THE FEDERAL TAX ALERT

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1 A PUBLICATION OF THE NATIONAL SOCIETY OF TAX PROFESSIONALS NOVEMBER/DECEMBER 2013 THE FEDERAL TAX ALERT TIGTA SAYS IRS NEEDS TO IMPROVE CORRESPONDENCE AUDIT SELECTION PROCESS, (REFERENCE NUMBER: ), (SEPTEMBER 6, 2013) In the News Page 1 TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION (TIGTA) RELEASES FISCAL YEAR 2013 STATUTORY REVIEW OF RESTRICTIONS ON DIRECTLY CONTACTING TAXPAYERS (REFERENCE NUMBER: Practice Managment Page 2 FEDERAL INCOME TAX ISSUES OF DIVORCED AND SEPARATED TAXPAYERS: PART IV, THE DETERMINATION AND ISSUES OF THE FILING STATUS OF HEAD OF HOUSEHOLD Practice Managment Page 3 IRS FORM 8082: NOTICE OF INCONSISTENT TREATMENT Practice Managment Page 5 DISPOSITION OF ASSETS PART II From The Hotline Corner Page 6 A TIMELY TIP FROM ENNIS T. PEA ANNOUNCEMENTS Etcetera Page 4 Announcements Page 11 IN THE NEWS TIGTA SAYS IRS NEEDS TO IMPROVE CORRESPONDENCE AUDIT SELECTION PROCESS, (REFERENCE NUMBER: ), (SEPTEMBER 6, 2013) According to a report by the Treasury Inspector General for Tax Administration (TIGTA), the IRS needs to improve its correspondence audit selection process. The IRS uses correspondence audits to address individuals suspected of underreporting their income tax liabilities. Correspondence audits often result in significant additional tax assessments and are more economical than other types of audits. The report was issued to the IRS Commissioner for the Small Business/ Self-Employed Division on August 27, Impact on Taxpayers: Correspondence audits result in significant additional tax assessments and are more economical than other types of audits. IRS statistics show that in Fiscal Year 2012, the IRS conducted 1.1 million correspondence audits and recommend approximately $9.2 billion in additional taxes. Why TIGTA Did the Audit: This audit was initiated to determine the effectiveness of filing checks made during the correspondence audit process in the Small Business/Self-Employed Division. Filing checks are used, in part, to determine whether the same pattern of noncompliance identified on an audited tax return is present on the prior and/or subsequent year tax returns, and if those tax returns warrant an audit. When properly completed, filing checks leverage IRS audit resources by increasing the overall compliance coverage of every audit. What TIGTA Found: During its audit TIGTA evaluated a statistical sample of 102 of 7,470 single-year correspondence audits in which the taxpayer involved agreed that they understated their tax liabilities by at least $4,000. Similar tax issues also existed on the prior and/or subsequent year tax returns for 43 of the 102 taxpayers (40%). TIGTA found that 32 of the 43 individuals (75%) did not have those tax returns audited and, as a consequence, may have avoided additional assessments ranging from $2,343 to $18,874.TIGTA found that a factor that contributed to the limited number of prior and/or subsequent year tax audits in the sample is the emphasis the IRS places on keeping its audit inventories free of older tax years so there is sufficient time to complete audits and assess any resulting taxes within the three-year assessment statute of limitations. TIGTA also found that control issues also exist over how current year audit results are used in deciding whether to audit the prior and/or subsequent year returns. What TIGTA Recommended: TIGTA recommended that the IRS develop and implement procedures that instruct how current year correspondence audit results are to be used in deciding whether the prior and/or subsequent year tax returns warrant an audit. In order to ensure that the instructions are followed, the procedures should include instructions for monitoring how well current year correspondence audit results are used in deciding to audit prior and/or subsequent year returns. The IRS agreed with TIGTA s recommendation and plans to develop an Internal Revenue Manual section to address the case selection and delivery process and the duties and roles of analysts and examiners. For the full report refer to Reference Number at TIGTA website / FEDERAL TAX ALERT NOVEMBER/DECEMBER 2013 PAGE 1 EDITOR@NSTP.ORG

2 FROM THE EDITOR The FTA Editors along with the NSTP Board and staff wish you and your families the best of the holiday season and a joyous New Year. In March, the FTA Editors took over and we are excited about the new content and direction of the monthly magazine. We have endeavored to establish an informational format to provide you with information on tax subjects useful in your practice. An index of the topics covered in 2013 will be available in the near future on the Member section of the NSTP website. The NSTP Board welcomed two new Directors: Rod Ervin of Washington state who was elected to the Board at the July business meeting and appointed Kristina Rice, CPA out of Florida to fill the vacant term recently vacated by Dana Minot, EA. Dana left the Board this summer to pursue other opportunities and we wish her the best in her future endeavors. There is no question of the importance of the NSTP staff in Vancouver, WA in the success of the programs sponsored by the organization. The staff is the central force that makes it happen for us by maintaining the website, getting out the books and materials to all the cities where the Fall Update Seminars are conducted, responding to member questions and requests, and supporting the work of the Board. While the rest of us are busy running our tax practices, managing staff, and balancing a personal life the NSTP staff is focused on providing the best service and experience for the members of the Society. And to you, our members, we are grateful for your continued support of the NSTP. Whether your support is through your membership renewal, attending one of the many workshops and seminars, or purchasing educational material we thank you. Look for additional changes to come in 2014 including an updated website, new educational opportunities, and partnerships with affiliated organizations to provide services and goods at a discounted price to NSTP members. Be sure to take advantage of the resources already available to you including the NSTP Hotline and the education dividend rewards program. Nina Tross, MBA, EA, RTRP Rod Ervin, RTRP, Retired CPA Paul LaMonaca, CPA, MST NSTP CALENDAR Following is a listing of upcoming special seminars and educational opportunities. For additional information visit our website at NSTP.org for meeting agendas, hotel locations, and registration information. January 2014: January 6 7, 2014: 2013 Fall Update, Las Vegas NV June 2014: June 25 27, 2014: 14th Annual Summer Special Topics, Williamsburg, VA July 2014: July 21 23, 2014: 2nd Annual West Coast Special Topics, Napa Valley, CA NOTICE TAX HOTLINE Monday, Wednesday & Friday 9:00AM - 2:00PM Pacific 10:00AM - 3:00PM Mountain 11:00AM - 4:00PM Central 12:00PM - 5:00PM Eastern DIRECT LINE Technical Tax advice provided by NSTP Hotline staff is based upon specific information conveyed by the member. Members should take special care in relying upon recommendations and opinions that reflect the understanding of the Hotline staff member. NSTP and the Hotline staff are not responsible for misapplication of information given. Members are responsible for the utimate verification and application of any information provided by NSTP. TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION (TIGTA) RELEASES FISCAL YEAR 2013 STATUTORY REVIEW OF RESTRICTIONS ON DIRECTLY CONTACTING TAXPAYERS (REFERENCE NUMBER: On August 30, 2013 TIGTA issued its final report to the Internal Revenue Service Chief, Appeals and the Commissioner, Small Business/ Self-Employed Division. Impact on Taxpayers: IRS personnel are required to stop an interview if the taxpayer requests to consult with a representative and may not bypass a representative without supervisory approval. Between October 2011 and September 2012, TIGTA s Office of Investigations closed 13 direct contact complaints involving IRS personnel, of which two employees were disciplined or counseled for their actions by IRS management officials. Why TIGTA Did the Audit: This audit was initiated because TIGTA is required to annually report on the IRS s compliance with Internal Revenue 7521(b)(2) and (c). The overall objective of this audit was to determine whether the IRS complied with the legal guidelines addressing the direct contact of taxpayers and their representatives. What TIGTA Found: The IRS has a number of policies and procedures in place to help ensure that taxpayers FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 2 Editor@nstp.org

