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If you are like the most of us – you have heard the term “Captive Insurance Company,” but have no idea what it means or how it works.  Most companies I deal with think they are “too small” to create a captive.  Well, not too fast – many middle market companies have reaped the benefits of creating a captive.  Discussed below, is a high-level summary of some of the benefits your business can obtain.

The use of captives is one of the best-defined strategies for closely-held and middle market companies.  They can provide a wide array of benefits for clients including lower insurance costs, improved risk management, diversified profits and tax planning opportunities.

Captives have generated much attention due to recent legislation allowing their formation in many states.  In addition, captives have been the subject of favorable rulings from regulatory agencies such as the Internal Revenue Service.

A captive is a legally bona fide insurance company.  It insures the risks of operating companies with which it shares common ownership.

Capture

Following are some of the benefits of implementing a captive insurance company:

  • Improved Insurance Program- The ability to customize a program to the operating company’s needs can result in (i) reduced costs; (ii) better claims management; (iii) stabilization of insurance rates; and (iv) the purchase of insurance at “wholesale” rates.
  • Enhance Tax Planning Opportunities

o    Income Tax. The operating company receives a deduction for bona fide insurance premium paid.  The captive receives this premium as income, but does not pay tax on it under the Code, provided those premiums are less than $1.2 million annually per captive.  The net result is that the captive converts taxable income to non-taxable income, less associated expenses and claims.

o    Estate and Gift Tax. The captive is not subject to estate or gift tax when properly structured.  Consequently, the value can pass to heirs without those taxes.

  • Improve Financials- The captive has appreciable expense and tax management benefits.  Provided the structure is compliant with any bank covenants, the overall financial solvency of Client should be improved.

Steve Talkowsky

 

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One of the questions asked most often from clients is whether they can currently deduct improvements to their property or must they capitalize and deduct ratably over many years.

In September, 2013, the IRS provided guidance when they issued the New Tangible Property Regulations (T.D. 9636). The regulations are applicable to tax years beginning on or after January 1, 2014.

Under the regulations dealing with improvements, an expenditure must be capitalized if it meets any of the “BAR” tests. That is, the expenditure results in a betterment to the unit of property, adapts the unit of property to a new or different use, or results in a restoration of the unit of property.

Betterment – an expenditure results in a betterment if it ameliorates a condition or defect that existed before the acquisition of the property or arose during the production of the property; is for a material addition to the property; or increases the property’s productivity, efficiency, strength, etc.  For an example of an amelioration of a pre-existing condition assume in Year 1, “A” purchases a store located on a parcel of land that contains underground gasoline storage tanks left by prior occupants.  The tanks had leaked prior to “A’s” purchase, causing soil contamination.  “A” is not aware of the contamination at the time of purchase.  In Year 2, “A” discovers the contamination and incurs costs to remediate the soil.  The remediation costs are for a betterment to the land because “A” incurred the costs to ameliorate a material condition or defect that existed prior to “A’s” acquisition of the land.

Adapts - An expenditure results in an adaptation to a new or different use if it adapts the unit of property to a use inconsistent with the taxpayer’s intended ordinary use at the time the taxpayer originally placed the property into service.  For an example of an adaptation to a new or different use, assume “A” is a manufacturer and owns a manufacturing building that it has used for manufacturing since Year 1, when “A” placed it in service.  In Year 30, “A” pays an amount to convert its manufacturing building into a showroom for its business.  To convert the facility, “A” removes and replaces various structural components to provide a better layout for the showroom and its offices.  The amount paid to convert the manufacturing building into a showroom adapts the building structure to a new or different use because the conversion to a showroom is not consistent with “A’s” ordinary use of the building structure at the time it was placed in service.  Therefore, “A” must capitalize the amount paid to convert the building into a showroom as an improvement to the building.

-  Restoration - An expenditure results in a restoration of an asset if the expenditure (1) restores basis that has been taken into account (e.g., as a loss or in computing gain or loss); (2) returns the unit of property to working order from a state of nonfunctional disrepair; (3) results in a rebuilding of the unit of property to a like-new condition after the end of the property’s alternative depreciation system class life; or (4) replaces a major component or substantial structural part of the unit of property.  For an example of a restoration, assume “A” owns a manufacturing building containing various types of manufacturing equipment.  “A” does a cost segregation study of the manufacturing building and properly determines that a walk-in freezer in the manufacturing building is section 1245 property as defined in section 1245(a)(3).  Several components of the walk-in freezer cease to function, and “A” decides to replace them.  “A” abandons the old freezer components and properly recognizes a loss from the abandonment of the components.  “A” replaces the abandoned freezer components with new components and incurs costs to acquire and install the new components.  “A” must capitalize the amounts paid to acquire and install the new freezer components because “A” replaced components for which it had properly deducted a loss.

