2012 federal income tax update for the ... federal income tax update for the construction industry...
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2012 FEDERAL INCOME TAX UPDATE
FOR THE CONSTRUCTION INDUSTRY
Anthony F. Dannible, CPA/ABV, CVA, CFF, CDA
Dannible & McKee, LLP
Financial Plaza
221 South Warren Street
Syracuse, New York 13202-2687
CONTRACTS - A MYRIAD OF TAX PLANNING IDEAS
I. TAX METHODS OF CONSTRUCTION ACCOUNTING – NUMEROUS
CHOICES??
A. Overview of a contractor’s long-term contract accounting choices.
1. The cash method;
2. The accrual method;
3. The accrual method, excluding retentions;
4. The hybrid method; and
5. Long-term contract methods (Internal Revenue Code Section 460).
B. Depending on size of its revenues, a contractor may need to choose both an
overall method of accounting and a method for long-term contracts.
C. Long-term contracts under Internal Revenue Code Section 460.
1. Definition of a long-term contract (Code Section 460(b)).
2. A “long-term” contract is a contract that is not completed within the same
taxable year in which it is entered into.
3. Thus, a contract need only span two (2) taxable years to be eligible for
long-term contract accounting.
4. In addition, the contract must either be a “building, installation,
construction, or manufacturing contract” to qualify for long-term.
D. Generally, no book/tax conformity required.
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II. YEAR-END TAX PLANNING WITH THE SPECIAL TAX ACCOUNTING
RULES FOR LONG-TERM CONTRACTS (Section 460).
A. Definition of a long-term contract (Internal Revenue Code Section 460(f)).
1. Section 460(f) defines a “long-term contract” as:
“…any contract for the manufacture, building, installation, or construction
of property if such contract is not completed within the taxable year in
which the contract is entered into.”
IMPORTANT
A contract that starts and finishes in the same tax year
is not a long-term contract under Section 460. The
accrual or accrual less retainage can apply.
2. Thus, a contract may only last a week, but if it goes beyond the end of the
year, it is a long-term contract.
OBSERVATION
This negates the notion that a contract must be longer
than 12-months to be a long-term contract for a
construction contractor.
3. Section 460(e)(4) defines a “construction contract” as any contract for the
building, construction, reconstruction, or rehabilitation of, or the
installation of any integral component to, or improvement of, real
property.
a. Applies to land, buildings, and inherently permanent structures
such as roadways, dams, and bridges.
b. An integral component to real property includes property not
produced at the site, but intended to be permanently affixed to the
real property.
4. Section 460(b) refers to any long-term contract rather than a contractor’s
overall accounting method.
a. A contractor may report some contracts under the completed cost
method (CCM) and may be required to use percentage-of-
completion for others.
b. The requirement to use a long-term contract method for some or
all its contracts does not change the contractor’s elected method of
accounting or the elected method of accounting for long-term
contracts.
5. Construction Management Contracts are not long-term contracts.
a. In an Industry Specialization Program Settlement Guideline issued
and the Revised Construction Industry Audit Guide, the Internal
Revenue Service has indicated that construction management
contracts generally requires the performance of personal services
and does not put the construction management firm at risk for
defects and mistakes in the construction.
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b. The narrow and restrictive definition under Section 460(e)(4)
denies long-term contract treatment to architects, engineers,
industrial and commercial painters, as well as engineering services
and construction management.
c. Internal Revenue Service has clarified in the final Regulations that
if a construction contract includes the performance of these
services that are not incident to or necessary for a long-term
contract, the contractor must allocate revenue and costs to that
activity and the contractor must account for these activities under
a permissible method of accounting other than a long-term
contract method.
6. Under the Regulations, contracts with “de minimis” construction activity
are not long-term contracts.
a. Regulation Section 1.460-1(b)(2)(ii) states that when a contract
includes land and the total allocable costs are less than 10 percent
of the contract total price, it is not a construction contract.
b. Internal Revenue Service Non-Docketed Advice Review 200006.
(i) Addresses land development vs. construction.
(ii) Provides guidance on home and residential construction.
c. Watch Dual-Purpose Contracts.
(i) Dual-Purpose Contract is when a contract requires the
contractor to furnish land and land improvements to the
land. The contract will not be classified as a construction
contract if the construction activities are de minimis.
EXAMPLE
Dual-purpose contract
Assume a customer and a contractor enters into
a contract for the contractor to provide land and
construct improvements to the land at a total
contract price of $1 million. The cost of the land
is $500,000 and estimated construction costs are
$200,000. This contract would be considered a
construction contract since total estimated costs
allocable to construction activities are more than
10 percent of the total contract price. However,
if estimated costs allocable to construction
activities are only $95,000, the contract is not a
construction contract and Section 460 would not
apply.
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B. Long-Term Contract Methods.
Cash Method Income as cash
received/expensed when paid
≤ $1 million – Revenue
Procedure 2001-10
≤ $10 million – Revenue
Procedure 2002-28
Accrual Method When earned or incurred Regulation Section 1.451-1(a)
Accrual with Deferral of
Retainages
Same as accrual excludes
retainage
Revenue Ruling 69-314
Completed-Contract (CCM) Billings or total contract price
once contract is finished and
accepted.
Costs are deferred as incurred.
Specific costs are outlined in
1.460-5(d).
Once completed, costs are closed
out to expense.
S,G&A costs are expensed as
incurred.
Exempt Percentage-of-
Completion (EPCM)
Contract price (including change
orders) multiplied by percent
complete.
Percent complete determined by
various alternative methods, such
as:
Cost-to-cost
Labor hours to total labor hours
Various other permitted input
and/or output measurements.
Based on economic performance
regulations of §461(h).
Costs determined by 1.460-5(d).
All costs are expensed as
incurred.
IRC §460(b)
Percentage-of-Completion
(PCM)
Revenues determined by only the
cost-to-cost formula.
Based on economic performance
regulations of §461(h).
Costs determined by 1.460-5(b).
All costs are expensed as
incurred.
IRC §460(b)(3)
Simplified Cost-to-Cost Method
Same formula as §460(b), except
costs determined as outlined by
§460(b)(4) or 1.460-5(c).
Based on economic performance
regulations of §461(h).
Job costs are direct material,
direct labor and depreciation,
amortization, and cost recovery
on equipment directly used.
All costs are expensed as
incurred.
Reg. 1.460-4(e), §460(a)
Percentage-of-Completion/
Capitalized-Cost Method
(PCCM)
Use PCM formula as §460(b)
with same type of costs for 70
percent, and use exempt contract
method for the remaining 30
percent.
For 70 percent, same as the §460
PCM method, the balance of the
contract is accounted for by the
exempt-contract method.
IRC §460
10 percent Deferral Method
Same as §460(b) above, except
that revenues and billings on all
contracts with less than 10
percent complete, determined by
cost-to-cost formula, are deferred
until greater than 10 percent
complete.
Based on economic performance
regulations of §461(h).
All costs are expensed as
incurred.
All costs on contracts less the 10
percent complete are not
expensed as incurred, but rather
are deferred in an account similar
to an inventory account.
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C. Code Section 460(a) mandates the percentage-of-completion method to
account for long-term contracts.
1. Section 460(b) measures revenue by determining the percentage of costs
incurred to date compared to total estimated contract costs, as defined in
Regulation Section 1.460-5(a) multiplied by the contract amount.
2. Exceptions are provided in Code Section 460(e).
III. SPECIFIC EXEMPTIONS FOR CERTAIN CONSTRUCTION CONTRACTS
(Section 460(E)).
A. The Small Contractor Exemption (Section 460(e)(1)(B)).
1. For a contractor to be able to fall under this exemption, contracts must be
for: (i) the construction or improvement of real property which are
estimated to be completed within two (2) years from the commencement
date of the contract and (ii) are performed by a contractor whose average
gross receipts for the three (3) taxable years preceding the taxable year in
which the contract is entered into do not exceed $10 million.
2. For purposes of the $10 million limit, businesses under common control
must be aggregated.
a. Gross receipts for purposes of this test are determined based on
the principles found in Regulation 1.263A-3(b).
b. In addition to the gross receipts from all of the taxpayer’s
businesses, a proportionate share of construction related gross
receipts from any person owning a 5 percent or greater interest in
or in which the taxpayer owns a 5 percent or greater interest is
included.
c. Ownership is determined as of the first day of the tax year.
3. If a contractor meets this exemption, then the contractor may use accrual,
accrual less retainage, completed contract (CCM), etc.
a. A small contractor must still capitalize production period interest.
b. A small contractor must compute AMT under the percentage-of-
completion method.
c. The permissible methods for exempt contractors listed in
Regulation Section 1.460-4(c)(1) does not include the cash
receipts and disbursement method.
IMPORTANT
However, the Internal Revenue Service has issued
Revenue Procedure 2001-10 and Revenue Procedure
2002-28 to continue the cash method or to automatically
switch to it.
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EXAMPLE
Contract Status
(A) (B) (C) (D) (E) (F)
1 100,000$ 65,000$ 100,000$ 65,000$ 100% 100,000$
2 500,000 400,000 360,000 300,000 75% 375,000
3 350,000 265,000 350,000 200,000 75% 262,500
4 850,000 660,000 500,000 400,000 61% 518,500
5 400,000 330,000 400,000 330,000 100% 400,000
2,200,000 1,720,000 1,710,000 1,295,000 1,656,000
(AxE)
% of Contr.
Revenue to
Recognize
Contr.
