican Land Trust (known as a fideicomiso) that holds title to residential real property is not a trust under federal tax law (Rev. Rul. 2013-14). Although a Mexican bank held legal title to the property, the bank had no duties with respect to the property, and the U.S. purchaser of the property was treated as the owner of the property for tax purposes. Instead, the relevant U.S. person was the owner of the real estate.

IMPACT.

Mexican law requires this arrangement for real estate owned by a U.S. citizen in certain "restricted zones" near the U.S.-Mexico border. If the arrangement had qualified as a trust, it could have been subject to reporting for U.S. taxes (and to penalties for non-reporting).

TAX ACCOUNTING

A number of court decisions and IRS determinations impacted tax accounting in 2013. Some of these are expected to play out further in 2014.

Private equity funds. The First Circuit Court of Appeals found that a private equity fund that invested in a distressed company was not a mere investor, but in fact was in a trade or business of managing the company (Sun Capital Partners III, LP, July 24, 2013). As a consequence, the equity fund was potentially liable to a multiemployer pension fund for a substantial share of the vested but unfunded benefits owed by the distressed company.

IMPACT.

Although the issue of investor liability to the pension fund did not directly involve the Internal Revenue Code, the court examined several tax cases on the trade or business issue. If a fund is treated as conducting a trade or business under the Tax Code, this would suggest that carried interest paid to fund managers is ordinary income, not capital gains, and could have other tax implications to private equity funds and others.

Deferred COI income. The IRS issued final regulations in July on the acceleration of cancellation of indebtedness (COI) income that was deferred by a C corporation as allowed under Code Sec. 108(i)during the 2009 and 2010 economic downturn (TD 9622). The regulations accelerate the deferred income if a C corporation has impaired its ability to pay the tax liability. The corporation must accelerate the remaining deferred income if it changes its tax status, ceases its corporate existence where Code Sec. 381(a) does not apply, or engages in an impairment transaction (the net value acceleration rule).

The IRS also issued final regulations (TD 9623) that explain when passthrough entities that deferred cancellation of indebtedness (COI) income must accelerate the recognition of that income. A partnership that defers COI income must allocate all the income to its direct partners in accordance with their distributive shares. The partnership can determine the amount of the partner's COI income that can be deferred and that must be included in income.

Severance pay. The U.S. Supreme Court announced in October that it will review In Re Quality Stores, 2012-2 USTC ¶50,551, decided in January by the Sixth Circuit Court of Appeals. The Sixth Circuit held that an employer's severance pay to terminated employees should be treated as supplemental unemployment compensation benefits (SUB payments) and was not wages for FICA taxation purposes.

IMPACT.

The potential monetary impact is significant. According to the IRS, the total dollar amount at issue could reach $1 billion.

COMMENT 

The U.S. government had asked for Supreme Court review. The Court of Appeals for the Federal Circuit previously found that SUB payments were subject to FICA taxation (CSX Corp., 2008-1 USTC ¶50,218). The Sixth Circuit's decision created a split among the Circuits.

Gift card sales. The IRS modified 2011 guidance allowing taxpayers that sell gift cards redeemable for goods or services by an unrelated entity to defer income on those sales (Rev. Proc. 2013-29). The IRS had allowed taxpayers receiving advance payments for goods to defer recognizing the income until the succeeding year, if the advance payments are not included on the taxpayer's financial statement. Instead, the payment will be recognized by the taxpayer in the current year only to the extent the gift card is redeemed by the entity during the tax year.

IMPACT.

The treatment of gift cards continues to evolve. The IRS's 2011 guidance worked well for transactions involving related parties, but not for unrelated parties. In expanding the treatment to unrelated parties, the IRS acknowledged that it intended to allow income deferral for all parties.

Safe harbor for OID. The IRS provided in May a safe harbor method of accounting—known as the proportional method—for original issue discount (OID) on a pool of credit card receivables (Rev. Proc. 2013-26). The proportional method is a simplified method that generally produces the same results as the statutory method required under Code Sec. 1272(a)(6).

IMPACT.

The IRS had challenged taxpayers' methods of accounting for OID as not clearly reflecting income, but lost a 2009 Tax Court decision, Capital One Financial Corp., CCH Dec. 57,945. The safe harbor method should reduce burdens and controversy for both taxpayers and the IRS, the IRS predicted. The method is available for tax years ending on or after December 31, 2012.

Mixed straddles. The IRS issued temporary and proposed regulations that would eliminate an investment strategy whereby taxpayers enter into an identified mixed straddle transaction to accelerate losses to offset built-in capital gains (TD 9627, NPRM REG-112815-12). The regulations explain how to account for unrealized gain or loss on a position before the taxpayer establishes an identified mixed straddle.

COMMENT 

The temporary regulations would have been applicable to all identified mixed straddles established after August 1, 2013, regardless of when any position that is a component of the identified mixed straddle was purchased or otherwise acquired. However, the IRS postponed the effective date (TD 9627, Correcting Amendments, NPRM REG-112815-12, Correction). The rules will now apply to identified mixed straddles established after the rules are finalized.

Straddle positions. The IRS issued final, temporary and proposed regulations in September to extend the definition of a position in personal property to an obligor's own debt, where payments on the debt are linked to the value of other personal property (TD 9635, NPRM REG-111753-12).

IMPACT.

Previously, a taxpayer's own debt had not been treated as property. The regulations allow the IRS to treat more financial instruments as part of a straddle and to require that losses on one part of the straddle be deferred until gains in the offsetting position are recognized. The 2013 regulations are now effective and are intended to discourage some investments.

Notional Principal Contracts. The IRS issued final regulations in November providing that the assignment of notional principal contracts and other derivative contracts to a third party will not be taxable to the nonassigning counterparty (TD 9369). The final regulations apply to assignments or transfers of derivative contracts on or after July 22, 2011, the date of temporary regulations (TD 9538) that provided for nontaxable treatment.

IMPACT.

Under the prior regulations, the IRS explained that it was unclear when an assignment was taxable to the nonassigning counterparty. Because the Dodd-Frank Wall Street Reform and Consumer Protection Act required the transfer of many derivative contracts, the IRS explained that it wanted to clarify when the transfer was nontaxable. The final regulations provide relief to nonassigning counterparties for the assignment of derivative contracts to third parties.

TAX SHELTERS

The IRS, through both guidance and litigation, continued its aggressive assault on the use of tax shelters that began in earnest over a decade ago. While the use of tax shelters has dropped dramatically over the past several years, other disguised "tax-avoidance techniques" continue to draw a following (see, in particular, the Foreign Compliance Measures part of this Tax Briefing).

Valuation misstatement penalty. Resolving a split among the Circuit Courts of Appeal, the U.S. Supreme Court unanimously held in December that the IRS may impose the 40 percent valuation misstatement penalty where two partnerships had engaged in a tax shelter transaction and lacked economic substance (Woods, SCt., 2012-2 USTC ¶50,604). Once the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim a basis in his or her partnership interest greater than zero, the court found. Where an asset's adjusted basis is zero, the valuation misstatement is deemed a gross misstatement.

IMPACT.

The case resolves the applicability of gross valuation misstatement penalties in cases where the IRS or the court determines that the transaction lacks economic substance. However, questions remain whether and to what extent partner level defenses can be asserted or waived in a partnership level proceeding to avoid the penalty.

COMMENT 

The Health Care and Education Reconciliation Act of 2010 provides a 40 percent penalty for underpayments attributable to a nondisclosed economic substance transaction entered into on or after March 30, 2010.

Material advisors. The IRS issued proposed reliance regulations clarifying the Code Sec. 6708 penalty for failure by material advisors to provide lists of their clients to the agency with respect to reportable transactions (NPRM REG-160873-04). If a material advisor fails to provide the requisite information within 20 business days, the material advisor is liable for a penalty of $10,000 per additional day of failure, unless the penalty is due to reasonable cause. The proposed regulations allow the IRS to grant an extension of the 20-day period.

IMPACT.

A material advisor may rely on the advice of an independent tax professional to establish reasonable cause. Reliance must be reasonable and in good faith, in light of all the other facts and circumstances, and the advice must have been received before the time the list is required to be furnished to the IRS.

STARS transactions. Several high profile cases in 2013 reviewed the question of whether or not the Structured Trust Advantaged Repackaged Securities (STARS) financial transaction promoted by a U.K bank had economic substance. Federal district courts have disagreed on this issue.

  • ? The Tax Court held that a so-called STARS transaction lacked economic substance and should be disregarded for federal tax purposes (Bank of New York Mellon Corporation, CCH Dec. 59,445).As a result, the taxpayer, a bank, was not entitled to claimed foreign tax credits.

  • ? The Court of Federal Claims similarly found that the STARS transaction lacked economic substance and had no business purpose (Salem Financial Inc., 2013-2 USTC ¶50,517).

  • ? In Santander Holdings USA, Inc., 2013-2 USTC ¶50,564, however, a district court expressly departed from the holding of recent cases and found that the transactions did have economic substance, allowing the taxpayer to claim foreign tax credits.

COMMENT 

If the government were to lose the Santander case on appeal, it would likely seek Supreme Court review.

FOCus tax shelter. The Fifth Circuit Court of Appeals affirmed a federal district court decision holding that a series of partnership transactions marketed under "Family Office Customized" or FOCus program lacked economic substance and that $18 million in claimed losses should therefore be disregarded (Nevada Partners Fund LLC, 2013-2 USTC ¶50,398).

COMMENT 

The IRS attacked schemes similar to the FOCus program in Notice 2000-44, the Son of BOSS currency straddle, and Notice 2002-50, the partnership straddle tax shelter. The court concluded that the FOCus program was not designed to make a profit, and that the investments had no business purpose and no economic substance.

Lease-in, lease-out transactions. Reversing the Federal Claims Court, the Court of Appeals for the Federal Circuit disallowed deductions claimed by the taxpayer in a lease-in, lease-out (LILO) transaction (Consolidated Edison Company of New York, 2013-1 USTC ¶50,136). The Federal Circuit found that a purported head lease and sublease were illusory.

In a separate case, the Tax Court applied the substance-over-form doctrine to conclude that an insurance company's lease-in, lease out (LILO) and sale-in, lease out (SILO) transactions were not leases(John Hancock Life Insurance Co., CCH Dec. 59,597). The insurance company was not entitled to deduct depreciation, rental expenses, interest expenses, and transactional costs incurred in connection with the various transactions.

IMPACT.

The Tax Court found that their substance was not the same as their form. The court found that several of the transactions closely resembled financing transactions instead of leases. Although the Second, Fourth, and Federal Circuits previously ruled against parties that have taken part in LILO and SILO transactions, the Tax Court had never examined the issue before.

2013 TAX DEVELOPMENTS—BY THE NUMBERS

The number of tax developments in 2013 was much greater than can be highlighted in this Tax Briefing. Developments here were selected based upon their impact on a broad cross-section of taxpayers, but this selection is not comprehensive. The following chart lists the number of 2013 tax developments reported by CCH over the past year in each of the following categories:

Tax Court Regular and Memo Decisions 

334

District and Appellate Court Decisions 

512

Treasury Regulations 

91

IRS Notices, Revenue Rulings and Procedures 

185

IRS Letter Rulings, TAMs, CCAs and E-mailed Advice 

942

IRS Announcements and News Releases 

162

FOREIGN COMPLIANCE MEASURES

In 2013, Treasury and the IRS continued to generate guidance, forms and other necessary tools to implement the Foreign Account Tax Compliance Act of 2010 (FATCA) and to take action with other foreign tax compliance and enforcement measures. Although some FATCA requirements have been delayed, Treasury and the IRS continue to make FATCA implementation a priority. The federal courts also addressed several significant issues in the foreign tax area.

FATCA

FATCA generally requires foreign financial institutions (FFIs) to report to the IRS information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest. To avoid withholding under FATCA, a participating FFI generally must enter into an agreement with the IRS to identify U.S. accounts; report certain information to the IRS regarding U.S. accounts; and withhold a 30-percent tax on certain U.S.-connected payments to non-participating FFIs and account holders who are unwilling to provide the required information.

Final reporting/withholding regulations. The IRS issued comprehensive final regulations under FATCA in January 2013 that set January 1, 2014 as the initial compliance date for FATCA (TD 9610). The final regulations describe the requirements for FFIs, nonfinancial foreign entities, and other taxpayers to comply with FATCA's reporting and withholding requirements.

IMPACT.

Since the passage of FATCA, there has been growing collaboration in the international community to identify and prevent tax evasion, Treasury has reported.

Implementation delayed. Treasury and the IRS subsequently revised the timelines for implementing FATCA (Notice 2013-43). Withholding requirements scheduled to generally begin on withholdable payments made after December 31, 2013 are postponed to payments made after June 30, 2014.

COMMENT 

Treasury is working to implement FATCA and to address base erosion and profit shifting (BEPS). Treasury plans to issue FATCA regulations for withholding agents and participating financial institutions in early 2014.

Intergovernmental Agreements. The final regulations help harmonize the U.S.'s regulatory requirements with the use of intergovernmental agreements (IGAs) to implement FATCA and to facilitate the exchange of the requisite information. The U.S. has developed two model IGAs. Under Model I, FFIs report the information required by FATCA to their respective governments, which then provide this information to the IRS. Under Model II, the foreign jurisdiction directs its FFIs to report the information required by FATCA directly to the IRS.

COMMENT 

The U.S. has entered into FATCA agreements with a number of foreign jurisdictions, including Switzerland, Japan (Model II), Germany, Norway, and Spain, and is engaged in negotiations with others.

FATCA forms. The IRS issued a draft form and instructions for the 2014 version of Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, for reporting of income under both Chapters 3 and 4. Other draft forms released by the IRS include:

  • ? Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Withholding and Reporting (Entities);

  • ? Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States tax Withholding and Reporting (Individuals);

  • ? Form W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding and Reporting; and

  • ? Form W-9, Request for Taxpayer Identification Number and Certification.

COMMENT 

The first FATCA reporting generally will be required for 2014, although the forms will not be due until 2015.

FATCA registration. The IRS opened a new online registration system in 2013 for financial institutions required to register with the agency under FATCA (IR-2013-69). FFIs can use the online registration system to create an account to provide the required information. The IRS will establish an online FATCA account for the FI and will assign global intermediary identification numbers (GIINs) to each FI.

The IRS issued a draft FFI agreement (Notice 2013-69) that substantially incorporated the requirements of the final FATCA regulations. The IRS followed up by issuing a final FFI agreement before the end of 2013 (Rev. Proc. 2014-13). The IRS also posted final Form 8957, Foreign Account Tax Compliance Act Registration, along with instructions.

COMMENT 

Financial institutions (FIs) may use paper Form 8957 as an alternative to the IRS's online registration system. Registration may begin January 1, 2014. The IRS will establish an online FATCA account for the FI and will assign global intermediary identification numbers (GIINs) to each FI.

IMPACT.

Entities can start to register before July 1, 2014 and obtain a GIIN. An FFI will then provide its GIIN to withholding agents to demonstrate that it is registered and approved. Otherwise, the agent will institute withholding required under FATCA effective July 1, 2014.

Information Sharing

The U.S., the United Kingdom and Australia announced in 2013 that they will share more tax information involving companies and trusts holding offshore assets of taxpayers under their respective jurisdictions (IR-2013-48). The countries have been working together to analyze data that identifies individuals who own the entities and advisers who assisted in establishing the entity structure.

COMMENT 

This information sharing is in addition to the provision of information by governments and financial institutions under FATCA. It also helps the three countries develop a better overall understanding of complex offshore structures that may be used to evade taxes.

Judicial Decisions

The federal courts issued several decisions in 2013 that struck at foreign-based tax abuses. Notable cases involved the treatment of foreign dividends and the issuance of "John Doe" summonses to banks suspected of holding unreported accounts.

CFC inclusions. Affirming the Tax Court, the Court of Appeals for the Fifth Circuit found that amounts reported as qualified dividend income by the owners of a controlled foreign corporation (CFC) were properly characterized as ordinary income (Rodriguez, 2013-2 USTC ¶50,420). The court rejected the taxpayer's argument that Code Sec. 951 inclusions under Subpart F should be deemed dividends. The court further observed that actual dividends require a distribution by a corporation and receipt by the shareholder. Code Sec. 951 inclusions involve no distribution, the court found.

Repatriated dividends. The Tax Court held that a U.S. taxpayer must reduce the dividends eligible for the Code Sec. 965 repatriation deduction by the amount of debt it was owed by its CFC to the taxpayer (BMC Software Inc., CCH Dec. 59,643). In this case, the debt resulted from the taxpayer's agreement with the IRS to recharacterize certain payments as loans rather than as contributions to capital.

COMMENT 

The law reducing dividends for an increase in related-party debt deters U.S. shareholders from loaning money to their CFCs and then bringing the funds back into the U.S. as repatriated dividends. The court took a strict view, applying the letter of the law even though there was no evidence of manipulation by the taxpayer.

"John Doe" summonses. A federal district court authorized the IRS to issue "John Doe" summonses to five U.S. banks that would require them to produce information on taxpayers with undisclosed foreign financial accounts in two foreign banks (Liabilities of John Does, S.D.N.Y.).

The Department of Justice reported that U.S. taxpayers participating in the IRS Offshore Voluntary Disclosure (OVD) program identified more than 450 undisclosed foreign financial accounts held at the foreign banks by U.S. account holders.

U.K. windfall profits tax. In a unanimous decision, the Supreme Court found that a United Kingdom windfall profits tax was a creditable excess profits tax for purposes of allowing a foreign tax credit under Code Sec. 901 (PPL Corp. et al., 2013-1 USTC ¶50,335). In a substance-over-form analysis that resolved a split among the circuits, the Supreme Court found that the tax, in essence, was "nothing more than a tax on actual profits above a threshold."

IMPACT.

The government has taken a strong stand against abusive foreign tax credit claims and attempts to recharacterize payments to foreign governments as income taxes. In this case, the Supreme Court decided there was no abuse. The decision allowed the taxpayer to claim the foreign tax credit and reduce its U.S. taxes for the windfall profits tax it paid to the U.K.

OECD Action Plan

The Organisation for Economic Co-operation and Development (OECD)—which includes the U.S.—released a multipronged Action Plan in 2013 to combat tax avoidance by multinational corporations (MNCs) that use base-erosion and profit-shifting (BEPS) techniques. The Action Plan sets a December 2015 deadline for countries to implement its 15 proposals through unilateral, bilateral, and multilateral measures. The OECD also advanced a plan to increase international cooperation and transparency through the automatic exchange of information between jurisdictions.

COMMENT 

The OECD defines BEPS as tax planning strategies that exploit gaps and mismatches in tax rules to make tax profits "disappear" for tax purposes or to shift profits to low-tax locations where there is little or no real activity. Although many BEPS practices are legal, they are still harmful, the OECD cautioned.

IMPACT.

Many U.S. tax reformers support a lower corporate tax rate, but only if it is accompanied by a broader base subject to U.S. taxes. These reformers believe that the OECD's BEPS strategy may play an important part in this effort.

Competent Authority and Advance Pricing Agreements

The IRS issued a draft revenue procedure in 2013 that would revise and update the processes for taxpayers seeking relief from double taxation to obtain competent authority assistance through the Mutual Agreement Program (MAP) (Notice 2013-78). The revenue procedure reflects the establishment of the IRS Large Business and International Division and of separate offices under the U.S. competent authority to handle requests for different types of assistance.

IMPACT.

The IRS expects that these revised competent authority procedures will operate more effectively and provide a more structured process for taxpayers to request relief and interact with the agency.

The IRS also issued a draft revenue procedure that would revise and update the procedures for taxpayers to negotiate an advance pricing agreement (APA) with the IRS (Notice 2013-79). An APA provides the transfer prices used for transactions between related parties owned by a multinational corporation.

IMPACT.

The APA and MAP offices have worked closely to seek efficiencies in processing their combined workloads. The creation of a single Advance Pricing and Mutual Agreement (APMA) office will likewise increase efficiency by eliminating the hand off of APA cases from one IRS office (the APA program) to another (competent authority).

Taxes Paid For FTC purposes. The IRS issued final regulations that disallow the foreign tax credit Pwhere the payments to a foreign government are attributable to a structured passive investment arrangement (TD 9634). These regulations finalized proposed regulations issued in 2011. There are six requirements for a passive arrangement. One is that substantially all of the entity's gross income is passive investment income, and all the entity's assets are held to produce passive income.

Dividend Equivalents

The IRS withdrew 2012 proposed regs and issued new proposed regs to impose withholding on dividend equivalents (NPRM REG-120282-10). At the same time, it adopted final regs that postponed the application of the withholding rules until January 1, 2016 (TD 9648). The 2013 proposed regs provide a new test, based on a financial instrument's "delta," which is the ratio of the change in fair market value of the contract to the change in the value of the property referenced by the contract.

IMPACT.

A 2010 law imposes 30 percent withholding on dividend equivalents. The IRS delayed withholding after it substantially revised the test for identifying dividend equivalents. The financial services industry had also indicated that it needs additional time to establish the necessary withholding systems.

EXEMPT ORGANIZATIONS

Exempt organizations were much in the news during 2013 largely because of the controversy surrounding the IRS's handling of applications for tax-exempt status from conservative organizations. This brought about some significant changes in the IRS executive ranks along with new regulations and rules.

