Senator Baucus Revs Up Tax Reform Discussion

Today (November 21, 2013) Senator Baucus released the third in a series of staff discussions on tax reform. This discussion focuses on depreciation (also called “cost recovery”) and tax accounting methods.

Not the most exciting topics, and I will not miss Thursday Night Football reading up on them. Let’s review them quickly.

The Senator leads off with:

America today is using a bloated tax code that was built for businesses close to 30 years ago. The code is completely outdated and acting as a brake on economic growth.  More must be done to simplify tax rules, lessen the burden on small businesses and jumpstart job growth.”

I cannot disagree with him, but I am not optimistic about politicians – today, tomorrow – keeping their hands off any tax reform. Remember that Chief Justice Roberts deemed ObamaCare to be a “tax” – even though the White House itself did not present brief or argue it to be a tax. With that level of verbal schizophrenia, I would wager that any “reform” would last about as long as when the first politician needs to get reelected.

Baucus is proposing the following depreciation changes:

(1) Reduce the number of depreciation classes to four: three for short- to mid-term property and one for longer-lived assets. There would be only one permitted depreciation method.

a.     By longer-lived, think real estate, which Baucus proposes to depreciate over 43 years.

COMMENT: There goes the never-worked-in-the-real-world-crowd again. I have thirty years in this business, and I have never seen a proposed real estate investment analyzed over a 43-year recovery. Doesn’t happen, folks.

(2) Slow depreciation from double-declining balance to declining balance. Real estate would remain straight-line.

(3)  Allow expanded general asset accounting. This means that asset categories are pooled, and depreciation is calculated by…

a.     Starting with last year’s asset pool balance

b.     Increased by additions and improvements

c.      Decreased by proceeds from asset sales and dispositions

d.     And multiplying the result by a depreciation factor

(4)  Repeal like-kind exchanges.

COMMENT: Yipes.

(5) Repeal depreciation recapture for pooled assets.

COMMENT: Yay!

Treat all gain from disposition of pooled assets as ordinary income.

          COMMENT: Nay!

(6)  The maximum cost of mixed- use vehicles is capped at $45,000.

a.     That means that – if a car is used for both business and personal use – the maximum cost that can be depreciated is $45,000. That amount in turn is depreciated over 5 years.

b.     I am not overly surprised. There is still a lot of abuse – truly – in this area.

Then there are some tax accounting changes:

(7) Repeal expensing for research and development expenses. The default treatment will be to capitalize and depreciate over 5 years.

COMMENT: This cannot make business sense. You want to explain this proposal change to Apple, Samsung, Pfizer, or any number of research-intensive companies?

(8) Disallow the deduction for advertising. In its place, you would deduct one-half immediately and then amortize the balance over 5 years.

COMMENT:  This makes no sense to an accountant. I associate depreciation and amortization with assets that have use or value over more than one year. Advertising doesn’t make that cut. Does anyone talk about the commercials from last year’s Super Bowl, for example?

(9) Treat “qualified extraction expenditures” the same way as research and development.

COMMENT: Think fracking. The United States is increasingly moving to energy independence (Bakken Shale, for example), even under a hostile Administration. Do you think this change is going to help or hurt that effort?

(10)  Repeal percentage depletion.

COMMENT: Same comment as (9).

(11)  Make permanent Section 179 expensing.

a.     The maximum expensing would be set at $1,000,000, with the phase-out beginning at $2,000,000.

COMMENT: Frankly, it’s about time.

(12)  The Section 197 amortization period is increased from 15 to 20 years.

(13)  All business with less than $10 million in annual gross receipts can use the cash basis of accounting and not account for inventory.

          COMMENT: Wait for it...

(14)  If you are not described in (13) then you are on the accrual basis of accounting.

COMMENT: When the government talks about accrual basis, they means that they want you to pay taxes on your receivables before you actually collect them.

(15)  Businesses described in (13) do not have to suffer through the Section 263A uniform capitalization calculations.

        COMMENT: Good. 

(16)  LIFO is repealed.  

COMMENT: I do not particularly care for LIFO, but I acknowledge that major industries use it extensively, and it is considered GAAP when auditors render their auditors’ report. The government is not chasing this down because they had brilliant debates while in accounting theory class. They want the jack.

(17) The completed contract method of accounting (think contractors) is repealed, except for small construction contracts.