3 are afforded the right to designate a qualified representative to act on their behalf in dealing with IRS personnel in a variety of tax matters. Each year, TIGTA focuses on an office or function of the IRS that interacts with taxpayers and their representatives on a routine basis. For this review, TIGTA analyzed how well the Office of Appeals (Appeals) has ensured that its personnel are appropriately including taxpayers representatives in its activities. A statistical sample of 96 of 72,239 cases closed by Appeals showed that Appeals personnel did not always involve representatives appropriately in some key actions. In 11 of 96 sampled cases, Appeals personnel deviated from procedures by attempting to contact the taxpayer directly by telephone or not ensuring that copies of taxpayer correspondence were sent to the taxpayer s authorized representative. In addition, no documentation was found in managerial reviews indicating that checks were made to ensure that Appeals personnel were involving representatives in all case actions and providing representatives copies of all original correspondence sent to the taxpayers. What TIGTA Recommended: TIGTA recommended that the Chief, Appeals, provide additional guidance to first-line managers and Appeals personnel that will reinforce the importance of ensuring that taxpayer representatives are involved in all case activities. This will help ensure that the procedures designed to afford taxpayers their right to appropriate and effective representation are followed and properly documented during the appeals process. The IRS agreed with TIGTA s recommendation and plans to update the Internal Revenue Manual to clarify front-line managers responsibilities for ensuring that procedures regarding the direct contact provisions of the Internal Revenue Code are followed and reinforce the importance of ensuring that representatives are involved in all case activities. For the full report go to TIGTA tigta.treas.gov or website tigta or contact Nancy A. Nakamora, Acting Assistant Inspector General Audit (Compliance and Enforcement Operations) (202) practice management FEDERAL INCOME TAX ISSUES OF DIVORCED AND SEPARATED TAXPAYERS: PART IV, THE DETERMINATION AND ISSUES OF THE FILING STATUS OF HEAD OF HOUSEHOLD In the last Federal Tax Alert (FTA) we continued our series on the Introduction to Federal Income Tax Issues of Divorced and Separated Taxpayer and in that article we detailed the issues pertaining to the Concerns of Married Taxpayers Filing Separately. In this issue of the FTA we walk through the steps needed for determining qualifications for a filing status as Head of Household and the benefits derived once the status is achieved. A taxpayers filing status is used in order to determine many things. First of all it determines whether or not the taxpayer has a federal income tax return filing requirement. In addition it dictates the standard deduction amount and it impacts the threshold amounts for various Internal Revenue Code provisions which are affected by adjusted gross income or modified adjusted gross income, and most importantly it determines the correct tax liability. Our last issue addressed the matter of a married taxpayer who was not filing a return with a spouse and now we are addressing the filing status when there is no spouse but there is a qualifying child. A filing status as head of household, under 2(b), is defined as an individual who is not married at the close of the taxable year, who is not The Federal Tax Alert is published 10 times a year by the National Society of Tax Professionals. Mailing address: The Federal Tax Alert, NE 95th St., Suite 100 Vancouver, WA Telephone: Opinions expressed in The Federal Tax Alert are those of the editors and contributors. a surviving spouse and either maintains as his home a household which constitutes for more than one-half of such taxable year the principal place of abode, as a member of such household of a qualifying child of the individual (as defined in 152(c) determined without regard to 152(e)) but not if such child is married at the close of the taxpayer s year, and not a dependent of such individual by reason of 152(b)(2) or 152(b)(3) or both, or A taxpayer could also qualify for the head of household status if there is a qualifying person. A qualifying person is one who is a dependent of the taxpayer, if the taxpayer is entitled to a deduction for the taxable year for such person under 151, or maintains a household which constitutes the principal place of abode of the father or mother of the taxpayer, if the taxpayer is entitled to a deduction for the taxable year for such father or mother under (b)(2) disallows the dependency deduction if the qualifying child files a joint return with his or her spouse; and 152(b)(3) disallows the dependency exemption if the child is not a citizen or national of the United States unless such individual is a resident of the United States or a country contiguous to the United States. 151 provides for the allowance of deductions for personal exemptions. The head of household filing status provides a taxpayer the following federal income tax advantages: 63 standard deduction is allowed even if the spouse files a separate return and elects to itemize deductions on Schedule A, 63 standard deduction amount is larger than the amount allowed if the taxpayer files single or married separate, 21 dependent care credit and 32 EIC are allowed. These credits are not permitted if the filing status is single or married separate, Editors: Rod Ervin, RTRP; Paul LaMonaca, CPA, MST; Nina Tross, MBA, EA, RTRP Subscription Services: Delta Johnson FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 3 Editor@nstp.org

