THE ELITE QUARTERLY Taxation T.M.

Transcription

1 THE ELITE QUARTERLY Taxation Published by CPElite, Inc. The Leader in Continuing Professional Education Newsletters CPE for Enrolled Agents, RTRPs, CPAs, Licensed Accountants, and CFPs Volume XXI, Number 1, Spring 2012 Issue 4 Hours of CPE Credit (Taxation) Phone and fax # , cpeliteinc@aol.com, web site We hope that you had a successful 2012 filing season. Many of you have renewed your newsletter subscription for 2012 for which we thank you. Many will want to become 2012 subscribers with this newsletter. Please see our subscriber advantages on page 19. Recall that we have 8 courses. All of the 2012 revised courses will be available by July 1. Also, our 2-hour Special Edition newsletter on ethics for enrolled agents will be available by mid summer. To better serve you, we are undergoing substantial changes to our website and our online testing process. Our new website will permit all purchasing, online testing, and records maintenance to be done conveniently at the website. We expect to be completed with these changes in the summer and will announce the launching of our revised website by . This newsletter as well as our other products qualify for CPE credit for Registered Tax Return Preparers (RTRPs) see page 19 for details. If you know any Registered Tax Return Preparer who needs CPE credit this year, we would appreciate your letting them know about us. If you are an owner of a company that employs RTRPs, please call us at we offer quantity discounts. As always, we thank you for being a customer we appreciate your business! Here are some of the items in this issue of the newsletter. 1. Congressional Action (pages 1-2), in the repeal of the 3% withholding requirement on payments to persons providing government services and the expansion of the Work Opportunity Tax Credit for qualified veterans. 2. IRS Rulings and Other Items (pages 2-8), including several items which report 2012 inflation adjustments, an interesting report from the National Taxpayer Advocate, and two rulings involving the accrual basis of accounting. 3. Court Decisions (pages 8-11), including a court decision on qualification for the homebuyer tax credit and a court decision involving prepaid drilling costs. 4. Treasury Items (pages 11-13), including a modification of the definition of limited partner under the passive activity loss rules and the extension of certain FICA and FUCA exceptions to disregarded entities. 5. An Elite Possibility (pages 13-14) dealing with some tax planning opportunities for children holding appreciated investments or savings bonds. 6. Quiz Questions (pages 15-16). 7. Answer Sheet (page 17). 8. Newsletter and Subscription Information (page 19), providing three options for using our newsletter for CPE credit. 9. Course Information (pages 19-20). 10. Enrolled Agent, RTRP, and CFP Information (page 19). 11. CPA and Licensed Accountant Self-Study CPE Information (page 19). LEARNING OBJECTIVE AND CONTENT LEVEL The primary learning objective of this newsletter is to make accounting and tax practitioners aware of recent legislation, IRS and Treasury items, and court decisions which are likely to have an impact on most tax practices. The content level of the newsletter material is an overview of these items. PREREQUISITES There are no prerequisites nor is advance preparation required for our newsletters CONGRESS CONGRESS REPEALS 3% WITHHOLDING REQUIREMENT BEFORE IT TAKES EFFECT On November 21, 2011, President Obama signed The 3% Withholding Repeal and Job Creation Act. There are two major provisions in this law. First, it repeals a new withholding requirement that was to take effect in The federal government as well as state and local governments would have been required to withhold 3% on payments to persons providing any property or services to the government agency after Congress was concerned that the withholding requirements would have reduced cash flow to employers that contract with the government and undermine job creation. Second, the Work Opportunity Tax Credit for hiring qualified veterans has been modified and extended through December 31, The credit now includes a credit for hiring unemployed veterans, doubles the credit for hiring qualified veterans with service-connected disabilities who have been unemployed, and continues the credit for all veterans with a service-connected disability. In addition, a tax-exempt organization is allowed a tax credit against its FICA tax obligations for hiring a qualified veteran. The tax credit can be as much as $2,400 for veterans experiencing short-term unemployment (at least 4 weeks but less than 6 months during the one-year period ending on the hiring date) and $5,600 for veterans experiencing long-term

2 unemployment (equal to or greater than 6 months). The maximum credit for a veteran with a service-connected disability who is hired within one year from being discharged or released from active duty is $4,800. **REVIEW QUESTIONS AND SOLUTIONS** Multiple Choice Questions 1. With respect to The 3% Withholding Repeal and Job Creation Act, which one of the following statements is false? a. Prior to this legislation, federal state, and local government agencies would have been required to withhold 3% on payments to persons providing any property or services to the government agency after b. The Work Opportunity tax credit is extended through December 31, c. The Work Opportunity tax credit for qualified veterans with a service-connected disability is twice the credit for qualified veterans experiencing short-term unemployment. Solutions 1. "B" is the correct response. The Work Opportunity tax credit is extended through December 31, 2012, not December 31, A" is an incorrect response. All governmental agencies would have been affected by the 3% withholding requirement. "C" is an incorrect response. The tax credit for qualified veterans with a service-connected disability is $4,800 while the tax credit for qualified veterans experiencing short-term unemployment is $2,400. The 3% Withholding Repeal and Job Creation Act IRS CERTAIN 2012 INFLATION-ADJUSTED AMOUNTS AFFECTING INDIVIDUALS ARE PROVIDED Revenue Procedure [10/21/11] contains inflation-adjusted amounts for some key items for For married couples filing jointly, the amounts of taxable income at which the various income tax rates begin to apply are: over $17,400 15%; over $70,700 25%; over $142,700 28%; over $217,450 33%; and, over $388,350 35%. For single taxpayers, the amounts of taxable income at which the various income tax rates begin to apply are: over $8,700 15%; over $35,350 25%; over $85,650 28%; over $178,650 33%; and, over $388,350 35%. The personal and dependent exemption amount for 2012 is $3,800, up $100 from The 2012 standard deduction amounts are: married couple filing jointly $11,900; married taxpayer filing separately $5,950; head of household $8,700; single $5,950; and, dependent the greater of $950, or the sum of $300 and the individual's earned income, not to exceed $5,950. For purposes of calculating the kiddie tax, the net unearned income of the child is reduced by $950, the same as for The income limit for the maximum earned income tax credit for 2011 is $6,210 for a qualifying individual with no children, $9,320 for a qualifying individual with one child, and $13,090 for a qualifying individual with either two or three or more children. The maximum 2012 earned income tax credit amounts are as follows: no child $475; one child $3,169; two children $5,236; and, three or more children $5,891. The taxpayer is not eligible for the earned income credit if certain investment income exceeds $3,200 in The modified AGI phaseout range for the $2,500 maximum deduction for interest paid on qualified education loans remains the same as for 2011 at $60,000 - $75,000 for single taxpayers, and increases by $5,000 to $125,000 - $155,000 for married taxpayers filing a joint return. The annual exclusion amount for gifts made in 2012 remains the same as for 2011 at $13,000. Note: There are 40 items in the procedure. To obtain the procedure, go to and type in "Revenue Procedure " in the "Search" box. CE PROVIDER RULES AFFECT TAX PROFESSIONALS In IRS News Release IR and Revenue Procedure [12/6/2011], the IRS issues rules with which providers of continuing education (CE providers) must comply. Beginning in 2012, the newest category of tax professionals subject to continuing education requirements is Registered Tax Return Preparers (RTRPs). RTRPs have a 15-hour annual CE requirement (10 hours of federal tax law topics, 3 hours of tax law updates, and 2 hours of ethics and / or professional conduct). Both EAs and RTRPs must ensure they obtain their CE from an IRS-approved CE provider. CE providers must obtain and renew annually their CE provider number and meet additional criteria. For the list of approved CE providers go to: IRS SPECIFIES 2012 MILEAGE RATES In Notice [12/9/11], the IRS updates the optional standard mileage rates for use by employees, selfemployed individuals, and other taxpayers in computing the deductible costs to operate a passenger automobile for business, charitable, medical, or moving expense purposes in Here are the rates: 55.5 cents per mile for 2012 business miles (the same as for the second half of 2011); 14 cents per mile for charitable contributions this rate is set by the Internal Revenue Code, and is the same as in 2011; and, 23 cents per mile for medical expenses and moving expenses (a half a cent reduction from the rate for the last half of 2011). 2