Overall, Baucus is trying to reduce corporate tax rates. At 35%, the United States has the dubious distinction of having the highest corporate tax rate in the world. There are consequences to having the highest rate, such as having less business.  To reduce rates, he has to raise money somewhere, and we see some of those sources above.

And remember folks: these are only proposals.

The IRS Meets An Actuary

I think it was November or December of last year that I met with a client. He was “behind” on his taxes, and he now wanted to do the right thing and catch up.  He passed me a Form 1099, which he described as bogus. It had his name and social security number, but he swore he did not know the payor or provide any services for them.

Could be. Mistakes happen all the time.

I am reviewing the Tax Court summary opinion in Furnish v Commissioner. It is not a technically difficult case – the “summary” part tells you that – but it made me think of my client.

Furnish is an actuary.

QUESTION: Do you know what an actuary does? These guys/gals bring math, statistics and financial modeling to bear in measuring and predicting uncertain outcomes. They may work for insurance companies, for pension plans, for banks and investment firms. Think of them as the Sheldon Coopers of the business world.

Furnish had bought life insurance policies back when. He used policy dividends to buy additional coverage over the years, and he thereafter used policy loans to pay premiums on some or all of the policies. If you use loans to pay premiums for long enough, the policy will eventually burnout. This means it runs out of money. The insurance company will then shut down the policy. It happens with some frequency.

This happened to Furnish. The insurance company then sent him a Form 1099 saying that he had $49,255 as taxable income from the burnout.

         QUESTION: How can you have income from a burnout?

ANSWER: There are three pieces to the answer: (1) you have written checks for the policy over the years. The total amount of checks is your “basis” in the policy; (2) you have loans on the policy; (3) the policy has built-up “cash value” over the years. When the policy burns out, the cash value is used to pay off the loans. If that cash value exceeds your basis, you have income. “Phantom” income perhaps, but still income.

Furnish doesn’t buy into the $49,255 at all. He contacts the insurance company and requests files and records back to the beginning of time. The insurance company had a problem, as those old files were nonelectronic and not easily retrieved.

The insurance company wants nothing to do with this guy. Their letters to him went something like “We are right. Why do you keep bothering us?”

Ah, but they were dealing with an actuary.

Furnish sends the IRS two tax returns: one reporting the $49,255 and one not reporting and explanations for each. I presume he did not have professional advice to handle it in this manner, but so be it. The IRS of course accepts the one with the $49,255 reported in income.

PAUSE: I’ll give you a moment to get over your shock.

The IRS wanted their money. Furnish tells the IRS that the insurance company was full of bunkum and the 1099 was incorrect. The IRS tells Furnish to have the insurance company correct their paperwork. Until then, the IRS wanted their money. Eventually Furnish took the matter to the Taxpayer Advocate.

No dice with the Advocate and the matter went before a Tax Court judge. At play is Code Section 6201(d), which reads:

           

In any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return field with the Secretary *** by a third party and the taxpayer has fully cooperated with the Secretary (including providing, within a reasonable period of time, access to and inspection of all witnesses, information, and documents within the control of the taxpayer as reasonably requested by the Secretary),  the Secretary shall have the burden of producing reasonable and probative information concerning such deficiency in addition to such information return.”

Furnish argued that he met the requirements of Section 6201(d). The IRS argued that he had not; that he raised the issue too late in the proceedings; that he showed only minor calculation issues; and that Furnish had bad breath. The only evidence the IRS presented was a declaration by an insurance company employee, agreeing that Furnish did in fact have bad breath.

The Court decided that Furnish had raised enough doubt whether the Form 1099 income could be materially incorrect, and that Furnish had interacted reasonably in providing information and otherwise responding to the IRS. Furnish had met the requirements of Section 6201(d), and the burden of proof shifted to the IRS.

The IRS, having presenting no additional evidence beyond a Form 1099 and a letter from the insurance company, lost. They did not meet the burden of proof.

CONCLUSION: Some commentators consider this decision an outlier, and the judge has taken criticism in the literature. My experience is for the IRS to require the taxpayer to have the issuer either void or amend the disputed information form. Makes sense, in truth. Many times the issuer will, but then there are those hard-luck cases. Furnish gives practitioners an option to consider.

If A Tax Credit Falls In The Woods And No One Hears It ...

