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Correcting a Misconception About Obamacare

Posted in Uncategorized, tagged , , , on October 3, 2012 | 1 Comment »

So last night, as I was trolling the Drudge Report for the latest in election news and teacher-student sex scandals, I noticed an article tilted “These are the Top 5 Worst Taxes ‘Obamacare’ Will Impose in 2013.”

Apparently, the list was first authored by the Grover Norquist-founded Americans for Tax Reform, a Section 501(c)(4) lobbying group that opposes “all tax increases as a matter of principle.”

In running through the list, I came upon #2: The ‘Obamacare’ ‘Haircut’ for Medical Itemized Deductions, which read as follows:

Currently, those Americans facing high medical expenses are allowed a deduction to the extent that those expenses exceed 7.5 percent of adjusted gross income (AGI). This tax increase imposes a threshold of 10 percent of AGI. By limiting this deduction, Obamacare widens the net of taxable income for the sickest Americans. This tax provision will most harm near retirees and those with modest incomes but high medical bills.

This, as you might expect, led to a spate of misspelled, grammatically incorrect reader comments about how Obamacare unfairly punished the elderly. There’s just one problem with this sentiment: it’s not accurate.

Yes, Section 213(a) of the Code was amended to increase the AGI threshold from 7.5% to 10% starting in 2013, meaning taxpayers will now have to generate medical deductions in excess of an extra 2.5% of their adjusted gross income before they begin reaping tax benefits. This much is true. But when the Americans for Tax Reform write — This tax provision will most harm near retirees  – and readers pile on by decrying President Obama’s willingness to screw over the elderly —  it tells me that these people didn’t actually read the new law.

Had they bothered to continue reading a few lines further into Section 213, they would have discovered that Section 213(f) was also amended, and it now provides:

(f) Special rule for 2013, 2014, 2015, and 2016.
In the case of any taxable year beginning after December 31, 2012, and ending before January 1, 2017, subsection (a) shall be applied with respect to a taxpayer by substituting “7.5 percent” for “10 percent” if such taxpayer or such taxpayer’s spouse has attained age 65 before the close of such taxable year.

In other words, the increase to the AGI threshold will not, as the AFTR’s report states, harm near retirees or the elderly, because for the next four years, the AGI threshold is not increased if either the taxpayer or the spouse is over 65. For all of those 65 and over in 2013, their medical expenses will be treated the exact same way in they were in 2012. And let’s be honest, in today’s economy, if you’re retiring before 65, you’ve got enough money that your medical expenses probably aren’t going to exceed 7.5, 10, or even 30% of your adjusted gross income.

Now that I’ve addressed that tiny bit of legislative minutiae and done my part to stem the spread of tax misinformation among people who are so rational they are still calling for the President’s birth certificate four years after his election, I can rest knowing that I’ve left the world a slightly better place.

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Supreme Court Declines to Hear Watson, A Critical Case on S Corporation Reasonable Compensation

Posted in Uncategorized, tagged , , , , , , , , , on October 2, 2012 | 3 Comments »

Yesterday, the Supreme Court of the United States denied certiorari to a tax case on an issue of first impression from the U.S. Court of Appeals for the Eighth Circuit — David E. Watson P.C. v. U.S., 668 F.3d 1008 (8th Cir., 2012).

You may remember Watson from our previous discussion here, or from this brilliantly written article in the Tax Adviser. Either way, Watson directly impacts tax advisors as it provides a long-awaited roadmap for quantifying a “reasonable compensation” amount for shareholder/employees in personal service S corporations.

Background

In late 2010, an Iowa district court held that David Watson, a partner with a CPA firm who paid himself only $24,000 in annual salary while taking out over $200,000 in annual distributions, had avoided payroll taxes by failing to pay himself reasonable compensation. Because Watson actually reported some compensation, however, the court was facing an issue of first impression: determining just what constituted “reasonable compensation” for Watson’s services. The resulting analysis provided the first court-approved roadmap for tax advisers to use in setting appropriate salary amounts for their S corporation shareholder-employee clients.

In setting Watson’s salary, the IRS engaged the services of a general engineer, who first sought to determine the health of Watson’s CPA firm. By analyzing financial ratios published by the Risk Management Association — particularly profits/sales and compensation/sales – the engineer found that Watson’s firm was very healthy, and that compared to similarly healthy firms, Watson’s compensation was unreasonably low.

