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Republicans’ 2017 overhaul of the tax code created a new 20-percent deduction of qualified business income (QBI), subject to certain limitations, for pass-through entities (sole proprietorships, partnerships, limited liability companies, or S corporations). The controversial QBI deduction—also called the "pass-through" deduction—has remained an ongoing topic of debate among lawmakers, tax policy experts, and stakeholders.

Republicans’ 2017 overhaul of the tax code created a new 20-percent deduction of qualified business income (QBI), subject to certain limitations, for pass-through entities (sole proprietorships, partnerships, limited liability companies, or S corporations). The controversial QBI deduction—also called the "pass-through" deduction—has remained an ongoing topic of debate among lawmakers, tax policy experts, and stakeholders.

The Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97), enacted at the end of 2017, created the new Section 199A QBI deduction for noncorporate taxpayers, effective for tax years beginning after December 31, 2017. However, under current law the QBI deduction will sunset after 2025. In addition to the QBI deduction’s impermanence, its complexity and ambiguous statutory language have created many questions for taxpayers and practitioners.

The IRS first released much-anticipated proposed regulations for the new QBI deduction, REG-107892-18, on August 8, 2018. The proposed regulations were published in the Federal Register on August 16, 2018. The IRS released the final regulations and notice of additional proposed rulemaking on January 18, 2019, followed by a revised version of the final regulations on February 1, 2019. Additionally, Rev. Proc. 2019-11 was issued concurrently to provide further guidance on the definition of wages. Also, a proposed revenue procedure, Notice 2019-7, was issued concurrently to provide a safe harbor under which certain rental real estate enterprises may be treated as a trade or business for purposes of Section 199A.

Wolters Kluwer recently interviewed Tom West, a principal in the passthroughs group of the Washington National Tax practice of KPMG LLP, about the Section 199A QBI deduction regulations. Notably, West formerly served as tax legislative counsel at the U.S. Department of the Treasury’s Office of Tax Policy. This article represents the views of the author only and does not necessarily represent the views or professional advice of KPMG LLP.

Wolters Kluwer: What is your general overview of the revised, final regulations for the Section 199A Qualified Business Income (QBI) or "pass-through" deduction?

Tom West: I think it is admirable that Treasury and IRS were able to publish these final regulations so quickly and address so many of the comments and questions that the proposed regulations generated. I think they realized how important this particular package was to so many taxpayers for the 2018 filing season and, while questions obviously remain, having these rules out in time to inform decisions for this year’s tax returns is helpful. In particular, the liberalized aggregation rules and the additional examples regarding certain specified service trades or businesses (SSTBs) are the most consequential in my mind.

Wolters Kluwer: What should taxpayers and practitioners keep in mind in consideration of relying on either the proposed or final regulations for the 2018 tax year?

Tom West: I have to imagine that when choosing between the two, for most taxpayers the final regulations will ultimately provide the better result. The ability to aggregate at the entity level, which was only provided in the final regulations, may be a key consideration for those taxpayers with more complicated or tiered structures. That said, I do think taxpayers need to be careful in their aggregation modeling because you are going to be stuck with your aggregation once you’ve filed. It may be that some taxpayers wait on getting locked into a particular aggregation and continue to study the new rules—and even wait on additional guidance that may be coming. However, it may be important to note that the final regulations provide that if an individual fails to aggregate, the individual may not aggregate trades or businesses on an amended return—other than for the 2018 tax year.

Wolters Kluwer: How is the removal of the proposed 80 percent rule regarding specified service trades or businesses (SSTBs) from the final regulations likely to impact certain taxpayers?

Tom West: First of all, I think the removal of this rule is a demonstration of two important dynamics. One, the critical importance of the engagement of taxpayers in the comment process, and, two, the government’s willingness to listen and adapt in their rule-making. I don’t know if there are particular industries or taxpayers who will be impacted, but I do know that the change is a very logical and appropriate one, and logic doesn’t always prevail in these processes, so I’m happy to give the regulators credit when it does.

Wolters Kluwer: Which industries may have been helped or hindered by the final regulations with respect to SSTB rules?

Tom West: I’m not sure specific industries were helped, but the biggest positive in terms of the SSTB final rules is the carryover from the proposed regulations of the treatment of the skill or reputation provision. Had Treasury and the IRS gone in a different direction, there was a risk of that provision swallowing the rest of the 199A regime—not to mention how much more subjective the already sometimes difficult SSTB determinations would have become.

Wolters Kluwer: Are there any lingering, unanswered questions among taxpayers or practitioners that particularly stand out when determining what constitutes SSTB income?

Tom West: I think many taxpayers who have both SSTB and non-SSTB activities were hoping for more clarity, either in rules or examples, on how to acceptably segregate business lines or on when (or if) certain activities are inextricably tied together. There are also still lingering questions regarding when a trade or business is an SSTB—particularly in the field of health.

Wolters Kluwer: Were there any surprises in the final regulations?

Tom West: I don’t know if I’m surprised, knowing the concerns that led them to the decisions they made, but the fact that Treasury and IRS held the line on some of the SSTB-related rules is notable. I’m thinking specifically of the so-called "cliff" effect of the de minimis rule and the fact that owners of certain kinds of SSTB businesses, e.g., sports teams, are not allowed to benefit from the Section 199A deduction.

Republicans’ 2017 overhaul of the tax code created a new 20-percent deduction of qualified business income (QBI), subject to certain limitations, for pass-through entities (sole proprietorships, partnerships, limited liability companies, or S corporations). The controversial QBI deduction—also called the "pass-through" deduction—has remained an ongoing topic of debate among lawmakers, tax policy experts, and stakeholders.

