Taxation Issues for CPAs

Transcription

1 1 Taxation Issues for CPAs Kevin J. Donovan, CPA, EA, MSPA, FCA Managing Member Pinnacle Plan Design, LLC 2 Types of Business Entities C Corporations S Corporations Sole Proprietorships Partnerships Limited Liability Companies (LLCs) Taxed as corp, partnership or sole prop Partnerships of P.C.s 3 1

2 C Corporations Profit taxed at corporate level at graduated rates (15% - 35%) Exception for certain Personal Service Corporations (PSCs)- 35% from first dollar [IRC 11(b)(2); 448(d)(2)] Dividends taxed at shareholder level Owned by shareholders Liability separate from owners 4 C Corporation Deductions Deductions for contributions made on behalf of all employees (including owners) taken at corporate level Deductions may cause losses resulting in carryback (2 years) or carryover (20 years) May elect to waive c/b and instead just c/o Fiscal year PSCs may c/o only IRC 172(b)(1)(A) / 172(b)(3) / 280H(e) 5 C Corporation Loss - example Corporation expects taxable income of $0 in 2016 and $375K in 2017 (before any pension) Cash from 2017 earnings will be available before 2016 tax return due Max DB deduction $225K for 2016; $150K for 2017 Latter presuming 2016 max and assets = $225K at val date Adopt DB plan in fund $225K by due date Creates loss of $225K in 2016 Fund plan for $150K for 2017 bringing 2016 taxable income to $225K ($375K $150K) before NOL C/O $225K NOL C/O from 16 will reduce 17 taxable inc to $0 6 2

3 C Corporation Loss - example Accrual basis corporation has taxable income of $100,000 each in 2014 and 2015 but limited cashflow Returns filed with taxable income and taxes paid 2016 break-even but $200,000 excess cash flow due to collection of receivables In 2016 adopt plan and create net operating loss of $200,000 Loss carried back to 2014 and 2015 and taxes paid recovered 7 S Corporations Profit passed through (taxed) to owners, taxed at individual level Profits taxed proportionate to ownership interest (whether or not distributed) Unlike in partnership distributions must be proportionate to ownership S status is a tax election effecting only how corporation is taxed Liability still separate from shareholders Owners treated as employees for plan purposes 8 S Corporation Deductions Deductions for contributions made on behalf of all employees (including owners) taken at corporate level IRS Form 1120S, line 17 Deductions may cause losses usage depends on shareholder basis Contributions to capital, shareholder loans to corporation, undistributed prior earnings 9 3

4 S Corporation Loss - example S corporation is break-even but has significant cash from undistributed prior earnings S shareholder is active in business; also has significant income from other sources S corporation can adopt plan and create loss which can be used to offset other income Must have basis which is likely due to undistributed prior earnings - IRC 1366(d) 10 S Corporation Compensation Compensation = payroll Shareholders have two forms of income: Payroll Pass-through (dividends) Pass-through income may not be recognized as compensation for plan purposes (Durando v. U.S., CA-9, 11/16/95) 11 S Corporation Compensation Example Medical practice has net income of $400K before salary to Doctor CPA tells Dr. to take only $50K in salary to avoid payroll taxes on balance of earnings Balance of earnings will pass through to personal tax return on Schedule K-1 For plan purposes compensation is $50,

5 S Corporation Comp. - Reasonableness Revenue Rulings and Spicer Accounting, Inc. 918 F 2d 90 (CA-9, 1990); Joseph Radtke, SC, 895 F 2d 1196 (CA-7, 1989); Watson v. U.S., 668 F.3d 1008 (2012); Glass Blocks Unlimited, TCM Reclassification of dividends to compensation results in taxes, penalties and possible plan qualification issues S election confirmation contains warning to this effect Contributions to qualified plans are considered compensation when determining reasonableness Reg (a)-1(b) 13 S Corporation Comp. - Reasonableness In 2008 the IRS issued a Fact Sheet (FS ) Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code. When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages. Subchapter S corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders. 14 S Corporation Comp. - Reasonableness The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages. 15 5

6 S Corporation Comp. - Reasonableness Generally, an officer of a corporation is an employee of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. Courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes. 16 S Corporation Comp. - Reasonableness Some factors considered by the courts in determining reasonable compensation: Training and experience Duties and responsibilities Time and effort devoted to the business Dividend history Payments to non-shareholder employees Timing and manner of paying bonuses to key people What comparable businesses pay for similar services Compensation agreements The use of a formula to determine compensation 17 S Corporation Comp. - Reasonableness Employer from previous example audited two years later and IRS determines that $150K of dividend distributions are to be reclassified as compensation. Dr s compensation therefore $200K instead of $50K What if employer sponsors safe harbor 401(k) plan? SH contributions were based on $50K instead of $200K. Twelve month period to deposit SH contributions passed. VCP? Also elective deferrals not withheld when dividend payments made so operational failure 18 6