No.
Contract
Amount
Estimated
Total Cost
Billings
through
12/31/0X
Cost Incurred
through
12/31/0X
(D-B)
% of
Comp.
Contract PCM Accrual CCM Cash
1 100,000$ 100,000$ 100,000$ 100,000$
2 375,000 360,000 N/A N/A
3 262,500 350,000 N/A N/A
4 518,500 500,000 N/A N/A
5 400,000 400,000 400,000 300,000
1,656,000$ 1,710,000$ 500,000$ 400,000$
Income Recognition Analysis
PCM Accrual CCM Cash
Fees billed to clients - net 1,656,000$ 1,710,000$ 500,000$ 400,000$
Direct costs of fees billed 1,295,000 1,295,000 395,000 345,000
Gross profit 361,000 415,000 105,000 55,000
Indirect expenses and overhead 205,000 205,000 205,000 205,000
Income/(loss) from operations 156,000 210,000 (100,000) (150,000)
Other expenses/(income):
Interest expense 32,000 23,000 28,000 28,000
Interest income (12,000) (3,000) (8,000) (8,000)
20,000 20,000 20,000 20,000
Income before income taxes 136,000 190,000 (120,000) (170,000)
Provision for income taxes (refund) 54,000 76,000 (48,000) (68,000)
Net income (loss) 82,000$ 114,000$ (72,000)$ (102,000)$
Operations
Company Taxable Year
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B. Specific exemptions for certain “home” construction contracts
(Section 460(e)).
1. Any home construction contract (Section 460(e)(1)(A)).
a. In determining whether a contract is a home construction contract,
Section 460(e)(6)(A) provides the following definition of a home
construction contract:
“Any construction contract that is 80 percent or more of the
estimated total contract costs (as of the close of the taxable year in
which the contract was entered into) are reasonably expected to be
attributable to (the building, construction, reconstruction, or
rehabilitation of, or the installation of any integral component to
or improvement of):
(i) Dwelling units (as defined in Section 168(e)(2)(A)(ii))
contained in buildings containing four or fewer dwelling
units; and
(ii) Improvements to real property directly related to such
dwelling units and located on the site of such dwelling
units.”
b. A homebuilder, regardless of his annual receipts, may use an
exempt contract method for home construction.
c. The definition of a home construction contract uses the term
“estimated total contract costs.”
d. All of the direct and indirect costs of construction, including
materials and raw land should be considered, as well as planning
and design activities incurred before construction begins.
e. In addition, Regulation Section 1.460-3(b)(2)(iii) provides that the
estimated total contract costs for each dwelling unit should also
include “their applicable share of the costs of any common
improvements, such as service roads and clubhouses.”
2. The Small Contractor Exemption (Section 460(e)(1)(B)).
a. For a contractor to be able to fall under this exemption, contracts
must be for: (i) the construction or improvement of real property
which are estimated to be completed within two (2) years from the
commencement date of the contract and (ii) are performed by a
contractor whose average gross receipts for the three (3) taxable
years preceding the taxable year in which the contract is entered
into do not exceed $10 million.
b. For purposes of the $10 million limit, businesses under common
control must be aggregated.
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3. If a contractor meets the home construction contract exemption, then the
contractor may use accrual, accrual less retainage, completed contract
method (CCM), etc.
a. A large or small contractor must still capitalize production period
interest.
b. The uniform capitalization rules in Section 263A do not apply.
c. The permissible methods for exempt contractors listed in
Regulation Section 1.460-4(c)(1) do not include the cash receipts
and disbursement method.
IMPORTANT
However, the Internal Revenue Service has
issued Revenue Procedure 2001-10 and Revenue
Procedure 2002-28 to continue the cash method
or to automatically switch to it.
4. Internal Revenue Service challenges to Home Construction Contractors.
a. Internal Revenue Service Non Docketed Service Advice Review
20006.
(i) Internal Revenue Service addresses whether or not a
developer who subdivides the property and installs roads,
sewers, electric lines, etc. is involved in “home
construction.”
(ii) Internal Revenue Service points out that a contract is not a
construction contract if it includes the provision of land
and the total allocable contract costs are less than
10 percent of the total contract price.
(iii) Internal Revenue Service points out that a construction
contract is a home construction contract if 80 percent of
the estimated contract costs are attributable to construction
of a dwelling unit and improvements to real property
directly related to such dwelling units.
(iv) If there are no construction activities related to dwelling
units, then there are no improvements to real property
related to such dwelling units.
(v) Q&A 44 in Notice 89-15 clarifies this off-site work such
as roads, sewers and other common features are
attributable to the dwelling units that the developer is
developing.
(vi) Internal Revenue Service points out that there must be
some construction activity on a dwelling unit in order for a
contract to qualify as a home construction contract.
(vii) Internal Revenue Service concludes that a land developer
is not involved in home construction.
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5. In TAM 200552012, the Internal Revenue Service concluded that a
taxpayer who was involved in land development and who was required to
provide common amenities and recreational facilities to be used by the
homeowners was not entitled to use the completed contract method
(CCM).
a. Internal Revenue Service concluded that Section 460 allows the
more favorable CCM of accounting to be used only by taxpayers
actively building the homes.
b. Taxpayer realized its income pursuant to its sales contract with the
builder, not the home construction contract with the consumer.
c. Internal Revenue Service held taxpayer should use percentage-of-
completion method (PCM).
6. Internal Revenue Service issued an Industry Audit Directive to all its field
offices in 2007 challenging the use of CCM by land developers.
C. Date taxpayer completes a long-term contract (Section 1.460-1(c)(3)).
1. The final Regulations indicate that a taxpayer’s contract is completed
upon the earlier of:
a. Use of the subject matter of the contract by the customer for its
intended purpose (other than for testing) and at least 95 percent of
the total allocable contract costs attributable to the contract have
been incurred; or
b. Final completion and acceptance of the subject matter of the
contract.
EXAMPLE I
In 2011, C, whose taxable year ends December 31,
enters into a contract to construct a building for B.
In November of 2012, the building is completed in
every respect necessary for its intended use, and B
occupies the building. In early December 2012, B
notifies C of some minor deficiencies that need to
be corrected, and C agrees to correct them in
January 2013. C reasonably estimates that the
cost of correcting these deficiencies will be less
than 5 percent of the total allocable contract costs.
C’s contract is complete under this section in 2012
because in that year, B used the building and C
had incurred at least 95 percent of the total
allocable contract costs attributable to the
building. C must use a permissible method of
accounting for any deficiency-related costs
incurred after 2012.
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EXAMPLE II
In 2011, C, whose taxable year ends December 31,
agrees to construct a shopping center, which
includes an adjoining parking lot, for B. By
October 2012, C has finished constructing the
retail portion of the shopping center. By
December 2012, C has graded the entire parking
lot, but has paved only one-fourth of it because
inclement weather conditions prevented C from
laying asphalt on the remaining three-fourths. In
December 2011, B opens the retail portion of the
shopping center and the paved portion of the
parking lot to the general public. C reasonably
estimates that the cost of paving the remaining
three-fourths of the parking lot when weather
permits will exceed 5 percent of C’s total allocable
contract costs. Even though B is using the subject
matter of the contract, C’s contract is not
completed in December 2012 because C has not
incurred at least 95 percent of the total allocable
contract costs attributable to the subject matter.
2. The final Regulations clarify that a subcontractor’s customer is the
general contractor.
3. For purposes of the look-back regulations, the final Regulations require a
taxpayer to delay the first application of the look-back method until the
taxable year in which the long-term contract is finally completed and
accepted.
4. Final completion and acceptance is determined without regard to whether
a dispute exists.
D. Severing and aggregating contracts (Section 1.460-1(e)).
1. The final Regulations allow a taxpayer to sever a long-term contract if
necessary to clearly reflect income, but only if the taxpayer has obtained
the Commissioner’s prior written approval.
2. The ability to sever or aggregate will depend on the following factors:
a. Pricing – Independent pricing of items in an agreement is
necessary for the agreement to be severed into two or more
contracts. Similarly, interdependent pricing of items in separate
agreements is necessary for two or more agreements to be
aggregated into one contract.
IMPORTANT
The separate delivery or separate acceptance
does not require an agreement to be severed.
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b. Separate Delivery or Acceptance – An agreement cannot be
severed into two or more contracts unless it provides for separate
delivery or acceptance of items that are the subject matter of the
agreement.
c. Reasonable Businessperson – Two or more agreements to perform
manufacturing or construction may not be aggregated into one
contract unless a reasonable businessperson would not have
entered into one of the agreements for the terms agreed upon
without also entering into the other agreement.
3. Exceptions.
a. Severance for PCM – A taxpayer may not sever a long-term
contract that would be subject to PCM without obtaining the
Commissioner’s prior written consent.
b. For options and change orders, a taxpayer must sever an
agreement that increases the number of units to be supplied to the
customer, such as through the exercise of an option or the
acceptance of a change order, if the agreement provides for
separate delivery or separate acceptance of the additional units.
4. Statement required to be filed with return.
a. If a taxpayer severs an agreement or aggregates two or more
agreements during the tax year, the taxpayer must attach a
statement to its original tax return.
b. The Statement must contain:
(i) The legend: “Notification of Severance or Agreement
Under 1.460-1(e)l;”
(ii) Taxpayer’s name; and
(iii) Taxpayer’s identification number.
NOTE
A PCM contract cannot be severed under
the change order exception.
