The Payroll Tax Two-Month Holiday (Continued)

Here is the IRS announcement last Friday (December 23) about the two-month payroll tax holiday.

IR-2011-124, Dec. 23, 2011

WASHINGTON — Nearly 160 million workers will benefit from the extension of the educed payroll tax rate that has been in effect for 2011. The Temporary Payroll Tax Cut Continuation Act of 2011 temporarily extends the two percentage point payroll tax cut for employees, continuing the reduction of their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid through Feb. 29, 2012. This reduced Social Security withholding will have no effect on employees’ future Social Security benefits.

Employers should implement the new payroll tax rate as soon as possible in 2012 but not later than Jan. 31, 2012. For any Social Security tax over-withheld during January, employers should make an offsetting adjustment in workers’ pay as soon as possible but not later than March 31, 2012.

Employers and payroll companies will handle the withholding changes, so workers should not need to take any additional action.

OBSERVATION: Kruse & Crawford CPAs is one of the “employers and payroll companies” that will handle the withholding changes. So, we have a payroll tax holiday that does not last all the months in a quarter. Apparently Congress realized that the servicers may not have been prepared for this, so Congress decreed that we have an additional month to get it right.

Under the terms negotiated by Congress, the law also includes a new “recapture” provision, which applies only to those employees who receive more than $18,350 in wages during the two-month period (the Social Security wage base for 2012 is $110,100, and $18,350 represents two months of the full-year amount). This provision imposes an additional income tax on these higher-income employees in an amount equal to 2 percent of the amount of wages they receive during the two-month period in excess of $18,350 (and not greater than $110,100).    

This additional recapture tax is an add-on to income tax liability that the employee would otherwise pay for 2012 and is not subject to reduction by credits or deductions. The recapture tax would be payable in 2013 when the employee files his or her income tax return for the 2012 tax year. With the possibility of a full-year extension of the payroll tax cut being discussed for 2012, the IRS will closely monitor the situation in case future legislation changes the recapture provision.

OBSERVATION: If you think about this, there is a certain amount of sense. The FICA wage base for 2012 is $110,100. Since the holiday is for less than the entire year, Congress felt it necessary to prorate the wage base, as otherwise one could “game” the system. One would do that by taking his/her first $110,100 of payroll in the first two months of the year. That would require noncommon fact patterns, but it could and would happen. I know that we – as tax planners - would have taken advantage of it where possible for our clients.

OBSERVATION: How is the tax preparer to know if someone received more than $18,350 of payroll in the first two months? Will there be yet another “box” on the 2012 W-2 for this?

COMMENT: I suspect that Congress will extend the holiday for the full year, and the clawback provision will be deleted at that time.

Retirement and Health Plan Limits for 2012

Here are the 2012 contribution limits for the following retirement plans:

·         401(k) limits increase from $16,500 to $17,000. The same limit applies to 403(b) and  457 plans.

·         IRA limits remain the same at $5,000

·         SEP limits increase from $49,000 to $50,000

·         SIMPLE limits remain the same at $11,500

·         Catch-up contributions remain the same

o   $5,500 for 401(k), 403(b) and 457 plans

o   $2,500 for SIMPLEs

o   $1,000 for IRAs

Here are the new limits for high deductible health plans:

·         Health Savings Accounts

o   Individual contribution limits increase from $3,050 to $3,100

o   Family contribution limits increase from $6,150 to $6,250

·         High Deductible Health Plans

o   Minimum out-of-pocket limits remain the same at $1,200 and $2,400 for individuals and families, respectively

o   Maximum out-of-pocket limits increase from $5,950 to $6,050 for individuals and from $11,900 to $12,100 for families

·         Flexible Spending Accounts

o   No federal limits for 2012 but your employer may designate a limit

o   Federal limit of $2,500 beginning in 2013

The New 1099 For Credit Card Reporting

It’s been over a year since we talked about the new IRS Form 1099-K. This was part of the Housing Assistance Act of 2008, and it was to – at least partially - “offset” the cost of the first homebuyer’s credit.

This is Congress passing laws, mind you, so the reporting did not apply until sales made on or after January 1, 2011. This means you may be receiving this new 1099 during the 2012 tax filing season.

Let’s talk about the “why” for this form.

Say that you are a vendor on eBay or Amazon. It used to be that eBay or Amazon did not have to send you a tax reporting form. Why would they? They did not pay you; rather, a number of buyers using eBay or Amazon paid you. Let’s use another example. Let’s say that you use PayPal or Google Checkout on your website. As a third party payment network, they did not have to report the transaction. Why would they? They did not pay you; they just processed the transaction whereby some else paid you.

This caught the attention of a Congress that has all but gone through our sofa cushions for the next thing to tax.

So, let’s say that you are selling stuff on eBay or otherwise accepting payment through PayPal. Will you receive a 1099-K? It depends. If you have sales of less than $20,000 a year or fewer than 200 transactions per year, then 1099-K reporting will not be necessary.

The look and feel of Form 1099-K is very similar to Form 1099-INT used by banks to report interest and Form 1099-DIV used to report dividends.