3 The depreciation component of the business standard mileage rate for 2012 is 23 cents per mile (a one cent increase from the 2011 rate). The IRS states that for owned automobiles that are placed in service, and for which the business mileage rate has been used for any year, depreciation will be considered to have been allowed at the following rates for the particular year in which the business mileage rate was used: cents per mile; cents per mile; and, cents per mile. Note: The IRS will make no changes to the limitation on the use of the standard rate for fleet operations a taxpayer is not permitted to use the business standard mileage rate if the taxpayer operates five or more vehicles at the same time. Compliance Pointers: [1] The business standard mileage rate may be used for transportation expenses paid or incurred on / after January 1, 2011, for automobiles used for hire, for example taxicabs (prior to January 1, 2011, the standard mileage rate could not be used for such automobiles). [2] Taxpayers still are not permitted to use the business standard mileage rate for a vehicle after using any MACRS depreciation method or after claiming a Section 179 deduction for a vehicle. TAXPAYER ALLOWED DEDUCTION FOR ACCRUED BONUSES EVEN THOUGH BONUS RECIPIENTS ARE NOT KNOWN AT YEAR END In Revenue Ruling [11/9/11], the issue is whether accrued bonuses are deductible in the year accrued if the employer does not know the identity of any particular bonus recipient and the amount payable to that recipient until after the end of the taxable year. Under the program, bonuses are paid to the company s employees for services performed during the taxable year. The bonus is based either (1) on a formula that is fixed prior to the end of the taxable year, taking into account financial data reflecting results as of the end of that taxable year, or (2) through other corporate action, such as a resolution by the company s board of directors or compensation committee, made before the end of the taxable year, that fixes the bonuses payable to the employees as a group. To be eligible for a bonus, an employee must perform services during the taxable year and be employed on the date that the company pays bonuses. Any bonus amount allocable to an employee who is not employed on the pay date is reallocated among other eligible employees. Under the accrual method, a liability is incurred in a taxable year only if (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred for the liability. The IRS ruling dealt only with the first requirement. It requires all events that establish the fact of the liability to occur before year end. Based on a previous IRS ruling, generally all events occur to establish the liability when the event fixing the liability, whether that be the required performance or other event, occurs, or payment is unconditionally due. In this case, the IRS ruled that the company s liability is established by the end of the year even though the identity of the ultimate recipients and the amount, if any, each employee receives cannot be determined by the end of the taxable year. Importantly, the fact that any bonus allocable to an employee who leaves prior to the pay date is reallocated to other employees does not change the total liability determined before year end. The IRS therefore ruled that the first prong of the three-prong test is satisfied. PAYMENTS FOR LEASED PROPERTY AND MAINTENANCE CONTRACT DO NOT MEET ECONOMIC PERFORMANCE RECURRING ITEM EXCEPTION An accrual-basis, calendar year corporation uses the recurring item exception to satisfy the economic performance (EP) requirement to accelerate qualified deductions. The EP requirement applies only to accrual-basis taxpayers. Generally, an item may not be deducted for income tax purposes before EP has occurred. A corporation enters into a one-year lease agreement (July 1 - June 30) for property used to generate business income. The corporation must pay the $50,000 lease payment at the beginning of the lease on July 1. In its financial statements, prepared in accordance with generally accepted accounting principles (GAAP), the corporation recognizes the payment as an expense ratably over the one-year lease period. In conjunction with the lease, the corporation enters into a one-year service contract with a maintenance company unrelated to the lessor of the property. The contract runs from July 1 - June 30. The maintenance company will provide inspection, cleaning, repair, and maintenance services for the property, general services that are provided on an ongoing and recurring basis. The $2,400 maintenance service payment must be paid in full at the beginning of the contract period, and it too is expensed ratably over the one-year lease period in its financial statements. In Revenue Ruling [12/13/11], the IRS considers two issues for each payment. For the property payment: (1) whether the liability amount is material (can not be deducted before EP has occurred) for purposes of the recurring item exception under the EP rule of Section 461(h); and, (2) whether the company s accrual of the liability over more than one taxable year results in better matching the liability with related income. For the maintenance contract payment: (1) whether the liability is properly characterized as a liability arising out of the provision of services rather than as a liability arising out of the provision of a warranty or service contract ; and, (2) whether the recurring item exception applies to a liability to provide services pursuant to a service contract that is characterized as a liability arising out of the provision of services (Treasury Regulation Section (d)(2)). For the property payment, the IRS concludes that the liability is material under the recurring item exception as it was deemed so for financial statement purposes in being accrued over more than one taxable year. Further, the IRS states that the company s treatment of the liability on its financial statements must be considered in determining if the matching requirement of the recurring item is satisfied. 3