Republicans’ 2017 overhaul of the tax code created a new 20-percent deduction of qualified business income (QBI), subject to certain limitations, for pass-through entities (sole proprietorships, partnerships, limited liability companies, or S corporations). The controversial QBI deduction—also called the "pass-through" deduction—has remained an ongoing topic of debate among lawmakers, tax policy experts, and stakeholders.

The Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97), enacted at the end of 2017, created the new Section 199A QBI deduction for noncorporate taxpayers, effective for tax years beginning after December 31, 2017. However, under current law the QBI deduction will sunset after 2025. In addition to the QBI deduction’s impermanence, its complexity and ambiguous statutory language have created many questions for taxpayers and practitioners.

The IRS first released much-anticipated proposed regulations for the new QBI deduction, REG-107892-18, on August 8, 2018. The proposed regulations were published in the Federal Register on August 16, 2018. The IRS released the final regulations and notice of additional proposed rulemaking on January 18, 2019, followed by a revised version of the final regulations on February 1, 2019. Additionally, Rev. Proc. 2019-11, I.R.B. 2019-9, 742, was issued concurrently to provide further guidance on the definition of wages. Also, a proposed Revenue Procedure, Notice 2019-7, I.R.B. 2019-9, 740, was issued, concurrently providing a safe harbor under which certain rental real estate enterprises may be treated as a trade or business for purposes of Section 199A.

Wolters Kluwer recently interviewed Tom West, a principal in the passthroughs group of the Washington National Tax practice of KPMG LLP, about the Section 199A QBI deduction regulations. Notably, West formerly served as tax legislative counsel at the U.S. Department of the Treasury’s Office of Tax Policy. This article represents the views of the author only and does not necessarily represent the views or professional advice of KPMG LLP.

Wolters Kluwer: Neither the proposed nor final regulations for Section 199A give guidance as to when rental real estate activity constitutes a Section 162 trade or business. How might the application of the safe harbor provided for in IRS Notice 2019-7 offer taxpayers clarity? And how might failure to qualify for the safe harbor impact the determination of whether the rental activity is a trade or business under Section 199A?

Tom West: The safe harbor is helpful but it appears to be intended for relatively smaller taxpayers who may have had questions about their activities rising to the level of a trade or business. I don’t think falling outside of the safe harbor is dispositive—especially in light of the recent policy statement from Treasury regarding sub-regulatory guidance.

Wolters Kluwer: Can you speak to the some of the complexity that may be involved in tax planning with respect to achieving the right balance between adequate W-2 wages and QBI?

Tom West: Other than for small taxpayers, there is only a benefit under Section 199A if the limitations are met. It does not do any good to have QBI but then have insufficient W-2 wages and qualified property to meet the limitations. So when taxpayers are evaluating what constitutes a qualified trade or business (or whether to aggregate qualified trades or businesses) they will need to determine the amount of W-2 wages with respect to each QTB. Aligning the W-2 wages with the QTB will be important—but the salary expense will also result in a reduction in the amount of QBI and therefore the amount of any Section 199A benefit—so modeling becomes critical. Consideration should also be given to any collateral consequences—for instance the impact of the alignment on allocation and apportionment for state taxes.

Wolters Kluwer: According to a March 18, 2019, Treasury Inspector General for Tax Administration (TIGTA) report, Reference Number: 2019-44-022, IRS management indicated that the timeline related to the issuance of Section 199A guidance did not provide enough time for the IRS to develop a QBI deduction tax form. Although the IRS did create a worksheet, do you have a prediction on what key elements may be included on the new form once released?

Tom West: I do think that worksheets could be developed that would facilitate the reporting of Section 199A information—particularly through tiered structures—so as to ease the reporting burden and enhance compliance.

Wolters Kluwer: The IRS has estimated that nearly 23.7 million taxpayers may be eligible to claim the Section 199A deduction and that more than 22.2 million (94 percent) of those eligible taxpayers will not require a complex calculation for the deduction. What notable differences do you expect there are between "complex" and the majority of calculations?

Tom West: For taxpayers under the Section 199A income thresholds ($157.5K single, $315K joint), the deduction is very easy to calculate and claim. Those taxpayers don’t need to worry about being in an SSTB, how much wages they paid, or the basis of their property. Once those taxpayers hit those income thresholds though, even in the phase-out range, things very quickly get complex—and that’s as a consequence of the statute; it is not something that the regulators can change.

Wolters Kluwer: Do you anticipate the IRS will issue further guidance on the Section 199A deduction?

Tom West: I do. As I said at the top, I think part of the government’s motivation in finalizing these regulations so quickly was providing guidance to taxpayers ahead of the tax-filing season. And while for the majority of taxpayers who are below the 199A cap there is probably now sufficient guidance, I think there are still a lot of questions for those with more complex situations. Given the number of taxpayers who are eligible for this deduction, and the importance of Section 199A as the big benefit to non-corporate businesses in what the Administration views as a signature legislative achievement, I have to believe that the government will be responsive to taxpayers’ requests for additional help on this provision. However, given that the provision is due to sunset, it will be important that any guidance is forthcoming in fairly short order to be of any usefulness to taxpayers.

Wolters Kluwer: At this time, do you have any recommendations for taxpayers and practitioners moving forward?

Tom West: As people are going through their tax filings this year, I’d keep a list of issues, questions, and areas where additional guidance would be helpful. It often happens that problems with new legislation or regulations don’t reveal themselves until taxpayers have to put pencil to paper and track their real-world numbers through returns. We’ll all have that experience this year and, with those lists of issues and questions in hand, there may be an opportunity to approach the IRS and Treasury in the hopes of getting resolution going forward. Keeping that list could also help identify areas for tax planning and perhaps ease the complexity of filing for 2019.

