2020 Filing Deadline for Calendar Year Partnerships

As part of its response to COVID, the IRS issued a series of notices, culminating with IRS Notice 2020-23, 2020-18 IRB (April 9, 2020), which generally extended the deadline to file tax returns and pay taxes to July 15, 2020. Pursuant to the Notice, any person with "a Federal tax return or other form filing obligation specified in this section III.A..., which is due to be performed (originally or pursuant to a valid extension) on or after April 1, 2020, and before July 15, 2020, is affected by the COVID-19 emergency for purposes of the relief described" in that section. Such "affected taxpayers" are entitled to the relief of the extended deadline.

The notice goes on to specify that the "filing obligations specified in this section III.A" include "[c]alendar year... partnership return filings on Form 1065, U.S. Return of Partnership Income...," which absent the Notice would normally be due on March 16, 2020. According, the Notice creates an ambiguity: Is the due date for calendar year partnership returns extended to July 15 because "calendar year partnership return filings" are specifically included on the list of specified federal form filing obligations entitled to relief, or does the due date for such returns remain at March 16 because they are not due on or after April 1, 2020? This ambiguity was noted shortly after the Notice was issued.

Unofficially resolving this ambiguity, the IRS website currently states, "Notice 2020-23 does not postpone any return filings that were due on March 16, 2020. If a fiscal year partnership or S-corporation has a return due to be filed on or after April 1, 2020, and before July 15, 2020, that filing requirement has been postponed to July 15, 2020." The website does not specifically mention "calendar year partnerships" like the Notice does.

As a practical matter, most partnership tax returns would have had extensions filed before March 16, 2020 anyway because the IRS guidance wasn't issued until after that due date. However, if an extension was not filed for your partnership's return, there is a good argument that binding guidance from the IRS granted an automatic extension to July 15, 2020.

Read More

Tax Credits for Paid Leave under FFCRA

The Families First Coronavirus Response Act (FFCRA) generally requires employers to provide up to two weeks of paid leave at regular pay rates for employees who can't work due to being sick with coronavirus, up to two weeks of paid leave at two-thirds of regular pay rates for employees who can't work due to a family member being sick with coronavirus, and up to ten weeks of paid leave at two-thirds of regular pay rates for employees who can't work because a child's school or child care provider is unavailable. Fortunately, all of an employer's costs for this qualified sick leave is designed to be offset by payroll tax credits.

By way of background, employers are required to withhold estimated employees' income taxes and payroll taxes (Social Security and Medicaid) from employees' paychecks and then match the payroll tax withholding and remit all of such funds to the IRS on (usually) a quarterly basis. The credit for paid leave under the FFCRA offsets the employer's portion of payroll taxes. However, the credits are refundable, meaning that if the qualified sick leave paid in respect of employees impacted by coronavirus exceeds the employer's portion of payroll tax for all employees, the employer will receive a refund from the IRS.

Regulations and forms for these new tax credits will be forthcoming. The most interesting aspect of these tax credits is that employers will apparently be able to retain income taxes withheld and both the employer's and the employees' share of payroll taxes up to the amount of qualified sick leave, rather than deposit such withholdings with the IRS and seek a refund. As I discussed in a prior post, these withholdings are considered to be held in trust for the IRS, and individuals who do not remit such taxes to the IRS will be personally liable for the entirety of such taxes. As such, employers should not utilize this method of reimbursement for qualified sick leave they pay without maintaining very careful records and waiting until final guidance is issued by the IRS. Trust fund taxes must never be used to cover any other expense.

Read More

Fixing Problems with Online IRS EIN Applications, Third Edition

This post is my third installment about fixing rejected online EIN applications submitted on the IRS's website. Consider the following potential causes:

Every EIN application requires a responsible party name and matching tax ID number. "Unless the applicant is a government entity, the responsible party must be an individual (i.e., a natural person), not an entity." Previously, it was possible for an entity that had not obtained its EIN online to be the responsible party for a new entity's online EIN application. This is no longer the case, and any attempt to obtain a new EIN using a business as the responsible party will result in an error.

The IRS will only issue an EIN to one responsible party per day. This limitation applies to all requests for EINs, whether through the online EIN application or by fax or mail. If an EIN has been issued to any entity by any application method on a particular day, the responsible party on that EIN application must wait until the next day before being the responsible party on another EIN application.

A rejected EIN application indicating Reference Number 101 has a name conflict. The IRS requires a unique entity name before it will issue an EIN, similar to how the secretary of state requires a unique entity name within that state before Articles or Certificates of Organization may be successfully filed. However, because the IRS is a federal agency issuing EINs for entities in all 50 states, it potentially checks for duplicate entity names across multiple states. There are numerous references to a state on the online EIN application, such as the physical location state, mailing address state, and the state where the Articles are or will be filed.