Please note that the expenditure is tested against all the BAR tests.  As such, if an expenditure does not constitute a betterment, the taxpayer may still have to capitalize it as an adaptation to a new use or as a restoration.  Expenditures on existing assets that do not meet the BAR tests are generally deductible repairs.

 

David Poillucci/Darren Thomas

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(Continuation from previous blog post…)

Despite the previously discussed requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation.  An exception to this default treatment is for real estate professionals, which will be discussed in my next blog post – Stay Tuned!

Would I make a grouping election?  The passive versus nonpassive status is largely non elective and is generally determined by actual participation of the owner in the activity. A voluntary reduction or increase in time spent in certain activities by owners can serve to change the classification of an activity to or from a passive activity. Another way of voluntarily changing the classification is to make a make grouping election to treat a passive and nonpassive entity as one combined entity for purposes of meeting the material participation rules.  This grouping election under Reg. Section 1.469-4 is for grouping one or more trade or business activities or rental activities as one single activity for purposes of meeting a material participation test. The grouped activities must constitute an appropriate economic unit.  Factors that support this definition include:

  • Similarities and differences in types of trades or businesses;
  • The extent of common control;
  • The extent of common ownership;
  • Geographical location; and
  • Interdependencies between or among the activities

So, for example, if you wished to group two activities, one in which an owner materially participates and the other in which he does not, the grouped single activity will be treated as a material participation activity, or nonpassive, to the owner.  However, there is an important limitation on grouping rental activities with other trade or business activities. A rental activity may not be grouped with a trade or business activity unless the activities being grouped together constitute an appropriate economic unit and

-The rental activity is insubstantial in relation to the trade or business activity;

-The trade or business activity is insubstantial in relation to the rental activity; or

-Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.

A grouping election under Reg. Section 1.469-4 must be reported on the tax return and the grouping cannot be changed in subsequent years unless the original grouping was inappropriate or a material change in facts and circumstances makes the grouping inappropriate. However, because the new net investment tax applies to activities which are passive, the regulations allow a “fresh start” for making a new grouping election starting in 2014, but a change to an existing grouping election can also be made in 2013 if the client is subject to the net investment tax in 2013.

Does the Net Investment Income Tax apply to a self-rental activity?

The self-rental rules were discussed frequently this tax prep season and given a fresh look because of their applicability to the new net investment income tax. If property is rented for use in a trade or business activity in which the taxpayer materially participates, the net income from the rental activity is considered a “self-rental” and that income is recharacterized as nonpassive. If the rental activity generates a net loss for the tax year, the income is not recharacterized and remains passive. Thus, the treatment can change from year to year. The treatment of the income or loss as nonpassive or passive retains the same character for net investment income tax purposes.

These questions will continue to be asked and examined for next filing season as we continue to get comfortable with the net investment tax.  Although the rules are not new, they have definitely been brought to light due to the new tax and the necessity to determine an activity’s classification as passive or nonpassive.  Of course, the above explanations are fairly general explanations for some very complicated tax areas that need to be read through thoroughly when dealing with these issues.

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As I recover from the latest busy season, I took time to reflect on what was the most common question I was asked.  Not surprisingly, it dealt with the material participation standards under Section 469 and the interplay with the net investment income tax under Section 1411

Although material participation rules are hardly new, they were given added importance with the introduction of the new net investment tax this filing season.  This new tax forced many of us to reexamine with our clients, their participation throughout the year in business entities in which they own an interest.  To complete the new Form 8960 we needed to go through the exercise of putting various ownership interests into separate buckets of nonpassive activities and passive activities, that is, activities in which the taxpayer materially participates or does not materially participate. This lead to further discussion on issues that we have always had to deal with such as passive loss limitations, grouping elections, self-rental rules and the real estate professional exception. Various common questions arose and are discussed in general below:

Is this activity passive or nonpassive?  Usually this question arose in the context of whether or not the activity was subject to the new net investment tax.  But, the answer tends to be more important for the reason for which the rule was first enacted: to limit the allowance of passive losses to the amount of passive income for the year.  A passive activity is defined in IRC 469(c) as the conduct of a trade or business in which the taxpayer does not materially participate.  A nonpassive activity is one that is not passive, and, therefore, one in which the taxpayer materially participates.  So, meeting the requirements for material participation is key to this determination.  Material participation is briefly defined in IRC Section 469(h) as involvement in the operations of an activity on a basis which is regular, continuous and substantial.  The Temporary Regulations under Reg. 1.469-5T enumerate seven tests, any one of which can be met to satisfy material participation in an activity:

1) The individual participates in the activity for more than 500 hours during such year.

