2014 Rehmann. Presented by: Andrew Rose, CPA Mike Bozimowski, JD, MST, CM Don McAnelly, CPA/ABV, CGMA Jeff Phillips, CFA, CPA Mike Robbins, CPA

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1 Presented by: Andrew Rose, CPA Mike Bozimowski, JD, MST, CM Don McAnelly, CPA/ABV, CGMA Jeff Phillips, CFA, CPA Mike Robbins, CPA

2 (commonly referred to as repair regs )

3 Page 3 andrew.rose@rehmann.com Principal Rehmann s Commercial Industry Group leader Experience in areas of taxation including S corporations, partnerships, like-kind exchanges, and alternative energy tax incentives Provides services including providing compliance and consulting to clients involved in construction and real estate

4 Page 4 Capitalize amounts paid to acquire, produce or improve tangible property. Generally required to capitalize amounts paid to either a.) increase the fair market value of the property, b.) substantially prolong the useful life of the property, or c.) adapt property to a new or different use. Expense all ordinary and necessary expenses including materials, supplies, and repairs. Amounts paid to keep property in an ordinarily efficient operating condition may be deducted as an expense. Taxpayers and the IRS have been at odds over these rules for decades with taxpayers wanting to expense expenditures and the IRS wanting to capitalize as improvements. The result has been a confusing mix of court rulings that utilize a facts and circumstances method to determine how to treat an expenditure.

5 Page 5 Generally required to capitalize amounts paid that result in either a betterment, adaptation or restoration (B.A.R. test) of a unit of property (UOP). Specific rules define what comprises a UOP. Betterment, adaptation and restoration are defined in general terms with numerous, specific examples provided in the regulations as guidance. De minimis safe harbors were created to simplify the process for smaller expenditures. New rules were created for the treatment of materials and supplies that require the identification of incidental and non-incidental materials and supplies. Most taxpayers will need to file one or more accounting method changes and elections to become compliant with the new regulations.

6 Page 6 Distinguish between unit of property (UOP) and building system Distinguish between structural component (Regs (e)(2))and major component or substantial structural part. Properly identify materials and supplies. Partial asset dispositions are now permitted. Guidance has been provided to determine the basis of the partial asset disposed. Going forward, generally a good idea to determine and then track cost of building and the 8 building systems identified in the final regulations. Cost segregation studies will continue to be an important tool and more focus should be placed on using them to accurately separate and classify fixed assets. Annual elections will likely be required in the tax return. Automatic change in accounting methods (Form 3115) will likely be required along with 2014 tax return.

7 Page 7 Analysis must start with determining the unit of property (UOP). Have to know the UOP to determine if the expenditure results in: Betterment Adaptation of the property to new or different use Restoration By relating expenditures to the repair of a larger UOP rather than a smaller UOP, taxpayer is in a better position to argue there is not a betterment, change in use or restoration.

8 Page 8 Special rules apply to buildings Unit of property = building and its structural components Expenditures restore UOP if they restore the building structure or one of nine defined building systems. A roof is considered part of the building structure (shell) Apply repairs standards separately to the building structure and the nine defined building systems. 1. HVAC 2. Plumbing systems 3. Electrical Systems 4. Escalators 5. Elevators 6. Fire protection and alarm systems 7. Security systems for protection of building and occupants 8. Gas distribution system 9. Any other system defined in published guidance

9 Page 9 If a UOP is not currently properly classified on a taxpayer s depreciation schedule, an automatic change in accounting method (Form 3115) will be required with the 2014 tax return. Most likely this will not result in a 481(a) adjustment. A common example would be a multi-building apartment development when the first three buildings were placed in service together as one single asset. The cost of the three buildings will need to be broken out into individual buildings and a Form 3115 will need to be filed with the 2014 return. Assuming depreciation was properly computed on the original asset, there will likely be no 481(a) adjustment from this change.

10 Page 10 Example 1: HVAC system incorporating 10 roof-mounted units is a building system and treated as a UOP. Example 2: Two elevator banks consisting of 3 elevators each is a building system and treated as a UOP. Example 3: Plumbing system in a office condominium is a building system and treated as a UOP. Example 4: Extension to office building is compared to the building structure and the buildings systems to determine if it is an improvement. Example 5: Power plant s boiler, turbine, generator and pulverizer are each treated as separate UOPs. Turbine blades are not separate UOPs. Example 6: Laundry plant s sorter, boiler, washer, dryer, ironer, folder and waste water treatment plant are separate UOPs. Example 7: Tortilla-making equipment is a UOP. Not plant property, so not broken into components.

11 Page 11 Example 8: HVAC system of leased building is a building system and is treated as a UOP. Example 9: Driveway constructed by lessee adjacent to leased building is separate UOP. Example 10: Driveway constructed by lessee but owned by lessor adjacent to leased building is separate UOP. Example 11: Two separate office spaces in same building subject to separate leases treated as two separate UOPs. Example 12: Warehouse extension added to retail sales facility is not a separate UOP. Example 13: Change in class of property as result of cost segregation study results in separate UOP because portion of property reclassified from nonresidential real property (with a 39 year life) to qualified retail improvement property (with a 15 year life).

12 Page 12 An amount paid results in a betterment only if it: 1. Ameliorates (fixes) a pre-existing material condition or defect at the time you acquired the property (regardless of whether taxpayer was aware of the defect), 2. Results in a material addition, or 3. Results in a material increase in capacity, productivity, efficiency, strength, quality or output. Replacements due to technological improvements or product enhancements do not necessarily require capitalization. Key is compare the condition of the property after the expenditure to the condition of the property when initially placed in service. Taxpayer s treatment of the expenditure on its financial statements is not a factor to be considered.

