The 2017 tax act signed into law on December 22, 2017 imposes a broad limit on the deductibility of business interest expense for tax years beginning in 2018 and later, which may result in increased tax liability for corporations and investors in pass-through businesses that finance acquisitions with debt.

Date: 12/22/2019 (PDF)

The 2017 tax act signed into law on December 22, 2017 imposes a broad limit on the deductibility of business interest expense for tax years beginning in 2018 and later, which may result in increased tax liability for corporations and investors in pass-through businesses that finance acquisitions with debt.

For purposes of the limitation on the deduction of business interest expense, “interest” also includes substitute interest payments, debt issuance costs, loan commitment fees, certain amounts that affect the economic cost of funds or yield of a borrowing or an interest-generating asset, and certain amounts predominantly associated with the time value of money.

If the business interest limitation applies to any of your businesses, then the amount of business interest expense that you may deduct is limited to the sum of: (1) 30% of adjusted taxable income; plus (2) 100% of business interest income; plus (3) 100% of floor plan financing interest.

For tax years beginning in 2018 through 2021, adjusted taxable income (ATI) is computed by starting with your taxable income for the tax year (disregarding the business interest limitation), and then adding to it and subtracting from it the following amounts:

Add to Taxable Income:

• business interest expense;
• net operating loss deduction;
• deduction for qualified business income;
• depreciation, amortization, or depletion deduction;
• capital loss carrybacks or carryovers; and
• any deduction or loss not properly allocable to a non-excepted trade or business.

Subtract from Taxable Income:

• business interest income;
• floor plan financing interest expense;
• the lesser of (i) gain realized on sale or disposition of property or (ii) deductions for depreciation, amortization or depletion taken for such property during a tax year beginning after 2017 (and similar adjustments for sales or dispositions of property held by a partnership or member of a consolidated group upon the sale or other disposition of the partnership interest or stock of the member); and
• any income or gain that is not properly allocable to a non-excepted trade or business.

For tax years beginning in 2022 and later, deductions for depreciation, amortization, or depletion are not taken into account in computing ATI.

Special rules and other adjustments apply to certain types of taxpayers when computing ATI.

Business interest expense does not include investment interest expense. However, all interest income and all interest expense of a C corporation (including, in certain cases, members of a consolidated group of corporations, REITs, and RICs) is treated as business interest income and business interest expense, unless the interest income or interest expense is allocable to an “excepted trade or business” (defined below). For example, investment interest expense that is passed through by a partnership to a C corporation partner generally would be considered business interest expense.

The business interest limitation generally applies to all taxpayers that have business interest expense. However, a small business taxpayer that meets the “gross receipts test” is exempt from the limitation. A business meets the gross receipts test if it is not a tax shelter and it has average annual gross receipts of $25 million or less for the three previous tax years. The $25 million amount is adjusted for inflation. Please note that “tax shelter” is defined broadly for this purpose, and includes any partnership or S corporation that allocates more than 35% of its losses for the year to limited partners or limited entrepreneurs.

The business interest limitation generally applies at the entity level to all business debt incurred, including debt incurred before 2018.

Interest that is allocable to an “excepted trade or business” is not treated as business interest.

Excepted trades and businesses are those in the trade or business of providing services as an employee, certain regulated utility trades or businesses, certain real property trades or businesses that make an irrevocable election to be excepted from the business interest limitation, and certain farming businesses that make an irrevocable election to be excepted from the business interest limitation.

For those businesses electing to be excepted from the business interest expense limitation, making the election involves a tradeoff: a real property business or farming business that makes the election must use the Alternative Depreciation System to depreciate certain types of property, which requires straight-line depreciation over a longer depreciable recovery period compared to depreciation under the General Depreciation System.

If you are engaged in both an excepted trade or business and a non-excepted trade or business, interest expense that is allocable to an excepted trade or business is not subject to the business interest limitation, and the amount of your items of income, gain, deduction, or loss, including interest income that is allocable to an excepted trade or business, is excluded in determining the business interest limitation. Therefore, you must allocate your tax items between excepted and non-excepted trades and businesses to determine the limitation.

Business interest expense not allowed as a deduction for a tax year is treated as a business expense paid or accrued in the next tax year, and can be carried forward indefinitely. Disallowed business interest expense carryforwards are subject to limitation in change-of-ownership situations.

Special rules regarding the carryover of disallowed business interest apply to partnerships and S corporations. For partnerships, any business interest expense that is not allowed as a deduction is passed through to the partners, and can be deducted by the partners only to the extent that there is excess taxable income from that specific partnership to absorb the deduction. For S corporations, disallowed business interest expense is carried over to the next tax year of the S corporation and is treated as interest expense paid or accrued by the S corporation in that year.

The business interest limitation applies at the consolidated return level, and a consolidated group has a single limitation. In calculating the limitation, a consolidated group's business interest expense and business interest income is, respectively, the sum of its members’ business interest expense and business interest income.

The business interest limitation applies to a foreign corporation that is a controlled foreign corporation (CFC), generally in the same manner as it applies apply to a domestic C corporation. If a CFC is a partner in a partnership, the limitation applies to the partnership in the same manner as if the CFC were a domestic C corporation.

The business interest limitation rules are complex and can significantly impact your tax liability. We suggest that you meet with us as soon as possible to discuss strategies to minimize the impact of the limitation, including determining whether your business qualifies to make an election to be excepted from the limitation, whether making the election is advisable in your situation, and if so, what steps we need to take to make the election.

This article contains general information only.  It is not tax advice and it should not be used as a basis for any business or tax decision. You should consult with a qualified professional before taking any action that may affect your business or you personally.

This article will give you a better understanding of the first-year expensing (also referred to as §179 expensing) and additional first-year depreciation (also referred to as bonus depreciation). Businesses that purchase capital assets are allowed to deduct the decline in value of the assets over their useful lives. This depreciation deduction is intended to help businesses to eventually recover the costs of capital assets.

Date: 12/20/2019 (PDF)

Certain provisions in the tax code enable you to accelerate recovery of your cost of certain plants, machinery, equipment, computer software, and other qualified property that you acquire for business use, rather than having to depreciate those costs over several tax years. Expensing (immediate write-off) is the primary cost recovery vehicle for capital assets (acquired for business use) placed in service from 2018 through 2022. The two mechanisms for deducting the cost of assets in the year they are placed in service are first-year expensing under Internal Revenue Code §179 and bonus depreciation under Internal Revenue Code §168(k).

Individuals and business entities that have taxable income greater than or equal to the amount of qualified first-year expensing property placed in service during the tax year, can elect to claim a first-year expensing deduction for up to $1 million of the cost such property. Most machinery and equipment, certain commercial building improvements, property used to furnish lodging, and certain computer software that businesses purchase (or lease under a capital lease) are qualified first-year expensing property, but rental real estate is not. First-year expensing is available for both new and used assets, and for both purchased and leased (under a capital lease) assets. To be eligible for the first-year expensing deduction, the assets must be used in the United States.

The $1 million annual limit on the first-year expensing deduction is reduced if you place in service more than $2.5 million in qualified first-year expensing property during the year. No first-year expensing deduction is allowed if you place in service $3.5 million or more in qualified first-year expensing property during the year. Because of this property cost limit, larger businesses generally claim bonus depreciation rather than first-year expensing.

In contrast to the first-year expensing deduction, there is no annual dollar limit on the bonus depreciation deduction amount, and bonus depreciation may be deducted even in a loss year. And unlike the first-year expensing deduction, the bonus depreciation deduction is not elective (except in the case of qualifying fruit- and nut-bearing plants). However, you may elect not to deduct bonus depreciation for any class of qualified property.

The bonus depreciation deduction is available to individuals, estates, trusts, and business entities that invest in new or used capital assets that have a depreciation recovery period of 20 years or less, as well as depreciable computer software, certain water utility property, qualified film, television, and live theater productions, and for farmers, specified fruit- and nut-bearing plants. Bonus depreciation is available for both purchased and leased (under a capital lease) assets. To be eligible for bonus depreciation, the assets must be used in the United States.

The percentage of the adjusted basis of qualified property that is deducted as bonus depreciation is 100% for most qualified property placed in service before 2023, but it is scheduled to be reduced by 20% per year from 2023 through 2026, and fully phased out by 2027.

Qualified improvement property — which before 2018 could qualify for both first-year expensing and bonus depreciation — now qualifies for first-year expensing only (subject to the annual dollar limit and the taxable income limit), but does not qualify for bonus depreciation. Qualified improvement property is an improvement to an interior portion of a commercial building if the improvement is placed in service after the date the building was first placed in service. However, qualified improvement property does not include building enlargements, elevators and escalators, and the internal structural framework of a building.

Both first-year expensing and bonus depreciation are highly technical in nature and subject to limits and exceptions. To fully leverage these deductions, it is important to understand their specific requirements. It is also advisable to monitor these provisions for further legislative amendment.

This article contains general information only.  It is not tax advice and it should not be used as a basis for any business or tax decision. You should consult with a qualified professional before taking any action that may affect your business or you personally.

The Patient Protection and Affordable Care Act (PPACA), 816 enacted March 23, 2010, and the Health Care and Education Reconciliation Act of 2010 (HCERA), 817 enacted March 30, 2010, ushered in a series of changes to the rules for obtaining and providing health care. The laws, as amended, are commonly referred to as the Affordable Care Act (or “ACA”). These rules are administered by the Departments of Treasury (and the IRS), Labor (DOL) and Health and Human Services (HHS), jointly or separately, as appropriate. 818

Date: 12/10/2019 (PDF)

The Patient Protection and Affordable Care Act (PPACA), 816 enacted March 23, 2010, and the Health Care and Education Reconciliation Act of 2010 (HCERA), 817 enacted March 30, 2010, ushered in a series of changes to the rules for obtaining and providing health care. The laws, as amended, are commonly referred to as the Affordable Care Act (or “ACA”). These rules are administered by the Departments of Treasury (and the IRS), Labor (DOL) and Health and Human Services (HHS), jointly or separately, as appropriate. 818

816 Pub. L. No. 111-148.

817 Pub. L. No. 111-152.

Note however that White House Executive Order 13765 dated January 20, 2017, directs governmental departments and agencies with authority and responsibility under the Affordable Care Act to “exercise all authority and discretion available to them to waive, defer, grant exemptions from, or delay the implementation of any provision or requirement of the [ACA] that would impose a fiscal burden on any State or a cost, fee, tax, penalty or regulatory burden on individuals, families, healthcare providers, health insurers, patients, recipients of healthcare services, purchasers of health insurance, or makers of medical devices, products or medications.” These directives are to be carried out “[t]o the maximum extent permitted by law,” indicating that compliance with ACA is required until other regulations or guidance is issued. Also, White House Executive Order 13813 dated October 12, 2017, directs the IRS, DOL, and HHS to consider proposing regulations and revising guidance to: expand small businesses’ access to association health plans (AHPs) (see ¶5920.11.C.4.); make available short-term, limited-duration insurance that lasts longer than three months and is renewable (see ¶5920.11.B.21.); and increase the availability of health reimbursement arrangements (HRAs) to workers and allow their use with nongroup coverage (see ¶5920.09.D.3.). In addition, White House Executive Order 13877, dated June 24, 2019, contains several directives, including but not limited to, that: (1) the IRS, DOL, and HHS to solicit comment on a proposal to require providers, issuers, and self-insured group health plans to provide or facilitate access to information about expected out-of-pocket costs before patients receive care; (2) the IRS issue guidance to expand patients' ability to select high-deductible health plans that can be used alongside an HSA, and that cover low-cost preventive care, before the deductible, for medical care that helps maintain health status for individuals with chronic conditions (see ¶5920.08.C.2.b.); (3) the Treasury propose regulations to treat expenses related to certain types of arrangements, potentially including direct primary care arrangements and healthcare sharing ministries, as eligible medical expenses; and (4) the Treasury issue guidance to increase the amount of FSA carryover funds.