If all of these state references are the same, the IRS will only check for previously-issued EINs with that entity name in that one state. If multiple states are reported, for example, if the Articles were filed in a different state than the business's physical address, the IRS will check both states for name availability before issuing an EIN, even though filing the Articles only requires a unique entity name in the one state where the Articles are being filed. In the past, it was possible to obtain an EIN over the phone in the case of a name conflict; however, the IRS no longer issues EINs over the phone.

Reference numbers 102, 103, 105, or 108 indicate that the name and tax ID number of the responsible party do not match IRS records. Reference number 104 means a third-party designee's contact information cannot be the same as the address or the phone number of the entity that is applying for an EIN. Reference numbers 109, 110, 112, or 113 mean that the online application is temporarily unable to assign EINs; try again later. Reference number 114 indicates that only one EIN will be assigned per day per responsible party. Reference number 115 indicates that the social security number listed for the responsible party is associated with someone who is deceased.

Reference Numbers 109 and 110 indicate technical problems and an EIN may still be obtainable using the exact same information that resulted in the error. The error might result from too many people trying to obtain an EIN at the same time. Try again later, or try closing and reopening the browser, using a different browser, using a different computer, clearing cookies, restarting the computer, or adjusting your security settings. Or, feel free to contact me; I would be happy to try and help.

Read More

Introduction to Qualified Opportunity Funds

The 2017 Tax Cuts and Jobs Act added sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code. The former provides for the designation of certain low-income communities as "qualified opportunity zones," and the later provides certain incentives for investment in such QOZs. IRS Notice 2018-48 provides a full list of population census tracts designated as qualified opportunity zones; investments within these zones can qualify for the new tax incentive.

The tax incentive permits a taxpayer who has realized a capital gain from the sale of property to an unrelated person to invest all or part of the gain amount into a "qualified opportunity fund" within 180 days of the realization event and elect to defer paying tax on the gain amount so invested. The deferral lasts until the earlier of (a) the date that the taxpayer sells the QOF investment or (b) December 31, 2026.

In addition, if the taxpayer holds the QOF investment for at least five years, ten percent of the deferred gain is permanently excluded from taxation, and if the taxpayer holds the QOF investment for at least seven years, a total of fifteen percent of the deferred gain is permanently excluded from taxation. Finally, if the taxpayer holds the QOF investment for at least ten years, all post-acquisition gain on the QOF investment can be permanently excluded from taxation.

A QOF is an entity organized as a corporation or a partnership for the purpose of investing in QOZ property. Such an entity uses IRS Form 8996 to initially certify that it is organized to invest in QOZ property as well as annually report that it meets the investment standards. Generally speaking, a QOF must hold 90% of its assets in QOZ property or pay a penalty. This tax incentive is a new and important opportunity for many taxpayers with capital gains.

See Maule, 597-2nd T.M., Tax Incentives for Economically Distressed Areas; Qualified Opportunity Zones.

Read More

50 States' Free Individual Income Tax Return E-Filing

Tax season is coming up, and most people in the U.S. will file a federal and state income tax return. Federal income tax returns can be e-filed for free through the IRS website. While most people do not use this option, all of the popular tax preparation services offer free federal and, in many cases, free state income tax e-filing for lower income families.

If you don't meet the income limitations, however, finding a way to e-file your return for free, particularly your state income tax return, is more difficult. One new option that includes free e-filing for federal and state tax returns is creditkarma.com; however, it is not as robust as other services, as this review has noted.

Fortunately, the department of revenue of many states allows free e-filing directly from the department's website. Since most state income tax returns rely heavily on the taxpayer's federal return, you will need to have already completed your federal return in order to use these services. Linked below are state government websites where state individual income tax returns can be e-filed. This post will be updated as better sources become available; please comment below if you come across broken links or better options than what I currently have:

Alabama	Illinois	Montana^	Rhode Island^
Alaska*	Indiana^	Nebraska	South Carolina^
Arizona^	Iowa^	Nevada*	South Dakota*
Arkansas^	Kansas	New Hampshire#	Tennessee#
California	Kentucky^	New Jersey	Texas*
Colorado	Louisiana	New Mexico	Utah
Connecticut	Maine	New York^	Vermont
Delaware	Maryland	North Carolina^	Virginia^
District of Columbia^	Massachusetts^	North Dakota^	Washington*
Florida*	Michigan^	Ohio	West Virginia^
Georgia^	Minnesota^	Oklahoma^	Wisconsin
Hawaii	Mississippi	Oregon	Wyoming*
Idaho^	Missouri^	Pennsylvania

* State does not have an income tax
^ State does not offer free online filing directly through the state revenue department's website
# State has an investment income tax in lieu of a traditional income tax

Read More

Alert: Fixing Problems with Online IRS EIN Applications

This post is an update to a prior post, with updated information about fixing rejected online EIN applications submitted on the IRS's website. Apparently, the IRS no longer allows entities to be the responsible party for an EIN application. According to the latest instructions for IRS Form SS-4, "Unless the applicant is a government entity, the responsible party must be an individual (i.e., a natural person), not an entity."