4 Since the company accrued the liability on its financial statements over the period of the lease, the IRS concluded the matching requirement was not satisfied. As a result, the IRS held that the property liability does not meet the recurring item exception, and may not be deducted in full in the first calendar year. For the maintenance contract payment, the IRS first concludes that the contract is a service liability, rather than a warranty payment liability. The services are general services provided on an ongoing and recurring basis, not a service that results from the occurrence of a unique or irregular circumstance necessitating repair or replacement of property that would be the case under a warranty contract. The IRS then applies its rules for service contracts to determine if the amount is not material or better matching is achieved by deducting it under the recurring item exception before EP occurs (as the services are provided). The IRS rules that the treatment under GAAP for financial statement purposes makes it material and thus not subject to the recurring item exception. Further, the IRS holds that, as the item is a service liability and not a payment liability, the better matching rule that permits a deduction under the recurring item exception before EP has occurred for a payment liability is not available. Therefore, the item may not be deducted in full for income tax purposes in the first calendar year. NATIONAL TAXPAYER ADVOCATE RELEASES HER ANNUAL REPORT TO CONGRESS The IRS states in IRS News Release IR [1/11/12] that National Taxpayer Advocate (NTA) Nina E. Olson has released her annual report to Congress, and it reports on some items in the report. The NTA states that the IRS s expanding workload and declining resources have resulted in (1) inadequate taxpayer service, (2) erosion of taxpayer rights, and (3) reduced tax compliance. The NTA cites the following as contributing to the IRS s excessive workload: (1) increasing Code complexity, (2) frequent Code changes 4,430 changes from 2001 through 2010, (3) need to provide service to an increasingly diverse taxpayer population, (4) increased IRS responsibility to administer economic and social policies, (5) surge in refund fraud and tax-related identity theft, and (6) implementation of new third-party information reporting requirements. She notes that the expansion of refundable credits in recent years has led to increased bogus refund claims. The IRS is relying more on automated data-matching procedures to identify potentially inaccurate claims and adjust tax liabilities in many cases, the taxpayer s return position is correct. The IRS has increased the number of IRS adjustments that it does not classify as audits, thus taking away established rights protections from the taxpayer, for example, the right to avoid repetitive and unnecessary examinations and the right to seek review of the IRS s determination in the U.S. Tax Court before the tax is assessed. The IRS s increased use of notices correcting math errors has confused taxpayers, and has led to genuine disputes not being able to be settled by the Tax Court because of the limited time frame that the taxpayer has to seek a Tax Court review. She states that when the IRS used math error authority in 2010 to disallow exemptions for dependent children on about 300,000 returns, ultimately it had to reverse about 55% of the adjustments! The NTA urges Congress to codify a Taxpayer Bill of Rights, observing that it has been 13 ½ years since there was major taxpayer rights legislation. IRS RULES WHETHER A PENSION PLAN PROPOSAL THAT ALLOWS EMPLOYEES TO RETIRE AND IMMEDIATELY BE REHIRED QUALIFIES UNDER SECTION 401 In Letter Ruling , the IRS rules on a taxpayer s proposal to be presented to the collective bargaining parties that contains a default schedule that will eliminate the ability of participants with 20 or more years of service to retire with an unreduced pension benefit. As a result, participants who have sufficient service to retire without a reduction in benefits will no longer be able to do so once the default schedule is in place. The taxpayer anticipates that participants who are eligible to retire and receive an unreduced service pension will elect to retire rather than wait until age 65 to receive their full pension benefit. Prior to elimination of the benefit, the taxpayer proposes to allow employees to "retire" on one day in order to qualify for the subsidized service pension benefit, and return to work the very next day or perhaps after a week has passed. The issue is whether the proposal would result in the disqualification of the retirement plan under Section 401(a). The IRS notes that under Treasury Regulation Sections 1.401(a)-1(b)(1)(I) and (b)(1)(i), a qualified pension plan is generally not permitted to pay benefits before retirement. As a result, an employee who "retires" with the explicit understanding between the employer and employee that he will immediately return to service with the employer has not legitimately retired and may not qualify for an early retirement benefit under the retirement plan. Therefore, the IRS concludes that the taxpayer s proposal would not qualify under Section 401(a). IRS ISSUES KEY LIMITATIONS COVERING 2012 RETIREMENT PLANS In IRS News Release IR [10/20/11], the IRS announces revised 2011 dollar limitations on benefits under qualified retirement plans that take effect on January 1, Most of the limitations for 2012 have increased from Here are some 2012 amounts that have increased: (1) the annual benefit under defined benefit plans increased $5,000 to $200,000; (2) the limitation for defined contribution plans increased $1,000 to $50,000; (3) the annual compensation limit increased $5,000 to $250,000; (4) the maximum exclusion for elective deferrals for IRC Section 401(k) plans, the federal government's Thrift Savings Plans, and IRC Section 457(b) government plans increased $500 to $17,000 ($22,500 for individuals age 50 or 4

5 older); (5) the limitation used in defining a highlycompensated employee increased $5,000 to $115,000; (6) the applicable dollar amount for determining the deductible amount for taxpayers who are active retirement plan participants increased $2,000 to $58,000 for single taxpayers, increased $2,000 to $92,000 for joint return taxpayers, and increased $4,000 to $173,000 for a joint return for which a taxpayer is not an active retirement plan participant but whose spouse is an active participant; and, (7) the AGI limitation for determining the maximum Roth IRA contribution for joint return taxpayers increased $4,000 to $173,000, and increased $3,000 to $110,000 for single taxpayers limitations that remained the same as for 2011 include the following: (1) the compensation amount regarding simplified employed pensions ($550); (2) the general limitation regarding SIMPLE contributions ($11,500); and, (3) the maximum IRA contribution for taxpayers less than age 50 ($5,000). IRS UPDATES GUIDANCE ON EMPLOYER INFORMATIONAL REPORTING FOR THE COST OF EMPLOYER-SPONSORED GROUP HEALTH INSURANCE In Notice [1/3/12], the IRS provides in a 39 question-and-answer format guidance on information reporting to employees of the cost of their employersponsored group health plan coverage. The guidance applies to Forms W-2 for Generally, all employers that provide coverage during a calendar year are subject to the reporting requirement, including federal, state, and local government entities, churches, and other religious organizations. However, an employer is not subject to the reporting requirement for any calendar year if the employer was required to file fewer than 250 Forms W-2 for the preceding calendar year. The amount of an employee s health FSA is required to be included in the aggregate reportable cost reported on Form W-2 if the amount of the health FSA for the plan year exceeds the salary reduction that is elected by the employee for the plan year. If the amount of salary reduction (for all qualified benefits) elected by an employee equals or exceeds the amount of the health FSA for the plan year, the employer does not include the amount of the health FSA for the employee in the aggregate reportable cost. For example, assume that an employer maintains an IRC Section 125 cafeteria plan that offers permitted taxable benefits (including cash) and qualified nontaxable benefits (including a health FSA). The plan permits contributions only through employee salary reduction elections, and it does not offer any employer flex credits. The employee makes a $2,000 salary reduction election for several qualified benefits under the plan, including $1,500 for a health FSA. Since $2,000 exceeds $1,500, none of the health FSA amount is included for purposes of determining the aggregate reportable cost on Form W-2. An employer is not required to include the cost of coverage under a dental plan or a vision plan if the plan meets the requirements for being excepted benefits under the Health Insurance Portability and Accountability Act (HIPAA). To be excepted, the plan either must be offered under a separate policy, certificate, or contract of insurance, or participants must have the right not to elect the dental or vision plan and, if they do not elect the dental or vision benefits, they must pay an additional premium or contribution for the coverage. The employer must include the cost of dental or vision plan coverage if the plan does not meet the HIPAA exception. IRS PROVIDES INFORMATION AND INITIATIVES ON THE TAX GAP In IRS News Release IR [1/6/12] and Fact Sheet FS [1/11/12], the IRS updates estimates on the tax gap and reviews initiatives that it has launched since 2008 to focus on improving the tax gap. The gross tax gap is defined as the amount of true tax liability faced by taxpayers that is not paid on time while the net tax gap represents the amount of tax liability that never is paid. The IRS s new tax gap estimate is for the 2006 tax year, the first update since its last review that covered the 2001 tax year. The gross tax gap estimate is $450 billion while the net tax gap estimate is $385 billion. The IRS found that the voluntary compliance rate (percentage of total tax revenues paid on time) was virtually unchanged from 2001 to 2006 (83.7% in 2001 to 83.1% in 2006). The net tax gap was virtually unchanged also: 86.3% in 2001, versus 85.5% in The tax gap is divided into three components: (1) nonfiling, (2) underreporting, and (3) underpayment. Underreporting is the biggest contributing factor to the tax gap, followed by underpayment, and then non-filing. The IRS noted that, for wages and salaries, where there is third-party information reporting and / or withholding, a net of only 1% of wage and salary income was misreported. In contrast, amounts subject to little or no information reporting had a 56% net misreporting rate in Some IRS initiatives launched since 2008 that focus on reducing the tax gap include: (1) tax return preparers over a period of several years paid preparers must register with the IRS, identify themselves on returns that they prepare, pass a competency exam, and complete annual continuing education; (2) basis reporting in 2011, stock brokers and mutual fund companies had to report basis and other information for most stock purchases, and in 2012 and thereafter such information will have to be reported for all stock purchases; (3) business taxes under new merchant card reporting requirements established for the 2011 tax year, third-party reporting data on business receipts had to be done (generally, the requirements apply to government entities and private businesses, as well as most types of payment cards, for example credit and debit cards); and, (4) uncertain tax positions beginning in 2011, certain large corporations were required to start making uncertain tax position (UTP) disclosures on their 2010 tax returns (UTP generally is a stance on a tax return where the corporation sets aside a reserve to either pay the higher amount of tax later or litigate the matter in the future). 5