(1) Individuals —   TPS 5920.16.A.1.

U.S. citizens and legal residents, unless exempted, must maintain minimum essential health care coverage or face penalties (which are reduced to zero for months beginning after 2018). Individuals may qualify for a health care premium tax credit or cost-sharing reductions to assist them in paying for coverage. 819

819 These requirements took effect starting in 2014. The 2017 tax act (Pub. L. No. 115-97) reduced to penalty amount to zero after 2018, as discussed in ¶5920.16.B.1. The Patient Protection and Affordable Care Act, Pub. L. No. 111-148, §10108, would have allowed qualifying low-income employees whose employer offers a free choice voucher to obtain health care coverage on their own using funds from the voucher, and would have provided tax benefits to employers offering the vouchers. Pub. L. No. 112-10, §1858, removed the voucher provisions of Pub. L. No. 111-148, §10108.

Group health plans generally are prohibited from imposing any preexisting condition exclusions on individuals. 820

820 This requirement also took effect starting in 2014. From 2010 through 2013, eligible individuals with a preexisting condition may have been able to obtain coverage under a temporary high risk health insurance pool program to provide health insurance coverage that does not impose any preexisting condition exclusion.

(2) Employers —   TPS 5920.16.A.2.

Employers are not required to offer health care coverage to their employees. However, as of 2015, 821 large employers—with 50 or more full-time-equivalent employees in the prior year—who do not offer health care coverage, or who offer coverage that does not meet minimum standards or is unaffordable to their employees, generally are subject to excise taxes (sometimes referred to as “play or pay” penalties) if any of their full-time employees obtain subsidized health insurance coverage through an Exchange.

821 Notice 2013-45 (transition relief provided for one year).

Also, large employers must report information about the health coverage that they offer, and all employers must report information about the health coverage that they provide.

Businesses with fewer than 25 employees may be eligible for tax credits to assist them in setting up or maintaining health plans. Small businesses also may offer plans to their employees through state health exchanges.

In addition, beginning in 2022, employers with self-insured plans and health insurance issuers that offer coverage beyond the required coverage (sometimes called “Cadillac” plan coverage) may have to pay an excise tax.

(3) Group Health Plans and Health Insurance Issuers —   TPS 5920.16.A.3.

Group health plans and health insurance issuers are faced with a variety of plan design and reporting and disclosure changes under the 2010 health care reform legislation. For example, for plan years beginning on or after September 23, 2010, insured group health plans cannot discriminate in favor of highly compensated individuals; plans that offer dependent child coverage must extend the coverage to children under the age of 26; plans cannot impose lifetime or annual limits (with restricted limits allowed during a phase-in period) or rescind coverage; plans must cover preventive health services; plans cannot contain preexisting condition exclusions for enrollees under age 19; and plans must develop and use uniform explanation of coverage documents and standardized definitions. See ¶5920.11.B., above.

Among the many requirements imposed for plan years beginning in and after 2014, plans cannot contain preexisting condition exclusions for adult enrollees or otherwise discriminate against any enrollees based on health status; and plans cannot impose excessive waiting periods. Health plans and health insurance coverage in existence on March 23, 2010, must comply with many new requirements, but are excluded from some requirements to the extent they retain “grandfathered” status. See ¶5920.11.B., above, for discussion of these plan requirements. See ¶5920.16.D.4., below, for discussion of the criteria a plan must satisfy to have grandfathered status.

Some requirements that apply to health plan insurers, but not funded group health plans, also apply to self-funded group health plans. Examples include the requirement to provide a summary of benefits and coverage explanation (see ¶5910.03.D.6.) and the payment of health insurance fees based on the average number of lives covered for each plan year ending after September 30, 2012, through plan years ending after September 30, 2019. 822

822 §4375, added by Pub. L. No. 111-148, §6301(e)(2) (health insurance issuers), discussed at ¶5920.16.E.3, below; §4376, added by Pub. L. No. 111-148, §6301(e)(2) (self-insured plans), discussed at ¶5920.16.D.5., below.

(4) Public Health Insurance Exchanges (Health Insurance Marketplaces) —   TPS 5920.16.A.4.

Each state can elect to establish an American Health Benefit Exchange (health exchange) — a governmental agency or nonprofit entity established to offer qualified health plans to qualified individuals and to provide for the establishment of a Small Business Health Options Program (SHOP Exchange) to assist qualified employers in enrolling their employees in qualified health plans offered in the small group market. 823 If a state does not set up a health exchange, the Secretary of HHS must establish and operate a health exchange within the state to offer qualified health plans. 824 This may be set up as a federally-facilitated exchange (with minimal state involvement) or a state partnership exchange. See ¶5920.11.B.19.b. Most exchanges fall within these last two categories.

823 Pub. L. No. 111-148, §1311(b) and 1311(d), as amended by Pub. L. No. 111-148, §10104(e). See ¶5920.16.C.6. Exchanges under the Affordable Care Act first became available in 2014.

824 Pub. L. No. 111-148, §1321(c); Pub. L. No. 111-148, §1322, as amended by Pub. L. No. 111-148, §10104(l).

This article contains general information only.  It is not tax advice and it should not be used as a basis for any business or tax decision. You should consult with a qualified professional before taking any action that may affect your business or you personally

This article will explain under what circumstances you may be eligible for the §199A deduction for qualified business income (QBI). 

Date: 01/15/2020 (PDF)

Editor's Note: The preamble to the final regulations indicates that for tax years ending in 2018 only, taxpayers may rely on the final regulations (T.D. 9847, 84 Fed. Reg. 2952 (Feb. 8, 2019)) in their entirety, or on the proposed regulations (REG-107892-18, 83 Fed. Reg. 40,884 (Aug. 16 2018)) in their entirety. The final regulations are effective for tax years ending after February 8, 2019. Anti-abuse rules are effective retroactively to the date of enactment of the 2017 tax act (December 22, 2017).

This article will explain under what circumstances you may be eligible for the §199A deduction for qualified business income (QBI).  

If you have income from a pass-through entity (or sole proprietorship) you may be entitled to a deduction equal to the lesser of the deductible amount of your QBI (generally 20% subject to the W-2 wage limitation) or 20% of your taxable income. You may also be able to deduct 20% of your qualified REIT dividends and qualified publicly traded partnership (PTP) income. Special rules apply for these additional items. The deduction applies to reduce your taxable income and is available whether or not you itemize. The deduction does not impact your calculation of self-employment tax.

QBI is your net amount of qualified items of income, gain, deduction, and loss with respect to each of your “qualified trades or businesses.” Qualified items are items that are allowed in the determination of your taxable income for the tax year, and are effectively connected with the conduct of a trade or business within the United States or Puerto Rico. Many items of income, gain, deduction, and loss are not qualified items. These items generally include capital gains and loss, dividends, interest, etc. In the case of a partnership or S corporation, your net amount of qualified items is the net amount of your allocable share of each qualified item. QBI does not include any amount paid by an S corporation to its shareholders that is treated as reasonable compensation; any guaranteed payment by a partnership to a partner for services rendered with respect to the trade or business; or any amount paid by a partnership to a partner who is not acting in his or her capacity as a partner for services rendered to the partnership. While the former three payment items are not QBI, they may serve to reduce QBI if the entity takes a deduction for these payments.

Your QBI must be earned through a trade or business. Trade or business has the same general meaning as it does for other purposes of tax law, with a few exceptions. First, if you rent or license tangible or intangible property to a trade or business which is commonly controlled, your rental activity may be a trade or business for purposes of the QBI deduction. Second, the IRS has proposed a safe harbor under which certain real estate enterprises may qualify as a trade or business if owners, employees, agents, or independent contractors perform 250 or more hours of rental services and other requirements are met. The trade or business of being an employee, is not a trade or business for purposes of the deduction. Additional rules may apply if your trade or business is a specified service trade or business.

If your deduction results from ownership of a pass-through entity, the Schedule K-1 you receive from the entity should report the net amount of QBI attributable to each trade or business or the aggregated trade or business of the entity. If the Schedule K-1 is blank in this regard, QBI is presumed to be zero, and we may need to contact the entity to issue amended schedules.

If the net amount of qualified items from your trade or business is a loss, you will have negative QBI and must proportionally offset your positive QBI from any other trades or businesses. If the net amount of QBI from all your trades or businesses is negative, you must carryover this amount to next year where it will proportionally offset positive QBI from other trades or businesses.

You must determine whether you have one trade or business or multiple trades or businesses. If you have multiple trades or businesses, it is possible that they can be aggregated together as one under special rules. In some cases, due to the W-2 wage limitation discussed below, aggregation may increase the amount of your deduction. You may have also received documentation from a pass-through entity in which you own an interest. If the entity aggregated any of its trades or businesses, you may not treat these trades or businesses as separate trades or businesses. You may, however, aggregate additional trades or businesses with the entity's aggregated group.

Calculation of the deduction is a fact intensive inquiry. If you claim the deduction and you understate the amount of tax required to be shown on your return by 5% or more, you could be subject to the substantial understatement of tax penalty.

If your taxable income does not exceed a threshold of $315,000 (joint filers), or $157,500 (all other taxpayers), your deduction is generally the lesser of: (1) 20% of your net QBI from all of your trades, plus 20% of your qualified REIT dividends and qualified PTP income; or (2) 20% of your taxable income.

Is your pass-through income from a “qualified trade or business”?

A qualified trade or business is defined as any trade or business other than a specified service trade or business or the trade or business of being an employee. A specified service trade or business cannot be aggregated with another trade or business. While no deduction is allowed for your income from the trade or business of being an employee, a deduction is allowed for your income from a specified service trade or business to the extent that your taxable income does not exceed the threshold amount. However, as your taxable income exceeds the threshold amount, your specified service trade or business income is partially or fully excluded from the deduction. The exclusion phases in based on the ratio of your table income in excess of the threshold amount to $100,000 (joint filers) and $50,000 (all other taxpayers). Thus, no deduction is allowed for your income from a specified service trade or business if your taxable income is more than $415,000 (joint filers) or $207,500 (all other taxpayers).