Are we are expecting problems with the new 1099-Ks? Oh yes. The 1099-K will include sales tax and shipping charges, for example. The 1099-K will report the gross amount of payment card and third-party network payments, so one has to be careful with the reporting of refunds. The IRS is already talking about segregating receipts on different lines of the tax forms so that they can match to the 1099-Ks. When you consider that the IRS has a computer-matching program that generates notices without the intercession of human eyes, this may well be a disaster waiting to happen.

FATCA Filing Season

This past Saturday the IRS released the final version of Form 8938, Statement of Specified Foreign Financial Assets, and on Monday released the instructions. This form is in response to FATCA, and represents a further tightening of reporting requirements for foreign income and assets.

What do you have to report? The easy answer is overseas bank accounts and securities accounts. It gets a little trickier with hedge and private equity funds. It will also pick up your loan to Grandma Gretchen. This is reporting for foreign assets, not just foreign bank accounts.

Here are the dollar amounts if you live in the U.S.:

·         If single or married filing separately

o   $50,000 on the last day of the year or $75,000 at any time during the year

·         If married filing jointly

o   $100,000 on the last day of the year or $150,000 at any time during the year

Here are the dollar amounts if you live overseas:

·         If single or married filing separately

o   $200,000 on the last day of the year or $300,000 at any time during the year

·         If married filing jointly

o   $400,000 on the last day of the year or $600,000 at any time during the year

Are the dollar thresholds ridiculously low? Of course.

Form 8938 does not replace the FBAR (TD-F 90.22.1), which is filed separately from your income tax return and is due in Detroit by June 30^th every year.

Eventually the IRS intends for Form 8938 to also apply to domestic entities, but for right now the IRS is limiting its reach to only individuals.

My take?

We used to expect that the IRS would not assess penalties unless tax was due. That in turn meant that we did not overly fear information returns - that is, returns with numbers on them but no line that said “tax due.” There were some exceptions, such as W-2s and 1099s, of course; otherwise, this rule of thumb worked reasonably well.

No longer. There are penalties to these forms even if there are no taxes due or all taxes have been reported.  Congress has taken umbrage on Americans having assets overseas. I am at a loss why a married couple (say my wife and I) would draw Congress’ attention solely by having $100,000 overseas. That is not enough money to get a starring role next to Michael Douglas in Wall Street II. It is not enough money to get me invited to a White House dinner, and certainly not enough to join a presidential vacation.

If you are even close to the dollar limits, please see a professional. Do not fool around with this, as the penalties can be severe.

How Could I Live Without Filing Taxes?

Status of the Payroll Tax Cut

The Senate today approved a two-month extension of the employee Social Security tax cut.

You will recall that the employee FICA rate was cut from 7.65 to 5.65 percent, but only for 2011. The FICA tax is composed of two parts: a social security tax of 6.2 percent and a Medicare tax of 1.45 percent. Together they add-up to 7.65 percent and are referred to as FICA. The social security portion was reduced in 2011 by 2 points – from 6.2 to 4.2 percent. It is this portion that we are discussing.

A number of economic and financial commentators have pointed out that 2011 economic growth has been roughly equivalent to this payroll tax cut.  Add to the mix an upcoming election year and the issue of extending the cut has become quite electric.

The bill will next go to the House, where there has been some activism to cut the tax for all of 2012, not just two months.

The President has indicated his intention to sign the bill when it arrives.

My take?

Payroll is reported to the IRS on a quarterly basis. The first quarter is January through March. Accountants and payroll services now have to subdivide the quarter to determine which tax rate to apply to the payroll. Would it have been that difficult - especially since nothing has been accomplished anyway – to have the payroll tax cut run the full quarter?

The Honeymooners Income Tax Episode

The IRS Wants More Levy Power

The IRS wants Congress to expand its tax levy authority.

This is a response against the taxpayer protections under the IRS Restructuring and Reform Act of 1998 (RRA). One of the changes required the IRS to provide at least 30 days notice of a levy action, as well as the taxpayer right to appeal such action. The purpose is to slow down collections and allow the taxpayer to propose alternatives or to reiterate information that collections has chosen to ignore.

After enactment of the RRA, the number of IRS levies dropped by approximately 85 percent, from 473,000 for fiscal 1998 to 75,000 in fiscal 2000. This has reversed recently, and there was a 73 percent increase from fiscal 2009 to 2010. During fiscal 2010 the IRS filed approximately 667,000 levies.

The IRS does have some valid arguments. In some circumstances, timing requirements may require multiple levy actions. Some sources of income are difficult to reach and are currently beyond the reach of a continuous levy.

NOTE: A continuous levy remains in effect until cancelled and provides recurrent cash to the IRS. The most common example is a wage garnishment. This is in contrast to a bank levy, which is good for only one instance. Should the IRS want more cash, it has to file another bank levy.

The IRS wants to expand the continuous levy to reach rental income, nonemployee compensation, royalties and fishing boat proceeds.