6 IRS PROPOSES CHANGES TO THE INNOCENT SPOUSE EQUITABLE RELIEF PROVISION The IRS recently proposed a revenue procedure [Notice ; 1/5/12] that would make changes to the criteria used in making innocent spouse equitable relief determinations under IRC Section 6015(f) from an unpaid tax or any deficiency, if relief is not available under the traditional relief provisions of Sections 6015(b) or (c). The proposed changes also apply to the equitable relief provision of Section 66(c) for taxpayers in community property states who do not file a joint return. In July of 2011, the IRS had eliminated the twoyear time limit that previously applied to requests for equitable relief. The procedure addresses the criteria used in making innocent spouse relief, and revises the factors for granting equitable relief. The IRS wants to ensure that requests for innocent spouse relief are granted, when appropriate, in the initial stage of the administrative process. The IRS will expand how it will take into account abuse and financial control by the nonrequesting spouse in determining if equitable relief is warranted. Also, the procedure provides new guidance on the potential impact of economic hardship, and the weight to be accorded to certain factual circumstances in determining equitable relief. The proposed procedure updates Revenue Procedure and, until the proposed procedure is finalized, the IRS will apply it instead of Revenue Procedure , unless the taxpayer would receive more favorable treatment under one or more of the factors in Revenue Procedure Formerly, a relief claim had to be filed within two years of the IRS s first collection activity. The new procedure requires that the claim be filed before the expiration of the period of limitation for collection under Section 6502 (generally 10 years after assessment of the tax) or, if applicable, the period of limitation for credit or refund under Section 6511 (generally, the period expires three years from the time the return was filed or two years from the time the tax was paid, whichever is later). The IRS clarifies in the procedure that no one factor or a majority of factors necessarily controls the relief determination. Depending on the facts and circumstances of the case, relief still may be appropriate if the number of factors weighing against relief is more than the number of factors weighing in favor of relief, or a denial of relief still may be appropriate if the number of factors weighing in favor of relief is more than the number of actors weighing against relief. With respect to the economic hardship equitable factor, the IRS provides minimum standards based on income, expenses, and assets in determining if the requesting spouse would suffer economic hardship if the request is not granted. The requesting spouse s actual knowledge of the item that gives rise to an understatement or deficiency no longer will be weighed more heavily than other factors. In determining if the requesting spouse had knowledge or reason to know that the nonrequesting spouse would not pay the tax reported as due, the IRS will consider if the requesting spouse reasonably expected that the nonrequesting spouse would pay the tax liability within a reasonably prompt time. A requesting spouse s legal obligation (for example, under a divorce decree or other legally binding agreement) to pay outstanding tax liabilities is a factor the IRS will consider in determining if equitable relief should be granted, in addition to whether the nonrequesting spouse has a legal obligation to pay the tax liabilities. The IRS notes that the fact that a requesting spouse subsequently is compliant with all federal income tax laws is a factor that may weigh in favor of equitable relief. **REVIEW QUESTIONS AND SOLUTIONS** True False Questions 2. For 2012, the IRS makes available a list of approved continuing education providers. 3. Based on a recent IRS letter ruling, if an employer s retirement plan allows employees to retire one day to qualify for pension benefits and then be rehired the next day, the retirement plan is in violation of Section 401(a). 4. Under an IRS proposed revenue procedure for innocent spouse relief under Section 6015 (c), the requesting spouse s actual knowledge of the item that gives rise to an understatement or deficiency will not be weighed more heavily than other factors. Multiple Choice Questions 5. Regarding the inflation-adjusted amounts for 2012, which one of the following statements is true? a. The 2012 standard deduction for head of household is $5,950. b. The taxable amount at which married joint return taxpayers reach the 35% tax rate is twice the amount at which single taxpayers reach the 35% tax rate. c. The 2012 annual gift exclusion is $13, For 2012, what is the mileage rate for miles driven for medical expense purpose? a. 14 cents per mile. b cents per mile. c. 23 cents per mile. 7. Which one of the following is not a requirement for deducting an expense under the accrual method? a. The amount of the liability can be determined with reasonable accuracy. b. The amount of the liability must be paid by the th 15 day of the third month following the close of the taxable year. 6

7 c. All the events have occurred that establish the fact of the liability. 8. Which one of the following statements is true about a recent IRS ruling on the economic performance recurring item exception for payments a company made for leased property and maintenance contract payments? a. The company sought to deduct the property payments over the lease term for the property. b. The company was an accrual-basis taxpayer. c. The maintenance contract payments were considered by the IRS to be a payment liability. 9. With respect to the recent NTA s annual report to Congress, which one of the following statements is false? a. The IRS is relying less on automated datamatching procedures to identify potentially inaccurate claims and adjust tax liabilities b. The IRS has increased the number of IRS adjustments that it does not classify as audits. c. The IRS is having to use declining resources to deal with an expanded workload. 10. Regarding 2012 retirement plan limitations, which one of the following statements is false? a. The limitation for defined contribution plans is $50,000. b. The maximum IRA contribution for individuals less than age 50 is $5,000. c. The maximum 401(k) exclusion for individuals less than age 50 is $22, Regarding recent IRS guidance on information reporting to employees of the cost of their employer-sponsored group health plan coverage, which one of the following statements is false? a. Churches and other religious organizations are subject to the reporting requirements. b. An employer who filed 100 Forms W-2 in 2011 is not subject to the reporting requirements in c. In all cases, the employer is required to include the cost of coverage under a dental plan or a vision plan on the employee s Form W With respect to recent IRS information and initiatives on the tax gap, which one of the following statements is true? a. For amounts subject to little or no information reporting in 2006, there was only a 1% misreporting rate. b. The voluntary compliance rate changed only slightly from 2001 to c. Beginning in 2012, basis reporting for stock purchases is not required. Solutions 2. True is the correct response. For the list of approved CE providers go to: ssl.kinsail.com/partners/irs/publiclisting.asp. False is the incorrect response. Beginning in 2012, Enrolled Agents and Registered Tax Return Preparers must ensure that they obtain their continuing education from an IRS-approved continuing education provider, who must obtain and renew annually their continuing education provider number with the IRS. IRS News Release IR and Revenue Procedure True is the correct response. A qualified pension plan generally is not permitted to pay benefits to an employee before the employee retires. Under the facts of the ruling, the IRS concluded that an employee who retires with the expectation of being rehired has not legitimately retired. False is the incorrect response. The IRS ruled that the proposal to pay benefits to retired employees who are rehired within a short time would violate Section 401(a). Letter Ruling True is the correct response. In a departure from its prior position, the IRS no longer will weigh more heavily than other factors the factor that the requesting spouse has actual knowledge of the item that gives rise to an understatement or deficiency. False is the incorrect response. The requesting spouse s actual knowledge of the item that gives rise to an understatement or deficiency no longer will be weighed more heavily than other factors. Notice "C" is the correct response. The annual gift exclusion for 2012 remains at $13,000. A" is an incorrect response. The 2012 standard deduction for head of household is $8,700. "B" is an incorrect response. For 2012, the 35% marginal tax rate kicks in for both joint return taxpayers and single taxpayers at taxable income above $388,350. Revenue Procedure "C" is the correct response. The 23 cents per mile rate is a half a cent reduction from the rate for the last half of