4 the AGI phase-out threshold amounts that reduce specific tax benefits begin at higher levels. Some of those benefits include: 24 Child Tax Credit, and 25B Retirement Contributions Savings Credit (Savers Credit on Form 8880). In order for a taxpayer to be able to claim a filing status as head of household the taxpayer must be considered as unmarried on the last day of the year. In order to qualify as unmarried a taxpayer must meet all of the following tests: files a separate return which includes any status of single, married filing separately or head of household, the taxpayer paid more than half of the cost of keeping up their home, and the spouse did not live in the taxpayer s home during the last 6 months of the tax year, A spouse is considered to live in a home even if the spouse is temporarily absent due to special circumstances. Special circumstances includes: illness, education, business, vacation or military service. It must be reasonable to assume under all the relevant facts and circumstances that the spouse will return to the home after the temporary absence and the taxpayer continued to keep up the home for the spouse during the absence. There is a special exception for claiming the dependency exemption if the noncustodial parent can claim the child because the custodial parent released the dependency exemption to the noncustodial parent with a signed written declaration that he or she would not claim the child as a dependent (Form 8332 Release/ Revocation of Release of Claim to Exemption for Child by Custodial Parent). For purposes of keeping up a home, the taxpayer must pay more than half of the cost of the upkeep for the tax year. This includes any rent, mortgage payments, real estate taxes, insurance, repairs, utilities, etc. and food eaten in the home. The cost of clothing education, medical treatment, vacations, life insurance, or transportation for any member of the household is not considered keeping up a home. The following Table 2 from IRS Publication 504 helps the Tax Professional in determining who is a qualifying person for purposes of the Head of Household filing status. In the next FTA we will address the issues concerning 151 Exemption Allowances. Et Cetera A TIMELY TIP FROM ENNIS T. PEA Don t Fall for Charity Scams Following Disasters IRS Special Edition Tax Tip , November 27, 2013 The IRS warns consumers not to fall for bogus charity scams. They often occur in the wake of major disasters like the recent tornadoes Table 2. IRS Publication 504: Who Is a Qualifying Person Qualifying You To File as Head of Household? 1 IF the person is your AND... THEN that person is... Qualifying child (such as a son, daughter, or grandchild who lived with you more than half the year and meets certain other tests) 2 Qualifying relative 4 who is your father or mother Qualifying relative 4 other than your father or mother (such as a grandparent, brother, or sister who meets certain tests) he or she is single he or she is married and you can claim an exemption for him or her he or she is married and you cannot claim an exemption for him or her you can claim an exemption for him or her 5 you cannot claim an exemption for him or her he or she lived with you more than half the year, and he or she is related to you in one of the ways listed under Relatives who do not have to live with you in Publication 501 and you can claim an exemption for him or her 5 he or she did not live with you more than half the year He or she is not related to you in one of the ways listed under Relatives who do not have to live with you in Publication 501 and is your qualifying relative only because he or she lived with you all year as a member of your household you cannot claim an exemption for him or her a qualifying person, whether or not you can claim an exemption for the person. a qualifying person. not a qualifying person. 3 a qualifying person. 6 not a qualifying person. a qualifying person. not a qualifying person. not a qualifying person. not a qualifying person. 1 A person cannot qualify more than one taxpayer to use the head of household filing status for the year. 2 See Table 3, later, for the tests that must be met to be a qualifying child. Note: If you are a noncustodial parent, the term qualifying child for head of household filing status does not include a child who is your qualifying child for exemption purposes only because of the rules described under Children of Divorced or Separate Parents (or Parents Who Live Apart under Exemptions for Dependents, later. If you are the custodial parent and those rules apply, the child is generally your qualifying child for head of household filing status even though the child is not a qualifying child for whom you can claim an exemption. 3 This person is a qualifying person if the only reason you cannot claim the exemption is that you can be claimed as a dependent on someone else s return. 4 See Table 3, later, for the tests that must be met to be a qualifying relative. 5 If you can claim an exemption for a person only because of a multiple support agreement, that person is not a qualifying person. See Multiple Support Agreement in Publication See Special rule for parent for an additional requirement. FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 4 Editor@nstp.org

5 in the Midwest or the typhoon in the Philippines. Thieves play on the goodwill of people who want to help disaster victims. They pose as a real charity in order to steal money or get private information to commit identity theft. The scams use different tactics. Offering charity relief, criminals often: Claim to be with real charities to gain public trust. Use names similar to legitimate charities. Use to steer people to bogus websites that often look like real charity sites. Contact people by phone or to get them to donate money or give their financial information. The IRS offers the following tips to help taxpayers who wish to donate to victims: Donate to qualified charities. Use the Exempt Organizations Select Check tool at IRS.gov to find qualified charities. Only donations to qualified organizations are tax-deductible. Legitimate charities are also listed on the Federal Emergency Management Agency website, fema.gov. For more information about the kinds of charities that can receive deductible contributions, see Publication 526, Charitable Contributions. Don t give out information. Don t give out Social Security numbers, credit card, bank account numbers or passwords to anyone. Scam artists use this information to steal identities and money. Don t give or send cash. For security and tax record purposes, don t give or send cash. Contribute by check, credit card or another way that provides documentation of the donation. Report suspected fraud. If tax or charity-related fraud is suspected, visit IRS.gov and click on Reporting Phishing at the bottom of the home page. Get more information about tax scams and schemes at IRS.gov. Click on Tax Fraud & Abuse at the bottom of the home page. You can also get Publication 526 at IRS.gov or call 800-TAX-FORM ( ). practice management IRS FORM 8082: NOTICE OF INCONSISTENT TREATMENT In our practices we prepare tax returns for pass-through entities such as Form 1065 for Partnerships, Form 1120S, for S-Corporations, and Form 1041 for Estates and Trusts. Since these entities generally do not pay the income tax the result of any net income, net loss, deductions or credits, etc. are required to be reported to the partners, shareholders and beneficiaries. These results are required to be reported to the owners and beneficiaries on a Schedule K-1 and the recipients are required to report the results in a consistent manner with the way in which they were reported by the entity on the Schedule K-1. However, there may be reasons for which the recipient may wish to report these items differently and if this is the case then the recipient could use IRS Form 8082 for this purpose. Form 8082 is titled Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR). The Form 8082 is used to notify the IRS of any inconsistency between the taxpayer s treatment of an item reported by the entity on the Schedule K-1 and how the taxpayer is actually reporting that particular item on their income tax return. The taxpayer could also use Form 8082 