Current Developments MSCPA Federal Tax Committee Mark H. Misselbeck, C.P.A., Presenter October 19, 2010
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1 Current Developments MSCPA Federal Tax Committee Mark H. Misselbeck, C.P.A., Presenter October 19, ) Federal Taxes Weekly Alert, Key 2011 tax items as calculated by RIA based on inflation data The standard deduction, exemption amount, and other tax items are adjusted annually for cost-of-living increases. The adjustments are based on the average Consumer Price Index (CPI) for the 12-month period ending the previous Aug. 31. The Aug CPI has been released by the Labor Department. (U.S. Department of Labor, Consumer Price Index (for all-urban consumers), 9/17/2010) Using the CPI for Aug. 2010, released on Sept. 17, 2010 (and the preceding 11 months), RIA has calculated 2011 indexed amounts for several tax items, as set forth below. However, RIA has calculated adjustments for fewer items than in past years because of the continuing uncertainty posed by Congressional inaction on the sunset provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L ). Under the sunset, the provisions of EGTTRA, other than those made permanent or extended by subsequent legislation, don't apply to tax years beginning after Rather, under the sunset, the Internal Revenue Code of '86 will be applied and administered to tax years beginning after 2010 as if the provisions of, and amendments made by, P.L had never been enacted. (Sec. 901(b) of P.L ) RIA observation: As of now, the Code is slated to revert to its status before the enactment of PL , except for those provisions made permanent or extended by subsequent legislation. Thus, unless Congress acts, the tax rates for individuals and estates and trusts will revert to their EGTRRA levels. For example, the top tax rate will be 39.6%, and, for individuals, the 10% rate will disappear. Absent Congressional action, a number of other items will revert to pre-egtrra levels. Congress may act to keep some items at current levels. However, which items, if any, will be protected remains unclear. Given this uncertainty, with the exception of the standard deduction, inflation projections are not provided for items impacted by the sunset, which are separately listed below. A more detailed discussion of many items impacted by the sunset (both items that are indexed for inflation and those that are not) may be found at Weekly Alert 39 07/22/2010 and 2. RIA observation: IRS is required to officially release the 2011 adjustments by Dec. 15, However, this deadline may be hard for IRS to meet if Congress doesn't timely act to address the EGTRRA sunset. Standard deductions. The basic standard deduction for 2011 will be: Joint return or surviving spouse $11,600*(up from $11,400 for 2010) Single (other than head of household $5,800 (up from $5,700 for 2010) or surviving spouse) Head of household $8,500 (up from $8,400 for 2010) Married filing separate returns $5,800* (up from $5,700 for 2010) *If the EGTRRA sunset kicks in, the standard deduction for married taxpayers filing jointly (and qualified surviving spouses) will be 167% of the standard deduction for single taxpayers. The standard deduction for married taxpayers filing separately would continue to be one-half of the standard deduction for joint filers. For an individual who can be claimed as a dependent on another's return, the basic standard deduction for 2011 will be $950 (same as for 2010), or $300 (same as for 2010) plus the individual's earned income, whichever is greater. However, the standard deduction may not exceed the regular standard deduction for that individual. For 2011, the additional standard deduction for married taxpayers 65 or over or blind will be $1,150 (up from $1,100 for 2010). For a single taxpayer or head of household who is 65 or over or blind the additional standard deduction for 2011 will be $1,450 (up from $1,400 for 2010). Kiddie tax. The exemption from the kiddie tax for 2011 will be $1,900 (same as for 2010). A parent will be able to elect to include a child's income on the parent's return for 2011 if the child's income is more than $950 and less than $9,500 (same as for 2010). AMT exemption for child subject to kiddie tax. The AMT exemption for 2011 for a child subject to the kiddie tax will be the lesser of (1) $6,800 (up from $6,700 for 2010) plus the child's earned income, or (2) $33,750 (same as for 2010). 1
2 RIA observation: In past years, Congress increased the regular (and not inflation adjusted) AMT exemption amounts when they were about to revert to lower levels. Personal exemption amount. The personal exemption amount for 2011 will be $3,700 (up from $3,650 for 2010). RIA observation: The minimum gross income thresholds for filing will also increase for 2011 since they are based on the basic standard deduction, the additional standard deduction, and the exemption amounts. Interest exclusion for higher education. The interest on U.S. savings bonds redeemed to pay qualified higher education expenses may be tax-free. The exclusion is phased-out for certain higher income individuals. The phase-out level is adjusted annually for costof-living increases. The phase-out for 2011 will begin at modified adjusted gross income above $71,100 ($106,650 on a joint return). For 2010, the corresponding figures are $70,100 and $105,100. Qualified transportation fringe benefits. For 2011, an employee will be able to exclude up to $230 (same as for 2010) a month for qualified parking expenses, and up to $120 a month (down from $230) of the combined value of transit passes and transportation in a commuter highway vehicle. Education credits. For 2011, the Hope (for 2009 and 2010 called the American Opportunity Credit) and Lifetime Learning credits phase out ratably for taxpayers with modified AGI of $51,000 to $61,000 ($102,000 to $122,000 for joint filers). For 2011, the Hope credit will be 100% of up to $1,200 of qualified higher education tuition and related expenses plus 50% of the next $1,200 such expenses. For 2010, the American Opportunity Credit (formerly called the Hope Credit) phased out ratably for taxpayers with modified AGI of $80,000 to $90,000 ($160,000 to $180,000 for joint filers). For 2010, the Lifetime Learning credit phased out ratably for taxpayers with modified AGI of $50,000 to $60,000 ($100,000 to $120,000 for joint filers). For 2010, the American Opportunity Credit (formerly called the Hope Credit) was 100% of up to $2,000 of qualified higher education tuition and related expenses plus 25% of the next $2,000 of such expenses. Adoption credit. An individual is allowed a