Category: Tax Services

Posted on May 17, 2017

It’s already starting to feel like summer in many parts of the country. But the forecast for Washington remains unclear as officials continue to discuss various tax-related issues.

No matter what happens in Washington, don’t get stuck in a holding pattern yourself. Give some attention to business and personal tax planning this summer. Here are 10 ideas that combine tax planning with summertime fun.

1. Entertain top business clients.

You may be eligible to write off 50% of the cost of business meals and entertainment if you entertain clients before or after a substantial business discussion. For instance, after you hammer out a business deal, you might treat a client to a round of golf and then dinner and drinks. The 50% limit applies to all the qualified expenses, including the amounts you pay for the client, yourself and your significant others.

2. Throw a company picnic.

You can generally deduct the cost of a picnic, barbecue or similar get-together. Not only will such an event provide your workers an opportunity to relax and socialize, but the 50% limit on meals and entertainment expense deductions also won’t apply. There is one caveat: The benefit must be primarily for your employees, who are not “highly compensated” under tax law. Otherwise, expenses are deductible under the regular business entertainment rules.

3. Donate household items to charity.

Are you planning to clean out the garage, attic or basement this summer? If so, you’ll probably find household goods — such as clothing and furniture — that you don’t want or need anymore. Consider donating these items to charity. Assuming they’re still in good condition, you may take a charitable deduction on your 2017 personal tax return based on the current fair market value of any donated items. Use an online guide or consult your tax professional for valuations.

4. Send the kids to day camp.

Parents who need to work may decide to send young children to summer day camp while school is out. Assuming certain requirements are met, the cost may qualify for a dependent care credit. Generally, the maximum credit is $600 for one child and $1,200 for two or more kids. Note that specialty day camps for athletics or the arts qualify for this break, but overnight camp doesn’t qualify. (Remember, tax credits lower your tax liability dollar for dollar, unlike deductions, which lower the amount of income that’s taxed.)

5. Buy an RV or boat.

If you take out a loan to purchase a recreational vehicle (RV) or boat for personal use this summer, the vehicle or vessel may qualify as a second home for federal income tax purposes. In other words, you may be eligible to write off the interest on the loan as mortgage interest on your personal tax return.

The IRS says that any dwelling place qualifies as a second home if it has sleeping space, a kitchen and toilet facilities. Therefore, the interest paid to buy an RV or boat that meets these requirements is tax-deductible under the mortgage interest rules. This deduction is available for interest paid on a combined total of up to $1 million of mortgage debt used to acquire, build or improve a principal residence and a second residence. Interest on additional home equity debt of up to $100,000 may also be deductible.

6. Minimize vacation home use.

Federal tax law allows you to deduct expenses related to renting out a vacation home to offset the rental income you receive. With summer already underway, you’ve probably worked out a rental schedule for your vacation home, but remember that you can’t deduct a loss if your personal use of the home exceeds the greater of 14 days or 10% of the time the home is rented out. If you expect to experience a loss, watch your personal use to ensure you remain below the 14-day or 10% limit. Other rules, however, might still limit your loss deduction.

7. Rent out your primary residence.

Do you live in an area where a summertime event — such as a major golf tournament, arts festival or marathon — will be held? If you rent out your home for no more than two weeks during the year, you don’t have to comply with the usual tax rules. In other words, you don’t have to report the rental income — it’s completely tax-free — but you can’t deduct rental-based expenses either.

8. Take advantage of business travel.

Suppose you’re required to go on a business trip this summer. You can write off much of your travel expenses as long as the trip’s primary purpose is business-related — even if you indulge in some vacationing. For instance, if you spend the business week in meetings and the weekend sightseeing, the entire cost of your airfare plus business-related meals, lodging and local transportation is deductible within the usual tax law limits. Just don’t deduct any personal expenses you incur.

9. Support a recent graduate.

If your child just graduated from college, this is probably the last year you can claim a dependency exemption for him or her. However, you must provide more than half of the child’s annual support to qualify for the $4,050 exemption.

To clear the half-support threshold, consider giving the graduate a generous graduation gift, such as a car to be used on the first job. Doing so will provide your child with a practical gift, as well as possibly helping you clear the support threshold required to claim a dependency exemption. Unfortunately, dependency exemptions may be reduced for high-income taxpayers. Consult a tax professional about this tax issue before purchasing a major graduation gift. It could impact the amount you’re willing to spend.

10. “Go fishing” for deductions.

The IRS won’t allow you to claim deductions for an “entertainment facility,” such as a boat or hunting lodge. But you can still write off qualified out-of-pocket entertainment expenses, subject to the 50% limit. For example, if you take a client out on your boat, no depreciation deduction is allowed — but you may be eligible to write off the 50% of the costs of boat fuel, food and drinks, and even the fish bait, if you qualify under the usual business entertainment rules.

More Tips Available

These tips show that tax planning doesn’t have to be tedious. Whether you decide to ship the kids off to day camp or take the plunge of buying a boat, summer tax planning can actually be fun — and your tax advisor may have other creative ideas. With the proper planning, you can bask in the sun and tax-saving opportunities all summer long.

Related Posts

Posted on May 15, 2017

Most of the time, how to classify gains and losses from selling an asset is fairly straightforward. But there are some gray areas that require a closer look at the facts and circumstances, especially when real estate is involved, as a couple of recent cases demonstrate.

Beyond Real Property

The issue of deciding how to classify gains and losses from selling an asset affects more than just real estate. In a 2017 private letter ruling, the IRS allowed a termination payment made pursuant to a patent sale agreement to be treated as a capital gain.

This ruling involved three individual taxpayers who owned a patent through a limited liability company (LLC) that was classified as a partnership for tax purposes. The LLC sold all substantial rights to the patent to a third party in exchange for payments from the third party based on sales of the patented product.

When the third party was acquired, it sought to end its obligations to the LLC by making a termination payment. The LLC accepted the offer. The IRS concluded that the Internal Revenue Code allowed favorable long-term capital gains treatment for the taxpayers’ respective shares of the LLC’s gain from the termination payment.
Why It Matters

Distinguishing between capital and ordinary gains and losses is an important issue for two reasons:

1. Tax rates on gains.

Net long-term capital gains recognized by individual taxpayers are taxed at much lower rates than ordinary gains. (“Long-term” means the asset has been held more than one year.) Under the current rules, the maximum individual federal rate on net long-term capital gains is generally 23.8%, if the 3.8% net investment income tax applies (20% + 3.8%). In contrast, the maximum individual rate on ordinary gains, including net short-term gains, is 43.4%, if the 3.8% net investment income tax applies (39.6% + 3.8%).

