CPA With a View

Passive Activity Rules - Review Your Status

Internal Revenue Code (IRC) Section 469 states that losses from passive activities can only be deducted against income from passive activities or when the activity is disposed. Generally, passive activity is any trade or business owned by the taxpayer that the taxpayer does not materially participate in and/or any rental activity owned by the taxpayer.

There are a variety of rules used to determine what is or is not 1) material participation or 2) a rental activity. Taxpayers and return preparers should review the rules each year to determine the correct classification (passive or non-passive) of the activity. Depending on the circumstances, one may want an activity to be classified as passive. For example, if the activity generates income, the income can be offset by other passive losses.

The basic rule is that one must participate more than 500 hours in a year to achieve material participation status. There are a few exceptions, see Treasury Regulation 1.469-5 and 1.469-5-T  for the rules.

Below are a few of the unusual rules relating to participation that may impact the classification of a business activity:

1)      When determining material participation in an activity, only participation when the activity is owned by the taxpayer counts. Therefore, if the activity is acquired or started late in the year, it may be difficult to meet the various hours-worked rules for material participation.

2)      If one is a limited partner in a limited partnership, the more than 500 hours of participation rule must be used to determine whether the partner passes the material participation event. LLC members may or may not be treated as limited partners under this rule, based upon the particular facts and circumstances.

3)      Participation by the taxpayer’s spouse counts as participation, even though the spouse has no ownership in the activity.

4)     If one materially participated in an activity 5 out of the last 10 years, they are considered to materially participate in the current year. The rule is 3 out of 5 years for Personal Service Activities.

5)     Time “on call” to perform service does not count as participation.

6)     All work and services provided count as participation except:

a) Work not customarily done by an owner won’t count if one of the principal purposes for doing the work is to obtain material participation status.

b)  Work performed as an investor not working day-to-day in the business is ignored. For example, reviewing financial statements or strategic plans in a non-managerial capacity.

7)      The executor or fiduciary of an estate or trust must materially participate in the activity for the activity to be considered non-passive to the estate or trust.

Next week, I will post some of the unusual rules relating to the definition of rental operations, certain activities that are passive and non-passive, and grouping activities into one.

The key is to review all business and rental activities each year and determine the proper status (passive or non-passive).  Then, work with your CPA to determine what can be done to classify them in the best way for tax purposes.

Grandma Turns 90

Sunday we celebrated Grandma’s 90^th birthday. Awesome Italian cook. I love her food. She gave me my awesome Italian wife. We celebrated at the boat house with 8 grandchildren and 18 great grandchildren. Pretty special day.

Stones Tour Rumor  

The rumors are picking up on a 2012 Stones tour. It would be a celebration of their 50^th year as a band. WOW would that be fun. Tax blogging from a Stones show. Can’t beat it.

Charitable Contributions

It's time to start gathering your 2011 tax information.

To take a deduction for charitable contributions, one must meet the substantiation and reporting requirements.  Using "same as last year" or "the normal amount" is not an option.

Below is a short summary of the requirements.

Contributions of less than $250

- Cash:  A bank record verifying the donee, the date and amount (i.e. a cancelled check or bank statement), a receipt from the donee verifying the date and amount, or payroll deduction record and pledge.

- Non Cash:  A receipt from the donee, the date of the contribution, description of the property and location of the property. One must also maintain documentation proving the value of the property and how it was determined, the date acquired and basis of the property, the percent of the property given, and any terms or conditions connected to the contribution.

Contributions of $250, but less than $500

- Cash:  Same as above plus a written acknowledgement from the donee indicating 1) the date and amount of the contribution, 2) whether or not any goods and services were provided by the donee as a result of the contribution, other than an intangible religious benefit, and if so, the value of such benefits.

-  Non Cash:  Same as cash above plus a description of the property and its location.

Contributions of more than $500 to $5,000

-  Cash:  Same as the $250 but less than $500 category.

-  Non Cash: Same as the $250 but less than $500 category plus Form 8283 needs to be filed and include how and when the property was acquired and the basis of the property.

Contributions of more than $5,000

-  Cash:  Same as the previous category.

-  Non Cash:  Same as above plus one must obtain a qualified appraisal, complete page two of Form 8283, and the appraiser and donee must sign Form 8283.