credit against income tax (and AMT) for qualified adoption expenses. The total expenses that may be taken as a credit for all tax years with respect to the adoption of a child by the taxpayer will be limited to $13,360 for 2011 (up from $13,170 for 2010). For 2011, the credit for the adoption of a special-needs child will be $13,360 under Code Sec. 36C(a)(3), regardless of the extent to which the taxpayer has qualified adoption expenses (up from $13,170 for 2010). The credit will begin to phase out at AGI of $185,210 (up from $182,520 for 2010). The phaseout will be complete at $40,000 above the threshold. Adoption exclusion. Similar inflation adjustments and phaseout rules apply for purposes of the exclusion for employer-provided adoption assistance. The total amount excludable per child (whether or not he has special needs) will be limited to $13,360 for 2011 (up from $13,170 for 2010). Note that the exclusion for the adoption of a child with special needs applies regardless of whether the employee has qualified adoption expenses. MAGI limits for making deductible contributions by active plan participants to traditional IRAs. In general, an individual who isn't an active participant in certain employer-sponsored retirement plans, and whose spouse isn't an active participant, may make an annual deductible cash contribution to an IRA up to the lesser of: (1) a statutory dollar limit (for 2011, $5,000, increased to $6,000 for those age 50 or older), or (2) 100% of the compensation that's includible in his gross income for that year. If the individual (or his spouse) is an active plan participant, the deduction phases out over a specified dollar range of modified adjusted gross income (MAGI). For taxpayers filing joint returns, the otherwise allowable deductible contribution will be phased out ratably for 2011 for MAGI between $90,000 and $110,000 (up from $89,000 and $109,000 for 2010). For 2011, for single taxpayers and heads of household, the otherwise allowable deductible contribution will be phased out ratably for MAGI between $56,000 and $66,000 (same as for 2010). For married taxpayers filing separate returns, the otherwise allowable deductible contribution will continue to be phased out ratably for MAGI between $0 and $10,000 (same as for 2010). 2
3 For a married taxpayer who is not an active plan participant but whose spouse is such a participant, the otherwise allowable deductible contribution will be phased out ratably for 2011 for MAGI between $169,000 and $179,000 (up from between $167,000 and $177,000 for 2010). MAGI limits for making contributions to Roth IRAs. Individuals may make nondeductible contributions to a Roth IRA, subject to the overall limit on IRA contributions. The maximum annual contribution that can be made to a Roth IRA is phased out for taxpayers with MAGI over certain levels for the tax year. For taxpayers filing joint returns, the otherwise allowable contributions to a Roth IRA will be phased out ratably for 2011 for MAGI between $169,000 and $179,000 (up from between $167,000 and $177,000 for 2010). For single taxpayers and heads of household it will be phased out ratably for MAGI between $107,000 and $122,000 (up from $105,000 and $120,000 for 2010). For married taxpayers filing separate returns, the otherwise allowable contribution will continue to be phased out ratably for MAGI between $0 and $10,000 (same as for 2010). Saver's credit. For tax years beginning in 2011, an eligible lower-income taxpayer can claim a nonrefundable tax credit for the applicable percentage (50%, 20%, or 10%, depending on filing status and AGI) of up to $2,000 of his qualified retirement savings contributions, as follows:... Joint filers: $0 to $34,000, 50%; $34,000 to $36,500, 20%; and $36,500 to $56,500, 10% (no credit if AGI is above $56,500).... Heads of households: $0 to $25,500, 50%; $25,500 to $27,375, 20%; and $27,375 to $42,375, 10% (no credit if AGI is above $42,375).... All other filers: $0 to $17,000, 50%; $17,000 to $18,250, 20%; and $18,250 to $28,250, 10% (no credit if AGI is above $28,250). By way of comparison, for tax years beginning in 2010, an eligible lower-income taxpayer can claim a nonrefundable tax credit for the applicable percentage (50%, 20%, or 10%, depending on filing status and AGI) of up to $2,000 of his qualified retirement savings contributions, as follows:... Joint filers: $0 to $33,500, 50%; $33,500 to $36,000, 20%; and $36,000 to $55,500, 10% (no credit if AGI is above $55,500).... Heads of households: $0 to $25,125, 50%; $25,125 to $27,000, 20%; and $27,000 to $41,625, 10% (no credit if AGI is above $41,625).... All other filers: $0 to $16,750, 50%; $16,750 to $18,000, 20%; and $18,000 to $27,750, 10% (no credit if AGI is above $27,750). Items impacted by EGTRRA sunset. Calculations were not done in this article for the following items, which will be impacted by the EGTRRA sunset if Congress does not act:... Phaseout of personal exemptions.... Tax rate schedules (but see 12 ).... Reduction of itemized deductions.... Earned income tax credit.... Refundable child credit. RIA observation: The regular child credit, which has not been indexed, also will drop if the EGTTRA sunset kicks in, see Weekly Alert 39 07/22/ Student loan interest deduction. RIA observation: For Senate passed legislation that would increase the expensing limit and investment based phaseout dollar amount for both 2010 and 2011, see 2. A number of tax figures are adjusted each year for inflation based on the average Consumer Price Index (CPI) for the 12-month period ending the previous Aug. 31. The Aug CPI has been released by the Labor Department. (U.S. Department of Labor, Consumer Price Index (for all-urban consumers), 9/17/2010) Using the CPI for Aug (and the preceding 11 months), RIA calculated and reported in a separate article (see 43) the increases for 2011 to the standard deduction, the personal exemption, and a number of other items. This article provides RIA-calculated adjustments for 2011 for health, charitable, compliance and special entity items. Adjustments for the first two items that follow are based on the medical care component of the CPI. Long-term care premiums. Amounts paid for insurance that covers qualified long-term care services are treated as medical expenses up to specified dollar limits that vary with the age of the taxpayer as of the close of the tax year. For a taxpayer age 40 or younger, the 2011 limit will be $340 (up from $330 for 2010); more than 40 but not more than 50, $640 (up from $620 for 2010); 3