7 S Corporation Comp. - Reasonableness Or employer sponsors DB plan where contribution influenced by current compensation. Additional $150K of compensation increases benefits and therefore funding requirement, resulting in possible funding deficiency 10% excise tax on failure to meet minimum funding requirement 19 Plan contributions and reasonable comp Treasury Regulation 1.404(a)-1(b) In order to be deductible under section 404(a), contributions must be expenses which would be deductible under section Contributions may therefore be deducted under section 404(a) only to the extent that they are ordinary and necessary expenses during the taxable year in carrying on the trade or business. In no case is a deduction allowable under section 404(a) for the amount of any contribution for the benefit of an employee in excess of the amount which, together with other deductions allowed for compensation for such employee's services, constitutes a reasonable allowance for compensation for the services actually rendered 20 Plan contributions and reasonable comp Consider Sole prop with comp $100K per year for last 3- years so avg comp = 100K Assume that at current age could adopt DB plan and get $100K deduction Since pension not deductible in determining SE tax there would be a sizeable SE tax (~$14K) Incorporate avg counts as controlled group $100K pension leaves no taxable income Reasonable comp OK due to above reg 21 7

8 DUE DATE OF DEPOSITS Accountants think they have until due date of tax return to make contributions. With partnerships this now lines up with minimum funding date (assuming plan year = tax year and extension filed) but sole props can still have until 10/15 to file Our letters always say contribution due earlier of due date of tax return or 8 ½ months after end of PY At least for minimum funding Deductibility of contributions post 9/15 but pre 10/ Greybook Q&A 7 to follow 22 Year deductible Presume that: payment made within 8 ½ months after year-end treated as prior year deposit for 412 not deducted on prior year tax return, and nothing in writing designates contribution is on account of prior tax year How about deposit made 10/15 (within 404(a)(6) period for Sole Prop) for calendar year plan? Can contribution be on account of one year for minimum funding purposes and another year for deduction purposes? 23 Year deductible Yes? Maybe? Revenue Ruling Taxpayer allowed to take deduction in 1975 for contribution made within 404(a)(6) period, but count for 412 in 1976 ( 412 did not apply until years beginning after 1975) Service cited following language in Temp. Reg (c)-12(c)(2) (allowing 8½ month post yearend period to satisfy minimum funding in case of pension plans other than single employer DB plans) 24 8

9 Year deductible The rules of this section relating to the time a contribution is deemed made for purposes of section 412 are independent from the rules contained in section 404(a)(6) relating to the time a contribution is deemed made for purposes of claiming a deduction for such contribution under section 404. [Temp. Reg (c)-12(c)(2)] (emphasis added) Greybook Q&A 7 (following slide) 25 Year deductible A company has a calendar taxable year and sponsors a pension plan with a calendar plan year. Which of the following combinations are acceptable for a contribution made during the contribution grace period (January 1, 2011 to September 15, 2011)? a) Deduct contribution in 2010, reflect on 2010 Schedule SB. b) Deduct contribution in 2010, reflect on 2011 Schedule SB. c) Deduct contribution in 2011, reflect on 2010 Schedule SB. d) Deduct contribution in 2011, reflect on 2011 Schedule SB. RESPONSE a), c), and d) are acceptable. IRC 404(a)(6) deems a contribution made after the last day of a taxable year to be made on the last day of a taxable year if the payment is made on account of such taxable year. A contribution is considered to be on account of the 2011 plan year when reported on the 2011 Schedule SB and thus cannot be deducted on the sponsor s 2010 tax return PERSONALLY I M NOT BUYING THIS! 26 Due Date Issue Effect of Extension. If a company files its tax return prior to the original due date, but after obtaining an extension of time for filing, the due date under 404(a)(6) is the extended due date. Revenue Ruling , affirmed by Revenue Ruling (see also 2002 IRS/ASPA Q&A #47) Conversely, an extension is not valid where the return is filed prior to the original due date and prior to filing for the extension. PLR

