Practical advice on current issues.
Benefits of Interest Charge Domestic International Sales Corporations
Taxpayers can use an interest charge domestic international sales corporation (IC-DISC) to obtain a tax incentive available to manufacturers, producers, resellers, and exporters of goods that are produced in the United States with an ultimate destination outside the United States. Taxpayers can also use IC-DISCs to defer the recognition of income related to foreign sales; however, this item focuses primarily on using IC-DISCs to reduce the income tax liability of a corporation's shareholders by converting ordinary income into qualified dividend income.
The number of IC-DISCs has seen a resurgence for a couple of key reasons. The repeal of the foreign sales corporation provisions 14 years ago and the extraterritorial income exclusion in 2005--both of which generally provided larger tax benefits--have made the IC-DISC an attractive tax incentive once again. The "fiscal cliff" in 2012 and the American Taxpayer Relief Act of 2012, P.L. 112-240, that followed it also held the qualified dividend tax rates well below the ordinary income tax rates, meaning that IC-DISCs could still be used effectively to reduce income taxes. Therefore, tax professionals will likely come across more of these when working with manufacturers or producers.
An IC-DISC reduces its shareholders' income tax liability by converting ordinary income from sales to foreign unrelated parties into qualified dividend income. An IC-DISC must be set up as a corporate entity (exempt from federal income tax under Sec. 991) separate from the related producer, manufacturer, reseller, or exporter.
Once the IC-DISC structure is in place, the related supplier can pay the IC-DISC a tax-deductible commission that is calculated based on the related supplier's foreign sales or foreign taxable income for the year. The IC-DISC then can distribute that commission to its shareholders in the form of qualified dividends under Sec. 995(b)(1). These calculations and payments are generally made once the tax year is complete and the related supplier's taxable income can be accurately determined or estimated. In this situation, the IC-DISC entity exists solely on paper and does not actually act as an intermediary between the related supplier and customer. This setup is common; however "buy/sell" IC-DISCs operate much like a distributor of goods in foreign countries. This item focuses on the former type of IC-DISC.
Who Can Benefit From an IC-DISC?
Entities that sell "export property" and are profitable can benefit from using an IC-DISC to reduce their income tax liability. Sec. 993(c) defines export property as property:
* That is manufactured, produced, grown, or extracted in the United States;
* That is then held for sale, lease, or rental for direct use, consumption, or disposition outside the United States; and
* The fair market value of which is not more than 50% attributable to articles imported into the United States.
The definition focuses on the source and ultimate use of the products and not their producer. Therefore, the benefits of an IC-DISC can be extended to the exporter in the supply chain as well. For example, brewers that produce beer that is sold and ultimately consumed outside the United States can use IC-DISCs to reduce their tax burdens because they are selling export property In addition to the brewers, the distributors that sell the beer to bars and retailers outside the United States also would be able to use an IC-DISC to reduce their tax burden because they, too, are selling export property
Determining the Commission
Many requirements need to be followed to obtain the tax benefits of an IC-DISC. One of the first obstacles is the taxable income hurdle. If the related supplier is in a tax loss situation for the year before paying the IC-DISC commission at year end, then the IC-DISC cannot be used in this capacity because, under Regs. Sec. 1.994-1(e)(1), IC-DISCs cannot cause a taxable loss for the related supplier in any year.
Assuming that the related supplier has taxable income for the year, it can use either of two primary methods to determine the commission to be paid to the IC-DISC under Sec. 994(a): (1) 4% of the qualified export receipts, or (2) 50% of the combined taxable income of the related supplier and IC-DISC from the sale of qualified export property (generally, this would be 50% of foreign taxable income). The higher the commission to the IC-DISC, the more taxable income is converted from ordinary income to qualified dividend income. This is why there is a limit on how much commission the related supplier can pay in a given year. However, the related supplier may select the method of commission calculation that is most beneficial to it each year.
The 4%-of-gross-receipts method is less complicated since it is a straight 4% of the qualified export receipts generated by the related supplier during the tax year. Qualified export receipts as defined under Sec. 993(a)(1) include:
* Gross receipts from the sale, exchange, or other disposition of export property;
* Gross receipts from the lease or rental of export property used by the lessee outside the United States;
* Gross receipts for services related to any qualified sale, exchange, lease, rental, or other disposition of export property;
* Gross receipts for engineering or architectural services for construction projects located outside the United States; and
* Interest on any obligation that is a qualified export asset (defined later).
This calculation method generally is used when the related supplier is selling a high volume of items with low profit margins.
The 50%-of-combined-taxable-income method requires more calculations and looks at both the related supplier's income and expenses and the IC-DISC's income and expenses, if any. To determine the combined taxable income attributable to the qualified export receipts (i.e., foreign taxable income), the principles of Sec. 861 are used to determine the source of the income and expense items for both the IC-DISC and the related supplier. The goal behind this calculation is to determine the taxable income from U.S. operations and from foreign operations. Fifty percent of the taxable income related to qualified export receipts (i.e., foreign operations) can then be used to determine the commission paid to the IC-DISC.
Under Regs. Secs. 1.994-1(c)(6)(iii) and 1.861-8, costs directly related to a specific class of income (in this case, foreign income vs. domestic income) are considered to be allocable to that class of income. Next, selling, general, and administrative (SG&A) costs that are directly related to either class or that support deductions related to either class are specifically allocated to that class. Lastly, items that cannot be directly allocated to either class are apportioned to each class based on the ratio of class receipts to the total gross receipts of the related supplier and IC-DISC. Once the domestic- and foreign-source taxable incomes are determined, the related supplier can pay 50% of the foreign-source income to the IC-DISC in the form of a tax-deductible commission. This method of determining the commission generally is used when the related supplier has a high profit margin on foreign sales.
Example. Commission expense calculation: Company A is a manufacturer of widgets in the United States and sells a portion of the widgets produced to Company C based in Canada for use in Company C's business in Canada. Company A decides to set up an IC-DISC to take advantage of the tax savings, and, after it sets up the IC-DISC, it has taxable income for the year of $100,000. The IC-DISC has no activity other than the commission received from Company A. The calculation of Company A's income is shown in Exhibit 1. Exhibit 1: Calculating income for Company A's IC-DISC Sales $ 500,000 Cost of goods sold $(350,000) SG&A expenses not specifically related to domestic or $ (50.000) foreign activities Taxable income $ 100,000 Exhibit 2: Company A activity Domestic Foreign Total Sales $250,000 $250,000 $500,000 COGS (225,000) (125,000) (350,000) SG&A (25.000) (25,000) (50.000) Net income $ 0 $100,000 $100,000 50% of combined taxable income $ 50,000
Of the $500,000 of sales, $250,000 comes from qualified export receipts. Of the $350,000 of cost of goods sold, $125,000 is directly related to qualified export receipts. The tax-deductible commission to the IC-DISC calculated under the 4%-of-qualified-export-receipts method would be $10,000 ($250,000 x 4%). Based on the information outlined above, the tax-deductible commission under the 50%-of-combined-taxable-income method would be $50,000. See the calculation in Exhibit 2 on the previous page.
Because the SG&A expenses are not related to either the foreign or domestic revenue, they are apportioned to each class of income based on the ratio of the specific class Of sales to total sales.
Paying the Commission
Both calculation methods require the related supplier to have an idea of what taxable income for the year may be before it can calculate a commission. This makes actually paying the commission to the IC-DISC prior to the tax year end difficult. Thus, under Regs. Sec. 1.994-1(e)(3), the commission, or a reasonable estimate of the commission, can be paid to the IC-DISC within 60 days after the close of the tax year. The estimated payment does not have to equal the final commission amount once all returns are finalized, but the cash does have to move in that time frame to take advantage of the benefits and generally would have to meet or exceed the final commission amount. If the related supplier does not make the payment within the 60-day window, the IC-DISC may lose the tax benefits associated with being an IC-DISC because that receivable is not a qualified export asset, which may cause the company to not meet the qualified export asset test to be treated as an IC-DISC.
Assuming that the commission is calculated as described above and the commissions and dividends are paid out every year, there is no statutory limit on how much income can be pushed through the IC-DISC annually, aside from the taxable income limitation and the limitations inherent in the commission calculations.
Structuring the IC-DISC
To derive a tax benefit from an IC-DISC, the ownership of both the related supplier and the IC-DISC entity must be carefully structured.