A bipartisan House bill has been introduced that would fix a GOP tax law drafting error known as the "retail glitch." The House bill, having over a dozen co-sponsors, is a companion measure to a bipartisan Senate bill introduced in March.

A bipartisan House bill has been introduced that would fix a GOP tax law drafting error known as the "retail glitch." The House bill, having over a dozen co-sponsors, is a companion measure to a bipartisan Senate bill introduced in March.

Immediate Expensing

The Restoring Investment in Improvements Act (HR 1869), sponsored by House tax writers Reps. Jimmy Panetta, D-Calif., and Jackie Walorski, R-Ind., would allow restaurants, retailers, and other leaseholders to immediately write off the cost of certain improvements. The Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97), enacted at the end of 2017, inadvertently excludes qualified improvement property (QIP) from the new 100 percent bonus depreciation provision.

The measure is a "small but critical fix for our job creators, and technical corrections like this are a normal part of the process when Congress enacts major reforms," Walorski said in a recent press release. "This bipartisan, commonsense bill will allow restaurants, retailers, and other small businesses to unlock the full benefits of tax reform and continue driving our nation’s economic growth."

Similarly, Panetta highlighted the negative impact that the loss of immediate expensing has caused many small businesses. "Our bill will allow restaurants, retailers, and other businesses to make the improvements they need to keep their stores competitive and safe and plan for the future," he said.

Although the "retail glitch" measure has solid bipartisan support, Democrats in general have seemed hesitant to fix any errors in the GOP tax law. To that end, House Ways and Means Committee Chairman Richard Neal, D-Mass., has said he would like to hold a hearing on technical corrections for the TCJA. The committee’s March 27 hearing on the TCJA did not specifically address technical corrections.

The House on April 9 approved by voice vote a bipartisan, bicameral IRS reform bill. The IRS bill, which now heads to the Senate, would redesign the IRS for the first time in over 20 years.

The House on April 9 approved by voice vote a bipartisan, bicameral IRS reform bill. The IRS bill, which now heads to the Senate, would redesign the IRS for the first time in over 20 years.

IRS Reform

The Taxpayer First Act of 2019 (HR 1957), as amended, cleared the House Ways and Means Committee by voice on April 2. The House and Senate both introduced the bicameral, bipartisan measure on March 28. If enacted, the bill would make numerous reforms to the IRS, some of which include modernizing antiquated information technology systems and enhancing taxpayer services and identity protections.

"With a new tax code, it is time for a new tax administrator," House Ways and Means Committee ranking member Kevin Brady, R-Tex., said in an April 9 statement. "I applaud the House for passing the Taxpayer First Act—a bold step to redesign the IRS to be an agency with one singular mission: putting taxpayers first."

The IRS Reform bill has been "years in the making," Brady said on April 9, echoing a joint statement that he and Ways and Means Chairman Richard Neal, D-Mass., along with other bipartisan tax writers recently issued. "The House Ways and Means Committee and the Senate Finance Committee have carefully and thoughtfully developed this legislation over several years, after numerous hearings and roundtables, in a bipartisan, bicameral manner," the lawmakers said.

AICPA Applauds Taxpayer First Act

The American Institute of CPAs (AICPA) issued an April 9 statement commending the House for passing HR 1957. "The AICPA appreciates the bipartisan recognition by members of the U.S. House of Representatives for bringing the Internal Revenue Service into the 21st Century," Edward S. Karl, vice president of taxation, said in a statement on behalf of the AICPA. "The AICPA has long been interested in and active in working to find ways to modernize the IRS so that it can better serve the needs of taxpayers and tax practitioners."

Free File Alliance

However, the bipartisan, bicameral bill has not advanced without its share of criticism. Several Democratic lawmakers have criticized a provision within the bill that would codify the Free File Alliance, which is an agreement between the IRS and certain tax preparation companies that includes the IRS being unable to directly assist in tax return preparation.

"Again and again in my service in the Senate I have battled the tax-preparation software industry to simplify filing taxes for the typical American," Senate Finance Committee (SFC) ranking member Ron Wyden, D-Ore., said in an April 9 statement. "During the debate on the tax administration bill, my staff pushed back on a prohibition on the agency competing with private tax preparation services, and I will continue to push for my proposal for the pre-filed ‘simple’ return and the principle that a taxpayer should not have to use a private company to pay their taxes online," he added.

Looking Ahead

It remains unclear when the Senate will take up the Taxpayer First Act bill. However, the bill is presently expected on Capitol Hill to easily be approved in the Senate.

Proposed regulations address gains that may be deferred when taxpayers invest in a qualified opportunity fund (QOF). Taxpayers may generally rely on these new proposed regulations. The IRS has also requested comments.

Proposed regulations address gains that may be deferred when taxpayers invest in a qualified opportunity fund (QOF). Taxpayers may generally rely on these new proposed regulations. The IRS has also requested comments.

The proposed regulations also withdraw and replace placeholder provisions in an earlier set of proposed regulations ( REG-115420-18). These concern:

• the definition of "substantially all"regulations
• transactions that can trigger includible gain;
• the timing and amount of deferred gain that is included;
• treatment of leased property used in the qualified opportunity zone (QOZ) business;
• use of QOZ business property in the QOZ;
• sourcing of income to the QOZ business; and
• the reasonable period for a QOF to reinvest proceeds from the sale of qualifying assets.