E. Percentage-of-completion method (PCM) – The contract price
(Section 1.460-4(b)(4)).
1. In general, revenue earned on a contract during the tax year is calculated
by multiplying the total contract revenue by the ratio of costs incurred on
the contract by the total estimated costs, and then subtracting from that
result any revenue recognized in prior tax years.
2. The costs used to calculate the completion factor can be computed using
two (2) different methods.
a. Simplified cost-to-cost method.
b. The cost-to-cost method.
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3. The Simplified Cost-to-Cost Method.
a. Contractors using the PCM for income tax purposes can elect
under Internal Revenue Code Section 460(b)(3)(A) to use a
simplified cost-to-cost method to compute revenue. This election
is also available to any cash basis contractor who must use the
percentage-of-completion/capitalized cost method.
b. If the simplified cost-to-cost method is used, the 10 percent
election is not available.
c. This method determines the contract’s completion factor using
only
(i) direct material costs;
(ii) direct labor costs; and
(iii) tax depreciation, amortization, and cost recovery
allowances on equipment and facilities directly used to
manufacture or construct property under the contract.
d. Subcontracted costs represent either direct material or direct labor
costs and must be allocated to a contract under the simplified cost-
to-cost method.
EXAMPLE
Using the simplified cost-to-cost method for income
ABC is a building contractor that started one
contract with a value of $1,000,000 in 2012. As of
December 31, 2012, ABC had incurred the
following costs:
Total
Cost Estimated
To Date Cost
Direct labor $ 100,000 $ 200,000
Direct materials 200,000 400,000
Depreciation/amort. 50,000 100,000
$ 350,000 $ 700,000
PCM 50% ($350 ÷ $700)
4. Cost-to-cost method.
a. Under the cost-to-cost method, all direct and indirect costs that
directly benefit a long-term contract are compared with the direct
and indirect estimated costs for that contract.
b. Direct costs include direct materials, direct labor, and subcontract
expenses. There are many indirect costs that must be considered.
c. Some additional costs, such as construction period interest, must
also be allocated to contracts.
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d. Costs become allocable to a contract once they have been
specifically used in the job.
e. An important issue involves the treatment of materials purchased
for a job but not yet included in the subject matter of the contract.
f. Tax cost accounting allows the contractor to treat the cost as
incurred if the materials have been specifically purchased and
dedicated to the job.
g. GAAP requires that these stored materials be pulled out of
contract costs and treated as inventory at the balance sheet date.
IMPORTANT
Subcontractor costs must be included in the
contract costs in determining the completion
factor under the PCM. The Internal Revenue
Service Appeals Settlement Guideline concludes
that a contractor cannot postpone the recognition
of subcontractor costs that have been incurred but
not yet paid for to reduce gross income. This
applies to materials, equipment and labor.
EXAMPLE
Computing Gross Profit Under the Percentage of Completion
ABC is a general contractor that has one contract uncompleted at the
end of 2012. The contract price is $1,200,000, costs incurred to date
totaled $600,000, and ABC estimates that another $400,000 in costs will
be incurred to complete the contract. In 2011, the first year of the
contract, ABC recognized $250,000 in contract revenue and incurred
$200,000 of costs. ABC will recognize $70,000 of gross profit in 2012,
computed as follows:
Costs incurred through the 2012 year-end $ 600,000
Estimated costs to complete 400,000
Total estimated costs $1,000,000
Percentage of completion = $600,000 ÷ $1,000,000 = 60%
Revenue earned through 2012 = 60% x $1,200,000 = $ 720,000
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2012 Gross Revenue:
Revenue earned through 2012 $ 720,000
Less: Revenue previously
recognized in 2011 (250,000)
Gross revenue to be recognized in 2012 $ 470,000
Cost of contract through 2012 $ 600,000
Less: Costs previously
deducted (200,000)
Costs to be deducted in 2012 (400,000)
Gross profit in 2012 $ 70,000
5. A taxpayer can reasonably estimate that an amount of contingent income
will be earned not later than the year when the taxpayer includes that
amount in income for financial purposes under generally accepted
accounting principles.
IV. NEW INTERNAL REVENUE SERVICE REGULATIONS PROVIDE GUIDANCE
ON DEDUCTION AND CAPITALIZATION OF TANGIBLE PROPERTY
EXPENDITURES (I
A. Overview.
1. Under the new Temporary Regulations, as a general rule, all costs that
facilitate the acquisition or production of such property must be
capitalized, with exceptions, for employee compensation and overhead
costs.
2. Investigation costs related to the acquisition of realty do not have to be
capitalized unless they are inherently facilitation.
3. A new rule requires taxpayers to capitalize repair-type expenses made to
assets before they are placed in service.
4. A de minimus rule allows taxpayers to expense the acquisition of some
assets, if the acquisition cost is expensed on the taxpayer’s financial
statements and certain other conditions are met.
B. The Temporary Regulations Rewrite the Rules on Deduction Versus
Capitalization of Tangible Property Costs.
1. The Regulations create all-encompassing guidelines on what constitutes
an improvement and creates a “BAR Test.”
2. Does the expenditure:
a. Result in a “Betterment” to the unit of property?
b. Does it “Adapt” the unit of property to a new or different use?
c. Does it “Restore” the unit of property?
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IMPORTANT
Much of the guidance in the Temporary
Regulations revolves around what constitutes a
“unit of property” (UOP). The definition of a
UOP for capitalization purposes may be the
same as, or radically different from, the
definition of a UOP for other purposes. For
example, the definition of a UOP for non-
building assets for capitalization purposes is very
similar to the definition of a unit of tangible
personal property for UNICAP purposes in
Regulation Section 1.263A-10. By contrast, the
definition of the UOP for a building is completely
different from the definition of a unit of real
property for purposes in Regulation
Section 1.263A-10.
C. Building Improvements.
1. In general, each building and it structural components are one UOP – the
“building.”
2. Amounts are treated as paid for an improvement to a building they
improve:
a. The building structure; or
b. Any designated building system.
3. A building structure consists of a building and its structural components
as defined in Regulation Section 1.48-1(e) (unless the component is a
building system) and includes “structural components” that include such
parts of a building as walls, partitions, floors, and ceiling, as well as any
permanent coverings therefore, such as paneling or tiling; windows and
doors; as well as other components relating to the operation or
maintenance of a building.
4. A building system consists of the following nine structural components
that is separate from the building structure, and to which the improvement
rules must be separately applied:
a. HVAC systems (including motors, compressors, boilers, furnace,
chillers, pipes, ducts, radiators);
b. Plumbing systems (including pipes, drains, valves, sinks,
bathtubs, toilets, water and sanitary sewer collection equipment,
and site utility equipment used to distribute water and waste to
and from the property line and between buildings and other
permanent structures);
c. Electrical systems (including wiring, outlets, junction boxes,
lighting fixtures and associated connectors, and site utility
equipment used to distribute electricity from property line to and
between buildings and other permanent structure);
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d. All escalators;
e. All elevators:
f. Fire-protection and alarm systems (including items such as
sensing devices, computer controls, sprinkler heads, sprinkler
mains, associated piping or plumbing, pumps, visual and audible
alarms, and alarm control panels);
g. Security systems that protect the building and its occupants
(including items such as locks, security cameras, motion detectors,
security lighting, and alarm systems);
h. Gas distribution system (including associated pipes and equipment
used to distribute gas to and from property line and between
buildings or permanent structures); and
i. Other structural components identified in published Internal
Revenue Service guidance that are not part of the building
structure and are specifically designated as building systems.
OBSERVATION
The division of a building into components is a
significant change from prior law where
taxpayers would likely have treated all
components of a building as one collective asset.
With the new Temporary Regulations, taxpayers
should consider capitalizing the different systems
of buildings as separate assets.
5. The new Temporary Regulations permit taxpayers to treat the retirement
of a structural component as a disposition so taxpayers can recognize a
“loss” before the disposition of the entire building.
6. Notwithstanding the above UOP rules, a component of a UOP must be
treated as a separate UOP if, when the UOP is initially placed in service
by the taxpayer.
a. The taxpayer properly treated the component as being within a
different class of property under Code Section 168(e) for MACRS
depreciation purposes than the class of the UOP of which the
component is a part; or
b. The taxpayer properly depreciated the component using a
different depreciation method than the depreciation method of the
UOP of which the component is a part.
NOTE
In any year after a UOP is initially placed in
service, if the taxpayer changes the treatment to
a proper MACRS class or method, then the
taxpayer must change UOP for the property.
- 17 -
7. Repairs undertaken contemporaneously with improvements.
a. New Regulations set aside the judiciously developed plan of
rehabilitation doctrine whereby a taxpayer must capitalize
otherwise deductible repair costs if they are incurred as part of a
general plan of renovation.
b. Regulations specifically provide that indirect costs made at the
same time as an improvement but that do not directly benefit or
are not incurred by reason of the improvement do not have to be
capitalized.
c. Taxpayer must still capitalize all the direct costs of an
improvement and all indirect costs that directly benefit or are
incurred by reason of an improvement (such as otherwise
deductible repair or component removed costs).
OBSERVATION
The Regulations make particular reference to
removal costs and do not prescribe how to treat
such costs. However, while reiterating that costs
of removing a component of a UOP must be
capitalized if they are incurred by reason of an
improvement, the Regulations indicate that the
cost of removing an “entire UOP” would not
have to be capitalized.