The instructions to Schedule A and Form 8283 and publications 17, 526,561, and 4303 include guidelines and explanations of the rules. These resources provide helpful information such as special exceptions for reporting contributions of marketable securities and small non-traded securities, vehicle donation, and understanding when “similar items” donated during the year to various charities get combined in determining which category above applies. These resources can be found on the IRS website.  www.irs.gov

New Years and Great Birthday Party

Had a great New Years in Florida. My wife Jan and I had a great time boating on "Miss You" our deck boat. Yes, it does have a Rolling Stones tongue on the back. I love being on the water. The bars are fun too.

Just celebrated Cami's sixth birthday at the Boat House Condo party room and indoor pool. What a great time with my family. Cami was so happy and beautiful. I love her.

Extension of the Payroll Tax Holiday

The House of Representatives agreed to pass the Senate version, with a slight modification, of the Bill to extend for two months (thru 2/29/12) the current 2% reduction in payroll taxes. The House and Senate will ratify it and the President is expected to sign it today.

The new House bill corrects the Senate provision by allowing employers to withhold employee payroll taxes at the 2% reduced rate of 4.2% on all compensation paid from 1/1/12 to 2/29/12, subject to the full Social Security tax wage base ($110,100). Consequently they can ignore the $18,350 cap (two-twelfths of the wage base of $110,100) on compensation eligible for the form 1/1/12 to 2/28/12 included in the Bill.

If an employee’s wages during the first two months of 2012 exceed $18,350, an amount equal to 2% of those excess wages would ultimately be recaptured on the worker’s individual tax return for 2012. 

This rule would only apply if the payroll tax reduction is not extended to the end of 2012 in the upcoming conference committee sessions expected to convene soon in order to negotiate a full-year extension or other 2012 legislation.

In other words, they aren’t done yet. Can’t wait to watch it unfold. 

Merry Christmas.

Payroll Tax Extension

As many of you may know, the House and Senate are fighting over how to a pass an extension of the payroll tax cut.  If they come to an agreement, I will submit a short post. 

Merry Christmas

My son is home from the military.  I look forward to spending time with him over the next week.  I will not be posting again until 2012, unless there is news out of Congress relating to the payroll tax extension.  Hope everyone has a Merry Christmas.

NEW Enhanced Work Opportunity Tax Credit (WOTC) for Hiring Qualified Veterans

The “3% Withholding Repeal and Jobs Creation Act”, signed into law Nov. 21, 2011, expands and extends the work opportunity tax credit (WOTC) for employing certain military veterans.

Please note, this is a technical blog post, but I believe it will help. I am a big supporter of our troops and anything that helps them deserves attention.

The WOTC allows employers who hire members of certain targeted groups, including qualified veterans, to get a credit against income tax of a percentage of first-year wages up to $6,000 per employee ($12,000 for certain qualified veterans; and $3,000 for qualified summer youth employees). Generally, the percentage of qualifying wages is 40% of first-year wages, for a maximum WOTC of $2,400 (40% × $6,000), or $4,800 for certain qualifying veterans (40% × $12,000). The 40% is reduced to 25% for employees who have completed at least 120, but less than 400, hours of service for the employer during the first year. 

The new law extends the existing WOTC for hiring qualified veterans, broadens the classes of qualified veterans, increases the WOTC for hiring some of them, “fast-tracks” the qualification process for qualified veterans, and provides tax-exempt employers with a credit against payroll tax for hiring qualified veterans.

Under the new law, employers will be able to claim the WOTC for qualified veterans who begin work for the employer before Jan 1, 2013. In other words, the WOTC gives a one-year extension to employers that hire qualified veterans.

Effective for individuals who begin work for the employer after Nov. 21, 2011, a qualified veteran is a veteran who is certified by the designated local agency as falling within one of the following four categories:

(1) The individual is a member of a family receiving assistance under a food stamp program under the Food Stamp Act of '77 for at least three months, all or part of which is during the 12-month period ending on the hiring date.

(2) The individual is entitled to compensation for a service-connected disability, and either:

  (a) has a hiring date that isn't more than one year after having been discharged or released from active duty in the U.S. Armed Forces, or

  (b) has aggregate periods of unemployment during the 1-year period ending on the hiring date that equal or exceed six months.

(3) The individual has aggregate periods of unemployment during the 1-year period ending on the hiring date which equal or exceed four weeks (but less than six months).

(4) The individual has aggregate periods of unemployment during the 1-year period ending on the hiring date which equal or exceed six months.

The maximum amount of qualifying first-year wages for which the WOTC may be claimed is:

(A) $12,000 for an individual who is a qualified veteran, is entitled to compensation for a service-connected disability, and has a hiring date that isn't more than one year after having been discharged or released from active duty in the U.S. Armed Forces.