if a Schedule K-1 was not received from the entity. In addition, a taxpayer could use Form 8082 if they believe that an item was not properly reported on the Schedule K-1, or an item which was reported on the Schedule K-1 that does not have to be reported on the taxpayer s return. In the instructions for Form 8082 the IRS provides an example that if the taxpayer is a partner in a partnership and believes that the percentage shown as the ownership percentage of capital at the end of the year was not properly reflected on the Schedule K-1, then the taxpayer could file Form 8082 to notify the IRS of this matter even though the taxpayer is not otherwise required to report that ownership percentage on the tax return. The instructions also state that sometimes the issue of inconsistency is discovered after filing the original return. As a result the taxpayer could file an amended return to report it and in the space provided on the amended return for writing an explanation for the amendment the taxpayer would enter See Attached Form If the correction does not affect the dollar amounts on the tax return, then no amounts need to be reported on the amended return if the Form 8082 is the only purpose for filing the amended return. The Form 8082 would provide all of the information needed. The Form 8082 requires that the taxpayer s name and identifying number are included. In Part I the taxpayer must check box (a) on line 1 which is the indication for notice of inconsistent treatment. On line 2 the taxpayer must check the box identifying the type of pass-through entity involved; Line 3 requires the employer identification number of the pass-through entity; Line 4 asks for the name, address and zip code of the entity; line 5 is the IRS Service Center where the entity return was filed; line 6 is the tax year of the entity and line 7 is the tax year of the taxpayer filing the Form Part II is the section which addresses the inconsistent treatment. Column (a) is the description of the inconsistent item; column (b) requires that the taxpayer indicate whether the inconsistency is in an amount of an item or in the treatment of an item. (It could be both). Column (c) requires the taxpayer to include the amount reported on the Schedule K-1 and column (d) requires the amount the taxpayer is actually reporting on the tax return being submitted; column (e) is the difference between columns (c) and (d). FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 5 Editor@nstp.org

6 There are multiple lines in Part II if there are multiple items of inconsistency. Part III is where the explanation for each of the items in Part II are described. There are times when tax professionals have a client s return on extension because the Schedule K-1 from a pass-through entity has not arrived in time to meet the extension deadline and the client wants to file timely. As the Tax Professional you could recommend that the client file a Form 8082 if the pass-through entity has not filed a tax return or provided the taxpayer with the required Schedule K-1 by the time that the taxpayer is required to file their tax return. There could be items of income, loss, deductions and credits that the taxpayer could be required to report on their return. It is recommended that the Tax Professional have a discussion with the client which includes an analysis of the history of the items reported from the entity on the Schedule K-1s from prior years. If the annual amounts are consistent or there is a pattern of growth or decline in the amounts being reported then an educated approach can be taken to determine an acceptable inclusion on the client s Form If the Schedule K-1 normally reports income of $X then maybe that should be the amount reported on the current year return. The Form 8082 will report that a Schedule K-1 was not received and the taxpayer is including an amount based on good faith efforts and estimates. If in prior years the Schedule K-1 normally reports losses and or deductions of $Y then that could be the amount to report again letting the IRS know on Form 8082 that the amounts are being reported as an estimate due to a lack of receiving the Schedule K-1. When and if the Schedule K-1 is received the return could be amended to reflect the actual passthrough results of the entity. Here is a good scenario for you as to when you would want to attach Form 8082 to the taxpayer s Form EXAMPLE: Don is a member of a limited liability company being treated as a partnership in which he owns 20% of the partnership interest. The preparer of the Form 1065 issues Don a Schedule K-1 which reports a $25,000 distributive share in Box 1 which would be included in his gross income for federal income tax purposes. The Schedule K-1 also reports the $25,000 in Box 14 which is self-employment income. However, Don is not an active member of the LLC because he does not provide services to the LLC and he doesn t have any authority to act on behalf of the LLC and doesn t have any responsibility for the debt of the LLC. For purposes of this investment Don is treated as if a limited partner in a limited partnership. When Don s Tax Professional is preparing Don s return he notices that Don s return is reporting a self-employment tax liability. When the tax professional compares last year s return to this year s return (Don had the same 20% ownership in the prior year) the selfemployment tax is noticed. When the LLC (on Don s behalf) contacts the person who prepared the Form 1065 and issued the Schedule K-1 the person can t be found and no change is made. This is the time when the Form 8082 should be used reporting that the Schedule K-1 Box 14 amount was reported as $25,000, but should be zero and attaching the explanation as to why it is being treated in an inconsistent manner. From the Hotline CORNER DISPOSITION OF ASSETS PART II Last month we looked into the characteristics of various types of disposition which can be sales, exchanges, foreclosures, repossessions, involuntary conversions, condemnations, non-taxable exchanges, and spousal transfers. Our approach addressed identifying these dispositions, this month we will delve into more specific issues. The most common type of disposition is through a sale of the asset. This most likely will produce a gain or loss. Once again, our main source of information is IRS Publication 544 Sales and Other Dispositions of Assets. Our first objective will be to classify the result as a capital gain or ordinary income transaction, followed closely by determining the holding period as either short-term or long term. This is a critical step for individuals because of the favorable tax rates relating to capital gains. The rules for determining long or short term holding period will be discussed later. As we will learn later, the losses may be limited. So, just what is a capital asset? Capital Assets. Almost everything an individual owns and uses for personal purposes, pleasure, or investment is a capital asset. We will discuss business property separately. The following are examples of the most commonly known capital assets: Stocks and bonds. Notes, or other evidences of debt, not considered business assets. Personal residences. Timber grown on the residential property. Household furnishings. Vehicles used for pleasure or commuting (including boats and bicycles). Collections of coins, stamps, baseball cards or other collectible media. Gems and jewelry Gold, silver and other metals Generally, property held for personal use is a capital asset and the sale or exchange of that property will produce a gain or loss. The gain will be taxable as a capital gain, but the loss from the sale or exchange is not deductible for tax purposes. The exception would be a loss relating to personal use property due to a casualty or theft. On the other hand, property held as an investment (including stocks and bonds) is a capital asset and FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 6 Editor@nstp.org