D. UOP for Assets Other than Buildings.
1. For real or personal property that is not classified as a building, all
components that are functionally interdependent comprise a single UOP.
2. Components are functionally interdependent if placing one component in
service depends on placing the other component in service.
3. New Regulations do not require that taxpayer to treat functionally
interdependent components as a separate unit of property if the taxpayer
initially assigns a different economic life to the component for financial
reporting or regulatory purposes.
4. The Regulations have a safe-harbor from capitalization for certain routine
maintenance costs.
E. Definition of Repairs and Maintenance.
1. A component acquired to maintain, repair or improve a unit of tangible
property owned, leased or serviced by the taxpayer and that is not
acquired as part of any single unit of property.
2. A unit of property that had an economic useful life of 12-months or less,
beginning when the property was used or consumed; or
3. A unit of property that had an acquisition or production cost of $100 or
less.
F. Factors Determining Routine Maintenance.
1. Recurring nature of the activity.
- 18 -
2. Industry practice.
3. Manufacturer’s recommendations.
4. Taxpayer’s experience (history).
5. Taxpayer’s treatment on its applicable financial statement.
NOTE
Routine maintenance does not include amounts paid
to return a unit of property to its ordinary efficient
operating condition – if the property has deteriorated
to a state of disrepair and is no longer functional for
its intended use.
6. If the routine maintenance involves a “betterment,” the cost of routine
maintenance is required to be capitalized.
G. Betterments.
1. Improves a material condition or defect that either existed prior to the
taxpayer’s acquisition of the unit of property or arose during the
production of the unit of property.
2. Results in a material addition.
a. Enlargement.
b. Expansion.
c. Extension.
3. Results in a material increase in capacity, productivity, efficiency,
strength or quality of the unit or the output of the unit of property.
H. De Minimus Rule of Expensing.
1. If a taxpayer expenses the purchase price of tangible property for
financial reporting purposes and has a “formal written accounting policy”
for expensing those amounts, the taxpayer can now deduct the amount for
tax purposes – up to a threshold.
2. Safe-Harbor Threshold.
a. The aggregate amount expensed must be less than or equal to 0.1
percent of the gross receipts; or
b. Two percent of the total depreciation and amortization expense for
the tax year.
CAUTION
The De Minimus Rule is only available to
taxpayers who have a financial statement filed
with the SEC, a certified audited financial
statement, or a financial statement required to
be filed with the Federal or state government or
agency (other than a tax return).
- 19 -
I. Large Business & International (LB&I) Division has Issued a Directive to
Field Agents in Examinations of Repair Versus Capitalization Issues.
1. Internal Revenue Service issued Revenue Procedure 2012-19 and
Revenue Procedure 2012-20 which provide procedures for taxpayers to
obtain automatic consent to change to the accounting methods in the
Temporary Regulations.
2. For pre-2012 audits, the LB&I Directive provides that for examination of
tax years beginning before January 1, 2012, the Internal Revenue Service
Examiner should:
a. Discontinue current exam activity with regard to the Issues;
b. Not begin any new exam activity with regard to the Issues;
c. Risk assess the Form 3115 and determine, in consultation with the
Change in Accounting Method Issue Practice Group, whether to
examine the Form 3115 where a taxpayer files a Form 3115 with
regard to the Issues on or after December 31, 2011 (i.e., the date
the Temporary Regulations were issued) for a tax year not
covered by the Temporary Regulations.
d. Take the following steps to discontinue exam activity with regard
to the Issues:
(i) Withdraw Forms 4564, Information Document Request.
(ii) Withdraw all Forms 5701, Notice of Proposed Adjustment,
which propose an adjustment to repair expenses related to
whether costs incurred to maintain, replace, or improve
tangible property must be capitalized under Code Section
263(a), and any correlative adjustments involving the
disposition of associated assets.
(iii) Develop and issue a Form 5701 with a Form 886-A,
Explanation of Adjustments, containing specified language
indicating that Internal Revenue Service neither accepts
not rejects the position taken in the tax return related to the
method to determine the proper treatment of amounts
incurred to repair tangible property, but that the taxpayer
has a two-year period to adopt the appropriate accounting
method in Revenue Procedure 2012-19 or Revenue
Procedure 2012-20.
3. For post-2011 audits, the LB&I Directive provides that for examination
of a return for a tax year beginning on or after January 1, 2012 but before
January 1, 2014, Internal Revenue Service Examiners should perform a
risk assessment regarding the method change if the taxpayer has filed a
Form 3115, Application for Change in Accounting Method, in accordance
with Revenue Procedure 2012-19 or Revenue Procedure 2012-20.
4. For examination for tax years beginning on or after January 1, 2014, the
Internal Revenue Service Examiner should apply the Regulations in effect
and follow normal exam procedures.
- 20 -
IMPORTANT
The Internal Revenue Service, on November 20, 2012,
released an advance copy of Notice 2012-73 (Notice).
The Notice indicates the Internal Revenue Service
intends to issue final regulations regarding the
deduction and capitalization of expenditures related to
tangible property in 2013, with an effective date
beginning on or after January 1, 2014, rather than
January 1, 2012, as provided when the temporary
regulations were introduced. But, that does not mean
that taxpayers should put plans to implement changes
on hold.
The Notice permits taxpayers to apply the temporary
regulations for taxable years beginning on or after
January 1, 2012, and before the effective date of the
final regulations. Taxpayers electing to adopt the
temporary regulations prior to taxable years beginning
on or after January 1, 2014, may continue to obtain the
automatic consent under Revenue Procedure 2012-19
and Revenue Procedure 2012-20.
V. FOR 2012 TAX RETURNS, THERE IS ENHANCED EXPENSING FOR
CERTAIN DEPRECIABLE ASSETS BUT IT IS REDUCED (Internal Revenue
Code Section 179).
A. The Small Business Jobs Act of 2010 increased the maximum regular Code
Section 179 tax deduction to $139,000 in 2012.
1. The $139,000 limitation is reduced by the excess amount of Section 179
property placed in service during the year that exceeds $560,000.
2. Unlike regular depreciation, the full expensing is not limited by the mid-
quarter or half-year convention and is allowed in full no matter when the
property is placed in service, even on the last day of the tax year.
3. Applies to new or used property additions, including off-the-shelf
software.
4. The increased Section 179 deduction and phase-out levels available for
qualified property placed in service in:
a. An empowerment zone;
b. A renewal community; or
c. Gulf Opportunity Zone
continue to be available in addition to the enhanced regular Section 179
maximum expense deduction.
- 21 -
EXAMPLE
ABC, an empowerment zone taxpayer, places qualified
zone property of $1,120,000 in service in 2012. ABC
can expense $174,000 in 2012 under Section 179. The
$139,000 under the Small Business Act is increased by
$35,000 for the cost of qualified zone property. In
addition, when determining whether or not the phase-
out of $560,000 is exceeded, only one-half of the value of
the cost of zone property is considered.
5. There is no alternative minimum tax (AMT) adjustment for property
expensed under Section 179.
6. Effective for property placed in service prior to January 1, 2013.
IMPORTANT
H.R. 3476 of the American, Growth, Recovery,
Empowerment and Entrepreneurship Act proposes to
extend the $500,000 to 2015.
B. Under the Small Business Jobs Act, the limitation was $500,000 in 2010 and
2011 and a $2 million phase-out and allowed taxpayers to expense up to
$250,000 of the $500,000 for qualified leasehold property.
C. No amount attributable to qualified real property can be carried over to a
tax year beginning after 2011.
1. Regardless of the general carryover rule for Section 179, there is no
carryover for unused expensing for real property placed in service in
2011.
2. To the extent that any amount is not allowed as a carryover to a tax year
beginning after 2011 due to the carryover limitation, the Internal Revenue
Code is applied as if no Section 179 election had been made.
OBSERVATION
Thus, any disallowed Section 179 deduction for real
property placed in service in 2011 that is carried over to
2012 is treated as if the property was placed in service
on the first day of the taxpayer’s last tax year beginning
in 2012.
EXAMPLE
X, a calendar year taxpayer, has no carryovers and
places $500,000 of qualified leasehold improvements
property in service in 2011. The maximum Section 179
is $250,000. Assuming X has taxable income of
$100,000, X’s unused Section 179 would be $150,000
($250,000 - $100,000) which cannot be carried over. X
can depreciate the excess $150,000 in 2012.
- 22 -
VI. FOR 2012 TAX RETURNS, THERE IS THE ENHANCED 50 PERCENT
ADDITIONAL BONUS DEPRECIATION (I 168( )).
A. Qualified property is eligible for the 50 percent additional first-year
depreciation deduction if:
1. Qualified property is acquired before January 1, 2013;
2. Taxpayer places the qualified property in service before January 1, 2013;
and
3. The original use of the qualified property commences with the taxpayer.
IMPORTANT
Qualified property that a taxpayer manufactures,
constructs or produces in its trade or business is
acquired by the taxpayer when the taxpayer begins
manufacturing or construction. However, there is a
special election for “components” constructed or
produced.
B. In order for property to qualify for the additional depreciation, property
must fall under one of the following classes of property:
1. Property to which Code Section 168 with a MACRS recovery period of
twenty (20) years or less;
2. Water utility property;
3. Computer software except for non-Section 197 computer software
amortized over fifteen (15) years; or
4. Qualified leasehold improvements.
PLANNING POINT
Based on the Hospital Corporation of America &
Subsidiaries vs. Commissioner, (1997) 109 T.C. 21 case,
the new bonus depreciation rule provides even greater
incentive to allocate a portion of the new twenty-seven
and one-half (27.5) or thirty-nine (39) year realty to a
five (5) or seven (7) year “fixture” where the 100
percent cost can be written-off up-front. The Internal
Revenue Service has issued a MSSP guide on cost
segregation.
