Winter 2014 Vol. 10, Issue 1 220 Market Avenue South Suite 700 Canton, Ohio 44702-2100 (330) 453-7633 INSIDE THIS ISSUE: A List of Key Expired Tax Breaks S Corporation Officer Must Take a Salary Material Participation, Basis, and Losses 1-4 5-6 6-8 A List of Key Expired Tax Breaks Several federal income tax breaks for individuals and businesses expired at the end of 2013. Although we're solidly into 2014, Congress has, so far, failed to extend many of the tax savings opportunities that you've become accustomed to. (Some observers predict that Congress won't act for months.) Here's a summary of some noteworthy deductions and credits that won't be available, or will be significantly reduced, in 2014. Many of these federal income tax breaks were available (at varying levels) for several years before expiring on New Year's Eve. Expired Tax Breaks for Individuals Option to Deduct State and Local Sales Taxes In 2013, individuals had the option of claiming an itemized deduction for general state and local sales taxes instead of claiming an itemized deduction for state and local income taxes. This option was beneficial for taxpayers who live in states with no personal income taxes and taxpayers who pay only minimal state income taxes. Tax-Free Treatment for Forgiven Principal Residence Mortgage Debt For federal income tax purposes, cancelled debts generally count as taxable cancellation of debt (COD) income. However, a temporary exception applied to COD income from cancelled mortgage debt that was used to acquire a principal residence. Under the temporary provision, up to $2 million of COD income from principal residence acquisition debt that was cancelled between 2007 and 2013 was treated as a tax-free item for federal income tax purposes. Check us out online www.hallkistler.com Subscribe to the digital version at www.hallkistler.com/contact-us Follow us Charitable Donations from IRAs Individual retirement account (IRA) owners who had reached age 70 1/2 by December 31, 2013, were allowed to make charitable donations of up to $100,000 directly out of their IRAs in 2013. The donations counted as IRA required minimum distributions. So, charitably-inclined seniors who had more IRA funds than needed could reduce taxes by arranging for IRA donations to take the place of taxable required minimum distributions in 2013. Deduction for Higher Education Tuition and Related Fees In 2013, you could deduct up to $4,000 (or up to $2,000 for higher-income folks) for qualifying higher education tuition and related fees paid for you, your spouse, Continued on page 2
Page 2 HK Bulletin...Expired Tax Breaks or your dependents. $500 Energy-Efficient Home Improvement Credit For 2013, taxpayers could claim a tax credit of up to $500 for certain energy-saving improvements to a principal residence. Salary Reduction for Transit Passes Your employer may allow you to sign up to reduce your taxable salary to pay for mass transit passes to commute to and from work. In 2013, the maximum monthly amount you could set aside on a tax-free basis was $245. The maximum monthly amount for 2014 will be only $130 unless Congress decides to allow a larger amount. (If that happens, the larger amount would be $250.) $250 Deduction for Teachers' School Expenses For 2013, teachers and other personnel at K-12 schools could deduct up to $250 of school-related expenses they paid out of their own pockets, regardless of whether they itemized or not. Deduction for Home Mortgage Insurance Premiums In 2013, eligible taxpayers were allowed to treat qualifying personal residence mortgage insurance premium amounts as deductible home mortgage interest. Charitable Qualified Conservation Contributions Charitable qualified conservation contributions are donations of real property interests (including remainder interests and easements) that restrict the use of real property. For individuals, the maximum write-off for 2013 qualified conservation contributions of long-term capital gain property was increased from the normal 30% to 50% of adjusted gross income. In addition, qualified conservation contributions were not counted when calculating an individual's allowable 2013 writeoffs for other charitable contributions. Qualified conservation contributions in excess of what could be written off in 2013 could be carried forward for 15 years (only a five-year carryover period is allowed under the normal rules). For an individual who was a qualified farmer or rancher, the qualified conservation contribution write-off for 2013 donations of farm or ranch real property could be as much as 100% of the donor's adjusted gross income. Zero Percent Tax Rate on Future Gains from Qualified Small Business Stock For qualified small business corporation (QSBC) stock that was issued in calendar year 2013, a 100% federal gain exclusion break is potentially available. That equates to a 0% federal income tax rate on future profits from selling QSBC shares down the road. You must hold the shares for more than five years to be eligible, and many companies will fail to meet the definition of a QSBC. Also, C corporation shareholders are ineligible. For QSBC shares issued in 2014, the "normal" gain exclusion percentage of 50% will apply unless Congress restores the 100% gain exclusion deal. Personal Credit for Alternative Fuel Vehicle Refueling Property In 2013, individuals could claim a federal tax credit for up to 30% of the cost of installing non-hydrogen alternative fuel vehicle refueling property. This credit could be claimed for expenditures such as equipment to recharge electric-powered car batteries at a principal residence. For individuals, the annual cap for this credit was only $1,000. A credit for hydrogen refueling property is allowed through 2014. Continued on page 3