8 A" is an incorrect response. The 14 cents per mile rate is the rate for miles driven for charitable contribution purposes, the same as for "B" is an incorrect response. The medical expense rate for the last half of 2011 was 23.5 cents per mile. Notice "B" is the correct response. Three requirements must be satisfied for an expense to be deducted in a taxable year under the accrual basis. Making the th payment by the 15 day of the third month after the close of the taxable year is not one of the requirements. A" is an incorrect response. Determining the liability with reasonable accuracy is the second requirement. "C" is an incorrect response. The first requirement is that all of the events have occurred that establish the fact of the liability. Revenue Ruling "B" is the correct response. The economic performance requirement applies only to accrualbasis taxpayers. A" is an incorrect response. The company wanted to deduct the prepayment in the first tax year, which covered only one-half of the lease term for the property. "C" is an incorrect response. The IRS concluded that the maintenance contract payments were a service liability, not subject to the same EP rules as a payment liability. Revenue Ruling "A" is the correct response. The IRS is relying more on automated data-matching procedures to identify potentially inaccurate claims and adjust tax liabilities, often when the taxpayer s return position ultimately is correct. B" is an incorrect response. The IRS has increased the number of IRS adjustments that it does not classify as audits: this action has resulted in many established rights protections being taken away from the taxpayer "C" is an incorrect response. The IRS s expanding workload and declining resources have resulted in inadequate taxpayer service, erosion of taxpayer rights, and reduced tax compliance. IRS News Release IR "C" is the correct response. $22,500 is the maximum 401(k) exclusion for individuals age 50 or older in For less than age 50, the limit is $17,000. A" is an incorrect response. The 2012 limitation for defined contribution plans increased $1,000 from 2011 to $50,000. "B" is an incorrect response. The maximum IRA contribution for individuals less than age 50 remains at $5,000 for IRS News Release IR "C" is the correct response. An employer is not required to include the cost of coverage under a dental plan or a vision plan if the plan meets the requirements for being excepted benefits under the Health Insurance Portability and Accountability Act. A" is an incorrect response. Generally, all employers that provide coverage during a calendar year are subject to the reporting requirement, including federal, state, and local government entities, churches, and other religious organizations. "B" is an incorrect response. An employer is not subject to the reporting requirement for any calendar year if the employer was required to file fewer than 250 Forms W-2 for the preceding calendar year. Notice "B" is the correct response. The voluntary compliance rate (percentage of total tax revenues paid on time) was virtually unchanged from 2001 to 2006 (83.7% in 2001 to 83.1% in 2006). A" is an incorrect response. 1% was the misreporting rate for wages and salaries, where there is third-party information reporting. The misreporting rate for amounts subject to little or no information reporting had a 56% net misreporting rate in "C" is an incorrect response. To the contrary, beginning in 2012 basis reporting will be required for all stock purchases. IRS News Release IR and Fact Sheet FS COURT DECISIONS TAX COURT RULES ON OCCUPANCY ISSUE FOR HOMEBUYER TAX CREDIT In Woods [10/27/11], the taxpayer entered into a contract for deed to purchase a house in 2008, took possession of the house in 2008, and claimed the first-time homebuyer tax credit pursuant to Section 36. The house required renovations before being ready for occupancy and the taxpayer intended to use the homebuyer tax credit to pay for the necessary renovations. Under the contract for deed purchase, the taxpayer made a down payment and agreed to pay the balance of the purchase price together with 7 percent interest over 184 months. The legal title to the property does not transfer to the taxpayer until all of the payments are made. Eight months after the agreement, 8

