Although the prospect of comprehensive tax reform is top of mind for many tax advisors, the 2017 filing season is based on rules that are known and won’t change. Year-end tax planning is generally no longer available, so what can tax professionals do to get the biggest bang for their clients’ tax buck? Congress took the uncertainty out of many popular individual and corporate tax provisions and credits with the passage of the Protecting Americans Against Tax Hikes Act (PATH Act) of 2015. The PATH Act made permanent many provisions like the research and development (R&D) tax credit that in previous years were left to expire at the end of one year only to receive retroactive renewal at the end of the next. Solidifying the status of many of these provisions helped with planning in 2016.
The IRS was also busy in 2016, with many pronouncements you should be aware of when advising your clients and preparing their returns. The IRS expanded the tangible property regulations de minimis safe harbor, which allows businesses to deduct more expenses for tangible property purchases. Other IRS developments, while not affecting individuals and businesses for their 2016 year-end, will have a significant operational impact. When discussing 2016 returns, don’t miss the opportunity to discuss the proposed partnership audit changes that will require new compliance processes for partnerships and their partners and LLCs and their members. Also, the estate planning landscape may change under the new Administration. However, make sure your clients are aware of the recently proposed family valuation discount changes that could significantly affect popular estate and gift tax planning strategies.
Tax season is the perfect time for you to discuss with your business and individual clients all of their planning opportunities and potential strategies for lowering their current and future tax bills.
Individual Savings
With Charitable Contributions, the Form is Everything. Supporting your charitable contributions with the correct form is critical, as the IRS has been very aggressive in denying deductions for improper reporting without consideration of the facts. If the gift is under $250, taxpayers are expected to substantiate the deduction through a canceled check, receipt or documented communication from the charitable recipient. If the contribution exceeds $250, the taxpayer must receive from the charity a substantiation letter that includes a statement that the taxpayer received nothing of value in exchange for his contribution. If the contribution is of property (except publicly traded stock) that exceeds $5,000 in value, the taxpayer must have a qualified appraisal, by a qualified appraiser, of the value. The IRS has been particularly aggressive about its enforcement of the appraisal requirement; if a taxpayer cannot produce the appropriate letter from the charity or has not attached the qualified appraisal or summary, as needed, the IRS is likely to determine that the donation is ineligible for the tax deduction. And that is based purely on the form, regardless of whether the taxpayer can prove all of the elements of the donation when it is challenged.
Make Sure Your Clients are Gifting. The gift and estate tax, with its 40% maximum rate, can be one of the largest taxes your client is likely to pay. Implementing strategies to reduce their tax liability is essential. One of the key ways clients can reduce their gift and estate tax is through the use of the annual gift exclusion. In 2016, an individual could make a $14,000 gift tax-free to each beneficiary. Married couples can split their gifts, so they can give up to $28,000 to each beneficiary without the gift being subject to the gift and estate tax. If clients are in community property states, gifts of community property are automatically “split.” Nevertheless, preparers should always elect on the tax return to split the gift in order to eliminate the possibility that the gift was made from separate property. To minimize the recipient’s tax liability, he can roll the money into a Roth IRA or use it to pay down student loan interest.
Certain expenses paid on behalf of another person, such as tuition costs and medical expenses, will not trigger a gift and estate tax liability. Making payments directly to a provider is not considered a gift for tax purposes.
In the event a gift exceeds the annual gift exclusion amount, utilizing the lifetime transfer exemption can also lower your estate tax. In 2016, the lifetime transfer exemption is $5,450,000 per person.
Use Family Valuation Discounts While They’re Available. Family-controlled entities have frequently used minority interest and lack of marketability discounts to lower the value of ownership interests in family entities transferred to other family members. The discounts allow more wealth to be transferred to family members without being subject to gift and generation skipping transfer taxes, so they are popular estate planning tools. The minority interest and marketability discounts can be as high as 30% if taken together.
The IRS, the Treasury Department and the Obama Administration have sought to limit the use of valuation discounts in the past few years, but attempts to pass it through legislation failed. In 2016, the IRS issued proposed regulations that would eliminate the use of the discounts. The proposed regulations would disregard certain restrictions on redemption and liquidation rights that allowed family-controlled entities to use the valuation discounts. Proposed changes would also treat the lapse of voting or liquidation rights by the transferor as an additional taxable transfer if the lapse occurs within three years of transferor’s death or the entity is controlled by the transferor’s family immediately before or after the lapse.