If your trade or business is operated as a pass-through entity, the entity should report to you whether the trade or business is a specified service trade or business. If your trade or business is operated as a sole proprietorship, you will need to determine whether you are engaged in a specified service trade or business. A specified service trade or business generally involves the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners (generally, a trade or business where a person receives fees, compensation, or other income, for endorsing a product, use of their likeness or other associated symbols, or appearances on television or other media), or which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. If only a small portion of the gross receipts of your trade or business are attributable to one of the listed fields, a de minimis rule may permit you to treat your trade or business as a qualified trade or business.

Application of the W-2 wage limitation

If your taxable income exceeds the threshold amount, the deductible amount of your QBI is equal to the lesser of 20% of your QBI with respect to the trade or business or the W-2 wage limitation. As your taxable income exceeds the threshold above, the W-2 wage limitation phases in and you will reduce the excess amount of your deduction based on the ratio of your table income in excess of the threshold amount to $100,000 (joint filers) and $50,000 (all other taxpayers).

The W-2 wage limitation is equal to the greater of: (1) 50% of the business's W-2 wages; or (2) the sum of (a) 25% of the business's W-2 wages, plus (b) 2.5% of the unadjusted basis (immediately after acquisition) of all qualified property.

In the case of a partnership or S corporation, you take into account your allocable share of W-2 wages and unadjusted basis (immediately after acquisition) of qualified property for the tax year. These items should be reported to you by the partnership or S corporation on Schedule K-1. If these items are blank they will be presumed to be zero, and we may need to contact the entity to amend the schedule.

W-2 wages are the total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the tax year of the taxpayer. W-2 wages do not include: (1) any amount that is not properly allocable to the QBI as a qualified item of deduction; and (2) any amount that was not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions). Amounts paid to independent contractors are not W-2 wages. If your business uses a third party such as a certified professional employer organization to pay your employees’ wages, you may still be able to include these wages in your W-2 wage calculation subject to certain additional rules.

Qualified property is tangible property of a character subject to depreciation: (1) that is held by, and available for use in, the qualified trade or business at the end of the tax year; (2) that is used in the production of QBI; and (3) for which the depreciable period has not ended before the end of the tax year. The depreciable period with respect to qualified property is the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of: (1) the date 10 years after that date; or (2) the last day of the last full year in the applicable recovery period that applies to the property. The unadjusted basis (immediately after acquisition) of qualified property is determined on the date the qualified property is placed in service.

Do you have any qualified REIT dividends or qualified PTP income?

If you have dividends from a REIT that are taxed as ordinary income, you have qualified REIT dividends. Income from a REIT that is taxed as capital gain, such as qualified dividend income and capital gains dividends, is not eligible for the deduction.

If you have income from a publicly traded partnership that is not taxed as a corporation, you may deduct up to 20% of the qualified PTP income from that publicly traded partnership. Qualified PTP income is the QBI, as described above, earned through a publicly traded partnership. If your taxable income is above the threshold amount, and your income from the publicly traded partnership is attributable to a specified service trade or business, your deduction may be partially or fully excluded based on ratio of your taxable income in excess of the threshold amount to $100,000 (joint filers) and $50,000 (all other taxpayers).

If you received either of these items from a pass-through entity, they should be reported to you on Schedule K-1.

This article contains general information only.  It is not tax advice and it should not be used as a basis for any business or tax decision. You should consult with a qualified professional before taking any action that may affect your business or you personally.

As a fundamental rule, taxpayers are entitled to take deductions only where specifically authorized by the Internal Revenue Code. Thus, because deductions are a matter of “legislative grace,” courts closely scrutinize taxpayers’ claims and reject those that do not clearly respect the letter of the law. Each taxpayer bears the burden of proving his or her entitlement to a deduction, and ambiguities are often resolved in favor of the government. Accordingly, taxpayers should carefully review their maintenance and reconditioning expenditures on property used in a trade or business to determine whether such amounts are deductible or capitalizable. Further, they should retain full and adequate records to substantiate all such costs.

Date: 01/16/2020 (PDF)

As a fundamental rule, taxpayers are entitled to take deductions only where specifically authorized by the Internal Revenue Code. Thus, because deductions are a matter of “legislative grace,” courts closely scrutinize taxpayers’ claims and reject those that do not clearly respect the letter of the law. Each taxpayer bears the burden of proving his or her entitlement to a deduction, and ambiguities are often resolved in favor of the government. Accordingly, taxpayers should carefully review their maintenance and reconditioning expenditures on property used in a trade or business to determine whether such amounts are deductible or capitalizable. Further, they should retain full and adequate records to substantiate all such costs.

A business expense deduction is generally allowed for all of the ordinary and necessary expenses paid or incurred by a taxpayer during the tax year in carrying on any trade or business. “Incidental repairs” are deductible business expenses for these purposes. However, expenditures that might be similar to repairs, for example, an expenditure that is for a betterment to the property, restores the unit of property, or adapts the property to a new or different use, must be capitalized or charged to the taxpayer's depreciation reserve rather than deducted. The line between a deductible repair expense and a nondeductible capital expenditure is indistinct; the difference between the two depends upon the factual context surrounding the expenditure. The same outlay that may be treated as a deductible repair in one set of circumstances may be a nondeductible capital expenditure in other situations.

An expenditure is generally deductible as an incidental repair if it is limited to keeping the affected property in its ordinarily efficient operating condition, whereas an amount paid to return a unit of property to its ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use, is a capital expenditure. An expenditure is considered to be a betterment — and thus a capital expenditure — if it ameliorates a material condition or defect that existed before the taxpayer acquired the property (or arose during the production of the property); if it is for a material addition to the property (including a physical enlargement, expansion, extension, or addition of a major component, or a material increase in capacity); or if it is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property.

Repairs incidental to an improvement must be capitalized only if they directly benefit or are incurred by reason of the improvement(s). Expenditures for work performed on depreciable assets that do not qualify as deductible repairs may nonetheless qualify for a bonus depreciation deduction or under the rule that allows you to elect to treat the cost of certain depreciable business assets as a current-year expense. The deductibility of environmental cleanup costs is governed by a special set of detailed rules.

Maintenance expenditures that do not improve the property (i.e., are not paid for a betterment or restoration of the property and do not adapt the property to a new or different use) generally may be deducted. Thus, taxpayers can deduct the costs of various expenditures that alleviate damage or deterioration, so long as the property is not improved. However, taxpayers cannot deduct indirect expenditures (e.g., otherwise deductible repairs) that directly benefit or are incurred by reason of an improvement.

A taxpayer ordinarily can deduct as a repair regularly recurring routine maintenance expenditures that a taxpayer expects to perform to keep the unit of property in its ordinarily efficient operating condition. When such activities happen regularly, an abnormally large expenditure resulting from the same cause is still deductible. On the other hand, a taxpayer must capitalize the cost to replace a major component or a substantial structural part of the unit of property.

There are a host of other factors or considerations that are relevant to the determination of whether a particular expenditure is deductible as a repair:

• Any properly-performed repair adds some value to the property repaired, but that does not necessarily mean its cost cannot be deducted.
• A common rule of thumb is that the cost of property having a useful life greater than one year must be capitalized. However, the test of deductibility considers whether the expenditure simply kept the property in, or restored it to, an efficient operating condition.
• The size of the expenditure does not control whether it is a deductible repair. Taxpayers have been permitted to deduct expenditures of significant magnitude in comparison to the value of the asset being repaired. Courts have also permitted taxpayers to deduct expenditures that were large in absolute terms if the criteria for a repair expense were satisfied. In addition, expenditures for repairs will not be disallowed merely because they significantly exceed the taxpayer's average annual repair expenditures. On the other hand, a taxpayer cannot deduct his cost to replace an asset on the ground that repairing the asset would be roughly comparable in cost.
• Case law suggests that extensive repairs to an asset shortly after its acquisition have materially altered the asset and are not deductible. Regulations state that taxpayers must capitalize expenditures that ameliorate a material condition or defect that existed before the taxpayer's acquisition of the unit of property. Thus, taxpayers should carefully consider the deductibility of repair and restoration expenditures incurred shortly after the acquisition of an asset.
• Taxpayers cannot deduct involuntary expenditures caused by regulatory requirements or some other governmental action if the expenditures do not fit the criteria for a repair deduction.
• Taxpayers can deduct the cost of materials and labor to conduct repairs, but a self-employed taxpayer may not deduct the value of his own labor to perform repairs.

Special rules apply to repair expenses that are incurred due to a casualty and to leased property. If a taxpayer consistently capitalizes a particular type of expenditure or treats it as a repair, any change to that treatment is generally a change in accounting method that may require IRS permission. Some changes are made by an election and are not considered a change in method of accounting.

Many of the rules in this area are complex and also may be affected by other tax laws. For this reason, the facts of your situation should be carefully reviewed.

This article contains general information only.  It is not tax advice and it should not be used as a basis for any business or tax decision. You should consult with a qualified professional before taking any action that may affect your business or you personally

On December 20, President Donald Trump signed the bipartisan, year-end government spending and tax package, just hours before federal funding was set to expire. Trump's signature on the over 2,000-page spending package avoided a government shutdown.

On December 20, President Donald Trump signed the bipartisan, year-end government spending and tax package, just hours before federal funding was set to expire. Trump's signature on the over 2,000-page spending package avoided a government shutdown.

Year-End Tax Package
The Further Consolidated Appropriations Act, 2020, (HR 1865), logs just over 700 pages and serves as only half of the government spending package for fiscal year 2020, which runs through September 30. Most notably, HR 1865 serves as the legislative vehicle for a year-end tax package, which carries a costly $426 billion price tag over a 10-year budget window, according to the nonpartisan Joint Committee on Taxation (JCT), JCX-54R-19.

Some of the tax-related provisions in the year-end package include, among other items:

• Retroactive and current renewal of over two dozen temporary tax breaks known as tax extenders, which have expired or would soon be expired, spanning from 2017 to 2019. Generally, the renewed tax breaks are extended through 2020, and the biodiesel and short-line railroad maintenance tax credits are extended until 2022;
• The Setting Every Community Up for Retirement Enhancement Act (SECURE Act) (HR 1994), which makes sweeping changes to retirement savings and employer retirement contributions provisions;
• Certain fixes to the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97); and
• Full repeal of three tax-related provisions of the Affordable Care Act (ACA) ( P.L. 111-148), two of which include the 2.3 percent excise tax on medical devices and the 40 percent excise "Cadillac" tax on high-dollar employer-sponsored health insurance plans.

The House approved HR 1865 on December 17 by a 297-to-120 vote. The Senate cleared the measure on December 19 by a 71-to-23 vote.

"So in the end, with more than $400 billion in tax cuts, there were lots of winners and the usual loser – the budget."

