Wednesday, February 13, 2013

Budget Deal Lets More Savers Convert To Roth 401(k)s

U.S. workers willing to take tax pain today in exchange for tax-free gains on earnings in their 401(k) retirement accounts later have a new avenue to do so.

The budget legislation passed by Congress Jan. 1 lets 401(k) participants convert any money in their tax-deferred accounts to a so-called Roth 401(k) account, if their employer offers one, which can be withdrawn tax-free in retirement. The change is projected to raise $12.2 billion in revenue over 10 years, according to the Joint Committee on Taxation, and help defray the cost of delaying spending cuts that had been set to take effect this month.

“This dramatically expands the number of participants who can use this provision,” said Bob Holcomb, executive director of legislative and regulatory affairs for JPMorgan Chase & Co.’s retirement plan services. “It will allow any amount to be transferred.”

The conversion opportunity can benefit people with significant balances, the up-front money to pay taxes now with funds outside their retirement account and years of tax-free earnings ahead of them or their heirs. Conversions to Roth 401(k)s had been limited to certain funds and to plans that allowed the switches. The law opens the opportunity to more workers who hold $5 trillion in employer-sponsored defined contribution plans including 401(k)s.

Deferring Taxes

Contributions to a traditional 401(k) account are tax- deferred, with taxes paid at ordinary income rates when the money is withdrawn in retirement. When savers put money into a Roth 401(k) account, they pay taxes on the money upfront in exchange for tax-free withdrawals later.

The new conversion opportunity may help wealthy investors who want to leave their retirement accounts to heirs and younger savers, said John Olivieri, a partner in the private clients group at New York-based law firm White & Case LLP.

“This is really a huge benefit to heirs,” Olivieri said. “Basically you can pay tax now for your kids.”
Younger investors may wish to convert a portion or all of their account if it’s a small part of their net worth because they have more time to make back the money they lose in paying the tax upfront, Olivieri said.

Fund Transfers

A provision in a 2010 law allowed some 401(k) participants to convert part of the money in their plan to a Roth 401(k) account, with restrictions: Their employer had to offer a Roth 401(k) and allow conversions. Funds transferred were limited to money eligible for distribution, such as that held by savers age 59½ and older, and some employer contributions, said Alison Borland, vice president of retirement solutions and strategies at Lincolnshire, Illinois-based Aon Hewitt. It is a unit of Aon Plc that administers 401(k) plans for about 5 million workers.

“Now they are saying you can convert any money,” said Ed Ferrigno, vice president of Washington affairs for the Plan Sponsor Council of America. The Chicago-based group represents about 1,000 employers that sponsor plans and lobbied for the 2010 law change as another way for participants to diversify their savings, Ferrigno said. The budget legislation may encourage more employers to offer Roth 401(k) accounts, even as questions remain about the logistics, he said.

Plan Guidance

“This isn’t going to happen overnight,” he said. “Treasury is going to have to issue guidance. Plans are going to have to make amendments.”

Americans held $5 trillion in defined contribution plans as of Sept. 30, including $3.5 trillion in 401(k)s, according to the Washington-based Investment Company Institute.

About 12 percent of plan sponsors offer and allow conversions to Roth 401(k) accounts and the majority of them don’t charge a fee for it, Borland said. Participants should ask whether there’s a cost for such a transaction, she said.

A taxpayer in the top income bracket with a 401(k) worth $1 million may pay 39.6 percent, or $396,000, in federal taxes this year when converting the entire account into a Roth 401(k). The legislation allows all or a portion of funds in an account to be converted to a Roth within the same plan, Olivieri said. Once the taxes are paid upfront, all of the additional earnings and appreciation in the account are tax-free, he said.

Congress has turned to Roth accounts before as a revenue raiser.

The government lifted income restrictions on converting an individual retirement account, or IRA, under a provision of a 2006 law that took effect in 2010. That’s when U.S. taxpayers making more than $100,000 a year in adjusted income could start making the transfers. There’s no limit on conversions if an investor has multiple IRAs, nor a cap on the amount that can be shifted.

PMA Profiles - Zare Tokatlian

Over the past 15 years, when client's have called PMA, chances are that they have spoken with Zare Tokatlian, EA - this month's focus for PMA Profiles.

Zare was born in Erevan, Aremia (when it was still part of the Soviet Union) and immigrated to the United States at the age of 14.  He graduated from Hollywood High School, of all places, where he excelled in Tennis and Soccer, sports which he still follows passionately today. However, his true passion lies in music.

Before becoming an accountant, Zare lived the life we all wanted at one time or another - he was a lead guitarist for his band, Shirak. Shirak, with music inspired by the Beatles, toured the Eastern seaboard playing to packed houses. But alas, Zare realized that his future was waiting for him, back in Los Angeles. The band eventually broke up, but he can still bring it if he picks up his electric guitar.

Zare's favorite food is Shishkabob and enjoys cooking for his entire family, especially when its special occasions like birthdays, the holidays, or graduations. And just as he enjoys cooking, he loves spending time with his wife and two wonderful children. As a family, the have traveled to Sevastopol, Mexico and several other exotic places.

When asked if he can be an instant expert in anything, he replied, "I would love to be an expert in figuring out how Congress thinks when it comes to the tax code"! ... Wouldn't we all!

Zare received his Enrolled Agent designation in 2010 and has been an integral part of PMA's growth through the years.

