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Written by: Sidney Kess CPA, J.D., LL.M.

Published: 10 January 2012

There are many factors contributing to tax uncertainty at this time. For individuals and tax practitioners alike, planning over the next several years is going to be challenging, to say the least, because of this uncertainty. Still, working within the framework of what is known can produce tax savings for those who take appropriate action. Understand the forces at work and the opportunities available now. 

What is contributing to uncertainty?

There are several pieces of legislation that intersect, resulting in some tax provisions expiring, some taking effect, and others simply unknown:

-  The Budget Control Act of 2011 (P.L. 112-25), enacted in August to save the country from default, could result in changes from the bipartisan joint committee authorized to raise $1.5 trillion over 10 years. What these changes might be is entirely unknown at this time. Proposals are scheduled to be voted on in Congress before the end of this year.

-  A jobs bill, following the President’s plan for job creation, could introduce new tax incentives for employers. Again, what these changes might be, when they would take effect, and how long they would run, is also unknown. The President proposes but it is up to Congress to enact. 

-  About two dozen tax provisions affecting individuals and businesses, which were extended temporarily by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312), are set to expire at the end of 2011.

-  Core provisions, including income tax rates, estate and gift tax rules, and other rules under the so-called Bush tax cuts, which were also extended temporarily by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312), are scheduled to expire at the end of 2012.

-  Several tax increases are set to begin in 2013 under the Patient Protection and Affordable Care Act of 2010 (PPACA) (P.L. 111-148), but constitutional challenges to this law may undo scheduled tax hikes. Also, the 2012 presidential race, along with elections in Congress, could produce dramatic political changes. These changes could lead to new or different tax policies, depending on who the winners are. What does all this mean for tax planning? It is necessary to drill down to the fine points of tax law to find tax-saving opportunities that can be used now.

Income tax planning

Because there is no long-term certainty about tax rates or other tax rules, it is difficult to nail down long-term planning strategies. Short-term savings can, however, be achieved by taking advantage of expiring provisions:

-  Homeowners who have not previously made energy-saving improvements may want to do so before the end of the year (Code Sec. 25C). A federal tax credit of up to $500 may be claimed. There may also be state-level tax breaks for energy improvements (find state-level incentives at www.dsireusa.org).

-  Homebuyers who obtain mortgage insurance to swing the purchase before the end of this year can deduct the premiums as home mortgage interest if income is below set limits (Code Sec. 163(h)(3)).

-  Those age 70-1/2 or older can transfer up to $100,000 from their traditional IRA to a public charity tax free (Code Sec. 408(d)(8)), minimizing their adjusted gross income. Besides reducing income tax, it can minimize or avoid a Medicare surtax for Part B premiums in 2013 (which is based on 2011 adjusted gross income.

-  Buying business equipment, which can be fully deductible using 100% bonus depreciation for new property (Code 168(k)(5)) or up to $500,000 under first-year expensing for pre-owned property (Code Sec. 179). Next year, bonus depreciation is set to be 50%, while first-year expensing will be only $125,000 (adjusted for inflation).

-  Leasehold, restaurant, and retail improvements made before the end of this year qualify for 100% bonus depreciation (Code Sec. 168(k)(5)). Next year, bonus depreciation is set to be 50%; the balance of the cost of these improvements will have to be depreciated.

-  Making certain charitable contributions, which entitles certain businesses making specific types of donations (e.g., books, food inventory, computers) to enhanced deductions (Code Sec. 170(e)).

-  Expensing of certain capital business costs, including film and television production costs (Code Sec. 1818(f)), environmental remediation costs (Code Sec. 198), and mine safety equipment (Code Sec. 179E)).

-  Investing in a qualified small business (a domestic C corporation involved in manufacturing, technology, retail, or wholesale activities) in order to qualify for a 100% exclusion on gain from the sale of stock held more than five years (Code Sec. 1202).

Some or all of these breaks could be extended beyond 2011, but there is no guarantee. The Joint Committee on Taxation has a complete list of provisions set to expire this year through 2020 at www.jct.gov/publications.html?func=startdown&id=3722.