The maximum individual federal rate on long-term capital gains attributable to real estate depreciation deductions (so-called “nonrecaptured Section 1250 gains”) is 28.8% (25% + 3.8%).

2. Deductibility of losses.

Ordinary losses are currently deductible — assuming other tax law provisions, such as the passive loss rules, don’t prevent that favorable treatment. In contrast, deductions for net capital losses are strictly limited.

Annual net capital loss deductions for individual taxpayers are limited to only $3,000 (or $1,500 for married individuals who file separately). Any excess net capital loss (above the currently deductible amount) is carried forward to the following tax year and is subject to the same limitation.

Net capital losses incurred by C corporations can’t be currently deducted. Instead, they only can be carried back for three years or carried forward for five years. (Note that these periods are different from those for net operating losses.)

Five-Factor Test for Classifying Real Property

Sales of capital assets qualify for treatment as capital gains or losses. Capital assets specifically exclude inventory. Inventory is property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s business.

The U.S. Tax Court and the Ninth U.S. Circuit Court of Appeals have identified the following five factors as relevant when determining whether real property is inventory:

  1. The nature of the acquisition of the property,
  2. The frequency and continuity of property sales by the taxpayer,
  3. The nature and extent of the taxpayer’s business,
  4. Sales activities of the taxpayer with respect to the property, and
  5. The extent and substantiality of the transaction in question.

Taxpayers have the burden of proving that real property isn’t inventory. If they fail to meet that burden of proof, the IRS will win the argument.

The Evans Case

In a recent decision, the Tax Court addressed the issue of whether a taxpayer’s redevelopment property was a capital asset or inventory held for sale to customers. (Jeffrey Evans v. Commissioner, T.C. Memo 2016-7)

The taxpayer was a full-time employee of a real estate development firm. Outside of his regular job, he personally purchased residential real estate properties in Newport Beach, Calif. He intended to demolish the existing structures on the property and build a two-unit residential structure that he would either sell or rent out. The taxpayer incurred costs to prepare the property for redevelopment, including:

  • Architectural, electrical, and mechanical plans and permits,
  • Property taxes, and
  • Interest expense.

The taxpayer borrowed $250,000, and the lender obtained a lien on the Newport Beach property. The taxpayer defaulted on the loan, and the lender foreclosed. The property was eventually sold at a loss in a foreclosure sale. The taxpayer’s position was that the foreclosure loss was an ordinary loss. The IRS claimed it was a capital loss.

Based on its evaluation of the five factors (above), the Tax Court concluded that the taxpayer’s personal real estate activities didn’t constitute a business. According to the Tax Court, the Newport Beach property was held for investment rather than held for sale to customers in the ordinary course of business. Therefore, the property was a capital asset and the taxpayer’s loss was a capital loss.

The Long Case

In another decision, the Eleventh U.S. Circuit Court of Appeals looked at whether an individual taxpayer’s proceeds from selling the rights to buy land and build a luxury condo project were properly characterized as long-term capital gain rather than ordinary income. (Philip Long v. Commissioner, 114 AFTR 2d 2014-6657, 11th Cir. 2014)

In this case, the taxpayer was a real estate developer who operated his business as a sole proprietorship. In 2006, he received $5.75 million in exchange for selling contract rights to buy a parcel of land in Fort Lauderdale, Fla., and build a luxury condominium tower on the parcel. He had been working on this project for 13 years and had obtained the contract rights in a lawsuit involving the property.

The taxpayer treated the proceeds from the contract rights sale as long-term capital gain on his 2016 income tax return. But the IRS, after auditing the taxpayer’s return, claimed that the proceeds were paid in lieu of future ordinary income payments and, therefore, counted as ordinary income.

The Tax Court agreed with the IRS that the proceeds constituted ordinary income, because the taxpayer intended to sell the land underlying the condo project to customers in the ordinary course of his business. On appeal, the Eleventh Circuit reversed the Tax Court’s decision.

The Eleventh Circuit pointed out that the Tax Court had erred by concluding that the taxpayer had sold the land underlying the condo project for the $5.75 million. In fact, he’d never owned the land. What he actually sold was the right to purchase the land pursuant to the terms of the condo development agreement and the associated right to build the condo tower.

The Eleventh Circuit noted that, in certain circumstances, contract rights can qualify as capital assets. Therefore, the real issue in this case was whether the taxpayer held the contract rights primarily for sale to customers in the ordinary course of his business. The Eleventh Circuit found no such evidence. Instead, the evidence showed that the taxpayer had always intended to develop the condo project himself, until he ultimately decided to sell his contract rights instead.

The Eleventh Circuit also concluded that the taxpayer had owned the contract rights for more than one year, because they resulted from a lawsuit that was filed two years earlier. Because the contract rights constituted a capital asset that the taxpayer had owned for more than a year, he was entitled to treat the proceeds from selling the rights as a long-term capital gain.

Need Help?

It’s almost always better to be able to characterize a taxable gain as capital rather than ordinary. Conversely, characterizing taxable losses as ordinary rather than capital is generally beneficial. Your tax advisor can help you understand this issue and, when debatable facts and circumstances arise, build a defensible case for favorable treatment of gains and losses.

Related Posts

Posted on May 4, 2017

Graduation can be one of the most exciting — and intimidating — times in your life. You’re officially an adult, and with that new-found independence comes financial responsibilities. No pressure, but the decisions you make today about spending and saving can mean the difference between struggling for the rest of your life and building a solid financial future.

The Boomerang Generation

Even if they already have a full-time job, recent graduates are increasingly choosing to live with their parent(s) or grandparent(s) to save money. But financial dependence is rarely the sole reason for “boomeranging” home. Instead:

  • Young people are waiting longer to get married compared to previous generations. Without a fiancé or spouse to encourage independent living arrangements, many graduates return home, until they finally tie the knot.
  • Many empty nesters miss their children and ask them to return, at least temporarily, to help with companionship, medical care and security, financial obligations, and day-to-day chores. Parents often mutually benefit from living with their adult children.