9 the IRS disallowed the credit and the taxpayer suspended renovations. The IRS argued that the tax credit should be denied because the taxpayer had not acquired legal or equitable title to the property. Even if the taxpayer satisfied the purchase requirement of Section 36, the IRS argued further that the house did not qualify as his principal residence because he did not live in it in To determine whether the taxpayer purchased the house, the Tax Court focused on whether the benefits and burdens of ownership shifted to the taxpayer. It noted that state law controls the determination of the taxpayer s interest in the property so it examined Texas property law, the state in which the property was located. The Tax Court relied on a Texas Supreme Court case which described the substance of a contract for deed as effecting a change of ownership when the purchaser becomes the equitable owner of the property. All that remains in the hands of the seller is bare legal title which is more in the nature of security to guarantee payment. As the taxpayer was required to pay all property taxes after the agreement and nothing in the agreement removed the taxpayer s obligations to make the monthly payments to the seller, the Tax Court ruled that the taxpayer had purchased the house for purposes of Section 36. With respect to satisfying the principal residence requirement, the IRS argued that the term principal residence under Section 36 should have the same meaning as under Section 121, the gain exclusion provision for the sale of a taxpayer s principal residence. The Tax Court noted that Section 121 requires a retrospective analysis in that the taxpayer must have owned the property and used it as the taxpayer s residence for 2 of the 5 taxable years preceding the sale. It noted further that Section 36 requires a prospective analysis. That is, principal residence is a primary dwelling of house that a taxpayer will occupy as his principal residence. The IRS argued that because the taxpayer never occupied the house, it cannot be his principal residence. In contrast, the taxpayer argued that he never was given the opportunity to establish the house as his principal residence because the IRS denied him the funds (tax credit) to make the renovations necessary for occupancy. The Tax Court agreed with the taxpayer. The taxpayer testified that he intended to occupy the house as his residence as his principal residence. The Tax Court indicated that it may accept a taxpayer s unverified testimony when it finds it to be credible and persuasive. Note: The taxpayer defended his positions without an attorney. It has been our experience that pro se taxpayers seldom win a tax case very often. The fact that the case was a regular Tax Court decision rather than a memorandum decision makes the favorable outcome for the taxpayer even rarer. TAX COURT DECIDES WHEN PREPAID DRILLING COSTS ARE DEDUCTIBLE In Caltex Oil Venture [1/12/12], the taxpayer is an accrual-basis partnership that uses the calendar tax year. It entered into a turnkey contract with an exploration corporation which drills oil and gas wells at two sites. By December 31, 1999, the partnership would pay the corporation $428, in cash and execute a $4,800,000 note for turnkey drilling costs and intangible drilling completion costs (IDCs). By the end of 1999, drilling permits were secured, and in early 2000 the corporation began preparation activities to drill the wells. However, no drill penetrated the ground for purposes of drilling a well during 1999 or The partnership claimed $5,172,666 as a deduction for IDCs on its 1999 Form The IRS disallowed all of the deduction. The issue in the case was whether the services attributable to the deduction were economically performed ( economic performance rule) during 1999, or within a time that the Code and regulations allowed the services to be treated as performed in The court noted that an accrual-basis taxpayer may not claim a deduction until the all-events test (liability established and amount determinable with reasonable accuracy) is met and economic performance has occurred. Under the general rule, economic performance occurs as the services are provided if the taxpayer s liability arises from a third party s providing services to the taxpayer. This general rule applies to IDCs under a turnkey contract for the drilling of an oil or gas well. The Tax Court ruled that the partnership could not fully deduct the IDCs in 1999 under the general rule because actual drilling had not occurred. Then, the court examined two exceptions: (1) an exception under Section 461(i)(2)(A) the 90-day rule ; and, (2) an exception under Treasury Regulation Section (d)(6)(ii) the 3 ½-month rule. Under the 90-day rule, a taxpayer may deduct IDCs in full before economic performance if drilling starts within 90 days after the close of the tax year in which the taxpayer pays the related IDCs. The IRS argued that the partnership could not deduct the IDCs in 1999 under this exception because no drill had penetrated the ground by March 30, 2000 (90 days after the close of the partnership s 1999 tax year). The partnership argued that it could deduct fully the related IDCs in 1999 because it had started drilling operations by securing drilling permits and beginning site preparation within the required 90-day period, asserting that it is not required that the drill bit actually penetrate the ground within the 90-day period. The court examined the statute and its plain language, and ruled for the IRS. Under the 3 ½-month rule, the IRS argued that for this exception to apply the partnership must reasonably expect all services due under the contract to be provided within 3 ½ months of the date of payment. The IRS focused on contracts for differentiated or severable services, arguing that if the contract provided for differentiated services, a 1999 deduction could be taken for the part of the services in the contract that could be broken out, were they reasonably expected to be provided within the 3 ½- month period. It asserted that the turnkey contract that the partnership had did not provide for differentiated services. The partnership argued that were the IRS s view of the 3 ½-rule applied, that is all of the services called for under a turnkey contract had to be performed within 3 ½ months of payment, the rule never would apply to the oil and gas industry. The court found that 9

10 the contract could apply to services that were specified in the contract, not the case here. Thus, the exception could apply to the oil and gas industry for such broken out, or specified services. The court ruled for the IRS that there was no 1999 deduction, since the turnkey contract was not differentiated and it did not specify that payments under the contract were allocated to specified services. SPOUSE IS ENTITLED TO HER SHARE OF REFUND PAID FROM A JOINT ACCOUNT The taxpayers filed joint returns and for five tax years the husband, unknown to the wife, did not remit payment of the federal income tax balances. The IRS assessed the amounts due plus additions to tax. The wife did not learn about the delinquencies until she saw IRS correspondence after their financial situation deteriorated about five years after the first return in question. The wife filed for divorce that year, though the contentious, difficult divorce was not finalized until four years later. In the year after the divorce filing, the couple sold their family home, held jointly, and deposited the net proceeds into a joint CD account. In the year of the home sale, the IRS received the wife s innocent spouse request for relief from the tax due for the five tax years. The IRS moved the couple s joint assessment accounts to separate mirrored accounts for the tax years, in accordance with its customary procedure. After the move, the IRS had a separate account for each spouse, reflecting for each the same liabilities from the joint filings. The year after the wife filed for innocent spouse relief, she sent the IRS a letter informing it about the joint CD account which held the home sale proceeds. Shortly after, the IRS denied her claim for innocent spouse relief. In the next year, the IRS issued two notices of levy to the bank with the CD account to satisfy the unpaid income tax liabilities. The IRS received levy payments from the bank to satisfy the liabilities. In the next year, the IRS said that it would cease collection activity regarding the wife s petition for innocent spouse protection relief. It maintained that her only relief could come from a refund, and she was not entitled to a refund because the liability was not paid with separate funds but with joint funds. The issue in Minihan [1/11/12] was whether the wife was prevented from obtaining a refund of the levied funds because they were funds from a joint account that was applied to her husband s tax account. The Tax Court did not decide if the wife was entitled to Section 6015(f) innocent spouse relief, but addressed if she were entitled to a refund of her part of the tax liability collected in the tax levy. It noted that the answer is easier when payments that are made are voluntary or, if involuntary, when the payments are from property owned by only one spouse. The answer is more complicated when the payment arises from a levy on jointly-owned property. The court reasoned that the key question is whether under state law the wife had a surviving separate legal interest in the levied assets. It stated that a lawful levy does not extinguish a third party s rights in levied property. It concluded that under the applicable state law, in this case she had a 50% ownership interest in the joint CD account. It held that she was entitled to a refund of half of the money the IRS seized from the joint account, if ultimately she were granted innocent spouse relief under Section 6015(f). TAXPAYERS LOSE IN TWO ALIMONY- RELATED CASES Two recent alimony cases provide an opportunity to revisit the requirements for payments to be deductible as alimony. Alimony payments must be paid in cash. In addition, Section 71(b) requires the following: (1) there must be a divorce or separation agreement; (2) the agreement does not indicate that the payment is not includible in gross income; (3) the former spouses are not members of the same household; and, (4) there is no liability to make the payment for any period after the death of the payee spouse and there is no liability to make any payment as a substitute for such payments after the death of the payee spouse. In Shelton [11/10/11], the separation agreement required the taxpayer to pay his former spouse $25,000 representing her share of his separation pay from military. The taxpayer deducted this payment on his tax return as alimony. However, the separation agreement specifically stated that each party waived any claim for maintenance from the other party. As a result, the Tax Court ruled that the $25,000 payment is not deductible as alimony. Because the settlement made clear that none of the payment represented alimony, the Tax Court also ruled that the taxpayer was subject to the 20% penalty on the amount of tax underpayment. In Moore [11/8/11], the tax treatment of the taxpayer s payment to his former spouse hinged on satisfying the fourth requirement. Unfortunately for the taxpayer, the divorce decree was silent as to whether his payments to his former spouse terminated on her death. As a result, the Tax Court had to look to state law (Indiana) to determine whether the payments would terminate if she died before all of the payments were made. Because the Tax Court was not able to find any Indiana law that states that maintenance payments automatically terminate on the death of the payee spouse, it ruled that the fourth requirement was not satisfied and the payments could not be deducted as alimony. Note: This case involved a timely filed motion for reconsideration by the taxpayer. Reconsideration is intended to correct substantial errors of fact or law and allow the introduction of newly discovered evidence. In this case, no new evidence was introduced so the Tax Court denied the taxpayer s motion for reconsideration. **REVIEW QUESTIONS AND SOLUTIONS** True False Questions 13. In an innocent spouse case, the Tax Court recently decided that a wife was not entitled to a refund of half of the money that the IRS seized from a joint account of the wife and her husband. 10