Volume 10, Issue 1 Page 3...Expired Tax Breaks Expired Tax Breaks for Businesses Research and Development Credit Businesses are no longer eligible for a long-standing tax break for increasing qualifying R&D expenditures (QREs), including wages, supplies, and certain consulting and contract research fees related to qualified research activities. In 2013, this credit generally equaled 20% of the amount by which current-year QREs exceeded a base-period amount (subject to a 6.5% maximum). Fifty Percent First-Year Bonus Depreciation Deduction For qualifying new (not used) assets that were placed in service (hooked up and ready for use) in calendar year 2013, taxpayers could write off 50% of the cost in the asset's first year of service. Qualifying assets included most software, certain "heavy" passenger vehicles, non-passenger vehicles, and equipment. Expanded Section 179 Deductions For tax years that began in 2013, eligible small and medium-sized businesses could immediately write off up to $500,000 of qualifying new and used assets, including most software, certain "heavy" passenger vehicles, non-passenger vehicles, equipment, and up to $250,000 of qualifying real estate improvements. Assets had to be placed in service (hooked up and ready for business use) by the end of the tax year that began in 2013 to be eligible. The maximum Section 179 deduction for tax years beginning in 2014 will be only $25,000, and no Section 179 deductions will be permitted for real estate improvements. Fifteen-Year Depreciation for Leasehold Improvements, Restaurant Property, and Retail Space Improvements Generally, taxpayers must depreciate non-residential real property straight-line over 39 years for federal tax purposes. But 15-year straight-line depreciation was allowed for the cost of qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail space improvements that were placed in service in 2013 (but not expensed under Section 179 or eligible for the 50% first-year bonus depreciation deal in 2013). Credit for Building Energy-Efficient Homes In 2013, homebuilders were eligible for a $2,000 tax credit for each new energy-efficient home they built in the United States, including manufactured homes. Firms could also claim this credit for substantially reconstructing and rehabilitating an existing home and making it more energy efficient. Homes that did not fully meet the energy-efficiency standards could qualify for a reduced $1,000 credit. A home had to be sold by December 31, 2013, for use as a residence to qualify for the credit. Credit for Manufacturing Energy-Efficient Appliances The credit for manufacturing energy-efficient dishwashers, clothes washers, and refrigerators in the U.S. expired at the end of 2013. The credit amounts per unit were $75 for qualifying dishwashers, $200 for qualifying refrigerators, and $225 for qualifying clothes washers. Business Credit for Alternative Fuel Vehicle Refueling Property In 2013, businesses could claim a federal tax credit for up to 30% of the cost of installing non-hydrogen alternative fuel vehicle refueling property. This credit could be claimed for expenditures such as a gas station's costs to install ethanol, compressed natural gas, or hydrogen refueling pumps or equipment to recharge electric-powered car batteries. For businesses, the annual cap for each location for this credit was $30,000. A Continued on page 4
Page 4 HK Bulletin...Expired Tax Breaks credit for hydrogen refueling property is allowed through 2014. S Corporation Built-In Gains Tax Exemption If you operate a corporation that recently converted from C to S status, a corporate-level built-in gains tax (also known as the BIG Tax) may apply when certain S corporation assets, including receivables and inventories, are converted to cash or sold within the "recognition period." The recognition period is normally the 10-year period that begins on the date when the corporation converted from C to S status. For eligible built-in gains that were recognized in tax years beginning in 2013, however, there was an exemption from the BIG Tax. The exemption applied if the fifth year of the S corporation's recognition period had gone by before the start of the tax year that began in 2013. Enhanced Charitable Deduction for Food Donations Businesses that