7 either the gain or loss will have tax consequences. While property held to produce rental income is a capital asset, its disposition will be discussed separately. Noncapital Assets. Since we have introduced the identification of capital assets, it might be well to illustrate some noncapital assets: 1. Stock in trade, inventory, and other property held mainly for the sale to customers in a trade or business, commonly known as inventory. See IRS Publication 538, Accounting Periods and Methods. 2. Supplies of a type regularly used or consumed in the ordinary course of a trade or business. 3. Accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of inventory-type properties. 4. Depreciable property used in a trade or business, or as rental property (including 197 intangibles, discussed later). This is true even if the property is fully depreciated. 5. Real property used in a trade or business or as rental property, again even if the property is fully depreciated. 6. U.S. Government publications received from the government for free or for less than the normal sales price. 7. A copyright, a literary, musical, or artistic composition; a letter, a memorandum; or similar property: a. Created by the taxpayer s personal efforts; or b. Prepared of produced for the taxpayer (for example a letter, memorandum, or similar property), or c. Received from a person who created the property or for whom the property was prepared under circumstances (such as by gift) entitling the taxpayer to the tax basis of the person who created the property, or for whom it was prepared or created. However, it is possible to treat as capital assets certain self-created musical compositions or copyrights sold or exchanged. The details of this election are found in IRS Publication 550 Investment Income and Expenses. 8. Any commodities derivative financial instrument held by a commodities derivatives dealer, unless it meets both of the following requirements: a. It is established to the satisfaction of the IRS that the instrument has no connection to the activities of the dealer as a dealer; and b. The instrument is clearly identitied in the dealer s records as meeting the above by the end of the day on which it was acquired, originated, or entered into. 9. Any hedging transaction that is clearly identified as a hedging transaction by the end of the day on which it was acquired, originated, entered into. Further explanation and details regarding 7, 8, and 9 above are in IRS Publication 544. Sales and Exchanges Between Related Parties. The characteristics of an asset or of a disposition transaction may be altered if the parties to the transaction are related. Different rules may apply, even if the property is depreciable. Definitions as to the specific relationships involved at individual, partnership and corporate levels are contained in IRS Publication 544. Gain on the sale or exchange of depreciable (or amortizable) property is ordinary income if the transaction is either directly or indirectly between specified pairs of entities. Conversely, the loss on the sale or exchange of property between related persons in not deductible. This applies to both direct and indirect transactions, but not to distributions of property from a corporation in a complete liquidation. Determining Ordinary or Capital Gain or Loss on Sale or Exchange of Business Property. The disposal of depreciable property is governed by the rules contained in 1231 of the IRC and may be either ordinary or capital in nature. If the property qualifies under 1245 or 1250, the disposal may trigger recognition of ordinary income under the depreciation recapture rules, with any remaining gain being considered 1231 gain. So what constitutes a 1231 transaction: Sale or exchanges of real property or depreciable personal property used in a trade or business (including property held for the production of rents or royalties and amortizable 197 intangibles) and held longer than one year. Sales or exchanges of leaseholds used in a trade or business and held longer than one year. Sales or exchanges of cattle and horses held for draft or breeding, dairy, or sporting purposes and held for two years or longer. Sales or exchanges of other livestock (other than poultry) which are held for draft, breeding dairy, or sporting purposes and held for one year or longer. Sale or exchanges of unharvested crops. The crop and land must be sold, exchanged, or involuntarily converted at the same time and to the same person and the land must have been held longer than one year. Cutting of, or disposal of, timber, if the cutting was elected to be treated as a sale or exchange. This also includes Evergreen Christmas trees that are more than 6 years old when severed from their roots and sold for ornamental purposes. The mining of coal or iron ore if the coal or iron had been owned for longer than one year and an economic interest in the coal or iron is kept by the seller. The condemnation of property held longer than one year. It must be business property or a capital asset held in connection with a trade or business or a transaction entered into for profit, such as investment property. It cannot be property held for personal use. Property affected by a casualty or theft and held for the production of rents and royalties, or investment property held for more than one year. However, if losses exceed gains they are not taken into account as FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 7 Editor@nstp.org

8 1231 transactions will be either ordinary or capital as follows: If there is a net 1231 loss, it is an ordinary loss. If there is a net 1231 gain it is ordinary gain up to the amount of the nonrecaptured 1231 losses from the previous 5 years. Therefore, if in any of the 5 preceding years there were 1231 losses that were not applied to 1231 gains, any net 1231 gain in the current year is ordinary to the extent of unused prior year losses. Example. In 2013, Fred has a $3,000 net 1231 gain. To figure how much he has to report as ordinary income and/or long-term capital gain, he must first determine his 1231 gains and losses from the previous 5-year period. Following is a recap of these gains and losses from 2008 through 2012: ($2,000) $1,300 Fred uses this information to figure how to report his net 1231 gain for 2013 as follows: 1. Net 1231 gain for 2013 $3, Net 1231 loss in 2009 ($2,000) 3. Net 1231 gain in , Remaining net 1231 from prior years ($ 700) 5. Gain from 2013 treated as ordinary income gain treated as long-term capital gain $2,300 Depreciation Recapture. The disposal of depreciable or amortizable property at a gain may trigger recapturing previously taken depreciation or amortization as ordinary income. It is important that permanent records be maintained to retain the facts necessary to provide information as to the depreciation or amortization allowed or allowable on the property. This would include the date and manner of acquisition, cost or other basis, depreciation or amortization, and all other adjustments that affect basis. If the property was acquired in a nontaxable exchange or gift, the records must also indicate whether the adjusted basis was figured using depreciation claimed by the person disposing of the property or on depreciation or amortization claimed by another person. The recapture of depreciation will depend on many factors, including the code section type of property and the type of disposal (e.g. sale or exchange, gift, transfers at death, likekind exchange, or involuntary conversion). Section 1245 Property. This includes any property that is or has been subject to an allowance for depreciation or amortization such as the following: 1. Personal property (either tangible or intangible). 