course cover 16 - calcpa/media/event materials/january...calcpa education foundation programs and...

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7Federal and California Tax Update

Kathleen K. Wright, MBA, CPA, JD, LLM

Learning today. Leading tomorrow.

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Notice to Readers

CalCPA Education Foundation programs and publications are designed to provide CPAs and financial professionals current, accurate information concerning the subject matter covered. However, the CalCPA Education Foundation gives no assurance that such information is comprehensive in its coverage of a subject matter or that it is suitable in dealing with specific client problems or business-related circumstances. Accordingly, information published or provided by the CalCPA Education Foundation should not be relied upon as a substitute for independent research to original sources of authority. The CalCPA Education Foundation does not render any accounting, legal or other professional advice, nor does it have any responsibility for updating or revising any programs or publications which it may present, distribute or sponsor. CPE Credit Policies Course, Conference, Onsite—The California Board of Accountancy (CBA) grants one CPE credit hour for each 50 minutes of class time. To qualify for CPE, a program must be at least 50 minutes in length. The CBA tracks CPE in 25-minute segments after the first 50 minutes. For each additional 25-minute segment completed, 0.5 CPE credit hours will be granted. To accurately track participation, registrants are required to legibly sign your name on the official sign-in sheet prior to the start of the event. If you arrive late, you must note your arrival time on the sign-in sheet. If you need to leave early, you must initial and note your departure time on the sign-in sheet to receive partial credit. The CBA requires CPE providers to closely monitor attendance during CPE. If you are not in the room during a portion of the CPE event, you will not receive credit. Your official record of attendance for the event is available via the My Events section of the website within one week. The host provider must retain the record of attendance, written educational goals and specific learning objectives, as well as a syllabus, which provides a general outline instructional objective and a summary of topics for the course for a period of five years. A copy of the educational goals, learning objectives, and course syllabus shall be made available to the CBA upon request. Webcast—For webcast participants to receive credit, three times every hour, you will be required to respond to an attendance question that appears on the screen. If viewing the webcast as part of a group, the group leader is required to answer the attendance questions on behalf of all participants. Group attendance is verified and documented by the group attendance form the day of the event. The CalCPA Education Foundation archives attendance records as required by the CBA to verify your CPE attendance in the event your CPE records are audited. Webcast are broadcast via the internet to those individuals who have registered for the webcast. The CalCPA Education Foundation takes all reasonable efforts to maintain the camera on the speaker, but does on occasion pan across the audience while following a speaker around the room. Furthermore, as the broadcast requires the use of microphones and other devices to amplify the speaker to both the live and webcast audience, an attendee’s voice may be broadcast during the webcast and, no attendee should have an expectation of privacy as to potentially being identifiable in the webcast. Self-Study—An online exam is included with your purchase. After studying the materials, to take the exam please go to www.calcpa.org/MySelfStudy. You may be asked to log in. Once you have logged in, find this product and click “Take Exam.” You will have a total of (3) attempts to take the final exam. Once you have completed the online final exam, you will be notified if you have passed or failed. To pass, you need a minimum passing grade of 70% (except for California regulatory review courses where the minimum passing grade is 90% as specified in Reg. Sec. 87.9(3)). You will be able to download your certificate of completion documenting the number of CPE credits earned for the course through your CPE Tracker at www.calcpa.org/CPE_Tracker. Please monitor the time it takes to complete the course. Record your total time and your comments about the course on the evaluation e-mailed to you. In accordance with the Standards of the National Association of State Boards of Accountancy (NASBA), one credit hour is granted for each 50 minutes of interactive self-study completed. Recommended credit hours are included in each course description. However, state boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Self-study courses must be completed by one year from date of purchase. If you have any problems or questions using your online course, please e-mail [email protected]. If you move before completing this course, please contact Member Services at (800) 922-5272 with your new address. Materials Terms and Conditions—CalCPA Education Foundation program materials, both hardcopy and electronic, are protected by U.S. copyright law. Materials are provided only for use by the participant registered for the program. You agree that you will not sell, distribute, transmit, or otherwise transfer all or any portions of the content of program materials without written permission from the author(s). Please contact the CalCPA Education Foundation course materials coordinator at [email protected] or (650) 522-3208 to obtain permission. eBook FAQs—Visit www.calcpa.org/ebooks to view frequently asked questions. Be sure to save your annotations made throughout the course. The CalCPA Education Foundation Guarantee—If any continuing education product fails to meet your expectations, or if you are not satisfied for any reason, you may return it within 30 days for an exchange or refund. (Shipping and handling fees are nonrefundable). Call Member Services at (800) 922-5272 for return instructions.

Copyright © 2016 Kathleen K. Wright, CPA, JD, LLM

No copyright claimed in U.S. Government materials.

FDCLU _________________________________________________________________________________________________________www.calcpa.org (800) 922-5272 rev 03/2015

http://www.calcpa.org/CPE_Tracker

mailto:[email protected]?subject=Self-Study

mailto:[email protected]

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1

CHAPTER 1 AFFORDABLE CARE ACT (ACA)

I. Table of Contents

II. Changes in 2016. ..................................................................................................................... 2 A. Employer Shared Responsibility. ........................................................................................ 2

1. Expatriates. ....................................................................................................................... 3 2. Health Reimbursement Arrangements. ............................................................................ 3 3. Penalties. .......................................................................................................................... 4 4. Reporting Requirements ................................................................................................... 5 5. The Excise Tax. ................................................................................................................ 6

III. Individual Healthcare Changes. ............................................................................................. 7 A. Premium tax credit ............................................................................................................... 7 B. Individual shared-responsibility provision .......................................................................... 7

IV. Changes in 2015: Employer Mandate .................................................................................. 8 A. Relief for employers with 50-99 employees . .................................................................... 9 B. Large Employer ................................................................................................................. 12

1. Determining status. ........................................................................................................ 13

V. Health Reimbursement Arrangements. ................................................................................. 17 A. Notice 2015-17. ................................................................................................................. 17

1. Transition Relief for Small Employers from the Code § 4980D Excise Tax ) .............. 18 2. Treatment of S corporation healthcare arrangements for 2-percent shareholder-employees. ............................................................................................................................ 19 3. Integration of Medicare premium reimbursement arrangement and TRICARE-related HRA with a group health plan. ............................................................................................. 20 4. Increases in employee compensation to assist with payments of individual market coverage. ............................................................................................................................... 21 5. Treatment of an employer payment plan as taxable compensation. .............................. 21

B. Reporting Requirements. ................................................................................................... 22 1. Employer Reporting on Form W-2. ............................................................................... 22 2. Health Care Coverage Reporting Requirements. ........................................................... 23

VI. Small Business and the ACA .............................................................................................. 25 A. Employer Self-Insured plans. ............................................................................................ 26

VII. Trade Preferences Extension Act of 2015. ........................................................................ 27 A. Health Coverage Tax Credit (HCTC) ............................................................................... 27

©2016. These materials are copyrighted and may not be reproduced or distributed in whole or in part without permission of the author/CalCPA Education Foundation.

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II. Changes in 2016.

A. Employer Shared Responsibility.

The employer shared responsibility provisions—also known as the employer coverage mandate—are the employer penalty provisions under the ACA. Penalties apply if an employer fails to offer minimum essential coverage that is affordable and provides minimum value to full-time employees working at least 30 hours per week.

• Employers with 100 or more full-time or equivalent employees (when adding together part-time employees' hours) are subject to the employer shared responsibility provisions in 2015.

• Employers with between 50 and 99 full-time or equivalent employees (“mid-size employers”) are subject to employer shared responsibility in 2016.

These employers must submit ACA information reporting forms to the IRS on or before Feb. 29 by mail (Feb. 28 being a Sunday), or file electronically by March 31. Employers filing 250 or more forms must do so electronically.

To prepare for employer shared responsibility, mid-size employers should:

• Identify full-time employees based on the ACA definition of full-time (those who average 30 hours of work per week in one month), considering special classifications such as staffing employees, independent contractors, temporary or short-term employees and even interns.

• Assess whether the monthly measurement method or look-back measurement method to determine full-time status is best based on the nature of the company’s workforce.

• Update plan documents and summary plan descriptions (SPDs) if necessary for the measurement method selected.

• Determine the appropriate safe harbor the company will use for the affordability calculation: W-2, rate of pay, or federal poverty line.

Example:

In January Company A has 40 full-time employees and 15 part-time employees who each worked 24 hours per week (96 hours per month). The total number of hours worked by part-timers is 1,440 hours (15 x 96). This is equal to a full time equivalent of 12 employees (1,440 / 120 hours = 12). The total employees for purposes of the ACA employer mandate is 52 (40 + 12).

Employers who do not know in advance how many hours an employee will work in a given time period can use a look-back period, called a standard measurement period, to measure full-time employees. The period cannot be less than three months nor exceed 12 months.


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Under recent legislation, individuals who have medical coverage under the TRICARE program or the Veteran’s Administration are not considered “employees” in determining whether an employer meets the 50-employee threshold to be an applicable large employer (IRC sec. 4980H( c)(2)(F).

Large employers subject to the ACA’s employer shared responsibility provisions this year should closely monitor their processes to ensure accurate implementation of the ACA’s measurement method and affordability calculation and document offers and waivers of coverage. Penalties will not be assessed until after employer reporting and individual tax filings in 2016, but once a penalty is assessed, there is no retroactive correction. If an employer finds a gap in its processes or a mistake, it should take steps to correct immediately to reduce the amount of potential penalties.

1. Expatriates.

Until further guidance, expatriate health plans do not have to comply with the market reforms as long as they continue to comply with the pre-Affordable Care Act group plan rules. For purposes of this relief, an “expatriate health plan” is an insured group health plan with respect to which enrollment is limited to primary insureds who reside outside of their home country for at least six months of the plan year and any covered dependents, and its associated group health insurance coverage (Notice 2015-43). The Expatriate Health Coverage Clarification Act of 2014 (Div. M, P.L. 113-235) provides generally that the ACA generally does not apply to:

(1) expatriate health plans; (2) employers with respect to expatriate health plans but solely in their capacity as plan sponsors of these plans; and (3) expatriate health insurance issuers with respect to coverage offered by such issuers under expatriate health plans.

The ACA continues to apply to expatriate health plans with respect to the employer shared responsibility rules of Code Sec. 4980H, the reporting requirements of Code Secs. 6055 and 6056, and the excise tax provisions of Code Sec. 4980I. Expatriate health plans can satisfy individual shared responsibility requirements either as an eligible employer sponsored plan or as a plan in the individual market depending on the arrangement.

2. Health Reimbursement Arrangements.

The IRS has taken the position that an arrangement under which an employer pays the premiums for current employees’ individual health coverage or reimburses them for such coverage violates the ACA market reforms that limit cost sharing. As a result, such a plan can cost an employer a $100 per day per affected employee in penalties. Under transition relief for 2014 and the first half of 2015 for small employers, the IRS agreed not to assert the excise tax solely for violation of this rule.


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The transition relief generally expired after June 30, 2015, but it continues to be available until further notice for payment or reimbursement arrangements for S corporation 2-percent plus shareholders. In addition, this relief has been extended to colleges that employ students if the reimbursement arrangement is offered in connection with other student health coverage (insured or self-insured) for a plan year or policy year beginning before January 1, 2017 (Notice 2016-17). Unlike premium reimbursement plans which are all but banned for arrangements that include more than one current employee reimbursement accounts aimed at co-pays and deductibles for employer health coverage, health reimbursement arrangements are permissible under the market reforms. However, there are a lot of details that plans have to get right for that to work. An HRA is allowed under the market reforms only if it is integrated with primary health coverage offered by an employer (whether the individual’s employer or spouse’s). An HRA is integrated with such coverage only if under the terms of the HRA, the HRA is available only to employees who are covered by primary group health plan coverage provided by the employer and that coverage meets the annual dollar limit prohibition. An HRA available to reimburse the medical expenses of an employee’s spouse and/ or dependents (a family HRA) may not be integrated with self-only coverage under the employer’s other group health plan. However, an HRA would be integrated if eligibility for coverage automatically applied only to individuals covered under the employer’s other group health plan, so that eligibility for expense reimbursement would expand automatically if the employee changed coverage from employee-only coverage to coverage including a spouse and/or dependents (and vice versa, for example, if the employee changed coverage from family coverage to employee-only coverage). The IRS has provided transition relief for this rule allowing employers to continue using an HRA that is available for the expenses of family members not enrolled in the employer’s other group health plan for plan years beginning before January 1, 2016. Furthermore, the IRS will not treat an HRA and group health plan that otherwise would be integrated based on the terms of the plan as of December 16, 2015, as failing to be integrated with an employer’s other group health plan for plan years beginning before January 1, 2017, solely because the HRA covers expenses of one or more of an employee’s family members even if those family members are not also enrolled in the employer’s other group health plan (Notice 2015-87).

3. Penalties.

Employers who fail to comply will be subjected to one of two penalties. The first penalty hits firms that don’t offer coverage to at least 95% of their full-timers if even one full-time employee buys insurance on the exchange and gets a tax credit to help pay the premiums. For 2016, the fine equals $2,160 times the total number of full-timers employed


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(less 30). 2015’s rules were more lenient: The fine was $2,080 per full-timer, 80 employees were disregarded, and the coverage rate was just 70%. Companies that offer unaffordable health insurance will owe a fine for 2016 equal to $3,240 for each full-timer who gets a subsidy for exchange-bought insurance. 2015’s fine was $3,120. For 2016, coverage is affordable if the required premium payin from a worker for self-only coverage doesn’t exceed 9.66% of total household income. Employers can base the 9.66% calculation on an employee’s rate of pay, W-2 wages or the federal poverty line, instead of household income. The employer’s health plan must also be designed to pay at least 60% of the cost of covered health benefits and provide substantial coverage of inpatient hospital and physician services. Some employers have started to receive subsidy notices from the exchanges. The letters let firms know that an employee got a subsidy to help buy health coverage on the exchange for 2015 because his or her employer didn’t offer affordable insurance. But the notices are going out to a limited number of firms...those whose employees provided the exchange with the employer’s address when they bought health coverage. The employer can appeal the findings in the letter if it disagrees with its contents. These notices are completely separate from IRS’s assessment of fines. The Internal Revenue Service will let employers know whether they owe a penalty. IRS will first send out a preliminary notice to employers of their potential liability and give them a chance to respond before officially assessing the monetary payment. The agency hasn’t yet begun sending its letters. It is still in the process of reviewing the information from the exchange, the data on Form 1095 health returns that were required to be filed for the first time this year by large employers, and the income tax returns of employees who claimed the premium credit.

4. Reporting Requirements

Employers received some welcome relief last December when the IRS extended employee notification and IRS filing deadlines for Affordable Care Act (ACA) information reporting on tax year 2015.

That could pose a challenge going forward, especially for employers that must provide 1095-Cs to employees by the end of January, indicating month-by-month coverage provided through the end of the previous December.

That won't leave much time, and HR should be prepared to act quickly:

ACA Information Reporting Forms

2015 Tax Year Deadlines (forms filed in 2016)

2016 Tax Year Deadlines (forms filed in 2017)

Forms 1095-B and 1095-C due to employees (to be postmarked if mailed, or sent by e-mail if

March 31, 2016 Jan. 31, 2017


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applicable conditions met). Forms 1094-B, 1095-B, 1094-C and 1095-C due to IRS if filing on paper.

May 31, 2016 Feb. 28, 2017

Forms 1094-B, 1095-B, 1094-C and 1095-C due to IRS if filing electronically.*

June 30, 2016 March 31, 2017

*Any employer filing 250 or more information returns during the calendar year must file these returns electronically. For employers with fewer than 250 returns, electronic filing is voluntary.

For employers, information reporting under tax code Sections 6055 and 6056 has been among the most onerous of the ACA's requirements:

Employers of any size that sponsored a self-insured health plan providing minimum essential coverage must distribute to enrolled employees and file with the IRS Form 1095-B, showing health plan enrollment.

Applicable large employers with 50 or more full-time employees or equivalents (when combining part-time hours) must distribute to enrolled employees and file with the IRS Form 1095-C, showing compliance with employer shared responsibility/minimum essential coverage requirements. If these employers self-insured their health plans, they may use Form 1095-C in lieu of Form 1095-B.

For IRS filings, Forms 1095-B and 1095-C are accompanied by transmittal forms 1094-B and 1094-C.

5. The Excise Tax.

Congress has provided temporary relief regarding three ACA excise taxes:

The start date for the 40 percent excise tax on high-cost employer-sponsored health coverage under Code Sec. 4980I (the “Cadillac plan tax”) is postponed from tax years beginning after December 31, 2017, to tax years beginning after December 31, 2019. In addition, when the tax does go into effect, the cost of the tax may be taken as a deduction. For 2017 only, there is a one year moratorium on the annual fee on health coverage providers imposed by Act Sec. 9010 of the ACA. The fee will resume after December 31, 2017. This moratorium does not affect the filing requirement and payment of these fees for 2016. Form 8963 (Rev. February 2016) must be filed by April 18, 2016. The excise tax on sales of medical devices has been suspended for a two year period, for sales on or after January 1, 2016, through 2017.


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III. Individual Healthcare Changes.

A. Premium tax credit

The premium tax credit (PTC), a refundable tax credit that can be paid to qualifying taxpayers in advance, applied beginning in 2014. It is intended to make health insurance affordable for individuals who do not have coverage from other sources, such as an employer or the government. The PTC amount is computed using the cost of the second lowest cost silver plan (SLCSP) less the amount the insureds are deemed to be able to contribute based on their income (IRC sec. 36B).

To qualify for the PTC, the individual must have household income (Sec. 36B(d)(2)) of at least 100% of the federal poverty line (FPL) and not more than 400% of the FPL. The FPL figures are included in the instructions to Form 8962, Premium Tax Credit, and are also provided by the Department of Health and Human Services (HHS). The prior year FPL figures are used. In addition, the individual must not have minimum essential coverage offered by the employer that also qualifies as affordable. For 2015, affordable means the self-only coverage offered cost the employee no more than 9.56% of household income (Rev. Proc 2014-37). In addition, the individual is not eligible for government-sponsored coverage, such as Medicare.

In 2016 the federal poverty levels change annually, as do the “applicable percentage” and the affordability factor. For 2016, a policy offered by an employer will be considered unaffordable if it costs the employer more than 9.66% of household income.

B. Individual shared-responsibility provision

Sec. 5000A imposes a penalty on individuals who do not have health coverage for any month of the year and are not exempt for that month. This payment, first effective in 2014, is referred to as the individual shared-responsibility provision (ISRP). To comply with the ISRP the taxpayer must determine whether all members of the “shared responsibility family” (Regs. Sec. 1.5000A-1(d)(4)) had coverage for all months of 2015. If yes, check the box on line 61 of Form 1040 (or equivalent on Form 1040-A or 1040-EZ), and nothing more is needed.

For any months when someone did not have coverage, determine whether an exemption is met. If yes, complete Form 8965 and file it with the return. For any month with no coverage or exemption, a payment is owed. The payment amount is phased in for 2014 and 2015. The penalty calculation is the greater of (A) or (B) below. The maximum penalty amount is capped at the national average bronze premium amount. For 2015, this amount is $207 per individual per month (Rev. Proc. 2015-15).


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2014 2015 2016 2017 and beyond

(A) Flat dollar amount

(limited to 3 times the flat

dollar amount)

$95/adult

(50% if under age 18)

$325/adult


$695/adult


Dollar amount is adjusted for inflation each

year

(B) Percentage of household

income less the filing threshold

1% 2% 2.5% 2.5%

Individuals also received new reporting forms in 2015 about their health coverage. Full-time employees who worked for an “applicable large employer” (ALE) in 2015 received Form 1095-C. If an ALE self-insures, all covered employees received Form 1095-C. In addition, anyone with insurance (other than from the marketplace) received Form 1095-B, Health Coverage. These forms indicate who had health insurance during the year.

Like Form 1095-A, Forms 1095-B and 1095-C are due to the individual by the end of January. However, just for 2015 forms, the IRS gave issuers of the Forms 1095-B and 1095-C additional time to file. Under Notice 2016-4, Forms 1095-B and 1095-C are due to individuals by March 31, 2016.

The Sec. 5000A penalty will be fully phased in for 2016. An exemption that applies to many uninsured individuals is affordability. This exemption is met if the cost of coverage exceeds a specified percentage of household income (as measured per Sec. 5000A(e)). The percentage is adjusted annually. It was 8.0% for 2014, 8.05% for 2015 and 8.13%

IV. Changes in 2015: Employer Mandate

Beginning in 2015, the Affordable Care Act (ACA) subjects applicable large employers (generally employers averaging 50 or more full-time employees, with some exceptions) to the shared responsibility rules. Under those rules, a large employer must provide health insurance or pay an excise tax. (IRC sec. 4980H). In addition, the employer may be subject to assessable payments if one or more of its employees receive a premium tax credit or cost sharing reduction when obtaining coverage on a government health insurance marketplace exchange. The IRS will determine whether an employer is subject to assessable payments based on individual tax returns and information reported by the employer and insurers for the particular period. The IRS will contact an affected employer, and the employer will have an opportunity to respond.

The starting date of the reporting requirements as well as the employer mandate itself, was pushed back from January 1, 2014, to January 1, 2015 (Notice 2013-45, 2013-45 I.R.B. 116). The employer mandate encompasses two distinct tax regimes: one for applicable large employers not offering coverage to their full-time employees, and the second for applicable large employers


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whose coverage fails one or more full-time employee on affordability or minimum value grounds. The first regime is meant to generate a higher assessment than the second, and the second is capped so that it can never result in a higher assessment than the first regime for a particular employer in a particular period. The two regimes have different rates as well as different ways of counting employees for their calculations.

An employer is never liable under both regimes for the same period.

There are two threshold issues. First, is the employer an applicable large employer for the pertinent year. An employer is an applicable large employer if it employed an average of at least 50 full-time employees on business days during the preceding calendar year. A second threshold issue is whether a full-time employee enrolled in an insurance exchange and received a health insurance premium tax credit or cost sharing reduction during the period in question. If the answer to both of these questions is yes, then the tax will probably apply barring an explanation from the employer such as compliance with the affordability safe harbor. IRS has issued final regs that provide guidance to employers that are subject to the employer mandate for health coverage under Code Sec. 4980H, which was enacted by the Affordable Care Act (ACA). For months beginning after Dec. 31, 2014, an applicable large employer is liable for an annual assessable payment if any full -time employee is certified to receive an applicable premium tax credit or cost-sharing reduction and either the employer:

(1) fails to offer to its full -time employees (and their dependents) the opportunity to enroll in minimum essential coverage (MEC) under an eligible employer -sponsored plan (Code Sec. 4980H(a) liability); or (2) offers its full -time employees (and their dependents) the opportunity to enroll in MEC under an eligible employer -sponsored plan that, with respect to a full -time employee who has been certified for the advance payment of an applicable premium tax credit or cost-sharing reduction, either is unaffordable or does not provide minimum value as these terms are defined in Code Sec. 36B(c)(2)(C) (Code Sec. 4980H(b) liability).

A stop-gap bill provides that an individual is not taken into account as an employee for the month if the individual has medical coverage for the month under a program for members of the U.S. Armed Forces (TRICARE) or a VA health care program. This provision may be applied retroactively, to months beginning after December 31, 2013. (See the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (H.R. 3236)

A. Relief for employers with 50-99 employees . For employers with 50-99 employees , who meet requirements (a) through (d) below, no assessable payment under Code Sec. 4980H(a) or Code Sec. 4980H(b) will apply for any calendar month during 2015 or, in the case of any non-calendar plan year that begins in


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2015 (2015 plan year), any calendar month during the portion of the 2015 plan year that falls in 2016. In order to qualify for the relief:

(a) Limited workforce size . The employer must employ on average at least 50 full -time employees (including full time equivalents (FTEs)), but fewer than 100 full -time employees (including FTEs) on business days during 2014. For this purpose, the determination of the number of full -time employees (including FTEs) is made in accordance with the otherwise applicable rules for determining status as an applicable large employer. (b) Maintenance of workforce and aggregate hours of service . During the period beginning on Feb. 9, 2014, and ending on Dec. 31, 2014, the employer does not reduce the size of its workforce or the overall hours of service of its employees in order to satisfy the workforce size condition set forth at (a) above. A reduction in workforce size or overall hours of service for bona fide business reasons will not be considered to have been made in order to satisfy the workforce size condition. For example, reductions of workforce size or overall hours of service because of business activity such as the sale of a division, changes in the economic marketplace in which the employer operates, terminations of employment for poor performance, or other similar changes unrelated to eligibility for this transition relief are for bona fide business reasons and will not affect eligibility for that transition relief. (c) Maintenance of previously offered health coverage. The employer does not eliminate or materially reduce the health coverage, if any, it offered as of Feb. 9, 2014. The new rules provide exceptions to this rule for certain small reductions if the employer does not alter the terms of its group health plans to narrow or reduce the class or classes of employees (or the employees' dependents) to whom coverage under those plans was offered on Feb. 9, 2014. (d) Certification of eligibility for transition relief. The employer certifies on a prescribed form that it meets the eligibility requirements set forth in paragraphs (a) through (c) above.

The term “coverage maintenance period” means (1) for an employer with a calendar year plan, the period beginning on Feb. 9, 2014, and ending on Dec. 31, 2015, and (2) for an employer with a non-calendar year plan, the period beginning on Feb. 9, 2014, and ending on the last day of the plan year that begins in 2015.

For employers first coming into existence in 2015 that are applicable large employers, the relief described above applies if: (1) the employer reasonably expects to employ and actually employs fewer than 100 full-time employees (including FTEs) on business days during 2015; (2) the employer reasonably expects to meet and actually meets the maintenance standards described in paragraphs (b) and (c) above, as measured from the date the employer is first in existence; and (3) the employer certifies in the manner described in paragraph (d) above.


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Code Sec. 4980H(a) transition relief. The preamble to the regs provides two types of Code Sec. 4980H(a) transition relief:

... For purposes of Code Sec. 4980H(a), the final regs provide that an applicable large employer member (i.e., one of multiple related entities that, due to the application of the aggregation rules, make up an applicable large employer ) would be treated as offering coverage to its full -time employees for a month if, for that month, it offers coverage to all but 5% or, if greater, 5, of its full -time employees . As provided in Reg. § 54.4980H-4(a), an employee is treated as having been offered coverage only if the employer also offered coverage to that employee's dependents. But see (7) below for transition relief for a failure to offer coverage to dependents for the 2015 plan year. Under the transition rule, for each calendar month during 2015 and any calendar months during the 2015 plan year that fall in 2016, an applicable large employer member that offers coverage to at least 70% of its full -time employees (and, to the extent required under Reg. § 54.4980H-4(a) and the transition relief referred to at (7) below, their dependents) will not be subject to an assessable payment under Code Sec. 4980H(a). ... In general, an assessable payment under Code Sec. 4980H(a) is equal to the number of all full -time employees (excluding 30 full -time employees ) multiplied by one-twelfth of $2,000 for each calendar month. For purposes of the liability calculation under Code Sec. 4980H(a), with respect to each calendar month, an applicable large employer member's number of full -time employees is reduced by that member's allocable share of 30. Accordingly, an applicable large employer with 50 full -time employees that is subject to an assessable payment under Code Sec. 4980H(a) may be subject to an assessable payment based on 20 employees (that is, 50 minus 30) times one-twelfth of $2,000 for each calendar month. Under the transition rule, for 2015 plus any calendar months of 2016 that fall within the employer's 2015 plan year, if an applicable large employer with 100 or more full -time employees (including FTEs) on business days during 2014 (or an applicable large employer member that is part of such an applicable large employer ) is subject to an assessable payment under Code Sec. 4980H(a), the assessable payment under Code Sec. 4980H(a) with respect to the transition relief period will be calculated by reducing an applicable large employer member's number of full -time employees by that member's allocable share of 80 rather than 30.

Shorter period permitted for determining applicable large employer status for 2015 . An applicable large employer is, with respect to a calendar year, an employer that employed an average of at least 50 full -time employees (including FTEs) on business days during the preceding calendar year. (Code Sec. 4980H(c)(2); Reg. § 54.4980H-2)


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Under the transition rule, an employer may determine its status as an applicable large employer by reference to a period of at least six consecutive calendar months, as chosen by the employer , during the 2014 calendar year (rather than the entire 2014 calendar year). Thus, an employer may determine whether it is an applicable large employer for 2015 by determining whether it employed an average of at least 50 full time employees (including FTEs) on business days during any consecutive six-month period in 2014. Coverage for January 2015 . The final regs provide, in general, that if an applicable large employer member fails to offer coverage to a full -time employee for any day of a calendar month, that employee is treated as not offered coverage during that entire month. (Reg. § 54.4980H-4(c)) Recognizing that many employers offer coverage for a new year effective as of the first day of the first pay period beginning on or after the first day of the year, the transitional rule provides that, if an applicable large employer member offers coverage to a full -time employee no later than the first day of the first payroll period that begins in January 2015 , the employee will be treated as having been offered coverage for January 2015 . Coverage for dependents. In order to avoid a potential assessable payment under Code Sec. 4980H, an applicable large employer member must offer coverage to its full -time employees and the full -time employees ' dependents. To provide employers sufficient time to expand their health plans to add dependent coverage, the transitional rule, extending a provision that was in the proposed regs, provides that any employer that “takes steps” during its 2015 plan year toward satisfying the Code Sec. 4980H provisions relating to offering coverage to full -time employees ' dependents, will not be liable for any assessable payment under Code Sec. 4980H solely on account of a failure to offer coverage to the dependents for that plan year. The relief is not available to the extent the employer offered dependent coverage during either the plan year that begins in 2013 (2013 plan year) or the 2014 plan year (meaning the relief is not available to the extent the employer had offered dependent coverage during either of those plan years and subsequently dropped that offer of coverage).

B. Large Employer Only applicable large employers are subject to the employer mandate, and to be an

applicable large employer an employer must employ at least 50 full-time employees or a combination of full-time and part-time employees that equals at least 50. For example, 40 full-time employees employed 30 or more hours per week on average plus 20 half-time employees employed 15 hours per week on average are equivalent to 50 full-time employees. Employers will determine each year, based on their current number of employees, whether they will be considered a large employer for the next year. For example, applicable large employer status for 2015 is determined based on the number of full-time employees the employer averages in 2014. Employers average their number of employees across the months in the year to see whether they


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meet the large employer threshold. The averaging can take account of fluctuations that many employers may experience in their work force across the year. (IRS Q&A on Employer Shared Responsibility Dec. 31,2012 Q&A 4).

Applicable large employer status is determined on a calendar year-by-calendar year basis. An employer is an applicable large employer for a particular calendar if it employed an average of at least 50 full-time employees on business days during the preceding calendar year. An employer is not subject to the shared responsibility assessable payment if:

Its work force exceeds 50 full-time employees for 120 or fewer days during the calendar year, and

The employees in excess of 50 employed during the 120-day period are seasonal workers. (IRC 4980H(c)(2)(B)(i)).

The shared responsibility rules apply to non-profit and government employers as well as for-profit employers. For purposes of determining whether an employer is an applicable large employer, an employer generally will take into account only work performed in the U.S. For example, if a foreign employer has a large workforce worldwide, but less than 50 full-time (or equivalent) employees in the U.S., the foreign employer generally would not be subject to the shared responsibility rules. A company that employs U.S. citizens working abroad generally would be subject to the shared responsibility rules only if the company had at least 50 full-time employees (or the equivalent combination of full-time and part-time employees), determined by taking into account only work performed in the U.S. Employees working only abroad, whether or not U.S. citizens, generally will not be taken into account for purposes of determining whether an employer meets the 50 full-time employee (or equivalents) threshold. Furthermore, for employees working abroad the time spent working for the employer outside of the U.S. would not be taken into account for purposes of determining whether the employer owes an shared responsibility payment or the amount of any such payment. (IRS Q&A on Employer Shared Responsibility, Dec. 31, 2012 Q&A 6).

Related employers and predecessor employers are treated as a single employer under aggregation rules. These include controlled groups of corporations, partnerships and proprietorships under common control, and affiliated service groups. In addition, if the employer was not in existence throughout the preceding calendar year, the determination of whether that employer is an applicable large employer is based on the average number of employees that it is reasonably expected the employer will employ on business days in the current calendar year. Employer for these purposes includes the employer's predecessors.

If the combined total meets the threshold, then each separate company is subject to the shared responsibility rules, even those companies that individually do not employ enough employees to meet the threshold. However, the rules for combining related employers do not apply for purposes of determining whether an employer owes a shared responsibility payment or the amount of any payment.

1. Determining status.


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An employer's status as an applicable large employer for a calendar year is determined by taking the sum of the total number of full-time employees (including any seasonal workers) for each calendar month in the preceding calendar year and the total number of full time equivalents (FTEs) (including any seasonal workers) for each calendar month in the preceding calendar year, and dividing by 12. If not a whole number, the result is rounded down to the next lowest whole number. If the result of the calculation is less than 50, the employer is not an applicable large employer for the current calendar year. If the result of this calculation is 50 or more, the employer is an applicable large employer for the current calendar year, unless the seasonal worker exception applies. An employer not in existence throughout the preceding calendar year is an applicable large employer for the current calendar year if it is reasonably expected to employ an average of at least 50 full-time employees (taking into account FTEs) on business days during the current calendar year and it actually employs an average of at least 50 full-time employees (taking into account FTEs) on business days during the calendar year. (Reg. 54.4980H-2(b)(3)).

The shared responsibility rules were originally scheduled to go into effect on January 1, 2014, with transition relief provided with that date in mind (the start date has been postponed a year). Under transition relief for 2013 for employers that are close to the 50 full-time employee threshold, rather than being required to use the full twelve months of 2013 to measure whether it has 50 full-time employees (or an equivalent number of part-time and full-time employees), an employer may measure using any six-consecutive-month period in 2013. So, for example, an employer could use the period from January 1, 2013, through June 30, 2013, and then have six months to analyze the results, determine whether it needs to offer a plan, and, if so, choose and establish a plan.

Seasonal worker exception. If the sum of an employer's full-time employees and FTEs exceeds 50 for 120 days or less during the preceding calendar year, and the employees in excess of 50 who were employed during that period of no more than 120 days are seasonal workers, the employer is not considered to employ more than 50 full-time employees (including FTEs) and the employer is not an applicable large employer for the current calendar year. For purposes of this rule only, four calendar months may be treated as the equivalent of 120 days. The four calendar months and the 120 days are not required to be consecutive. A seasonal worker is a worker who performs labor or services on a seasonal basis and retail workers employed exclusively during holiday seasons.

Although seasonal workers who work more than 30 hours a week do not count for purposes of counting full time employees to determine applicable employer status, they do count as full time employees for purposes of determining shared responsibility payment amounts.

Full-time employees. A full-time employee with respect to any month is an employee who is employed on average at least 30 hours of service per week. Under proposed reliance regulations, 130 hours of service in a calendar month is treated as the monthly equivalent of at least 30 hours of service per week, provided the employer applies this equivalency rule on a reasonable and consistent basis.

Full time equivalents. Although part-time employees do not count for purposes of determining shared responsibility payments, they nevertheless do count for purposes of determining large employer status. An employer must include full-time equivalent employees


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(FTEs) determined by dividing the aggregate number of hours of service of employees who are not full-time employees for the month, by 120. Under proposed reliance regulations, all employees (including seasonal workers) who were not employed on average at least 30 hours of service per week for a calendar month in the preceding calendar year are included in calculating the employer's FTEs for that calendar month. The number of FTEs for each calendar month in the preceding calendar year is determined by calculating the aggregate number of hours of service for that calendar month for employees who were not full-time employees (but not more than 120 hours of service for any employee) and dividing that number by 120. In determining the number of FTEs for each calendar month, fractions are taken into account.

Example: Assume that Diva Corp. has, in addition to full-time employees, five part-time employees for the month. The part-time workers' aggregate number of hours of service for the month is 480. Based on the service hours of its part-time workers, Diva must add four full-time equivalent employees (480 aggregate hours of service / 120) to the number of its full-time employees for that month in determining if it is an applicable large employer.

Example: For 2015 and 2016, ParentCo. owns 100 percent of all classes of stock of Sub1 and Sub2, and they are a controlled group of corporations. ParentCo has no employees at any time in 2015. For every calendar month in 2015, Sub1 has 40 full-time employees and Sub2 has 60 full-time employees. Because ParentCo, Sub1 and Sub2 have a combined total of 100 full-time employees during 2015, they are an applicable large employer and each is treated as an applicable large employer member for 2016.

Example: During each calendar month of 2015, the employer company has 20 full-time employees (each averages 35 hours of service per week), 40 part time employees (each averages 90 hours of service per month), and no seasonal workers. Each of the 20 employees who average 35 hours of service per week count as one full-time employee for each month. To determine the number of FTEs for each month, the total hours of service of the employees who are not full-time employees (but not more than 120 hours of service per employee) are aggregated and divided by 120. The result is that the employer has 30 FTEs for each month (40 × 90 = 3,600, and 3,600 ÷ 120 = 30). Because the company has 50 full-time employees (the sum of 20 full-time employees and 30 FTEs) during each month in 2015, and because the seasonal worker exception is not applicable, the company is an applicable large employer for 2016.

Example: During 2015, the employer 40 full-time employees for the entire calendar year, none of whom is a seasonal worker. In addition, the company has 80 seasonal full-time workers who work for the company from September through December, 2015. The company has no FTEs during 2015. Before applying the seasonal worker exception, the company has 40 full-time employees during each of eight calendar months of 2015, and 120 full-time


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employees during each of four calendar months of 2015, resulting in an average of 66.5 employees for the year (rounded down to 66 full-time employees). However, the company’s workforce equaled or exceeded 50 full-time employees (counting seasonal workers) for no more than four calendar months (treated as the equivalent of 120 days) in calendar year 2015, and the number of full-time employees would be less than 50 during those months if seasonal workers were disregarded. Accordingly, because after application of the seasonal worker exception, the company is not considered to employ more than 50 full-time employees and it is not an applicable large employer for 2016.

Example: Same facts as in Example 4, except that the employer company has 20 FTEs in August, some of whom are seasonal workers. The seasonal worker exception does not apply if the number of an employer's full-time employees (including seasonal workers) and FTEs equals or exceeds 50 employees for more than 120 days during the calendar year. Because the employer has at least 50 full-time employees for a period greater than four calendar months (treated as the equivalent of 120 days) during 2015, the exception does not apply. The employer averaged 68 full-time employees in 2015: [(40 × 7) + (60 × 1) + (120 x 4)] ÷ 12 = 68.33, rounded down to 68, and accordingly, the employer is an applicable large employer for calendar year 2016.

Example: The employer is incorporated on January 1, 2015. On January 1, 2015, it has three employees. However, prior to incorporation, its owners purchased a factory intended to open within two months of incorporation and to employ approximately 100 employees. By March 15, 2015, the employer has more than 75 full-time employees. Because the employer can reasonably be expected to employ on average at least 50 full-time employees on business days during 2015, and actually employs an average of at least 50 full-time employees on business days during 2015, the employer is an applicable large employer. (Reg. 54.4980H-2(d) Examples 1 through 5).

For employees paid on an hourly basis, an employer must calculate actual hours of service from records of hours of service and hours for which payment is made or due. For employees paid on a non-hourly basis, an employer must calculate hours of service by using one of the following methods:

Using actual hours of service from records of hours of service and hours for which payment is made or due;

Using a days-worked equivalency whereby the employee is credited with eight hours of service for each day for which the employee would be required to be credited with at least one hour of service in accordance with the rule for hourly employees; or

Using a weeks-worked equivalency whereby the employee is credited with 40 hours of service for each week for which the employee would be required to be credited with at least one hour of service in accordance with the rule for hourly employees.


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An employer must use one of these three methods for calculating the hours of service for non-hourly employees, but an employer is not required to use the same method for all non-hourly employees. The employer may apply different methods for different classifications of non-hourly employees, provided the classifications are reasonable and consistently applied. Similarly, an applicable large employer member is not required to apply the same methods as other applicable large employer members of the same applicable large employer for the same or different classifications of non-hourly employees, provided that in each case the classifications are reasonable and consistently applied by the applicable large employer member.

An assessable payment for an employer that does not offer coverage to at least 95 percent (70% in 2015) of its full-time employees is based on the total number of full-time employees (minus 30). An assessable payment for an employer that does offer such coverage is based only on the number of full-time employees that claim a premium tax credit. An employer may use a look-back method for determining in advance whether or not an employee is to be treated as a full-time employee, based on the hours of service credited to the employee during a previous period.