Code Sec. 501(c)(4) organizations. In May, the IRS announced that some applications for tax-exempt status under Code Sec. 501(c)(4) had been inappropriately flagged for extra scrutiny. The announcement resulted in numerous Congressional hearings. Some senior IRS officials, including then Acting IRS Commissioner Steven Miller, retired, resigned or were placed on administrative leave. President Obama appointed Daniel Werfel as Acting Commissioner and directed him to conduct a top-down review of the agency's operations, processes and practices. In June, Werfel reported that there was no sign of intentional wrongdoing by agency personnel or involvement by parties outside the agency (IR-2013-62). Werfel also announced a streamlined application process for affected organizations going forward (IR-2013-62).

COMMENT 

Werfel also moved to curb IRS spending after reports of excessive expenditures on conferences and training, including video parodies of 1960s television shows surfaced. Werfel told Congress that these expenses were "unfortunate vestiges from a prior era" and the agency took "bold steps" to ensure spending in the future is appropriate.

Proposed 501(c)(4) regulations. In November, the IRS announced proposed regulations intended to clarify tax-exempt status under Code Sec. 501(c)(4) (IR-2013-92, NPRM REG-134417-13). The IRS explained that it intended to replace the current facts and circumstances test used to determine if an organization is engaged in political campaign activities with more definite rules. The proposed regulations would provide that the promotion of social welfare does not include direct or indirect candidate-related political activity.

IMPACT.

Candidate-related political activity would generally encompass communications that expressly advocate for a clearly identified political candidate or candidates of a political party; activities closely related to candidates and elections, such as "get-out-the-vote" drives and distribution of any material prepared by or on behalf of a candidate; and any contribution that is recognized under campaign finance law as a reportable contribution.

GOVERNMENT SHUTDOWN

On October 1, 2014, the IRS furloughed nearly 90 percent of its employees after a lapse in appropriations. Certain core-functions remained in operation, including the processing of most tax payments. The Tax Court also closed. But federal district and circuit courts generally remained open. On October 17, President Obama signed the Continuing Appropriations Act, 2014, which reopened the federal government through mid-January. On December 26, President Obama signed the Bipartisan Budget Act of 2013, which effectively keeps the government open for two more years.

IMPACT.

During the shutdown, all furloughed employees were instructed not to perform any work-related activities. After funding was restored, the IRS cautioned taxpayers to expect delays as employees caught up with work. Taxpayers should also be prepared for a delayed start to the 2014 filing season, which is scheduled to open on January 31, 2014 (IR-2013-100).

COMMENT 

Unrelated to the lapse in appropriations were furlough days in 2013 due to sequestration under the Budget Control Act of 2011. IRS employees were furloughed for several days under sequestration in 2013. The Bipartisan Budget Act of 2013 appears to remove the need for future furlough days.

TAX ADMINISTRATION

Not only did the IRS have to deal with a 16-day shutdown in October, the agency also had a number of important tax administration projects on its agenda, most notably its campaign against tax-related identity theft.

Identity theft. Starting in January, the IRS ramped up its efforts to curb tax-related identity theft, especially those designed to protect taxpayers filing 2012 returns (FS-2013-2, FS-2013-3). The IRS expanded the Identity Protection Personal Identification Number (IP PIN) program and increased the number of employees engaged in identity theft detection work. Additionally, the IRS began using new filters to screen returns for possible identity theft. The IRS and law enforcement agencies also launched a sweep of identity theft suspects during the 2013 filing season (IR-2013-17). In April, the IRS expanded its partnership with local law enforcement agencies to curb identity theft (IR-2013-34).

IMPACT.

Taxpayer identity theft typically involves a criminal using an individual's personal information to fraudulently file a tax return and claim a refund. This type of identity theft often peaks early in the filing season because criminals want to receive fraudulent refunds early. Taxpayers may not discover that their identities have been stolen until their true returns ares kicked back by the IRS.

Return preparers. In January, a federal district court ruled that the IRS had overreached its authority in issuing return preparer oversight regulations (Loving, DC-DC, 2013-1 USTC ¶50,156). Several unenrolled preparers challenged the IRS regulations, arguing that the IRS did not have the statutory authority to require them to become Registered Tax Return Preparers (RTRPs) or obtain another IRS-recognized credential. After the decision was announced, the IRS suspended its RTRP program. The IRS appealed to the Court of Appeals for the District of Columbia Circuit, which heard oral arguments in September 2013, and a decision is expected to be announced in early 2014.

COMMENT 

The IRS initially halted its Preparer Tax Identification Number (PTIN) program but resumed that program in early February after the court modified its order to clarify that the order did not affect the requirement that all paid tax return preparers obtain a PTIN.

Disclosure authorizations. The IRS announced in May that it would extend the 60-day period to 120 days for submitting Code Sec. 6103(c) taxpayer authorizations that permit disclosure of returns and return information to third-party designees (TD 9618).

Opinion/advisory letters. The IRS established a program on June 28, 2103 for issuing opinion and advisory letters for Code Sec. 403(b) pre-approved plans (403(b) prototype plans and volume submitter plans) (Rev. Proc. 2013-22). Under the program, the IRS will issue an opinion or advisory letter as to whether the form of the plan meets the requirements of Code Sec. 403(b). An employer may then satisfy the written plan requirement and know that its plan meets the requirements of Code Sec. 403(b) by adopting a plan that has received an opinion or advisory letter.

Fast track settlement. The IRS announced in November that it expanded its Fast Track Settlement (FTS) program to small businesses nationwide (IR-2013-88). Under FTS, taxpayers under examination with issues in dispute will work directly with IRS representatives from SB/SE's Examination Division and Appeals to resolve those issues.

Installment agreements/OICs. The IRS issued final regulations (effective January 1, 2014) increasing the fee for an installment agreement from $105 to $120. The charge to restructure or reinstate a defaulted agreement increases from $45 to $50. The fee for a direct debit agreement authorizing monthly payments remains $52 ($43 for lower-income taxpayers). The IRS also raised the user fee for processing an offer-in-compromise (OIC) from $150 to $186 (TD 9647).

Audits/information document requests. All information document requests (IDRs) issued after June 30, 2013 must be issue-focused and discussed with the taxpayer. The taxpayer and the examiner must also discuss the appropriate deadline (LB&I-04-0613-004, LB&I-04-1113-009).

IMPACT.

Under the new rules, IRS examiners must discuss the information to be requested in the IDR with the taxpayer before the IDR is issued, and the IRS and the taxpayer must mutually agree on a reasonable response date. If a taxpayer does not respond to the IDR by that date, the case must proceed to the graduated, three-step enforcement process. This process, assuming the taxpayer could not respond to the IDRs by the dates specified at each step, would involve first a delinquency notice, then a pre-summons letter, and finally a summons.

Timely filing presumption. In June, the U.S. Court of Federal Claims found that an estate's claim for a refund of tax was not timely filed because the estate's representative did not exercise prudence by doing everything expected of him to ensure timely delivery (Langan, FedCl, 2013-2 USTC ¶60,668). The complaint was sent by overnight mail one day before the filing deadline but arrived four days later.

COMMENT 

The court found that rather than do everything that could reasonably be expected to ensure delivery, the estate's representative had waited until 11:00 p.m. to send the complaint. Waiting until such a late hour was not reasonable, the court found.

Whistleblowers. The IRS announced in February that it had collected $592 million in FY 2012 resulting from whistleblower actions, compared to $48 million in FY 2011. The IRS also paid out $125 million in awards to whistleblowers in FY 2012. However, whistleblower awards for FY 2013 were reduced by 7.2 percent because of sequestration under the Budget Control Act of 2011.

COMMENT 

Congress overhauled the whistleblower awards program in 2006 and created the IRS Whistleblower Office. The IRS has been criticized by some lawmakers for moving slowly in processing whistleblower claims. The agency may be more aggressive in its whistleblower actions under its new Commissioner.

2013 filing season delay. The IRS delayed the start of the 2013 filing season (for 2012 tax returns) in response to the passage of late tax legislation (ATRA). To give its employees more time to program processing systems for the new tax laws, the IRS moved the start date of the 2013 filing season to January 30, 2013.

IMPACT.

Some taxpayers were unable to file returns until later in the 2013 filing season because programming for certain schedules and forms took longer than anticipated. These included Forms 4562, Depreciation and Amortization; 5695, Residential Energy Credits; and 8582, Passive Activity Loss Limitations.

COMMENT 

As discussed above, the start of the 2014 filing season is also delayed. The 2014 filing season is scheduled to open on January 31, 2014 for individuals.

Penalty relief. In March, the IRS announced that taxpayers filing 2012 returns with forms that were principally delayed by passage of ATRA might be eligible for relief from the Code Sec. 6651(a)(2)failure to pay penalty (IR-2013-31, Notice 2013-24). The IRS indicated it would abate the failure to pay penalty if the taxpayer requested a filing extension, paid the estimated tax liability by the original return's due date, and paid any remaining tax by the extended due date of the return.

2013 Year-End Tax Planning

Posted by Admin Posted on Feb 04 2014

Year-End 2013 Brings New Challenges And Opportunities

Year-end 2013 brings many new planning opportunities along with the traditional year-end tax planning strategies. It also brings challenges - for both individuals and businesses. There is much for taxpayers and their tax advisors to consider in taking action before 2013 ends, including the important changes made by the American Taxpayer Relief Act of 2012 (ATRA) (signed into law on January 2, 2013), the provisions in the Patient Protection and Affordable Care Act of 2010 (Affordable Care Act) (scheduled to take effect in 2013, 2014) the Supreme Court's decision on same-sex marriage and the release of significant new IRS rules on many pressing issues. There is also the prospect of comprehensive tax reform in 2014, which will require some "crystal ball" forecasting of what Congress may or may not do in the coming year. On top of everything, the IRS shutdown in October could delay the start of the 2014 filing season, although the long-term effects have yet to be determined.

This briefing explores some of the 2013 year-end planning opportunities available to taxpayers, especially as the result of provisions that are new-for-2013 and those that at the moment are scheduled to expire after 2013. Of course, every taxpayer's situation is unique and a year-end planning strategy, whether for an individual, family or business, should be customized in consultation with a tax professional.

STRATEGY.

For higher income taxpayers, 2013 also represents a year of increased tax burden in comparison to previous years. Not only did ATRA set the maximum income tax rate at 39.6 percent, but the Affordable Care Act's new surtax on net investment income (NII) and Additional Medicare Tax also began to apply as of January 1, 2013. The combination of these and other factors makes year-end planning all that more crucial.

COMMENT 

At the time this Briefing was posted, the IRS had furloughed nearly 90 percent of its personnel in response to a lapse in appropriations after fiscal year (FY) 2013. The IRS has instructed taxpayers to file returns and pay taxes as normal during the shutdown. Notices and other automated functions are operating. However, the IRS is not responding to taxpayer questions during the shutdown. What long-term effects the shutdown will have, particularly for the 2014 filing season, are uncertain.

PLANNING FOR INDIVIDUALS

The approach of year-end 2013 brings more certainty to tax planning than in 2012 because of ATRA. In addition to the permanent extension of the Bush-era tax cuts for lower and middle income taxpayers, ATRA also revived the 39.6 percent tax bracket (at new levels) for higher income individuals, revived the personal exemption phaseout (PEP) and limitation on itemized deductions (Pease limitation) (at new levels), increased the maximum tax rate on qualified dividends and capital gains, and made many additional changes. And, as already noted, the Affordable Care Act brings two additional considerations that need to be factored into year-end planning by higher-income taxpayers for the first time in 2013 the NII surtax and the new Additional Medicare Tax.

Tax Rates

For 2013 and subsequent years, the individual income tax rate schedules reflect a continuation of the rates under the "Bushera" tax cuts, except for the addition of a new 39.6 percent rate for the highest bracket. Thus, the individual income tax rates for 2013 and future years are 10, 15, 25, 28, 33, 35 and 39.6 percent. As in the past, each taxable income rate bracket is increased slightly each year based upon an inflation factor. The starting points for the 39.6 percent bracket for 2013 and 2014 (as projected for inflation) are:

2013

2014

Married filing jointly and surviving spouse

$450,000

$457,600

Heads of households

$425,000

$432,200

Unmarried individuals

$400,000

$406,750

Married filing separately

$225,000

$228,800

STRATEGY.

Because the highest rate for estates and trusts starts at a relatively low level of taxable income ($11,950 in 2013 and $12,150 in 2014), executors and trustees should consider making distributions to beneficiaries before year end, which generally will pass that amount of taxable income through to those beneficiaries and escape tax at the comparatively high estate/trust level.

Capital Gains/Dividends

Starting in 2013, ATRA has raised the top rate for capital gains and dividends to 20 percent, up from the Bush-era maximum 15 percent rate. This top rate is generally aligned with the same income levels at which the new 39.6 percent income tax rate bracket starts: long-term capital gains and qualified dividends, to the extent they would be otherwise taxed at the 39.6 percent rate as marginal ordinary income, will be taxed at the 20 percent rate.

IMPACT.

Absent ATRA, the maximum tax rate on net capital gain of all noncorporate taxpayers would have reverted to 20 percent (10 percent for taxpayers in the 15 percent bracket) starting January 1, 2013. On the other side of the spectrum, because of ATRA, taxpayers with incomes below the top of the 15 percent income tax bracket for 2013 and in the future will continue to be subject to a zero percent capital gains/dividends rate.

COMMENT 

The 28 and 25 percent tax rates for collectibles and unrecaptured Code Sec. 1250 gain, respectively, continue unchanged after 2012. Also unchanged is the application of ordinary income rates to short-term capital gains, except that now taxpayers may potentially be subject to a higher top rate (39.6 percent instead of 35 percent). This could be even higher (43.4 percent) if the NII surtax applies (see below).

STRATEGY.

Taxpayers may consider using carryforward losses from 2012 by recognizing capital gains to the extent of the available carryfowards, preferably short-term gains if available, since they are taxed at the ordinary-income rates. Carryforward net capital losses from pre-2013 transactions, which would have only offset capital gains at a maximum 15 percent rate, are able to offset capital gains at the new, higher rates without adjustment for the rate change.

STRATEGY.

Holding capital assets for more than 12 months before taxable disposition to avoid short-term capital gain status is usually advisable, unless sufficient loss offsets have been recognized, or market conditions indicate otherwise.

STRATEGY.

Year-end planning should also look to avoiding spikes in income, whether capital gains or other income, which may push capital gains into either the 39.6 percent bracket or the 20 percent capital gains bracket. Spreading the recognition of certain income between 2013 and 2014, rather than recognizing it all in either 2013 or 2014, may accomplish this goal.

Qualified Dividends. Generally, dividends received from a domestic corporation or a qualified foreign corporation, on which the underlying stock is held for at least 61 days within a specified 121-day period, are qualified dividends for purposes of the reduced, capital gains tax rate. Certain dividends do not qualify for the reduced tax rates and are taxed as ordinary income. These include, dividends paid by credit unions, mutual insurance companies, and farmers' cooperatives.

CAUTION.

Installment payments are subject to the tax rates for the year of the payment, not the year of the sale. The capital gains portion of payments made in 2013 and later is now taxed at the 20 percent rate for higher-income taxpayers.

Surtax On Net Investment Income (NII)

Starting in 2013, higher-income taxpayers may be liable for a 3.8 percent NII surtax. The NII surtax on individuals equals 3.8 percent of the lesser of:

(1)

Net investment income for the tax year, or

(2)

The excess, if any of:

(a)

the individual's modified adjusted gross income (MAGI) for the tax year, over

(b)

the threshold amount.

The threshold amount is equal to:

  • ? $250,000 in the case of joint returns or a surviving spouse,

  • ? $125,000 in the case of a married taxpayer filing a separate return, and

  • ? $200,000 in any other case.

CAUTION.

The NII tax threshold amounts are not indexed for inflation. Although both the 39.6 percent ordinary income rate, the 20 percent capital gain/dividend rate, and the 3.8 percent rate are commonly referred to as affecting "higher income" taxpayers, the income threshold for being subject to the 3.8 percent NII tax is significantly lower than the others. Therefore, a greater number of taxpayers will be subject to the 3.8 percent rate for the NII surtax.

IMPACT.

Depending upon the character of the NII income, combined NII tax and regular income tax rates can cause NII be taxed at 23.8 percent if long-term capital gain or qualified dividends, or at 36.8, 38.8, or 43.4 percent if short-term gains or passive activity income is involved. At the 23.8 percent level, the difference in tax paid on net capital gains and dividends between 2012 and 2013 is nearly a 60 percent increase.

STRATEGY.

Taxpayers should consider keeping threshold income below the $250,000/$125,000/$200,000 NII tax threshold levels if possible by spreading income out over a number of years or offsetting the income with above-the-line deductions. In particular, spikes in income should be carefully managed in connection with Roth IRA conversions, taxable sales of large assets (including primary residences, if gain is not fully protected by the Code Sec. 121 primary residence exclusion), and other "one-time" events. Taxpayers should also be aware that the threshold amounts are keyed to all income and not just net investment income.

STRATEGY.

All net investment income should be monitored for exposure to the NII surtax. Net investment income is more than simply capital gains and dividends. Principally, it also includes income from a business in which the taxpayer is a passive participant. Rental income may also be considered NII unless earned by a real estate professional. Taxpayers should also carefully weigh the impact of IRS regulations under Code Sec. 1411 on any year-end maneuvers, including the impact of the self-rental rule as well as passthrough income from an active owner of an S corporation or partnership.

STRATEGY.

Quarterly estimated tax payments may have required adjustment throughout 2013 because of the increase in rates for capital gains and other net investment income. The run up in the stock markets earlier this year may have contributed to this situation. Although make-up payments for fourth-quarter estimated tax may help lessen any eventual estimated tax penalties, they will not eliminate them. However, directing an employer to increase wage withholding for the balance of 2013 to make up the difference can eliminate any estimated tax penalty entirely and retroactively with respect to all 2013 quarters.

COMMENT 

At the time this Briefing was prepared, the IRS had not finalized Form 8960, Net Investment Income Tax, nor its instructions, which taxpayers will use to report liability for the NII surtax.

Additional Medicare Tax

Effective for tax years beginning after December 31, 2012, the Additional Medicare Tax increases the employee-share of Medicare tax by an additional 0.9 percent of covered wages in excess of certain"higher income-level" threshold amounts. Similarly, the Additional Medicare Tax increases Medicare tax on self-employment income for any tax year beginning after December 31, 2012 by an additional 0.9 percent of self-employment income in excess of certain threshold amounts.

Threshold amounts. The Additional Medicare Tax is not imposed until an individual's covered wages, compensation and/or self-employment income exceed the threshold amount for the taxpayer's filing status. The threshold amounts are: $200,000 for single individuals (and heads of household); $250,000 for married couples filing a joint return; and $125,000 for married individuals filing separate returns.

COMMENT 

The threshold amounts are not indexed for inflation and therefore will remain the same for 2014 and subsequent years as for 2013. All wages subject to regular Medicare Tax are subject to the Additional Medicare Tax.

IMPACT.

Single individuals liable for Additional Medicare Tax after 2012 pay 1.45 percent Medicare tax on the first $200,000 of compensation plus 2.35 percent (1.45 percent + 0.9 percent) on compensation in excess of $200,000. Married couples filing a joint return pay 1.45 percent Medicare tax on the first $250,000 of compensation plus 2.35 percent (1.45 percent + 0.9 percent) on compensation in excess of $250,000. Unlike Social Security tax, there is no cap on the amount of compensation subject to Medicare tax.

COMMENT 

The threshold amounts are identical to those set for the NII tax. However, despite some relationship between these two taxes, income that escapes the NII tax does not necessarily get caught by the 0.9 percent Medicare tax, or vice versa.

STRATEGY.

Taxpayers liable for Additional Medicare Tax will calculate Additional Medicare Tax liability on their individual income tax returns. Taxpayers who anticipate liability for Additional Medicare Tax may request that their employer(s) take out an additional amount of income tax withholding, which would be applied against taxes shown on the taxpayer's individual income tax return, including any Additional Medicare Tax liability.

CAUTION.

The IRS has cautioned that if an employee has amounts deferred under a nonqualified deferred compensation plan, and the nonqualified deferred compensation is taken into account as wages for FICA (Social Security and Medicare) purposes under a special timing rule, the nonqualified deferred compensation would likewise be taken into account under the special timing rule to determine the employer's obligation to withhold Additional Medicare Tax.

Withholding. An employer is required to collect Additional Medicare Tax with respect to wages earned for duties performed by the employee for the employer only to the extent the employer pays wages to the employee in excess of $200,000 in a calendar year. This rule applies without regard to the employee's filing status or other wages/compensation.

STRATEGY.

The employer's obligation to withhold Additional Medicare Tax starts at $200,000. This is distinct (as explained above) from the threshold amounts for liability for Additional Medicare Tax. Individuals who receive wages from more than one employer, and who expect those wages to exceed the threshold amounts, should consider increasing their withholding or making estimated tax payments. Under proposed IRS regulations, interest-free adjustments of employer underpayments of Additional Medicare Tax generally may be made only if the error is ascertained in the same year the wages or compensation was paid.

Alternative Minimum Tax

Year-end planning was made more complicated in the past because of uncertainty over the reach of the alternative minimum tax (AMT). Congress had originally intended that the AMT operate so that very wealthy taxpayers could not escape taxation. Because the AMT had not been indexed for inflation, along with other factors, the AMT began to encroach on middle income taxpayers. To prevent this, Congress routinely "patched" the AMT by increasing the exemption amounts and making other changes. ATRA permanently patches the AMT for 2013 and subsequent years.