Without the valuation discounts, business owners can give as much without triggering the estate and gift tax. Transfers would have to be reevaluated in light of the lifetime exemption of $5.45 million per person as well as the annual gift exclusion. Post-transfer appreciation of the assets the owners retain would still be included in their estates.
The comment period on the proposed regulations ended late in 2016, so the earliest the rules would go into effect would be in 2017. Check to see if your clients took advantage of the year-end window to make transfers that took advantage of the family valuation discounts, so you can report them accordingly.
Business Savings
Think Twice About Bonuses. It is not an uncommon practice for accountants to minimize the taxable income of C corporations by paying out the year-end net taxable income as bonuses to the shareholders. This tradition may have a new wrinkle in the form of the IRS disallowing the bonus deduction, reclassifying it as a dividend, and tacking penalties on top.
In Brinks, Gilson & Lione v. Commissioner, the Tax Court held that a law firm established as a C corporation was not entitled to take advantage of this time-honored tradition. The law firm, which was on the cash method of accounting, had 65 shareholder attorneys who were entitled to dividends as and when declared by the board. For at least 10 years before and including the years in issue, however, the law firm had not paid a dividend. The board intended the sum of the shareholder attorneys' year-end bonuses to exhaust book income. The law firm had invested capital, measured by the book value of its shareholders' equity, of about $8 million at the end of 2007 and about $9.3 million at the end of 2008. The Tax Court concluded that an outside investor would demand a return on his capital if he had that amount invested, and therefore the firm could not reasonably eliminate any return on investment by making bonus payments. The law firm conceded, and the Tax Court tacked on some hefty penalties. The take-away from this case is that tax professionals should be very judicious as to how they advise companies in paying bonuses to zero out business income.
And make sure in any case where bonuses are paid by the March 15 deadline that they qualify for the 2016 deduction. The IRS has come down very hard on bonus plans that do not satisfy the letter of the law. For example, the IRS released advice which digs deep into the nuances of employee bonus plans and how easily they can fail to establish a fixed liability by year end, thus delaying the deduction for the bonuses until the year in which they are paid. The bonus plans discussed in this ruling were largely formula driven, yet each of them was subject to some action after year end that caused them to fail the "all-events test":
Reservation of Right to Modify or Cancel Bonuses – Even if a bonus plan contains a fixed formula for determining the amount of employee bonuses, if under the bonus plan the employer reserves the right to unilaterally modify or cancel the bonuses prior to payment, the employer has no legal obligation to pay the bonuses and, thus, they are not deductible until actually paid to the employees.
Required Approval of Bonuses – Even if an employee bonus plan is based on numerical targets that are established during the year in which the services are performed, if the calculated bonuses still must be approved by the board of directors or a compensation committee before they can be paid, and that approval does not take place until after year end, the bonuses are not deductible until they are paid. The IRS concluded that since the board or committee already approved the numerical targets used in the bonus computations, the fact that they still must approve the bonuses themselves before they can be paid suggests that the approval is not a mere formality or ministerial act.
Bonuses Based on Performance Appraisals – If some portion of the pre-established bonus formula is based on the employees' individual performance scores, and those performance scores are based on individual performance appraisals that are not completed until after year end, then the fact of the liability has not been established by year end (because a performance score of zero would yield a bonus of zero), nor has the amount of the liability been determined by year end.
Remember the Expanded Safe Harbor in the Tangible Property Regulations. The de minimis safe harbor election under the final tangible property regulations allows businesses to deduct expenses for tangible property that they would have otherwise had to capitalize. Businesses using the safe harbor can deduct, up to a set threshold, tangible property expenses or items with an economic useful life of less than 12 months.
For businesses with audited financial statements, the de minimis safe harbor threshold is $5,000 per item or invoice. For businesses without an audited financial statement, the de minimis threshold had been $500. The IRS recognized the $500 threshold was too low, so in late 2015, it released IRS Notice 2015-82, increasing the de minimis threshold to $2,500.