V. Health Reimbursement Arrangements. A common question to emerge after enactment of ACA relates to the consequences to the employer if the employer does not establish a health insurance plan for its own employees, but reimburses those employees for premiums they pay for health insurance (either through a qualified health plan in the Marketplace or outside the Marketplace). Under IRS Notice 2013-54, such arrangements are described as employer payment plans. An employer payment plan generally does not include an arrangement under which an employee may have an after-tax amount applied toward health coverage or take that amount in cash compensation. As explained in Notice 2013-54, these employer payment plans are considered to be group health plans subject to the market reforms, including the prohibition on annual limits for essential health benefits and the requirement to provide certain preventive care without cost sharing. Notice 2013-54 clarifies that such arrangements cannot be integrated with individual policies to satisfy the market reforms. Consequently, such an arrangement fails to satisfy the market reforms and may be subject to a $100/day excise tax per applicable employee (which is $36,500 per year, per employee) under section 4980D of the Internal Revenue Code. In 2015, the IRS issued Notice 2015-17, which provides relief from the excise tax penalty. Both Notices are discussed here.

A. Notice 2015-17.

This notice reiterates the conclusion in previous guidance addressing employer payment plans, including Notice 2013-54, 2013-40 I.R.B. 287, that employer payment plans are group health plans that will fail to comply with the market reforms that apply to group health plans under the Affordable Care Act (ACA). For this purpose, an employer payment plan as described in Notice 2013-54 refers to a group health plan under which an employer reimburses an


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employee for some or all of the premium expenses incurred for an individual health insurance policy or directly pays a premium for an individual health insurance policy covering the employee, such as arrangements described in Revenue Ruling 61-146, 1961-2 C.B. 25. This notice also provides transition relief from the assessment of excise tax under Internal Revenue Code (Code) § 4980D for failure to satisfy market reforms in certain circumstances. The transition relief applies to employer healthcare arrangements that constitute:

(1) employer payment plans, as described in Notice 2013-54, if the plan is sponsored by an employer that is not an Applicable Large Employer (ALE) under Code § 4980H(c)(2) and §§ 54.4980H-1(a)(4) and -2;

(2) S corporation healthcare arrangements for 2-percent shareholder-employees;

(3) Medicare premium reimbursement arrangements; and

(4) TRICARE-related health reimbursement arrangements (HRAs).

Certain questions/answers from Notice 2015-17 are reproduced below with comment:

1. Transition Relief for Small Employers from the Code § 4980D Excise Tax )

Small employers have in the past often offered their employees health coverage through arrangements that would constitute an employer payment plan as described in Notice 2013-54. If an employer offered coverage through such an arrangement, will the employer owe an excise tax under Code § 4980D?

In general, yes; however, this notice provides limited transition relief for coverage sponsored by an employer that is not an ALE under §§54.4980H-1(a)(4) and -2.

Notice 2013-54 concludes that the arrangements constituting employer payment plans as described in that notice fail to comply with the market reforms and may subject employers to the excise tax under Code § 4980D. At the same time, the Departments understand that some employers that had been offering health coverage through an employer payment plan may need additional time to obtain group health coverage or adopt a suitable alternative.

The SHOP Marketplace addresses many of the concerns of small employers. However, because the market is still transitioning and the transition by eligible employers to SHOP Marketplace coverage or other alternatives will take time to implement, this guidance provides that the excise tax under Code § 4980D will not be asserted for any failure to satisfy the market reforms by employer payment plans that pay, or reimburse employees for individual health policy premiums or Medicare part B or Part D premiums (1) for 2014 for employers that are not ALEs for 2014, and (2) for January 1 through June 30, 2015 for employers that are not ALEs for 2015. After June 30, 2015, such employers may be liable for the Code § 4980D excise tax.


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For purposes of this Q&A-1, an ALE generally is, with respect to a calendar year, an employer that employed an average of at least 50 full-time employees (including full-time equivalent employees) on business days during the preceding calendar year. See Code § 4980H(c)(2) and §§ 54.4980H-1(a)(4) and -2. For determining whether an entity was an ALE for 2014 and for 2015, an employer may determine its status as an applicable large employer by reference to a period of at least six consecutive calendar months, as chosen by the employer, during the 2013 calendar year for determining ALE status for 2014 and during the 2014 calendar year for determining ALE status for 2015, as applicable (rather than by reference to the entire 2013 calendar year and the entire 2014 calendar year, as applicable).

Employers eligible for the relief described in this Q&A-1 that have employer payment plans are not required to file IRS Form 8928 (regarding failures to satisfy requirements for group health plans under chapter 100 of the Code, including the market reforms) solely as a result of having such arrangements for the period for which the employer is eligible for the relief. This relief does not extend to stand-alone HRAs or other arrangements to reimburse employees for medical expenses other than insurance premiums.

2. Treatment of S corporation healthcare arrangements for 2-percent shareholder-employees.

IRS Notice 2008-1, 2008-2 I.R.B. 1, provides that if an S corporation pays for or reimburses premiums for individual health insurance coverage covering a 2-percent shareholder (as defined in Code § 1372(b)(2)), the payment or reimbursement is included in income but the 2-percent shareholder-employee may deduct the amount of the premiums under Code § 162(l), provided that all other eligibility criteria for deductibility under Code § 162(l) are satisfied. (This arrangement is referred to in this notice as a 2-percent shareholder-employee healthcare arrangement.) Is a 2-percent shareholder-employee healthcare arrangement subject to the market reforms?

The Departments are contemplating publication of additional guidance on the application of the market reforms to a 2-percent shareholder-employee healthcare arrangement. Until such guidance is issued, and in any event through the end of 2015, the excise tax under Code § 4980D will not be asserted for any failure to satisfy the market reforms by a 2-percent shareholder-employee healthcare arrangement. Further, unless and until additional guidance provides otherwise, an S corporation with a 2-percent shareholder-employee healthcare arrangement will not be required to file IRS Form 8928 (regarding failures to satisfy requirements for group health plans under chapter 100 of the Code, including the market reforms) solely as a result of having a 2-percent shareholder-employee healthcare arrangement.

The guidance provided in this Q&A-2 (including the guidance provided in the preceding paragraph) does not apply to reimbursements of individual health insurance coverage with respect to employees of an S corporation who are not 2-percent shareholders (but see Q&A-1).

The Treasury Department and the IRS are also considering whether additional guidance is needed on the federal tax treatment of 2-percent shareholder-employee healthcare arrangements. However, unless and until additional guidance provides otherwise, taxpayers may


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continue to rely on Notice 2008-1 with regard to the tax treatment of arrangements described therein for all federal income and employment tax purposes. To the extent that a 2-percent shareholder is allowed both the deduction under Code § 162(l) and the premium tax credit under Code § 36B, Revenue Procedure 2014-41, 2014-33 I.R.B. 364, provides guidance on computing the deduction and the credit with respect to the 2-percent shareholder.

Code § 9831(a)(2) provides that the market reforms do not apply to a group health plan that has fewer than two participants who are current employees on the first day of the plan year. Accordingly, an arrangement covering only a single employee (whether or not that employee is a 2-percent shareholder-employee) generally is not subject to the market reforms whether or not such a reimbursement arrangement otherwise constitutes a group health plan. If an S corporation maintains more than one such arrangement for different employees (whether or not 2-percent shareholder-employees), however, all such arrangements are treated as a single arrangement covering more than one employee so that the exception in Code § 9831(a)(2) does not apply. For this purpose, if both a non-2-percent shareholder employee of the S corporation and a 2-percent shareholder employee of the S corporation are receiving reimbursements for individual premiums, the arrangement would be considered a group health plan for more than one current employee. However, if an employee is covered under a reimbursement arrangement with other-than-self-only coverage (such as family coverage) and another employee is covered by that same coverage as a spouse or dependent of the first employee, the arrangement would be considered to cover only the one employee.

3. Integration of Medicare premium reimbursement arrangement and TRICARE-related HRA with a group health plan.

If an employer offers to reimburse Medicare premiums for its active employees, does this arrangement create an employer payment plan under Notice 2013-54? If so, may the employer payment plan be integrated with another group health plan to satisfy the annual dollar limit and preventive services requirements? Similarly, does an arrangement under which an employer reimburses (or pays directly) some or all of medical expenses for employees covered by TRICARE constitute an HRA subject to the market reforms? If so, may the HRA be integrated with another group health plan to satisfy the annual dollar limit and preventive services requirements?

An arrangement under which an employer reimburses (or pays directly) some or all of Medicare Part B or Part D premiums for employees constitutes an employer payment plan, as described in Notice 2013-54, and if such an arrangement covers two or more active employees, is a group health plan subject to the market reforms. An employer payment plan may not be integrated with Medicare coverage to satisfy the market reforms because Medicare coverage is not a group health plan. However, an employer payment plan that pays for or reimburses Medicare Part B or Part D premiums is integrated with another group health plan offered by the employer for purposes of the annual dollar limit prohibition and the preventive services requirements if (1) the employer offers a group health plan (other than the employer payment plan) to the employee that does not consist solely of excepted benefits and offers coverage providing minimum value; (2) the employee participating in the employer payment plan is actually enrolled in Medicare Parts A and B; (3) the employer payment plan is available only to


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employees who are enrolled in Medicare Part A and Part B or Part D; and (4) the employer payment plan is limited to reimbursement of Medicare Part B or Part D premiums and excepted benefits, including Medigap premiums. Note that to the extent such an arrangement is available to active employees, it may be subject to restrictions under other laws such as the Medicare secondary payer provisions. An employer payment plan that has fewer than two participants who are current employees (for example, a retiree-only plan) on the first day of the plan year is not subject to the market reforms and, therefore, integration is not necessary to satisfy the market reforms.

Notice 2015-17 also explains health reimbursement arrangements with respect to TRICARE (the health care program for uniformed service members (the Military Health System).

4. Increases in employee compensation to assist with payments of individual market coverage.

If an employer increases an employee's compensation, but does not condition the payment of the additional compensation on the purchase of health coverage (or otherwise endorse a particular policy, form, or issuer of health insurance), is this arrangement an employer payment plan?

No. As described in Notice 2013-54, an employer payment plan is a group health plan under which an employer reimburses an employee for some or all of the premium expenses incurred for an individual health insurance policy or directly pays a premium for an individual health insurance policy covering the employee, such as arrangements described in Rev. Rul. 61-146. The arrangement described in this Q&A-4 does not meet that description. In addition, because the arrangement described in this Q&A-4 generally will not constitute a group health plan, it is not subject to the market reforms. Providing employees with information about the Marketplace or the premium tax credit under Code § 36B is not endorsement of a particular policy, form, or issuer of health insurance.

5. Treatment of an employer payment plan as taxable compensation.

Notice 2013-54 provides that the payment arrangement described in Rev. Rul. 61-146 is an employer payment plan. May the reimbursements or payments under an arrangement described in Rev. Rul. 61-146 be provided on an after-tax basis and, if so, will this cause the arrangement not to be a group health plan (and accordingly not to be subject to the market reforms)?

No. Rev. Rul. 61-146 holds that under certain conditions, if an employer reimburses an employee's substantiated premiums for non-employer sponsored hospital and medical insurance, the payments are excluded from the employee's gross income under Code § 106. This exclusion also applies if the employer pays the premiums directly to the insurance company. The holding in Rev. Rul. 61-146 continues to apply, meaning only that payments under arrangements that meet the conditions set forth in Rev. Rul. 61-146 are excludable from the employee's gross income under Code § 106 (regardless of whether the employer includes the payments as wage


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payments on the Form W-2). However, Rev. Rul. 61-146 does not address the application of the market reforms and should not be read as containing any implication regarding the application of the market reforms. As explained in Notice 2013-54, an arrangement under which an employer provides reimbursements or payments that are dedicated to providing medical care, such as cash reimbursements for the purchase of an individual market policy, is itself a group health plan. Accordingly, the arrangement is subject to the market reform provisions of the Affordable Care Act applicable to group health plans without regard to whether the employer treats the money as pre-tax or post-tax to the employee. Such employer health care arrangements cannot be integrated with individual market policies to satisfy the market reforms and, therefore, will fail to satisfy PHS Act §§ 2711 (annual limit prohibition) and 2713 (requirement to provide cost-free preventive services) among other provisions.

B. Reporting Requirements.

1. Employer Reporting on Form W-2.

Employers are required to disclose the aggregate cost of employer-sponsored health insurance coverage provided to their employees on the employee's Form W-2. Contributions to any health savings account (HSA) or Archer medical savings account (MSA) of the employee or the employee's spouse or salary reduction contributions to a flexible spending arrangement under a cafeteria plan will not be included. This employer disclosure requirement was to begin with the Form W-2 for the 2011 tax year. However, the IRS deferred the requirement, making it optional for 2011 Forms W-2, and generally effective for 2012 Forms W-2. Until the IRS issues further guidance, smaller employers that are required to file fewer than 250 Forms W-2 for the preceding calendar year are not subject to the reporting requirement. Employers are required to disclose the aggregate cost of "applicable employer-sponsored coverage" provided to employees annually on the employee's Form W-2 (IRC 6051(a)(14)). Regardless of whether the employee or employer pays for the coverage, the aggregate cost of the coverage reported is determined under rules similar to those used in IRC 4980B(F)(4) to determine the applicable premiums for purposes of the COBRA continuation coverage requirements of group health plans. They are determined on an annual basis, and may be based on the information available on December 31 of the year (Notice 2012-9) For purposes of the new reporting requirement, "applicable employer-sponsored coverage" means, with respect to any employee, coverage under any group health plan made available to the employee by the employer that is excludable from the employee's gross income under IRC 106. Coverage is treated as applicable employer-sponsored coverage regardless of whether the employer or employee pays for the coverage. Applicable employer-sponsored coverage does not include coverage for long- term care, accidents, or disability income insurance. Nor does it include coverage that applies to only a specified disease or illness, hospital indemnity, or other fixed indemnity insurance, the payment for which is not excludable from gross income and deductible under IRC 162(l).


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Applicable employer-sponsored coverage does not include any salary reduction contributions to a flexible spending arrangement under a cafeteria plan or contributions to an Archer medical savings account or health savings account of the employee or the employee's spouse. A health reimbursement account (HRA) of the employee is also not reportable, even if the HRA is the only coverage provided (Notice 2012-9). This provision only requires disclosure of the aggregate cost of employer-sponsored health insurance coverage by the employer. It does not require a specific breakdown of the various types of medical coverage. Thus, if an employee enrolls in employer-sponsored health insurance coverage under a medical plan, a dental plan and a vision plan, the employer must report the total cost of all of these health related insurance policies. Accordingly, an employer will not be subject to any penalties for failure to meet such requirements for 2011. However, for 2012 Forms W-2 (and Forms W-2 for later years unless and until further guidance is issued), an employer is not subject to the reporting requirement for any calendar year if the employer was required to file fewer than 250 Forms W-2 for the preceding calendar year. Whether an employer is required to file fewer than 250 Forms W-2 for a calendar year is determined based on the Forms W-2 that employer would be required to file if it filed Forms W-2 to report all wages paid by that employer and without regard to the use of an agent under IRC 3504 (Notice 2012-9).

2. Health Care Coverage Reporting Requirements.

Beginning in 2015, any person or entity (including self-insured employers) who provides minimum essential health care coverage to an individual during a calendar year is required to file a return in the following calendar year reporting such coverage in the form and manner prescribed by the Secretary of the Treasury. Such a person is also required to furnish a written statement to the individual with respect to whom information is reported, detailing the contents of the information return. The first returns will be filed in 2016 for 2015 coverage. Information reporting required for health insurance coverage.—Beginning in 2015, every provider of minimum essential health care coverage to an individual during a calendar year is required to file a return reporting such coverage, at such time as the Secretary of the Treasury may prescribe (IRC 6055(a)). The first returns will be filed in 2016 for 2015 coverage. A provider required to file a return under these rules is also required to furnish a written statement to the individual with respect to whom information is reported, detailing the contents of the information return. The information reported under IRC 6055 will enable taxpayers to establish and the IRS to verify that the taxpayers have the required minimum essential coverage during a calendar year. The Secretary of the Treasury, in consultation with the Secretary of Health and Human Services, is required to send a written notification to each individual who files an individual income tax return and who is not enrolled in minimum essential coverage. The notification must be sent no later than June 30 of each year, and must contain information on the services available


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through the Exchange operating in the state in which the individual resides.

a) Who is required to report.

The reporting requirements apply to:

• health insurance issuers, or carriers (as defined in 5 U.S.C. 8901), for all insured coverage; • plan sponsors of self-insured group health plan coverage; • the executive department or agency of a governmental unit that provides coverage under a government-sponsored program, and • any other person that provides minimum essential coverage to an individual (Reg. 1.6055-1( c)(1)).

• Self-insured applicable large employers that are subject to reporting requirements under IRC 6056, report on Forms 1094-C (transmittal) and 1095-C (employee statement). Other providers file Forms 1094-B (transmittal) and 1095-B (employee statement)). The required return must contain the name, address and taxpayer identification number (TIN) of the responsible individual insured, and the name and TIN of each other individual obtaining coverage under the policy. The return must also include the name, address, and employer identification number (EIN) for the reporting entity. The required return must also include the dates during which the insured was covered under minimum essential coverage during the calendar year. Final regulations do not require reporting of the specific dates of coverage, and instead require reporting of the months for which, for at least one day, the individual was enrolled in coverage and entitled to receive benefits An individual who has coverage on any day in a month is treated as having minimum essential coverage for the entire month. Therefore, the specific coverage dates are not necessary for administering and complying with rules relating to minimum essential coverage. If the provided minimum essential coverage consists of health insurance coverage of a health insurance issuer provided through a group health plan of an employer, the return must include the name, address and employer identification number of the employer sponsoring the plan, and the portion of the premium, if any, required to be paid by the employer. If the coverage is a qualified health plan in the small group market offered through an Exchange, the return must also include such other information as the Secretary of the Treasury may require for administration of the new credit for employee health insurance expenses of small employers. Thankfully, the IRS final regulations do not require the reporting of the following four items stated as required in the legislation: (1) the length of any waiting period; (2) the employer’s share of the total allowed costs of benefits provided under the plan; (3) the monthly premium for the lowest- cost option in each of the enrollment categories; and (4) the months, if any, during which any of the employee’s dependents were covered under the plan. For this purpose, the return must report whether the coverage is qualified health plan enrolled in through a SHOP Exchange and the SHOP’s unique identifier. No information


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reporting is required for arrangements that provide benefits in addition or as a supplement to minimum essential coverage, such as a health reimbursement arrangement. Additionally, no reporting is required for coverage offered to individuals who do not enroll. The required return and transmittal form must be filed on or before February 28 (or March 31, if filed electronically) of the year following the calendar year in which the reporting entity provided minimum essential coverage to an individual. High-volume filers (i.e., those who file at least 250 health coverage provider returns during the calendar year) have to file electronically. A person required to file a return under these rules is also required to furnish a written statement to each individual whose name is reported on the return, showing the name, address and phone number of the person required to make the return, and the information required to be shown on the return with respect to that individual. The statement must be furnished on or before January 31 of the year following the calendar year for which the information return was required to be made. Failure to file an information return reporting health insurance coverage or failure to include correct or complete information on such a return is subject to the existing penalties for failure to file correct information returns under IRC 6721 Similarly, the present- law penalties for failure to furnish correct payee statements under IRC 6722 apply to failure to furnish statements to individuals with respect to whom information is reported or failure to include correct or complete information on such statements. Penalties. Failure to file an information return reporting on health insurance coverage or failure to include correct or complete information on the return is subject to the existing penalties for failure to file correct information returns under IRC 6721. Similarly, the present-law penalties for failure to furnish correct payee statements under IRC 6722 apply to failure to furnish statements to individuals with respect to whom information is reported or failure to include correct or complete information on such statements.

VI. Small Business and the ACA Qualified small employers may buy qualified health plans (QHPs)-private health insurance that has been certified as meeting certain standards-through the Small Business Health Options Program (SHOP) Marketplace. The SHOP Marketplace may be a convenient option for many employers, because everything, including employee enrollment, can be handled online. Like other employer-sponsored coverage, the employer is still able to determine the coverage that employees may enroll in, how much the employer premium contribution will be, the length of open enrollment and waiting periods. To qualify for a SHOP plan, a business must satisfy the following requirements:

Have at least one common-law employee on payroll This criteria does not include a business owner or the owner's spouse, so individuals who are self-employed with no


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employees cannot get coverage through the SHOP (though once the business is considered otherwise eligible for SHOP, the business owner and spouse may also sign up for coverage through the SHOP). Offer coverage to all fall-time employees. A full-time employee is any employee working 30 or more hours per week on average. The employer does not have to offer coverage to part-time employees. Ensure at least 70% of those full-time employees enroll in the SHOP Market- place plan. This is referred to as "minimum participation percentage." Certain states set their minimum participation percentage level at a different percentage. Have a principal business address or an employee with a primary worksite in the coverage area. See Healthcrtre.gov to determine what SHOP Marketplace coverage is offered in each area. Employ 50 or fewer full-time equivalent employees (FTEs), including part- time employees. The number goes up to 100 in 2016.

Similar to the individual marketplace, SHOP Marketplace plans are available in four categories or "metal levels": Bronze, Silver, Gold, and Platinum. All plans offer similar benefits, but differ in how much the employee pays for things like deductibles and copayments and the total amount they spend out-of-pocket for the year. Generally, the lower the premium the employee pays, the higher the out-of pocket costs and vice-versa. In all states, employers can select one plan and offer it to all employees. In certain states, employers can choose a plan category (such as Gold or Silver) and allow employees to choose any plan from any insurance company in that category. This is called Employee Choice. The states which offer this option in 2015 include Arkansas, Florida, Georgia, Indiana, Iowa, Missouri, Nebraska, North Dakota, Ohio, Tennessee, Texas, Virginia, Wisconsin and Wyoming. All employers that offer health coverage for more than one employee are subject to the group health plan requirements, whether the coverage is provided through an insurer or through direct employer funding. These are minimum coverage and participation standards set out for all employers, and enforced by the IRS through a $100 per day, per affected employee excise tax.

A. Employer Self-Insured plans. An employer who opts for a self-insured plan might qualify for the premium tax credit (PTC). The PTC is a federal subsidy for eligible taxpayers, and is provided on a sliding scale depending on the size of the family and household income. If the taxpayer is eligible for and claims this benefit, the self-employed health insurance deduction is still available, but only for the non-subsidized portion.


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As a plan sponsor, the taxpayer with a self insured plan must pay the PCORI fee imposed on employers who provide health insurance. This fee supports the "Patient-Centered Outcomes Research Institute" through a trust fund, and is generally known as the PCORI fee. It is assessed at the rate of $2 multiplied by the average number of lives covered under the plan. The fee ends after September 30, 2019. (Code Sec. 4376). Providers providing insurance coverage must also comply with Coverage Information reporting. Under Code Sec. 6055, every provider of "minimum essential coverage" must report coverage information by filing an information return with the IRS and furnishing a statement to individuals. Generally, providers are insurers, carriers, or government agencies providing coverage, and any employer with a self-insured plan. This involves Form 1094-B and 1095-B described above. In addition, and starting in 2018, a 40-percent excise tax is imposed on health coverage providers to the extent that the aggregate value of employer sponsored health coverage for an employee exceeds a threshold amount (Code Sec. 4980I). For insured plans, the insurer pays the tax, but for self-insured plans the entity that "administers the plan benefits" will pay the tax. The tax is 40% of the excess benefit, computed on a monthly basis. This excess is the cost for the month over an amount equal to 1/12th of the annual amount (which is $10,200 for 2018 for self-only coverage and $27,500 for all other plans.) These annual amounts are adjusted by the change in cost of health care coverage from 2010 to 2018, when the tax starts.

VII. Trade Preferences Extension Act of 2015.

The Trade Preferences Extension Act of 2015 (H.R. 1295) extends a number of trade agreements as well as trade adjustment assistance (TAA) and the Health Coverage Tax Credit (HCTC). It also revises several Tax Code provisions.

A. Health Coverage Tax Credit (HCTC)

Individuals who qualify for Trade Adjustment Assistance (TAA) may be eligible for the HCTC. The HCTC under IRC sec. 35 provides a refundable credit for 72.5 percent of a covered individual's premiums for qualified health insurance of the individual and qualifying family members. Generally, a covered individual is an individual who is an eligible TAA recipient, an eligible alternative TAA recipient, an eligible Reemployment TAA recipient or an eligible Pension Benefit Guaranty Corporation (PBGC) pension recipient. An individual is an eligible PBGC pension recipient for any month if the individual is age 55 or over as of the first day of the month and receives a benefit for the month, any portion of which is paid by the PBGC. Certain family members may be eligible to receive the HCTC. Covered individuals may apply the HCTC to help offset the cost of qualified health insurance, which includes certain COBRA continuation coverage; coverage under a health insurance program offered to state employees or a comparable program; and certain coverage under a group health plan that is available through the employment of the eligible individual's spouse. Covered individuals cannot be enrolled in Medicaid, Medicare, CHIP, TRICARE, or certain other federal programs.


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The HCTC had expired. It has now been retroactively reinstated and is now available for months beginning before January 1, 2020. The HCTC expired after 2013. The Tax Preferences Extension Act makes the HCTC available retroactively to the start of 2014. Lawmakers directed the IRS to publicize the retroactive extension of the HCTC.


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CHAPTER 2 PATH ACT


II. PATH Act. ............................................................................................................................... 1 A. Bonus Depreciation. ............................................................................................................ 1

1. Qualified Improvement property. ..................................................................................... 3 B. IRC sec. 179 expense election. ............................................................................................ 4 C. De minimis safe harbor. ...................................................................................................... 5

III. Chart of Changes Made by PATH Act. ................................................................................. 6

II. PATH Act. The "Protecting Americans from Tax Hikes (PATH) Act of 2015" (P.L. 114-113, 12/18/2015) made a number of significant taxpayer-friendly changes in the tax law. These changes are summarized in the chart which is attached. Almost all of these changes will affect tax returns filed in 2016, but few have a wider impact on ordinary businesses than the retroactive permanent extension of the enhanced IRC sec. 179 expensing rules and the 5-year extension of 50% bonus first-year depreciation.

A. Bonus Depreciation.

Under pre-PATH Act law, IRC sec. 168(k) generally allowed an additional first-year depreciation deduction (also called bonus first-year depreciation) equal to 50% of the adjusted basis of qualified property acquired and placed in service after Dec. 31, 2011, and before Jan. 1, 2015 (before Jan. 1, 2016 for certain longer-lived and transportation property).The additional first-year depreciation deduction was allowed for both regular tax and alternative minimum tax (AMT) purposes, but was not allowed for purposes of computing earnings and profits. The basis of the property and the depreciation allowances in the year of purchase and later years were appropriately adjusted to reflect the additional first-year depreciation deduction. A taxpayer could elect out of additional first-year depreciation for any class of property for any tax year. The PATH Act extended bonus depreciation for qualified property acquired and placed in service during 2015 through 2019 (subject to a phase down), through 2020 for certain longer-lived and transportation property. Eligible taxpayers will be able to claim:

(1) a 50% bonus depreciation allowance for qualified property placed in service in 2015 through 2017;

(2) a 40% bonus depreciation allowance for qualified property placed in service in 2018; and

(3) a 30% bonus depreciation allowance for qualified property placed in service in 2019.


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( IRC sec. 168(k) ) The percentages apply to certain longer-lived and transportation property placed in service one year later than shown in the list above. The above changes, which were enacted late in 2015, are retroactive. Thus, a fiscal year taxpayer that, for its tax year ending in calendar year 2015 (the 2015 year), could benefit from the bonus depreciation, but filed its 2015 tax year return before the retroactive extension of bonus depreciation, may want to consider filing an amended return. The IRS will allow such taxpayers to amend their 2014/2015 fiscal year return to claim the bonus depreciation for 2015 if a 2015/2016 tax return has not been filed. Taxpayers who have already filed a 2015/2016 fiscal year return may not file an amended return and will need to file a change of accounting method with their 2016/2017 fiscal year return in order to claim missed bonus depreciation. Taxpayers who elected our of bonus depreciation on a 2014/2015 fiscal year return are allowed to revoke the election without IRS consent by filing an amended 2014/2015 fiscal year return by the later of Nov. 11, 2016 or before a 2015/2016 fiscal year return is filed. (Rev. Proc. 2016-48). The PATH Act also provided that:

• For property placed in service after Dec. 31, 2014 and before Jan. 1, 2020, the IRC sec. 280F limitation for passenger autos and for light trucks or vans (i.e., passenger autos built on a truck chassis, including minivans and sport-utility vehicles (SUVs) built on a truck chassis, rated at 6,000 pounds gross (loaded) vehicle weight or less) is increased (subject to a phase down) for qualified property subject to bonus depreciation. For an auto or light truck or van placed in service in 2015 through 2017, the limitation is increased by $8,000; for an auto or light truck or van placed in service in 2018, the limitation is increased by $6,400; and for an auto or light truck or van placed in service in 2019, the IRC sec. 280F limitation is increased by $4,800. ( IRC sec. 168(k)(2) )

• For property placed in service after Dec. 31, 2014, the 15-year recovery period for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property is retroactively restored and made permanent. ( IRC sec. 168(e)(3)(E) ) For property placed in service after Dec. 31, 2015, qualified leasehold improvement property is no longer qualified property, but instead a new category, "qualified improvement property" (which includes qualified leasehold improvement property and qualified retail improvement property) is qualified property (eligible for bonus depreciation); qualified restaurant property may or may not meet the requirements for qualified improvement property. First-year bonus depreciation is allowed for qualified improvement property without regard to whether the improvements are property subject to a lease, and there is no requirement that the improvement must be placed in service more than three years after the date the building was first placed in service. ( IRC sec. 168(k)(3) ) See below.

• For plants planted or grafted after Dec. 31, 2015 and before Jan. 1, 2020, bonus depreciation (subject to a phase down) is allowed for certain trees, vines, and plants bearing fruit or nuts when planted or grafted, rather than when placed in service; 50% for a plant that is planted or grafted in 2016 or 2017; 40% for a plant that is planted or


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grafted in 2018; and 30% for a plant that is planted or grafted in 2019. ( IRC sec. 168(k)(5) )

• For tax years beginning after Dec. 31, 2014 and before Jan. 1, 2020, the elective exchange by corporations trading bonus and accelerated depreciation for the refund of otherwise deferred AMT credits is retroactively restored and extended (subject to a phaseout). ( IRC sec. 168(k)(4) )

• The special rule for the allocation of bonus depreciation to a long-term contract is extended for five years to property placed in service before Jan. 1, 2020 (Jan. 1, 2021, in the case of certain longer-lived and transportation property). ( IRC sec. 460(c)(6)(B) )

• For property placed in service after Dec. 31, 2014 and before Jan. 1, 2017, first-year 50% bonus depreciation allowance for second generation biofuel plant property is retroactively restored and extended. ( IRC sec. 168(l)(2)(D) ) Example: On June 1, 2015, Smallco, a calendar-year taxpayer, bought 5-year MACRS property for $526,000 and immediately placed it in service. The property qualifies for bonus depreciation and IRC sec. 179 expensing. Smallco didn't buy any other property eligible for the IRC sec. 179 election in 2015. Smallco makes the IRC sec. 179 election and depreciates the remaining property using the accelerated 200% declining balance method of depreciation; a 5-year recovery period; the half-year convention; and the optional depreciation tables. For 2015, Smallco is allowed a $500,000 deduction under IRC sec. 179 . Smallco reduces the $526,000 cost by the $500,000 IRC sec. 179 deduction, resulting in an unadjusted depreciable basis of $26,000, which yields a 50% bonus depreciation deduction of $13,000 ($26,000 × 50%). Smallco has an unadjusted depreciable basis of $26,000 (which is reduced by $13,000 bonus depreciation) resulting in a remaining adjusted depreciable basis of $13,000 and an allowable depreciation deduction in 2015 of $2,600 ($13,000 × 20%, the annual depreciation rate from the optional depreciation tables). Thus, Smallco's total deduction for 2015 on property costing $526,000 is $515,600.

1. Qualified Improvement property.

Qualified improvement property is defined as any improvement to an interior portion of a building which is nonresidential real property (whether or not the nonresidential real property is depreciated under MACRS) if the improvement is placed in service after the date the building was first placed in service. Expenditures which are attributable to the enlargement of a building, any elevator or escalator, or the internal structural framework of the building are excluded from the definition of qualified improvement property. The improvement can qualify if the building


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was first placed in service by any person. The only requirement is that the improvements are placed in service on or after January 1, 2016.

Qualified improvement property is defined much more broadly than qualified leasehold improvement property because the improvement does not need to be made pursuant to a lease and improvements to common areas qualify. Any property that meets the definition of qualified leasehold improvement property will necessarily meet the definition of qualified improvement property and should be eligible for bonus depreciation in 2016.

Qualified improvement property does not qualify for a 15-year recovery period unless it meets the definition of qualified leasehold improvement property, qualified retail improvement property, or qualified restaurant property. Qualified improvement property which does not qualify for a 15-year recovery period is depreciated over 39-years as nonresidential real property using a mid-month convention.

B. IRC sec. 179 expense election. Under IRC sec. 179 , a taxpayer, other than an estate, a trust, or certain noncorporate lessors, may elect to deduct as an expense, rather than to depreciate, up to a specified amount of the cost of new or used tangible personal property or certain real property placed in service during the tax year in the taxpayer's trade or business. The maximum annual expensing amount generally is reduced dollar-for-dollar by the amount of IRC sec. 179 property placed in service during the tax year in excess of a specified investment ceiling. Amounts ineligible for expensing due to excess investments in expensing-eligible property can't be carried forward and expensed in a subsequent year. Rather, they can only be recovered through depreciation. The amount eligible to be expensed for a tax year can't exceed the taxable income derived from the taxpayer's active conduct of a trade or business. Any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding tax years. The PATH Act made the following changes to the IRC sec. 179 expensing election:

• The $500,000 expensing limitation and $2 million phase-out amounts are retroactively extended and made permanent. ( IRC sec. 179(b) )

• For any tax year beginning after Dec. 31, 2015, both the $500,000 and $2 million limits are indexed for inflation. ( IRC sec. 179(b)(6) ) For tax years beginning in 2016, the annual cap (as adjusted for inflation) remains at $500,000. The investment limitation, however, is increased form $2 million to $2,010,000.

• The rule that allows expensing for computer software is retroactively extended and made permanent. ( IRC sec. 179(d)(1)(A)(ii) )

• For tax years beginning after Dec. 31, 2015, air conditioning and heating units are eligible for expensing. ( IRC sec. 179(d)(1) )

• For tax years beginning after Dec. 31, 2014, an expensing election or specification of


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property to be expensed may be revoked without IRS's consent. ( IRC sec. 179(c)(2) ) Thus, the ability to revoke a IRC sec. 179 election without IRS consent is made permanent.

• Qualified real property is eligible to be expensed for tax years beginning before 2016 ( IRC sec. 179(f)(1) ), but no portion of disallowed expensing may be carried to a tax year beginning after Dec. 31, 2015. ( IRC sec. 179(f)(4) ) For tax years beginning after Dec. 31, 2015, expensing of qualified real property is made permanent without a carryover limitation ( IRC sec. 179(f)(1) , IRC sec. 179(f)(4) ), and the $250,000 expensing limitation with respect to qualifying real property is eliminated. ( IRC sec. 179(f) )

C. De minimis safe harbor. The expensing break is separate from, and is available in addition to, the de minimis safe harbor in the capitalization regs that allows businesses to elect to expense their outlays for "lower-cost" business assets. Under this safe harbor, which applies to an amount paid during the tax year to acquire or produce a unit of property, or acquire a material or supply, and which generally applies to amounts paid in tax years beginning on or after Jan. 1, 2014, qualifying businesses with an applicable financial statement (AFS) can expense eligible property if the amount paid doesn't exceed $5,000 per invoice (or per item as substantiated by the invoice). If the taxpayer does not have an AFS, the same rule applies except that the amount paid for eligible property can't exceed $2,500 per invoice (or per item as substantiated by the invoice). Assets expensed under the de minimis safe harbor election may be deducted in the year of purchase, assuming that the costs that otherwise qualify as ordinary expenses, and assuming the costs don't have to be capitalized under the uniform capitalization (UNICAP) rules of IRC sec. 263A .

Example: Large Corp, a calendar year corporation that has an AFS, has a written accounting policy at the beginning of 2015, which it follows, to expense amounts paid for property costing $5,000 or less. In 2015, it pays $750,000 to buy 500 computers at $1,500 each, and $250,000 to buy 50 high-speed network printers at $5,000 each. Each computer and printer is a unit of property, and the amounts paid for them meet the requirements for the de minimis safe harbor. During 2015, Large Corp also spends a total of $1 million on other equipment and business assets that are not eligible for the de minimis safe harbor and instead must be capitalized. Large Corp, which isn't subject to the UNICAP rules of IRC sec. 263A , elects to apply Reg. § 1.263A-1(f) (i.e., the de minimis safe harbor rule) to amounts paid in tax years beginning on or after Jan. 1, 2014. Large Corp will be able to deduct $1.5 million of the total cost of its machinery and equipment purchases during 2015 ($1 million under the de minimis safe harbor, and $500,000 under the IRC sec. 179 expensing election


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III. Chart of Changes Made by PATH Act.

IRC Section:

24 Section 101. Enhanced child tax credit made permanent. The child tax credit (CTC) is a $1,000 credit. To the extent the CTC exceeds the taxpayer’s tax liability, the taxpayer is eligible for a refundable credit (the additional child tax credit) equal to 15 percent of earned income in excess of a threshold dollar amount (the “earned income” formula). Until 2009, the threshold dollar amount was $10,000 indexed for inflation from 2001 (which would be roughly $14,000 in 2015). Since 2009, however, this threshold amount has been set at an unindexed $3,000 and is scheduled to expire at the end of 2017, returning to the $10,000 (indexed for inflation) amount. The provision permanently sets the threshold amount at an unindexed $3,000.

No CA credit.

25A Section 102. Enhanced American opportunity tax credit made permanent. The Hope Scholarship Credit is a credit of $1,800 (indexed for inflation) for various tuition and related expenses for the first two years of post-secondary education. It phases out for AGI starting at $48,000 (if single) and $96,000 (if married filing jointly) – these amounts are also indexed for inflation. The American Opportunity Tax Credit (AOTC) takes those permanent provisions of the Hope Scholarship Credit and increases the credit to $2,500 for four years of post-secondary education, and increases the beginning of the phase-out amounts to $80,000 (single) and $160,000 (married filing jointly) for 2009 to 2017. The provision makes the AOTC permanent.

No CA credit.

32 Section 103. Enhanced earned income tax credit made permanent. Low- and moderate- income workers may be eligible for the earned income tax credit (EITC). For 2009 through 2017, the EITC amount has been temporarily increased for those with three (or more) children and the EITC marriage penalty has been reduced by increasing the income phase-out range by $5,000 (indexed for inflation) for those who are married and filing jointly. The provision makes these provisions permanent.

CA has their own EITC.

62(a)(2)(D) Section 104. Extension and modification of deduction for certain expenses of elementary and secondary school teachers. The provision permanently extends the above-the-line deduction (capped at $250) for the eligible expenses of elementary and secondary school teachers. Beginning in 2016, the provision also modifies the deduction to index the $250 cap to inflation and include professional development expenses.

CA does not conform.


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132(f) Section 105. Extension of parity for exclusion from income for employer-provided mass transit and parking benefits. The provision permanently extends the maximum monthly exclusion amount for transit passes and van pool benefits so that these transportation benefits match the exclusion for qualified parking benefits. These fringe benefits are excluded from an employee’s wages for payroll tax purposes and from gross income for income tax purposes.

CA has their own provision.

164 Section 106. Extension of deduction of State and local general sales taxes. The provision permanently extends the option to claim an itemized deduction for State and local general sales taxes in lieu of an itemized deduction for State and local income taxes. The taxpayer may either deduct the actual amount of sales tax paid in the tax year, or alternatively, deduct an amount prescribed by the Internal Revenue Service (IRS).

CA doea not conform.

170(b) Section 111. Extension and modification of special rule for contributions of capital gain real property made for conservation purposes. The provision permanently extends the charitable deduction for contributions of real property for conservation purposes. The provision also permanently extends the enhanced deduction for certain individual and corporate farmers and ranchers. The provision modifies the deduction beginning in 2016 to permit Alaska Native Corporations to deduct donations of conservation easements up to 100 percent of taxable income.


408(d)(8) Section 112. Extension of tax-free distributions from individual retirement plans for charitable purposes. The provision permanently extends the ability of individuals at least 701⁄2 years of age to exclude from gross income qualified charitable distributions from Individual Retirement Accounts (IRAs). The exclusion may not exceed $100,000 per taxpayer in any tax year.

CA does conform.

170 Section 113. Extension and modification of charitable deduction for contributions of food inventory. The provision permanently extends the enhanced deduction for charitable contributions of inventory of apparently wholesome food for non-corporate business taxpayers. The provision modifies the deduction beginning in 2016 by increasing the limitation on deductible contributions of food inventory from 10 percent to 15 percent of the taxpayer’s AGI (15 percent of taxable income (as modified by the provision) in the case of a C corporation) per year. The provision also modifies the deduction to provide special rules for valuing food inventory.