In addition, within a few months the IRS expects to address administrative rules for a QOF that fails to maintain the required 90-percent investment standard, as well as information reporting requirements.

Finally, the IRS expects to revise Form 8996, Qualified Opportunity Fund, for 2019 and subsequent tax years. These revisions may require additional information, including the employer identification number (EIN) for the QOF business, and the amounts invested by QOFs and QOZ businesses located in particular QOZs.

"Substantially All" for QOZ Business

The 2018 regulations provided that a trade or business satisfies the "substantially all" test for a QOZ business if at least 70 percent of its tangible property is qualified opportunity zone business property. The new proposed regulations generally extend this 70-percent threshold to the "substantially all" tests for use. However, in the holding period context, the "substantially all" threshold is 90 percent.

Original Use of Purchased Tangible Property

The proposed regulations generally provide that the "original use" of tangible property acquired by purchase by any person starts on the date when that person or a prior person:

• first places the property in service in the qualified opportunity zone for purposes of depreciation or amortization; or
• first uses the property in the qualified opportunity zone in a manner that would allow depreciation or amortization if that person were the property’s owner.

Used tangible property will satisfy the original use requirement with respect to a QOZ so long as the property has not been previously used (that is, has not previously been used within that QOZ in a manner that would have allowed it to depreciated or amortized) by any taxpayer

In addition, a building or other structure that has been vacant for at least five years before being purchased by a QOF or QOZ business satisfies the original use requirement. Improvements made by a lessee to leased property satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis of the improvements.

Land can be treated as QOZ business property only if it is used in a trade or business of a QOF or QOZ business. The holding of land for investment does not give rise to a trade or business, and the land cannot be QOZ business property. Anti-abuse rules determine whether unimproved land can be qualifying property. However, other purchased real property generally must be substantially improved, determined on an asset-by-asset basis.

Leased Tangible Property in QOZ

Leased tangible property may be QOZ property if:

• the lease is entered into after 2017; and
• substantially all of the property’s use is in a QOZ during substantially all of the lease period.

However, the first-use requirement does not apply to leased tangible property. The leased property can generally also be acquired from a related person, though several conditions apply. The proposed regulations also provide methods for valuing the leased property.

QOZ Businesses

The proposed regulations:

• provide that in determining whether a substantial portion of intangible property of a QOZ is used in the active conduct of a trade or business, a substantial portion is at least 40 percent;
• address real property that straddles a QOZ;
• provide three safe harbors and a facts-and-circumstances test for determining whether a corporation or partnership derives at least 50 percent of its gross income from the active conduct of a qualified business;
• define "trade or business" by reference to Code Sec. 162, except that the ownership and operation (including leasing) of real property used in a trade or business can also be the active conduct of a trade or business; and
• provide a safe harbor for working capital.

Other Business Rules

The proposed regulations also address:

• Section 1231 gains;
• relief regarding the 90 percent asset test, including relief for newly contributed assets and QOF reinvestments;
• the amount of an investment for purposes of the deferral election;
• inclusion events, the timing on basis adjustments, includible amounts, and special rules for partnerships and S corporations;
• gifts and bequests;
• exceptions for disregarded transfers and some nonrecognition transactions;
• distributions and contributions;
• consolidated return provisions;
• holding periods and tacking rules;
• anti-abuse rules;
• special rules for Indian tribes and tribally leased property.

Comments Requested; Public Hearing Scheduled

A public hearing on the proposed regulations is scheduled for 10 am on July 9, 2019, at the New Carrollton Federal Building in Latnham, MD. Public comments may be mailed or hand-delivered to the IRS, or submitted via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-120186-18).

The IRS has provided a safe harbor for professional sports teams to avoid the recognition of gain or loss when trading players and/or draft picks. Under the safe harbor provision, the traded player’s contract or the traded draft pick would have a zero basis.

The IRS has provided a safe harbor for professional sports teams to avoid the recognition of gain or loss when trading players and/or draft picks. Under the safe harbor provision, the traded player’s contract or the traded draft pick would have a zero basis.

Value of Professional Sports Contracts

Professional sports teams enter into contracts with their personnel (e.g., managers, coaches, players, etc.). Typical personnel contracts provide an agreed-upon amount of compensation for a certain duration of service. The value of such a contract may fluctuate based on a variety of factors, including:

• player performance;
• the changing needs of the team and of other teams;
• a player’s effect on fan attendance; and
• the number of years until a player becomes a free agent and is able to sign a contract to play for any team in a league.

Other considerations affecting the value of a player contract include:

• the size of the team’s market (i.e., whether a smaller city or a major urban population);
• the cost of player development; and
• the impact of injuries and slumps on player performance.

In most cases, teams do not trade personnel contracts or draft picks unless the team thinks that it is receiving contracts of an equal or greater value. Because each party believes that they are receiving personnel contracts or draft picks of an equal or greater value, it is difficult to assign a monetary value to them. Accordingly, the IRS developed a safe harbor whereby each team is able to treat the traded contracts or draft picks as having a basis of zero, thus avoiding the recognition of gain or loss on the trade.

Safe Harbor Requirements

In order to use the safe harbor, professional sports teams must meet the following requirements:

• all teams involved in the trade must use the safe harbor;
• teams may only trade personnel contracts, draft picks, and/or cash;
• personnel contracts and/or draft picks cannot be Code Sec. 197 intangibles; and
• the financial statements of all teams involved in the trade must not reflect assets or liabilities resulting from the trade other than cash.

