Change in Office-In-Home Rules (Starting Next Year)

The IRS surprised me yesterday.

Do you ever work from home? Let me phrase it differently: do you have an office-in-home, as the IRS defines the term?

I have an office at home and I work from home occasionally (I try to keep my workload at the office). I do not however have an office-in-home for tax purposes. Why? My office would have to meet one of three criteria to rise to a tax deduction:

 

(1)   My office–in-home is the principal place of my trade or business

·        I will not meet this test as I have an office in Cincinnati.

(2)   A place where I meet with clients, patients or customers in the normal course of my business

·        Granted, I do a lot of my work on a computer or over a cell phone, but I primarily meet with clients at my office in Cincinnati.

(3)   I work from home for the convenience of my employer

·        The IRS has interpreted this test to mean that the employer does not provide the employee with an office, so the employee – needing a place to work – has one in his/her home. If the employer does provide an office, one will have an almost insurmountable challenge in meeting this test. There may be some latitude in a hoteling situation, but you get the idea. I will likely fail this test.

Let’s say that you meet one of the three tests. Perhaps you freelance as a second job. That freelancing may qualify you for the office-in-home deduction. We meet for preparation of your taxes. We discuss expenses related to your office-in-home: the interest, taxes, utilities, insurance, security and etc. We calculate the depreciation. We then have to prorate between the personal use of your home and the business use. All the while, I am remembering that just putting this deduction on your return increases your odds of audit selection.

So the IRS came out yesterday and provided a simplified rule for an office-in-home. They will spot you $5 per square foot – up to 300 square feet - for your office. No depreciation. No proration of expenses. There is a downside: you will not be able to carryover excess office-in-home deductions under this method. There is an upside: you can elect annually which method you want to use. Obviously if you have more than 300 square feet, or your expenses run more than $5 per square foot, you will probably elect to use actual expenses.

• NOTE: The simplified election starts with tax year 2013. We cannot use this election when preparing your 2012 individual tax return, unfortunately.

By the way, let me clarify what the IRS means by office-in-home. Any direct expenses you have – say a camera or film for a photographer or payroll for an employee – are not considered office-in-home expenses. An alternate phrasing is that these expenses would be avoidable if you did not engage in the business activity. The office-in-home expenses are indirect and unavoidable. That is, you would still have the mortgage, taxes, and insurance whether you freelanced or not.

New Business Tax Provisions

So what are the key business tax changes from the American Tax Relief Act of 2012? Here are the ones that caught my eye:

(1)  Bonus depreciation extended through 2013.

The bonus allows one to immediately deduct 50% of the cost of qualifying assets.  If you buy a backhoe, for example, you can immediately expense one-half the cost – and you get to depreciate the remaining half.  

(2)  S corporation built-in gain tax recognition period

OK, this one is somewhat obscure. Suffice to say that a C corporation that switches to an S corporation cannot sell its business until after several years have run. It used to be that the period was 10 years, then reduced to 7 and then to 5 years. The Act extends the 5 years for sales through 2013.

What this is about is allowing tax planners to restructure businesses, or parts of businesses, for sale, in the hope of spurring – or at least not deterring – business and job activity.

 

(3)  Expensing for certain film and television activities

If Peter Jackson had filmed The Hobbit in the United States, he would have been able to expense the first $15 million in production costs. Three-fourths of the movie production must take place in the U.S.

The Act extends this break through 2013.

(4)  Increase in Section 179 expensing

Section 179 allows taxpayers to immediately expense equipment used in a business. Normally this type of expenditure would be depreciated over time (barring the bonus depreciation discussed in (1) above). Section 179 however has a limit on the amount that can be expensed and the amount of assets you can purchase and still qualify for the break.

In 2011 the amount that could be expensed was $500,000 as long as assets purchased did not exceed $2 million. That dropped to $125,000 and $500,000 for 2012. The Act retroactively changes 2012 to and sets 2013 at $500,000 and $2 million.

(5)  Faster depreciation of leasehold improvements

The Act extends the 15-year depreciation period for qualifying leasehold, retail and restaurant leasehold improvements.  

For example, the new Mad Mike’s at the Newport Levee would have been depreciated over 39 years. Now it can be depreciated over 15 years.

(6)  Research tax credit 

The Act extends the research credit through 2013.           

This credit is available for improvements in the production process as well as to the product itself. Think Apple and Pfizer.

(7)  Work opportunity tax credit 

This is the tax credit for hiring individuals on welfare, being released from prison, collecting social security disability and so forth.  

The credit is not insignificant: 40% of the first $6,000 in wages. 

Who is this credit important to? Think Cracker Barrel and ....