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512 Section 114. Extension of modification of tax treatment of certain payments to controlling exempt organizations. The provision permanently extends the modification of the tax treatment of certain payments by a controlled entity to an exempt organization.


1367 Section 115. Extension of basis adjustment to stock of S corporations making charitable contributions of property. The provision permanently extends the rule providing that a shareholder’s basis in the stock of an S corporation is reduced by the shareholder’s pro rata share of the adjusted basis of property contributed by the S corporation for charitable purposes.


38, 41 Section 121. Extension and modification of research credit. The provision permanently extends the research and development (R&D) tax credit. Additionally, beginning in 2016 eligible small businesses ($50 million or less in gross receipts) may claim the credit against alternative minimum tax (AMT) liability, and the credit can be utilized by certain small businesses against the employer’s payroll tax (i.e., FICA) liability.

CA has its own credit.

45P Section 122. Extension and modification of employer wage credit for employees who are active duty members of the uniformed services. The provision permanently extends the 20- percent employer wage credit for employees called to active military duty. Beginning in 2016, the provision modifies the credit to apply to employers of any size, rather than employers with 50 or fewer employees, as under current law.

No CA credit.

168 Section 123. Extension of 15-year straight-line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements. The provision permanently extends the 15-year recovery period for qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property.



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179 Section 124. Extension and modification of increased expensing limitations and treatment of certain real property as section 179 property. The provision permanently extends the small business expensing limitation and phase-out amounts in effect from 2010 to 2014 ($500,000 and $2 million, respectively). These amounts currently are $25,000 and $200,000, respectively. The special rules that allow expensing for computer software and qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) also are permanently extended. The provision modifies the expensing limitation by indexing both the $500,000 and $2 million limits for inflation beginning in 2016 and by treating air conditioning and heating units placed in service in tax years beginning after 2015 as eligible for expensing. The provision further modifies the expensing limitation with respect to qualified real property by eliminating the $250,000 cap beginning in 2016.

CA has its own provision.

871(k) Section 125. Extension of treatment of certain dividends of regulated investment companies. The provision permanently extends provisions allowing for the pass-through character of interest-related dividends and short-term capital gains dividends from regulated investment companies (RICs) to foreign investors.


1202 Section 126. Extension of exclusion of 100 percent of gain on certain small business stock. The provision extends the temporary exclusion of 100 percent of the gain on certain small business stock for non-corporate taxpayers to stock acquired and held for more than five years. This provision also permanently extends the rule that eliminates such gain as an AMT preference item.

CA does not have exclusion.

1374 Section 127. Extension of reduction in S-corporation recognition period for built-in gains tax. The provision permanently extends the rule reducing to five years (rather than ten years) the period for which an S corporation must hold its assets following conversion from a C corporation to avoid the tax on built-in gains.

For CA use 10 years.

953, 954 Section 128. Extension of subpart F exception for active financing income. The provision permanently extends the exception from subpart F income for active financing income.


42 Section 131. Extension of temporary minimum low-income housing tax credit rates for non-Federally subsidized buildings. The provision permanently extends application of the 9- percent minimum credit rate for the low-income housing tax credit for non-Federally subsidized new buildings.



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42 Section 132. Extension of military housing allowance exclusion for determining whether a tenant in certain counties is low-income. The provision permanently extends the exclusion of military basic housing allowances from the calculation of income for determining eligibility as a low-income tenant for purposes of low-income housing tax credit buildings.


897, 1445 Section 133. Extension of RIC qualified investment entity treatment under FIRPTA. The provision permanently extends the treatment of RICs as qualified investment entities and, therefore, not subject to withholding under the Foreign Investment in Real Property Tax Act (FIRPTA).


45D Section 141. Extension of new markets tax credit. The provision authorizes the allocation of $3.5 billion of new markets tax credits for each year from 2015 through 2019.

No CA credit.

51, 52 Section 142. Extension and modification of work opportunity tax credit. The provision extends through 2019 the work opportunity tax credit. The provision also modifies the credit beginning in 2016 to apply to employers who hire qualified long-term unemployed individuals (i.e., those who have been unemployed for 27 weeks or more) and increases the credit with respect to such long-term unemployed individuals to 40 percent of the first $6,000 of wages.

No CA credit.

168(k) Section 143. Extension and modification of bonus depreciation. The provision extends bonus depreciation for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period). The bonus depreciation percentage is 50 percent for property placed in service during 2015, 2016 and 2017 and phases down, with 40 percent in 2018, and 30 percent in 2019. The provision continues to allow taxpayers to elect to accelerate the use of AMT credits in lieu of bonus depreciation under special rules for property placed in service during 2015. The provision modifies the AMT rules beginning in 2016 by increasing the amount of unused AMT credits that may be claimed in lieu of bonus depreciation. The provision also modifies bonus depreciation to include qualified improvement property and to permit certain trees, vines, and plants bearing fruit or nuts to be eligible for bonus depreciation when planted or grafted, rather than when placed in service.


954(c)(6) Section 144. Extension of look-thru treatment of payments between related controlled foreign corporations under foreign personal holding company rules. The provision extends through 2019 the look-through treatment for payments of dividends, interest, rents, and royalties between related controlled foreign corporations.



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108 Section 151. Extension and modification of exclusion from gross income of discharge of qualified principal residence indebtedness. The provision extends through 2016 the exclusion from gross income of a discharge of qualified principal residence indebtedness. The provision also modifies the exclusion to apply to qualified principal residence indebtedness that is discharged in 2017, if the discharge is pursuant to a written agreement entered into in 2016.

CA exclusion has expired.

163 Section 152. Extension of mortgage insurance premiums treated as qualified residence interest. The provision extends through 2016 the treatment of qualified mortgage insurance premiums as interest for purposes of the mortgage interest deduction. This deduction phases out ratably for a taxpayer with AGI of $100,000 to $110,000.


222 Section 153. Extension of above-the-line deduction for qualified tuition and related expenses. The provision extends through 2016 the above-the-line deduction for qualified tuition and related expenses for higher education. The deduction is capped at $4,000 for an individual whose AGI does not exceed $65,000 ($130,000 for joint filers) or $2,000 for an individual whose AGI does not exceed $80,000 ($160,000 for joint filers).


45A Section 161. Extension of Indian employment tax credit. The provision extends through 2016 the Indian employment tax credit. The Indian employment credit provides a credit on the first $20,000 of qualified wages paid to each qualified employee who works on an Indian reservation.

No CA credit.

45G Section 162. Extension and modification of railroad track maintenance credit. The provision extends through 2016 the railroad track maintenance tax credit. The provision modifies the credit to apply to expenditures for maintaining railroad track owned or leased as of January 1, 2015 (rather than January 1, 2005, as under current law).

No CA credit.

45N Section 163. Extension of mine rescue team training credit. The provision extends through 2016 the mine rescue team training tax credit. Employers may take a credit equal to the lesser of 20 percent of the training program costs incurred, or $10,000.

No CA credit.

54E Section 164. Extension of qualified zone academy bonds. The provision authorizes the issuance of $400 million of qualified zone academy bonds during 2016. The bond proceeds are used for school renovations, equipment, teacher training, and course materials at a qualified zone academy, provided that private entities have promised to donate certain property and services to the academy with a value equal to at least 10 percent of the bond proceeds.



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168 Section 165. Extension of classification of certain race horses as 3-year property.

The provision extends the 3-year recovery period for race horses to property placed in service during 2015 or 2016.


168 Section 166. Extension of 7-year recovery period for motorsports entertainment complexes. The provision extends the 7-year recovery period for motorsport entertainment complexes to property placed in service during 2015 or 2016.


168(j) Section 167. Extension and modification of accelerated depreciation for business property on an Indian reservation. The provision extends accelerated depreciation for qualified Indian reservation property to property placed in service during 2015 or 2016. The provision also modifies the deduction to permit taxpayers to elect out of the accelerated depreciation rules.


179E Section 168. Extension of election to expense mine safety equipment. The provision extends the election to expense mine safety equipment to property placed in service during 2015 or 2016.


181 Section 169. Extension of special expensing rules for certain film and television productions. The provision extends through 2016 the special expensing provision for qualified film, television, and live theater productions. In general, only the first $15 million of costs may be expensed.


199 Section 170. Extension of deduction allowable with respect to income attributable to domestic production activities in Puerto Rico. The provision extends through 2016 the eligibility of domestic gross receipts from Puerto Rico for the domestic production deduction.


1391 Section 171. Extension and modification of empowerment zone tax incentives. The provision extends through 2016 the tax benefits for certain businesses and employers operating in empowerment zones. Empowerment zones are economically distressed areas, and the tax benefits available include tax-exempt bonds, employment credits, increased expensing, and gain exclusion from the sale of certain small-business stock. The provision modifies the incentive beginning in 2016 by allowing employees to meet the enterprise zone facility bond employment requirement if they are residents of the empowerment zone, an enterprise community, or a qualified low-income community within an applicable nominating jurisdiction.



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7652(f) Section 172. Extension of temporary increase in limit on cover over of rum excise taxes to Puerto Rico and the Virgin Islands. The provision extends the $13.25 per proof gallon excise tax cover-over amount paid to the treasuries of Puerto Rico and the U.S. Virgin Islands to rum imported into the United States during 2015 or 2016. Absent the extension, the cover-over amount would be $10.50 per proof gallon.


936 Section 173. Extension of American Samoa economic development credit. The provision extends through 2016 the existing credit for taxpayers currently operating in American Samoa.

No CA credit.

4191 Section 174. Moratorium on medical device excise tax. The provision provides for a two- year moratorium on the 2.3-percent excise tax imposed on the sale of medical devices. The tax will not apply to sales during calendar years 2016 and 2017.


25C Section 181. Extension and modification of credit for nonbusiness energy property. The provision extends through 2016 the credit for purchases of nonbusiness energy property. The provision allows a credit of 10 percent of the amount paid or incurred by the taxpayer for qualified energy improvements, up to $500. No CA credit.

30C Section 182. Extension of credit for alternative fuel vehicle refueling property.

The provision extends through 2016 the credit for the installation of non-hydrogen alternative fuel vehicle refueling property. (Under current law, hydrogen-related property is eligible for the credit through 2016.) Taxpayers are allowed a credit of up to 30 percent of the cost of the installation of the qualified alternative fuel vehicle refueling property.

No CA credit.

30D Section 183. Extension of credit for 2-wheeled plug-in electric vehicles. The provision extends through 2016 the 10-percent credit for plug-in electric motorcycles and 2-wheeled vehicles (capped at $2,500).

No CA credit.

40(b)(6) Section 184. Extension of second generation biofuel producer credit. The provision extends through 2016 the credit for cellulosic biofuels producers.

No CA credit.

40A Section 185. Extension of biodiesel and renewable diesel incentives. The provision extends through 2016 the existing $1.00 per gallon tax credit for biodiesel and biodiesel mixtures, and the small agri-biodiesel producer credit of 10 cents per gallon. The provision also extends through 2016 the $1.00 per gallon production tax credit for diesel fuel created from biomass. The provision extends through 2016 the fuel excise tax credit for biodiesel mixtures.



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45 Section 186. Extension and modification of production credit for Indian coal facilities. The provision extends through 2016 the $2 per ton production tax credit for coal produced on land owned by an Indian tribe, if the facility was placed in service before 2009. A coal facility is allowed only nine years of credit. The provision modifies the credit beginning in 2016 by removing the placed-in-service-date limitation, removing the nine-year limitation, and allowing the credit to be claimed against the AMT.

No CA credit.

45, 48 Section 187. Extension and modification of credits with respect to facilities producing energy from certain renewable resources. The provision extends the production tax credit for certain renewable sources of electricity to facilities for which construction has commenced by the end of 2016.

No CA credit.

45L Section 188. Extension of credit for energy-efficient new homes. The provision extends through 2016 the tax credit for manufacturers of energy-efficient residential homes. An eligible contractor may claim a tax credit of $1,000 or $2,000 for the construction or manufacture of a new energy efficient home that meets qualifying criteria.

No CA credit.

168(l) Section 189. Extension of special allowance for second generation biofuel plant property. The provision extends through 2016 the 50-percent bonus depreciation for cellulosic biofuel facilities.


179D Section 190. Extension of energy efficient commercial buildings deduction. The provision extends through 2016 the above-the-line deduction for energy efficiency improvements to lighting, heating, cooling, ventilation, and hot water systems of commercial buildings.


45(i) Section 191. Extension of special rule for sales or dispositions to implement FERC or State electric restructuring policy for qualified electric utilities. The provision extends through 2016 a rule that permits taxpayers to elect to recognize gain from qualifying electric transmission transactions ratably over an eight-year period beginning in the year of sale (rather than entirely in the year of sale) if the amount realized from such sale is used to purchase exempt utility property within the applicable period.


6426 Section 192. Extension of excise tax credits relating to alternative fuels. The provision extends through 2016 the 50 cents per gallon alternative fuel tax credit and alternative fuel mixture tax credit.



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30B Section 193. Extension of credit for new qualified fuel cell motor vehicles. The provision extends through 2016 the credit for purchases of new qualified fuel cell motor vehicles. The provision allows a credit of between $4,000 and $40,000 depending on the weight of the vehicle for the purchase of such vehicles.


6402 Section 201. Modification of filing dates of returns and statements relating to employee wage information and nonemployee compensation to improve compliance. The provision requires forms W-2, W-3, and returns or statements to report non-employee compensation (e.g., Form 1099-MISC), to be filed on or before January 31 of the year following the calendar year to which such returns relate. The provision also provides additional time for the IRS to review refund claims based on the earned income tax credit and the refundable portion of the child tax credit in order to reduce fraud and improper payments. The provision is effective for returns and statements relating to calendar years after the date of enactment (e.g., filed in 2017).


6721 Section 202. Safe harbor for de minimis errors on information returns and payee statements. The provision establishes a safe harbor from penalties for the failure to file correct information returns and for failure to furnish correct payee statements by providing that if the error is $100 or less ($25 or less in the case of errors involving tax withholding), the issuer of the information return is not required to file a corrected return and no penalty is imposed. A recipient of such a return (e.g., an employee who receives a Form W-2) can elect to have a corrected return issued to them and filed with the IRS. The provision is effective for returns and statements required to be filed after December 31, 2016.


6109 Section 203. Requirements for the issuance of ITINs. The provision provides that the IRS may issue taxpayer identification numbers (ITIN) if the applicant provides the documentation required by the IRS either (a) in person to an IRS employee or to a community-based certified acceptance agent (as authorized by the IRS), or (b) by mail. The provision requires that individuals who were issued ITINs before 2013 are required to renew their ITINs on a staggered schedule between 2017 and 2020. The provision also provides that an ITIN will expire if an individual fails to file a tax return for three consecutive years. The provision also directs the Treasury Department and IRS to study the current procedures for issuing ITINs with a goal of adopting a system by 2020 that would require all applications to be filed in person. The provision is effective for requests for ITINs made after the date of enactment.



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24 Section 204. Prevention of retroactive claims of earned income credit after issuance of social security number. The provision prohibits an individual from retroactively claiming the earned income tax credit by amending a return (or filing an original return if he failed to file) for any prior year in which he did not have a valid social security number. The provision applies to returns, and any amendment or supplement to a return, filed after the date of enactment.

No CA credit.

25A Section 205. Prevention of retroactive claims of child tax credit. The provision prohibits an individual from retroactively claiming the child tax credit by amending a return (or filing an original return if he failed to file) for any prior year in which the individual or a qualifying child for whom the credit is claimed did not have an ITIN. The provision applies to returns, and any amendment or supplement to a return, filed after the date of enactment.

No CA credit.

32 Section 206. Prevention of retroactive claims of American opportunity tax credit. The provision prohibits an individual from retroactively claiming the American Opportunity Tax Credit by amending a return (or filing an original return if he failed to file) for any prior year in which the individual or a student for whom the credit is claimed did not have an ITIN. The provision applies to returns, and any amendment or supplement to a return, filed after the date of enactment.

CA does not have credit.

6695 Section 207. Procedures to reduce improper claims. The provision expands the paid-preparer due diligence requirements with respect to the earned income tax credit, and the associated $500 penalty for failures to comply, to cover returns claiming the child tax credit and American Opportunity Tax Credit. The provision also requires the IRS to study the effectiveness of the due diligence requirements and whether such requirements should apply to taxpayer who file online or by filing a paper form. The provision applies to tax years beginning after December 31, 2015.


6213 Section 208. Restrictions on taxpayers who improperly claimed credits in prior year. The provision expands the rules under current law, which bar individuals from claiming the earned income tax credit for ten year if they are convicted of fraud and for two years if they are found to have recklessly or intentionally disregarded the rules, to apply to the child tax credit and American Opportunity Tax Credit. The provision adds math error authority, which permits the IRS to disallow improper credits without a formal audit if the taxpayer claims the credit in a period during which he is barred from doing so due to fraud or reckless or intentional disregard. The provision applies to tax years beginning after December 31, 2015.



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6676 Section 209. Treatment of credits for purposes of certain penalties. The provision applies the 20-percent penalty for erroneous claims under current law to the refundable portion of credits (reversing the Tax Court decision in Rand v. Commissioner). The provision also eliminates the exception from the penalty for erroneous refunds and credits that currently applies to the earned income tax credit, and the provision provides reasonable-cause relief from the penalty. The provision generally applies to returns filed after December 31, 2015.


6694 Section 210. Increase the penalty applicable to paid tax preparers who engage in willful or reckless conduct. The provision expands the penalty for tax preparers who engage in willful or reckless conduct, which is currently the greater of $5,000 or 50 percent of the preparer’s income with respect to the return, by increasing the 50 percent amount to 75 percent. The provision applies to returns prepared for tax years ending after the date of enactment.

CA has its own penalty.

6050S Section 211. Employer identification number required for American opportunity tax credit. The provision requires a taxpayer claiming the American opportunity tax credit to report the employer identification number (EIN) of the educational institution to which the taxpayer makes qualified payments under the credit. The provision applies to tax years beginning after December 31, 2015, and expenses paid after such date for education furnished in academic periods beginning after such date.


6050S Section 212. Higher education information reporting only to include qualified tuition and related expenses actually paid. The provision reforms the reporting requirements for Form 1098-T so that educational institutions are required to report only qualified tuition and related expenses actually paid, rather than choosing between amounts paid and amounts billed, as under current law. The provision applies to expenses paid after December 31, 2015 for education furnished in academic periods beginning after such date.


117 Section 301. Exclusion for amounts received under the Work Colleges Program. The provision exempts from gross income any payments from certain work-learning-service programs that are operated by a work college as defined in section 448(e) of the Higher Education Act of 1965. The provision is effective for amounts received in tax years beginning after date of enactment.



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529 Section 302. Improvements to section 529 accounts. The provision expands the definition of qualified higher education expenses for which tax-preferred distributions from 529 accounts are eligible to include computer equipment and technology. The provision modifies 529-account rules to treat any distribution from a 529 account as coming only from that account, even if the individual making the distribution operates more than one account. The provision treats a refund of tuition paid with amounts distributed from a 529 account as a qualified expense if such amounts are re-contributed to a 529 account within 60 days. The provision is effective for distributions made or refunds after 2014, or in the case of refunds after 2014 and before the date of enactment, for refunds re-contributed not later than 60 days after date of enactment.


529A Section 303. Elimination of residency requirement for qualified ABLE programs. The provision allows ABLE accounts (tax-preferred savings accounts for disabled individuals), which currently may be located only in the State of residence of the beneficiary, to be established in any State. This will allow individuals setting up ABLE accounts to choose the State program that best fits their needs, such as with regard to investment options, fees, and account limits. The provision is effective for tax years beginning after December 31, 2014


139F Section 304. Exclusion for wrongfully incarcerated individuals. The provision allows an individual to exclude from gross income civil damages, restitution, or other monetary awards that the taxpayer received as compensation for a wrongful incarceration. A “wrongfully incarcerated individual” is either: (1) an individual who was convicted of a criminal offense under Federal or state law, who served all or part of a sentence of imprisonment relating to such offense, and who was pardoned, granted clemency, or granted amnesty because of actual innocence of the offense; or (2) an individual for whom the conviction for such offense was reversed or vacated and for whom the indictment, information, or other accusatory instrument for such offense was dismissed or who was found not guilty at a new trial after the conviction was reversed or vacated. The provision applies to tax years beginning before, on, or after the date of enactment.


105(j) Section 305. Clarification of special rule for certain governmental plans. The provision extends the special rule under current law for certain benefits paid by accident or health plans of a public retirement system to such benefits paid by plans established by or on behalf of a State or political subdivision. To qualify, such plans must have been authorized by a State legislature or received a favorable ruling from the IRS that the trust’s income is not includible in gross income under either section 115 or section 501(c)(9) of the tax code, and on or before January 1, 2008, have provided for payment of medical benefits to a deceased participant’s beneficiary. The provision is effective for payments after the date of enactment.



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408(p) Section 306. Rollovers permitted from other retirement plans into simple

retirement accounts. The provision allows a taxpayer to roll over amounts from an employer-sponsored retirement plan (e.g., 401(k) plan) to a SIMPLE IRA, provided the plan has existed for at least two years. The provision applies to contributions made after the date of enactment.

CA automatically conforms.

6511 Section 307. Technical amendment relating to rollover of certain airline payment amounts. The provision clarifies the effective dates of Public Law 113-243 to allow certain airline employees to contribute amounts received in certain bankruptcies to an IRA without being subject to the annual contribution limit. The provision is effective as if included in Public Law 113-243.


72(t) Section 308. Treatment of early retirement distributions for nuclear materials couriers, United States Capitol Police, Supreme Court Police, and diplomatic security special agents. The provision extends the relief under current law, which provides an exception to the 10- percent penalty on withdrawals from retirement accounts before age 50 for public safety officer, to include nuclear materials couriers, United States Capitol Police, Supreme Court Police, and diplomatic security special agents. The provision is effective for distributions after December 31, 2015.


7508(e) Section 309. Prevention of extension of tax collection period for members of the Armed Forces who are hospitalized as a result of combat zone injuries. The provision requires that the collection period for members of the Armed Forces hospitalized for combat zone injuries may not be extended by reason of any period of continuous hospitalization or the 180 days after hospitalization. Accordingly, the collection period expires 10 years after assessment, plus the actual time spent in a combat zone. The provision applies to taxes assessed before, on, or after the date of the enactment.


856, 857 Section 311. Restriction on tax-free spinoffs involving REITs. The provision provides that a spin-off involving a REIT will qualify as tax-free only if immediately after the distribution both the distributing and controlled corporation are REITs. In addition, neither a distributing nor a controlled corporation would be permitted to elect to be treated as a REIT for ten years following a tax-free spin-off transaction. The provision applies to distributions on or after December 7, 2015, but shall not apply to any distribution pursuant to a transaction described in a ruling request initially submitted to the IRS on or before such date, which request has not been withdrawn and with respect to which a ruling has not been issued or denied in its entirety as of such date.

CA does conform.


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856 Section 312. Reduction in percentage limitation on assets of REIT which may be

taxable REIT subsidiaries. The provision modifies the rules with respect to a REIT’s ownership of a taxable REIT subsidiary (TRS), which is taxed as a corporation. Under the provision, the securities of one or more TRSs held by a REIT may not represent more than 20 percent (rather than 25 percent under current law) of the value of the REIT’s assets. The provision is effective for tax years beginning after 2017.


857 Section 313. Prohibited transaction safe harbors. The provision provides for an alternative three-year averaging safe harbor for determining the percentage of assets that a REIT may sell annually. In addition, the provision clarifies that the safe harbor is applied independent of whether the real estate asset is inventory property. The provision generally is effective for tax years beginning after the date of enactment. However, the clarification of the safe harbor takes effect as if included in the Housing Assistance Tax Act of 2008.


562 Section 314. Repeal of preferential dividend rule for publicly offered REITs. The provision repeals the preferential dividend rule for publicly offered REITs. The provision is effective for distributions in tax years beginning after 2014.


562 Section 315. Authority for alternative remedies to address certain REIT distribution failures. The provision provides the IRS with authority to provide an appropriate remedy for a preferential dividend distribution by non-publicly offered REITs in lieu of treating the dividend as not qualifying for the REIT dividend deduction and not counting toward satisfying the requirement that REITs distribute 90 percent of their income every year. Such authority applies if the preferential distribution is inadvertent or due to reasonable cause and not due to willful neglect. The provision applies to distributions in tax years beginning after 2015.


857 Section 316. Limitations on designation of dividends by REITs. The provision provides that the aggregate amount of dividends that could be designated by a REIT as qualified dividends or capital gain dividends will not exceed the dividends actually paid by the REIT. The provision is effective for distributions in tax years beginning after 2014.

CA does conform.


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856 Section 317. Debt instruments of publicly offered REITs and mortgages treated as real estate assets. The provision provides that debt instruments issued by publicly offered REITs, as well as interests in mortgages on interests in real property, are treated as real estate assets for purposes of the 75-percent asset test. Income from debt instruments issued by publicly offered REITs are treated as qualified income for purposes of the 95-percent income test, but not the 75- percent income test (unless they already are treated as qualified income under current law). In addition, not more than 25 percent of the value of a REIT’s assets is permitted to consist of such debt instruments. The provision is effective for tax years beginning after 2015.

CA does conform.

856 Section 318. Asset and income test clarification regarding ancillary personal property. The provision provides that certain ancillary personal property that is leased with real property is treated as real property for purposes of the 75-percent asset test. In addition, an obligation secured by a mortgage on such property is treated as real property for purposes of the 75-percent income and asset tests, provided the fair market value of the personal property does not exceed 15 percent of the total fair market value of the combined real and personal property. The provision is effective for tax years beginning after 2015.

CA does conform.

857 Section 319. Hedging provisions. The provision expands the treatment of REIT hedges to include income from hedges of previously acquired hedges that a REIT entered to manage risk associated with liabilities or property that have been extinguished or disposed. The provision is effective for tax years beginning after 2015. CA does conform.

857 Section 320. Modification of REIT earnings and profits calculation to avoid

duplicate taxation. The provision provides that current (but not accumulated) REIT earnings and profits for any tax year are not reduced by any amount that is not allowable in computing taxable income for the tax year and was not allowable in computing its taxable income for any prior tax year (e.g., certain amounts resulting from differences in the applicable depreciation rules). The provision applies only for purposes of determining whether REIT shareholders are taxed as receiving a REIT dividend or as receiving a return of capital (or capital gain if a distribution exceeds a shareholder’s stock basis). The provision is effective for tax years beginning after 2015.


857 Section 321. Treatment of certain services provided by taxable REIT subsidiaries. The provision provides that a taxable REIT subsidiary (TRS) is permitted to provide certain services to the REIT, such as marketing, that typically are done by a third party. In addition, a TRS is permitted to develop and market REIT real property without subjecting the REIT to the 100- percent prohibited transactions tax. The provision also expands the 100-percent excise tax on non-arm’s length transactions to include services provided by the TRS to its parent REIT. The provision is effective for tax years beginning after 2015.



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897, 1445 Section 322. Exception from FIRPTA for certain stock of REITs. The provision

increases from 5 percent to 10 percent the maximum stock ownership a shareholder may have held in a publicly traded corporation to avoid having that stock treated as a U.S. real property interest on disposition. In addition, the provision allows certain publicly traded entities to own and dispose of any amount of stock treated as a U.S. real property interest, including stock in a REIT, without triggering FIRPTA withholding. However, an investor in such an entity that holds more than 10 percent of such stock is still subject to withholding. The provision applies to dispositions and distributions on or after the date of enactment.


897 Section 323. Exception for interests held by foreign retirement or pension funds. The provision exempts any U.S. real property interest held by a foreign pension fund from FIRPTA withholding. The provision applies to dispositions and distributions after the date of enactment.


1445 Section 324. Increase in rate of withholding of tax on dispositions of United States real property interests. The provision provides that the rate of withholding on dispositions of United States real property interests is increased from 10 percent to 15 percent. The increased rate of withholding, however, does not apply to the sale of a personal residence where the amount realized is $1 million or less. The provision is effective for dispositions occurring 60 days after the date of enactment.


897 Section 325. Interests in RICs and REITs not excluded from definition of United States real property interests. The provision provides that the “cleansing rule” (which applies to corporations that either have no real estate or have paid tax on their real-estate transactions) applies only to interests in a corporation that is not a qualified investment entity. In addition, the proposal provides that the cleansing rule applies to stock of a corporation only if neither the corporation nor any predecessor of such corporation was a regulated investment company (RIC) or REIT at any time during the shorter of (a) the period after June 18, 1980 during which the taxpayer held such stock, or (b) the five-year period ending on the date of the disposition of the stock. The provision applies to dispositions on or after the date of enactment.



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245 Section 326. Dividends derived from RICs and REITs ineligible for deduction for United States source portion of dividends from certain foreign corporations. The provision provides that for purposes of determining whether dividends from a foreign corporation (attributable to dividends from an 80-percent owned domestic corporation) are eligible for a dividend received deduction, dividends from RICs and REITs are not treated as dividends from domestic corporations, even if the RIC or REIT owns shares in a foreign corporation. The provision applies to dividends received from RIC and REITs on or after the date of enactment of this Act.


170(b), 501(h) Section 331. Deductibility of charitable contributions to agricultural research organizations. The provision provides that charitable contributions to an agricultural research organization are subject to the higher individual limits (generally up to 50 percent of the taxpayer’s contribution base) if the organization commits to use the contribution for agricultural research before January 1 of the fifth calendar year that begins after the date of the contribution. In addition, agricultural research organizations are treated as public charities per se, without regard to their sources of financial support. The provision is effective for contributions made on or after the date of enactment.


5551 Section 332. Removal of bond requirements and extending filing periods for certain taxpayers with limited excise tax liability. The provision allows producers of alcohol that reasonably expect to be liable for not more than $50,000 per year in alcohol excise taxes to pay such taxes on a quarterly basis rather than twice per month (and those reasonably expecting to be liable for not more than $1,000 per year to pay such taxes annually, rather than on a quarterly basis). The provision also exempts such producers from bonding requirements with the IRS. The provision is effective 90 days after the date of enactment.


831(b) Section 333. Modifications to alternative tax for certain small insurance companies. The provision increases the maximum amount of annual premiums that certain small property and casualty insurance companies can receive and still elect to be exempt from tax on their underwriting income, and instead be taxed only on taxable investment income. The provision increases the maximum amount from $1.2 million to $2.2 million for calendar years beginning after 2015, and indexes it to inflation thereafter. To ensure that this special rule is not abused, the provision also requires that no more than 20 percent of net written premiums (or if greater, direct written premiums) for a tax year is attributable to any one policyholder. Alternatively, a company would be eligible for the exception if each owner of the insured business or assets has no greater an interest in the insurer than he or she has in the business or assets, and each owner holds no smaller an interest in the business than his or her interest in the insurer. The provision is effective for tax years beginning after 2016.



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1201 Section 334. Treatment of timber gains. The provision provides that C corporation timber gains are subject to a tax rate of 23.8 percent. The provision is effective for tax year 2016.


5041 Section 335. Modification of definition of hard cider. The provision defines hard cider for purposes of alcohol excise taxes as a wine with an alcohol content of between 0.5 percent and 8.5 percent alcohol by volume, with a carbonation level that does not exceed 6.4 grams per liter, which is derived primarily from apples, apple juice concentrate, pears, or pear juice concentrate, in combination with water. The provision is effective for articles removed from the distillery or bonding facility during calendar years beginning after 2015.


414 Section 336. Church Plan Clarification. The provision prevents the IRS from aggregating certain church plans together for purposes of the non-discrimination rules, which prevent highly compensated participants from receiving disproportionate benefits under the plan, and it provides flexibility for church plans to decide which other church plans with which they associate. The provision also prevents certain grandfathered church defined-benefit plans from having to meet certain requirements relating to maximum benefit accruals, and it allows church plans to offer auto-enroll accounts similar to 401(k)s. Additionally, the provision make it easier for church plans to engage in certain reorganizations and allows church plans to invest in collective trusts. The provision generally is effective on or after the date of enactment.

CA does conform.

179D Section 341. Updated ASHRAE standards for energy efficient commercial buildings deduction. The provision modifies the deduction for energy efficient commercial buildings by updating the energy efficiency standards to reflect new standards of the American Society of Heating, Refrigerating, and Air Conditioning Engineers beginning in 2016.


6426 Section 342. Excise tax credit equivalency for liquefied petroleum gas and liquefied natural gas. The provision converts the measurement of the alternative fuel excise tax credit for liquefied natural gas and liquefied petroleum gas from 50 cents per gallon to 50 cents per energy equivalent of a gallon of diesel fuel, which is approximately 29 cents per gallon for liquefied natural gas and approximately 36 cents per gallon for liquefied petroleum gas. The provision is effective for fuel sold or used after 2015.



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118 Section 343. Exclusion from gross income of certain clean coal power grants to non- corporate taxpayers. The provision excludes from gross income certain clean power grants received under the Energy Policy Act of 2005 by an eligible taxpayer that is not a corporation. The provision requires an eligible taxpayer to reduce the basis of tangible depreciable property related to such grants by the amount excluded. The provision requires eligible taxpayers to make payments to the Treasury equal to 1.18 percent of amounts excluded under the provision. The provision is effective for grants received in tax years after 2011.


664(e) Section 344. Clarification of valuation rule for early termination of certain charitable remainder unitrusts. The provision clarifies the valuation method for the early termination of certain charitable remainder unitrusts. The provision is effective for the termination of trusts after the date of enactment.


267 Section 345. Prevention of transfer of certain losses from tax indifferent parties. The provision modifies the related-party loss rules, which generally disallow a deduction for a loss on the sale or exchange of property to certain related parties or controlled partnerships, to prevent losses from being shifted from a tax-indifferent party (e.g., a foreign person not subject to U.S. tax) to another party in whose hands any gain or loss with respect to the property would be subject to U.S. tax. The provision generally is effective for sales and exchanges of property acquired after 2015.


3512 Section 346. Treatment of certain persons as employers with respect to motion picture projects. The provision allows motion picture payroll services companies to be treated as the employer of their film and television production workers for Federal employment tax purposes. The provision is effective for remuneration paid after 2015.


7803 Section 401. Duty to ensure that IRS employees are familiar with and act in accord with certain taxpayer rights. The provision amends the tax code to require the IRS Commissioner to ensure that IRS employees are familiar with and act in accordance with the taxpayer bill of rights, which includes the right to: 1. be informed; 2. quality service; 3. pay no more than the correct amount of tax; 4. challenge the position of the IRS and be heard; 5. appeal a decision of the IRS in an independent forum; 6. finality;7. privacy; 8. confidentiality; 9. retain representation; 10. a fair and just tax system. The provision is effective on the date of enactment.


Section 402. IRS employees prohibited from using personal email accounts for official business. The provision prohibits employees of the IRS from using a personal email account to conduct any official business, codifying an already established agency policy barring use of personal email accounts by IRS employees for official governmental business. The provision is effective on the date of enactment.


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6103 Section 403. Release of information regarding the status of certain

investigations. The provision allows taxpayers who have been victimized by the IRS, for example, through the unauthorized disclosure of private tax information, to find out basic facts, such as whether the case is being investigated or whether the case has been referred to the Justice Department for prosecution. The provision applies to disclosures made on or after the date of enactment.


7123 Section 404. Administrative appeal relating to adverse determinations of tax-exempt status of certain organizations. The provision requires the IRS to create procedures under which a 501(c) organization facing an adverse determination may request administrative appeal to the IRS Office of Appeals. This includes determinations relating to the initial or continuing classification of (1) an organization as tax-exempt under section 501(a); (2) an organization under section 170(c)(2); (3) a private foundation under section 509(a); or (4) a private operating foundation under section 4942(j)(3). The provision applies to determinations made after May 19, 2014.


6033 Section 405. Organizations required to notify Secretary of intent to operate under 501(c)(4). The provision provides for a streamlined recognition process for organizations seeking tax exemption under section 501(c)(4). The process requires 501(c)(4) organizations to file is a simple one-page notice of registration with the IRS within 60 days of the organization’s formation. The current, voluntary 501(c)(4) application process will be eliminated. Within 60 days after an application is submitted, the IRS is required to provide a letter of acknowledgement of the registration, which the organization can use to demonstrate its exempt status, typically with state and local tax authorities.


7428 Section 406. Declaratory judgments for 501(c)(4) and other exempt organizations. The provision permits 501(c)(4) organizations and other exempt organizations to seek review in Federal court of any revocation of exempt status by the IRS. The provision applies to pleadings filed after the date of enactment.


1203(b) Section 407. Termination of employment of Internal Revenue Service employees for taking official actions for political purposes. The provision makes clear that taking official action for political purposes is an offense for which the employee should be terminated. The bill amends the Internal Revenue Service Restructuring and Reform Act of 1998 to expand the grounds for termination of employment of an IRS employee to include performing, delaying, or failing to perform any official action (including an audit) by an IRS employee for the purpose of extracting personal gain or benefit for a political purpose. The provision takes effect on the date of enactment.



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2501(a) Section 408. Gift tax not to apply to contributions to certain exempt organizations. The provision treats transfers to organizations exempt from tax under section 501(c)(4), (c)(5), and (c)(6) of the tax code as exempt from the gift tax. The provision applies to transfers made after the date of enactment.


6051 Section 409. Extend Internal Revenue Service authority to require truncated Social Security numbers on Form W-2. The provision requires employers to include an “identifying number” for each employee, rather than an employee’s SSN, on Form W-2. This change will permit the Department of the Treasury to promulgate regulations requiring or permitting a truncated SSN on Form W-2. The provision is effective on the date of enactment.


Section 410. Clarification of enrolled agent credentials. The provision permits enrolled agents approved by the IRS to use the designation “enrolled agent,” “EA,” or “E.A.” The provision is effective on the date of enactment.


6031 Section 411. Partnership audit rules. The provision corrects and clarifies certain technical issues in the partnership audit rules enacted in the Bipartisan Budget Act of 2015.


6404 Section 421. Filing period for interest abatement cases. The provision permits a taxpayer to seek review by the Tax Court of a claim for interest abatement when the IRS has failed to issue a final determination. The provision applies to claims for interest abatement filed after the date of enactment.


7463 Section 422. Small tax case election for interest abatement cases. The provision expands the current-law procedures for the Tax Court to consider small tax cases (i.e., cases with amount in dispute that are under $50,000) to include the review of IRS decisions not to abate interest, provided the amount of interest for which abatement is sought does not exceed $50,000. The provision applies to cases pending and cases commenced after the date of enactment.


7482 Section 423. Venue for appeal of spousal relief and collection cases. The provision clarifies that Tax Court decisions in cases involving spousal relief and collection cases are appealable to the U.S. Court of Appeals for the circuit in which an individual’s legal residence is located or in which a business’ principal place of business or principal office of agency is located. The provision applies to Tax Court petitions filed after the date of enactment.



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6330 Section 424. Suspension of running of period for filing petition of spousal relief and collection cases. The provision suspends the statute of limitations in cases involving spousal relief or collections when a bankruptcy petition has been filed and a taxpayer is prohibited from filing a petition for review by the Tax Court. Under the provision, the suspension is for the period during which the taxpayer is prohibited from filing such a petition, plus 60 days. The provision applies to Tax Court petitions filed after the date of enactment.


7453 Section 425. Application of Federal rules of evidence. The provision requires the Tax Court to conduct its proceedings in accordance with the Federal Rules of Evidence (rather than the rules of evidentiary rules applied by the United States District Court of the District of Columbia, as under current law). The provision applies to proceedings commenced after the date of enactment.


7466 Section 431. Judicial conduct and disability procedures. The provision authorizes the Tax Court to establish procedures for the filing of complaints with respect to the conduct of any judge or special trial judge of the Tax Court and for the investigation and resolution of such complaints. The provision applies to proceedings commenced 180 days after the date of enactment.

N/A

7470A Section 432. Administration, judicial conference, and fees. The provision extends to the Tax Court the same general management, administrative, and expenditure authorities that are available to Article III courts and the Court of Appeals for Veterans Claims. The provision also permits the Tax Court to conduct an annual judicial conference and charge reasonable registration fees. Additionally, the provision authorizes the Tax Court to deposit certain fees into a special fund held by the Treasury Department, with such funds available for the operation and maintenance of the Tax Court. The provision is effective on the date of enactment.

N/A

7441 Section 441. Clarification relating to United States Tax Court. The provision clarifies that the Tax Court is not an agency of, and shall be independent of, the Executive Branch. The provision is effective upon the date of enactment.

N/A

Section 501. Modification of effective date of provisions relating to tariff classification of recreational performance outer wear. The provision delays implementation of changes in the classification of certain recreation performance outerwear products that would inadvertently increase tariffs on some of those products. N/A


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Section 502. Agreement by Asia-Pacific Economic Co-operation members to reduce rates of duty on certain environmental goods. The provision ensures that the reduction of tariffs on certain environmental goods to fulfill an agreement by members of the Asia-Pacific Economic Cooperation (APEC) forum is implemented in accordance with the Trade Priorities and Accountability Act of 2015.