Then there are questionable IRS arguments. For example, the Treasury Inspector General for Tax Administration (TIGTA) reviewed a sample of 30 cases where the taxpayer appealed a levy action. It found that appeals can be used to delay collection action. Gosh, I could have told them that without a study; it doesn’t mean, however, that the appeal right per se is without merit. In 28 cases Appeals upheld the levy action. The IRS extrapolates this to mean that the appeals protection under RRA is being abused.

Let’s talk about IRS abuses. The RRA protections were not enacted because the IRS was an innocent party. There are cases where the IRS has pursued levies for less than $30.  There are cases of IRS levies without any notification. We presently have a representation client where collections is pursuing more than $20,000 while we simultaneously are reducing that amount by almost 80 percent through a reconsideration. We put in a CDP request to put the brakes on collections and clue them that there is a favorable adjustment coming from exam. Do I even need to comment on IRS inflexibility with an unemployed/underplayed taxpayer who cannot continue a payment plan at the same amount as before being unemployed/underemployed?

Let me clue you in on a tax “secret.” The IRS says it will work with you if circumstances overwhelm your payment plan. However, the IRS keeps a golden key to itself. The IRS can reject a restructuring if one has defaulted on a payment plan. Think about this. I have a client who entered into a payment plan. Circumstances have been difficult, including foreclosure. She has continued her payments to the IRS, although sometimes in smaller amounts than agreed to. She takes pride in having lived up to her obligation. I contacted the IRS to formally restructure the plan to something like the following:

                First three months          $25 per month

                Next three months         $50 per month

                Next three months         $75 per month

               

The IRS refused. Why? Because she “defaulted” on her plan. Now think about this for a moment. My client is held in the same regard as a tax scofflaw who has never paid and has no intention of ever paying. Her default? She reduced her payment because she works for $7.50 per hour and is broke. She did not miss a payment, mind you, only reduced it. To be fair, we will work something out with the IRS, but it is a needless headache for both her and me. I do think it shows a blockheaded attitude at the IRS. Some of us – government employees excluded, apparently – can be fired.

Count me on the “nay” side of any proposal to expand IRS levy authority. Show me some proof of “kinder and gentler” before I board this bus.

Be Careful With Foreign Tax Information Returns

Today we filed an extension for a client company with a foreign subsidiary. I was recently reading a Chief Counsel’s Advice concerning the same type of tax return that our client will be filing in a few months.

There is an additional form to file when one owns a foreign corporation. That is Form 5471 “Information Return of U.S Persons with Respect to Certain Foreign Corporations.” The common ownership threshold for filing is 10 percent. There is a twist in which an officer or director has a responsibility to file, even if the officer or director owns no shares directly, as long as a US citizen owns at least 10 percent.

Frankly, this is a confusing return. There are four types of “filers,” and each has to fill-out – or not fill-out- certain sections of the return. One may have to provide an income statement for the foreign company, for example, or track its earnings and profits.

The 2010 HIRE Act amended the tax Code (Section 6501(c )(8)) so that the statute of limitations for an income tax return to which an international “information return“ relates does not start until the information return is filed.

What does this mean? Well, Form 5471 is considered an “information return.” This means that it has numbers on it, but there is no line that says “tax due.” There is a similar form (Form 8865) for foreign partnerships and another (Form 3520) for foreign trusts.

So you own (enough of) a foreign corporation to file Form 5471. The accountant doesn’t think about it and files the corporate return without it.  The IRS in CCA 201104041 clarified that the statute of limitations on the corporate return does not begin to run until the Form 5471 is filed.

The client referred to above is new to the firm. One of the reasons that they switched firms? Their former CPA had not been filing Forms 5471.

If you remember, there are also penalties for not filing foreign information returns, including Form 5471. That however is for another blog post.

Olsen v Commissioner

You may recall that there is a”super” penalty that the IRS can assess if one understates his/her tax by too much. This penalty is not trivial: it is 20% and is called the accuracy-related penalty. In many cases the IRS assesses the penalty as a mathematical exercise. You can however request that the penalty be abated by providing a reasonable cause for doing so. A long illness or the death of a close family member, for example, has long been considered as reasonable cause.

We now have a new reasonable cause. I suspect that it will enter the tax lexicon as the “Geithner” defense, for the secretary of the Treasury under President Obama.

Here is what happened.

Kurt Olsen (KO)’s wife received interest income for 2007 from her mother’s estate. This means that she received a Schedule K-1, an unfamiliar form to the Olsens. KO normally prepared the tax returns, and he liked to use TurboTax. Upon receipt of the K-1, he upgraded his version of TurboTax as a precaution in handling this unfamiliar tax form.

TurboTax uses an interview process to obtain information. Using this process, KO entered the name and identification number of the estate. He also took a swing at entering the interest income, but something went wrong. The interest income did not show up on the return. KO was quite responsible and used the verification features in his upgraded software, but he did not discover the error.

The IRS did, though. They sent him a notice requesting an additional $9,297 in tax. The change in tax was large enough to trigger the “super” penalty of $1,859 ($9,297 times 20 percent).