(8)  Veterans credit 

Technically this is a subset of the work opportunity credit from (7) above. 

Unemployed and disabled veterans are a qualifying category for the tax credit, although the credit amount can vary from $2,400 to $9,600 depending on how long the veteran has been unemployed and whether disabled. 

(9)  The Nascar loophole 

If you were thinking of building a “motorsports entertainment complex,” the Act will allow you to take accelerated depreciation. You have to build it soon, though.

 This one could not be more obvious if Jeff Gordon ran over you.           

(10)   Cover over of the rum excise tax 

There is an excise tax of $13.50 on every gallon of rum sold in the United States. That would normally be a business-breaker, but the government refunds almost all the tax - $13.25 – to Puerto Rico and the Virgin Islands in the form of economic aid. This is called the “cover over.” 

By far most of the money goes to Puerto Rico.

However... 

Do you know Diageo? They are based in London and produce  – among others - Captain Morgan rum. A few years ago, they moved their production of Captain Morgan from Puerto Rico to St. Croix, which is in the Virgin Islands. It seems that the USVI was able to provide a (1) 90% tax break, (2) a bigger kickback of the cover over, and (3) an exemption from property taxes.  

     

(11)    The “Subpart F active financing exception”

You ever wonder how a company like General Electric can pay no corporate income tax?           

Well, one way is that they lost a lot of money in previous years. This provision is another way.  

The U.S. (generally) considers interest earned by a U.S. corporation anywhere in the world to be a passive business activity. Makes sense, as accountants could easily move interest from country to country. By calling it passive, the goal is to make the interest taxable to the U.S. There are exceptions, of course, and this is one. 

This provision came into being in 1997 and with a significant amount of lobbying by General Electric. Why? Think G.E. Capital, and you are on the right track. It allows one to establish a captive finance company overseas, generate profits there but not pay taxes on the profits until the money is brought back to the U.S. 

This provision has been extended many times since 1997. It has now been extended again.

Cost Segregation and Buying a Business

Have you heard of cost segregation studies? This is an engineering-based study, usually conducted in tandem with an accounting firm, to break-out the cost of real estate and improvements into more tax-advantaged asset categories. For example, a sidewalk can be depreciated faster than a building. It would therefore be tax-advantageous to separate the cost of the sidewalk from that of the building and claim the faster depreciation. A virtual cottage industry has sprung up in the profession to do these cost segregation studies.

What if you buy a business and simultaneously do a cost segregation study? Sounds like the perfect time to do one. What if you buy a business and do the study later?

Let’s talk about Peco Foods Inc (Peco).

Peco is the parent of a consolidated group engaged in poultry processing. Through subsidiaries, Peco acquired its Sebastopol, Mississippi plant in 1995.  Peco and the seller agreed to allocate a $27,150,000 purchase price among 26 asset categories, including:

·         Processing plant building

·         Hatchery real property

·         Waste water treatment plant

·         Furniture and equipment

·         Machinery and equipment

Peco obtained an appraisal in connection with this acquisition. The appraisal listed more than 750 separate assets.

Peco acquired a second plant in Canton, Mississippi for $10,500,000 in 1998. This time Peco and the seller allocated the purchase price across only three asset categories:

·         Land

·         Land improvements

·         Machinery, equipment, furniture and fixtures

Peco obtained an appraisal on Canton after-the-fact. The appraisal included more than 300 separate assets. 

In 1999 Peco hired Moore Stephens Frost (MSF) for a cost segregation study of the two plants.  According to the study, Peco was entitled to additional depreciation expense of $5,258,754 from 1998 through 2002.

            NOTE: I will pass on saying that $5.2 million is not chicken feed.

Peco was now required to alert the IRS that it was changing its depreciation. It was changing what it earlier called a “building” to “machinery” or “equipment” or whatever. It had to attach a form - Form 3115 – to its tax return. Peco explained that it was breaking-out the Sebastopol and Canton depreciation schedules into more categories.

The IRS nixed the whole thing.

Why? There are special rules when someone acquires enough assets of another business to constitute the purchase of that business. This is referred to as an “applicable” asset acquisition, and the seller and buyer have to alert the IRS of how the purchase price is to be allocated. Here is Code Section 1060:

If in connection with an applicable asset acquisition, the transferee and transferor agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate.

Each party’s argument is straightforward:

         IRS:    Taxpayer has to allocate according to the acquisition agreement.
           Peco:  No, I don’t because the wording is vague.          

The Court pointed out that the Sebastopol agreement used the phrase “processing plant building.” The inclusion of the word “building” was important. The Court even read the description of “building” from the Merriam Webster College Dictionary.  Equipment inside a building is not the same as the building. Why would Peco use the word “building” if it did not in fact mean a building?

