- Details
- Written by: T. STEEL ROSE, CPA, AND JASMINE TEMARES
The main purpose of tax research is to help clients find solutions to their tax problems. Tax law is continuously changing, so tax researchers must find the most authoritative, useful and updated resources to solve their clients’ tax problems.
While tax law is complex, tax researchers demand simplicity, which is why many look to tax research software for immediate and total access to tax resources. As tax law and technology evolve, so do tax research solutions. Tax research solutions offer the ability to quickly search thousands of sources and databases to provide the most up-to-date and useful results.
This issue, we tapped several resources to gain their expertise on tax research. BNA Software offers five situations when researchers need to gauge nexus exposure. Editor T. Steel Rose, CPA, explains how taxalmanac.org’s tax forums offer practical tax advice and how Tax Analysts e-book provides unique tax explanations for practitioners. CCH, a Wolters Kluwer business discusses the importance of interpretive regulations in tax research. For efficient tax law research and analysis, LexisNexis offers tips from integrating live citations to looking for trusted law literature.
Read on to discover more helpful tax research advice, as the top tax research vendors share their tips to solve tax problems.
5 Situations When You Need to Gauge Your Exposure
For state tax purposes, ‘‘nexus’’ means the threshold of contact that must exist between a taxpayer and a state before the state has the power to tax an out-of-state business. The U.S. Constitution requires that there be some minimum connection between a state and the person, property, or transaction it seeks to tax before taxable or substantial nexus can be found to exist.
Despite this constitutional pro-tection, states vary in determining what particular activities performed within their borders might trigger nexus, and then income or sales tax obligations for an out-of-state business.
From a company’s standpoint, the need to gauge nexus exposure generally arises in these five scenarios:
Startups. A company begins operating in only one state, but grows quickly and begins to regularly transact business activities in other jurisdictions.
Mergers, Acquisitions, and Re-organizations. Due diligence reveals nexus exposure in a jurisdiction either before or after the purchase of a target entity.
Change of Tax Personnel. A business replaces its tax manager. The new tax department head concludes that the former manager either incorrectly concluded that the company was not subject to tax in a particular jurisdiction or pursued an overly aggressive nexus policy.
Financial Reporting. A company must comply with FIN 48 or other financial reporting rules by listing nexus exposure as an “uncertain tax position.”
Expanding Nexus Standards. New legislation or case law, results in increased nexus exposure for out-of-state companies.
Different standards have emerged for income tax nexus and sales and use tax nexus.
For income tax, nearly all the states adhere to an “economic nexus” policy, under which a business that is not physically present in a state could be subject to tax if it engages in activities such as issuing credit cards to residents.
For sales tax, however, a company must be physically present within the jurisdiction to trigger nexus.
Despite these standards, gauging a company’s exposure can be challenging because nexus is a notoriously gray area of tax law. There is a general lack of state guidance regarding many types of nexus-creating activities. Even where guidance exists, state tax department nexus determinations tend to be fact specific and subject to interpretation.
Performing regular nexus reviews and keeping apprised of changes to state nexus laws will help guard against unwelcome surprises in this area.
— BNA Software
Tax Forums Offer Advice to Practitioners
At first glance taxalmanac.org looks dated. The opening main page feature article is Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 enacted 12/27 of 2010.
The first item under the General information button is 2005 Tax Rate Schedule. A note at the bottom of the page states, “This page was last modified on 2 November 2008, at 21:53.”
You can’t tell a book by its cover in this instance, because the strength of this Web site is in the forums where tax practitioners try to help each other and post very specific problems, sometimes in dealing with the IRS. While you can’t rely on the advice, you can obtain an experienced perspective. One such contributor is Dave Fogel. Responding to a question on how to deal with the IRS question during an audit: “Do you know of any errors on the return?” Fogel responded:
“Regarding your first question, under section 10.21 of Circular 230, you have an obligation to inform the client of the additional errors and the consequences of not correcting them. You have no duty to disclose these errors to the IRS agent.
However, the second question is the problem because you cannot lie to the IRS agent. TKelly recommends that you reply, “I cannot answer that question,” and that you inform the agent about the law of privilege. I presume that the “law of privilege” that TKelly is referring to is Sec. 7525. This section protects communications between a taxpayer and the tax practitioner, and your knowledge of the errors might not be entitled to the confidential protection provided in this section because they aren’t “communications” — you discovered them on your own after going through the return and the client’s records.