10 Due Date Issue Consider an employer that has a $50,000 overpayment on their taxes when considering their pension contribution Refund needed for pension contribution Due date of tax return is 3/15 On 3/10 extension filed until 9/15 Return filed 3/15 claiming pension deduction Refund received on 4/30 and used to fund pension 28 Plan must be in existence Engineered Timber Sales, Inc. v. Comr., 74 T.C. 808 (July 22, 1980) Tax court ruled plan must be in existence & executed prior to end of employer s tax year in order for a deduction to be taken IRS reiterated this in Rev. Rul Plan must be in existence The Service also ruled in that if, under local law, a valid trust has been created by the end of the taxable year except for the existence of corpus, the trust will be deemed to be in effect if the corpus is furnished no later than the due date (including extensions) of the employer's tax return. Accordingly, it is not necessary to open an account for the trust prior to the end of the tax year. It is simply necessary that the documents are properly executed

11 Plan must be in existence So using fiscal year plan where plan year begins in tax year, ends after tax year, and executing plan before end of plan year but after end of tax year does not result in deduction in prior tax year Plan year 9/1/15-8/31/16 Tax year 1/1/15-12/31/15 Plan signed 8/31/16 cannot take deduction in 2015 irrespective of fact that it s signed before end of plan year that begins in tax year 31 Partnerships Reg (e)- 1A(f)(1) in the case of a defined contribution plan, a partner's distributive share of deductions allowed the partnership under section 404 for contributions on behalf of a self-employed individual is that portion of the deduction which is attributable to contributions made on his behalf i.e., if DC plan, partner deducts on personal tax return amounts contributed on his/her behalf 32 Partnerships Reg (e)- 1A(f)(2) In the case of a defined benefit plan, a partner's distributive share of contributions on behalf of self-employed individuals and his distributive share of deductions allowed the partnership under section 404 for such contributions is determined in the same manner as his distributive share of partnership taxable income. See section 704, relating to the determination of the distributive share and the regulations thereunder. (emphasis added) 33 11

12 Partnerships IRS/ASPA Q. Field Service Advice indicates that 1.404(e)- 1A(f)(2), which requires allocations of defined benefit plan deductions to be made in accordance with each partner's profits interest, is still valid. Is this true? Assume a partnership has three equal partners, two of whom are covered under the partnership s DB plan at a cost of $75,000 each. There are no other employees. The 404 reg appears to say that each partner is responsible for funding (and deducting) $50,000. A. Absent a special allocation in the partnership agreement we agree with the above result. A special allocation in the partnership agreement could result in the deduction being allocated to the two covered employees. 34 Partnerships Not being a lawyer, I m hesitant to opine on what the partnership agreement, written or oral, would have to say. From IRS Publication 541 The partnership agreement includes the original agreement and any modifications. The modifications must be agreed to by all partners or adopted in any other manner provided by the partnership agreement. The agreement or modifications can be oral or written. Of late IRS apparently has been challenging allocations on audit 35 Partnerships Percentage of compensation deduction issues with partnerships Code and ERISA clear that for retirement plan purposes the partnership is the employer and the partners are each employees It follows from there that the deduction limits are determined at the partnership level 36 12

13 Partnerships Consider Two 50% partners each with $150K comp (after required adjustments) Total employee comp $200K So total comp $500K and DC deduction limit $125K $25K allocated to employees $50K to each partner 37 Partnerships CPAs will often contact TPA and say their software is limiting partner to $37,500 (i.e. 25% of their comp) They need to be told to override software possibly by lying to system and telling it it s a DB plan Software has no way of knowing there s comp over and above the partners that is supporting deduction 38 Unrelated partnerships Recent question on ACOPA Board Two partners own 30% each of partnership (P1) that has a PBGC covered CB plan and a 401(k) plan New, UNLREATED partnership (P2 - in which they are both partners) wants CB + PSP No common law employees P1 SE $600k each; P2 $500k each Pension deductions taken on partner s individual returns for all plans Obviously 39 13

14 Unrelated partnerships Recent question on ACOPA Board Question (1) does P2 plan force 6% cap on the P1 PS deduction? Question (2) same question but does it force a 6% cap on the partners return? Question(3) since there s only 1 (personal) return for each partner, but 2 K-1 s, can each partner have TWO $265,000 limits or is $265k limit imposed on an omnibus level resulting in one $265k limit? E.g. Section 179 limit applies both at entity and individual levels 40 Unrelated partnerships Recent question on ACOPA Board Answer 1 As long as each plan is only sponsored by the specific partnership and the two partnerships are not under common control per 414(c) or an affiliated service group under 414(m), then each partnership stands alone when applying benefit and deduction limits to its plans Be careful to line up contributions and deductions for each plan with the income derived from the partnership sponsoring that plan You can then have multiple plans from different partnerships with multiple benefits and contribution limits 41 Unrelated partnerships Recent question on ACOPA Board Answer 2 Agree (with Answer 1) on legal issue However, showing that on the individual return especially showing a DC deduction of twice the DC 415 limit could prompt an audit or be questioned on audit and you will have to explain the issue to them Possibly have CPA do an attachment explaining in advance 42 14