IC-DISCs that are owned directly by the related supplier and structured as passthrough entities (partnerships and S corporations) are able to pass through the qualified dividend income directly to their individual partners or shareholders. Parent-subsidiary or brother-sister entity structures both work well when the related supplier is a passthrough entity. Related suppliers structured as passthrough entities, coupled with the parent-subsidiary ownership structure of the IC-DISC, work well when cash flow is a concern, because the passthrough entity pays the dividend to the IC-DISC and then receives the cash dividend back from the IC-DISC. The passthrough entity is then able to pass the character of the qualified dividend income it received from the IC-DISC up to the shareholders or partners without having to actually distribute the cash out of the company to realize the tax savings.
Related suppliers that are structured as C corporations and own IC-DISCs in a parent-subsidiary structure do not benefit from an IC-DISC in this way because those dividends do not qualify for the dividend-received deduction under Sec. 246(d). In this structure, the commission paid to the IC-DISC, and the dividend received back from it, create a tax deduction and corresponding dividend income in equal offsetting amounts.
To effectively derive a benefit from an IC-DISC in conjunction with a related supplier structured as a C corporation, the shareholders of the C corporation must also own the IC-DISC stock directly (a brother-sister entity structure). This works best when the C corporation is a closely held entity with only a few shareholders. This entity type and structure work best when cash flow is not a problem for the company or the shareholders. Since a C corporation is not a passthrough entity, the cash has to move from the C corporation to the IC-DISC and back up to the IC-DISC shareholders for them to realize the tax savings. This could potentially strip the operating company of vital capital. However, the shareholders could also turn around and loan the money back to the operating entity to remedy that problem temporarily.
The two diagrams in Exhibit 3 on the next page show two examples of how IC-DISCs can be set up in conjunction with a related supplier that is a C corporation (left diagram) and a passthrough entity such as a partnership or S corporation (right diagram). The red arrows show the flow of the commission payments from the related supplier to the IC-DISC, and the green arrows show the flow of dividends from the IC-DISC to the related supplier/shareholders.
Setup of an IC-DISC
IC-DISCs are incorporated as C corporations and set up at the state level. An election is made to treat the entity as an IC-DISC, similar to how an S election is made. Under Regs. Sec. 1.992-2(a), the election to be treated as an IC-DISC is made on Form 4876A, Election to Be Treated as an Interest Charge DISC, and must be filed within 90 days of the beginning of the tax year in which the election -will take effect.
Once the corporation has been set up and the election has been made, assuming the entity meets the requirements to maintain IC-DISC status, all foreign sales from that point on can be used to calculate the commission payment from the related supplier to the IC-DISC. If an election is not made within 90 days, the regulations do not provide for late-filing relief, and it may be necessary to start over with a new corporate entity. However, the IRS has granted extensions of time to file the election under Regs. Secs. 301.9100-1 and -3 in private letter rulings (see Letter Rulings 201221003 and 201025043).
Requirements to Maintain IC-DISC Status
To qualify as an IC-DISC under Sec. 992(a)(1) and Regs. Sec. 1.992-1, the entity must maintain the following requirements annually:
* 95% or more of the gross receipts the IC-DISC receives are qualified export receipts;
* The adjusted basis of the qualified export assets meets or exceeds 95% of the total adjusted basis of all assets held by the IC-DISC;
* The corporation maintains only one class of stock;
* The par value of the stock is at least $2,500 for each day of the tax year;
* The corporation maintains separate books and records; and
* The election to be an IC-DISC described above is in effect for the tax year.
Qualified export .assets under Sec. 993(1)) include:
* Export property;
* Assets used primarily in connection with the sale, lease, or other specified activities relating to qualified export property, and in connection with performing certain services;
* Sufficient cash required to meet the working capital requirements; and
* Amounts on deposit in the United States used to acquire other qualified export assets, subject to the limitations of Regs. Sec. 1.993-2(j).
If an IC-DISC does not meet and maintain these requirements each year, it could lose IC-DISC status and the associated tax savings.
Planning With IC-DISCs
The IC-DISC is an often overlooked structure that can generate significant tax savings for a wide variety of taxpayers. As long as the entity has been set up according to the IRS regulations and is operated within the requirements of Secs. 991-997, there is very little risk associated with using an IC-DISC to reduce tax. Determining who or what qualifies, how to set up the entity, and how to report activity correctly is a complex task and far more detailed than can be described in this item. However, as the economy continues to pick up and manufacturers continue to sell products to foreign companies and "re-shore" their operations to the United States, the IC-DISC is a tax incentive that is likely to see more use in the future.
From Samuel Buck, CPA, AKT LLP, Lake Oswego, Ore.
Update on the Medical Device Excise Tax
Section 1405 of the Health Care and Education Reconciliation Act, P.L. 111-152 (which amended the Patient Protection and Affordable Care Act, P.L. 111-148), provides that any "manufacturer, producer, or importer" of taxable medical devices must pay a tax equal to 2.3% of the sale price of the medical device. Sec. 4191 imposes the tax on all sales of taxable medical devices after Dec. 31,2012. The medical device industry has made numerous requests to repeal the tax, arguing that it may jeopardize jobs or force companies to scale back critical research.
The tax is assessed regardless of a company's profitability. Further compounding the issue, companies might not be able to pass on the cost of the tax to group purchasing organizations (GPO) and integrated hospital networks if those customers can resist paying the additional cost or any proposed price increases.
The IRS issued final regulations in December 2012 (T.D. 9604) and issued interim guidance with Notice 2012-77. On Feb. 3, the IRS posted "Medical Device Excise Tax: Frequently Asked Questions," which are available at tinyurl.com/btfpm4j.
A "taxable medical device" is defined as any device covered under Section 201(h) of the Federal Food, Drug, and Cosmetic Act (FFDCA), P.L. 75-717, that is intended for use by humans. These devices are listed with the U.S. Food and Drug Administration (FDA) under Section 5100) of the FFDCA. This includes all biologic devices that are listed with the FDA. Section 201(h) of the FFDCA defines "device" as an "instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article." All such devices are subject to the excise tax unless a specific exemption applies.
Statutory exemptions are provided for eyeglasses, contact lenses, and hearing aids. Exemptions are also provided for devices generally purchased by the general public at retail for personal use, such as home-use lab tests, over-the-counter devices, prosthetic and other orthotic devices not requiring insertion by a medical professional, therapeutic shoes, etc. The excise tax does not apply to devices exported or destined for export outside the United States or for devices sold for further manufacturing.
The so-called retail exemption applies to any medical devices that are "regularly available for purchase and use by individual consumers who are not medical professionals, and if the design of the device demonstrates that it is not primarily intended for use in a medical institution or office or by a medical professional" (Regs. Sec. 48.4191-2(b)(2)). The retail exemption includes devices bought over the internet or by telephone that are not otherwise FDA Class III devices (those not of a type generally purchased by the general public at retail for individual use), although the retail exemption is not limited by FDA device classification.
Fifteen examples of exempt and nonexempt devices are provided by the IRS (Regs. Sec. 48.4191-2 (b)(2)(iv)). The examples and related guidance conclude that devices that fall within the retail exemption and are not subject to the excise tax include nonsterile absorbent-tipped applicators, adhesive bandages, snake bite suction kits, denture adhesives, pregnancy test kits, blood glucose monitors, prosthetic legs, mechanical and powered wheelchairs, portable oxygen concentrators, urinary ileostomy bags, and therapeutic alternating-current-powered adjustable home-use beds. Examples of devices that do not fall within the retail exemption and are therefore subject to the excise tax are mobile X-ray systems, nonabsorbable silk sutures, nuclear magnetic resonance imaging systems, and powered flotation therapy beds.
The preamble to the final regulations also makes clear that certain dental devices that are customized for individual patients, such as crowns and bridges, may be subject to the excise tax, as requests for a special rule exempting such devices were denied. However, the preamble further states that customized dental devices may qualify for the exemption if, based on all the facts and circumstances, they are of a type generally purchased by the general public at retail for individual use.
The interim guidance also addresses medical convenience kits (two or more devices enclosed in a single package for the convenience of health care professionals or end users). Pending further guidance, the excise tax does not apply to the sale of any domestically produced convenience kits. However, it will apply to any taxable medical device that goes into the medical convenience kits, meaning that producers will need to allocate costs to determine the ultimate sale price of the medical device subject to the new tax.
Letter Ruling 201351002 dealt with a company that produced convenience kits assembled abroad, sometimes containing taxable medical devices that were also manufactured abroad. The ruling held that since the U.S. company retained title to the devices, it was the "producer" of the convenience kits assembled abroad, making them "domestically produced" convenience kits. However, any medical device similarly produced by the company and included in the convenience kit was subject to the excise tax.