KO knew he owed the tax, but he felt that the penalty was unfair. He felt strongly enough about the penalty that he pursued the issue all the way to the Tax Court. He represented himself under a special forum for small cases.

                Note: The tax term for representing yourself is “pro se.”

Now, the Tax Court has not been forthcoming in considering “tax software” as a reasonable cause. The Court has long expected one to use the software properly. In fact, a famous case (Bunney v Commissioner) has the Court stating that “tax preparation software is only as good as the information one inputs into it.”

The Court however took pains to distinguish KO, commenting that…

·         “We found petitioner to be forthright and credible.”

·         “It is clear that his mistake was isolated as he correctly reported the source of the income.”

·         “He did not repeat any similar error in preparing his tax return.”

·         “Petitioner acted reasonably in upgrading his tax preparation software to a more sophisticated version.”

The Court found reasonable cause to abate the penalty.

The key thing is that the taxpayer had an unusual source of income. He did not know where to look to check that the income had been properly included on his return. He did however meticulously follow the verification features in the software, and he relied – not unreasonably – on the software to report this transaction correctly.

This type of case unfortunately cannot be used as precedent. Tax Court Judge Armen also took care to cite the “unique facts and circumstances of this case.” Nonetheless, as more and more taxpayers use software to prepare their returns, it is expected that we will see more and more instances of the “Olsen” defense. 

Payroll Tax Cut Voted Down

I was reading this morning that the Senate was unable to pass a payroll tax cut bill yesterday. There were two bills and neither passed.

You may recall that the employee share of FICA was reduced from 6.2 to 4.2 percent for 2011. The balance of 1.45 percent for Medicare was untouched. The purpose was to stimulate, or at least not depress, the economy.

The problem is that the 2 percent reduction expires at the end of 2011.

The politicians now want to extend the program. The Senate Democrats proposed a plan to reduce the 6.2 percent withholding to 3.1 percent. In an unanticipated move, the Democrats proposed this be paid for by a tax increase on the wealthy.

The Republicans proposed extending the tax cut at 2 percent and paying for it by freezing federal salaries and streamlining the federal workforce by 10 percent. This was predictably described as extreme.

The President demanded action and announced his next vacation.

The House is taking up the issue next.

Get Ready for Stock Cost-Basis Reporting

There will be changes in how your stockbroker reports your stock trades for 2011.

Your broker now has to report the “cost” of your stock trades. This is a new rule for 2011. It came in as part of the 2008 Emergency Stabilization Act, also known as the bank bailout bill. You can anticipate that the purpose of this rule is to raise taxes.

There are three steps to the phase-in of this bill:

(1)    For 2011 (that is, the 2012 tax season), brokers are to report cost on all equity trades, if the equity was bought on or after January 1, 2011.

(2)    For 2012 (the 2013 tax season) brokers will report cost for mutual funds, dividend reinvestment plans and many exchange –traded funds bought on or after January 1, 2012.

(3)    For 2013 (the 2014 tax season), the rule will be extended to bonds and options.

There is a tax trap in here, so let’s go over it. The trap releases if you bought the security at different times and prices. Brokers refer to this as “accumulation.” Each time you buy the stock is called a “lot.”Let’s use the following accumulation as an example:

Let’s say you bought Sirius XM Radio at the following prices:

                January, 2010                     500 shares           $0.70

                May, 2011                           400 shares           $2.31

                August, 2011                      300 shares           $1.71                   

You sell 300 shares today at $1.77 per share. What is your cost for the 300 shares?

The IRS has provided four options:

(1)    First-in, first, out (FIFO).

a.       Under this rule, your cost would be 300 times $0.70 = $210.

(2)    Last-in, first out (LIFO)

a.       Under this rule, your cost would be 300 times $1.71 = $513.

(3)    Highest cost

a.       Under this rule, your cost would be 300 times $2.31 = $693

(4)    Specific identification

a.       You get to pick which shares you sold. All things being the same, you would probably select the May, 2011 lot and use $693 as cost.

Under our example, your answer could vary from a gain of $321 to a loss of $162.  It is quite a swing.

Where is the trap?

You have to tell the broker which method you are using, and you have to tell them before the settlement date of the trade. This is very different from the way it has been, which previously allowed the accountant to decide which method to use when preparing your return. We many times contacted a broker for lot dates, shares and cost when a client had accumulated a position in a stock. We had the luxury (if it could be called that) of doing so when preparing the return. This now has to be done within three business days of the trade date.

There is also another trap. If you do not select a method, the IRS will select it for you. The IRS will decree that you selected the first-in, first-out method. That is a fine method, but if you look back at our example, you will see that it is also the method that reports the least cost, and therefore the most gain, to the IRS. Remember what I said about raising revenue for the government?

 And the final trap? By the time you get to me, there is nothing I – as your tax CPA – can do.

Related Party and Tax Deductions

If you are a partnership, LLC or S corporation and report on the accrual basis, this may apply to you.

You may be aware that there are restrictions on deductions between related accrual-basis and cash-basis entities or individuals. These are the “related party” rules of IRC Section 267 and are well-known to tax accountants. By the way, these rules drive on a one-way street: the effect is to delay the deduction, not to delay the income.