N/A

Section 601. Budgetary effects. The provision provides for the bill’s treatment for PAYGO purposes.

N/A


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CHAPTER 3 GROSS INCOME


II. Olympic medals. .............................................................................................................................. 1 III. Announcement 2016-25: Gas Leak in Southern California. .................................................... 2

IV. Section 108 and exclusions from COD income. ......................................................................... 3 A. Regulations issued on bankruptcy and insolvency for disregarded entities. ...................................... 4

V. State payments. ................................................................................................................................ 4

VI. Workers Compensation. ................................................................................................................ 4 VII. Settlement Payments .................................................................................................................... 4

II. Olympic medals.

Prize money awarded to a U.S. athlete by the United States Olympic Committee (USOC), as well as the fair market value of any gold, silver, and bronze medal, are excluded from the U.S. athlete’s gross income. The exclusion applies to individuals whose adjusted gross income does not otherwise exceed $1 million ($500,000 for a married individual filing separately).

Generally prizes and awards are included in taxable income. However, there are certain exceptions to the general rule requiring the inclusion of prizes and awards in gross income. An individual may exclude qualified scholarship and fellowships under Code Sec. 117 and certain employee achievement awards. In addition, recognition awards received by the individual for religious, charitable, scientific, educational, artistic, literary, or civic achievement are excludable from gross income. However, a recognition award is only excludable if the taxpayer is selected without any action on his or her part to enter the contest or proceeding; the taxpayer is not required to render substantial future services as a condition to receiving the prize or award; and the prize or award is transferred unused by the payer to a qualified charitable organization or governmental unit pursuant to a designation made by the taxpayer.

Under new IRC sec. 74(d), the Olympic and Paralympic awards are excluded from gross income. Prize money awarded to a U.S. athlete by the United States Olympic Committee (USOC), as well as the fair market value of any gold, silver, and bronze medal received on account of competition in the Olympic or Paralympic Games, are excluded from the U.S. athlete’s gross income (as added by United States Appreciation for Olympians and Paralympians Act of 2016 (P.L. 114-239)).


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This exclusion covers not only the fair market value of the medal, but also prize money awarded by the USOC for each medal won, in the amounts of $25,000 for each gold medal, $15,000 for each silver medal, and $10,000 for each bronze medal. U.S. Paralympic athletes receive $5,000, $3,500 and $2,500 respectively for each gold, silver and bronze medal awarded (Joint Committee on Taxation, Description of H.R. 5946, the “United States Appreciation for Olympians and Paralympians Act” (JCX-72-16), September 13, 2016.

The exclusion does not apply to any taxpayer with adjusted gross income (AGI) exceeding $1 million for the tax year ($500,000 for a married individual filing a separate return). The dollar threshold is determined without regard to the exclusion. On the other hand, the exclusion is taken into account when calculating the AGI or modified AGI (MAGI) for various other tax provisions including:

taxation of Social Security and Railroad Retirement benefits under Code Sec. 86;

exclusion of U.S. savings bond interest used for higher education expenses under Code Sec. 135;

exclusion of benefits under employer adoption assistance program under Code Sec. 137;

deductible contributions to a traditional IRA under Code Sec. 219;

deduction of student loan interest under Code Sec. 221;

above-the-line deduction for tuition and fees under Code Sec. 222; and

limits of the deduction of passive activity losses and credits under Code Sec. 469.

The new law is effective for prizes and awards received after December 31, 2015 (Act Sec. 2(b) of the United States Appreciation for Olympians and Paralympians Act of 2016 (P.L. 114-239).

III. Announcement 2016-25: Gas Leak in Southern California.

Residents near a gas storage facility in Southern California who were forced to vacate their homes won't have to pay taxes on compensation paid to them by Southern California Gas Co., according to an announcement by the IRS.

On October 23,2015, Southern California Gas Company (SoCal Gas) discovered a natural gas leak at the Aliso Canyon storage field, which was sealed on February 18, 2016. Residents of nearby areas complained of numerous adverse health effects as a result of the gas leak, including nausea, dizziness, vomiting, shortness of breath, and headaches. Because the gas leak caused significant symptoms for area residents, the Los Angeles County Department of Public Health directed SoCal Gas to offer free, temporary relocation to affected residents. Pursuant to the directive and subsequent court orders, SoCal Gas is required to either pay on behalf of or reimburse affected residents for certain relocation and cleaning expenses incurred


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generally for the period beginning November 19, 2015 through May 31, 2016. These expenses include:

Hotel expenses, including meal reimbursement ($45 per day for an individual age 18 and older; $35 per day or $25 per day for a child based on age), mileage reimbursement, parking expenses, pet boarding fees, internet fees, electric vehicle charging fees, and laundry fees; Expenses of staying with friends or family at the rate of $150 per day, and mileage reimbursement; Expenses of renting another home for a lease term (including a lease term extending beyond May 31, 2016) as approved by SoCal Gas, including expenses of housewares, appliances, pet fees, furniture rental, utility fees, and moving expenses; Mileage allowances or alternative transportation for a resident whose child or children attended the relocated area schools until the date the resident exited the relocation program. If, however, a resident enrolled a child in a school outside of the affected area, SoCal Gas must pay the mileage allowance until the child no longer attends the reenrolled school or the school year ends, whichever occurs first; Expenses of cleaning the interior of an affected individual’s home prior to returning home according to protocols established by the Los Angeles County Department of Public Health; Air filtration and purification expenses; Expenses of cleaning residue from the exterior of an affected individual’s home, outdoor fixtures, and exterior furniture and appliances; Expenses of a vehicle detailing treatment; and Other expenses not specifically described in the relocation plan based on SoCal Gas’s evaluation of the expenses.

Questions have been raised concerning the taxability of these expenses paid on behalf of or as reimbursements to affected area residents. Existing guidance does not specifically address these questions. In Announcement 2016-25 the IRS stated that they would not require affected area residents include these payments or reimbursements in gross income. However, family and friends who received payments under the relocation plan for housing affected area residents must include these payments in gross income under § 61 of the Internal Revenue Code, unless these amounts are properly excludable from gross income under § 280A (relating to the exclusion for rental income from a taxpayer’s residence for less than 15 days during the taxable year).

IV. Section 108 and exclusions from COD income.


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A. Regulations issued on bankruptcy and insolvency for disregarded entities. Generally applicable for discharges of indebtedness occurring on or after June 10, 2016, the owner of a grantor trust or disregarded entity is considered as the taxpayer for purposes of applying the exclusion for reasons of bankruptcy or insolvency. As such, the bankruptcy exclusion only applies if the owner of the grantor trust or disregarded entity is under the jurisdiction of the court in a Title 11 case as the Title 11 debtor, regardless of whether the grantor trust or disregarded entity is a Title 11 debtor. Similarly, the insolvency exclusion only applies to a grantor trust or disregarded entity if the owner is insolvent, regardless of whether the grantor trust or disregarded entity is insolvent. Where the owner of the grantor trust or disregarded entity is a partnership, the exclusions will only apply if each of the partners to whom income is allocable is a Title 11 debtor or insolvent, whichever is applicable. Similar proposed regulations had been released in 2011, and the IRS has stated it will not challenge return positions consistent with those rules. (Reg. 1.108.9 as added by T. D. 9771).

V. State payments. In LTR 201623003 ( March 01, 2016) a state’s payments to caregivers to defray costs of in-home care were determined to be tax-free. The State Medicaid programs pay for the cost of a caregiver’s home-based services provided to aged, blind or disabled individuals who would otherwise require institutional care. Family members may be caregivers under the programs. The aid qualifies as nontaxable difficulty-of-care payments under IRC sec. 131.

VI. Workers Compensation.

In John Thompson, Jr., and Desree Thompson v. Commissioner (Docket No. 3094-14S. Filed May 12, 2016) an individual had taxable Social Security income (SSI) as a result of the worker’s compensation payments that he received for an injury suffered while performing services for the U.S. Postal Service. The SSI disability benefits that he had applied for and was otherwise entitled to receive for the year at issue were entirely offset on account of the taxpayer’s receipt of worker’s compensation benefits. The offset did not reduce the taxable amount of the Social Security benefits despite the fact that Social Security Administration had not actually paid such benefits to the taxpayer. Since the taxpayer applied for SSI disability benefits, this outcome was unavoidable.

VII. Settlement Payments In an Action on Decision, the IRS makes clear that it will not follow the result reached by the Tax Court in Cosentino v. Commissioner, (T.C. Memo. 2014-186) IRB No. 2016-16 April 18, 2016. The issue in the case was whether an amount the taxpayers received from an accounting firm, to settle a claim that the taxpayers incurred additional income tax liability because of the firm's advice that they enter into an abusive tax shelter, is excludible from their gross income as a restoration of lost capital.


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The taxpayers, husband and wife, each had a 50% direct interest in a partnership that received rental income from real estate rentals. In 2002, the taxpayers wanted to dispose of a rental property held by the partnership through a like-kind exchange and sought advice from an accounting firm. The accounting firm advised the taxpayers to enter into an abusive tax shelter in an attempt to artificially increase the partnership's basis in the property. In 2003 , the partnership disposed of the property in a like-kind exchange with boot. On its 2003 partnership return, the partnership reported a small amount in recognized gain and no deferred gain on the like-kind exchange. Had it not relied on the abusive tax shelter to report an improperly inflated adjusted basis in the relinquished property, the partnership would have reported realized gain of almost $2.4 million, of which almost $2 million would be recognized for 2003. In 2005, upon learning that the transaction was abusive, the taxpayers filed amended returns for 2002 and 2003 to report the correct gain from the like-kind exchange and pay the correct Federal and state income taxes on the recognized gain, as well as interest and penalties. The taxpayers also disclosed their participation in the abusive tax shelter. In 2006, the taxpayers filed suit against the accounting firm, seeking to recover $640,749.80 in fees, in losses from the transaction , and in income tax deficiencies, interest, and penalties paid to Federal and state tax authorities. In 2007, a settlement was reached in which the accounting firm paid the taxpayers $375,000: The taxpayers did not include any of the settlement proceeds on their 2007 Federal income tax return. In a notice of deficiency, the Service rejected the taxpayer's exclusion of the settlement proceeds. The Tax Court held that, except for those portions to which the tax benefit rule applies or to which no actual loss on the taxpayers' part was attributable, the settlement proceeds were excludible from gross income because they represented a return of lost capital. The court noted that the taxpayers did not know the transaction advised by the accounting firm was abusive and their intent was to defer gain recognition on the disposition of the rental property through a like-kind exchange. Relying on two cases that the court found similar to this case, and which involved settlement payments in malpractice lawsuits, the court concluded that the taxpayers paid Federal and state income taxes and other expenses they would not have paid had they not relied on the accounting firm's erroneous advice. The Service disagrees with the Tax Court's holding. Gross income includes "all income from whatever source derived" unless subtitle A of the Internal Revenue Code provides otherwise. Sec. 61(a). "When a claim is resolved by settlement, the relevant question for the tax treatment of a settlement award is: 'In lieu of what were the damages awarded?"' Milenbach v. Commissioner, 318 F.3d 924, 932 (9th Cir. 2003) (quoting Raytheon Prod. Corp . v. Commissioner, 144 F.2d 110, 113 (1st Cir. 1944)). The payments are includible in gross income if they are to replace lost profits, and are excludible from gross income as a return of capital if they are to compensate for the loss or destruction of capital. In large part, the Service believes that the settlement was lost profits and taxable.


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CHAPTER 4 DEDUCTIONS


Medical Expense. ..................................................................................................................................... 1

II. Medical Expense.

For decades, medical expenses for all taxpayers that itemized were deductible to the extent they cumulatively exceeded 7.5% of adjusted gross income (AGI). However, in 2010, the Affordable Care Act (ACA) raised this floor. For tax years beginning after Dec. 31, 2012, the floor beneath the itemized deduction for medical expenses was increased from 7.5% of AGI to 10% of AGI. (Code Sec. 213(a), as amended by Health Care Act Sec. 9013(a))

To abate the outcry from older Americans, Congress postponed raising the floor for seniors only. For tax years beginning after Dec. 31, 2012 and ending before Jan. 1, 2017—i.e., for 2013, 2014, 2015, and 2016—the 7.5% floor applies if the taxpayer or his or her spouse has reached age 65 before the close of the tax year. (Code Sec. 213(f)) But the postponement ends this year and the 10% floor will take effect for seniors for tax years ending after Dec. 31, 2016.

The higher floor could mean a sharp reduction in itemized deductions for those taxpayers likeliest to incur the heaviest medical bills. A taxpayer's first step to coping with the upcoming hike in the medical expense deduction floor is to make sure he or she is claiming or will be able to claim all legitimate medical expenses.

Deductible medical expenses are unreimbursed payments for the diagnosis, mitigation, treatment, prevention of disease or for the purpose of affecting the body's structure or function (Code Sec. 213(d)(1)), and the costs of nursing services (Reg. § 1.213-1(e)(1)(ii)) and related insurance payments and transportation expenses.

The following is a non-exclusive list of deductible medical costs:

• Advance payments for lifetime care or "founder's fee" paid either monthly or as a lump sum under an agreement with a retirement home, but only for the part of the payment that's properly allocable to medical care. The agreement must require the taxpayer to pay a specific fee as a condition for the home's promise to provide lifetime care that includes medical care. (Rev Rul 75-302, 1975-2 CB 86, IRS Pub. 505 (2015), p. 10) The deductible portion may be determined on the basis of the facility's own experience or that of a comparable facility. • Attending a medical conference on a chronic disease suffered by an individual, his spouse, or dependent (but not meal and lodging costs). (Rev Rul 2000-24, 2000-1 CB


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963) • Capital improvements to the home (e.g., an elevator) to a taxpayer's property (including capital expenditures to accommodate a residence to a physically handicapped individual) may be deductible medical expenses if the primary purpose of the improvements is the medical care of taxpayer, his spouse, or dependents. Generally, the medical deduction is limited to that part of the expenses that exceeds the amount by which the improvement increases the value of taxpayer's property. (Reg. § 1.213-1(e)(1)(iii)) But some expenses incurred by or for a physically handicapped individual to remove structural barriers in his residence to accommodate his physical condition (e.g., constructing access ramps, widening doorways, installing support bars, moving or modifying electrical outlets and fixtures) are presumed not to increase the value of the residence and may be deductible in full. (Reg. § 1.213-1(e)(1)(iii)) • Contact lenses (as well as the cost of equipment and materials required for using them, such as saline solution and enzyme cleaner). (IRS Pub. 505 (2015), p. 7) Contact lens insurance also is deductible. (Rev Rul 74-429, 1974-2 CB 83) • Cosmetic surgery or similar procedure, but only if necessary to ameliorate a deformity arising from, or directly related to, a congenital abnormality, a personal injury resulting from an accident or trauma or a disfiguring disease (Code Sec. 213(d)(9))—e.g., breast reconstruction surgery after cancer mastectomy. • Diagnostic tests aiding in the detection of heart attack, diabetes, cancer, and other diseases (but not the collection and storage of DNA, absent a showing of how the DNA will be used for medical diagnosis). (Rev Rul 2007-72, 2007-50 IRB 1154, PLR 200140017). • Dental treatment, including fillings, x-rays, fluoride treatment, cleanings, etc. (IRS Pub. 505 (2015), p. 7) • Eyeglasses, artificial teeth or limbs, braces, elastic stockings, special shoes, wheelchairs, hearing aids, and similar items. (Reg. § 1.213-1(e)(1)(ii)) • Eye surgery to correct defective vision, including laser procedures (e.g., LASIK). (Rev Rul 2003-57, 2003-22 IRB 959) • Health insurance (including dental insurance) plan premiums, but premiums paid by an employer-sponsored health insurance plan aren't deductible unless the amounts paid are taxed to the employee (included in taxable compensation box 1 of Form W-2). (IRS Pub. 505 (2015), page 5) • Legal expenses paid to authorize treatment for mental illness. (Rev Rul 71-28, 1971-2 CB 165) • Medical Part B (supplementary medical insurance benefits for the aged and disabled) voluntary premiums, and voluntary premiums (e.g., paid by those not covered


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by social security) under Medicare Part A (basic Medicare) (Code Sec. 213(d)(1)(D)), plus Medicare Part D (voluntary prescription drug insurance) premiums. But mandatory employment or self-employment taxes paid for basic coverage under Medicare A are not deductible. (Reg. § 1.213-1(e)(4)(i)(a)) • Nonlicensed healthcare providers that provide physician-ordered assistance and supervision to a patient suffering from dementia. (Estate of Lillian Baral, (2011) 137 TC 1137 TC 1) • Nursing services (need not be performed by a registered or trained nurse). (Reg. § 1.213-1(e)(1)(ii)) Amounts for such services include room and board, as well as social security taxes, medical insurance and unemployment taxes paid with respect to the service provider. However, if the service provider also performs personal and household services, amounts paid must be divided between the time spent performing household and personal services (nondeductible) and the time spent for nursing services (deductible). (IRS Pub. 505 (2015), p. 12) • Payments to providers of medical services, including: psychologists, physicians, surgeons, specialists or other medical practitioners, chiropractors, dentists, optometrists, osteopaths, psychiatrists, and Christian Science practitioners. • Prescription drugs (e.g., not aspirin) and insulin, if legally procured. (Code Sec. 213(b), Code Sec. 213(d)(3)) A controlled substance (such as marijuana) obtained for medical purposes, in violation of the federal Controlled Substances Act, isn't legally procured and is nondeductible, even if state law permits its doctor-prescribed use. (Rev Rul 97-9, 1997-1 CB 77) • Qualified long-term care services (unless provided by a relative who isn't a licensed professional, or by a related corporation or partnership). (Code Sec. 213(d)(1)(C), Code Sec. 213(d)(11)) These services include necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitative services, and maintenance or personal care services, which are required by a chronically ill individual and provided under a plan of care prescribed by a licensed health care practitioner. (Code Sec. 7702B(c)(1)) • Qualified long-term care (LTC) insurance premiums, up to annual inflation-indexed limits. For 2016, the limits are as follows for an individual who attained the indicated age before the close of the tax year: age 40 or less, $390; more than 40 but not more than 50, $730; more than 50 but not more than 60, $1,460; more than 60 but not more than 70, $3,900; and more than 70, $4,870. (Code Sec. 213(d)(10)) Qualified LTC insurance contracts must provide only coverage of qualified LTC services, must not pay or reimburse expenses to the extent the expenses are reimbursable under Medicare (or would be but for a deductible or coinsurance amount), must be guaranteed renewable, and must meet other detailed requirements. (Code Sec. 7702B(b))


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• Service animals used in mental health therapy. (Information Letter 2011-0129) • Smoking cessation programs and prescribed drugs designed to alleviate nicotine withdrawal, but not non-prescription nicotine gum and nicotine patches. (Rev Rul 99-28, 1999-1 CB 1269) • Transportation expenses primarily for and essential to medical care. (Code Sec. 213(d)(1)(B)) This includes food and lodging expenses while en route to the place of medical treatment (Reg. § 1.213-1(e)(1)(iv)), as well as taxi, car train, plane, and bus fares and the cost of ambulance services. Taxpayers also may deduct as a medical expense amounts paid for lodging (not food) while away from home, that's primarily for and essential to medical care in a hospital or equivalent, up to $50 per night for each individual. (Code Sec. 213(d)(2))

� Weight-loss program for treatment of a specific disease (e.g., obesity, hypertension), but not the cost of diet food. (Rev Rul 2002-19, 2002-16 IRB 778).

A. California Conformity. California, but not federal law, allows a deduction for medical expenses and health insurance costs incurred on behalf of a registered domestic partner In addition, California has not adopted the federal amendment that increased the threshold for the itemized deductions for unreimbursed medical expenses from 7.5% of adjusted gross income (AGI) to 10% of AGI for regular income tax purposes. Adjustments must be made on Sch. CA (540).

III. Start-Up Expenses. Taxpayers who pay or incur start-up costs for a trade or business and who subsequently enter the trade or business can elect to expense up to $5,000 of the costs. The $5,000 deduction amount is reduced dollar for dollar when the start-up expenses exceed $50,000. The balance of start-up expenses, if any, are amortized over the 180-month period starting with the month in which the business begins ( IRC sec. 195). The election must be made no later than the date for filing the return (including extensions) for the tax year in which the business begins or is acquired. The election is made by completing Part VI of Form 4562. A taxpayer who does not make the election must capitalize the expenses.

A commercial airline pilot was not entitled to deduct a loss she sustained in connection with an aviation activity for the tax year at issue. Although the individual fully intended to enter into an aviation business for profit and committed substantial time and money to that endeavor, her activities had not ripened into an active trade or business in the tax year at issue. The individual acquired an airplane, drafted a business plan and filed articles of organization for her business. These were all preparatory steps to beginning her aviation business. However, other than a picture and short statement posted on her personal Facebook page, the individual did nothing to formally advertise to the general public that her aviation activity was open for


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business or to describe and promote the various services that her aviation activity would offer to its clients. The individual’s informal efforts to promote her aviation activity, her optimism that an acquaintance would become a paying client and the complimentary flight she provided to a friend did not impress the court as evidence that the aviation activity was actually functioning and performing the activities for which it was organized. Further, the aviation activity did not have any clients, contracts for aviation services or gross receipts for the tax year at issue. Therefore, the expenses incurred before the business was started were not deductible. Once the business begins, the company can make an election to deduct up to $5,000 of pre-opening costs and amortize the balance over 180 months. (Tizard, TC Summ. Op. 2016-42).

IV. Passive Activity Losses. The Service continues to eye returns that report large real estate losses, especially those taken by taxpayers claiming to be real estate professionals. Real estate professionals have to satisfy two time tests to deduct their rental losses in full.

They must spend over half of their working hours and more than 750 hours per year materially involved in real estate as a developer, builder, broker, landlord or the like. These time tests are hard to meet if a filer is employed outside of the real estate field. Since 2007, the IRS has been pulling returns of individuals with real estate losses who claim they are real estate pros and whose W-2 forms show lots of wage income.

In the Joseph D. Moon and Darsey C. Moon v. Commissioner, (Docket No. 11173-14S, 28391-14S. Filed May 23, 2016) the couple did not engage in passive rental activities because the taxpayers materially participated in the activities, which were not per se passive. Generally, rental activities are per se passive regardless of whether the taxpayer materially participates. However, the rental activities of the taxpayers were not treated as per se passive because the taxpayers showed that: (1) more than one-half of the personal services performed in trades or businesses during the tax years at issue was performed in real property trades or businesses in which they materially participated; and (2) they performed more than 750 hours of services during the year in real property trades or businesses in which they materially participated. The requirement of material participation is incorporated into each of these tests. Therefore, the taxpayers satisfied the requirements of IRC sec. 469( c)(7)(B).

The couple took big losses from three rental houses that they owned. The husband was a full-time pilot, and the wife worked part-time as a ski instructor. She actively managed the rental properties and kept a contemporaneous logbook documenting the number of hours spent. The Tax Court found the log reliable and decided the real estate losses weren’t passive.

V. Fines and Penalties. An insider trader doesn’t get a tax write-off for forfeiting his profits. A former executive was convicted of insider trading and sentenced to jail. He was also forced to return the stock sale


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gains that were derived from his crime which were profits that he had reported as taxable income on his prior-year tax return. After he claimed a loss deduction when he paid back his ill-gotten gains, the IRS objected. In 2014, a federal trial court rejected the Service’s argument that the forfeited gain rose to the level of a nondeductible fine or penalty. But an appeals court in D.C. has now reversed that decision and disallowed his loss. ( Nacchio v. United States, U.S. Court of Appeals, Federal Circuit; 2015-5114, 2015-5115, June 10, 2016).


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CHAPTER 5 CREDITS


II. Credits ..................................................................................................................................... 1 A. Energy Efficient Credits. ..................................................................................................... 1

1. Energy Efficient Windows. .............................................................................................. 1 2. Solar Panels. ..................................................................................................................... 1

III. Offsetting Research Credit against Payroll Tax. ................................................................... 2

IV. Education Credits. .................................................................................................................. 4 A. American Opportunity Tax Credit. ...................................................................................... 4 B. AOTC and University reporting procedures. ....................................................................... 4

II. Credits

A. Energy Efficient Credits.

1. Energy Efficient Windows. For property placed in service before 2017, individuals are allowed a nonrefundable personal credit for improvements to their principal residence that meet certain energy efficiency standards. The credit is equal to the sum of:

(1) 10% of amounts paid or incurred for energy-efficient building envelope components plus (2) amounts paid or incurred (up to specified dollar limits) for the purchase of residential energy property.

The credit is limited to $500 ($200 for windows), minus the credits claimed in previous years. PATH extended through 2016 the credit for energy-saving items added to one’s residence, such as windows, insulation, roofs and doors. It stays at 10% with a $500 maximum. Any credits taken in prior years count against the $500. And many items are capped: No more than $50 for circulating fans, $150 for furnaces and $200 for windows

2. Solar Panels. The residential energy efficient property credit is available for qualified solar electric property, qualified solar water heating property, qualified fuel cell property, qualified small wind energy property, and qualified geothermal heat pump property. (IRC sec. 25D). The credit is 30% of the total cost of qualified property. .


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For solar energy systems installed in a residence, the full credit applies through 2019 and then phases out until it ends after 2021. The break for geothermal heat pumps, residential wind turbines and fuel cell property currently expires after this year.

A “qualified solar electric property expenditure” is an expenditure for property that uses solar energy to generate electricity for use in a dwelling unit. The dwelling unit must be located in the U.S. and used as a residence by the taxpayer. An expenditure for a solar panel or other property installed as a roof (or portion of a roof) won't fail to qualify solely because it's a structural component of the structure on which it's installed.

III. Offsetting Research Credit against Payroll Tax.

Effective for tax years beginning after December 31, 2015, a qualified small business may elect to apply a portion of its research credit against the 6.2 percent payroll tax imposed on the employer’s wage payments to employees by (IRC sec. 3111(a)). Under Code Sec. 280C, the deduction for research and experimental expenditures otherwise allowed by IRC sec. 174 is reduced by the amount of the research credit. Alternatively, a taxpayer may elect a reduced research credit. The election may only be made five times (i.e., for any five tax years). In determining the number of times that the election has been made, elections made by any other person treated as a single taxpayer with the taxpayer are taken into account. The payroll tax credit portion of the research credit is equal to smallest of the following amounts:

(1) The amount specified by the taxpayer in its election to claim the credit (not to exceed $250,000);

(2) The research credit determined for the tax year (determined without regard to the election made for the tax year); or

(3) In the case of a qualified small business other than a partnership or S corporation, the amount of the business credit carryforward under IRC sec. 39 from the tax year of the election (determined without regard to the election made for the tax year).

The payroll tax credit portion may only be applied against the taxpayer’s 6.2 percent share of payroll tax liabilities and may be carried forward indefinitely against such future payroll tax liabilities if necessary, as explained below. Any payroll tax credit that is unused in a tax year may not be treated as a general business credit that may be carried forward and applied against the regular tax.

A partnership or corporation (including an S corporation) is a qualified small business during a tax year if its gross receipts are less than $5 million and the partnership or corporation did not have gross receipts in any tax year preceding the five-tax-year period that ends with the tax year of the election.

A taxpayer other than a partnership or a corporation, e.g., an individual, is a qualified small business during a tax year if the taxpayer's gross receipts for the election year are less than $5 million and it had no gross receipts in any tax year preceding the five-tax-year period that


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ends with the tax year of the election. Gross receipts for this purpose are determined by taking into account gross receipts received by the taxpayer in carrying on all of its trades or businesses.

Gross receipts are determined under IRC sec. 448(c )(3) without regard to IRC sec. 448 (c )(3)(A). Therefore, gross receipts are reduced by returns and allowances made during the tax year and predecessor entities are taken into account in applying the gross receipts test. In addition, gross receipts for a short tax year are determined on an annualized basis. IRC sec. 448 generally requires corporations and partnerships with a C corporation partner to use the cash method of accounting unless average annual gross receipts for a three-tax-year period do not exceed $5 million. Note that the $5 million limitation for the qualified small business election is based solely on gross receipts received during the election year and not on average gross receipts.

Example

Partnership A, a calendar-year taxpayer, has $4 million of gross receipts in 2016. It has $10 million of gross receipts in 2015, 2014, 2013, and 2012. It had no gross receipts in 2011 and earlier tax years. Partnership A may make the election for its 2016 tax year because it had less than $5 million in gross receipts in the year of the election and no gross receipts in any tax year that preceded 2012 which is the first tax year of the five-tax year period that ends with the 2016 election year. It does not matter that its gross receipts exceeded $5 million during the four years preceding the election year.

The election must specify the amount of the research credit to which the election applies. The election deadline is on or before the due date (including extensions) of the qualified small business’s income tax return or information return. The election may only be revoked with IRS consent. In the case of a partnership or S corporation the election is made at the entity level.

The election may not be made if the taxpayer (including any person treated as a single taxpayer with the taxpayer) made an election for five or more preceding tax years.

The amount specified in any election may not exceed $250,000. Although a taxpayer may make an election that specifies $250,000 as the amount to which the election applies, the amount of the credit that may be claimed is in fact limited to the lesser of the amount of the research credit for the tax year or, in the case of a partnership or S corporation, the business credit carryforward for the tax year (both determined without regard to the payroll credit) if one of these amounts is less than $250,000.

Each person treated as a single taxpayer under the aggregation rules (IRC sec. 41(f) must make the election separately for any tax year. The $250,000 election limit is allocated among all persons treated as a single taxpayer.

The payroll tax credit allowed for the quarter may not exceed the 6.2 percent payroll tax imposed on the employer for the quarter on the wages paid with respect to the employment of all individuals in the employ of the taxpayer.


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A qualified small business taxpayer making the payroll tax credit election claims a credit against its payroll tax liability for the first calendar quarter which begins after the date on which the taxpayer files its income tax return for the tax year of the election. The payroll tax credit applies to tax years beginning after December 31, 2015. The credit, therefore, may be claimed against the payroll tax liability for the first quarter beginning after the date on which taxpayer’s 2016 return is filed (e.g., July - September 2017 quarter for a calendar year individual filing 2016 Form 1040 on the April 15, 2017 deadline).

Any excess credit is carried forward and applied to the payroll tax liability in succeeding quarters until the entire credit is used up.

Deductions allowed for payroll taxes are not reduced by the amount of the payroll tax credit.

It appears that the IRS is adding a section to Form 6765 for firms wanting to make the election. Filers will transfer the amount figured there to the newly developed Form 8974 to compute the credit. They then carry over the 8974 figure to line 11 of the 941.

IV. Education Credits.

A. American Opportunity Tax Credit.

The cost of a computer isn’t eligible for the American Opportunity Tax Credit unless a university requires students to have one. in this case a taxpayer purchased a computer for his college English class. He was traveling a lot and used the computer to prepare a paper for the course. The amount isn’t a qualifying expenditure for the credit because the computer wasn’t needed as a condition of enrollment ( Mameri, TC Summ. Op. 2016-47). The rules are more lax when it comes to 529 college savings plans. Tax-free payouts are allowed for the cost of computers, software, internet access and the like if used primarily by the beneficiary during his or her years in college. Tighter rules will apply to preparers of returns that claim the child credit and the American Opportunity Tax Credit. Starting with 2016 tax returns due in 2017, preparers will have to document how they figured a filer’s claim was valid, similar to the rules that now apply to returns claiming the earned income credit. IRS is revising Form 8867 to include a due diligence checklist for all three credits. Preparers who don’t attach the form to 2016 returns are subject to a penalty of $510 for each failure.

B. AOTC and University reporting procedures. Colleges and universities get more time to comply with a new reporting rule. Legislation enacted last Dec. requires schools to report on Form 1098-T tuition and related expenses received, beginning with post-2015 payments. In the past, they could choose to report amounts received or billed, and many opted for the second. IRS says it won’t impose penalties on those


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who report amounts billed on 2016 1098-Ts filed in early 2017. This will give schools more time to update their computer software. A recent case illustrates why the IRS is concerned about this issue. A university billed a student in Nov. 2010 and Jan. 2011 for her tuition for the following spring semester. She financed her education through student loans, which were disbursed directly to the school in Jan. 2011. On the 2011 Form 1098-T, the school reported tuition billed to her in 2011, and not the total amount received. But she figured her 2011 American Opportunity credit based on the amount she paid through student loans. The Service claimed her credit was too high after its computers identified the mismatch, but the Tax Court agreed with the taxpayer.

The Tax Court has concluded that, despite inadequacies in the university's Form 1098-T, Tuition Statement, the taxpayer paid $3,640 in qualified tuition and related expenses in 2011. Accordingly, IRS erred in completely disallowing her claim for a $2,500 American Opportunity Tax Credit (AOTC).

Individuals may elect to claim a personal, partially refundable AOTC equal to 100% of up to $2,000 of qualified higher education tuition and related expenses plus 25% of the next $2,000 of expenses paid for education furnished to an eligible student in an academic period. So, the maximum AOTC is $2,500 a year for each eligible student. (IRC sec. 25A) In general, the AOTC is allowed only for payments of qualified tuition and related expenses paid by the taxpayer during the tax year for education furnished to the eligible student during any academic period beginning in that tax year (i.e., for payments of qualified tuition and related expenses for an academic period beginning in the same tax year as the year the payment is made). However, under an exception, if qualified tuition and related expenses are paid during one tax year for an academic period that begins during the first three months of the next tax year, the academic period is treated for AOTC purposes as beginning in the earlier year.

Loan proceeds disbursed directly to an eligible educational institution are treated as paid on the date the institution credits the proceeds to the student's account. For example, in the case of any loan issued or guaranteed as part of a federal student loan program under Title IV of the Higher Education Act of '65, loan proceeds will be treated as paid on the date of disbursement by the eligible educational institution.

For tax years beginning after June 29, 2015 (i.e., after the year at issue in this case), unless otherwise provided by IRS, no education credit or tuition and fees deduction is allowed unless the taxpayer receives a written statement (i.e., a payee statement) that contains all of the information required .

For expenses paid after Dec. 31, 2015 for education furnished in academic periods beginning after that date, higher education institutions are required to report only qualified tuition and related expenses actually paid (rather than choosing between amounts paid and amounts billed, as previously provided). ( IRC sec. 6050S).

For tax years beginning after 2015, a taxpayer claiming the AOTC must provide the employer identification number (EIN) of the educational institution attended by the individual to


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whom the credit relates. For expenses paid after Dec. 31, 2015, an eligible educational institution to which qualified tuition and related expenses were paid must also include its employer identification number (EIN) on the information return that it provides to IRS.

Following the enactment of these provisions, numerous eligible educational institutions informed IRS that implementation of the law change will require computer software reprogramming and other changes that cannot be implemented in time to meet the applicable filing and furnishing due dates for Form 1098-T for calendar year 2016. IRS indicated that it will not impose penalties under Code Sec. 6721 or Code Sec. 6722 with respect to 2016 Forms 1098-T solely because the eligible educational institution reports the aggregate amount billed for qualified tuition and related expenses for the 2016 calendar year. Thus, eligible educational institutions will continue to have the option of reporting either the amount of payments of qualified tuition and related expenses received or the amount of qualified tuition and related expenses billed for the 2016 calendar year without being subject to penalties. This gives schools more time to update their computer software.


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CHAPTER 6 SALE OR EXCHANGE


II. Termination Fees ..................................................................................................................... 1 A. CRI-Leslie LLC. V. Commissioner (U.S. Tax Court, Dkt. No. 1454-14, 147 TC —, No. 8, September 7, 2016 and Stock Acquisition. ................................................................................. 1

II. Termination Fees

A. CRI-Leslie LLC. V. Commissioner (U.S. Tax Court, Dkt. No. 1454-14, 147 TC —, No. 8, September 7, 2016 and Stock Acquisition.

In this case, a TEFRA partnership was not allowed to subject its right to retain forfeited deposits from a canceled sale of real property to capital gain treatment. The property did not constitute "property that is a capital asset" and, therefore, IRC sec. 1234A did not apply. The property, a hotel, was acquired for use in the partnership’s hotel and restaurant business as property used in a trade or business classified under IRC sec. 1231. The partnership entered into an agreement to sell the property; however, the purchaser defaulted on the agreement and forfeited an amount paid to the partnership during the tax year. Had the partnership sold the property according to the agreement’s terms, the gain from the sale would have resulted in a IRC sec. 1231 gain, but the partnership reported the forfeited deposits as net long-term capital gain on its Schedule K. However, neither the statutory construction nor the case law supported an extension of the definition of "capital asset" as used in IRC sec. 1234A to property described in IRC sec. 1231 and a final partnership administrative adjustment recharacterized the capital gain as ordinary income.


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CHAPTER 7 THE “SHARING ECONOMY”


II. The Sharing Economy ............................................................................................................. 1 A. Issues Impacting the Sharing Economy .............................................................................. 2

III. Crowdfunding. ....................................................................................................................... 3 A. Reward-based crowdfunding ............................................................................................... 3 B. Equity crowdfunding ........................................................................................................... 3 C. Donation-based crowdfunding ............................................................................................ 4 D. Information Letter 2016-36 ................................................................................................. 4

II. The Sharing Economy

The sharing economy, otherwise known as the "on-demand" or "access" economy, is a developing area of internet-based business that presents many tax-related uncertainties for its participants. An emerging area of activity in the past few years, the sharing economy has changed how people commute, travel, rent vacation places and perform many other activities. Also referred to as the on-demand, gig or access economy, sharing economies allow individuals and groups to utilize technology advancements to arrange transactions to generate revenue from assets they possess - (such as cars and homes) - or services they provide - (such as household chores or technology services). Although this is a developing area of the economy, there are tax implications for the companies that provide the services and the individuals who perform the services.

The core "sharing economy" does have many similarities to traditional bartering. For example, instead of bartering with a neighbor to trade stays at vacation homes, one can use online platforms like HomeAway or VRBO to swap stays or purchase nights at vacation homes around the world. The sharing economy also makes use of information technology to connect those with available assets or services to those who want access to such assets or services. Whether the assets are rented (e.g., Airbnb, VRBO, HomeAway, and Zipcar), lent (e.g., Prosper and LendingClub), resold (e.g., Ebay, Rent the Runway, Bag Borrow & Steal), shared (e.g., Uber and Lyft), invested (e.g., crowdfunding), or leased (e.g., WeWork and MakeOffices), new digital platforms have given rise to unprecedented exchanges of assets and services.

For tax practitioners, the wide range of sharing economy activity presents a problem because many taxpayers do not view participating in the sharing economy as something that could give rise to taxable income. The primary challenge continues to be awareness of the tax compliance issues arising out of the sharing economy. As noted by the National Taxpayer Advocate in her testimony before Congress (May 16, 2016), 34 percent of those who reported earning income in the sharing economy did not know they need to file quarterly estimated tax payments, 36 percent did not understand what records they would need to maintain as a small business for tax purposes, 43 percent did not set aside money to meet their tax obligations, and


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69 percent did not receive any tax information from the sharing economy platform they used to earn their income. Further, until the launch of the new Sharing Economy Resource Center on August 22, 2016, the IRS had issued no significant guidance tailored to address participants in the sharing economy.

Those sharing economy participants who do not earn significant income from the sharing economy, especially those who prepare their own returns, might not want to worry about calculating estimated tax payments. Thus, they might want to increase tax withholding from their paychecks to ease the burden of calculating estimated tax payments and the risk of estimated tax penalties. For those who have regular jobs and expect to owe less than $1,000 in income tax from sharing-economy activities after applying federal income tax withholding, there is no need to make estimated tax payments. Also, those taxpayers whose Adjusted Gross Income was $150,000 or less can avoid any estimated tax penalties if they pay, via withholding or timely estimated tax payments, 100 percent of their income tax liability from the last year. For those participants in the sharing economy who anticipate a possible spike in income during the year (e.g., beach home rental in the summer) they might also want to increase withholding to ensure the safe harbor shields them from penalties.

Worker classification is complex and one of the most commonly misunderstood areas in the sharing economy. Small businesses should look to three main factors to distinguish employees and independent contractors. The three factors are: behavioral control; financial control; and the relationship of the parties. Behavioral control relates to whether the service provider is subject to direction and control by the business (i.e., how the work is performed). Financial control relates to the service provider’s opportunity for profit or loss, the reimbursement of expenses, and the investment by the service provider in his or her business. The relationship of the parties looks to how the service provider and business relate to one another (e.g., contracts, insurance, paid leave, long-term relationship, etc.). Federal employment tax rules are highly fact specific because they are based on common law rules developed by years of case law. As such, most small businesses should seek professional advice if they hire independent contractors.