Under the interim rules in Notice 2012-77, until further guidance is issued, the medical device tax is imposed on the sale of a convenience kit by an importer. However, in the case of an imported convenience kit in which taxable articles and nontaxable articles are sold together in the kit, the tax applies only to that portion of the importer's sale price allocable to the taxable articles. In cases in which the items in the convenience kit are also sold separately, the taxable portion of the kit is determined by taking the ratio that the separate sale price of the taxable articles bears to the sum of the sale prices of both the taxable and nontaxable articles and applying it to the manufacturer's sale price of the kit. In cases in which the items in the convenience kit are not sold separately, this is calculated by comparing the actual costs of the items in the convenience kit. For example, if the cost of the taxable article is 60% of the total cost of the kit, then the excise tax will apply to 60% of the sale price charged by the manufacturer for the convenience kit.
The regulations state that the manufacturer, producer, or importer making the sale of the taxable medical device is liable for the tax imposed under Sec. 4191(a) and Regs. Sec. 48.4191-1(c). This point was confirmed in an early court case in. this area. In Chemence Medical Products, Inc. v. Medline Industries, Inc., No. 1:13-CV-500-TWT (N.D. Ga. 12/4/13), a district court held that Chemence, the manufacturer, rather than the distributor, Medline Industries Inc., was responsible for paying the excise tax.
In Letter Ruling 201420004, released on May 16, 2014, the IRS held that a contract manufacturer, Company 1, which produced a medical device for Company 2 under a license agreement, and where all intellectual property rights related to the medical device remained with Company 2, was not the manufacturer for purposes of the excise tax.
A sale creating liability for the excise tax occurs when title to the device passes from the manufacturer to the purchaser. This includes any installment sales. Also, for purposes of the medical device excise tax, a lease is considered a sale. In addition, a medical device used as a demonstration product may also create a liability for the excise tax under certain circumstances.
Many medical device companies sell their products to stocking distributors or to contractors/representatives that sell directly to hospitals. This is a blended distribution model and requires the company to make some detailed calculations. The IRS interim guidance provides rules for determining the constructive purchase price upon which the tax will be based. Special rules apply to sales to related parties or affiliates (see Secs. 4216(b)(3) and (4) and Notice 2012-77).
It is important to note that the sale price for calculating the excise tax does not include the excise tax itself; the actual cost of transportation, delivery, installation, or insurance; discounts, rebates, and similar allowances granted to the purchaser; local advertising charges; or charges for a warranty paid at the purchaser's option. Medical device companies generally include the excise tax in their cost of sales and then deduct it for tax purposes.
A company pays the excise tax by filing Form 720, Quarterly Federal Excise Tax Return. Each company must file its own Form 720; the regulations do not allow an affiliated group of corporations to file a consolidated return for purposes of paying the excise tax. Semimonthly deposits of the tax must be made--on the 15th and last day of each month--in all instances where the tax liability is expected to exceed $2,500 for the quarter. Form 720 is filed with the IRS quarterly and is due on the last day of the month following the end of the quarter. In general, a company must make deposits through the Electronic Federal Tax Payment System (EFTPS) (which requires the transaction to be initiated at least one day before the due date). Companies that expect to have sales that are exempt from the excise tax, such as export sales, are required to register with the IRS using Form 637, Application ibr Registration (Ibr Certain Excise Tax Activities). Failure-to-file or failure-to-pay penalties can be abated upon a showing of reasonable cause.
The medical device excise tax with its complex regulations and reporting requirements is particularly onerous because it essentially amounts to a sales tax on members of a targeted industry group regardless of whether they have profits. And, according to the Medical Device Manufacturers Association, 80% of all medical device companies employ fewer than 50 employees. The financial impact of the tax on these small companies is still to be determined.
From Roger W. Lusby III, CPA, CMA, AEP, CGMA, Frazier & Deeter LLC, Alpharetta, Ga.
Only Smallest Charitable Trusts Benefit From Streamlined Application
It is not unusual for a tax adviser to suggest to a client involved in estate tax planning to leave some assets to a charity. Clients who would like to see their charitable endeavors perpetuated are frequently inclined to set up a charitable entity, such as a trust or private foundation, which they often fund with money from an IRA or other qualified plan. The thought is that while these assets are potentially subject to both income tax and estate tax if received by an individual, a tax-exempt entity would avoid both taxes. However, to avoid income taxes, the entity receiving the funds has to either obtain IRS approval of its tax-exempt status or make qualified charitable contributions under Sec. 642(c).
The IRS in August 2014 issued Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, as a procedure to simplify the process of obtaining tax-exempt status. When it was published, Commissioner John Koskinen described it as a common-sense approach to help reduce lengthy processing delays for small tax-exempt groups and, ultimately, larger organizations as well. The instructions for Form 1023-EZ estimate about 51/2 hours of preparation time, 10 hours of recothkeeping, and about 21/2 hours to learn how to prepare the three-page form. However, the instructions are 10 pages, and one has to complete a 26-question Form 1023-EZ Eligibility Worksheet to determine whether an organization qualifies and then find the organization's category and code from the National Taxonomy of Exempt Entities (NTEE) system.
More importantly, an organization cannot use Form 1023-EZ if its assets exceed $250,000 or its annual gross receipts are more than $50,000. The IRS's news release indicated this form could help organizations such as a gardening club. If that is the goal, the gardening club should act quickly before it starts to grow larger.
If an organization does not qualify to file Form 1023-EZ, then it must complete Form 1023. The instructions to that form are much longer, and it is estimated to take at least 9 1/2 hours to prepare. Recordkeeping time is estimated to be a minimum of 89 hours. From a practical point of view, it is very costly for many good charitable organizations to prepare it.
Example: A charitable trust is established under a client's will. The client left an IRA of $1 million with instructions to distribute the funds to certain Sec. 501(c)(3) organizations over at least a 10-year period.
Which return should be filed for this charitable trust? A charity that files a Form 990-PF, Return (private Foundation, electronically without getting tax-exempt status approved will have the form rejected by the IRS. Instead, the form must be submitted by mail with the Form 1023 that has already been submitted to the IRS attached. The organization can expect that it will take a while to get approval when it submits Form 1023, but it must file the Form 990-PF in the meantime.
What if the client does not want to spend the money to prepare Form 1023? The tax adviser is left with filing a Form 1041, US. Income Tax Return for Estates and Trusts, and possibly paying taxes. Regs. Sec. 1.642(c)-1 provides for a charitable deduction for amounts paid in the current year and the following year to qualified charities. There is no longer a provision for deducting amounts set aside for charitable purposes unless the organization is part of a pooled charitable trust or was organized before 1970.
In the example above, where it was not the grantor's intent to distribute all of the money over a two-year period, a considerable amount of taxable income could be trapped in the trust if it is funded completely with the proceeds of an IRA. All of those funds would be taxable to the trust if they are not distributed in the first two years.
The IRS should realize that while it is a good idea to have a Form 1023-EZ, the limits for qualifying to file need to be increased substantially. The IRS should consider increasing the asset limit from $250,000 to $2.5 million.
From Sol Schwartz, CPA, Sol Schwartz & Associates PC, San Antonio
Tax Planning for Private Foundations
Tax planning is often used by for-profit entities and individual taxpayers to ensure they structure transactions in a manner that minimizes tax liability. However, tax planning can and should also be used by not-for-profit entities. In particular, private nonoperating foundations should employ tax planning techniques to lower the entity's excise tax rate from 2% to 1%. The potential tax savings that would result from proper tax planning would be better used to further the foundation's exempt purpose.
Private nonoperating foundations must pay federal excise taxes at a rate of either 1% or 2% on net investment income. To avoid paying the 2% rate, private foundations must ensure that their current-year qualifying distributions (grants, donations, etc.) exceed the rolling average of distributions divided by assets from the preceding five years, plus 1% of current-year net investment income. The best way to accomplish this is for the foundation to distribute a consistent percentage (distributions / average non--charitable-use assets) of the foundation's non--charitable-use assets each year. The foundation can manipulate both the numerator (qualifying distributions) and denominator (non--charitable-use assets) by implementing tax planning techniques throughout the year and by performing a calculation during the final month of the foundation's fiscal/calendar year to determine if the foundation has made sufficient distributions.
Each year, a private foundation must distribute 5% of the foundation's average non-charitable-use assets. However, foundations are able to make up shortfalls in qualifying distributions up to one year after the end of the current year end. Non-charitable-use assets consist of assets that are not integral to the operation of the foundation, such as cash--although 1.5% of the foundation's cash balance is deemed to be a charitable-use asset--and investments (stocks, bonds, real estate, mutual funds, etc.), whereas assets such as computers, desks, vehicles, and buildings are considered charitable-use assets.