Previously, it was possible for an entity that had not obtained its EIN online to be the responsible party for a new entity's online EIN application. In recent months, I have become aware that many IRS online EIN applications are resulting in an error page that doesn't include a reference number. The cause of this error page could be identifying an entity as the responsible party. Unless you are a government entity, you'll need to list an individual with a social security number as the responsible party for all online IRS EIN applications. Thanks to Joel in New Jersey for bringing this to my attention.

Read More

Avoiding a Partnership Tax Return Filing Requirement

According to the IRS, a partnership is a "relationship between two or more persons who join to carry on a trade or business..."  No formal agreement is required; in fact, a partnership can be formed inadvertently, in which case an IRS Form 1065 partnership tax return must be filed.  However, there are a few situations where two or more persons can carry on a trade or business without creating a partnership tax-filing requirement.

If two or more persons have a business relationship that, for tax purposes, constitutes a corporation or trust, obviously such an arrangement is not a partnership. However, a venture that is not a corporation or trust avoids partnership classification if the parties are merely sharing expenses. In addition, a married couple has the option of not filing a partnership tax return if they "materially participate as the only members of a jointly owned and operated business" and file a joint tax return.

Such an arrangement is known as a "qualified joint venture" and cannot be operated through a state-law entity. However, a husband and wife in a community property state may own and operate a business through a state law entity other than a corporation, such as an LLC, and elect to have that LLC disregarded for federal income tax purposes. The business entity must be owned as community property and have no other owners; if so, no partnership tax return is required. These rules are contained in Rev. Proc. 2002-69.

A final example of partnership-type arrangement that does not give rise to a partnership tax return requirement is co-ownership of real property, other than mineral property, but including rental property. Each co-owner must be a tenant-in-common, and title to the property as a whole may not be vested in a state-law entity. However, each tenant may own their interest in the property through an entity that is disregarded for tax purposes. A number of other requirements are set forth in Rev. Proc. 2002-22 which, if satisfied, will result in no partnership filing requirement.

In summary, a partnership can automatically arise for federal tax purposes even where no entity exists under local law. An arrangement of this kind includes a "syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on..." However, arrangements like those described above avoid partnership classification.

Read More

Donations of S-Corp Stock

Public charities have been permitted shareholders of S-Corporations since 1998. Since that time, charitably-inclined business owners have sought to donate shares of their closely-held business stock to charitable organizations. Normally, donating long-term capital gain property to a charity is highly tax efficient because (1) the donor receives a deduction for the fair market value of the donated asset, (2) the donor avoids paying tax on the asset's built-in gain, and (3) the charity, being tax-exempt, also avoids paying tax on any gain from the sale of the asset. In a previous post, I addressed some situations where the charity may some tax.

In the case of S-Corp stock, however, charities pay a lot of tax. Section 512(e)(1)(B)(ii) of the Internal Revenue Code requires that "any gain or loss on the disposition of the stock in the S corporation" is included in unrelated business taxable income (UBTI). Unlike the gain on "virtually every other asset that a charity might own," only the gain on the sale of S-Corp stock is includible in UBTI. See Christopher R. Hoyt, Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems. This is a significant issue because charities typically seek to sell closely-held business interests as quickly as possible, especially stock in S-Corporations.

However, different charities pay different rates of tax on sales of S-Corp stock. Specifically, charities that are trusts pay less tax on gains included in UBTI than do charities that are corporations. This is because trusts are taxed at trust rates, which impose a 20% rate on long-term capital gains, whereas all corporate income, including long-term capital gains, is taxed at corporate rates of around 35%. Moreover, a trust is able to deduct up to 50% of its adjusted gross income for donations to other charities, while corporations are limited to 10%.

This is what makes a Donor Advised Fund at a charity that (1) is a trust and (2) maximizes contributions to other charities, such as Fidelity Charitable, an attractive target for a gift of S-Corp stock. The legal structure of the charity reduces the tax erosion of the gift, while the donor still has the right to advise what organization will ultimately receive the proceeds from the stock sale. Below is a comparison of the post-tax benefits that a corporate charity and trust charity would enjoy from the donation and immediate sale of S-Corporation stock:

	Corporation	Trust
Gain from S-Corp. Shares	1,000,000	1,000,000
Maximum Charitable Deduction	(100,000)	(500,000)
Net Unrelated Business Taxable Income	900,000	500,000
Estimated Tax Rate	35%	20%
Unrelated Business Income Tax	315,000	100,000
Effective Tax Rate	31.5%	10%

Read More

Donations of Closely-Held Business Interests

A charitable donation of long-term capital gain property is a useful tax-planning technique for charitably-inclined individuals. The reason this works is because the donor (1) receives a deduction for the fair market value of the donated asset and (2) avoids paying tax on the built-in gain of the asset. However, in the case of a donation of an interest in a closely-held business taxed as a partnership, two issues often arise which impact this strategy: Business liabilities and ordinary-income property.