4 more than 50 but not more than 60, $1,270 (up from $1,230 for 2010); more than 60 but not more than 70, $3,390 (up from $3,290 for 2010); and more than 70, $4,240 (up from $4,110 for 2010). Payments received under qualified long-term care insurance. Amounts received under a qualified long-term care insurance contract are generally excludable as amounts received for personal injuries and sickness, subject to a per diem limitation, which will be $300 in 2011 (up from $290 for 2010). Archer MSAs. For Archer medical savings account (MSA) purposes, in 2011, a high deductible health plan will be a health plan with an annual deductible of at least $2,050 and not more than $3,050 (up from $2,000 and $3,000 for 2010), in the case of self-only coverage, and with an annual deductible of at least $4,100 and not more than $6,150 (up from $4,050 and $6,050 for 2010), in the case of family coverage, and under which the annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits doesn't exceed... $4,100 (up from $4,050 for 2010) for self-only coverage, and... $7,500 (up from $7,400 for 2010) for family coverage. Insubstantial benefit charitable contribution limitation. Certain de minimis benefits provided by a charity to a donor don't affect the donor's charitable contribution deductions. Under these rules, charitable contributions will be fully deductible in 2011 if (1) the donor makes a minimum payment of $48.50 ($48 for 2010) and receives certain benefits with a cost of not more than $9.70 ($9.60 for 2010) or (2) the charity mails or otherwise distributes free unordered low-cost articles with a cost of not more than $9.70 ($9.60 for 2010). In addition, charitable contributions will be fully deductible if the benefit received by the donor isn't more than the lesser of $97 (up from $96 for 2010) or 2% of the amount of the contribution. Dues paid to agricultural or horticultural organizations. Annual dues not exceeding $148 for 2011 (up from $146 for 2010) for membership in an agricultural or horticultural organization won't be unrelated business income despite any benefits or privileges to which members of the organization will be entitled. Reporting exemption for exempt organizations with lobbying expenditures. For 2011, social welfare, agricultural and horticultural organizations are exempt from the requirement that they report to their members the portion of their dues allocable to lobbying if 90% or more of their annual dues are received from persons, families, or entities who pay dues of $103 or less (up from $101 for 2010). Maximum hourly fee for attorneys under Code Sec. 7430(c)(1). The maximum hourly amount allowed for attorney's fees to a prevailing party under Code Sec. 7430(c)(1) will be $180 an hour for fees incurred in 2011 (same as for 2010). Mechanics' lien priority over tax liens. The holder of a lien for $6,990 or less for the repair or improvement of a personal residence will have priority over notices of tax liens filed in This is up from $6,890 for Sales price priority over tax liens. A nondealer purchaser of household goods, personal effects, etc. will be protected against a tax lien filed in 2011 if the sales price is not over $1,400 (up from $1,380 for 2010). Property exempt from levy. The value of property exempt from levy under Code Sec. 6334(a)(2) (fuel, provisions, furniture, and other household personal effects, as well as arms for personal use, livestock, and poultry) may not exceed $8,370 for levies in 2011 (up from $8,250 for 2010). The value of property exempt from levy under Code Sec. 6334(a)(3) (books and tools necessary for the trade, business, or profession of the taxpayer) may not exceed $4,180 for levies issued in 2011 (up from $4.120 for 2010). Using the CPI for Aug (and the preceding 11 months), RIA calculated and reported in a separate article (see 43) the increases for 2011 to the standard deduction, the personal exemption, and a number of other items. This article provides RIA-calculated adjustments for 2011 for transfer tax and foreign items. Gift tax annual exclusion. For gifts made in 2011, the gift tax annual exclusion will be $13,000 (same as for gifts made in 2010). Special use valuation reduction limit. For estates of decedents dying in 2011, the limit on the decrease in value that can result from the use of special valuation will be $1,020,000 (up from $1,000,000 for 2009, when the estate tax was last imposed). 4
5 Determining 2% portion for interest on deferred estate tax. In determining the part of the estate tax that is deferred on a farm or closely-held business that is subject to interest at a rate of 2% a year, for decedents dying in 2011 the tentative tax will be computed on $1,360,000 (up from $1,330,000 for 2009) plus the applicable exclusion amount. RIA observation: The two preceding items are included on the assumption that the estate tax returns in Increased annual exclusion for gifts to noncitizen spouses. For gifts made in 2011, the annual exclusion for gifts to noncitizen spouses will be $136,000 (up from $134,000 for 2010). Reporting foreign gifts. If the value of the aggregate foreign gifts received by a U.S. person (other than an exempt Code Sec. 501(c) organization) exceeds a threshold amount, the U.S. person must report each foreign gift to IRS. (Code Sec. 6039F(a)) Different reporting thresholds apply for gifts received from (a) nonresident alien individuals or foreign estates, and (b) foreign partnerships or foreign corporations. For gifts from a nonresident alien individual or foreign estate, reporting is required only if the aggregate amount of gifts from that person exceeds $100,000 during the tax year. For gifts from foreign corporations and foreign partnerships, the reporting threshold amount will be $14,375 in 2011 (up from $14,165 for 2010). Expatriation. Under a mark-to-market deemed sale rule, all property of a covered expatriate is treated as sold on the day before the expatriation date for its fair market value. However, for 2011, the amount that would otherwise be includible in the gross income of any individual under these mark-to-market rules is reduced by $636,000 (up from $627,000 for 2010). Foreign earned income exclusion. The foreign earned income exclusion amount increases to $92,900 in 2011 (up from $91,500 in 2010). It is projected that if the current rates are extended for all taxpayers, the rate brackets and "break points" in each category of filer will remain the same for Document Header Checkpoint Contents Federal Library Federal Editorial Materials Federal Taxes Weekly Alert Newsletter Preview Documents for the week of 09/23/ Volume 56, No. 38 Articles Key 2011 tax items as calculated by RIA based on inflation data (09/23/2010) 2010 Thomson Reuters/RIA. All rights reserved. 