                EXAMPLE ONE:

Sanctuary, Inc is a C Corporation and accrual-basis taxpayer. It owes $34,000 at year-end to Sam (a Schedule C) for the provision of goods or services. Sam is a 51% shareholder.  Sam is on the cash-basis, as most individuals are. Sanctuary, Inc cannot deduct the $34,000 until Sam includes it in income, because more-than-50% ownership triggers the related party rule.

                EXAMPLE TWO:

Sam (a Schedule C) owes Sanctuary, Inc $27,000 at year-end for the provision of goods or services.  Sam (a Schedule C) cannot deduct this until it makes payment. Sam (a Schedule C) is, after all, on the cash-basis. Sanctuary, Inc is quite unruffled by all this. As an accrual-basis entity, it will report the $27,000 in income without waiting for Sam’s (a Schedule C) deduction.

The trap here is the more-than-50 percent rule. The 50% requirement goes away if the transaction is between an S corporation, partnership/LLC and a shareholder or partner/member.

Change Sanctuary to a partnership, LLC or S corporation and the threshold drops to any ownership. As an example, an accrual to a 2-percent S- corporation shareholder would be disallowed under the related party rules.

Why? Here is how I make sense of it. As a pass-through investor, both sets of numbers will wind up on one income tax return. The IRS is therefore stricter than it would be if the numbers wound up on two tax returns, such as between a C corporation and an individual.

IRS Buyout Packages

I saw today in Government Executive that the IRS is extending buyout packages to as many as 5,400 IRS employees. The buyouts are capped at $25,000 per person, and eligible employees have until November 22 to decide.

Why are they doing this?

Both the House and Senate have proposed cutting the IRS fiscal 2012 budget by up to $500 million.

Do Tax Preparers Get Penalized On Their Own Returns?

Do tax preparers ever get penalized by the IRS on their own returns?

We are going to look at one today: Joyce Anne Linzy (JAL). She is party to a Tax Court Memorandum Decision issued on November 7, 2011.

JAL is a tax preparer with more than 15 years’ experience. During 2007 she operated an income tax return preparation business. She owned an apartment building in which she both lived and worked: the business was on the first floor and she lived on the second floor. She also rented out second-floor space that she did not use as a residence.

There were a number of proposed IRS adjustments for the Court to consider:

1.    JAL omitted $2,500 of gambling income.

This is actually the least of her problems.

2.    JAL claimed almost $35,000 of contract labor.

There is no problem with claiming this deduction, but the IRS expects one to maintain documentation to substantiate the deduction upon examination. Here is the Court’s language on this matter:

“Petitioner presented canceled checks, bank account statements, receipts and invoices purporting to substantiate various items claimed as business expenses deductions. These records are not well organized, and have not been submitted to the Court in a fashion that allows for easy association with the portions of the deductions that remain in dispute. Nonetheless, we make what sense we can with what we have to work with…”

The Court is trying to work with JAL. They are referring to the Cohan rule: if the Court knows that a taxpayer incurred an expense, it can (with some statutory exceptions) allow estimates of the actual expenses. JAL must be quite the tax adept, though, as the Court goes on…

“None of the numerous receipts petitioner offered in support of her claimed contract labor expense were for contract labor.”

“The checks are photocopied such that the dates are missing or incomplete, and the full amount cannot be determined…”

Oh, oh.

“These records are incomplete, and there is not enough information to permit a reasonable estimate. Accordingly, respondent’s complete disallowance of petitioner’s … deduction for contract labor is sustained.”

3.    Mortgage interest

JAL used one-third of the building for her tax return business. She deducted one-half of the mortgage interest as a business expenses.

Seems like simple math.

4.    Depreciation

During 2007 she purchased several depreciable items. She did not depreciate the cost of these items but instead claimed the costs as contract labor expenses.

Some of these items could not be immediately expensed under Section 179 because they related to building improvements. These items included siding and tuck pointing. Buildings of course have a long depreciation life, so the swing between immediately expensing and depreciating over many years is magnified.

There was no fallback position here for JAL.

5.    Charitable contributions

You may be aware that you are required to get a timely statement from the charity describing the contribution and that you received nothing of monetary value in return, or to estimate the amount if there was monetary value. You are supposed to have this in hand before you file your return.

JAL seems to have forgotten this.

She deducted a $2,500 donation to Schneider School.

Here is the Court:

               

“Although petitioner received a receipt from the Chicago Public Schools, it does not qualify as a contemporaneous written acknowledgement because it does not state whether she received any goods or services in return for her contribution.”

She deducted a $7,500 donation to Faith Deliverance.

Again, here is the Court:

               

“The letter does not state whether petitioner received goods or services in exchange for contribution and was not received by the earlier of her return’s filing date or its due date…. Thus there is no contemporaneous written acknowledgement from the donee that would permit petitioner to deduct the contributions.”

6.    The substantial understatement penalty

This is a “super penalty” if you misstate your taxable income by too much. The IRS defines “too much” as more than 10% of the final tax but at least $5,000.