In addition, by informing the agent about the “law of privilege,” the agent will become suspicious and will probably expand the audit to other areas of the return. Instead, I would recommend that you reply, “Let me get back to you on this after I’ve had a discussion with my client.” Then convince the client to disclose the errors to the agent. If the client is unconvinced, then withdraw from the engagement. On further investigation it turns out Fogel, is a CPA, EA, who is also admitted to practice before U.S. Tax Court and has 35 years experience representing clients.
There are other useful resources on the site including the Research Resources section on the left side of the main page.
The Importance of Interpretive Regulations
Although there have been extensive changes in the techniques for doing tax research in recent years with the growing sophistication of online tax research tools, there is a perception that the analysis of the results of that tax research has not changed much over the years. There are still the primary sources of tax research from the Congress (the Internal Revenue Code, tax treaties and legislative history), from the Administration (Regulations, Rulings, Notices and whatever other documents can be obtained from Treasury and the IRS), and from the Judiciary (court decisions). Then there are the secondary sources of expert analysis and commentary.
Knowing the weight to be placed on the results of that tax research has, however, become increasingly important with increased penalties on taxpayers and return preparers with respect to the support for the positions taken on those returns. The weight given to particular results of tax research determines the amount of authority for a certain tax position. The Internal Revenue Code is always given the most weight in tax research. After that, would generally come regulations, since Congress has given the Treasury general authority to interpret the Internal Revenue Code. Of course, even a regulation could be trumped by a Supreme Court decision stating that the regulation was an improper interpretation of Congressional intent in the statute.
There has been a recent change in the weight to be given to types of tax regulations. Under the traditional view of tax research, there are two types of regulations. Interpretive regulations, enacted under the general statutory authority to interpret the Internal Revenue Code, were to be given less weight than legislative regulations, where Congress in the specific Code provision being interpreted states that the Treasury is to issue regulations fleshing out the meaning of the provision. Legislative regulations were to be given the force and effect of law unless they were arbitrary, capricious, or manifestly contrary to the statute (the Chevron standard). Interpretive regulations were to be given deference if they implemented that statute in a reasonable manner, giving consideration to the plain language, origin and purpose of the statute and the proximity of the timing of the regulations to the enactment of the statute (the National Muffler standard).
In the Supreme Court’s recent decision in Mayo, however, the Court adopts the Chevron standard for both legislative and interpretive regulations. In weighing the results of tax research, interpretive regulations move up a notch. This is already making it more difficult to challenge regulations in court and could also affect the weight to be given to a tax position taken on a return.
— CCH, a Wolters Kluwer business
Speed, Accuracy Aid in Tax Law Research
Speed and accuracy are two key elements to efficient tax law research and analysis. When they are both possible, tax law professionals work faster, smoother and with more confidence for better service to their clients. When one element is not present, however, things bog down and more time is spent either finding or verifying tax law and related issues.
With this in mind, here are a few tips on what to look for in tax law technology that combine the elements of speed and accuracy to aid in tax law work:
Integrate live citations, IRS Code and Treasury Regulations with other sources of related information. Look for and use technology solutions that not only offer codes and regulations, but also provide easy and seamless access to related analytical content, law reviews, case annotations, legislative history and other resources. This improves research efficiency and thoroughness by giving the user instant access to multiple tax sources related to a Code or Regulation section, thereby reducing the number of searches.
Choose resources that offer shortcuts to find and verify law. Finding the right law, code or regulation is one thing, while verifying it as accurate, valid and up-to-date is another. Tax law technologies that offer ways to do this quickly can be of great assistance — not only in terms of speed, but in a user’s confidence that he or she has indeed found valid law. For example, some leading tax law solutions feature drop down menus that enable the user to pull up the authority needed and check to make sure that it’s still good Federal or state law with a “wizard” tool. Look for these and use them if your solution offers them, as they do offer a way to find what you need and enable you to move on quickly to your next step.
Look for trusted tax law literature. An effective tax law technology solution will also offer up integrated access to a library of treatises and other written information about tax law to help professionals stay up to date and assist in the thoroughness and accuracy of analysis.
—LexisNexis
Tax E-Book Offers Unique Tax Explanations
When it comes to tax research, Tax Analysts should not be overlooked. They recently announced a new e-book of the entire Internal Revenue Code and Regulations. The interactive e-book with the entire Internal Revenue Code and Regulations will update quarterly. Tax Analysts offers a unique perspective to help explain taxes to tax clients.
For example, according to their State Tax Notes, “Wireless subscribers in 47 states pay taxes, fees and government-mandated charges that exceed the general retail sales tax rate.” Specifically, “the average American pays a whopping 16.26% on their wireless phone and broadband bills, with Nebraska residents paying as much as 23.69%.”