Because relief of debt is considered taxable income, a donor who has been allocated a share of a partnership's liabilities and who transfers the interest to a charity is deemed to have engaged in two separate transactions. First, a sale transaction has occurred, whereby the donor realizes income equal to the amount of debt relief. Second, a donation has occurred, whereby the donor makes a contribution equal to the fair market value of the interest less the amount of debt relief. The donor's basis is allocated pro-rata between the two transactions, meaning the donor will recognize and pay tax on the gain arising from the "bargain sale."

The donation is further complicated if the partnership owns ordinary-income property. This is because I.R.C. § 170 requires the amount of a charitable deduction to be reduced to the extent that a sale or exchange of the contributed property would generate ordinary income.

Chapter 7 of the IRS's Partnership Audit Technique Guide contains an example addressing the impact of the debt-relief issue, which I've modified below so that it also illustrates the impact of ordinary-income property, or "hot assets." In this example, an individual donor contributes a partnership interest valued at $50,000 to a public charity. The donor's basis in the interest is $40,000 and the donor is allocated $30,000 of partnership liabilities. In addition, the partnership owns a fully-depreciated piece of equipment which, if sold, would result in $2,000 of ordinary income allocated to the donor. The consequences of this donation on the donor should be as follows:

Bargain Sale:			Footnotes:
	Deemed Proceeds:	30,000	1.
	Allocated Basis (pro-rata):	-24,000	2.
	Gain on Bargain Sale:	=6,000
	Ordinary Income Portion:	1,200	3.
	Capital Gain Portion:	4,800
Donation:
	Gross Donation:	20,000
	Ordinary Income:	-800	4.
	Allowable Deduction:	=19,200

1. Rev. Rul. 75-194, 1975-1, C.B. 80.
2. Treas. Reg. § 1.1011-2(c).
3. The proper allocation of the gain on the bargain sale between ordinary income and capital gain is not clear. See Jonathan G. Tidd, Charitable Gifts of Limited Partnership and Limited Liability Company Interests, Trusts & Estates, October 2015.
4. I.R.C. § 170(e)(1)(A).

Read More

Updated: Fixing Problems with Online IRS EIN Applications

This post is an update to a prior post, with updated information about fixing rejected online EIN applications submitted on the IRS's website. Consider the following potential causes:

Every EIN application requires a responsible party name and matching tax ID number. Often, this will be an individual and their social security number, but sometimes the responsible party is another business with another EIN number. The IRS will not process online EIN applications if the responsible party is an entity with an EIN previously obtained through the internet. In other words, unless the responsible party is an individual with a social security number or an entity with an EIN that was not obtained through the internet, the online EIN application will always return an error.

If the first two numbers of the entity's EIN Number begin with 20, 26, 27, 45, 46, or 47, that EIN number was obtained through the online EIN application. Accordingly, that entity can never be a responsible party for another online EIN application; you will have to apply over the phone or list another responsible party on the online application, such as the individual who owns the entity. If the responsible party's EIN begins with 30, 32, 35, 36, 37, 38, 61, 80, 84, 90, or 91, that EIN number was not obtained through the online EIN application, and that entity should be able to be a responsible party on another online EIN application.

The IRS will only issue an EIN to one responsible party per day. This limitation applies to all requests for EINs, whether through the online EIN application or by phone, fax, or mail. If an EIN has been issued to any entity by any application method on a particular day, the responsible party on that EIN application must wait until the next day before being the responsible party on another EIN application.

A rejected EIN application indicating Reference Number 101 has a name conflict. The IRS requires a unique entity name before it will issue an EIN, similar to how the secretary of state requires a unique entity name within that state before Articles or Certificates of Formation may be successfully filed. However, because the IRS is a federal agency issuing EINs for entities in all 50 states, it potentially checks for duplicate entity names across multiple states. There are numerous references to a state on the online EIN application, such as the physical location state, mailing address state, and the state where the Articles are or will be filed.

If all of these state references are the same, the IRS will only check for previously-issued EINs with that entity name in that one state. If multiple states are reported, for example, if the Articles were filed in a different state than the business's physical address, the IRS will check both states for name availability before issuing an EIN, even though filing the Articles only requires a unique entity name in the one state where the Articles are being filed. Applying for an EIN over the phone may be required in these name conflict situations; often, the IRS agent will ask to see a copy of the Articles before issuing an EIN.

Reference numbers 102, 103, 105, or 108 indicate that the name and tax ID number of the responsible party do not match IRS records. Reference number 104 means a third-party designee's contact information cannot be the same as the address or the phone number of the entity that is applying for an EIN. Reference numbers 109, 110, 112, or 113 mean that the online application is temporarily unable to assign EINs; try again later. Reference number 114 indicates that only one EIN will be assigned per day per responsible party.