Under ATRA, the exemption amounts for 2013 are $51,900 for single individuals and heads of household and $80,800 for married couples filing a joint return and surviving spouses. ATRA provides that these amounts are indexed for inflation after 2013. Taxable income that exceeds the exemption amount is subject to a 26 percent AMT rate on the first $175,000 of alternative minimum tax income (AMTI) and a 28 percent on any AMTI above this $175,000 amount. ATRA also allows taxpayers to take all of the nonrefundable personal credits against regular and AMT liability.

COMMENT 

CCH projects that, for 2014, the AMT exemption for married joint filers and surviving spouses will be $82,100 (up from $80,800 in 2013). For heads of household and unmarried single filers, the exemption will be $52,800 (up from $51,900 in 2013).

STRATEGY.

Taxpayers who were accustomed to reviewing their AMT liability versus regular tax liability in years before ATRA permanently patched the AMT should continue their analysis. Some taxpayers may find that their AMT liability and regular tax liability are roughly equal from year to year. Other taxpayers may find that they have had significant fluctuations in income from year to year and could explore the benefit from being able to shift some AMT-triggering items from an AMT year to a non-AMT year.

STRATEGY.

For many taxpayers, large amounts of certain items may trigger AMT liability. These include, but are not limited to, itemized deductions for medical expenses, the addition of certain income from incentive stock options, changes in income from installment sales, and more. Some taxpayers may benefit from participating in an employer's pretax medical deduction plan, which could reduce their taxable compensation and AMT liability.

STRATEGY.

Taxpayers who discover they are not liable for AMT for 2013, but who had been liable for the AMT in a past year, may be eligible to take a minimum tax credit against their regular tax this year. This credit cannot, however, be used to reduce AMT liability in a future year. Additionally, the minimum tax credit is allowed only for the AMT caused by deferral items (such as depreciation) and not exclusion items (such as the standard deduction).

COMMENT 

President Obama has proposed to replace the AMT with the so-called "Buffett Rule," which would impose a minimum tax of 30 percent on taxpayers with incomes above $1 million. In April 2013, the Senate rejected the Buffett Rule as proposed in a bill sponsored by Democrats. Senate Democrats could reintroduce the bill in 2014.

Pease Limitation

ATRA revived and modified the "Pease" limitation (named for the member of Congress who sponsored the original legislation) on itemized deductions for higher income taxpayers. The Pease limitation had been eliminated as part of the Bush-era tax cuts through 2012. The Pease limitation "applicable threshold" levels under ATRA for 2013 are:

  • ? $300,000 for married couples and surviving spouses;

  • ? $275,000 for heads of households;

  • ? $250,000 for unmarried taxpayers; and

  • ? $150,000 for married taxpayers filing separately.

IMPACT.

Without ATRA, the applicable threshold for the Pease limitation for 2013, as adjusted for inflation and as computed under Bush-era sunset rules, would have been $178,150 ($89,075 for individuals married filing separately).

COMMENT 

The dollar amounts are adjusted for inflation for tax years after 2013. For 2014, they are projected to be $305,050 for married couples filing joint returns; $279,650 for heads of household; $254,200 for single taxpayers; and $152,525 for married taxpayers filing separate returns.

IMPACT.

The Pease limitation reduces the total amount of a higher-income taxpayer's otherwise allowable itemized deductions by three percent of the amount by which the taxpayer's adjusted gross income exceeds an applicable threshold. However, the amount of itemized deductions is not reduced by more than 80 percent. Certain items, such as medical expenses, investment interest, and casualty, theft or wagering losses, are excluded.

Personal Exemption Phaseout

ATRA revived and modified the personal exemption phaseout (PEP). The threshold adjusted gross income amounts for the PEP mirror those of the revived Pease limitation:

  • ? $300,000 for married couples and surviving spouses;

  • ? $275,000 for heads of households;

  • ? $250,000 for unmarried taxpayers; and

  • ? $150,000 for married taxpayers filing separately.

IMPACT.

Under the phaseout, the total amount of exemptions that may be claimed by a taxpayer is reduced by two percent for each $2,500, or portion thereof (two percent for each $1,250 for married couples filing separate returns) by which the taxpayer's adjusted gross income exceeds the applicable threshold level.

Child Tax Credit

For 2013, the child tax credit is $1,000 per qualifying child. Before ATRA, the child tax credit had been scheduled to revert to $500 per qualifying child. ATRA, however, made permanent the $1,000 amount for 2013 and subsequent years.

IMPACT.

The child tax credit is not indexed for inflation. As a result, the "real" value of the credit will continue to decline.

STRATEGY.

When claiming the child tax credit, taxpayers should assess other expenses related to children, such as educational and child care costs, which could qualify for special tax breaks, as year-end approaches. In divorce or separation situations, the taxpayer entitled to the child credit is often aligned with the taxpayer who claims the dependency exemption and the child and dependent care credit. Absent an agreement between the parties, it is critical that a determination of the amount of time that a child lives within a certain household be made. It is also essential to determine whether more than half of the child's support is provided by one of the parties. These considerations make year-end assessments, and follow-up contributions or other tweaks to these threshold requirements, important in some cases.

Medical Expense Deduction

Before 2013, taxpayers who itemized deductions could claim a deduction for qualified unreimbursed medical expenses to the extent those expenses exceeded 7.5 percent of adjusted gross income (AGI). Effective for tax years beginning after December 31, 2012, the 7.5 percent threshold generally increases to 10 percent. Taxpayers (or their spouses) who are age 65 or older before the close of the tax year, however, may continue to apply the 7.5 percent threshold for tax years through 2016.

STRATEGY.

For deductions by cash-basis taxpayers in general, including for purposes of the medical expense deduction, a deduction is permitted only in the year in which payment for services rendered is actually made. Under this general rule, payment by credit card constitutes payment in the year the charge is made, as opposed to the year in which the credit card statement is paid. Prepayment of medical expenses prior to the year in which services are rendered, however, generally does not accelerate the deduction, absent some legitimate payment-in-advance requirement of the service provider.

COMMENT 

The AMT threshold for itemized deductions remains unchanged at 10 percent. No exception for those age 65 or older exists.

Health Flexible Spending Arrangements

Beginning in 2013, the Affordable Care Act caps annual contributions to health flexible spending arrangements (health FSAs) at $2,500. Any salary reductions in excess of $2,500 will subject an employee to tax on distributions from the health FSA. The $2,500 maximum amount is indexed for inflation after 2013. For 2014, the cap is projected to be $2,500, the same as in 2013.

STRATEGY.

Use-it-or-lose-it rules for health FSAs allow cafeteria plans to provide for a 2½ month grace period after the current year to incur expenses and request reimbursement. However, plans are not required to offer this grace period so participants should check before year-end whether a grace period applies to them. Also relevant to year-end is the requirement that an election as to the amount contributed to an FSA be made before the tax year to which it will apply.

Sunsetting "Extenders"

Some popular, but temporary, tax incentives known as "extenders" are scheduled to expire after 2013. Whether Congress will extend them again is questionable. While all have their supporters, Congress appears likely to take an extremely budget-conscious approach toward any tax provision it may consider, in addition to being divided on most tax issues in general. Taxpayers should accordingly consider acting upon the benefits provided by these provisions now, before year-end 2013, whenever possible. The extenders provisions include:

State and Local Sales Tax. Taxpayers may elect to deduct state and local sales taxes in lieu of state and local income taxes. Although this incentive is scheduled to sunset at the end of 2013, it appears to be the most politically-backed extender and, therefore, may survive through another extension until tax reform permanently addresses its place.

Teachers' Classroom Expense Deduction. Primary and secondary education professionals may take an above-the-line deduction for qualified unreimbursed expenses up to $250 paid during the year.

Exclusion of Cancellation of Indebtedness on Principal Residence. This provision allows taxpayers to exclude from income cancellation of mortgage debt of up $2 million on a qualified principal residence, but only through 2013.

Transit Benefits. Parity in the amount of transit fringe benefits that may be enjoyed pre-tax by employees has allowed those using public transportation and van pooling to benefit at the same higher-level as is available to taxpayers receiving qualified parking benefits ($245 for 2013). This parity will expire after 2013 unless extended by Congress, thus reducing the benefit for public transportation and van pooling to $130 per month for 2014 (as projected for inflation).

Mortgage Insurance Premiums. Mortgage insurance premiums have been allowed to be treated as qualified residence interest.

Contribution of Capital Gains Real Property for Conservation. Contributions of capital gain real property for conservation purposes have been allowed to be taken against 50 percent of an individual's charitable contribution base, allowing for a larger charitable contribution amount.

IRA Distributions to Charity. Tax-free distributions, up to a maximum of $100,000 per taxpayer each year, from individual retirement accounts to public charities by individuals age 70½ or older, have been allowed as an alternative to taking an itemized deduction.

Same-Sex Marriage

On June 26, 2013, the U.S. Supreme Court struck down Section 3 of the Defense of Marriage Act in E.S. Windsor, 2013-1 ustc 50,400. The Court held that Section 3, which had defined marriage for federal purposes as the union of one man and one woman, was unconstitutional. Subsequently, the IRS announced a general rule in Rev. Rul. 2013-17 recognizing same-sex marriages nationwide.

Place of Celebration Approach. All same-sex marriages are recognized for all federal tax purposes, regardless of whether a couple resides in a jurisdiction that recognizes same-sex marriage or in a jurisdiction that does not recognize same-sex marriage. All legally married same-sex couples will be treated as married for all federal tax purposes, including income and gift and estate taxes.

IMPACT.

Under the place of celebration approach used by the IRS, a couple that marries in a state that recognizes same-sex marriage and subsequently moves to a state that does not recognize same-sex marriage will continue to be treated as married for all federal tax purposes. The IRS has taken the same approach to common law marriages for over 50 years.

IMPACT.

The Supreme Court did not strike down Section 2 of DOMA, which provides that states do not have to recognize same-sex marriages recognized in other states. The result is a patchwork of laws, with some states recognizing same-sex marriage and others not. As of the time this Briefing was prepared, 13 states and the District of Columbia recognized same-sex marriage.

Filing Status. The IRS announced different rules for different tax years:

  • ? Tax Year 2013 and Subsequent Years. For tax year 2013 and beyond, same-sex spouses generally must file using a married filing separately or jointly filing status.

  • ? Prior Tax Years. For tax year 2012, and all prior tax years, same-sex spouses who file an original tax return on or after September 16, 2013 (the effective date of Rev. Rul. 2013-17), generally must file using a married filing separately or jointly filing status. For tax years 2011 and earlier, same-sex spouses who filed their tax returns timely may choose, but are not required, to amend their federal tax returns to file using a married filing separately or jointly filing status, provided the period of limitations for amending the return has not expired.

STRATEGY.

Married same-sex couples should explore the potential benefits of filing amended returns for open tax years. Generally, the limitations period for filing a refund claim is three years from the date the return was filed or two years from the date the tax was paid, whichever is later. Some taxpayers may have filed protective claims to keep the limitations period open for certain years.

IMPACT.

Along with filing status, IRS recognition of same-sex marriage nationwide allows same-sex couples to take advantage of many tax incentives that include special rules for married filing jointly taxpayers, such as the adoption credit.

Employee Benefits. As a result of DOMA, taxpayers may have paid taxes on the fair market value of employer-provided health care coverage for their same-sex spouse.

In Notice 2013-61, the IRS announced two optional special administrative procedures for employers to make claims for refunds or adjustments of employment taxes for certain benefits paid to same-sex spouses. Under the first procedure, employers may use the fourth quarter 2013 Form 941, Employer's Quarterly Federal Tax Return, to correct any overpayments of employment taxes for the first three quarters of 2013. Under the second procedure, employers may file one Form 941-X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund, for the fourth quarter of 2013 to correct any overpayments of FICA taxes for all quarters of 2013.

Domestic Partners. IRS recognition of same-sex marriage does not apply to registered domestic partners, individuals in a civil union, or similar relationships. Taxpayers in these types of relationships must continue to file their federal income tax returns as single individuals, even if they are able to file state returns jointly. Registered domestic partners may not file as married filing jointly or married filing separately, because the individuals are not considered married or spouses for federal tax purposes.

IMPACT.

A registered domestic partner can itemize his or her deductions regardless of whether his or her partner itemizes or claims the standard deduction. Although Code Sec. 63(c)(6)(A) prohibits a taxpayer from itemizing deductions if the taxpayer's spouse claims the standard deduction, this provision does not apply to registered domestic partners because they are not considered married for federal tax purposes.

LIFE CYCLE CHANGES IMPORTANT TO YEAR-END STRATEGIES

In addition to changes in the tax law, year-end tax strategies should also consider personal circumstances that changed during 2013 as well as what may change in 2014. These "life cycle" changes include:

  • ? Change in filing status: marriage, divorce, death or head of household changes

  • ? Birth of a child

  • ? Child no longer young enough for child credit

  • ? Child who has outgrown the "kiddie" tax

  • ? Casualty losses

  • ? Changes in medical expenses

  • ? Moving/relocation

  • ? College and other tuition expenses

  • ? Employment changes

  • ? Retirement

  • ? Personal bankruptcy

  • ? Large inheritance

  • ? Business successes or failures

ESTATE AND GIFT TAXES

After a number of years during which significant uncertainty existed over the federal estate and gift tax system, ATRA finally provided a permanent structure under which planning can now take place. ATRA permanently provides for a maximum federal unified estate and gift tax rate of 40 percent with an inflation-adjusted $5 million exclusion for gifts made and estates of decedents dying after December 31, 2012.

IMPACT.

The applicable exclusion amount, as adjusted for inflation, is $5,250,000 for gifts made and estates of decedents dying in 2013. The exclusion is projected to increase to $5,340,000 in 2014.

ATRA also preserved the annual gift tax exclusion. This exclusion allows taxpayers to give up to an inflation-adjusted $14,000 to any individual, gift tax free and without counting the amount of the gift toward the lifetime $5 million exclusion, adjusted for inflation.

IMPACT.

The $14,000 limit applies to 2013 gifts. The same $14,000 limit is projected for 2014.

There is no limit on the number of individual donees to whom gifts may be made under the $14,000 exclusion. Spouses may "split" their gifts to each donee, effectively raising the per donee annual maximum exclusion to $28,000. Spouses may give an unlimited amount of gifts to one another without any gift tax imposed.

STRATEGY.

Maximizing each year's annual gift tax exclusion (now at the $14,000 level) has been a traditional year-end tax strategy that should continue post-ATRA. The annual exclusion cannot be carried over and added onto next year's exclusion; it is a classic use-it-or-lose-it benefit. For example, $14,000 given to Individual X on December 31, 2013, and another $14,000 given to Individual X on January 1, 2014 are both gift tax free. If a split gift election between spouses is made, those gifts may be doubled to a $56,000 maximum given tax free. Funds given to support a dependent do not count toward the $14,000 limit; nor do funds given directly to college to pay tuition or to a medical service provider.

STRATEGY.

Gifts of appreciated property are counted for purposes of the annual exclusion and gift tax, in general, at their market value, rather than the donor's basis. However, the donor's basis must be used in computing any gain on a subsequent sale by the donee. Frequently, a donee may be in a lower tax bracket than the donor, therefore gifting appreciated property potentially saves income tax as well as gift tax. In particular, those donees currently within the 10 or 15 percent rate income tax bracket may realize a zero percent capital gain tax. "Kiddie tax"implications (in which the donee may be taxed at the same rate as the donor), however, must be considered within this strategy.

PLANNING FOR BUSINESSES

Businesses seeking to maximize tax benefits through 2013 year-end tax planning may want to consider two general strategies:

(1)

Use of traditional timing techniques for income and deductions; and

(2)

Special consideration of significant tax incentives (known as tax extenders) scheduled to expire at the end of 2013.

IMPACT.

Business incentives scheduled to end with 2013 include bonus depreciation, enhanced Code Sec. 179 expensing, the Work Opportunity Tax Credit, and many other business-friendly provisions. Although Congress has routinely renewed these tax extenders in the past, current politics over budget concerns, and the impression that the economy may no longer need extraordinary stimulus measures, may point to 2013 year-end as the last occasion for businesses to take advantage of one or more of these special benefits.

IMPACT.

Ultimately, the fate of many of the tax extenders may be decided when Congress takes up comprehensive tax reform. However, as partisan politics continue in Washington, prospects steadily diminish for a "grand bargain" in which the extenders would carry a January 1, 2014 effective date.

New for business owners. Businesses should also be aware of those tax rules that are new-for-2013. In particular, increased tax rates on higher-income individuals effective for 2013 may impact business strategies directed toward minimizing taxes for business owners with either pass-through or dividend income. Also important for year-end 2013, are tax strategies in connection with recently-issued final "repair" regulations.

Code Section 179 Expensing

An enhanced Code Sec. 179 expense deduction is available through 2013 to taxpayers (other than estates, trusts or certain noncorporate lessors) that elect to treat the cost of qualifying property (Code Sec. 179 property) as an expense rather than a capital expenditure. The annual dollar limitation on Code Sec. 179 expensing for tax years beginning in 2012 and 2013, as increased by ATRA, is $500,000. Similarly, for tax years beginning in 2012 and 2013, an annual $2 million overall investment limitation applies before the maximum $500,000 deduction must be reduced, dollar-for-dollar, for amounts above that $2 million amount.

IMPACT.

The Code Sec. 179 deduction phases out completely in a tax year beginning in 2013 if the taxpayer places more than $2.5 million of Code Sec. 179 property in service. In contrast, for tax years beginning after 2013, that dollar limit is scheduled to plummet under current law to $25,000 unless otherwise extended by Congress. The phase-out ceiling is also scheduled to drop to $200,000 in 2014 unless otherwise extended by Congress. As a result, purchases of otherwise qualifying property in excess of only $225,000 in 2014 will reduce the Code Sec. 179deduction to $0.

STRATEGY.

A business could maximize its benefits under Code Sec. 179 by expensing property that does not qualify for bonus depreciation (such as used property) and property with a long modified accelerated cost recovery system (MACRS) depreciation period. For example, given the choice between expensing an item of MACRS five-year property and an item of MACRS 15-year property, the 15-year property should generally be expensed since it takes 10 additional tax years to recover its cost through annual depreciation deductions as opposed to recovery of the cost of the five-year property.

Carry forward. The Code Sec. 179 deduction is also limited to the taxpayer's taxable income derived from the active conduct of any trade or business during the tax year, computed without taking into account any Code Sec. 179 deduction, deduction for selfemployment taxes, net operating loss carryback or carryover, or deductions suspended under any provision. Any amount disallowed by this limitation may be carried forward and deducted in subsequent tax years, subject to the maximum dollar and investment limitations, or, if lower, the taxable income limitation in effect for the carryover year.

STRATEGY.

Since the maximum dollar limit for 2014 is scheduled to fall to $25,000 (unless the $500,000 amount is extended to at least the same degree by Congress), business should not assume that a carryover will be fully absorbed immediately in 2014. Monitoring 2013 taxable income in 2013 for this purpose therefore is important within an overall Code Sec. 179 strategy.

Qualifying property. Code Sec. 179 property is generally defined as new or used depreciable tangible Code Sec. 1245 property that is purchased for use in the active conduct of a trade or business. Off-the-shelf computer software is also included for 2013 in the definition of qualifying property as is some real property (discussed below).

STRATEGY.

Under current law, off-the-shelf computer software and certain real property will not qualify for Code Sec. 179 expensing after 2013, even at the lower $25,000 ceiling. This makes year-end strategies that take advantage of them in 2013 particularly critical.

Qualified real property. The Code Sec. 179 expensing allowance for qualified real property, is scheduled to expire for property placed in service after 2013. Qualified real property for expensing purposes includes qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.

Code Sec. 179 expensing versus bonus depreciation. Unlike Code Sec. 179 expensing, there is no dollar cap on the amount of bonus depreciation that a business may claim (Bonus depreciation is discussed below). Additionally, Code Sec. 179 property encompasses used property, while bonus depreciation is limited to first-use by the taxpayer.

COMMENT 

Bonus depreciation is keyed to a calendar year and generally ends after December 31, 2013. Rules for 2013 Code Sec. 179 expensing, on the other hand, apply for tax years beginning in 2013.

Bonus Depreciation

ATRA generally allows for 50 percent bonus depreciation during 2012 and 2013. After 2013, bonus depreciation is scheduled to expire (except for certain noncommercial aircraft and longer production period property which may be eligible for 50 percent bonus depreciation through 2014).

Qualifying property. Qualified property for bonus depreciation purposes must be depreciable under the Modified Accelerated Cost Recovery System (MACRS) and have a recovery period of 20 years or less. These requirements encompass a wide variety of assets. The property must be new and placed in service (as well as acquired) before January 1, 2014 (placed in service before January 1, 2015 for certain noncommercial aircraft and longer production period property).

STRATEGY.

Unlike regular depreciation, under which half or quarter year conventions may be required, a taxpayer is entitled to the full, 50-percent bonus depreciation irrespective of when during the year the asset is purchased. Year-end placed-in-service strategies therefore can provide an almost immediate "cash discount" for qualifying purchases, even when factoring in the cost of business loans to finance a portion of those purchases.

STRATEGY.

Although a bonus-depreciation election should be factored into a year-end strategy, a final decision on making it is not required until a return is filed. Further, bonus depreciation is not mandatory. Certain taxpayers should consider electing out of bonus depreciation to spread depreciation deductions more evenly over future years.

CAUTION.

Bonus depreciation's placed-in-service deadline for certain noncommercial aircraft and property with a longer production period was extended by ATRA for an additional year, but its acquisition date remains at before January 1, 2014, as under the general rule. Property acquired pursuant to a written binding contract entered into before January 1, 2014, is deemed acquired before January 1, 2014.