13 Page 13 Not a Betterment Replacement of asbestos insulation with Similar non-asbestos insulation (Ex 2) Minor repairs and maintenance shortly after purchase (Ex 3, 4) Retail refresh limited to cosmetic and layout changes (Ex 6, 7) Relocate cash registers (Ex 9) Add concrete lining to meat plant (Ex 12) Roof membrane (Ex 13) Removal of drop ceiling (Ex 18) Replace 2 of 10 HVAC units that are 10% more efficient (Ex 20) Betterment Remediation of soil by previous owner (Ex 1) Bring assisted living building up to higher standards (Ex 5) Retail refresh along with increased storage, second loading dock (Ex 7) Major remodel of retail (Ex 8) Relocate machines to increase capacity (Ex 10) Doubling depth of channel (Ex 15) 25% increase in depth of channel (Ex 17) 50% reduction in energy or power costs (Ex 21) Add restaurant drive through

14 Page 14 Replace and reconfiguring display tables and racks to provide better exposure of the merchandise Make corresponding lighting relocations and flooring repairs, Move one wall to accommodate the reconfiguration of tables and racks Patch holes in walls Repaint the interior structure with a new color scheme to coordinate with new signage Replace damaged ceiling tiles Clean and repair wood flooring throughout the store building, and Power washing building exteriors.

15 Page 15 Improvement needs to be capitalized if paid to adapt a UOP to a new or different use. Improvement needs to be capitalized if the adaptation is not consistent with the taxpayer s ordinary use of the unit of property at the time originally placed in service by the taxpayer.

16 Page 16 Not a Change in Use Combine 3 leased retail spaces into 1 leased retail space (Ex 2) Minor refresh of building in anticipation of sale (Ex 3) Clean up contamination after closing manufacturing plant (Ex 4) Convert a portion of grocery store space to a sushi bar (Ex 6) Convert a portion of hospital emergency room to an outpatient surgery center (Ex 7) Change in Use Convert manufacturing plant to showroom space (Ex 1) Regrade land to accommodate sale of land for residential development (Ex 4) Reconfigure part of a retail pharmacy to a walk-in clinic (Ex 5)

17 Page 17 Amount is paid to restore UOP if it: 1. Is a replacement of a UOP and the taxpayer has properly deducted a loss for that component; 2. Is for the replacement of a component of a UOP and taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component. 3. Is for the repair of damage to a UOP for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss or casualty event (but only to the extent of the claimed casualty loss). 4. Returns the UOP to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use; 5. Results in the rebuilding of the UOP to a like-new condition after the end of its ADS class life; or 6. Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property. It is this provision the IRS uses to say roof replacements now must be capitalized.

18 Page 18 Not a Restoration Replace power switch (Ex 13) Roof membrane (Ex 15) Replace 1 of 3 furnaces in HVAC system (Ex 16) Replace of 3 of 10 roof-mounted HVAC units (Ex 18) Replace 30% of electrical (Ex 21) Replace 8 of 20 sinks (Ex 23) Replace 100 of 300 exterior windows comprising 8.3% surface area (Ex 25) Replace lobby floors which comprise < 10% sq. footage (Ex 28) Replace 1 of 4 elevators (Ex 30) Restoration Replace entire roof (Ex 14) Replace single chiller in HVAC (Ex 17) Replace sprinkler system (Ex 19) Replace entire electrical system (Ex 20) Replace all toilets and sinks with similar quality and function (Ex 22) Replace 200 of 300 exterior windows comprising 16.67% surface (Ex 26) Replace 100 of 300 exterior windows comprising 30% of surface area (Ex 27) Replace floors in all public areas comprising 40% of sq. footage (Ex 29) Replace 1 of 4 elevators and claim partial disposition loss (Ex 31)

19 Page 19 Amounts paid to improve a unit of property over a period of time are required to be capitalized. Provision covers a plan of improvement taking place over a period of time. Whether the amounts paid are related to the same improvement is based upon facts and circumstances. How is period of time defined? Regulations do not define; based upon facts and circumstances. 1 to 3 year period most likely need to treat as related and capitalize. More than 5 year period most likely treat as unrelated. 3 to 5 year period will rely on facts and circumstances. But remember individual facts and circumstances are key!

20 Page 20 Routine maintenance consists of recurring activities that are expected to be performed on a building or other unit of property (UOP) as a result of its use to keep the asset in its ordinary efficient operating condition. Taxpayer must reasonably expect to perform the activities more than once during the useful life of the asset (or a 10 year period for a building) beginning at the time the asset is placed in service. Routine maintenance includes inspections, cleanings, and replacement of damaged or worn parts with comparable parts. The safe harbor does not apply to any expenditure that would be considered betterment, restoration or adaptation. Must file an automatic change in accounting method (Form 3115) to adopt the safe harbor method.

21 Page 21 Acquisition costs the new rules Taxpayer must capitalize amounts paid to acquire or produce a UOP. Generally the invoice price. Amounts paid to defend or perfect title must be capitalized into the cost of the property. Must capitalize amounts paid to facilitate the acquisition of real or personal property Must capitalize inherently facilitative costs (accounting, legal, appraisals, environmental, etc.) Must capitalize costs for work performed prior to placed in service dates

22 Page 22 Removal costs are not capitalized if basis of the asset is taken into account in realizing gain or loss. Costs of removing a component of a UOP are treated as any other indirect cost incurred during the improvement of property. Removal costs are capitalized if they directly benefit or are incurred by reason of an improvement. Removal costs unrelated to any improvement may be deducted. This provision provides an opportunity to claim prior year losses when capitalizing replacement and did not previously take into account remaining basis.

23 Page 23 Example 1 Removal costs incurred to replace original columns and girders supporting a second floor thereby permitting greater storage of supplies must be capitalized as a betterment because the taxpayer did not elect to treat the disposed items as a partial disposition. Example 2 Same facts as Example 1, except the taxpayer elects to treat the disposal of the structural components as a disposition. In this case, the removal costs do not have to be capitalized, but the other costs of the betterment still must be capitalized. Example 3 Costs to remove old shingle and replace with new shingles do not have to be capitalized as long as the replacement of the shingles does not constitute an improvement to the building in this example they are assumed to not improve the building because they were comparable to the original shingles. Example 4 Same facts as Example 3, except taxpayer elects to treat the replacement as a partial disposition. In this case the new shingles must be capitalized. However, the cost of removing the old shingles does not have to be capitalized regardless of their relation to the improvement.