Next time when you call the Diamond Bar offices of PMA, and Zare happens to answer the phone, say hello to him and ask him about his tennis game! And if you are a tennis player as well, he may take you up on a friendly match!

Tuesday, January 8, 2013

What's New on the 2012 1040

There is not much new for the 2012 federal income tax return - other than the annual indexing for inflation.
Single (and married filing separate) = $5,950
Married filing joint = $11,900
Head of household = $8,700
Dependent = the greater of earned income plus $300 or $950, not to exceed $5,950.
The additional standard deduction amounts for taxpayers age 65 and older or blind are:
Single or head of household = $1,450
Married (joint or separate) = $1,150
The 2012 Form 1040 and 1040A are the same as their 2011 counterparts. Certain lines are marked "reserved," though. Lines 23 and 34 on the 2012 Form 1040, and Lines 16 and 18 on the 1040A, are "reserved" for the deductions for educator expenses and tuition and fees, respectively. Similarly, item b of Line 5 under "Taxes You Paid" on the 2012 Schedule A is "Reserved" for the option to deduct state and local sales taxes instead of state and local income taxes.
These deductions expired  +Dec. 31 but were extended as part of last-minute compromise tax legislation after the IRS "went to press" with 2012 forms.

Thankfully the tax compromise bill also permanently extended the Alternative Minimum Tax "patch" retroactive to 2012. Even so, because Congress waited until literally the very last minute to pass the extensions, the processing of 2012 income tax returns and the issuance of tax refunds will be delayed.

Wednesday, January 2, 2013

Tax Changes Included in Congress' Fiscal Cliff Legislation

Here is a summary of the provisions included in the bill, which the President is expected to sign.

Tax rates beginning January 1, 2013 - A top rate of 39.6% (up from 35%) will be imposed on individuals making more than $400,000 a year, $425,000 for head of household, and $450,000 for married filing joint.

2% Social Security reduction gone

AMT permanently patched - A permanent AMT patch, adjusted for inflation, will be made retroactive to 2012.

Dividends and capital gains - The maximum capital gains tax will rise from 15% to 20% for individuals taxed at the 39.6% rates (those making $400,000, $425,000, or $450,000 depending on filing status, as noted above).

Itemized deduction and personal exemption phase-outs - The itemized deduction phase-out is reinstated, and personal exemption phase-out will be reinstated, but with different AGI starting thresholds (adjusted for inflation): $300,000 for married filing joint, $275,000 for head of household, and $250,000 for single.

Estate tax - The estate tax regime will continue to provide an inflation-adjusted $5 million exemption (effectively $10 million for married couples) but will be applied at a higher 40% rate (up from 35% in 2012).

Personal tax credits - The $1,000 Child Tax Credit, the enhanced Earned Income Tax Credit, and the enhanced American Opportunity Tax Credit will all be extended through 2017.

Other personal deductions and exclusions 

The following deductions and exclusions are extended through 2013:
  • Discharge of qualified principal residence exclusion;
  • $250 above-the-line teacher deduction;
  • Mortgage insurance premiums treated as residence interest;
  • Deduction for state and local taxes;
  • Above-the-line deduction for tuition; and
  • IRA-to-charity exclusion (plus special provisions allowing transfers made in January 2013 to be treated as made in 2012).
Business provisions
  • The Research Credit and the production tax credits, among others, will be extended through 2013;
  • 15-year depreciation and §179 expensing allowed on qualified real property through 2013;
  • Work Opportunity Credit extended through 2013;
  • Bonus depreciation extended through 2013; and
  • The §179 deduction limitation is $500,000 for 2012 and 2013.

Friday, December 21, 2012

Small Business Stock Exclusion for California Declared Unconstitutional

The Cutler case was a win for the taxpayers who filed the appeal, but is turning out to be a costly decision for all other small business stock owners.

The FTB has determined that because the California Court of Appeal held that R&TC §§18152.5 and 18038.5 (California’s small business stock provisions) are unconstitutional, they are now invalid and unenforceable. (FTB Notice 2012-03)

The FTB will deny the small business stock exclusion and deferral for 2012 and later years. They will also disallow exclusions claimed by taxpayers for years beginning on or after January 1, 2008. This means they expect taxpayers who benefited from a small business stock exclusion or deferral for a year beginning on or after January 1, 2008, to file an amended return, or they can expect a bill from the FTB.

Taxpayers who claimed the exclusion or deferral for years beginning before January 1, 2008, are not being asked to amend returns because the statute of limitations is close to expiring or has expired for most of these returns. If these taxpayers are involved in a pending audit or appeal, they may still be allowed the exclusion or deferral.

For the full text of the Notice, go to:

Wednesday, December 19, 2012

PMA Profiles - Sagar K. Parikh

Sagar Parikh is a partner at Parikh, Mehta & Associates and brings a wealth of knowledge and experience to the firm's clients.  Sagar's education and prior work experience serves as a foundation for his client service.  He holds a Masters in Business Taxation from the University of Southern California and has spent many years working with the nations largest closely held businesses during his time at Deloitte Tax LLP.

Over and beyond taxes, Sagar is a Registered Investment Advisor, and is in a unique position to incorporate taxes and investments to form a forward looking financial plan to guide clients through all phases of their financial life.

Outside the office, Sagar’s been blessed with a wonderful family, highlighted by his young, energetic son.  To unwind, he enjoys spending time with his family, and is an avid sports fan … unwaveringly devoted to the Dodgers and Trojans.  He’s also a passionate fantasy football player.  He seems to believe he’s “one of the best,” although I’m sure his league mates would disagree.

