IRS Spells Out Rules for Enhanced Research Credit

Posted on May 31, 2017July 22, 2024 by Debra Barcuch

The research credit is back and maybe better than ever. This business credit, which had expired and been reinstated numerous times since its inception in 1981, was permanently preserved by the Protecting Americans from Tax Hikes (PATH) Act of 2015. What’s more, the PATH Act version of the credit contains a couple of key enhancements, making it even more attractive to some manufacturing firms.

Now the IRS has issued interim guidance relating to the “new and improved” research credit. The guidance provides important information on an election for qualified small businesses. (Notice 2017-23, 3/31/17)

Background Information

The research credit is intended to encourage spending on research activities by established firms and startups. In its current form, the credit generally equals the sum of:

20% of the excess of qualified research expenses for the year over a base amount,
The university basic research credit (i.e., 20% of the basic research payments), and
20% of the qualified energy research expenses undertaken by an energy research consortium (see box).

For this purpose, the base amount is a fixed-base percentage (not to exceed 16%) of average annual receipts from a U.S. trade or business, net of returns and allowances, for the four years prior to the year of claiming the credit. It can’t be less than 50% of the annual qualified research expense. In other words, the minimum credit is equal to 10% of qualified research expenses (50% rule times the 20% credit).

But be aware that the credit is available only for qualified expenses. This includes an expense if:

It qualifies as a research and experimentation expenditure under Section 174 of the tax code,
It relates to research undertaken for the purpose of discovering information that is technological in nature and the application of which is intended to be useful in developing a new or improved business component, and
Substantially all of the activities of the research constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality.

When the PATH Act permanently preserved the research credit, it improved it for qualified small businesses in two ways:

1. AMT liability. Effective for 2016 and thereafter, an eligible small business may claim the research credit against alternative minimum tax (AMT) liability. For this purpose, the business must have $50 million or less in gross receipts.

2. Payroll taxes. Also effective for 2016 and thereafter, a qualified small business may elect to claim the research credit against up to $250,000 in payroll taxes annually for up to five years. In this case, the company must have less than $5 million in gross receipts.

Regarding the payroll tax election, the credit amount is applied against the Old Age, Survivors and Disability Insurance (OASDI) tax liability paid for employees, the portion of FICA commonly called “Social Security tax.” For wages earned in 2017, the employer share of Social Security tax is equal to 6.2% of each employee’s wages up to a base of $127,200. The Social Security Administration (SSA) adjusts this wage base annually.

A manufacturing firm or other business entity must make the election to use the research credit against payroll tax liability on an original return. Thus, the election can’t be claimed on amended returns. Because the election takes effect for credits generated in 2016, it is available to offset payroll taxes during the second quarter of 2017.

New IRS Guidance

The new Notice includes interim guidance with respect to the payroll tax election.

First, it clarifies that the definition of “gross receipts” used to qualify a business is determined under Section 448(c)(3) of the tax code without regard to Section 448(c)(3)(A) and its accompanying regulations. In essence, this means that there’s no exclusion of amounts representing returns or allowances, receipts from the sale or exchange of capital assets under Section 1221, repayments of loans or similar instruments, returns from a sale or exchange not in the ordinary course of business and certain other amounts.

Second, to make a payroll tax credit election, the IRS requires a qualified small business to attach a completed Form 6765 (Credit for Increasing Research Activities) to a timely return, including any extensions, for the appropriate tax years.

Third, the new Notice provides interim relief for qualified small businesses that filed returns for tax years after 2015 in a timely fashion, but failed to make the payroll tax credit election. In this case, the entity may make the election on an amended return filed on or before December 31, 2017. To accomplish this, the business must either:

Indicate on the top of its Form 6765 that the form is “FILED PURSUANT TO NOTICE 2017-23;” or
Attach a statement to this effect to the Form 6765.

A qualified small business can claim the payroll tax credit for the first calendar quarter beginning after it makes the election by filing the Form 6765. Similarly, if the small business files annual employment tax returns, it may claim the credit for the return including the first quarter beginning after the date on which the business files the election. The business is instructed to attach a completed Form 8974, providing the Employer Identification Number (EIN) shown on Form 6765, to the employment tax return.

When your small business files quarterly employment tax returns, use Form 8974 to apply the Social Security tax limit to the amount of the payroll tax credit elected in Form 6765 to determine the credit amount allowed on its quarterly return. If the payroll tax credit elected exceeds the employer share of the Social Security tax for that quarter, the excess determined on Form 8974 is carried over to the next quarter, subject to the applicable Social Security tax limit.

The new guidance, which is technical in nature, is probably best left to the tax professionals. What manufacturing firm owners and managers can take away is the realization that the research credit, which is valuable in its own right, can now be used to offset payroll tax liability for qualified small businesses. Factor this into your business decisions.

Simple Does It

In lieu of claiming the regular 20% research credit, your firm can rely on the alternative simplified credit (ASC).

Currently, the ASC is equal to 14% of the amount by which qualified expenses exceed 50% of the average for the three preceding tax years. The ASC, which first became available in 2007, replaced the alternative incremental research credit (AIRC).

Some manufacturing firms prefer the ASC to the regular credit. For instance, the ASC may be used instead of the regular credit if the firm has a high base amount for the regular calculation, doesn’t have detailed records to support qualified expenses during the base period years, has experienced significant growth in receipts in recent years or has a complex history of organizational activity (e.g., mergers, acquisitions and dispositions).