Application

Sports teams using the safe harbor will not recognize any gain or loss if they only trade personnel contracts or draft picks. However, teams that receive cash in a trade will recognize the amount of cash received as gain. In addition, the team providing cash to another team in the trade will receive basis in the personnel contract or draft pick equal to the amount of cash that it provided. A team providing cash to another team in a trade for two or more draft picks or personnel contracts must allocate its basis to each personnel contract or draft pick received from the other team by dividing the basis by the number of personnel contracts or draft picks received.

In certain cases, a team may have unrecovered basis in a draft pick or personnel contract under Code Sec. 167(c). In those instances, the team may recognize gain or loss based on the difference between the unrecovered basis and any cash received.

Effective Date

Teams may use the safe harbor for any trades involving personnel contracts or draft picks entered into after April 10, 2019. However, teams may choose to apply these rules in any open tax year.

As businesses weather challenging economic times, one boost can come from depreciation.  The term “depreciation” is often associated with complicated accounting and tax transactions but the fundamental concept is fairly simple. Depreciation should not be overlooked as a valuable tool.

As businesses weather challenging economic times, one boost can come from depreciation.  The term “depreciation” is often associated with complicated accounting and tax transactions but the fundamental concept is fairly simple. Depreciation should not be overlooked as a valuable tool.

Basics

Depreciation is essentially an income tax deduction.  Depreciation allows you to recover the cost or other basis of qualified property. The rules for depreciation vary depending on the type of property.  In recent years, these rules have been made more complex by tax legislation for bonus depreciation and special treatment of certain property.  We’ll discuss bonus depreciation later.

Generally, tangible property is depreciable. Tangible property is depreciable if it is subject to wear and tear. Tangible property includes machinery and equipment, motor vehicles, and furniture.  Land, however, is not tangible property for depreciation purposes.  Intangible property also may qualify for depreciation.  One of the most widely used types of intangible property in every business activity is computer software.  Copyrights and patents, which are intangible property, are also depreciable.  Many types of property are not depreciable (although there are always exceptions). One type of business property that is not depreciable is inventory.

Use

To be depreciable, the property, whether tangible or intangible, must be used for business or in other income-producing activities. It is not the nature of the property itself which is determinative but rather the purpose for which the property is held. If you use property for business and for personal purposes, you can only deduct depreciation based only on the business use of that property.

Depreciation begins when a taxpayer places property in service for use in a trade or business or for the production of income. The property must have a determinable useful life of more than one year. Property that is placed in service and disposed of in the same year cannot be depreciated. Property ceases to be depreciable when you have fully recovered the property’s cost or other basis or when you retire it from service, whichever happens first.

Let’s look at an example: Olivia owns a small candy company.  Olivia purchases a new candy-making machine. The machine is delivered in November 2012. However, the machine is not installed and operational until February 2013. If the machine had been ready and available for use when it was delivered, it would be considered placed in service in 2012 even if it was not actually used until 2013.

Methods

Generally, the method for calculating depreciation is determined by the type of property and when the property was placed in service. For tangible property, there are currently three systems of depreciation in effect, depending on when the property was placed in service. They are the modified accelerated cost recovery system (MACRS) for property placed in service after 1986, the accelerated cost recovery system (ACRS) for property placed in service after 1980 but before 1987, and the pre-1981 system (which included the straight-line method, declining-balance method, and certain other methods based on useful life and salvage value) for property placed in service before 1981.

Bonus depreciation

Bonus depreciation is intended to encourage businesses to make capital investments by enabling them to write these investments off more quickly. Under current law, 50 percent bonus depreciation is available for qualified property acquired after December 31, 2007 and placed in service before January 1, 2013 (before January 1, 2014 in the case of certain property with a long production period and certain noncommercial aircraft).  A 100 percent bonus depreciation rate applies to property acquired after September 8, 2010 and placed in service before January 1, 2012 (before January 1, 2013 for certain property with a long production period and certain noncommercial aircraft).  Several bills are pending in Congress to extend 100 percent depreciation through 2012.

Let’s look at an example:  ABC Co., a calendar-year taxpayer, acquires and places in service business equipment that costs $1 million on June 1, 2012. Under current law, ABC may claim an additional first-year depreciation deduction of 50 percent of the basis of the property, or $500,000. The remaining $500,000 of adjusted basis is recovered under the depreciation provisions other than the additional allowance.

Other considerations

While the basic concept of depreciation itself may be simple, strategies in its implementation to minimize tax liability sometimes may not be so straightforward.  Decisions over whether to classify a particular asset within one or another depreciation “class,” whether certain components of a building can be depreciated faster than the building itself, whether something is an improvement that requires depreciation or a repair that may be deducted immediately in full, and whether early disposition of a particular asset raised the pitfall of depreciation recapture are some of the many “fine points” surrounding depreciation that can make a significant difference in a business’ taxable income.

If you have any questions about depreciation, please contact our office.

Education tax incentives are often underutilized because the rules are so complex. Some of the incentives are tax credits; other deductions. There are also savings plans for education costs. Making things even more complicated is the on-again, off-again nature of the education tax incentives.  Under current law (as of June 2012), several taxpayer-friendly features of the incentives are scheduled to expire.

Education tax incentives are often underutilized because the rules are so complex. Some of the incentives are tax credits; other deductions. There are also savings plans for education costs. Making things even more complicated is the on-again, off-again nature of the education tax incentives.  Under current law (as of June 2012), several taxpayer-friendly features of the incentives are scheduled to expire.