Could this option work for your family? The negative stigma associated with living in a family member’s spare bedroom or basement is rapidly disappearing. A Pew Research survey reports that roughly 75% of young adults who live with their parents are satisfied with their living situation and upbeat about their future finances. That’s about the same satisfaction level as young adults who live on their own. Parents are reportedly just as happy about their adult kids living with them.

Here’s a list of important questions to consider as you start your journey:

1. Where Should You Live?

Depending on where you want to live and how much you earn, you probably can’t move into your dream home right away. The cost of a studio in a big city could potentially get you a huge place out in the country. Your location of choice is tied to many variables — job, family and personal preferences.

To avoid overspending, be realistic about how much you can afford. As a rule of thumb, roughly one-third of your net monthly take-home pay should be used to finance the place you live. If your starting income is modest, you’ll likely pay a higher percentage for housing.

If you decide to rent, always read the entire lease before signing on the dotted line. Find out such details as how long the lease lasts, whether it includes utilities and if there are any fees for terminating the lease early.

If you’ve already saved up money for a down payment, consider buying a condo or single family home. Interest rates are near historic lows. And the sooner you purchase, the quicker you start building equity and claiming tax benefits that come with owning a home.

If you can find a roommate, you’ll have extra money for other living expenses, such as furniture and bills for phone, cable TV and Internet access. Also, don’t forget renter’s insurance to cover your personal belongings in the event of a theft, fire, flood or other disaster. Alternatively, consider the upsides of living with your parents for a little while longer. (See “The Boomerang Generation” at right.)

2. How Much Should You Save Each Month?

No one wants to live paycheck to paycheck. Doing so can lead to significant stress if you lose your job, become disabled or incur a major expense (like a medical bill or car repair). It’s smart to set aside a predetermined amount from each paycheck that goes directly into savings. This amount should be separate from your retirement savings (see below).

Keeping a separate savings account will help prevent you from thinking that this amount is part of your disposable income. As a rule of thumb, you should try to build a “rainy day fund” that equals three to six months of net monthly take-home pay. When the unexpected strikes, you’ll be glad you saved.

3. Why Should You Begin Saving for Retirement Now?

It may seem premature to think about retirement when you start your first real job. But you can amass a large nest egg by saving small amounts when you’re young, because your contributions have time to compound. Plus, any money you put into tax-deferred accounts lowers your taxes in the year you contribute. (Income taxes will be due when you eventually withdraw funds from these accounts, however.)

If your employer offers a retirement plan, such as a 401(k) plan, sign up as soon as possible. Also, find out if your employer makes “matching contributions.” This means the employer adds in a percentage, say 25% or 50%, for every dollar you contribute. Besides employer-provided plans, there are many other retirement planning tools. For example, Roth and traditional IRAs may be beneficial, depending on your personal situation.

As an added bonus, you may be able to borrow from a 401(k) account or take money from an IRA, without paying an early withdrawal penalty, for several reasons, including the purchase of a first home.

4. Do You Need to Buy (or Finance) a Car?

After putting money toward living expenses, savings and retirement, new graduates need to budget for another essential: transportation. Again, you might not be able to afford your dream car right away. Moreover, a car may not be a necessity, especially if you live and work in a city with reliable public transportation.

If you decide to buy a car, consider saving money with a used car. Another way to save money is to look for a car loan with the lowest possible interest rate by:

  • Checking your credit. Consider a co-signer if your credit rating isn’t very good or if you haven’t established any credit rating yet.
  • Shopping around for interest rates at your bank, credit union and various car dealerships. Try to get quotes from at least three different sources.

If you finance a vehicle through the dealership (because it’s convenient) and later find a lower rate elsewhere, you can pay off the original loan with the lower rate loan. Just make sure the original loan doesn’t include any prepayment penalties. Some homeowners even use home equity loans to finance their vehicles, because the interest is generally tax deductible.

5. What Types of Insurance Do You Need?

Graduation is a good time to make critical decisions about auto, health and life insurance coverage.

Most new graduates get their health insurance coverage through an employer. If you’re unemployed or your employer doesn’t provide coverage, you may be allowed to stay on your parents’ policy for a few more years (until you turn 26). This is likely to hold true even if the Affordable Care Act (ACA) is repealed, as that provision was retained in the bill to repeal the ACA, which stalled in the House earlier this year.

If you can’t get coverage through a parent’s health insurance provider, you need to consider other ways to comply with the ACA’s individual mandate — or you’ll face the shared responsibility penalty. Nonexempt U.S. citizens and legal residents will generally owe this penalty if they fail to have minimum essential coverage for themselves and their dependents for any particular month. Coverage options for the unemployed include:

  • Certain government sponsored programs (such as Medicare, Medicaid, and the Children’s Health Insurance Program),
  • Plans obtained on the individual market,
  • Certain grandfathered group health plans, and
  • Certain other coverage specified by the U.S. Department of Health and Human Services in coordination with the IRS.

There are a number of exceptions to the penalty, such as the one for eligible lower-income individuals and the one for some people whose existing health insurance plans were canceled.

Also consider obtaining life insurance. If you sign up when you’re young and healthy, the rates are generally less expensive. Depending on your needs later in life, as well as health issues that can creep up over time, the cost could rise significantly in the future.

6. How Can Discretionary Spending Help You Build Credit?

Any money that’s left over from your paycheck is available for discretionary items, such as vacations, dining out, pets, clothing and personal pampering. Credit cards can be a convenient way to pay for discretionary items, and, as an added bonus, they often accrue rewards points that can be redeemed in the future.

If you don’t already have a credit card, sign up for one to help build credit. But resist the temptation to spend beyond your means. Always pay off your credit cards in full monthly — or you’ll likely incur high interest rates on any unpaid balances. Interest-free financing offers (for, say, a mattress or an appliance) can be another way to save money and build credit, but you must pay off the balance in full before the deal expires — or you’ll incur high interest charges from the original purchase date.

Need Help?

As soon as you graduate, it’s important to establish relationships with tax, business and legal advisors. During your career, you’ll likely need help from experienced professionals who can assist you as your needs evolve. By initiating these relationships now, you’ll know whom to contact when help is needed.