A. Issues Impacting the Sharing Economy

The IRS guidance regarding employee versus independent contractor should be expanded and targeted to the sharing economy. The IRS’s Sharing Economy Tax Center provides links to prior IRS guidance for employees and businesses but does not specifically address the sharing economy. As it has done in other areas, the IRS could issue FAQs, or include examples, that specifically address common factual scenarios in the sharing economy. This would give taxpayers some context for how to apply the rules currently posted on the IRS website.

One big item the agency needs to address is the Form 1099 reporting rules, specifically in which situations online payers must issue a 1099-MISC versus a 1099-K. The 1099-MISC is required when annual payments to a nonemployee exceed $600. Third-party networks must send a 1099-K to payees who have over 200 transactions and were paid more than $20,000. Compliance with these rules is all over the place. Many third-party networks file 1099-K. Others use the 1099-MISC. Some send both.


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And there are those who send neither if the 1099-K threshold amounts aren’t met.

Among the following tax issues that may apply to those participating in the sharing economy:

• Issues for Individuals Performing Services o Filing Requirements o Employee or Independent Contractor o Tax Payments, Including Estimated Tax Payments o Self-Employment Taxes o Depreciation o Rules for Home Rentals o Business Expenses

• Employment Tax Issues for the Companies Providing Services o Determining Whether the Individuals Providing Services are Employees or

Independent Contractors o Employer/Payer Employment Tax Obligations

III. Crowdfunding.

A. Reward-based crowdfunding

Reward-based crowdfunding involves raising capital by soliciting small amounts of money from a large number of investors, usually over the internet. It has become an increasingly popular way for small businesses to secure capital. On platforms such as Kickstarter and Indiegogo, individuals and companies offer consumers products, merchandise, experiences, or other perks in exchange for pledging money to help them bring a project to life. These projects range from service-based businesses such as restaurants, to creative endeavors such as films, TV shows, and graphic novels, and to products such as gadgets and clothing.

Project creators set a fundraising goal to be met within a certain period of time. In most cases, funding is all-or-nothing: If users fail to meet their goal, they receive no money, and their backers are not charged. If they do meet their goal, the platform typically collects a percentage of the funds they raised as a fee. Kickstarter, for example, charges 5% of funds raised, and its payment processors charge fees of around 3% to 5%.

B. Equity crowdfunding

Equity crowdfunding is where the business sells their securities to a large number of investors. Once, only accredited investors using licensed online portals or broker-dealers could buy securities from crowdfunded companies.

SEC regulations released in March 2015, however, have opened up equity crowdfunding to a wider pool of investors. These rules allow businesses to raise up to $50 million in 12 months and accept investments from unaccredited investors. There are no limits on how much an individual


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can invest in a Tier 1 company—one with an offering size of $20 million or lower. Individuals can invest up to 10% of the greater or their annual income or net worth in Tier 2 companies: those with an offering size between $20 million and $50 million.

Tier 1 companies must have their financials reviewed by an accountant, while Tier 2 companies must have their financial statements audited and publish annual reports. Tier 2 companies are also exempt from the requirement to register their offerings in each state in which they sell securities.

C. Donation-based crowdfunding

Donation-based crowdfunding enables individuals, groups, and not-for-profit organizations to raise money on sites such as GoFundMe and YouCaring. Users can raise funds for almost any charitable cause, including a family member's medical bills, rebuilding a house destroyed by a natural disaster, or sending schoolchildren to a competition. Some charity crowdfunding sites charge organizers a percentage of funds donated, while others, such as YouCaring, are free except for the fees levied by payment processors. Typically, the pledges received from donation-based crowdfunding are considered gifts and therefore are not taxable to the campaign creator.

Crowdfunding is growing at an explosive rate. In 2014, $16.2 billion was raised through crowdfunding worldwide, more than double the $6.1 billion raised in 2013. Questions abound regarding the proper tax treatment of this funding mechanism and the IRS has recently issued Information Letter 2016-36 which partially addresses some of these issues.

D. Information Letter 2016-36

IRS Chief Counsel has examined the tax treatment of crowdfunding and noted that the income tax consequences to a taxpayer of a crowdfunding effort depend on all the facts and circumstances surrounding that effort.

Chief Counsel first determined that IRC sec. 61(a) generally provides that gross income includes all income from whatever source derived. Gross income includes all accessions to wealth, whether realized in the form of cash, property or other economic benefit. However, some benefits that a taxpayer receives are excluded from income, either because they do not meet the definition of gross income or because a specific exclusion exists.

Further, money received without an offsetting liability, such as a repayment obligation, that is neither a capital contribution to an entity in exchange for a capital interest in the entity nor a gift, is included in income, Chief Counsel observed. The facts and circumstances of a particular situation must be considered to determine whether the money received in that situation is income.

According to Chief Counsel, crowdfunding revenues generally are included in income if they are not (1) loans that must be repaid; (2) capital contributed to an entity in exchange for an equity interest in the entity; or (3) gifts made out of detached generosity and without any "quid


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pro quo." Crowdfunding revenues also must generally be included in income to the extent they are received for services rendered or are gains from the sale of property, Chief Counsel determined.

Chief Counsel also looked to the constructive receipt rules. Income although not actually reduced to a taxpayer's possession is constructively received in the tax year during which it is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available. Income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. However, a self-imposed restriction on the availability of income does not legally defer recognition of that income, Chief Counsel noted.


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CHAPTER 8 COST CAPITALIZATION


II. Repair Regulations. ................................................................................................................. 1 A. What has changed. ............................................................................................................... 2 B. De Minimis Rule for Materials and Supplies. ..................................................................... 2

1. Taxpayers With AFS ........................................................................................................ 3 2. Taxpayers Without AFS ................................................................................................... 4 3. Acquisitions of Units of Property .................................................................................... 4 4. Acquisitions of Components of Unit of Property ............................................................ 4 5. Property with an Economic Useful Life of 12 Months or Less ....................................... 5 6. Production of Unit of Property ......................................................................................... 5 7. Applicable Financial Statement Defined ......................................................................... 5

C. Remodel/Refresh Safe Harbor. ............................................................................................ 6 D. Accounting Method Changes. ........................................................................................... 13

III. Rev Proc. 2015-20. .............................................................................................................. 13 A. Qualifying for the Simplified Election. ............................................................................. 13 B. Relief Provided by Rev Proc. 2015-20. ............................................................................. 14 C. What to consider in making the election to use the simplified procedure. ........................ 14 D. Rev. Proc 2016-29. ............................................................................................................ 16 E. California Conformity. ....................................................................................................... 17

II. Repair Regulations.

On September 13, 2013 the IRS issued final regulations related to deduction and capitalization of tangible assets. (T.D. 9636) These final regulations provide a general framework for distinguishing capital expenditures from supplies, repairs, maintenance, and other deductible business expenses. The final regulations retain many of the provisions of the 2011 temporary and proposed regulations (2011 temporary regulations), which in many instances incorporated standards from case law and other existing authorities under sections 162 and 263(a). The final regulations also modify several sections of the 2011 temporary regulations in response to comments received and to clarify and simplify the rules while achieving results that are consistent with the case law. The final regulations adopt the same general format as the 2011 temporary regulations, where Reg. 1.162-3 provides rules for materials and supplies, Reg.1.162-4 addresses repairs and maintenance, Reg.1.263(a)-1 provides general rules for capital expenditures, Reg. 1.263(a)-2 provides rules for amounts paid for the acquisition or production of tangible property, and Reg.1.263(a)-3 provides rules for amounts paid for the improvement of tangible property. However, the final regulations refine and simplify some of the rules contained in the 2011 temporary regulations and create a number of new safe harbors.


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In addition, these regulations finalize certain temporary regulations under section 167 regarding accounting for and retirement of depreciable property and section 168 regarding accounting for MACRS property, other than general asset accounts. However, these regulations do not finalize the rules under Reg.1.168(i)-1 or Reg. 1.168(i)-8 addressing the definition of disposition for property subject to IRC 168. Instead, to address significant changes in this area, revised regulations under IRC 168 are being proposed concurrently with these final regulations.

A. What has changed.

Changes to the temporary regs were made to “clarify, simplify, and refine,” as well as to create several new safe harbors. The most significant changes include:

▪ A revised and simplified de minimis safe harbor under Reg. 1.263(a)-1(f); ▪ The extension of the safe harbor for routine maintenance to buildings; ▪ A new annual election for smaller taxpayers to deduct some maintenance and improvement costs for buildings; ▪ A new annual election to capitalize repair costs that are capitalized on the taxpayer’s books and records; and ▪ Refined criteria for defining betterments and restorations to tangible property.

The final repair regulations are organized as follows: ▪ Materials and supplies (Reg. §1.162-3); ▪ De minimis safe harbor (Reg. §1.263(a)-1(f)); ▪ Amounts paid for the acquisition or production of tangible property (Reg. §1.263(a)-2); and ▪ Amounts paid for the improvement of tangible property (capitalization v. repair) (Reg. §1.263(a)-3).

The final repair and MACRS regulations must be followed by all taxpayers starting in tax

years beginning on or after January 1, 2014. However, the final regulations - or the temporary regulations — may (at a taxpayer’s discretion) be followed retroactively back to a tax year beginning on or after January 1, 2012, and before January 1, 2014.

The proposed MACRS regulations dealing with GAAs and dispositions may also be applied to tax years beginning on or after January 1, 2012, and before January 1, 2014. This section discusses the changes noted above that were made in 2015/2016. B. De Minimis Rule for Materials and Supplies. The final regulations make taxpayer-friendly changes to the de minimis expensing rule originally provided in the temporary repair regulations (Reg. §1.263(a)-1(f)). Most significantly, the overall ceiling on the amount deductible under the de minimis rule is eliminated and replaced with a per-item limitation of $5,000 for taxpayers with an applicable financial statement (AFS) and a $500 per-item limitation for taxpayers without an AFS. Under the temporary regulations, the de minimis rule did not apply to a taxpayer without an AFS (Temp. Reg. §1.263(a)-2T(g)).


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Subsequent to the release of the final regulations, small practitioners continued to voice

concerns related to the $500 limitation. Commentators noted that many “small” purchases cost more than $500 and, further, this policy did not conform to what was used for accounting purposes. Commentators also commented on the wide disparity between taxpayers with an AFS and those without an AFS. Therefore, in 2015 Treasury issued Notice 2015-82 (Nov. 24, 2015) which raised the safe harbor per-item limitation for taxpayers without an AFS to $2,500. The notice is effective for costs incurred during tax years beginning on or after January 1, 2016. However, the notice goes on to explain that the IRS will not raise upon examination the issue of whether a taxpayer without an AFS can utilize the de minimis safe harbor of $2,500 per invoice.

Under the temporary regulations, the de minimis rule was not an election and was adopted by filing an accounting method change. Under the final regulations, the de minimis rule is an annual elective safe harbor and may not be adopted by filing an accounting method change.

As revised by the final regulations, the safe harbor provides that a taxpayer may not capitalize amounts paid (cash basis taxpayer) or incurred (accrual basis taxpayer) that cost less than a specified amount for:

▪ the acquisition of a unit of tangible property; ▪ the production of a unit of property; or ▪ materials or supplies (Reg. §1.263(a)-1(f)(1)).

The safe harbor does not apply to:

▪ land; ▪ amounts paid for property that is or is intended to be included in inventory;

▪ rotable, temporary, and standby emergency spare parts that are capitalized and depreciated; and ▪ rotable and temporary spare parts accounted for under the optional method of accounting for rotable parts (Reg. §1.263(a)-1(f)(2)).

1. Taxpayers With AFS

A taxpayer with an AFS may elect the safe harbor for a particular tax year only if:

1. The taxpayer has at the beginning of the tax year written accounting procedures that treat as an expense for non-tax purposes (a) amounts paid for property costing less than a specified dollar amount, or (b) amounts paid for property with an economic useful life of 12 months or less; 2. The taxpayer treats the amount paid for the property as an expense on its AFS in accordance with its written accounting procedures; and 3. The amount paid for the property (i.e., the amount paid that is to be expensed for tax purposes) does not exceed $5,000 per invoice (or per item as substantiated by the invoice) (Reg. §1.263(a)-1(f)(1)(i)).


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2. Taxpayers Without AFS

The same requirements apply to a taxpayer without an AFS with the following two

differences: ▪ The accounting procedure that must be in effect at the beginning of the tax year does not need to be written; and ▪ The amount paid for the property may not exceed $2,500 per invoice (or per item as substantiated by the invoice) (Reg. §1.263(a)-1(f)(1)(ii)).

Even though many taxpayers did not have expensing policies in effect at the beginning of their 2012 or 2013 tax years, the IRS declined to grant transitional relief for taxpayers who would otherwise have been able to apply the de minimis rule. Even though a written policy is not required, it is highly recommended.

The taxpayer’s financial or book-expensing policy may set a lower or higher per-item

limit than $2,500/$5,000 regulatory limit. If a lower limit is set, the lower limit also applies for tax purposes. If a higher limit is set, the tax deduction remains subject to the applicable $2,500 or $5,000 cap. The taxpayer’s accounting policy can also set different limits for different types of property and provide specific exclusions.

The goal of these rules is to align tax and book expensing. For taxpayers with an AFS, standards applicable to the AFS should prevent a taxpayer from adopting an expensing policy that materially distorts taxable or book income. For taxpayers without an AFS, the $2,500 per item limit, in the IRS’s view, operates to achieve this result.

If a taxpayer’s expensing policy exceeds the applicable $2,500/$5,000 level, the taxpayer may still make the case upon audit that a greater amount is reasonable under the facts and circumstances because it does not materially distort income. The $2,500/$5,000 limit is a safe harbor, rather than an absolute limit. Examining agents do not need to revise materiality thresholds already in place with a taxpayer to line up with the safe harbor limitations.

3. Acquisitions of Units of Property

The de minimis safe harbor most typically applies to acquisitions of separate units of property that cost no more than the $2,500/$5,000 per item limit.

4. Acquisitions of Components of Unit of Property

The cost of acquiring a component of a unit of property is deductible under the de minimis rule only if the component is a material or supply. Components acquired to repair a unit of property are materials and supplies regardless of cost and, therefore, are deductible under the de minimis rule in the year the cost is paid or incurred, so long as the cost of the component does


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not exceed the applicable per-item limit (usually $2,500 or $5,000). If the cost exceeds the per-item limit, it is deductible in the year the component is used or consumed as a material or supply.

5. Property with an Economic Useful Life of 12 Months or Less

Property with an economic useful life of 12 months or less is a type of material and supply that is covered by the de minimis safe harbor if the taxpayer’s book expensing policy provides for the expensing of such property (Reg. §1.263(a)-1(f)(3)(vii)).

It is not necessary for the accounting procedure to specify a cost limit on property with a

short economic useful life that is expensed for financial accounting purposes. The default limit for tax purposes is considered $5,000 or $2,500, as applicable. However, the accounting procedure must specify a limit for other types of property.

6. Production of Unit of Property

Although the de minimis rule applies to amounts paid or incurred for the production of a unit of property that fall within the $2,500/$5,000 per-item limitation, the uniform capitalization rules will generally require the capitalization of such amounts (Reg. §1.263(a)-1(f)(3)(v)).

“Produce” for purposes of the de minimis rule is defined to mean construct, build, install,

manufacture, develop, create, raise, or grow. Production does not include improvements to a unit of property (Reg. §1.263(a)-1(c)(2)). Production is similarly defined under the UNICAP rules but includes the direct and indirect costs of improving property.

7. Applicable Financial Statement Defined

An “applicable financial statement” is defined as:

1. A financial statement required to be filed with the Securities and Exchange Commission (SEC) (the 10-K or the Annual Statement to Shareholders); 2. A certified audited financial statement that is accompanied by the report of an independent certified public accountant (or in the case of a foreign entity, by the report of a similarly qualified independent professional) that is used for (a) credit purposes; (b) reporting to shareholders, partners, or similar persons; or (c) any other substantial non-tax purpose; or 3. A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or the Internal Revenue Service) (Reg. §1.263(a)-1(f)(4)).

A taxpayer may have more than one of the preceding applicable financial statements. For purposes of applying the de minimis rule, the statement in the highest category (i.e., item (1)


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being the highest) is treated as the AFS. This will be treated as the statement for which a written accounting procedure must be in effect (Reg. §1.263(a)-1(f)(4)).

C. Remodel/Refresh Safe Harbor.

Under Rev. Proc 2015-56 (Nov. 19, 2015) qualified taxpayers with an applicable financial statement (AFS) engaged in the trade or business of operating a retail establishment or a restaurant may adopt a safe harbor method of accounting for determining whether qualified expenditures paid or incurred to remodel or refresh a qualified building are deductible or must be capitalized as improvements under the general tangible property improvement rules of IRC sec. 263 or IRC sec. 263A. Note that these rules apply only to taxpayers with applicable financial statements, which eliminates most small businesses who do not meet this requirement. A qualified taxpayer adopting this method of accounting claims a current deduction for 75 percent of qualified remodel-refresh costs and capitalizes and depreciates the remaining costs. If the safe harbor method is adopted the partial disposition election to claim losses on retired structural components does not apply. The safe harbor does not apply to costs paid during a temporary closing that lasts 21 consecutive calendar days or longer. A qualifying taxpayer must file a change in accounting method to use the remodel-refresh safe harbor. Once a taxpayer has adopted the safe harbor method of accounting, it continues to apply to all future remodel-refresh projects until the taxpayer obtains permission to change its method of accounting for remodel-refresh expenditures. A qualified taxpayer that uses the remodel-refresh safe harbor may not elect to apply the safe harbor that allows “small” taxpayers with average annual gross receipts of $10 million or less to deduct up to $10,000 of combined repair and capital expenditures for a building. This restriction does not prevent a small taxpayer from making the “small” taxpayer election, it only prevents taking the repairs and capital expenditures paid during the remodel-refresh project into account in determining the deduction allowed under the election. In addition, a qualified taxpayer that uses the remodel-refresh safe harbor may not use the safe harbor for routine maintenance for amounts paid for qualified costs that are subject to the remodel-refresh safe harbor method. Same as the above restriction, this rule does not apply to amounts paid for excluded remodel-refresh costs or amounts not incurred in a remodel-refresh project. The safe harbor only applies to a taxpayer with an applicable financial statement as defined for purposes of the de minimis expensing safe harbor. The taxpayer must either sell merchandise at retail or prepare and sell meals, snacks or beverages for immediate on or off-premises consumption. However, a taxpayer that owns, or leases, a qualified building that is leased, or sublet, to a taxpayer that falls within one of these two qualifying categories and incurs remodel-refresh costs may also adopt the safe harbor method.


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A qualifying retailer is a taxpayer in the trade or business of selling merchandise to customers at retail, for which the taxpayer reports or conducts activities with North American Industry Classification System (NAICS) codes beginning in 44 or 45 (relating to retail trades and businesses). However, taxpayers that primarily report or conduct activities within the following codes do not qualify:

Code 4411 (automotive dealers Code 4412 (other motor vehicle dealers Code 447 (gas stations) Code 45393 (manufactured home dealers) Code 454 (nonstore retailers)

Selling merchandise to customers at retail includes the sale of identical goods to resellers if the sales to resellers are conducted in the same building and in the same manner as retail sales to non-reseller customers (for example, warehouse clubs, home improvement stores). To qualify by selling food, the taxpayer must be in the trade or business of preparing and selling meals, snacks, or beverages to customers for immediate on-premises and/or off-premises consumption. A qualified building means each “building unit of property” used by a qualified taxpayer primarily for selling merchandise to customers at retail or primarily for preparing and selling food or beverages to customer order for immediate on-premises and/or off-premises consumption. A building unit of property consists of the entire building, including its structural components. The building that the safe harbor applies to must be placed in a general asset account. A qualified taxpayer must make a late general asset account election to include in a general asset account any asset that is MACRS property, that comprises a qualified building, that was placed in service in a tax year prior to the first tax year that the taxpayer uses the remodel-refresh safe harbor, and that is owned by the taxpayer at the beginning of the first tax year that the qualified taxpayer uses the remodel-refresh safe harbor. The qualified taxpayer makes this late election on its original federal tax return for the first tax year that the taxpayer uses the remodel-refresh safe harbor. The late election is treated as a change in accounting method. The safe harbor only applies to a “remodel refresh project.” A remodel-refresh project means a planned undertaking by a qualified taxpayer on a qualified building to alter its physical appearance and/or layout for one or more of the following purposes:

To maintain a contemporary and attractive appearance To more efficiently locate retail or restaurant functions and products To conform to current retail or restaurant building standards and practices To standardize the consumer experience if a qualified taxpayer operates more than one qualified building To offer the most relevant and popular goods within the industry


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To address changes in demographics by changing product or service offerings and their presentations A remodel-refresh project does not include a project that consists only of repainting and cleaning the building.

Remodel-refresh costs are amounts paid by the qualified taxpayer for remodel, refresh, repair, maintenance, or similar activities performed on a qualified building as part of the remodel-refresh project. The deductible portion of remodel-refresh costs are not deducted until the tax year when the capital expenditure portion of the remodel refresh costs are placed in service. The IRS provides the following nonexclusive list of types of qualifying remodel-refresh costs:

Painting, polishing, or finishing interior walls Adding, replacing, repairing, maintaining, or relocating permanent floor, ceiling, or wall coverings, including millwork Adding, replacing, repairing, maintaining, or relocating kitchen fixtures Adding, replacing, or modifying signage or fixtures Relocating departments, eating areas, check-out areas, kitchen areas, beverage areas, management space, storage space, or similar areas, within the existing footprint of the qualified building Increasing or decreasing the square footage of departments, eating areas, check-out areas, kitchen areas, beverage areas, management space, storage space, or similar areas within the existing footprint of the qualified building Adding, relocating, or removing a room or rooms (for example, dressing rooms, “private” dining space, front office space, or break rooms) within the existing footprint of the qualified building Moving, constructing, or altering walls within the existing footprint of the qualified building Adding, relocating, removing, replacing, or re-lamping lighting fixtures, or adding reflectors, mirrors, or other similar devices to existing lighting fixtures Repairing, maintaining, retrofitting, relocating, adding, or replacing building systems within the existing footprint of the qualified building Making non-structural changes to exterior facades Relocating, replacing, or adding windows or doors (including replacing a manual door with an automatic door) within the existing footprint of the qualified building Repairing, maintaining, or replacing the roof or portion of the roof within the existing footprint of the qualified building Replacing façade materials around windows and entrances Repair and maintenance to the qualified building that directly benefits or is incurred by reason of a remodel-refresh project Removal and demolition, other than demolition subject to IRC sec. 280B, of structural components of a qualified building (for example, insulation, windows, drywall, and similar property) that directly benefit or are incurred by reason of a remodel-refresh project Obtaining permits or other similar authorizations that directly benefit or are incurred by reason of a remodel-refresh project


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Architectural, engineering, and similar services that directly benefit or are incurred by reason of a remodel-refresh project.

Certain costs paid during a remodel-refresh project are not taken into account in computing the safe harbor deduction and capitalization amounts. These costs include:

Remodel-refresh costs paid during a temporary closing of normal business hours that lasts longer than 21 consecutive calendar days Section 1245 property An intangible acquired or created by the taxpayer, including the creation or maintenance of computer software Land, including nondepreciable land improvements, or depreciable land improvements (for example, sidewalks, parking lots, depreciable landscaping). The initial acquisition, production, or lease of a qualified building, including purchase price, construction costs, transaction costs, and the costs of work performed prior to the date that the qualified building is initially placed in service by the qualified taxpayer The initial build-out of a leased qualified building, or a portion thereof, for a new lessee Activities to rebrand a qualified building performed within two tax years following the closing date of (1) an acquisition or initial lease of the qualified building by the qualified taxpayer or a person related, or (2) the acquisition by the qualified taxpayer or a person related, to the qualified taxpayer of a controlling interest in the qualified building or in a lease of the qualified building. Activities performed to ameliorate a material condition or defect that existed prior to the qualified taxpayer's acquisition or lease of the qualified building or that arose during the production of the qualified building (generally, an unusual event in the retail or restaurant business), regardless of whether the qualified taxpayer was aware of the condition or defect at the time of acquisition or production Material additions to a qualified building, including the building systems. Material additions are capitalized as betterments. Restoration caused by damage to the qualified building for which the qualified taxpayer is required to take a basis adjustment as a result of a casualty loss Adapting more than twenty percent (20%) of the total square footage of a qualified building to new or different use or uses, The cost of any property for which the qualified taxpayer has claimed a deduction under IRC sec. 179.

The 25 percent capital expenditure portion for each qualified building is depreciated using MACRS beginning when the capital expenditure portion is placed in service by the qualified taxpayer, taking into account the applicable MACRS convention. Expenditures that have the same depreciation period and are placed in service on the same date, taking into account the applicable convention, are treated as a single asset for depreciation purposes. The qualified taxpayer must make an election to place each asset attributable to the capitalized expenditure portion in a general asset account. A qualified taxpayer may not make the partial disposition in the tax year the safe harbor method is adopted or in later tax years for any portion of an original qualified building or any


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portion of any improvement or addition to an original qualified building. The revocation of a partial disposition election is made by filing an accounting method change. The designated automatic accounting method change number is 221. The revocation only applies with respect to a qualified building for which a qualified taxpayer uses the remodel refresh safe harbor method of accounting provided. If the revocation is made for partial disposition elections made for more than one qualified building the revocations are filed on the same Form 3115.

Example: X, a calendar-year taxpayer, makes a partial disposition election (late or current) with respect to building B in its 2014 tax year. X does not file an amended return or Form 3115 to revoke the election. X files a Form 3115 to begin using the remodel-refresh safe harbor with its federal tax return for the 2016 tax year. X cannot apply the remodel-refresh safe harbor to the amounts paid for any remodel-refresh project for building B that are paid before the 2016 tax year in which X changes its method of accounting to utilize the remodel-refresh safe harbor. Therefore, the remodel-refresh safe harbor does not apply to the costs paid before 2016 for any remodel-refresh project on building B but does apply to the costs paid in 2016 and subsequent taxable years for any remodel-refresh project on qualified building B. If X had filed timely amended returns or a timely accounting method change to revoke all prior year partial disposition elections, the remodel-safe harbor would have applied to earlier remodel-refresh costs.

The following examples illustrate the application of the revenue procedure. In each example, it is assumed that V, W, X, and Y are qualified taxpayers within the scope of the revenue procedure, that V, W, X, and Y file their federal income tax returns on a calendar year basis, that they have not elected to apply the de minimis safe harbor and that, unless otherwise stated, they use the remodel-refresh safe harbor method of accounting.

Example (1): V is in the trade or business of operating a nationwide chain of retail stores that sell a variety of retail goods to customers. To maintain a contemporary and attractive environment, to continue to offer the most relevant and popular products, and to reflect the changing demographics of its customers, V periodically undertakes planned projects whereby it incurs amounts to alter the physical appearance and layout of the buildings it uses for its retail sales. These projects often include the remodel, refresh, repair, and maintenance of IRC Sec. 1250 property that is comprised of V's qualified buildings and IRC sec. 1245 property that is located within these qualified buildings. Each project includes activities such as relocating or changing the square footage of certain departments, check-out areas, storage spaces, and dressing rooms within the footprint of the existing buildings; removing, constructing, and altering walls within the footprint of the existing buildings; moving lighting and replacing lighting fixtures with more efficient lighting; replacing bathroom fixtures with more updated and efficient fixtures; replacing or reconfiguring display tables and racks; patching and repainting interior walls and


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exterior structures; and replacing floor tiles, ceiling tiles, and signage. These projects also include changes to the electrical systems, HVAC systems, and plumbing systems within the buildings' existing footprints to accommodate the structural changes, new product offerings, and bathroom upgrades. V's retail stores remain open to customers during the project, although parts of the store buildings are closed at different times during the process. In Year 1, V pays $3 million for these activities to be performed on one of its qualified buildings and places the related property into service. Of the $3 million, V pays $1 million for IRC sec. 1245 property, including new display tables and racks, information kiosks, checkout counters, and other equipment. For Year 1, V files a change in method of accounting to use the remodel-refresh safe harbor method of accounting. V's $3 million project on its building is a remodel-refresh project because V pays amounts to alter the physical appearance and layout of its retail sales building to maintain a contemporary and attractive environment, to continue to offer the most relevant and popular products, and to reflect the changing demographics of its customers. Of the $3 million remodel-refresh costs paid for the project, $1 million was paid for IRC sec. 1245 property, which is treated as excluded remodel-refresh costs. Therefore, V incurs $2 million of qualified costs ($3 million remodel-refresh costs less $1 million excluded remodel-refresh costs). Under the remodel-refresh safe harbor method of accounting: (A) V treats 75% of the $2 million qualified costs ($1,500,000,00) as amounts deductible under IRC sec. 162 in Year 1, the taxable year the improvements to the qualified building are placed in service, and V treats the remaining 25% of the $2 million qualified costs ($500,000) as improvements to the qualified building that must be capitalized in Year 1 under IRC secs. 263(a) and 263A; (B) V depreciates the $500,000 of improvements and (C) V makes a general asset account election to include the $500,000 of improvements in a general asset account (or multiple general asset accounts if the costs are for improvements with different recovery periods). Because Year 1 is the first taxable year that V uses the remodel-refresh safe harbor method of accounting, V also must make a late general asset account election to include in general asset accounts all assets that are MACRS property that comprise the qualified building, that are placed in service by V before Year 1, and that are owned by V at the beginning of Year 1. Because the qualified building (including the structural components) is in a general asset account, V would not recognize a loss for, and would continue to depreciate, the amounts allocable to the portions of the building and building systems removed as part of the remodel-refresh project. Example 2. Example: Assume the same facts as Example 1, except during V's remodel-refresh project, a portion of the $2 million paid for the project is for constructing an addition to the back of the qualified building to increase its storage and unloading space. This addition materially increases the square footage of the qualified building. The work also involves adding extensions to the electrical system and the HVAC system of the building to provide lighting, power, and ventilation throughout the new space. As part of the material addition to the qualified building, the extensions of the electrical system and HVAC


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system also constitute material additions. Thus, the amounts paid for these additions, including related removals costs for the previously existing wall and any removed HVAC and electrical system components, are excluded remodel-refresh costs and, as such, are excluded from the qualified costs for purposes of applying the remodel-refresh safe harbor. For purposes of applying the remodel-refresh safe harbor, V must exclude from qualified costs the amount paid for constructing the addition to the back of the qualified building and extending the electrical and HVAC systems through this addition, and these excluded costs must be analyzed separately under the cost capitalization provisions (IRC secs. 162, 263 and 263A. However, V may apply the remodel-refresh safe harbor method to the amounts in Example 1 that are qualified costs ($2 million less the amount paid for constructing the addition to the back of the qualified building and extending the electrical and HVAC systems through this addition). In addition, because the qualified building (including its structural components) is in a general asset account, V would not recognize a loss for, and would continue to depreciate, the amounts allocable to the portions of the building, electrical system, and HVAC system removed as part of the remodel-refresh project. Example: Assume the same facts as Example 1, except during V's remodel-refresh project, V pays $100,000 (of the $3 million total) to reinforce the foundation of the qualified building by sealing cracks and adding additional structural support to the building's basement. Beginning prior to the date V acquired the qualified building, the building began shifting and sinking as a result of inadequate foundation support. The sealing and addition of structural support in the building's basement consist of activities that ameliorate the inadequate foundation support, a material condition or defect that existed prior to V's acquisition of the building. Accordingly, the amounts paid by V for this work constitute excluded remodel-refresh costs and are not included in determining qualified costs for purposes of applying the remodel-refresh safe harbor. Thus, V must exclude the $100,000 paid to reinforce the foundation of the qualified building from qualified costs, and these excluded costs must be analyzed under IRC secs. 162, 263 and 263A. However, V may still apply the remodel-refresh safe harbor method to the $1,900,000 of qualified costs ($3,000,000 less $1,100,000). In addition, because the qualified building (including its structural components) is in a general asset account, V would not recognize a loss for, and would continue to depreciate, the amounts allocable to the portions of the qualified building removed by reason Accounting Method Changes. In conjunction with the issuance of the final repair regulations, the IRS issued procedures for taxpayers to follow in making accounting method changes to comply with the final regulations. On Jan. 24, 2014, the government issued Rev. Proc. 2014-16, which provides the rules for taxpayers to change their accounting methods to comply with the repair regulations. On Sept. 18, 2014, the government issued Rev. Proc. 2014-54, which


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provides the rules for taxpayers to change their accounting methods to comply with the final disposition regulations.

D. Accounting Method Changes.

On Jan. 16, 2015, the IRS issued Rev. Proc. 2015-13 and Rev. Proc. 2015-14, which collectively provide the rules for making accounting method changes, including those to comply with the final regulations. Additionally, on Feb. 13, 2015, the IRS released Rev. Proc. 2015-20, which provides an exception to the general procedures for complying with the final regulations for certain small business taxpayers.

Rev. Proc. 2014-16 (Rev. Proc. 2014-16, I.R.B. 2014-7, January 24, 2014) and other related guidance led many to believe that every taxpayer who filed a depreciation schedule in their tax return would be required to file a Form 3115 (Request for a Change of Accounting Method) with their 2014 tax returns to properly adopt these rules. Although the Form 3115 itself is not that difficult, it does require computing a “Section 481” adjustment which effectively restates all prior years to reflect the change in accounting method. After an outpouring of requests for simplification, the IRS released Rev. Proc. 2015-20 (Rev. Prov. 2015-20, I.R.B. 2015-9, February 13, 2015) that provides the taxpayer with an election that eliminates this requirement. As with any election, there are trade-offs.

III. Rev Proc. 2015-20.

A. Qualifying for the Simplified Election.

The IRS states in Rev. Proc. 2015-20 that the purpose behind the election is to make it easier for small business to comply with the final regulations. The revenue procedure applies to a taxpayer with one or more separate and distinct trade or business(es) that meet the following test: Total assets of less than $10 million on the first day of the tax year for which change in method of accounting is effective; or Average annual gross receipts of $10 million or less for the prior three taxable years.

Total assets are determined by the accounting method that the taxpayer uses in keeping the books and records of the trade or business at the end of the tax year. Gross receipts for each tax year are defined as the trade or business’s receipts for the tax year that are recognized under the method of accounting used for federal tax purposes. This includes total sales (net of returns and allowances), receipts for services and income from investments. Investment income is broader than just what is included in taxable income. It includes interest (including tax-exempt interest), dividends, rents, royalties and annuities regardless of whether amounts are derived from the taxpayer’s ordinary trade or business. Gross receipts from the sale of capital assets are


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reduced by the adjusted basis in the property sold. (IRS Q&A entitled Tangible Property Final Regulations which references Reg. sec. 1.263(a)- 3(h)(3)(iv) for the definition of gross receipts.) This is a particularly taxpayer friendly provision as it does not require aggregation of gross receipts of all entities owned by the taxpayer. Separate and distinct trade or business is defined as a business with “complete and separable books and records”. (Rev. Proc. 2015-20, Section 4 that references Reg. sec. 1.446-1(d) for definition of separate and distinct trades or businesses). This means that there are basically no related party rules that need to be applied. The “separate trade or business” requirement means that some of the entities under common ownership could qualify for this relief, while others do not. This may offer planning options to real estate investors who own multiple properties in different legal entities (with separate books and records.) In addition, the test is an “or” test meaning that if the taxpayer meets either the asset or the gross receipts threshold, they qualify as a “small business” and can use the simplified procedure. This exception should eliminate the need for many taxpayers to file a Form 3115 and compute a Sec. 481 adjustment.

B. Relief Provided by Rev Proc. 2015-20.

Rev. Proc. 2015-20 allows the taxpayer to change to certain methods of accounting by taking into account only amounts paid or incurred in taxable years beginning on or after Jan. 1, 2014.

Changes required by the final regs will be made using the “cut off” method, which means that qualifying taxpayers will only have to take into account amounts paid or incurred and dispositions in taxable years beginning on or after January 1, 2014. Although a change using the “cut off” method is a change in method of accounting, Rev. Proc. 2015-20 allows taxpayers to make these changes without filing a Form 3115. Although a separate statement is not required in the 2014 tax return, the IRS does note in their Q&A on this topic that if the taxpayer elects the simplified procedure, then inclusion of a separate statement indicating that the taxpayer is using this method might be appropriate to demonstrate compliance with the final repair regulations. (Link to Q&A on Tangible Property Final Regulations: http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Tangible-Property-Final-Regulations).

C. What to consider in making the election to use the simplified procedure.

If you make the election, you will not receive audit protection for the trade or business amounts paid or incurred in years prior to January 1, 2014. What this means is that the IRS can go back and make a change on a prior years tax return if an improper method of accounting was used. This is not a significant risk if the taxpayer has been in compliance with the law that applied in prior years.


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What is probably of more concern to most taxpayers is that they will not be able to take deductions related to prior years’ expenditures that were capitalized (and now the final regulations clarify that such expenditures can be deducted). This issue most commonly relates to replacement property where the replacement cost was capitalized and the adjusted basis of the old unit could not be determined. Therefore, the taxpayer simply kept depreciating the cost of the old unit and capitalized the cost of the new unit (and started depreciating that cost as well). The final regs provide acceptable procedures to estimate basis of the partial disposition that allow taxpayers to write off the cost of the old unit.

Example:

In 2008, Alex (your client) repaired the roof of a large industrial warehouse that he rented. About 25% of the roof was replaced, and the cost was capitalized and has been depreciated ever since. Under the final repair regulations, the expenditure is categorized as a repair and deductible (as it is not substantial and does not qualify as an improvement/betterment). Alex has the option of making an automatic accounting method change and taking the undepreciated balance of the asset as a negative Sec. 481(a) adjustment in 2014. If Alex does not make a partial disposition election, then he keeps depreciating the cost of the old roof over its remaining useful life.

Alex has a lot to consider. He must determine whether he can utilize the additional deduction in his 2014 tax return. Since this is rental property, it is more likely a passive activity, and Alex’s deductions are limited to passive income (or the rental income from this property if this is his only passive property). If Alex does not qualify to claim the $25,000 deduction for active participation, then the deduction for the old roof might very well be suspended.

Further, if Alex makes the election, he will not receive audit protection for the trade or business amounts paid or incurred in years prior to January 1, 2014. What this means is that the IRS can go back and make a change on a prior years tax return if an improper method of accounting was used. This might not be a significant risk, if Alex has been in compliance with the law that applied in prior years.

If Alex can use the deduction, then in addition to the benefit of an immediate write-off, Alex effectively reduces the accumulated depreciation that may be subject to Sec. 1250 depreciation recapture upon sale of the warehouse.

If Alex decides to take the prior year loss, he must compute the basis of the old roof and the related depreciation. The regulations now allow Alex to use a “reasonable method” to determine the original cost of the replaced roof. The regulations suggest three methods that are “reasonable” which include, discounting the cost of the replacement property using the producer price index (which measures the average change over time of prices received by domestic sellers of goods and services); pro rata allocation; and a prior cost segregation study.


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If the taxpayer elects to use the simplified procedure, then all changes made that are related to the final regulations must be made using the simplified procedure.

If at some point after the first tax year beginning in 2014, the taxpayer decides to change their accounting method by filing a Form 3115 and computing a Sec. 481 adjustment, then the adjustment is calculated by taking into account only amounts paid or incurred in tax years beginning in 2014. In other words, the taxpayer cannot in a later year request a change of accounting related to the final regulations and make the change retroactively effective if the simplified method was used in 2014. (IRS Q&A on Tangible Property Final Regulations).

D. Rev. Proc 2016-29.

Accounting method changes under the final repair regulations are made using the automatic procedures provided in Sec. 11.08 of Rev. Proc. 2016-29, effective for Form 3115s filed on or after May 5, 2016 for a year of change ending on or after September 30, 2015. Rev. Proc. 2016-29 supersedes Rev. Proc. 2015-14. Previously, Sec. 10.11 of Rev. Proc. 2015-14 provided the automatic changes to comply with the final repair regulations, generally effective for changes filed on or after January 16, 2015 for a year of change ending on or after May 31, 2014. These amendments are now incorporated into the text of Sec. 11.08 of Rev. Proc. 2016-29 to the extent they remain applicable.

Eligibility/scope limitations. The eligibility limitations of Rev. Proc. 2015-13, Sections 5.01(d) (preventing a taxpayer from filing a Form 3115 in its last year of a trade or business) and (f) (preventing a taxpayer from filing the same accounting method change for the same specific item twice in a five year period, ending in the year of change) do not apply for a change made under Sec. 10.11 of Rev. Proc. 2015-14 for any tax year beginning before January 1, 2015. This deadline was extended to tax years beginning before January 1, 2016 by Rev. Proc. 2016-29 for Forms 3115 filed on or after May 5, 2016 for a year of change ending on or after September 30, 2015. Thus, the same change for the same specific item may be filed any number of times for the 2012, 2013, 2014, and 2015 tax years.