2. Other tangible property (except buildings and their structural components) used as any of the following: a. An integral part of manufacturing, production, or extractions, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services. b. A research facility in any of the above activities. c. A facility in any of the above activities for the bulk storage of fungible commodities. 3. That part of real property (not included in(2) with an adjusted basis reduced by (but not limited to) the following: a. Amortization of certified pollution control facilities. b. The 179 expense deduction. c. Deduction for clean-fuel vehicles and certain refueling property. d. Deductions for capital costs incurred in complying with Environmental Protection Agency sulfur regulations. e. Deduction for certain qualified refinery property. f. Deduction for qualified energy efficient commercial building property. g. Amortization of railroad grading and tunnel bores, if in effect before the repeal by the Revenue Reconciliation Act of h. Certain expenditures for child care facilities. i. Expenditures to remove architectural and transportation barriers to the handicapped and elderly. j. Deduction for qualified tertiary injectant expenses. k. Certain reforestation expenditures. l. Deduction for election to expense qualified advanced mine safety equipment property. 4. Single purpose agricultural (livestock) or horticultural structures. 5. Storage facilities (except buildings and their structural components) used in distributing petroleum or any primary product of petroleum. 6. Any railroad grading or tunnel bore. The gain treated as ordinary income on the sale, exchange, or involuntary conversion of 1245 property, including a sale and leaseback transaction, is the lesser of: 1. The depreciation and amortization allowed or allowable on the property. 2. The gain realized on the disposition. Determining the depreciation allowed or allowable is the amount actually taken in prior years. If, in prior years proper deductions were taken under one method, the amount allowed for prior years will not be increased even though a greater amount would have been allowed under another proper method. However, if no depreciation was claimed at all in those prior years, the adjustment will be made using the straight line method. Publication 544 lists the various deductions that are considered depreciation and amortization. FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 8 Editor@nstp.org

9 Section 1250 Property. This includes all real property that is subject to an allowance for depreciation and that is not and has never been 1245 property. It includes a leasehold of land or 1250 property subject to an allowance for depreciation. Once a 1250 property becomes a 1245 property because of a change in use, it can never again be treated as 1250 property. Gain on the sale of 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property. Additional depreciation should not be confused with unrecaptured depreciation which relates to the taxation rate of a capital gain on disposition, which will be discussed later. Additional depreciation is the amount of actual depreciation adjustments that are more than the depreciation figured using the straight line method on property held for more than one year. If the property is held for one year or less, all the depreciation is additional depreciation. However, there will not be additional depreciation if any of the following conditions apply to the disposed property: Depreciation was taken using the straight line method on property that was qualified property, but an election was made to NOT claim any special depreciation allowance. In addition, if the property was in a renewal community, no election was made to claim a commercial revitalization deduction for property placed in service before January 1, The property was residential lowincome rental property held for 16⅔ years or longer. The alternate ACRS method of depreciation was chosen for the property, which was a type of 15-,18-, or 19-year real property covered by the 1250 rules. The property was residential rental property or nonresidential real property placed in service after 1986 (or after July 31, 1986, if the choice to use MACRS was made); it had been held for more than one year; and, if the property was qualified property, but an election was made to NOT claim any special depreciation allowance. In addition, if the property was in a renewal community, no election was made to claim a commercial revitalization deduction. The applicable percentage used to figure the ordinary income because of additional depreciation depends on whether the real property disposed of is nonresidential real property, residential rental property, or low-income housing. For nonresidential rental property, the applicable percentage for periods after 1969 is 100%. For periods before 1970, the percentage is zero, thus no ordinary income will be realized for additional depreciation before 1970 will be realized from its disposition. In the case of residential rental property, (that is, 80% or more of the gross income is from dwelling units), other than low-income housing, the applicable percentage for periods after 1975 is 100%. The percentage for periods before 1976 is zero, thus no ordinary income will be realized for additional depreciation before The applicable percentage for lowincome housing is 100% minus 1% for each full month the property was held over 100 full months. If the property had been held for at least 16 years and 8 months, the percentage is zero and no ordinary income will result from its disposition. For the disposition of property via a foreclosure, or for property acquired by gift or specific construction, additional rules are outlined in PUB 544. The amount of gain treated as ordinary income is calculated using the steps contained in part III of Form Installment Sales. If you report the sale of property under the installment method, any depreciation recapture under 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payemtns are received in that year! If the gain exceeds the depreciation recapture, report the rest of the gain using the rules of the installment method. For this purpose, include the recapture income in your installment sale basis to determine the proper gross profit on the installment sale. If multiple assets are included in the installment sale transaction, figure the gain on each asset separately so that it may be properly reported. Allocate the selling price and the payments received in the year of sale to each asset and report any depreciation recapture income before using the installment method of any remaining gain. Gifts. If the disposition of depreciable personal or real property is by gift, the seller does not report any income on the transaction. However, if the person who receives it (the donee) sells or otherwise disposes of the property in a disposition subject to recapture (at a gain) then