The court then looked internally at Watson’s firm, noting that Watson was paid less than those subordinate to him. In fact, Watson’s salary was less than what the firm was paying recent college graduates.

Finally, to quantify the appropriate salary, the engineer utilized MAP surveys conducted by the AICPA, which indicated that the average non-owner director of a CPA firm the size of Watson’s would be paid $70,000. The engineer then grossed up this salary by 33% to account for Watson’s stake as a shareholder, resulting in “reasonable” compensation of $93,000 for each of 2002 and 2003.

The District Court agreed, citing Watson’s experience, expertise, and time devoted to his role as one of the primary earners at a well-established firm.

In February 2012, the Eighth Circuit Court of Appeals affirmed the District Court’s decision. Watson appealed once more to the Supreme Court, but saw that dream die yesterday.

With Watson apparently in the books as concluded tax law, now is an appropriate time to remind ourselves what we can take away from this important decision:

What Can We Learn?

Above all else, Watson established that the IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing. At a minimum, in setting the compensation of our S corporation shareholder-employee clients, we must consider the following:

1. Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

2. Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.

3. Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years.  Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was  paid a smaller salary than recent college graduates. Clearly, this is not advisable.

4. What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.

5. Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisors should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.

6. Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue. In doing so, the payroll tax savings on Watson’s remaining distributions amounted only to the 2.9% Medicare tax.

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List of Expiring (And Expired) Tax Provisions: 12.31.2012

Posted in Uncategorized, tagged , , , , on October 1, 2012 | 1 Comment »

Coming on the heels of my Friday post regarding the impending expiration of the COD exclusion for mortgages secured by a taxpayer’s primary residence, Roger McEowen of Iowa State University published this wonderful 5-page chart detailing 1) those provisions set to expire at 12.31.2012 as part of the sunset of the Bush tax cuts, 2) those provisions set to expire at 12.31.2012 unrelated to the Bush tax cuts and 3) those provisions that previously expired at 12.31.2011 and may be candidates for a Lazarus-like revival. With year-end planning just around the corner, it’s a must read.

Hat tip: Joe Kristan at Roth & Co.

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Weekend Roundup

Posted in Uncategorized, tagged , , , , , , , on October 1, 2012 | Leave a Comment »

Boy, that Tebow trade has really added a dynamic new element to the Jets’ offense, no?

A few pictures from a Sunday spent in and around Leadville, CO, the highest (think altitude, not reefer) incorporated city in the U.S.

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So this is why my college years were so lonely. All the chicks with loose morals were economic majors.

If everyone’s so fired up about the 47% of Americans who don’t pay income tax, perhaps we should tax them. Howard Gleckman has five ways you could do it. His most novel suggestion: fix the economy and get people working again.

Hey, maybe Romney’s plan to cut rates while keeping tax revenue level is possible. After all, it worked for Reagan.

From the WSJ: Is your political contribution tax-deductible?

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How Much Do You Trust Congress? Exclusion from COD Income Related To Primary Residence Mortgages is Set to Expire in Three Months

Posted in Uncategorized, tagged , , , , , , , , on September 28, 2012 | 2 Comments »

If you are one of the 97% of Americans whose home is worth significantly less than when they purchased it, you’ve likely been seeking out some type of debt modification with your lender. Or perhaps things have gotten so bad that you’re contemplating a foreclosure or short sale.

Here’s the thing: anytime a mortgage is modified (i.e., reduced), the borrower is required to recognize cancellation of indebtedness (COD) income under Section 61(a)(12). Similarly, if a property is sold at foreclosure or in a short sale and the underlying mortgage is recourse (meaning the borrower has personal responsibility for any excess loan deficiency remaining after the sale), then to the extent the remaining deficiency is forgiven, the borrower will again recognize COD income.

In the foreclosure or short sale context, this COD income is NOT treated as gain from the sale of the property, and thus is not eligible for exclusion under Section 121 (allowing a $500,000 exclusion for MFJ taxpayers who have owned/used the home as their principal residence for 2 of prior 5 years).

When the sh*t hit the fan in the real estate market in 2006 Congress recognized that something had to be done, as it seemed patently unfair to tax homeowners on COD income when they couldn’t even afford to service the underlying mortgage. And while exclusions to COD income have always existed under Section 108, prior to 2007 those exclusions were only of use to a homeowner if the homeowner were insolvent or bankrupt.