To determine the required minimum qualifying distributions, the foundation must calculate the average value of each type of non-charitable-use asset. Each type of non-charitable-use asset, however, can be valued on a different date during the month, allowing the foundation to artificially inflate or deflate the value of non-charitable-use assets. Cash must be valued as of the final day of the month, but investments can be valued on any day the taxpayer chooses. Once that date is chosen, it must be consistently applied going forward.
Net investment income for private foundations is the amount by which the sum of gross investment income and capital gain net income exceeds deductions allowed in Sec. 4940(c)(3). Gross investment income is defined to include interest, dividends, rents, and royalties. Allowable deductions are the ordinary and necessary expenses paid or incurred in connection with the production of the gross investment income. These expenses can include:
* Advisory fees;
* Taxes (but not the excise tax of either 1% or 2% on net investment income);
* Compensation of officers or other employees; and
When an expense is incurred for both the operation of the charity and for the production of investment income, it must be appropriately allocated between the two. For instance, if an employee acts in an investment advisory role and also performs routine daily activities such as accounting, bookkeeping, or grant-making, then his or her time must be apportioned between investment and operating expenses.
By setting the valuation date of investments on a day other than the final day of the month--which is the mandatory valuation date of cash--for example, on the 15th of the month, the exempt organization could artificially increase or decrease its average non-charitable-use assets. If the exempt organization were to buy or sell investments on the day before the end of the month, the foundation would decrease or increase the amount of cash on hand as of the valuation date. If the foundation then purchased or sold investments on the 14th--in the example, a valuation date of the 15th has been chosen for investments--the amount of investments would increase or decrease on the valuation date. In essence, the non-charitable-use assets would be manipulated to be counted twice, thus increasing the denominator, resulting in a lower percentage being used to determine the threshold required for current-year distributions to qualify for the 1% rate on net investment income.
By consulting a tax adviser, the foundation can determine the appropriate course of action to follow so that it pays only the 1% excise tax rate. Although the difference in the tax rate is only 1%, it can save a considerable amount of money for even a smaller nonoperating private foundation, which can be used to further its exempt purpose.
From Jeremy Bottlinger, CPA, Wallace, Plese + Dreher LLP, Chandler, Ariz.
Expenses & Deductions
Substantiating Expenses: All or Nothing
Under Sec. 274(d), for certain expenses, taxpayers are required to be able to provide specific detailed information to substantiate the expenses. As the recent case of Garza, T.C. Memo. 2014-121, demonstrates, this is an 0-or-nothing proposition. Without proper substantiation, no deduction is allowed for a Sec. 274(d) expense, even if the court believes that a legitimate expenditure was made.
Sec. 274(d) identifies four classes of expenses for which specific substantiation is required:
* Sec. 274(d)(1) for travel expenses (including meals and lodging while away from home);
* Sec. 274(d)(2) for any item with respect to an activity that is of a type generally considered to constitute entertainment, amusement, or recreation, or with respect to a facility used in connection with such an activity;
* Sec. 274(d)(3) for business gifts (which are limited to $25); and
* Sec. 274(d)(4) for expenses with respect to any listed property (as defined in Sec. 280F(d)(4)).
In Garza, the court said that "while we believe that petitioner had business travel expenses in relation to his employment, the Court must heed the strict substantiation requirements of section 274(d)."To support its ruling, the court cited DeLima, T.C. Memo. 2012-291, in which the Tax Court indicated that it had no doubt that the taxpayer used a vehicle for business purposes, but it was bound to deny the vehicle expense deduction because she failed to follow the requirements of Sec. 274(d) and the regulations.
Listed property, as defined in Sec. 280F(d)(4), covers assets that are used by the vast majority of closely held businesses: (1) any passenger car or other vehicle used for transportation; (2) property of a type generally used for purposes of entertainment, recreation, or amusement; (3) any computer or peripheral equipment (as defined in Sec. 168(1) (2)(B)); and (4) any other property of a type specified in regulations.
Certain vehicles that cannot be used for more than a de minimis amount of personal use are exempted from the substantiation requirements. However, it is important for businesses to discuss trucks, vans, and SUVs with a qua1ified tax professional to determine if the vehicles are exempt.
Sec. 274(d)(4) requires the taxpayer to substantiate "by adequate records or by sufficient evidence corroborating the taxpayer's own statement":
* The amount of the expense or other item;
* The time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift;
* The business purpose of the expense or other item; and
* The business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift.
The impression from the above paragraph is that "a taxpayer's own statement" by itself does not carry weight in the IRS's consideration of whether to allow a deduction. As Garza and other cases show, the IRS and the courts look for contemporaneous records with the details listed above and, lacking it, they may disallow the deduction.
Garza demonstrates the importance of keeping detailed contemporaneous records for business vehicles that can be used for personal purposes and observing other Sec. 274(d) substantiation requirements. Taxpayers and their tax advisers need to understand what type of documentation is required to take a deduction on a tax return. As indicated above, the courts and the IRS will not allow any deduction without this documentation.
From Michael D. Koppel, Gray, Gray & Gray LLP, Canton, Mass.
Foreign Income & Taxpayers
Complex Foreign Reporting Rules Make Compliance Difficult for Individual Taxpayers
For several years, the IRS and Treasury have been aggressively pursuing taxpayers who willfully conceal foreign bank accounts and income derived from them. Because of this, many taxpayers should by now be well aware of the requirement to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), and the steep penalties and possible criminal prosecution that could accompany failing to do so.
Other foreign reporting requirements may not be as well-known by less sophisticated individual taxpayers; therefore, these reporting requirements may be overlooked, causing those individuals to bear heavy penalties for noncompliance. These include reports required by Sec. 6038, such as reports of ownership of and transactions with controlled foreign corporations on Form 5471, Information Return of US. Persons With Respect to Certain Foreign corporations, and Form 926, Return by a US. Transferor of Property to a Foreign Corporation; reports of foreign partnerships on Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships; and reports of ownership interests in and income from passive foreign investment companies (PFICs) on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
There are two reasons individual taxpayers often overlook the reporting requirements for the above forms. One is that the filing requirements are complex and often confusing. An individual taxpayer, without proper advice from an experienced tax professional, may not be aware that he or she is subject to certain filing requirements. Another reason is that individual taxpayers often invest in foreign corporations, partnerships, and/or PFICs indirectly through one or multiple investment partnerships and are not aware of reportable events entered into by the investment partnerships during the tax year. In addition, although Schedules K-1 from investment partnerships will disclose information regarding reporting requirements in their footnote sections, a taxpayer may not be aware that he or she needs to aggregate reportable amounts that are included on multiple Schedules K-1 to determine if he or she meets a filing threshold.
Certain filing requirements are fulfilled by the investment partnership the individual taxpayer invests in. The taxpayer, however, must be cautious because he or she may still need to fiilfill filing obligations under one or more reporting requirements that are not covered by reporting done by the investment partnership.
Reporting requirements for Forms 5471 and 8865 largely depend on the individual taxpayer's ownership of the foreign corporation or partnership during and at the end of the tax year, including shares or interests that the taxpayer owns constructively. Therefore, for reporting purposes, an individual taxpayer cannot simply determine the interests or shares in a foreign corporation or partnership that the taxpayer directly owns during and at the end of the tax year. Constructive ownership is defined in. Sec. 267(c), which states that an interest owned directly or indirectly by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by its owners, partners, or beneficiaries. Also, an individual taxpayer is considered to own an interest that is owned directly or indirectly by or for his or her family, which includes his or her spouse, brothers, sisters, ancestors, and lineal descendants.
Transfers of Cash or Property to a Corporation or Partnership
A taxpayer must report certain transfers of property by the taxpayer or a related person to a foreign corporation on Form 926, including a transfer of cash of $100,000 or more to a foreign corporation in a transfer described in Sec. 6038B(a)(1)(A), which includes Sec. 351 transfers. For purposes of this rule, transfers made to the same foreign entity, directly or indirectly, over the course of the 12-month period ending on the date of the transfer are aggregated to determine whether the filing requirement is triggered. Therefore, it does not necessarily matter if each individual cash transfer to the same foreign corporation is less than $100,000. If the total of the taxpayer's cash investments during the 12-month period ending on the date of transfer equals or exceeds $100,000, the filing requirement is triggered.