Related Posts

Posted on May 1, 2017

Have you been contemplating moving to another state with lower taxes? Your move could lower your state tax bill, but you want to make sure to establish that the new state is your place of legal residency (also known as your “domicile”) for state tax purposes. Otherwise, the old state could come after you for taxes after you’ve moved. In the worst-case scenario, your new state could expect to get paid, too. Here’s what you need to do to establish residency in the new state — and why moving your pet could be a deciding factor.

Recognize the Significance of Establishing Domicile

If you make a permanent move to a new state, it’s important to establish legal domicile there if you want to escape taxes in the state you left. The exact definition of legal domicile varies from state to state. In general, however, your domicile is your fixed and permanent home location and the place where you plan to return, even after periods of residing elsewhere.

Because each state has its own rules regarding domicile, you could wind up in the worst-case scenario of having two states claiming you owe state income taxes. That could happen when you establish domicile in the new state but don’t successfully terminate domicile in the old state.

Moreover, if you die without clearly establishing domicile in just one state, both the old and new states may claim that your estate owes income taxes and any state death taxes. So, it’s critical to know the rules that apply in your new and old states — and follow them.

How to Establish Domicile in a New State

Here are some actions that can help you establish domicile in a new state:

  • Keep a log that shows how many days you spend in the old and new locations. (You should try to spend more time in the new state, if possible.)
  • Change your mailing address.
  • Get a driver’s license in the new state and register your car there.
  • Register to vote in the new state. (You can probably do this in conjunction with getting a driver’s license.)
  • Open and use bank accounts in the new state. Close accounts in the old state.
  • File a resident income tax return in the new state, if it’s required. File a nonresident return or no return (whichever is appropriate) in the old state.
  • Buy or lease a residence in the new state, and sell your residence in the old state or rent it out at market rates to an unrelated party.
  • Change the address on important documents, such as passports, insurance policies, and wills or living trusts.

The more time that elapses after you move to a new state and the more steps you take to establish domicile in that state, the harder it will be for your old state to claim that you’re still a resident for tax purposes.

Don’t Forget the Dog

In the facts underlying a recent decision by the New York Division of Tax Appeals, the taxpayer lived in New York City until he took a job as chief executive officer at Match.com, which was based in Dallas, Texas. Ultimately, the court determined that he was legally domiciled in Texas, because that’s where he kept one of his nearest and dearest possessions — his dog. (In re Gregory Blatt, N.Y. Division of Tax Appeals, No. 826504, Feb. 2, 2017)

The taxpayer’s initial agreement with Match.com called for him to work in New York City. But in 2009, he decided to lease an apartment in Dallas and work from the Dallas office. His employment contract was amended to show that his principal place of employment was Dallas. He kept ownership of an apartment in New York City, although it was listed for sale after he agreed to work out of Dallas. He also kept a boat in New York, which he used while vacationing in the Hamptons.

By the spring of 2011, the taxpayer had terminated his employment with Match.com and moved back to New York City. Later in 2011, he sold his apartment in New York City and moved to the Hamptons.

For 2009 and 2010, the taxpayer claimed to be domiciled in Texas and, therefore, filed New York nonresident/part-year resident income tax returns for those two years. After being audited by the New York Division of Taxation, he was charged for state and city income taxes, interest and penalties totaling $430,065 on the grounds that New York City was his legal domicile for the entire time he was employed by Match.com.

Fortunately, the taxpayer was able to convince the New York Division of Tax Appeals that his domicile for 2009 and 2010 was, indeed, Dallas. The following factors helped persuade the court to accept Dallas as the taxpayer’s domicile:

  • He started going to the gym in Dallas, which he had never done in New York,
  • He had his prescriptions filled in Dallas, and
  • He obtained a Texas driver’s license and was registered to vote there.

As it turned out, the tipping point came when the taxpayer moved his dog to Dallas in November 2009. The significance of this action was documented in an email the taxpayer sent to a friend in which the taxpayer stated that moving the dog was the final step that he hadn’t previously been able to come to grips with. By taking the dog to Dallas, the taxpayer demonstrated that Dallas was officially his new home. The New York Division of Tax Appeals agreed, noting that moving items that are “near and dear” tends to demonstrate a person’s intention to change domicile.

Consult a Tax Pro

Planning to move to a new state with lower taxes? Unless you establish domicile in the new state and terminate residency in the old one, you could come under scrutiny by state tax authorities. Your tax advisor can explain the rules in your old and new states and how to avoid potential pitfalls.

Related Posts

Posted on Apr 25, 2017

Real estate owners who rent their properties often incur tax losses due to depreciation write-offs and other allowable deductions. However, the ability to deduct those losses might be postponed indefinitely by the passive activity loss (PAL) rules. In general, these rules limit deductions for rental property PALs to the amount of income that you have from other passive activities — or until you dispose of the loss-producing property.

Exceptions to the PAL Rules for Rental Real Estate

Owners of rental real estate may qualify for two special exceptions to the IRS rules on passive activity losses (PALs). Those properties for which you qualify for either of these exceptions are exempt from the PAL rules, and you can generally deduct losses from those properties in the current year.

Small Landlord Exception

If you qualify for this exception, you’re allowed to currently deduct up to $25,000 of passive losses from rental real estate properties, even if you have no passive income. To qualify, you must own at least 10% of the property generating the loss, and you must “actively participate” with respect to the property in question.

To prove active participation, you don’t have to mow lawns or unclog drains. Instead, you must demonstrate that you exercise management control over the property by, say, approving tenants and leases, authorizing maintenance and repairs, and so forth.

Unfortunately, rental properties owned through limited partnerships are specifically excluded from the small landlord exception. Also, many owners will be ineligible, because the exception is phased out for taxpayers with adjusted gross income (AGI) between $100,000 and $150,000 — and it’s completely phased out for taxpayers with AGI at or above $150,000.

Real Estate Professional Exception

To qualify for this exception, you must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate. In addition, those hours must be more than half the time you spend working during the year.

Next, you’ll need to prove that you materially participate in one or more rental properties. Examples of simple ways real estate owners can prove material participation are:

  • Spend more than 500 hours on the activity during the year.
  • Spend more than 100 hours on the activity during the year and making sure no other individual spends more time than you.
  • Make sure the time you spend on the activity during the year constitutes substantially all the time spent by all individuals.