Understanding slated changes

Changes set to become effective in 2013 may lead to some tax action now. (As mentioned earlier, these changes could be eliminated by court decisions on the PPACA or by a new Congress.) In 2013, there are two key tax changes that are scheduled to apply:

-  There is a 0.9% Medicare tax on wages and self-employment income over $200,000 for single individuals and $250,000 for married couples (Code Sec. 3101(b)(2)). This additional tax applies only to the employee share of Medicare tax and the employee portion of the Medicare tax within the self-employment tax.

-  There is a 3.8% Medicare tax on investment income if modified adjusted gross income (MAGI) exceeds $200,000 for single individuals and $250,000 for married couples (Code Sec. 1411). The tax applies to the greater of net investment income or MAGI over the $200,000/$250,000.

The result of these changes could be realignment of investment portfolios. For example, tax-exempt bonds may become more attractive, despite current low yields, in view of these Medicare surtaxes for higher-income individuals. Conversions to Roth IRAs before 2013 will help to reduce MAGI when taxpayers would otherwise have to begin to take required minimum distributions (note that the surtax does not apply to IRA distributions). Deferred annuities and life insurance may also be attractive.

Wealthy individuals may want to take another look at using family limited partnerships and family limited liability companies to hold investments for the family. These entities will not pay the Medicare surtaxes. However, these entities should only be set up with the assistance of tax professionals who are knowledgeable in estate planning to ensure the entities have a business purpose and meet other tax rules so they will not be disqualified.

For small businesses, there may be a shift from sole proprietorships and limited liability companies (LLCs) to S corporations to minimize the 0.9% surtax on wages and self-employment income. Self-employed individuals, including LLC members in most cases, pay self-employment tax (which includes the Medicare tax) on their share of business profits, while S corporation owner-employees only pay FICA (which includes the Medicare tax) on wages. Thus, S corporations can be used to limit this surtax for business owners.

Estate tax planning

Currently, there is a $5 million exemption amount for transfers during life or at death. This exemption amount applies through 2012. What the estate, gift, and generation-skipping transfer tax rules will be after 2012 remains to be seen.

Lifetime transfers are a way to reduce the size of an estate, and some wealthy individuals may want to take full advantage of the exemption for lifetime transfers. Those who utilized the former $1 million lifetime exemption amount for gifts can now make an additional $4 million in gifts tax free.

All individuals probably want to review their estate plans. The goal for many individuals will be to retain flexibility for these plans so they are adaptable to tax changes that may result.

Between now and the end of the year, individuals can make tax-free gifts that do not erode the lifetime exemption amount. The annual exclusion limit for gifts in 2011 is $13,000 per individual ($26,000 if a spouse consents to the gift). This limit applies on a per-donee basis. Thus, a single grandparent with four married grandchildren could give away $104,000 ($13,000 x 8, which is 4 grandchildren and 4 of their spouses).

Those who want to add funds to a child’s or grandchild’s 529 college savings plan can do so to optimize lifetime transfers. A contribution of $65,000 can be made gift-tax free; under a special rule, five times the annual exclusion limit, or $65,000 ($13,000 x 5) can be made in a single year.

Final word

Any tax changes enacted before the end of 2011 could produce saving opportunities. Stay alert to possible new tax laws and actions to take as a result.

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Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 20 November 2011

By: Sidney Kess, CPA, J.D., LL.M. |  Key provisions of the Patient Protection and Affordable Care Act (also referred to as the Affordable Care Act, ACA, or Obamacare) (P.L. 111-148) are set to take effect on January 1, 2014. This includes the individual mandate, which requires all individuals without an exemption to have minimum essential health coverage or pay a penalty (Code Sec. 5000A). Individuals must also have coverage for their dependents up to age 18. In the case of an adopted child or a child placed for foster care, the requirement for coverage starts with the first month after the legal adoption or acceptance of the placement.

Final regulations on the individual mandate clarify some important rules (T.D. 9632, 8/27/13). The final regulations generally follow proposed regulations issued last February (REG-148500- 12). The preamble to the final regulations discusses commentators’ suggestions, most of which were rejected by the IRS.