the donee must take into account the depreciation previously taken to figure the gain to be reported as ordinary income. If property is given to a charitable organization, the deduction for a charitable contribution is figured by reducing the fair market value of the property by the ordinary income and short-term capital gain that would have resulted had the property been sold at fair market value on the date of the contribution. Further details regarding this type of transaction can be found in IRS PUB 526, Charitable Contributions. If 1245 or 1250 property is transferred to a charitable organization for less than its fair market value to obtain a charitable deduction, the ordinary income from depreciation is figured under different rules. First, figure the ordinary income as if the property had been sold at its fair market value. Then allocate that amount between the sale and contribution parts of the transfer in the same proportion that the adjusted basis was allocated to figure the gain. This is referred to as a bargain sale, which will be discussed later. Transfers at Death. Property that is transferred to an heir at death may receive a step-up in basis, but no ordinary income is reported by either the decedent or the beneficiary. A Like-Kind Exchange or Involuntary Conversion does not trigger FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 9 Editor@nstp.org

10 recapture of depreciation unless money or property other than the like-kind, similar, related property is received (boot) in the transaction. If boot or non-similar property is received, then ordinary income from depreciation recapture is limited to the sum of the gain that must be include in income under the rules for like-kind exchanges or involuntary conversions; and the fair market value of the like-kind, similar or related property other than the depreciable property acquired in the transaction. Reporting Gains and Losses. Under current regulations promulgated by the IRS, many transactions are required to be reported on Information Returns such as Form 1099-B Proceeds from Broker and Barter Exchange Transactions and Form 1099-S, Proceeds from Real Estate Transactions. These forms contain amounts reported to the IRS, their absence does NOT relieve the seller from an obligation to report the transaction! Gains and losses are initially reported on Form 4797, Sales of Business Property or Form 8949, Sales and Other Dispositions of Capital Assets. Amounts from these forms may then carry forward to Schedule D (Form 1040, for individuals). Form 1099-B is the form used to report most sales of stocks, bonds, or certain commodities through a broker. Many brokers will modify their statements to comply with the 1099-B. Form 1099-S must be provided on certain real estate transactions by the person responsible for closing the transaction. A substitute reporting is allowed, provided all the required information is reported. Required is the reporting of the following types of property: Land (improved or unimproved), including air space. An inherently permanent structure, including any residential, commercial, or industrial building. A condominium unit and its related fixtures and common elements (including land). Stock in a cooperative housing corporation Form 8949 is used by individuals, corporations and partnerships to report: All sales or exchanges of capital assets, including stocks, bonds, and certain real estate transactions Gains from involuntary conversions (other than from casualty or theft) of capital assets NOT held for business or profit. Nonbusiness bad debts. PLEASE NOTE: Form 8949 has changed for 2013! We will discuss it in a future article. Schedule D (Form 1040), is used by individuals to report the totals from Form 8949, as well amounts from: Form 2439, for amounts withheld by a Regulated Investment Company (Mutual Fund) or Real Estate Investment Trust; Form 4684, for an involuntary conversion due to casualty or theft;, Form 4797, for a disposition of business property; Form 6198, for a disposition of an interest in, or property used in, an activity to which the At-Risk Limitations apply; Form 6252, for an installment sale, Form 6781, for gains or losses from 1256 contracts and straddles; Form 8582, for disposition of an interest in, or property used in a passive activity; Form 8824, for like-kind exchanges; and Forms K-1 from pass-through entities. Long and Short Term. Where the gain or loss is reported depends on how long it was held before disposition. This holding period will also determine how the transaction is taxed. If a capital asset is held one year or less, the gain or loss is short-term. If the property was held more than one year the gain or loss is considered a long-term transaction. To determine if the property qualifies as long-term, begin counting on the day after acquisition and include the day of disposal in the holding period. The holding period for certain assets can be governed by separate rules. The holding period for patent property is considered long term, regardless of when it was acquired or when the disposition takes place. The same is true for inherited property. The holding period for an installment sale is determined at the point of sale and continues throughout the installment period. (The tax rate in affect at the time of sale also continues throughout the installment period). In a nontaxable exchange the holding period for the newly acquired asset begins with the date the surrendered asset was acquired. If property is acquired by gift, the holding period includes the time the asset was held by the done. In a corporate liquidation, the holding period for property received generally starts on the day after it is received. The same is true for common stock withdrawn from a profit sharing plan. Property sold with a retained security interest (installment sale) and later repossessed, includes the holding period before the sale. Nonbusiness bad debts are always considered short-term capital losses. In addition to the above rules, the following rules apply to holding periods for other types of assets: Stocks or bonds bought on a securities market The holding period starts the day after the security was purchased and ends on the trading date the security was sold. U.S. Treasury notes and bonds If bought at auction, the holding period begins the day after notification of bid acceptance. If purchased through subscriptions, it begins the day after the subscription was submitted. Real property purchased Generally, the day after title to the property is received. Ordering Net Gain or Loss. The net gain or loss for each holding class (long-term or short-term) is calculated first. Short term transactions are FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 10 Editor@nstp.org