11 Multiple Choice Questions 14. In a recent Tax Court case involving the homebuyer tax credit, which one of the following statements is false? a. The Tax Court relied on state law to determine whether the benefits and burdens of ownership had passed to the buyer. b. Section 121 (gain exclusion provision relating to the sale of taxpayer s principal residence) was used to determine whether the home was the buyer s principal residence. c. The taxpayer intended to use the homebuyer credit to make the home repairs necessary to occupy the home. 15. Which one of the following was a fact in a recent Tax Court case that addressed whether a partnership could deduct intangible drilling contract costs in the year they were paid? a. Drilling permits for the oil and gas wells were secured in the year the costs were paid. b. A drill had penetrated the ground in the year the costs were paid. c. The turnkey drilling contract was differentiated and specified that payments under the contract were allocated to specified services. 16. With respect to two recent court cases dealing with alimony, which one of the following statements is true? a. If the divorce decree is silent as to whether the payments cease upon the death of the recipient, the payments automatically fail to qualify as alimony. b. Because the separation agreement required the taxpayer to pay his former spouse part of his military separation pay, the payment was treated as alimony. c. When a taxpayer makes a timely motion for reconsideration of the Tax Court s decision, a favorable outcome is not likely if the taxpayer fails to introduce new evidence. Solutions 13. False is the correct response. The court decided that the wife was entitled to a refund of half of the money the IRS seized from the joint account, if ultimately she were granted innocent spouse relief under Section 6015(f). True is the incorrect response. The court applied state law in determining that the wife had a 50% ownership interest in the joint CD account with their bank. Minihan. 14. "B" is the correct response. The Tax Court noted that Section 121 requires a retrospective analysis whereas Section 36 requires a prospective analysis. Therefore, Section 121 was not used to determine whether the home was the buyer s principal residence. A" is an incorrect response. The Tax Court examined Texas State law and ruled that a contract for deed purchase made the purchaser the equitable owner of the property. "C" is an incorrect response. The facts of the case indicated that the house required renovations before being ready for occupancy and the taxpayer intended to use the homebuyer tax credit to pay for the necessary renovations. Woods. 15. "A" is the correct response. By the end of the year in which the contract costs were paid, the drilling permits were secured B" is an incorrect response. No drill had penetrated the ground for purposes of drilling a well during either the year the contract costs were paid, or the following year. "C" is an incorrect response. The contract was not differentiated and it did not specify that payments under the contract were allocated to specified services. Caltex Oil Venture. 16. "C" is the correct response. Reconsideration is intended to correct substantial errors of fact or law and allow the introduction of newly discovered evidence. A" is an incorrect response. When the divorce decree is silent as to whether the payments cease upon the death of the recipient, courts have examined state law to determine if the payments continue. If they do not, this requirement is satisfied. "B" is an incorrect response. Both parties specifically waived their right to receive maintenance from the other party, so none of the payment was treated as alimony. Shelton and Moore TREASURY TREASURY AMENDS DEFINITION OF LIMITED PARTNER UNDER THE PASSIVE ACTIVITY LOSS RULES In REG [11/28/11], the Treasury issued proposed regulations regarding the definition of an 11

12 interest in a limited partnership as a limited partner for purposes of determining whether a taxpayer materially participates in an activity under the passive activity loss rules. Under the Treasury regulations, there are seven ways that a partner may qualify as a material participant in an activity. Section 469(h)(2) provides that, except as provided in the regulations, a limited partner shall not be treated as an interest with respect to which a taxpayer materially participates. The current regulations permit an individual taxpayer to establish material participation in a limited partnership but limits the individual taxpayer to use of only three of the seven regulatory tests. The regulations generally provide that a partnership interest is considered a limited partner interest if the liability for the obligations of the partnership are limited under State law to a determinable fixed amount. Under the Uniform Limited Liability Company Act of 1996, LLC members of member-managed LLCs do not lose their limited liability by participating in the management and conduct of the company's business. The Treasury notes that some court opinions have ruled that an interest in a limited liability company is not considered a limited partnership interest for purposes of the Section 469 material participation tests. The proposed regulations provide that an interest in an entity will be treated as an interest in a limited partnership under section 469 if (1) the entity is treated as a partnership for tax purposes, and (2) the holder of the interest does not have rights to manage the entity at all times during the entity's taxable year under the law of the jurisdiction in which the entity was organized and under the governing agreement. That is, the focus of whether an LLC interest is a limited partnership interest shifts from whether the holder is liable for the entity s debts to whether the holder participates in management. Rights to manage include the power to bind the entity. TREASURY EXTENDS CERTAIN FICA AND FUTA EXCEPTIONS TO DISREGARDED ENTITIES Generally, wages up to a set amount are subject to FICA and FUTA taxes. There are some exceptions, including the following: (1) service performed by a child (generally under the age of 18 for FICA purposes and age 21 for FUTA purposes) in the employ of the child s mother or father; (2) domestic service in a private home of the employer which is performed by an individual employed by the individual s spouse, son, or daughter; and, (3) service performed by an employee where both the employer and employee are members of a religious faith opposed to participation in the Social Security Act (only for FICA taxes). With respect to the first two exceptions, services performed in the employ of a corporation are not within the exceptions because of the lack of a family relationship between the employee and the individual employing him. Similarly, a religious organization that is incorporated cannot qualify for the third exception because it cannot be considered a member of a qualifying religious sect. Effective in 2009, the Treasury regulations were amended to provide that for purposes of determining who is liable for employment taxes, as well as all other employment tax obligations related to wages paid for services rendered, a disregarded entity is treated as a corporation. In Treasury Decision 9554 [10/31/11], the Treasury notes that the 2009 regulations were not intended to render the above FICA and FUTA exceptions inapplicable to disregarded entities that were eligible for the exceptions prior to the effective date of the regulations. As a result, it has issued temporary regulations that continue to treat disregarded entities as a corporation for all employment tax purposes, except the entity will be disregarded for the limited purposes of applying the FICA and FUTA tax exceptions noted above. In this case, the owner of the disregarded entity will be treated as the employer and the employee will be considered to be an employee of the owner. TREASURY FINALIZES REGULATIONS ON DAMAGE AWARDS In Treasury Decision 9573 [1/20/12], the Treasury Department issues final regulations that relate to the gross income exclusion for amounts received on account of personal physical injuries or physical sickness. The regulations delete the requirement that to qualify for the gross income exclusion, damages received from a legal suit, action, or settlement must be based on tort or tort type rights. The regulations provide that the Section 104(a)(2) exclusion may apply to damages recovered for a personal physical injury or physical sickness under a statute that does not provide for a broad range of remedies, and that the injury need not be defined as a tort. The regulations note that developments in this area have eliminated the need to base the exclusion on tort cause of action and remedy concepts. In this regard, they note a Supreme Court case [Schleier] that interpreted the exclusion to exclude only damages that are directly linked to personal injuries or sickness. Also, they point to the 1996 Code change that states that only damages for personal physical injuries or physical sickness are excludable from gross income. In response to the published proposed regulations that preceded the final regulations, a commentator had asked for guidance on whether an award claimant has either constructive receipt or the current economic benefit of a damage award that is set aside for the claimant s benefit in a trust or fund. Other commentators had asked that the final regulations define certain personal injuries as physical injuries and describe the circumstances in which emotional distress is attributable to physical injuries (emotional distress is not treated as a physical injury or physical sickness under the Code). The Treasury did not adopt the requests made by the commentators. Note: The gross income exclusion for damages continues to be an area of contention between taxpayers and the IRS. In December 2011 alone, three of the Tax Court s 28 decisions involved the Section 104 exclusion. 12