Joseph Thorndike, director of the tax history project at Tax Analysts, explains that when it comes to tax holidays, “The balance of evidence at this point suggests not particularly successful at creating jobs, if that’s the goal. You could make a marginally better case that as far as stimulus goes, they stimulate the economy, but they’re not the most effective form of stimulus.’”
When clients complain that taxes are rising, David Cay Johnston, a columnist for Tax Notes points out that, “The effective rate for the top 400 taxpayers has gone from 30 cents on the dollar in 1993 to 22 cents at the end of the Clinton years to 16.6 cents under Bush, so their effective rate has gone down more than 40 percent.”
Taking the historical view Thorndike states that the federal income tax, “Enacted as a wartime measure in 1862, roughly 10 percent of Americans, mostly the more affluent Northern citizens, were paying income tax in the late 1860s, compared with 50 percent today.”
Martin Sullivan, an economist at Tax Analysts believes there are dangers in de-fanging the IRS. According to Sullivan, “Taxpayers will lose their fear of the IRS and stop paying taxes, expecting that they could make good the next time the U.S. government offers a reprieve. ‘It actually reduces compliance with the rules,’ he said as reported by The New York Times, ‘In the long run, it’s a revenue loser.’”
Sullivan also reported that booking such a large percentage of its profits in low-tax countries has, “allowed G.E. to bring its U.S. effective tax rate to rock-bottom levels (3.6%).”
In response to the elusive how much salary to pay a Sub-S corporation owner Sullivan reported in The Wall Street Journal that, “The average pay for a Sub-S owner was recently $38,400.” His inference was that was too low.
Sullivan makes the point that, “Short-term incentives for accelerated depreciation, which Congress enacted in 2008, 2009, and 2010 cause companies to report lower current tax expenses.”
Bringing in the practical implications of tax legislation Christopher Bergin, president and publisher of Tax Analysts clarifies, “One of my least favorite tax credits is the ethanol production credit,’ notes ‘In addition to taking care of the farmers and ethanol producers, the credit drives up the price of feed, which drives up the price of pigs, which drives up the price of bacon.”
Free Tax Research Sources
Free tax research abounds on the Internet. The caveat is, buyers beware, or in this case, tax researchers beware. It may not be dependable to build a case for a private ruling, but may be very useful for tax preparation reassurance.
Of course, irs.gov/taxpros has a wealth of free tools. Of note is the Practitioner Priority Service (866-860-4259) where tax law (option 1 after you call) and client account-related issues can be addressed. You will need a POA to have specifics mailed to you. The Practitioner Priority Service is for all tax practitioners weekdays, 8:00 a.m. until 8:00 p.m. your local time (Alaska and Hawaii follow Pacific Time). The IRS customer service representative handled my question (quickly) about the taxability of social security benefits after receiving $32,000 of other income. He also provided a helpline for social security calculations issues, 800-772-1213, available 7-7, M-F. This representative was not knowledgeable about when to take social security benefits at 62 or later, but did confirm that social security statements being mailed out has been suspended due to budget constraints.
Tax.com was named Web site of the Month by The CPA Journal in February stating that, “The site’s mission is to help the average taxpayer find out about the tax system, but there are many resources that will be of interest to experienced professionals. Tax.com provides a variety of free or low-cost materials, from articles to calculators to short videos.”
The tax forums found at taxalmanac.org host discussions where tax practitioners try to help each other by posting and responding to very specific problems. The opening main page feature article appears dated. It features Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which was enacted at the end of 2010 making it six months old. Disregarding dated imperfections the strength of this Web site is under the hood, in the forums specifically.
- Details
- Written by: T. STEEL ROSE, CPA, AND JASMINE TEMARES
In possibly the most fascinating year for business taxes, 2010 encapsulates all that is intriguing about tax planning. With this group of tax tips, the contributors provide thought provoking guidance on an array of useful subjects: 2nd Story Software offers tips to keep small business tax clients tax healthy; RedGear Technologies helps you determine if your client qualifies as an eligible small employer; CCH Small Firm Services discusses the importance of monitoring any changes to state apportionment formulas; CCH, a Wolters Kluwer business explains how the Mayo Supreme Court case impacts the overstated basis regulations and cases; Intuit provides a quick rundown of the various Retirement Plans for Small Business; Drake Software uses some humor to acquaint readers with the vagaries of Schedule M-3 to reconcile book and tax differences; and Thomson Reuters provides a comparative table glimpse to maximize Bonus Depreciation and Section 179 Deductions.