(2)The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3)The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4)The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5)The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6)The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7)Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

Stay tuned for more in part 2 next week…

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A new chapter was added to the ongoing dispute as to whether student athletes should be compensated for (i) the part they play in helping their respective schools generate millions of dollars in revenue from ticket sales and the use of their individual player likenesses, and (ii) the predominant amount of time that is spent as an athlete as opposed to a student.  It is a deeper issue than simply framing it as “pay for play”, but that discussion is one for another day …

What is important for our purposes is that the National Labor Relations Board (“NLRB” or the “Board”) recently ruled Northwestern University’s scholarship football players (differentiated from walk-on players) are “employees” under the National Labor Relations Act (the “Act”), and as such, have the right to unionize for collective bargaining purposes.

The Board’s ruling will be appealed, so the practical application of this unionization right and the resulting sub-issues from the decision will be delayed as of this writing.  However, there are theoretical tax matters that will play a part in the debate, and that could emerge if student-athletes are in-fact deemed “employees”.  Furthermore, the reasoning that the NLRB used to reach its conclusion that student-athletes are “employees” may also be the basis for which student-athletes would be taxed.

Without going into extensive detail, the NLRB determined that the Northwestern football players receive the substantial economic benefit of a scholarship in exchange for performing football-related services, under what amounts to be a contract-for-hire.  Additionally, the Board made note of the extensive amount of control that the football coaching staff and University have over the players, and that if team rules are broken, scholarships can be revoked:

  • NCAA rules prohibit players from receiving additional compensation or otherwise profit from their athletic ability and/or reputation, so scholarship players are dependent on their scholarships to pay for basic necessitates, including food and shelter;
  • Players devote 40-60 hours per week for football, depending on whether it is in-season versus the off-season, despite the NCAA’s prescribed limitation of 20 hours per week once the academic  year begins;
  • Coaches control living arrangements, outside employment, the ability to drive personal vehicles, travel arrangements off-campus, social media, use of alcohol or drugs, and gambling;
  • Players also are sometimes unable to take courses in certain academic quarters because they conflict with scheduled team practices.

At this point it is not entirely clear what student-athletes would be taxed on because if the decision is ultimately affirmed, there could be conflicting definitions and concepts in the tax code with respect to “gross income”, “compensation for services” and “qualified scholarships.”

For income tax purposes, “gross income” means all income from whatever source it is derived, and this includes compensation for services.  Until now student-athletes have not been considered employees, which is essentially why their scholarship (or parts of) have not previously been taxed.  But the NLRB went to great lengths to detail how the Northwestern football players currently receive compensation for playing football (the reason it saw fit to classify them as employees).  On that same basis, the IRS would likely take the position that the granted scholarships are compensation for services, and are thus taxable income to the student-athletes.  Whether the current statutory language would have to be amended or exclusions would have to be created to properly allow for this taxation is a secondary issue.

Yet there are other benefits the Northwestern football players have cited which they feel would outweigh the negative impact of taxes they might incur.  If the decision is upheld, players might be able to qualify for workers’ compensation benefits as a result of injuries suffered on the field.  Moreover, instead of coaches having unilateral control over the schedules and rules players must abide by at the risk of losing scholarships, the union the players could form would bargain with the university over “working conditions”.  This would be similar to the way in which the NFL and MLB players’ unions bargain for benefits of their respective players.

However, rights that are bargained for by this theoretical union could lead to further questions for the university.  For example, if players successfully bargained for health benefits, Title IX (which demands equal treatment of male and female athletes) might require equivalent benefits to all of the other athletic programs on campus.  Conversely, bargained-for benefits such as safer football helmets or equipment would not necessitate comparable action on the part of the school.

The NLRB ruling in the Northwestern case is restricted to private universities, meaning efforts by student-athletes of state schools would be governed by each state’s laws on unions of public employees.  However, this decision is an initial step in what will be a lengthy process that ultimately could re-shape the National Collegiate Athletics Association (“NCAA”) … and tax issues will most certainly have a substantial impact along the way.

CJ Stroh, Esq.