Overview

On October 1, 2013, the health insurance marketplace opened so that individuals could enroll for coverage starting on January 1, 2014. Individuals will have access to a menu of health plans: bronze, silver, gold, and platinum. The more precious the metal, the higher the premiums but the lower the out-of-pocket costs. Using the marketplace is simply an online portal that can be used to compare health care options and make a selection. Individuals need to enter personal information, including income and household size.

As of now, there are 16 states, including Connecticut and New York, as well as the District of Columbia, that have set up their own marketplaces. About half a dozen states are planning “partnerships” with the federal government.

For individuals in states without a marketplace, such as New Jersey, there is a federal exchange. Details about the marketplace, including links to state marketplaces, can be found at HealthCare.gov (https://www.healthcare.gov/marketplace/ individual) and the Kaiser Family Foundation (http://kff.org/state-healthexchange- profiles).

Governance of the Affordable Care Act is left primarily to three government departments: the Treasury (through the IRS), the Department of Health and Human Services, and the Department of Labor. Each issues its own guidance; there is some overlap. The following discussion centers on IRS guidance.

Maintenance of Minimum Essential Coverage

Every nonexempt individual must have minimum essential coverage, which is now defined by the regulations. Minimum essential coverage is coverage under any of the following types of plans: -An employer-sponsored plan (Reg. Sec. 1.5000A-2(c)). - A plan in the individual market, which in 2014 includes coverage obtained through a health insurance marketplace. - Any other health plan recognized by the U.S. Department of Health and Human Services (Reg. Sec. 1.5000A- 2). For 2014, it has recognized student health plans as minimum essential coverage (www.cms.gov/Newsroom/MediaReleaseDatabase/ Fact-Sheets/2013-Fact- Sheets-Items/2013-06-26.html).

Pregnancy coverage under Medicaid is not treated as minimum essential coverage. However, women who are eligible for pregnancy-related Medicaid may not know at open enrollment for the 2014 coverage year that such coverage is not minimum essential coverage. Accordingly, the IRS anticipates issuing guidance providing that women covered with pregnancy-related Medicaid for a month in 2014 will not be liable for the shared responsibility payment for that month.

Computation of the Shared- Responsibility Payment

Individuals who opt not to carry health coverage and who are not exempt must make a shared-responsibility payment. The U.S. Supreme Court (NFIB v. Sebelius, S.Ct., 6/24/13) called this payment a tax (a penalty) and it is figured as such. For 2014, the penalty is the lesser of 1% of modified adjusted gross income or $95. The penalty is one-half that amount for any uncovered dependent up to age 18. Modified adjusted gross income for this purpose is adjusted gross income increased by any foreign earned income exclusion and tax-exempt interest.

The tax is scheduled to increase in 2015 to $325 and 2% and, in 2016, to $695 and 2.5%. After 2016, the dollar limit will be indexed for inflation.

The regulations provide examples on how to figure the penalty in different situations (e.g., part-year coverage; change in the family during the year).

Administrative issues

The payment is made by individuals on their income tax returns. Married persons filing joint returns are jointly and severally liable for the tax.

It is unclear exactly how the penalty will be enforced. The IRS is precluded from filing a lien or levy against a taxpayer who owes the penalty. Also, there are no criminal sanctions for noncompliance with the penalty. Presumably, the IRS can withhold a tax refund as an offset to the penalty. The preamble to the final regulations makes it clear that the penalty is not subject to the accuracy-related penalty under Code Sec. 6662.

The final regulations, however, do not explain how someone claims an exemption. Presumably, IRS forms and publications will address this matter. It will not impact filing 2013 income tax returns in 2014, so there is time for more guidance.

Conclusion

Despite postponement of the employer mandate to 2015, the individual mandate is still scheduled to start on January 1, 2014. Thus, the final regulations under Code Sec. 5000A apply to months beginning after December 31, 2013. It is likely that in addition to these final regulations, additional guidance on the individual mandate will be forthcoming. For example, the preamble to the final regulations promise that future guidance will address the impact of the cost of wellness programs in determining an individual’s required contributions toward health coverage.

