Last Minute Tax “Relief”

Western Snowy Plover

Whew!  I am so relieved to have a full two weeks to do an entire year of tax planning for our clients.  Thank you, Congress.  Nice holiday gift.

2014 Tax Increase Prevention Act

In the recently enacted “Tax Increase Prevention Act of 2014,” Congress has once again extended a package of expired or expiring individual, business, and energy provisions known as “extenders.” The extenders are a varied assortment of more than 50 individual and business tax deductions, tax credits, and other tax-saving laws which have been on the books for years but which technically are temporary because they have a specific end date. Congress has repeatedly temporarily extended the tax breaks for short periods of time (e.g., one or two years), which is why they are referred to as “extenders.” The new legislation generally extends the tax breaks retroactively, most of which expired at the end of 2013, for one year through 2014.

This is an overview of the key tax breaks that were extended by the new law.

Individual extenders

The following provisions which affect individual taxpayers are extended through 2014:

… the $250 above-the-line deduction for teachers and other school professionals for expenses paid or incurred for books, certain supplies, equipment, and supplementary material used by the educator in the classroom;

… the exclusion of up to $2 million ($1 million if married filing separately) of discharged principal residence indebtedness from gross income;

… parity for the exclusions for employer-provided mass transit and parking benefits;

… the deduction for mortgage insurance premiums deductible as qualified residence interest;

… the option to take an itemized deduction for State and local general sales taxes instead of the itemized deduction permitted for State and local income taxes;

… the increased contribution limits and carryforward period for contributions of appreciated real property (including partial interests in real property) for conservation purposes;

… the above-the-line deduction for qualified tuition and related expenses; and

… the provision that permits tax-free distributions to charity from an individual retirement account (IRA) of up to $100,000 per taxpayer per tax year, by taxpayers age 70 and ½ or older.

Business extenders

The following business credits and special rules are generally extended through 2014:

… the research credit;

… the temporary minimum low-income housing tax credit rate for nonfederally subsidized new buildings;

… the military housing allowance exclusion for determining whether a tenant in certain counties is low-income;

… the Indian employment tax credit;

… the new markets tax credit;

… the railroad track maintenance credit;

… the mine rescue team training credit;

… the employer wage credit for activated military reservists;

… the work opportunity tax credit;

… qualified zone academy bond program;

… three-year depreciation for racehorses;

… 15-year straight line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements;

… 7-year recovery period for motorsports entertainment complexes;

… accelerated depreciation for business property on an Indian reservation;

… 50% bonus depreciation (extended before Jan. 1, 2016 for certain longer-lived and transportation assets);

… the election to accelerate alternative minimum tax (AMT) credits in lieu of additional first-year depreciation;

… the enhanced charitable deduction for contributions of food inventory;

… the increase in expensing (up to $500,000 write-off of capital expenditures subject to a gradual reduction once capital expenditures exceed $2,000,000) and an expanded definition of property eligible for expensing;

… the election to expense mine safety equipment;

… special expensing rules for certain film and television productions;

… the deduction allowable with respect to income attributable to domestic production activities in Puerto Rico;

… the exclusion from a tax-exempt organization’s unrelated business taxable income (UBTI) of interest, rent, royalties, and annuities paid to it from a controlled entity;

… the special treatment of certain dividends of regulated investment companies (RICs);

… the definition of RICs as qualified investment entities under the Foreign Investment in Real Property Tax Act;

… exceptions under subpart F for active financing income;

… look-through treatment for payments between related controlled foreign corporations (CFCs) under the foreign personal holding company rules;

… the exclusion of 100% of gain on certain small business stock;

… the basis adjustment to stock of S corporations making charitable contributions of property;

… the reduction in S corporation recognition period for built-in gains tax;

… the empowerment zone tax incentives;

… the American Samoa economic development credit; and

… two provisions dealing with multiemployer defined benefit pension plans (dealing with an automatic extension of amortization periods and shortfall funding method and endangered and critical rules), are extended through 2015.