Reference Numbers 109 and 110 indicate technical problems and an EIN may still be obtainable using the exact same information that resulted in the error. The error might result from too many people trying to obtain an EIN at the same time. Try again later, or try closing and reopening the browser, using a different browser, using a different computer, clearing cookies, restarting the computer, or adjusting your security settings. Or, feel free to contact me; I would be happy to try and help.

Read More

Help with State Income Tax Audits

Just as the IRS conducts tax audits, so do the states. If you become involved in a state tax audit, keep in mind that Internal Revenue Code Section 6103 authorizes the IRS to share tax information with state governments for tax administration purposes. Among the information exchanged between the IRS and state taxation authorities is individual and business return information. One of the procedures that state taxing authorities use in selecting returns for audit is comparing the information (or the lack thereof) reported on an individual's federal income tax return with what is reported on their state income tax return.

With this in mind, one of the first steps in dealing with a state income tax audit is to gather all information on your account with the IRS. Basic information is readily available on a taxpayer's tax return transcript, a copy of which can be easily obtained through the IRS's Get Transcript webpage. Keep in mind that it will take around 10 days to receive your transcript. As mentioned below, this could potentially be different than the information on your tax return.

Once you have a copy of your IRS transcript, compare income and expense items with the corresponding items under review by your state tax commission. Many states use federal AGI as a key figure in the calculation of state income tax liability, so a difference in federal AGI reported by the IRS and federal AGI reported on your state income tax return could have triggered the audit.

If there are discrepancies, consider why that might be the case. Did you file your federal return but forget to file your state return (or vice versa)? Did the IRS make changes to your tax return? I've even seen a case of a false IRS return filed by a third party engaging in federal refund fraud that triggered a state income tax audit. Of course, you should always talk with a tax professional at the very earliest sign of an audit. With the right information and good advice, you can make any necessary changes to your returns and arrive at a fair resolution of your state income tax audit.

Read More

IRS Notice 784 - Trust Fund Recovery Penalty

As mentioned in a previous post, the IRS pays out tax refunds (often constituting amounts an employer has withheld from an employee's paycheck in excess of that employee's income tax liability) before verifying if the employer has actually withheld those amounts or paid them to the IRS. This is a flawed method and helps explain why the IRS is extremely concerned that employers remit these withheld taxes, as well as social security and Medicaid taxes, to the IRS.

One enforcement mechanism is the Trust Fund Recovery Penalty (TFRP), which is described IRS Notice 784, which is referenced in the IRS's website and current Internal Revenue Manual. Since Notice 784 effectively explains the TFRP but does not appear to be generally available on the web, I quote it here:

Could You be Personally Liable for Certain Unpaid Federal Taxes?

If you are an employer, you must withhold federal income, social security (or railroad retirement), and Medicare taxes from your employee’s wages or salaries. If you provide communication or air transportation services, you also may have to collect certain excise taxes from people who paid you for the services. (Get Pub. 510 for more information on excise taxes.) These taxes are called trust fund taxes and must be paid to the Internal Revenue Service through tax deposits or as payments made with the applicable returns.

The trust fund recovery penalty. – If trust fund taxes willfully aren’t collected, not truthfully accounted for and paid, or are evaded or defeated in any way, we may charge a trust fund recovery penalty. This penalty is equal to the amount of the trust fund taxes evaded, not collected, not accounted for, or not paid to IRS. We also charge interest on the penalty.

Who has to pay the penalty? – The trust fund recovery penalty may apply to a person or persons IRS decides is responsible for collecting, accounting for and paying the trust fund taxes and who acted willfully in not doing so. If IRS can’t immediately collect the taxes from the employer or business, we will decide who the responsible person or persons are and who acted willfully.

“Willfully” means voluntarily, consciously, and intentionally. A responsible persons acts “willfully” if this person knows that the required actions are not taking place for any reason. Paying other business expenses instead of trust fund taxes is considered willful behavior.

Any person who had responsibility for certain aspects of the business and financial affairs of the employer (or business) may be a responsible person. A responsible person may be an officer or employee of a corporation, or a partner or employee of a partnership. This category may include accountants, trustees in bankruptcy, members of a board, banks, insurance companies, or sureties. The responsible person can even be another corporation, a volunteer director/trustee, or employee of a sole proprietorship. Responsible persons may include those who direct or have authority to direct the spending of business funds.

If we charge you this penalty, we may take your assets (except exempt assets) to collect the amount owed.

Avoid the penalty. – You can avoid the trust fund recovery penalty by making sure that all taxes are collected, accounted for, and paid to IRS when required. Make your tax deposits and payments on time. IRS employees are available to assist you if you need information on tax deposits and payments. You may telephone the IRS tax information number in your area for help. Pub. 937, Employment Taxes and Information Returns, Pub. 15, Employer’s Tax Guide, and Form 941, Employer’s Quarterly Federal Tax Return, are also helpful and available from IRS.

Source: Bloomberg BNA, Tax and Accounting Center, links added by me.