were not operated as C corporations were entitled to an enhanced charitable contribution if they donated food to qualified charities in 2013. This provision was intended for non-c corporation businesses that have food inventories, such as restaurants and grocery stores. These deductions are normally limited to the taxpayer's basis in the food or its fair market value, whichever is lower. But in 2013, the temporarily enhanced deduction equaled the lesser of: The taxpayer's basis in the food plus one-half the value in excess of basis; or Two times the taxpayer's basis in the food. The same enhanced deduction rule has been available to C corporations for years, and still is. The taxpayer's total charitable contribution deduction for food donations under this provision generally could not exceed 10% of net income for the tax year from sole proprietorships, S corporations, or partnerships (or other non-c corporation entities) from which the food donations are made. Favorable Rules for C Corporation Farm and Ranch Qualified Conservation Contributions Qualified conservation contributions are charitable donations of real property interests, including remainder interests and easements that restrict the use of real property. For qualified C corporation farming and ranching operations, the maximum write-off for qualified conservation contributions was increased from the normal 10% of adjusted taxable income to 100% of adjusted taxable income in 2013. Qualified conservation contributions in excess of what could be written off in 2013 could be carried forward for 15 years. Favorable Rule for S Corporation Donations of Appreciated Assets For tax years beginning in 2013, a favorable shareholder basis rule applied for stock in S corporations that made charitable donations of appreciated assets. For such donations, each shareholder's tax basis in the S corporation's stock was only reduced by the shareholder's pro-rata percentage of the company's tax basis in the donated assets. Without this provision, a shareholder's basis reduction would have equaled the passed-through write-off for the donation (a larger amount than the shareholder's pro-rata percentage of the company's tax basis in the donated asset). This provision was taxpayer-friendly because it left shareholders with higher tax basis in their S corporation shares, which is almost always beneficial to shareholders. Would you like to read the HK Bulletin on-line? Subscribe by sending your request to info@hallkistler.com. Be sure to include your name, address and email. Or visit www.hallkistler.com and sign up on the Contact Us page.
Volume 10, Issue 1 Page 5 Do you operate your business as an S corporation? If you work for the corporation, you generally must take a salary. An officer who performs more than minor services for a corporation, and who receives remuneration in any form, is considered an employee and is subject to employment taxes. In recent years, the IRS has become more aggressive in auditing S corporations on this point. One case illustrated some of the issues involved in S corporation compensation. Facts of the Case S Corporation Officer Must Take a Salary Glass Blocks Unlimited was an S corporation with Frederick Blodgett as its president and sole shareholder. As the name implied, the corporation sold and distributed "glass blocks" for the real estate market. Blodgett worked full-time for the corporation. There were no other full-time employees, but the company used day laborers. With the downturn in the real estate market, the business experienced financial difficulties, and Blodgett transferred funds to the company in order to cover operating expenses and other costs. In 2007, he transferred $30,000 from his family trust. His fiancé at the time contributed $15,000 in 2007, and an additional $10,000 in 2008. Blodgett took no salary in 2007 or 2008, but did take distributions of not less than $30,844 in 2007, and $31,644 in 2008. For 2007, the corporation reported gross receipts of $832,579 and net income of $877; for 2008, gross receipts were $701,388 and net income was $8,950. The corporation also reported the repayment of $29,132 of loans from shareholders in 2007 and $8,391 in 2008. Loans from shareholders were shown on the balance sheet on the return. Blodgett did not have any other employment during 2007 or 2008, and the only income he reported on his Form 1040 was the pass-through income from the S corporation and $11 in interest income. In an employment tax audit, the IRS determined that Blodgett should be classified as the taxpayer's employee and that the distributions ($30,844 for 2007 and $31,644 in 2008) constituted wages for which FICA taxes should have been paid. The court noted that for employment tax purposes, wages are defined as "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash" (with certain exceptions). The critical fact is whether a payment actually received is remuneration for employment. The court noted Blodgett was the taxpayer's only officer and performed substantially