Friday, December 7, 2012

Items to Consider for Recognizing Capital Gains in 2012

Now that the election is over, it appears more likely that the Bush-era tax cuts will expire, at least for upper-income taxpayers. In addition, implementation of the Patient Protection and Affordable Care Act, commonly known as Obamacare, will usher in an additional Medicare surtax of 3.8 percent on unearned income above certain threshold levels. Individuals holding appreciated assets may be wondering if they should recognize capital gains at 2012 tax rates. A number of factors should be considered before deciding whether or not to recognize capital gains in 2012. Several of these factors are briefly discussed later below. As always, you should consult with us to discuss the impact of a capital gain strategy on your overall portfolio and your individual income tax liability.
Future Tax Rates  
It is expected that starting in 2013, the top federal capital gains tax rate will be 23.8 percent, consisting of the following: The top capital gains tax rate of 20 percent (up from 15 percent in 2012) plus an additional Medicare surtax of 3.8 percent. This is applied to the lower of net investment income (e.g., capital gain or dividends) or Modified Adjusted Gross Income (MAGI) over $200,000 ($250,000 if married).
Even at this late date, 2013 tax rates are not assured, and Congress may very well enact legislation that changes 2013 tax rates altogether. As unreliable as predicting 2013 tax rates may be, prediction of long-term future tax rates is even less reliable. Therefore, the possibility that tax rates will differ from the expected 2013 rates should be considered. 
Investment Returns and Expected Holding Period
The time value of money makes it preferable to delay payment of income taxes until a later period. However, since future income tax rates are expected to be higher, recognition of capital gains in 2012 may prove to be beneficial. Factors that influence the advantage/disadvantage of recognition of capital gains in 2012 include the future investment return, the expected number of years before the asset is sold (holding period), and future tax rates. As mentioned earlier, assuming a current capital gains tax of 15 percent and a future capital gains tax of 23.8 percent for a given expected return, recognition of capital gains in 2012 should be considered if the asset would otherwise be held for less than the number of years indicated in the table below. 
Expected returns and associated holding periods. Contact your Relationship Manager for more information.
Note as the expected return of the asset increases, the number of years that an asset needs to be held to justify deferral of capital gains decreases. When determining the required holding period, inflation-adjusted (real) returns should be used, since inflation has a corrosive effect on purchasing power over time. If an asset is expected to be held indefinitely (until the taxpayer’s death), or if the asset is expected to be gifted to charity, capital gains taxes will likely not be incurred for this asset in the future. Thus, recognition of capital gains should not be considered. Conversely, if the taxpayer has high liquidity needs that would shorten the assets expected holding period, recognition of gains in 2012 could prove to be advantageous. 
If capital gains are expected to be realized before the holding period indicated above, either through turnover, portfolio rebalancing or diversification, consideration should be given to recognizing capital gains at 2012 rates. Reduction of large, concentrated positions should be strongly considered, as diversification provides additional benefits through reduction of overall risk within a portfolio. 
State and Local Tax Implications
The above discussion focuses on federal income tax only. While this may be appropriate for jurisdictions that have little or no income tax burden, most states and many local jurisdictions impose an income tax, primarily based on federal taxable income. Taxpayers living in a high tax jurisdiction, such as California or New York, should be mindful of the impact of capital gains on state and local income tax liabilities. 

Sales and Use Tax Rate Will Increase on January 1, 2013

Special Notice

Due to voter approval of Proposition 30, the statewide sales and use tax rate will increase one quarter of one percent (0.25%) on January 1, 2013. The higher tax rate will apply for four years -- January 1, 2013 through December 31, 2016.
For a listing of tax rates, please visit our City and County Tax Rates webpage at
In addition to the statewide sales and use tax rate increase, voters in some cities and counties approved a number of new or increased district taxes that will go into effect April 1, 2013. These new or increased district taxes will be sent to taxpayers in a separate notice.
What if I collect tax at the lower rate for sales made after January 1, 2013?
If you incorrectly collect sales tax reimbursement or use tax at the lower rate after January 1, 2013, you will still owe the 0.25 percent difference.
If a customer purchases merchandise before January 1, 2013, but returns it after that date, what tax rate should I use to refund the tax payment?
You should refund tax based on the rate in effect at the time of the sale (for example, the amount you collected from the customer).
What if I enter into a fixed-price contract?
The statewide 0.25 percent rate increase will apply to all taxable sales and purchases made as part of fixed priced contracts and fixed price lease agreements that were entered into prior to January 1, 2013. The increased rate will replace the rate in effect at the time you entered into the fixed-price contract or fixed-price lease agreement.
What if I have additional questions?
If you have questions about this notice, the tax rate increase, or how the increase may affect the overall tax rate in your area, please visit our tax rate increase webpage. You may also call our Taxpayer Information Section at 1-800-400-7115 (TTY:711). Customer Service representatives are available to assist you weekdays from 8:00 a.m. to 5:00 p.m. (Pacific time), except state holidays. In addition to English, assistance is available in other languages.

Tuesday, December 4, 2012

IRS Releases Guidance on New Obamacare Investment Tax

10 Things We Learned from the New Obamacare Investment Tax Regulations via 

Yesterday, the IRS released long-awaited guidance on the additional “Obamacare” tax on net investment income slated to take effect on January 1, 2013. This guidance came in the form of proposed regulations under Section 1411 that,  oddly enough, are not effective until tax years beginning after December 31, 2013. However, taxpayers may rely on these proposed regulations until final regulations are issued, which is expected to happen sometime during 2013.