Put all this advice together and you have a resource for tax clients through Sept. 15th to complete 2010 returns; and then, it’s back to planning for 2011.
Keep Small Business Clients Tax Healthy
Small business owners take on multiple duties. Among the more challenging responsibilities are taxes. Help keep your small business clients tax healthy year round with these tips.
Inform clients of tax deadlines to help them avoid cash flow disruption and penalties. Consider giving clients personalized calendars, and if you haven’t already, provide prepared Form 1040 ES.
Help clients define and pay labor properly. It’s not unusual for small business owners to misunderstand the difference between employees and independent contractors. Be sure clients understand they must withhold income, Medicare and Social Security taxes from employee paychecks, and pay the employer’s share of Medicare, Social Security and unemployment taxes.
Educate your clients on small business tax breaks. For 2011, the deduction for business start-up costs is worth twice as much and phases out at a higher amount. Legislation also extended the increased deduction amount, phase-out limit and definition of Section 179 property. First-year bonus depreciation was also extended. For property placed in service after September 8, 2010, and before January 1, 2012, bonus depreciation is 100 percent. The Small Business Jobs Act of 2010 included a deduction for health insurance premiums when calculating self-employment tax. Self-employed individuals can deduct 100 percent of health insurance costs for themselves, their spouses and dependents.
Remind clients to track deductible expenses. Whether they deduct actual vehicle expenses or use the standard mileage rate (51 cents per mile in 2011), have them keep detailed documentation including mileage and purpose. Detailed logs should also be kept for travel expenses and business use of their home.
Advise clients to protect information from theft and data loss. Tips include shredding sensitive data before recycling and never sharing financial information with unauthorized personnel. Recommend scanning important documents and saving backup copies on a password-protected and secure external drive or cloud setting. Keep digital photographs of valued assets.
— 2nd Story Software
Does Your Client Qualify as an Eligible Small Employer?
Agreat opportunity became available for eligible small employers to offset their tax liability and for tax-exempt eligible small employers to qualify for a refundable credit.
The small employer health insurance premium credit was one of the first health care reform provisions to take effect from the Patient Protection and Affordable Care Act, enacted March 23, 2010.
The credit may be used to offset an employer’s alternative minimum tax (AMT) liability for the year. The credit is effective for taxable years beginning in 2010 through 2013. The maximum credit for small employers is 35 percent of premiums paid, and 25 percent for tax-exempt small employers.
Eligible small employers may receive the credit if they had fewer than 25 full-time equivalent (FTE) employees for the taxable year; paid average annual wages to employees of less than $50,000 per FTE; and offered employer-paid health insurance premiums for each employee enrolled in health insurance coverage under a qualifying arrangement. (The employer must pay at least 50 percent of the premium for employee-only plan.)
The following individuals are excluded from the credit: business owners, including sole proprietors, LLC members, partners in a partnership, “2 percent shareholders” in an S corporation, 5 percent or more owners in a C corporation; family members of the individuals listed above; and seasonal employees.
To determine the amount of health care tax credit, fill out Form 8941, Credit for Small Employers Health Insurance Premiums. The credit is claimed on Form 3800, General Business Credit, part II and Form 990-T, part IV for tax-exempt entities. If the business is unable to use the credit in the current year, the credit may be carried back one year and carried forward 20 years, except in 2010 when the credit may only be carried forward.
Additional items to note when claiming the credit:
- The employer’s deduction for health insurance premiums must be reduced by the amount of credit claimed.
- The premium used to claim the credit is not reduced by any state premium credit or subsidy. However, the credit cannot be more than the net out-of-pocket premium paid by the employer.
- After 2013, the credit percentage increases to 50 percent.
— RedGear Technologies
Changing State Apportionment
Navigating the complex landscape of state taxation can be difficult. For companies operating in multiple states, the challenges are intensified.
Each state’s tax code affects how a business can allocate their taxable income. For tax professionals, it’s important to monitor any changes to state apportionment formulas as these rates can impact bottom line tax payments.
Lately, several states have increased the weight of a business’ sales in their apportionment formulas. And, this trend seems to be catching on. For tax year 2011, the following states will adjust their apportionment formulas to focus on a business’ sales as the main factor in determining taxable income.
- Indiana — Apportionment formula will be solely based on the sales factor.
- California — Certain taxpayers can elect to apportion income using sales factor alone.
- Minnesota — Increase sales factor to 90% of the apportionment formula.
- Utah — Increase sales factor to 67% of the apportionment formula.
(100% sales factor apportionment formula predicted for 2013.)
