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- 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
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- Written by: TIM BERRY, ESQ
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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.