Energy-related extenders

The following energy provisions are retroactively extended through 2014:

… the credit for nonbusiness energy property;

… the second generation biofuel producer credit (formerly cellulosic biofuels producer tax credit);

… the incentives for biodiesel and renewable diesel;

… the Indian country coal production tax credit;

… the renewable electricity production credit, and the election to claim the energy credit in lieu of the renewable electricity production credit;

… the credit for construction of energy efficient new homes;

… second generation biofuels bonus depreciation;

… the energy efficient commercial buildings deduction;

… the special rule for sale or disposition to implement federal energy regulatory commission (FERC) or State electric restructuring policy for qualified electric utilities;

… the incentives for alternative fuel and alternative fuel mixtures; and

… the alternative fuel vehicle refueling property credit.

Happy Shopping!

IRS 1099-K Notices: has IRS noticed you?

higas-sos-fly-fishing-fly

Remember those pesky 1099-K forms you received earlier this year?  Well, even though IRS gave up on “matching” the income reported on those forms into your business or personal tax returns, they have undertaken something much worse:  a fishing expedition with your name on the bait.

IRS is now sending out four different types of 1099-K notices called “Letters”:

Letter 5035 – a letter hinting that you “may have” underreported your income with no response required.  A shot across the bow.

Letter 5036 – a letter that does more than hint that you have underreported your income – it provides dollar amounts showing that an unusually high percent of your income came from credit cards and 3rd party payers, and demanding a written response in 30 days explaining why you should not file an amended return and which describes your internal controls and cash receipts procedures and other reasons why a high percentage of total gross receipts comes from credit card transactions.

Letter 5039 – a letter which makes the same assertions as Letter 5036 and requires the taxpayer to complete Form 14420 within 30 days to explain why your income reflects an unusually high percentage of credit card and other 3rd party transactions reported on 1099-K.

Letter 5043 – a letter which alleges that compared to others in your industry, you have underreported your income, citing specific percentages and dollar amounts, and demanding a written response within 30 days explaining why you should not file an amended return and which describes your internal controls and cash receipts procedures and other reasons why a high percentage of total gross receipts comes from credit card transactions.

The response-required letters go to the Tax Examiner section of the IRS, so that should give you a clue that if your response is unsatisfactory it is highly likely that an audit will be initiated.

I have a number of concerns about these notices, but my primary one has to do with the fact that the taxpayer is not being notified of an audit.  These 1099-K Letters are an end run around IRS’ obligations to properly inform taxpayers of their rights and duties during an examination, which includes the right to representation.  Taxpayers may blithely respond, or perhaps even ignore these notices without realizing the implications.

Secondly, IRS makes bald-faced assertions in Letter 5043 which allege specific amounts of unreported income, using statistics which are not cited, and which are supposedly based on the industry code used on the tax return.  As we know, these codes are very broad and somewhat outdated, so that your business may be nothing at all like another business using the same catch-all code.  And, where do their statistics come from?  Are they 10 years old or 1 year old?  Knowing how understaffed IRS is, I am going to guess that the statistics used are not recent.

Finally, the whole idea of 1099-K reporting was to tap the underground economy.  That is a very good goal and one that I fully support.  Unfortunately, these 1099-K letters do no such thing.  Instead of matching 1099-K’s into tax returns, the IRS is going after legitimate businesses whose cash receipts model may not fit their idea of the norm.  This approach will have no impact whatsoever on the multitude of eBay sellers, construction contractors, and others who make up a chunk of the underground economy in the U.S.  We need IRS to go back to the drawing board to re-think the 1099-K matching process and come up with a solution that meets the public policy objective from which this requirement originated.