all of the work necessary to operate the business, and his services generated all of the corporation's income. The taxpayer contended a portion of the distributions represented repayment of loans between itself and Blodgett and should not be considered wages. According to him, transfers to the corporation of $45,000 in 2007 and $10,000 in 2008 were loans. The IRS argued they were contributions to capital. The court considered the factors when evaluating whether amounts transferred to a closely held corporation are loans or capital contributions, and sided with the IRS in finding they were not bona fide loans. The taxpayer also argued that $15,680 would be reasonable compensation based on a 20-hour week and a salary of $15.25 per hour. The court found Blodgett's involvement in the business was more substantial, and that he worked more than 20 hours a week. Finally, even at $15.25 per hour, the salaries of $30,844 and $31,644 were reasonable for a full-time employee. The court allowed the IRS's computation of the employment tax, as well as penalties for failure to deposit taxes and Continued on page 6
Page 6 HK Bulletin...Take a Salary failure to file employment tax returns. (Glass Blocks Unlimited, T.C. Memo. 2013-180) Lessons from the Case This isn't the only case involving insufficient salaries from S corporations. What makes this one interesting is that the court allowed the full amount of the distributions to be classified as salaries, despite the fact that the business was only nominally profitable at the time. Clearly, reporting no salary on the line for officers' compensation on Form 1120S is asking for trouble. But how much of a salary should you take? That's not an easy question. A professional with an advanced degree who takes a salary of $30,000 a year for the full-time management of an S corporation generating $500,000 in net income would be suspect. But taking a salary of $175,000 a year for a 40-hour week might not be. In arriving at a reasonable salary, the IRS and the courts could look at a number of factors, including the nature of the work performed, the success of the business, past salary, comparisons of the employee's salary to those paid by similar companies for similar services, the character and condition of the company, time spent, potential conflicts of interest, presence of a contract or formula for determining salary, loan restrictions, etc. If the business requires additional capital (for example, because it's expanding) and the profits are plowed back into the business, you may be able to justify a smaller salary. Taking distributions suggests the business doesn't need the cash, and it's a way to compensate the officer/shareholder other than through salary. On the other hand, in a business with a large capital investment, an officer/shareholder might be able to justify the distributions as a return on investment. That's particularly true if prior disbursements have been small because of cash flow problems. What if you really have little involvement with the business? You might want to document your time on other activities, whether spending time at your vacation home or working at another business. But before doing so, you might want to consider the 3.8% net investment income tax on passive income generated from partnerships, S corporations, etc. Claiming you don't materially participate in the business would subject you to the tax. Material Participation, Basis, and Losses In order to deduct losses associated with an S corporation, partnership, LLC, or even a sole proprietorship, there are a number of tests to pass. In one U.S. Tax Court case, the taxpayers ran into the two most frequently encountered issues: basis and material participation. Facts of the Case Patrick and Patricia Montgomery were involved in two businesses. The first, Utility Design, Inc. (Design) performed engineering work on telephone-related infrastructure. Because of conflict-of-interest rules, Design could not perform construction work on the projects for which it performed engineering work, so Patrick Montgomery formed UDI Underground LLC (UDI) to perform construction work. On Form 1065, the taxpayers claimed Patricia Montgomery was an LLC member and Patrick was not. As a 40% member, that portion of the losses of UDI was passed through to Patricia. The IRS argued that some or all of her losses should be disallowed because she did not materially participate in the business. (Losses from passive activities are generally only allowed to the extent of passive income.) According to the court, the couple credibly testified that Patricia handled all of the office functions, managed payroll, prepared documents, met with members of the company, and attended business meetings. She worked on company matters daily and discussed the company's business with her husband. Patrick started the company, secured a contract with AT&T, and handled various operational aspects of the business, including buying equipment, hiring employees, etc. Continued on page 7