Reclassifying Business Expenses as Constructive Dividends

Posted on May 30, 2017July 22, 2024 by Debra Barcuch

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that’s helpful and appropriate for your business. No Deduction for Dividends

Beyond Personal Expenses

Constructive dividends can come in many shapes and sizes. The most common example is when a shareholder mistakenly tries to claim personal expenses — such as medical, vehicle or housing costs — as business expenses. Other types of related-party transactions that the IRS may reclassify as constructive dividends include:

An excessive payment for corporate use of a shareholder’s personal property, such as rental payments for the company’s office or warehouse space,
A purchase or lease by a shareholder of company property at a price that’s significantly below fair market value,
A purchase or lease by the company of a shareholder’s property at a price that far exceeds fair market value,
Excessive compensation paid to shareholders or their family members,
Use of company-owned vehicles and other company property by shareholders (or their family members) without paying fair market value, and
A corporate loan (often at a below-market interest rate) made to a shareholder to fund personal items, where there’s no reasonable expectation of repayment.

The IRS sometimes challenges deductions claimed for certain types of business expenses. In doing so, an examiner might claim that payments made by a corporation to a shareholder for personal items or that are above or below fair market value constitute “constructive dividends.” Reclassifying business expenses as dividends has adverse tax consequences, as a recent case demonstrates.

Typically, a successful corporation pays out dividends to its shareholders, based on earnings for the year. The exact amount of dividends a shareholder receives depends on his or her proportionate share in the company. These dividends are declared by the company on a specified date and then paid out in cash or reinvested in more shares for the shareholder.

However, a corporation may make other payments to one or more shareholders, which the IRS might classify as “constructive dividends.” This often happens when owners of a closely held business use corporate funds to pay personal expenses. But it can also occur at multibillion-dollar conglomerates, and it may involve more than just running personal expenses through the business. (See “Beyond Personal Expenses” at right.)

The crux of the matter is: Owning all (or part) of a company doesn’t give you the unrestricted right to pay and record expenses in the manner in which you see fit. Notably, there are tax rules and restrictions that must be followed.

Tax Consequences

From an income tax perspective, dividends paid out by corporations are taxable to shareholders at the personal level. Qualified dividends received by a C corporation shareholder are taxable at the same preferential tax rates as long-term capital gains. Currently, the maximum tax rate for qualified dividends is 15% (20% if you’re in the top ordinary income tax bracket).

On the downside, dividends can’t be deducted by the corporation. So, dividends are paid using after-tax dollars, meaning they’re effectively taxed twice.

Compensation and most other types of payment (such as consulting or management fees) are taxable to shareholders at ordinary income tax rates. However, these legitimate expenses are usually fully deductible by the company (unless they aren’t at arm’s length). As a result, depending on its circumstances, a corporation may try to disguise dividends as compensation or some other type of payment.

This is where the IRS could jump into the fray. If it treats a payment as a constructive dividend, the business deduction the corporation tried to claim for that payment (for example, a compensation deduction) is disallowed, thereby increasing its tax liability. Furthermore, the IRS may impose penalties and interest for tax underpayments. And, if the company’s owners purposely evaded their tax responsibilities, they may face criminal sanctions.

For the shareholders, constructive dividends are taxable as ordinary income. However, unlike compensation, a dividend payment isn’t subject to payroll taxes. Therefore, the overall tax results for shareholders will vary.

Case in Point

The IRS is likely to step in if it perceives that a company is paying personal expenses on behalf of shareholders. That was the main issue presented to the U.S. Tax Court in a recent case. (Luczaj & Associates v. Commissioner, T.C. Memo 2017-42, March 8, 2017)

The taxpayers, a married couple residing in California, owned a C corporation. The husband held 51% of the stock, and the wife owned 49%. The wife was the company’s sole employee during the tax years in question, while the husband worked full-time as a high school adult transition coordinator, supervising and teaching special needs students.

The corporation was engaged in the business of originating home mortgages, acting as an independent contractor for California Mortgage Group (CMG). Its main function was to solicit clients for CMG. After the company referred clients to CMG, those individuals were offered loans to help purchase homes.

The wife’s sole responsibility was client recruitment for CMG. She had a desk in CMG’s main office in California, where she worked at least two days a week. She testified at trial that she worked from home the rest of the week and typically met clients at home or in a public place.

For 2012 and 2013, the corporation claimed deductions for a wide variety of expenses, including travel and entertainment, insurance, telephone, advertising, gifts, medical expenses, utilities and maintenance, depreciation, and dues and subscriptions. Some of these expenses included repairs to the couple’s personal residences, swimming pool costs and personal entertainment expenditures.

The IRS contested most of the reported business expenses due to lack of substantiation or lack of business purpose. It argued that the payments constituted constructive dividends to the shareholders. Finally, the IRS imposed accuracy-related penalties for the tax years in question.

The Tax Court agreed with the IRS. The court determined that many of the expenses that were claimed as marketing and promotional expenses were actually payments of personal expenses that directly benefited the shareholders. For instance, the wife claimed 100% business use of two vehicles, but didn’t follow IRS procedures for documenting business use. The court also ruled that payments may be treated as constructive dividends without the corporation making a formal declaration of dividends.

The Bottom Line

It’s easy to run afoul of the IRS on this issue. So, businesses always should keep detailed, contemporaneous records to support deductions and other tax positions, especially when it comes to transactions with related parties.

The IRS generally won’t, for example, treat a payment as a constructive dividend if the company can demonstrate that it lacked sufficient earnings to pay dividends or that a payment was, in fact, used to pay ordinary and necessary business expenses, rather than personal expenses.

In some instances, expenses may fall into a “gray area” where you’re unsure of the appropriate tax treatment. If you have questions or concerns about your situation, ask your professional tax advisor for help.

Are Contingent Attorneys’ Fees Tax Deductible?

Posted on May 25, 2017 by Debra Barcuch

If you agree to a contingent-fee arrangement with your attorney, you may wonder whether the expense is deductible for federal income tax purposes. Unfortunately, the guidance on this controversial issue isn’t favorable to taxpayers in most situations.

Beyond Taxable Recoveries to Individuals

The main article focuses on contingent fees related to taxable judgments or settlements collected by individual claimants in cases that aren’t business-related. Here’s an overview of the rules that apply to contingent fees for other types of recoveries.