2.) Federal Tax Day - Current,I.4IRS Notice Allows Various Methods for Measuring Ownership Changes Under Code Sec. 382, IRS Official Says, (Sep. 22, 2010) Notice , I.R.B , 12 (TAXDAY, 2010/06/14, I.4), confirms that a variety of methods for measuring ownership changes under Code Sec. 382 are acceptable, an IRS official stated on September 21 at a program sponsored by the D.C. Bar. The guidance reduces the impact of fluctuating stock values and the uncertainties created for determining ownership changes. The IRS will accept any reasonable attempt to measure increases in ownership, provided the method is used consistently, Mark Jennings of the IRS Office of Associate Chief Counsel (Corporate) told practitioners. Each year that there is an ownership shift, taxpayers must use the same method to measure the change in values, Jennings said. Once there has been an ownership change, the taxpayer can "start over" and can use a different method of determining ownership changes, according to Jennings. The IRS has requested comments before it issues regulations on the approaches taken by taxpayers to compare stock values, Jennings noted. He said that the IRS is examining whether there should be just one method or multiple methods in the regulations. If the regulations were to permit more than one method, another issue is whether the taxpayer could shift methods from year to year. The IRS is also concerned that any guidance be administrable. If the regulations allow multiple methods, it can be burdensome on both taxpayers and the IRS to "run the numbers" for so many methods. Jennings explained that Notice allows a taxpayer to choose a method that produces an ownership change. He also said that fluctuations in value do not themselves produce a testing date. The methods reducing the impact of fluctuations are based on the stock s historical value when purchased, but a new purchase must be counted at current value and cannot be altered to reflect the stock s historic value, Jennings said. Code Sec. 382 limits the amount of net operating losses (NOLs) that a corporation can claim if the corporation has undergone an ownership change. This results from a transfer of stock that causes one or more 5-percent shareholders to increase their ownership in the loss corporation by more than 50 percentage points over a three-year testing period. The tax code says that fluctuations in stock value should not cause an ownership change. 5
6 Mark Hoffenberg of KPMG LLP, Washington, D.C., who moderated the program, said that the existing regulations seem to count fluctuations in value, by tracking fair market value and triggering ownership changes. The full value method described in Notice is based on fair market value. The IRS has issues private letter rulings that allow taxpayers to eliminate fluctuations, Hoffenberg said. Notice allows taxpayers to use variations of the hold constant principle to eliminate the impact of fluctuations. This method establishes the value of shares on the date the share is acquired, relative to other classes of stock, and factors out fluctuations in the value of stock held by passive shareholders. Michael Wilder of McDermott, Will & Emery LLP, Washington, D.C., also participated in the program, discussing the treatment of certain debt cancellations when a parent corporation holds a note from its wholly owned subsidiary. The treatment depends on the application of various provisions under Code Sec. 108(e), whether the subsidiary is solvent or insolvent, whether stock is issued as part of the transaction, and whether the note is cancelled or retained. By Brant Goldwyn, CCH News Staff Notice ,Internal Revenue Service, (Jun. 11, 2010) Notice , I.R.B , June 11, [Code Sec. 382] Loss corporations: Ownership change triggering limitation on losses: Multiple classes of stock: Fluctuations in relative value: Guidance. The IRS has provided guidance concerning how to measure an owner shift in a loss corporation, for purposes of applying the Code Sec. 382 limitation on the use of net operating losses (NOLs), when the loss corporation has more than one class of stock outstanding whose values fluctuate relative to each other. The guidance addresses two methodologies for measuring value. These include the "full value methodology", in which value of all shares is measured by "marking" the shares to value on every testing date, but daily fluctuations in value between testing dates are ignored, and the "hold constant principle" (HCP) that looks to the relative value of a tested share on its acquisition date and only marks acquired shares to value. Until additional guidance is issued, the IRS will not challenge any reasonable application of either the full value methodology or the HCP provided that a single methodology is applied consistently to the extent specified. Back references: 17, and 17, I. Background A. Overview of 382(l)(3)(C) Many of the critical determinations under 382 depend upon the value of the stock owned by a particular shareholder. For example, whether an ownership change under 382(g) occurs depends upon whether one or more 5-percent shareholders have increased their ownership in the loss corporation by more than 50 percentage points. Such ownership determinations are by reference to value; i.e., the relative fair market value of the stock owned to the total fair market value of the corporation's outstanding stock. See (a)(3)(i) of the Income Tax Regulations. Section 382(l)(3)(C) provides that, except as provided in regulations, any change in proportionate ownership of the stock of a loss corporation attributable solely to fluctuations in the relative fair market values of different classes of stock shall not be taken into account. The regulations under 382 do not provide any specific guidance on 382(l)(3)(C). Instead, T(l) sets forth a heading and a reservation: Changes in Percentage Ownership which are attributable to fluctuations in value. [Reserved.] The Treasury Department (Treasury) and the IRS are aware that taxpayers employ a number of different methodologies in interpreting and applying 382(l)(3)(C). For example, some taxpayers have interpreted more general provisions of the regulations to require the valuation of all outstanding shares of stock of a corporation on every testing date. See (a)(3)(i) and T(c)(1). Under this interpretation, the effect of 382(l)(3)(C) is limited to ensuring that a testing date does not occur solely by virtue of a fluctuation in the relative values of different share classes. For purposes of this notice, such a valuation of all shares on every testing date is referred to as a Full Value Methodology. Other taxpayers have interpreted 382(l)(3)(C) more broadly, factoring out fluctuations in value on a testing date based upon relative value ratios among different classes of stock established at the time a particular share of stock was acquired. There are variations in the methods that apply this view, described in more detail below, but the essential principle upon which the broader interpretation is based is that, as to a particular share, value ratios between and among various 6