A taxpayer who files no accounting method changes to comply with the repair regulations in 2014 will not be limited by the eligibility limitations from filing under the automatic consent procedure in 2015 or a later tax year assuming the taxpayer is not audited prior to filing the changes for the 2015 or later tax year. Similarly, a taxpayer who files some changes but not others for 2014, would not be prohibited from filing the types of changes that were not made in 2014 in 2015 or a later tax year, assuming the particular change is not by its terms prohibited from being made after 2014 (e.g., an accounting method change to make a late partial disposition election). Further, a taxpayer who files the same change may file the same change any number of times so long as the change does not involved the same “specific item.” If the phrase “specific item” is construed strictly a taxpayer should be able to file a change from capitalizing to deducting the cost of particular items of property and then file the same change from capitalizing to deducting a cost of a different item of property without regard to the eligibility limitations since these changes do not involve the same “specific item” (of property).


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Advance Consent Required if Credits Claimed. Rev Proc 2016-29 adds a rule that prevents a taxpayer from using the automatic method procedure to change from capitalizing and depreciating the asset to deducting its cost as a repair expense if the taxpayer claimed any type of income tax credits on the asset. If a credit was claimed, a taxpayer must file a change from capitalizing to deducting using the advance consent procedure. The IRS is concerned that taxpayer might be claiming both a credit and a repair deduction on the same asset.

In addition, the automatic consent procedure may not be used to change from capitalizing to deducting if the taxpayer is a corporation that made an election to forego bonus depreciation and claim an unused alternative minimum tax credit.

Certain changes/accounting methods that were permissible under the temporary or proposed MACRS tangible property regulations are obsolete in 2013 (the last year the temporary or proposed MACRS tangible property regulations could be applied on a tax return). The changes are obsolete as 2013 was the last tax ear in which the temporary or proposed regulations could be applied.

Rev. Proc. 2016-29 also removes the accounting method change allowed by Rev. Proc. 2015-14 to make late MACRS general asset account elections for assets placed in service in tax years beginning before January 1, 2012. This election was required to be made no later than taxpayer’s last tax year beginning before January 1, 2014 and is now obsolete.

Agents have their instructions on auditing and proper application of IRS’s tangible property rules. A new IRS guide instructs auditors on what issues to look for during an examination. Agents will check whether businesses were required to file accounting method changes. They’ll also analyze safe-harbor expensing elections for small purchases and improvements that are otherwise required to be capitalized. Firms with audited financial statements can elect to deduct such items costing up to $5,000. Those without certified financials have a $2,500 ceiling.

E. California Conformity.

The FTB has been particularly generous in their interpretation of the state’s conformity to these regulations. Although there were limited if any issues regarding conformity under the Personal Income Tax Law, the same could not be said for the Corporate Tax Law (CTL). Although the CTL does not directly conform to IRC sec. 263, the statute does include a separate provision that reads the same as the comparable federal provision. (Cal. Rev. & TC 24422). In this case, prior case law and FTB administrative guidance indicate that the state will follow federal interpretations under IRC sec. 263 unless the FTB advises to the contrary. (Meanly v. McColgan (1942); FTB Technical Advice Memorandum 2002-0353; FTB Notice 2009-8.) With respect to the new rules on partial dispositions, there was more uncertainty as California has never conformed to MACRS or ACRS under the CTL. In the March 2015 issue of FTB’s Tax News, the FTB stated that they would conform to the repair regulations (including the partial disposition provisions and the simplified filing procedure of Rev Proc 2015-20.) They do caution that although a partial disposition deduction will be allowed on the California tax return, the numbers will be different because of use of different depreciation methods


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CHAPTER 9 PARTNERSHIPS


II. Partnership Audit Rules. ......................................................................................................... 1 A. Early Elections. ................................................................................................................... 5

III. State Conformity. ................................................................................................................... 7 A. Arizona ................................................................................................................................ 8

IV. S Corporations and Shareholder Expenses. ......................................................................... 10

V. Partnerships and SMLLCs. .................................................................................................... 10

II. Partnership Audit Rules.

As part of its budget agreement enacted in 2015, Congress replaced the rules governing the audit procedures for partnerships established by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) as well as the special rules for electing large partnerships, with a new audit regime for all partnerships under which adjustments are made at the partnership level, and the tax due as a result of the adjustments is collected from the partnership. (Section 1101 of the Bipartisan Budget Act of 2015, P.L. 114-74, enacted Nov. 2, 2015, replacing Secs. 6221 through 6255 and Secs. 771 through 777 with new Secs. 6221 through 6241, all for partnership tax years beginning after 2017.)

Not effective until partnership tax years beginning in 2018, the new audit procedures are unlikely to be put into practice before 2020, for returns filed in 2019. However, partnerships may elect to adopt the rules for any tax year beginning after the date of the statute's enactment, Nov. 2, 2015. IRS has recently released guidance on how to make the early elections that are discussed herein.

The TEFRA rules for auditing partnerships were enacted in 1982 to facilitate IRS audits, including those of mass-marketed tax shelter partnerships, which after 1986 largely disappeared as a result of the passive activity loss rules. However, over the last two decades, growth in the number and size of large partnerships has created new challenges to the IRS's ability to audit these entities. Although Congress created an elective regime allowing partnerships with 100 or more partners to pay tax, interest, and penalties on adjustments to the partnership return, very few partnerships elected this option. In July 2014, the U.S. Government Accountability Office (GAO) reported that the number of large partnerships (defined as those with at least $100 million in assets and at least 100 direct or indirect partners) more than tripled from 2002 to 2011, but only 0.8% of such entities were audited by the IRS due to a number of resource issues including the complexity of auditing multi-tiered partnerships. The Partnership Audit Simplification Act of 2015 was the result.


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In essence, these rules make all adjustments to items of income, gain, loss, deduction, or credit of all partnerships at the partnership level, with the partnership, rather than partners, generally liable for any resulting imputed underpayment. However, in certain cases partnerships will be able to elect out of the new rules.

Upon electing out for a tax year, the partnership is subject to the general rules for the assessment and collection of tax deficiencies. Therefore, any adjustment to partnership taxable income will flow through to the partners with the assessment of tax, and the statute of limitation for the assessment will be determined at the partner level, perhaps resulting in inconsistent treatment among the partners. Similarly, partners will make any extension of a statute of limitation, settlement agreement, notice of deficiency, petition to the Tax Court, or suit for a refund individually on a partner-by-partner basis.

Since this is an annual election, a partnership may elect out in some years and not in other years. A partnership may elect out, under procedures to be issued, for a year if:

The partnership is required to issue no more than 100 Schedules K-1, Partner's Share of Income, Deductions, Credits, etc., to its partners. Sec. 6221(b)(1)(B). Under law in effect before 2018, to be excluded from the TEFRA rules, a partnership must not have more than 10 partners, each of which must be an individual, C corporation, or estate of a deceased partner (current Sec. 6231(a)(1)(B

Each partner is an individual, an estate of a deceased partner, an S corporation, a C corporation, or a foreign entity that would be treated as a C corporation if it were domestic;

An election is filed with a timely filed return identifying the names and identification numbers of the partners; and,

The partnership notifies each partner of the election.

Small partnerships with 100 or fewer qualifying partners are therefore, allowed to elect out of the new rules, and those partnerships and partners are subject to the general rules that apply to auditing individual taxpayers. To elect out, the partners must all be individuals, C corporations, foreign entities that would be treated as C corporations if domestic, S corporations, estates of deceased partners, or others if the Treasury secretary prescribes in guidance. Thus, partnerships with partners that are themselves partnerships or trusts are unable to elect out absent further guidance. The provision also contains several consent and election rules, with special rules for specific partners, such as S corporations. The election to opt out is made for a particular year with a timely filed return for that tax year. Where an S corporation is a partner, the names and taxpayer identification numbers of the S corporation's shareholders must be included with the election statement, and the Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., of the S corporation's shareholders (as well as the S corporation itself) count in measuring the 100-partner limit. Most important, the IRS is authorized to issue similar rules allowing partnerships to elect out regardless of the type of entities owning a partnership interest,


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as long as the total number of Schedules K-1 required to be issued by the partnership and its partners do not exceed 100 and the partnership discloses the identities of indirect partners.

For determining whether a foreign entity is a C corporation for purposes of the election out, the regulations defining when a foreign entity is to be treated as a corporation for U.S. tax purposes apply. They provide that, absent an entity classification election, only certain per se corporations will be treated as corporations and identify one or more such entities for each of 87 countries. Other foreign entities may become a qualified partner for the election out if they check the box on Form 8832, Entity Classification Election, to be treated as a domestic corporation. Finally, regulations will need to make clear whether a disregarded entity or nominee holding an interest will be disregarded in determining who owns the interest.

As stated above, absent an election out, all adjustments to the partnership's income, gain, loss, deduction, or credits are made at the partnership level. The IRS will only notify the partnership and its "partnership representative" (further described below) of any audit or proposed adjustments and will ultimately issue a "notice of final partnership adjustment," All notices are sufficient if mailed to the last known address of the partnership representative or partnership, even if the partnership has terminated. Within 90 days after the date of mailing of a notice of final partnership adjustment, the partnership (i.e., the partnership representative) may file a petition in federal court.

Upon the expiration of 90 days after the mailing of the notice of final partnership adjustment, or if a petition is filed, upon the decision of a court being final, the IRS will assess and collect any tax, interest, or penalties relating to the adjustment at the partnership level. For a net adjustment increasing the partnership's taxable income for a year under audit (the "reviewed year") the partnership is required to pay any additional tax (the "imputed underpayment" in the year that the adjustment is finalized (the "adjustment year").

If the partnership no longer exists when a partnership adjustment takes effect, the adjustment is taken into account by its former partners.

Finally, an adjustment that does not result in an imputed underpayment is taken into account by the partnership in the adjustment year as a reduction in nonseparately stated income or an increase in nonseparately stated loss. Treating the adjustment as a nonseparate item results in ordinary income or loss, changing the partnership's net taxable income, while any adjustment to a credit is treated as a separately stated item directly changing the partnership's tax.

The imputed underpayment payable by the partnership is the net adjustments multiplied by the "highest rate of tax in effect for the reviewed year under section 1 or 11" (i.e., the higher of the highest individual or corporate rate). Currently that would be 39.6% individual rate which is higher than the 35% maximum corporate tax rate. There is no provision for collecting self-employment tax or net investment income tax that might otherwise arise if the adjustment were passed through to the partners.

The imputed underpayment rate does not take into account the character of the income, so that capital gains or qualified dividends are taxed at the same 39.6% rate. The IRS is


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authorized to issue guidance on multiple rate disparities that can arise because of the fact that partners can be corporations, tax exempts entities and special rules for allocation of certain partnership items.

The partnership must pay the imputed underpayment no later than the due date (determined without regard to extensions) of its tax return. Interest is imposed on the payment for the period beginning on the day after the return due date for the reviewed year and ending on the return due date for the adjustment year or, if earlier, the date payment is made. Penalties attributable to the imputed underpayment are determined at the partnership level and are paid by the partnership. The partnership cannot take a deduction for any payment it makes; but, presumably, after a partner's basis is increased for its share of any adjustment to income, the partner's basis is reduced for the share of the payment made.

In lieu of paying the tax itself, a partnership may elect within 45 days after receiving a notice of final partnership adjustment for a reviewed year to furnish each partner in the reviewed year a statement (presumably, a revised Schedule K-1) of the partner's share of the adjustment. In this case, the partner will then self-assess any added tax computed as if the adjustment had been properly reported for the reviewed year, but the assessment is reported and paid on the return for the year the revised Schedule K-1 is received.

Interest on the additional tax to the partner is may be higher than it would be if assessed against the partnership. This is because the interest is determined from the due date of the partner's return for the reviewed year at a rate two-percentage points higher than the general interest rate on underpayments, i.e., the short-term applicable federal rate plus five percentage points.

Additional computations may be required for tax attributes. For example, where a partner sold its interest between the reviewed year and the adjustment year, the partner's basis in the partnership may be affected, changing the gain or loss from the sale in the subsequent year. Other tax attributes, such as NOL carryovers, suspended passive activity losses, at-risk amounts, etc., for years subsequent to the reviewed year may also need redetermination.

Multitiered structures will need to be addressed in future guidance. Pushing out the adjustment is a strategy that will probably be used by many partnerships, especially those that do not have sufficient cash to pay the assessment.

Instead of the IRS's changing the partnership's income and issuing a notice of final partnership adjustment, the partnership itself may file an "administrative adjustment request" (AAR) to adjust its taxable income. When a partnership files an AAR for a prior tax year, it takes the adjustment into account in the tax year the AAR is filed, not the prior year. The partnership addresses the change to its taxable income either by paying a tax itself or by issuing adjusted Schedules K-1, with the tax paid by the partners with their returns for the current year without the filing of amended returns.

A partnership that does not elect out of the new audit regime must designate (in a manner to be prescribed by the IRS) a partner or another person with a substantial presence in the United


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States as the partnership representative, and if no person is so designated by the partnership, the IRS may select any person as the partnership's representative. The partnership representative has sole authority to act on behalf of the partnership and may bind the partnership and all partners in IRS audits as well as in any court proceeding.

Therefore, unlike under prior law, the IRS will no longer be obligated to provide any notices to anyone other than the partnership representative, who no longer needs to be a partner.

Adjustments under these new rules may not be made to a partnership tax year more than three years after the latest of:

The date the partnership return for the year was filed; The return due date, including extensions ; or The date the partnership files an AAR for the tax year.

In addition, the period for adjustment remains open for 270 days after the date an imputed underpayment is changed and the partnership makes all required submissions to the IRS and for 330 days after the date of any notice of proposed partnership adjustment. These rules governing partnership audits, including AARs, are generally effective for partnership tax years beginning after Dec. 31, 2017. However, a partnership may elect under procedures to be prescribed by the IRS to apply the new provisions (other than the election-out rules) to any tax year beginning after Nov. 2, 2015, and before Jan. 1, 2018..

A. Early Elections.

The IRS issued temporary regulations governing elections to have the newly enacted partnership audit procedures apply to certain tax years beginning before Jan. 1, 2018 (T. D. 9780) The rules permit the election to made before Jan. 1, 2018, by partnerships that have received notices of selection for examination of the partnership for that tax year. Those partnerships must make the election to have the new audit procedures apply within 30 days of the date of notification. Any election made under this provision must contain certain information, which is discussed below.

The Bipartisan Budget Act (BBA) of 2015, P.L. 114-74, repealed the TEFRA rules governing partnership audits that had been in effect since 1982 and replaced them with a new centralized partnership audit regime that generally assesses and collects tax at the partnership level. It also replaced the rules that applied to electing large partnerships with these new rules. The new rules apply to partnership tax years beginning after Dec. 31, 2017. Partnerships can elect to have some of the new rules apply for tax years beginning after Nov. 2, 2015, and before Jan. 1, 2018, and the rules issued today govern the time, manner, and form of making this election.

The election may be revoked only with the IRS’s consent, and a taxpayer cannot request an extension of time for making the election under Regs. Sec. 301.9100-3. An election will not


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be valid if it frustrates the purposes of Section 1101 of the BBA (Temp. Regs. Sec. 301.9100-22T(a)).

Partnerships selected for audit that wish to make the election must file a statement with the words “Election under Section 1101(g)(4)” written at the top and send it to the individual identified in the notice of selection for examination as the IRS contact person. The statement must be in writing and dated and signed by the tax matters partner, as defined under Sec. 6231(a)(7) (of the TEFRA rules), and the regulations, or by an individual who has authority to sign the partnership return for the tax year under Sec. 6063, the regulations, and any applicable forms and instructions. An individual’s dating and signing this election statement is prima facie evidence that the individual is authorized to make the election on the partnership’s behalf.

The statement must include:

• The partnership’s name, taxpayer identification number (TIN), and the partnership tax year for which the election is being made;

• The name, TIN, address, and daytime telephone number of the individual who signs the statement;

• Language indicating that the partnership is electing for Sec. 1101(c) to apply for the partnership return for the tax year in the notice of selection for examination;

• The information required to properly designate the partnership representative under new Sec. 6223, including the name, TIN, address, telephone number, and any additional information the IRS requires;

• Representations that the partnership is not insolvent and does not reasonably anticipate becoming insolvent before the matters under audit are resolved;

• Representations that the partnership has not filed, and does not reasonably anticipate filing or having filed, a voluntarily or involuntary bankruptcy petition under Chapter 11; and

• Representations that the partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay any potential imputed underpayment for the partnership tax year under audit.

This statement must be signed, with a penalties of perjury statement at the end, by the individual who is duly authorized to make the election (Temp. Regs. Sec. 301.9100-22T(b)).

The temporary regulations also provide an exception to the general rule that only partnerships that have received a notice of selection for examination may elect into the new partnership audit regime. Partnerships that have not received a notice of selection that wish to file an administrative adjustment request under Sec. 6227 may also elect into the new regime; however, partnerships not selected for audit cannot make the election before Jan. 1, 2018 (Temp. Regs. Sec. 301.9100-22T(c)).

Identical proposed regulations open to comment were issued at the same time.


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III. State Conformity.

At the state level calculating this tax liability and potential adjustments for different partner types may be significantly more complicated than at the federal level. If states try to adopt similar procedures in which the partnership can pay tax for the partners, various considerations will need to be examined, specifically regarding the different types of partners, nexus and apportionment. This section looks at the impact for California and discusses newly enacted legislation in Arizona conforming to the partnership audit rules.

A state will tax resident individuals on the entirety of their income but tax nonresidents on the portion of their income sourced to that state. Therefore, a state that chooses to adopt the federal rules may want the partnership to compute the tax for the resident individuals on the entire adjustment and not just the portion sourced to that state. However, what happens when the partnership is not doing business in the state where the individual partner is a resident? California will generally take the position that if the general partner is a resident (or California is the state of commercial domicile) then the partnership is also doing business in the state and is required to file (and if a limited partnership, pay the minimum franchise tax). If California adopts rules similar to the Budget Act, then they would probably require the partnership to make the state adjustment.

If the states do adopt these rules, and the general partner changes state of residence between the reviewed year and the adjustment year. Questions may arise on which state of residence should be used in calculating the tax -- should it be based on the partner's state of residence in the reviewed year or in the adjustment year? Additional issues regarding double taxation may arise if the original residence state and the new residence state enact conflicting approaches.

As discussed above, a state will tax resident individuals on all of their income but will tax nonresidents only on the portion of their income sourced to that state. To avoid double taxation, resident individuals usually receive a credit for taxes paid to nonresident states. California allows residents to claim a credit in the year the tax is paid to the other state, or within one year of the tax payment if made because of an audit. If the partnership pays the tax on the adjustment, then question are raised whether this would be deemed to be a payment of the partner and eligible for the credit for tax paid to other states. This would be the case with an S Corporation, but the law is not clear with respect to a partnership that pays the tax on behalf of the partnership.

A separate consideration is whether states permit a credit for entity-level taxes, such as the Illinois replacement tax. Several states allow the credit only for taxes imposed on the partner (that is, they do not allow a credit for entity-level taxes). How will these states differentiate between entity-level taxes and audit adjustments imposed on the partnership? This might not be a problem for states such as California that permit a credit for the resident individual's share of entity-level taxes. However, there are other forms of tax that, while not true income taxes, are treated as such for some purposes.

EXAMPLE:


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ABC Partnership has three partners A, B, and C during its first year of operation, 2012. Partner C leaves the firm and is replaced with Partner D in 2014. In addition, Partner E also joins the firm in 2014.

In 2015 an audit is concluded for year 2013, resulting in an assessment for underpayment. In the above scenario, in situations in which the entity pays the tax, the adjustment year partners -- Partners A, B, D and E-- will be liable for the underpayment obligation because the partnership is required to pay the tax in the adjustment year, and they are the partners during the adjustment year. Consider Partner C, who received a benefit through the underpayment of his or her tax obligation during the reviewed year. As a result, Partner C receives a windfall and Partner E is liable for a tax obligation that was incurred before Partner E was even a partner.

Further, it is not clear that partnerships have sufficient information to properly calculate the tax after credits. Many states (including California) require that a nonresident partner's tax be computed based on the taxpayer's everywhere income. Should the partnership proceed as if every partner is taxed at the highest rate in every state? The breadth of information that would be required to accurately calculate these taxes and the resulting credits could be substantial and inaccessible.

Multitiered structures are very complex and raise many additional questions under the Budget Act rules. . It is doubtful that tiered partnerships will have the information required to properly calculate the tax for the ultimate owners. For many tiered partnerships, this will require acquiring information from several tiers up the ownership chain. For example, state calculations require the income to be sourced to the state via apportionment or allocation. In California, for example, unitary partnerships may flow up apportionment factors and combine them with the upper-tier entity's apportionment factors.

A. Arizona

Despite the complexities noted above, Arizona has adopted these rules.

A.R.S. section 43-327(B)(1) provides that if the partnership passes through to each partner the partner's distributive share of the adjustments pursuant to A.R.S. section 43-1414(B)(2), the statement provided to the partner under A.R.S. section 43-1414(B)(2) is considered to be a change in taxable income by the IRS. The partners are then required to file amended returns within 150 days after the final determination of the partnership adjustments by the IRS, to report their share of the adjustments reported to them by the partnership under A.R.S. section 43-1414(B)(2). A partnership that passes the adjustments through to the partners is required to provide the statements to the partners within 90 days of the final determination of the partnership adjustments. Therefore, if the partnership provides the statements in the time required, the partners would have at least an additional 60 days (150 minus 90) to amend their Arizona income tax returns. Note: in the case of an increase in Arizona taxable income of the partnership, if the partnership does not provide the required statements to the department and the partners within the 90 days, the partnership has to pay the tax.


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A.R.S. section 43-327(B)(2) provides that if the partnership is required to pay the tax, the partnership shall pay the tax within 90 days of the final determination of the partnership adjustments by the IRS.

A.R.S. section 42-1104(B)(5) provides that if a taxpayer does not report the change by the IRS or fails to file an amended return as required by section 43-327, "the department may assess any deficiency resulting from such adjustments within four years after the change, correction, or amended return is reported to or filed with the United States Internal Revenue Service regardless of any previous examinations by the department."

• For purposes of amounts passed through to the partners, under A.R.S. section 43-327(B)(1), the adjustments to the partnership by the IRS are considered adjustments to the partners, and the partners are required to file amended returns with Arizona within 150 days of the final determination of the partnership adjustments by the IRS. Therefore, if the adjustments are passed through to the partner and the partner does not file the amended return to Arizona within the required 150 days, the department will have four years from when the federal change was made to the partnership to issue an assessment.

• If the tax is paid by the partnership, the partnership is required to file and pay the tax within 90 days of final determination by the IRS. Therefore, if the partnership does not file the amended return to Arizona and pay within the required 90 days, the department will have four years from when the federal change was made to the partnership to issue an assessment.

• Note: A.R.S. section 42-1106 provides that the period within which a claim for refund may be filed or allowed is the period in which the department may make an assessment under A.R.S. section 42-1104.

A.R.S. section 42-1104(B)(6) provides that if the taxpayer files within the period required in A.R.S. section 43-327, the department will have the longer of six months from the date the amended return is filed with the department or the period the SOL is open for other reasons.

The new law addresses situations in which the partnership is audited by the IRS and assessed an imputed underpayment under IRC section 6225. A.R.S. section 43-1414(B)(2) addresses situations in which the partnership was assessed an imputed underpayment for federal purposes but for Arizona purposes the adjustments result in a net reduction in Arizona taxable income. The definition of Arizona taxable income (A.R.S. section 43-1401) basically includes all the income and adjustments originally required to be reported by the partnership on their original Arizona partnership return plus the total determined under A.R.S. section 43-1414(A). The amount determined in A.R.S. section 43-1414(A) could be a reduction even though the federal adjustments are positive if the related Arizona subtractions are greater than the federal increase. Also, because the federal changes could include credit adjustments that do not apply to Arizona, the Arizona starting point after the federal credit adjustments are removed could be a net reduction.

The adjustments in A.R.S. section 43-1414(A) are to simply determine the correct income before apportionment. If the total adjustments are passed through to the partners


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(regardless of whether an increase or decrease), the apportionment and allocation provisions are not taken into account at the partnership level. This is similar to how the income is passed through on the original partnership return. The partnership calculates apportionment information for the partners to use, depending on the partner's situation.

For example:

• If the partner is a resident individual, no apportionment information is provided because a resident individual is taxable on all income regardless of source.

• If the partner is a nonresident, the partnership provides the apportionment information to determine the portion that is sourced to Arizona.

• If the partner is a corporation or another partnership, the information is provided by the partnership to the partner. However, how the apportionment is used will depend on whether the partnership income is considered business or nonbusiness income.

IV. S Corporations and Shareholder Expenses. IRS's determination that S corporation’s payments of personal expenses on behalf of President/sole shareholder were wages subject to employment taxes was rejected, although President was clearly employee since he was sole officer and performed substantial services for taxpayer, In addition, certain of the advances by a shareholder to his wholly owned corporation are loans, the Tax Court decides, even though there was no promissory note, interest or fixed repayment date. The owner, who was also the president of the company and performed substantial services, made multiple advances to his firm over the years. The parties treated the amounts as debt, and the shareholder expected to be repaid. The Tax Court held that the company’s payment of the owner’s personal expenses is a loan repayment. The S Corporation, which paid the shareholder’s monthly home mortgage and car payments, recorded the remittances as debt repayment on its books. IRS recharacterized them as wages, since the firm didn’t pay its owner a salary. But to the agency’s chagrin, the Court sided with the taxpayer . Evidence, including that taxpayer listed advances as loans on its books and consistently paid President's recurring home mortgage and personal vehicle expenses regardless of value of services he provided to it, showed that parties intended advances to create debtor-creditor relationship; and facts that number of those advances were made in years when business was operating profitably and growing showed that president had reasonable expectation of repayment such that those advances were in fact loans. And although advances he made in other years when business was struggling and when neither he nor taxpayer were able to obtain financing from unrelated 3d parties were more in nature of capital contributions, repayments it made during those years went to outstanding loan balance. (Scott Singer Installations, Inc. v. Commissioner, (2016) TC Memo 2016-161).

V. Partnerships and SMLLCs.


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Be aware that if your client is in a partnership that owns a single-member LLC your client could owe self-employment tax on the LLC’s income. Under existing rules, an individual who owns 100% of an LLC that elects to be disregarded for tax purposes pays SECA tax on self-employment earnings from the LLC’s activities. New regulations extend this to an LLC wholly owned by a partnership. The partners will owe SECA tax in the same manner as partners in a partnership that doesn’t own a disregarded entity. Additionally, the LLC won’t be the employer of any partner in the partnership. This eliminates the option of treating the partners as employees of the partnership and have their pay subject to W-2 withholding. Per the regs, the partners will have to make estimated self-employment tax payments.


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CHAPTER 10 CORPORATIONS


II. Apple’s Ruling from European Commission. ......................................................................... 1

III. Treasury Issues Inversion Regulations and Proposed Earnings Stripping Regulations ........ 3

II. Apple’s Ruling from European Commission.

The European Commission's initial announcement that it was investigating a number of tax rulings between Apple Inc. and Ireland focused largely on transfer pricing and whether certain agreements reflected the “arm's length” standard. However, the recent press release announcing the Commission's ruling that Apple Inc. pay up to $14.5 billion in taxes to Ireland focused largely on the “economic reality” of the overall arrangement. The decision has been met with significant criticism in the U.S., including by Apple itself, the Administration and politicians on both sides of the aisle. This could be seen as a plus, if it prompts Congress to move forward on corporate tax reform.

The “Treaty on the Functioning of the European Union” (TFEU) generally prohibits EU State aid by Member States (including Ireland) unless it is justified by reasons of general economic development. Article 107(1) of the TFEU defines State aid as “any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favoring certain undertakings or the production of certain goods...in so far as it affects trade between Member States.” The European Commission is in charge of ensuring compliance with EU rules on State aid.

Since June 2013, the European Commission has been investigating the “tax ruling” practices of EU Member States. Tax rulings are essentially comfort letters issued by tax authorities to provide a company clarity on how its corporate tax will be calculated or the use of special tax provisions. They include advance pricing arrangements (APAs), which are arrangements that determine in advance an appropriate set of criteria for the determination of the transfer pricing of certain intra-group transactions over a fixed period of time. According to the European Commission, tax rulings are legal, but they may not use methodologies that would give a company an unfair competitive advantage over other companies. Unless the selective advantage is justified by reasons of general economic development, it may violate EU State aid rules.

Apple Sales International and Apple Operations Europe are two Irish incorporated companies that are fully-owned by the Apple group, ultimately controlled by the U.S. parent, Apple Inc. They hold the rights to use Apple's intellectual property to sell and manufacture Apple products outside North and South America under a cost-sharing agreement with Apple Inc. under which they make yearly payments to Apple in the U.S. to fund research and


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development efforts conducted on their behalf. These expenses are deducted from the profits recorded by Apple Sales International and Apple Operations Europe in Ireland each year.

The taxable profits of Apple Sales International and Apple Operations Europe in Ireland are determined by a tax ruling granted by Ireland in '91, which in 2007 was replaced by a similar second tax ruling. This tax ruling was terminated when Apple Sales International and Apple Operations Europe changed their structures in 2015.

Apple Sales International is responsible for buying Apple products from equipment manufacturers around the world and selling these products in Europe (as well as in the Middle East, Africa and India). Apple set up their sales operations in Europe in such a way that customers were contractually buying products from Apple Sales International in Ireland rather than from the shops that physically sold the products to customers. As a result, Apple recorded all sales, and the profits stemming from these sales, directly in Ireland.

Ireland issued two tax rulings concerning the internal allocation of these profits within Apple Sales International that allowed most profits to be allocated away from Ireland to a “head office” within Apple Sales International. This “head office” was not based in any country and did not have any employees or own premises. Its activities consisted solely of occasional board meetings. As a result, only a fraction of the profits of Apple Sales International were subject to tax in Ireland. The remaining vast majority of profits were allocated to the “head office,” where they remained untaxed. Apple Operations Europe benefitted from a similar tax arrangement. The company was responsible for manufacturing certain lines of computers for the Apple group. The majority of the profits of this company were also allocated internally to its “head office” and not taxed anywhere.

According to a press release issued on June 11, 2014, the European Commission was undertaking an investigation of Apple's transfer pricing arrangement in Ireland. The release specifically described the Commission's role as examining whether “the individual rulings issued by the Irish tax authorities on the calculation of the taxable profit allocated to the Irish branches of Apple Sales International and of Apple Operations Europe” involve State aid. It stated that, based on preliminary analysis, the Commissioner had concerns that the calculations used to set the taxable basis “could underestimate the taxable profit.”

On the same day that the investigation was announced, the European Commission sent a letter to Ireland announcing its decision to initiate a formal investigation under the TFEU and requesting further information. The 21-page letter focused largely on transfer pricing, including a detailed description of the “arm's length” principle for allocating profit among companies within the same corporate group. It provided an overview of Apple's corporate structure in Ireland, including the two companies at the center of this dispute, as well as information on their taxable income, taxes paid, and applicable tax rulings. The letter noted that some of the terms of the tax rulings in question appeared “to be reverse engineered,” and it also questioned the appropriateness of the agreements based simply on their duration, which was significantly longer than standard APAs and which didn't necessarily take into account “possible changes to the economic environment.”


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In response to the European Commissioner's State aid investigations (including but not limited to Apple), the U.S. Treasury Department issued a White Paper on Aug. 24, 2016 expressing a number of concerns, including that the Commission was purportedly using an “EU-only” arm's length principle, undermining “the international consensus on transfer pricing standards.”

On Tuesday, Aug. 30, 2016, Apple was ordered to pay up to €13 billion ($14.5 billion) in taxes, plus interest to the Irish government after the Commissioner's ruling that a special scheme to route profits through Ireland was illegal state aid. The Ruling (as summarized in a press release issued by the EU) stated that the Irish tax rulings allowed the two companies to internally allocate almost all sale profits to purported “head offices” that the Commission concluded “existed only on paper,” had no employees or premises, and “were not subject to tax in any country.” Only the Irish branch of Apple Operations Europe had the capacity to generate any income from trading, i.e. from the production of certain lines of computers for the Apple group; therefore, sales profits of Apple Operation Europe should have been recorded with the Irish branch and taxed there.

The Commission determined that the tax treatment of Apple in Ireland is illegal under EU state aid rules, because it gives Apple a significant advantage over other businesses that are subject to the same national taxation rules. As a result of the allocation method endorsed in the two tax rulings issued by Ireland, Apple only paid an effective corporate tax rate that declined from 1% in 2003 to 0.005% in 2014 on the profits of Apple Sales International. Accordingly, the Commission ordered Ireland to re-allocate all profits from sales previously indirectly allocated” to the head offices and “apply the normal corporation tax” to these amounts.

III. Treasury Issues Inversion Regulations and Proposed Earnings Stripping Regulations A corporate inversion is a transaction in which a U.S.-parented multinational group changes its tax residence to reduce or avoid paying U.S. taxes. More specifically, a U.S.-parented group engages in an inversion when it acquires a smaller foreign company and then locates the tax residence of the merged group outside the United States, typically in a low-tax country. Typically, the primary purpose of an inversion is not to grow the underlying business, maximize synergies, or pursue other commercial benefits. Rather, the primary purpose of the transaction is to reduce taxes, often substantially. After a corporate inversion, multinational corporations often use a tactic called earnings stripping to minimize U.S. taxes by paying deductible interest to their new foreign parent or one of its foreign affiliates in a low-tax country. Treasury has previously said it was considering potential guidance in this area. In September 2014 and November 2015, Treasury announced guidance that made it more difficult for companies to undertake an inversion and reduced the economic benefits of doing so. In April, 2016 Treasury took additional action to address this problem by issuing temporary regulations on inversions and proposed regulations to address earnings stripping. Specifically, the temporary regulations make it more difficult for companies to invert by:


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Limiting inversions by disregarding foreign parent stock attributable to certain prior inversions or acquisitions of U.S. companies. Some foreign companies may avoid section 7874 – the tax code’s existing curbs on inversions - by acquiring multiple American companies over a short window of time or through a corporate inversion. The value of the foreign company increases to the extent it issues its stock in connection with each successive acquisition, thereby enabling the foreign company to complete another, potentially larger, acquisition of an American company to which section 7874 will not apply. Over a relatively short period of time, a significant portion of a foreign acquirer’s size may be attributable to the assets of these recently acquired American companies. In addition, Treasury also issued proposed regulations (also on April 4, 2016) which address the issue of earnings stripping by targeting transactions that increase related-party debt that does not finance new investment in the United States (Action under section 385 of the code)

· Under current law, following an inversion or foreign takeover, a U.S. subsidiary can issue its own debt to its foreign parent as a dividend distribution. The foreign parent, in turn, can transfer this debt to a low-tax foreign affiliate. The U.S. subsidiary can then deduct the resulting interest expense on its U.S. income tax return at a significantly higher tax rate than is paid on the interest received by the related foreign affiliate. In fact, the related foreign affiliate may use various strategies to avoid paying any tax at all on the associated interest income. When available, these tax savings incentivize foreign-parented firms to load up their U.S. subsidiaries with related-party debt.

· The proposed regulations make it more difficult for foreign-parented groups to quickly load up their U.S. subsidiaries with related-party debt following an inversion or foreign takeover, by treating as stock the instruments issued to a related corporation in a dividend or a limited class of economically similar transactions. For example, the proposed regulations:

Treat as stock an instrument that might otherwise be considered debt if it is issued by a subsidiary to its foreign parent in a shareholder dividend distribution: Address a similar “two-step” version of a dividend distribution of debt in which a U.S. subsidiary (1) borrows cash from a related company and (2) pays a cash dividend distribution to its foreign parent; and Treat as stock an instrument that might otherwise be considered debt if it is issued in connection with certain acquisitions of stock or assets from related corporations in transactions that are economically similar to a dividend distribution.

· The proposed regulations generally do not apply to related-party debt that is incurred to

fund actual business investment, such as building or equipping a factory.

· In addition, the proposed regulations only apply to debt issued between related corporations, subject to a general anti-abuse rule for structured transactions involving unrelated


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persons, that are members of groups that have more than $50 million of intercompany debt that otherwise would be treated as stock under the regulations. These proposed regulations apply to instruments issued after April 4. Treasury intends to move swiftly to finalize them.

· Under current law, instruments are generally treated as entirely debt or entirely equity for federal tax purposes. This all-or-nothing approach can create distortions when the facts support treating debt as part debt and part stock. The proposed regulations would implement statutory authority to treat an instrument issued to a related party as in part debt and in part equity to eliminate these distortions. Under current law, it can be difficult for the IRS to obtain information to conduct a debt-equity analysis of related-party instruments, especially information that demonstrates the intent to create a genuine debtor-creditor relationship. This lack of detail in a taxpayer’s documentation can make IRS enforcement difficult.

· Under the newly issued proposed regulations, companies are required to undertake certain due diligence and complete documentation up front to establish that a financial instrument is really debt. Specifically, the proposed regulations require key information be documented, including a binding obligation for issuer to repay the principal amount borrowed, creditor’s rights, a reasonable expectation of repayment, and evidence of ongoing debtor-creditor relationship.

· If these requirements are not met, instruments will be characterized as equity for tax purposes. Groups opposing the regs have filed a lawsuit. The U.S. Chamber of Commerce and the Texas Assn. of Business are asking a court to toss the part of the regulations that caused Pfizer and Ireland-based Allergan to call off their proposed merger. Pfizer Inc. decided to terminate its $160 billion merger with Allergan, marking an end to the largest-ever health-care acquisition as officials in Washington crack down on corporate inversions.

Pfizer will need to pay a $400 million fee to Allergan for expenses relating to the deal, the person said, asking not to be identified as the information is private. Allergan, which is run from New Jersey but has a legal domicile in Dublin, last year agreed to merge with Pfizer in a deal that would have given the New York-based company a foreign address and a lower tax rate.

In an inversion, a U.S. company shifts its tax address overseas, often through a merger. In the Pfizer-Allergan deal, the new company would have been located in Ireland. The Treasury Department said Monday that new rules would limit companies’ ability to participate in inversion transactions if they’ve already done them within the past 36 months. Allergan has been involved in several such acquisitions in that time frame. Ever since a tax-law change in 2004, the main way that U.S. companies have been able to claim a foreign address has been to buy a smaller company abroad and adopt its domicile. The law requires the foreign company to be at least one-fourth the size of the U.S. one. Monday’s proposed rule tightens that restriction by


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saying that if a foreign company has bulked up through mergers with other U.S. companies in the last three years, as Allergan has, that additional bulk isn’t counted toward its size.

In addition, the proposed regulations targeting earnings stripping is under a barrage of attacks. Earnings stripping is a tactic in which a foreign firm lends funds to a related U.S. firm, and the interest on the loan is written off by the borrower for U.S. tax purposes and is taxable to the foreign company at its lower rate. Under IRS’s proposed rules, this related-party debt is to be treated as stock in certain cases so that the “borrower” can’t take interest deductions on the instrument. Many business organizations and tax lobbyists say IRS has gone too far, and they’re asking it to pull the regulations


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CHAPTER 11 PROCEDURE


II. Compliance with PATH Act. .................................................................................................. 1 A. Qualified Real property ....................................................................................................... 1 B. Bonus Depreciation. ............................................................................................................ 2

1. Election to Forgo Bonus Depreciation ............................................................................. 2 III. IRS Voluntary Registration Program. .................................................................................... 2

IV. FACTA Reporting. ................................................................................................................. 4 A. Hom, 9th Circuit. .................................................................................................................. 4

II. Compliance with PATH Act.

In Rev. Proc. 2016-48, the IRS issued guidance for taxpayers to take advantage of a number of tax provisions that had expired at the end of 2014 but were retroactively extended to the beginning of 2015 in December 2015. Specifically, the procedure addresses Sec. 179 expensing, bonus depreciation, and the election to take a credit against alternative minimum tax (AMT) liability in lieu of bonus depreciation for “round 5 extension property.”

Sec. 179 permits a deduction for the cost of certain property placed in service during the tax year. The higher limits on this deduction ($500,000 expensing limit and $2 million phaseout threshold) were perpetually in danger of expiring as Congress did not make them permanent until it enacted the Protecting Americans From Tax Hikes (PATH) Act of 2015, Division Q of the Consolidated Appropriations Act, 2016, P.L. 114-113. The PATH Act also retroactively reinstated the $250,000 limit on qualified real property for 2015.

Bonus depreciation, which permits taxpayers to elect to take a current deduction of a percentage (currently 50%) of the cost of property for the year it was placed in service had also expired, but it was not made permanent by the PATH Act. It was extended retroactively and through 2019 (and 2020 for certain property). A related provision allows taxpayers to elect to forgo bonus depreciation and instead claim an AMT credit.

Because the PATH Act was enacted after many taxpayers had filed their 2014 returns, they may not know how to take advantage of these tax changes. The revenue procedure provides the procedures taxpayers must follow.