C. The original use must begin with the taxpayer (Regulation 1.168(k)-1(b)(3)).
1. Original use means the first use to which the property is put, whether or
not that use corresponds to the use of the property by the taxpayer.
2. Additional capital expenditures incurred by the taxpayer to recondition or
rebuild the property satisfy the “original use” requirement.
3. Under Internal Revenue Service Regulation 1.168(k)-1(b)(3)(i) indicates
that property that contains used parts will be treated as new and will not
be treated as used if the cost of the reconditioned or rebuilt property is not
more than 20 percent used.
- 23 -
D. The new property must be purchased within the applicable time period.
1. The applicable time period for acquired property is after September 8,
2010, and before January 1, 2013, but only if no binding written contract
for the acquisition is in effect before September 8, 2010; or
IMPORTANT
An important exception is available for “components”
of self-constructed assets started prior to September 8,
2010.
2. With respect to property that is manufactured, constructed, or produced
by the taxpayer for use by the taxpayer, the taxpayer must begin the
manufacture, construction, or production of the property after
September 8, 2010, and before January 1, 2013.
3. Property that is manufactured, constructed, or produced for the taxpayer
by another person under a contract that is entered into prior to the
manufacture, construction, or production of the property is considered to
be manufactured, constructed, or produced by the taxpayer.
4. An extension of the placed-in-service date of one year (i.e., to January 1,
2013) is provided for certain property with a recovery period of ten years
or longer and certain transportation property.
E. No overall ceiling on bonus depreciation.
1. Unlike the Section 179 first-year depreciation that is phased-out, if more
than $560,000 in additions is placed in service in 2012, the new
50 percent bonus depreciation has no such requirement.
2. Unlike the Section 179 expense deduction, all taxpayers can take
advantage of this new provision.
EXAMPLE
On July 1, 2012, ABC purchases and places in service
construction equipment that is five-year MACRS
property costing $10 million. ABC can elect 50 percent
bonus depreciation of $5 million for tax year 2012.
3. The amount of the 50 percent bonus depreciation deduction is not
affected by a short tax year.
4. The 50 percent bonus depreciation deduction is not allowed for purposes
of computing earnings and profits.
IMPORTANT
Most states disallow the increased expensing allowance
and/or first year bonus depreciation deductions.
F. In 2013, the Section 168(k) bonus depreciation is eliminated.
- 24 -
IMPORTANT
For planning purposes, current law allows taxpayer to expense
50 percent of new qualified additions acquired before
January 1, 2013. Taxpayers should review their capital
expenditures and consider accelerating additions into 2012.
G. Comparison of Section 179 versus the 50 percent bonus depreciation.
Section 179 50% Bonus Depreciation**
Types of Activities Active trade or business only All activities (rentals)
Modify Election Yes
Big Advantage Generally-No
Deduction Limited $500,000 in 2010-2011
$139,000 in 2012
$25,000 in 2013
No limit
1031 basis New cash only 50% of basis
Consider trade-ins
Purchase Amount Limits $2,000,000 in 2010-2011 None
** For property acquired after September 8, 2010, and prior to
January 1, 2012, 100 percent bonus depreciation was allowed.
VII. FIRST-YEAR DEPRECIATION LIMIT FOR PASSENGER AUTOMOBILES IS
INCREASED BY $8,000 IF THE AUTOMOBILE IS “QUALIFIED PROPERTY”
(Internal Revenue Code Section 168(k)(2)(F)(i)).
A. For 2012, an additional $8,000 is added to the first year cap for new luxury
automobiles, trucks and vans.
B. For 2012, the following Table shows the depreciation limitation:
PASSENGER AUTOMOBILES
TAX YEAR NO BONUS WITH BONUS
1st Tax Year $3,160 $11,160
2nd
Tax Year 5,100 5,100
3rd
Tax Year 3,050 3,050
Each Succeeding 1,875 1,875
TRUCKS AND VANS
TAX YEAR NO BONUS WITH BONUS
1st Tax Year (2009) $3,360 $11,360
2nd
Tax Year 5,300 5,300
3rd
Tax Year 3,150 3,150
Each Succeeding 1,875 1,875
IMPORTANT
The Internal Revenue Service has provided owners and lessees
with Tables detailing limitations on the above deductions in
Revenue Procedure 2011-26.
- 25 -
EXAMPLES
$ 60,000 Purchase price
-0- Section 179 (limited)
60,000
(A) (8,000) Bonus depreciation (no limit other than autos)
52,000 Remaining basis
20% Year 1 rate
10,400 Year 1 depreciation
(B) 3,160 Luxury auto limit
(A)+(B) $ 11,160 2012 deduction
50% Bonus Section 179 and Bonus
$ 60,000 Purchase price $ 60,000 Purchase Price
-0- Section 179 (limited) (25,000) Section 179 (limited)
60,000 35,000
(30,000) Bonus depreciation (30,000) Bonus depreciation
(no limit) (no limit)
30,000 Remaining basis 5,000- Remaining basis
20% Year 1 rate 20% Year 1 rate
$ 6,000 Year 1 depreciation $ 1,000- Year 1 depreciation
$ 36,000 2012 deduction $ 56,000 2012 deduction
$ 60,000 Purchase price
(60,000) Section 179 (up to $139,000)
-0-
-0- *Bonus depreciation (no limit)
-0-
20% Year 1 rate
$ 60,000 2012 deduction
*Could also have claimed 50% bonus if truck was a new
truck.
C. Unlike the Section 179 deduction, the purchase of a “used vehicle” does not
qualify for the additional 50 percent first year deduction.
D. There is no AMT depreciation adjustment for qualified property for the
entire period.
- 26 -
E. There is an important exception where a passenger vehicle with an enclosed
body that is built on a truck chassis is not considered to be a passenger auto
if it has a gross vehicle weight rating (GVWR) – the manufacturer’s
maximum weight rating when loaded to capacity – above 6,000 pounds.
1. “Heavy” passenger vehicles that meet the preceding definition are
considered trucks under the Internal Revenue Code and are thus eligible
for the favorable depreciation rules outlined above – as opposed to the
stingy luxury auto rules that apply to passenger autos.
2. Quite a few SUVs, pickups, and vans qualify as heavy.
F. Reduced Section 179 deduction for heavy SUVs.
1. A lower $25,000 limit exists on Section 179 deductions for heavy SUVs
with GVWRs of 14,000 pounds or less.
VIII. CONSTRUCTION GROSS RECEIPTS THAT QUALIFY FOR THE DOMESTIC
PRODUCTION ACTIVITIES DEDUCTION ( ).
A. A contractor is allowed a deduction under Internal Revenue Code
Section 199(a)(1) against gross income equal to 9 percent of qualified
production activities income (QPAI).
1. Contractor must be engaged in a qualified production activity (QPA).
2. Qualified production activity includes construction performed in the
United States.
3. Contractor must determine qualified domestic production gross receipts.
B. Domestic Production Gross Receipts (DPGR).
1. The Regulations define DPGR from construction activities as a taxpayer’s
gross receipts from construction activities that are directly related to
erection or substantial renovation of real property located in the United
States.
a. Includes residential or commercial buildings.
b. Includes infrastructure improvements such as roads, power lines,
water systems, etc.
2. Gross receipts from the sale of tangible property may be included in
DPGR (at the election of the taxpayer) if they are less than 5 percent of
total receipts.
3. Construction does not include activities performed by others that are
secondary to the construction, such as hauling or delivery materials.
4. Painting and land improvements are considered to be construction
activities only if performed in connection with other activities that
constitute erection or substantial renovation of real property.
5. The Standard for determining whether there has been a substantial
renovation of real property is the Standard applied under Internal
Revenue Code Section 263(a) to determine whether a taxpayer’s activities
result in permanent improvements or betterments of property, such that
the cost must be capitalized.
- 27 -
C. On February 24, 2011, the Tax Court ruled in Gibson & Associates v.
Commissioner, 136 TC10 that the taxpayer receipts were domestic
production gross receipts to the extent the taxpayer erected or substantially
renovated real property.
1. This is the first Court decision on Section 199.
2. Provides important guidance in two important areas:
a. What constitutes an “item” or a “unit” of real property under
Section 199; and
b. What constitutes “substantial renovation” of real property.
D. Court Addressed an Item or Unit of Real Property (UOP) under
Section 199.
1. In defining real property, the Section 199 Regulations use the
Section 263(a) Regulations.
2. Regulation Section 1.199-3(m)(3) defines real property to mean:
a. Buildings (including structural components);
b. Inherently permanent structures other than machinery;
c. Inherently permanent land improvements; and
d. Infrastructure.
3. Regulation Section 199-3(m)(4) defines “infrastructure” in part to include
such things as roads, power lines, water systems, etc.
4. The Court cited Regulation 1.263(a)-10(b)(1) stating “a unit of real
property includes any components of real property owned by the taxpayer
that are functionally interdependent.”
5. Court concluded that the relevant item to analyze was each bridge that
Gibson worked on, not each component part.
E. The Court defined “substantial renovation” of real property.
1. Regulation Section 1.199-3(m)(5) defines substantial renovation as:
a. Materially increasing the value of the real property;
b. Substantially prolonging the useful life of the real property; and/or
c. Adapting the property to a new or different use.