24 Page 24 Defined as tangible property that is used or consumed in the taxpayer s operations that is not inventory and that are: 1. Components acquired to maintain, repair, or improve a UOP; 2. Consists of fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months of less; 3. A UOP with an economic useful life of 12 months or less; 4. A UOP costing $200 or less; OR 5. Identified as such in guidance General rule for when deducted: Incidental (not inventoried) deduct when paid (provided clearly reflects income) Non-incidental (tracking consumption) deduct when first used or consumed in taxpayer s operations Rotable, temporary, emergency spare parts deduct when part is disposed; deduct when used (and include in income when removed from service); treat as depreciable property. Required method change (Form 3115) to adopt new rules

25 Page 25 Taxpayer purchases 3 microwaves for a total cost of $500. Each microwave is considered a UOP and costs less than $200 and therefore would be considered materials and supplies. Deductible when first placed in service (unless the taxpayer has a de minimis safe harbor election in place). Items purchased for rental costing less than $200 each are materials and supplies and deductible when first used in the rental business. So if purchased in year 1, but not used until year 2, then deductible in year 2. Appliances separate UOP; may qualify as materials and supplies. Carpeting not a separate UOP; part of a building component; may be deductible. Windows not a separate UOP; part of a building component; may be deductible.

26 Page 26 Annual election made in tax return. Allows taxpayer to deduct expenditures below a set threshold. Threshold is $500 per invoice or per item unless the taxpayer has an applicable financial statement (AFS). If AFS, threshold is $5,000. AFS = audited or government-required financial statement. Taxpayer must maintain a written accounting policy. Book treatment must match tax treatment. Applies to property with a useful life of 12 months or less if the amount per invoice (or item) does not exceed the $500/$5,000 threshold. The $500/$5,000 threshold are safe harbor amounts taxpayers may elect a higher capitalization threshold if they can justify the amount. Threshold is $200 if the taxpayer does not have an accounting policy or if the annual election is not made.

27 Page 27 Taxpayers with average annual gross receipt for the 3 preceding tax year of $10 million or less may elect to not capitalize improvement to property if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities performed on eligible building property does not exceed the LESSER of: (1) 2% of the unadjusted basis of the eligible building or (2) $10,000. Eligible building property building, condominium, cooperative, or leased building or portion of building that has an unadjusted basis of $1 million or less. In case of lease, the unadjusted basis is deemed to be the total amount payable over the expected lease term without any discounting. Must make annual election in the tax return.

28 Page 28 Example 1 Taxpayer who incurs $5,500 of repairs can expense under small taxpayer safe harbor because the expenses do not exceed the lesser of 2 % of the building s unadjusted basis of $750,000 or $10,000. Example 2 Taxpayer who incurs $10,500 of repairs cannot expense under the small taxpayer safe harbor because while the expenses do not exceed 2% of the building s unadjusted basis of $750,000 (which is $15,000), they do exceed $10,000. The limitations is the lesser of 2% of the unadjusted basis or $10,000. Example 3 Taxpayer with two rental properties, both of which have an unadjusted basis of $1 million or less, may test each building separately to determine if the expenses applicable to each can be deducted under the small taxpayer safe harbor. In the case of building 1, the taxpayer can expense under the safe harbor because the lesser of limitation is met; however, in the case of building 2, the taxpayer cannot deduct under the safe harbor because while the expense is less than $10,000, it also is not less than 2% of the unadjusted basis of the building which was $300,000 in the example. Point here is that it is a building by building analysis.

29 Page 29 Taxpayer may elect to capitalize repair and maintenance costs on an annual basis. Costs must be incurred in the taxpayer s trade or business. Book and tax treatment must be the same. Taxpayer is not required to capitalize ALL repairs and maintenance. Election only applies to those repairs and maintenance costs treated as capital expenditures by the taxpayer for books. Annual election attached to tax return. Election may be beneficial if the taxpayer capitalizes certain expenditures which potentially could be classified as repairs and maintenance provides a backup plan in the event of an IRS auditor attempts to disallow depreciation claiming the asset should have been expense as a repair.

30 Page 30 New regulations provide that the disposition rules apply to a partial disposition of an asset. This rule allows taxpayers to elect to claim a loss upon the disposition of a structural component of a building or upon the disposition of a component of any other asset (properly included in one of the asset classes through 00.4 of Rev. Proc ) without identifying the component as an asset before the disposition event For 2014, ability exists to review depreciation schedules and record partial asset dispositions that occurred in prior years. Most commonly this will apply when roofs and other major building components were replaced in a prior year. Will require an automatic change in accounting method (Form 3115) be filed with the 2014 return. The undepreciated basis of the PAD will result in a negative 481(a) adjustment which will be deductible in Additional benefit of eliminating depreciation recapture upon sale of the building.

31 Page 31 Example 1: Taxpayer replaces 1 of 4 elevators in office building and does not make the special partial disposition election to claim a loss on the remaining basis of the disposed elevator. Replacement of the elevator must be capitalized as a betterment or restoration (example doesn t say which) and the remaining cost of the disposed elevator continues to be depreciated as part of the building. Example 2: Same facts as Example 1, but the taxpayer has componentized the building in its fixed asset systems. If no election is made to claim a loss on partial disposition, no loss is claimed and the results are the same as Example 1. Example 3: Same facts as Example 1, but in this case the taxpayer makes the special partial disposition election. In this case, the taxpayer can claim a loss on the remaining basis of the elevator and must capitalize the cost of the new elevator.