Furthermore, the individual tax-payer--not the foreign entity--is responsible for reporting his or her share of the transfer on Form 926. Similarly, an individual who contributes property with a fair market value (FMV) of over $100,000 (when added to the value of any other property contributed to the partnership by that person or by any related person during the 12-month period ending on the date of transfer) to a partnership in return for an interest in the partnership must report the contribution on Form 8865.
PFIC Reporting Requirements
Form 8621 reporting requirements for individual taxpayers that own direct or indirect investments in PFICs are another complex area. Most individual taxpayers' filing requirements for PFICs result from investments they have made in a domestic or foreign partnership or corporation that invests in PFICs. Regardless of whether the taxpayer's ownership in the PFICs is direct or indirect, the individual taxpayer generally must file Form 8621 if he or she receives a direct or indirect distribution from a PFIC and/or recognizes gain on a direct or indirect disposition of PFIC stock and in several other situations. A Form 8621 must be filed for each PFIC in which the individual taxpayer owns a direct or indirect interest. If the individual taxpayer owns a PFIC through a foreign partnership, then as the "first U.S. owner," the taxpayer generally must file Form 8621.
Sec. 6038 includes severe penalties for filing late or with incomplete information. Filing Forms 5471 and 8865 late or with incomplete information can result in a $10,000 penalty for each tax year for each foreign entity and additional penalties of up to $50,000 for a continuing failure to file. A late or incomplete filing of Form 926 can result in a penalty equal to 10% of the property's FMV at the time of transfer. This penalty is limited to $100,000, unless the failure was due to intentional disregard. For Form 8621, there is no explicit penalty for nonreporting if there is no distribution from the PFIC; however, if the taxpayer does not file a required Form 8621, the statute of limitation may be suspended on the taxpayer's entire tax return until the form is filed.
For tax professionals, it is important to comb through all the footnotes in a Schedule K-1 from a foreign entity and ask clients about potential constructive ownership. It is also a best practice to aggregate applicable reportable amounts from all Schedules K-1 to determine whether they exceed the reporting thresholds.
From Amanda Lu, CPA, DZH Phillips, San Francisco
Gains & Losses
Land Sales: Is the Taxpayer Considered a Dealer or Investor?
When land is sold, it is often assumed that long-term capital gain rates apply to the transaction. While these rates may apply to the majority of sales, recent decisions from the Tax Court and a U.S. district court in California are reminders that land may not always be a capital asset that gives rise to a capital gain when sold. Land may also be held for sale to customers in the ordinary course of business, in which case gain on the sale of the land will be ordinary income. Both decisions use a standard, five-factor test that has been developed in case law to determine which category the land in question falls into. These factors focus not only on the circumstances leading up to the sale but also the seller's intent during the acquisition of the property. Using them, the court is required to:
1. Analyze the nature of the acquisition. Was the land initially purchased for investment or development? At that time, was the taxpayer's primary service and/or principal product real estate?
2. Assess the frequency and continuity of the taxpayer's property sales. Is the taxpayer often involved in land sales, indicating that the land is more like inventory than an investment?
3. Consider the nature and extent of the taxpayer's business. Were the taxpayer's actions to increase the land's value more like those of a developer or an investor?
4. Examine the level of the seller's involvement when selling the property. Did the taxpayer spend a significant amount of time finding buyers and negotiating property sales?
5. Evaluate the extent and substantiality of the sale transaction. Were there any red flags indicating that (1) the sale may not have been at arm's length or (2) the price may not have been at market value?
In a recent case, Pool, T.C. Memo. 2014-3, the Tax Court considered these five factors in ruling that the taxpayers improperly reported ordinary partnership income as capital gain. The case involved a limited liability company, Concinnity LLC, which purchased 300 acres of undeveloped land divided into four sections. Three of the sections were part of an exclusive rights agreement with a development company, and the LLC eventually sold these sections to the development company in two installment sales. On Concinnity's 2005 return, the LLC reported the taxable portion of the payments received in 2005 from these sales as a long-term capital gain. The IRS audited the partnership and disallowed capital gain treatment, concluding that Concinnity was a dealer in real estate.
The Tax Court examined the five factors and came to the following conclusions: (1) Concinnity purchased the land to divide and sell to customers; (2) Concinnity failed to prove that its sales of land were not frequent enough to be considered to be in the ordinary course of business; (3) Concinnity took more of a developer's role than an investor's role because the company improved the land with water and wastewater systems, found additional investors, and brokered the land sale deals; (4) there was little proof that Concinnity did not actively seek out buyers for individual lots before it sold the three sections of land to the development company; and (5) the sale to the development company was at a price well above market value and thus was not at arm's length. As a result of these findings, the Tax Court denied Concinnity's partners' capital gain treatment on the sale of the property.
In another recent court decision, Allen, No. 13-cv-02501-WHO (N.D. Cal. 5/28/14), the U.S. District Court for the Northern District of California determined that three of the five factors in the case proved the property sale in question was more similar to a sale to a customer in the ordinary course of business than to a sale of a capital asset.
In the late 1980s, Fredric and Phyllis Allen purchased several acres of land to develop and sell in East Palo Alto, Calif. After attempting to develop the property themselves, which included hiring engineers for planning purposes, the Aliens changed their focus and instead tried to find investors to develop and sell the property. In 1999, the property was sold to a real estate development corporation under an installment sale arrangement. On their 2004 Form 1040, US. Individual Income Tax Return, the Aliens reported the final installment payment of $63,662 as a long-term capital gain.
The IRS denied the long-term capital gain treatment, arguing that the Aliens held the property for resale and not as investment property. The court sided with the IRS. It found that the first and fourth factors were determinative, stating that Allen held the property for resale because "the evidence is compelling that Fredric Allen intended to develop the Property when he purchased it and that he undertook substantial efforts to develop it during the time that he owned it."The court also considered the other factors, but found that the support they gave for the Aliens' position was not strong enough to change its conclusion based on the first and fourth factors.
Steps to Take
Because courts will generally use the five-factor test, taxpayers can plan how they structure, undertake, and account for a land sale to reduce the chance that a court will hold that it was not a sale of investment property. Based on these factors, taxpayers can take the following steps to avoid this result:
Segregate property in the books and records: The segregation of books supports a taxpayer's intent to hold a piece of property while also increasing the chances of capital gain treatment when the taxpayer sells the investment property.
Report items as investment expense: Deductions related to a piece of property, such as interest expense, should be reported as investment expenses. Classifying these expenses as business expenses provides an indication that the taxpayer held the property for sale in the ordinary course of business.
Stating investment purpose in governing documents: if an investor is a partnership, LLC, or corporation, the entity's governing documents should state that the entity's sole purpose is investment activities. The meeting minutes of the entity should also express this intent.
Using separate entities: One factor that determines a seller's intent is the frequency of sales (factor 2). To avoid dealer status, it may be advantageous to hold investment property in a separate legal entity with a different ownership structure.
Insubstantial nature of the real estate activity: Taxpayers who can show that the time spent in investment activities is insignificant when compared with the time spent in their everyday occupation may be able to achieve investor status.
Considering the gap between longterm capital gain tax rates and the highest ordinary income tax rates, the services CPAs can provide become more important to clients. While it may be beneficial to achieve dealer status if a taxpayer has net operating losses, it is often more beneficial for taxpayers that are not in the real estate business to attain investor status and the preferential tax rates associated with that status. By properly structuring real estate transactions and appropriately setting up records and books, taxpayers have the opportunity to establish dealer or investor status to achieve the desired tax treatment.
From Nick Finkenauer. CPA, McGowen. Hurst. Clark & Smith PC. Des Moines, Iowa
Divorce Litigation: How Much Is a Professional Practice Worth?
Few experiences in a valuation expert's professional practice provide as much personal challenge and mental stimulation as being an expert witness in a court of law. During divorce proceedings, often the most challenging issue is the valuation of marital property for distribution. These types of valuations are especially difficult for the assets of a business or business interest. This item concentrates on valuations of professional practices during divorce proceedings. The term "professional practice" includes businesses in the fields of medicine, law, engineering, and other professional services.
When a professional gets divorced, the value of his or her practice or business interest is usually included as a marital asset for the purposes of property distribution. Additionally, the income generated from the practice is generally used to determine alimony and/or child support payments. Valuation experts understand that because of differing laws, states use widely varying standards to measure an asset's value. The same follows for the recognition and measurement of the value of personal goodwill compared with practice or enterprise goodwill.
While the divorcing professional's attorney has a responsibility to serve as an advocate, the valuation expert has no such responsibility. He or she must remain independent and objective during the valuation engagement. When the valuation expert is a CPA, he or she is also bound by the AICPA Code of Professional Conduct and the AICPA Statement on Standards for Valuation Services (SSVS1). Objectivity requires the CPA/valuation expert to be impartial, intellectually honest, disinterested, and free of any conflicts of interest.