These proposed regulations are both interesting and longer than the Old Testament. I’m kidding of course; they’re not interesting at all. But that doesn’t mean you shouldn’t be aware of several areas of guidance that may not have been covered in the past. Luckily, I’ve got you covered.
But before we get into the meat of the regulations, a quick reminder of the general application of the new investment surtax is in order.
General Rule
Beginning January 1, 2013, taxpayers will pay an additional 3.8% Medicare tax on the lesser of:
  • The taxpayer’s “net investment income,” or
  • The taxpayer’s “modified adjusted gross income” less the “applicable threshold.”
Clearly, some definitions are in order:
Net Investment income includes:
  • Interest, dividends, capital gains, rent and royalty income, and non-qualified annuities,
  • Income and gains from passive activities,
  • Income and gains from businesses involved in the trading of financial instruments and commodities, and
  • Gains from the sale of interests in partnerships and S corporations to the extent the taxpayer is a passive owner.
Net investment income is reduced by deductions properly allocable to the investment income or net gain.
Modified Adjusted Gross Income, assuming a taxpayer has no foreign earned income, will be exactly the same as adjusted gross income.
The applicable threshold is:
  • For married taxpayers filing jointly: $250,000.
  • For married taxpayers filing separately: $125,000.
  • For all other taxpayers: $200,000.
Let’s put it all together with an example:
Example: Hansel, a single taxpayer, earns $195,000 in compensation and $30,000 of dividend and interest income during 2013. These are his only items of income or loss.
Hansel is subject to the 3.8% Medicare tax on the lesser of:
1. Net investment income, or $30,000, or
2. MAGI ($225,000) less the applicable threshold ($200,000) or $25,000.
Thus, Hansel owes tax of 3.8% on $25,000 in addition to his regular income tax responsibility on the same income.
Now that we’ve got the ground rules covered, let’s take a look at what we learned from 80 pages of proposed regulations:
1. It’s patriotic. The new tax is imposed only upon citizens or residents of the U.S; it does not apply to nonresident aliens. If a U.S. citizen is married to a nonresident alien, the spouses will be treated as married filing separately for purposes of the additional tax. As a result, the U.S. citizen or resident spouse will be subject to a $125,000 threshold and must determine his or her own modified adjusted gross income and net investment income.
However, the regulations allow the taxpayers to make an election to file a joint return under Section 6013(g) — which is required if a U.S. citizen or resident wishes to file a joint return with a nonresident alien — for purposes of not only of the income tax, but the investment surtax as well. With this election, the taxpayers will be treated as joint filers for purposes of computing the surtax on net investment income, and can combine their MAGI and net investment income and use the full $250,000 threshold.
2. No proration for (most) short periods. If a taxpayer dies during the year, necessitating the filing of a short period return, the threshold amount is not reduced or prorated. In the unlikely event that a taxpayer changes their annual accounting period, however, the threshold must be prorated based on the number of months in the short period.
3. Four exceptions to business income as net investment income. If a taxpayer owns a sole proprietorship, a single-member LLC disregarded as separate from the owner, or an interest in a partnership or S corporation, any income or gain generated from the activity will be net investment income unless:
  1. The activity is engaged in an active trade or business, AND
  2. The income is derived from the ordinary course of that trade or business, AND
  3. The activity is not a passive activity to the taxpayer (under the definition of Section 469), AND
  4. The activity is not engaged in the trading of financial instruments.
With regards to the third exception, in simple terms, your interest in an S corporation or partnership is passive unless you meet one of seven “material participation” tests found in the Section 469 regulations. I won’t reproduce them here, as I’ve covered them previously:

An item of income must meet all four exceptions to be excluded from the definition of net investment income. For example, if a taxpayer’s earns income from an activity that is not a trade or business, it is irrelevant whether the taxpayer materially participates in the activity. In addition, placing a trade or business between the taxpayer and an activity that is not a trade or business will not change the results:

Example: Bobby Taylor, an individual, owns an interest in UTP, a partnership, which is engaged in a trade or business. UTP owns an interest in LTP, also a partnership, which is not engaged in a trade or business. LTP receives $10,000 in dividends, $5,000 of which is allocated to Bobby through UTP.  The $5,000 of dividends is not derived in a trade or business because LTP is not engaged in a trade or business. This is true even though UTP is engaged in a trade or business. Accordingly, Bobby’s $5,000 of dividends are net investment income.
If all four exceptions are met, however, income earned in the ordinary course of an activity’s business will not be treated as net investment income:
Navin R. Johnson, an individual, owns stock in an S corporation, S. S is engaged in a trade or business that is not a trade or business of trading in financial instruments or commodities. Navin materially participates in S, so the activity is not passive to him within the meaning of section 469.
S earns $100,000 of interest in the ordinary course of its trade or business, of which $5,000 is Navin’s pro rata share.  Because:
  1. S is engaged in a trade or business,
  2. The $5,000 of income is earned in the ordinary course of the trade or business,
  3. The activity is not passive to Navin, and
  4. The activity is not engaged in the business of trading in financial instruments,
Navin has met all four exceptions and the $5,000 of interest is not included in his net investment income.
Pursuant to Section 469, rental activities are treated as passive by default. As a result, unless a taxpayer meets the “real estate professional” exception (discussed later), income from a rental activity will always be considered net investment income.
4. But there’s a catch:
It would be very easy to take those exceptions and conclude that any income earned from a trade or business in which a taxpayer materially participates is excluded from net investment income, but that would be a mistake. This is because when an activity, such as a partnership or S corporation, earns investment income such as interest or dividends, Section 469 treats this income as portfolio income that is not earned in the ordinary course of a trade or business. As a result, even if a taxpayer materially participates in the partnership or S corporation, because the activity’s portfolio income does not meet the second exception of being earned in the ordinary course of a trade or business, the income continues to meet the definition of net investment income:
Example: Billy Hoyle works 520 hours during 2013 in an S corporation in which he is also the sole shareholder. The S corporation is engaged in a trade or business that does not involve trading in financial instruments. The S corporation earns $40,000 in income in the ordinary course of its trade or business and $15,000 of interest and dividend income.
Even though:
  1. The S corporation is engaged in a trade or business,
  2. Billy materially participates in the S corporation, and
  3. The S corporation is not engaged in the business of trading in financial instruments,
Only the $40,000 of income earned in the ordinary course of the S corporation’s business meets all four exceptions and is excluded from net investment income. The $15,000 of interest and dividend income fails to meet the second exception because portfolio income is not treated as incurred in the ordinary course of a trade or business. Thus, Billy must include the $15,000 of portfolio income in his net investment income.
5. Being an employee is a trade or business. For purposes of the proposed regulations, an employee is treated as engaged in the trade or business of being an employee. Therefore, wages are never considered net investment income. The rule gets more generous, however; because wages are earned in the ordinary course of the taxpayer’s trade or business of being an employee, even if a taxpayer receives interest income from an employer as part of a payment of deferred compensation, the interest is not considered net investment income.
6. Taxpayers get a fresh start with passive activity groupings. As discussed above, in order for a taxpayer to exclude from net investment income the income earned by an activity, the taxpayer must not be a passive investor in the activity. To satisfy this standard, the taxpayer must “materially participate” in the activity under one of the seven tests of Section 469. Because these tests are largely based on hours spent by the taxpayer in the activity, however, as the taxpayer engages in more and more activities, it becomes difficult to satisfy the tests for each venture.
The Section 469 regulations provide relief from such a logistical hurdle by permitting taxpayers to group activities that represent an appropriate economic unit for purposes of measuring material participation. While a discussion of the grouping possibilities and requirements is beyond the scope of this post, it’s important to understand why the grouping rules exist:
Example: Walter White owns an interest in two S corporations. Both corporations are engaged in the active conduct of a trade or business, and neither corporation is a trader in financial instruments. Walter spends 520 hours on S Corporation 1, but only 40 hours on S corporation 2. Under the Section 469 regulations, absent an election to group the two activities, Walter would materially participate in S Corporation 1, but not S Corporation 2.
Assuming the interests in the two corporations represent an appropriate economic unit, Walter may group them together for purposes of testing material participation. Because Walter spends 560 hours on the combined activity, he materially participates in both S corporations and neither activity is passive to Walter. As a result, income earned in the ordinary course of  the trade or business of both S Corporation 1 and S Corporation 2 will not be considered net investment income.
The concept of grouping activities is important for two reasons under the proposed regulations. First, a taxpayer’s grouping under the Section 469 regulations will also be used to determine whether a taxpayer materially participates in an activity for purposes of applying the tax on net investment income. More importantly, the Section 469 regulations provide that once a taxpayer has grouped activities, they are stuck with them. The potential impact of the enactment of Section 1411, however, has inspired the IRS to grant all taxpayers a fresh start and the ability to regroup their activities.
The proposed regulations provide that taxpayers may regroup their activities in the first tax year beginning after December 31, 2013, in which the taxpayer has modified adjusted gross income in excess of the threshold and has net investment income. However, taxpayers may rely on the proposed regulations and regroup activities for a tax year beginning in 2013 if they will be subject to the investment surtax during that year.
This ability is quite significant, as it allows taxpayers to reconfigure previous groupings that may no longer be advantageous. Note, however, that a taxpayer electing to regroup their activities must comply with all disclosure requirements.
7. Don’t be fooled by rental/non-rental groupings. In very limited circumstances, the Section 469 regulations permit a taxpayer to group rental and non-rental activities. This does not change the nature of any rental income earned by the rental activity as net investment income, however. Thus, even if a grouping of a rental activity with a trade or business converts the rental activity from passive to non-passive, the rental income will still be considered net investment income.
Winky Dinky Dogs, an S corporation, purchases a building during the current year. The building houses a retail business and also contains several rental apartments. Because the activities are conducted in one building, the taxpayer concludes that they are an appropriate economic unit and groups them together. Because the shareholder materially participates in the combined activity, the net rental income is treated as nonpassive, not as a passive activity. This does not change the fact that the rental income is considered net investment income.

8. Net loss from the sale of property can’t offset other investment income. Similar to the rules discussed at #4 above, if an activity is a trade or business that is neither passive to the taxpayer nor engaged in the activity of trading financial instruments, gain from the sale of assets (other than working capital) are not considered net investment income.