Luxury car depreciation caps. Along with the sunset of bonus depreciation, the additional $8,000 first-year depreciation cap for passenger automobiles under Code Sec. 280F to account for bonus depreciation is scheduled to expire after 2013.

STRATEGY.

The scheduled sunsetting of the additional $8,000 first-year depreciation amount may give businesses an additional incentive to purchase (and place into service) a vehicle before year-end 2013. The additional $8,000 amount could be extended by Congress as in the past but there is no guarantee that it will do so again.

Final Repair/Capitalization Regulations

In September 2013, the IRS released much-anticipated final "repair" regulations that explain when taxpayers must capitalize costs and when they can deduct expenses for acquiring, maintaining, repairing and replacing tangible property. The final regulations make many significant taxpayer-friendly changes to temporary regulations issued in 2011. The final regulations are considered to challenge virtually every business because of their broad application.

Compliance timetable. The final regulations apply to tax years beginning on or after January 1, 2014, but provide taxpayers with the option to apply either the final or temporary regulations to tax years beginning after 2011 and before 2014. The IRS has promised critical "transition guidance" later this year to help taxpayers deal with implementation regarding how to apply the regulations for years prior to 2014 as well as what change-of-accounting procedures should be followed.

STRATEGY.

As a result of the final regulation's optional retroactive effective date, some taxpayers may be better off putting certain procedures into place before the start of 2014 to maximize benefits; other taxpayers may consider filing amended returns for 2012 and 2013 to take advantage of certain elections provided in the final regulations. Under all circumstances, taxpayers must use only permissible procedures in their tax years beginning in 2014. Because of all these immediate options and requirements, taxpayers should work on integrating a response to the final regulations as part of their 2013 year-end planning, and have a definite plan in place before mandatory rules become effective on January 1, 2014.

De minimis expensing alternative. The final regulations also include a new de minimis expensing rule that allows taxpayers to deduct certain amounts paid or incurred to acquire or produce a unit of tangible property. If the taxpayer has an Applicable Financial Statement (AFS), written accounting procedures for expensing amounts paid or incurred for such property under certain dollar amounts, and treats such amounts as expenses on its AFS in accordance with its written accounting procedures, the final regulations allow up to $5,000 to be deducted per invoice.

STRATEGY.

To take advantage of the $5,000 de minimis rule, taxpayers must have written book policies in place at the start of the tax year that specify a per-item dollar amount (up to $5,000) that will be expensed for financial accounting purposes. Calendar-year taxpayers, therefore, should have a policy in place by year-end 2013 to qualify for 2014.

STRATEGY.

For smaller businesses, the final regulations added a safe harbor for taxpayers without an AFS. The per-item or invoice threshold amount in that case is $500.

15-Year Recovery For Leasehold/Retail Improvements, Restaurant Property

ATRA extended through 2013 the 15-year recovery period for qualified leasehold improvements, qualified retail improvements and qualified restaurant property. To qualify for this accelerated recovery period, the qualifying property must be placed in service before January 1, 2014.

Qualified restaurant property is any Code Sec. 1250 property that is a building or an improvement to a building. More than 50 percent of the building's square footage must be devoted to preparation of meals and seating for on-premise consumption of prepared meals.

Qualified leasehold improvement property is any improvement made by the lessor or lessee under or pursuant to the terms of a lease to an interior part of a building that is nonresidential real property that is more than three years old.

Qualified retail improvement property is any improvement to an interior portion of nonresidential real property that has been in service for more than three years. The improved interior portion must be open to the general public and used in the retail trade or business of selling tangible personal property.

Work Opportunity Tax Credit

Eligibility for the Work Opportunity Tax Credit (WOTC) ends on December 31, 2013. Among other requirements, an employer must hire members of certain targeted groups and have those individuals start work before January 1, 2014.

Targeted groups. Targeted groups include qualified individuals in families receiving certain government benefits, individuals who receive supplemental Social Security Income or long-term family assistance, and veterans.

Amount. The credit is generally equal to 40 percent of the qualified worker's first-year wages up to $6,000 ($3,000 for summer youths and $12,000, $14,000, or $24,000 for certain qualified veterans). For long-term family aid recipients, the credit is equal to 40 percent of the first $10,000 in qualified first year wages and 50 percent of the first $10,000 of qualified second-year wages.

Advanced certification required. On or before the day the employee begins work, the employer must receive a written certificate from the designated local agency (DLA) indicating that the employee is a member of a specific targeted group. Employers can use Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit, to obtain the certification.

Research Tax Credit

ATRA extended the Code Sec. 41 research tax credit through 2013. The research credit may be claimed for increases in business-related qualified research expenditures and for increases in payments to universities and other qualified organizations for basic research. The credit applies to excess of qualified research expenditures for the tax year over the average annual qualified research expenditures measured over the four preceding years.

COMMENT 

Although the research tax credit enjoys significant bipartisan support in Congress, the Obama Administration, and the business community, its estimated $14.3 billion 10-year revenue cost for making it permanent will likely persuade Congress once again to enact a one- or two-year extension of the credit, and perhaps waiting to do so retroactively sometime in 2014.

Small Business Stock

To encourage investment in small businesses and specialized small business investment companies (SSBICs), Code Sec. 1202(a) allows a noncorporate taxpayer to exclude from gross income a specified percent of the gain realized from the sale or exchange of qualified small business stock held for more than five years. As extended by ATRA, a full 100-percent exclusion applies to qualified small business stock that is acquired after September 27, 2010, and before January 1, 2014, and held for more than five years. Under current law, the percentage that is excluded reverts to 50-percent (60-percent for empowerment zone stock) for qualifying stock acquired after December 31, 2013.

COMMENT 

Eligible gain from the disposition of qualified stock of any single issuer is subject to a cumulative limit for any given tax year is equal to the greater of: (1) $10 million ($5 million for married taxpayers filing separately), reduced by the total amount of eligible gain taken in prior tax years; or (2) 10 times the taxpayer's adjusted basis in all qualified stock of a corporation disposed of during the tax year.

STRATEGY.

Year-end planning for 2013 that takes advantage of the sunsetting 100 percent exclusion requires attention to two dates: (1) The Code Sec. 1202 stock must be acquired before January 1, 2014, which in turns requires steps taken by the corporation under state law or otherwise to issue such stock; and (2) taxpayers who hold such shares need to wait five-years before disposition; even being a single day short of the five-year period - measured from the acquisition date - eliminates any benefit, with no proration allowed. Certain exchanges of similar stock before the five year period however are permitted.

Recognition Period for S Built-in Gains

A corporate-level tax, at the highest marginal rate applicable to corporations, is imposed on an S corporation's net recognized built-in gain (for example, gain that arose prior to the conversion of a C corporation to an S corporation that is recognized by the S corporation during the recognition period). That recognition period, specified under Code Sec. 1374, is generally the 10-year period beginning with the first day of the first taxable year for which the corporation becomes an S corporation. ATRA extended a reduced recognition period of five years through 2013.

STRATEGY.

The disposition of property with built-in gain before the end of 2013 should be considered for property already held for five years, or more. After December 31, 2013, that property must be held for 10 years unless Congress again changes the rule.

Other Provisions Sunsetting at Year End

Many more valuable business tax extenders are scheduled to expire after 2013. These tax benefits include:

  • ? New Markets Tax Credit;

  • ? Employer wage credit for activated military reservists;

  • ? Subpart F exceptions for active financing income;

  • ? Look through rule for related controlled foreign corporation payments;

  • ? Enhanced deduction for charitable contributions of food inventory;

  • ? Tax incentives for empowerment zones;

  • ? Indian employment credit;

  • ? Low-income tax credits for non-federally subsidized new buildings;

  • ? Low-income housing tax credit treatment of military housing allowances;

  • ? Treatment of dividends of regulated investment companies (RICs);

  • ? Treatment of RICs as qualified investment entities; and

  • ? Adjusted-basis reduction of stock after S corp. charitable donation of property.

COMMENT 

Some extenders were not extended by ATRA and have thus expired. Their supporters are likely to fight for renewal in 2014. These include brownfields remediation expensing and tax incentives for the District of Columbia.

ENERGY INCENTIVES

Energy tax incentives should be considered within a taxpayer's overall year-end tax strategy. ATRA extended a number of energy tax incentives, primarily business-related credits, but also some consumer oriented benefits. With sunset looming, taxpayers should weigh the value of these incentives, and take appropriate action before year-end.

Code Sec. 25C Nonbusiness Energy Property Credit

ATRA extended the Code Sec. 25C nonbusiness energy property credit through December 31, 2013. This nonrefundable credit is available for qualified energy efficiency improvements (building envelope components such as energy efficient doors and windows), and residential energy property expenditures (such as energy efficient heat pumps, furnaces, central air conditioning systems and water heaters). The lifetime aggregate amount of the credit that may be claimed by a taxpayer cannot exceed certain maximum amounts. Among them is an overall $500 lifetime limit for the credit, as well as a $200 cap for exterior windows and doors.

STRATEGY.

Proof that installation has occurred on or before January 1, 2014, is essential due to this credit's sunset date. In addition, the qualified energy efficiency improvements and qualified energy property must be installed in or on a United States dwelling unit owned by the taxpayer and used as his or her principal residence. The property must originally be placed in service by the taxpayer, and there must be a reasonable expectation that the qualified energy efficiency improvements will remain in use for at least five years.

COMMENT 

The Code Sec. 25D residential energy efficient property credit, by contrast, is not scheduled to expire after 2013. The Code Sec. 25D credit rewards taxpayers who make energy efficient improvements, such as installing small wind turbines and other qualified property before 2017.

Plug-in Elective Drive Motor Vehicle Credit

Code Sec. 30D provides a credit for Qualified Plug-in Electric Drive Motor Vehicles, including passenger vehicles and light trucks. The total amount of the credit allowed for a vehicle is limited to $7,500. For qualified 2- or 3-wheeled plug-in electric drive vehicles, the cap is the lesser of $2,500 or 10 percent of its cost.

COMMENT 

The credit begins to phase out for a manufacturer's vehicles when at least 200,000 qualifying vehicles have been sold for use in the United States (determined on a cumulative basis for sales after December 31, 2009). Eligible vehicles include the 2012-2014 Ford Focus Electric; the 2013 Ford Fusion Energi, the 2013 Ford C-MAXEnergi, and the 2011-2012 Nissan LEAF.

STRATEGY.

To be entitled to the credit, original use must start with the taxpayer. For a 2013 credit, the vehicle must be acquired by the taxpayer by year-end 2013. The credit for qualified 2- or 3-wheeled vehicles ends after 2013; the four-wheel vehicle credit continues until manufacturer sales exceed the 200,000 threshold.

Renewable Resources Credit

ATRA modified the Code Sec. 45 renewable electricity production tax credit for electricity produced from wind and other qualified facilities. ATRA replaced certain placed-inservice deadlines with new deadlines and revised certain definitions, including the term "municipal solid waste." The amount of the credit varies depending on the type of technology.

More Expiring Energy Credits

Other energy tax incentives scheduled to expire after 2013 include:

  • ? Credits for alternative fuel vehicle refueling property;

  • ? Credits for cellulosic biofuel production;

  • ? Credits for biodiesel and renewable diesel;

  • ? Production credits for Indian coal facilities;

  • ? Credit for energy-efficient new home construction;

  • ? Credit for energy-efficient appliance manufacture;

  • ? Allowance for cellulosic biofuel plant property;

  • ? Special rules for sales of electric transmission property; and

  • ? Tax credits and outlay payments for ethanol.

TRADITIONAL INCOME AND DEDUCTIONS DEFERRAL/ACCELERATION STRATEGIES

Year-end 2013 presents unique challenges. Traditional year-end planning techniques nevertheless remain important both to maximize benefits in connection with what's new and to do so within the usual ebb and flow of the taxpayer's personal economy. The following traditional income and deduction acceleration techniques and their reciprocal deferral strategies should be considered:

Income Deferral/Acceleration:

  • ? Enter into/ Sell installment contracts

  • ? Defer/ Receive bonuses before January

  • ? Hold/ Sell appreciated assets

  • ? Hold/ Redeem U.S. Savings Bonds

  • ? Accumulate/ Declare special dividend

  • ? Postpone/ Complete Roth conversions

  • ? Delay/ Accelerate debt forgiveness income

  • ? Minimize/ Maximize retirement distributions

  • ? Delay/ Accelerate billable services

  • ? Structure/ Avoid mandatory like-kind exchange treatment

Deductions and Credits Acceleration/Deferral

  • ? Bunch itemized deductions into 2013 and take standard deduction into 2014/reverse steps

  • ? Pay bills in 2013/ Postpone payments until 2014

  • ? Pay last state estimated tax installment in 2013/ delay payment until 2014

  • ? Accelerate economic performance/ postpone performance

  • ? Watch AGI limitations on deductions/credits

  • ? Watch net investment interest restrictions

  • ? Match passive activity income and losses

AFFORDABLE CARE ACT

When Congress passed the Affordable Care Act in 2010, it delayed the effective date of several key provisions until 2014. In July 2013, the Obama administration announced a further delay in the Affordable Care Act's employer shared responsibility payment provision (also known as the employer mandate). The individual shared responsibility provision (known as the individual mandate) has not been delayed and starting in 2014, individuals must carry health insurance or otherwise pay a penalty unless exempt.

Employer Mandate

The Affordable Care Act requires that an applicable large employer pay an assessable payment if either:

  • ? The employer fails to offer to its full-time employees (and their dependents) the opportunity to enroll in minimum essential coverage under an eligible employer-sponsored plan and any full-time employee is certified to the employer as having received a premium assistance tax credit or cost-sharing reduction; or

  • ? The employer offers its full-time employees (and their dependents) the opportunity to enroll in minimum essential coverage under an eligible employer-sponsored plan and one or more full-time employees is certified as having received a premium assistance tax credit or cost-sharing reduction.

These two methods of calculating the tax are mutually exclusive for any particular period. The amount of the assessable payment for an employer that does offer coverage to its full-time employees is capped so that it can never exceed the assessable payment if it had not offered coverage. The IRS in proposed regulations has softened the rules somewhat by treating an employer as offering coverage to its full-time employees even if it fails to offer coverage to up to 5 percent of them.

IMPACT.

Code Sec. 4980H defines an applicable large employer with respect to a calendar year as an employer that employed an average of at least 50 full-time equivalent employees on business days during the preceding calendar year. Proposed regulations issued by the IRS treat 130 hours of service in a calendar month as the monthly equivalent of 30 hours of service per week. Hours worked by part-time employees (individuals working fewer than 30 hours per week) are converted into FTEs and are included in the calculation used to determine whether a firm is a large employer. Seasonal workers are excluded from this calculation if the number of full-time employees and FTEs exceeds 50 for 120 days or less during the preceding calendar year, and the employees in excess of 50 during those days are seasonal workers.

Delay. In July 2013, the Obama administration announced that employer (and insurer) reporting requirements (discussed below) under the Affordable Care Act will be delayed for an additional year (to 2015). As a result, the administration also delayed the employer mandate for one additional year (to 2015).

STRATEGY.

Part-time employees (those working fewer than 30 hours per week) are counted to determine employer size. However, penalties are assessed only with respect to full-time employees that work 30 or more hours per week. The testing period for the average 50 full-time employee threshold under the employer mandate is generally the preceding calendar year with some transition relief available. For the 2015 mandate, therefore, staffing numbers starting January 1, 2014 will be immediately relevant and may call for a taxpayer's review of its workforce as part of 2013 year-end planning.

Employer and Insurer Reporting

The Affordable Care Act generally requires applicable large employers to file an information return (known as a Code Sec. 6056 return) that reports the terms and conditions of the health care coverage provided to the employer's full-time employees for the year. Health insurance issuers, sponsors of self-insured health plans, government agencies, and other entities that provide minimum essential coverage must file similar information returns (known as Code Sec. 6055 returns). Following the White House's announcement of the delay in employer and insurer reporting, the IRS issued transition relief and proposed regulations.

IMPACT.

Under proposed regulations, an applicable large employer would generally report information about coverage (including contact information for the employer and the number of full-time employees) as well as a list of full-time employees and information about coverage offered to each, by month, including the cost of self-only coverage. Applicable large employers also must furnish Code Sec. 6056 statements to qualified employees. The statements would describe, among other things, information about coverage.

IMPACT.

Because of the delay in reporting, Code Sec. 6056 returns must be filed with the IRS no later than February 28 (March 31 if filed electronically) of the year immediately following the calendar year to which the return relates. The IRS explained that the first Code Sec. 6056 returns required to be filed for calendar year 2015 must be filed no later than March 1, 2016 (February 28, 2016 falls on a Sunday) or March 31, 2016, if filed electronically. Employee statements must be furnished on or before January 31 of the year immediately following the calendar year to which the employee statement relates. The first Code Sec. 6056 employee statements (statements for 2015) must be furnished no later than February 1, 2016 (January 31, 2016 falls on a Sunday), the IRS explained.

STRATEGY.

The IRS has encouraged voluntary compliance with the employer and insurer information reporting requirements for 2014 and is expected to issue additional guidance before January 1, 2014. Additionally, electronic filing of Code Sec. 6056 returns is required except for an applicable large employer filing fewer than 250 returns during the calendar year. All returns (including Forms W-2) are aggregated for the purpose of applying the 250-return threshold, the IRS explained. Code Sec. 6056 employee statements may be provided electronically if notice, consent and other requirements are met.

W-2 Reporting

Separate from Code Sec. 6056 reporting (discussed above), the PPACA requires employers that provide applicable employer-sponsored coverage to report the cost of that coverage on the employee's Form W-2, Wage and Tax Statement. Small employers - generally employers filing fewer than 250 Forms W-2 for the previous calendar year - are temporarily exempt from reporting. Other entities, such as multi-employer plans, are also eligible for the temporary relief.

IMPACT.

At the time this Briefing was prepared, the IRS had not announced any change in the temporary relief available to small employers and others. The IRS has advised that when the temporary relief is terminated, it will give small employers and others sufficient lead time to plan to meet the reporting requirements.

Individual Mandate

Beginning January 1, 2014, the Affordable Care Act generally requires individuals to carry minimum essential coverage for each month, qualify for an exemption or make a payment when filing his or her return. Minimum essential coverage for purposes of the individual mandate is employer-sponsored coverage, coverage through a state or federal Marketplace, Medicare, Medicaid, and other plans. Certain individuals may be exempt, including individuals whose income is below the minimum threshold for filing a return, members of a health care sharing ministry, individuals unlawfully present in the U.S., and others.

IMPACT.

The individual shared responsibility payment (penalty) is $95 in 2014 or the flat fee of one percent of taxable income, $325 in 2015 or the flat fee of two percent of taxable income, $695 in 2016 or 2.5 percent of taxable income (the $695 amount is indexed for inflation after 2016).

IMPACT.

An individual is treated as having coverage for a month so long as he or she has coverage for any one day of that month.

IMPACT.

Individuals who have short gaps in coverage will not be subject to the individual shared responsibility payment. Gaps of three months or less are generally allowed.

SELECTED AFFORDABLE CARE ACT EFFECTIVE DATES

Provision

Effective Date

Employer Mandate

Delayed to 2015

Individual Mandate

2014

Premium Assistance Tax Credit

2014

Employer Code Sec. 6055 Reporting

Delayed to 2015*

W-2 Health Care Reporting

Indefinite for Small Employers

*

Voluntary for 2014

STRATEGY.

Certain individuals must obtain an exemption certificate from a Marketplace to verify their exemption from the individual mandate. However, individuals who are not required to file a return are automatically exempt for that year.

Premium Assistance Tax Credit

The Affordable Care Act created the Code Sec. 36B premium credit to help offset the cost of health insurance coverage obtained through a Marketplace. Based upon the estimate made by the Marketplace, the individual can decide if he or she wants to have all, some, or none of the estimated credit paid in advance directly to the insurance company to be applied to monthly premiums. Taxpayers who do not opt for advance payment may claim the credit when they file their federal income tax return for the year.

IMPACT.

The Code Sec. 36B credit is linked to household income in relation to the federal poverty line (FPL). Generally, taxpayers whose household income for the year is between 100 percent and 400 percent of the federal poverty line for their family size may be eligible for credit. The credit for 2014 is based on the 2013 FPL guidelines.

IMPACT.

Eligibility for the Code Sec. 36B credit may be more widespread than initially apparent. For 2013, for residents of one of the 48 contiguous states or Washington, D. C., the following illustrates when household income would be between 100 percent and 400 percent of the federal poverty line: $11,490 (100%) up to $45,960 (400%) for one individual; $15,510 (100%) up to $62,040 (400%) for a family of two; $23,550 (100%) up to $94,200 (400%) for a family of four.

IMPACT.

The employer mandate penalty is triggered for an applicable large employer if one or more of its full-time employees obtains a premium tax credit. Lower paid employees are likely to qualify for the credit if they are not offered minimum essential coverage from the employer.

Small Employer Health Insurance Credit

The Affordable Care Act provides a tax credit to encourage eligible small employers to provide health insurance coverage to their employees. Starting in 2014, a taxpayer may claim the Code Sec. 45Rcredit for two-consecutive tax years, beginning with the first tax year in or after 2014 in which the eligible small employer attaches Form 8941, Credit for Small Employer Health Insurance Premiums, to its income tax return, or in the case of a tax-exempt eligible small employer, attaches Form 8941 to Form 990-T, Exempt Organization Business Income Tax Return. A taxpayer may claim the credit for tax years beginning in 2010 through 2013 without those years counting toward the two-consecutive tax year period.