32 Page 32 Regulations provide a method for taxpayers to correct prior year classifications in the treatment of expenditures. Review depreciation schedules and identify any expenditures for repairs and maintenance that were capitalized under prior rules. The ability to write these off eliminates potential future depreciation recapture. Review repair and maintenance account for any expenditures treated as repairs that should have been capitalized.. Need to file an automatic change in accounting method (Form 3115) with the 2014 tax return to take advantage of this provision. A net negative adjustment will be deductible in A net positive adjustment will be taken into income over 4 years starting in 2014.

33 Page 33 Determine if the de minimis safe harbor (DMSH) election will be adopted and the appropriate threshold to be used. Should the capitalization policy use an amount higher than $500 or $5,000? Ensure the appropriate written accounting policy is in place. Modify internal processes to comply with the Regulations regarding capitalization, repairs and materials and supplies. Review depreciation schedules to identify potential prior year partial asset dispositions, depreciation methods and lives needing correction, and repairs that should be expensed. Consider reviewing prior repair and maintenance expenses for expenditures that should have been capitalized. This will probably depend upon how aggressive the company was in expensing repair and maintenance in prior years. Consider the financial statement impact of current, past and future changes to treatment of expenditures. Keep in mind any loan covenants.

34 Page 34 Prepare appropriate Form 3115s for automatic changes in accounting methods. Some will be required; others will be optional based upon the taxpayer s circumstances. Changes most commonly needed will be: Treatment of materials and supplies Capitalization versus repairs and maintenance Identify the unit of property Change depreciation methods and bonus Prior year partial asset dispositions Proper treatment of removal costs Adopting the routine maintenance safe harbor

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37 Page Principal Rehmann s Commercial Industry Group leader Specializes in tax services including the various state and local taxes, merger and acquisition assistance, settlement negotiations as well business and strategic planning Experience includes consulting for various industries for clients both large and midsized

38 Page 38 The information provided herein is educational in nature and is based on authorities that are subject to change. You should contact your tax adviser regarding application of the information provided to your specific facts and circumstances. All views expressed are those of the presenter and should not be construed as an opinion of the firm represented.

39 Page 39 State Business Activity Taxes

40 Page 40 Excise Taxes Payment for having done business in the state Usually based on net income Franchise and License Taxes Payment for the right to conduct business in the state Usually based on net worth, but can be net income Often paid in advance of privilege period Other Tax Types Gross Receipts Taxes Gross Margin Taxes Some states impose a combination of these taxes

41 Page 41 State Nexus and Jurisdiction to Tax

42 Page 42 Nexus ( link ) describes the amount and degree of business activity that must be present before a state can tax an entity s income. Defined by state statute, case law and/or regulation and, consequently, tends to vary from state to state. Constitutional principles apply to all states. Commerce Clause requires that: Activities taxed must have a substantial nexus with the taxing state; The tax must be fairly apportioned; The state tax must not discriminate against interstate commerce; and The tax must be fairly related to the services provided by the state. Due Process Clause requires: A minimal connection between interstate activities and taxing state (See Mobil Oil Corp.), and An apportionment formula not be unreasonable and arbitrary in its application States Rights to by-pass federal Treaty law to impose tax

43 Page 43 Physical Presence Maintaining an office in the state Employees in the taxing state Services Continuous, systematic, and regular contact Independent agent Doing business within the state Owning property in the state Deriving income from sources within the state 2014 Rehmann

44 Page 44 Economic Presence Geoffrey v. South Carolina and use of intangibles Other state decisions (no Supreme Court decisions) Sherwin Williams v. Com r of Revenue (MA) Lanco, Inc. v. Director, Division of Taxn. (NJ) ACME Royalty Co. (MO) Agency Nexus Activities of in-state person create nexus due to agency relationship. See Tyler Pipe. Affiliate Nexus Related companies either by agency or statute

45 Page 45 Jurisdiction is a state s power to impose a tax. Defined by state statute, case law and/or regulation and also varies from state to state. Imposition statutes are construed narrowly against the state. A tax at the following rate of adjusted gross income is imposed on that part of the adjusted gross income derived from sources within Indiana of every corporation Public Law (15 USC 381, et seq.) Federal limitation on states power to impose income tax Applies only to sellers of tangible personal property that Solicit orders by an employee or representative Orders sent outside the state for approval Filled by shipment or delivery from a point outside the state

46 Page 46 Domestic corporations (corporations that are incorporated under the laws of the taxing state) and resident individuals Foreign commerce (Although some states administratively have extended the statute s provisions to foreign commerce, the practice is not uniform.) Sale of intangible property Activities connected with the sale of a service Taxes not based on income: Net worth tax Sales or use tax Capital stock tax

47 Page 47 Solicitation is not defined in the statute States adopted varying interpretations as to what constituted solicitation and what exceeded Ohio and automobiles Wrigley v. Wisconsin Rejected a narrow construction of solicitation Concluded de minimus exception is applicable under Public Law Decided Wrigley s non-immune activities were neither ancillary to requesting orders nor de minimus

48 Page 48 Soliciting orders for sales by any type of advertising Soliciting through an in-state resident employee or representative of the company Carrying free samples and promotional materials Furnishing and setting up display racks and advising customers on the display of the company s products Providing automobiles to sales personnel for their use in conducting protected activities Passing orders, inquiries, and complaints on to the home office Missionary sales activities, i.e., the solicitation of indirect customers for the company s goods Coordinating shipment or delivery (and providing information about same) either prior to or subsequent to the placement of an order Checking of customers' inventories (for re-order, but not for other purposes such as quality control) Maintaining a sample or display room for 14 days or less at any one location within the state during the tax year Recruiting, training, or evaluating sales personnel Mediating direct customer complaints when the purpose is solely for ingratiating the sales personnel with the customer and facilitating requests for orders Owning, leasing, using, or maintaining personal property for use in a sales rep s in-home office

49 Page 49 State Income Tax Calculation

50 Page 50 IRC Conformity - Each state makes its own decision relating to conformity to the Internal Revenue Code (IRC). Some states compute taxable income in the same manner as federal for the tax year Other states have adopted the IRC in its entirety, but have adopted the Code in effect as of a certain date (e.g., Kentucky uses IRC as of December 31, 2006) Other states have adopted the Internal Revenue Code, but have specifically not adopted certain provisions of the Code such as bonus depreciation.