"There were numerous fits and starts, but this result is a reminder that Congressional muscle memory on extenders is very strong, so ultimately the members did what they always do – extend them," John Gimigliano, principal-in-charge of the federal legislative and regulatory services group in the Washington National Tax practice of KPMG LLP told Wolters Kluwer. "Some might be surprised to see the ACA taxes rolled back, but it has always felt like those items were on borrowed time; it was really just a question of when and how they were repealed, not whether. So in the end, with more than $400 billion in tax cuts, there were lots of winners and the usual loser – the budget."

SECURE ACT
The bipartisan SECURE Act, which cleared the House in May but remained stalled in the Senate most of the year, makes a number of major as well as administrative changes for retirement savings affecting both individuals and employers.

Some of those changes are noted as follows:

IRA Changes

• Moving the start date for requirement required minimum distributions (RMDs) to the year the owner turns 72;
• Ending the 70 1/2 age limit for contribute contributions to an IRA; and
• Shortening the distribution period for nonspouse inherited IRAs to a 10-year maximum.
  The 10-year window for distributions to a nonspouse beneficiary applies regardless of when the IRA owner dies. Thus, the change will severely limit the use of "stretch IRAs" as an effective planning tool. Limited exceptions are available.

401(k) Changes

• Requiring plans to offer participation to long-term, part-time employees;
• Encouraging auto-enrollment by increasing the cap; and
• Streamlining the safe harbor for non-elective contributions.

Employers with 401(k) plans must offer employees who work between 500 and 1000 hours year an additional means to participate in the plan. The rule change would only affect 401(k) cash or deferral arrangements, and no other qualified plans.

Retirement Plans for Small Employers

Several changes are made to encourage more small employers to offer retirement benefits to their employees, such as:

• Adding a new tax credit for small employers using auto-enrollment plans;
• Increasing the credit for small employer pension plan start-up costs; and
• Allow small employers of two or more to band together to participate in a new class of pooled multiple employer plans (MEPs).

Congress Adjourns Until 2020
After an eventful two-week sprint to the finish line, Congress adjourned for the year on December 20. Lawmakers are expected to return to Washington, D.C. during the week of January 6, 2020.

The Fifth Circuit U.S. Court of Appeals ruled that the Patient Protection and Affordable Care Act’s (ACA) ( P.L. 111-148) individual mandate is unconstitutional because it can no longer be read as a tax, and there is no other constitutional provision that justifies this exercise of congressional power. However, the central question of whether the rest of the ACA remains valid after Congress removed the penalty for not having health insurance remained unanswered. Instead, the case was sent back to the district court to reconsider how much of the ACA could survive without the individual mandate penalty.

The Fifth Circuit U.S. Court of Appeals ruled that the Patient Protection and Affordable Care Act’s (ACA) ( P.L. 111-148) individual mandate is unconstitutional because it can no longer be read as a tax, and there is no other constitutional provision that justifies this exercise of congressional power. However, the central question of whether the rest of the ACA remains valid after Congress removed the penalty for not having health insurance remained unanswered. Instead, the case was sent back to the district court to reconsider how much of the ACA could survive without the individual mandate penalty.

District Court
According to the opinion, "the rule of law demands a careful, precise explanation of whether the provisions of the ACA are affected by the unconstitutionality of the individual mandate as it exists today." Therefore, the opinion directs the district court to carefully consider whether the mandate can be legally distinct from the rest of the law. The opinion instructs the district court to answer two questions: Which parts of the ACA "are indeed inseverable" now that the mandate is no longer enforced and whether a ruling in the case should apply only to the Republican-led states that sued to overturn the law, an issue raised by Trump administration lawyers.

Dissenting Opinion
A dissenting opinion discussed that Congress made it clear that it wanted the rest of the ACA to stand and sending the case back to the lower court was criticized. The opinion also highlighted that sending the case back to the lower court merely identifies serious flaws in the district court’s analysis and remands for a do-over, which will unnecessarily prolong this litigation and the concomitant uncertainty over the future of the health care sector.

Proposed qualified opportunity zone regulations issued on October 29, 2018 ( REG-115420-18) and May 1, 2019 ( REG-120186-18) under Code Sec. 1400Z-2 have been finalized with modifications. The regulations. which were issued in a 550 page document, are comprehensive.

Proposed qualified opportunity zone regulations issued on October 29, 2018 ( REG-115420-18) and May 1, 2019 ( REG-120186-18) under Code Sec. 1400Z-2 have been finalized with modifications. The regulations. which were issued in a 550 page document, are comprehensive.

The regulations address issued related to all aspects of the gain deferral rules and also various requirements that must be met for an entity to qualify as a qualified opportunity fund (QOF) or as a qualified opportunity zone business. Duplicative rules regarding QOFs and qualified opportunity zone businesses have been combined and definitions of key terms added. The regulations detail which taxpayers are eligible to make the election, the types of capital gains eligible for deferral, and the method of making deferral elections. Revisions are made to the rules applying the statutory 180-period and other requirements with regard to the making of a qualifying investment in a QOF.

The IRS will reflect these regulations in updated forms, instructions, and other guidance in January 2020.

Benefits of QOF Investments
Taxpayers may elect to temporarily defer capital gain in income if the gain is invested within 180 days in a QOF. The gain is recognized on Dec. 31, 2026, or if earlier, upon the occurrence of an inclusion event such as the sale of the QOF investment. However, 10 percent of the deferred gain is not recognized if the investment is held five years and 15 percent is not recognized after seven years. In addition, taxpayers may exclude recognition of gain on appreciation in the investment if the investment in the qualified opportunity fund is held for at least 10 years.

Section 1231 gains
The final regulations provide that eligible gains include the gross amount of eligible section 1231 gains unreduced by section 1231 losses regardless of character. The proposed regulations took a "netting" approach. The 180-day period for an eligible taxpayer to invest an amount with respect to an eligible section 1231 gain begins on the date of the sale of the section 1231 asset rather than at the end of the tax year.

RICS and REITS
The 180-day period for RIC or REIT capital gain dividends generally begins at the close of the shareholder’s tax year in which the capital gain dividend would otherwise be recognized by the shareholder. To ensure that RIC and REIT shareholders do not have to wait until the close of their tax year to invest capital gain dividends received during the tax year, the final regulations also provide that shareholders may elect to begin the 180-day period on the day each capital gain dividend is paid. The 180-day period for undistributed capital gain dividends, however, begins on either the last day of the shareholder’s tax year in which the dividend would otherwise be recognized or the last day of the RIC or REIT’s tax year, at the shareholder’s election.

The aggregate amount of a shareholder’s eligible gain with respect to capital gain dividends received from a RIC or a REIT cannot exceed the aggregate amount of capital gain dividends that the shareholder receives as reported or designated by that RIC or that REIT for the shareholder’s tax year.

Installment Sales
The final regulations allow an eligible taxpayer to elect to choose the 180- day period to begin on either (i) the date a payment under an installment sale is received for that tax year, or (ii) the last day of the tax year the eligible gain under the installment method would be recognized. Therefore, if the taxpayer defers gain from multiple payments under an installment sale, there might be multiple 180-day periods, or a single 180-day period at the end of the taxpayer’s tax year, depending upon taxpayer’s election.

Partners, S Corporation Shareholders, and Trust Beneficiaries
The final regulations provide partners, S shareholders, and beneficiaries of decedents’ estates and non-grantor trusts with the option to treat the 180-day period as commencing upon the due date of the related entity’s tax return, not including any extensions. This rule does not apply to grantor trusts.

Gain from Disposal of Partial Interest in QOF Investment
Gain arising from an inclusion event is eligible for deferral even though the taxpayer retains a portion of its qualifying investment after the inclusion event. If an inclusion event relates only to a portion of a taxpayer’s qualifying investment in the QOF, (i) the deferred gain that otherwise would be required to be included in income (inclusion gain amount) may be invested in a different QOF, and (ii) the taxpayer may make a deferral election with respect to the inclusion gain amount, so long as the taxpayer satisfies all requirements for a deferral election on the inclusion gain amount.

Post-December 31, 2026 Gain Ineligible
Gain arising after December 31, 2026 (including gain mandatorily recognized on that date) is not eligible for deferral.

Death Related Transfers of QOF Investments
A qualifying investment received by a beneficiary in a transfer by reason of death remains a qualifying investment in the hands of the beneficiary.

Acquisition of Eligible Interest from Person Other than a QOF
A taxpayer may make a deferral election for an eligible interest acquired from a person other than a QOF. The final regulations do not require the transferor to have made a prior deferral election for the acquirer of an eligible interest to make the election.

Further, for interests in entities that existed before the enactment of the deferral provision, if such entities become QOFs, then the interests in those entities, even though not qualifying investments in the hands of a transferor, are eligible interests that may (i) be acquired by an investor and (ii) result in a qualifying investment of the acquirer if the acquirer has eligible gain and the acquisition was during the 180-day period with respect to that gain.

Built in Gains
Built-in gain of a REIT, a RIC, or an S corporation potentially subject to corporate-level tax is eligible for deferral. If the deferral election is made, the amount of gain is not included in the calculation of the entity’s net recognized built-in gain.

Identification of Disposed Interests in a QOF
The final regulations permit taxpayers to specifically identify QOF stock that is sold or otherwise disposed. If a taxpayer fails to adequately identify which QOF shares are disposed of, then the FIFO identification method applies. If, after application of the FIFO method, a taxpayer is treated as having disposed of less than all of its investment interests that the taxpayer acquired on one day and the investments vary in its characteristics, then a pro-rata method applies to the remainder.

The specific identification method does not apply to the disposition of interests in a QOF partnership.

Deferred Gain Retains Tax Attributes
The final regulations make it clear that if a taxpayer is required to include in income some or all of a previously deferred gain, the gain so included has the same attributes that the gain would have had if the recognition of gain had not been deferred. If a deferred gain cannot be clearly associated with an investment in a particular QOF, an ordering rule applies to make this determination.

Effective Date
The final regulations are generally applicable to tax years beginning after 60 days after publication in the Federal Register.

With respect to the portion of a taxpayer’s first tax year ending after December 21, 2017, that began on December 22, 2017, and for tax years beginning after December 21, 2017, and on or before 60 days after publication in the Federal Register taxpayers may rely on either the proposed regulations or the final regulations but not both.

The IRS has issued final regulations that provide guidance on transfers of appreciated property by U.S. persons to partnerships with foreign partners related to the transferor. Specifically, the regulations override the general nonrecognition rule under Code Sec. 721(a) unless the partnership adopts the remedial allocation method and certain other requirements are satisfied. The regulations affect U.S. partners in domestic or foreign partnerships.

The IRS has issued final regulations that provide guidance on transfers of appreciated property by U.S. persons to partnerships with foreign partners related to the transferor. Specifically, the regulations override the general nonrecognition rule under Code Sec. 721(a) unless the partnership adopts the remedial allocation method and certain other requirements are satisfied. The regulations affect U.S. partners in domestic or foreign partnerships.