Determining the Standard of Valuation
Before beginning the engagement, the valuation expert must determine the appropriate standard of value that applies in the state or jurisdiction of the divorce. A family law attorney can inform the valuation expert of the appropriate standard of value to be used that reflects specific procedures in the particular state or jurisdiction. These standards include fair market value, fair value, investment value, and intrinsic value. Many states prefer fair market value but do not allow for the determination of goodwill. While these states want to follow the fair-market-value standard, they make no assumption that the business will be sold. This is not really fair market value.
Some states have begun requiring that business valuations be based on the intrinsic-value standard. SSVS1 says intrinsic value is "the value that an investor considers, on the basis of an evaluation of available facts, to be the 'true' or 'real' value that will become the market value when other investors reach the same conclusion." In other words, intrinsic value is the value of the business or business interest to its current owner.
Besides identifying the applicable standard of value, the valuation expert must also fully understand how that particular jurisdiction mandates the standard. Reliance on an incorrect standard of value could lead to an incorrect conclusion--causing a court to exclude the valuation report and testimony from evidence--and possibly later form the basis of a malpractice lawsuit.
SSVS1 defines goodwill as an "intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified." Goodwill is generally separated into three categories: entity or practice goodwill, professional or personal goodwill, and goodwill that is transferable.
Practice goodwill is the value associated with the professional practice and is based on location, policies and procedures, staff retention, established patient/client base, and patient or client records. Practice goodwill is based on the assumption that clients or patients are likely to stay with the practice despite a change in ownership.
Personal professional goodwill assumes that the professional practice has a higher value because of the particular professional's knowledge, experience, skill, and reputation. The implication is that if the practitioner were to leave to go to another practice, his or her clients would follow.
Transferable goodwill is personal as it relates to the individual, but, over a certain period, it can be transferred to another person. These types of assets include personal relationships or specialized knowledge that could be transferred through employee training or development. It also includes contact lists or client or patient relationships that are transferable. The assumption is that, over time, this goodwill will be transferred to new ownership and typically would be coupled with a covenant not to compete.
The valuation expert must distinguish professional goodwill, practice goodwill, and transferable goodwill from one another. While court decisions in a majority of states have supported the notion that the other types of goodwill are assets of the marital estate of a professional practitioner during a divorce, most states do not consider professional goodwill a marital asset. However, in some states, professional goodwill is a part of the marital property even if it is not transferable. There is no "one size fits all" or "magic formula" for determining the amount of professional goodwill versus practice or entity goodwill versus transferable goodwill. Unfortunately, because there is no objective way to determine personal goodwill, the valuation expert must rely on his or her professional judgment.
In addition to assessing the value of tangible assets owned by the professional practice, the assessment includes other intangible assets besides goodwill, such as patient or client lists, medical or client records, and covenants not to compete. Often, the intangible value of goodwill and covenants not to compete is greater than the value of the tangible assets.
Determining the Valuation Date
State law determines the appropriate date on which to value the professional practice for divorce purposes. The valuation date may be the date the couple separates, the date the divorce action is filed, a date based on the trial date, or some other date. In addition, some states may determine the value of the practice included in the marital estate based on its value at the time of marriage and its value at the time of divorce.
Most divorce litigation disputes are settled outside the courtroom, but the emotional stress for the valuation expert stems from the apprehension that the valuation will end up in court (see Udell, Ch. 23, "When the Marriage Is Over, What Is the Practice Worth?" in BVR's Guide to Physician Practice Valuation (Business Valuation Resources 2012)). The valuation expert must be prepared to present complex financial and technical matters in a clear, logical, and concise manner. The consultant must be able to defend his or her conclusions and testimony under cross-examination by an often knowledgeable and usually hostile interrogator. In professional practice divorces, large gains and losses, both economic and personal, may result.
In professional practice divorce engagements, as well as other valuation engagements, there is no substitute for thorough homework and preparation. This includes understanding significant aspects of the case. It is vital to document supporting opinions and to be well-organized. Further, the expert must be able to communicate to the judge (or jury) the basis of his or her opinion and recall pertinent facts about the valuation engagement. These issues primarily relate to the use of appropriate standards of valuation, valuation methods, and discounts; presenting credible evidence; considering potential capital gain taxes; and classifying goodwill appropriately as either marital or separate property.
A successful valuation engagement in any divorce litigation requires sound judgment and well-documented conclusions. The valuation expert must be confident that the conclusions are objective, reasonable, and based on relevant facts and circumstances. In addition, the valuation expert must be confident that his or her conclusions are defensible in court. Many courts make their determination from previous decisions made in other states as well as their own. The successful valuation expert must have practical knowledge of relevant case law. This insight is likely to enhance the value of his or her services to referring attorneys.
From John E. Plageman, CPA, CFE, CVA, Whaley Hammonds Tomasello PC, McDonough. Ga.
Personal Financial Planning
Navigating Through Divorce: Top Five Financial Planning and Tax Considerations
Advisers must consider a number of issues when helping a client navigate through a divorce. Emotions are at their peak, but careful thought and planning must take place before the divorce agreement is finalized, to prevent future financial and legal headaches. This item discusses the five top issues that financial advisers and CPAs should consider throughout a client's divorce negotiations.
1. What Constitutes Alimony? Will It Be Tax-Deductible?
Sec. 215 grants a deduction for a taxpayer who pays alimony, but the definition of alimony and related requirements are contained in Sec. 71(b). Alimony must be in the form of cash and:
* Payments must be received by, or on behalf of, a spouse under a written divorce or separation instrument;
* The written document cannot designate that the payments will not be includible in gross income of the payee and not be deductible by the payer;
* The payer and payee cannot live in the same household;
* The payments must terminate upon death of the payee spouse; and
* The parties cannot file a joint return.
If any of these requirements are not met, the payments do not qualify as alimony. (Note that each payment or stream of payments as indicated in the divorce decree or separation agreement is tested separately for all alimony criteria.)
Even if the payments meet these requirements, they must not be excessively front-loaded as defined under Sec. 71(f). If there was a decline in the amount paid over the first three years, there may be recapture, which will affect the tax deduction. For the payer to properly deduct settlement payments as alimony, the parties must be willing to spread payments relatively evenly over the first three post-separation years.
To further complicate matters, alimony rules vary from state to state. Some states rely on a needs-based alimony statute, while others divide community property in favor of the lower-earning spouse to compensate for lack of alimony payments. Furthermore, in certain community property states (where the community does not terminate until the divorce or separation is finalized), the interim support may be only a division of community income. Thus, alimony treatment is inappropriate in this case.
A practitioner cannot rely on the mere fact that the payments are called alimony. A payment will be deemed to be child support if it is reduced when a contingency related to the child occurs or at a time that can be clearly associated with such a contingency (Temp. Regs. Sec. 1.71-1T(c)). If support payments are reduced within six months before or after a child attains age 18, 21, or the local age of majority, then the amount of the decrease can be determined to be child support. The same rechaxacteriza-don can occur if payments are to be reduced on two or more occasions within one year before or after a different child of the payer spouse attains an age from 18 to 24. Beyond these bright-line tests, other contingencies may include reductions when the child gets a job, attends college, joins the military, or moves away from home. Even if the chance of the contingency is remote, the fact that there is a contingency may lead to the recharacterization of a portion of the maintenance as child support, which the payer may not deduct.
In some cases, the parties may not want to treat payments as alimony. In these cases, an election can be made for federal income tax purposes by stating in the applicable agreement or decree that the payments are not to be treated as alimony for tax purposes. This may be appropriate if the divorcing parties' tax brackets are similar; the payer does not realize a tax benefit from the deduction; the payments are purposely front-loaded; the payer has established an alimony trust; or an agreement cannot be reached to indemnify the payee for the tax that is due on the payments (when alimony is being used as a property settlement).
2. The QDRO: Is It Truly Qualified? Planning Opportunities Abound
A qualified domestic relations order (QPRO) is a tool to designate retirement benefits to an alternate payee. To be qualified, a domestic relations order (DRO) must meet the requirements of Sec. 414(p) and be submitted to the plan administrator for approval. Since DROs can be complicated, numerous drafts may need to be submitted before the DRO becomes qualified. It is therefore crucial that the QDRO be formally reviewed and changes made before the divorce is final, to ensure the document achieves the intended results.