15 Compensation for self-employed (SE) persons at times results in circular calculations. In general, compensation is net income from self employment, less deduction for ½ of self-employment tax, less deductions for employer contributions made to qualified plans on behalf of the SE person 43 Deduction on behalf of SE person limited to earned income (before plan contributions) from trade or business establishing plan Precludes deduction in case of minimum funding required for DB plan to extent minimum funding exceeds earned income 44 SE persons must normally make quarterly tax payments to cover income taxes as well as self-employment taxes, latter being SE person s version of FICA and Medicare taxes Whereas employees have income and payroll taxes withheld from their paychecks SE persons are responsible for 100% of FICA and Medicare taxes whereas in the employee-employer relationship the employer picks up half of the cost 45 15

16 Above issues make it tempting to simply treat partners as employees life seems simpler giving such folks a paycheck and withholding taxes from such paychecks and having the employer pickup half of the FICA and Medicare cost Apparently some accountants think this is OK, and many of us have been faced with situation where we ve been informed that a partner has SE income as well as W-2 income Is this OK? 46 IRS and the courts say no In a series of revenue rulings (69-184, , ) the Service held that an individual cannot be both an employee and a partner for employment tax purposes The Service also held that to the extent a partner renders services outside the scope of the partnership such services are those of an independent contractor and not an employee This Service s response to Code Section 707(a)(1) which provides If a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner. 47 What to do? Assume you receive a census for a partnership and the two 50% partners have W-2 wages listed, let s say $150,000 each In addition, the K-1s shows SE income for the partners of $100,000 each The partnership sponsors a cash balance plan that provides that the partners each get a pay credit of 50% of compensation and the partnership s intention is to fund the pay credits What s the pay credit? 48 16

17 Recall partner s compensation is reduced for plan contributions made on the partner s behalf If entire $250,000 was SE income (and assuming no outside W-2 income) SE tax would be ($250,000 *.9235 *.029) + (118,500 *.124) = $6,695 + $14,694 = 21,389 and deduction for ½ of the SE tax would be $10,695 Compensation before pension would be $239,305 and pay credit would be $239,305 / 150% = 159,537 *.5 = $79,768 (i.e., Compensation would be $250,000 10,295 79,768 = 159,537 and the pay credit would be $159,537 * 50% = 79,768.) 49 With mixed bag how to handle? First, it would seem to me, irrespective of how comp reported, deduction still limited to SE income Pay credit would be $75K from W-2 income plus some number from SE income, latter recognizing the full amount of the pension deduction (which again, we ve deemed to be equal to pay credit) SE tax on the $100,000 of SE income would be $100,000 *.9235 *.029 = $2,678 and the deduction for ½ of the SE tax would therefore be $1,339 What s pay credit though? 50 I would say compensation for the SE piece is ($100,000 $75,000 $1,339)/150% = $15,774 The pay credit would then be $75, ,774/2 = $82,887 That is, compensation is $150, ,774 = $165,774, and 50% of $165,774 is $82,887 What if there isn t enough SE income? 51 17

18 For example, what if in the previous example the W-2 was $150,000 but SE income was only $10,000 (and the deduction for ½ of SE tax was $134)? It would seem to me that the deduction would be limited $9,866. But the pay credit would still be $75,000. What to do in such a situation? 52 Ask the accountant, as he/she is the one that created the issue in the first place In the end there will be a minimum required amount that likely will exceed the SE income In such a case funding certainly shouldn t occur until following year at which time accountant could correct reporting going forward and hopefully have ample SE income for deduction 53 For what it s worth, others have argued that partner should be treated as two persons a regular employee to the extent of W-2 comp and a self-employed person to the extent of SE income With such treatment the portion of the deduction allocable to the employee portion would be deducted on the partnership return creating a loss that possibly could be used against other income Personally I see no support for this treatment 54 18