Background
Code Sec. 721(a) generally provides that no gain or loss is recognized by either a partnership or any of its partners upon a contribution of property to the partnership in exchange for a partnership interest. In Code Sec. 721(c), the Treasury Secretary has regulatory authority to override this nonrecognition provision for gain realized on the transfer of property to a domestic or foreign partnership if the gain, when recognized, would be includible in the gross income of a person other than a U.S. person.

Under temporary regulations issued in 2017, if a U.S. person contributes certain property with built-in gain to a partnership that has foreign partners related to the transferor, then gain will be recognized unless the gain deferral method is applied with respect to the property ( Temporary Reg. §§1.721(c)-2T; 1.721(c)-3T). Under a de minimis exception, nonrecognition continues to apply if the sum of all built-in gain property contributed to the partnership during the tax year does not exceed $1 million.

The final regulations adopt the temporary regulations with certain modifications.

Related Person Definition
The final regulations modify the definition of related person in certain situations. This modification provides relief when certain foreign individual partners of a partnership would be treated as a related person with respect to a domestic corporation by reason of Code Sec. 267(c)(3).

Consistent Allocation Method
The final regulations add a new sentence in Reg. §1.721(c)-3(c)(1). Upon a variation (as described in Reg. §1.706-4(a)(1)) of a U.S. transferor’s interest in a Code Sec. 721(c) partnership, book items with respect to section 721(c) property that are allocated under the interim closing method (as described in Reg. §1.706-4) will be treated as allocated in the same percentage for applying the consistent allocation method in a single tax year, unless the variation results from a transaction undertaken with a principal purpose of avoiding the tax consequences of the gain deferral method.

Reporting Requirements
The 2017 regulations required much of the reporting to be on statements attached to returns. Since the 2017 regulations were issued, however, the IRS has updated and added new schedules to Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, to facilitate compliance with these reporting requirements. The IRS has also issued new Form 8838-P, Consent To Extend the Time To Assess Tax Pursuant to the Gain Deferral Method (Section 721(c)). The final regulations generally require taxpayers to use these forms and schedules.

The final regulations also clarify the duration for which the U.S. transferor must extend the period of limitations on the assessment of tax under Reg. §1.721(c)-6(b).

Technical Termination Rules
The Tax Cuts and Jobs Act, ( P.L. 115-97) (the "TCJA") eliminated technical terminations. However, the applicability date for these final regulations relates back to the applicability date provided in the 2017 regulations, which is before the effective date provided in the TCJA. Accordingly, the final regulations retain technical termination rules, but their application will be limited. The rules will only apply to technical terminations occurring on or after the applicability date provided in the 2017 regulations but before the effective date for the repeal of Code Sec. 708(b)(1)(B) provided in the TCJA.

Effective Date
The regulations are effective on the date of filing with the Federal Register. For dates of applicability, see Reg. §§1.197-2(l)(5)(i), 1.704-1(f), 1.704-3(g)(1), 1.721(c)-1(e), 1.721(c)-2(e), 1.721(c)-3(e), 1.721(c)-4(d), 1.721(c)-5(g), 1.721(c)-6(g), and 1.6038B-2(j)(4).

The IRS has released Publication 5382, "Internal Revenue Service Progress Update / Fiscal Year 2019—Putting Taxpayers First." This new annual report describes accomplishments across the agency, and highlights the work of IRS employees during the past year. It covers a variety of taxpayer service efforts, including development of the new Taxpayer Withholding Estimator, as well as operations support efforts on areas involving information technology modernization, human capital office initiatives, and others.

The IRS has released Publication 5382, "Internal Revenue Service Progress Update / Fiscal Year 2019—Putting Taxpayers First." This new annual report describes accomplishments across the agency, and highlights the work of IRS employees during the past year. It covers a variety of taxpayer service efforts, including development of the new Taxpayer Withholding Estimator, as well as operations support efforts on areas involving information technology modernization, human capital office initiatives, and others.

"This report is about more than what happened during the past year," IRS Commissioner Chuck Rettig wrote in the report’s opening message to taxpayers. "It’s also designed to provide insight into the people serving this country on behalf of the IRS, and provide a glimpse into the future," he added.

IRS Pub. 5382 also focuses criminal investigation results and efforts involving civil enforcement. Also discussed are ongoing compliance areas, including micro-captives, syndicated conservation easements, and virtual currency. The report further covers the IRS’s implementation of new tax laws, and the IRS’s ongoing work on the new Taxpayer First Act of 2019.

Individual Audits Down
Taxpayers are now half as likely to be audited by the IRS for their individual income tax returns as they were a decade ago. As described in IRS Pub. 5382, the IRS audited 0.45 percent of individual (1040) income tax returns during fiscal year (FY) 2019. This number is down from 1.1 percent of tax returns audited in 2010. The IRS’s ongoing loss to its total workforce is largely to blame for the consistent decline in IRS audits, according to the report.

"The IRS lost more than 29,618 full time positions between FY 2010 and FY 2019, which includes Information Technology, Operations Support, Taxpayer Service and Enforcement personnel. These losses directly correlate with a steady decline in the number of individual audits during the past nine years," the report notes.

Hill Reaction
Although individual audits have significantly decreased, Democratic lawmakers on Capitol Hill are criticizing the fact that the IRS continues to conduct more examinations on lower-income individual taxpayers than it does on higher-income taxpayers or corporations. However, the IRS has said previously that audits on higher-income individuals and businesses are significantly more complex and require more resources.

"IRS audit rates are at their lowest levels in 40 years, allowing the wealthy and well-connected to steal from taxpayers with no consequences," Senate Finance Committee ranking member Ron Wyden, D-Ore., said in a January 7 statement. "The bulk of tax avoidance and fraud comes from corporations, pass-through business and those at the top. Ensuring the wealthy and corporations pay what they owe takes the most resources and manpower, and I’m working with the IRS to get a clear picture on funding and staffing levels needed to audit top earners at 2010 levels," Wyden added.

Currently, the IRS anticipates that up to 31 percent of its workforce (nearly 19,719 full-time employees) will retire within the next five years. The IRS’s workforce decline is expected to create a "significant risk of a large knowledge and experience gap for the nation’s tax agency," according to the IRS report.

Bridget Roberts, the Acting National Taxpayer Advocate, released her 2019 Annual Report to Congress. The report discusses the key challenges facing the IRS regarding the implementation of the Taxpayer First Act, inadequate taxpayer service and limited funding of the agency. Further, Roberts released the third edition of the National Taxpayer Advocate’s "Purple Book," which presents 58 legislative recommendations designed to strengthen taxpayer rights and improve tax administration.

Bridget Roberts, the Acting National Taxpayer Advocate, released her 2019 Annual Report to Congress. The report discusses the key challenges facing the IRS regarding the implementation of the Taxpayer First Act, inadequate taxpayer service and limited funding of the agency. Further, Roberts released the third edition of the National Taxpayer Advocate’s "Purple Book," which presents 58 legislative recommendations designed to strengthen taxpayer rights and improve tax administration.

Taxpayer First Act
The report highlighted that the Taxpayer First Act ( P.L. 116-25) had made the most comprehensive revisions to IRS procedures since the IRS Restructuring and Reform Act of 1998, including some 23 provisions previously recommended by the National Taxpayer Advocate. Further, the Taxpayer First Act also required the IRS to develop four strategic plans:

• a comprehensive taxpayer service strategy (due to Congress by July 1, 2020);
• a comprehensive plan to redesign the IRS’s organizational structure (due to Congress by Sept. 30, 2020);
• a comprehensive employee training strategy that includes taxpayer rights training (due to Congress by July 1, 2020); and
• a multi-year plan to meet IRS information technology (IT) needs.

Key IRS Challenges
The biggest challenge facing the IRS is its struggle to complete its mission. The IRS aims to "provide America’s taxpayers top-quality service by helping them understand and meet their tax responsibilities and enforce the law with integrity and fairness to all." The report emphasizes that the IRS is struggling to meet both of those goals, and attributes the IRS’s shortcomings mostly to budget constraints but also to a culture in which the agency focuses on its own priorities without adequately factoring in the needs of taxpayers.

The report states that the IRS is among the lowest-performing federal agencies in providing a positive customer experience. During fiscal year (FY) 2019, the report said that the IRS received approximately 100 million telephone calls, and customer service representatives answered only 29 percent. The report further states that the IRS has also struggled to enforce the law with "fairness to all". The report urges the IRS to prioritize phone service for taxpayers against whom it takes collection action.

Low Budget
Since 2010, the IRS budget has been reduced by about 20 percent after adjusting for inflation, and the number of full-time equivalent employees has declined by about 22 percent. The report points out that answering 100 million telephone calls, conducting audits, and taking enforcement actions require adequate staffing, and the IRS cannot substantially improve its performance without additional resources. The report urges Congress to increase IRS funding and particularly for taxpayer service and IT modernization, and to change the budget rules to account for the revenue additional IRS appropriations are likely to generate.

Identifying Taxpayer Needs and Preferences
Despite the IRS’s significant funding limitations, the report urges the IRS to utilize the Taxpayer First Act requirements – to develop plans to revamp its taxpayer service strategy, organizational structure, employee training strategy, and technology priorities – as a roadmap for a once-in-a-generation reassessment of its objectives and operations.

While noting that the IRS has developed strategies in a vacuum without soliciting taxpayer feedback and taking into account taxpayer needs and preferences, the report suggests a full-scale cultural shift. The report also expressed concern that the IRS has declined to include the National Taxpayer Advocate or a Taxpayer Advocate Service (TAS) representative as part of a core team created to coordinate its Taxpayer First Act implementation activities.

The report also makes numerous recommendations to improve the customer experience, including that the IRS take the following actions:

• Conduct multi-disciplined, comprehensive research into taxpayer needs and preferences.
• Require that all IRS business units, including those charged primarily with enforcement, develop a detailed customer service strategy.
• Appoint a Chief Customer Experience Officer to coordinate service initiatives across IRS business units.
• Ensure that taxpayers who cannot work with the IRS digitally, or whose issues are not resolved online, can reach and work with an IRS employee.
• Address the needs of practitioners who interact with the IRS on behalf of large numbers of taxpayers.
• For each proposal included in its customer service strategy, include cost estimates, milestones, and taxpayer-focused performance measures so the effectiveness of the strategy in improving customer service can be measured over time.

Other Matters
The report also:

• identified 10 "most serious problems";
• provided status updates on two problems identified in previous reports;
• made dozens of recommendations for administrative change;
• made 58 recommendations for legislative change;
• analyzed the 10 tax issues most frequently litigated in the federal courts; and
• presented four research studies.

The IRS has modified the applicability dates for proposed regulations under Code Sec. 382 that were issued with NPRM REG-125710-18, September 10, 2019 (2019 proposed regulations). The IRS is withdrawing the text of the proposed applicability dates, and proposing revised applicability dates. The newly issued proposed rules would also provide transition relief.