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When the calendar turns to mid-March and tax season makes the leap from annoying to soul-crushing, I spend more time than I should daydreaming about goin’ all Walter White and breaking bad, only instead of cooking meth, I’d use my well-honed number-crunching skills to become an underground bookie.

Oh, what a life it would be. Instead of spending March Madness in a tiny office cranking out tax returns, I’d spend it in a giant war room complete with wall-to-wall flat screens, building my riches on the failed dreams of student athletes. I’d work the phone better than Gordon Gecko, avoiding detection by using subversive colloquialisms like “unit” and “juice.” I’d threaten to break thumbs with impunity. And I’d make money. Lots and lots of money. Because the house never loses.

The house doesn’t lose because it is (generally) indifferent to who the bettors favor. Not to get into Gambling 101, but if you bet $100 on the Seahawks + 2 ½ in the Super Bowl, you won $100, But if you bet $100 on the Broncos to cover the 2 ½ points (sucker), you lost $110. The $10 the loser pays over and above the wagered amount is the “vig.”

Thanks to the vig, bookies generally don’t care who people are betting on, as long as the bets are fairly even on both sides. And of course, bookies have the advantage of being able to move the line to make sure this happens.

When it comes to horse racing — which in my bookie fantasy world, I will  occasionally dabble in but not invest heavily – the house has an added level of protection in the form of “parimutuel wagering.” It works like so:

The entire amount wagered on a particular race is referred to as the betting pool or “handle.” The pool can then be managed to ensure that the track receives a share of the betting pool regardless of the winning horse. This share of the betting pool that the track keeps for itself is often referred to as the “takeout,” and the percentage is driven by state law, but generally ranges from 15% to 25%.

The takeout is then used to defray the track’s expenses, including purse money for the winning horses, taxes, licenses, and fees. The takeout can also be used, if needed, to cover any shortfall in the amount necessary to pay off winning bettors. To the extent any excess takeout remains after covering these two classes of obligations, the track has profit.

Once the betting pool has been reduced by the takeout, the balance is generally used to pay off any winning wagers, with the excess, once again, representing profits. Great business model, isn’t it?

Yesterday, an enterprising CPA with a raging gambling habit threatened to strike a blow for bettors everywhere when he took on the IRS in the Tax Court and argued that the portion of his wagers attributable to the “takeout” were deductible without limitation. But before we can understand the significance of the case, we need to understand some basics about the taxation of gambling.

Treatment of Gambling Expenses, In General

Section 165(d) provides that “losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.” Generally, any winnings are reported on page 1 of the Form 1040, while the losses (but only to the extent of winnings) must be claimed as itemized deductions. Thus, if a bettor is one of the 66% of Americans who don’t itemize their deductions, they would effectively be whipsawed – they would be forced to recognize the gambling income, but would receive no benefit from the losses.

Section 162, however, generally allows a deduction for “all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.”

Putting these two provisions together, many bettors have taken the position that if their gambling activities are so frequent, continuous and substantial as to rise to the level of an unhealthy addiction a Section 162 trade or business, then gambling losses are deductible as Section 162 business expenses, and are not subject to the loss limitations imposed by Section 165(d). In their view, if the gambling activity constitutes a business, because the losses (along with the gains) should be reported on Schedule C, rather than itemized deductions, the losses should be permitted in full.

The courts have repeatedly shot this theory down, holding that even a professional gambler who properly reports his activity on Schedule C may only deduct losses to the extent of gains.

In a very important 2011 decision out of the Tax Court, however, the court held that while gambling losses are limited to the extent of gambling winnings, any non-loss expenses of a professional gambler engaged in a trade or business – items like automobile expenses, travel, subscriptions and handicapping data – are not subject to the Section 165(d) limitation. Thus, a professional gambler could reduce his winnings to zero by his losses, and then further deduct any non-loss business expenses, generating a net loss from the activity. (See Mayo v. Commissioner, 136 T.C. 81 (2011).)

And that brings us back to our gambling CPA.  In Lakhani v. Commissioner, 142 T.C. 8 (2014), settled yesterday, an accountant/prolific track bettor made the compelling argument that his portion of the track’s “takeout expenses” represented non-loss business expenses rather than gambling losses, and were thus deductible without limitation. The taxpayer posited that by extracting takeout from the taxpayer’s wagers and using those funds to pay the track’s operating expenses, the track was acting in the capacity of a fiduciary. The taxpayer further likened the process to that of an employer who collects payroll taxes from his employees and remits them to the IRS and state agencies. Stated in another manner, the taxpayer argued that he was paying the operating expenses of the track, with the track acting as a conduit by collecting the takeout and using the funds.