The results for businesses in states that are adopting a heavily weighted sales factor can be good or bad, depending on the company specifics. For example, if an office has significant amounts of payroll and property, but low sales in a state that uses a sales-only or sales-heavy weighted formula, then the income taxable to the state would be much lower than in a state where the property, payroll and sales are evenly weighted. On the other hand, high sales and little to no property or payroll in a state that uses a sales-only or sales-heavy weighted factor could create a significant tax bill.
As state apportionment formulas change, tax professionals must keep current on the effects in order to best advise their business clients on important future decisions.
— CCH Small Firm Services
Trouble for Overstated Basis Statute of Limitations Disputes With IRS
The recent Federal Circuit Court of Appeals decision in Grapevine signals trouble for taxpayers in overstated basis cases. However, the Tax Court decision in Carpenter gives taxpayers continued hope.
In pursuing tax shelter cases involving overstated basis, the IRS has often filed Final Partnership Administrative Adjustments (FPAAs) after the normal three-year statute of limitations, and taxpayers have challenged the FPAA as being untimely. The IRS has countered that a six-year statute of limitations applies, under Code Secs. 6501(e)(1)(A) and 6229(c)(2), arguing that, in cases not involving a trade or business, overstated basis is an omission from gross income.
The IRS must distinguish an old Supreme Court case, Colony, Inc. v. Commissioner, 357 U.S. 28 (1958), finding that, although the predecessor to Code Sec. 6501(e) was not unambiguous, the legislative history indicated that the term “omits from gross income” was intended to refer to failure to include, not merely understate, an item. The IRS, to distinguish Colony, relies on changes to the statute when Code Sec. 6501(e) was adopted, using the prior language only in the context of a trade or business, arguing that overstated basis is otherwise an omission from gross income.
The IRS adopted temporary regulations in 2009, finalized in 2010, that specifically interpreted the statutory language as meaning that an omission from gross income includes overstated basis outside of the trade or business context.
This left the courts to also evaluate the weight to be given to these IRS regulations under the standards of two Supreme Court cases, Chevron and National Muffler. The National Muffler standard looked down on regulations enacted long after the statute and in response to adverse court decisions. The Chevron standard merely asks if the statute was ambiguous and, if so, whether the regulations were a reasonable interpretation of the statute. A number of courts continued to reject the IRS position on overstated basis relying on Colony and the National Muffler standard.
In January, 2011, the Supreme Court in Mayo, 131 S. Ct. 704 (January 11, 2011), adopted the more relaxed Chevron standard for the review of IRS regulations. In Grapevine, the Court of Appeals for the Federal Circuit, which had held for the taxpayer in an earlier case (Salmon Ranch), now ruled for the IRS, giving deference to the regulations under the Chevron standard endorsed by the Supreme Court in Mayo.
In April, 2011, the Tax Court held in Carpenter that the regulations were still invalid, even under the Chevron standard, finding the statute unambiguous. The issue is likely to end up with the Supreme Court.
— CCH, a Wolters Kluwer business
Retirement Planning for Small Businesses
It’s always a good idea to plan for retirement, especially with generous government incentives involved. There are a variety of retirement plans available to small businesses that allow the employer and employee a tax favored way to save for retirement. Contributions made by the owner for himself or herself and for employees can be deducted. Furthermore, the earnings on the contributions grow tax-free until the money is distributed from the plan.
SEP Plan (Simplified Employee Pension) (for employer only). This plan allows you to avoid setting up a profit-sharing or money purchase plan, and instead, adopt a SEP arrangement and make contributions to an IRA. Deductible contributions are limited to the lesser of 25% of the participant’s compensation (up to $245,000) or $49,000.
Qualified Plans (Keogh) (for employer only). Although the rules surrounding these profit sharing or money purchase plans are more complex than SEP and SIMPLE Plans, these plan types are more flexible. Deductible contributions are limited to the lesser of 25% of the participant’s compensation (up to $245,000) or $49,000.
SIMPLE Plan (Savings Incentive Match Plan for Employees) (for employer and employees). Under this plan, the business owner takes a deduction and employees receive a salary deferral. The contribution limit is $11,500 (per employer or employee) with an additional catch-up contribution limit of $2,500 for those age 50 or older. The employer can match the contribution up to 3% of compensation or make a non-elective contribution of 2% compensation.
Individual 401(k) Plan (Elective Deferral) (for employer and employees). The individual 401(k) plan is similar to the traditional 401(k) plan with added benefits for the small business owner. The owner can contribute and deduct up to 25% of compensation plus an additional $16,500 salary deferral up to a $49,000 maximum ($54,500 for those who are age 50 and over). For employees, the contribution and salary deferral limit is $16,500 with an additional $5,500 catch-up contribution available to those age 50 or over. Employers can match employee contributions.