A. Qualified Real property

The PATH Act, which was signed into law on December 18, 2015, extended the election to use up to $250,000 of the $500,000 annual IRC 179 expensing limit to expense the cost of qualified real property. IRC sec. 179(f)(4), which prohibited a taxpayer from carrying unused


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IRC sec. 179 carryovers attributable to expensed qualified real property to a tax year beginning in 2015 and required the unused carryforward to be treated as property placed in service on the first day of a taxpayer’s last tax year beginning in 2014, was amended to allow carryover to tax years beginning in 2015 and prohibit carryovers to 2016. Unused carryovers are now required to be treated as placed in service on the first day of the last tax year beginning in 2015.

A taxpayer who filed a return for a tax year beginning in 2014 may have treated an unused IRC sec. 179 carryover attributable to qualified real property as property placed in service on the first day of the 2014 tax year in accordance with IRC sec. 179(f)(4), prior to amendment by the PATH Act.

In general, under the guidance, a taxpayer that treated an unused carryover of a IRC sec. 179 deduction on qualified real property as property placed in service on the first day of the taxpayer’s last tax year beginning in 2014 may continue that treatment or amend its 2014 return to carryover the disallowed deduction to its 2015 tax year return. Note that, if the 2015 return has already been filed, it will also be necessary to amend that return to deduct the unused carryforwards from 2014 and treat any unused portion of the carryforwards as property placed in service in 2015.

B. Bonus Depreciation.

For bonus depreciation, the revenue procedure applies to a taxpayer that did not claim the 50% additional first-year depreciation for some or all qualified property placed in service after Dec. 31, 2014, on its fiscal-year tax return beginning in 2014 and ending in 2015 or on its return for a short tax year of less than 12 months beginning and ending in 2015. The procedure explains what these taxpayers should do, depending on what choices they make with regard to bonus depreciation.

1. Election to Forgo Bonus Depreciation

Finally, the revenue procedure permits taxpayers to elect to treat round 5 extension property (property eligible for bonus depreciation under the PATH Act) as eligible for the AMT credit in lieu of bonus depreciation. The procedure explains how to do this and warns taxpayers that they must make the election in the first tax year ending after Dec. 31, 2014, even if they do not place any round 5 property in service in that year, if they wish to apply the election to property placed in service in a subsequent year.

III. IRS Voluntary Registration Program.

A. AICPA Litigation. In 2014, the American Institute of Certified Public Accountants sued IRS, claiming that its voluntary annual-filing-season program for unenrolled preparers is an end run around a prior ruling that struck down the registered tax return preparer rules. After a district court tossed the case, an appeals court reversed and sent it back down to the District Court. Now, for the second


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time in as many years, the district court has sided with IRS and thrown out the case, although it is expected that the AICPA will appeal the decision. (American Institute of Certified Public Accountants v. IRS et al.; No. 1:14-cv-01190, USDC DC, 8/3/16)

The return to the District Court did not turn out favorably for the AICPA, as the case was again dismissed, but this time because the AICPA claim failed the “zone-of-injury” test for the statute under which they filed the suit. As the opinion explains:

As the Supreme Court articulated in Lujan v. National Wildlife Federation, 497 U.S. 871 (1990), the grievance or interest relevant to the "zone of injury" inquiry is a precise one: "[T]he plaintiff must establish that the injury he complains of (his aggrievement, or the adverse effect upon him) falls within the [relevant statute's] ‘zone of interests.’” Id. at 883 (emphasis in original). Elaborating on this point, the D.C. Circuit has clarified that "on any given claim[,] the injury that supplies constitutional standing must be the same as the injury within the requisite ‘zone of interests.’” Mountain States Legal Found. v. Glickman, 92 F.3d 1228, 1232 (D.C. Cir. 1996) (emphasis added); accord Texas v. United States, 809 F.3d 134, 163 (5th Cir. 2015) (“Texas satisfies the zone-of-interests test not on account of a generalized grievance but instead as a result of the same injury that gives it Article III standing.”), aff’d by equally divided court sub nom. United States v. Texas, 136 S. Ct. 2271 (2016). This limitation is quite important here, as the only injury that currently supplies AICPA with constitutional standing -- competitive injury by way of brand dilution -- is a narrow one indeed.

The District Court on remand noted that the Court of Appeals had only granted the AICPA standing based on a “brand dilution” possibility under the program, even though the AICPA had primarily argued for “consumer confusion” as a harm under the program. The Court of Appeals had rejected the idea that “consumer confusion” had any impact on this case.

The District Court rejected the AICPA’s arguments of harm via consumer confusion and the requirement to supervise unenrolled preparers, finding the Court of Appeals had not found issue with the Court’s original conclusion that those do not give rise to a harm. Rather, the Court looks solely at the “dilution of the brand” concept for CPAs.

The Court held that the only valid theory would be that AICPA members are protected against unenrolled preparers by 5 USC §330(a). The Court then found that Congress’s primarily goal in enacting the limitations on practice before the IRS found in 5 USC §330(a) was to protect consumers and not the preparers allowed to practice.

B. Unenrolled Preparers Litigation. IRS’s voluntary program for unenrolled preparers may be under attack again. An unenrolled preparer in Texas and some of her clients have filed a lawsuit in federal District Court in New Mexico claiming that IRS lacks the authority to implement its annual filing season program. This is the annual filing season program which allows unenrolled tax return preparers to voluntarily become certified to prepare tax returns by taking various courses and passing certain exams. These unenrolled preparers allege that this program violates the Court of Appeals


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prior ruling that held that the IRS does not have the statutory authority to regulate tax return preparation. (Rivero et. al. v. Internal Revenue Service, 1:16-DV-946). The suit also alleges that the Service is improperly auditing and harassing taxpayers whose returns are done by preparers who opt not to take the 18 hours of courses. Four states regulate unenrolled preparers. They are California, Maryland, New York and Oregon. Oregon has a set of tough rules that have been in effect for years, requiring preparers who aren’t CPAs, lawyers or enrolled agents to register, pass a test and take classes. California, Maryland and New York all require a combination of registration and classes or testing. New York’s rules have recently been overhauled to impose stricter requirement. Illinois now monitors preparers, but chose not to regulate them. A new law requires preparers of Ill. tax returns to include their preparer tax ID numbers. The state’s tax authorities hope this will make it easier to identify problem preparers, i.e., those who habitually make errors or take unsubstantiated positions on returns and share the data with other states. Fines are imposed for failure to comply.

IV. FACTA Reporting.

A. Hom, 9th Circuit. A poker player’s accounts at two online poker websites were not foreign financial accounts for purposes of the Foreign Account Tax Compliance Act (FATCA). However, his account with an entity that engaged in money transmissions was a foreign financial account because the entity was located in and regulated by the United Kingdom. A gambler had accounts on two poker websites maintained outside the U.S. He was allowed to deposit and withdraw money and carry outstanding balances. A lower court ruled the accounts were subject to the foreign-account-reporting rules, but an appeals court nixed the ruling because the sites didn’t function as banks. The dictionary definition of a bank is "an establishment for the custody, loan, exchange or issue of money, for the extension of credit and for facilitating the transmission of funds" and there was no evidence that the online poker accounts were established for any of those purposes. They instead facilitated online gambling, and the funds were used to play poker. Therefore, he’s not required to report on the accounts to IRS each year (United States of America, Plaintiff-Appellee v. John C. Hom, Defendant-Appellant., U.S. Court of Appeals, Ninth Circuit, 14-16214, July 21, 2016.)

B. Expanded FACTA Reporting: Final Regs Require Domestic Entities To Report Foreign Assets Under FATCA

The IRS has issued final regs under IRC sec. 6038D that require "specified domestic entities" to report their interests in specified foreign assets under the Foreign Account Tax Compliance Act (FATCA). Unlike the reporting requirements for U.S. individuals with interests


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in specified foreign assets, which have taken effect, the rules for specified domestic entities do not take effect until tax years that begin after December 31, 2015.

Generally, taxpayers have to report their specified foreign assets if the assets have an aggregate value exceeding $50,000 on the last day of the year or $75,000 at any time during the year. These thresholds apply to both individuals and entities. Under Reg. §1.6038D-4, the taxpayer must report the maximum value of the specified foreign financial asset during the portion of the taxable year in which the specified person has an interest in the asset.

The IRS has previously issued temporary, proposed and final regs on the IRC sec. 6038D reporting requirements for reporting by individuals. The proposed regs also discussed reporting by entities, but the 2014 final regs did not address what entities are specified domestic entities.

The new final regs define a specified domestic entity as a domestic corporation, partnership or trust that is formed or used to hold, directly, or indirectly, specified foreign assets. The entity’s status is determined annually. The reporting requirements apply to a domestic corporation or partnership that satisfies two conditions:

• The entity is closely held by an specified individual; and • At least 50 percent of the entity’s gross income is passive income, or 50 percent of its

assets are assets that produce passive income.

A corporation is closely held if the individual owns, directly or indirectly, at least 80 percent of its stock by vote or value. Similarly, a partnership is closely held if an individual owns at least 80 percent of its profit or capital interests. Constructive ownership rules apply as defined under IRC sec. 267.

Under the final regs, the percentage of passive assets equals the weighted average percentage of passive assets, measured quarterly. The value of assets is their fair market value or book value reflected on the entity’s balance sheet. Passive income includes income from nine different categories, including dividends, interest, dividend equivalents, rents and royalties (unless from the entity’s trade or business), annuities, gains from the sale or assets producing passive income, commodity transactions, and income from notional principal contracts. The regs provide an exception for income of entities acting as dealers.

The proposed regs included a principal purpose test, providing that a corporation or partnership was a specified entity if at least 10 percent of its income or assets was passive and the entity was formed or used for a principal purpose of avoiding IRC sec. 6038D. The IRS concluded that the 50-percent tests sufficiently capture situations in which an individual may use the entity to circumvent the reporting requirements, and that entities should be able to determine their reporting obligations based on objective requirements, rather than a subjective tests. Although the final regs eliminate this test, the IRS warned that it would continue to monitor whether corporations and partnerships are being used inappropriately to avoid reporting.


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The IRS declined in the final regs to expand the exceptions for domestic entities to exclude certain domestic trusts, publicly traded partnerships, or employer trusts. In most cases, it thought that other rules were sufficiently broad to exclude these entities.

The IRS has issued proposed regulations which will require foreign-owned single-member U.S. LLCs to disclose their owner, get an employer identification number and comply with a strict reporting regime. The lack of current reporting rules for these disregarded entities allows foreign taxpayer to hide assets in them and go undetected. Proposed regulations would treat U.S. LLCs that are 100% owned by a foreign person as corporations for the limited purposes of reporting and record maintenance. They’d have to annually file IRS Form 5472 to disclose transactions between the entity and its owner or other related parties, such as sales, contributions and distributions. IRS would turn over the information to foreign governments under exchange agreements and also use it for domestic compliance purposes.

V. Installment Agreements

Paying overdue taxes in installments is about to become more expensive, as the IRS is proposing a substantial fee hike scheduled to go into effect January 1, 2017.

The Online Payment Agreement (OPA) may be used by individual with $50,000 or less in combined income tax liability, interest, and penalties, as well as businesses with $25,000 or less in combined tax, interest, and penalties. Taxpayers who are ineligible for an OPA generally use Form 9465, Installment Agreement Request. For installment agreements entered into before January 1, 2017, the IRS generally charges taxpayers a $120 user fee. The fee is only $52 for taxpayers who pay by direct debt from their bank account and $43 for low-income taxpayers. 91 The IRS charges taxpayers a user fee of $50 for restructuring or reinstating an installment agreement before January 1, 2017. (Reg. 300.1(b)).

For installment agreements entered into on or after January 1, 2017, the IRS has proposed to generally charge taxpayers a $225 user fee. The fee is proposed to increase to $107 for taxpayers who pay by direct debit from their bank account. Alternatively, the IRS has proposed a new user fee of $149 for taxpayers who apply for an installment agreement through the OPA application process. The fee is only $31 for taxpayers who apply the OPA process and pay by direct debit from their bank account. The user fee for low-income taxpayers is proposed to remain at $43, but will be reduced to $31 if the taxpayers apply for the agreement through the OPA process and pay by direct debit from their bank account. (Prop. Reg. 300.1(b)).

VI. Transferee Liability

A. U. S. v. McNicol (CA 1 7/15/2016).

The Court of Appeals for the First Circuit, affirming a district court, has found that a surviving spouse who served as executrix of her deceased husband's estate was personally liable


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for the estate's unpaid taxes in an amount equal to the value of the assets that she transferred to herself instead of using to pay the government's priority tax claim. The record established her liability under the federal priority statute—specifically, that she distributed assets of the estate, that the estate was insolvent, and that she was aware of the unpaid taxes at the time of the distribution.

The federal priority statute, 31 USC 3713, directs that the government be paid first when the estate of a deceased debtor has insufficient assets to pay all of its debts. Personal liability may be imposed upon a fiduciary of an estate who fails to honor a priority claim of the government. (31 USC 3713(b))

For personal liability to attach, the government must establish that:

(1) the fiduciary distributed assets of the estate;

(2) the estate was insolvent at the time of the distribution or the distribution rendered the estate insolvent (i.e., with liabilities in excess of assets); and

(3) the distribution took place after the fiduciary had actual or constructive knowledge of the liability for unpaid taxes..

Robert Reitano died in July of 2002, survived by his wife (appellant Marci McNicol; executrix of the estate) and four minor children. At the time of his death, Mr. Reitano owed over $340,000 in unpaid federal income tax liabilities. Since these liabilities exceeded the value of his estate, the estate was insolvent

The assets of the estate consisted almost entirely of stock in two corporations, one 100% owned by the estate, the other 50% owned by the estate and 50% owned by Ms. McNicol.

Nothing was paid, and IRS eventually served Ms. McNicol with a formal notice of potential liability under the federal priority statute (31 USC 3713(b)) and brought suit. The district court ultimately held on summary judgment that she was liable under the federal priority statute up to the value of the transferred assets and entered judgment against her personally for $125,938. This amount reflected the selling price of the assets of the estate, less a lien against one. Ms. McNicol appealed.

The Court determined that Ms. McNicol's was liable under 31 USC 3713(b) and concluded that the district court's determination was proper. The acknowledged facts unambiguously showed that she effected asset transfers by distributing “virtually all” of the assets of Mr. Reitano's estate to herself, that the estate was insolvent at the time of the transfers because its tax liabilities far exceeded the value of its assets, and that she was aware of the unpaid tax liabilities at the time of the transfers.

VII. Professional Employer Organizations.


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Effective for wages for services performed on or after January 1, 2016, a certified professional employer organization (CPEO) is treated as the sole employer of a work site employee performing services for a customer of the CPEO with respect to remuneration the CPEO paid to the employee. (IRC sec. 3511as added by the Achieving a Better Life Experience Act of 2014, P. L. 113-295, Act §206(a) (December 19, 2014); Proposed Reg. 31.3511-1(a)(1)). A CPEO is a person who:

(1) timely applies to be treated as a certified professional employer organization; and (2) has been certified by the IRS as meeting the requirements for certification.

The IRS has provided detailed procedures for applying to become certified as a CPEO, as well as interim guidance that modifies and clarifies certain application requirements. Applicants will apply electronically (no paper applications will be accepted). The IRS began accepting application materials in July 2016.

For a CPEO to qualify as the sole employer of a particular individual, at least 85 percent of the individuals performing services for the CPEO’s customer at the work site where the individual works must be employed under contract with the CPEO. The CPEO rules do not apply when a customer is related to the CPEO, and in certain other situations.

Employers sometimes contract with a professional employer organization (PEO)—also known as an employee-leasing organization—to help the employer lower health and worker's compensation insurance costs, or provide other employee benefits. The PEO performs the federal employment tax withholding, reporting, and payment functions related to workers performing services for the client. A PEO might also perform other functions for the client, such as managing human resources, employee benefits, workers compensation claims, and unemployment insurance claims.

Generally, a PEO is one party of a three-party transaction. The PEO contracts with the workers to provide services to the lessee. The PEO also contracts with its customers to provide the workers that the customer needs. The customer generally pays the PEO an administration fee that is a percentage of the total payroll for these services. This fee is added to the employer's other payroll costs, such as income tax withholding, FICA and FUTA taxes, and insurance premiums.

The PEO essentially becomes the workers' employer for tax and insurance purposes. It is responsible for paying the employees and for the related federal employment tax compliance, while the lessee-employer client retains control of the workers' day-to-day activities. In most cases, however, the employees working in the client’s business are the client’s common-law employees for federal tax purposes, and so the client is legally responsible for federal employment tax compliance.

The CPEO program is voluntary; a person is not obligated to apply for or obtain certification as a CPEO.


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VIII. Record Retention. The IRS reminds taxpayers who are employers that they must keep payroll tax records for at least four years after the due date for employees to file their income tax returns for the particular year, Records to be retained include wages, payment dates, and employee data such as their names, dates of employment, Social Security numbers and addresses. Also, copies of all W-4 forms, payroll returns, and amounts and dates of tax deposits. In addition, copies of worker health coverage forms should be kept at least three years after the deadline for filing these documents. These are the 1094 and 1095 forms that, starting this year, many employers must file to report employee insurance data.


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CHAPTER 12 DEFERRED COMPENSATION AND RETIREMENT PLANS


II. IRA Rollover Deadlines. ......................................................................................................... 1 III. Section 83(b) elections. .......................................................................................................... 2

II. IRA Rollover Deadlines.

In Rev Proc. 2016-47, the IRS announced that a taxpayer who fails to meet the requirement to roll over distributions from retirement accounts within the normal 60-day period can make a written self-certification to an IRA trustee or plan administrator that a contribution meets one of the 11 specific reasons listed in the revenue procedure for excusing the missed 60-day deadline. The trustee or administrator can rely on the taxpayer’s self-certification, subject to verification if the taxpayer is audited. The certification must match the sample in the appendix of the revenue procedure word for word or be “substantially similar in all material respects.”

To qualify for this relief, the IRS cannot have previously denied relief to the taxpayer for that rollover, and the taxpayer must have missed the 60-day deadline for one of the following 11 reasons:

• The financial institution receiving the contribution or making the distribution to which the contribution relates made an error;

• The distribution check was misplaced and never cashed; • The distribution was deposited into an account that the taxpayer mistakenly thought was

an eligible retirement plan; • The taxpayer’s principal residence was severely damaged; • A member of the taxpayer’s family died; • The taxpayer or a member of the taxpayer’s family was seriously ill; • The taxpayer was incarcerated; • Restrictions were imposed by a foreign country; • The post office made an error; • The distribution was made on account of a levy under Sec. 6331, the proceeds of which

have been returned to the taxpayer; or • The party making the distribution delayed providing information that the receiving plan

or IRA required to complete the rollover despite the taxpayer’s reasonable efforts to obtain it.

The rollover contribution must be made to the plan or IRA as soon as practicable after the reason or reasons for missing the 60-day deadline no longer prevent the taxpayer from making


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the contribution. This requirement is deemed to be satisfied if the contribution is made within 30 days after the reason or reasons no longer prevent the taxpayer from making the contribution. Form 5498, IRA Contribution Information, will be amended to permit plan trustees or administrators to report these rollovers. The plan administrator or IRS trustee may rely on the certification unless it is aware of facts contrary to the self-certification.

According to the IRS, the taxpayer’s self-certification is not a waiver of the 60-day requirement because the IRS can still deny the waiver on audit if it determines the taxpayer did not meet the requirements.

Rev. Proc. 2016-47 also includes a sample self-certification letter for taxpayers to give to their IRA trustee or retirement plan administrator. The revenue procedure is effective August 24, 2016.

III. Section 83(b) elections. Final regs, which adopt 2015 proposed reliance regs without change, eliminate the requirement that taxpayers submit a copy of a IRC sec. 83(b) election with their tax returns for the year in which the property subject to the election was transferred. Under this election , taxpayers can choose to report income in the year nonvested property is received in connection with the performance of services rather than when the property is substantially vested under the IRC sec. 83 rules. IRC sec. 83(b)(1) provides that any person who performs services in connection with which property is transferred may elect to include in gross income for the tax year of the transfer the excess of the fair market value of the property over the amount paid for it. IRC sec. 83(b)(2) provides that an election made pursuant to IRC sec. 83(b)(1) must be made in the manner prescribed by IRS and must be made not later than 30 days after the date of the transfer. Under the prior version of Reg. §1.83-2(c), a IRC sec. 83(b) election was made by filing one copy of a written statement with the IRS office with which the taxpayer files his return. In addition, one copy of such statement had to be submitted with the income tax return for the year of transfer. Since the introduction of the e-file program, IRS has encouraged taxpayers to file returns electronically. However, in recent years, it became aware that many taxpayers who wished to electronically file (e-file) their annual income tax return have been unable to do so because of the requirement in the prior version of Reg. §1.83-2(c) that they submit a copy of their IRC sec. 83(b) election with their income tax return. The 2015 proposed reliance regs eliminated the requirement that taxpayers must submit a copy of a IRC sec. 83(b) election with their tax return for the year in which the property subject to the election was transferred. This was accomplished by removing the second sentence from the prior version of Reg. §1.83-2(c). (Prop Reg § 1.83-2(c)) In the preamble to the proposed regs, IRS reminded taxpayers of their general


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recordkeeping responsibilities under IRC sec. 6001 , and more specifically of the need to keep records that show the basis of property owned by the taxpayer. Taxpayers must maintain sufficient records to show the original cost of the property and to support the tax treatment of the property transfer reported on the taxpayers' returns. Generally, a copy of any IRC sec. 83(b) election made with respect to property must be kept until the period of limitations expires for the return that reports the sale or other disposition of the property.

The final regulations apply to property transferred on or after Jan. 1, 2016, but taxpayers also may rely on the guidance in the identical proposed rules for property transferred on or after Jan. 1, 2015. In addition, Rev. Proc. 2012-29, which provides the general rules for making a Sec. 83(b) election, is revoked to the extent it is inconsistent with these regulations.


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CHAPTER 13 ESTATE TAX


II. Estate Tax Deductions ............................................................................................................. 1 A. Estate of James Heller, (2016) 147 TC No. 11. ................................................................... 1

III. Basis Reporting. ..................................................................................................................... 2

II. Estate Tax Deductions

A. Estate of James Heller, (2016) 147 TC No. 11. The Tax Court has upheld an estate's theft loss deduction under IRC sec. 2054 for losses

incurred by a limited liability company (LLC) in which it held a 99% interest. The LLC's sole asset was an account that, during the settlement of the case, became worthless as a result of Bernie Madoff's Ponzi scheme.

The federal estate tax is imposed on the transfer of an individual's property at death and on certain other transfers. The tax is imposed on the "taxable estate," which is the value of the gross estate reduced by various deductions. One such deduction is for casualty losses incurred during the settlement of the estate, including losses arising from fires, storms, shipwrecks or other casualties, or from theft, if the losses are not compensated for by insurance or otherwise.

James Heller (the decedent) died on Jan. 31, 2008. At that time, he owned a 99% interest

in James Heller Family, LLC (JHF), with the remaining 1% shared equally by his son and daughter. Harry Falk managed JHF, the only asset of which was an account with Bernard L. Madoff Investment Securities, LLC (the Madoff account).On or around Mar. 5, 2008, Mr. Falk and the decedent's children were appointed coexecutors of the decedent's estate. Between Mar. 4 and Nov. 28, 2008, Mr. Falk withdrew $11.5 million from the Madoff account and distributed it according to JHF's ownership interests, with the estate's share, approximately $11.4 million, used to pay taxes and administrative expenses.

On Dec. 11, 2008, Bernard Madoff was arrested and charged with securities fraud relating to a multibillion-dollar Ponzi scheme. Mr. Madoff ultimately pled guilty to various Federal crimes on Mar, 21, 2009, including securities fraud, investment adviser fraud, money laundering, and perjury. As a result of the Ponzi scheme, the Madoff account and the estate's interest in JHF became worthless.


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On Apr. 1, 2009, the estate timely filed Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, on which it reported a $26.3 million gross estate, including the $16.6 million date-of-death value of the decedent's 99% interest in JHF. The estate also claimed a $5.2 million theft loss deduction relating to the Ponzi scheme, the amount of which reflected the difference between the value of the estate's interest in JHF reported on the estate tax return and the estate's share of the amounts withdrawn from the Madoff account throughout 2008 before it became worthless ($16.6 million − $11.4 million).

IRS issued the estate a notice of deficiency on Feb. 9, 2012 disallowing the theft loss deduction because the estate didn't incur a theft loss during its settlement. The estate challenged this disallowance in the Tax Court.

The Tax Court allowed the deduction. The estate tax, the Court reasoned, is one imposed on the value of property transferred to beneficiaries, and a loss in that context is a reduction in the value of property held by the estate. Thus, JHF's loss of its sole asset as a result of the Ponzi scheme resulted in the estate incurring a loss during its settlement because the value of its interest in JHF decreased from $5.2 million to zero.

The Court rejected IRS's argument that the loss was incurred by JHF and not the estate, finding that such was contrary to the broad "arising from" language of IRC sec. 2054. Looking both to the plain language of the statute as well as to relevant case law, the Court found that there was a "sufficient nexus" between the theft and the estate's loss to allow the deduction. Notably, the nexus between the theft and the value of the estate's JHF interest was "direct and indisputable," in that the worthlessness of the interest arose from the theft.

In addition, the Court found that its construction was consistent with the purpose of the estate tax. It noted that estate tax deductions are designed to ensure "that the tax is imposed on the net estate, which is really what of value passes from the dead to the living." (Jacobs, (1936) 34 BTA 594 ) Here, the theft extinguished the value of the estate's JHF interest, diminishing the value of property available to the decedent's heirs.

III. Basis Reporting. The basis of property received by reason of a decedent’s death must be consistent with the value for estate tax purposes. The basis of any property to which the stepped-up basis rules of IRC sec. 1040 apply shall not exceed (1) the estate tax value and (2) in the case of the value of property that is not finally determined for estate tax purposes and with respect to which a state-ment is provided by the executor in accordance with IRC sec. 6035 the value reported on that statement. The consistency in reporting is applicable to property that was includible in the dece-dent’s gross estate and resulted in increased estate tax liability (reduced by applicable credits) on the estate.

The executor of an estate that is required to file a federal estate tax return under IRC sec. 6018 or a beneficiary that is required to file a return under IRC sec. 6018 must provide to the IRS


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and to each person acquiring an interest in property that was included in the decedent’s gross es-tate a statement that identifies the value of each interest in property as it was reported on the es-tate tax return. The information is reported on Form 8971, Information Regarding Beneficiaries Acquiring Property From a Decedent.

The filing requirements do not apply to estate tax returns filed solely for the purposes of making a portability election or a generation-skipping transfer tax election or exemption alloca-tion.

Form 8971 must be furnished to the IRS at the time prescribed by the IRS. This time will be no later than the earlier of:

• the date which is 30 days after the due date of the federal estate tax return (including ex-tensions); or

• the date which is 30 days after the date the estate tax return is filed.

The IRS has delayed the due dates for Form 8971 until June 30, 2016. The IRS issued the delay in order to provide executors and such other persons the opportunity to review the proposed reg-ulations to be issued under Code Secs. 1014(f) and 6035 before preparing a Form 8971 and any Schedule A. Notice 2016-27.


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CHAPTER 14 PAYROLL TAXES


II. Form W-2 filing changes. ....................................................................................................... 1 III. Self-Employment Tax ............................................................................................................ 1

A. Thomas L. Ryther v. Commissioner. .................................................................................... 1

II. Form W-2 filing changes. A reminder that employers face W-2 filing changes beginning next year. Employers will be required to file W-2s with the federal government by Jan. 31, up from the current deadlines of Feb. 28 for paper returns and March 31 for e-filings. The earlier due date will match the date for sending copies of the forms to employees. The Jan. 31 deadline will also apply to 1099s reporting nonemployee compensation. IRS stated previously that having these forms earlier will help it spot tax ID theft and fraudulent refunds. In addition, only the final four digits of Social Security numbers need go on W-2s sent to employees. The full number will have to be listed on the copy the Service gets.

III. Self-Employment Tax

A. Thomas L. Ryther v. Commissioner.

In Ryther v. Commissioner, (U.S. Tax Court, Dkt. No. 17002-13, TC Memo. 2016-56, March 28, 2016) the issue was whether the activity (which generated $300,000 over a seven year period) was subject to self-employment tax. The Tax Court held that the taxpayer was not liable for self-employment tax on the income generated by his sales of scrap steel. The scrap was not held for sale to customers in the ordinary course of a trade or business because the sales were not part of a trade or business. The individual acquired the scrap steel after it was abandoned by the trustee of his bankrupt steel fabrication business. Over several years, the individual sporadically sold the scrap steel; he did not do anything to create the scrap, or to enhance its value, and he sold it for the published market price with very little effort. He only made one or two sales a month over seven years, but generated more than $300,000 in sales. He reported the sales as other income (thus avoiding the self-employment tax).

The Tax Court ruled that he did not owe the SECA tax because his sporadic sales activity did not give rise to a trade or business. In addition, the individual did not use the proceeds from the scrap sales to purchase more scrap, but continued to slowly liquidate the large pile of abandoned scrap to pay his personal expenses.


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CHAPTER 15 OTHER MATTERS


II. Payroll Agents and Penalties. .................................................................................................. 1 A. Kimdun Inc., D. C. California. ............................................................................................ 1

II. Payroll Agents and Penalties.

A. Kimdun Inc., D. C. California.

A payroll agent’s embezzlement doesn’t void a penalty for undeposited taxes. The employer remains on the hook for the taxes, a district court decides, even though the payroll service stole the tax deposits (Kimdun Inc., D.C., Calif.). These cases are extremely troubling and is most likely the primary factor which influenced Congress to pass a law requiring the Service to establish a voluntary certification program for professional employer organizations. Many employers that use certified payroll agents will not be liable for penalties

Effective for wages for services performed on or after January 1, 2016, a certified professional employer organization (CPEO) is treated as the sole employer of a work site employee performing services for a customer of the CPEO with respect to remuneration the CPEO paid to the employee. A CPEO is a person who:

(1) timely applies to be treated as a certified professional employer organization; and (2) has been certified by the IRS as meeting the requirements for certification.

Employers sometimes contract with a professional employer organization (PEO)—also known as an employee-leasing organization—to help the employer lower health and worker's compensation insurance costs, or provide other employee benefits. The PEO performs the federal employment tax withholding, reporting, and payment functions related to workers performing services for the client. A PEO might also perform other functions for the client, such as managing human resources, employee benefits, workers compensation claims, and unemployment insurance claims. The PEO essentially becomes the workers' employer for tax and insurance purposes. It is responsible for paying the employees and for the related federal employment tax compliance, while the lessee-employer client retains control of the workers' day-to-day activities.


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For a CPEO to qualify as the sole employer of a particular individual, at least 85 percent of the individuals performing services for the CPEO’s customer at the work site where the individual works must be employed under contract with the CPEO. For employment tax purposes, a CPEO entering into a service contract with a customer with respect to a work site employee is treated as the successor employer, and the customer is treated as the predecessor employer for the duration of the service contract.

Effective for wages for services performed on or after January 1, 2016, a certified professional employer organization (CPEO) is treated for federal employment tax purposes as the sole employer of a covered employee performing services for a customer of the CPEO with respect to remuneration paid to the employee by the CPEO. There are a number of special rules that apply to the certified CPEO which are beyond the scope of this item.


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CHAPTER 1 NEXUS

I. Table of Contents II. Developments. .................................................................................................................................. 1

A. Statutory Standards defining nexus. ........................................................................................................ 1 1. States that now use a Statutory Nexus Standard. ........................................................................................... 1 2. Ohio: Crutchfield v. Testa. .................................................................................................................................. 1

B. State Challenges to “physical presence” requirement of Quill. ............................................................ 3 C. Waters Edge 80/20 requirement. .............................................................................................................. 4

III. Update on Flow Through Entities. ............................................................................................... 6 A. Out of State Corporate Ownership Interest in a Pass-Through Entity. ............................................... 6

1. General Partnership Ownership Interest. ......................................................................................................... 6 2. Limited Partnership interest and LLCs. ............................................................................................................ 6 3. Out of State LLC doing business in the State because of activities of LLC Member in the State. 18

IV. Sales Tax Nexus Issues. .............................................................................................................. 20

II. Developments.

A. Statutory Standards defining nexus.

1. States that now use a Statutory Nexus Standard. Nine states have adopted a statutory standard for nexus are Alabama, California, Colorado, Connecticut, Michigan, New York, Ohio, Tennessee, Virginia and Washington. The economic standard threshold adopted by these states varies.

2. Ohio: Crutchfield v. Testa.

An interesting issue is being presented to the Ohio Supreme Court in Crutchfield v. Testa (Ohio Supreme Court, Case No. 2015-0386). Ohio imposes the CAT on taxpayers with annual gross receipts from Ohio customers in excess of $500,000. The taxpayers in Crutchfield are Internet retailers with no “standard” physical presence in Ohio such as employees, merchandise, etc. Oral argument was held on May 3, 2016.

This case challenges the factor-based presence standards and has significant implications for both sales and use tax and franchise/income tax purposes. Ever since the U.S. Supreme Court’s decision in Quill Corp. v. North Dakota (504 U. S. 298, May 26, 1992) it has been understood that under the U.S. Commerce Clause, some type of physical presence is required for purposes of establishing taxable nexus for sales and use tax purposes. Although, both federal and


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state courts have upheld various scenarios involving economic nexus as meeting constitutional requirements for assessing a state income/franchise tax and sales tax.1 The lower courts in the Ohio litigation have upheld the State’s factor based nexus standard.

The issue appears to be a secondary one, likely only a fallback in the event that the state's factor-presence nexus standard is not constitutional. But if "Internet nexus" can be successfully invoked, it would have even broader implications. Rather than imposing tax on major retailers with at least half a million dollars in in-state sales, the rule could impose the CAT on every business that sells products on its website or offers a smartphone application.

The theory that is developing is that digital communications can establish physical presence by letting a customer download a mobile app or by leaving behind HTTP "cookies" -- small files that track a customer's activity on a website.

The taxpayers argue that the department is basing its assessments in part on a novel theory of "Internet nexus," in which a business can have a virtual presence in Ohio when a customer in the state accesses the company's website from a computer or mobile device in the state.

The theory is based on several reports that have studied digital security and privacy issues. The first report was written by Ashkan Soltani, then a consultant on digital security and privacy issues, and now the chief technologist for the Federal Trade Commission. The Soltani report begins with a look at the operation of browser cookies, which are small data files saved onto customers' computers each time they visit a website.

The report said that the files can come from the company that owns the website itself, or may come from a third party hired by the company to provide other services, such as advertising, marketing, or tracking. A cookie can store a vast amount of information -- a customer's physical location, the products looked at, the links clicked, the products placed into an online shopping cart, the customer's search history, and plenty more.

When the user leaves the website, the cookie is left behind on the computer to relay all that information back to the website the next time the user revisits it.

Looking specifically at the cookies from Newegg's website (a second company involved with Ohio on the same issue) , the report said it found more than 50 different cookies left behind -- one from the company itself and dozens more from third parties.

When a customer moves off his computer and into a mobile application, the report said, retailers have access to even more detailed information because a smartphone can generate cookies that more reliably identify the customer and his exact location.

1 Tenth Circuit recently ruled that physical presence is not required for sales and use notice and reporting requirements. (Direct Marketing Assoc. v. Brohl, U. S. Court of Appeals 10th Circuit, Case No. 12-1175.)


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The report also noted that Newegg uses "caching" to help its website load faster, pushing image files and other pieces of data onto the customer's computer so that they do not need to be repeatedly downloaded. The website will instruct the customer's computer to retain those files after the customer leaves the website, sometimes for decades.

The nexus arguments are that a retailer establishes a physical presence by leaving behind cookies and cached files on computers and smartphones throughout the state. The second argument is directed at Quill's purposeful availment test, arguing that Newegg used these technologies in order to target and provide services to residents of the State of Ohio. By collecting incredibly detailed information about customers' geographic location and purchasing preferences -- and then using that information to tailor their websites and marketing for individual customers -- retailers are deliberately directing their efforts at customers in Ohio, the report said.

A second report from Professor Joseph Turow of the University of Pennsylvania, takes another angle altogether -- putting digital marketing into historical context and setting up an argument that websites have become the functional equivalent of a door-to-door salesman in the customer's home.

"The basic proposition of the door-to-door salesman is that his interactions with customers yield actionable information," the report said. "This has expanded such that an industry, rather than one person, interacts with customers, categorizes their behaviors, and develops suggestions for other sellers based on them."

In one example, the data may tell a retailer that a customer spent time looking at a product and at least began the process of purchasing it before eventually aborting the entire transaction. Newegg would use that information to remarket the product on the user's next visit to the website, or send an e-mail with a coupon for the product, the report said. Although it's still a remote sale, the report argued, that level of interaction makes online marketing less like mail orders or telephone sales, and more like sending a salesman to knock on the customer's door and customize a pitch based on the cues in her house and her responses to his questions and suggestions.

It is important to note that more and more states are adopting a factor-based threshold for corporate franchise and income tax purposes (Alabama, California, Colorado, Connecticut, Michigan, New York, Ohio, Tennessee, and Virginia). Some states, such as South Dakota,4 are even abandoning the physical presence test and adopting factor-based nexus thresholds for sales and use taxes as well. In South Dakota, economic nexus is established for entities exceeding annual South Dakota sales of $100,000 or 200 transaction sales of tangible personal property, products transferred electronically, or services for delivery into South Dakota.

B. State Challenges to “physical presence” requirement of Quill.

Wayfair Inc., Overstock.com, Inc., and Newegg Inc. have filed suit challenging the recently enacted South Dakota sales tax statute (which was enacted to challenge the physical


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presence standard set by Quill with respect to sales tax collection by the state).This case presents a single question of federal constitutional law: whether the "physical presence" substantial nexus standard of Quill Corp. v. North Dakota, 504 U.S. 298 (1992) -- an opinion that remains undisturbed by subsequent congressional or Supreme Court action -- bars the imposition of a sales tax collection and reporting obligation upon the Defendants under South Dakota Senate Bill 106 ("S.B. 106" or "the Act")). On March 22 South Dakota Gov. Dennis Daugaard (R) signed into law SB 106, which provides that "any seller selling tangible personal property, products transferred electronically, or services for delivery into South Dakota, who does not have a physical presence in the state" is required to remit sales tax if in the prior or current calendar year the seller meets either of two alternative criteria: (a) the seller's gross revenue from sales delivered into South Dakota exceeds $100,000; or (b) the seller made sales for delivery into South Dakota in 200 or more separate transactions. The bill contains a lengthy statement of legislative purpose, which proclaims an "urgent need for the Supreme Court of the United States to reconsider [the Quill ] doctrine" and asserts an "immediate intent to require collection of sales taxes by remote sellers."8 The law took effect May 1.

Other states have followed the South Dakota lead. In September 2015 the Alabama Department of Revenue promulgated a much-ballyhooed regulation that expressly applies to out-of-state sellers "who lack an Alabama physical presence but who are making retail sales of tangible personal property into the state."4 Under the rule, an out-of-state seller is subject to Alabama sales and use tax collection obligations without regard to any physical presence in the state if the seller (1) makes at least $250,000 in sales to Alabama customers and (2) engages in any of the activities that, by statute, purport to require tax reporting in the state. The rule's adoption followed fast on the heels of the Legislature's enactment of the Simplified Sellers Use Tax Remittance Act, a new law that allows sellers that have no physical presence in Alabama to collect and remit a flat 8 percent sales tax on all sales into the state, rather than the combined state and local tax (which can be more, or less, than 8 percent in total) for each of the state's hundreds of local taxing jurisdictions. Alabama Commissioner of Revenue.

C. Waters Edge 80/20 requirement.

A foreign corporation that has established economic nexus without any physical presence in California could make a water's-edge election to avoid including its income and factors in the combined report. The key question for such an election is what income will be excluded – a deceptively complex question made even more difficult by the adoption of economic nexus provisions.

Under existing law, a business entity is considered to be doing business in California for tax years beginning on or after Jan. 1, 2011, if it actively engages in any transaction for the purpose of financial or pecuniary gain or profit. In addition, if a business entity has a minimum amount of property, payroll, or sales in California, then it will be considered to have economic nexus in California. In 2015, those amounts were $53,644 of property or payroll and $536,446 of sales.


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If a foreign corporation has established economic nexus in California, then it will have a filing requirement and be subject to California's franchise tax. The general rule is that all foreign corporations are excluded from the water's-edge combined report if the election is in effect. Therefore, if the foreign corporation makes a water's-edge election, it can exclude its income and factors from the water's-edge return unless it has either effectively connected income (ECI) or a 20% or higher U.S. apportionment factor.