You only have to meet one of these requirements to meet the material participation standard for an activity. Additionally, you can elect to combine all rental properties into a single group and treat the combined group as one property for purposes of passing one of the material participation tests.
Unfortunately, rental property owners often have little or no passive income. But, if you qualify for one of the special exceptions to the PAL rules for small landlords or real estate professionals, you may be able to deduct losses in the year they’re incurred. (See “Exceptions to the PAL Rules” at right.)

If you’re unsure if you qualify for one of the special exceptions, consider these recent U.S. Tax Court cases that help clarify the IRS guidance.

Taxpayer Qualifies for Exception, Despite Lack of Recordkeeping

The Tax Court recently concluded that a taxpayer who kept poor records was able to provide sufficient oral evidence to qualify for the real estate professional exception to the PAL rules. (Beth Hailstock v. Commissioner, T.C. Memo 2016-146)

In this case, the taxpayer had quit her job with the City of Cincinnati and began buying real estate. Between 2005 and 2009, she had acquired over 30 properties that she rented (or attempted to rent). She spent more than 40 hours each week on the venture and had no other employment. Her tasks included: checking messages for work orders, purchasing materials and supplies, supervising workers doing renovations, and meeting with and conducting background checks on prospective tenants. However, the taxpayer didn’t maintain records of the time she spent on these activities.

However, the Tax Court concluded that the taxpayer’s oral testimony was sufficient to establish that she qualified as a real estate professional and that she met the material participation standard for each of her rental properties by passing the facts and circumstances test. Specifically, her testimony established the substantial amount of time and money that she spent on the rental properties and her extensive and time-consuming duties in operating them.

The Tax Court was also favorably impressed by the fact that the taxpayer reported sizable amounts of rental income for the tax years in question. Therefore, she was allowed to currently deduct her rental real estate losses under the real estate professional exception. However, the Tax Court warned her to keep contemporaneous time logs in the future to prove how much time she spent on the rental properties.

Important note: The taxpayer didn’t elect to aggregate all of her rental properties into one activity for purposes of applying the PAL rules. Therefore, she had to meet the material participation standard for each individual property in order for losses from each property to be exempt from the PAL rules.

No Exception Allowed for Exaggerated Time Logs

In another Tax Court decision, the taxpayers were a married couple who owned two rental properties: a former residence in Massachusetts and an interest in two apartment buildings in Cairo, Egypt. Here, the court concluded that the taxpayers didn’t qualify for the real estate professional exception. (Mahmoud and Jane Makhlouf v. Commissioner, T.C. Summary Opinion 2017-1)

For 2010, the taxpayers claimed substantial losses from the rental properties. They also claimed that they spent significant time managing the properties and, therefore, qualified for the real estate professional exception. To prove they met the material participation standard, the taxpayers provided spreadsheets that documented their heavy involvement in the rental properties.

The IRS had disallowed most of the rental losses on the grounds that the taxpayers didn’t qualify for the real estate professional exception. The Tax Court concluded that the taxpayers failed to prove that they spent more than 750 hours in real property rental activities in which they materially participated, because the hours summarized on their spreadsheets were inflated, duplicative and not supported by contemporaneous recordkeeping.

Married Couple Didn’t Qualify for Exceptions

The Tax Court again sided with the IRS in another case. Here, married taxpayers attempted to deduct losses from real estate activities, but the court concluded that the losses were limited under the PAL rules. (Mary and Bradley Hatcher v. Commissioner, TC Memo 2016-188)

In this case, the husband was a real estate loan originator. The small landlord exception was unavailable because the couple’s income was too high. The real estate professional exception was unavailable because the taxpayers failed to show that either spouse qualified as a real estate professional.

Although the husband actively participated in managing the rental properties and had previously originated real estate loans, he didn’t originate any such loans during the tax year in question or maintain any records to show how much time he devoted to his real estate activities.

His oral testimony also showed that he did not pass the more-than-750-hour test. So, the amount of losses the couple could deduct was limited to any income earned from other passive sources. The taxpayers generated no passive income for the tax year in question, so the PAL rules disallowed any write-offs from the rental activities.

Need Help?

For more information on deducting losses from rental properties or to determine whether your real estate activities qualify for special exceptions to the PAL rules, contact your tax advisor. He or she can help you navigate the guidance and substantiate any allowable deductions for rental property losses.

Related Posts

Posted on Apr 21, 2017

Legal expenses incurred by individuals are typically not currently deductible under the federal income tax rules. Instead, they’re most often treated as either personal outlays (which are nondeductible) or as part of the cost of acquiring an asset, such as real estate.

When Can You Claim a Nonbusiness Deduction for Legal Expenses?

As stated in the main article, an individual’s legal expenses aren’t usually deductible. But here are two more exceptions to the general rule that may apply, even if the expenses aren’t business-related:

1. Expenses for Production or Collection of Income and to Handle Tax Matters

You can deduct legal expenses incurred for 1) the production or collection of income, such as legal actions to collect unpaid wages and alimony, or 2) the determination, collection or refund of any tax. However, these types of legal expenses must be treated as miscellaneous itemized deduction items. Miscellaneous itemized deduction items can’t be deducted under the alternative minimum tax (AMT) rules and can be written off only to the extent they exceed 2% of your adjusted gross income under the regular tax rules.

2. Expenses for Certain Discrimination and Whistleblower Claims

You can claim “above-the-line” deductions for legal expenses incurred in certain discrimination lawsuits and for attempts to collect whistleblower awards. You don’t have to itemize expenses to benefit from above-the-line deductions — and they’re fully deductible under the AMT rules.
In the latter situation, legal costs usually aren’t deductible right away; instead, they may be capitalized and amortized over a number of years if the asset is used for a business or rental activity.

A recent U.S. Tax Court decision and IRS Private Letter Ruling (PLR) showcase exceptions to the general rule and when taxpayers may be eligible for current deductions for legal expenses.

Tax Court Decision

In Ellen Sas v. Commissioner (T.C. Summary Opinion 2017-2), an employee who was fired by her employer was allowed to write off legal expenses as a miscellaneous itemized deduction.

Here, the taxpayer received a $612,000 bonus from her employer before being terminated for alleged breach of fiduciary duty. When the employer attempted to recover the bonus, the taxpayer counterattacked, alleging employment discrimination.