Read More

Tax Refund Fraud

To continue the theme of my last post, this post discusses a specific type of identity theft: tax refund fraud. According to NBC News (and which I can verify from my own experience), all it takes to be able to electronically file a fraudulent tax return in someone else's name is a matching name, birth date, and social security number. With that information, all a thief needs to do is fabricate some wages and an employer, report a bogus tax withholding amount, and the difference between those two numbers will be refunded however the thief directs. This works because, to quote NBC:

By law, the tax-refund system as it is currently constituted amounts to a "pay first, ask questions later" system... In other words, an imaginative crook in possession of the three basic items of a person's identity could... get the money within 30 days—the amount of time the law says that the agency must refund tax filers.

Actually, by entering their own direct deposit information on the fraudulent return, the thief could get the refund in a couple days and not have to worry about trying to cash a refund check in the victim's name. Alternatively, a patient thief could paper file a fraudulent return and not even need the victim's birth date since that is not requested on the tax form itself.

The only obstacle to success in this crime is a voluntary program whereby some financial institutions can refuse to deposit a tax refund into an account on which there is a different name from the taxpayer. But not all institutions perform this cross check. Here is some Q&A from the Bureau of the Fiscal Service, a division of the Treasury that operates the federal government's deposit systems:

Can an RDFI [Receiving Depository Financial Institution] rely strictly on the account number in the ACH Entry Detail Record when posting a tax refund payment to a customer's account?

Yes, an RDFI may post IRS tax refunds received through the Automated Clearing House (ACH) network using the account number only....

Is an RDFI liable for an IRS tax refund sent to an account that does not belong to the named or intended recipient?

No. An RDFI is not liable for an IRS tax refund sent through the ACH network to an erroneous or fraudulent account since the IRS provided incorrect account information.

In other words, the IRS is required by law to authorize a refund before verifying if it is legitimate, and the Bureau of the Fiscal Service will authorize the deposit into any account reported to them by the IRS. The bank has no obligation to verify that the name on the refund destination account matches the name of the taxpayer. The real taxpayer will be left to clean up the mess when they discover they can't file their own return. Of course, the thieves will likely be caught after the fact, but the moral of the story is to avoid the mess by protecting your personal identification information and filing your tax return early.

Read More

Tax Protester Arguments Work, Until They Don't

Certain individuals and groups insist that portions of the Internal Revenue Code do not apply to them. The reasoning in support of this position is generally based upon words and phrases in statutes and cases taken out of context. Many of these arguments have been deemed "frivolous" by the IRS, the making of which subjects the "tax protester" to additional penalties.

Because the U.S. tax system depends, in large part, on voluntary compliance, tax protesters can point to various circumstances as "proof" that the techniques "work," at least temporarily. The IRS may accept tax returns with obviously understated income or overstated expenses and may pay out refunds as well. This "works," as Peter J. Reilly, writing for Forbes, pointed out, "if you are just about maximizing your current lifestyle rather than accumulating net worth and entirely amoral when it comes to meeting tax obligations."

Collection due process affords taxpayers a chance to appeal to the Tax Court, a process I outlined in a previous post. All tax protester arguments fail at Tax Court, the result being a judgment against the taxpayer for taxes due and probably penalties. While most Tax Court judges don't bother writing an opinion in tax protester cases, Judge Ronald L. Buch, a new Tax Court judge, took the opportunity to write a very detailed opinion in a recent one. The discussion section of the opinion beings with this, which should cause would-be tax protesters to reconsider their course of action:

This case has occupied an inordinate amount of the Court’s time. The Court could have disposed of the entire matter summarily by reference to Crain v. Commissioner or any number of 6 other cases that stand for the proposition that we need not address frivolous arguments (citing Crain v. Commissioner, 737 F.2d 1417, 1417 (5th Cir. 1984) ("We perceive no need to refute these arguments with somber reasoning and copious citation of precedent; to do so might suggest that these arguments have some colorable merit.")

The case, Waltner v. Commissioner, TC Memo 2014-35, is a good read for anyone who thinks they may have found a book or website promoting a loophole in the Internal Revenue Code. Judge Buch had a clear intent to "inform the public of the court’s analysis" of frivolous positions of tax protesters. Hopefully, some will listen.

Read More

Prepaid Expenses

With some exceptions, taxpayers using the cash method of accounting must recognize income when funds are received and may take deductions only when expenses are actually paid. Accrual method taxpayers generally must recognize income when all events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy; expenses may be deducted when all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

At year end, and assuming a taxpayer will be in the same or lower tax bracket in the following year, deferring income until the next year and accelerating expenses to the current year will defer taxes and save money. However, this can only be done within the restrictions discussed above. With respect to accelerating expenses, a further complication is that any expense attributable to an asset with a life that extends beyond the current tax year generally must be capitalized, as opposed to being fully deducted in the current tax year.