Unfortunately, not all attorneys are well-versed in QDR0s, and this could produce disastrous results. If it is later determined that the QDRO does not meet the requirements of Sec. 414(p), the participant spouse may be taxed on the distribution and subsequent paymen to the nonparticipant spouse. Further, if the nonparticipant spouse dies, the benefits could go to the participant spouse instead of to the nonparticipant spouse's estate.
Multiple planning opportunities are available with a QDRO. A distribution under a QDRO to an alternate payee can be made before the participant spouse becomes eligible to take a distribution. This can allow for debts to be paid and add liquidity to a settlement when no other liquid assets are available to split. In addition, the after-tax value of the qualified plan might be greater in the hands of the nonparticipant spouse. Income could be shifted to a lower-taxed party without the same alimony limitations. Additionally, it is important that the QDRO specify that the nonparticipant spouse is treated as the surviving spouse. Otherwise, if the participant spouse dies before payments begin, there is no obligation to make payments to a former spouse.
The alternative payee's cash flow needs are another important consideration and should be assessed before rolling over QDRO distributions into an IRA, as the 10% penalty is not assessed on a distribution to an alternate payee pursuant to a QPRO, regardless of age (Sec. 72(t)(2)(C)). Once the funds are in an IRA, the 10% early withdrawal penalty applies if the alternate participant is under age 591/2 and no other exception applies. Alternatively, if the plan allows, the funds can be held in a separate account with the plan trustee, especially if the alternate payee is under age 59 1/2.
For more information regarding Q_DR0s, see the U.S. Department of Labor's page with frequently asked questions, available at tinyurl.com/7qymc.
3. Jointly Owned Primary Residence
A primary residence is often a divorcing couple's largest asset. Maximizing the Sec. 121 exclusion is therefore an important consideration. In some situations, it could make sense to sell the home in advance of the divorce to repay the mortgage and report the transaction on a joint return, taking advantage of the full $500,000 exclusion under Sec. 121 if the divorcing couple otherwise qualify. However, sometimes one or both parties to a divorce do not want to sell the home. One spouse could be emotionally attached to it or may want to wait until minor children are grown up. Alternatively, the home might be "underwater" (worth less than the principal amount of the mortgage), and the couple want to hold the property until the value rebounds enough to pay the debt.
If a client no longer lives in the home but the former spouse is using it, the nonresiding spouse may be able to qualify for the Sec. 121 gain exclusion even if his or her own usage does not meet the two-year rule. Sec. 121(d) (3) allows the former spouse who gave up the use of property to count the period that the resident spouse is using it. This is allowed as long as the usage and ownership requirements were followed pursuant to a divorce or separation instrument.
If a client is using the property and remarries, the new spouse could also qualify for the Sec. 121 exclusion. The new spouse would have to meet the usage requirement. In contrast, a new spouse of the nonresiding former spouse would not qualify since he or she would not meet the usage test.
How are mortgage payments and property tax payments on a home treated when the home is owned jointly? It depends. If the client is required by the instrument to make the full mortgage and property tax payments as maintenance and holds joint title to the home, the full amount of the payments would not be maintenance, since half of the payments would be considered payments for his or her own property. The half deemed paid on behalf of the spouse would be deductible as alimony, and the half that is considered the payer's share of qualified mortgage interest and property taxes could be deductible on Schedule A, Itemized Deductions. (The resident spouse may deduct the other half.) When the home is eventually sold, the proceeds are usually reduced accordingly for the spouse who lived in the home but did not pay the mortgage and property taxes post-divorce.
If both spouses are making payments, the mortgage interest and property tax deductions generally are attributed to the spouse who makes the payment. If the couple reside in a community property state and pay the mortgage and property taxes from a community checking account, then the deduction will generally be split equally between the spouses. (Note that most states differ in their treatment, so planners should consult proper counsel prior to advising clients.)
4. Life Insurance and Securing Future Payments
In addition to providing tax planning, advisers can help clients reduce risk and ease their fears about the future. The client may be concerned that the other party to the divorce will be unable to pay a property settlement or that maintenance payments will be insufficient to provide economic security. These issues should be addressed before the divorce is final.
Life insurance: This can be a cost-effective tool to secure future payments if the payer dies before his or her obligation is met. A term policy can cover a period of time; a whole life policy provides the ability to pull from the cash surrender value for urgent cash flow needs. There are many variations in between, so a trusted insurance expert should be consulted before providing recommendations to a client. The following issues need to be considered:
* Who should own the policy, and who should pay the premiums? For payments to be considered maintenance, the recipient spouse needs to be the policy owner, not the insured. It is often best to have the recipient spouse make the payments to avoid a situation where the payee spouse suddenly decides to stop making payments, causing the policy to lapse.
* A client should be advised to request that the other spouse apply for life insurance in advance of the final settlement. Waiting until after the judgment has been finalized can be disastrous if the spouse applying for the insurance is uninsurable. In this case, other options can be considered before the divorce is final.
* Not all life insurance is equal. If the payer is merely designating the former spouse as the beneficiary on an employer-provided plan, the policy might not be maintained if the payer loses his or her job or the employer decides to stop carrying the coverage.
Disability insurance: If the payer spouse is still employed, disability insurance is another useful tool to ensure cash flow when faced with a disability.
Annuities: An annuity can be a great way to simphiv and secure payments, but this can be expensive with certain products. If the annuity is owned by the payer, the taxable income would be offset by the alimony deduction. This can help address any concerns about smoothing out support payments, since the annuity will pay out a fixed amount of income.
5. Planning Before and After the Divorce Is Final
The case is not over when the divorce is finalized. Without proper planning, clients can get lost in the details and be caught off-guard as assets are distributed and sold. Cash flow needs can be an issue if the spouse's finances are not thoroughly analyzed. Even though a client has legal representation, the frill financial and tax picture might not have been analyzed and considered. For instance, will a client
receive mostly liquid or illiquid assets? Will there be a tax impact if the client needs to sell an asset for cash? Does the settlement agreement consider after-tax effects and provide for equitable treatment between spouses? Has the client considered that all assets are not created equal from a risk standpoint? Although the fair market value of two assets may be the same before settlement, it might not be months afterward.
As trusted advisers, CPAs can help clients better understand the divorce process and final settlement before it's too late. Legal terms are difficult for clients to understand, especially when emotions and stress are at their peak. If possible, CPAs should meet with a client throughout divorce negotiations to be sure that pertinent areas are being considered, including:
* Insurance and risk management;
* Spousal employee benefits;
* Investment management;
* Tax impact of receiving or paying alimony;
* Cash flow before and after the divorce;
* Business or property valuations;
* Retirement planning; and
* Estate planning.
Once the judgment has been finalized, the client's financial picture is likely to change dramatically. It is prudent to revisit the will, beneficiary designations, budgeting, financial plan, and future goals. The client may need a referral to a new team of professionals and will often look to his or her CPA as a trusted adviser and competent guide through these murky waters.
From Elizabeth Hutchison, CPA, CDFA; Jenifer Pratt, CPA/PFS; and Jaime Stimpson, CPA/PFS, CSEP, AKT Wealth Advisors LP, Lake Oswego, Ore.
State & Local Taxes
Federal Relief From State Tax Discrimination Against Railroads
Approximately 500 railroads operate within the United States. In spite of the many virtues of railroad technology, by the mid-1960s the U.S. railroad industry had fallen on hard times. Between 1960 and 1980 most railroads suffered from poor profitability, deteriorating infrastructure, outdated rolling stock, and a lack of investor confidence.
Discriminatory taxation of railroad property and operations by state and local governments was cited as one of the many causes of the industry's decline. In 1976, President Gerald Ford signed the Railroad Revitalization and Regulatory Reform Act (4-R Act), P.L. 94-210, which included a tax antidiscrimination provision codified as 49 U.S.C. Section 28. In 1978, this provision was amended and recodified as 49 U.S.C. Section 11503. Finally, the provision was superficially amended and recodified in 1995 as 49 U.S.C. Section 11501. This item refers to the various provisions of the tax antidiscrimination law as currently codified. This item discusses almost exclusively federal case law, but a substantial body of state case law specifically applies to Section 11501.
The Substance of the Statute
Section 11501(b) prohibits states and their subdivisions (1) from assessing rail transportation property at values with a higher ratio of assessed value to true market value than the ratio of assessed value to market value of other commercial and industrial property in the same assessment jurisdiction; (2) from levying or collecting a tax on an assessment in violation of paragraph (1); (3) from levying or collecting a tax on railroad property at a rate that exceeds the rate on commercial and industrial property in the same jurisdiction; and (4) from imposing another tax that discriminates against a rail carrier providing transportation services.