All other gains — for example, those from a passive activity or an activity engaged in financial trading – will be considered net investment income. Under the proposed regulations, the taxpayer cannot use a net loss from the disposition of an asset to offset other net investment income:
Example; Henry Hill, an unmarried individual, realizes a capital loss of $40,000 on the sale of P stock and realizes a capital gain of $10,000 on the sale of Q stock, resulting in a net capital loss of $30,000. Both P and Q are C corporations. Henry has no other capital gain or capital loss.  In addition, Henry receives wages of $300,000 and earns $5,000 of gross income from interest. For income tax purposes, Henry may use $3,000 of the net capital loss against other income and the remaining $27,000 is a capital loss carryover.
For purposes of determining Henry’s net investment income, Henry’s gain of $10,000 on the sale of the Q stock is also reduced by his loss of $40,000 on the sale of the P stock.  However, because net gain may not be less than zero, Henry may not reduce his interest income of $5,000 by the $3,000 of the excess of capital losses over capital gains allowed for income tax purposes.
Similarly, while a taxpayer’s net operating loss carryforward can be utilized to reduce their taxable income and modified adjusted gross income, the proposed regulations provide that it cannot reduce a taxpayer’s net investment income. The reason for this rule is obvious: it is not practical to trace what portion of a taxpayer’s net operating loss is properly attributable to investment income.
9. Long-awaited clarity on the sale of S corporation stock and partnership interests. Under the proposed regulations, stock in an S corporation or an interest in a partnership is not considered property used in a trade or business, and thus any gain resulting from a sale of such stock or partnership interest is considered net investment income.
There is an exception, however, for a sale when:
  1. The S corporation or partnership is engaged in at least one trade or business,
  2. At least one of the activity’s trades or businesses is not the trading of financial instruments, and
  3. The activity is not passive to the taxpayer.
Read in the negative, one might conclude that if a taxpayer materially participates in an activity that is engaged in a trade or business that is not the trading of financial instruments, any gain would not be net investment income. While that is typically the case, a we’ll see below, the mechanics of the new regulations do not provide a blanket removal of the gain from the computation of investment income, but rather a mechanical adjustment to the gain. In certain circumstances, this may result in some gain being subject to the additional Medicare tax even if the the taxpayer meets the requirements above.
Here’s how it works:
Step 1: the taxpayer must compute the gain or loss on the sale of the stock or partnership interest,
Step 2: the taxpayer next looks through to the entity, and the entity is deemed to have disposed of all of its assets in a fully taxable transaction for cash equal to the fair market value,
Step 3: the hypothetical gain or loss is then allocated to the selling shareholder or partner (this is done in accordance with any special allocations required pursuant to a partnership agreement or Sections 704(b) or (c)), and
Step 4: the gain computed in step 1 is then adjusted to account for any gain that is not considered net investment income because it meets the three exceptions above.
There are limitations to the amount of adjustment in Step 4. If a taxpayer recognizes a gain on the sale of the stock or partnership interest, the adjustment cannot result in a net loss for net investment income purposes, nor can a taxpayer recognize more gain for net investment income purposes than he actually realized on the sale. On the opposite side, if the taxpayer recognized a loss on the sale of the stock or the partnership interest, an adjustment cannot result in a net gain for net investment income purposes, nor can a taxpayer recognize a larger loss for net investment income purposes then they actually realized on the sale.
An modified example from the proposed regulations will make some sense of it all:
Individuals A and B are shareholders of S Corporation (S).  A owns 75 percent of the stock in S, and B owns 25 percent of the stock in S.  During Year 1, S is engaged in a single trade or business.  S is not passive to A, nor is S involved in the trading of financial instruments.
S has three properties (1, 2, and 3) held exclusively in S’s trade or business that have an aggregate fair market value of $120,000.  On September 1 of Year 1, A sells his S stock to C for $90,000.  At the time of the disposition, A’s adjusted basis in his S stock is $75,000.  S’s properties have the following adjusted bases and fair market values immediately before the disposition:
Property          Adjusted Basis            Fair Market Value
1                      $10,000                       $50,000
2                      $70,000                       $30,000
3                      $20,000                       $40,000

Step 1: On the stock sale to C, A recognizes a gain of $15,000 ($90,000 minus $75,000). Because S is not a passive activity to A and is not engaged in the trading of financial instruments, A should not have to include the full gain in his net investment income.