Eventually, all claims against the employee were dismissed, and she was allowed to keep the bonus. But she incurred almost $81,000 in legal fees — and wanted to deduct them on her personal tax return as part of the expenses for a business that she and her husband operated.

IRS auditors concluded that the legal expenses constituted unreimbursed employee business expenses, which should be classified as miscellaneous itemized deductions. This category of deductions can be claimed only to the extent that they exceed 2% of your adjusted gross income (AGI). But you’re allowed to combine unreimbursed employee business expenses with other miscellaneous itemized deduction items — such as job search costs, fees for tax advice and tax preparation, and expenses related to taxable investments — when attempting to clear the 2%-of-AGI threshold.

Important note: Miscellaneous itemized deductions are disallowed under the alternative minimum tax (AMT) rules. So, if you’re subject to the AMT, these deductions won’t benefit you.

The taxpayer took her case to the Tax Court. But it agreed with the IRS that the legal costs were unreimbursed employee business expenses because they arose from the taxpayer’s business of being an employee (albeit a former employee at the point they were incurred).

IRS Private Letter Ruling

In a recent PLR, the taxpayer had experience managing closely held companies, and he had agreed to serve as the managing shareholder of a newly formed corporation in exchange for a management fee. After another shareholder became dissatisfied with the corporation’s performance, the taxpayer was sued for alleged breach of contract, breach of fiduciary duty and fraud.

The taxpayer incurred legal fees to unsuccessfully defend against these charges and unsuccessfully appeal the initial court decision against him. In addition, he paid fees to accounting consultants and an expert witness. And, he had to pay court-ordered compensatory and punitive damages to his legal adversary, as well as the adversary’s legal fees.

The taxpayer wanted to deduct all of these expenses, which clearly originated in the conduct of his business as the managing shareholder of the troubled corporation. Therefore, the IRS concluded that the taxpayer’s payments to satisfy the final judgment against him (including compensatory and punitive damages and his adversary’s legal costs) and his own legal expenses and related costs to unsuccessfully defend against the claims could be currently deducted as business expenses.

Important note: This conclusion won’t necessarily apply to other taxpayers in the same or a similar situation. By requesting a PLR, a taxpayer asks the IRS, for a fee, to provide guidance on federal income tax questions. PLRs interpret and apply tax laws to that particular taxpayer’s specific set of facts. A PLR helps eliminate uncertainty before the taxpayer’s return is filed — and it’s binding on the IRS if the taxpayer fully and accurately described the proposed transaction in the request and carries out the transaction as described. Technically, a PLR can’t be relied on by other taxpayers. However, as a practical matter, PLRs are often used by tax professionals as guides to the IRS position on issues.

Business vs. Personal

Individuals will sometimes incur legal expenses that are legitimately business-related and, therefore, deductible. But, if you’re audited, the IRS will routinely disallow legal expense deductions unless you can adequately prove that the expenses are indeed business-related (including related to the business of being an employee). In the right circumstances, your tax advisor can help you put together evidence to support deductible treatment for legal expenses.

Related Posts

Posted on Apr 17, 2017

This time of year there are around 30,000 internships posted online, according to Burning Glass Technologies, a labor market research firm. The top 10 categories are business operations, marketing, engineering, sales/business development, media/communications/public relations, data analytics, finance, information technology development (IT), arts and design, and project management.

How many of them will be successful, from the perspective of the employer — and the intern? The answer depends on how many employers think through what they want their interns to accomplish, and how much effort they’re willing to put into managing them.

The biggest mistake employers can make in bringing interns on board is to regard them merely as an inexpensive source of labor, worthy only of performing menial tasks to give a break to full-time staff. With that approach, not only will you have a disgruntled intern on your hands — who may leave you early — but you miss out on the chance to develop a potentially valuable new-hire down the road.

Not Your Personal Assistant

“Interns are there to learn about your business, not to replace your personal assistant,” advises one internship placement service.

It might be better to think of internships as a way to keep your talent pipeline flowing, or a no-fault audition for future employment.

Also, when interns are given the opportunity to learn how to do meaningful jobs, important tasks are accomplished that might otherwise have to be put off. You probably have potentially valuable, but non-urgent, jobs that nobody seems to have time to do. Often, it could be a research project that a smart intern could easily complete.

When an internship is structured to provide “meaningful” work (and it’s promoted that way), you’ll have a lot more highly qualified prospects knocking at your door. Also, keep in mind that students sometimes have more current technical skills in certain areas, such as computer applications and social media, than others who have been out of school for several years or more.

Getting the most out of an internship program requires identifying areas of need by surveying department managers, and then creating a job description. It also requires assigning responsibility for supervising the intern, ideally to a relatively junior (but well-regarded) manager with whom the intern will feel comfortable.

A common approach to internship design, particularly in smaller organizations, is creating a “rotating internship.” Structuring the program to move the intern between multiple departments can be an efficient way of filling manpower gaps caused by summer vacation schedules. It also allows the intern to gain a greater variety of experience — something interns generally seek.

What Attracts Interns

Here are some more features that prospective interns say are important to them:

  • A clear job description that lets them know, in advance, what they will be doing, as a way to seek a good fit before coming on board,
  • Meaningful work — even if a few unglamorous clerical tasks are assigned from time to time,
  • The chance to be a bona fide team member allowed to participate in relevant staff meetings,
  • Regular feedback and access to supervisors for guidance and mentoring, and
  • Reasonable compensation.

Yes, compensation. While interns generally aren’t expecting high pay, few will work for free. In fact, it may not even be legal to not pay an intern anything below minimum wage. In a for-profit setting, the Fair Labor Standards Act (FLSA) generally applies to interns. There are some exceptions, however.

Free Labor?

“The determination of whether an internship or training program meets the exclusion depends upon all of the facts and circumstances of each such program,” says the Labor Department (DOL). Here are six criteria the DOL uses in making the determination. The more of these points that apply, the stronger the case for exemption from the FLSA:

  1. The internship, even though it includes work in the actual facilities of the employer, is similar to training which would be given in an educational environment;
  2. The internship experience is for the benefit of the intern;
  3. The intern doesn’t displace regular employees, but works under close supervision of existing staff;
  4. The employer that provides the training derives no immediate advantage from the activities of the intern; and on occasion its operations may actually be impeded;
  5. The intern isn’t necessarily entitled to a job at the conclusion of the internship; and
  6. The employer and the intern understand that the intern isn’t entitled to wages for the time spent in the internship.