American Opportunity Tax Credit

The American Opportunity Tax Credit (AOTC) is an enhanced version of the old Hope credit. The AOTC offers eligible taxpayers a credit of 100 percent of the first $2,000 of qualified tuition and related expenses and 25 percent of the next $2,000.  That means the credit reaches a maximum of $2,500.   

Four years. The AOTC can be claimed for the first four years of a student’s post-secondary education (including college and university, vocational school and other qualified institutions of learning).

The full AOTC is available to individuals whose modified adjusted gross income is $80,000 or less ($160,000 or less for married couples filing a joint return). If your modified adjusted gross income is above that amount, the credit begins to phase out.  Eligible individuals may receive a refund of 40 percent of the AOTC. 

Sunset.  The AOTC is scheduled to expire after 2012.  At that time, the old Hope credit will return.

Lifetime Learning Credit

The Lifetime Learning Credit is often in the shadow of the AOTC.  One reason may be that the Lifetime Learning Credit and the AOTC cannot be claimed in the same year. The Lifetime Learning Credit reaches $2,000 for qualified educational expenses.

Key difference. There is one very valuable difference between the Lifetime Learning Credit and the AOTC. There is no limit on the number of years the Lifetime Learning Credit can be claimed.  This requires careful planning.  Individuals who are considering graduate school may want to use the AOTC for undergraduate expenses and the Lifetime Learning credit for graduate school expenses.

No sunset.  The Lifetime Learning Credit is not scheduled to expire after 2012.  It is one of the few tax incentives that have essentially remained unchanged in recent years.

Student Loan Interest Deduction

Individuals who took out loans to finance their post-secondary education may qualify for a deduction. Student loan interest is interest you paid during the year on a qualified student loan. The loan proceeds must have been used for qualified higher education expenses, including tuition and room and board.

Above-the-line. The student loan interest deduction (and the expired higher education deduction discussed below) is an above-the-line deduction. This means you can claim the deduction even if you do not itemize deductions.

Sunsetting features. Under current law, there is no limitation as to the number of months during which interest paid on a student loan is deductible.  After December 31, 2012, a 60-month limitation is scheduled to return. The student loan interest deduction is subject to income limits.  Under current law, the   deduction is reduced when modified adjusted gross income exceeds $60,000 for single individuals ($125,000 for married couples filing a joint return) and is completely eliminated when modified adjusted gross income is $75,000 or more for single individuals ($155,000 for married couples filing a joint return). After December 31, 2012, these income limitations are scheduled to be significantly lower.

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts (ESAs) are similar to IRAs. Contributions are not tax-deductible but the funds grow tax-free until distributed. Distributions are tax-free if they are used for qualified education expenses of the beneficiary.

Not just post-secondary.  Under current law, funds in a Coverdell ESA can be used for elementary and secondary school expenses as well as post-secondary education costs.  Coverdell ESAs are the only education tax incentive to offer this feature.  The AOTC, Lifetime Learning Credits and 529 plans (discussed below) are limited to post-secondary education.  However, this special feature of Coverdell ESAs is scheduled to expire after 2012.  At that time, Coverdell ESA dollars will only be available for post-secondary expenses.

Contribution limitation.  Total contributions to a Coverdell ESA cannot be more than $2,000 in any year for the beneficiary. This rule applies no matter how many Coverdell ESAs are established. However, the $2,000 amount is scheduled to fall to $500 after 2012. Income limitations also apply. If you use the funds in a Coverdell ESA for a non-qualified purpose, there is a 10 percent additional tax.

529 Plans

States and institutions of higher learning can create so-called “529 plans.” Funds in a 529 plan can be used for qualified post-secondary expenses, such as tuition and room and board, of the designated beneficiary.  Contributions are not tax-deductible but distributions are tax-free, so long as they pay qualified expenses. There are many 529 plans. Before selecting one, please contact our office.  We can help you select the 529 plan that meets your expectations.

No income limitations. 529 plans are similar to Coverdell ESAs with one very important difference. There are no income limitations for contributors. 

Higher education deduction

Finally, there is the higher education deduction.  This popular deduction allows eligible individuals to claim a deduction for certain higher education costs.  The higher education tuition deduction reaches $4,000.  That’s the good news....the bad news is that the deduction expired after 2011.

May be renewed.  There have been several attempts in Congress to renew the deduction for 2012 but they have failed to pass.  Congress could renew the deduction late in 2012 or early in 2013 and make the deduction retroactive to January 1, 2012.

Like other education incentives, the higher education deduction had some restrictions.  One of the most important is income.  An individual’s modified adjusted gross income could not exceed $80,000 ($160,000 if married filing a joint return).

We have covered a lot of ground discussing these education tax incentives.  Please contact our office for more details and to discuss how we can create a plan using some or all of these incentives that delivers the most value.

Proposals to reform retirement savings plans were highlighted during an April 2012 hearing by the House Ways and Means Committee.  Lawmakers were advised by many experts to move slowly on making changes to current retirement programs that might discourage employers from sponsoring plans for their workers.  Nevertheless, it is clear that Congress wants to make some bold moves in the retirement savings area of the tax law and that likely it will do so under the broader umbrella of general “tax reform.” While tax reform is gaining momentum, it is unlikely to produce any change in the tax laws until 2013 or 2014. Considering that retirement planning necessarily looks long-term into the future, however, now is not too soon to pay some attention to the proposals being discussed.

Testimony

The Chief of Actuarial Issues and Director of Retirement Policy for the American Society of Pension Professionals and Actuaries testified that current federal tax incentives can transform taxable bonuses for business owners into retirement savings contributions that benefit both owners and employees. “This incentive for the business owner to contribute for other employees results in a distribution of tax benefit that is more progressive than the current income tax structure," she observed.