To take advantage of the de minimis safe harbor, taxpayers must have had an accounting policy in place at the beginning of the tax year to expense items beneath a threshold. If the company’s policy is to expense items at a threshold that is lower than the de minimis safe harbor election, it will only be able to expense items beneath that lower threshold. Businesses must also be able to demonstrate they follow that capitalization policy in their books and records. If businesses meet both of these conditions, they can make the de minimis safe harbor election on their federal tax return.
Businesses had the opportunity to maximize the de minimis threshold in 2016 if they followed their capitalization policy on a per-invoice or per-item basis. The expanded threshold provides additional opportunities for tax deductions for assets such as computers, tablets, smart phones and high-end office furniture.
Cost Segregation Studies. Cost Segregation studies provide a unique opportunity for post-year-end tax planning. As long as the study applies to property placed in service during open years, amended returns provide the possibility of refunds for your clients. And make sure you talk to clients about having a cost segregation study performed on newly constructed, renovated or recently acquired buildings.
Cost segregation studies classify tangible property and building improvements from their typical 39-year depreciable lives into shorter depreciable lives. Evaluating your tangible property and improvements in this manner presents an opportunity to accelerate certain depreciation deductions, some of which will be decreasing after 2017.
It is critical to have a cost segregation study performed in a year when your taxable income can withstand the accelerated deductions. Tax rates did not increase significantly in 2016, which makes it a good time to take advantage of a cost segregation study.
Maximize Bonus Depreciation and 15-Year Straight Line Depreciation. Businesses have the opportunity to take deductions for property placed in service during the year and for certain property improvements. Long-term planning for these deductions had been difficult because the 15-year straight-line depreciation and bonus depreciation provisions were some of the tax provisions that were in danger of expiring each year. Both received a renewal from the PATH Act; the 15-year straight-line rule was permanently extended and the bonus depreciation provision was extended through 2019.
Certain expenses are no longer subject to a 39-year depreciable life and instead benefit from a straight-line 15-year depreciation period. Eligible expenses include three types of property: qualified leasehold improvements, qualified restaurant property and qualified retail improvement property.
Qualified restaurant property includes a building and any building improvements if more than 50% of the building’s square footage is related to the preparation of and seating for consumption of prepared meals. Qualified retail improvement property includes improvements to the interior portion of a building made more than three years after the building was first placed in service, where such building is open to the public and used in a retail trade of business or selling of personal tangible property.
Qualified leasehold improvements must be made to the interior portion or structural component of non-residential real property made pursuant to a lease. The improvement must have been made more than three years after the building was first placed in service and the lease for the property cannot be between related persons.
The bonus depreciation deduction for qualified leasehold improvement property is replaced with a bonus deduction for “qualified improvement property” made to the interior portion of a nonresidential building, whether or not the building is subject to a lease. Qualified improvement property is the same as qualified leasehold improvement property, discussed above, except that qualified improvement property need not be placed in service (a) pursuant to the terms of a lease or (b) more than three years after the improved building was first placed in service. In addition, qualified improvement property may include structural components that benefit an internal common area.
Bonus depreciation provisions also apply to new tangible personal property and off-the-shelf computer software. In 2016, businesses can deduct 50% of the basis of qualifying property placed in service during the year. Under the PATH Act, the bonus depreciation amount is 50% through 2017, but in 2018 it decreases to 40%, and in 2019 it will be 30%.
To maximize the bonus depreciation and 15-year straight-line depreciation option, businesses should be evaluating their improvement projects. Qualified improvements made before the end of 2017 can maximize the benefits of the two offerings.
Don’t Forget the Domestic Production Activities Deduction. The Section 199 Domestic Production Activities Deduction (DPAD) offers a 9% deduction that can offset regular and alternative minimum tax liabilities. Businesses apply the so-called “manufacturer’s deduction” to the lesser of the qualified production activities income or their taxable income. Deductions cannot exceed 50% of the W-2 wages related to a company’s domestic production activities, nor can companies with current net losses use the DPAD.
Companies looking to use the DPAD should approach the deduction with care. Determining the types of activities that qualify for DPAD can be challenging because the IRS has not provided specific guidance on what constitutes manufacturing and production activities; however, many companies have been successful with activities that might not at first blush seem like they would be eligible.