7 classes of stock are fixed, or held constant, on the date a particular share is acquired (hereafter, the Hold Constant Principle, or HCP ). The remainder of this section describes the government's understanding of the Full Value Methodology, the Hold Constant Principle, and two methodologies that implement the HCP. B. Full Value Methodology Under a Full Value Methodology, the determination of the percentage of stock owned by any person is made on the basis of the relative fair market value of the stock owned by such person to the total fair market value of the outstanding stock of the corporation. Thus, changes in percentage ownership as a result of fluctuations in value are taken into account if a testing date occurs, regardless of whether a particular shareholder actively participates or is otherwise party to the transaction that causes the testing date to occur; essentially, all shares are marked to market on each testing date. Example 1. Upon formation, corporation X issues $20 of convertible preferred stock to A and issues two shares of common stock to B for $80, such that A and B own 20 percent and 80 percent, respectively, of X. The fortunes of X deteriorate, and, two years later, when the common stock has a value of $2.50 per share and the preferred stock has a value of $20, B sells one share of common stock to C. At the time of B's sale to C, X is a loss corporation. On that testing date, A will be treated as increasing its proportionate interest from 20 percent to 80 percent ($20/$25) under the Full Value Methodology as a result of the upward fluctuation in value of the preferred stock relative to the common stock. As Example 1 illustrates, an ownership change under 382 would occur as a consequence of the sale of stock worth 10% of the loss corporation's value because a stake originally representing 20% of the corporation's value has fluctuated upward to 80% on the testing date, for a cumulative shift of 70 percentage points. The Full Value Methodology is a narrow interpretation of 382(l)(3)(C), but it may be viewed as giving effect to the statutory language by not requiring value marks more frequently than each testing date (e.g., daily fluctuations in value between various classes are ignored, where such fluctuations occur between testing dates). C. Hold Constant Principle Broadly stated, under the Hold Constant Principle, the value of a share, relative to the value of all other stock of the corporation, is established on the date that share is acquired by a particular shareholder. On subsequent testing dates, the percentage interest represented by that share (the tested share ) is then determined by factoring out fluctuations in the relative values of the loss corporation's share classes that have occurred since the acquisition date of the tested share. Thus, as applied, the HCP is individualized for each acquisition of stock by each shareholder. Moreover, the ownership interest represented by a tested share is adjusted for the dilutive effects of subsequent issuances and the accretive effects of subsequent redemptions following the tested share's acquisition date. Example 2. Upon formation, corporation X issues $20 of convertible preferred stock to A and issues two shares of common stock to B for $80, such that A and B own 20 percent and 80 percent, respectively, of X. The fortunes of X deteriorate, and, two years later, when the common stock has a value of $2.50 per share and the preferred stock has a value of $20, B sells one share of common stock to C. At the time of B's sale to C, X is a loss corporation. On that testing date, although A actually owns 80% of the value of X, A will be treated as owning 20% of the value of X for purposes of 382(g), under the Hold Constant Principle. As Example 2 illustrates, A would still be treated as owning 20 percent of X on the testing date because the HCP hypothesizes that (for purposes of determining A's percentage ownership) the common stock and the preferred stock maintain the relative values that existed on the acquisition date of the tested share (here, each share held by A). The only share that is marked to value is the one share acquired by C, representing only 10% of the corporation's equity value on the date of acquisition. Thus, no ownership change under 382 would occur as a consequence of the acquisition of that share by C. The Hold Constant Principle may thus be viewed as giving effect to the statutory language of 382(l)(3)(C) by factoring out fluctuations in the value of stock held by passive shareholders across multiple testing dates. The factoring out process generally continues for a particular share until the holder is no longer treated as owning the tested share for 382 purposes (e.g., the holder engages in affirmative activity such as a taxable sale). What follows is a description of two methodologies that implement the HCP. 1. Alternative Methodology 1: Look Back from Testing Date One methodology for implementing the Hold Constant Principle is to recalculate the hold constant percentage represented by a tested share to factor out changes in its relative value since the share's acquisition date (hereafter, Alternative 1 ). This methodology was described by a commentator in See generally Mark R. Hoffenberg, Owner Shifts and Fluctuations in Value: A Theory of Relativity, 106 Tax Notes 1446 (March 21, 2005). Generally, this methodology calculates the percentage interest represented by a tested share on a testing date, beginning with the value of the tested share on the testing date, and then making adjustments based on the changes in relative value of the tested share to the value of all the stock of the loss corporation that have occurred since the tested share's acquisition date. 7
