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.