However, even if you might not be obligated to satisfy the same standards applicable to regular employees, consider that you might be limiting your pool of applicants by seeking only volunteers. And, if you run the program well, you’ll probably get more than your money’s worth.

How do you find qualified candidates? A basic web search using the phrase “how to find summer interns” yields links both to job matching services specializing in internships, as well as the top general job boards that post internship positions.

Related Posts

Posted on Apr 14, 2017

Feeling the urge to purge? April 18, 2017, was the deadline for individuals and C corporations to file their federal income tax returns for 2016 (or to file for an extension). Before you clear your filing cabinets of old financial records, however, it’s important to make sure you won’t be caught empty-handed if an IRS auditor contacts you.

Still Not a Paperless Society

E-filing is on the upswing. According to the Data Book released by the IRS in March, about 69% of tax returns were filed electronically in fiscal year 2016, up from about 65% in fiscal year 2014.

You might think those numbers suggest we’re close to becoming a paperless society, at least when it comes to filing income taxes. That would be a wrong assumption.

Even if you recently filed your 2016 tax return electronically, you probably printed out a hard copy for your files. Add that paper to the financial reports, bank statements, receipts and other documents you may have been holding onto for years and it’s likely your filing cabinets and closets are overflowing with paper.

For Individuals

In general, you must keep records that support items shown on your individual tax return until the statute of limitations runs out — generally, three years from the due date of the return or the date you filed, whichever is later. That means that now you can generally throw out records for the 2013 tax year, for which you filed a return in 2014.

In most cases, the IRS can audit your return for three years. You can also file an amended return on Form 1040X during this time period if you missed a deduction, overlooked a credit or misreported income.

So, does that mean you’re safe from an audit after three years? Not necessarily. There are some exceptions. For example, if the IRS has reason to believe your income was understated by 25% or more, the statute of limitations for an audit increases to six years. Or, if there’s suspicion of fraud or you don’t file a tax return at all, there is no time limit for the IRS to launch an inquiry.

Here are some basic guidelines for individuals.

Completed tax returns.

Many tax advisors recommend that you hold onto copies of your finished tax returns forever. Why? So you can prove to the IRS that you actually filed. Even if you don’t keep the returns indefinitely, you should hang onto them for at least six years after they are due or filed, whichever is later.

Backup records.

Any written evidence that supports figures on your tax return, such as receipts, expense logs, bank notices and sales records, should generally be kept for at least the three-year period.

Important note: There are some cases when taxpayers get more than the usual three years to file an amended return. You have up to seven years to take deductions for bad debts or worthless securities, so don’t toss out records that could result in refund claims for those items.

Real estate records.

Keep these for as long as you own the property, plus three years after you dispose of it and report the transaction on your tax return. Throughout ownership, keep records of the purchase, as well as receipts for home improvements, relevant insurance claims and documents relating to refinancing. These help prove your adjusted basis in the home, which is needed to figure the taxable gain at the time of sale, or to support calculations for rental property or home office deductions.

Securities.

To accurately report taxable events involving stocks and bonds, you must maintain detailed records of purchases and sales. These records should include dates, quantities, prices, dividend reinvestment and investment expenses, such as broker fees. Keep these records for as long as you own the investments, plus the statute of limitations on the relevant tax returns.

IRAs.

The IRS requires you to keep copies of Forms 8606, 5498 and 1099-R until all the money is withdrawn from your IRAs. With the introduction of Roth IRAs, it’s more important than ever to hold onto all IRA records pertaining to contributions and withdrawals in case you’re ever questioned.

If an account is closed, treat IRA records with the same rules as securities. Don’t dispose of any ownership documentation until the statute of limitations expires.

Issues affecting more than one year.

Records that support figures affecting multiple years, such as carryovers of charitable deductions, net operating loss carrybacks or carryforwards, or casualty losses, need to be saved until the deductions no longer have effect, plus seven years, according to IRS instructions.

For Businesses

The record-retention guidelines are slightly different for businesses. Here are the basics.

Employee records.

Keep personnel records for three years after an employee has been terminated. Also maintain records that support employee earnings for at least four years. This timeframe should cover various state and federal requirements. (However, don’t throw away records that might involve unclaimed property, such as a final paycheck not claimed by a former employee.)

Timecards specifically must be kept for at least three years if your business engages in interstate commerce and is subject to the Fair Labor Standards Act. However, it’s a best practice for all businesses to keep the files for several years in case questions arise.

Employment tax records.

Keep four years from the date the tax was due or the date it was paid, whichever is longer.

Travel and entertainment records.

For travel and transportation expenses supported by mileage logs and other receipts, keep supporting documents for the three-year statute of limitations.

Sales tax returns.

State regulations vary. For example, New York generally requires sales tax records to be retained for three years, while California requires four years, and Arkansas, six. Check with your tax advisor.

Business property.

Records used to substantiate the cost and deductions (such as depreciation, amortization and depletion) associated with business property must be maintained to determine the basis and gain (or loss) on the sale. Keep these for as long as you own the asset, plus seven years, according to IRS guidelines.

Proper Disposal Protocol

Regardless of whether you’re tossing out personal or business financial documents, always shred them thoroughly first. Also, use proper disposal protocol for any computers and other electronic equipment (such as printers and copiers) that may contain financial data. Simply deleting files using File Manager isn’t enough. Unless you use proper disposal protocol, tech-savvy hackers may be able to recreate sensitive data from the device’s hard drive when it was thrown out, donated to a charity, or returned to the lessor after the lease term expired.

If you have any questions regarding financial records retention, contact your tax advisor for more information.

Related Posts

Posted on Apr 12, 2017

The IRS has issued an Information Letter that explains the tax treatment of an employer who provided parking to employees in an unconventional way. In the arrangement, the employer purchased parking spots from a parking vendor and then allowed employees who wanted to use the parking spots to pay the employer for them using the employees’ own after-tax compensation. The IRS stated the arrangement doesn’t qualify for tax-free treatment.

The Law

Under the Internal Revenue Code, employers that provide an employee with a “qualified transportation fringe” can exclude the benefit from the employee’s gross income. A “qualified transportation fringe” includes “qualified parking.” The tax code defines “qualified parking” as parking an employer provides that’s located on or near the employer’s business premises.