11 considered before long term transactions. This includes short term capital gains or losses from partnerships, S corporations, and fiduciaries and any short term loss carryovers. After calculating the net short-term gain or loss, the net long-term gain or loss is calculated including the following items: Net 1231 gain from Part I, Form 4797, after any adjustment for nonrecaptured 1231 losses from prior tax years. Capital gain distributions from regulated investment companies (mutual funds) and real estate investment funds. Long-term capital gains from passthrough entities such as partnerships, S corporations, and fiduciaries. Long-term capital losses carried over from prior years. The result is the net long-term capital gain or loss. The short-term and long-term amounts are then combined. If the result is a gain, it will be taxable. If there are only net short term gains, they will be taxed at ordinary income tax rates. If there are long-term gains they will be taxed at zero, 15% or 20% depending upon the taxpayer s taxable gross income. If there are short-term losses, they will first reduce long-term gains. Capital Losses. If there are both long and short-term net losses they are used to offset ordinary income, subject to limitations. They are limited up to $3,000 per year, unless the filing status is Married Filing Separate, which limits the deduction to $1,500. The remainder is carried forward. The losses do not lose their identity in carryovers. Unused capital loss carryovers are carried forward to the following year. When a loss is carried forward it remains long-term or short-term. A long-term capital loss carried over to the following year will reduce that year s long-term capital gains before it reduces that year s short-term capital gains. The amount of capital loss carryover is the amount of the net loss that is more than the lesser of: 1. The allowable capital loss deduction for the year, or 2. The taxable income increased by the capital loss deduction for the year and the deduction for personal exemptions. If the deductions are more than the gross income for the tax year, use the negative taxable income in computing the amount in item (2) above. PUB 550 has a worksheet to accomplish this confusing task in Chapter 4 Reporting Capital Losses. Example. Bill and Diane had a net capital loss carryover from 2011 to 2012 in the amount of $5,000. They had no capital transactions in Their Adjusted Gross Income for 2012 was $26,000 (after deducting $3,000 of capital loss carryover from However, their itemized deductions for 2012 were $30,000, which meant that the income on line 41 (after itemized deductions and before personal exemptions) was ($4,000). Since this amount exceeds the amount claimed as capital loss by $1,000, Bill and Diane would have had negative income without using the capital loss carryover. Thus, the capital loss carryover from 2012 to 2013, would be $5,000, as none of it was eligible to be used in This is the calculation from the worksheet in PUB 55. Keep in mind that when figuring the amount of any capital loss carryover to the next year, you must take into consideration the current year s allowable deduction, whether or not it was claimed or whether or not a return for the current year was required. With the exception of a discussion on navigating Form 8949 (which we will approach in a later issue) this concludes our examination of the disposition of assets. ANNOUNCEMENTS 2014 MILEAGE RATES: The IRS has announced the mileage rates for Business 56 cents Moving/Medical 23.5 cents Charity 14.0 cents Both the Moving/Medical and Business mileage reimbursement rates were reduced by one half cent from the 2013 mileage rates. The Charity miles is set by Congressional action and has not changed in many years. HOTLINE HOURS EXPANDED FOR TAX SEASON: the Hotline will be open 5 days a week starting January 1st and Saturday service will be added on February 1st. Be sure to take advantage of this valuable member benefit. There is no charge to NSTP members for calls to the Hotline. The new Hotline hours starting January 1st are as follows January 1st - January 31st Monday - Friday 9:00AM - 2:00PM Pacific 10:00AM - 3:00PM Mountain 11:00AM - 4:00PM Central 12:00PM - 5:00PM Eastern February 1st - April 15th Monday & Tuesday 6:00AM - 2:00PM Pacific 7:00AM - 3:00PM Mountain 8:00AM - 4:00PM Central 9:00AM - 5:00PM Eastern Wednesday, Thursday & Friday 9:00AM - 5:00PM Pacific 10:00AM - 6:00PM Mountain 11:00AM - 7:00PM Central 12:00PM - 8:00PM Eastern Saturday 8:00AM - 12:00PM Pacific 9:00AM - 1:00PM Mountain 10:00AM - 2:00PM Central 11:00AM - 3:00PM Eastern FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 11 Editor@nstp.org

12 REGISTER EARLY! ENJOY HUGE DISCOUNTS! REGISTER NOW THROUGH DECEMBER 31, 2013 Enjoy a $ discount on registration Enter to win one (1) night hotel stay during the seminar ABSOLUTELY FREE 3 Winners will be announced at lunch on Tuesday, July 22, 2014 JANUARY 1 THROUGH MARCH 31, 2014 Enjoy a $50 discount on registration APRIL 1 THROUGH MAY 31, 2014 Enjoy a $25 discount on registration Announcing NSTP s 2014 Napa Special Topics Napa, CA July 21-23, 2014 The Annual Ethics Session Monday Morning Ethics for the Tax Professional in 2014 and Circular 230 Issues after the Loving Case Monday, July 21, :00am to 10:40am 2 CPE Credit Hours The Annual Executive Session Monday Afternoon "Introduction and Review of Worker Classification Issues: Independent Contractors vs. Employee" Monday, July 21, :00pm to 5:00pm 4 CPE Credit Hours Special Topics Workshop Choose which you would like to attend AM vs. PM Tuesday Morning Session 1: "Introduction to IRS Form 1041 Income Taxation of Estates and Trusts" or Session 2: Introduction to Foreign Tax Issues Including ITIN Issues Tuesday, July 22, :00am to 12:00pm 4 CPE Credit Hours Each Tuesday Afternoon Session 1: "Introduction to IRS Form 1041 Income Taxation of Estates and Trusts" or Session 2: Introduction to Foreign Tax Issues Including ITIN Issues Tuesday, July 22, :00pm to 5:00pm 4 CPE Credit Hours Each Up to 18 CPE Credits Available Wednesday Morning "Overview of the 2010 Health Care Act: Affordable Care Act" and Introduction and Review of the Defense of Marriage Act (DOMA) after the Windsor Supreme Court Decision: The Issues, the Opportunities and the Traps Wednesday, July 23, :00am to 12:00pm 4 CPE Credit Hours Where: Embassy Suites Napa Valley 1075 California Blvd. Napa, CA EMBASSY ( ) *Room Rate: *$ per night *Rate available from July 20-22, 2014 Hotel cutoff date: June 17, 2014 Group Code: NST or mention National Society of Tax Professionals For additional details or to register online please visit our website at REGISTER EARLY! ENJOY HUGE DISCOUNTS! REGISTER NOW THROUGH DECEMBER 31, 2013 Enjoy a $75.00 discount on registration Enjoy one (1) webinar of your choice ABSOLUTELY FREE JANUARY 1 THROUGH MARCH 31, 2014 Enjoy a $50 discount on registration Enjoy one (1) webinar of your choice ABSOLUTELY FREE APRIL 1 THROUGH MAY 31, 2014 Enjoy a $25 discount on registration Announcing NSTP s 2014 Williamsburg Special Topics Williamsburg, VA June 25-27, 2014 Up to 18 CPE Credits Available The 4th Annual Ethics Session - Wednesday Morning Ethics for the Tax Professional in 2014 and Circular 230 Issues after the Loving Case June 25, :00am to 10:40am 2 CPE Credit Hours The 6th Annual Executive Session Wednesday Afternoon "Introduction and Review of Worker Classification Issues: Independent Contractors vs. Employee" June 25, :00pm to 5:00pm 4 CPE Credit Hours Special Topics Workshop Thursday & Friday "Federal Income Tax Issues of the 2010 Health Care Act: Affordable", Introduction and Review of the Defense of Marriage Act (DOMA) after the Windsor Supreme Court Decision: The Issues, the Opportunities and the Traps and Introduction and Review of the Differences of Dealing with Innocent Spouse and Injured Spouse Issues June 26, :00am to 4:45pm 8 CPE Credit Hours "Discovering and Meeting the Financial and Tax Issues of Retirement Planning" June 27, :00am to 12:00pm 4 CPE Credit Hours Where: Holiday Inn Patriot 3032 Richmond Road *Room Rate: $74.00 plus 10% state/local tax and Williamsburg, VA $2.00 occupancy tax per room night For additional details or to register online please visit our website at FEDERAL TAX ALERT NOVEMBER/december 2013 PAGE 12 Editor@nstp.org