The IRS has modified the applicability dates for proposed regulations under Code Sec. 382 that were issued with NPRM REG-125710-18, September 10, 2019 (2019 proposed regulations). The IRS is withdrawing the text of the proposed applicability dates, and proposing revised applicability dates. The newly issued proposed rules would also provide transition relief.

Proposed Regulations and Notice 2003-65
The 2019 proposed regulations would provide guidance on the inclusion of items of income and deductions in the calculation of built-in gains and losses under Code Sec. 382(h). The proposed regulations would apply to ownership changes that occur after the date the proposed regulations are published as final regulations in the Federal Register.

Notice 2003-65, 2003-2 CB 747, provides interim guidance for identifying built-in gains and losses under Code Sec. 382(h). This notice permits taxpayers to rely on safe harbor approaches for applying Code Sec. 382(h) to an ownership change prior to the effective date of temporary or final regulations issued under that provision.

Delay of Applicability Date
To address concerns raised by taxpayers and practitioners, the IRS has withdrawn the text of Proposed Reg. §1.382-2(b)(4) and Proposed Reg. §1.382-7(g) contained in the 2019 proposed regulations, and replaced it with a revised proposed applicability date text. To avoid any gap between the date on which taxpayers can no longer rely on Notice 2003-65 and the date on which the final regulations are applicable, the applicability date of the final regulations would be 30 days after the date such regulations are published in the Federal Register (delayed applicability date). Exceptions exist for two situations discussed below.

Notice 2003-65 will remain applicable to ownership changes to which the final regulations do not apply.

Limiting Duplicative Application
The first exception to the delayed applicability date relates to the rule in Proposed Reg. §1.382-7(d)(5), which provides that certain carryforwards of business interest expense disallowed under Code Sec. 163(j) would not be treated as recognized built-in losses under Code Sec. 382(h)(6)(B), if such amounts were allowable as deductions during the five-year recognition period set forth in Code Sec. 382(h)(7)(A). This rule eliminates the possible duplicative application of Code Sec. 382 to certain disallowed business interest expense carryforwards.

The IRS has determined that Proposed Reg. §1.382-7(d)(5) should be finalized before the remainder of the rules in the 2019 proposed regulations, and that taxpayers should be allowed to retroactively apply this rule. To that end, the IRS expects that Proposed Reg. §1.382-7(d)(5) will be finalized as part of the Treasury decision that finalizes the proposed Code Sec. 163(j) regulations (see 83 FR 67490), and that taxpayers will be permitted to apply the rule to prior periods. The IRS continues to study the remainder of the rules in the 2019 proposed regulations.

Transition Relief
Under the proposed transition relief provisions, the final regulations would not apply to certain ownership changes that occur after the delayed applicability date. To qualify for the transition relief, the ownership change must occur immediately after an owner shift or equity structure shift that occurs pursuant to:

• a binding agreement in effect on or before the delayed applicability date and at all times thereafter;
• a specific transaction described in a public announcement made on or before the delayed applicability date;
• a specific transaction described in a filing with the Securities and Exchange Commission submitted on or before the delayed applicability date;
• a transaction described in a private letter ruling request submitted to the IRS on or before the delayed applicability date; or
• a court order (or a plan confirmed, or a sale approved, by court order) in a title 11 or similar case, provided that the taxpayer was a debtor in a case before such court on or before the delayed applicability date.

The relevant owner shift or equity structure shift must be a specific, identifiable transaction.

Taxpayers may continue to rely on Notice 2003-65 for to any ownership change qualifying for transition relief, even though the notice will be obsoleted on the delayed applicability date. However, a taxpayer may choose to apply the final regulations to such an ownership change.

The Treasury and IRS have issued final regulations on the due diligence and reporting rules for persons making certain U.S. source payments to foreign persons. Guidance is also provided on reporting by foreign financial institutions on U.S. accounts. The regulations are effective on the date the regulations are published in the Federal Register.

The Treasury and IRS have issued final regulations on the due diligence and reporting rules for persons making certain U.S. source payments to foreign persons. Guidance is also provided on reporting by foreign financial institutions on U.S. accounts. The regulations are effective on the date the regulations are published in the Federal Register.

Obtaining a Foreign TIN and Date of Birth
Temporary regulations provided that beginning January 1, 2017, a beneficial withholding certificate provided to document an account maintained at a U.S. branch or office of a financial institution was required to include a foreign taxpayer identification number (TIN) and the date of birth for an individual, in order to treat the certificate as valid. In response to comments regarding the difficulty of the requirements, the Treasury and IRS issued Notice 2017-46.

The notice provided a one-year delay in the implementation of the requirements for payments made on or after January 1, 2018, and a transitional rules to phase in the foreign TIN requirement for certificates provided before January 1, 2018. The transitional rules allow an otherwise valid certificate to remain valid until January 1, 2020. For payments made after January 1, 2020, a withholding agent may treat a pre-2018 as valid if the foreign TIN is obtained on a written statement or is in the withholding agent’s files. In Notice 2018-20, the IRS stated that it intended to expand its list of jurisdictions that do not issue foreign TINs to their residents to include jurisdictions that requested to be on the list, even if they issue foreign TINs.

The final regulations incorporate the temporary regulations and Notices with minor changes, by:

• providing, with respect to withholding certificates signed on or after January 1, 2018, that a separate written statement is an acceptable way to collect a foreign TIN, if the written statement contains an acknowledgment that the statement is part of the withholding certificate;
• clarifying the exception to the foreign TIN requirement for an account holder that is a government, international organization, foreign central bank or resident of a U.S. territory; and
• clarifying that a withholding agent may rely on the date of birth on a withholding certificate, unless it knows or has reason to know that the date of birth is incorrect.

Nonqualified Intermediaries
A nonqualified intermediary is generally required to provide a withholding agent a Form W-8IMY, a withholding statement, and documentation for each payee for which the intermediary receives a payment. The final regulations clarify that the general standards of knowledge that apply to withholding agents apply to a nonqualified intermediary for reliance on payee documentation, for making the representation that the information on the certificate is not inconsistent with other account information that the nonqualified intermediary has.

A nonqualified intermediary may provide a withholding statement that does not include a chapter 4 recipient code for one or more payees if the withholding agent can determine the appropriate code based on other information included on or associated with the withholding statement, or contained in the withholding agent’s records.

Electronic Signatures
A withholding agent can accept an electronically signed withholding certificate if the certificate reasonably demonstrates to the withholding agent that it has been electronically signed by the recipient identified on the form or authorized by the recipient to sign the form.

The final regulations allow the withholding agent to also consider documentation or other information that the withholding agent has that supports that the withholding certificate was electronically signed, absent actual knowledge that the information or documentation is incorrect.

Additional Changes
The final regulations also make clarifications with respect to withholding certificates and statements furnished through a third party repository.

Regarding the claim of a reduced rate of withholding under a treaty, the final regulations modify the general standard of knowledge by providing that:

• the withholding agent has reason to know that a claim of reduced rate under a treaty is unreliable or incorrect when it can check a list on the IRS website regarding the existence of the treaty, and
• a withholding agent can rely on a beneficial owner’s claim regarding a limitation of benefits (LOB) provision, absent actual knowledge that the claim is unreliable or incorrect.

The final regulation also extend the time for withholding agents to obtain treaty statements, with respect to specific LOB provisions for preexisting accounts, to January 1, 2020.

Taxpayers have been provided with additional guidance for complying with the Code Sec. 871(m) regulations on dividend equivalent payments for 2021, 2022, and 2023. The Treasury Department and the IRS intend to amend the regulations to delay the effective/applicability date of certain rules. Further, the phase-in period provided in Notice 2018-762, I.R.B. 2018-40, 522, has been extended.

Taxpayers have been provided with additional guidance for complying with the Code Sec. 871(m) regulations on dividend equivalent payments for 2021, 2022, and 2023. The Treasury Department and the IRS intend to amend the regulations to delay the effective/applicability date of certain rules. Further, the phase-in period provided in Notice 2018-762, I.R.B. 2018-40, 522, has been extended.

Dividend Equivalent Payments
A dividend equivalent amount is essentially an amount directly or indirectly determined by reference to a U.S. dividend. Code Sec. 871(m) treats dividend equivalent payments as U.S. source dividends. These payments are subject to 30-percent withholding (or a lower treaty rate) if received by a nonresident alien or foreign corporation.

The Code Sec. 871(m) regulations include final and temporary regulations under Code Secs. 871(m), 1441, 1461, and 1473.

Phase-in Year Extended
The effective/applicability date for the specified notional principal contract (NPC) rules under Reg. §1.871-15(d)(2) and the specified equity-linked instrument (ELI) rules under Reg. §1.871-15(e) will be revised. These rules will not apply to any payment made with respect to any non-delta-one transaction issued before January 1, 2023.

The IRS will take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply with the Code Sec. 871(m) regulations in enforcing those regulations—

• for any delta-one transaction in 2017 through 2022; and
• for any non-delta-one transaction that is a Code Sec. 871(m) transaction under Reg. §1.871-15(d)(2) or Reg. §1.871-15(e) in 2023.

Further, the period when the IRS will take into account the extent to which a qualified derivatives dealer made a good faith effort to comply with the Code Sec. 871(m) regulations and the relevant provisions of the 2017 Qualified Intermediary (QI) Agreement is extended through 2022.

The 2017 QI Agreement will be revised so that a QDD will be treated as satisfying the obligations that specifically apply to a QDD under that agreement for 2017 through 2022.

Simplified Standard Extended
The period when the simplified standard applies for withholding agents to determine whether transactions entered into were combined transactions is extended to include 2021 and 2022. Transactions entered into in 2017 through 2022 that are combined under the simplified standard will continue to be treated as combined for future years. They will not stop being combined transactions by applying Reg. §1.871-15(n) (the combined transactions rule in the regulations), or by disposing of less than all of the potential Code Sec. 871(m) transactions that are combined under this rule.

Transactions entered into in 2017 through 2022 that are not combined under the simplified standard will not become combined transactions by applying Reg. §1.871-15(n) to them in future years, unless a reissuance or other event causes the transactions to be retested to determine whether they are Code Sec. 871(m) transactions.

Phase-In Relief for Qualified Derivatives Dealers Extended
Regarding qualified derivatives dealers (QDDs), Reg. §1.871-15(q)(1), Reg. §1.871-15(r)(3), and Reg. §1.1441-1(b)(4)(xxii)(C) will be amended so that a QDD will not be subject to tax on dividends and dividend equivalents received in 2021 and 2022 in its equity derivatives dealer capacity or withholding on those dividends (including deemed dividends). A QDD will have to compute its Code Sec. 871(m) amount using the net delta approach beginning in 2023.

A QDD will remain liable under Code Sec. 881(a)(1) for tax on dividends and dividend equivalents that it receives in any other capacity, and on any other U.S. source FDAP payments that it receives (whether or not in its equity derivatives dealer capacity). A QDD is also responsible for withholding on dividend equivalents it pays to a foreign person on a Code Sec. 871(m) transaction.