IMPACT.

An eligible small employer for purposes of the Code Sec. 45R credit is an employer that has no more than 25 FTEs for the tax year, whose employees have average annual wages of less than $50,000 per FTE (adjusted for inflation after December 31, 2013), and that has a qualifying arrangement in effect that requires the employer to pay a uniform percentage (not less than 50 percent) of the premium cost of a qualified health plan offered by the employer to its employees through a SHOP Marketplace.

IMPACT.

For tax years beginning during or after 2014, the maximum Code Sec. 45R credit for an eligible small employer (other than a tax-exempt employer) is 50 percent of the employer's premium payments. The maximum credit for tax-exempt employers for those years is 35 percent. For 2010-2013, the maximum credit has been 35 percent for taxable employers and 25 percent for tax-exempt employers.

2012 AMERICAN TAXPAYER RELIEF ACT

Posted by Admin Posted on Jan 07 2013

2012 AMERICAN TAXPAYER RELIEF ACT

_____________________________________________________________________________________________________________________________________

President Signs Eleventh-Hour Agreement To Avert Fiscal Cliff

The tax side of the "Fiscal Cliff" has been averted. The U.S. Senate overwhelmingly passed legislation to avert the so-called fiscal cliff on January 1, 2013 by a vote of 89 to 8, sending the American Taxpayer Relief Act of 2012 (HR 8, as amended by the Senate) to the House, where it was similarly approved on January 1, 2013 by a vote of 257 to 167. The American Taxpayer Relief Act allows the Bush-era tax rates to sunset after 2012 for individuals with incomes over $400,000 and families with incomes over $450,000; permanently "patches"the alternative minimum tax (AMT); revives many now-expired tax extenders, including the research tax credit and the American Opportunity Tax Credit; and provides for a maximum estate tax of 40 percent with a $5 million exclusion. The bill also delays the mandatory across-the-board spending cuts known as sequestration. President Obama signed the bill into law on January 2, 2013.

IMPACT.

Individuals with incomes above the $450,000/$400,000 thresholds will pay more in taxes in 2013 because of a higher 39.6 percent income tax rate and a 20 percent maximum capital gains tax. Nevertheless, all taxpayers will find less in their paychecks in 2013 because of what the American Taxpayer Relief Act did not include: the new law effectively raises taxes for all wage earners (and those self-employed) by not extending the 2012 payroll tax holiday that had reduced OASDI taxes from 6.2 percent to 4.2 percent on earned income up to the Social Security wage base ($113,700 for 2013).

IMPACT.

The American Taxpayer Relief Act avoids draconian automatic sunset provisions that were scheduled to take effect after 2012 under the Bush-era tax cuts in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) (both as extended by subsequent legislation, including the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Relief Act). Without the American Taxpayer Relief Act, individual tax rates on all income groups would have increased, taxpayer-friendly treatment of capital gains and dividends would have completely disappeared, the child tax credit would have plummeted to $500, enhancements to education tax incentives would have ended, the federal estate tax would have reverted to a maximum rate of 55 percent, and many other popular but temporary incentives would no longer be available.

INDIVIDUAL INCOME TAX RATES

The American Taxpayer Relief Act of 2012 makes permanent for 2013 and beyond the lower Bush-era income tax rates for all, except for taxpayers with taxable income above $400,000 ($450,000 for married taxpayers, $425,000 for heads of households). Income above these levels will be taxed at a 39.6 percent rate.

IMPACT.

The 10, 15, 25, 28 and 33 percent marginal rates remain the same after 2012, as does the 35 percent rate for income between the top of the 33 percent rate (projected to be at $398,350 for most taxpayers) and the $400,000/$450,000 threshold at which the 39.6 percent bracket now begins.

Individual marginal tax rates of 10, 15, 25, 28, 33, and 35 percent at the end of 2012, therefore, are now set going forward at the same 10, 15, 25, 28, 33, and 35 rates, but with an additional 39.6 percent rate carved out from the old 35 percent bracket range. The fiscal cliff agreement also uses the same $400,000/$450,000 taxable income threshold to apply a higher capital gains and dividend rate of 20 percent, up from 15 percent (see discussion, at"Capital Gains and Dividends," below).

IMPACT.

The bracket ranges for the extension of the 35 percent rate now cover only a relatively small sliver of what had constituted the upper-income range. As projected for annual inflation, the range of the 35 percent tax bracket for 2013 because of the Bush-era rate extensions begins at $398,350, for all individual brackets, except half ($199,175) for married taxpayers filing separately. The 35 percent income bracket ranges for 2013, therefore, are:

  • ▪ $398,350 - $400,000 for single filers

  • ▪ $398,350 - $425,000 for heads of household

  • ▪ $398,350 - $450,000 for joint filers. surviving spouses

  • ▪ $199,175 - $225,000 for married filing separately

IMPACT.

Taxpayers who find themselves within the 39.6 percent marginal income tax bracket nevertheless also benefit from extension of all Bush-era rates below that level.

As with all tax bracket ranges, the new law directs that the $450,000/$400,000 beginning of the 39.6 percent bracket be adjusted for inflation after 2013 based upon the standard formula of Code Sec. 1 (f). Also relevant, however, the new law did not adopt recommendations that had been floated for several years that would lower the inflation-factor applied annually to all tax bracket ranges, thereby raising slightly more tax revenue each year.

COMMENT 

Full sunset of the Bush-era tax rates would have replaced the 10, 15, 25, 28, 33 and 35 percent rates with the Clinton-era rate schedule of 15, 28, 31, 36, and 39.6 percent.

COMMENT 

President Obama had initially proposed a $250,000/$200,000 threshold for higher rates. This proposal had been based upon a modified adjusted gross income (AGI) amount. The new law not only raises the dollar value but also simplifies that proposal by keying the $450,000/$400,000 threshold amounts to bottom-line taxable income.

COMMENT 

Although these rates are now made "permanent," nothing would stop Congress from reconsidering the entire tax rate structure again in the future, as part of overall tax reform or even earlier as debt ceiling negotiations get under way shortly.

Trusts and estates. The American Taxpayer Relief Act similarly retains the Bush-era tax rates for all bracket levels that apply to trusts and estates, except for the highest rate bracket. That top rate increases to 39.6 percent and, as confirmed by a Joint Committee on Taxation Legislation Counsel, applies to what was the entire 35-percent bracket range and, therefore, is projected to begin in 2013 for taxable income in excess of $11,950.

Marriage Penalty Relief

The American Taxpayer Relief Act extends all existing marriage penalty relief. Before EGTRRA, married couples experienced the so-called marriage penalty in several areas. EGTRRA gradually increased the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return. The 2010 Tax Relief Act extended EGTRRAs marriage penalty relief through 2012.

IMPACT.

Without marriage penalty relief, the standard deduction for married couples would be 167 percent of the deduction for single individuals rather than 200 percent. For joint filers in 2013, that would have meant a drop of $1,950, from $12,200 to $10,150.

EGTRRA also gradually increased the size of the 15 percent income tax bracket for a married couple filing a joint return to twice the size of the corresponding rate bracket for an unmarried individual filing a single return. The 2010 Tax Relief Act extended this treatment through 2012 only. Without that relief, the top of the 15 percent rate bracket in 2013 for married taxpayers filing jointly would be set at a projected $60,550 rather than $72,500.

CAPITAL GAINS/DIVIDENDS RATES

The American Taxpayer Relief Act raises the top rate for capital gains and dividends to 20 percent, up from the Bush-era maximum 15 percent rate. That top rate will apply to the extent that a taxpayer's income exceeds the thresholds set for the 39.6 percent rate ($400,000 for single filers; $450,000 for joint filers and $425,000 for heads of households).

All other taxpayers will continue to enjoy a capital gains and dividends tax at a maximum rate of 15 percent. A zero percent rate will also continue to apply to capital gains and dividends to the extent income falls below the top of the 15 percent income tax bracket?projected for 2013 to be $72,500 for joint filers and $36,250 for singles. Qualified dividends for all taxpayers continue to be taxed at capital gains rates, rather than ordinary income tax rates as prior to 2003.

IMPACT.

Absent the American Taxpayer Relief Act, the maximum tax rate on net capital gain of all noncorporate taxpayers would have reverted to 20 percent (10 percent for taxpayers in the 15 percent bracket) starting January 1, 2013.

The 28 and 25 percent tax rates for collectibles and unrecaptured Code Sec. 1250 gain, respectively, continue unchanged after 2012. Also unchanged is the application of ordinary income rates to short-term capital gains; only long-term capital gains, those realized on the sale or disposition of assets held for more than one year, can benefit from the reduced net capital gain rate.

Generally, dividends received from a domestic corporation or a qualified foreign corporation, on which the underlying stock is held for at least 61 days within a specified 121-day period, are qualified dividends for purposes of the reduced tax rate. Certain dividends do not qualify for the reduced tax rates and are taxed as ordinary income. Those include (not an exhaustive list) dividends paid by credit unions, mutual insurance companies, and farmers' cooperatives.

CAUTION 

Installment payments received after 2012 are subject to the tax rates for the year of the payment, not the year of the sale. Thus, the capital gains portion of payments made in 2013 and later is now taxed at the 20 percent rate for higher-income taxpayers.

COMMENT 

Starting in 2013, under the Patient Protection and Affordable Care Act (PPACA), higher income taxpayers must also start paying a 3.8 percent additional tax on net investment income (NII) to the extent certain threshold amounts of income are exceeded ($200,000 for single filers, $250,000 for joint returns and surviving spouses, $125,000 for married taxpayers filing separately). Those threshold amounts stand, despite higher thresholds now set for the 20 percent capital gain rate that previously had been proposed by President Obama to start at the same levels. The NII surtax thresholds are not affected by the American Taxpayer Relief Act. Starting in 2013, therefore, taxpayers within the NII surtax range must pay the additional 3.8 percent on capital gain, whether long-term or short-term. The effective top rate for net capital gains for many "higher-income" taxpayers thus becomes 23.8 percent for long term gain and 43.4 percent for shortterm capital gains starting in 2013.

CCH PROJECTED* TAX RATES FOR 2013

UNDER AMERICAN TAXPAYER RELIEF ACT OF 2012

Single Individuals


If taxable income is:

The tax will be:

Not over $8,925

10% of taxable income

Over $8,925 but not over $36,250

$892.50 plus 15% of the excess over $8,925

Over $36,250 but not over $87,850

$4,991.25 plus 25% of the excess over $36,250

Over $87,850 but not over $183,250

$17,891.25 plus 28% of the excess over $87,850

Over $183,250 to $398,350

$44,603.25 plus 33% of the excess over $183,250

Over $398,350 to $400,000

$115,586.25 plus 35% of the excess over $398,350

Over $400,000

$116,163.75 plus 39.6% of the excess over $400,000


Married Couples Filing Jointly


If taxable income is:

The tax will be:

Not over $17,850

10% of taxable income

Over $17,850 but not over $72,500

$1,785 plus 15% of the excess over $17,850

Over $72,500 but not over $146,400

$9,982.50 plus 25% of the excess over $72,500

Over $146,400 but not over $223,050

$28,45750 plus 28% of the excess over $146,400

Over $223,050 but not over $398,350

$49,919.50 plus 33% of the excess over $223,050

Over $398,350 but not over $450,000

$107,768.50 plus 35% of the excess over $398,350

Over $450,000

$125,846 plus 39.6% of the excess over $450,000


* The IRS is expected to release official 2013 tax rate tables shortly now that legislation has resolved the uncertainty surrounding the rates.

PERMANENT AMT RELIEF

The American Taxpayer Relief Act "patches" the AMT for 2012 and subsequent years by increasing the exemption amounts and allowing nonrefundable personal credits to the full amount of the individuals regular tax and AMT. Additionally, the American Taxpayer Relief Act provides for an annual inflation adjustment to the exemption amounts for years beginning after 2012.

The American Taxpayer Relief Act increases the 2012 exemption amounts to $50,600 for unmarried individuals; $78,750 for married taxpayers filing jointly and surviving spouses; and $39,375 for married taxpayers filing separately. The 2013 AMT exemption amounts are projected to be $80,750 for married filing jointly and qualified widow(er)s, $51,900 for single and head of household, and $40,375 for married taxpayers filing separately.

IMPACT.

Without the AMT patch, the AMT exemption amounts for 2012 would have been $33,750 for unmarried individuals; $45,000 for married taxpayers filing jointly and surviving spouses; and $22,500 for married taxpayers filing separately, down dramatically from the $48,450/$74,450/$37,225 levels of 2011. The latest patch immediately saves over 60 million taxpayers from being subject to AMT on returns about to be filed for the 2012 tax year.

IMPACT.

The American Taxpayer Relief Act provides that all nonrefundable personal credits are allowed to the full extent of the taxpayer's regular tax and AMT liability, effective for tax years beginning after 2011.

COMMENT 

Acting IRS Commissioner Steven Miller estimated that 80 to 100 million taxpayers may experience a delay in filing their 2012 returns if Congress failed to enact an AMT patch before year-end 2012.

COMMENT 

Although a "permanent" AMT patch is welcomed by many taxpayers, the future of the AMT itself could be decided later this year or next year if Congress tackles comprehensive tax reform. The AMT could, as some lawmakers have proposed, be abolished. President Obama previously proposed to replace at least part of the AMT with the so-called Buffett Rule as a part of comprehensive tax reform. The White House has explained the Buffett Rule in general terms as ensuring that taxpayers making over $1 million annually would pay an effective tax rate of at least 30 percent. In 2012, the Senate rejected the Paying a Fair Share Act, which would implement the Buffett Rule. It is unclear if Democrats will reintroduce the bill or whether it will be considered within the overall framework of possible tax reform later in 2013.

NO GRAND BARGAIN

The American Taxpayer Relief Act is nowhere close to the grand bargain as envisioned by the President and many lawmakers after the November elections. Effectively, it is a stop-gap measure to prevent the onus of the expiration of the Bush-era tax cuts from falling on middle income taxpayers. Congress must still address sequestration. Congress is likely to revisit tax policy and spending cuts when it tackles the expected increase on the nation's debt limit in February. Slowing the growth of entitlements, such as through a "chained-CPI"is certain to be a controversial topic in upcoming debates.

PEASE LIMITATION

The American Taxpayer Relief Act officially revives the "Pease" limitation on itemized deductions, which was eliminated by EGTRRA as extended by the 2010 Tax Relief Act. However, higher "applicable threshold" levels apply under the new law:

  • ▪ $300,000 for married couples and surviving spouses;

  • ▪ $275,000 for heads of households;

  • ▪ $250,000 for unmarried taxpayers; and

  • ▪ $150,000 for married taxpayers filing separately.

IMPACT.

The applicable threshold for the Pease limitation for 2013, as adjusted for inflation and as computed under the sunset rules, would have been $178,150 ($89,075 for individuals married filing separately). Thus, the American Taxpayer Relief Act does not call for a full revival of the Pease limitation at former levels.

COMMENT 

The dollar amounts are adjusted for inflation for tax years after 2013.

The Pease limitation, named after the member of Congress who sponsored the original provision, reduces the total amount of a higher-income taxpayer's otherwise allowable itemized deductions by three percent of the amount by which the taxpayer's adjusted gross income exceeds an applicable threshold. However, the amount of itemized deductions is not reduced by more than 80 percent. Certain items, such as medical expenses, investment interest, and casualty, theft or wagering losses, are excluded.

COMMENT 

President Obama has previously proposed to limit the value of all itemized deductions for "higher-income" taxpayers to 28 percent. Whether this proposal will replace or add to the Pease limitation in future tax proposals remains to be seen.

PERSONAL EXEMPTION PHASEOUT

The American Taxpayer Relief Act also officially revives the personal exemption phaseout rules, but at applicable income threshold levels slightly higher than in the past:

  • ▪ $300,000 for married couples and surviving spouses;

  • ▪ $275,000 for heads of households;

  • ▪ $250,000 for unmarried taxpayers; and

  • ▪ $150,000 for married taxpayers filing separately.

Under the phaseout, the total amount of exemptions that may be claimed by a taxpayer is reduced by two percent for each $2,500, or portion thereof (two percent for each $1,250 for married couples filing separate returns) by which the taxpayer's adjusted gross income exceeds the applicable threshold level.

IMPACT.

The applicable thresholds for the personal exemption phaseout for 2013 if full sunset had occurred would have been $178,150 for single taxpayers and $267,200 for married couples filing a joint return.

FEDERAL ESTATE, GIFT AND GST TAXES

The American Taxpayer Relief Act permanently provides for a maximum federal estate tax rate of 40 percent with an annually inflation-adjusted $5 million exclusion for estates of decedents dying after December 31, 2012.

IMPACT.

The maximum estate tax rate for estates of decedents dying after December 31, 2010 and before January 1, 2013 is 35 percent with a $5 million exclusion (indexed for inflation for 2012 at $5.12 million). Effective January 1, 2013, the maximum federal estate tax rate was scheduled to revert to 55 percent with an applicable exclusion amount of $1 million (not indexed for inflation), its levels before enactment of estate tax reform in 2001 and subsequent legislation.

COMMENT 

The federal estate tax almost appeared to be a deal-breaker in the Senate. Republicans wanted complete repeal while the President insisted on a 45 percent rate with a $3.5 million exemption.

COMMENT 

The most recent estate tax legislation, the 2010 Tax Relief Act, provided for a complicated application of the tax depending on the year in which the decedent died. First, the 2010 Tax Relief Act provided for a maximum estate tax rate of 35 percent for decedents dying after December 31, 2009 and before January 1, 2013, and an applicable exclusion amount of $5 million for decedents dying after December 31, 2009 and before January 1, 2013, Second, the 2010 Tax Relief Act allowed estates of decedent's dying in 2010 to opt out of the revived estate tax. Estates of decedents dying after December 31, 2009 and before January 1, 2011 had the option to elect not to apply the estate tax regime under the 2010 Tax Relief Act. Such estates could have elected to apply either (1) the estate tax based on the 2010 Tax Relief Act's 35 percent top rate and $5 million applicable exclusion amount, with stepped-up basis or (2) no estate tax and modified carryover basis rules under EGTRRA.

Portability

The American Taxpayer Relief Act makes permanent "portability" between spouses. Prior to the permanent extension, portability was only available to the estates of decedents dying after December 31, 2010 and before January 1, 2013.

IMPACT.

Portability allows the estate of a decedent who is survived by a spouse to make a portability election to permit the surviving spouse to apply the decedent's unused exclusion (the deceased spousal unused exclusion amount (DSUE)) to the surviving spouse's own transfers during life and at death.

State Death Tax Credit/Deduction

The American Taxpayer Relief Act extends the deduction for state estate taxes.

IMPACT.

Before 2005, a credit was allowed against the federal estate tax for state estate, inheritance, legacy, or succession taxes. EGTRRA repealed the state death tax credit for decedents dying after 2004 and replaced the credit with a deduction.

More Estate Tax Provisions

The American Taxpayer Relief Act extends a number of provisions affecting qualified conservation easements, qualified family-owned business interests (QFOBIs), the installment payment of estate tax for closely-held businesses for purposes of the estate tax, and repeal of the five percent surtax on estates larger than $10 million.

Gift Tax

The American Taxpayer Relief Act provides a 40 percent tax rate and a unified estate and gift tax exemption of $5 million (inflation adjusted) for gifts made after 2012.

COMMENT 

The 2010 Tax Relief Act provided that for gifts made after December 31, 2010, the gift tax was reunified with the estate tax, with a tax rate through 2012 of 35 percent and an applicable lifetime unified exclusion amount of $5 million (adjusted annually for inflation).

GST Tax

The American Taxpayer Relief Act provides for a 40 percent GST tax rate with a $5 million exemption and extends a number of GST tax-related provisions scheduled to expire after 2012. They include the GST deemed allocation and retroactive allocation provisions; clarification of valuation rules with respect to the determination of the inclusion ratio for GST tax purposes; provisions allowing for a qualified severance of a trust for purposes of the GST tax; and relief from late GST allocations and elections.

H.R. 8: SELECTED ESTIMATED REVENUE EFFECTS

Expenditures*


Retention of 10,25 and 28% Brackets

$654.8 billion

Child Tax Credit

$354.4 billion

Tax Dividends with 0/15/20% Rate Structure

$231 billion

American Opportunity Tax Credit

$67.2 billion

Marriage Penalty Relief

$55.6 billion

Earned Income Credit

$29 billion

Energy Tax Incentives

$18.1 billion

Research Tax Credit

$14.3 billion

Partial Repeal Of Pease Limitation/PEP

$10.5 billion


Revenue Raisers*


Transfers Of Amounts In Applicable Retirement Plans To Roth Accounts

$12.1 billion


Other Provisions


Sunset Of Payroll Tax Holiday

$93.2 billion**


* Over 10 years (revenue scoring is mandated for 10 years. Certain provisions are permanent, others expire after 2013 or subsequent years) (JCX-13-1).

**Over 10 years as projected in 2012 by the Joint Committee on Taxation (JCX-17-12).

Note. According to the Congressional Budget Office, the overall estimate of the budgetary effects of H.R. 8 over 10 years is $-3.63 trillion in revenues.

RETIREMENT SAVINGS

The American Taxpayer Relief Act makes a valuable change to the treatment of retirement savings and opens up an important planning opportunity. Generally, participants with 401(k)s and similar plans have been allowed to roll over funds to designated Roth accounts in the same plan subject to certain qualifying events or age restrictions. The American Taxpayer Relief Act lifts most restrictions, and now allows participants in 401(k) plans with in-plan Roth conversion features to make transfers to a Roth account at anytime. Congress made this change because conversion is a taxable event and will raise revenue.