Nontaxable Awards

An injured party can’t deduct attorneys’ fees incurred to collect a tax-free judgment or settlement, including a court-awarded recovery for a physical injury or sickness. In other words, no deductions are allowed for fees to collect tax-free compensation.

Punitive Damages

As a general rule, payments for punitive damages — which are designed specifically to punish the wrongdoer — and payments of interest are taxable even if they’re paid as part of the compensation for physical injuries or sickness. Therefore, contingent attorneys’ fees allocable to the collection of punitive damages or interest will be treated as miscellaneous itemized deductions. (See main article.)

Business-Related Payments

In cases involving business-related judgments or settlements, taxpayers are allowed to deduct all ordinary and necessary expenses incurred in carrying on an active business. Legal expenses constitute such ordinary and necessary expenses when they arise from an active business venture.

However, fees to acquire a business asset, such as real estate or a patent, must be capitalized as part of the cost of acquiring the asset and then depreciated or amortized. Finally, legal expenses incurred in connection with the business of being an employee are treated as miscellaneous itemized deductions, which can be unfavorable for the taxpayer. (See main article.)

Non-Contingent Attorneys’ Fees

In general, attorneys’ fees that aren’t contingent on the outcome of a case are treated in the same fashion as contingent fees. For example, non-contingent fees paid to collect a taxable non-business judgment or settlement would be treated as miscellaneous itemized deductions unless the above-the-line exception applies. (See main article.) And non-contingent fees paid to collect a tax-free judgment or settlement wouldn’t be deductible.

The federal income tax treatment of contingent fees paid to an attorney out of a taxable non-business judgment or settlement has been a source of confusion. Here’s an overview of the outcome of litigation between individual taxpayers and the IRS, along with a taxpayer-friendly exception to the general rule.

History Lesson

Some court decisions have concluded that an individual claimant must:

Include 100% of the taxable portion of a legal judgment or settlement in gross income, and
Treat the related contingent attorneys’ fee as a miscellaneous itemized deduction.

Taxpayers don’t generally favor this treatment, because miscellaneous itemized deductions are subject to a 2%-of-adjusted-gross-income threshold under the regular federal income tax rules. Additional miscellaneous itemized deductions are completely disallowed under the alternative minimum tax (AMT) rules. So, the actual allowable write-off for contingent fees is significantly reduced or maybe even completely disallowed if the taxpayer is subject to AMT.

Instead, taxpayers favor other court decisions that exclude contingent fees from the claimant’s gross income, because the fees are considered “owned” by the attorney rather than the claimant. This reasoning is consistent with the fact that the claimant never takes possession of the cash; rather, contingent fees go straight to the attorney.

Supreme Court Decision

Which treatment is correct: treating the fees as a miscellaneous itemized deduction or excluding them from gross income? The Supreme Court addressed this question in 2005, ruling that an individual taxpayer must include in gross income the portion of a taxable judgment or settlement that goes to the taxpayer’s attorney under a contingent-fee arrangement. (Commissioner v. Banks, II, 95 AFTR 2d 2005-659, Supreme Court 2005)

The decision was based on the Supreme Court’s review of Banks (a Sixth Circuit Court of Appeals decision) and Banaitis (a Ninth Circuit Court of Appeal decision). In both of those decisions, the appellate courts had reversed the U.S. Tax Court, concluding that the taxpayers could exclude from gross income amounts paid to their attorneys under contingent-fee arrangements.

The Supreme Court disagreed with these reversals, however. The Court ruled that, even though the value of taxpayers’ legal claims are speculative at the time they enter into a contingent-fee arrangement with an attorney, that factor doesn’t cause the arrangement to be properly characterized for tax purposes as a partnership or joint venture between taxpayer and attorney.

The Court concluded that the attorney-client relationship is more properly characterized as a principal-agent relationship. As such, the taxpayer (the principal) must include the entire taxable amount earned from the legal action in gross income and then hope to be able to claim a deduction for contingent fees paid to the attorney (the agent).

In essence, the Supreme Court’s decision reaffirmed one of the oldest principles in federal income taxation: A taxpayer can’t assign taxable income to someone else, even though the attempt to do so may occur before the income is actually earned. Instead, taxpayers must include the income on their return when it’s earned, and then hope to be able to deduct amounts that go to other parties (such as contingent fees paid to attorneys).

Taxpayer-Friendly Exception

The Supreme Court’s decision seems to close the door on any argument that contingent attorneys’ fees paid out of a taxable non-business judgment or settlement can be excluded from a claimant’s gross income. But Congress provided an exception that basically amounts to the same thing for certain taxpayers.

Specifically, the Internal Revenue Code permits an above-the-line deduction for attorneys’ fees and court costs paid in legal actions involving:

Certain claims of unlawful discrimination,
Certain claims against the federal government, and
Private causes of action under the Medicare Secondary Payer statute.

Treating the expense as an above-the-line deduction means you don’t need to itemize deductions on your tax return to benefit. Under this treatment, contingent attorneys’ fees are effectively subtracted from taxable income on your return, so you don’t have to pay tax on money that went to your attorney. The Internal Revenue Code provides a list of legal actions that are defined to be for unlawful discrimination, including, but not limited to, claims of violations of:

The Civil Rights Acts of 1964 and 1991,
The Congressional Accountability Act of 1995,
The National Labor Relations Act,
The Family and Medical Leave Act of 1993,
The Fair Housing Act,
The Americans with Disabilities Act of 1990, and
Various whistleblower statutes.

Important note: Above-the-line deduction treatment for qualifying contingent legal fees and related costs effectively allows you to directly subtract these expenses from the amount of the judgment or settlement that you claim. So, you pay taxes on only the amount you keep.

For More Information

Determining the proper tax treatment of an individual’s attorneys’ fees can be tricky. Your tax advisor can figure out the right answer. Get your advisor involved early in litigation, because he or she might be able to help you achieve a more tax-favorable result by planning ahead.