2. Critical issue was substantial renovation versus repair.
3. Court reported the Internal Revenue Service argument that the
rehabilitation of one or more components of real property would be a
repair unless all the property’s major components were replaced.
IMPORTANT
If a contractor is making a repair, the repair will not be
domestic production gross receipts (DPGR).
- 28 -
IX. PRE-CONTRACTING YEAR COSTS (
).
A. In CCA 201111006, the Chief Counsel’s Office addressed a situation where a
taxpayer entered an agreement requiring the taxpayer to incur design and
development costs.
B. Taxpayer asserted that the design and development costs were currently
deductible.
1. The taxpayer asserted that the design and development costs arise from its
operational activities rather than a “long-term contract activity.”
2. The taxpayer maintained that its design and development costs represent
allocable contract costs only when the design and development benefit an
existing long-term contract.
3. The taxpayer referred to Regulation Section 1.460-1(d), which provides
that if the performance of a non-long-term contract activity is incident to
or necessary for the manufacture, building, installation, or construction of
the subject matter of one or more of the taxpayer’s long-term contracts,
the costs attributable to that activity must be allocated to the long-term
contracts benefitted.
C. The Chief Counsel’s Office maintained that Section 460 does not expressly
impose the condition that allocable contract costs arise only where they will
benefit an existing long-term contract.
1. The Chief Counsel’s Office found the statutory definition of independent
research and development expenses in Section 460 to be germane to the
analysis.
2. Two categories of independent research and development expenses are
established in Section 460.
a. The first category includes only those costs incurred to benefit
existing long-term contracts.
b. The second category of allocable research and developments
costs, however, includes costs performed under an agreement
without requiring the contemporaneous existence of a benefitted
long-term contract.
IMPORTANT
For construction companies engaged in “design
build,” the design and development costs for a
particular contract will be pre-construction costs
that are not currently deductible. Keep in mind
that these costs will qualify for the research and
development credit under Internal Revenue
Code Section 41(b).
- 29 -
X. ACCRUED BONUSES – THE YEAR OF DEDUCTION (
).
A. Generally, compensation that is accrued to an employee is deductible by the
accrual basis employer provided the compensation is received by the 15th
day of the third calendar month after the employer’s year end.
B. Internal Revenue Service issued Chief Counsel Advice 200949040 that
denied deduction until year paid.
1. Under taxpayer’s incentive compensation plan, employees are required to
be employed by the taxpayer on the date bonuses are paid to receive
compensation.
2. Internal Revenue Service concluded that liability was not fixed at year
end and was contingent.
3. Even though the bonuses were based on company performance in prior
year, economic performance did not occur and the liability is not fixed
until the date bonuses are paid since service had to continue.
C. Internal Revenue Service recently issued Revenue Ruling 2011-29 that
permits the taxpayer to deduct accrued bonuses if the employer can
establish “the fact of the liability” under Section 461, even though the
employer does not know the identity of any particular bonus recipient and
the amount payable to that recipient until after the end of the year.
XI. SHAREHOLDERS COULD INCREASE BASIS IN S CORPORATIONS TO
DEDUCT LOSSES ( ).
A. The Tax Court in Maguire, TCM 2012-160, held that shareholders in two
related S corporations were not prohibited from receiving a distribution
from one S corporation and then contributing the assets to another to
increase their tax basis to deduct losses.
1. Taxpayer distributed accounts receivable to shareholders.
2. Taxpayers executed a separate written shareholder resolution.
3. Adjusting journal entries were made in the books.
B. Internal Revenue Service contended no economic outlay.
1. Court took exception and held that funds lent to an S corporation that
originates with another entity owned by the shareholders does not
preclude that the loan lacks economic substance.
2. Related cases.
a. Ruckriegel, TCM 2006-78.
b. Yates, TCM 2001-280.
c. Culnen, TCM 2000-139.
OBSERVATION
The Internal Revenue Service’s position is also
reflected in the recent Internal Revenue Service
Proposed Regulations on back-to-back loans.
- 30 -
XII. LONG-AWAITED PROPOSED REGULATIONS ISSUED ON “BACK-TO-
BACK LOANS” ( ).
A. On June 12, 2012, the Internal Revenue Service released the much
anticipated proposed regulations addressing basis increases for back-to-
back loans made by S corporation shareholders.
1. A back-to-back loan in the S corporation context refers to an arrangement
in which an S corporation shareholder borrows funds from an unrelated or
related third party, and then lends such funds to the S corporation.
2. A loan can be structured as a back-to-back loan at the outset to enable the
shareholder to obtain a basis increase immediately on the infusion of
funds into the corporation, or a back-to-back loan may arise later when a
loan that originally was structured as a direct loan from the third party to
the S corporation is restructured as a back-to-back loan in order to
increase basis.
3. Section 1366(d)(1)(B) does not specifically define what is indebtedness
of the S corporation to the shareholders.
4. Cases and rulings interpreting Section 1366(d)(1)(B) have established
two requirements that generally must be met in order for a loan to
constitute “indebtedness of the S corporation to the shareholder” within
the meaning of Section 1366(d)(1)(B):
a. A debt must run directly from the S corporation to the
shareholder.
b. The shareholder must have made an “actual economic outlay.”
5. Cases and rulings interpreting Section 1366(d)(1)(B) generally have held
that debt of the S corporation must be owed to the shareholder, and not to
a related entity, for the debt to increase the shareholder’s basis available
to absorb losses from the S corporation.
6. Thus, shareholders have been denied an increase in basis with respect to
loans made to their S corporations by other corporations.
B. The Proposed Regulations Under Section 1366-2.
1. Proposed Regulation 1.1366-2(a)(2)(ii) specifically provides that a
shareholder does not obtain a basis increase merely by guaranteeing a
loan or acting as a surety, accommodation party, or in any similar
capacity relating to a loan.
2. The proposed regulation provides that when a shareholder makes a
payment on bona fide debt for which the shareholder has acted as
guarantor or in a similar capacity, based on the facts and circumstances,
the shareholder may increase its basis of debt to the extent of such
payment.
NOTE
This is consistent with the overwhelming majority of
courts that have considered whether shareholders may
increase their basis as the result of guarantees of
S corporation debt.
- 31 -
3. Under the proposed regulations, an incorporated pocketbook transaction
increases basis of debt only where the transaction creates a bona fide
creditor-debtor relationship between the shareholder and the borrowing S
corporation.
NOTE
The Preamble to the proposed regulations also
emphasizes that they do not address how to determine
the basis of the shareholder’s stock in an S corporation
for purposes of Section 1366(d)(1)(A). Consequently,
left unchanged is the conclusion found in published
guidance that a shareholder of an S corporation is not
allowed to increase his or her basis in an S corporation
under Section 1366(d)(1)(A) upon the contribution of
the shareholder’s own unsecured demand promissory
note to the corporation. Unfortunately, this also leaves
the door open for the Internal Revenue Service to still
apply the actual economic outlay test, as it did recently
in Maguire.
C. Proposed Regulation 1.1366-2(a)(2)(iii) provides four examples of how the
regulations operate:
Example 1
A is the sole shareholder of S, an S corporation. A makes a
loan to S. The example provides that if the loan is bona fide
debt from S to A, A’s loan to S increases A’s basis under
Section 1366(d)(1)(B). Example 1 goes on the provide that the
result is the same if A made the loan to S through an entity that
is disregarded as an entity separate from A under
Regulation 301.7701-3.
Example 2
A loan made to S directly from Bank. A guarantees Bank’s
loan to S. Example 2 provides that no basis increase is allowed
as a result of the guarantee until A makes actual payments on
the guarantee to the Bank
Example 3
The classic back-to-back loan transaction. A is the sole
shareholder of two S corporations, S1 and S2. S1 loans
$200,000 to A, who then loans $200,000 to S2. Example 3
provides that if A’s loan to S2 is a bona fide debt from S2 to A,
A’s back-to-back loan increases his basis under
Section 1366(d)(1)(B).
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Example 4
A is the sole shareholder of S1 and S2. S1 makes a loan
directly to S2, and subsequently S1 assigns its creditor position
in the note to A by making a distribution to A of the note. The
example provides that under local law, after S1 distributed the
note to A, S2 was relieved of its liability to S1 and was directly
liable to A. Example 4 concludes that if the note is bona fide
debt from S2 to A, the note increases A’s basis under
Section 1366(d)(1)(B).
XIII. DON’T BE PASSIVE WITH PASSIVE ACTIVITY LOSSES – REAL ESTATE
PROFESSIONAL (
).
A. Generally, Section 469 disallows any passive losses from offsetting any other
types of income, such as interest, dividends and compensation.
1. A rental activity is generally treated as passive regardless of whether or
not the taxpayer materially participates.
2. There is a special exception to the annual passive activity loss rules.
3. The key to this exception is meeting the two requirements for a “real
estate professional.”
a. More than one-half of the personal services performed in trades or
businesses by the taxpayer during such taxable year are performed
in real property trades or businesses in which the taxpayer
materially participates; and
b. Such taxpayer performs more than 750 hours of services during
the taxable year in real property trades or businesses in which the
taxpayer materially participates.