STATE AND LOCAL SALES TAX DEDUCTION

The American Taxpayer Relief Act extends through 2013 the election to claim an itemized deduction for state and local general sales taxes in lieu of state and local income taxes.

IMPACT.

Because of the extension, taxpayers in states without income taxes continue to be able to elect to claim an itemized deduction for state (and local) general sales taxes.

CHILD TAX CREDIT

The American Taxpayer Relief Act extends permanently the $1,000 child tax credit. Certain enhancements to the credit under Bush-era legislation and subsequent legislation are also made permanent.

IMPACT.

Absent the American Taxpayer Relief Act, the child tax credit was scheduled to revert after 2012 to $500 per qualifying child (dependents under age 17 at the close of the year). The child tax credit has been set at the $1,000 level since 2003 and is not adjusted each year for inflation. The American Taxpayer Relief Act keeps the child tax credit at the $1,000 level, still without inflation adjustments, for future years.

IMPACT.

Bush-era and subsequent legislation modified the refundable component of the child tax credit, provided that the refundable portion of the credit does not constitute income, provided that the credit is allowable against regular income tax and AMT, repealed the AMT offset against the additional child tax credit for families with three or more children; and eliminated the supplemental child tax credit. The American Taxpayer Relief Act extends all these modifications as well.

COMMENT 

The current provision that reduces the earnings threshold for the refundable portion of the child tax credit to $3,000 is extended through 2017.

TAX REFORM SOLUTION?

Since passage of the 2010 Tax Relief Act, several proposals for comprehensive tax reform have been unveiled in Washington that may hold promise for a more permanent solution. A presidential panel developed the so-called Simpson-Bowles plan. The GOP has put forward several proposals for comprehensive tax reform, also calling for reduced individual income tax rates, while both parties have struggled to strike a "grand bargain." Later in 2013, a broader, more permanent solution may be found.

EARNED INCOME CREDIT

The American Taxpayer Relief Act makes permanent or extends through 2017 enhancements to the earned income credit (EIC) in Bush-era and subsequent legislation. The enhancements to the EIC made by Bush-era and subsequent legislation include (not an exhaustive list) a simplified definition of earned income, reform of the relationship test and modification of the tie-breaking rule. The IRS also has additional authority with respect to mathematical errors.

IMPACT.

Expiration of the EIC enhancements would result in the credit phaseout being determined by reference to modified adjusted gross income rather than adjusted gross income. The Bush-era legislation substituted adjusted gross income to reduce the number of calculations necessary to compute EIC.

OTHER CHILD-RELATED TAX RELIEF

Adoption Credit/Assistance

The American Taxpayer Relief Act extends permanently Bush-era enhancements to the adoption credit and the income exclusion for employer-paid or reimbursed adoption expenses up to $10,000 (indexed for inflation) both for non-special needs adoptions and special needs adoptions.

COMMENT 

The adoption credit phases out for taxpayers above specified inflation-adjusted levels of modified adjusted gross income. The phase-out level for 2012 started at $189,710. For 2013, the beginning point for phasing out the adoption credit is projected to be $191,530. The limit on the adoption credit is projected to be $12,770 for 2013.

Child And Dependent Care Credit

The American Taxpayer Relief Act extends permanently Bush-era enhancements to the child and dependent care credit. The current 35 percent credit rate is made permanent along with the $3,000 cap on expenses for one qualifying individual and the $6,000 cap on expenses for two or more qualifying individuals.

COMMENT 

Expenses qualifying for the child and dependent care credit must be reduced by the amount of any dependent care benefits provided by the taxpayer's employer that are excluded from the taxpayer's gross income. For 2012, total expenses qualifying for the credit are capped at $3,000 in cases of one qualifying individual or at $6,000 in cases of two or more qualifying individuals subject to income thresholds. For 2013, absent extension, these monetary amounts would have decreased to $2,400 in cases of one qualifying individual or $4,800 in cases of two or more qualifying individuals, subject to income thresholds.

COMMENT 

The amount of the credit under the American Taxpayer Relief Act continues to be adjusted gross income (AGI) sensitive. The credit is reduced by one percentage point for each $2,000 of AGI, or fraction thereof, above $15,000 through $43,000. Taxpayers with AGI over $43,000 are allowed a credit equal to 20 percent of employment-related expenses. Absent the American Taxpayer Relief Act, the AGI range would have been reduced to $10,000 through $28,000.

COMMENT 

The child and dependent care credit is intended to help individuals pay child and dependent care expenses so the taxpayer (if married, a joint return must be filed) can work or look for work. A child, for purposes of this tax benefit, must be under 13 years of age at the close of the tax year. A qualifying dependent who is disabled, however, may be of any age if he or she is a dependent, or spouse, who lives with the taxpayer for more than half the year. EGTRRA and subsequent legislation increased the maximum amount of eligible employment-related expenses for purposes of the dependent care credit and made other enhancements. The 2010 Tax Relief Act had extended these enhancements through 2012.

Employer-Provided Child Care Credit

The American Taxpayer Relief Act extends permanently the Bush-era credit for employer-provided child care facilities and services.

American Opportunity Tax Credit

The American Taxpayer Relief Act extends through 2017 the American Opportunity Tax Credit (AOTC). The AOTC is an enhanced, but temporary, version of the permanent HOPE education tax credit.

IMPACT.

The AOTC rewards qualified taxpayers with a tax credit of 100 percent of the first $2,000 of qualified tuition and related expenses and 25 percent of the next $2,000, for a total maximum credit of $2,500 per eligible student. Additionally, the AOTC applies to the first four years of a student's post-secondary education. The HOPE credit, in contrast, is less generous and applies to the first two years of a student's post-secondary education.

COMMENT 

The AOTC was one of the signature pieces in President Obama's American Recovery and Reinvestment Act of 2009 and the President has often urged Congress to make the AOTC permanent.

OTHER EDUCATION INCENTIVES

The American Taxpayer Relief Act makes permanent or extends a number of enhancements to tax incentives designed to promote education. Many of these enhancements were made in Bush-era legislation, extended by subsequent legislation and are scheduled to expire after 2012. Some enhancements, notably the American Opportunity Tax Credit, had been made in President Obama's first term.

Deduction For Qualified Tuition And Related Expenses

The American Taxpayer Relief Act extends until December 31, 2013 the above-the-line deduction for qualified tuition and related expenses. The bill also extends the deduction retroactively for the 2012 tax year.

COMMENT 

The above-the-line deduction for higher education tuition and related expenses expired after 2011. The higher education tuition deduction was created by EGTRRA and extended by subsequent laws, most recently by the 2010 Tax Relief Act, but only through the end of 2011.

IMPACT.

In 2011, the last year in which the deduction was available under current law, the deduction reached a maximum of $4,000 for taxpayers whose modified AGI did not exceed $65,000 ($130,000 for joint filers), and $2,000 for taxpayers whose modified AGI exceeded $65,000 but did not exceed $80,000 ($160,000 for joint filers)

COMMENT 

Taxpayers cannot claim the higher education tuition deduction in the same tax year that they claim the AOTC or the Lifetime Learning credit. A taxpayer also cannot claim the hither education tuition deduction if anyone else claims the AOTC or the Lifetime Learning credit for the student in the same tax year.

Student Loan Interest Deduction

The American Taxpayer Relief Act permanently suspends the 60-month rule for the $2,500 above-the-line student loan interest deduction. The American Taxpayer Relief Act also expands the modified adjusted gross income range for phaseout of the deduction permanently and repeals the restriction that makes voluntary payments of interest nondeductible permanently.

IMPACT.

Absent the American Taxpayer Relief Act, the 60-month limitation on the number of months during which interest paid on the student loan is deductible was scheduled to be revived after 2012.

Coverdell Education Savings Accounts

The American Taxpayer Relief Act extends permanently Bush-era enhancements to Coverdell education savings accounts (Coverdell ESAs). These enhancements include a $2,000 maximum contribution amount and treatment of elementary and secondary school expenses as well as post-secondary expenses as qualified expenditures.

IMPACT.

Absent the American Taxpayer Relief Act, the maximum contribution amount to a Coverdell ESA was scheduled to decrease from $2,000 to $500 after 2012.

COMMENT 

Under the American Taxpayer Relief Act, qualified educational expenses continue to include expenses incurred while attending an elementary, secondary or post-secondary school.

Employer-Provided Education Assistance

The American Taxpayer Relief Act extends permanently the exclusion from income and employment taxes of employer-provided education assistance up to $5,250.

COMMENT 

The employer may also deduct up to $5,250 annually for qualified education expenses paid on behalf of an employee.

Federal Scholarships

The American Taxpayer Relief Act makes permanent the exclusion from income for the National Health Service Corps Scholarship Program and the Armed Forces Scholarship Program.

MORE INDIVIDUAL TAX EXTENDERS

Teachers' Classroom Expense Deduction

The American Taxpayer Relief Act extends through 2013 the teacher's classroom expense deduction. The deduction, which expired after 2011, allows primary and secondary education professionals to deduct (above-the-line) qualified expenses up to $250 paid out-of-pocket during the year.

COMMENT 

Qualified expenses must be reduced by any reimbursements.

Exclusion Of Cancellation Of Indebtedness On Principal Residence

Cancellation of indebtedness income is includible in income, unless a particular exclusion applies. This provision excludes from income cancellation of mortgage debt on a principal residence of up $2 million. The American Taxpayer Relief Act extends the provision for one year, through 2013.

IMPACT.

Homeowners have struggled to keep up with their mortgage payments and have also faced declines in the value of their principal residence. This provision avoids further financial penalties.

Transit Benefits

The American Taxpayer Relief Act extends parity in transit benefits through December 31,2013. These benefits are a tax-free fringe benefit to employees. Parity in the exclusion limit expired after 2011.

Mortgage Insurance Premiums

This provision treats mortgage insurance premiums as deductible interest that is qualified residence interest. The American Taxpayer Relief Act extends this provision through December 31, 2013. The provision originally expired after 2011.

IMPACT.

This provision provides an additional itemized deduction by treating mortgage insurance premiums as deductible qualified residence interest.

Contribution of Capital Gains Real Property for Conservation

The Act extends for two years, through December 31, 2013, the special rule for contributions of capital gain real property for conservation purposes. The special rule allows the contribution to be taken against 50 percent of the contribution base. The Act also extends for two years the special rules for contributions by certain corporate farmers and ranchers.

IMPACT.

The special rule thus allows a larger charitable contribution.

IRA Distributions to Charity

The American Taxpayer Relief Act extends for two years, through December 31, 2013, the provision allowing tax-free distributions from individual retirement accounts to public charities, by individuals age 70½ or older, up to a maximum of $100,000 per taxpayer each year.

IMPACT.

The Act provides special transition rules. One rule allows taxpayers to recharacterize distributions made in January 2013 as made on December 31, 2012. The other rule permits taxpayers to treat a distribution from the IRA to the taxpayer made in December 2012 as a charitable distribution, if transferred to charity before February 1, 2013.

BUSINESS TAX PROVISIONS

Many popular but temporary tax extenders relating to businesses are included in the American Taxpayer Relief Act. Among them are Code Sec. 179 small business expensing, bonus depreciation, the research tax credit, and the Work Opportunity Tax Credit.

IMPACT.

Despite predictions by some lawmakers that Congress would allow some of the tax extenders to permanently expire after 2012 (or, for some provisions, like the research credit, to expire after 2011), the American Taxpayer Relief Act extends many extenders, albeit through 2013. Ultimately, the fate of many of the extenders thereafter may be decided if Congress takes up comprehensive tax reform.

Code Sec. 179 Small Business Expensing

The American Taxpayer Relief Act extends through 2013 enhanced Code Sec. 179 small business expensing. The Code Sec. 179 dollar limit for tax years 2012 and 2013 is $500,000 with a $2 million investment limit. The rule allowing off-the-shelf computer software is also extended.

IMPACT.

Without the American Taxpayer Relief Act, the Code Sec. 179 dollar limit for tax years beginning in 2012 would have been $125,000 (subject to inflation adjustment) with a $500,000 investment limit (again, subject to inflation adjustment). In tax years after 2012, the dollar limit would have reverted to $25,000 with a $200,000 investment limit. This significant decrease in the value of the incentive has now been postponed to tax years after 2013.

Bonus Depreciation

The American Taxpayer Relief Act extends 50 percent bonus depreciation through 2013. Some transportation and longer period production property is eligible for 50 percent bonus depreciation through 2014.

IMPACT.

Bonus depreciation has been used as an economic stimulus in many tax bills in recent years. One hundred percent bonus depreciation generally expired at the end of 2011 (with certain transportation and longer period production property eligible for 100 percent bonus depreciation through 2012).

IMPACT.

Bonus depreciation also relates to the vehicle depreciation dollar limits under Code Sec. 280F, which imposes dollar limitations on the depreciation deduction for the year in which a taxpayer places a passenger automobile in service within a business, and for each succeeding year. If bonus depreciation had not been extended, 2012 would have been the final year in which substantial first-year writeoffs for the purchase of a business automobile may be available.

COMMENT 

To be eligible for bonus depreciation, qualified property must be depreciable under the Modified Accelerated Cost Recovery System (MACRS) and have a recovery period of 20 years or less. These requirements encompass a wide variety of assets. The property must be new and placed in service before January 1, 2014 (January 1, 2015 for certain longer production period property and certain transportation property). Subject to the investment limitations, Code Sec. 179 expensing remains a viable alternative, especially for small businesses. Property qualifying under Code Sec. 179 expensing may be used or new, in contrast to bonus depreciation's ?first-use? requirement.

Research Tax Credit

The American Taxpayer Relief Act extends through 2013 the Code Sec. 41 research tax credit, which expired after 2011. The incentive rewards taxpayers that engage in qualified research activities with a tax credit.

IMPACT.

The research tax credit, which had expired at the end of 2011, enjoys significant bipartisan support in Congress and President Obama has called for making permanent the credit. One obstacle to its extension is its cost, which the Joint Committee on Taxation has estimated to be $14.3 billion over 10 years.

COMMENT 

Commonly called the research or research and development credit, the incremental research credit may be claimed for increases in business-related qualified research expenditures and for increases in payments to universities and other qualified organizations for basic research. The credit applies to excess of qualified research expenditures for the tax year over the average annual qualified research expenditures measured over the four preceding years.

Work Opportunity Tax Credit

The American Taxpayer Relief Act extends through 2013 the Work Opportunity Tax Credit (WOTC), which rewards employers that hire individuals from targeted groups with a tax credit.

IMPACT.

Under the revived WOTC, employers hiring an individual within a targeted group (generally, otherwise hard-to-employ workers) are eligible for a credit generally equal to 40 percent of first-year wages up to $6,000. The WOTC is part of the general business credit.

COMMENT 

The Vow to Hire Heroes Act of 2011 (Heroes Act) extended the WOTC for unemployed veterans and unemployed veterans with service-connected disabilities through 2012. The WOTC for qualified veterans can be as high as $9,600. The Heroes Act did not extend the non-veteran WOTC provisions. The American Taxpayer Relief Act extends the WOTC for qualified veterans as well as for those within prior targeted groups.

Qualified Leasehold/Retail Improvements, Restaurant Property

The American Taxpayer Relief Act extends through 2013 the 15-year recovery period for qualified leasehold improvements, qualified retail improvements and qualified restaurant property.

SEQUESTRATION DELAYED TWO MONTHS

The Budget Control Act of 2011 imposed sequestration (across-the-board spending cuts), effective after 2012. The American Taxpayer Relief Act temporarily postpones sequestration for two months. Approximately one-half of the delay will be paid for by allowing and taxing rollovers of funds from applicable retirement accounts (such as 401(k)s) to Roth IRAs. This treatment is estimated to raise $12.1 billion over 10 years.

MORE BUSINESS TAX EXTENDERS

A number of other business tax extenders expired after 2011 and they are extended through 2013 under the American Taxpayer Relief Act. They include, among others:

  • ▪ New Markets Tax Credit;

  • ▪ Employer wage credit for activated military reservists;

  • ▪ Subpart F exceptions for active financing income;

  • ▪ Look through rule for related controlled foreign corporation payments;

  • ▪ Railroad track maintenance credit;

  • ▪ Seven-year recovery period for motorsports entertainment complexes;

  • ▪ 100 percent exclusion for gain on sale of qualified small business stock;

  • ▪ Reduced recognition period for S corporation built-in gains tax;

  • ▪ Enhanced deduction for charitable contributions of food inventory;

  • ▪ Tax incentives for empowerment zones;

  • ▪ Indian employment credit;

  • ▪ Accelerated depreciation for business property on Indian reservations;

  • ▪ Special expensing rules for qualified film and television productions;

  • ▪ Mine rescue team training credit;

  • ▪ Election to expense advanced mine safety equipment;

  • ▪ Qualified zone academy bonds;

  • ▪ Low-income tax credits for non-federally subsidized new buildings;

  • ▪ Low-income housing tax credit treatment of military housing allowances;

  • ▪ Treatment of dividends of regulated investment companies (RICs);

  • ▪ Treatment of RICs as qualified investment entities;

  • ▪ S corporations making charitable donations of property;

  • ▪ New York Liberty Zone tax-exempt bond financing; and

  • ▪ Economic development credit for American Samoa.

Not extended. Certain business provisions were not extended by the American Taxpayer Relief Act. These include:

  • ▪ Enhanced deduction for corporate charitable contributions of book inventory;

  • ▪ Enhanced deduction for corporate charitable contributions of computers;

  • ▪ Tax incentives for the District of Columbia; and

  • ▪ Expensing of brownfields remediation costs

CONGRESS ALLOWS IRS TO LEVY ON THRIFT SAVINGS FUND ACCOUNTS

On January 1, 2013, the Senate approved by unanimous consent HR 4365, which clarifies that Thrift Savings Fund accounts are subject to federal tax levy. The House passed HR 4365 in July 2012.

The Federal Employees Retirement System Act of 1986 (FERSA) protects assets in Thrift Savings Fund accounts from levy, subject to certain exceptions. HR 4365 clarifies that the IRS can levy on Thrift Savings Fund accounts to collect unpaid taxes.

HR 4365 requires any revenue generated to be used solely for deficit reduction. In 2012, the Congressional Budget Office (CBO) estimated that HR 4365 would raise $24 million over 10 years.

ENERGY INCENTIVES

The American Taxpayer Relief Act extends a number of energy tax incentives, primarily business-related credits. The Act also extends the Code Sec. 25C non-business energy property credit.

Energy Credits For Individuals

The Code Sec. 25C credit is available to individuals who make energy efficiency improvements to their existing residence. The lifetime credit limit is $500 ($200 for windows and skylights) under the 2010 Tax Relief Act. The American Taxpayer Relief Act extends the credit at the $500 level through December 31, 2013.

Renewable Resources

The American Taxpayer Relief Act extends through 2013, the Code Sec. 45 production tax credit for facilities that produce energy from wind facilities. The Act also excludes recycled paper from the definition of municipal solid waste.

Other energy tax incentives extended by the American Taxpayer Relief Act through 2013, include:

  • ▪ Credits for alternative fuel vehicle refueling property;

  • ▪ Credits for cellulosic biofuel production;

  • ▪ Credits for biodiesel and renewable diesel;

  • ▪ Production credits for Indian coal facilities;

  • ▪ Credit for energy-efficient new homes;

  • ▪ Credit for energy-efficient appliances;

  • ▪ Allowance for cellulosic biofuel plant property;

  • ▪ Special rules for sales of electric transmission property; and

  • ▪ Tax credits and outlay payments for ethanol.

No extension. Certain incentives have not been extended by the American Taxpayer Relief Act:

  • ▪ Credits for refined coal facilities;

  • ▪ Percentage depletion for oil and gas from marginal wells (no longer suspended); and

  • ▪ Grants for certain energy property in lieu of tax credits.

AFFORDABLE CARE ACT

The American Taxpayer Relief Act amends several provisions of the Patient Protection and Affordable Care Act. The American Taxpayer Relief Act repeals the CLASS Program (a national voluntary insurance program) and reduces certain loan funding for the Consumer Operated and Oriented Plan program (CO-OP program).

IMPACT.

In 2011, HHS announced that it was suspending implementation of the CLASS program. The American Taxpayer Relief Act formally repeals the CLASS program. The American Taxpayer Relief Act authorizes the creation of a special commission to explore development of a long term care program.

Analysis of Post-2012 Net Investment Income and Additional Medicare Taxes

Posted by Admin Posted on Dec 11 2012

Reliance Regs Tackle New 3.8 Percent Net Investment Income Tax And 0.9 Percent Additional Medicare Tax

The IRS has issued long-awaited and much-needed proposed reliance regulations on the operation of the two new surtaxes imposed under 2010 health care legislation: the 3.8 percent Net Investment Income (NII) Tax under Code Sec. 1411 and the 0.9 percent Additional Medicare Tax under Code Secs. 3101(b)(2) and 1401. Both surtaxes are scheduled to spring into full effect on January 1, 2013. The proposed reliance regs ?and frequently asked questions (FAQs) on the IRS website? seek to address many of the gaps in application of these surtaxes that have been questioned by tax professionals, employers and taxpayers. At the same time, the proposed reliance regs create new questions about application of the surtaxes. The guidance on each of these new surtaxes is extensive and is immediately critical for affected taxpayers.