Transition Rules Extended
Withholding agents may apply the qualified securities lender (QSL) transition rules described in Notice 2010-46, I.R.B. 2010-24, 757, for payments made in calendar years 2021 and 2022.

Anti-Abuse Rule
The anti-abuse rule in Reg. §1.871-15(o) will continue to apply during the phase-in years. This means that a transaction that would not otherwise be treated as a Code Sec. 871(m) transaction (including as a result of the new guidance) might still be a Code Sec. 871(m) transaction under the anti-abuse rule.

Taxpayer Reliance
Taxpayers and withholding agents can rely on the new guidance before the Treasury and IRS amend the Code Sec. 871(m) regulations and the 2017 QI Agreement.

The IRS has issued final regulations that amend the rules relating to hardship distributions from Code Sec. 401(k) plans. The final regulations are substantially similar to the proposed regulations. Further, plans that complied with the proposed regulations satisfy the final regulations as well. The regulations are effective on September 23, 2019.

The IRS has issued final regulations that amend the rules relating to hardship distributions from Code Sec. 401(k) plans. The final regulations are substantially similar to the proposed regulations. Further, plans that complied with the proposed regulations satisfy the final regulations as well. The regulations are effective on September 23, 2019.

The final regulations:

• reflect statutory changes affecting Code Sec. 401(k) plans, including changes made by the Bipartisan Budget Act of 2018 ( P.L. 115-123); and
• affect participants in, beneficiaries of, employers maintaining, and administrators of plans that include cash or deferred arrangements or provide for employee or matching contributions.

Deemed Immediate and Heavy Financial Need
The final regulations modify the safe harbor list of expenses for which distributions are deemed to be made on account of an immediate and heavy financial need. The final regulations:

• add "primary beneficiary under the plan" as an individual for whom qualifying medical, educational, and funeral expenses may be incurred;
• modify the expense listed in existing Reg. §1.401(k)-1(d)(3)(iii)(B)(6) to provide that the limitations in Code Sec. 165(h)(5) do not apply for this purpose; and
• add to the list a new type of expense, relating to expenses incurred as a result of certain disasters.

Distribution Necessary to Satisfy Financial Need
The final regulations modify the rules for determining whether a distribution is necessary to satisfy an immediate and heavy financial need, by:

• eliminating any requirement that an employee be prohibited from making elective contributions and employee contributions after receipt of a hardship distribution; and
• eliminating any requirement to take plan loans prior to obtaining a hardship distribution.

In particular, the final regulations, like the proposed regulations, eliminate the safe harbor in existing Reg. §1.401(k)-1(d)(3)(iv)(E), under which a distribution is deemed necessary to satisfy the financial need only if elective contributions and employee contributions are suspended for at least six months after a hardship distribution is made and, if available, nontaxable plan loans are taken before the hardship distribution is made.

Expanded Sources for Hardship Distributions
The final regulations modify existing Reg. §1.401(k)-1(d)(3) to permit hardship distributions from Code Sec. 401(k) plans of elective contributions, qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), and earnings on these amounts, regardless of when contributed or earned.

Section 403(b) Plans
A hardship distribution of Code Sec. 403(b) elective deferrals is subject to the rules and restrictions set forth in Reg. §1.401(k)-1(d)(3). Accordingly, the preamble to the proposed regulations had stated that the new rules relating to a hardship distribution of elective contributions from a Code Sec. 401(k) plan generally apply to Code Sec. 403(b) plans. Because this requirement is retained in the final regulations, at Reg. §1.401(k)-1(d)(3)(iii)(B), it applies to Code Sec. 403(b) plans.

Applicability Dates
The changes to the hardship distribution rules made by the Bipartisan Budget Act of 2018 are effective for plan years beginning after December 31, 2018.

Plan Amendments
The Treasury Department and IRS expect that plan sponsors will need to amend their plans’ hardship distribution provisions to reflect the final regulations, and any such amendment must be effective for distributions beginning no later than January 1, 2020. The deadline for amending a disqualifying provision is set forth in Rev. Proc. 2016-37, I.R.B. 2016-29,136.

In order to be tax deductible, compensation must be a reasonable payment for services. Smaller companies, whose employees frequently hold significant ownership interests, are particularly vulnerable to IRS attack on their compensation deductions.

In order to be tax deductible, compensation must be a reasonable payment for services. Smaller companies, whose employees frequently hold significant ownership interests, are particularly vulnerable to IRS attack on their compensation deductions.

Reasonable compensation is generally defined as the amount that would ordinarily be paid for like services by like enterprises under like circumstances. This broad definition is supplemented, for purposes of determining whether compensation is deductible as an ordinary and necessary expense, by a number of more specific factors expressed in varying forms by the IRS, the Tax Court and the Circuit Courts of Appeal, and generally relating to the type and extent of services provided, the financial concerns of the company, and the nature of the relationship between the employee and the employer.

Why IRS Is Interested

A chief concern behind the IRS's keen interest in what a company calls "compensation" is the possibility that what is being labeled compensation is in fact a constructive dividend. If employees with ownership interests are being paid excessive amounts by the company, the IRS may challenge compensation deductions on the grounds that what is being called deductible compensation is, in fact, a nondeductible dividend.

Another area of concern for the IRS is the payment of personal expenses of an employee that are disguised as businesses expenses. There, the business is trying to obtain a business expense deduction without the offsetting tax paid by the employee in recognizing income. In such cases, a business and its owners can end up with a triple loss after an IRS audit: taxable income to the individual, no deduction to the business and a tax penalty due from both parties.

Factors Examined

The factors most often examined by the IRS in deciding whether payments are reasonable compensation for services or are, instead, disguised dividend payments, include:

1. The salary history of the individual employee
2. Compensation paid by comparable employers to comparable employees
3. The salary history of other employees of the company
4. Special employee expertise or efforts
5. Year-end payments
6. Independent inactive investor analysis
7. Deferred compensation plan contributions
8. Independence of the board of directors
9. Viewpoint of a hypothetical investor contemplating purchase of the company as to whether such potential investor would be willing to pay the compensation.

Failure to pass the reasonable compensation test will result in the company's loss of all or part of its deduction. Analysis and examination of a company's compensation deductions in light of the relevant listed factors can provide the company with the assurance that the compensation it pays will be treated as reasonable -- and may in the process prevent the loss of its deductions.

Note: In the case of publicly held corporations, a separate $1 million dollar per person cap is also placed on deductible compensation paid to the CEO and each of the four other highest-paid officers identified for SEC purposes. (Certain types of compensation, including performance-based compensation approved by outside directors, are not included in the $1 million limitation.)

The S Corp Enigma

The opposite side of the reasonable compensation coin is present in the case of some S corporations. By characterizing compensation payments as dividends, the owners of these corporations seek to reduce employment taxes due on amounts paid to them by their companies. In these cases, the IRS attempts to recharacterize dividends as salary if the amounts were, in fact, paid to the shareholders for services rendered to the corporation.

Caution. In the course of performing the compensation-dividend analysis, watch out for contingent compensation arrangements and for compensation that is proportional to stock ownership. While not always indicators that payments are distributions of dividends instead of compensation for services, their presence does suggest the possibility. Compensation plans should not be keyed to ownership interests. Contingent and incentive arrangements are also scrutinized by the IRS. The courts have frequently ruled that a shareholder has a built-in interest in seeing that the company is successful and rewarding him for increasing the value of his own property is inappropriate. Similar to the reasonable compensation test, however, this rule is not hard and fast. Accordingly, the rules followed in each jurisdiction will control there.

Conclusions

Determining whether a shareholder-employee's compensation is reasonable depends upon many variables, such as the contributions that employee makes to your business, the compensation levels within your industry, and whether an independent investor in your company would accept the employee's compensation as reasonable.

Please call our office for a more customized analysis of how your particular compensation package fits into the various rules and guidelines. Further examination of your practices not only may help your business better sustain its compensation deductions; it may also help you take advantage of other compensation arrangements and opportunities.

'Tax risk management" is a fairly recent term first used by large accounting firms to underscore to businesses the opportunities and pitfalls inherent within the particular tax positions taken by a business at any point in time. The collapse of Enron and WorldCom, and Congress's response through Sarbanes/Oxley legislation, have elevated corporate tax departments from what were once sleepy backroom operations to key participants in corporate bottom-line performance. Tax reserves and other tax forecasts now take a more prominent role in SEC-required disclosure and their resulting impact on shareholder value. Corporate boards and top executives are now held directly responsible for tax-related mistakes.

In tandem with tighter legislative rules, the corporate tax world itself has become more complicated. From state and local tax considerations and a growing federal tax code to aggressive audit positions by the IRS on tax-shelter type transactions to the growing body of international tax rules that a global business must follow, the tax world for many businesses has become considerably more dangerous. Like a juggler trying to keep too many balls in the air at once, businesses are feeling more pressure on the tax side of their operations. The greater the number of balls (or tax risk situations) in the air, the greater the need is for preventive management of them.

Tax risk management, however, is no longer confined to large public companies listed on a major stock exchange. The "trickle down" of tax problems from public corporations to private businesses, run as corporations, partnerships or LLCs, to small businesses is evident. Lenders, take-over prospects, and co-owners are all acutely concerned with the financial health of a business. Tax considerations now play an increasingly vital role in determining whether any particular business can receive a clean bill of health. Past positions taken on open-year tax returns, the likelihood of the success of any ongoing tax strategy, stepped up IRS audits, changing tax accounting rules and the growing complexity of the tax code itself, not to mention state and local tax law considerations and the increasingly large penalties that taxing authorities are free to assess if a tax position turns out to be incorrect, make tax risk management essential for the smaller business as well.

How much tax risk is your business carrying? The first step to finding a solution to a problem is determining the extent of the problem. Do you know how many "dropped balls" on the tax-side of your business it would take to bankrupt your operations or set them back several years? If you have neglected this side of managing your business, or if you want some reassurance that you are prepared for "worst case" tax scenarios, please feel free to give this office a call.

For partnerships and entities taxed like partnerships (e.g., limited liability companies), each partner must compute the basis of his/her partnership interest separately from the basis of each asset owned by the partnership. Because the basis of this interest is critical to determining the tax consequences resulting from any number of transactions (e.g., distributions, sale of your interest, etc..), if your business is taxed as a partnership, it is important that you understand the concept of tax basis as well as how to keep track of that basis for tax purposes.

For partnerships and entities taxed like partnerships (e.g., limited liability companies), each partner must compute the basis of his/her partnership interest separately from the basis of each asset owned by the partnership. Because the basis of this interest is critical to determining the tax consequences resulting from any number of transactions (e.g., distributions, sale of your interest, etc..), if your business is taxed as a partnership, it is important that you understand the concept of tax basis as well as how to keep track of that basis for tax purposes.

Note: The term "partnership interest" generally refers to an interest in any type of entity taxed as a partnership. The term "partnership" usually means any entity that is taxed as a partnership, and the term "partner" refers to any owner of an entity taxed as a partnership.