As a result, in 2007 Congress enacted Section 108(a)(1)(E), which provides that a taxpayer that is neither insolvent nor in bankruptcy can still exclude up to $2,000,000 of COD income related to the discharge (in whole or in part) of qualified principal residence indebtedness. This exclusion applies where a taxpayer restructures his or her acquisition debt on a principal residence, loses his or her principal residence in a foreclosure, or sells a principal residence in a short sale.

For these purposes:

  • Qualified principal residence indebtedness is debt that meets the Section 163(h)(3)(B) definition of acquisition indebtedness for the residential interest expense rules but only with respect to the taxpayer’s principal residence (i.e., does not include second homes or vacation homes), and with a $2 million limit ($1 million for married filing separate taxpayers) on the aggregate amount of debt that can be treated as qualified principal residence indebtedness.
  • Acquisition indebtedness includes refinanced debt to the extent the refinancing does not exceed the amount of the refinanced acquisition indebtedness.
  • For purposes of these rules, a principal residence has the same meaning as under the Section 121 home sale gain exclusion rules.

Why do you care? Because as of today, this exclusion is set to expire on December 31, 2012. That means you have to ask yourself: How much do you trust Congress to get an extension done before year end? If you do, then by all means, take your time with your debt modification/foreclosure/short sale efforts. But if you don’t, you might want to get a sense of urgency about getting something done with your bank prior to year end, so you can take advantage of Section 108(a)(1)(e) while it’s here.

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Coloradans May Soon Be Able to Get High Without Having To First Pretend They Have Cataracts

Posted in Uncategorized, tagged , , , , , , on September 27, 2012 | 2 Comments »

There are three things you’ll find in almost annoying abudance in every mountain town: soul patches on the men, dreadlocks on the women, and weed. Lots and lots of weed.

In Colorado, however, you can’t limit the love of marijuana to the denizens of its ski towns. To wit: in Denver — where medical marijuana has been legal since 2000 — there are more dispensaries within the city limits than there are Starbucks in the entire state.

Now, with state tax revenues lagging and criminal justice costs rising, Colorado is turning to an unlikely, albeit logical, solution to its woes: weed for all.

This November, residents of Colorado will vote on Amendment 64, which would legalize and regulate marijuana sales just as it’s done for booze and cigarettes. The goal, quite obviously, is to raise tax revenue. Just how much tax revenue is anyone’s guess:

State analysts project somewhere between $5 million and $22 million a year. An economist whose study was funded by a pro-pot group projects a $60 million boost by 2017.

The cause of the confusion, of course, is because buying recreational marijuana is currently illegal, nobody can be certain what the market for legal weed will be. Muddling matters further, there is no guarantee that those currently buying illegal marijuana would shift their loyalties to legalized outlets. After all, if I learned nothing else from the film ”Pineapple Express” — and I didn’t — it’s that the pot smoker-drug dealer bond is a strong one forged through loyalty, trust and PlayStation, and is unlikely to be cast aside so capriciously.

Should the legislation pass — and right now, it looks possible but not likely — it will be fascinating to sit back and watch the state-wide elation greeting free-market marijuana be quickly destroyed by the heavy hand of the IRS. As we’ve discussed before, the Service has used a little known Code section, Section 280E to be specific, to deny all of the tax deductions related to medicinal marijuana dispensaries, effectively taxing the business on 100% of their revenues.

The same section would apply equally to legal recreational sales, because marijuana will remain on the federal controlled substance list, and thus the IRS would be able to wield Section 280E to deny any and all deductions related to “trafficking” in the drug. With a string of recent successes in the Tax Court featuring medicinal dispensaries, the IRS would have a strengthened resolve to pursue recreational sellers of the drug, and likely tax them out of existence.

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Romney Camp Puts A Crimp in Predicting 2013 Tax Rates

Posted in Uncategorized, tagged , , , , , on September 26, 2012 | Leave a Comment »

After spending three weeks in Aspen as my family’s indentured servants, my parents set off on their return to New Jersey this morning.  And let me tell you, there is no more relaxing, stress-free process than preparing two 70-year olds for a day of air travel. Reminds me of this bit of genius from The Onion:

Dad Suggests Arriving At Airport 14 Hours Early

On the tax front, we here at Double Taxation are determined to keep our comparison of the presidential candidates’ tax proposals as current and accurate as possible. But it’s not always easy. For example, the staple of Mitt Romney’s plan has been the “20% across-the-board” reduction in the individual income tax rates, resulting in a decrease of the top rate from 35% to 28%.