IMPACT:

Immediate action is advisable on a number of fronts. Year-end tax planning may indicate the need to accelerate income otherwise subject to one or both of the surtaxes. Employers may need to adjust their payroll practices immediately for certain employees on January 1, 2013. Investment strategies and asset allocations may need revisiting as may use of deferred compensation plans. Elections pursuant to the proposed NII regs should be considered. Planning is further complicated by uncertainty over the fate of the Bush-era tax cuts after 2012: sunset of those rates for higher-income taxpayers starting in 2013 could mean a combined income and NII surtax rate as much as 43.4 percent on investments, and an additional 0.9 in Additional Medicare Tax on top of a possible 39.6 percent rate on wages and other income.

Comment

Some taxpayers and employers delayed preparing for the new NII surtax and the Additional Medicare Tax, waiting to see if the U.S. Supreme Court would uphold the 2010 health care legislation and/or if the GOP would win the White House. The Supreme Court upheld the legislation (except for some provisions relating to Medicaid) in June 2012. Any remaining prospects for repeal or rollback of the 2010 health care legislation were diminished with Mitt Romney's loss to President Obama. Of course, Congress and the White House could revisit the NII surtax and the Additional Medicare Tax as part of comprehensive tax reform discussions in 2013.

Reliance Regulation Status

Both sets of regs (NII and Additional Medicare Tax) are proposed and as such, are subject to a public comment and reassessment process before they are finalized. The proposed regs are generally proposed to be effective for tax years beginning after calendar year 2013, and the IRS has indicated its intention to issue final regs sometime in 2013. In the meantime, the IRS stated that taxpayers may rely on the proposed regs. However, the IRS warns bluntly against any attempt to take advantage of unintentional loopholes in its language that the IRS drafters did not catch. In the preamble to the NII proposed reliance regs in particular, the IRS puts aggressive tax planning on notice that it will review transactions that manipulate net investment income to avoid the new surtax, and will, "in appropriate circumstances ? challenge such transactions based on applicable statutes and judicial doctrines."

THE 3.8 PERCENT NII SURTAX CALCULATION

For tax years beginning after December 31, 2012, the NII surtax on individuals equals 3.8 percent of the lesser of:

  • ▪ Net investment income for the tax year, or

  • ▪ The excess, if any of

    (a)

    (i) the individual's modified adjusted gross income (MAGI) for the tax year, over

    (b)

    (ii) the threshold amount.

The threshold amount, as defined under Code Sec. 1411(b), means:

  • ▪ $250,000 in the case of a taxpayer making a joint return or a surviving spouse,

  • ▪ $125,000 in the case of a married taxpayer filing a separate return, and

  • ▪ $200,000 in any other case.

IMPACT:

These threshold amounts are not indexed for inflation. Consequently, the number of affected taxpayers is expected to increase over time because of inflation. Congress could revise the thresholds in the future to reflect inflation or choose to index the thresholds for inflation. At this time, however, there appear to be no plans in Congress or the Obama administration to index the thresholds for inflation.

EXAMPLE:

Alyce, an unmarried U.S. citizen, has MAGI of $220,000 and $50,000 of NII. Alyce would pay $760, the 3.8 percent NII tax on $20,000.

Comment

Trusts and estates are also subject to the NII surtax but operate under a different set of rules in connection with NII base and threshold amounts. (See Trusts and Estates, below).

MAGI. MAGI for purposes of the NII surtax computation is defined under Code Sec. 1411(d) as adjusted gross income without a Code Sec 911(a)(1) foreign earned income exclusion or Code Sec. 911(d)(6) offset. The proposed reliance regs further explain that adjusted gross income for individuals follows the normal AGI definition under Code Sec. 62 (and likewise, AGI under Code Sec. 67(e) for estates and trusts). However, the proposed reliance regs caution that additional adjustments to AGI may be required because of ownership interests (for example, investments) in controlled foreign corporations or passive foreign investment companies (Prop. Reg. §1.1411-1(b)).

Short tax years. The proposed reliance regs explain that a threshold amount is generally not prorated in the case of a short tax year; for example, because of death (Prop. Reg. §1.1411-2(d)(2)). However, if the short year is the result of a change of annual accounting period, the proposed reliance regs generally require reduction of the applicable threshold amount to an amount that bears the same ratio to the full threshold amount as the number of months in the short period bears to twelve (Prop. Reg. §1.1411-2(d)(2)(ii)).

NET INVESTMENT INCOME

At the heart of the NII surtax proposed reliance regs are efforts by the IRS to more precisely define "net investment income" subject to the 3.8 percent tax.

Comment

The IRS explained in the preamble to the proposed reliance regs that one of the general purposes of Code Sec. 1411 that it tries to fulfill through the proposed reliance regs is "to impose a tax on unearned income or investments of certain individuals, estates, and trusts." Despite the simplicity of this mission statement, defining net investment income in the proposed reliance regs requires the lion's share of the 159 pages of the just-released preamble and regs.

Code Sec. 1411(c)(1) defines net investment income as the sum of:

  • ▪ (i) Category (i) income: Gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in Code Sec. 1411(c)(2);

  • ▪ (ii) Category (ii) income: Other gross income derived from a trade or business described in Code Sec. 1411(c)(2); and

  • ▪ (iii) Category (iii) income: Net gain attributable to the disposition of property, other than property held in a trade or business not described in Code Sec. 1411(c)(2),

    over

  • ▪ Deductions properly allocable to such gross income or net gain.

Sec. 1411(c)(2) trade or business categories for net investment income. Code Sec. 1411(c) (2) describes two categories of trades and businesses to which the NII surtax applies:

  • ▪ Any trade or business that is a passive activity (under Code Sec. 469) with respect to the taxpayer; and

  • ▪ A trade or business of trading in financial instruments or commodities.

Comment

Thus, interest, dividends, etc. are not net investment income if they are derived in the ordinary course of a trade or business that is not a passive activity with respect to the taxpayer and that is not trading of financial instruments or commodities. The IRS refers to this as the "ordinary course of a trade or business exception."

Comment

If items of net investment income (including properly allocable deductions) pass through a partnership or S corp, the passthrough entity must separately state the items on Schedule K-1s issued to investors, a potentially burdensome requirement.

Use of other Tax Code provisions. Despite its declaration of independence from being forced to apply other Tax Code principles to addressing Code Sec. 1411 issues, the IRS does give blanket approval in its preamble to the proposed reliance regs to the operation of certain Tax Code provisions side-by-side with Code Sec. 1411. Therefore, except as otherwise provided in the proposed reliance regs, the following Tax Code chapter 1 principles apply:

Gain that is not recognized under chapter 1 for a tax year is not recognized for that year for purposes of section 1411, including:

Deferral or disallowance provisions of chapter 1 that the proposed reliance regs interpret as applying to a determination of NII include:

Further, carryover deductions in connection with these deferral or disallowance provisions otherwise allowed in determining adjusted gross income (AGI) are also allowed in determining NII.

IMPACT:

One concern receiving attention in the popular press lately has been the application of the 3.8 percent NII surtax to profits on the sale of a residence. The proposed reliance regs confirm that gain that is otherwise subject to income tax on the sale of a principle residence is also subject to classification as NII. However, through examples, the IRS reminds taxpayers that: first, gain is taxed only over and above the home sale exclusion permitted under Code Sec. 121 (generally, $500,000 of gain for joint filers and $250,000 of gain for most others); and second, the applicable threshold amount for being subject to the NII surtax must be exceeded. The taxable gain over and above the Code Sec. 121 exclusion, however, does contribute to the amount of modified adjusted gross income used to determine the threshold amount.

Exceptions to general Tax Code principles. "To prevent circumvention of the purposes of the statute," the proposed reliance regs modify the Chapter 1 rules in certain cases. Examples include treating substitute interest and dividends as investment income even though not technically considered dividends or interest under Chapter 1; and treating under Code Sections 959(d), 1293(c), or 1291 as net investment income. Also carved out from general Chapter 1 treatment is the definition of adjusted gross income as it relates to investments in controlled foreign corporations and passive foreign investment companies.

MAGI THRESHOLDS FOR NET INVESTMENT INCOME SURTAX AFTER DECEMBER 31, 2012*

Filing Status

Threshold Amount


Married filing jointly

$250,000


Married filing separately

$125,000


Single

$200,000


Head of household (with qualifying person)

$200,000


Qualifying widow(er) with dependent child

$250,000


Note: The income thresholds are not indexed for inflation. *from irs.gov, Net Investment Income Tax FAQs


Category (i) Income

Category (i) income (as described in Code Sec. 1411(c)(1)(i) within the three-part enumerated definition of net investment income) includes interest, dividends, annuities, royalties, and rents "other than such income which is derived in the ordinary course of a trade or business not described in paragraph 2" (that is, from such interest, dividends, etc., not otherwise captured as NII under Code Sec. 1411(c)(2), which is explained, below, in "Category (ii) income")

Interest and dividends. The IRS elaborated in the preamble to the proposed reliance regs on the definition of interest, dividends, annuities, royalties, and rents. Interest and dividends includes any items treated as interest or dividends under chapter 1 (Code Secs. 1-1400). Dividends include corporate dividends (and constructive dividends), as well as amounts treated as dividends under other provisions of the Code and regs, for example, Sec. 1248 (gain from the sale of certain foreign corporations). The IRS clarified that net investment income also includes distributions from previously taxed earnings and profits.

IMPACT:

By far, the most common items of NII for most individuals will be the interest earned on bank accounts and the dividends realized on stock investments paid through brokerage accounts. Net capital gains, another common item of NII for a significant number of taxpayers, is a category (ii) item. Discussed below.

IMPACT:

Corporate dividends paid in 2013 out of 2012 earnings and profits, for example, will not escape being classified as NII subject to NII tax in 2013. Making dividend distributions before 2012 year-end is an immediate strategy that should be considered, especially in expectation that the Bush-era tax cuts will expire for higher income individuals after 2012.

Comment

Substitute interest and dividends paid in a securities-lending transaction or sale-repurchase transaction are treated as interest and dividends and, therefore, as net investment income. The IRS explained this treatment is necessary to prevent taxpayers from avoiding the tax by lending their securities over a payment date.

Annuities. Gross income from annuities includes a variety of payments made under an annuity, endowment or life insurance contract that are includible in gross income under Code Sections 72(a), 72(b), or 72(e). While the Tax Code does not define the term "annuity," the proposed reliance regs rely on the treatment of payments under Code Sec. 72. The IRS explained in the preamble to the proposed reliance regs that gain from the sale of an annuity contract is treated as income from an annuity if the sales price does not exceed the annuity's surrender value.

Comment

The gain from the excess of the sales price over the surrender value of an annuity is treated as gain from the disposition of property, under the third category (category (iii)) of net investment income.

Royalties and rents. Royalties include amounts received from mineral, oil and gas royalties. Payments for the use of patents, copyrights, goodwill, trademarks, franchises, and similar property are also treated as royalties. Rents include amounts paid for the use of (or right to use) tangible property.

Trade or business exception to category (i) income. Interest, dividends, etc., are not included in net investment income if they meet the ordinary course of a trade or business exception. This exception is determined under a two-part test:

  • ▪ First, the item must be "derived in" a trade or business not described in section 1411(c)(2);and

  • ▪ Second, if the item is derived in a trade or business not described in section 1411(c)(2), then such item must also be derived in the "ordinary course" of the trade or business.

Derived in. To determine whether the trade-or-business exception to category (i) income applies, it is first necessary to determine whether the item is derived in a trade or business described in Code Sec. 1411(c)(2). For a sole proprietor and a disregarded entity, this determination is made at the individual level. For an individual, estate, or trust (the taxpayer) that owns an interest in a trade or business through a passthrough entity (a partnership or S corporation), this determination is made as follows:

  • ▪ Whether the trade or business is a passive activity with respect to the taxpayer is determined at the taxpayer level, in accordance with Code Sec. 469 (passive activity loss rules);

  • ▪ Whether the trade or business involves trading in financial instruments or commodities at the passthrough entity level. If the entity is involved in this business, the income retains its character when passing through to the taxpayer (Prop. Reg. §1.1411-4(b)(2)).

The IRS reiterated in the preamble to the proposed reliance regs that if the passthrough entity is not engaged in any trade or business, its income will not qualify for the trade or business exception, even if the individual or an intervening entity is engaged in a trade or business. The individual's status under Code Sec. 469 (active or passive participant) is irrelevant if the passthrough entity is not engaged in a trade or business.

EXAMPLE:

Allen is engaged in a trade or business that is not described in Code Sec. 1411(c)(2) and the trade or business has gross income (royalties) Such gross income is derived in Allen's trade or business, and therefore Allen meets the first part of the ordinary course of a trade or business exception to category (i) NII tax. However, if Allen's trade or business is a passive activity with respect to Allen or if Allen's trade or business is trading in financial instruments or commodities, the ordinary course of a trade or business exception would be inapplicable because the income is derived in a trade or business described in Code Sec. 1411(c)(2) and is therefore NII under that latter category.

Ordinary course. The proposed reliance regs do not provide guidance on the meaning of "ordinary course." The IRS instructed that taxpayers should rely on case law and other sections of the regs that address this issue, such as Lilly, 343 U.S. 90 (Sup.Ct. 1953), and Reg. §1.469-2T(c)(3)(ii) (providing rules for determining whether certain portfolio income is excluded from the definition of passive activity gross income).

Wages. Wages and other compensation are not subject to the NII surtax. The IRS explained in the preamble to the proposed reliance regs that amounts paid by an employer to an employee as wages subject to income tax withholding are not NII, because they are derived in the ordinary course of a trade or business of being an employee. In this manner, they qualify for the trade or business exception.

Comment

The IRS clarified in the preamble to the proposed reliance regs that nonqualified deferred compensation paid to an employee under Code Sections 409A, 457(f), 457A, or other provisions, is not NII. However, because portfolio income (such as interest or dividends) under Code Sec. 469 is not considered derived in the ordinary course of a trade or business, it is net investment income under Category (i).

Category (ii) Income

Category (ii) income (as described in Code Sec. 1411(c)(1)(ii) within the enumerated definition of net investment income) consists of "other gross income" from a trade or business in one of the categories for net investment income (passive income or trading in financial instruments or commodities). For a passive activity, other gross income generally includes gross income that is not interest, dividends, etc., described in Category (i), and that is not net gain from the disposition of property.

EXAMPLE:

Beth owns an interest in a partnership that runs a cattle ranching business. The business is a trade or business under Code Sec. 162. Beth does not materially participate in the business; thus, the partnership is a passive activity with respect to Beth, as described in Code Sec. 1411(c)(2)(A). The business generates net income from the sale of beef, and a portion of the income is allocated to Beth. Beth's income from the cattle ranch is other gross income derived from a trade or business described in Code Sec. 1411(c)(2).

For the trading of financial instruments or commodities, other gross income will include gain from property held in the trade or business (rather than Category (iii) net gains). Other gross income also includes mark-tomarket gain under Code Sec. 475(f).

Category (iii) Income

Category (iii) income (as described in Code Sec. 1411(c)(1)(iii) within the enumerated definition of net investment income) consists of taxable net gain from the disposition of property, other than property held in the passive/financial instruments trade or business categories. A disposition includes the sale, exchange, transfer, conversion, settlement, cancellation, termination, lapse or expiration of property. The rules of Chapter 1 determine whether there has been a disposition under Code Sec. 1411. Thus, a disposition includes a distribution of money from a partnership to a partner that exceeds the partner's basis.

IMPACT:

Net capital gains from investment accounts are perhaps the most common category (iii) type of income. In that regard, it is important to note that shortterm or long-term gains are subject to the same 3.8 percent surtax, irrespective of the ordinary income rate applied to shortterm gains or the lower rate applied to long-term capital gain.

EXAMPLE:

Dylan, an unmarried individual, rents a boat to Bailey for $100,000 in what is a passive activity under Code Sec. 469(c). In the next year (2013), Dylan sells the boat to Bailey, recognizing a gain of $500,000 on the sale. Since the boat was not considered held in a trade or business not described in Code Sec. 1411(c)(2) because it was a trade or business that was a passive activity with respect to Dylan, the gain will be subject to NII surtax under category (iii).

Comment

The IRS explained in the preamble to the proposed reliance regs that capital gain dividends from mutual funds and real estate investment trusts are net gain under Category (iii), not dividend income under Category (i). Gain or loss from a nontrader who marks to market assets under Code Sec. 1256 is net investment income.

Comment

The gain and loss rules under Chapter 1 determine net gains under Category (iii). For example, if gain is not recognized under Code Sec. 1031 on a like-kind exchange, it is not recognized as net investment income.

Losses may also be taken into account in determining net gain. This would apply to losses deductible under Code Sec. 165 if the property is not held in a trade or business, or if the property is held in a trade or business category related to net investment income. Capital losses that exceed capital gains are not recognized for Code Sec. 1411, but the $3,000 of losses allowable to noncorporate taxpayers may offset gains from the disposition of noncapital assets.

Exception. Category (iii) NII generally applies if the property disposed of is not held in a trade or business, or is held in a trade or business described in the one of the categories for net investment income (a passive activity; trading in financial instruments or commodities). Category (iii) does not apply to property held in a trade or business that is not described in the categories for net investment income (Prop. Reg. §1.1411-4(d)(3)(ii)(A)).

Whether property is "held" in a trade or business is determined in the same manner as whether gross income is "derived in" a trade or business. For sole proprietors and disregarded entities, this determination is made at the individual level. For taxpayers holding a passthrough interest, determining whether the trade or business is passive is also made at the individual level, while determining whether the trade or business is trading in financial instruments or commodities is determined at the entity level (Prop. Reg. §1.1411-4(d)(3)(ii)(B).

NET INVESTMENT INCOME

Over 100 pages within the proposed reliance regulations (Prop. Reg. §1.1411) and preamble (NPRM REG-130507-11) are devoted to clarifying the definition of Net Investment Income set forth in Code Sec. 1411(c):

1411(c)(1)In general.?

The term "net investment income" means the excess (if any) of?

1411(c)(1)(A) the sum of?

1411(c)(1)(A)(i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2),

1411(c)(1)(A)(ii) other gross income derived from a trade or business described in paragraph (2), and

1411(c)(1)(A)(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over

1411(c)(1)(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.

1411(c)(2) Trades and businesses to which tax applies.? A trade or business is described in this paragraph if such trade or business is?

1411(c)(2)(A) a passive activity (within the meaning of section 469) with respect to the taxpayer, or

1411(c)(2)(B) a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2).

EXCEPTION FOR QUALIFIED PLAN DISTRIBUTIONS

Under Code Sec. 1411(c)(5), NII does not include any distribution from a plan or arrangement described in Code Sections 401(a), 403(a), 403(b), 408, 408A, or 457(b). The proposed reliance regs explain that distributions from qualified plans would encompass:

  • ▪ A qualified pension, stock bonus, or profit sharing plan;

  • ▪ A qualified annuity plan;

  • ▪ A tax-sheltered annuity plan;;

  • ▪ An individual retirement account (IRA)

  • ▪ A Roth IRA; or

  • ▪ A Section 457(b) plan of a state, local government, or tax-exempt organization.

The proposed reliance regs confirm that most transfers from one of these plans will qualify as an exempt distribution. Actual distributions, deemed distributions, rollovers and corrective distributions, permitted distributions to purchase life insurance or similar arrangement are all exempt from NII surtax (Prop. Reg. §1.1411-8(b)).

CAUTION:

The IRS reminded taxpayers in the preamble to the proposed reliance regs that distributions that may be excluded from NII may be included in gross income under the regular chapter 1 rules of the Tax Code and, therefore, would be taken into account in determining MAGI for purposes of calculating the amount of NII subject to NII surtax.

EXCEPTION FOR ITEMS SUBJECT TO SELF-EMPLOYMENT TAX

The proposed reliance regs follow the lead of Code Sec. 1411(c)(6) in excluding from NII any item taken into account in determining self-employment income under Code Sec. 1401(b). The proposed reliance regs clarify that "taken into account" means income included and deductions allowed in determining net earnings from self-employment. A special rule for traders in financial instruments and commodities specifies that certain deductions in excess of those used to reduce self-employment income are allowed in determining NII (Prop Reg. §1.1411-9(b)).

CFCs AND PFICs

The proposed reliance regs provide special rules for controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs) (Prop. Reg. §1.141110). Dividends and gains from the stock of a CFC (as defined in Code Sec. 957(a)) or of a PFIC (as defined in Code Sec. 1297(a)) are included in computing net investment income. The rules apply to an individual, estate or trust that is a U.S. shareholder of a CFC, or that is a U.S. person that directly or indirectly owns an interest in a qualified electing fund (which involves an election made with respect to a PFIC).

IMPACT:

Inclusions to a U.S. shareholder under the CFC rules are not dividends unless expressly provided in the Tax Code. Similarly, inclusions to a U.S. person owning shares in a PFIC are not dividends. As a result, these amounts are not net investment income unless the amounts are derived from a trade or business to which the tax applies (Category (ii) income) (Prop. Reg. §1.1411-10(b)).

Previously taxed income. Under the income tax rules, distributions of previously taxed earnings and profits are not included in income when there is an actual distribution from the foreign corporation. However, the proposed regulations treat actual distributions of earnings and profits (even if previously taxed under Chapter 1) as dividends that are includible in net investment income under Code Sec. 1411(c)(1)(A)(i) (Prop. Reg. §1.1411-10(c)(2)). Furthermore, any gain from the disposition of stock in a CFC or PFIC will give rise to Category (iii) net investment income (net gain from the disposition of property).

The rules on previously taxed income require basis adjustments to the stock of the CFC or PFIC. These adjustments would be calculated differently under the income tax and net investment income provisions, the IRS explained in the preamble.