51 Page 51 Common State Modifications and Requirements Starting point Federal taxable income Line 28 or Line 30 Eases administrative burden of computing state taxable income and creates a degree of uniformity Despite broad conformity to federal tax base, state addition and subtraction modifications vary Proforma Federal Return for STATE TAX purposes 2014 Rehmann

52 Page 52 Common State Modifications (continued) Additions (continued) Related Party Royalty and Interest Expenses» Royalties NC» Royalties and Intangible related interest GA, IN, MS, MI, NY, RI, TN, VA and OR» Royalties and All Intercompany interest AL, AR, CT, DC, IL (80/20, other), MD, MA, NJ, OH and WV» Royalties, All Intercompany interest and Other Expenses KY, SC and WI There are a number of exceptions, which should be explored 2014 Rehmann

53 Page 53 Most states allow NOL deductions but the specific rules vary Line 30 Starting Point Generally states that begin with federal line 30 require the add-back of the federal NOL and then allow a subtraction for post-apportioned state-specific NOL. Pre-Apportionment - NOL applied to state income tax calculation prior to the application of the apportionment factor. Post-Apportionment NOL applied to state income tax calculation after the application of the apportionment factor. States may have carryback/carryover provisions that differ from the federal NOL rules. Some states will occasionally suspend or limit state NOLs.

54 Page 54 Franchise Tax Calculation

55 Page 55 Generally based on the corporation s balance sheet Franchise tax base may include any combination of equity, debt and intercompany debt Typical franchise tax calculation: Common Stock + Additional Paid in Capital + Retained Earnings +/- Other Adjustments = Capital Subject to Apportionment X Apportionment % = Apportioned Capital X Tax Rate = Franchise Tax Liability before Credits - State Credits = Franchise Tax Liability

56 Page 56 Apportionment and Allocation

57 Page 57 A business that operates only in its home state reports 100% of its income is taxable in the home state. A business that operates in its home state and another state will generally apportion and allocate income. Most states require a business to be taxable in another state as a precondition to apportion.

58 Page 58 Different approaches that attempt to determine the amount of income earned in a particular state State Statutory Concept If income is non-business, then it is allocated. If it is business income, then it is apportioned. To determine if income is business or non-business: Transactional Test Regular course of taxpayer s trade or business Functional Test Acquisition, disposition or management integral to taxpayer s business Is the Functional Test subject to the Transactional Test or is it a standalone test?

59 Page 59 The Constitutional Concept Mead Unitary / Non-Unitary If non-unitary income, then it is allocated If unitary income, then it is apportioned Old Law: Bendix sold stock in ASARCO Inc. and treated the gain as allocable, nonbusiness income for NJ corporate income tax purposes. NJ said the income was business income and should be subject to apportionment. [Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768, 1992] Rather than isolating the intrastate income-producing activities from the rest of the business, a State may tax a corporation on an apportioned sum of the corporation's multistate business, if the business is unitary. This known as operational income. [ASARCO Inc. v. Idaho State Tax Comm'n, 458 U.S. 307].

60 Page 60 Apportionment is a method of assigning the income of a multistate corporation among various states State Property / Everywhere Property = Property Factor State Payroll / Everywhere Payroll = Payroll Factor State Sales / Everywhere Sales = Sales Factor Apportionment weighting Standard Three Factor Double Weighted Sales Single Sales Factor Other Weightings

61 Page 61 Sales generally means all gross receipts from transactions and activity in the regular course of the taxpayer s trade or business Sales of goods and services Interest Dividends Rentals and Royalties Proceeds or Gain/(Loss) from sales of property, unless extraordinary Other income

62 Page 62 Sales of Tangible Personal Property Destination Test Reflects underlying policy to provide tax revenue to market states Exception if purchaser is U.S. government Dock Sales Out-of-state purchaser takes delivery at the seller s loading dock Sales of Intangibles General rule = cost of creation/performance state v. market Software licensing = location of use/mpu

63 Page 63 Service Receipts Cost of Performance Rule Sales of services attributed to the state in which the income-producing activity is performed. If the incomeproducing activity is performed in two or more states, the sale is attributed the state in which a greater proportion of the activity is performed, based on the costs of performance. A poorly developed area of state tax law with a number of open questions: What is an income-producing activity?» A single transaction?» A series of related transactions?» A revenue stream?» All of the service revenue?

64 Page 64 Service Receipts Market States - Has the perceived political appeal of reducing tax burden on service providers that have in-state facilities but provide services to out-of-state customers. Potential for nowhere income also creates an incentive for regional and national service providers to locate facilities in a market state. Nowhere income is income that is not taxed anywhere at the state level. States with market-based approaches include Georgia, Illinois, Iowa, Maine, Maryland, Minnesota, Utah and Wisconsin. Market States have taken a number of different approaches IL services received & throw-out rule MI, OH, WA location of benefit OK location of customers MN, WI other approaches More complexity

65 Page 65 Example: A consulting company is headquartered in Indiana. Consultants travel to customer locations in Illinois which represent 40% of company s total revenue. However, 90% of the work is performed at the Indiana office. Indiana is a cost of performance state. Therefore, 100% of sales are sourced to Indiana because more than 50% of the costs are incurred in Indiana. Illinois is a market state. As a result, 40% of company s sales are also sourced to Illinois the location of company receiving the consulting services. Illinois Sales of services are attributed to Illinois if the services are received in Illinois. Services provided to a corporation, partnership or trust may only be attributed to a state where the customer has a fixed place of business. If the state where the services are received is not readily determinable, or if it is a state where the customer has no fixed place of business, the services are deemed to be received at the location from which the services were ordered. If the ordering office cannot be determined, the services are deemed to be received at the office where the customer was billed. If the taxpayer is not taxable in the state in which the services are received, the sale is excluded from both the numerator and denominator.