(B) $24,000 for an individual who is a qualified veteran, is entitled to compensation for a service-connected disability, and has aggregate periods of unemployment during the 1-year period ending on the hiring date which equal or exceed six months.

 (C) $14,000 for an individual who is a qualified veteran and has aggregate periods of unemployment during the 1-year period ending on the hiring date which equal or exceed six months.

(D) $6,000 for veterans who qualify under the family assistance rule above and for veterans who qualify under the new category (i.e., veterans who are unemployed for four weeks or more, but less than six months).

The enhanced maximum amounts of qualifying wages also seem to apply if the qualified veteran completes at least 120, but less than 400, hours of service for the employer during the one-year period beginning with his or her hire date. For these reduced hours, the reduced credit percentage (25%) applies.

The IRS, at its discretion, may provide alternative methods for certification of a veteran who is a qualified veteran.

Tax-exempt employers get a payroll-tax credit for hiring qualified veterans. A tax-exempt employer may, subject to the limits described below, claim a WOTC for hiring qualified veterans. The credit is allowed against the Social Security Tax that exempt employers pay on the wages of all of their employees.

The credit applies to both the old categories of qualified veterans and the new categories created by the new law.

The following modifications apply to tax-exempt employers’ WOTC calculation.

• The credit percentage of qualifying first-year wages is 26% (instead of 40%).
• The credit percentage is 16.25% (instead of 25%) for a qualified veteran who has completed at least 120, but less than 400, hours of service for the employer.
• The tax-exempt employer may only take into account wages paid to a qualified veteran for services in furtherance of the activities related to the purposes or function constituting the basis of the organization's tax-exempt status.

 

WOW that is enough information.

If you are hiring, please contact your state employment agency, get a list of qualified veterans waiting for a job and take a look at them. They served our country to protect our freedom. The least we can do is give them a shot. You get a WOTC to boot.  My son is currently serving -  served two tours in IRAQ.  His grandfathers served in WW II and my niece’s son is serving in Afghanistan. Thank God for our troops.

Year-End Planning: Plan to Maximize Your Domestic Production Deduction

Businesses can claim a domestic production activities deduction (DPD) under Internal Revenue Code (IRC) Section 199 to offset income from domestic manufacturing and other domestic production activities.

The DPD equals 9% of the smaller of:

(1) the taxpayer's "qualified production activities income" (QPAI) or

(2) the taxpayer's taxable income (modified adjusted gross income, for individual taxpayers), excluding the DPD.

Qualified production activities eligible for the DPD include items such as:  the manufacture, production, growth or extraction of qualifying production property by a taxpayer in the U.S.; construction or substantial renovation of real property in the U.S.; and engineering and architectural services performed in the U.S. relating to the construction of real property.

The DPD can't exceed 50% of the applicable W-2 wages of the employer for the tax year.  The wages must be allocable to the taxpayer's domestic production activities, and they include tips and other compensation as well as elective deferrals to 401(k) and other plans. 

The DPD for oil-related activity is subject to a special reduction to QPAI.

It is important for businesses to calculate the tentative DPD and the W-2 deduction cap before year-end.  If the wage deduction cap will limit the otherwise available deduction, the business may want to pay or accrue additional compensation to maximize the DPD (for example, in the case of a closely held business whose owners do not draw substantial salaries).

Properly allocating expenses in determining QPAI is important. If activities don’t impact QPAI, the expenses related to the activity should not be allocated to QPAI. It’s worth spending time analyzing your activities and following the expense allocation rules which can be complex; it could increase the 9% DPD.

Also, if certain amounts are being paid to owners of pass-through entities (S-Corporations, Partnerships and LLCs), such as interest, rents, compensation; reducing these amounts generally has no impact on taxable income, but may increase QPAI thereby increasing the DPD.

The lesson is, don’t wait until tax preparation time to review your QPAI, review it before year end and determine how you can maximize QPAI and avoid the taxable income and wage limitation.

Holiday Kick-off Weekend

What an awesome Thanksgiving day and weekend. The  Christmas season is here. What a great time of year. My family loves it. This year our soldier son will join us. That is special. Time to get in the mood. Go get your tree. I can’t wait to hang up my Internal Revenue Code ornament.

Self-Employed Health Insurance Deduction - Make Applicable Reimbursements by Year End

Section 162(l) allows the following to deduct premiums paid for medical, dental and qualified long-term care insurance covering the owner and his or her spouse, dependents and children under age 27:  Self-Employed Persons; Partners of a partnership; LLC members of LLCs taxed as partnerships; and more than 2% owners of S-corporations and LLCs taxed as S-corporations.