Step 2: Upon a hypothetical disposition of S’s properties for cash equal to fair market value, S would receive $50,000 for Property 1, $30,000 for Property 2, and $40,000 for Property 3. The determination of gain or loss on the deemed sale of S’s properties is as follows:
Property          Adjusted Basis            Fair Market Value       Gain or Loss
1                      $10,000                       $50,000                       $40,000
2                      $70,000                       $30,000                       ($40,000)
3                      $20,000                       $40,000                       $20,000
Step 3: A is allocated $30,000 gain from Property 1, $30,000 loss from Property 2, and $15,000 gain from Property 3. 
Step 4: Because all three properties are held in S’s trade or business, which is not passive to A or engaged in the trading of financial instruments, A must make an adjustment to the amount of gain recognized from the sale of the stock. The gain or loss on each of the three properties are added together ($30,000 minus $30,000 plus $15,000), resulting in a negative adjustment of $15,000.  A’s gain of $15,000 on the disposition of the interest is thus reduced by $15,000, and A has zero gain with respect to the stock disposition for purposes of computing his net investment income.
As I mentioned above, however, it’s not fair to simply assume that because a taxpayer’s activity is a non-passive trade or business outside the realm of financial trading, no gain will result on the disposition of the stock or partnership interest. As seen below, differences in inside and outside basis can yield a different result:
Same facts as in the previous example, except that A’s adjusted basis in his S stock is $70,000.  On the stock sale to C, A recognizes a gain of $20,000 ($90,000 minus $70,000). The deemed sale would result in a negative adjustment of $15,000 ($30,000 minus $30,000 plus $15,000), just as it did previously.  Thus,  A’s net gain of $20,000 on the disposition of the interest under is reduced by $15,000, and A has $5,000 net gain with respect to the stock disposition for purposes of computing his net investment income.
Another interesting aspect of the disposition rules is the treatment of installment sales. As a reminder, an installment sale is any sale where at least one payment is to be received after the year of sale. If the underlying asset qualifies, the seller can recognize the gain as payments are received, with part of each payment representing gain, and part representing a return of the seller’s basis in the asset.
The proposed regulations provide that if a taxpayer sells an interest in an S corporation or partnership interest on the installment method, any adjustment to net gain is computed in the year of sale and is taken into account proportionately as each payment is received and gain is recognized.
The regulations go on to provide that if a taxpayer sells an interest in an S corporation or partnership prior to the enactment of Section 1411 (i.e., January 1, 2013), the taxpayer can make an irrevocable election to apply the net gain adjustment rules just discussed.
I take this to mean that that if a taxpayer does not make this election, then all of the gain recognized by the taxpayer in subsequent years under the installment method for sales taking place prior to 2013 will be considered net investment income, with no allowable reduction for the adjustment mandated by the proposed regulations, because those regulations are not effective until January 1, 2013.
If this is indeed the case, taxpayers who have already entered into installment sales that will generate gain beyond 2012 would be well advised to make this election on their 2013 tax return, compute and adjust the net gain resulting from the sale under the proposed regulations, and ensure that they are only including in net investment income the amount of gain that would be recognized after adjustment for the exceptions discussed above.
Here’s how I see this clause of the regulations playing out. Keep in mind, at this point, this is simply my interpretation:
Example: A sells his S corporation stock in December 2012. The S corporation is non-passive to A, it conducts a trade or business, and is not engaged in trading financial instruments. A has basis of $100 in his S stock and sells the stock for $500, resulting in $400 of gain. A sells the stock for five annual payments of $100 each.
Under the installment method, A would recognize $80 of gain when each of the five payments are received. Pursuant to the proposed regulations, A is permitted to reduce his net gain of $400 by the amounts excludable by virtue of the fact that S conducts an active trade or business that is nonpassive to A and is not engaged in the trading of financial instruments. Assume that after following the four-step process discussed above, A is entitled to $400 negative adjustment to his gain for purposes of Section 1411, and thus has no net investment income.
I interpret these regulations as dictating that because the sale occurred prior to the effective date of Section 1411, if A fails to make an election in 2013 to apply the regulations to the installment sale gain, the $80 of gain received during that year — and in each subseuqent year — will be considered net investment income. If this is true, it is in the best interest of A to make the election on his 2013 return and compute the negative adjustment to his gain for net investment income purposes. In that case, each year, when A recognizes $80 of installment sale gain, he will be permitted to reduce the gain by the applicable negative $80 adjustment.
I plan to call the author of the regulations on Monday to confirm my understanding.

In perhaps the most annoying aspects of these proposed regulations, a taxpayer is required to attach a lengthy list of disclosures to his tax return in each year that a taxpayer disposes of S corporation stock or a partnership interest subject to these rules.

10. What to do with real estate professionals. If there’s one area that appears to remain unclear, it’s the treatment of “real estate professionals.” As I mentioned in #3 above, rental activities are considered passive by default unless a taxpayer qualifies as a “real estate professional” under Section 469(c)(7). In general, this requires satisfying two tests:
1. More than one-half of the taxpayer’s personal services performed throughout the year must be performed in real property trades or businesses in which the taxpayer materially participates, and
2. The taxpayer must perform more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.
It has been anticipated that if a taxpayer met these requirements, any rental income would not be subject to the 3.8% surtax. In the preamble to the regulations, however, the IRS ominously states the following:
If a taxpayer meets the requirements to be a real estate professional in section 469(c)(7)(B), the taxpayer’s interests in rental real estate are not (passive), and the rental real estate activities of the taxpayer will not be passive activities if the taxpayer materially participates in each of those activities.  However, a taxpayer who qualifies as a real estate professional is not necessarily engaged in a trade or business (within the meaning of section 162) with respect to the rental real estate activities.  If the rental real estate activities are section 162 trades or businesses, the rules in section 469(c)(7) and §1.469-9 will apply in determining whether a rental real estate activity of a real estate professional is a passive activity for purposes of section 1411(c)(2)(A).  However, if the rental real estate activities of the real estate professional are not section 162 trades or businesses, the gross income from rents derived from such activity will not be excluded under section 1411(c)(1)(A)(i) by the ordinary course of a trade or business exception.  The ordinary course of a trade or business exception is inapplicable because the rents are not derived from a trade or business and will therefore be subject to section 1411. 
This appears to call into play the age-old question of whether a rental activity rises to the level of a trade or business. If it does, the rental income, by virtue of the exceptions discussed at #4 above for non-passive trades or businesses, will not be considered net investment income. To the contrary, if the rental activity does not rise to the level of a trade or business, the fact that it is no longer treated as passive courtesy of the real estate professional rules will not change the fact that the rental income is considered net investment income.
Unfortunately, there is no bright-line test for whether a rental activity constitutes a trade or business; rather, it requires a facts and circumstances analysis. But in general, the more active and involved the property owner is in the rental, the better chance that it rises to the level of a trade or business. Regardless, this level of ambiguity with such an important issue is concerning.
I plan to follow up with the IRS on Monday with some of these remaining issues. In the meantime, I hope you found this helpful.