Contributions to these retirement plans can be made up until the due date of the tax return. The small business owner is also allowed a tax credit equal to 50% of the first $1,000 incurred in starting up a plan. It’s smart to consult with a financial planner before deciding on a plan that best suits the business.
— Intuit
Schedule M-3: Scarier Than Semicolons?
Tax preparers used to fear using semicolons in business writing and managed to avoid them. Now tax preparers face a peril more frightening than punctuation and can leave even a seasoned tax preparer quaking in his/her dress shoes: the Schedule M-3.
Gone are the days when there was only the sweet, complacent Schedule M-1 to reveal the book-to-tax differences! The monster Schedule M-3 is now required for entities with assets in excess of $10 million.
The Schedule M-3 is unavoidable for many preparers of corporation and partnership tax returns and most preparers will have to learn a few things about the M-3.
The schedule is three pages long and has other peripheral forms, statements, and attachments. It’s involved, complicated, and has foreign-sounding phrases like “Hedging transactions.”
The instructions for the Form 1120 Schedule M-3 are 27 pages long! Clearly completing the Schedule M-3 is not a project to undertake during tax-season. Once the return requiring the schedule is prepared a reconciliation shows that Schedule M-3, Part II, line 30 totals don’t match the amount reported on Form 1120, page 1, line 28. What’s wrong?
Temporary or permanent differences are missing. The schedule needs more information provided only in the audit papers and detailed financial statements, not the tax return. And, for certain lines, the IRS requires detailed statements in a specific format.
Still out of balance! Amounts with no differences have not been taken into consideration. Those are reported on page 2, Part II, line 28, which reads “Other items with no differences.”
Part I, line 4a, asks for “Worldwide consolidated net income (loss)” from income statement source identified in Part I, line 1,” and line 4a doesn’t tie to the corporation’s income statement. The book and tax income reported on Part II is correct. What is missing? The includible amounts from the other includible or nonincludible entities are not included and don’t belong on Parts II or III.
What’s this about assets and liabilities on Part I? What do those have to do with the book-to-tax net income or (loss) reconciliation? The information is required by the IRS, but most tax return preparers do not agree with providing the information.
— Drake Software
Maximizing Bonus Depreciation and Section 179 Deductions in 2011
Taxpayers who acquire assets for use in their trade or business or rental activity have a good chance of writing off the entire cost this year.
Section 179 expensing. For tax years beginning in 2011, the Section 179 deduction limit is $500,000, reduced (but not below zero) by the cost of qualifying property over $2 million. So, the deduction is not fully phased out until the cost of qualifying property (placed in service during the year) reaches $2.5 million.
Bonus depreciation. Assets that would have qualified for 50% bonus depreciation (as in effect in 2010) qualify for 100% bonus depreciation, if they are acquired and placed in service after Sept. 8, 2010, and before 2012 (2013, for certain long-production property and aircraft). Solely for this test, property is acquired when the taxpayer pays or incurs its cost.
Additional planning considerations. When determining whether the mid-quarter convention applies, assets expensed under Section 179 are not counted, but basis deducted as bonus depreciation is.
Taxpayers can elect out of bonus depreciation, but the election applies to all additions within that asset class (e.g., five-year property) placed in service that year. The Section 179 expensing election is made asset-by-asset and taxpayers can elect to expense less than the full amount of an asset’s basis.
— Thomson Reuters
- Details
- Written by: TIM BERRY, ESQ
A
s recently as March 2010, it was estimated that there is over $4.3 trillion invested in IRAs (“Retirement Snapshot, First Quarter 2010”, Investment Company Institute), and another $12 trillion, if you look at the entire retirement plan market (Ibid.). These numbers reflect the fact that over 40% of US households have an Individual Retirement Account (IRA).
Even though these investment accounts permeate our financial lives, few professional advisors, much less the individual owners themselves, really know the rules governing individual retirement accounts.
The challenge is that due to the complications of the tax code, everyday occurrences can cause an IRA to be completely and fully distributed for tax purposes. Additionally, if the IRA is considered distributed for tax reporting purposes, it has probably lost any asset protection as an asset exempt from the claims of creditors as well.
Prohibited Transactions and IRAs
As a general rule, IRAs are accounts that are exempt from taxes on their earnings (26 USC 408(a)). The beneficiary is only taxed when taxpayers start taking distributions from the IRA (26 USC 408(d)).