Comment

To minimize complexity from this different treatment, the proposed reliance regs provide an election that should result in consistent treatment for both purposes (Prop. Reg. §1.1411-10(g)). The reliance regs permit an election for a tax year that begins before January 1, 2014, as well as specifying that the election, if made, must be made for the first tax year beginning after December 31, 2013, during which applicable CFC or qualified electing fund holdings exist. Once made, the election is irrevocable to all future years, subject to IRS discretion.

PROPERLY ALLOCABLE DEDUCTIONS

In determining net investment income under Code Sec. 1411(c)(1), the three categories of income items (referred to as gross income or net gain) are reduced by deductions that are properly allocable to the income. Only amounts paid or incurred to "produce" the income may be deducted.

NII may not be less than zero. If a deduction is not entirely used in the current year, the balance can only be carried over to another year if the underlying code section allows it, such as a suspended passive activity loss allowed in a later year under Code Sec. 469(b) (Prop. Reg. §1.1411-4(f)(1)(ii)).

IMPACT:

Under Code Sec. 469(g)(1), suspended passive losses may be deducted in the year that the taxpayer disposes of its interest in the passive activity. The IRS requested comments on how to treat these losses under Code Sec. 1411.

Under the proposed reliance regs, a net operating loss (NOL) deduction cannot reduce net investment income, because the items comprising the NOL are not tracked, once included in the NOL, and the overall NOL itself is not "properly allocable" to any specific item of income (Reg. §1.1411-4(f)(1)(ii)).

EXAMPLE:

Anna, an unmarried individual, has an NOL of $20,000 in Year One. In Year Two, Anna has $200,000 of wages, $100,000 from trading in financial instruments or commodities, and $10,000 in trading activity expense deductions. Anna's $20,000 NOL is allowed in Year Two as an income tax deduction and as a deduction in computing modified adjusted gross income under Code Sec. 1411(a)(1)(B). However, the $20,000 NOL is not allowed in computing Anna's NII; thus, Anna's NII is $90,000 (the net income from the trading activity).

Allowable ("properly allocable") deductions include the following:

  • ▪ Rents and royalties - deductions described in Code Sec. 62(a)(4), such as depletion (Prop. Reg. §1.1411-4(f)(2));

  • ▪ Interest income - penalties described in Code Sec. 62(a)(9) for penalties upon early withdrawals of savings;

  • ▪ Trade or business deductions described in Code Sec. 62(a)(1);

  • ▪ Certain itemized deductions, such as investment interest, investment expenses, and taxes (Prop. Reg. §1.1411-4(f) (3)(i)); and

  • ▪ Miscellaneous itemized deductions, but only after application of the 2-percent floor and the overall deduction limit under Code Sec. 68 (Prop. Reg. §1.1411-4(f)(3)(ii)).

EXAMPLE:

Barbara, an unmarried individual, pays $4,000 of interest on debt incurred to purchase stock. Barbara has $5,000 of investment income, and has $10,000 of income from a trade or business that is a passive activity. The interest expense is deductible against the investment income for income tax purposes under Code Sec. 163(d). The interest expense may be deducted in determining Barbara's Code Sec. 1411 NII.

Losses under Code Sec. 165 are deductible only in computing net gain (Category (iii) income from the disposition of property), and only to the extent of gains, so they are not properly allocable deductions (Prop. Reg. §1.1411-4(f)(4)). The IRS notes that "net gain" cannot be less than zero and that any excess losses are not allowed in computing net investment income.

NET INVESTMENT INCOME SURTAX PROPOSED RELIANCE REGS-TOPICS ADDRESSED

The proposed reliance regulations on the 3.8 percent net investment income tax are proposed to be effective January 1, 2014, but may be relied on immediately by taxpayers until final regulations are released. They are organized under the following headings:

§1.469-11. Effective date and transition rules ((iv) Regrouping for taxpayers subject to section 1411)

§1.1411-1 General rules.

§1.1411-2 Application to individuals.

§1.1411-3 Application to estates and trusts.

§1.1411-4 Definition of net investment income.

§1.1411-5 Trades and businesses to which tax applies.

§1.1411-6 Income on investment of working capital subject to tax.

§1.1411-7 Exception for dispositions of interests in partnerships and S corporations.

§1.1411-8 Exception for distributions from qualified plans.

§1.1411-9 Exception for self-employment income.

§1.1411-10 Controlled foreign corporations and passive foreign investment companies.

SECTION 1411 TRADES OR BUSINESSES

Code Sec. 1411(c)(1)(A) defines the items that comprise NII: (i) gross income from interest, dividends, royalties, etc., unless derived in the ordinary course of a trade or business to which the NII surtax does not apply; (ii) other gross income derived from a trade or business to which the NII surtax applies; and (iii) net gain from the disposition of property other than property in a trade or business to which the NII tax does not apply.

The trade or business described under Code Sec. 1411(c)(2) to which the NII surtax applies consists of:

To define a trade or business, the preamble to the proposed reliance regs refers to Code Sec. 162, which permits a deduction for all the ordinary and necessary expenses paid or incurred in carrying on "a trade or business." The proposed reliance regs incorporate the rules under Code Sec. 162, including the large body of law and administrative guidance that has developed.

Comment

The IRS predicted in the preamble to the proposed regs that use of the Code Sec. 162 definition of trade or business would simplify taxpayer compliance.

Passive activities. Code Sec. 1411 is intended to take into account gross income from, and net gain attributable to, a passive activity with respect to the taxpayer that involves the conduct of a trade or business. However, the IRS explained in the preamble to the proposed regs that the definition of trade or business and passive activity is more restrictive for Code Sec. 1411 purposes than under Code Sec. 469 in two respects:

  • Code Sec. 469 includes any activity conducted in anticipation of the commencement of a trade or business, and any activity involving research or experimentation under Code Sec. 174; and

  • ▪ While Code Sec. 469 defines passive activity as any trade or business in which the taxpayer does not materially participate, it also includes any rental activity in the definition of passive activity.

Application of existing Code Sec. 469 rules. Code Sec. 469 and its regs provide rules for determining whether trade or business activities and certain rental activities are passive activities with respect to a taxpayer. The IRS explained in the preamble to the proposed reliance regs that these rules will also apply in determining whether a Code Sec. 162 trade or business is a passive activity for purposes of Code Sec. 1411(c)(2)(A). Within this scope are:

  • ▪ The material participation requirements of Code Sec. 469(h)(1) and Reg. §1.469-5T;

  • ▪ The rules treating the rental real estate activities of real estate professionals as an active trade or business if the taxpayer materially participates, provided the rental real estate activities are a trade or business under Code Sec. 162;

  • ▪ The rules and exceptions that treat rental activities as being (or not being) a per se passive activity. However, if the rental activity is not a trade or business under Code Sec. 162, the income will be NII; and

  • ▪ The grouping rules for determining the scope of a taxpayer's trade or business and whether the activity is a passive activity; provided that a grouping of rental activities with another trade or business will not convert rental income into other gross income that avoids the NII surtax.

Fresh start regrouping. Ordinarily, a taxpayer that groups activities cannot regroup the activities in subsequent years. Significantly, because of the enactment of Code Sec. 1411, the IRS will allow taxpayers a "fresh start" where they may regroup their activities in tax years beginning in 2013. The regrouping must comply with the disclosure and reporting requirements of Reg. §1.469-4(e) and Rev. Proc. 2010-13.

IMPACT:

A regrouping election had been on the short list of relief measures requested by many practitioners and taxpayers. Regrouping to indicate material participation can assist in avoiding the NII surtax although may change the dynamics for netting passive losses and income. A taxpayer may only regroup activities once and any such regrouping will apply to the tax year for which the regrouping is done and all subsequent years. The proposed reliance regs provide no specific deadline for regrouping; nor do they indicate whether a regrouping made now would be allowed to be changed again when the regs are made final.

Comment

Rev. Proc. 2010-13 generally requires taxpayers to report their groupings and regroupings of activities and the addition of specific activities within their existing groupings of activities for purposes of Code Sec. 469 and its regs.

Rental activity. The IRS, in an example in the proposed reliance regs, explains what has been an elusive application of interrelated principles to rental activity (Prop. Reg. §1.1411-5(b)(2), Ex 1).

EXAMPLE:

Abby, an unmarried individual, rents a commercial building to Brandon for $50,000 in Year 1. Abby's rental activity does not involve the conduct of a Code Sec. 162 trade or business, but under Code Sec. 469(c)(2), Abby's rental activity is a passive activity. However, since the rental activity is not considered a trade or business within the meaning of Code Sec. 162, Abby's rental income of $50,000 is not derived from a trade or business to which the NII tax applies. However, Abby's rental income of $50,000 will still constitute gross income from rents under Category (i) [gross income from interest, dividends, annuities, royalties, rents, substitute interest payments, and substitute dividend payments, except to the extent excluded by the ordinary course of a trade or business exception] because Category (i) does not require a trade or business (Prop. Reg. §1.1411-4(a)(1)(i)).

Passive income restrictions. Code Sec. 469 restricts taxpayers from artificially generating passive income from certain passive activities. These rules interact with the Code Sec. 1411 requirements.

Portfolio income. Interest, dividends, etc. that are not derived in the ordinary course of a trade or business are treated as portfolio income under Code Sec. 469 and are not used to determine whether there is income or loss from an activity. Therefore, the items in Category (i) of NII will be included in Code Sec. 1411, because portfolio items are not derived in the ordinary course of a trade or business.

Comment

There are special rules under Code Sec. 469 for working capital, for recharacterizing net income, and for substantially appreciated property. These items, discussed elsewhere in the proposed reliance regs, generally will be subject to Code Sec. 1411 (see Working Capital discussion, below).

The activity of trading personal property (as specifically defined in Code Sec. 1092(d)), for the account of owners of interests in the activity, is not a passive activity under Code Sec. 469. Although the income is not from a passive activity, it may be subject to the NII surtax under Code Sec. 1411 if the activity is a trade or business of trading in financial instruments or commodities, as described in Code Sec. 1411(c)(2)(B).

Comment

Code Sec. 1092 concerns straddles and other financial instruments.

Trading in financial instruments or commodities. It is necessary to distinguish among dealers, traders, and investors to determine whether trading in financial instruments (or commodities) is a trade or business under Code Sec. 162. The proposed reliance regs do not change the state of the law with respect to the classification of dealers, traders or investors.

A dealer in securities purchases from customers or sells to customers, or regularly offers to enter into positions with customers, and is involved in a trade or business. A trader seeks profit from market swings and will be engaged in a trade or business if the trading is frequent and substantial. An investor seeks income from interest, dividends and longterm appreciation. A person who qualifies as a trader may be engaged in a trade or business for Code Sec. 1411(c)(2)(B).

Comment

The IRS reiterated in the preamble to the proposed reliance regs that management of one's own investments is not considered a Code Sec. 162 trade or business no matter how extensive or substantial the investments might be. Nevertheless, income from personal investment management is typically category (i) income subject as such to the NII surtax.

The proposed reliance regs borrow the definition of financial instruments in Code Sec. 731. A financial instrument includes stock and other equity interests, debt, options, forwards or futures, notional principal contracts, other derivatives, and interests in any of these items, including short positions and partial units (Prop. Reg. §1.1411-5(c)). "Commodities" has the same meaning as in Code Sec. 475(e)(2).

WORKING CAPITAL EXCEPTION

Trade or business income does not include income earned from the investment of working capital. The IRS acknowledged in the preamble to the proposed reliance regs that neither Code Sec. 469 nor Code Sec. 1411 define "working capital." According to the IRS, the term generally refers to capital set aside for use in, and for the future needs of, a trade or business. Working capital may be invested in income producing liquid assets, such as savings accounts, certificates of deposit, money market accounts, shortterm bonds, and similar investments.

IMPACT.

NII surtax on working capital can pose an unexpected liability for a business conducted by a sole proprietor, partnership, or S corp, which otherwise escapes the NII surtax. Any income from the investment of working capital is subject to the NII surtax based upon the proposed reliance regs (Prop. Reg. §1.1411-6). Cash-intensive businesses using interest-bearing accounts, as well as businesses that park some extra funds until a project begins, should be alert to this "hidden" NII surtax in connection with an active business operation.

EXAMPLE:

Adam is the sole owner/operator of a restaurant that does business as an S corp and maintains an interest-bearing checking account with an average daily balance of $2,500 to hold cash receipts and pay ordinary and necessary business expenses. The S corp also has set aside an additional $20,000 for the potential future needs of the business. Both the checking account and $20,000 are considered working capital, with interest earned on them subject to NII surtax imposed on Adam, who is allocated the interest through the S corp (Prop. Reg. §1.1411-6(b)).

Comment

The preamble to the proposed reliance regs refers to working capital as capital that "may not be necessary for the immediate conduct of the trade or business." But the above example in the proposed reliance regs appears to demonstrate that the government will not enter into the task of trying to determine whether capital is "necessary for the immediate conduct of the business."

Comment

For purposes of the NII surtax on working capital investment income, Code Sec. 1411(c)(3) directs the IRS to apply a rule similar to Code Sec. 469(e)(1)(B) of the passive activity loss rules. Under Code Sec. 469(e)(1) (B), portfolio-type income, such as interest, that is generated by working capital is not derived in the ordinary course of a trade or business, cannot be characterized as passive income, and therefore cannot offset a taxpayer's passive losses.

Allocable deductions. In determining NII, the IRS explained in the preamble to the proposed reliance regs that a taxpayer may take into account allocable deductions related to losses or deductions from the investment of working capital. Prop. Reg. §1.1411-4(f) describes properly allocable deductions, such as investment expenses or investment interest expenses, but does not specifically discuss expenses from investing working capital.

EXCEPTION FOR DISPOSITION OF PARTNERSHIPS/S CORP INTERESTS

Generally, an interest in a partnership or S corp (a "passthrough" interest) is not considered property held in a trade or business (although the underlying business itself may be). Therefore, gain or loss from the sale of a passthrough interest would be included in NII under Category (iii).

Exception. Despite this general rule, the amount of gain (or loss) on the disposition of a passthrough interest that is included in NII under Category (iii) is limited to the net gain (or loss) that would be taken into account if the partnership or S corp sold all of its assets at fair market value immediately before the disposition of the interest (a deemed sale) (Code Sec. 1411(c)(4); Prop. Reg. §1.1411-7(a)).

IMPACT.

The IRS explained in the preamble to the proposed reliance regs that Congress intended to put the transferor of a passthrough interest in a similar position as if the partnership or S corp had disposed of all of its properties and then passed its gain or loss through to its owners (including the transferor).

Use of property. To achieve parity between the sale of a passthrough interest and the sale of the entity's assets, the proposed reliance regs apply Code Sec. 1411(c)(4) on a property-by-property basis (Prop. Reg. §1.1411-4(d)(3)). This is because the Code Sec. 1411(c)(4) exception applies only where the property is held in a trade or business that is not a passive activity or trading business described in Code Sec. 1411(c)(2). Thus, it must be determined whether each of the entity's deemed-sold properties was used in a trade or business that qualifies for the exception.

IMPACT.

According to the preamble to the proposed reliance regs, this means that the exception does not apply where (1) there is no trade or business; (2) the trade or business is a passive activity (within the meaning of Prop Reg §1.1411-5(a)(1)) with respect to the transferor of the interest; or (3) the partnership or S corp is in the trade or business of trading in financial instruments or commodities (within the meaning of Prop Reg §1.1411-5(a) (2)). The exception, the IRS explained, would not apply because there would be no change in the category (iii) amount of net gain determined upon the asset sale.

Underlying properties. The transferor of the interest computes gain or loss from the sale of the underlying properties using a deemed asset sale method, and then determines if there is an adjustment to the gain or loss from the disposition of the passthrough interest.

If there is a gain on the sale of the interest, and some of the underlying property is not described in Code Sec. 1411(c)(2), a negative adjustment that reduces gain from the sale of the interest may be required. In this case, the Code Sec. 1411(c)(4) exception would apply, NII would be reduced, and there would be less NII surtax due.

IMPACT.

The proposed reliance regs on deemed sales apply partnership basis adjustment rules under Code Sec. 743. The IRS explained in the preamble to the proposed reliance regs that this approach could impose a burden on owners of the passthrough interests, and requested comments on other methods that would be less burdensome.

Deemed asset sale method. Use of the deemed asset sale method (Deemed Sale) in the proposed reliance regs is a multi-step approach to determining whether the exception for dispositions of partnership/S corp interests applies.

  • ▪ The first step is a hypothetical disposition of all the entity's properties, including goodwill, for cash in a fully taxable transaction at fair market value (FMV) of the entity's properties immediately before disposition of the interest.

  • ▪ The second step is a separate computation of gain or loss on each of the entity's properties (including goodwill), determined by comparing the FMV of each property with its adjusted basis.

  • ▪ The third step is the allocation of the gain or loss from each property to the transferor, taking into account the partnership agreement or relevant S corp provisions.

  • ▪ The fourth step is the determination of whether the gain or loss allocated to the transferor for each property would have been taken into account under category (iii).

Thus, if a property is either held in a trade or business described in section 1411(c)(2) or is not held in a trade or business, there will be no adjustment of the transferor's gain (or loss) taken into account as NII. For properties that do not fall into these categories, there is an adjustment under section 1411(c) (4) calculated in the following manner: the gains and losses from the properties are aggregated, with a net gain creating a negative adjustment, and a net loss creating a positive adjustment (Prop. Reg. §1.1411-7(c)).

IMPACT.

The IRS pointed out in the preamble of the proposed reliance regs that if, for example, the transferor has a gain of $100,000 on the disposition of the interest, the Code Sec. 1411(c)(4) adjustment cannot be greater than $100,000, and cannot result in a loss.

Special situations. The proposed reliance regs provide special rules for various situations (Prop. Reg. §1.1411-7):

  • ▪ If property was held in more than one trade or business in the previous 12 months, the gain must be allocated among the trades or businesses on a basis that reasonably reflects the use of the property.

  • ▪ Special rules determine the gain or loss from goodwill for purposes of the Code Sec. 1411(c)(4) exception. If the taxpayer disposed of S corp stock and made a Code Sec. 338(h)(10) election, the exception does not apply, because the sale of stock is treated as an actual asset sale by the S corp.

  • ▪ If the taxpayer sells the passthrough interest in an installment sale, the adjustment to net gain is calculated in the year of the disposition, but the gain and any adjustment are deferred. If an installment sale attributable to a disposition of an interest in a partnership or S corp occurred before the effective date of Code Sec. 1411, taxpayers may elect into the proposed reliance regs.

  • ▪ If a qualified subchapter S trust sells S corp stock, any gain or loss recognized on the sale will be that of the trust, not of the income beneficiary.

Comment

Any transferor making a Code Sec. 1411(c)(4) adjustment must attach a statement to the transferor's return for the year of the disposition. The statement must include: (1) a description of the disposed-of interest; (2) the name and taxpayer identification number (TIN) of the entity disposed of; (3) the fair market value of each property of the entity; (4) the entity's adjusted basis in each property; (5) the transferor's allocable share of gain or loss with respect to each property; (6) information regarding whether the property was held in a trade or business not described in Code Sec. 1411(c)(2); (7) the amount of the Code Sec. 1411(c)(1)(A) (iii) gain on the disposition of the interest; and (8) the computation of the adjustment under Prop Reg §1.1411-7(c)(5) (Prop. Reg. §1.1411-7(d)).

TAXPAYERS SUBJECT TO NII SURTAX

Individuals

The NII surtax applies to individuals, with the exception of nonresident aliens (Code Sec. 1411(a), (e)). The proposed reliance regs define "individual" in two ways:

(1)

the NII surtax applies to any natural person, except for natural persons who are nonresident aliens; and

(2)

the NII surtax applies to any citizen or resident of the United States (Prop. Reg. §1.1411-2(a)(1)).

Joint returns: U.S. citizen or resident married to nonresident alien. For purposes of applying the NII tax to U.S. citizens or residents married to nonresident aliens, the spouses generally must be treated as married filing separately. Under normal rules, the nonresident alien's investment income will be exempt from NII surtax while the U.S. citizen or resident alien will be subject to the lower $125,000 threshold amount and must determine his or her separate net investment income and modified adjusted gross income (MAGI) (Prop. Reg. §1.1411-2(a)(2)(i)). However, if these married taxpayers elect under Code Sec. 6013(g) to file jointly by treating the nonresident alien as a resident of the U.S., the proposed reliance regs would allow them to elect to be treated as making the same election for purposes of Code Sec. 1411. In that case, the threshold amount is $250,000 and all income is combined.

IMPACT.

Prop Reg. §1.1411-2(a)(2)(i) (B)(2) sets forth the procedural requirement for making such an election, which delegates certain specifics to be determined by the IRS. Consistent with the existing Code Sec. 6013(g) election, the deadline for the NII surtax election presumably will be when 2013 returns are filed in 2014.

Bona fide residents of U.S. territories. The application of the NII surtax to a bona fide resident of a U.S. territory depends on whether the U.S. territory has a mirror code system of taxation (Prop. Reg. §1.1411-2(a)(2)(iv)). Residents of those territories that have a mirror system (Guam, the Northern Mariana Islands and the United States Virgin Islands) generally are not subject to the NII surtax. Bona fide residents of non-mirror code jurisdictions (American Samoa and Puerto Rico) are subject to NII surtax if they have U.S. reportable income that gives rise to both NII and modified adjusted gross income exceeding the threshold amount. However, a different result may apply to bona fide residents who are