Green Tax Breaks: Are You Claiming All the Credits You Deserve?

Posted on May 24, 2017July 23, 2024 by Debra Barcuch

In recent years, the IRS has offered “green” tax credits to individuals who purchase qualifying residential energy-efficient equipment and certain electric vehicles. Some of these breaks expired at the end of 2016. But others are still ripe for the taking in 2017 and beyond. Here’s what you need to know to take advantage.

Expanded Green Tax Breaks for 2016

For 2016, individual taxpayers could claim a 30% federal tax credit for the following expenditures for a U.S. residence, including a vacation home:

Qualified solar electricity generating equipment,
Qualified solar heating equipment,
Qualified wind energy equipment,
Qualified geothermal heat pump equipment, and
Qualified fuel cell electricity generating equipment. (The maximum credit is limited to $500 for each half-kilowatt of fuel cell capacity.)

For 2017, only the first two items are still eligible for the 30% credit.

Additionally, a more modest residential energy credit also expired at the end of 2016. It had a lifetime maximum of $500 and covered qualified expenditures for:

Advanced main air circulating fans,
Natural gas, propane, and oil furnaces and hot water boilers,
Electric heat pumps,
Electric heat pump water heaters,
Biomass fuel stoves,
High-efficiency central air conditioners,
Natural gas, propane and oil water heaters,
Energy-efficient windows, skylights and doors,
Energy-efficient roofing products, and
Energy-efficient insulation.

You can claim these now-expired credits on your 2016 federal tax return if you completed installation of the qualified equipment last year. If you already filed your 2016 return without claiming your rightful credits, your tax pro can help you file an amended return to collect the tax savings.

Residential Solar Energy Credit

You can claim a federal income tax credit equal to 30% of expenditures to buy and install qualifying energy-saving solar equipment for your home. Because this gear is expensive, it can generate big credits. And there are no income limits — even billionaires are eligible for this tax break. The 30% credit is available through 2019. In 2020, the credit rate drops to 26% and then to 22% in 2021. After that, the credit is scheduled to expire.

The credit can be used to reduce both your regular federal income tax bill and your alternative minimum tax (AMT) bill, if applicable.

The credit equals 30% of qualified expenditures (including costs for site preparation, assembly, installation, piping and wiring) for the following:

Qualified solar electricity generating equipment. This must be installed in a U.S. residence, including your vacation home. You must use the residence personally; so, the credit can’t be claimed for a property that is used exclusively as a rental.

Qualified solar water heating equipment. This also must be installed in a U.S. residence, including your vacation home. To qualify for the credit, at least half of the energy used to heat water for the property must be generated by the solar equipment. The credit can’t be claimed for a property that is used only as a rental. Also, you can’t claim the credit for equipment used to heat a swimming pool or hot tub. No credit is allowed unless the equipment is certified for performance by the nonprofit Solar Rating & Certification Corporation or a comparable entity endorsed by the state where your residence is located. Keep the certification with your tax records.

You can only claim the credit for expenditures on a “home,” which can include a house, condo, co-op apartment, houseboat, or mobile home, or a manufactured home that conforms to federal manufactured home construction and safety standards.

Keep track of how much you spend, including any extra amounts for site preparation, assembly, and installation. Also record when the installation is completed, because you can claim the credit only in the year when the installation is complete. In addition, ask your tax advisor whether you’re eligible for state and local tax benefits, subsidized state and local financing deals, and utility company rebates.

Credit for New Plug-In Electric Vehicles

Another green tax break that’s still available for 2017 and beyond is the federal income tax credit for qualifying new plug-in electric vehicles. The credit can be worth up to $7,500.

To be eligible for the credit, a vehicle must:

Be new (not used or rebuilt),
Draw propulsion from a battery with at least four kilowatt hours of capacity,
Use an external source of energy to recharge the battery (thus the term “plug-in”),
Be used primarily on public streets, roads, and highways,
Have four wheels,
Meet applicable federal emission and clean air standards, and
Be used primarily in the United States.

It can be either fully electric or a plug-in electric/gasoline hybrid. Finally, the vehicle must be purchased rather than leased. If you lease an eligible vehicle, the credit belongs to the manufacturer, and that may be factored into a lower lease payment.

The credit equals $2,500 for a vehicle powered by a four-kilowatt-hour battery, with an additional $417 for each additional kilowatt hour of battery capacity. The maximum credit is $7,500. Buyers of qualifying vehicles can rely on the certification of the allowable credit amount provided by the manufacturer or distributor.

The credit begins phasing out over four calendar quarters once the total number of qualifying vehicles sold by a particular manufacturer for use in the United States reaches 200,000. So far, no manufacturers have crossed that line, although General Motors might reach this threshold in 2018 or 2019 if sales of the Chevy Bolt and Volt continue at their current pace.

The credit can be used to offset your regular federal income tax and any alternative minimum tax (AMT) liability. And there are no income restrictions.

Not all eligible vehicles qualify for the maximum $7,500 credit. Some plug-in electric/gas hybrids are eligible only for lower amounts. According to Edmunds.com, the current list of eligible vehicles and credit amounts is as follows:

Fully Electric Vehicles

Make and Model	Credit
BMW i3	$7,500
Chevrolet Bolt	$7,500
Fiat 500e	$7,500
Ford Focus Electric	$7,500
Hyundai Ioniq Electric	$7,500
Kia Soul EV	$7,500
Mercedes-Benz B-Class EV	$7,500
Nissan Leaf	$7,500
Tesla Model S	$7,500
Tesla Model X	$7,500

Plug-In Electric/Gas Hybrids

Make and Model	Credit
Audi A3 e-tron	$4,205
BMW i3 (with range extender)	$7,500
BMW i8	$3,793
Chevrolet Volt	$7,500
Chrysler Pacifica	$7,500
Ford C-Max Energi	$4,007
Ford Fusion Energi	$4,007
Hyundai Sonata Plug-In Hybrid	$4,919
Kia Optima Plug-In	$4,919
Toyota Prius Prime	$4,502
Volvo XC90 T8	$4,585

In addition, residents of some states may be eligible for state income tax credits, rebates, or reduced vehicle taxes and registration fees for buying or leasing electric vehicles.