The Court went through the same exercise with the Canton property.

The Court pointed out that – for it to set aside the written agreement – it would have to hold that the language was vague and ambiguous. Problem is, the Court did not think the language was vague or ambiguous at all. The Court observed that Peco had an appraisal prior to entering into one of the contracts, but it saw no need to further detail or reword its asset acquisition schedule. The second schedule was even more restrained, having only three categories. The Court observed that Peco did not seem to have any trouble with its schedules and categories until after it met Moore Stephens Frost (MSF), who clued them in on the advantages of cost segregation. The Court hinted its disapproval over retroactive tax planning, and it decided that it could not determine that the allocation was inappropriate. That meant that Peco was bound by the documents it signed. 

What is the moral of the story? The first of course is the importance of words in tax practice. Sometimes there is no room for “you know what I mean.” This is one of those areas.

The second moral is cynical. Had there been no written allocation of the assets, or even an incomplete allocation, then Peco might have won the case. Why? Because both sides would not have named every dollar in the deal. This would have left unclaimed ground, and Peco could have claimed that ground.

To be fair, the IRS is not keen on cost segregation. It is aware of the cottage industry that has sprung up after Hospital Corporation of America. It is one thing to be tracking the cost breakout as a building is being constructed or renovated. It is another to have an engineer come in and submit “what-if” numbers on an existing building or land improvement. Notice that the IRS did not contest the validity or credibility of MSF’s cost segregation study. All it did was hold Peco to its own (and) earlier cost allocation when it purchased the two businesses. That was enough.

President’s “Plan For Economic Growth and Deficit Reduction”

I was reviewing the tax provisions of the President’s “Plan for Economic Growth and Deficit Reduction.” It is possible that the “Super Committee” may adopt some of the tax provisions, so perhaps it is worthwhile to review the proposals.

(1)  Extend through 2012 the 100% bonus first-year depreciation.

(2)  Reduce the employer portion of the social security tax from 6.2% to 3.1%.

a.       This would cap-out at $5 million in payroll.

b.      Therefore the maximum cut would be $155,000 ($5,000,000 times 3.1%).

(3)  Create a tax credit for hiring employees who have been out-of-work for more than 6 months.

(4)  Create a tax credit to offset the increase in social security tax attributable to payroll increases over the corresponding period of the preceding year.

a.       So if your payroll was $1 million last year and $1.5 million this year, you would receive a credit for the social security taxes on the $0.5 million increase.

b.      There is a cap of $50 million.

c.       The credit would be good for the last quarter of this year and all of 2012.

(5)  The pre-EGTRAA tax rates would return for those making over $200,000 and $250,000.

OBSERVATION: Senator Schumer thinks these limits should be higher for New Yorkers. He is the senator from … New York.

(6)  Limit the tax rate at which high-incomes can reduce their tax to 28% for itemized deductions, excluded foreign income, health insurance and other selected deductions.

OBSERVATION: Right… make the calculation so complicated that even tax software won’t be able to get it right. Perhaps Congress and the WH should start with eliminating the phase-outs for personal exemptions, itemized deductions, student loan interest, education credits, child credit, AMT exemption and etc that would make this a circular calculation to stress even a mathematics graduate student.

(7)  Reduce the employee social security tax from 6.2% to 3.1%.

OBSERVATION:  Read this in conjunction with (2) above.

(8)  Repeal last-in first-out accounting (LIFO).

OBSERVATION: There is no accounting reason for this, as LIFO is considered to be a generally accepted accounting principle. It forms the tax accounting backbone of virtually every vehicle dealership in the nation.

(9)  Repeal the use of lower-of-cost –or-market inventory accounting.

OBSERVATION: Again, there is no accounting reason for this.

(10)  Increase the net FUTA tax from 0.6% to 0.8%.

OBSERVATION:  FUTA was increased on a “temporary” basis from 0.6% to 0.8% in 1976, although it went back to 0.6% this year. Does that sound “temporary” to you?

(11)  Eliminate the percentage depletion and intangible drilling cost provisions for oil and gas companies.

(12)  Eliminate coal activity expensing of exploration and development costs, as well as percentage depletion for hard mineral deposits and capital gains for royalties.

(13)  Modify the transfer-for-value exception on life insurance contracts.

OBSERVATION: Seems the viatical industry has drawn attention to itself.

(14)  Require business jets to be depreciated over 7 years rather than 5.

(15)  Revise the rules on transfers of intangibles to controlled foreign corporations.

OBSERVATION:  Think Google.

(16)  Revise the rules on the deductibility of interest paid to foreign persons.

I leave it to you to deem how serious you consider these proposals.