8 2. Alternative Methodology 2: Ongoing Adjustments from Acquisition Date The second methodology for implementing the HCP tracks the percentage interest represented by a tested share from the date of acquisition forward, adjusting for subsequent dispositions and for the subsequent issuance or redemption of other stock (hereafter, Alternative 2 ). Generally, the increase in percentage ownership represented by the acquisition of a tested share during the testing period is established on the date the tested share is acquired. This increase is reduced (but not below zero) for subsequent dispositions of shares by the owner. To the extent the particular shareholder is not engaging in acquisitions or dispositions, the percentage ownership calculation rolls over from one testing date to another. Whereas under Alternative 1, the loss corporation generally determines the relative value of shares of its stock at the beginning of the testing period, or an earlier date, this may not be necessary under Alternative 2. Thus, Alternative 2 may involve fewer calculations on a particular testing date than Alternative Common Elements of Both HCP Methodologies a. Acquisitions Under either Alternative 1 or Alternative 2, the loss corporation determines, on each testing date during a testing period, the value of a tested share acquired on that testing date as compared to the value of all the stock of the loss corporation on that date (i.e., neither alternative factors out value fluctuations for actual acquisitions). b. Dispositions and sourcing Under either of the HCP alternative methodologies, a shareholder's increase in proportionate interest during a testing period will be reduced by share dispositions. The government is aware of at least two methods to account for dispositions in such cases. One method may account for the effect of a share disposition based upon the percentage ownership that the sold share represents on the date of its disposition (as opposed to the percentage represented by that share on its acquisition date) (a fair market value approach ). Another method may account for the effect of a share disposition based upon the percentage ownership that the sold share represented on another testing date during the testing period upon which the selling shareholder acquired shares. As one example, if the shares disposed of are being offset against shares of another class acquired during the testing period, the percentage offset could be determined as of the date the other class was acquired (a share equivalent approach ). The results obtained would be as if sold shares were converted into a share-equivalent number of shares of the acquired class. Example 3. A purchases 10 shares of X's common stock for $10 on testing date 1, when each share of common stock represents one percent of X. X is a loss corporation. On testing date 1, A also holds 2 shares of participating preferred stock, with each share valued at $2 and each preferred share representing 2 percent of X. On testing date 2, A disposes of one share of the preferred stock. Under a share-equivalent approach, A may be considered to have disposed of two shares of common stock, which is the common share equivalent of one share of preferred stock as determined on the acquisition date of the common stock. If a taxpayer determines the effect of a share disposition based upon the percentage represented by the sold share on the share's acquisition date, under either of the two methodologies, the taxpayer must also determine the source of shares disposed of where a 5- percent shareholder has had multiple acquisitions and dispositions of loss corporation stock. For example, tested shares of a single class likely will represent different percentages of a loss corporation depending upon when the tested shares were acquired. In these cases, taxpayers may treat sold shares as being sourced pro rata from all acquisitions, as being sourced first from the most recent acquisition ( LIFO ), or as being sourced first from the first acquisition ( FIFO ). c. Redemptions and issuances Section 382 takes into account not only trading in loss corporation shares, but also the redemptions and issuances of shares, for purposes of tracking changes in percentage ownership by 5-percent shareholders. For this purpose, a redemption may be analogized to a pro-rata acquisition by non-redeeming shareholders of the redeemed shares, while an issuance may be analogized to a pro-rata sale of shares by shareholders holding stock immediately before the issuance to those shareholders acquiring shares in the issuance. There are a variety of possible approaches in applying the HCP to stock redemptions and issuances. In a redemption, 382 views the remaining shareholders as having acquired a greater interest in the corporation with respect to their shares held immediately after the redemption. Applying the HCP, the size of this acquisition for each shareholder could be determined either by reference to current values at the time of the redemption or relative values in effect when the non-redeemed shareholders established their positions. 8
9 In an issuance, 382 views the interest in the corporation held by pre-existing shareholders with respect to their preexisting shares as being reduced. In applying the HCP, the effect of the issuance on preexisting shares, could also be determined by reference to current or relative historical values. Whether current or historical values are used in determining the effect of subsequent redemptions or issuances can make a substantial difference in the amount of the owner shifts determined for 5-percent shareholders. Moreover, even if historical values are used, the use of one HCP alternative versus another can produce differing results. See generally NYSBA Tax Section, Report on the Treatment of Fluctuations in Value under Section 382(l)(3)(C), Dec. 22, 2009, reprinted in 2009 TNT (Example 5 in the report). Finally, (j)(3) and (5) contain a special rule for determining the effects of certain cash issuances. Sections (j)(2) and (5) contain a special rule for determining the effect of certain small issuances. The issues discussed in this notice are relevant in determining the amount of exempted stock under the cash issuance rule, and the allocation of exempted stock among direct public groups under both rules. d. Non-disposition transactions For purposes of applying a method based on the HCP, an owner of loss corporation stock is not treated as disposing of or acquiring loss corporation stock to the extent the owner remains treated as an owner of the loss corporation, or its successor, under 382 and the regulations thereunder. See generally T(h)(2) (relating to constructive stock ownership); T(f)(18)(iv) (stock of the loss corporation, as the context may require, includes any indirect interest in the loss corporation); T(j)(2)(iii)(B)( 1)( i) (relating to equity structure shifts). In these cases, the original acquisition date and other hold constant characteristics are