One opportunity for accelerating expenses is discussed in Treas. Reg. 1.263(a)-4(f): "[A] taxpayer is not required to capitalize under this section amounts paid to create (or to facilitate the creation of) any right or benefit for the taxpayer that does not extend beyond the earlier of (i) 12 months after the first date on which the taxpayer realizes the right or benefit; or (ii) the end of the taxable year following the taxable year in which the payment is made." The regulation gives examples that specifically allow the following for an accrual method taxpayer:

On December 1, a corporation pays $10,000 for rent or insurance on a one-year lease or policy that begins December 15 of that same year. Because benefit attributable to the payment neither extends more than a year beyond the first date the benefit is realized nor beyond the end of the taxable year following the taxable year in which the payment is made, the payment need not be capitalized and may be deducted in full in the current year. In this way, taxpayers with certain prepaid expenses can defer taxes and save money.

Read More

Basics of Foreign Income Taxation

From a U.S. perspective, personal income taxation is based on (1) citizenship, (2) residency, and (3) income source. U.S. citizens are taxed on U.S. source and foreign source income, regardless of residence. Non-citizen residents (those who possess a green card or who were present in the U.S. 31 days during the current year and 183 days over the last three years) are taxed the same as U.S. citizens. Non-citizen, non-residents are usually taxed only on U.S. source income.

Different applications of these basic principles apply to the U.S. territories. For example, U.S. citizens residing in Puerto Rico are taxed similar to non-citizen, non-residents even though Puerto Rico is a U.S. territory: only U.S. source income is taxed by the U.S. In contrast, U.S. citizens residing in American Samoa are taxed on worldwide income but can exclude American Samoa source income; each territory is different.

Those who are taxed on worldwide income by the U.S. and who also have foreign source income and pay taxes to foreign countries may be able to (1) exclude foreign source income from reported U.S. gross income, (2) deduct foreign taxes paid from U.S. gross income, or (3) receive a credit against U.S. taxes for foreign taxes paid. These rules are intended to prevent the same income from being fully taxed by two different countries.

For those not taxed on worldwide income, properly determining the source of income for tax purposes is critical. In general, the U.S. considers personal service income to be sourced from where the services are performed. Interest income is sourced to the payer of the interest. Dividend income is U.S. source if paid by a U.S. corporation and foreign source if paid by a foreign corporation (but different rules apply where a foreign corporation is generating income "effectively connected" to the U.S.) With some exceptions, rents and royalties are sourced to the location of the property generating the income. Income from the sale of personal property is sourced to the seller's location, with special rules for inventory and intangibles. Gains from the sale of real estate is sourced to the location of the real property.

This is a broad overview of general principles that apply to U.S. worldwide income taxation. Other issues that could arise include tax withholding on U.S. source income of foreign persons, tax treaties between the U.S. and foreign countries, and foreign account reporting requirements, to name a few. It is never a bad idea to engage local counsel when dealing with foreign income and tax reporting.

Read More

Unrelated Business Income Tax

Certain organizations are exempt from paying income tax under the Internal Revenue Code. These include charitable, religious, and scientific organizations; certain pension, profit sharing, and stock bonus plans; IRAs; colleges and universities; and medical savings and college savings accounts. To the extent that these organizations generate "exempt function income," such as "income from dues, fees, charges, or similar items paid by members for the purposes for which exempt status was granted," such income is not subject to federal income tax.

For exempt organizations, income that meets certain characteristics is not exempt function income and is instead unrelated business taxable income on which tax must be paid. Activities that (1) constitute a trade or business, (2) are regularly carried on, and (3) are not substantially related to furthering the exempt purpose of the organization generate unrelated business taxable income.

A "trade or business" is defined as "any activity carried on for the production of income from selling goods or performing services." To be "regularly carried on," the activities would "show a frequency and continuity, and [be] pursued in a manner similar to, comparable commercial activities of nonexempt organizations." Finally, for an activity to be "not substantially related" to the exempt purpose, the activity would lack a "[substantial] causal relationship to achieving exempt purposes (other than through the production of income)."

The specific rules regarding UBIT are numerous, with certain types of income being subject to UBIT depending on the type of exempt organization that generates the income or the intended purpose of the income. Deductions directly connected with producing the unrelated income are generally deductible in a similar manner as regular business deductions, although certain types of deductions are disallowed. Conceptually, the purpose behind the UBIT rules is to prevent normal for-profit businesses from experiencing unfair competition from an exempt organization engaging in the exact same activity without having to pay the tax that the for-profit business pays.

Read More

Avoid Owning Real Estate in a Corp

Tony Nitti, writing for Forbes, wrote a great article earlier this year that clearly explains Why You Should Never Hold Real Estate In A Corporation. Following is a summary of the primary reasons, contrasted with owning real estate in a partnership:

Capital Contributions: If an individual transfers real property to a corporation in exchange for stock, they must own 80% of the vote and value of the corporation immediately after the transfer; otherwise, a gain must be recognized and tax paid on the difference between the individual's basis in the property and the fair market value. In contrast, "appreciated property can be contributed to a partnership in exchange for a partnership interest [as small as a 1%] without triggering any gain."