Wednesday, November 28, 2012

IRS Initiating Form 1099-K Compliance Program

A new IRS compliance program aimed at finding underreporting of gross receipts by taxpayers who receive Form 1099-K information returns from credit card companies or third-party transaction networks launches this week, a senior IRS official confirmed November 27.

Ruth Perez, deputy commissioner of the IRS Small Business/Self-Employed Division, told Tax Analysts that the first notices under the program will be sent out later in the week of November 26. "Our initial footprint in this area is going to be small while we learn," she said, adding that the initiative will touch a variety of businesses of different sizes.

Under section 6050W, entities that process credit card, payment card, and third-party network transactions must track the gross amounts of those transactions by merchant and report monthly and annual gross amounts to the IRS, as well as provide statements to payees. In a November 16 post to its website, the IRS announced that it will be sending out new notices related to Form 1099-K, "Merchant Card and Third-Party Network Payments," to taxpayers who may have underreported their gross receipts. A taxpayer may receive a notice if a mismatch occurs between amounts on the taxpayer's tax return and Form 1099-K statements the IRS received, as the discrepancy shows "an unusually high portion of receipts from credit payments and other Form 1099-K reportable transactions," the Service said.

An unresolved point of contention between the IRS and taxpayers has been the required reporting on Form 1099-K of gross payment amounts that don't line up with a taxpayer's net, taxable, or gross income on a tax return. Practitioners believe the IRS went astray in its decision in the final regulations to base reporting on transactions rather than payments. The preamble to the final section 6050W regulations admits its definition of gross amounts "is not intended to be an exact match of the net, taxable, or even the gross income of a payee." 

The IRS made an informal announcement earlier in the year that it would not require reconciliation of gross receipts and merchant card transactions on Form 1120, "U.S. Corporate Income Tax Return," and other business income tax forms. In a February letter to the National Federation of Independent Business, then-IRS Deputy Commissioner for Services and Enforcement Steven Miller wrote that "there will be no reconciliation required on the 2012 form, nor do we intend to require reconciliation in future years." 

The sample notices posted on the IRS website offer a variety of responses required from taxpayers. The least intrusive letter simply asks the taxpayer to review the provided information for accuracy, while another letter requests that the taxpayer send the IRS written notice of any inaccuracies on the Form 1099-K. A third letter requires the taxpayer to fill out a form verifying reported income and explain why its gross receipts from card payments were higher than anticipated, which could lead to the IRS proposing adjustments to the tax return. (For the letters and form, see

Practitioners have expected the IRS to use Form 1099-K reported amounts as general indicators of tax noncompliance through a matching process. 

The notion of a compliance program requiring documented responses has raised concerns that reconciliation might be resurrected later. The turnaround time has been quick from when many business taxpayers filed their 2010 tax returns in September to the current issuance of letters suggesting underreporting.

To taxpayers who worry that the compliance initiative is a new effort to require reconciliation of discrepancies between Forms 1099-K and the taxpayer's tax return, Perez emphatically dismissed the notion. "This is not another attempt at reconciliation," she said.

Perez said the IRS has been working hard to develop a "strong and well-reasoned implementation plan for compliance efforts" concerning section 6050W. The agency will have a learning period in handling Forms 1099-K, she acknowledged, saying, "It's the first year we have this information." But the IRS is "doing a good job in developing different approaches to use this information as effectively and efficiently as possible," she said. The IRS made the letters available online as soon as they were ready in order to give taxpayers advance notice, she said.

In all its efforts, the IRS is making sure it has a "balanced approach to ensure taxpayers are not unreasonably burdened," Perez said. That means the Service is conducting outreach on several levels, she said, adding, "We are dedicated to having an open forum on this issue and will make necessary adjustments as we hear back from stakeholders and gain experience from our people."

Deborah Pflieger of Ernst & Young LLP said the Form 1099-K compliance initiative makes sense. "As someone who has seen large merchant payers spend significant amounts of time and money adjusting to the new reporting requirements, I am relieved at the idea that the IRS is actually going to be using the data it receives," she said. Form 1099-K information allows the IRS to "effectively conduct a smell test to see which taxpayers have significant differences in gross receipt amounts between the form and their tax return that is unlikely to be simply the product of sales returns or other adjustments such as changes from cash to accrual accounting," she said.

"These letters to taxpayers are a shot across the bow that the IRS is looking to ensure accurate reporting to close the tax gap," Pflieger said. Although Form 1099-K matching will never be as easy as the matching process the IRS has in place for interest and dividend reporting on individual taxpayers' returns, section 6050W gives the government a good tool to pinpoint outlier merchants, she said.

Benson Goldstein, senior technical manager for taxation at the American Institute of Certified Public Accountants, said, "One of the issues that needs to be addressed going forward is the compliance burden for businesses that these notices might create. We will be talking to our members to learn about their experiences with this program so that we can interact with IRS leadership to provide feedback as appropriate."

Article reprduced from TaxNotes Daily