 

 

Heading Toward Tax Season

xena110708As filing season approaches for the 2012 tax year, I am presenting here a few selected tax tips and updates that are often overlooked by traditional tax sources, hopefully brief enough to not induce boredom but complete enough to give you some valuable information:

The 1099 Matching Nightmare Continues

  • 1099-MISC:  Don’t forget to EXCLUDE payments to vendors made with credit cards from your total 1099-MISC payments.  Those payments will get reported to vendors on Form 1099-K.  If you do get 1099s that are wrong, ask the payer to correct the 1099.  If that is a pain, then report the full amount on your tax return, and then back out the erroneous portion somewhere on your expense lines.  And, make sure you can document why the 1099 you received is wrong.
  • 1099-K:  Even though IRS claims it is not now or ever going to match 1099-K payments into your tax returns, there’s a reason you are getting a 1099-K and that is to tap the underground economy by making sure that all businesses are reporting their gross income.  If you report less gross income than is shown on your Form 1099-K you will be subject to IRS inquiry, for which they have developed new notices related to Form 1099-K.  Be sure to provide all Forms 1099-K to your tax preparer so that they can help you avoid receiving these notices.
  • 1099-B:  If you receive broker 1099s related to your investments, you are by now used to receiving corrected 1099s, often long after you have filed your returns.  Due to new basis matching requirements, you will need to seriously consider whether you are better off extending your tax returns while you wait for all the corrections to come through, rather than having to amend your returns later for the corrections, or having to respond to IRS notices.  IRS plans to match all 1099-B reporting on the new Form 8949, first developed in 2011.  There are now 6 different ways to report capital gains and losses, and there are 21 different codes to use when reporting.  Due to the extra time involved, investors should seriously consider consolidating their brokerage accounts in order to save on accounting fees at tax time.

Charitable Contribution Receipts Must Contain Required Language       

Even if you have a “contemporaneous” receipt (one that you have in hand at the time you file your tax returns), it may be defective and result in the complete disallowance of your charitable deductions.  It MUST contain required language concerning whether or not the donor received any goods or services in exchange for a contribution.  If it doesn’t your contribution deduction will be disallowed in full.

W-2 Reminders to include HSA payments and Health Insurance Premiums

Don’t forget to include ALL H.S.A. payments on the W-2 Form, Box 12, not just payments made by employees through a cafeteria plan.  The purpose of this is to make sure that taxpayers are not contributing beyond the maximum amounts allowed in 2012 to their H.S.A. plans.

For 2012, you don’t have to report the value of health insurance premiums on the W-2s if you issue fewer than 251 W-2s.  If issue more than 250 W-2s, you must report the value of the health insurance premiums on Form W-2.  The reporting is “informational only” and is not subject to income or payroll taxes.

City of Portland Business Tax Rental Property Exemption Is Gone, Gone, Gone

If you own a few rental properties in Portland, but have no other business activities you may be blissfully unaware of the long reach of the City of Portland Business Tax.  Beginning in 2012, the City successfully changed its tax code to include ALL rental activity, not just owners with over 9 rental units within the City.  Don’t panic yet:  there’s a new exemption of $20,000 in gross income with 1 or 2 rentals, but you still have to file a special new Form to receive your exemption.  More info is available at the City’s website.  Remember that the City of Portland has its own special version of taxation without representation:  the gross receipts exemption means gross receipts EVERWHERE, including rentals you own in other states and capital gains on ANYTHING except securities, and includes all activities of your spouse if you file jointly, even if your spouse does not live in the City or have any business interests or activities there.

City of Portland School Arts Tax – You owe the City $35

This was the infamous Measure proposed by Mayor Adams which even arts and education groups such as Stand for Children opposed, mainly because only about ½ of the revenue raised will go to fund arts teachers for our public schools.  It did pass, however, so beginning in 2012 a new form is required of EVERY CITY RESIDENT AGE 18 AND OVER, accompanied by a $35 payment, or an exemption request for those below the poverty level.  The City of Portland is administering the tax, and the filing form has not even been developed yet.  However, the city has designated this link which will go live when the forms are ready:   http://www.artstax.net

Taxes in the Twilight Zone

twilight-zone-spiralI love watching Twilight Zone episodes because it is fun to imagine a world where the usual laws of nature are slightly askew and anything becomes possible.  Fanciful minds can do a lot with that.  Yet, some of those episodes are a bit creepy, even scary and sometimes disturbing.