66 Page 66 Alternative Apportionment Rule (MTC) May petition for or be required to use: Separate accounting Inclusion of one or more factors Other method Apportionment provisions presumed to fairly attribute income Must show business activity attributed to state is all out of appropriate proportion and leads to grossly distorted result Taxpayer has burden of proof, if taxpayer requests alternative apportionment method Amended returns do not constitute a petition for relief

67 Page 67 Filing Methods: Separate, Combined, Consolidated and Unitary

68 Page 68 Separate Return Method Indiana (Combined for FIT) Tennessee (Combined for FIT) Combined Report Method Nexus Combined Consolidated Return Method Elective Consolidation vs. Forced Trend in legislation for states to move from separate company filings to unitary filing e.g., D.C., MI, NY, OH, and TX

69 Page 69 Unitary Business Theory holds that the various parts of a business (e.g., sales and manufacturing) are sufficiently related to each other to require they be treated as a single, unitary business. While the theory was first applied to divisions of a single corporation, it also applies to multiple corporations that constitute a unitary business group. Some states treat partnerships and S corporations as members of the unitary group, others do not. If a taxpayer is carrying on a single business through multiple corporations within and without the state, the state has the requisite connection to the out-of-state activities of the business to justify inclusion in the taxpayer s apportionable income base.

70 Page 70 Two requirements (sample rules, actual vary by state) Control Test: One of which owns or controls, directly or indirectly more than 50% of the ownership interest with voting rights or interests with comparable rights; and Relationship Test: Business activities result in a flow of value between or among the persons in the unitary business group OR that has business activities or operations that are integrated with, are dependent upon or contribute to each other OR the existence of vertical or horizontal integration Note: see various states definitions of indirect ownership through attribution or construction ownership, e.g., IRC 318, IRC 267 or other methods of attribution.

71 Page 71 The prerequisite to a constitutionally acceptable finding of unitary business is a flow of value... Container Corporation 483 US 159(1983) Common tests for flow of value: Functional integration through same line of business or steps in a vertically integrated process; Centralized management with actual control, centralized departments or function; or Economies of scale which exists whenever a function is enhanced through the sharing of the group s resources.

72 Page 72 Water s Edge Group Generally, only includes all U.S. persons, other than U.S. foreign operating entities Worldwide Group Includes all members of group who meet both the control and relationship tests, regardless of whether entities are foreign or domestic Rehmann

73 Page 73 Pass-Through Entities

74 Page 74 Typically taxed in the same manner as federal for state income tax purposes: Exceptions apply, i.e. Tennessee Franchise and other hybrid taxes are typically imposed and paid at the entity level Kentucky for LLET; Michigan MBT (through 12/31/2011); Ohio CAT; Texas Gross Margin 2014 Rehmann

75 Page 75 Individual Owners Individual owners typically have state income tax filing requirements based on their distributive shares of income. Many states require that entities withhold income tax on individual owners distributive share of income. Most states have composite filing options, which allows the entity to pay the income tax on behalf of the owner Rehmann

76 Page 76 Non-Individual Owners Income & apportionment factors flow through to the non-individual owners (pre-apportionment method). A few states (unitary v. non-unitary) flow through income after apportionment (post-apportionment method). Some states flow up factors only if the partner and the partnership have a unitary relationship Most states require that entities withhold income tax on non-individual owners distributive share of income. Ownership in a pass-through entity will typically result in nexus at the non-individual owner level.

77 Page 77 Sales and Use Tax

78 Page 78 Overview Types of Sales and Use Taxes Nexus vs Income Tax Nexus Foundation of Tax 2014 Rehmann

79 Page 79 Sales tax first enacted and imposed by numerous states during the 1930 s Depression to raise revenue In the U.S. 45 states and DC impose some sort of sales and use tax, except: New Hampshire Oregon Montana Alaska (City of Juneau & Anchorage impose local sales tax) Delaware (rentals/leases are subject to a rental tax)

80 Page 80 Sellers Privilege Tax Imposed on seller Tax does not have to be separately stated Seller must pay whether or not tax is collected States include: AZ, CA, MI & SC Vendee or Consumers Excise Tax Imposed on buyer Seller must pay, but has easier claim for recovery if not paid by buyer Tax must be separately stated States include: NY, OH, PA

81 Page 81 Transaction Tax Tax imposed on the sale or purchase of TPP at retail Buyer and seller equally liable for payment of tax Tax must be separately stated States include: FL, GA, IL, SD, TX, WV Gross Receipts Tax Imposed on and borne by seller Similar to Sellers Privilege Tax, but has fewer exemptions States include: AL, HI, NM, and WA

82 Page 82 What does it mean to have Nexus Seller maintains place of business in state Own or lease property Sales representation Truck deliveries Provide assembly, service, or repair of TPP, either directly or through an agent Amazon Nexus What actions should a client take? Sales and use tax registration Voluntary Disclosure Amnesty Programs

83 Page 83 Elements of Sales and Use Tax Sale at retail of tangible personal property Use of tangible personal property acquired in a retail transaction 2014 Rehmann

84 Page 84 The Tax Base Tangible Personal Property personal property that can be seen weighed, measured, felt, or touched Intangible Personal Property cannot be weighed, measured felt or touched Real Property land, buildings, and property affixed to real property are generally not part of the tax base In Florida, the rental of real estate is subject to sales and use tax Services some states have enumerated services that are subject to sales and use tax

85 Page 85 Retail Sale Sales tax is based on the sale to the ultimate consumer at retail Sales to Consumer sales to the consumer who will use the property for their own use Common Exclusions: Discounts Transportation (shipping and/or delivery) Charges (some states) Custom v. Canned Software (most states) Services (some states)

86 Page 86 Sales and Use Tax Exemptions (varies by state) Exemption based on type of entity making the purchase Federal Government State and Local Government Charitable Organizations Exemption based on type of transaction Resale Casual or Isolated Sales Exemption based on type of property or use Manufacturing or Industrial Processing Agricultural Packaging Food (if not for immediate consumption) Clothing Prosthetic Devices