Medical insurance includes voluntary Medicare premiums for the taxpayer, the spouse and the dependents.  However, see below for rules relating to insurance plans and required reimbursements by certain employers if the employer doesn’t remit the payments to the insurance company or Medicare.

This is  a change in position by the IRS. In the past, the IRS indicated no Medicare premiums were deductible under Section 162(l). Now, only Medicare Part  A mandatory payments don’t qualify for the deduction. This is a refund opportunity for taxpayers who did not deduct Voluntary Medicare Premiums under this rule in the past. Amended returns should be filed to claim the refund.

The deduction is limited to the earned income generated by the owner from the applicable business. The deduction is taken on page one of Form 1040 before Adjusted Gross Income (i.e. above the line), not as an itemized deduction subject to phase outs and alternative minimum tax adjustments. The insurance must be part of a plan established by the applicable business. The insurance can be either in the name of the business or the taxpayer. The premium payments can be paid by the business or by the individual participating in the plan. For Partners, LLC members and S-corporation shareholders, if the premium is paid by the owner, the partnership, LLC or S-Corporation must reimburse them for the premium.

S-corporation’s deduct the premium and must report the amount on the owners W-2 Form. Partnerships and LLCs treat it the same, but add the premium to the partners or members guaranteed payments (similar to wages).  The owners deduct the premiums reported on the W-2 or as guaranteed payments on their individual  tax return.

Each business should have a written plan detailing the coverage, including Medicare premiums; who is paying the premiums to the insurance company and Medicare; and the reimbursement policy, if paid by the owner.

WARNING-If the owners are responsible for remitting the premiums directly to the insurance company and the business is an S-corporation, partnership or LLC , make sure they get reimbursed by year end. Otherwise a perfectly legitimate deduction will be lost.

Happy Thanksgiving

I hope everyone has a wonderful Thanksgiving. It is one of my favorite holidays-Family, Food and Football. You can’t beat it. I will be at the boat house condo swimming in the indoor pool and eating Thanksgiving dinner with Patrick, Cami, Max, Keira, Jimmy, Vinny and Jack. My seven grandchildren. I can’t wait.

I may even take a day off from reading tax information. No, I don’t think I so. 

Rumors on Gift Tax Law Changes

Unofficial comments are being made all over the Internet and the press that the Congressional Super Committee, in charge of the debt ceiling and deficit reduction project, may recommend reducing the 2011 and 2012 $5,000,000 lifetime gift tax exclusion back to the 2009 level of $1,000,000 effective November 23, 2011.  This is the date they are required to report their recommendation.

Hard to believe this may happen, but who knows. Anyone contemplating large gifts in 2011 and 2012 should talk to their advisors ASAP and monitor the committee’s action and press releases.

This is Congress back at making planning impossible. I will post any updates as they are released.

Deferred Compensation Year-End FICA Withholding

Generally, when tax practitioners are dealing with deferred compensation arrangements, their primary focus is on complying with Internal Revenue Code (IRC) Section  409A. That section and the applicable treasury regulations contain the rules that one needs to follow for most deferred compensation plan design and plan administration. One should review all deferred compensation arrangements to make sure, if they are subject to IRC Section 409A, the plan document complies with the rules and the plan is operated accordingly.

Another section that is not as well known, but applies to most deferred compensation arrangements is IRC Section 3121(v)(2) and the applicable treasury regulation, 31.3121(v)(2).

IRC Section 3121(v)(2) and treasury regulation 31.3121(v)(2) includes rules relating to deferred compensation subject to FICA (social security and medicare) tax withholding and the employer match (FICA taxes). There are many definitions, provisions and examples in the regulations that practitioners should be aware of. Failure to pay FICA taxes can result in penalties and interest.

The basic rule is that deferred compensation is subject to FICA taxes when the service provider no longer has a substantial risk of forfeiture relating to the deferred compensation. In most cases, this is well before the date the deferred compensation is paid and subject to income tax.

A substantial risk of forfeiture is defined by referencing it to IRC Section 83. Basically, it means one has a substantial risk of forfeiture if they are required to provide substantial future services in order to receive the compensation. In other words, if the amount is payable, regardless of future services, it is not subject to a substantial risk of forfeiture and is therefore subject to FICA taxes when the amount is clearly determinable.