4. An individual taxpayer materially participates in an activity if he or she
meets any one of the following tests:
a. He or she participates more than 500 hours during the year;
b. His or her participation is substantially all of the participation of
individuals in that activity for the year (including individuals who
are not owners of interests in the activity);
c. He or she participates more than 100 hours and no other
individual participated more;
d. The activity is a significant participation activity and his or her
aggregate participation in all significant participation activities
exceeds 500 hours;
e. He or she materially participates for 5 out of 10 years immediately
preceding the year in issue;
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f. The activity is a personal service activity and he or she materially
participated for any three years preceding the year in issue; or
g. On all the facts and circumstances, he or she participated on a
regular, continuous, and substantial basis during the year.
5. Rather than attempt to substantiate “material participation” for each rental
property, an election can be made to “aggregate the properties.”
B. Real Estate Professional Status.
1. In Bosque v. Commissioner, TC Memo 2011-79, the Court held that an
attorney did not qualify as a real estate professional, but did actively
participate in real estate rental.
a. Taxpayer kept daily logs.
b. Taxpayer held to materially participate.
c. Taxpayer failed the 750 hours test and held not to be a real estate
professional.
2. In Anyika v. Commissioner, TC Memo 2011-69, the Tax Court held that
a Pennsylvania engineer was not a real estate professional and his real
estate rental activities were passive activities.
a. Taxpayer worked as an engineer 7.5 hours per week for 48 weeks
or 1800 hours per year.
b. Taxpayer alleged that he worked 800 hours as a real estate
professional.
c. Court explained that he would have had to work more than 1800
hours engaged in the real estate business to attain the “more than
one-half of the personal services in real property trades and
businesses.”
C. Losses from Real Estate Rentals are Passive and Limited.
1. Irvine v. Commissioner, TC Memo 2012-32.
a. Taxpayer failed to elect to treat all interests in rental real estate as
a single rental unit.
b. The Court evaluated each of their properties separately in order to
determine whether or not the taxpayer materially participated in
real estate activities for each property.
c. Taxpayer showed he spent over 812 hours in real estate business
which included the hours he spent as a pilot.
d. However, while the hours claimed in the real estate activities were
more than half of his personal services, not all his hours counted
towards “material participation.”
2. Donald W. Task vs. Commissioner, TC Memo 2010-78.
a. Task owned 33 rental properties.
b. Task showed via work logs that he was a real estate professional.
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c. Task failed to elect to aggregate the properties as a single activity
under Section 469(c)(7)(A).
d. He failed to prove he materially participated in each activity.
e. Taxpayer had aggregated his rental activities, but had failed to
make a formal election.
f. Court concluded that Task failed to satisfy the material
participation test.
D. Internal Revenue Service Revenue Procedure 2010-13, 2010-4.
1. Internal Revenue Service has finalized system for reporting groupings
and regrouping of passive activities.
2. Taxpayers, including partnerships and S corporations, must report on
their annual tax returns, certain changes to the taxpayer’s groupings of
passive activities.
3. A statement is required for new groupings that are grouped as a single
activity.
a. Statement must identify names, addresses and EIN.
b. Must contain a declaration that the grouped activities constitute an
appropriate economic unit.
4. Statement is required for regrouping.
5. Failure to report means that each trade or business activity or rental
activity will be treated as a separate activity.
6. Effective for 2011.
E. Real Estate Professionals Allowed Late Election to Aggregate Rental Real
Estate Interests under Revenue Procedure 2011-34.
1. Under Revenue Procedure 2011-34, a taxpayer is treated as having made
a timely election under Section 469(c)(7)(A) to treat all interests in rental
real estate as a single rental real estate activity.
2. Taxpayer is eligible for this extension, if he represents that he:
a. Failed to make the election solely because he failed to timely meet
the requirements in Regulation 1.469-9(g);
b. Filed all prior year tax returns consistent with the election;
c. Timely filed each prior year tax return; and
d. Had reasonable cause for having not made the election.
3. Taxpayer must attach the required statement under Regulation 1.469-9(g)
to an “amended” return for the most recent year.
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XIV. TAXPAYER WAS PROHIBITED FROM DEDUCTING MANAGEMENT FEES
PAID BY ONE RELATED ENTITY TO ANOTHER (
).
A. The Tax Court in Fuhrman, TC Memo 2011-236 held that the Taxpayer was
not entitled to deduct management fees it paid to its wholly-owned
C corporation.
1. Tax Court found that Fuhrman failed to establish that the amounts
charged for management fees were “ordinary and recurring.”
2. Tax Court challenged whether the amounts charged were at arm’s-length.
3. Fuhrman had no support to demonstrate how the management fees were
determined.
4. There was no written contract.
5. No documentation as to provide contemporaneous support.
B. Related Tax Court Cases.
1. In ASAT, Inc., 108 TC 147, the Tax Court held that the Taxpayer could
not deduct consulting fees it paid to its subsidiary when the Taxpayer
failed to establish how the fees were determined.
a. No written contract.
b. No detail or invoices.
c. No evidence of the provider’s skills to support the charges.
2. In Trailers, Inc., TC Memo 2011-105, the Tax Court held that a
taxpayer’s wholly-owned S corporation was not entitled to deduct
management fees paid to another of his wholly-owned S corporations
where the evidence did not adequately support the services and who
performed them.
XV. EXPENSE REIMBURSEMENT REGULATIONS (
).
The Service has issued proposed regulations to clarify the definition of
reimbursement or other expense allowance arrangements and how the deduction
limitations apply to reimbursement arrangements between three parties.
A. Deductions for certain expenses for entertainment, amusement, or
recreation activities and for facilities used in connection with entertainment,
amusement, or recreation activities are limited.
1. The amount allowable as a deduction for any expense for food,
beverages, entertainment activities, or entertainment facilities is generally
limited to 50 percent of the amount otherwise allowable.
2. However, these limitations do not apply to an expense a taxpayer pays or
incurs in performing services for another person under a reimbursement
or other expense allowance arrangement with the other person.
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3. The exception applies if the taxpayer is an employee performing services
for an employer and the employer does not treat the reimbursement for
the expenses as compensation and wages to the taxpayer.
4. In that case, the employee is not treated as having additional
compensation and has no deduction for the expense. The employer bears
and deducts the expense and is subject to the deduction limitations.
5. If the employer treats the reimbursement as compensation and wages, the
employee may be able to deduct the expense as an employee business
expense.
a. The employee bears the expense and is subject to the deduction
limitations, and the employer deducts an expense for
compensation, which is not subject to the deduction limitations
under Section 274.
6. The exception also applies if the taxpayer performs services for a person
other than an employer and the taxpayer accounts (substantiates, as
required) to that person.
NOTE
In a reimbursement or other expense allowance
arrangement in which a client or customer reimburses
the expenses of an independent contractor, the
deduction limitations do not apply to the independent
contractor to the extent the independent contractor
accounts to the client by substantiating the expenses as
required. If the independent contractor is subject to
the deduction limitations, the limitations do not apply to
the client.
B. In the case of any expenditure for entertainment, amusement, recreation,
food, or beverages made by one person in performing services for another
person (whether or not the other person is an employer) under a
reimbursement or other expense allowance arrangement, the limitations on
deductions apply either to the person who makes the expenditure or to the
person who actually bears the expense, but not to both.
1. If an expenditure of a type described herein properly constitutes a
dividend paid to a shareholder, unreasonable compensation paid to an
employee, a personal expense, or other nondeductible expense, nothing in
this exception prevents disallowance of the expenditure to the taxpayer
under other provisions of the Code.
C. In the case of an employee’s expenditure for entertainment, amusement,
recreation, food, or beverages in performing services as an employee under
a reimbursement or other expense allowance arrangement with a payor (the
employer, its agent, or a third party), the limitations on deductions apply:
1. To the employee to the extent the employer treats the reimbursement or
other payment of the expense on the employer’s income tax return as
originally filed as compensation paid to the employee and as wages to the
employee for purposes of withholding; and
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2. To the payor to the extent the reimbursement or other payment of the
expense is not treated as compensation and wages paid to the employee in
the manner provided in the preceding paragraph.
D. In the case of an expense for entertainment, amusement, recreation, food, or
beverages of a person who is not an employee (referred to as an independent
contractor) in performing services for another person (a client or customer)
under a reimbursement or other expense allowance arrangement with the
person, the limitations on deductions apply to the party expressly identified
in an agreement between the parties as subject to the limitations.
E. If an agreement between the parties does not expressly identify the party
subject to the limitations, the limitations apply:
1. To the independent contractor (which may be a payor described in the
preceding paragraph) to the extent the independent contractor does not
account to the client or customer; and
2. To the client or customer if the independent contractor accounts to the
client or customer.
F. The term reimbursement or other expense allowance arrangement means:
1. For these purposes, an arrangement under which an employee receives an
advance, allowance, or reimbursement from a payor (the employer, its
agent, or a third party) for expenses the employee pays or incurs; and
2. For these purposes, an arrangement under which an independent
contractor receives an advance, allowance, or reimbursement from a
client or customer for expenses the independent contractor pays or incurs
if either:
a. A written agreement between the parties expressly states that the
client or customer will reimburse the independent contractor for
expenses that are subject to the limitations on deductions; or
b. A written agreement between the parties expressly identifies the
party subject to the limitations.
XVI. WORKER CLASSIFICATION ISSUES UNDER ATTACK BY INTERNAL
REVENUE SERVICE.
A. Employers should evaluate whether workers are properly classified as
independent contractors and not as employees.
1. Internal Revenue Service enforcement under the Employment Tax
National Research payment.