87 Page 87 Capital/Finance Leases Meets the 4 part test 1. PV of the minimum lease payments greater or equal to 90% of the FMV of the equipment 2. Lease period covers over 75% of the useful life of the equipment 3. Lease includes a bargain purchase option 4. Title transfers at the end of the lease Sales and use tax due on the purchase price Operating/ True Leases Fails the capital lease test In Illinois, lessor owes sales/use tax on equipment cost. Lease stream is not subject to tax Sales tax in most states is due on the lease stream

88 Page 88 Manufacturing Machinery and Equipment Exemption Qualifying Machinery and Equipment Replacement Parts Gas and Electricity Packaging Equipment Packaging Supplies 2014 Rehmann

89 Page 89 Documentation to Substantiate the Exemption Blanket Exemption Certificates Single or Unit Exemption Certificates State-specific Resale Exemption Certificates MTC s Model Multistate Certificate Manufacturing Exemption Certificates Note: the key is the seller will always need to be able to provide a state auditor with some type of acceptable documentation that the sale was exempt and why.

90 Page 90 Custom Software is software that is designed, created and developed for and to the specifications of an original purchaser is not subject to tax Sales of "canned" computer software are typically taxable retail sales All other retail sales of computer software are taxable Companies may sometimes avoid the sales and use tax liability on retail sales of software by having it delivered electronically to certain states. i.e. California, Florida, New Jersey, and North Carolina take the position that because the electronic delivery of software is not an exchange of tangible personal property, it is therefore not subject to sales and use tax.

91 Page 91 Software Licenses DOR regulations recognizes that software that is restricted by a manufacturer s license restricts the users freedom to utilize the program are not taxable Typical shrink wrapped software license agreements restricting the customer from copying the program will not qualify as a licensing agreements that is exempt from tax Rehmann

92 Page 92 ASP Services Provide Remote Access to Software Software is not downloaded to client servers. User IDs and passwords are issued. May be part of data processing and information services. Guidelines for sales and use tax are still in development for many states. ASP may be treated as a software license in some states.

93 Page 93 Property Taxes

94 Page 94 Overview Tax Determination Assessment Process Types of Property Valuation Personal Property/Real Property Reporting Michigan Proposal Rehmann

95 Page 95 Property taxes are often the primary source of funding for local government units, including Schools County and township governments Cities and towns Libraries and Fire and solid waste districts Property taxes are typically administered and collected by local government officials. Property taxes are an ad valorem tax, meaning that they are allocated to each taxpayer proportionately according to the value of the taxpayer's property.

96 Page 96 Discovery Property Identification Situs Property Classification Data Collection and Analysis Property Valuation Preparation and Certification of Roll Notification Program Appeals Procedure Tax Bill Repeat Annually

97 Page 97 Lien date When liability attaches to the property Assessment date When property is valued Vary by jurisdiction Most states use January 1 Due date Personal property self-assessed from taxpayers via personal property tax return filings

98 Page 98 Personal Real Intangible Exempt Property Public property Assets used and owned by a charitable or public service organization (hospitals, schools, etc.) Implements of husbandry and farm commodities Personal household goods

99 Page 99 Reporting Requirements Vary by Jurisdiction Taxability Varies by Jurisdiction and may be Considered Real or Personal Property

100 Page 100 Money or Deposits Stocks Bonds Patents Core Deposits Goodwill Customer Lists Assembled Workforce Leasehold Interests Trademarks Copyrights Covenants Not to Complete Employment Contracts Development Costs Exploration Rights Franchises Licenses 2014 Rehmann

101 Page 101 The minute you begin to sell across any border foreign or domestic- you need to determine: The level of activity in each jurisdiction Has it grown to create nexus with given jurisdiction Which taxes has this nexus creating activity subjected you to. How do I report those tax for which I have established a filing requirement Rehmann

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104 Page Principal Director of Rehmann Healthcare Management Advisors Serves as the primary CPA contact for healthcare clients in East Michigan Has been published in numerous healthcare-related periodicals on healthcare financial matters and the Patient Protection and Affordable Care Act

105 Page Applicable Large Employer requirements for large employers (greater than 100 FTEs) become effective Applicable Large Employer requirements for mid-size employers (between 50 and 100 FTEs) become effective The ACA has a Double Whammy set for 2016 for employers with employees, subject to the employer mandate and, be forced into the small group market, where premiums are higher and benefits tend to be less and or more expensive. As a result, many midsized employers are now considering going self-insured. 4. Measurement Period Process are you looking into this? 5. SHOP Exchange the SHOP is open for business do you have less than 50 FTEs... Are you shopping?

106 Page Workforce Size Requirement between and you cannot make workforce reductions to help avoid the impact of ACA 7. IRS notice Cannot jettison employees to the Exchange under an employer sponsored plan. This essentially prohibits pretax reimbursement of individual policy premiums. 8. HIPAA-HPID Deadline Delayed until Further Notice health plans were to have an identifier ID. 9. Some ACA Fees: Transitional Reinsurance fee Counts were due now it is December 5, 2014, payments start in 2015 PCORI fee have you been paying this?