An American Benefits Council representation warned at the hearing that the wisest course for lawmakers is to not enact new laws that would disrupt the success of the current system. Short-term retirement legislation designed to boost tax revenues generally do so by eliminating the existing savings incentives and eroding the amount that workers actually save.

Committee Chairman Dave Camp, R-Mich. questioned whether the large number of retirement plans now existing with their different rules and eligibility criteria leads to confusion, reducing the effectiveness of the incentives in increasing retirement savings. Ranking member Sander Levin, D-Mich., questioned the value of making tax reform-inspired changes to retirement plans. "Tax reform should approach retirement savings incentives with an eye toward strengthening our current system and expanding participation, not as an opportunity to find revenue," Levin said.

JCT report

In advance of the hearing, the Joint Committee on Taxation (JCT) summarized the tax treatment of current-law retirement savings plans and described some recent reform proposals in a report, “Present Law and Background Relating to the Tax Treatment of Retirement Savings” (JCX-32-12). The report highlighted several of the recent proposals on retirement savings:

Automatic enrollment payroll deduction IRA.  President Obama has proposed mandatory automatic enrollment payroll deduction IRA programs.  An employer that does not sponsor a qualified retirement plan, SEP, or SIMPLE IRA plan for its employees (or sponsors a plan and excludes some employees) would be required to offer an automatic enrollment payroll deduction IRA program with a default contribution to a Roth IRA of three percent of compensation. An employer would not be required to offer the program if the employer has been in existence less than two years or has 10 or fewer employees.

Expand the saver's credit.  The Administration has also proposed to make the retirement savings contribution credit, known as the saver's credit, fully refundable and for the saver’s credit to be deposited automatically in an employer-sponsored retirement plan account or IRA to which the eligible individual contributes. In addition, in place of the current credit ranging from 10 percent to 50 percent for qualified retirement savings contributions up to $2,000 per individual, the proposal would provide a credit of 50 percent of such contributions up to $500 (indexed for inflation) per individual.

Consolidate plans.  The JCT also reviewed two retirement proposals from the Bush administration:  Consolidating traditional and Roth IRAs into a single type of account called Retirement Savings Accounts (RSAs) and creating Lifetime Savings Accounts (LSAs) that could be used to save for any purpose with an annual limit for contributions of $2,000. The JCT explained that the tax treatment of RSAs and LSAs would be similar to the current tax treatment of Roth IRAs (contributions would not be deductible, and earnings on contributions generally would not be taxable when distributed). Additionally, the Bush Administration had proposed to consolidate various current-law employer-sponsored retirement arrangements under which individual accounts are maintained for employees and under which employees may make contributions into a single type of arrangement called an employer retirement savings account (ERSA).

The American Society of Pension Professionals and Actuaries (ASPPA) told the Ways and Means Committee that the large number of plans with different rules and criteria does not reduce the effectiveness of the incentives in increasing retirement savings. ”Consolidating all types of defined-contribution type plans into one type of plan would not be simplification,” the ASPPA cautioned. “It would disrupt savings, and force state and local governments and nonprofits to modify their retirement savings plans and procedures.”

The family partnership is a common device for reducing the overall tax burden of family members. Family members who contribute property or services to a partnership in exchange for partnership interests are subject to the same general tax rules that apply to unrelated partners. If the related persons deal with each other at arm's length, their partnership is recognized for tax purposes and the terms of the partnership agreement governing their shares of partnership income and loss are respected.

Interfamily gifts

Because of the tax planning opportunities family partnerships present, they are closely scrutinized by the IRS. When a family member acquires a partnership interest by gift, however, the validity of the partnership may be questioned. For example, a partnership between a parent in a personal services business and a child who contributes little or no services is likely to be disregarded as an attempt to assign the parent's income to the child. Similarly, a purported gift of a partnership interest may be ignored if, in substance, the donor continues to own the interest through his power to control or influence the donee's business decision. When a partnership interest is transferred to a guardian or trustee for the benefit of a family member, the beneficiary is considered a partner only if the trustee or guardian must act independently and solely in the beneficiary's best interest.

Capital or services

The determination of whether a person is recognized as a partner depends on whether capital is a material income-producing factor in the partnership. Any person, including a family member, who purchases or is given real ownership of a capital interest in a partnership in which capital is a material income-producing factor is recognized as a partner automatically. If capital is not a material income-producing factor (for example, if a partnership derives most income from services, a family member is not recognized as a partner unless all the facts and circumstances show a good faith business purpose for forming the partnership.

If the family partnership is recognized for tax purposes, the partnership agreement generally governs the partners' allocations of income and loss. These allocations are not respected, however, to the extent the partnership agreement does not provide reasonable compensation to the donor for services he renders to the partnership or allocates a disproportionate amount of income to the donee. The IRS can re-allocate partnership income between the donor and donee if these requirements are not met.

Investment partnerships

The general rule for determining gain recognition for marketable securities does not apply to the distribution of marketable securities by an investment partnership to an eligible partner. An investment partnership is a partnership that has never been engaged in a trade or business (other than as a trader or dealer in the certain specified investment-type assets) and substantially all the assets of which have always consisted of certain specified investment-type assets (which do not include, for example, interests in real estate or real estate limited partnerships).

If a family limited partnership (FLP) qualifies as an investment partnership, the FLP could redeem the partnership interest of an eligible partner with marketable securities without the recognition of any gain by the redeemed partner. To qualify, substantially all the assets of the FLP must always have consisted of the eligible investment assets, and the holding of even totally passive real estate interests (real estate that does not constitute a trade or business), for instance, must be kept to a minimum. In addition, any eligible partner must have contributed only the specified investment assets (or money) in exchange for his or her partnership interest.