Need Help?

These green tax breaks are available for a limited time only. Contact your tax advisor for help claiming and maintaining adequate records to support these eco-friendly purchases.

Wedding Bells and Taxes: Tax Issues to Consider Before Tying the Knot

Posted on May 22, 2017 by Debra Barcuch

Summer — the traditional wedding season — is just around the corner. Marriage changes life in many ways. Here’s how it may affect your tax situation.

Marital Status

Your marital status at year end determines your tax filing options for the entire year. If you’re married on December 31, you’ll have two federal income tax filing choices for 2017:

File jointly with your spouse, or
Opt for “married filing separate” status and then file separate returns based on your income and your deductions and credits.

Here are two reasons most married couples file jointly:

1. It’s simpler. You only have to file one Form 1040, and you don’t have to worry about figuring out which income, deduction and tax credit items belong to each spouse.

2. It’s often cheaper. The married filing separate status makes you ineligible for some potentially valuable federal income tax breaks, such as the child care credit and certain higher education credits. Therefore, filing two separate returns may result in a bigger combined tax bill than filing one joint return.

Risks of Filing Jointly

Filing jointly isn’t a sure-win for one big reason: For years that you file joint federal income tax returns, you’re generally “jointly and severally liable” for any underpayments, interest and penalties caused by your spouse’s deliberate misdeeds or unintentional errors and omissions.

Joint-and-several liability means the IRS can come after you for the entire bill if collecting from your spouse proves to be difficult or impossible. They can even come after you after you’ve divorced.

However, you can try to claim an exemption from the joint-and-several-liability rule under the so-called “innocent spouse” provisions. To successfully qualify as an innocent spouse, you must prove that you:

Didn’t know about your spouse’s tax failings,
Had no reason to know, and
Didn’t personally benefit.

If you file separately, you’re certain to have no liability for your spouse’s tax misdeeds or errors. So, if you have doubts about a new spouse’s financial ethics, the best policy may be to file separately.

Penalty vs. Bonus

You’ve probably heard about the federal income tax “penalty” that happens when a married joint-filing couple owes more federal income tax than if they had remained single. The reason? At higher income levels, the tax rate brackets for joint filers aren’t twice as wide as the rate brackets for singles.

For example, the 28% rate bracket for singles starts at $91,901 of taxable income for 2017. For married joint-filing couples, the 28% bracket starts at $153,101. If you and your spouse each have $90,000 of taxable income in 2017, for a total of $180,000, you’ll pay a marriage penalty of $807. That’s because $26,900 of your combined taxable income will fall into the 28% rate bracket ($180,000 – $153,100). If you stay single, none of your income will be taxed at more than 25%. The marriage penalty is usually a relatively modest amount; so, it’s probably not a deal-breaker.

On the other hand, many married couples collect a federal income tax “bonus” from being married. If one spouse earns all or most of the income, it’s likely that filing jointly will reduce your combined tax bill. For a high-income couple, the marriage bonus can amount to several thousand dollars a year.

Important note: The preceding explanation of the marriage penalty and bonus assumes that the current federal income tax rates will remain in place for 2017. However, rates and rate brackets could change depending on tax reforms that may be proposed and enacted before year end. Ask your tax advisor for the latest details on federal tax reform efforts.

Home Sales

When people get married, they often need to combine two separate households before or after the big day. If you and your fiancé both own homes that have appreciated substantially in value, you may owe capital gains tax.

However, there’s a $250,000 gain exclusion for single taxpayers who sell real property that was their principle residence for at least two years during the five-year period ending on the sale date. The gain exclusion increases to $500,000 for married taxpayers who file jointly.

Suppose you and your fiancé both own homes. You could both sell your respective homes before or after you get married. Assuming you’ve both lived in your respective homes for two of the last five years, then you could both potentially claim the $250,000 gain exclusion. That’s a combined federal-income-tax-free profit of up to $500,000.

Conversely, let’s say you sell your home and move into your spouse’s home. After you’ve both used that home as your principal residence for at least two years, you could sell it and claim the larger $500,000 joint-filer gain exclusion.

In other words, you could potentially exclude up to $250,000 of gain on the sale of your home. Then you could later claim a gain exclusion of up to $500,000 on the sale of the house that your spouse originally owned. With a little patience and some smart tax planning, you could potentially exclude a combined total gain of $750,000 on your home sales.

Got Questions?

Getting hitched may open up new tax risks — and some new tax planning opportunities. It pays to be well-informed. Contact your Cornwell Jackson tax advisor for guidance on how getting married could change your tax situation in 2017.

Give Employees a Running Start with a Strong Onboarding Program

Posted on May 22, 2017 by Debra Barcuch

Your new hire may be thrilled to have secured a job with your company. But most likely, he or she will still be nervous at the outset. More than that, the first few weeks on the job is a time of vulnerability, presenting hazards both for the new employee and for your organization.

Research in a report by the Society for Human Resource Management (SHRM) underscores just how big the danger is. That is, half of hourly workers leave new jobs within about four months, and half of senior outside hires fail within 18 months. But employers that implement step-by-step programs orienting employees toward their new roles and organizational norms are more effective than those that don’t.

The 4 “Cs”

What are the ingredients of an effective onboarding program? Here are four dimensions:

Compliance. Acquaint new employees with basic employer policies, including legal requirements.
Clarification. Make sure new employees know what’s expected of them.
Culture. Give employees a sense of formal and informal organizational norms.
Connection. Facilitate the development of relationships that employees need to feel comfortable and know where to get answers.