If the IRA engages in a prohibited transaction as per 26 USC 4975(c), the IRA ceases to be an IRA as of the first day of the taxable year the prohibited transaction occurred. Furthermore, the account is treated as if it made a distribution, at fair market value of all it assets as of the first day of the taxable year (26 USC 408 (e)(2)).
For example, Joe has a $100,000 IRA on January 1, 2009. On October 31, Joe engages in a prohibited transaction with his IRA, now valued at $75,000. Since the account is no longer an IRA, Joe has not only lost all future tax deferral, but he now owes taxes on $100,000 of income as that was the value of the account on January 1.
Among other things, a prohibited transaction is defined under 26 USC 4975(c)(1)(b) as “lending of money or other extension of credit between a plan and a disqualified person.” The IRA owner is considered a disqualified person to the IRA.
Brokerage Agreements Create Prohibited Transactions
In general, a requirement of opening an IRA with a brokerage firm is to agree to the brokerage firm’s standardized “brokerage agreement.”
A typical term in the brokerage agreement is a requirement for the client to personally guarantee the account and/or grant the brokerage firm a lien on all other assets including personal accounts the client may have at the firm.
Recently, we requested a ruling from the Department of Labor as to whether such language would be considered an extension of credit and thus a prohibited transaction. (Under Reorganization Plan No. 4 of 1978, effective December 31, 1978, the authority of the Secretary of the Treasury to issue interpretations regarding section 4975 of the Code was transferred to the Secretary of Labor. The Secretary of the Treasury is bound by the interpretation of the Secretary of Labor pursuant to such authority.) In October of 2009, the DOL released Opinion 2009-3A. In its Opinion, the DOL stated, “Here, the requested granting of a security interest in the assets of the IRA owner’s personal accounts to the broker to cover the IRA’s debts to the broker is akin to a guarantee of such debts by the IRA owner. This would amount to an extension of credit from the IRA owner to the IRA."
Didn’t think a brokerage firm could require such a guarantee? Read some of the following and come to your own conclusions:
“Security Interest. As security for the repayment of my present or future indebtedness under the Account Agreement or otherwise, I grant to XXXX Investments a first, perfected and prior lien, a continuing security interest, and right of set-off with respect to all securities and other property that are, now or in the future, held, carried, or maintained for any purpose in or through my Brokerage Account or Settlement Choice and any present or future accounts maintained by or through you or your affiliates,” Brokerage Firm A.
“Granting a Lien on Your Accounts. As security for the repayment of all present or future indebtedness owed to us by each Account Holder, each Account Holder grants to us a first, perfected and prior lien, a continuing security interest, and right of set-off with respect to, all property that is now or in the future, held, carried or maintained for any purpose in or through XXXX, and, to the extent of such Account Holder’s interest in or through,” Brokerage Firm B.
Ramifications
Based upon the ruling by the DOL, it appears there are millions of zombie IRAs. While the average citizen and professional advisor are acting on the belief the IRA is “qualified,” there is a very high likelihood the IRAs are not qualified and are instead mounting up very large tax bills.
Even more troublesome is the fact that transactions that would normally be commonplace with “qualified” IRAs do nothing but add more to the unknown tax bill.
Consider rollovers and transfers of IRAs. In order to rollover or transfer from one IRA to another, you obviously need a “qualified” IRA as the starting point. If the account is no longer an IRA that would mean non-qualified funds are being transferred into a qualified fund. Under the tax code, these “excess” contributions are subject to a 6% excise tax each year they remain in the plan (26 USC 4973).
Example: Steve had an IRA worth $100,000. In 2005, he opened an account for his IRA at a brokerage firm that required him to personally guarantee the account. His account would be considered fully distributed as of January 1, 2005. In 2007, Steve rolled what he thought was an IRA into an IRA with a new brokerage firm. If the account was still $100,000, Steve is now liable for an excise tax of $6,000 a year in addition to any other taxes that came due when he engaged in the inadvertent prohibited transaction.
By the way, right now the hot financial planning topic is to convert a traditional IRA over to a Roth IRA.
What happens if someone doesn’t have a traditional IRA anymore? Are they allowed to convert what is now merely a personal investment account into a Roth? No. Instead of building up tax-free income, they are building up 6% annual excise tax fees.
Another concern is the bankruptcy protection given to IRAs. In most jurisdictions, IRAs are considered exempt assets, not subject to the claims of their creditors.
If in fact the IRA has engaged in a prohibited transaction, the IRA is no longer an IRA and thus no longer an exempt asset. I personally know of a number of bankruptcy trustees who are now reviewing debtor’s IRAs to see if they have run afoul of the prohibited transaction rules.