Volume 10, Issue 1 Page 7... Basis, and Losses Spousal Participation The court found the couple had no other interests other than Design and UDI, spent the bulk of their time working for UDI, and that Patricia met the first (500 hours during the year) and seventh test (regular, continuous, and substantial basis) for material participation. The court noted that participation by a spouse counts as participation by the member, partner, or shareholder. The IRS argued that the taxpayers maintained no log, diary, etc. to support their claim of participation. The court noted that such records are not required if participation can be established by other reasonable means. That could include identification of services performed over a period of time and the approximate number of hours spent, based on appointment books, calendars, or narrative summaries. In this case, the testimony of the taxpayers was sufficient. The second issue in the case involved the taxpayers' basis in Utility Design, an S corporation. You can claim passthrough losses from an S corporation up to the amount of your basis. Basis includes both stock and loan basis (in other words, your initial investment adjusted for income, losses, and distributions). For an S corporation, your loan basis includes only amounts loaned directly by you to the corporation. It does not include any guarantee of loans from a third party, such as a bank. (The rules are different for a partnership.) Design ran into financial difficulties. During the year at issue, Patrick Montgomery made substantial loans to Design, and the IRS gave him credit for these amounts in adjusting his basis. In addition, Design defaulted on a $1 million bank loan, which the couple personally guaranteed. The taxpayers argued that their basis should be increased by the amount of a judgment imposed on the taxpayers as a result of their guarantee of the bank loan. The court noted that when an S corporation shareholder guarantees a loan by a bank to the corporation, no debt has been created between the S corporation and the shareholder. However, once the S corporation shareholder pays the bank pursuant to the guarantee, the S corporation becomes indebted to the shareholder. It is the payment by the guarantor that gives rise to indebtedness and basis. The mere fact that the debtor defaults and makes the guarantor liable is not sufficient. The court did not allow any increase in basis over that allowed by the IRS. (Montgomery, T.C. Memo. 2013-151) Lessons from the Case In order to deduct losses from a partnership, LLC, S corporation, or sole proprietorship, you must materially participate in the business. (Losses you can't deduct aren't lost but suspended.) If you've only got one source of income -- your business -- it's unlikely the IRS will challenge your participation. However, your situation may not be as straightforward. For example, let's say you have a regular job and run a machine shop as a sideline. You should be prepared to substantiate your hours worked in the sideline business. The closer you are to the material participation requirement thresholds, the more cautious you should be. If you're concerned, check with your tax adviser. Poor planning can result in the worst of both worlds. It's not unusual for a parent to advance most, if not all, the funds for a venture but not participate in the activity. The son or daughter does all the work. The parent or other investor can't currently deduct the losses because he or she doesn't materially participate, and the son or daughter can't deduct them because he or she has no basis. Material participation has now become important with respect to profitable activities as a result of the new 3.8% net Continued on page 8
Page 8 HK Bulletin...Basis, and Losses investment income tax on interest, dividends, and passive activities. If you materially participate in the business, the tax doesn't apply. Your equity basis in an S corporation, partnership, LLC, or even a sole proprietorship is usually uncomplicated. However, the rules with respect to debt basis are more subtle. For S corporations, you need to make a true economic outlay in order to generate basis. A direct loan to the corporation is required. One option is for the shareholder to borrow from a bank or other party and loan the funds to the corporation. But funds you borrow from another shareholder don't count. There are some steps you can take if you're approaching the end of the year and you have insufficient basis to take the losses. You can reduce items that you would pay to yourself, such as your salary, but be aware of the compensation rules. Not taking distributions can also help. Utilizing these losses, or deciding not to, should be an important part of your year-end planning. Karen M. Brenneman, CPA, MT Managing Partner Michael G. Eberhart, CPA, CVA Senior Partner John J. Skakun, CPA Partner S. Franklin Arner, CPA Partner Keith A. Arner, CPA, CVA Partner 220 Market Avenue South, Suite 700 Canton, Ohio 44702-2100 (330) 453-7633 www.hallkistler.com