preserved. Thus, for example, if a shareholder exchanges loss corporation stock for other loss corporation stock in a value-for-value recapitalization, the stock received in the exchange would retain the same hold-constant characteristics as the surrendered shares. This principle also applies to reorganizations described in T(j)(2)(iii)(B)( 1)( i) and holding company formations. II. Guidance Because of the complexity of the issues involved in measuring owner shifts of loss corporation stock where fluctuations in value are present, the IRS and Treasury have determined that it is appropriate to accept taxpayers' reasonable attempts to measure increases in ownership where fluctuations in value are present. Accordingly, the IRS will not challenge any reasonable application of either a Full Value Methodology or the HCP, provided that a single methodology (as described below) is applied consistently to the extent required in this Notice. The IRS and Treasury believe that each of the HCP alternative methodologies discussed in section I above including the common elements of both for dealing with various transactions such as issuances and redemptions are reasonable applications of the HCP. Taxpayers may rely on the guidance provided in this notice until such time as the IRS and Treasury issue additional guidance under 382(l)(3)(C). A. Acquisitions All reasonable applications of either the Full Value Methodology or the HCP must determine the increase in ownership represented by the acquisition of a share of stock by dividing the fair market value of that share on the acquisition date by the fair market value of all of the outstanding stock of the loss corporation on that date. For this purpose, an acquisition does not include a deemed acquisition of stock by non-redeeming shareholders resulting from a redemption. In addition, under a HCP methodology, an acquisition is not an event upon which the acquiring shareholder marks to fair market value other shares that it holds. However, the IRS and Treasury view any alternative treatment of an acquisition as inconsistent with 382(l)(3)(C). For example, the IRS intends to challenge a methodology that fixes the relative fair market value of a class of preferred stock to common stock on the issue date of the preferred stock, regardless of the actual value of either class on the subsequent date that a shareholder whose percentage ownership is being computed acquires a share of either such class of stock. B. Consistency In general, a taxpayer may employ any methodology that is a reasonable application of either a Full Value Methodology or the HCP in determining when an ownership change has occurred. For prior years, a taxpayer may change its methodology by amending returns. However, a taxpayer must generally employ a single methodology consistently to all testing dates in a consistency period. With respect to a particular testing date (the current testing date ), the consistency period includes all prior testing dates, beginning with the latest of 9
10 (1) the first date on which the taxpayer had more than one class of stock; (2) the first day following an ownership change; or (3) the date six years before the current testing date. In some cases, a methodology implementing the HCP may treat as the acquisition date for a tested share a date that is later than the date the share was actually acquired. The issuance of a second class of stock generally establishes the acquisition date for the preexisting class as well as the second class. Moreover, taxpayers may substitute certain other dates, if later, for the date shares were acquired, such as, if used consistently: May 6, 1986; January 1, 1987; or the beginning of the testing period. C. Closed Years Notwithstanding the foregoing, a taxpayer may not employ a methodology in a year not barred by the statute of limitations (an open year ) if using that methodology would have changed the taxpayer's Federal income tax liability for a year barred by the statute of limitations (a closed year ) in the consistency period, unless the position taken in the closed year is not consistent with any reasonable methodology. A taxpayer taking a position in a closed year that is not consistent with any reasonable methodology may adopt any single methodology that is a reasonable application of either the Full Value Methodology or the HCP, regardless of whether use of that methodology would have changed its liability in a closed year, provided that the adopted methodology is applied consistently to the greatest extent permitted by the statute of limitations. The effect of the consistency period rule is that a taxpayer generally is free to adopt any reasonable methodology as long any inconsistent returns in the consistency period can be and are amended. In addition, there is no necessary correlation between the start of a consistency period, which governs the taxpayer's choice of methodology, and the acquisition date for shares of stock, which is an element of HCP methodologies. D. Single Methodology For purposes of this Notice, a single methodology means a methodology that applies a consistent treatment to a given situation, even on different testing dates (e.g., applying a LIFO convention for all share disposition sourcing determinations if using an HCP alternative). A single HCP methodology might treat the accretive effect of redemptions differently from other acquisitions but should not treat the dilutive effect of issuances differently from other dispositions. To determine the amount of exempted stock pursuant to the cash issuance exception of (j)(3), a taxpayer using an HCP methodology may either use the hold constant percentages determined for its direct public groups under its methodology or the percentages determined based upon current values. Allocations of exempted stock under (j)(5) (relating to the small issuance and cash issuance exceptions) should be determined under that same methodology. III. Request for Comments The IRS and Treasury plan to issue proposed or temporary regulations on the application of 382(l)(3)(C) in fluctuation in value situations, and request comments on that subject, including the issues addressed in this notice. A. Threshold Question The threshold question is whether interpreting 382(l)(3)(C) broadly to require rules for factoring out fluctuations in value, such as may be done through methodologies employing the HCP, is appropriate in light of the purposes of 382 and administratively viable. The primary purpose of 382's loss limitation rules is to preserve the integrity of the carryover provisions. The carryover provisions perform a needed