Generally, qualifying activities include the:
• Manufacture, production, growth, extraction, installation, development, improvement or creation of qualifying production property (tangible personal property) by a taxpayer either in whole or in significant part within the United States;
• Construction or substantial renovation of real property in the U.S., including residential and commercial buildings and infrastructure, such as roads, power lines, water systems and communications facilities;
• Engineering and architectural services performed in the U.S. relating to the construction of real property;
• Farming of agricultural products and food; and
• Processing of agricultural products and food (but not the sale of food and beverages prepared by the taxpayer at a retail establishment).
Results from court cases and guidance released by the IRS Chief Counsel provide some additional guidance. Retail pharmacy photo processing activities qualify for the DPAD. Electronic book publishing activities do not. Gift basket production qualified, but producing items that repackage other items, direct mail advertising and traditional billboards generally do not.
The Partnership Audit Rules Are Coming! Partnerships and LLCs need to take a very close look at the new partnership audit rules passed under the Bipartisan Budget Act of 2015. The 2015 legislation repeals the TEFRA unified partnership audit procedures and special rules relating to electing large partnerships (ELPs) and establishes new provisions. These new rules will require amendments to virtually every partnership and LLC agreement in existence, and any new partnership or LLC should incorporate provisions affected by these rules.
Congress changed the rules because of the increase in the number of partnership tax returns filed each year, the administrative challenges to conducting an IRS examination under the old rules and the disproportionate amount of large partnerships being audited compared to corporations. Historically, smaller partnerships — those with 10 or fewer partners — usually were audited through the partnership’s individual partners. Partnerships with more than 10 members were audited using the TEFRA procedures, and partnerships with more than 100 could elect for ELP treatment.
With the new rules, partners and partnerships will follow a unified and streamlined regime. The general rule will now be that the assessment and collection of underpaid taxes, penalties and interest will occur at the partnership level. Several alternatives to the default rule are available and will require careful consideration on a case-by-case basis. Partners must report partnership items consistently on their individual returns; if there are differences between the two returns, the partner must disclose them and the reason for the discrepancy.
Partnerships with less than 100 partners (determined by the number of Form K-1s issued by the partnership) can choose to opt out of the new partnership rules. To do so, each partner must be an individual, C corporation, any foreign entity that would be treated as a C corporation if it were domestic, S corporation or estate of a decreased partner. That means that partnerships with other partnerships as partners are ineligible. Opting out generally means that the partners and the partnership will be audited using the pre-TEFRA regime involving separate audits of the individual partners.
Don’t Fall into the Partner Self Employment Tax Trap. Self-employment taxes are generally applied to the net earnings from an individuals’ trade or business. In the partnership context, distributions to a limited partner from a limited partnership are generally not subject to self-employment tax, except to the extent of guaranteed payments. Because LLC members have limited liability similar to limited partners, there has been confusion about whether and to what extent distributions are subject to self employment tax. A recent opinion from IRS Chief Counsel found that members of an investment management firm LLC taxed as a partnership are subject to self employment taxes on all of the amounts distributed to them.
The case involved a management firm that served as the investment manager for funds set up as limited partnerships. Investors in the limited partnership funds were considered passive limited partners. The management fund served as the general partner and managed the funds’ investment activities. Members of the management firm LLC provided management services to the fund and received distributive shares from the management firm for the services they provided managing the funds’ assets. The management firm did not receive distributive shares from the funds themselves; rather, its income was derived from management fees for the funds.
The IRS found that the investment firm’s LLC members were being compensated as part of their trade or business, and as such, their partnership distributions from the management firm should be taxed. In Rev. Rul. 69-184, the IRS stated that a partner who provides services to the partnership is a self employed individual rather than an employee of the partnership. Also, the Tax Court reached a similar conclusion in the context of a limited liability partnership operating as a law firm in Renkemeyer, Campbell, and Weaver LLP v. Commissioner, 136 TC 137 (2011).
Although the IRS proposed regulations to better define who qualifies as a limited partner (and therefore which distributions would be exempt from self employment tax), the proposed regulations were never finalized, making the treatment of LLC member distributions somewhat of a gray area. That being said, it is evident, at least in the context of an LLC whose members’ services provide the bulk of the income, that the IRS and the Tax Court believe that 100% of the income allocable to the members is subject to self employment tax.
Bill Smith is a Managing Director with CBIZ MHM National Tax Office. He consults nationally on a broad range of tax services, including foreign and domestic transactional tax planning for corporations, partnerships, LLCs and individuals.
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