When you’ve got these dimensions covered, the results will generally be lower turnover and higher job satisfaction (which tend to go hand-in-hand), better performance, reduced employee stress and effective career management.

Be Prepared

The most effective onboarding programs are obviously customized to the specific employer’s organization. For example, the Massachusetts Institute of Technology (MIT) gives its managers detailed onboarding checklists. The checklists identify anticipated outcomes for each of several phases of the process.

One key to success at MIT is getting started before a new employee arrives. The goal — and outcome, if successful — is that the new employee finds a “welcoming work environment with informed colleagues and a fully equipped work space,” according to the school’s website.

MIT emphasizes that new employees should feel as settled in as possible the day they start. That requires making sure the new employee’s workstation is well-equipped and functional (with computers and phones hooked up). In addition, incumbent employees should be prepared to greet new hires and begin establishing working relationships with them. MIT also endorses linking up new hires with a “buddy” to smooth their transition.

On the first day, in addition to having all of the above set to go, MIT managers are expected to:

Outline the employee’s schedule for the first week,
Describe the purpose and goals, and place these in the organizational structure of the new hire’s department, along with his or her role within the department, and
Review the job description, duties and expectations, as well as basic work policies, and employee benefits.

In theory, there should be no surprises at this point (assuming the job was described accurately during the hiring process). Other routine HR paperwork tasks, such as completing I-9 forms, will also need to occur, though they aren’t technically part of an onboarding program.

Over the course of the first week, if not on the first day, the new employee should have an initial assignment in hand. He or she also should be informed about the performance review and goal-setting process, as well as the probationary employment period.

Debriefing Sessions and More

During this early period, an effective onboarding program will include debriefing sessions after the new hire has attended meetings. The purpose is to ensure appropriate takeaways have been absorbed. This also is a good time to check that the new employee has signed up for or completed any training that may be helpful or is required.

After the employee has had a month on the job, you should seek feedback on how the work is going, and how well-acclimated the new employee feels to the organization. Inevitably there will be some questions, but even if very few arise, you’re communicating your willingness to answer questions in the future.

It’s also important to discreetly assess whether a new employee is fitting in socially and building relationships with coworkers. The MIT checklist suggests managers continue introducing the new hire to key people and ensure he or she is invited to relevant events.

By the time the six-month milestone arrives, if the onboarding process has done its job, says MIT, the new employee should have “gained momentum in producing deliverables, begun to take the lead on some initiatives,” and have a degree of confidence and a feeling of engagement in his or her new role.

A performance review should be conducted at that point, which can mark the end of the formal onboarding process. However, if the review identifies performance shortfalls, it’s important to identify whether the problem is in the onboarding process or elsewhere. Either way, the indicated issues should be addressed promptly.

Obviously, problems with a job can arise at any point. But as the saying goes, “well begun is half done.” A strong start gives an employee a running chance for success in a new position and a chance to make a real contribution to your company.

Seven Considerations as You Plan for the Trump Tax Plan

Posted on May 18, 2017July 23, 2024 by Debra Barcuch

Text Tax Reforms appearing behind ripped brown paper.

This is not a political article. It is more about pondering the possibilities for manufacturers who are waiting to see how a new federal tax plan may change how they structure their businesses. With tax reform on the legislative horizon, we looked at a handful of potential changes under discussion to provide some context for tax planning later this year.

Seven Considerations as You Plan for the Plan

You have your Trump tax plan and you have your Republican “A Better Way” blueprint for America plan. I’m not stepping into the role of telling you which plan is better. That’s why we elect political representatives and choose which media to follow. I’m going to attempt, given the current legislative updates, to highlight the areas of most importance to manufacturers and distributors. We expect that some version of tax reform will occur in 2017. In the meantime, use this as a guide to anticipate a change in business structure or other tax planning decisions.

We will address the following areas:

Capital expenditures
Interest expense deduction
Tax rates by business structure
Cross-border provisions
Employer mandates for health care coverage
Export income exclusion
Carried interest

100% First-Year, Write-offs of Capital Expenditures

The Republican tax plan aligns with the Trump plan on allowing companies to write off all spending on new capital investments, from equipment to computers. The idea is to boost spending on productivity-enhancing outlays, according to an article in Bloomberg. In theory, it sounds better to write off all your capital expenses in one year rather than over time, as the current tax code allows.That being said, it may be a non-event for many mature companies with minimal annual capital expenditures, as we currently enjoy a potential $500,000 annual full expensing election under Section 179 and there is also additional bonus depreciation available under the current law.

So this proposed change will particularly benefit companies with significant capital spending plans or the expansion into a new production line or lines that may have been postponed.

It was interesting to note in the Bloomberg article that companies with large capital outlays may be viewed as more progressive or “newer,” and therefore more attractive to future investors. Regardless, companies so far don’t seem to be rushing out to buy new equipment in anticipation of 100 percent, first-year write-offs.

Conclusion: Stick to your budgets and plan your capital expenditures as if it’s still 2016. Don’t place reliance on this additional tax benefit if you exceed these limits, but consider it a potential “bonus” if the law falls in your favor.

Loss of Interest Expense Deduction

In addition to potentially boosting the cost of PE deals and making asset deals more attractive, the loss of the interest expense deduction is designed to make debt financing less attractive for businesses and individuals.

Under the current tax code, interest expense on debt financing — from home mortgages, business loans, stock purchases — is deductible. It’s deductible for private equity firms that use investor cash and third-party leverage to finance the purchase of stock. With the exception of the mortgage interest deduction on your primary home, the Trump and Republican tax plans both propose to eliminate the interest expense deduction to offset the loss of tax revenue from the proposed 100 percent capital expense depreciation.

Companies that purchase physical assets will be better off expensing capital purchases than relying on interest expense deductions. However, companies that are heavily leveraged and PE firms potentially end up paying more tax.