Conclusion
If your client has an IRA, they need to make sure that neither they nor the IRA have inadvertently engaged in a prohibited transaction that would cause the IRA to be fully distributed and fully subject to taxes. If in fact they have run afoul of the IRS rules on IRAs, they need to immediately contact a professional to start the IRS retroactive relief process.
Tim Berry, Esq., specializes in issues with retirement plans and has been asked to provide numerous continuing education classes on the topic. You can reach him at
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- Written by: Robert E. McKenzie, J.D. & Robert A. McKenzie, J.D.
For most taxpayers, whether businesses or individuals, the chances of an examination are about 1%. For a taxpayer earning over $1,000,000 per year, the odds exceed 8%. The odds of examination can increase dramatically because of the information reported on or omitted from returns.
For example, one way the IRS selects returns for examination is by assigning a Discriminating Function System Score (DIF Score). Taxpayers receive higher DIF scores and are more likely to get examined when they: 1) report high incomes, 2) are self employed, 3) fail to file necessary schedules/forms, 4) receive large refunds, 5) deduct casualty losses, 6) claim tax credits, 7) report foreign bank accounts, 8) fail to report income reported to the IRS by third parties on information returns or 9) earn a higher income and report losses from rental property. In fact, earning a substantial income alone can increase a taxpayer’s odds of examination by more than 750%.
The IRS also considers currency transaction reports (a report of a cash deposit of more than $10,000), document mismatches, information from informants and referrals from other federal agencies when selecting returns for examination.
The IRS reports annually on its examination of returns in Publication 55B, the Internal Revenue Service Data Book. During the 2010 fiscal year, the IRS examined 1,735,083 returns, 0.9% of the 187,124,450 returns filed during the 2009 calendar year. Individual income tax returns made up more than 91% of the returns selected for examination, and the rate of audit of those returns exceeded 1%. The IRS also examined 28,733 partnership and S corporation returns and 29,903 C corporation returns. High-income taxpayers were examined much more frequently than other taxpayers.
The IRS categorizes individual income tax returns as follows: returns with total positive income under $200,000, returns with total positive income of at least $200,000 and under $1,000,000, returns with total positive income of $1,000,000 or more and international returns. Individual income tax returns with total positive income of $1,000,000 or more, i.e. high-income individuals, were the most likely to be examined with 8.4% of the returns filed being selected. Business owners with gross receipts of $100,000 – $199,999 came in second with 4.7%. IRS studies of the tax gap have shown that although over 98% of wage earners report their income, the compliance rate among the self-employed is much lower. Therefore, the IRS seeks to exam more schedule C returns.
The IRS’s motivation for examining higher income individuals is very clear: examinations of high-income individuals result in more tax being assessed for the same amount of work. In 2010, the IRS examined more than 275,000 business returns without Earned Income Tax Credits. The average recommended change for those returns was between $2,619 and $31,979. Comparatively, the average change for high-income individuals was between $151,874 and $163,520. Since the labor involved in examining the two types of returns is relatively similar, the IRS elects to audit high-income individuals where it is likely to assess more tax. The IRS’s examinations of high-income taxpayers, who account for only .017% of the filed returns, resulted in a total proposed increase in tax of $2,613,872,000 in 2010, more than 31% of the total proposed change for all returns.
Interestingly, high-income tax returns are also among the least likely to contain errors. In 2010, the IRS examined 32,494 returns from high-income individuals. Of that total, 25% of the returns examined in the field and 34% of the returns examined by correspondence were not changed. Comparatively, the examination of some business returns resulted in changes more than 90% of the time.
C corporations are under similar scrutiny to individual taxpayers. While C corporations have an overall examination rate of 1.4%, more than 16% of the C corporations with assets in excess of $10,000,000 were examined in 2010. The examination rate increases dramatically as assets increase and is 98% for the largest C corporations.
S corporations and partnerships are some of the least likely taxpayers to be examined, with only .4% of the returns filed being selected. But, pass through entities are often subject to de facto examinations when their shareholders and/or partners are examined.
Like a business, the IRS looks for the biggest return on its investment of time. Considering that a revenue agent could complete as many as 60 small business examinations to match the tax increase from the examination of a single, high-income individual, there is little mystery to the IRS selection process.
Robert E. McKenzie, J.D., is a partner at Arnstein & Lehr, LLP in Chicago, IL, and is co-author of Representing the Audited Taxpayer Before the IRS. Robert A. McKenzie, J.D., is an associate at Arnstein & Lehr, LLP.