Based on this position, the taxpayer argued that he was entitled to non-loss gambling business deductions in excess of $250,000 between 2005 and 2009.

The IRS disagreed with the taxpayer’s argument, countering that because the takeout is paid from the pool remaining from losing bets, “it is inseparable from the wagering transactions,” and thus constitutes wagering losses that are subject to the limits of Section 165(d). Furthermore, the Service argued that the taxpayer could not deduct business expenses for amounts paid from the takeout by the track for taxes, fees, and licenses, etc… because these were expenses owed by the track, not the individual bettor.

The Tax Court sided with the IRS, holding that the taxpayer’s share of the takeout expenses represented wagering losses that could only be deducted to the extent of winnings under Section 165(d). In reaching this conclusion, the court differentiated between an employer remitting payroll taxes on the behalf of an employee and a track using takeout funds to pay its operating expenses.

The employee, the court stated, is ultimately responsible for his share of the payroll taxes on his wages, and it is the remittance of these taxes by the employer that discharges the employee of this obligation. To the contrary, at no point are the expenses of the track imposed on the individual bettor; they are always obligations of the track. The tracks use of the takeout to pay its expenses, the court stated, does not discharge any obligation of the bettor.

As a result, the court concluded that because the track’s expenses were never an obligation or expense of the bettor, the takeout could not qualify as the bettor’s business expense. Instead, the takeout represented an additional gambling loss by the taxpayer, and could only be deducted – when added to his other losses – to the extent of his winnings.

follow along on twitter @nittigrittytax

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Earlier today, House Ways and Means Committee Chairman Dave Camp released his long-awaited and highly anticipated proposal for tax reform. The proposal promised to present the most thorough, sweeping changes to the law since the 1986 Act, and it didn’t disappoint.

Before we begin our analysis of the plan let me start by saying that while I clearly admire Chairman Camp for his tireless push to simplify the industry in which I ply my trade, I’d be remiss if I didn’t point out the irony that in the tax world, even a proposal for “simplification” stretches to nearly 1,000 pages.

Because there’s so much to take in, we’ll be separating our analysis into two parts

Part 1: Proposal for individual tax reform

Part II: Proposal for business tax reform

Let’s get to it with Part 1, Chairman Camp’s proposal for individual tax reform.

Streamlining of Individual Income Tax Rates

Current Law

Effective January 1, 2013, we now have seven income tax rates that are applied against so-called “ordinary income,” (i.e. income from wages, business income, interest, etc…): 10%, 15%, 25%, 28%, 33%, 35%, and a top rate of 39.6%. If you’ve ever wondered how efficient this type of structure is, consider that in 2013, the 35% rate was only applied on single taxpayers with incomes in excess of $398,351 but less than $400,000. Yes, we had a tax bracket that was $1,649 wide.

Because our tax system is a progressive one, taxpayers don’t pay a flat rate of tax on all earned income; rather, as income increases, so does the tax rate applied to the income. Thus, when someone proclaims that they are in the “39.6% bracket,” that does not mean they paid 39.6% on all of their income; rather, it means they paid 39.6% on their last dollar of income. It also means that they are likely insufferable.

No matter how you slice it, a system with seven brackets – and a high of nearly 40% — is far from ideal.

Camp Solution

Camp’s proposal would consolidate the current seven brackets into three, consisting of 10%, 25%, and 35% rates. Generally, the new 10% rate would replace the old 10% and 15% brackets, meaning it would cover all income earned up to approximately $73,800 if married, $36,900 if single (for simplicy’s sake, from this point on I will refer to married versus single thresholds or limitations like so: $73,800/$36,900).

The new 25% bracket would replace the former 25%, 28%, 33% and 35% brackets, meaning single taxpayers with taxable income between $36,900 and $400,000 would pay a 25% rate on that income, while married taxpayers with taxable income between $73,800 and $450,000 would pay a 25% rate on that income.

If you happen to earn taxable income in excess of $450,000/$400,000, then you will pay a rate of 35% on the excess, as opposed to 39.6% under current law.

Excluded from this top rate of 35% — meaning it would be taxed at a top rate of 25% — would be any income earned from “domestic manufacturing activities,” which is defined as “any lease, rental, license, sale, exchange, or other disposition of tangible personal property that is manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States, or (2) construction of real property in the United States as part of the active conduct of a construction trade or business.”

Click here to read the rest on Forbes

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