Everybody knows that tax deductions aren't allowed without proof in the form of documentation. What records are needed to "prove it" to the IRS vary depending upon the type of deduction that you may want to claim. Some documentation cannot be collected "after the fact," whether it takes place a few months after an expense is incurred or later, when you are audited by the IRS. This article reviews some of those deductions for which the IRS requires you to generate certain records either contemporaneously as the expense is being incurred, or at least no later than when you file your return. We also highlight several deductions for which contemporaneous documentation, although not strictly required, is extremely helpful in making your case before the IRS on an audit.

Everybody knows that tax deductions aren’t allowed without proof in the form of documentation.  What records are needed to “prove it” to the IRS vary depending upon the type of deduction that you may want to claim.  Some documentation cannot be collected “after the fact,” whether it takes place a few months after an expense is incurred or later, when you are audited by the IRS.  This article reviews some of those deductions for which the IRS requires you to generate certain records either contemporaneously as the expense is being incurred, or at least no later than when you file your return.  We also highlight several deductions for which contemporaneous documentation, although not strictly required, is extremely helpful in making your case before the IRS on an audit.

Charitable contributions.  For cash contributions (including checks and other monetary gifts), the donor must retain a bank record or a written acknowledgment from the charitable organization. A cash contribution of $250 or more must be substantiated with a contemporaneous written acknowledgment from the donee.  “Contemporaneous” for this purpose is defined as obtaining an acknowledgment before you file your return.  So save those letters from the charity, especially for your larger donations.

Tip records.  A taxpayer receiving tips must keep an accurate and contemporaneous record of the tip income.  Employees receiving tips must also report the correct amount to their employers.  The necessary record can be in the form of a diary, log or worksheet and should be made at or near the time the income is received.

Wagering losses.  Gamblers need to substantiate their losses. The IRS usually accepts a regularly maintained diary or similar record (such as summary records and loss schedules) as adequate substantiation, provided it is supplemented by verifiable documentation.  The diary should identify the gambling establishment and the date and type of wager, as well as amounts won and lost. Verifiable documentation can include wagering tickets, canceled checks, credit card records, and withdrawal slips from banks.

Vehicle mileage log.  A taxpayer can deduct a standard mileage rate for business, charitable or medical use of a vehicle.  If the car is also used for personal purposes, the taxpayer should keep a contemporaneous mileage log, especially for business use.  If the taxpayer wants to deduct actual expenses for business use of a car also used for personal purposes, the taxpayer has to allocate costs between the business and personal use, based on miles driven for each.

Material participation in business activity.  Taxpayers that materially participate in a business generally can deduct business losses against other income.  Otherwise, they can only deduct losses against passive income.  An individual’s participation in an activity may be established by any reasonable means.  Contemporaneous time reports, logs, or similar documents are not required but can be particularly helpful to document material participation.  To identify services performed and the hours spent on the services, records may be established using appointment books, calendars, or narrative summaries.

Hobby loss.  Taxpayers who do not engage conduct an activity with a sufficient profit motive may be considered to engage in a hobby and will not be able to deduct losses from the activity against other income.  Maintaining accurate books and records can itself be an indication of a profit motive.  Moreover, the time and activities devoted to a particular business can be essential to demonstrate that the business has a profit motive.  Contemporaneous records can be an important indicator.

Travel and entertainment.  Expenses for travel and entertainment are subject to strict substantiation requirements. Taxpayers should maintain records of the amount spent, the time and place of the activity, its business purpose, and the business relationship of the person being entertained. Contemporaneous records are particularly helpful.

A disregarded entity refers to a business entity with one owner that is not recognized for tax purposes as an entity separate from its owner.  A single-member LLC ("SMLLC"), for example, is considered to be a disregarded entity. For federal and state tax purposes, the sole member of an SMLLC disregards the separate legal status of the SMLLC otherwise in force under state law.

A disregarded entity refers to a business entity with one owner that is not recognized for tax purposes as an entity separate from its owner.  A single-member LLC ("SMLLC"), for example, is considered to be a disregarded entity. For federal and state tax purposes, the sole member of an SMLLC disregards the separate legal status of the SMLLC otherwise in force under state law.

As the result of being “disregarded,” the SMLLC does not file a separate tax return.  Rather, its income and loss is reported on the tax return filed by the single member.

• If the sole owner is an individual, the SMLLC's income and loss is reported on his or her Form 1040, U.S. Individual Income Tax Return. This method is similar to a sole proprietorship.
• If the owner is a corporation, the SMLLC's income or loss is reported on the corporation's Form 1120, U.S. Corporation Income Tax Return (or on Form 1120S in the case of an S Corporation). This treatment is similar to that applied to a corporate branch or division.

An SMLLC is not the only entity treated as a disregarded entity. Two corporate forms are also disregarded: a qualified subchapter S subsidiary and a qualified REIT subsidiary. However, SMLLCs are by far the most common disregarded entity currently in use.

For federal tax purposes, the SMLLC does not exist. All its assets and liabilities are treated as owned by the acquiring corporation.

Even though a disregarded entity’s tax status is transparent for federal tax purposes, it is not transparent for state law purposes. For example, an owner of an SMLLC is not personally liable for the debts and obligations of the entity. However, since the entity is disregarded, the owner is generally treated as the employer of disregarded entity employees for employment tax purposes.

For further details on disregarded entities or how this tax strategy may fit into your business operations, please contact our offices.