Conclusion: Make a plan to pay off or refinance any high interest debt in 2017 and actively try to lock in any low interest debt for long term installment loans.

Change Business Structure or Not?

Both the Trump and Republican tax plans propose a large federal corporate/business tax rate reduction, putting the new rate at 15 or 20 percent. It was a key campaign promise, and comments made by President Trump in March regarding a tax reform package emphasized that he wants to lower the overall tax burden on businesses. Followers expect that release of details is still months away.

It’s unclear so far whether manufacturers should consider a business structure change. One proposal talks about a lower tax rate for all businesses, while another noted that only C Corps would get the tax rate reduction to bring them in line with the tax structure of S Corps.

Conclusion: Watch for more details on the proposed tax rate reductions this summer. If your business is structured as an S Corp, there may (or may not) be a reason to discuss a structure change.

Zero Deduction for Cost of Imported Materials

One area that hasn’t been talked about much in the media, but will need more attention, is the cross-border provision for imported materials. Currently, manufacturers that use imported materials in their products can deduct the cost of those materials. A new proposal would eliminate the deduction on imported materials and only allow a deduction on U.S. sourced materials.

With a dramatic increase in the cost of materials to produce products, any lowering of the corporate tax rate will offer far less benefit for these manufacturers. It will also hit distributors of imported foreign materials hard.

With this proposal, I anticipate reporting complexity for manufacturers that have some products with imported materials and others with no imported materials. Also, if a product is partially assembled in a foreign country, is the cost of labor still deductible while the materials cost is excluded? Enterprise systems would have to be reconfigured to account for proper tracking.

If passed, this increased cost will likely be passed on to retailers and consumers — adding to inflationary concerns.

Conclusion: Consider to what extent — if any — your company currently imports materials or partially assembled products. The jury is out on what form cross-border protections will take and may include a phased-in approach to offset huge tax burdens on U.S. importers.

Elimination of the Employer Mandate

Although not completely related to tax reform, something that President Trump and Republicans both agree on is elimination of the employer mandate to provide health care benefits. Because a healthcare reform plan is still a work in progress , we still have the employer mandate.

Conclusion: Although we will all be pleased with the reduction in the exhaustive paperwork and reporting requirements of Obamacare, provide health care benefits anyway. It’s a baseline competitive feature for recruitment and retention of your most talented.

Planned Income Exclusion for domestically produced exported goods may eliminate need for IC-DISC structure

One of the cross-border tax proposals is that U.S. manufacturers that are exporting goods will get a 100 percent exclusion of these export revenues from U.S. tax. There are significant practical issues and questions surrounding this broad brush proposal, not limited to what is defined as U.S. manufacturing. Does use of domestic distribution that does both export and domestic distribution qualify for this exclusion, will certain countries be excluded, will certain maquiladora arrangements be grandfathered or phased in over time?

Export tax minimization has been historically achieved through the IC-DISC (Interest Charge-Domestic International Sales Corporation). This helpful and sometimes misunderstood tax break for manufacturers and some professionals will be mostly obsolete if a tax reform bill excludes tax 100 percent on U.S.-based exports.

Set up as a separate entity, the IC-DISC is available to small and mid-sized manufacturers that export goods, but it may also apply to professionals like engineering or architectural firms that work on a project that will be built overseas. Manufacturers of parts of products that are exported may also be eligible. IC-DISC allows a reduction on 50 percent of export income by more than 50 percent. Profits are taxed at the lower dividend rate (15%) as opposed to ordinary income tax rates (34%+).

The elimination of taxes on exports may provide a boon to U.S. manufacturers, but it is widely anticipated that other countries may combat the U.S. shift in tax law with additional tariffs or import fees – that may eliminate or at least dampen the ability of manufacturers to use this tax advantage to help compete in overseas markets.

Conclusion: Investigate the IC-DISC if you think your company’s export activities are sufficient to set up this structure, and use this as a back-up position in the event the “as defined” export exclusion becomes a more narrowly defined opportunity for utilizing this tax advantage. That being said, do the up front due diligence and cost benefit modeling – but delay any structure set-up action until later this summer.

Eliminating the Carried Interest in Private Equity Structures

I don’t know how many times President Trump talked about eliminating “the carried interest loop-hole” during his campaign, but I’m sure someone tracked it in a video montage. Carried interest is defined by IRS regulation rather than statute, so the President could move forward without the assistance of Congress. The Republican tax proposal doesn’t mention this tax break.

Elimination of carried interest would result in equity investors paying more for distributions coming out of portfolio companies, which doesn’t impact owner-operator companies insofar as their tax rates, but it could add to concerns over inflation as investors seek to make up the losses through improved corporate performance.

Conclusion: If you have private equity investors as shareholders or they are a significant part of your overall exit plan, make sure you have a clear understanding of the changing tax metrics to this investor class, as there may be a required change(increase) to tax distributions from the Operating Company to address these metrics. Overall, it could cause some revision or amendment to various waterfall calculations and preferred return calculations to address the economic impact to this shareholder group.

While we’re waiting to see which elements of which tax reform proposal come out on top, consider the results of your previous tax year. If there are areas that didn’t pan out as you hoped, the Tax Group at Cornwell Jackson is available to review your returns and identify any opportunities that make sense — for 2017 at least.

Gary Jackson, CPA, is the lead tax partner at Cornwell Jackson. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience in both managing Cornwell Jackson and in providing tax planning to individuals and business leaders across North Texas. Contact him at gary.jackson@cornwelljackson.com.

10 Simple (and Fun) Ways to Cut Taxes This Summer

Posted on May 17, 2017 by Debra Barcuch

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.

Capital vs. Ordinary: Classifying Income and Losses Affects Your Taxes

Posted on May 15, 2017July 22, 2024 by Debra Barcuch

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:

The nature of the acquisition of the property,
The frequency and continuity of property sales by the taxpayer,
The nature and extent of the taxpayer’s business,
Sales activities of the taxpayer with respect to the property, and
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.