JAL had no problem leaping over this hurdle.

The IRS can waive this penalty if one has “reasonable cause.” There are a number of factors that constitute reasonable cause, but a common one is reliance on a tax professional. In fact, I drafted a letter this week requesting abatement of this very penalty, and the reason I gave was their reliance on a tax professional. What happens, however, when you are a tax professional and it is your OWN tax return?

Here is the Court:

“Petitioner’s records were insufficient to substantiate several of her claimed deductions, and she failed to keep adequate books and records. Furthermore, petitioner, a tax return preparer with more than 15 years experience, improperly deducted….Petitioner offered no evidence that she acted with reasonable cause and in good faith. Accordingly, we hold that petitioner is liable … due to negligence or disregard of rules or regulations.”

The penalty alone was over $3,100.

What can I say about JAL?

A lesson here is that the Tax Court is going to hold a professional preparer to a higher standard. Now, JAL was not an attorney, CPA or enrolled agent, but when she stepped into “professional preparer” shoes the Court was going to be less lenient. It is not unreasonable, as others pay you for knowing more about the tax system than the average person. It seems to me that JAL did not rise to the occasion.

When I Grow Up, I Want To Be a Tax Accountant

IRS Levy On a Paycheck

I am looking at a decision from the Court of Appeals for Kentucky. On first blush, the issue is so clear-cut that I wonder what the appellant was thinking even pursuing the issue. Of interest to us, however, is the issue itself.

William Hunter (WH) worked for the University of Louisville. WH got himself in trouble with the IRS. He must have ignored every notice sent him, as in June, 2006 the IRS served a notice of levy on UofL’s payroll department.

UofL did what it had to do – it notified WH that it would comply with the notice.

More than 3 years later, WH sued UofL, alleging that it wrongfully diverted wages due him. The university immediately filed and won a motion to dismiss. WH appealed.

The Appeals Court schooled WH. More specifically, it pointed to Code Sec 6332(d)(1):

Any person who fails or refuses to surrender any property or rights to property, subject to levy, upon demand by the Secretary, shall be liable in his own person and estate to the United States in a sum equal to the value of the property or rights not so surrendered, but not exceeding the amount of taxes for the collection of which such levy has been made, together with costs and interest on such sum at the underpayment rate … from the date of such levy ….

This is pretty clear for the tax code. Once UofL was levied – and if it refused to comply - it became liable. I don’t believe that UofL was interested in stepping into those shoes.

There is more in Sec 6332(d)(2):

In addition to the personal liability imposed by paragraph (1), if any person required to surrender property or rights to property fails or refuses to surrender such property or rights to property without reasonable cause, such person shall be liable for a penalty equal to 50 percent of the amount recoverable under paragraph (1).

So, in addition to being personally liable, the IRS can hit UofL with a 50% penalty.

Why was I surprised that WH pursued this action against UofL? Let’s look at Sec 6332(e):

Any person in possession of …property or rights to property subject to levy upon which a levy has been made who, upon demand by the Secretary, surrenders such property or rights to property …to the Secretary … shall be discharged from any obligation or liability to the delinquent taxpayer and any other person with respect to such property or rights to property arising from such surrender or payment.

This means that UofL was immune to suit, and the Appeals Court decided that UofL was immune to suit. How did WH even find an attorney willing to pursue this matter?

What is the lesson here?

First of all, the IRS will attempt numerous ways and times before it will levy. There likely have been many ignored notices before the IRS resorts to a levy. A payroll levy can be quite harsh, because the IRS provides for limited exemptions. The excess is to be remitted to the IRS. One can lose 75% of his/her paycheck to a levy.

What if you are the employer and receive a levy? First, call in the employee and explain the situation. Strongly encourage the employee to contact the IRS and pursue a payment alternative. Perhaps it is an installment agreement. It can be an offer in compromise. If the situation is financially dire, the IRS may even agree to place the taxpayer in “do not collect” status. And explain that you, as an employer, have no choice but to observe the levy.

Foreign Mutual Funds

Let’s talk about PFICs.

It is pronounced “Pea Fick,” and it is shorthand for a passive foreign investment company. We are continuing our “foreign” theme of late.

A PFIC is a foreign mutual fund. Think about your funds at Fidelity or Vanguard and relocate them to Bonn or London. That is all you have done, but with that act you have entered a twilight world of odd tax reporting.

Why? Treasury does not like foreign mutual funds. Why? That question has several possible answers, but I believe that a large part is because Treasury cannot control the taxation. A mutual fund in the United States is a “regulated investment company.” One of the requirements is that it has to pass along its taxable income to its investors in order to preserve its tax standing. Shift that fund to Bonn, and the German fund manager may not have the same level of concern in maintaining that “regulated investment company” status. The German fund manager may do something unconscionable, such as not declare dividends or distribute income to investors. That would allow the German fund to delay tax consequence to its U.S investors, possibly for many years. Why, the U.S. investor may eventually report the income as capital gain rather than ordinary dividend income. This is clearly an unacceptable scenario.

It didn’t use to be this way. The law for PFICs changed in 1986.