2. In September of 2011, the Internal Revenue Service entered into a
memorandum of understanding with the Department of Labor and “states
to share information regarding employee classifications.”
B. Section 530 under the Revenue Act of 1978 offers relief.
1. Taxpayers must consistently treat the workers in question as non-
employees;
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2. The inconsistent treatment of even one employee can cause this
requirement to not be met;
3. It must report the compensation on Form 1099 for all years; and
4. It must have a reasonable basis for treating the workers as non-
employees.
C. Internal Revenue Service announced a “Voluntary Classification Settlement
Program” (VCSP) for employers to voluntarily re-classifying workers as
employees.
1. The program applies to taxpayers who are currently treating their workers
(or a class or group of workers) as independent contractors or other
nonemployees and want to prospectively treat the workers as employees.
2. To be eligible:
a. The taxpayer must have consistently treated the workers as
nonemployees, and must have filed all required Forms 1099 for
the workers for the previous three years.
b. The taxpayer cannot currently be under audit by the Internal
Revenue Service.
c. The taxpayer cannot be currently under audit concerning the
classification of the workers by the Department of Labor or by a
state government agency. A taxpayer who was previously audited
by the Internal Revenue Service or the Department of Labor
concerning the classification of the workers will only be eligible if
the taxpayer has complied with the results of that audit.
3. A taxpayer who participates in the VCSP will agree to prospectively treat
the class of workers as employees for future tax periods. In exchange, the
taxpayer:
a. Will pay 10 percent of the employment tax liability that may have
been due on compensation paid to the workers for the most recent
tax year, determined under the reduced rates of Section 3509 of
the Internal Revenue Code;
b. Will not be liable for any interest and penalties on the liability;
and
c. Will not be subject to an employment tax audit with respect to the
worker classification of the workers for prior years.
NOTE
Additionally, a taxpayer participating in the
VCSP will agree to extend the period of
limitations on assessment of employment taxes
for three years for the first, second, and third
calendar years beginning after the date on which
the taxpayer has agreed under the VCSP closing
agreement to begin treating the workers as
employees.
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4. The amount due under the VCSP is calculated based on compensation
paid in the most recently closed tax year, determined at the time the
VCSP application is being filed.
EXAMPLE
In 2010, employer paid $1,500,000 to workers that are
the subject of the VCSP. All of the workers that are the
subject of the VCSP were compensated at or below the
Social Security wage base (e.g., under $106,800 for
2010). Employer submits the VCSP application on
October 1, 2011, and Employer wants the beginning
date of the quarter for which Employer wants to treat
the class or classes of workers as employees to be
October 1, 2012. Employer looks to amounts paid to
the workers in 2010 for purposes of calculating the
VCSP amount, since 2010 is the most recently
completed tax year at the time the application is being
filed. Under Section 3509(a), the employment taxes
applicable to $1,500,000 would be $160,200 (10.68
percent of $1,500,000). Under the VCSP, the payment
would be 10 percent of $160,200, or $16,020.
5. The 10.68 percent effective rate applies under the VCSP in 2011 since the
most recently closed tax year is 2010. The 10.28 percent effective rate
applies under the VCSP in 2012 since the most recently closed tax year is
2011. The rate of 3.24 percent applies to compensation above the Social
Security wage base in both situations. These effective rates constitute the
sum of the rates as calculated under Section 3509(a).
XVII. LOOK-BACK INTEREST – ANOTHER INTERNAL REVENUE SERVICE
AUDIT ISSUE (Internal Revenue Code Section 460(b)(1)(B) and Internal Revenue
Service Regulation 1.460-6(a)(1)).
A. Application of look-back.
1. In the year of completion, income from certain long-term contracts
accounted for under either the percentage-of-completion method or
percentage-of-completion-capitalized-cost method is allocated among the
prior taxable years on the basis of actual contract price and costs instead
of estimated contract price and costs.
2. The underpayment or overpayment of tax that results from this
reallocation of income, for each affected prior taxable year, is determined
and the taxpayer must either pay look-back interest if the reallocation
reveals a deferral of tax liability, or is entitled to a refund of interest if the
reallocation shows an acceleration of tax liability.
B. Post-completion revenue and expenses.
1. In addition to the year of completion, look-back applies to any post-
completion year for which the taxpayer must adjust the total contract
price or total allocable contract costs.
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2. However, the taxpayer may elect not to have look-back method apply in
de minimus cases.
C. Alternative minimum tax (AMT).
1. Look-back not only applies to long-term contracts reported under the
percentage-of-completion method for regular income tax purposes but
also applies to long-term contracts that must be reported under the
percentage-of-completion method for alternative minimum tax purposes.
2. Includes CCM contracts used for regular tax.
D. Percentage-of-completion-capitalized-cost method (PCCM).
For long-term contracts reported under the percentage-of-completion-capitalized-
cost method, look-back applies to the portion of the contract that is subject to
percentage-of-completion. In the case of long-term residential contracts
(buildings with four or more dwelling units), the portion is 70 percent. Look-
back may also apply to the remaining 30 percent portion for alternative minimum
tax purposes.
E. Exceptions from the application of look-back.
1. Home construction contract – The look-back method does not apply to
home construction contracts (defined in Internal Revenue Code Section
460(e)(6)(A)).
2. Mandatory de minimus exception – The look-back method does not apply
to any long-term contract that is completed within two years of the
contract commencement date and has a gross contract price that does not
exceed the lesser of $1,000,000 or 1 percent of the average annual gross
receipts for the three tax years preceding the tax year of completion.
3. Elective de minimus discrepancies exception – A taxpayer may elect not
to apply look-back if the cumulative taxable income under the contract
for each prior year is within 10 percent of the cumulative look-back
income for each prior year.
F. Filing and reporting look-back interest.
1. The computation of the amount of deferred or accelerated tax liability
under the look-back method is hypothetical and it does not result in
amending prior years’ tax liability.
2. Definitions:
a. Filing year – The taxable year in which long-term contracts are
completed or adjusted (post-completion adjustments).
b. Redetermination year – Each prior tax year that is affected by
income from contracts completed or adjusted in the filing year.
3. Form 8697 is used to compute and report look-back interest due or to be
refunded.
a. For each filing year, the taxpayer will either owe look-back
interest or be entitled to a refund as the “net” result of computing
look-back interest on one or more redetermination years.
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b. Thus, a current filing year may contain both hypothetical
overpayments and underpayments for prior years, but the net
result determines whether look-back interest is owed by the
taxpayer or should be refunded.
c. The Form 8697 consists of two methods, represented as Part I and
Part II, for computing look-back interest.
(i) Form 8697, Part I – Regular Method.
(ii) Form 8697, Part II – Simplified Marginal Impact Method.
G. New Changes to the Look-Back Form.
1. The filing year has been added as a column.
a. Income tax liability is recomputed in the filing year for the effect
of the filing year look-back adjustment.
b. Line 3 of the filing year column becomes the line 1 entry of the
subsequent year look-back redetermination
c. Line 4 of the filing year column is used instead of actual tax in
line 5 of the redetermination year.
2. Line 2 – The total column (2(c)) has been opened up.
a. All line 2 columns when added should result in “0.”
b. Look-back does not increase or decrease income – it only
reallocates it from year to year.
3. Signature – There is now a second signature line for the spouse for joint
returns.
H. Common errors made in look-back.
1. For refunds requested by individuals, failure to include both signatures on
the Form 8697. If the related income tax return (Form 1040) is a joint
return, both signatures are required on the Form 8697.
2. Improperly computing interest from the NOL carryback year. The tax
liability is hypothetically re-determined in the tax year the NOL
carryback is absorbed, but interest to be computed for that carryback year
is only from the due date (not including extensions) of the tax year that
generated the NOL to the due date of the filing year (not including
extensions).
3. Simplified marginal impact method incorrectly applied at the flow-
through entity level for those taxpayers electing this method. There are
only two instances in which look-back interest is applied at the entity
level of a flow-through entity (Form 1120-S or Form 1065).
a. The pass-through entity is widely-held and required to use SMIM.
b. Following the conversion of a C corporation into an S corporation
the look-back method is applied at the entity level with respect to
contracts entered into prior to the conversion. See Treasury
Regulation Section 1.460-6(g)(3)(iv).
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4. For taxpayers electing SMIM, the overpayment ceiling is not being
applied – the net hypothetical overpayment of tax should be limited to the
taxpayer’s total Federal income tax liability as adjusted (i.e., prior
applications of look-back, NOL carrybacks, etc.). The overpayment
ceiling does not apply to widely-held pass-through entities; taxpayers
who are required to use SMIM. See Treasury Regulation Section 1.460-
6(d)(2)(iii).
5. Separate members of a consolidated group erroneously file Form 8697.
The consolidated entity must file the Form 8697 using the consolidated
entity’s EIN.
6. The interest rate for computing look-back interest is incorrectly being
changed as the quarterly rates change. The quarterly rate that is in effect
on the date after the due date of a taxpayer’s return should be applied to
the entire “interest accrual period” (an annual period), and it does not
change quarterly during the year.
7. Forms 8697 claiming refunds are improperly attached to the tax return
reducing the current year’s tax liability. Forms 8697 refunds that must be
filed separately from the income tax return.
8. Schedules of contract income reallocation are not attached to the Form
8697 – only owners of pass-through entities are exempt from this
requirement.
9. The cumulative changes to look-back taxable income and look-back tax
liability for each redetermination year are not being properly reported on
the Form 8697.
* * *