13 **REVIEW QUESTIONS AND SOLUTIONS** True False Questions 17. As a result of recent treasury regulations, the focus of whether an LLC interest is treated as an interest in a limited partnership under the passive activity loss rules shifts from whether the interest holder participates in management to whether he is liable for the entity s debts. Multiple Choice Questions 18. As a result of recent treasury regulations, which one of the following employees will be subject to FICA taxes in 2012? a. A 17-year old employee who works for a corporation owned solely by the employee s parents. b. An employee of an LLC treated as a disregarded entity where the owner of the entity and employee are members of a religious sect that is opposed to participation in the Social Security Act. c. A 16-year old employee who works for an LLC treated as a disregarded entity owned solely by the employee s parents. 19. With respect to the gross income exclusion provision for damage awards, which one of the following statements is false? a. The exclusion applies only to awards for damages connected directly to personal injuries or sickness. b. Based on recent Tax Court decisions, the issue is not one that often is litigated. c. Only damage awards for personal physical injuries or physical sickness are excludable from gross income. Solutions 17. False is the correct response. To the contrary, the focus shifts from whether the interest holder is liable for the entity s debts to whether he participates in management. True is the incorrect response. Under the Uniform Limited Liability Company Act of 1996, LLC members of member-managed LLCs do not lose their limited liability by participating in the management and conduct of the company's business. As a result, several court cases have held that an LLC interest is not considered a limited partnership interest when the LLC member participates in management. REG "A" is the correct response. Services performed in the employ of a corporation are not within the exceptions from employment tax that apply because of the lack of a family relationship between the employee and the individual employing him. B" is an incorrect response. The owner of the disregarded entity will be treated as the employer and the employee will be considered to be an employee of the owner. Since the owner and employee are members of a religious sect that is opposed to participation in the Social Security Act, the FICA exception regarding religious sects applies. "C" is an incorrect response. Since the owner of the disregarded entity is the employee s parents and the employee is less than age 18, the FICA exception for employing certain family members applies. Treasury Decision "B" is the correct response. In December 2011 alone, about 11% of the Tax Court s decisions involved the Section 104 exclusion. A" is an incorrect response. A Supreme Court decision interpreted the provision to exclude only damage awards that are directly linked to personal injuries or sickness. "C" is an incorrect response. A 1996 Code change states that only damage awards for personal physical injuries or physical sickness are excludable from gross income. Treasury Decision AN ELITE POSSIBILITY While tax professionals engage in extensive tax planning with their clients, it is easy to forget about the taxpayer s children and the potential tax-savings opportunities available to the taxpayer s children who are about to embark on a career and begin to pay income taxes. It could be that the children had been gifted savings bonds, stocks, or other property that has appreciated, and now is the time to sell some of these assets before their income tax rates rise. Two items to consider disposing of in 2012 are savings bonds and appreciated stocks, especially under two scenarios. In scenario #1, assume the child either will be graduating from college in the Spring of 2012 or graduating from high school in 2012 but does not plan on pursuing college. Assume that both obtain full-time employment in the last half of the year and no longer qualify as a dependent on the parent s tax return. For most situations, the child s tax bracket in 2012 will be 15% (taxable incomes between $8,701 and $35,350). In this case, it may never be a better time to cash in their savings bonds and unload some or all of their appreciated stocks. Depending on the amount of income or gain, the savings bond income will be taxed at 15% and the tax on the capital gain income will be zero as long as the taxable income stays below $35,351! After 2012, the capital gain rates are expected to 13

14 increase to 10% for taxpayers in the 15% bracket and 20% for taxpayers above the 15% bracket. If the child really wants to hold on to the appreciated stocks because he or she feels it is a good investment, they can sell the stock and buy it back. The wash sales provision only applies to losses so selling the stock for a gain and buying it back has the effect of increasing the basis of the stock without having to pay tax on the appreciation since the gain is taxed at zero percent. In scenario #2, the child is not graduating in 2012, has little income, and is a dependent of the parent(s). While it still is a good idea to dispose of savings bonds and appreciated stocks for tax purposes, the kiddie tax rules need to be considered. The kiddie tax will apply if the child s unearned income exceeds $1,900 and one of the following applies: (1) the child is less than age 18; (2) the child is less than age 19 and did not have earned income that was more than half of the child s support; or, (3) the child was a full-time student over age 18 and under age 24 and did not have earned income that was more than half of the child s support. An orderly disposal of savings bonds and/or appreciated stocks could be made over multiple years whereby the recognition of unearned income is limited to either (1) $950 so no tax is paid (current standard deduction for a dependent child with only unearned income), or (2) $1,900 so the kiddie tax does not apply and only $950 ($1,900 - $950 standard deduction) is subject to tax at a rate of 10%. Unearned income in excess of $1,900 generally is taxed at the parent s tax rate. **REVIEW QUESTIONS AND SOLUTIONS** Multiple Choice Questions 20. In this issue s Elite Possibility, we recommend that taxpayers children consider disposing of some of their U.S. savings bonds or appreciated stock. Which one of the following factors would nullify most if not all of the tax advantages reported in the Elite Possibility. a. The child s 2012 marginal tax rate is above 15%. b. The child is older than age 17 and no longer a dependent of the taxpayer. c. The child is less than 18. Solutions 20. "A" is the correct response. When the child s marginal rate is above 15%, long-term capital gain income will be taxed at 15% rather than zero percent. This eliminates the advantage of disposing of appreciated stocks and minimizes the tax savings of reporting savings bond interest (at best a 10% savings (35% - 25% marginal rate)) in B" is an incorrect response. If the child is no longer a dependent of the taxpayer (parent) and above age 17, the kiddie tax does not apply. If the child s marginal tax rate is 15% or below, there is no tax on long-term capital gain recognized in "C" is an incorrect response. Although the kiddie tax will apply, the child can realize substantial tax savings on the first $1,900 of unearned income realized in An Elite Possibility All rights reserved. The reproduction or translation of these materials is prohibited without the written permission of CPElite. The material contained in CPElite's courses and newsletters qualifies for CPE credit designed to enhance the professional knowledge of the individual. The material is sold with the understanding that CPElite is not engaged in rendering legal, accounting, tax, or other professional services in a consulting capacity "We have entered into an agreement with the Office of Director of Practice, Internal Revenue Service, to meet the requirements of 31 Code of Federal Regulations, Section 10(g), covering maintenance of attendance records, retention of program outlines, qualifications of instructors and length of class hours. This agreement does not constitute an endorsement by the Director of Practice as to the quality of the program or its contribution to the professional competence of the enrolled individual." CPElite, Inc. is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be addressed to the National Registry of CPE Sponsors, 150 Fourth Avenue North, Suite 700, Nashville, TN, Web site: