Posted on Nov 7, 2016

On October 5, 2016, the IRS released new temporary and final Section 752 regulations. Sec. 752 of the Internal Revenue Code and related regulations explain how to allocate partnership debt among partners for purposes of calculating the basis of their partnership interests. This calculation determines what’s often referred to as the partners’ “outside basis” in the partnership (their basis for deducting losses and receiving tax-free distributions). In some situations, the new regulations make it more difficult for partnerships to manipulate the rules to increase the outside basis of certain partners for tax planning purposes. In most situations, however, the effects of the new regulations are neutral.

Here are the most important changes included in the new Sec. 752 regulations — and how they may affect your investments in partnerships and limited liability companies (LLCs).

Why Sec. 752 Matters

A partner’s share of partnership liabilities, as determined under the Sec. 752 rules, is added to the partner’s outside basis. That gives the partner more room to deduct partnership losses and/or receive tax-free partnership distributions.

However, a reduction in a partner’s share of partnership liabilities, as determined under the Sec. 752 rules, is treated as a deemed cash distribution that reduces the partner’s outside basis. A reduction can trigger a taxable gain to the extent the deemed distribution — along with actual cash distributions and actual distributions of certain marketable securities — exceeds the partner’s outside basis.

For these reasons, the Sec. 752 rules are important. In general, these rules apply equally to LLCs that are treated as partnerships for federal tax purposes. For simplicity, this article uses the terms 1) “partnership” to refer more generally to both partnerships and LLCs that are treated as partnerships for tax purposes, and 2) “partner” to refer more generally to the owners of those entities (partners and LLC members).

How to Define a “Payment Obligation”

IRS temporary regulations typically have the same authority as final regulations. As such, they are in force as of the specified effective date. However, temporary regulations may be amended before being reissued as final regulations, with a new effective date for any changes.

A new temporary regulation issued in October clarifies when a partner is considered to have a payment obligation with respect to a partnership recourse debt for purposes of allocating that debt among the partners under the Sec. 752 rules. (Recourse debt is debt for which the borrower is personally liable — the lender can collect what is owed beyond any collateral.)

Without having a payment obligation with respect to a recourse liability, a partner generally can’t be allocated any basis from that liability under the Sec. 752 rules. However, in some cases, a partner can be allocated basis from a recourse liability when a taxpayer related to the partner has a payment obligation with respect to that liability.

The new guidance stipulates that the determination of the extent to which a partner or related person has a payment obligation with respect to a recourse liability is based on the facts and circumstances at the time of the determination. It also lists some specific factors that should be considered.

To the extent that the obligation of a partner or related person to make a payment with respect to a partnership recourse liability is not recognized under this rule, the payment obligation is ignored for purposes of allocating that debt to that partner under the Sec. 752 rules. All statutory and contractual obligations relating to the payment obligation are considered in applying this rule.

Example 1: Payment Obligations

If a partner guarantees a partnership recourse debt, but the guarantee isn’t legally binding under applicable state law, the purported guarantee won’t be recognized as a payment obligation. Therefore, the guarantee will have no impact on how that debt was allocated to that partner under the Sec. 752 rules.

 

The new clarification of payment obligations with respect to partnership recourse debts generally applies to liabilities incurred or assumed by a partnership on or after October 5, 2016. It also applies to payment obligations imposed or undertaken with respect to a partnership liability, other than liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken pursuant to a written binding contract in effect prior to that date.

A partnership can, however, elect to apply all the new rules to all of its liabilities as of the beginning of the first taxable year of the partnership that ends on or after October 5, 2016 (calendar year 2016 for a calendar year partnership). A special transitional rule allows the impact of the new rules to be postponed for up to seven years in some situations when the new rules would be harmful to a partner.

Important note: This temporary regulation is basically neutral in its effect on partners.

How to Handle Guarantees of Recourse Debt and Exculpatory Liabilities

Another new temporary regulation creates a new term called “bottom-dollar payment obligation.” For purposes of allocating recourse liabilities among partners under the Sec. 752 rules, a bottom-dollar payment obligation isn’t recognized. That means it’s ignored for purposes of allocating the entity’s recourse liabilities under the Sec. 752 rules.

In this context, so-called exculpatory liabilities are treated as recourse debts. Exculpatory liabilities are debts that are secured by all partnership property. Therefore, they’re effectively recourse to the partnership, even though no partner is personally liable.

The new guidance also requires partnerships to disclose to the IRS all bottom-dollar payment obligations for the tax year in which the bottom-dollar payment obligation is undertaken or modified.

Important note: The new rules for bottom-dollar payment obligations are primarily aimed at LLCs treated as partnerships for tax purposes that use member guarantees of exculpatory liabilities. Guarantees of LLC exculpatory liabilities have been used “creatively” to increase the basis of certain LLC members in their membership interests (outside basis). The IRS doesn’t look kindly on these types of arrangements, and the new rules make it more difficult to use them for tax planning purposes. As such, the new rules are unfavorable to taxpayers.

Limited liability partnerships (LLPs) can also have exculpatory liabilities. But LLPs are unlikely to have bottom-dollar payment obligation arrangements, because LLPs are most often used simply to operate professional practices. In contrast, some LLCs have been used as “creative” tax-planning vehicles.

Exculpatory liabilities aren’t relevant in the context of garden-variety general or limited partnerships, because one or more of their general partners will always be personally liable for partnership recourse debts.

Example 2: Guarantee of First and Last Dollars of LLC Exculpatory Liability

Individual taxpayers A, B and C are equal members (owners) of ABC LLC, which is treated as a partnership for federal tax purposes. ABC borrows $1 million from the bank. The $1 million liability is an exculpatory liability of ABC, because all of ABC’s assets are potentially exposed to the debt, but none of the three members have any personal liability for the debt.

Member A guarantees payment of up to $300,000 of the debt if any part of the $1 million isn’t recovered by the bank. Member B guarantees payment of up to $200,000, but only if the bank otherwise recovers less than $200,000.

Member A is obligated to pay up to $300,000 if, and to the extent that, any part of the $1 million liability isn’t recovered by the bank. So, Member A’s guarantee is not a bottom-dollar payment obligation, and his or her payment obligation is recognized for Sec. 752 purposes. Therefore, Member A is allocated $300,000 of basis from the $1 million debt, because he or she has an economic risk of loss to that extent.

On the flip side, Member B is obligated to pay up to $200,000 only if, and to the extent that, the bank otherwise recovers less than $200,000 of the $1 million loan. So, Member B’s guarantee is a bottom-dollar payment obligation, which is not recognized under the new guidance, because Member B isn’t considered to bear any economic risk of loss for the $1 million liability.

In summary, the first $300,000 of ABC’s $1 million liability is allocated to Member A. The remaining $700,000 is allocated to Members A, B and C under the rules for nonrecourse liabilities, because none of ABC’s members have any personal liability for the $700,000.

The same effective date and transitional relief rules that apply to the updated definition of payment obligations with respect to recourse debts also apply to the new rules regarding bottom-dollar payment obligations.

How to Allocate Excess Nonrecourse Liabilities

Under the Sec. 752 rules, partnerships must allocate nonrecourse liabilities among the partners using a three-tiered procedure. The last tier applies to so-called excess nonrecourse liabilities, which are allocated according to the partners’ percentage shares of partnership profits.

Effective for partnership liabilities incurred or assumed on or after October 5, 2016 — subject to an exception for pre-existing binding contracts — a new final regulation stipulates that the partnership agreement can specify the partners’ percentage interests in partnership profits for purposes of allocating excess nonrecourse liabilities.

But the specified percentages must be reasonably consistent with valid allocations of some other significant item of partnership income or gain. This is often referred to as the “significant item method” of allocating excess nonrecourse liabilities.

The new regulation also allows two other alternative methods of allocating excess nonrecourse liabilities. Moreover, excess nonrecourse liabilities aren’t required to be allocated under the same method each year.

Important note: This new final regulation is basically neutral in its effect on determining the outside basis of partners.

Where to Find Additional Information

This is only a brief summary of the key changes under the new temporary and final Sec. 752 regulations. Consult your Cornwell Jackson tax professional for full details on how the new rules might affect your partnership (or LLC) and its partners (or members).

Posted on Nov 4, 2016

In October, the IRS issued new guidance targeting strategies that are used to exploit the tax benefits associated with partnerships and limited liability companies (LLCs) that are treated as partnerships for tax purposes. In a nutshell, under the new guidance, property transactions between partners and partnerships are more likely to be classified as disguised sales and, therefore, subject to taxes. Here’s a summary of the most important aspects of the new temporary and final regulations on disguised sales that apply to these entities.

IRS temporary regulations typically have the same authority as final regulations. As such, they are in force as of the specified effective date. However, temporary regulations may be amended before being reissued as final regulations, with a new effective date for any changes.

Contributing Appreciated Property

In general, partners who contribute appreciated property (with a fair market value that exceeds its basis) to their partnerships don’t recognize any taxable gains under federal income tax rules. But there are exceptions to this general rule.

The most common exception occurs when the partnership assumes debt that encumbers the contributed property, and the assumed debt is large enough to cause the partner’s basis in the partnership interest — his or her “outside basis” — immediately after the contribution to be negative.

In that case, a taxable gain — equal to the negative outside basis amount — is triggered. The gain increases the contributing partner’s outside basis to zero. It’s fairly uncommon for such gains to occur, because the contributing partner’s outside basis is increased by the partner’s share of all partnership liabilities, including liabilities that encumber the contributed property.

Triggering the Disguised Sale Rules

However, when the dreaded “disguised sale rules” apply, contributions of appreciated property can trigger taxable gains that contributing partners may not have anticipated. That’s mainly because the partnership’s assumption of liabilities encumbering contributed appreciated property can be treated as disguised sale proceeds.

Disguised sale gains can also be triggered when a partner contributes appreciated property and receives distributions of cash or other assets from the partnership that are deemed to be related to the property contribution. Distributions that occur within two years (before or after) of the date the property was contributed are automatically assumed to be disguised sale proceeds, unless the facts and circumstances indicate to the contrary.

From a tax perspective, the disguised sale rules are bad news for partners that contribute appreciated property to their partnerships. So, it’s important to understand these rules and avoid triggering them whenever possible. But planning around the disguised sale rules has been made more difficult thanks to final and temporary IRS regulations that were issued in October.

Important note. The disguised sale rules, including the new regulations, apply equally to LLCs that are treated as partnerships for federal tax purposes. For simplicity, this article uses the terms 1) “partnership” to refer more generally to both partnerships and LLCs that are treated as partnerships for tax purposes, and 2) “partner” to refer more generally to the owners of those entities (partners and LLC members).

Identifying Exceptions to the Disguised Sale Rules

Fortunately, partners can avoid the disguised sale rules with certain favorable exceptions that have been updated under the new IRS guidance, including:

Exception for reimbursements of preformation expenditures. Certain reimbursements by a partnership to a contributing partner for capital expenditures related to contributed property that were incurred before the contribution — so-called preformation expenditures — aren’t included in disguised sale proceeds. In other words, such reimbursements can’t trigger or increase a disguised sale gain.

The new final regulations include several taxpayer-friendly changes to the preformation expenditure exception that are effective for transfers that occur on or after October 5, 2016.

Exception for qualified liabilities. For years, IRS regulations have provided special rules for the treatment of liabilities incurred or transferred in connection with certain contributions of property to partnerships. These rules were designed to trigger taxable disguised sale gains in certain circumstances, including situations where a partner encumbers a property with debt in anticipation of contributing the property to a partnership.

The treatment of liabilities under the disguised sale rules hinges on whether they’re qualified liabilities. A qualified liability that the partnership assumes (or takes property subject to) is treated as consideration for disguised sale purposes only if the property contribution would have been treated as a disguised sale without considering the qualified liability — in other words, when the contributing partner is deemed to receive other consideration, such as cash, in exchange for the property contribution.

On the other hand, liabilities that are not qualified liabilities are always treated as consideration in determining if a property contribution and a liability assumption together constitute a disguised sale. Therefore, nonqualified liabilities that encumber appreciated property and that are assumed by a partnership can easily trigger disguised sale gains.

Distinguishing between Qualified and Nonqualified Liabilities

According to the final regulations, qualified liabilities include the following:

  1. Debt incurred more than two years before the property contribution.
  2. Debt incurred less than two years before the property contribution but not incurred in anticipation of the contribution.
  3. A liability the proceeds of which can be traced to capital expenditures made in connection with the contributed property (such as acquisition or improvement costs).
  4. A liability that was incurred in the ordinary course of the business in which property transferred to the partnership was used or held (such as trade payables), but only if all the assets related to that business are transferred (other than assets that aren’t material to the continuation of the business).
  5. For transactions where all transfers occur on or after October 5, 2016, a liability that wasn’t incurred in anticipation of the transfer of the property to a partnership, but that was incurred in connection with a trade or business in which property transferred to the partnership was used or held but only if all the assets related to that trade or business are transferred other than assets that are not material to a continuation of the trade or business.

Debts (other than acquisition debt, improvement debt and trade payables) incurred within two years of the property contribution are presumed to have been incurred in anticipation of the property contribution unless the facts and circumstances clearly indicate otherwise.

If property subject to liabilities that aren’t qualified liabilities is contributed to a partnership, the liabilities are treated as disguised sale consideration to the extent that the contributing partner is relieved of the liability.

Here’s an example of how the disguised sale rules can work under the final regulations, which apply to transactions for which all transfers occur on or after October 5, 2016.

Example 1: Partnership’s Assumption of Nonrecourse Liability Encumbering Transferred Property

Partners A and B form the AB Partnership (a 50/50 deal) to rent office space. Partner A transfers $500,000 in cash to the partnership. Partner B transfers an office building with a fair market value (FMV) of $1 million and an adjusted basis of $400,000.

The office is also encumbered by a $500,000 nonrecourse liability that the partnership assumes. Partner B incurred the liability 12 months earlier to finance the acquisition of other property. No facts rebut the presumption that the liability was incurred in anticipation of transferring the property to the partnership. The partnership agreement provides that all partnership items are allocated equally between Partners A and B.

The $500,000 nonrecourse liability isn’t a qualified liability. Under IRS regulations, Partner B must be allocated 50% of the liability ($250,000) for disguised sale purposes.

Therefore, the partnership’s assumption of the liability is treated as a transfer of $250,000 of disguised sale consideration to Partner B. That’s the amount by which the $500,000 liability exceeds Partner B’s $250,000 share of the liability under the disguised sale rules immediately after the partnership’s assumption of the liability.

In summary, Partner B is treated as having sold $250,000 of the FMV of the office building to the partnership in exchange for the partnership’s assumption of a $250,000 liability. Therefore, Partner B must recognize a disguised sale gain of $150,000. The gain is calculated by taking $250,000 of disguised sale proceeds and subtracting the basis of $100,000 for the part of the property that is deemed to be sold in the disguised sale ($250,000/$1,000,000 x $400,000).

Partner A is unaffected by the disguised sale rules.

Discouraging Contributions of Leveraged Assets to Partnerships and LLCs

For disguised sale purposes only, a new temporary IRS regulation forces partnerships to determine a partner’s percentage share of any liabilities assumed by a partnership when encumbered property is contributed to the partnership — whether the liability is recourse or nonrecourse and whether it’s guaranteed by the contributing partner — using the contributing partner’s percentage share of partnership profits. A partner’s percentage shares of partnership profits must be determined based on all facts and circumstances at the time of the property contribution.

Important note: The new rule can result in adverse tax consequences for taxpayers that contribute leveraged assets to partnerships, as illustrated by the following example.

Example 2: Partnership’s Assumption of Recourse Liability Encumbering Transferred Property

Partner C transfers Property Y to a partnership in which Partner C has a 50% interest in partnership profits. Property Y has a FMV of $10 million, and it’s subject to an $8 million liability that Partner C incurred and guaranteed immediately before transferring the property. Partner C used the $8 million of debt proceeds to finance other expenditures unrelated to the partnership.

Upon the transfer of the property, the partnership assumed the $8 million liability, which is a recourse debt. Under federal tax law, the entire $8 million liability is allocated to Partner C for purposes of determining his basis in his partnership interest (outside basis), because he guaranteed the debt.

Under the facts in this example, however, the $8 million liability is not a qualified liability for disguised sale purposes. Therefore, the partnership’s assumption of the liability results in a deemed transfer of consideration to Partner C in connection with his transfer of Property Y to the partnership. Even though Partner C is allocated the entire amount of the $8 million liability for outside basis purposes, he’s allocated only 50% of the liability ($4 million) for disguised sale purposes. This is pursuant to the rule stating that his share of the liability for disguised sale purposes equals his 50% interest in partnership profits.

In summary, Partner C is deemed to receive disguised sale proceeds of $4 million upon transferring Property Y to the partnership. That amount equals the excess of the $8 million liability assumed by the partnership over Partner C’s share of the liability for disguised sale purposes ($4 million). This is the outcome even though Partner C remains personally liable for the entire $8 million liability because he guaranteed it.

This example illustrates only one of many unfavorable changes included in the new temporary IRS regulation. Be especially cautious when contributing leveraged assets to partnerships for any transfers that occur on or after January 2, 2017. The tax results under the disguised sale rules can be surprisingly unfavorable.

Finding Additional Information

This is only a brief summary of the new temporary and final disguised sale regulations. Consult your tax professional for full details on how the new rules might affect your partnership (or LLC) and its partners (or members).

Posted on Sep 13, 2016

Fall is a good time to pause and review your financial planning strategy. A lot can happen in a year. If your personal life, market conditions or tax laws have changed, you may need to revise your long-term financial plans. Here are some retirement and estate planning considerations that may be worthwhile.

IRS Proposal Threatens Discounts on Transfers of Family-Owned Business

For years, proactive taxpayers have used family limited partnerships (FLPs) and other family-owned business entities in estate planning. If properly structured and administered, these estate-planning tools allow high net worth individuals to transfer their wealth to family members and charities at a substantial discount from the value of entities’ underlying assets. Examples of assets that may be contributed to an FLP include marketable securities, real estate and private business interests.

Important Note. The FLP must be set up for a legitimate purpose (such as protecting assets from creditors and professional-grade asset management) to preserve valuation discounts.

Valuation discounts on FLPs relate to the lack of control and marketability associated with owning a limited partner interest. These interests are typically subject to various restrictions under the partnership agreement and state law.

The IRS has targeted FLPs and other family-owned businesses in various Tax Court cases. To strengthen its position in court, the IRS issued a proposal in August that could significantly reduce (or possibly eliminate) valuation discounts for certain family-owned business entities. Among other changes, the proposal would add a new category of restrictions that would be disregarded in valuing transfers of family-owned business interests.

If finalized, the proposed changes won’t go into effect until 2017 (at the earliest). So there still may be time to use these estate-planning tools and be grandfathered in under the existing tax rules. If you’ve been considering setting up an FLP or transferring additional interests in an existing one, it may be prudent to act before year end.

Contact your estate planning advisor for more details on this proposal — or to utilize this strategy before any new restrictions go into effect.

Roth IRAs

Do you understand the key differences between traditional and Roth IRAs? Roth IRAs can be an effective retirement-saving tool for people who expect to be in a higher income tax bracket when they retire. Here’s how it typically works.

You open up a Roth IRA and make after-tax contributions. The tax savings come during retirement: You don’t owe income taxes on qualified Roth withdrawals.

As an added bonus, unlike with traditional IRAs, there’s no requirement to start taking annual required minimum distributions (RMDs) from a Roth account after reaching age 70 1/2. So you’re free to leave as much money in your Roth account as you wish for as long as you wish. This important privilege allows you to maximize tax-free Roth IRA earnings, and it makes the Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth IRA money to help finance your own retirement).

The maximum amount you can contribute for any tax year to any IRA, including a Roth account, is the lesser of:

  1. Your earned income for that year, or
  2. The annual IRA contribution limit for that year. For 2016, the annual IRA contribution limit is $5,500, or $6,500 if you’ll be age 50 or older as of year end.

If you’re married, both you and your spouse can make annual contributions to separate IRAs as long as you have sufficient earned income. For this purpose, you can add your earned income and your spouse’s earned income together, assuming you file jointly. As long as your combined earned income equals or exceeds your combined IRA contributions, you’re both good to go.

Unfortunately, your ability to make annual Roth contributions may be reduced or eliminated by a phaseout rule that affects high-income individuals. But you may be able to circumvent this rule by making an annual nondeductible contribution to a traditional IRA and then converting the account into a Roth IRA. In this indirect fashion, high net worth individuals can make Roth contributions of up to $5,500 if they’re under age 50 or up to $6,500 if they’re at least 50 and younger than 70 1/2 as of the end of the year. (Once you hit 70 1/2, you become ineligible to make traditional IRA contributions, and that shuts down this strategy.)

If you’re married, you can double the fun by together contributing up to $11,000 or up to $13,000 if you’re both at least 50 (but under age 70 1/2). There are various rules and restrictions to using this strategy, and it may be less advantageous if you have one or more existing traditional IRAs. So, consult with your tax advisor before attempting it.

Self-Directed IRAs

Self-directed IRAs expand the menu of investment options available in a typical IRA. For instance, with a self-directed IRA you may be able to include such alternatives as hedge funds, real estate and even equity interests in private companies. These types of investments often offer higher returns than traditional IRA investment options.

But self-directed IRAs aren’t a free-for-all. The tax law prohibits self-dealing between an IRA and “disqualified” individuals. For example, you can’t lend money to your IRA or invest in a business that you, your family or an IRA beneficiary controls. The consequences for self-dealing can be severe, so consult with your financial advisor before making the switch.

Deductible Losses on Underperforming Stocks

Do you own stocks and other marketable securities (outside of your retirement accounts) that have lost money? If so, consider selling losing investments held in taxable brokerage firm accounts to lower your 2016 tax bill. This strategy allows you to deduct the resulting capital losses against this year’s capital gains. If your losses exceed your gains, you will have a net capital loss.

You can deduct up to $3,000 of net capital loss (or $1,500 if you are married and file separately) against ordinary income, including your salary, self-employment income, alimony and interest income. Any excess net capital loss is carried forward to future years and puts you in position for tax savings in 2017 and beyond.

Gifts of Appreciated Assets

Suppose you are lucky enough to have the reverse situation: You own stocks and other marketable securities (outside of your retirement accounts) that have skyrocketed in value since they were acquired. Taxpayers in the 10% or 15% income tax brackets can sell the appreciated shares and take advantage of the 0% federal income tax bracket available on long-term capital gains. Keep in mind, however, that depending on how much gain you have, you might use up the 0% bracket and be subject to tax at a higher rate of up to 20%, or 23.8% when considering the Medicare surcharge that may apply.

While your tax bracket may be too high to take advantage of the 0% rate, you probably have loved ones who are in the lower tax brackets. If so, consider gifting them assets to sell.

Important Note. Gains will be considered long-term if your ownership period plus the gift recipient’s ownership period equals at least a year and a day.

Giving qualified-dividend-paying stocks to family members eligible for the 0% rate is another tax-smart idea. But before making a gift, consider the gift tax consequences.

The annual gift tax exclusion is $14,000 in 2016 (the same as 2015). If you give assets valued at more than $14,000 (or $28,000 for married couples) to an individual during 2016, it will reduce your $5.45 million gift and estate tax exemption — or be subject to gift tax if you’ve already used up your lifetime exemption. Also keep in mind that if your gift recipient is under age 24, the “kiddie tax” rules could potentially cause some of his or her capital gains and dividends to be taxed at the parents’ higher rates.

Charitable Donations

Charitable donations can be one of the most powerful tax-savings tools because you’re in complete control of when and how much you give. No floor applies, and annual deduction limits are high (20%, 30% or 50% of your adjusted gross income, depending on what you’re giving and whether a public charity or a private foundation is the recipient).

If you have appreciated stock or mutual fund shares that you’ve owned for more than a year, consider donating them instead of cash. You can generally claim a charitable deduction for the full market value at the time of the donation and avoid any capital gains tax hit.

If you own stocks that are worth less than you paid for them, don’t donate them to a charity. Instead, sell the stock and give the cash proceeds to a charity. That way, you can generally deduct the full amount of the cash donation while keeping the tax-saving capital loss for yourself.

Life Changes

Have there been any major changes in your personal life, such as a recent marriage or divorce, the birth or adoption of a new child, or a death in the family? If so, you may need to revise the beneficiaries on your retirement accounts and life insurance policies. You also may need to update your will and power of attorney documents.

Life changes can be stressful, and it’s very common for these administrative chores to be overlooked. But failure to update financial plans and legal documents can lead to unintended consequences later on, either when you die or if you become legally incapacitated and need someone else to make certain decisions on your behalf.

Got Questions?

These are just a handful of financial issues to consider at year end. Your financial and legal advisors can run through a more comprehensive checklist of planning options based on your personal circumstances. Call Cornwell Jackson to schedule a meeting as soon as possible, before the hustle and bustle of the holiday season starts.

Posted on Aug 5, 2016

Are you drawing too much salary from your construction company — or perhaps not enough? Be careful: The IRS may challenge deductions for wages it thinks are unreasonable.

In a recent case, the co-owners of a cement contracting business chose to pay themselves a certain amount of compensation, contested the IRS’s refusal to allow part of the compensation as deductible and eventually won the case (H. W. Johnson, Inc., TC Memo 2016-95). The U.S. Tax Court’s decision revolved around the “independent investor” test.

Separate Divisions

The company was owned by the retired founder’s wife (51% interest) and his two sons (24.5% each). It grew to become one of the largest concrete contractors in Arizona, with more than 200 employees. Annual revenue rose rapidly after the sons assumed control of daily operations. When they took over in 1993, the company showed revenue of $4 million. That mushroomed to $23.87 million in 2003 and $38 million in 2004, the two tax years questioned by the IRS.

Each brother supervised a division of the company, overseeing all operations including:

  • Contract bidding and negotiation,
  • Project scheduling and management,
  • Equipment purchase and modification,
  • Personnel management, and
  • Customer relations.

Working 10 to 12 hours a day, five to six days a week, the brothers were at job sites daily and regularly operated equipment. They each were readily available if problems arose and were known locally for their responsive and hands-on management style.

The concrete work that the brothers supervised required considerable technical skill. Over the years, their business built an excellent reputation with developers, inspectors and other contractors for timely, quality performance. As a result, the company routinely won contracts even when it wasn’t the lowest bidder.

During the two years in dispute, the brothers personally guaranteed loans allowing the business to buy materials and supplies. In 2003, faced with the possible disruptions in their concrete supply, the brothers partnered with investors to start a concrete supply business — despite their mother’s objections about the risks. This move allowed the company to prosper when others were suffering.

The board of directors voted to pay the brothers $4,025,039 and $7,300,916 in 2003 and 2004, respectively. But the IRS partially denied the company’s deductions for this compensation, finding that $811,039 for 2003 and $768,916 for 2004 wasn’t reasonable.

Tax Court Outcome

The Tax Court applied the five factor test used by the U.S. Court of Appeals for the Ninth Circuit, to which an appeal in this case would have gone. Based on the appeals court’s landmark ruling in Elliotts v. Commissioner (716 F.2d at 1245-1247), five factors are used to determine reasonable compensation:

  1. The employee’s role in the company,
  2. A comparison with other businesses,
  3. The character and condition of the company,
  4. Potential conflicts of interest, and
  5. Internal consistency in compensation.

According to the court opinion, the IRS argued that the current case hinged on the “fourth Elliotts factor; namely, whether a hypothetical independent investor would receive an adequate return on equity after accounting for [the brothers’] compensation.”

Responding to that argument, the Tax Court said that the annual return after payment of the compensation closely approximated the return generated by comparable companies. Accordingly, it said that an independent investor would have been satisfied with the return.

After examining all the factors, the Tax Court concluded that the compensation paid to the brothers was reasonable under the circumstances and, thus, deductible. Each brother was integral to the success of the business — including performance that resulted in remarkable growth in revenue, assets and gross profit margins during the years at issue.

Takeaway for Contractors

For contractors, the takeaway from this Tax Court ruling is to be sure you’re familiar with the independent investor test and how it applies to IRS challenges of compensation arrangements for shareholder-employees. Although there’s no definitive bright line test on what constitutes “reasonable,” the courts have historically cited several factors that vary by jurisdiction. These include:

  • Amounts similar businesses pay their shareholder-employees,
  • Reasons for paying high compensation (spell them out in your corporate minutes),
  • The nature, extent and scope of the taxpayer’s work,
  • The taxpayer’s qualifications and experience,
  • The size and complexity of the business,
  • General economic conditions,
  • The employer’s financial condition,
  • The employer’s salary policy for all employees,
  • Compensation paid in previous years,
  • Whether the employer and employee are dealing on an arm’s-length basis, and
  • Whether the employee guaranteed the employer’s debts.

No single factor is greater than the other. The decision generally comes down to the number of factors weighing for or against reasonable compensation.

Remember to pay reasonable amounts for services actually rendered. These actions should help protect you if the IRS ever comes calling,

Also, it makes a big tax difference whether amounts paid to owners and other high-income employees are treated as compensation or dividends. Compensation is deductible from the employer’s taxable income; dividends aren’t and effectively represent a second level of taxation on corporate income.

For this reason, some employers choose to maximize the tax benefits by increasing the compensation. However, if a company simply pays its employees whatever it wants, it could find itself in hot water with the IRS. Typically, when the IRS successfully challenges an amount as “unreasonable,” the difference between the payment and a reasonable amount attributable to services provided can’t be deducted.

Best Defense

Of course, reasonable compensation issues don’t always involve excessive amounts. In some cases business owners may arrange for low or even no wage payments to reduce payroll taxes. As a result, the owners must argue with the IRS that they should be paid less, not more. If you find yourself in such a situation, you can bolster your position by spelling out the reasons for a low salary — including plans to use funds for expansion — in your corporate minutes.

The IRS may re-characterize compensation even if the business is running a loss — for an example, see Glass Blocks Unlimited (TC Memo 2013-180, 8/7/13). But, whatever the reason for the agency’s scrutiny, your construction company’s best first response to an IRS compensation challenge is to contact your CPA for professional guidance in building your defense.

Posted on Mar 28, 2016

Form 3115 - Accounting Word CloudOn March 24, 2016, The Internal Revenue Service (IRS) made an announcement regarding the revisions of Form 3115. This was the first update since 2009, and the changes are now required to be used, however the IRS will still accept the previous version of Form 3115 until April 19, 2016. We have summarized the major changes from the IRS below and answered some of the most common questions received by our tax professionals on this subject.

What is new about Form 3115-Application for Change in Accounting Method in 2016?

The new form updates the previous form with formatting changes, allows for multiple change numbers, and adds some new significant questions. Below, we have detailed some of the major changes; however, this is a summary of some of the major changes and should not be considered as an all-encompassing list.

  1. Duplicate Copy: The IRS has always required a duplicate copy of the form to be filed along with the original. Under the old procedures this form was to be filed in Ogden, Utah. As of January 2016 this duplicate copy is to be filed in Covington, Kentucky.
  2. Multiple Changes in Accounting: The IRS has added spacing to allow for multiple changes in accounting to be taken on one form.
  3. Legal Basis: On Page 3, Part II, Lines 16a and 16b the IRS requires that the legal basis supporting the changes be provided. The IRS indicated that in many situations taxpayers had made automatic changes without providing enough legal information to confirm that the taxpayer qualified for the change. Previously this information was only required for non-automatic changes.

These are just three of the changes under this new form. Tax preparers that utilize a Form 3115 should make themselves aware of the modifications to this new form. Per the request of the IRS, if a taxpayer has had a form prepared for the 2015 tax year that has not yet been filed, the form should be updated to the new Form 3115 prior to filing.

In addition to a new Form 3115 and instructions, the IRS announced that the filing location for the duplicate form is changing. Previously under Rev Proc 2015-13, taxpayers were required to file a duplicate Form 3115 with the Ogden, Utah, service center. Effective Jan. 1, 2016, taxpayers should file the duplicate form at the Covington, Kentucky, service center. If prior to April 20, 2016, a taxpayer filed their duplicate Form 3115 with the IRS at either the Ogden, Utah, or Covington, Kentucky, locations using the 2009 Form 3115, the taxpayer may file the original Form 3115 with their return using either the 2009 Form 3115 or the 2015 version.

The filing address to be used for the Covington, Kentucky, center is:

Internal Revenue Service
201 West Rivercenter Blvd.
PIN Team Mail Stop 97
Covington, KY 41011-1424

Click here for a link to the updated Form 3115 – Application for Change in Accounting Method.

Types of Accounting Methods Available

What are the different types of accounting methods available?
Cash basis and accrual basis are accounting methods that determine when and how you report income and expenses for tax purposes.  In the U.S., the IRS wants you to use the same method each year when reporting income.  Depending on your specific situation, there may be additional rules around when to use cash or accrual basis.

What is cash basis?
When cash basis is used as the accounting method, income is reported as payments are received, instead of invoices are issued. Expenses are reported when you pay bills. If invoices are used and bills are received to pay later, then this report method will affect the amount reflected in your A/R and A/P accounts.

What is accrual basis?
With accrual basis as the accounting method, income is reported as soon as invoices are sent to a client (instead of when money is received) and expenses are reported when bills are received.
Accrual basis is more accurate than cash basis reporting. It also allows for better business management by revealing trends in income and expenses well in advance of the actual payments being made or received.

Considering a change in accounting method for your business?

If you are considering a change in accounting method for your business, be sure to ask the right questions before making a move.

  1. How often can a company change its accounting method?
  2. What straight-line method changes require IRS approval?
  3. How does the Tax Year and Accounting Method Impact the Tax Picture for my business?
  4. If the total amount of the change is less than $25,000, can I spread the adjustment out over several years?

For guidance on this issue, talk to one of our tax professionals today. We’re here to help. Gary Jackson, CPA is the tax and consulting partner and can help determine if a change in accounting method would benefit your business.