Congress’ failure to act timely to provide any kind of certainty about tax law both for 2012 and for future years has definitely defied the usual laws which govern rational behavior.  Clearly Republican lawmakers would rather tax the poor and middle class than allow taxes to become progressive again on the top 1%, and it is quite clear that they wish to further the shameful increase in wealth and income inequality in the U.S.

Thanks to this failure, we have wandered across the obscure boundaries of normal reality into twilight zone of taxation.  Here is an overview of our current creepy, scary, and disturbing tax system:

Creepy

  • The zero percent tax rate for millionaires.  How is it possible that millionaires could pay no tax even though they have taxable income?  The zero percent rate was carefully crafted by Bush-era policy makers to permit this by allowing ordinary deductions to first offset ordinary income.  If ordinary deductions, such as charitable contributions, mortgage interest, state income taxes and investment management fees offset an investor’s interest income in full, that investor can be in a position to pay zero percent on all capital gain and dividend income up to the bottom of the 15% bracket.  This is up to $70,700 per year (Married Filing Joint) that is being taxed at zero percent.  The rest of us will pay tax on all of our capital gain and dividend income, because we are working for a living, and can’t possibly manipulate our tax bracket to get below the 15% level.  For investors, this is easy to control, through timing of capital gains, and through investment choices such as the use of municipal bonds or non-dividend paying stocks. And, how many working poor do you know that have an investment portfolio?  Creepier still:  Obama’s tax proposal will not impact this bizarre anomaly – the only hope for this provision to die is for us to fall off the fiscal cliff and keep diving.

Scary

  • The Alternative Minimum Tax affecting some 33 million taxpayers this year, compared to 4 million last year.  Thanks to Congress’ failure to enact the annual “AMT patch” – something it has been doing for decades – means that the AMT exemption amount will revert back to its non-inflation-indexed amount.  This is because the original law failed to index the exemption for inflation.  Rather than fix this permanently, Congress continuously “patches” the exemption amount each year by indexing it to inflation for that year only.  This is because actually fixing the AMT would be far too rational, and remember, we are in the Twilight Zone.  So, millions of taxpayers will see dramatic increases in their tax bills for 2012, and it will especially hit those with incomes between $100,000 and $200,000, with an average increase of about $3,000.  Not only that, failure to patch the AMT has caused IRS to delay being able to finalize its tax forms for 2012.  The latest news from the IRS Commissioner is that one hundred million taxpayers will not be able to file their returns until sometime in March of 2013.

Disturbing

  •  Unfair income matching rules which target low income taxpayers, while failing to tax the bulk of the underground economy.  I have always found it interesting that Congress and the IRS have gone to great lengths to make sure that baby sitters, housekeepers, and child care providers report their income and pay their taxes.  Yet, construction contractors are not subject to 1099 requirements when payments to them are non-business related, such as when they are remodeling your house.  In order to claim a child care credit or compensate your nanny, IRS makes sure that everything gets reported on a W-2 or is otherwise matched to the worker’s tax return.  Also, they are hell-bent on making sure that restaurant servers report their tips.  Why don’t we have these same kinds of requirements for plumbers, builders, and construction contractors.  Ever wonder about how construction workers can be paid “under the table?”  It might be because the contractors themselves are not reporting their income, so paying someone under the table becomes a piece of cake.  Most industry observers are well aware of this kind of outrageous noncompliance, but nothing has been proposed to tax what is probably a huge portion of the underground economy.  I’m not just picking on contractors, though.  A legitimate tax system is one in which all income is taxed, not just the income of the poor and working class.

Why the Portland/Multnomah County Business Tax Needs Reform

Mayor Sam Adams recently announced a tax amnesty for scofflaws who have so far succeeded in not rendering unto the City/County what they owe in business income taxes.  While I am not a big fan of amnesty programs, as they reward the wrong behavior and the wrong taxpayers, it is not surprising that businesses and property owners who have “nexus” within the City/County find themselves out of compliance with the tax code.  Some do so deliberately, while others may simply be blissfully unaware of their tax obligations.