I am looking at a proposed rule for the Section 45R credit for small employers that offer health insurance.  The IRS says I have until November 25 to respond with comments.

Let’s talk about nonsense that tax practitioners have to work with.

This credit was added as an inducement for smaller employers to provide health insurance while waiting for the balance of the ObamaCare scaffolding to be erected.

As credits go, it was cumbersome to calculate and – by many reports – quite ineffective.  Many practitioners consider the credit to be such a joke they will not even bother to calculate it. Why? The professional fee to calculate the credit could be more than the credit itself.

The restrictions on the credit eviscerated almost any benefit it could provide.

(1) The credit applied to firms less than 25 employees. However, its sweet spot was ten employees, and the credit began to phase-out in excess of that number.  That eleventh employee would cost you when calculating the credit.

(2) The credit phased-out when average payroll exceeds $50,000. It sweet spot was $25,000 or less, and the credit began to phase-out in excess of that number.  Many of us were quizzical on the $25,000 strike, as average American household income is approximately twice that amount. Maybe Congress was dividing the average household income between two spouses. Who knows.

(3) Owners and their families were excluded from the credit. For many small businesses, the owner and family are a significant portion, if not the majority, of the work force. Congress had already imposed the 10/25 and $25,000/$50,000 rules, so was it necessary to also have an “off with the owners’ heads” rule? 

COMMENT: Someone please explain to Congress that excluding owners from a tax incentive is not incentivizing.

(4) There was a cumbersome calculation of “full-time equivalents” that may have tested the limited accounting resources of many small employers.

(5) The employer had to pay at least 50% of the premiums for all employees to qualify for the credit. This may be the least onerous requirement.

The credit – when finally calculated – was 35% of the health insurance premiums remaining after excluding the owners and running the two phase-outs.

… and the company had to reduce its tax deduction for health insurance by that 35%.

The credit will still be available in 2014, and it has been expanded from 35% to 50%. However the credit can only be used two more times, so if an employer uses the credit in 2014 and 2015, that employer has exhausted its maximum Section 45R mandated remaining number-of-years. Why? Who knows.

In addition, the employer has to obtain its insurance through the Small Business Health Options Program (SHOP).

NOTE: SHOP is the company-sponsored health insurance Exchange and is the counterpart to the individual health insurance Exchange.

The credit will not be available if the employer provides insurance through other means, such as through an insurance agent.

COMMENT: Think about that for a moment. Why is the credit unavailable if one purchases insurance for one’s employees through an insurance agent, a professional one may have used and relied upon for years? How does this requirement have the employees’ best interest at heart? I am at a loss to see any business reason for this. I immediately see a political-hack reason for excluding health insurance that is not sitting on a government website, however.

Let’s go though some recent headlines as we step through the looking glass:

• SHOP was to be accessible starting October 1, as were individual policies. 
• The SHOP website is accessible through HealthCare.gov, or it would be assuming the thing ever works.
• The Obama administration said in 2011 that SHOP would allow small employers to offer a choice of qualified health plans to their employees, akin to larger businesses. This “choice option” was to be available in January 2014. Administration officials have said they would delay the “choice option” until 2015 in the 33 states where the federal government runs the exchanges. This means employers would have only one plan to choose from for 2014.

COMMENT: Think about that “choice.” Yep, small businesses will be lining up to buy this thing.

• The Obama administration announced on September 26 that the opening of SHOP would be delayed a month, until November 1.
• On Tuesday, October 29, 2013, Marilyn Tavenner, the Head of the Center for Medicare & Medicaid Services, said the SHOPS would be functional “at the end of November.”

COMMENT: That is how Steve Jobs expanded Apple – by demanding “functional.” Shoot for the stars there, government bureaucrat.

• Businesses seeking coverage effective January 1, 2014 must enroll by December 15. Remember Ms. Tavenner’s comment about the “end of November.” This means that small could have as little as 15 days to enroll in SHOP.

In the Administration’s defense, the SHOP can admit employees throughout the year, so its January 1 start is not as critical as the individual Marketplace.

What is on the other side of the looking glass?

• A cumbersome credit calculation …
• That will expire after two more uses …
• For health insurance a small business may not be able to buy, resulting in  …
• A tax credit that approaches a work of fiction.

The bottom line is that the credit was almost useless before, and it is more useless now.

I guess that is my comment.