19 Partnership of P.C.s Plans of affiliated service groups treated as multiple employer plans [Prop. Reg (m)-3(c)] Multiple employer plans provide for separate deduction limit for each employer [IRC 413(c)(6)] Special election for plans in effective prior to 1989 Somewhat common in professional settings where partners are individual PCs and LLC employs non-owners 55 Partnership of P.C.s For non-pbgc plans this means one person partner/corps with $265K of owner only payroll can deduct either $15,900 DC plus max DB, or $82,150 between DC and DB CPA needs to make sure comp is taken! Deduction for employees at LLC level usually not an issue 56 Excess contributions Recall combined plan limit 25% of comp Ignoring first 6% to DC What if more than 6% contributed to DC, and DB will bring total over 31% If DC contributed after year-end deduct excess over 6% in year contributed (while considering as prior year for plan purposes) If DB contributed after year-end consider amount over 31% as year contributed for tax purposes Otherwise election to ignore DB for penalty Zimmerman posting? 57 19

20 Excess contributions In soft guidance to IRS examiners posted on the IRS website on May 19, 2016, the IRS stated Absent further guidance, if nondeductible contributions are found during an examination, the IRC Section 4972(c)(7) election should be deemed to have been made by the employer and the excise tax under IRC Section 4972(a) should not be asserted, unless (1) the sponsor is making contributions to a multiemployer plan that exceed the full-funding limitation or (2) the sponsor is also making contributions to a defined contribution plan in the same year that exceed the IRC Section 404(a)(7) limits. 58 Excess contributions If the sponsor is making nondeductible contributions to a non-pbgc covered defined benefit plan (such as a professional service employer plan that has never had more than 25 active participants) and is contributing to a defined contribution plan, contact TEGEDC Area Counsel Why does it matter?? ( 59 Controlled Group Deductions Consider: Two corporations, both owned by the same individual. Corp A sponsors a 3% safe harbor 401k plan with 2% profit sharing (Plan A), Corp B sponsors a defined benefit plan (Plan B). Assume all combined testing passes, and Plan A contributions are necessary for testing to pass in Plan B. In the past, Corp A has taken the deduction for contributions made to Plan A and Corp B has taken the deduction for contributions made to Plan B. In 2016, Corp A has no income, but Corp B does. Can Corp B make the contributions and take the deduction for these made to Plan A? 60 20

21 Controlled Group Deductions First, keep in mind that since this is a controlled group, the deduction limits are determined on a combined basis. So 404(a)(7) will apply to the group. [IRC 414(b)] Next, what do the regulations say about allocation of this deduction limit to the members of the controlled group? What regs!? Finally, since 404 does not specify who can deduct contributions, we should look to Controlled Group Deductions Code 162: This section determines if expenses are ordinarily deductible by a trade or business. It limits deductions to expenses which are ordinary and necessary In the past, the IRS has ruled that it is not an ordinary and necessary business expense for one corporation to provide retirement benefits for the employees of another corporation. Rev Rul , Rev Rul , Rev Rul , PLR But can it be argued that the contributions to Plan A by Corp B are necessary in order for Plan B to remain qualified? 62 Controlled Group Deductions In Rev Rul , the IRS stated that the only exception to having each corporation take the deduction for the contributions allocated to its own employees is for termination liability payments under IRC 404(g). 404(g) specifically grants a corporation authority to deduct contributions made for purposes of meeting their termination liability for a PBGC plan, even though the corporation did not employ the employees in the plan. This is the only known exception for deductions 63 21

22 Controlled Group Deductions But what if Corp A wants/needs to deduct the contributions made to Plan B? IRC 412(b)(2) states that each member of a controlled group shall be jointly and severally liable for payments of contributions required under code 430. Is this sufficient to justify the ordinary and necessary requirement under 162? Many think so, but there is nothing official. Until we get regulations under 404, we need to be careful. Safest course of action is for each corporation to deduct the contributions based on compensation paid by that corporation. 64 Overlapping Plan/Tax Year - DC Effect of overlapping Plan/Tax Year Recall 25% limit based on tax-year compensation Example Calendar plan-year June 30 tax-year Participant comp. June 30, 2016 = $400,000 Employer contribution for 2015 plan-year = $75,000 If timely, $25,000 of contribution for 2016 plan year could be deducted in tax-year-ended June 30, 2016 But not matching cont. on post 6/30/16 deferrals Revenue Rulings ; Overlapping Plan/Tax Year - DB Plan Year Tax Year Limit determined for plan year beginning within tax year Limit determined for plan year ending within tax year Weighted average of above based on number of months of each plan year falling within taxable year Same alternative used for each taxable year unless consent to change accounting method obtained under IRC 446(e) Reg (a)-14(c) Still valid? 66 22