This is because the City/County tax code, unlike its counterparts among other municipalities, taxes only certain businesses and individuals.  It relies on a very narrow tax base, and thus has an extremely high flat rate of 3.65%.  It is essentially a payroll tax on successful business owners, and an income/capital gains tax on successful property owners.

But more importantly, the tax punishes privately held companies who do business within City/County borders while rewarding public companies doing the same.  How can this be?  Well, here’s a real life example from my CPA practice:  Locally owned company with 3 shareholders, nets $4 million before owner salaries, and $1 million after owner salaries.  In my example, none of the shareholders actually live within the City/County boundaries.  What is their City of Portland/Multnomah County Business Tax?   The total tab will be $136,500.  If this same business were to be bought out by a publicly traded company, and management salaries were the same, the business would now have a tab of $36,500.  In this example, that’s a $100,000 punishment for the locally owned company.  Outrageous, no?

This strange phenomenon takes place because wages over $87,000 paid to more than 5% owners are “added back” to business net income to determine the tax.  Basically, you have a payroll tax on owners who pay themselves more than $87,000 per year, a tax that is not paid by companies who do not have more than 5% owners.

Further, the filing requirements imposed by the City are highly invasive (and perhaps illegal?).  Taxpayers who owe no tax whatsoever to the City/County are still required to provide copies of their individual tax returns, along with related Schedules C, D, and E, even though they have no income to report.  The TriMet tax, administered by the State of Oregon has no such requirements.  If you don’t owe the tax, you simply don’t file.

But, this is not so with the City/County.  I have clients who fear their personal financial details are now sitting on some City employee’s desk, and that information that is required by federal law to be kept in strict confidence is being exposed to those who have no need (or right?) to see such information.

But worst of all, the City/County tax is neither a fair tax nor a simple tax.  It relies on a narrow tax base (unfair) and it is one of the most complex and arcane municipal tax codes I have ever encountered.  A fairer and simpler tax would be a payroll tax/self-employment tax similar to the TriMet tax.  It could have a very low rate because of its broad tax base, and would be extremely simple to administer by simply tacking it on to the Oregon quarterly OQ filing. 

A broader tax base would also help to discourage local businesses from the practice of fleeing the City/County boundaries to escape the tax.  Regardless of what City leaders may say about this practice, every CPA I know has experience with clients who have relocated out of the City/County boundaries to avoid the tax.

In the meantime, if you own property or do business within the City/County borders and have not been filing your tax returns, now is the time to find out if the amnesty program can help you get into compliance.

Update June 20, 2012:  This just in from my tax law reporting service: 

“Oregon—Income Tax: Portland Confidentiality Provision Amended

Portland has amended its provision regarding confidentiality of business license tax taxpayers to provide that, in addition to existing prohibitions, it is unlawful for any Portland employee, agent, or elected official or any person who has acquired information to divulge, release, or make known in any manner identifying information about any taxpayer applying for tax amnesty, unless otherwise required by law. Ordinance No. 185312, City of Portland, effective May 9, 2012″

So, what is the penalty for unlawfully disclosing taxpayer information?  From the City Code: 

“7.02.730 Criminal Penalties for Violation of the Business License Law by City Employee or Agent.Printable Version
Anyone knowingly violating Section 7.02.230 may be punished, upon conviction thereof, by a fine not exceeding $500.00 or by imprisonment for a period not exceeding six (6) months, or by both fine and imprisonment.  Any City employee that is convicted will be dismissed from employment and is ineligible for holding any position of employment or office in the City for a period of five (5) years thereafter.  Any agent of the City that is convicted is ineligible for participation in any City contract for a period of five (5) years thereafter.”