Contributions of Property Subject to a Mortgage: Even if a contribution of real property to a corporation is otherwise exempt from gain, if the property is subject to a mortgage, "and the corporation assumes that liability as part of the transfer, the transfer triggers gain to the extent the liability exceeds the tax basis of the property." In contrast, it is "much less likely that a partner contributing leveraged property to a partnership will recognize gain" due to the inside and outside basis rules of partnership taxation.

Sale or Distribution: While it is possible to contribute real property to a corporation without being required to pay tax, the same is not true for getting the property out. If appreciated property is distributed from a corporation, "the corporation recognizes gain as if it had sold the property for its fair market value." The same treatment applies if the property is actually sold by the corporation. Furthermore, withdrawing the sales proceeds from a C-Corporation can result in double taxation to the shareholder. In the case of a distribution from an S-Corp, "the distribution will not be taxed a second time at the shareholder level..., [however the shareholder] cannot take the property out of the corporation without incurring a tax bill." In contrast, "when a partnership distributes property to a partner in a current distribution, generally no gain or loss is recognized by either the partnership or the partner;" only basis adjustments are required.

In addition to the problems listed above, owning real estate within a taxable entity other than a partnership can result in loss limitations, lost step-up in basis of the underlying assets upon the death of a shareholder, and lost step-up in basis for the purchaser of an interest in a corporation owning appreciated assets. It is almost always better to own real estate in a partnership or disregarded entity.

Read More

Home Office Deduction Safe Harbor

In addition to being a rumored audit risk, the deduction for a home office has been relatively complex, both the deduction calculation itself as well as its effect on other parts of Form 1040. For example, under the regular home office deduction method, actual expenses such as rent, real estate taxes, internet, gas and electric, phone, insurance, and other costs attributable to the square footage of the home office space must be calculated and detailed records maintained. Furthermore, home-related itemized deductions must be apportioned between Schedule A and Schedule C. Finally, while depreciation can be deducted for the portion of the home used for business, that depreciation must be recaptured upon the sale of the home.

In Revenue Procedure 2013-13, the IRS has provided an easier option. Using the "simplified" or "safe harbor" home office deduction method, a business owner can take a standard $5 deduction for each square foot of the home used exclusively for business, up to 300 square feet. There is no need to apportion house expenses to the office space, and all home-related itemized deductions may be claimed in full on Schedule A.

There is no home depreciation deduction or later recapture of depreciation for the years the simplified option is used. While deduction amounts in excess of gross income may not be carried forward as in the regular method, preparing Form 8829 is not required when electing the simplified method; calculated expenses are simply entered on Line 30 of Schedule C.

The criteria for who can take the regular or simplified home office deduction is the same: The room or section of the home used for business must be exclusively used on a regular basis (1) as a place of business used by patients, clients, or customers; (2) in connection with the trade or business if it is a separate structure unattached to the home; or (3) as the principal place of business. A home office will qualify as a principal place of business if it is used exclusively and regularly for administrative or management activities of the trade or business and no other fixed location for conducting substantial administrative or management activities of the business exists.

The IRS is strict about the exclusivity requirement. If the home office doubles as a guest bedroom, for example, the taxpayer does not qualify to take the deduction. However, the home office can be a section of a room if clearly partitioned from the rest of the room and personal activities are excluded from the business section.

While the extra complexity of the regular home office deduction method may be worth it for large home offices with high expenses, the simplified method is a good option for many other business owners who work out of their house.

Read More

Income Shifting to Children

A fundamental tax-mitigation technique is shifting income from taxpayers in high tax brackets to taxpayers in lower brackets. One of the ways this can be accomplished for business owners is by paying their children a salary for working for the business. Not only does this shift taxable income from the parent's higher-bracket to the children's lower-bracket while keeping everything within the family, this technique can also save payroll taxes compared to hiring non-family employees.

According to the IRS, "[p]ayments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child." Furthermore, children claimed as dependents on a parent's return and who make less than $6,200 for 2014 do not owe any income tax and are not required to file a tax return, although filing would be necessary in order to receive a refund of income tax withheld.

A parent can also match the child's wages up to $5,500 with a Roth IRA contribution in the child's name. This will reduce the parents' future tax on investment income by the amount of the return on the contribution, which would grow tax-free.

In addition to passing income in the form of "active" wages to children, "passive" income can also be passed to children. In order to take advantage of this opportunity, the "kiddie tax" must be avoided. If the tax applies, the income is taxed at the parent's highest rate instead of the child's, completely negating the strategy. However, parents can still transfer income-generating assets to children, and if the income for the tax year is under $2,000 in 2014, the child's lower rate applies. As children reach the age of majority and continue earning substantially less than their parents, the opportunities to shift passive income increases.

Read More