You are going to be specially taxed. You however can choose one of three methods of taxation:

(1)    The Excess Distribution Method

This is the default method and is found in Section 1291 of the Internal Revenue Code.

At first glance it sounds good. You pay no tax until you either sell or receive an “excess distribution.” When you do, the IRS presumes that the income was earned ratably over the years you owned the fund. You have to pay tax at the highest marginal tax rate. It does not matter what your actual tax rate was. What if the fund lost money for 8 years, had one great year that made up for all losses and then you sold at a profit. ? Doesn’t matter. The IRS presumes that your profit was earned pro rata over 9 years. Now you are late on your taxes (remember, you did not include the profit in your prior year returns because there WAS NO PROFIT). You now have to pay tax using the highest-marginal tax rates. For 9 years. And then there is interest on the late taxes.

Oh, you may not be allowed to claim the loss if you sell the PFIC at a loss.

 You really do not want to use this method.

(2)    The Mark to Market Method

This option was added to the Code in 1997.

You mark your PFIC to market every year-end. In other words, you pay taxes on the difference between the share price on January 1^st and December 31^st. Every year.

You forfeit capital gains and losses. Whatever income or loss you report is ordinary. Sorry.

The big requirement here is that the PFIC has to have published fund prices. If the prices are not published, you simply cannot use the mark to market method.

(3)    The Qualified Electing Fund

This is the method I have normally seen. The problem is that the fund has to provide certain information annually. As that information has meaning only to a U.S. taxpayer, the fund may decide that it is not worth the time and cost and refuse to provide it. In practice, I have seen these funds go through investment houses such as Goldman Sachs. Goldman can pool enough U.S. investors to make it worthwhile to the foreign fund manager, so the fund agrees going in that it will provide this additional information annually.

A QEF is basically like a partnership. It passes-though its income to the U.S. investor – whether distributed or not – and the U.S. investor pays taxes on it. Ordinary income is taxed at ordinary rates, and capital gains at capital gains rates. What changes is that Treasury does not wait for a distribution.

A QEF should be elected in the first year you own the QEF. If so, you avoid the “excess distribution” regime altogether. If you make the election in a later year, then there is a procedure to “purge” the earlier PFIC treatment.

The QEF election is made fund by fund.

Yes, there is a special form to use with PFICs. It is Form 8621 “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” It can be an intimidating three pages of tax-speak.

I saw PFICs a few years back, as we had several well-heeled clients. What I generally saw was a K-1, perhaps from a hedge fund. That fund in turn invested, and some of its investments were PFICs. The fund K-1 would arrive with its booklet of information, explanation and disclosures. The PFICs inside would further swell the page count. I remember these K-1s going on for 30 or 40 pages. These K-1s are not for young tax accountants.

As I said, Treasury really does not like foreign mutual funds.

Do You Have To Report Foreign Gifts?

My brother-in-law is married to an English citizen. My other brother-in-law lives near Saffron Walden, north of London. Perhaps it is because of my wife’s family, but I have paid attention to the tax issues of expatriates for a long time.

Let’s reverse the direction, however, for today’s discussion. Let’s say that you are a U.S. citizen or green card holder. You live in the United States. It is the family that lives abroad. You receive a gift or bequest from the family. To simplify the discussion, let’s stipulate that the family has no ties to the U.S., other than having you in the family. Maybe you are the in-law.

What does your tax radar tell you?

Generally there is no U.S. gift tax on a gift from overseas – with some exceptions. There are always exceptions. The gift could be subject to U.S. gift tax if it is “U.S. situs” property. In general, tangible property located in the U.S. is “U.S. situs” property. Examples would include:

·         Residence

·         Vacation property

·         Boat

·         Cash

Did I say cash? Yep. The IRS considers cash to be tangible property. The IRS could, for example, consider a check given to you in the U.S. to be a gift of personal property subject to the gift tax. I personally would visit the family overseas, receive the check and sidestep this issue altogether. I have never understood why cash is singled out. I like to remember tax law by understanding what the law is attempting to reach, but this rule has never made sense to me.

Generally intangible property is not considered “U.S. situs” property. Intangibles would include stocks and bonds, for example. There is a different rule with respect to U.S. stocks and bonds and the estate tax, but we are discussing only gift tax today.

Short of transferring a house to you, it is unlikely that your in-laws will have a U.S. gift tax return. You however may have to file Form 3520, “Annual Return to Report Transaction With Foreign Trusts and Receipt of Certain Foreign Gifts,” depending on the amount of the gift. The good news is that there is no tax with Form 3520. It is a reporting form. You are required to file Form 3520 only if gifts from individuals exceed $100,000 for the year. There is a lower threshold for gifts from a foreign corporation or partnership - $14,375. I have never seen a gift from a foreign corporation or partnership, however.

But remember to file the 3520, because if you don’t file the penalties will be 5% of the gift amount for each month you don’t file.

I suspect you figured out where the IRS gets its money on foreign gifts.

Chapter 7 Bankruptcy and Taxes

It was one of the last individual tax returns I saw this year going into October 15, so the topic is on my mind.