Section 11501(a) defines an "assessment" as a valuation for property tax levies; an "assessment jurisdiction" as a geographical area in a state used to determine assessed values; "rail transportation property" as property used to carry out rail services subject to the jurisdiction of the Surface Transportation Board of the U.S. Department of Transportation; and "commercial and industrial property" as property, other than transportation, farming, and timber-growing property, devoted to a commercial or industrial use and subject to a property tax levy.
Procedure and Constitutionality
Section 11501(c), notwithstanding the Tax Injunction Act (28 U.S.C. [section]1341), empowers federal district courts to enjoin states and their subdivisions from violating the provisions of Section 11501(b). Relief can be granted for assessment violations only if the rail property assessment/market value ratio is 5% greater than the commercial and industrial assessment/market value ratio. Restitution of back taxes to an aggrieved plaintiff is not authorized (Atchison, Topeka and Santa Fe R. Co. v. Lennen, 732 F.2d 1495 (10th Cir. 1984)). Because intrastate railroads are subject to the jurisdiction of the Surface Transportation Board under 49 U.S.C. Section 10501(a)(2), equitable relief under Section 11501 can be sought by shortline intrastate railroads.
States have latitude to exempt whole classes of property from taxation without running the risk of an injunction under Section 11501 because exempted property is not part of the assessed property against which discrimination is measured under the law (see Department of Rev. of Ore. v. ACF Indus., Inc., 510 U.S. 332 (1994)). States may also impose fees on railroads that are not charged to other industries without running afoul of Section 11501 if those fees essentially cover the states' costs of regulating railroads (see Union Pacific R. Co. v. Oregon Pub. Util Comm'n, 899 F.2d 854 (9th Cir. 1990)).
In general, the 11th Amendment to the U.S. Constitution bars federal courts from hearing suits brought against state governments. State governments have moved for dismissal of Section 11501 suits on 11th Amendment grounds. However, federal courts have upheld federal jurisdiction in these cases because discriminatory taxation violates the Equal Protection Clause of the 14th Amendment, and Section 5 of the 14th Amendment empowers Congress to enforce the 14th Amendment by appropriate legislation (see CSX Transp., Inc. v. New York State Office of Real Property Servs., 306 F.3d 87 (2d Cir. 2002)).
Standing to Sue
Railroads are not the only plaintiffs that can sue under Section 11501. Companies that lease specialty railroad cars to shippers can bring an action to enjoin state agencies from collecting discriminatory property taxes on their leased equipment (see ACF Indus. v. California State Bd. of Equalization, 42 F.3d 1286 (9th Cir. 1994)). It is unnecessary for a plaintiff to exhaust its state administrative remedies before bringing suit under 49 U.S.C. Section 11501 (see Union Carbide Carp. v. State Bd. (flax Cow/2'n [degrees]find., 161 F.R.D. 359 (S.D. Ind. 1993)).
De Jure and De Facto Discrimination
Federal courts have systematically enjoined state taxes on rail property that were facially discriminatory against railroads and their property (see Union Pacific R. Co. v. State Tax Comm'n of Utah, 716 F. Supp. 543 (D. Utah 1988), and General Am. Transp. Co. v. Kentucky, 791 F.2d 38 (6th Cir. 1986)). The more difficult questions arise in cases where state appraisals and practices result in arguably discriminatory effects against the rail industry.
Oversight of State Appraisal and Assessment
Some federal courts had taken the position that the methodology states employed to appraise railroad property could not be challenged by the railroads, provided the methodology was rational and not adopted to discriminate against railroad property. However, the U.S. Supreme Court in CSX Transp. Inc. v. Georgia State Bd. of Equalization, 552 U.S. 9 (2007), held that the railroads could challenge the states' appraisal methods under the 4-R Act. For a unanimous Court, Chief Justice John Roberts wrote,
We do not see how a court can go about determining true market value if it may not look behind the State's choice of valuation methods. Georgia insists there is a clear and important distinction between valuation methodologies and their application. As the State would have it, the statute allows courts to question only the latter. We find no distinction between method and application in the language of the Act, and see no passage limiting district court fact-finding in the manner the State proposes. [CSX Transp., 552 U.S. at 9.]
Federal district courts have uniformly held that the state as a whole was the proper assessment jurisdiction to compare railroad appraisals and assessments with commercial and industrial appraisals and assessments. In Burlington Northern R. Co. v. Bair, 815 F. Supp. 1223 (S.D. Iowa 1993), the court wrote,
A comparison of the assessment ratio for commercial and industrial property throughout the state with [Burlington Northern's] true market value would tend to be more reliable because of the greater number of parcels involved. In addition, all the railroads that run through Iowa would be subject to the same assessment ratio for commercial and industrial property, thus eliminating any competitive advantage or disadvantage which might result from possible uneven assessments in different counties. [Burlington Northern, 815 F. Supp. at 12411
Another Tax That Discriminates Against a Rail Carrier
Section 11501(b)(4) prohibits states from imposing any other tax that discriminates against rail carriers providing transportation. This has generally been construed to ban all types of taxes that burden the railroads more than other industries, especially state tax schemes that benefit other modes of transportation, such as airlines, trucks, or barges, at the expense of the railroad industry.
In Atchison, Topeka and Santa Fe R. Co. v. Bair, 338 N.W.2d 338 (Iowa 1983), the Iowa Supreme Court, citing what is now Section 11501, struck down an Iowa fuel tax imposed only on railroads that was dedicated to propping up the most financially troubled railroads operating in Iowa. The court first dismissed the state's argument that the only purpose of Section 11501 was to invalidate discriminatory property taxes. The court then focused on the practicalities of the intended use of the funds, such as refurbishing major portions of the bankrupt Rock Island Railroad, and that other modes of transportation would not be subject to the tax.
In Burlington Northern R. Co. v. Triplett, 682 F. Supp. 443 (D. Minn. 1988), the federal district court in Minnesota enjoined the Minnesota Department of Revenue from collecting the state's fuel tax as it was applied to railroads. The court based its decision on (1) the fact that an equal tax was applied to the truck and barge industry; (2) the taxes collected from the trucking industry were spent on the trucking industry's roadbed; and (3) the railroad industry maintained its own right of way and did not benefit at all from the funds collected.
On the other hand, in Midwest Railcar Repair, Inc. v. South Dakota Deft of Rev., 659 F.3d 664 (8th Cir. 2011), the Eighth Circuit seems to have ignored economic reality and the purpose of Section 11501 by upholding a tax that burdened railroads but not airlines. Midwest's complaint was that South Dakota's imposition of a use tax on the tangible personal property Midwest used to repair railcars, while exempting tangible personal property used to repair aircraft, violated Section 11501. The tax was upheld because the plaintiff was not sufficiently connected to the railroad industry. The decision noted that successful nonrailroad plaintiffs, such as rail car leasing companies, in prior cases were held to fall within the protection of Section 11501 because they "were in effect adjuncts, if indeed not corporate subsidiaries, of the railroads to which they provided rail cars, rather than unaffiliated enterprises that merely provided railcar repair services" (Midwest Railcar, 659 F.3d at 670).
Vigilance Against Discrimination
Railroads and their suppliers should remain on guard against state and local tax discrimination with respect to all forms of state tax law and procedure. It may be easy to identify and halt tax schemes that facially discriminate against the rail industry. However, de facto discrimination can be discovered and enjoined only with great effort.
From John Gillis, J.D., MBA, CPA, Wegner CPAs LLP, Madison, Wis.
There is no statutory limit on how much income can be pushed through the IC-DISC annually, aside from the taxable income limitation and the limitations inherent in the commission calculations.
The regulations state that the manufacturer, producer, or importer making the sale of the taxable medical device is liable for the tax imposed under Sec. 4191(a) and Regs. Sec. 48.4191-1(c).
Garza demonstrates the importance of keeping detailed contemporaneous records for business vehicles that can be used for personal purposes and observing other Sec. 274(d) substantiation requirements.
When a professional gets divorced, the value of his or her practice or business interest is usually included as a marital asset for the purposes of property distribution.
If it is later determined that the QDRO does not meet the requirements of Sec. 414(p), the participant spouse may be taxed on the distribution and subsequent payment to the nonparticipant spouse.
Editor: Michael D. Koppel, CPA/PFS/CITP, MSA, MBA
Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||on interest charge domestic international sales corporation taxation|
|Author:||Koppel, Michael D.|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 2014|
|Previous Article:||Analysis of and reflections on recent cases and rulings.|
|Next Article:||New written tax advice and other revisions to Circular 230 and their effect on CPAs.|