Parking is considered be provided by the employer if:

  • It’s on property that the employer owns or leases;
  • The employer pays for it; or
  • The employer reimburses the employee for parking expenses.

The Facts of the Case

Here are some of the details involved in this case:

  • The employer paid the parking vendor directly for the parking spots.
  • Employees who wished to use the secure parking had to agree, in writing, to reimburse the employer by having the monthly parking fee deducted from their paychecks in the month prior to using the parking.
  • The employees couldn’t get a refund of the withheld funds if they didn’t use the parking.
  • The cost of the parking was less than the federal statutory limit ($255 a month in 2017).
  • The employees weren’t given the option of choosing between taxable cash compensation and parking. As a result, the employer didn’t exclude the cost of the parking from the taxable wages of the employees who elected to use it. Instead, the employer simply deducted the cost of the parking from the employees’ after-tax wages.

The IRS Response

The employees who elected to use the parking spots asked the IRS whether the amounts deducted from their wages for parking could be excluded from their income and wages as a qualified parking benefit.

In responding, the IRS stated the arrangement didn’t meet the requirements to be considered qualified parking under the tax code. (IRS Information Letter 2017-0007) These type of letters are provided by the IRS National Office in response to requests from taxpayers for general information. They are for informational purposes only and don’t constitute a ruling.

The IRS noted that if the employer instead decided to reimburse employees for qualified parking expenses, it could do so either by providing the reimbursements in addition to the employee’s regular wages or, alternatively, the employer could provide the reimbursements in place of pay. Reimbursements provided in place of pay are called “compensation reduction arrangements.” Under compensation reduction arrangements, the employer permits the employees to elect to reduce their taxable compensation in order to receive tax-free reimbursements for parking expenses that the employees have actually incurred.

If you have questions about the tax implications of your fringe benefits (or of your employees), consult with your tax advisor.

Related Posts

Posted on Apr 5, 2017

Do you have an interest in — or authority over — a foreign financial account? If so, the IRS wants you to provide information about the account by filing a form called the “Report of Foreign Bank and Financial Accounts” (FBAR).

The annual deadline for filing FBARs has been changed. It now coincides with the tax filing deadlines for individuals, under the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015. So, for accounts held in 2016, you must generally file FBARs by April 18, 2017. (Formerly, the deadline was June 30, excluding weekends and holidays.)

Important note: If you fail to meet the annual FBAR due date, the Financial Crimes Enforcement Network (FinCEN) will grant an automatic extension to October 15. Accordingly, specific requests for this extension aren’t required.

Reporting Requirements

FBARs are not filed with federal tax returns. Each year, citizens and resident aliens of the United States, as well as domestic partnerships, corporations, estates and trusts, must generally file an FBAR form electronically with the FinCEN if:

  1. They have a direct or indirect financial interest in — or signature authority over — one or more accounts in a foreign country. This includes bank accounts, brokerage accounts, mutual funds, trusts or other types of foreign financial accounts, and
  2. The total value of the foreign accounts exceeds $10,000 at any time during the calendar year.

An individual who jointly owns an account with a spouse may file a single FBAR report as an individual. FBARs may be required even if the foreign account doesn’t produce any taxable income.

Taxpayers also may be subject to FBAR compliance if they file an information return related to certain foreign corporations, foreign partnerships, foreign disregarded entities, or transactions with foreign trusts and receipt of certain foreign gifts. Some individuals are exempt, however.

Exceptions to the Rules

FBAR filing exceptions are available for the following U.S. taxpayers or foreign financial accounts:

  • Certain foreign financial accounts jointly owned by spouses,
  • United States persons included in a consolidated FBAR,
  • Correspondent/nostro accounts,
  • Foreign financial accounts owned by a governmental entity,
  • Foreign financial accounts owned by an international financial institution,
  • IRA owners and beneficiaries,
  • Participants in and beneficiaries of tax-qualified retirement plans,
  • Certain individuals with signature authority over — but no financial interest in — a foreign financial account,
  • Trust beneficiaries (but only if a U.S. person reports the account on an FBAR filed on behalf of the trust), and
  • Foreign financial accounts maintained on a United States military banking facility.

Important note: Filers living abroad may coordinate FBAR filing with their tax return deadline (June 15, 2017).

Penalties for Noncompliance

Take the FBAR requirement seriously. Failing to file an FBAR can result in the following penalties if assessed after August 1, 2016, and associated violations occurred after November 2, 2015:

  • An inflation-adjusted civil penalty of as much as $12,459 per violation, if the failure wasn’t willful. This penalty may be waived if income from the account was properly reported on the income tax return and there was reasonable cause for not reporting it.
  • A civil penalty equal to the greater of: 1) 50% of the account, or 2) $124,588 per violation, if the failure to report was willful.
  • Criminal penalties and time in prison.

The IRS states that the FBAR “is a tool to help the U.S. government identify persons who may be using foreign financial accounts to circumvent U.S. law. Investigators use FBARs to help identify or trace funds used for illicit purposes or to identify unreported income maintained or generated abroad.”

Beyond FBARs

Another initiative to combat tax fraud using offshore accounts is the Foreign Account Tax Compliance Act (FATCA). It led to the creation of Form 8938, “Statement of Specified Foreign Financial Assets.” This form must be attached to your federal income tax return each year if your specified foreign financial assets exceed these reporting thresholds:

  • For unmarried taxpayers living in the United States, the total value of your specified foreign financial assets is more than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year.
  • For married taxpayers filing a joint income tax return and living in the United States, the total value of your specified foreign financial assets is more than $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year.
  • For married taxpayers filing separate income tax returns and living in the United States, the total value of your specified foreign financial assets is more than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year.

Different reporting rules and limits apply for taxpayers living abroad. Form 8938 covers an expanded list of foreign assets not covered by FBAR. And filing Form 8938 does not exempt you from having to file an FBAR.

The penalty for failing to file Form 8938 is $10,000, with an additional penalty up to $50,000 for continued failure to file after IRS notification. A 40% penalty on any understatement of tax attributable to a transaction related to the nondisclosed assets can also be imposed.

For Assistance

Consult with a tax professional if you have an interest in — or authority over — a foreign account. Your tax advisor can ensure you meet the requirements for reporting foreign accounts and help avoid penalties for noncompliance.

Related Posts