The topic is bankruptcy. It seems that I have seen or discussed bankruptcy more in the last three years than in the balance of my career years combined. There are peculiar tax rules to bankruptcy. Today I want to talk about chapter 7, also known as liquidation, as that is the type of bankruptcy that I have been seeing the most.

Chapter 7 is the classic bankruptcy. Your assets and liabilities pass to the bankruptcy trustee. The trustee sells what he/she can and pays what is possible to the creditors. When done the judge discharges the bankruptcy and one is free of all debts. Depending on the state you may retain certain types of assets. The example I am familiar with is the primary residence in Florida. Some debts may follow you out of bankruptcy. An example is the loan on your car. You reaffirm the debt because you want, or need, to keep the car. If you want the car you have to keep the debt.

Upon filing a Chapter 7, your assets and liabilities past to the bankruptcy estate, which is normally represented by a trustee. It may be that some assets do not pass, but let’s not include that issue in our discussion. The estate also succeeds to one’s tax attributes. Think of attributes as tax benefits waiting to happen: a net operating loss or a general business tax credit, for example. When they finally kick-in, there is a benefit – meaning a reduction in tax – to you.

Why is this important? Because the estate is a separate taxpaying entity. When calculating its tax, the trustee can use your tax attributes to offset the estate’s tax. So, if you have an NOL, the trustee can use it to offset the estate’s taxable income. When you remember that the NOL can only be used once, this has meaning to you. If the trustee uses it, then you cannot.

There is another important tax consideration to bankruptcy. You may already know that debt discharged in bankruptcy is not taxable to you. Did you know, however, that you have to reduce your tax attributes to the extent that you have discharged debt? If you have $56,000 of debt discharged and have a $61,000 NOL carryforward, you have to reduce that NOL carryforward to $5,000 ($61,000 – 56,000).

What is the estate taxed on? Remember that one’s assets move to the estate upon filing Chapter 7. If the income can be traced to the asset, then the income is taxable to the estate as long as the asset is inside the estate. Examples include:

·         Dividends on stocks

·         Interest on bonds

·         Royalties on mineral rights or patents

·         Rental income on rental real estate

·         Capital gains or losses from selling stocks and bonds

What is not taxable to the estate? The classic example is your paycheck. It cannot be traced to an asset inside the estate, so it is not taxable to the estate. It is however taxed to you.

So the estate files a tax return for interest and dividends. You file a tax return for your wages. You now have two tax returns where there used to be just one.

And that is how the estate uses up your tax attributes. When the estate is discharged, it should tell you what is left on the tax attributes, because now you can use what is left. There may be nothing left.

This works well if the estate is large enough to have its own tax return. Frankly, what I have seen in recent years (at least the last 5 years) are small bankruptcy estates. These estates generally do not file a separate estate return, although technically they are supposed to. Rather all the estate numbers (think dividends and the sale of the stock that generated them) are combined with the taxpayer’s other non-bankruptcy numbers (think W-2) and reported on taxpayer’s individual income tax return. Now it becomes important for the CPA to remember the tax attribute rule, because there is no separate estate return to remind him/her.

This past weekend I met with a client who had $79,901 discharged in Chapter 7. There was no separate bankruptcy estate tax return. We did not make an election to end the client’s tax year upon the date of the Chapter 7 filing. She did have tax attributes to reduce. The client’s tax consequence went as follows:

                Debt discharged                                              79,901

                Net operating loss carryover                     ( 43,268)

                Capital loss carryover                                   ( 11,045)

                                                                                              25,588

                Note receivable                                              ( 25,588)

                                                                                                    -0-

The client lost the NOL and capital loss carryovers to the debt discharge. The amount left over reduced the client’s basis in a note receivable from a partnership. Think about this for a moment. What happens when our client is repaid the note in the future? Our client would receive more money than the client has basis in the note. Is this a taxable event? You bet. Why did we select the note? Because the note is in a partnership that is unlikely to ever repay our client in full. We considered the risk of the “phantom income” to be slight.

The IRS does not intend for bankruptcy to be “free.” From a tax perspective, what the IRS wants is for the bankruptcy to be tax-neutral over a period of time. In the above example, our client was not taxed on the $79,901, but the IRS has immediately eliminated $54,313 of tax benefits. The IRS further hopes that our client is repaid the note in full, because that will trigger $25,588 of phantom income. At that point $54,313 + 25,588 equals $79,901, which was the discharged income the IRS did not tax. To the IRS this would constitute a “push,” as it was out only the time value of the tax but not the tax itself.

Is there an order how the tax attributes are to be used up? Of course. The order is as follows:

·         Net operating loss carryover

·         General business credit carryover

·         Minimum tax credit carryover

·         Capital loss carryover

·         Basis of property

·         Passive activity loss and credit carryovers

·         Foreign tax credit carryover

There are other types of bankruptcy than Chapter 7. There is Chapter 13, which is a reorganization of debt for an individual. Chapter 12 is for farmers and Chapter 11 is for businesses. Perhaps we will talk about them – on another day.