Romney has also promised that his tax cuts won’t increase the deficit, meaning he’ll raise an offsetting amount of tax revenue elsewhere, largely through the reduction of existing deductions and preferences.

As we’ve discussed, once the math-types put these two concepts together, they revealed a couple of glaring holes, the most publicized of which was the notion that the tax rates could not be reduced while remaining revenue neutral without shifting a significant amount — $86 billion — of the tax burden from those earning in excess of $250,000 to those with income below that threshold.

While Romney’s camp continues to question the accuracy of the criticism, they’ve now got a backup plan. According to advisor Kevin Hassett, Romney would rather back off his promised tax cuts then raise taxes on the poor.

If you think the base-broadeners don’t add up, if you think he can’t get to 28 percent, then the right thing that would happen, as you know, if you’re going to have a revenue-neutral reform, is that they would have a different change in rates.

Governor Romney says he can get to 28 percent. He believes he can get to 28 percent. When he’s in office, he’ll try to do it. But if Congress won’t give him the base-broadening he needs to get to 28 percent, there’s no way in hell that anyone believes that he’s going to increase taxes by $2,000 on people with incomes below $20,000. I just can’t believe that the Obama campaign would say that, and that an economist for the Obama campaign would be up here repeating these stupid and inane talking points.

What’s the point? This goes without saying, but simplifying the tax code will not be an easy process. Most experts agree that the optimal tax system is one defined by lower rates and fewer deductions, and that is most certainly not the system we have in place today.

Romney’s proposals are a step in the right direction, but voters need to understand that such an undertaking requires flexibility. The remarks from Romney’s advisor will likely be targeted by Democrats as a sign that Romney is going back on his campaign promises, but to hold Romney to the specific points he set forth in his proposals and not afford him several alternatives to reach the desired result — revenue-neutral tax simplification that maintains the progressivity of the Code — is an unfair reaction that serves only to stand in the way of much needed tax reform.

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Who — Aside From the Rap Community — Doesn’t Pay Any Income Tax?

Posted in Uncategorized, tagged , , , , , , on September 25, 2012 | 4 Comments »

Unless you’ve been living in a cave, you likely already know that Mitt Romney created a bit of an uproar when, behind closed doors, he suggested that because 47% of all Americans pay no income tax, they will vote Democratic “no matter what;” the theory being that Romney’s proposals to cut income tax cannot resonate with a group that pays no income tax.

Now, obviously, there’s no way to link tax filings to voter records to test the accuracy of Romney’s statement, but we can learn a bit more about who comprises this tax-indifferent 47 percent. And to that end, the Tax Policy Center’s got us covered with Five Myths About the 47 Percent.

Among the more interesting tidbits:

  • The TPC estimates that of the 47% percent, only 0.1% earn income in excess of $200,000. That would indicate that fewer taxpayers are “gaming the system” than some would have you believe.
  • Rather, the vast majority of people who pay no federal income tax have low earnings, are elderly or have children at home. Furthermore, fewer than half of individuals in households with incomes below $30,000 voted in 2008, compared with about 60 percent of people with higher incomes. And because these lower income taxpayers do — when they vote — tend to vote Democratic, it appears Romney may actually benefit, rather than suffer, from this tax-indifferent — and apparently — election-indifferent — portion of the population.
  • Many of the taxpayers who pay no income tax are not the beneficiaries of Democratic “safety net” legislation, but rather bipartisan efforts to help those in need.  For example, Presidents Ronald Reagan and Bill Clinton both favored the earned-income tax credit (EITC), which has helped millions of families stave off poverty.

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IRS Rules That State Law Doesn’t Dictate Whether Two Properties Are Like Kind

Posted in Uncategorized, tagged , , , , , , on September 24, 2012 | 2 Comments »

Under the tax law, taxpayers are afforded favorable treatment when instead of selling appreciated property, they “exchange” it for other property; the idea being that the taxpayer has not cashed out its investment in the property, but rather simply changed the form of the investment.