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Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 08 September 2011

By Sidney Kess, CPA, J.D., LL.M

The IRS has about four dozen guides for its examiners to use when auditing tax returns. The guides are instructions to auditors, but are very instructive to taxpayers who want to know what the IRS is looking for. Being forewarned is forearmed in auditing-proofing a return to the extent possible. Here are some of the key points found in these two new audit guides.

Audit guide on attorneys

In March of this year, the IRS released a new guide entitled Attorneys Audit Technique Guide (3/11). The guide explains to auditors how lawyers operate and what to look for in income and expenses. The guide is employed regardless of the entity that is used to provide the services (e.g., sole proprietorship, partnership, corporation, limited liability partnership). However, different entities present unique issues to be considered, such as whether adequate compensation is taken by owners from practices that are S corporations.

Records. The guide tells auditors the type of attorney records to review in order to find information about income and expenses. These include:

• Appointment book
• Client card index
• Receipts journal or Daily log
• Disbursements journal, book, petty cash journal, or other record showing a breakdown of regular expenses paid from bank accounts, as well as disbursements made from client trust funds. These disbursement records should provide a mechanism from which disbursements chargeable to a specific client can be noted on their records for billing purposes.
• Accounts Receivable journal showing billed receivables.
• Individual client accounts including a description of services rendered, charges and credits, a summary of unbilled charges and work in progress, and final invoices.
• Case time records for each client.
• Register of cases in progress (typically organized by client’s name).
• Time summary reports, sorted by attorney and by client, listing the time, dates of work, billings and/or charges.

The guide instructs auditors on how to deal with claims of attorney-client privilege in looking at attorneys’ records. As a general rule, the attorney-client privilege protects disclosures of confidential communications but does not protect the identity of a client and the nature of a fee arrangement. Usually, attorneys cannot refuse to provide information required by information reporting statutes based upon the attorney-client privilege (see, e.g., Goldberger & Dublin, P.C., (CA-2) 935 F.2d 501 (1991).

Trust bank accounts. The auditor is also advised that attorneys typically have a main bank account for the firm. They also have one or more trust accounts, which may be interest-bearing; these accounts are unique to attorneys. There are two types of trust accounts: the General Trust Account and Segregated Trust Accounts. The General Trust accounts (called “Interest on Lawyer Trust Account” (IOLTA)) are administered under the direction of the program for IOLTA accounts, which are created by state legislation or the state’s court system. Therefore, these bank accounts may show either the identification number of the Bar Association, the IOLTA Program recipient or the client. The auditors are advised to contact the appropriate State Bar Association to determine the proper handling of these accounts and their earnings. Some states, including New York, have a statute detailing the disposition of interest paid on IOLTA accounts.

Client-related expenses. Attorneys, especially those working on a contingency basis, may pay expenses for their clients. Auditors are instructed to check whether attorneys properly reflect reimbursements from clients, either as gross receipts or as offsets to actual expenses.

Audit steps. The guide tells auditors how to conduct an examination. They have access to Accurint, which provides information on a person, their business, their professional standing, their assets, pending or resolved litigation, and other matters; this is the first thing that auditors are supposed to check. They are also advised to check the Internet for additional information.

Initial interview questions. The auditors are looking for income. Here are some suggested questions from the guide:

• How much cash was on hand at beginning and end of year?
• Were any loan proceeds received?
• Were referral fees received from other attorneys?
• Was compensation received in forms other than cash? Define bartering and use examples such as property interests, services, other assets received from a client in lieu of normal compensation.
• Are there any foreign accounts or offshore interests?
• Are there any interests in other entities?
• What Internet sites are maintained by the taxpayer?
• Online income sources including consulting, online bartering?
• Other online services provided?

The guide also contains lists of questions about the firm’s history, payroll, method of operation, and internal controls.

Key audit issues. In addition to probing about income, the auditors are looking at various expenses, including travel and entertainment costs, promotion and advertising, and advanced client costs. They also investigate the issue of employee versus independent contractor and corporate officers who are employees (if the firm is incorporated).