EEOC and Some Courts Expand Sex Discrimination Definition

Posted on May 8, 2017 by Debra Barcuch

Last year, the Equal Employment Opportunity Commission (EEOC) filed its first two cases in federal court charging employers with failing to protect employees from discrimination and harassment based on their homosexuality. The federal agency has already received more than a thousand complaints of this nature, but only recently has the agency taken employers to court. Other cases have been settled, or simply not pursued.

Although the EEOC’s position can be overruled by federal courts, several trial courts have accepted the proposition that “sexual orientation discrimination is, by its very nature, discrimination because of sex.”

And recently, the U.S. Court of Appeals for the Seventh Circuit (which covers Wisconsin, Illinois and Indiana) upheld that view. It did so in an 8 to 3 “en banc” ruling — all of the court’s judges weighed in — after a smaller three-judge panel had taken the opposite point of view.

Whether or not discrimination had occurred wasn’t in question, but merely whether it was illegal.

Key Ruling

In the en banc decision, the court noted that while the U.S. Supreme Court has not yet explicitly ruled on this question, it has “over the years issued several opinions that are relevant to the issue,” including its 2015 decision to prevent states from banning gay marriage. The Supreme Court has also upheld rulings prohibiting discrimination against people on the basis of their failure to conform to gender stereotypes.

“It creates a paradoxical legal landscape in which a person can be married on Saturday and then fired on Monday for just that act,” the appeals court observed.

The Seventh Circuit case involved a part-time professor at a community college who had been with the school for 14 years in that capacity, and never had a negative review. Although she was qualified for several full-time positions that were open, she was consistently turned down, without even being granted an interview. She attributed the college’s refusal to hire her for any of the full-time positions to discrimination based on her sexual orientation.

Note: An executive order signed by President Clinton in 1998 expanded the scope of an earlier anti-discrimination executive order. That order prohibited companies that work under federal contracts from employment discrimination based on sexual orientation. President Obama broadened it again in 2014 to include gender identity.

Two Federal Court Cases

In 2016, when the EEOC announced its first two sexual orientation discrimination federal court cases, it described them as follows:

In one, the supervisor of a gay male employee “repeatedly referred to him using various anti-gay epithets and made other highly offensive comments.” When the employee complained to a more senior manager, he was told that the supervisor “was just doing his job” and failed to take any steps to stop the harassment. The employee resigned. The employer filed a motion to dismiss the EEOC case but the U.S. District Court denied it and agreed with the EEOC that sexual orientation discrimination is a type of sex discrimination.

In the other case, involving similar harassment of a gay female employee, the employee was terminated in what the EEOC alleged was retaliation after she had complained about the harassment and called an employee hotline. That case was settled after the employer agreed to pay $202,200 and provide significant equitable relief.

EEOC Stance

Even before President Obama signed the executive order which banned gender identity discrimination by federal contractors, the EEOC was pursuing such cases. For example, it supported the discrimination case of a transgender federal employee in 2012. On its website, the EEOC lists examples of discrimination allegations it has received that it considers unlawful.

Here are four involving gender identity:

Failing to hire an applicant because she’s a transgender woman;
Firing an employee because he’s planning or has made a gender transition;
Denying an employee equal access to a common restroom corresponding to the employee’s gender identity; and
Harassing an employee because of a gender transition. For example, by intentionally and persistently failing to use the name and gender pronoun that corresponds to the gender identity with which the employee identifies, and that the employee has communicated to management and employees.

For many employers, it might not even matter how the EEOC could respond to an employee’s allegation of gender identity or sexual orientation discrimination. That’s because about 22 states have their own sexual orientation anti-discrimination laws on the books.

Practical Pointers

Meanwhile, here are four employment practices to consider in light of the evolving legal landscape:

- If you already conduct — or plan to conduct — anti-discrimination and anti-harassment training, don’t neglect to include sexual orientation and gender identity as examples of discrimination or harassment categories.

- Be aware that the Occupational Safety and Health Administration (OSHA) has published a “Guide to Restroom Access for Transgender Workers.” This guide states that “all employees, including transgender employees, should have access to restrooms that correspond to their gender identity.”

- Be cautious about imposing gender-based dress codes that could impact transgender employees, especially when the nature of the job makes such a dress code essential. In a case like this, it’s generally a good idea to apply the dress code of the gender that a transgender employee is transitioning to, for that employee, even before the transition is complete.

Along similar lines, use names and pronouns for transgender employees suitable for the gender they’re transitioning to.

Obviously these employment issues are complex and the legal sands are shifting. It’s prudent, therefore, to consult with a labor attorney with expertise in these issues when formulating policies or taking actions involving lesbian, gay, bisexual and transgender employees and job applicants.

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Debriefing Sessions and More

Seven Considerations as You Plan for the Plan

100% First-Year, Write-offs of Capital Expenditures

Loss of Interest Expense Deduction

Change Business Structure or Not?

Zero Deduction for Cost of Imported Materials

Elimination of the Employer Mandate

Planned Income Exclusion for domestically produced exported goods may eliminate need for IC-DISC structure

Eliminating the Carried Interest in Private Equity Structures

1. Entertain top business clients.

2. Throw a company picnic.

3. Donate household items to charity.

4. Send the kids to day camp.

5. Buy an RV or boat.

6. Minimize vacation home use.

7. Rent out your primary residence.

8. Take advantage of business travel.

9. Support a recent graduate.

10. “Go fishing” for deductions.

More Tips Available

Beyond Real Property

1. Tax rates on gains.

2. Deductibility of losses.

Five-Factor Test for Classifying Real Property

The Evans Case

The Long Case

Need Help?

Key Ruling

Two Federal Court Cases

EEOC Stance

Practical Pointers

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