averaging function by reducing distortions caused by the annual accounting system. If carryovers can be transferred in a way that permits a loss to offset unrelated income, no legitimate averaging function is performed. The loss limitation rules of 382 generally apply when shareholders who bore the economic burden of a corporation's pre-change loss no longer hold a controlling interest in the corporation. In such a case, the possibility arises that new shareholders will contribute income producing assets (or divert income producing opportunities) to the loss corporation, resulting in a greater utilization of the loss corporation's pre-change losses than would have been the case had there been no ownership change. See Staff of the Joint Comm. on Taxation, 100th Cong., 1st Sess., General Explanation of the Tax Reform Act of (Comm. Print 1987). The application of the HCP could result in the avoidance of an ownership change, even though the shareholders who did not bear the economic burden of the loss corporation's pre-change loss have assumed a controlling interest in the loss corporation. Consider, for example, a case in which the value of a loss corporation's common stock declines steeply in relation to the relative value of its voting 10
11 preferred stock, permitting preferred shareholders who bought in with a 10 percent interest (by value) to obtain a 90 percent interest (by value), while being held constant at 10 percent. In such a case, arguably, there is the heightened possibility that a pre-change loss could be offset against unrelated income. For example, the preferred shareholders could enhance their controlling position by causing a recapitalization in which they obtain the majority of the common stock and, thereby, a significantly greater potential to participate in the growth of the company. Thereafter, they could contribute income producing assets (or built-in gain assets) to the loss corporation in order to offset resulting income (or gain recognized) against the corporation's loss attributes (provided the value of the stock issued in exchange for the contributed assets was insufficient to cause an ownership change). A similar opportunity to avoid the application of 382 could present itself to shareholders who bought the common stock when it represented 10 percent of the value of the loss corporation, followed by a large upward fluctuation in its relative value. On the other hand, arguably Congress enacted 382(l)(3)(C) because it did not view owner shifts and possibly ownership changes attributable to valuation changes with as much policy concern as it viewed acquisitions. By limiting the operation of the statute to testing dates, Congress may have expressed a greater tolerance for shifts in corporate ownership that would have occurred even in the absence of events giving rise to a testing date. In a period of broad-based economic growth, where all other factors are equal, it can be expected that common stock will increase in value relative to preferred stock, which effect alone could result in owner shifts and possibly ownership changes. The converse result can be expected in a period of broad-based economic contraction. Arguably, in most of such cases, the shareholders considered to have acquired a greater percentage of the loss corporation's stock do not thereby have a greater incentive to contribute income producing assets to the loss corporation. The IRS and Treasury appreciate any comments on this threshold question. B. Possible Application of the HCP Part II of this notice permits broad application of the HCP until such time as future guidance is provided. If application of the HCP is to be required or permitted in future guidance, comments are requested as to whether to continue to permit the use of a range of methodologies to implement the HCP (and, if so, how broad a range) or to require that a particular HCP methodology (or methodologies) be used. The IRS and Treasury would appreciate any comments regarding which methodology or methodologies best implement the HCP from the standpoint of theory, practicality, and administrability. Under an alternative approach, the HCP could be applied only in limited circumstances, such as to protect a loss corporation's ability, in the event of bankruptcy, to make use of the special provisions of 382(l)(5) and (6). The IRS and Treasury request comments on whether it would be appropriate to limit the HCP to special circumstances and how the HCP might be applied in those situations. Comments are also requested as to the appropriate methodologies for dealing with (i) the deemed acquisition by non-redeeming shareholders occurring as a result of a redemption, (ii) the deemed disposition by preexisting shareholders occurring as a result of the issuance of other shares, (iii) the amount of stock exempt under the cash issuance exception of (j)(3), and (iv) the allocation of exempt stock to direct public groups under the cash and small issuance exceptions of (j)(5). Comments are requested as to the extent to which appropriate methodologies applied to the above enumerated items ought to be applied consistently to said items. C. Instructions Comments should include a reference to Notice Send submissions to Internal Revenue Service, Attn: CC:PA:LPD:PR Room 5203 ( Notice ), P.O. Box 7604, Ben Franklin Station, Washington, D.C or hand-deliver comments Monday through Friday between the hours of 8:00 a.m. and 4:00 p.m. to Courier's Desk, Attn: CC:PA:LPD:PR Room 5203 ( Notice ), Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC Alternatively, comments may be sent electronically via the following address: Notice.Comments@irscounsel.treas.gov. Please include the notice number in the subject line of any electronic communication. All materials submitted will be available for public inspection and copying Wolters Kluwer. All rights reserved. 3.) WORKERS WERE EMPLOYEES, NOT INDEPENDENT CONTRACTORS - Bruecher Foundation Services, Inc., 105, AFTR2d 2020 (CA-5, 2010) The Fifth Circuit in Bruecher Foundation Services, Inc., 105, AFTR2d 2020 (CA-5, 2010), held that workers used by the taxpayer in its business were the taxpayer's employees for employment tax purposes, and not independent contractors.. The taxpayer was a corporation wholly owned by its president. Its business consisted primarily of residential foundation repair and grading projects. In its tax filings, the taxpayers recognized two employees, its president and a secretary, and treated workers who performed manual labor involved in the foundation repair as independent contractors. 11
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