107 Page New reporting requirements s (and 1095 s) will become due in early 2016, but you may voluntarily file for 2014 in The form 1095-A will most likely be filed in 2015 as it reports premium assistance received. 11. Small business health insurance credit Is still available, but you must be getting coverage through the SHOP exchange 12. Are you providing employees with: A Marketplace notice? An Exchange Application notice? 13. Has the ACA made Health Insurance more affordable? (Impact of the Balanced Budget Act of 1997)

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110 The information in this presentation is not intended to provide specific advice and should not be constructed as recommendations for any individual. To determine which investments may be appropriate for you, consult with your financial, tax or legal professional Rehmann

111 Page Principal Rehmann s Chief Investment Officer for Rehmann Financial Areas of Service Investment Analysis & Portfolio Design Qualified & Non-qualified Corporate Retirement & Compensation Plans Multi-generational Financial Planning Retirement & Estate Planning Insurance Analysis & Strategies Income & Estate Tax Planning

112 Page Tax Changes for Roth Conversion Opportunities in How Obamacare and Healthcare Laws May Affect Your Taxes 4. Distributions: Ways to Help Keep What s Yours 5. Tax Smart Asset Location 6. Gift-Tax Exclusions 7. Pros and Cons: Treasury Securities and Tax-Exempt Municipals 8. To Give or Not to Give: Giving Appreciated Assets to Charity

113 Page 113 The highest tax bracket starts at Adjusted Gross Income (AGI) over $406,750 ($457,600 for married couples filing jointly.) Pease itemized deductions are limited with incomes of $254,200 or more ($305,050 for married couples filing jointly.) Personal Exemption Increased (PEP) to $3,950 in 2014 from $3,900 in The Alternative Minimum Tax (AMT) exemption amount for tax year 2014 is $52,800 for individuals and $82,100 for married couples filing jointly.

114 Page 114 Minimize income taxes Maximize contributions to retirement accounts 2014 Rehmann Qualified Plans (IRAs, TSA, 401Ks, 403bs)- Plan distributions may be subject to tax and 10% penalty if withdrawn before age 59 ½.

115 Page % 20.0% 20.0% 15.0% Tax Rates for Highest Tax Bracket 25%-35% Income Tax Bracket 39.6% Income Tax Bracket Long-term Capital Gains Dividend Income Source: Tax Policy Center

116 Page 116 Shift taxable investments to tax-deferred accounts Revisit asset allocation 2014 Rehmann

117 Page (k) limits unchanged. Taxpayers may contribute up to $17,500 to their 401(k), 403(b), most 457 plans and federal Thrift Savings Plan (TSP) in 2014.The catch-up contribution limit for employees age 50 and older is also unchanged at $5,500. IRA limits unchanged. The limit on IRA contributions will continue to be $5,500 in Individuals age 50 and older can contribute an additional $1,000. Larger IRA income limits. The tax deduction for traditional IRA contributions is phased out for savers with a workplace retirement plan with incomes between $60,000 and $70,000 and $96,000 and $116,000 for married couples. Higher Roth IRA income cutoffs. The AGI phase-out range for Roth IRAs is $114,000 to $129,000 for singles and heads of household and $181,000 to $191, Rehmann Source: Morningstar.com

118 Page 118 Federal Transfer Taxes 2013 Tax Year 2014 Tax Year Federal gift tax exemption $5.25 million $5.34 million Federal estate tax exemption $5.25 million $5.34 million Federal generation-skipping transfer (GST) tax exemption $5.25 million $5.34 million Estate, gift, and GST tax top rate 40% 40% Annual Gift Exclusion $14,000 $14,000 Source: Tax Policy Center

119 Page 119 If funds used to pay the tax are not taken from the IRA, the taxpayer has more assets taking advantage of tax-free growth. When possible, it s best to pay those taxes with funds outside your retirement accounts. Roth distributions are tax-free, meaning they won t be subject to the new Medicare tax or add to your gross income. Tax rates may be higher at the time of withdrawal from the Roth IRA (particularly for taxpayers who will always be in the highest tax bracket). The taxpayer can choose to undo the Roth conversion until Oct.15 of the year following the conversion (2015 for conversions done in 2014 in this case). There are no Required Minimum Distributions from a Roth IRA as there are from a traditional IRA when a taxpayer reaches 70 and a half. You can leave a Roth to your heirs, giving them tax-free income. Source: irs.gov, taxfoundation.org

120 Page 120 If the Roth IRA earnings are quite low over the time the funds are held in the Roth IRA, the benefits of tax-free growth are lessened. If the Roth IRA loses money over its life, the Roth conversion is unlikely to be beneficial. If the tax rates applied to IRA withdrawals during retirement are lower than the tax rate paid on the conversion, the Roth conversion may not be advantageous. This will depend on the length of the withdrawal period. If converting a Roth IRA significantly increases your tax burden this year. Benefits of the Roth IRA conversion are significantly reduced if the taxpayer uses funds from the IRA to pay the tax on the conversion. To qualify for the tax free penalty free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to a qualified distribution. Sources: irs.gov, taxfoundation.org 2014 Rehmann

121 Page $95 per adult or 1% of family income* $325 per adult or 2% of family income* $695 per adult or 2.5% of family income* *whichever is greater. The penalty cannot be greater than the national average premium for bronze coverage, estimated to be $4,500-$5,000 in Source: money.cnn.com and Kaiser Family Foundation

122 Page 122 Medicare Wage Tax - Single Taxed at 2.35% $1,200,000 $1,000,000 $800,000 Taxed at 1.45% $600,000 $400,000 $200,000 $200,000 $0 Source:

123 Page 123 Maximize contributions to qualified accounts to reduce gross income. Business owners: Consider defined-benefit plans that allow large deductible contributions.

124 Page Take an inventory of all potential sources of retirement income including pensions, 401(k), 457, or 403(b) accounts, IRAs, Social Security, annuities, and personal savings. 2. Determine the tax treatment for each and what it might be if your income sources change. 3. Determine whether you need to adjust your asset allocation to move assets into tax-deferred accounts or maximize contributions to reduce your reportable income. 4. Determine which assets are subject to required minimum distributions. These distribution rules apply to many retirement plans and generally start on the April 1st following the year you turn 70 and a half. 5. Create a plan to minimize taxes now, (especially if you fall into the highest tax bracket) and when you pass assets to your heirs.

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130 Page Principal Rehmann s Director of Tax Serves as a firm-wide tax authority and leads the financial institutions group tax team Experience in the tax consulting and planning area for bank holding companies, manufacturing entities, including mergers and acquisitions, S-Corporations, and financial analysis