Bottom line. Any attorney or firm under examination should review this audit guide to anticipate what is to come. Those who are not under examination may want to review the guide as well to see where records, operations, or other matters can be changed to better withstand an audit.

Business Consultants

Last month, the IRS posted the Business Consultants Audit Techniques Guide (Rev. 7/11). According to the guide, business consulting is one of the fastest growing industries in the world today, and for many displaced workers, consulting is something they say they are doing while searching for a job. The guide attempts to identify audit issues unique to this market segment. Again, the guide applies to all consultants regardless of the entity used to run the activity.

Audit issues. Obviously, auditors are looking to find income that is not reported (or reported incorrectly) and expenses that should not have been deducted. Some of the income-related issues that the auditors are looking for include:

Bartering income that is not reported.

Shifting or assigning income between the consultant and his/her corporation in order to reduce income and/or self-employment taxes

Some of the expense-related issues that the auditors are looking for include:

Compensation for labor (whether workers are employees or independent contractors)

Meals and entertainment (to determine whether deductible items were for personal rather than business purposes; whether amounts were reimbursed by clients)

Travel both domestically and abroad

The auditors are also instructed to look for personal service corporations (PSCs). These C corporations pay a flat 35% tax rate on their taxable income. PSCs are also subject to certain restrictions. Consulting businesses that operate as C corporations usually are PSCs.

Another key audit issue concerns the hobby loss rule (Code Sec. 183). If the activity shows a loss, auditors are instructed to determine whether the activity is engaged in with a profit motive so that losses are deductible. If there is no profit motive, losses are not business losses; they are deductible only to the extent of income from the activity, and only as a miscellaneous itemized deduction (in excess of 2% of adjusted gross income).

Conclusion

There are many other audit technique guides for different industries. For example, the most recently posted guide is for the wine industry. This guide covers vineyards, wineries, and marketing and sales of wine. There is also a guide for the retail industry that came out two years ago. Tax professionals should check the list of audit guides so they can better advise clients about IRS-identified issues for their industries.

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Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 20 July 2011

By Sidney Kess, CPA, J.D., LL.M & Christopher M. Ferguson, J.D.

The tough economy may be easing, but it isn’t over for many taxpayers. In an effort to provide help to those who are struggling, the IRS has announced changes to its lien process and certain other actions that can help taxpayers who are trying to work their way out of financial difficulty, including their tax problems.

Background

The IRS issues more than 600,000 federal tax liens each year. Several years ago when the recession first took hold, the IRS initiated relief for homeowners who had liens placed on their residences (IR-2008-141, 12/16/08). That program expedited the process of removing a lien to make it easier for distressed homeowners to refinance their mortgages or sell their homes. The options:

• Taxpayers who were looking to refinance their home mortgage could request that the IRS make a tax lien secondary to the lien by the lending institution that is refinancing or restructuring a loan.
• Taxpayers who were looking to sell their homes for less than the amount of the mortgage (i.e., homeowners “under water”) could request that the IRS discharge its claim.

The following year, the IRS added other assistance for financially-distressed taxpayers (IR-2009-9, 1/16/09). These included such measures as flexibility for missed payments by taxpayers paying off back taxes on an installment payment agreement and additional review of home values for those requesting an Offer in Compromise.

Now, the IRS has announced a new round of initiatives to help certain taxpayers who are experiencing financial difficulties.

Changes in the IRS Lien Process

The IRS can obtain liens on taxpayers’ property in order to secure payment of outstanding taxes. By filing a Notice of Federal Tax Lien, the government obtains priority rights to collect back taxes versus claims by certain other creditors. Tax liens, however, can be an impediment for struggling taxpayers to get back on their feet; it hinders their ability to do just about anything that can be impacted by their FICO score (a credit score based on an individual’s credit history), such as borrow money, buy or rent a home, buy or lease a car, or even get a job.

In recognition of the impact of liens on financially-challenged taxpayers, the IRS has announced favorable revisions to its lien process (IR-2011-20, 2/24/11).