The initial basis in your partnership interest depends on how you acquired your interest. The basis of a partnership interest that you obtained in exchange for a contribution of cash or property to the partnership is equal to the amount of money you invested plus the adjusted basis of any property that you contributed. If you purchased your partnership interest, your initial basis will be the amount of cash you paid plus the fair market value of any property that you provided as part of the purchase price.

Generally, if you receive your partnership interest as a gift, your basis will be the same basis that the donor had in the partnership interest before he or she gave it to you. On the other hand, if you inherit your partnership interest, your initial basis in the partnership interest generally will be the fair market value of the partnership interest on the date of the partner's death.

Each year, various adjustments must be made to the tax basis in your partnership interest to reflect certain partnership transactions that have occurred during the year. The basis in your partnership interest is increased to reflect your proportional share of partnership income (both taxable and tax-exempt income). This increase protects you as a partner from being taxed again when (1) the partnership distributes cash to you or (2) when you dispose of your partnership interest. The basis in your partnership interest also increases if you make additional contributions of cash or other property to the partnership.

The basis in your partnership interest is likewise decreased each year to reflect your share as a partner of any partnership losses and your share of any nondeductible expenses. This adjustment is made to prevent you from obtaining a tax benefit when the partnership makes a distribution to you or when you dispose of your partnership interest. Your basis in the partnership also must be decreased by any actual or deemed distributions you received from the partnership. However, the basis in your partnership interest may never be reduced below zero.

Adjustments to a partner's basis also must be made to reflect any increases or decreases in a partner's share of the partnership's liabilities

It is important that a partnership keep proper records of all transactions that occur during the year and take the time to make the basis adjustments using these basis computation rules as close in time to the occurrence of the transaction as possible.

The general guidelines detailed above will give you a good foundation of knowledge for computing the basis of your partnership interest. For more information about how to track your basis in your partnership interest, please contact the office.

If you are considering selling business property that has substantially appreciated in value, you owe it to your business to explore the possibility of a like-kind exchange. Done properly, a like-kind exchange will allow you to transfer your appreciated business property without incurring a current tax liability. However, since the related tax rules can be complex, careful planning is needed to properly structure the transaction.

If you are considering selling business property that has substantially appreciated in value, you owe it to your business to explore the possibility of a like-kind exchange. Done properly, a like-kind exchange will allow you to transfer your appreciated business property without incurring a current tax liability. However, since the related tax rules can be complex, careful planning is needed to properly structure the transaction.

Like-kind exchanges: The basics

The tax law permits you to exchange property that you use in your business or property that you hold for investment purposes with the same type of property held by another business or investor. These transactions are referred to as "like-kind" exchanges and, if done properly, can save your business from paying the taxes that normally would be due in the year of sale of the appreciated property.

Instead of an immediate tax on any appreciation in the year of sale, a like-kind exchange allows the appreciated value of the property you're transferring to be rolled into the working asset that you'll be receiving in the exchange. Mixed cash and property sales, multi-party exchanges, and time-delayed exchanges are all possible under this tax break.

What property qualifies?

In order to qualify as a tax-free like-kind exchange, the following conditions must be met:

• The property must be business or investment property. You must hold both the property you trade and the property you receive for productive use in your trade or business or for investment. Neither property may be property used for personal purposes, such as your home or family car.
• The property must not be held primarily for sale. The property you trade and the property you receive must not be property you sell to customers, such as merchandise.
• Most securities and instruments of indebtedness or interest are not eligible. The property must not be stocks, bonds, notes, chooses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest, including partnership interests. However, you can have a nontaxable exchange of corporate stocks in certain circumstances.
• There must be a trade of like property. The trade of real estate for real estate, or personal property for similar personal property is a trade of like property.

Examples:

Like property:

• An apartment house for a store building
• A panel truck for a pickup truck

Not like property:

• A piece of machinery for a store building
• Real estate in the U.S. for real estate outside the U.S.

• The property being received must be identified by a specified date. The property to be received must be identified within 45 days after the date you transfer the property given up in trade.
• The property being received must be received by a specified date.The property to be received must be received by the earlier of:
  1. The 180th day after the date on which you transfer the property given up in trade, or
  2. The due date, including extensions, for your tax return for the year in which the transfer of the property given up occurs.

Dealing with "boot" received

If you successfully make a straight asset-for-asset exchange, as discussed earlier, you will not pay any immediate tax with respect to the transaction. The property you acquire gets the same tax "basis" (your cost for tax purposes) as the property you gave up. In some circumstances, when you are attempting to make a like-kind exchange, the properties are not always going to be of precisely the same value. Many times, cash or other property is included in the deal. This cash or other property is referred to as "boot." If boot is present in an exchange, you will be required to recognize some of your taxable gain, but only up to the amount of boot you receive in the transaction.

Example:

XYZ Office Supply Co. exchanges its business real estate with a basis of $200,000 and valued at $240,000 for the ABC Restaurant's business real estate valued at $220,000. ABC also gives XYZ $35,000 in cash. XYZ receives property with a total value of $255,000 for an asset with a basis of $200,000. XYZ's gain on the exchange is $55,000, but it only has to report $35,000 on its tax return - the amount of cash or "boot" XYZ received. Note: If no cash changed hands, XYZ would not report any gain or loss on its tax return.

Using like-kind exchanges in your business

There are several different ways that like-kind exchanges can be used in your business and there are, likewise, a number of different ways these exchanges can be structured. Here are a couple of examples:

Multi-party exchanges. If you know another business owner or investor that has a piece of property that you would like to acquire, and he or she only wants to dispose of the property in a like-kind exchange, you can still make a deal even if you do not own a suitable property to exchange. The tax rules permit you to enter into a contract with another business owner that provides that you are going to receive the property that he or she has available in exchange for a property to be identified in the future. This type of multi-party transaction can also be arranged through a qualified intermediary with unknown third (or even fourth) parties.

Multiple property exchanges. Under the like-kind exchange rules, you are not limited in the number of properties that can be involved in an exchange. However, the recognized gain and basis of property is computed differently for multiple property exchanges than for single property-for-property exchanges.

Trade-ins. You could also structure a business to business trade-in of machinery, equipment, or vehicles as a like-kind exchange.

There are many ways that you can advantageously use the like-kind exchange rules when considering disposing of appreciated business assets. However, since the rules are complicated and careful planning is critical, please contact the office for assistance with structuring this type of transaction.

Limited liability companies (LLCs) remain one of the most popular choice of business forms in the U.S. today. This form of business entity is a hybrid that features the best characteristics of other forms of business entities, making it a good choice for both new and existing businesses and their owners.

Limited liability companies (LLCs) remain one of the most popular choice of business forms in the U.S. today. This form of business entity is a hybrid that features the best characteristics of other forms of business entities, making it a good choice for both new and existing businesses and their owners.

An LLC is a legal entity existing separately from its owners that has certain characteristics of both a corporation (limited liability) and a partnership (pass-through taxation). An LLC is created when articles of organization (or the equivalent under each state rules) are filed with the proper state authority, and all fees are paid. An operating agreement detailing the terms agreed to by the members usually accompanies the articles of organization.

Choosing the LLC as a Business Entity

Choosing the form of business entity for a new company is one of the first decisions that a new business owner will have to make. Here's how LLCs compare to other forms of entities:

C Corporation: Both C corporations and LLCs share the favorable limited liability feature and lack of restrictions on number of shareholders. Unlike LLCs, C corporations are subject to double taxation for federal tax purposes - once at the corporate level and the again at the shareholder level. C corporations do not have the ability to make special allocations amongst the shareholders like LLCs.

S Corporation: Both S corporations and LLCs permit pass-through taxation. However, unlike an S corporation, an LLC is not limited to the number or kind of members it can have, potentially giving it greater access to capital. LLCs are also not restricted to a single class of stock, resulting in greater flexibility in the allocation of gains, losses, deductions and credits. And for estate planning purposes, LLCs are a much more flexible tool than S corporations

Partnership: Partnerships, like LLCs, are "pass-through" entities that avoid double taxation. The greatest difference between a partnership and an LLC is that members of LLCs can participate in management without being subject to personal liability, unlike general partners in a partnership.

Sole Proprietorship: Companies that operate as sole proprietors report their income and expenses on Schedule C of Form 1040. Unlike LLCs, sole proprietors' personal liability is unlimited and ownership is limited to one owner. And while generally all of the earnings of a sole proprietorship are subject to self-employment taxes, some LLC members may avoid self-employment taxes under certain circumstances

Tax Consequences of Conversion to an LLC

In most cases, changing your company's form of business to an LLC will be a tax-free transaction. However, there are a few cases where careful consideration of the tax consequences should be analyzed prior to conversion. Here are some general guidelines regarding the tax effects of converting an existing entity to an LLC:

C Corporation to an LLC: Unfortunately, this transaction most likely will be considered a liquidation of the corporation and the formation of a new LLC for federal tax purposes. This type of conversion can result in major tax consequences for the corporation as well as the shareholders and should be considered very carefully.

S Corporation to an LLC: If the corporation was never a C corporation, or wasn't a C corporation within the last 10 years, in most cases, this conversion should be tax-free at the corporate level. However, the tax consequences of such a conversion may be different for the S corporation's shareholders. Since the S corporation is a flow-through entity, and has only one level of tax at the shareholder level, any gain incurred at the corporate level passes through to the shareholders. If, at the time of conversion, the fair market value of the S corporation's assets exceeds their tax basis, the corporation's shareholders may be liable for individual income taxes. Thus, any gain incurred at the corporate level from the appreciation of assets passes through to the S corporation's shareholders when the S corporation transfers assets to the LLC.

Partnership to LLC: This conversion should be tax-free and the new LLC would be treated as a continuation of the partnership.

Sole proprietorship to an LLC: This conversion is another example of a tax-free conversion to an LLC.

While considering the potential tax consequences of conversion is important, keep in mind how your change in entity will also affect the non-tax elements of your business operations. How will a conversion to an LLC effect existing agreements with suppliers, creditors, and financial institutions?

Taxation of LLCs and "Check-the-Box" Regulations

Before federal "check-the-box" regulations were enacted at the end of 1996, it wasn't easy for LLCs to be classified as a partnership for tax purposes. However, the "check-the-box" regulations eliminated many of the difficulties of obtaining partnership tax treatment for an LLC. Under the check-the-box rules, most LLCs with two or more members would receive partnership status, thus avoiding taxation at the entity level as an "association taxed as a corporation."

If an LLC has more than 2 members, it will automatically be classified as a partnership for federal tax purposes. If the LLC has only one member, it will automatically be classified as a sole proprietor and would report all income and expenses on Form 1040, Schedule C. LLCs wishing to change the automatic classification must file Form 8832, Entity Classification Election.

Keep in mind that state tax laws related to LLCs may differ from federal tax laws and should be addressed when considering the LLC as the form of business entity for your business.

Since the information provided is general in nature and may not apply to your specific circumstances, please contact the office for more information or further clarification.