The amount subject to the tax and the rules for identifying when the amount is determinable depend on the type of deferred compensation. The regulations refer to account balance plans and non-account balance plans.  Think of them as defined contributions and defined benefit plans in the qualified plan world.

When an amount of an account balance plan isn’t subject to a substantial risk of forfeiture, it is subject to FICA taxes. Any increase in the account after such date, due to credits for account balance earnings or growth, is not subject to FICA tax. Other amounts, additional contributions, and the earnings or growth added to them are subject to FICA taxes on the date they are no longer subject to a substantial risk of forfeiture. 

For non-account balance plans, the present value of future deferred compensation payments, not subject to a substantial risk of forfeiture, is the amount subject to the FICA taxes. The regulations require the use of a reasonable discount rate, which takes the current economic climate into consideration, to calculate the present value amount.  Each time the amount of payments changes, additional FICA taxes are calculated. For non-account balance plans, the amount is determinable when the amount of the payments and the date the payments commence are known.

Regulations allow employers up to December 31 to transmit FICA taxes for liabilities generated in a specific year.

Deferred compensation includes the obvious deferred compensation arrangements, generally, amounts owed to service providers as of year end that are not paid with 2.5 months following the year end.  They include phantom stock plans and similar arrangements. It doesn’t include restricted stock plan, stock options and stock appreciation rights.

Year end is around the corner. Review your deferred compensation arrangements and determine whether you are complying with the FICA tax requirements or how to comply with the requirements. If you haven’t complied in the past, develop a plan to get caught up.

Hockey Started

I watched my two favorite hockey players this weekend. It was grandson Patrick and Max at mite hockey practice. The best hockey to watch. Five- and  six-year-olds falling all over the place and having fun. Not the regular intensity. It was an awesome hour in a freezing arena.

Year-End Planning: Research and Development Credit

If your business develops, designs, manufactures, fabricates, assembles or constructs products, you may qualify for the Internal Revenue Code (IRC) Section 41 credit for increasing research activities. 

The credit equals 20% of wages and supplies spent on qualifying research activities in excess of a base amount. The base amount is calculated using various historical research and development activity of the taxpayer. The 20% amount is reduced for certain alternative calculations and elections.  The credit generally will not be less than 7% of qualifying expenditures. In addition, several states have similar state level credits for research and development activity. 

The key to securing the credit is identifying activity that qualifies for the credit, documenting the project and substantiating the expenses incurred. 

Below is a list of activities that qualify for the credit:

• Developing a new or improved product or formula
• Developing prototypes
• Designing tool, molds and dies
• Testing new technologies and concepts
• Testing new materials
• Developing new and improved manufacturing, constructing and assembly processes
• Developing or upgrading software - special rules apply to internal use software

To determine whether activities may qualify for the credit, you need to answer “yes” to the following questions regarding a project:

1)    Did the activity relate to any of the following results?

• A new or improved function or product
• Improved performance
• Improved reliability
• Improved quality of a product
• Established the capability for developing or improving a product or process
• Established the method for developing or improving a product or process
• Determined the design of a new product or process

2)    Did the activity rely on any of the following sciences?

• Physical
• Biological
• Engineering
• Computer

3)    Were any of the following uncertain at the beginning of the activity?

• Capability of achieving the desired result
• Method of achieving the desired result
• Design or appearance of the desired result

I highly recommend implementing a system to identify and substantiate qualifying activities. You will maximize your credit and withstand IRS scrutiny.

It is not too late to figure out what you did in 2011 that qualifies. Do it now, don’t wait until your tax return is being prepared. You want to know the credit amount to assist in 2011 tax planning and projected tax calculations.

Also, many taxpayers amend tax returns to claim additional credits, once I explain what qualifies. This is limited to years where the statute of limitations has not expired (generally 3 years) and the taxpayer’s ability to document the project and substantiate the cost.

Finally, it is important to remember that S-Corporation shareholders, LLC members, and partners in partnerships 1) have limitations on the amount of the credit and 2) for those who do not materially participate in the business have an alternative minimum tax preference for research and development expenditures. Proper planning is a must in these situations.

Florida Boating

I spent a long weekend in Fort Myers Beach boating, relaxing on the beach and having fun at the Tiki bars.  First experience with my deck boat. I named her Miss You after the Rolling Stones song from the Some Girls album released in 1978. 

Now that I have been back home for a while, the name makes perfect sense. I miss being on the beautiful Gulf of Mexico listening to tax podcasts.  I will be back a few times before tax season starts and after tax season in May with all eight of my grandkids. Can't wait.