Tax lien threshold. The IRS has promised to significantly raise the dollar threshold for obtaining liens. The new limits will reflect cost-of-living increases and should be announced early in 2012.

Tax lien withdrawal. A tax lien is not lifted until the tax bill has been satisfied. However, the IRS has promised to change the procedures so that it is easier to obtain a lien withdrawal. Under the new procedure, the lien will be withdrawn once full payment has been made and the taxpayer requests that the lien be lifted. As part of the revised procedure, IRS collection personnel will be allowed to withdraw the lien. The IRS will issue a Release of the Notice of Federal Tax Lien within 30 days after the tax due (plus interest and any penalties) has been paid or within 30 days after the IRS accepts a bond guaranteeing payment of the tax.

Even better, taxpayers who have an unpaid tax bill of $25,000 or less and have a Direct Debit Installment Agreement may have the lien withdrawn before full payment is made. The IRS will set a probationary period during which the taxpayer must demonstrate repayment of outstanding taxes. Once this period has passed, the lien will be withdrawn.

The Online Payment Agreement application at IRS.gov can be used to set-up with Direct Debit Installment Agreements. Those who have outstanding installment agreements can convert to a Direct Debit Installment Agreement in order to have the lien withdrawn.

Details about requesting the release of a federal tax lien can be found in IRS Publication 1450, Request for Release of Federal Tax Lien, at irs.gov.

Small Business Installment Agreements

Taxpayers who cannot pay their tax bill in a lump sum may be able to obtain an installment agreement to spread their payments over time. A Streamlined Installment Agreement is available to taxpayers who meet four requirements:

• They have filed all necessary tax returns;
• The amount owed does not exceed a threshold amount $25,000;
• They did not acquire the tax debt more than five years ago; and
• They will be able to make monthly payments to pay off the tax debt in 60 months or less.

The minimum monthly payment amount usually is the balance due divided by 60 months. This is then adjusted upward by as much as 20% for interest and penalties with respect to the taxes due. For example, assume that an individual owes $12,000 in back taxes. The monthly payment amount likely will be $240 ($12,000/60 months + 20% of $200).

In recognition of the importance of small businesses to the U.S. economy, the IRS has promised to Streamline Installment Agreements for these small businesses (IR-2011-20, 2/24/11). In the past, only small businesses with outstanding tax debt under $10,000 could participate in this program; the threshold has now been raised to $25,000 or less in unpaid taxes. Those with balances in excess of the new limit can qualify for a Streamlined Installment Agreement by paying down their debt so that they fall within the $25,000 limit.

To use the Streamlined Installment Agreement, small businesses must use a Debit Installment Agreement. The period for paying the small business’ taxes due is limited to 24 months, rather than the 60 months available to individual taxpayers.

Offers in Compromise

Taxpayers who do not believe they can or will ever be able to pay all of their outstanding tax bills or do not believe that the amount that the IRS claims they owe is correct can offer to pay a reduced amount through a process called Offer in Compromise (OIC). The offer is not automatically accepted, but there has been increasing pressure put on the IRS (especially by the National Taxpayer Advocate in her 2010 Annual Report at www.irs.gov/pub/irs-utl/arcdedication_preface_toc.pdf) to make the process more taxpayer-friendly and more widely utilized.

Those requesting an OIC must file Form 656, Offer in Compromise, when there is doubt that the outstanding amount can be collected in full through a lump sum or an installment agreement, or Form 656-L, Offer in Compromise (Doubt as to Liability), when it is believed that the tax liability is incorrect. In addition, usually Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, and/or Form 433-B, Collection Information Statement for Businesses, must also be submitted. However, these forms are not required when an OIC is made solely as to doubt as to liability. Details about the OIC process are explained in Form 656-B, Offer in Compromise Booklet.

There is a streamlined OIC process for certain taxpayers, which has undergone some favorable changes (IR-2011-20, 2/24/11). The IRS has now increased the threshold of eligibility for the streamlined OIC to cover taxpayers with annual incomes up to $100,000. To participate, taxpayers must have tax liability of less than $50,000; the prior limit had been $25,000.