Contrast this to the penalty on IRS employees for unlawful disclosure of federal tax information (which is the same information the City employees have about its licensees): 

“Penalties for Unauthorized Disclosure-Internal Revenue Code

Internal Revenue Code Sections 7213 and 7431 describe the penalties for unauthorized disclosure of federal information.

Under Section 7213 of the Internal Revenue Code, a governmental actor’s unauthorized disclosure is a felony that may be punishable by a $5,000 fine, five years imprisonment or both. Under Section 7213A of the Internal Revenue Code, the unauthorized inspection of federal tax information is punishable by a $1,000 fine, one year imprisonment or both. Section 7431 of the Internal Revenue Code permits a taxpayer to bring suit for civil damages in a U.S. District Court, including punitive damages in cases of willful disclosure or gross negligence, as well as the cost of the action.”

As you can see, City employees are subject to far less punishment than IRS employees who unlawfully disclose the exact same confidential information.

To Group or Not to Group: That is the Tax Question

IRS recently came out with new rules regarding how taxpayers must elect to group passive and active business and rental activities together.  Grouping a passive activity with an active one can help taxpayers avoid the dreaded “material participation rules” – designed to blur your eyes and make you sleepy and irritable.  Oddly, the passive activity rules upon which this new required grouping election is based were enacted back in 1987 with the infamous Tax Reform Act.  Um…that was 25 years ago. 

 Importantly, for tax years 2011 and forward, the new guidance from IRS makes it necessary for all business owners with more than one “activity” to consider whether and how to apply these rules to their undertakings.  Here is an overview of how the rules work:

  1.  You can group rental or other passive activities with trade or business activities where one is insubstantial to the other and if they constitute an “appropriate economic unit.”  This involves analyzing factors identified in Regulation 1.469-4:  similarities and differences among the business activities, extent of common ownership, geographic location, and interdependence.  (However, you cannot group rental real estate activities with personal property rental activities.)  Example:  a manufacturing S corporation produces waste metals that can be recycled or sold for scrap.  For business reasons, the corporation’s owners form a separate S corporation to handle the recycled material, either selling it or ensuring its proper disposal.  The recycling company’s revenues are miniscule compared to the manufacturing company, and it tends to generate losses.  The owners don’t spend much time managing the recycling company, but if they elect to group the two companies together, they can treat the recycling company as active, never again worrying about the passive activity rules.
  2. You can group a rental activity with a trade or business activity if the rental is to the business, and all the owners have the same ownership percentages in each entity.  Example:  an LLC owns a building, rented out to a printing company, also an LLC.  The owners of the printing company own the rental LLC in the same proportions as their ownership in the printing company.  Each individual owner can decide whether or not to group the two activities together, which results in converting LLC rental losses and income to active status, and avoids suspended rental losses where the owner’s incomes are too high to take advantage of the losses. 
  3. You can’t change or revoke your grouping election unless there is a material change in the underlying facts, or unless the original grouping was clearly erroneous.  You can, however, add to the group.
  4. If you don’t decide which activities to group for 2011 by attaching the required statement, IRS will take the position that nothing has been grouped (but you may carry on with prior groupings and are not required to disclose prior groupings to IRS.)  Grouping elections can be made in future years, but they cannot be retroactive.  Groupings made prior to 2011 will not be disturbed, so long as the taxpayer consistently maintains the grouping.
  5. You must disclose to IRS, by attaching the required statement from Rev. Proc. 2010-13 all:  new groupings for 2011; additions to prior groupings; changes to ANY groupings.  You do not have to disclose grouping elections made prior to 2011.
  6. Grouping elections can be made first at the entity level and then at the individual level, but an owner in an S corporation or partnership cannot un-group an activity that has already been grouped at the entity level.

Generally, there is no good reason to group rental activities together into one passive group.  Doing so would mean that passive activity losses would remain suspended until each property in the group is finally sold.

Unfortunately, there is neither a bright line test, nor a safe harbor, to help taxpayers determine which activities can be grouped.  So, it’s a good idea to carefully review the rules with your CPA firm to evaluate the best course of action.