Specifically, Section 1031(a) of the Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

Stated simply, a taxpayer recognizes no gain if instead of selling appreciated property, they exchange it for property that is “like kind.” And this, as you can imagine, is where issues arise. What is “like kind” property? The regulations offer scant guidance:

Section 1.1031(a)-1(b) of the regulations provides that the words “like kind” have reference to the nature or character of the property and not to its grade or quality. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.

This much is clear, however: This like-kind requirement precludes a taxpayer from exchanging real property for personal property, or vice versa.

As a result, over the years numerous court cases have sought to answer the question of whether Property A was “like kind” to Property B by looking to state law classifications. For example, in Commissioner v. Crichton[i], the 5th Circuit determined that a mineral right was real property under Louisiana state law and thus of like kind to other real property. Similarly, in Peabody Natural Resources Co. v. Commissioner[ii], the Tax Court determined that under New Mexico law, coal supply contracts constituted real property interests and were of like kind to the relinquished gold mine.

These decisions have led some practitioners to question whether state law classifications are in fact determinative in concluding whether two properties are of like kind. Last Friday, in PLR 201238027, the IRS clarified that state law classifications, while relevant, are not determinative of whether properties are of like kind. Rather, all facts and circumstances should be considered.

In the Ruling, the IRS presented four scenarios. In each of the four scenarios, similar properties were exchanged for one another. Under state law, however, the properties were classified differently. For example, in Case 1, a natural gas pipeline in State A (constructed along a right of way on real property) that was classified as personal property in State A was exchanged for a State B natural gas pipeline that was  constructed along a right of way on real property and that was classified as real property in State B. (The right of ways associated with the exchanged pipelines in State A and State B are also exchanged.)

The IRS declined to base its decision as to the like kind nature of the properties solely on their respective state law classifications. Instead, the Service looked to certain informative sections of the Code to glean how they classified property as personal or real, specifically, Sections 48, 263A, and 1245:

For example, § 1.263A-8(c)(1) of the regulations provides, in part, that real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Section 1.263A-8(c)(3) describes “inherently permanent structures” as including “property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time, such as swimming pools, roads, bridges, tunnels . . . telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment. . . .”

Section 1.48-1(c) of the regulations provides in part, that for purposes of § 1.48-1, the term “tangible personal property” means any tangible property except land and improvements, including structural components of such buildings or structures. It further provides that “production machinery, printing presses, transportation and office equipment. . . contained in or attached to a building constitutes tangible personal property for purposes of the credit allowed by section 38.”  

Finally, § 1245(a)(3) provides that “§ 1245 property” is any property which is or has been subject to depreciation under § 167 and which is either personal property or other tangible property used as an integral part of certain activities, including manufacturing.  

Acknowledging that relying solely on state law classifications could yield absurd results – for example, in Case 1 where identical pipelines are exchanged but their respective states classify them as personal and real property, respectively, treating the properties as not being like kind would make little sense – the IRS concluded the basic nature and character of the property involved should override the state law treatment.

Applying these concepts to Case 1, since both pipelines were inherently permanent structures that were affixed to real property that will remain for an indefinite period of time, they both qualified as real property under the definition found at Regulation Section 1.263A-8(c)(1). Thus, the exchange of one pipe line for the other qualified as a like kind exchange under the meaning of Section 1031.

[i] 122 F.2d 181 (5th Cir. 1941).

[ii] 126 T.C. 261 (2006).

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Weekend Roundup

Posted in Uncategorized, tagged , , , , , , on September 24, 2012 | Leave a Comment »

I spent the weekend doing some mountain bike-assisted leaf peeping, as the fall colors are in “full splendor” mode right now in the Rockies:

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On to the tax stuff. For good or bad, there’s no bigger story in the tax world right now than the release of Mitt Romney’s 2011 tax returns. It’s a shame in a way, because it has to suck to publish your most sensitve personal information only to immediately have every hack (i.e., me) scrambling to their laptops to offer up their unsolicited opinions regarding your financial dealings on the internet. But such is the way of the world, so below are some links to other, more reputable sources and their thoughts on the Romney returns:

NY Times

Washington Post

The Atlantic

Forbes

Of course, as I’ve mentioned before, the bigger question is: will the information contained within those 300 pages of tax return really have an impact on election day? The Wall Street Journal has some theories.

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