Although these corporations are included in the Water’s Edge tax return, the way they are included is different. If the foreign corporation has ECI, then it will be included in the combined report to the extent of its ECI. If the foreign corporation has a 20% or higher U.S. apportionment factor, then it will be fully included in the water's-edge combined report.

If a foreign corporation does not have any ECI, it may still be included in the water's-edge combined report if its U.S. apportionment percentage is 20% or more (Cal. Code Regs. tit. 18, §25110(d)(2)(B)). Cal. Rev. & Tax. Code Section 25110(a)(1)(B) states that any corporation (other than a bank) will be fully included in the water's-edge combined report regardless of where it is incorporated if the average of its property, payroll, and sales factors within the United States is 20% or more. The general rule requires the use of a three-factor evenly weighted apportionment formula to determine whether the 20% test is met. Although a single sales factor formula is required for years beginning on or after Jan. 1, 2013, the regulations still retain the rules for determining the property and payroll factor (Cal. Code Regs., tit. 18, §§25129 and 25132).

When California changed to a double-weighted sales factor for years beginning on or after Jan. 1, 1993, the Franchise Tax Board issued Legal Ruling 95-5 to address questions raised by taxpayers regarding the calculation of the 20% U.S. apportionment factor rule. The question was whether to apply the double-weighted sales factor to the calculation or continue to apply the traditional three-factor formula. The legal ruling concluded that the three-factor formula should continue to apply for purposes of the 20% rule even though the apportionment factor rules changed to a double-weighted sales factor. Based on the analysis in Legal Ruling 95-5, it would appear that California will continue to apply the three-factor formula today.

The market-based-sourcing rules apply to the single sales factor formula, however if California is going to require a three-factor formula in determining the 20% rule, then it would typically follow the cost-of-performance rules would apply. These rules were left in the statute (despite the fact that California has now switched to market based sourcing.) This was done for the express purpose of providing taxpayers with a reference point if the property / payroll factor continued to be required for certain computations.

In summary, since California now applies the economic nexus and market-based-sourcing rules, a foreign corporation with no physical presence in California may actually have a filing requirement and taxable income in the state. A water's-edge election will not necessarily prevent the foreign corporation from having to partially or fully include its income and factors in the combined report. If the entity meets the 20% test or has ECI, then it will be included in the Water’s Edge tax return regardless of whether these numbers fall below the statutory standard.


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III. Update on Flow Through Entities.

A. Out of State Corporate Ownership Interest in a Pass-Through Entity.

In many, but not all, states, corporations that have an interest in a pass-through entity must aggregate its apportionment factors with its distributive share of the pass-through entity's factors. This is not, however, a hard-and-fast rule. Some states require apportionment at the entity level. In other states, only for a pass-through entity with which a taxpayer has a unitary relationship may the taxpayer aggregate the apportionment factors.

States generally take the position that an ownership interest in a partnership, or limited

liability company (LLC) classified as a partnership, doing business in the state is sufficient to create constitutional nexus for a nondomiciliary corporation. In asserting nexus, the states rely primarily on the aggregate theory of partnership, which holds that a partnership is the aggregation of its owners rather than an entity that is separate from its owners. Under this theory, the partners are viewed as direct owners of the partnership’s assets. Based on the aggregate theory, most states take the position that the mere ownership of a partnership interest is sufficient to create constitutional nexus for a nondomiciliary corporation, regardless of whether the corporation is a general or limited partner.

Extending jurisdiction to collect the income tax to a nonresident who owns an interest in

a pass-through entity is an issue that has been discussed by the Courts and in the literature for many years. It is fairly well settled that in most states (including California) that a corporate partner in a partnership doing business in the State is subject to the State’s corporate income or franchise tax on its distributive share of the partnership income, even if the corporate partner is only a limited partner and has no other ties to the state. The activities of a limited partner may not rise to the level of “doing business” in the state, however its investment in a partnership doing business (and earning income in the state) is sufficient to create a connection to assess the tax through no more than a passive investment. (see CRIV Investments Inc. v. Department of Revenue (4046 Ore. TC (1997)) Now the states are going well beyond this result and asserting that the out of state corporate limited partner is in fact “doing business” in the state.

1. General Partnership Ownership Interest. The only state where a general partner interest or an LLC interest does not create nexus is

New Hampshire.

2. Limited Partnership interest and LLCs.

Some states provide different nexus standards for corporate limited partners, reflecting the view that a limited partnership interest is a passive investment. Other states provide special exemptions for corporate partners of investment partnerships and/or partnerships engaged in trading activities.

a) California.


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Cal Rev and Tax Code 23101(d) (which defines the factor presence nexus standard) provides that sales, property and payroll include the taxpayer’s pro rata share of pass through entities. This is true regardless of whether the partner is unitary with the partnership. FTB Guidelines analyze this provision by looking at a number of different relationships that could create nexus with the state. An out of state partner or member of an LLC (taxed as a partnership) will be deemed to be doing business in the state if they own an interest in a flow through entity that is doing business in the state and their share of the activity exceeds the factor presence thresholds.

Example: Corporation E, an out-of-state corporation, has no property or payroll but has $450,000 of sales to customers located in California. Corporation E also has a 30 percent limited partnership interest in Limited Partnership X, which is doing business in California. For tax year 2011, Partnership X has $30,000, $50,000 and $200,000 in property, payroll and sales in California, respectively. Corporation E is considered to have the following distributive shares of property, payroll and sales from Partnership X:

Flow - through Partnership Property = $9,000 ($30,000 x 30%) Flow - through Partnership Payroll = $15,000 ($50,000 x 30%) Flow - through Partnership Sales = $60,000 ($200,000 x 30%) Corporation E is doing business in California because it has a total of $510,000 sales in the state ($450,000 of its own sales + $60,000 of Partnership X’s sales.)

Corporation E would be deemed to be doing business in California even if the $510,000

of California sales flowed through entirely from the limited partnership interest. Prior to the enactment of the factor presence nexus standard, an out of state corporate limited partner was not doing business in the state solely through ownership of a limited partnership interest in a partnership that was doing business in the state. In Appeal of Amman & Schmid Finanz AG, the SBE held that foreign corporations are not subject to the corporate franchise tax because they are limited partners in one or more limited partnerships doing business in California. (Appeal of Amman & Schmid Finanz AG, et al., SBE, April 11, 1996). In that case, the taxpayers did not meet the active participation requirement for “doing business” in the state. Under the bright line nexus standard, the active participation standard no longer applies.

(1) Investment Partnerships.

California does recognize an exception for investment partnerships. Partners in a qualified investment partnership may exclude their distributive share of income from qualified investment securities regardless of the partnership’s presence in California. Investment of partners’ capital for long-term appreciation, as opposed to buying and selling securities to profit from short-term price changes is not the conduct of a business in California and does not produce California-source income, even if the partnership has offices and employees in


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California to facilitate those investments.

Cal. Rev and TC 17955 provides that a nonresident will not be taxed on dividends, interest, or gains and losses from qualifying investment securities if their only contact with the state is through a broker, dealer or investment advisers located in the state. This same exemption is applied to a partner in an investment partnership, a beneficiary in a qualifying estate or trust, and a unit holder in a regulated investment company.

In order to qualify, the qualifying partnership or estate or trust must have no less than

90% of its total assets in qualifying investment securities, deposits at banks and office space and equipment necessary to carry out its activities. In addition no less than 90% of its gross income must consist of interest, dividends and gains from the sale or exchange of qualifying investment securities.

(2) LLCs: Out of state Corporate Members.

In the January 2014 edition of Tax News (the monthly newsletter of the FTB) the FTB Chief Counsel discusses return filing requirements for members of LLCs with multiple members. The article states that if the LLC is treated as a partnership and its members are treated as partners, then the term “partnership” refers to a traditional partnership known as a “general partnership.” In a general partnership, all of the partners are “general partners”, who have the right to manage and conduct partnership business”. The Chief Counsel concludes that the “doing business” analysis flows from this form of entity decision, meaning that if the members have the right to manage the business, then they are characterized as “general partners” whether they exercise that right or not. This is the basis for the FTB assertion that out of state passive corporate members in an LLC are doing business in the state. The Chief Counsel goes on to recognize that in the Appeal of Anman & Schmid Finanz AG, et al. (1996)(96-SBE-008) the Board of Equalization (SBE) held that a limited partner in a limited partnership was not “doing business” in California even though the limited partnership was doing business in the state. The SBE drew this distinction based on the conclusion that the general partner of a limited partnership has the rights, powers and restrictions of a partner in a general partnership, which include the right to manage and conduct partnership business, but limited partners do not have these rights. Acts of the general partner bind the partnership, but a limited partner is not bound by the obligations of the partnership unless that partner is also named as a general partner or has participated in the control of the limited partnership’s business. This analysis looks to management ability and control of the decision making process of the entity, not the question of limited liability of the member as the deciding factor. The FTB therefore, concludes that since members of an LLC have statutory rights to participate in the affairs of the LLC that they cannot be viewed as limited partners and therefore, like general partners are deemed to be doing business in the state. This view ignores an important discussion in the Appeal of Anman & Schmid Finanz AG,


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et al. wherein the SBE commented that in the record of the appeal only one of the limited partnership agreements of the limited partnership that was doing business in California was presented for review. This agreement did not conflict with the general provisions of the California limited partnership law. Therefore, the SBE states that they assumed that the limited partners’ rights and liabilities as generally recognized by California partnership law and “not as those rights and liabilities might be permissibly altered by partnership agreements” would be deemed to apply. However, if the SBE had been able to review the partnership agreements that had been permissibly modified by state law, then it is implied that the SBE would have considered that modification in its analysis. California’s LLC statute has always provided the LLC with the option of determining how it will be managed. Effective January 1, 2014 SB 323 (Ch. 12-419) replaced the existing LLC statute (the “Old Act”) with the Revised Uniform Limited Liability Company Act (RULLCA). RULLCA continues to allow the LLC to determine if it wants to be manager-managed or member- managed, although RULLCA does modify the procedure to implement the distinction. The new law requires a written statement designating the LLC a manager-managed LLC in the LLC’s articles of organization and written operating agreement (which now must be in writing). This modification changes the relationship of the parties. Under the RULLCA if the LLC is to be managed by one or more managers, then the members lose their right to approve business decisions or to bind the LLC vis-à-vis third parties. (Cal. Corp. Code §17703.01(b)(1)). Further, only managers may bind the LLC as to matters in the ordinary course of business and a document executed by two managers (or a single manager if called for in the Manager Statement) on behalf of the LLC with a third party is conclusively binding upon the LLC. (Cal. Corp. Code §17703.01(d)). If the test in California for “doing business” is based on who has control of the decision making process as evidenced by the LLC’s written operating agreement (now required) then arguably limited partnership status can be achieved by the LLC through inclusion in the operating agreement of provisions that delegate management authority to Managers. If possible, every LLC operating in the state with nonresident non-managing members should insure that they have revised their operating agreement to reflect manager-managed status. Stretching the concept of nexus to include passive corporate non-managing members means an annual tax return filing requirement plus payment at a minimum of $800 (the statutory minimum tax under Cal Rev & TC §23153). The FTB has also issued Legal Ruling 2014-01 which addresses when a business entity with a membership interest in a multiple-member limited liability company (hereafter "LLC") that is classified as a partnership for tax purposes, required to file a California return and pay any applicable taxes and fees. The results of the ruling and related examples are summarized here. A creature of state law, every LLC is organized under a state statute that creates the entity, gives it a legal existence separate from its owners (i.e., its “members”), shields the members from vicarious liability, governs the company's operations, and controls how and when the entity comes to an end. LLCs are "hybrid" business entities in the sense that they have some of the characteristics of both partnerships (i.e., members typically have the right to participate in the management of the business similar to general partners of general or limited partnerships) and corporations (i.e., liability protection for the members analogous to shareholders of corporations).


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Despite their existence under civil law, LLCs are not recognized as an entity choice for tax law purposes. Thus, LLCs must be viewed differently for tax law purposes than they are for civil law purposes. Accordingly, tax questions involving LLCs and their members must be addressed by using applicable tax law principles that flow from the entity choice the LLC makes for tax law purposes under the federal entity classification election system,1 and not from civil law principles. California tax law conforms to the federal entity classification election system (commonly referred to as the "check-the-box" regulations) by mandating that an eligible business entity be either classified or disregarded for California tax purposes, just as it is for federal tax purposes. Under the federal check-the-box tax classification regulations, "an eligible entity"3 with two or more members is classified as a partnership unless it checks the box to be classified as an association (and thus, a corporation under Treas. Reg., § 301.7701-2(b)(2)). For tax purposes, the federal check-the-box tax classification scheme establishes the form of the business, and all of the tax law consequences of that decision are based on the applicable analysis for the form of entity chosen. For example, if an LLC with two or more members chooses to be treated as a corporation for tax purposes, then its members will be treated as shareholders of that corporation for tax purposes. Alternatively, if an LLC with two or more members does not check the box to be treated as a corporation, it is by default treated as a partnership for tax purposes,5 and its members are treated as partners in that partnership for tax purposes. In this context, the term "partnership" refers to a traditional general partnership. In a general partnership, all of the partners are "general partners," who have the right to manage and conduct partnership business. Subdivision (a) of Revenue and Taxation Code section 23101 defines "doing business" as "… actively engaging in any transaction for the purpose of financial or pecuniary gain or profit." It is not necessary that there be a regular course of business or transactions It is important to note that having a California return filing obligation and being subject to all applicable taxes and fees as a result of "doing business" in California under Section 23101, is different from the requirement to register to do business in California with the California Secretary of State. The obligation to register with the California Secretary of State arises under the definition of "transacting intrastate business" in the California Corporations Code, which defines that term as, "… enter[ing] into repeated and successive transactions of business in this state, other than in interstate or foreign commerce." (See Cal. Corp. Code, §§ 191(a) and 17708.03(a); see also former Cal. Corp. Code, § 17001(ap) To constitute “doing business” in California; any activity in this state meeting the statutory definition is sufficient. In addition, the term "actively," the opposite of “passively” or “inactively,” means active participation in any transaction for the purpose of financial or pecuniary gain or profit. A transaction does not need to result in actual profit for purposes of Section 23101; the relevant inquiry is simply whether the activity or transaction was motivated by financial or pecuniary gain or profit.

For taxable years beginning on or after January 1, 2011, a taxpayer is also "doing business" in California if any of the following conditions are satisfied:


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• A taxpayer is organized or commercially domiciled in California, or • A taxpayer's California sales, property, or payroll exceed the amounts then applicable under paragraphs (2), (3), or (4) respectively, of subdivision (b) of Section 23101. (Subdivision (d) provides that these amounts include a taxpayer's pro rata or distributive share from pass-through entities.)

Subchapter K of the Internal Revenue Code outlines the manner in which partnerships are taxed. Subsection (b) of Internal Revenue Code section 702 provides that, "The character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share … shall be determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership." California conforms to these federal Subchapter K provisions. Thus, for tax purposes, the business of the partnership is the business of each partner. For this reason, wherever a partnership does business, the activities of the partnership are attributed to each partner, with the consequence that in geographic locations where the partnership is "doing business," the partners are also "doing business." This is true because a partner is recognized as deriving a share of partnership income and loss from the place where the partnership transacts its business.

If an LLC is treated as a partnership for tax purposes, both the LLC and its members, are subject to the same legal principles applicable to any partnership. Thus, if an LLC classified as a partnership for tax purposes is "doing business" in California under Section 23101, the members of the LLC are themselves "doing business" in California. This is true even in the case of "manager-managed" LLCs. Members of LLCs generally have the right to participate in the management of the business. Part of that power necessarily includes the right to delegate the power to manage the business in favor of a manager, and the power to revoke that delegation at any time. This analysis is not affected by whether or not members participate in the management of an LLC or appoint a manager to do so because the members' rights to participate in the management of the business arise out of the statutory relationship between an LLC and its members. Partners are considered co-owners of the partnership enterprise and the partnership acts as a conduit through which the enterprise is operated. "The courts have recognized that the execution of an agreement relinquishing control is itself an exercise of the requisite right of control over the conduct of the partnership business." Thus, the distinction between "manager-managed" LLCs and "member-managed" LLCs is not relevant for purposes of determining whether a member of an LLC, which is "doing business" in California and is classified as a partnership for tax purposes, is "doing business" here within the meaning of Section 23101.

It is well established that partners of a partnership are "doing business" in California if the partnership is "doing business" in California. In a narrow exception, in the Appeals of Amman & Schmid Finanz AG, et al., 96-SBE-008, April 11, 1996 (hereafter "Amman & Schmid"), the State Board of Equalization (hereafter "the Board") held that out-of- state corporations whose only California contacts were as limited partners in limited partnerships were not "doing business" in California even if the limited partnerships were "doing business" in California. The Board drew this distinction based on the conclusion that the general partner of a limited partnership has the rights and powers of a partner in a general partnership, which


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include the right to manage and conduct partnership business. Conversely, limited partners of a limited partnership do not have the power to manage and conduct partnership business. Thus, the decision of the Board hinged on the right to manage or control the decision making process of the entity, not whether a partner enjoys limited liability. The default rules in California's LLC Act provides that members of LLCs have the right to manage and conduct the LLC's business. Therefore, following the Board's logic in the Amman & Schmid decision, if an LLC is classified as a partnership for tax purposes, the members, who are considered general partners for tax purposes, are "doing business" where the LLC, i.e., a general partnership for tax purposes, is "doing business," even though the members have limited liability protection. Example: LLC Only Registered To Do Business in California.

LLC "A" is an LLC with two or more members, and is classified as a partnership for tax purposes. During a taxable year beginning on or after January 1, 2011, LLC A is registered to do business in California, but has no activities or factor presence in California sufficient to constitute "doing business" within the meaning of subdivisions (a) or (b) of Revenue and Taxation Code section 23101. Does LLC A have a California return filing requirement and obligation to pay all applicable taxes and fees? Yes. In this situation, LLC A has a California return filing requirement and is subject to the LLC tax and fee because it is registered to do business in California. Member B: Member "B" is a "corporation" that is a member of LLC A holding a 15 percent interest in LLC A. During the same taxable year beginning on or after January 1, 2011, Member B is not incorporated, organized, or registered to do business in California, and has no activities or factor presence in California sufficient to constitute "doing business" within the meaning of subdivisions (a) or (b) of Section 23101, and has no California source income. Does Member B have a California return filing requirement and obligation to pay all applicable taxes and fees as a result of its membership interest in LLC A? No. The fact that LLC A has a California return filing requirement and obligation to pay all applicable taxes and fees solely by virtue of registering to do business in California does not result in its member, Member B, also having a California return filing requirement and obligation to pay all applicable taxes and fees. In this situation, Member B does not have a California return filing requirement and is not subject to the franchise tax as a result of its membership interest in LLC A, because LLC A's act of registering to do business in California is not a transaction or activity for the purpose of financial or pecuniary gain or profit that is attributed to Member B.


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Example: LLC Only Organized in California

LLC "C" is an LLC with two or more members, and is classified as a partnership for tax purposes. LLC C is organized in California within the meaning of paragraph (1) of subdivision (b) of Section 23101. During a taxable year beginning on or after January 1, 2011, LLC C has no other activities or factor presence in California sufficient to constitute "doing business" within the meaning of subdivisions (a) or (b) of Section 23101. Does LLC C have a California return filing requirement and obligation to pay all applicable taxes and fees? Yes. In this situation, LLC C has a California return filing requirement and is subject to the LLC tax and fee because it is organized in California.23 Member D: Member "D" is a corporation that is a member of LLC C holding a 15 percent interest in LLC C. During the same taxable year beginning on or after January 1, 2011, Member D is not incorporated, organized, or registered to do business in California and has no activities or factor presence in California other than through its membership in LLC C, and has no California source income. Does Member D have a California return filing requirement and obligation to pay all applicable taxes and fees as a result of its membership interest in LLC C? No. The fact that LLC C has a California return filing requirement and obligation to pay all applicable taxes and fees solely by virtue of organizing in California does not result in its member, Member D, also having a California return filing requirement and obligation to pay all applicable taxes and fees. Although being organized in California is considered "doing business" within the meaning of paragraph (1) of subdivision (b) of Section 23101, the act of organizing in California is not attributed to the LLC's members for purposes of whether the members are "doing business" in this state. In this situation, Member D does not have a California return filing requirement and is not subject to the franchise tax as a result of its membership interest in LLC C, because LLC C's act of organizing in California is not a transaction or activity for the purpose of financial or pecuniary gain or profit that is attributed to Member D. Example: LLC Commercially Domiciled in California LLC "E" is an LLC with two or more members, and is classified as a partnership for tax purposes. During a taxable year beginning on or after January 1, 2011, LLC E is commercially domiciled in California within the meaning of paragraph (1) of subdivision (b) of Section 23101.


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Does LLC E have a California return filing requirement and obligation to pay all applicable taxes and fees? Yes. In this situation, LLC E is "doing business" in California within the meaning of Section 23101 because it is commercially domiciled in California; therefore, it has a California return filing requirement and is subject to the LLC tax and fee. Member F: Member "F" is a corporation that is a member of LLC E holding a 15 percent interest in LLC E. During the same taxable year beginning on or after January 1, 2011, Member F is not incorporated, organized, or registered to do business in California and has no activities or factor presence in California other than through its membership in LLC E. Does Member F have a California return filing requirement and obligation to pay all applicable taxes and fees as a result of its membership interest in LLC E? Yes. The term "commercial domicile" refers to the principal place from which the trade or business of the taxpayer is directed or managed. Put another way, the location of a taxpayer's commercial domicile is based on activity; i.e., the location of the day-to-day management of the business. Therefore, because LLC E is commercially domiciled in California, one or more of its members are engaging in day-to-day management, which constitutes a transaction or activity in California for the purpose of financial or pecuniary gain or profit within the meaning of Section 23101. Because LLC E is classified as a partnership for tax purposes, this activity is attributed to each of LLC E's members under general principles of partnership law, and thus, the members are "doing business" in California within the meaning of Section 23101. The members have a California return-filing requirement and must pay all applicable taxes and fees. In this situation, Member F is "doing business" in California within the meaning of Section 23101; therefore, it has a California return-filing requirement and is subject to the franchise tax. Example: LLC "Doing Business" in California LLC "G" is an LLC with two or more members, and is classified as a partnership for tax purposes. During a taxable year beginning on or after January 1, 2011, LLC G has activities or factor presence in California sufficient to constitute "doing business" within the meaning of subdivisions (a) or (b) of Section 23101. Does LLC G have a California return filing requirement and obligation to pay all applicable taxes and fees? Yes. In this situation, LLC G is "doing business" in California within the meaning of Section 23101; therefore, it has a California return-filing requirement and is subject to


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the LLC tax and fee.28 Member H: Member "H" is a corporation that is a member of LLC G holding a 15 percent interest in LLC G. During the same taxable year beginning on or after January 1, 2011, Member H is not incorporated, organized, or registered to do business in California and has no activities or factor presence in California other than through its membership in LLC G. Does Member H have a California return filing requirement and obligation to pay all applicable taxes and fees as a result of its membership interest in LLC G? Yes. Because LLC G is classified as a partnership for tax purposes and is "doing business" in California within the meaning of Section 23101, all of LLC G's members are "doing business" in California, and thus have California return filing requirements and are subject to all applicable taxes and fees, because the attribute of "doing business" by LLC G is attributed to its members under general principles of partnership law. In this situation, Member H is "doing business" in California within the meaning of Section 23101; therefore, it has a California return-filing requirement and is subject to the franchise tax. Example: "Manager-Managed" LLC "Doing Business" in California LLC "I" is an LLC with two or more members, and is classified as a partnership for tax purposes. During a taxable year beginning on or after January 1, 2011, LLC I has activities or factor presence in California sufficient to constitute "doing business" within the meaning of subdivisions (a) or (b) of Section 23101. LLC I is a "manager-managed" LLC. Does LLC I have a California return filing requirement and obligation to pay all applicable taxes and fees? Yes. In this situation, LLC I is "doing business" in California within the meaning of Section 23101; therefore, it has a California return filing requirement and is subject to the LLC tax and fee.30 Member J: Member "J" is a corporation that is a member of LLC I holding a 15 percent interest in LLC I. During the same taxable year beginning on or after January 1, 2011, Member J is not incorporated, organized, or registered to do business in California and has no activities or factor presence in California other than through its membership in LLC I. Does Member J have a California return filing requirement and obligation to pay all applicable taxes and fees as a result of its membership interest in LLC I?


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Yes. Because LLC I is classified as a partnership for tax purposes and is "doing business" in California within the meaning of Section 23101, all of LLC I's members are "doing business" in California, and thus have California return filing requirements and are subject to all applicable taxes and fees, because LLC I's attribute of "doing business" is attributed to its members under general principles of partnership law. The distinction between "manager-managed" LLCs and "member-managed" LLCs is not relevant for purposes of determining whether members of an LLC classified as a partnership for tax purposes are "doing business" in California within the meaning of Section 23101. In this situation, Member J is "doing business" in California within the meaning of Section 23101; therefore, it has a California return-filing requirement and is subject to the franchise tax. Example: California Sales Exceed the Sales Amount in Section 23101(b)(2) LLC "K" is an LLC with two or more members, and is classified as a partnership for tax purposes. During a taxable year beginning on or after January 1, 2011, the sales in California of LLC K exceed the sales amount then applicable in paragraph (2) of subdivision (b) of Section 23101. Does LLC K have a California return filing requirement and obligation to pay all applicable taxes and fees? Yes. In this situation, LLC K is "doing business" in California within the meaning of Section 23101; therefore, it has a California return-filing requirement and is subject to the LLC tax and fee.32 Member L: Member "L" is a corporation that is a member of LLC K holding a 15 percent interest in LLC K. During the same taxable year beginning on or after January 1, 2011, Member L's distributive share of the California sales of LLC K, exceed the sales amount then applicable in paragraph (2) of subdivision (b) of Section 23101. However, Member L is not incorporated, organized, or registered to do business in California and has no activities or factor presence in California other than through its membership in LLC K. Does Member L have a California return filing requirement and obligation to pay all applicable taxes and fees as a result of its membership interest in LLC K? Yes. Member L is "doing business" in California because its distributive share of the California sales of LLC K, as provided by subdivision (d) of Section 23101, exceeds the sales amount then applicable in paragraph (2) of subdivision (b) of Section 23101. A separate reason Member L is "doing business" in California is because LLC K, which is classified as a partnership for tax purposes, is "doing business" in California under


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Section 23101. Because LLC K is treated as a partnership, its attribute of "doing business" in California is attributed to all of its members under general principles of partnership law. Thus, all of LLC K's members are "doing business" in California; and therefore, have a California return filing requirement and are subject to all applicable taxes and fees. In this situation, Member L is "doing business" in California within the meaning of Section 23101; therefore, it has a California return-filing requirement and is subject to the franchise tax.

In all of the situations presented above, the LLCs in question have California return

filing requirements and are subject to the LLC tax and fee. In the first two situations, the corporate members in question are not required to file California returns and are not subject to the franchise tax because the LLCs' acts of registering to do business in California and organizing in California are not attributed to their members. Conversely, in the remaining situations, the corporate members in question have California return filing obligations and are subject to the franchise tax, because the activities of the LLCs are attributed to their members under general principles of partnership law, and those activities constitute "doing business" within the meaning of subdivisions (a) or (b) of Revenue and Taxation Code section 23101. Additionally, in Situation 6, Member L is also "doing business" in California because its distributive share of the California sales of LLC K exceed the sales a

Swart Enterprises Inc. v. Franchise Tax Board (Superior Court, Fresno County (California), No. 13CECG02171, November 14, 2014) is a case filed in Fresno Superior Court regarding doing business issues and LLCs. Swart is a company whose principal place of business is in Iowa, although they also have business operations in Kansas and Nebraska. They do not do business in California, but in 2007 they did invest $50,000 in an LLC that was organized in California and acquired, leased and disposed of capital equipment. The LLC was manager-managed by a single manager, and Swart was a passive investor with a .02% interest. This case finds California joining other states in their quest to stretch nexus concepts to their constitutional limits.

In an order on motions for summary judgment, a California superior court ruled that an out-of-state corporation with no business activities or physical presence in California, whose sole connection with California was its ownership interest in a manager-managed California limited liability company (LLC), was not doing business in California and, therefore, was not subject to the $800 minimum franchise tax. The Franchise Tax Board (FTB) took the position that an entity owning an interest in an LLC operating in California is doing business in California per Rev. & Tax. Code Sec. 23101 (actively engaging in any transaction for the purpose of financial or pecuniary gain or profit) and, therefore, is subject to the minimum franchise tax, even if owning the interest in the LLC is the entity’s sole connection with California. However, "actively " requires active participation, and here the transaction in which the corporation invested in the LLC took place a couple years before the tax year at issue. Passively holding an investment in the LLC in the relevant tax year did not constitute actively engaging in a transaction for gain or profit.


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The FTB asserted that under Reg. 23101, the purchase and sale of securities constitutes doing business in the state, and an interest in an LLC is a "security." However, Reg. 23101 does not use the term "securities," but instead states that "doing business" includes the purchase and sale of stocks or bonds. While stocks and bonds may be securities, not every investment in any security falls within the meaning of "doing business."

The FTB also argued that because the LLC elected to be treated as a partnership for tax purposes, the corporation, as a partner, had the right to manage and conduct partnership business and was doing business in the state on that basis. However, the corporation had no interest in specific property of the LLC, was not personally liable for the LLC’s obligations, played no role in the LLC’s management and had no right to do so, and could not act as an agent for the LLC or bind it in any way. The FTB suggested that the corporation exercised control over the business by relinquishing control to the manager of the LLC. However, this ignored the fact that the corporation made its investment in the LLC 16 months after the LLC was formed (i.e., it was not a founding member). Also, its ownership interest (about 0.2%) was not large enough for it to influence any decision regarding the removal of a manager.

3. Out of State LLC doing business in the State because of activities of LLC Member in the State.

a) California. Partnerships and LLCs are considered doing business in California if they have general partners or members in the state. Although general partners are charged with the responsibility of managing the affairs of the partnership under state law, this is not the case with members of an LLC. The FTB takes the position that any activity, including solicitation for sales by a California resident member that is a for profit transaction on behalf of the foreign LLC results in the foreign LLC engaging in business in California. The FTB arrives at this conclusion by virtue of the fact that members of LLCs have the right to act on behalf of and manage an LLC. The fact that the California resident member is not the managing member of the foreign LLC does not mean that the member’s presence in California would not cause the foreign LLC to be doing business here. This concept has almost been elevated to a presumption that a California resident member’s California activities will constitute doing business by the out of state LLC unless the taxpayer is able to present evidence to show that the California resident member’s activities did not cause the foreign LLC to be doing business in California. The FTB has won several cases in this area such as the Appeal of Mockingbird Partners, LLC (SBE May 17, 2006). In this case the SBE upheld the imposition of the minimum tax imposed on a limited liability company with out of state investment property whose member agents engaged in business activities on behalf of the LLC in California. The LLC owned, operated and managed residential rental property located in Montana. The rental property was managed on a daily basis by a firm located in Montana. The LLC had two members who lived in California. The operating agreement stated that one of the members was responsible for general and financial administration, including bill payment, bookkeeping, financial statement preparation and tax returns. The operating agreement authorized the members to open a bank account in San Francisco and both members had the right to sign checks on the account.


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According to the SBE, since the LLC members were California residents and since every LLC member is an agent of the LLC for conducting business of the LLC (unless the articles of organization or operating agreement restrict the scope of the agent’s authority) the LLC was doing business in California. This result is not impacted by the factor presence nexus standard and is a restatement of existing law.

(1) Disregarded Entities.

The FTB issued Legal Ruling 2011-01 on January 11, 2011, regarding the activities of a disregarded entity. For federal income tax purposes, disregarded entities are treated as a sole proprietor if the sole owner is an individual, or as a branch or division of the owner if the sole owner is any entity other than an individual. (Reg. 1.7701-2(a)). California recognizes the disregarded entity status and has now addressed the question regarding whether the sole owner of a disregarded entity is doing business in California if the owner has no other activities in the State other than the disregarded entity. (Legal Ruling 2011-01, January 11, 2011).

The FTB’s legal ruling takes the position that the activities will be attributed from the disregarded entity to the owner so that the owner — who otherwise might not be doing business in California — is now considered to be doing business here. The ruling addresses the Qualified Subchapter S Subsidiary (Qsub) and the Single Member Limited Liability Company (SMLLC). .

The FTB ruling analyzes several situations. In each situation, the sole owner is a corporation incorporated in a state other than California and that — except for the activities of the disregarded entity — would otherwise not be doing business in California. The disregarded entity is also formed in another state but has activities within California that constitute doing business.

Example: "A" is a QSub, which was validly formed under the laws of a state other than California, which has not registered to do business in California, and which has activities in California sufficient to constitute "doing business". The owner of A ("X") is a corporation validly formed under the laws of a state other than California, which has made a proper election to be treated as an S corporation, and which has made the election to treat A as a QSub. X has no separate activities in California sufficient to constitute "doing business" within California. X fails to file the California franchise tax return required for Owner. The Franchise Tax Board ("FTB") determines that X is "doing business" in California due to the activities of A, and assesses tax, interest, and a penalty for failure to file a franchise tax return. X asserts California has no legal authority to tax X because X has not established nexus with California. X further asserts the activities of A do not create nexus with California. Under Cal. Rev and Tax Code 23800.5 if a Qsub has activities sufficient to constitute “doing business” in the state, then the activities of the Qsub are by operation of law treated as activities of the S Corporation. (Cal. Rev and Tax Code 23800.5(a)(2)(B). Therefore, the Qsub owner is “doing business” in California and therefore must pay a franchise tax or the minimum tax, whichever is greater.


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Example: "B" is an SMLLC, which was validly formed under the laws of a state other than California, which has not registered to do business in California, and which has activities in California sufficient to constitute "doing business" within California. The sole owner of B ("Y") is a corporation validly formed under the laws of a state other than California. B is disregarded as an entity separate from its sole owner, Y, for federal and California income and franchise tax purposes. Y has no separate activities in California sufficient to constitute "doing business" within California. Y fails to file the California franchise tax return required for Owner.

The Franchise Tax Board ("FTB") determines that Y is doing business in California due to the activities of B, and assesses tax, interest, and a penalty for failure to file a franchise tax return. Y asserts California has no legal authority to tax Y because Y has not established nexus with California. Y further asserts the activities of B do not create nexus with California.

In the case of an SMLLC, federal and California regulations allow the SMLLC to elect how the SMLLC will be taxed for income/franchise tax purposes. Specifically, the SMLLC may elect (1) to disregard the SMLLC's status as an entity separate and distinct from its owner, or (2) to have the SMLLC classified as an association taxable as a corporation. If the SMLLC does not make an affirmative election, the default treatment under the Treasury Regulations is to disregard the SMLLC's status as an entity separate and distinct from its owner.

If the separate entity status of the SMLLC is disregarded for income/franchise tax purposes, the activities of the SMLLC are treated in the same manner as a sole proprietorship, branch, or division of the owner. Thus, if a corporation owns the SMLLC, the activities of the SMLLC are treated in the same manner as the activities of a branch or division of the corporate owner. If the activities of a branch or division are sufficient to be considered "doing business" in California, those activities are sufficient to treat the corporate owner as "doing business" in California.

IV. Sales Tax Nexus Issues. Much of e-commerce is not now subject to sales tax. A Supreme Court decision (Quill v. North Dakota) shields out-of-state sellers with no physical presence in the buyer’s home state from having to collect sales tax. Collection is required of retailers with a physical presence, such as a store, factory or warehouse. In the era of online buying, states are taking the lead in wanting the rules changed. States have been hoping for years that Congress would act on this issue. Lawmakers’ efforts have stalled with respect to proposed legislation that would have required firms with Web sales of over $1 million to collect sales taxes from buyers who live in the state. Indeed, the U. S. Supreme Court itself invited the states to enact legislation that challenged Quill. U.S. Supreme Court Justice M. Anthony Kennedy has invited "the legal system


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[to] find an appropriate case for this Court to reexamine Quill and Bellas Hess.” (Direct Marketing Association v. Brohl, 814 F3d 1129 (10th Cir. 2016)). "A case questionable even when decided, Quill now harms States to a degree far greater than could have been anticipated earlier. . . . It should be left in place only if a powerful showing can be made that its rationale is still correct." Several states have accepted the challenge with South Dakota enacting legislation that directly conflicts with the Supreme Court ruling. Sellers who have no physical presence in S.D. and make over $100,000 in yearly sales or 200 transactions in the state are required to collect sales tax from S.D. buyers. The new law just took effect, and a lawsuit has already been filed claiming it’s unconstitutional. Many believe that this case could ultimately make its way up to the Supreme Court, and states are hoping the high court will overturn or narrow its decades-old decision. Alabama is another example. Out-of-state sellers must collect Ala. sales tax if their annual in-state sales exceed $250,000. A legal challenge was recently filed. More states are expected to follow suit, including Mass., Utah and Vt. A number of states have taken a less drastic approach, akin to that of N.Y. Online sellers must collect N.Y. sales tax if they pay websites operated by N.Y. residents for referral business. Clicking through Web links can establish the required nexus. The law has been challenged in court and ruled to be valid. California, Louisiana, Georgia, North Carolina and many other states have passed laws based on similar principles. Some states are forcing more reporting obligations on out-of-state sellers. Colorado and Oklahoma are prime examples. To assist in enforcing use tax in Colo., the state requires out-of-state retailers to annually report to the state and customers on sales that exceed $500. In February, a federal appeals court OK’d the validity of the law.


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CHAPTER 2 APPORTIONMENT

Table of Contents

I. Gillette Litigation. ............................................................................................................................................... 1

II. Throwback: Appeal of Craigslist ................................................................................................................ 5

III. Throwback: CCR 2016-03. ...................................................................................................................... 10 A. Chief Counsel Ruling 2016-03 ............................................................................................................................. 10

IV. Proposed Regulations: Market Based Sourcing ................................................................................ 10 A. General Definition Section. ................................................................................................................................... 11 B. Benefit of the Service Section. .............................................................................................................................. 11 C. Sales from Intangible Property Section. D. Assignment of marketable securities section. .................................................................................................. 12 E. Operative Dates. ......................................................................................................................................................... 13

V. Apportionment and Startups. ..................................................................................................................... 13 A. Apportionment and No Sales. ............................................................................................................................... 13

I. Gillette Litigation.

In The Gillette Company & Subsidiaries v. The State of California, Franchise Tax Board1 the taxpayer asked the Court what significance should be given to California’s 1974 “ratification and approval” of the Multistate Tax Compact in relationship to subsequently enacted, conflicting provisions of State law. In Gillette, six taxpayers had filed refund claims on the basis that they were entitled to use an equally weighted three factor formula to apportion their business income to California (as allowed under Cal. Rev & Tax Code §38006, otherwise included in the statute as part of California’s enactment of the Multistate Tax Compact in 1974). In 1993 the Legislature amended Cal Rev & Tax Code §25128 to give double weight to the sales factor. FTB denied the refund claims of these six taxpayers on the basis that Cal Rev & Tax Code §25128 essentially repealed and superseded the formula set forth in Cal Rev & Tax Code §38006. The Court of Appeal upheld the taxpayer’s argument that enactment of the Compact by California gave the taxpayers an election to use either apportionment method. The original opinion was withdrawn by the Court, and reissued on October 2, 2012 with the same result.

In July 2012, the California Court of Appeal ruled that multistate taxpayers could validly

elect to use the Multistate Tax Compact's (MTC's) equally weighted 3-factor formula to apportion and allocate income for state corporation franchise (income) tax purposes.2 The Compact's optional 3-factor formula, enacted by the state in 1974, was not repealed and superseded by the 1993 amendment to Cal Rev. and Tax Code §25128 that required use of the 1 San Francisco County Superior Court, Case No. CGC-10-495911. 2 Cal. Rev and Tax Code §38006.


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double-weighted (sales factor) apportionment formula because such an interpretation, urged by the Franchise Tax Board (FTB), would be unconstitutional, violative of the prohibition against impairing contracts. The Court concluded that the Compact was a valid multistate compact, and California was bound by it and its 3-factor apportionment election provision unless and until California withdrew from the Compact by enacting a statute that repeals Cal. Rev. and Tax Code §38006. (The Gillette Co., et al. v. Franchise Tax Board, Cal. Ct. App., DKT. No. A130803, 07/24/2012 (certified for publication).). Prior to the issuance of this opinion, but after the oral arguments, California enacted SB 1015 repealing, effective June 27, 2012 3, the Multistate Tax Compact.

The taxpayers in Gillette, were numerous multistate corporations that had originally filed utilizing the state’s double-weighted sales factor apportionment formula, but subsequently filed refund claims for several tax years on the basis of the fact that they should have been allowed to make an election to use the Compact’s equally-weighted apportionment formula. California had become a member of the Compact during 1974, several years after the Compact was adopted by the requisite seven states. States entered into the Compact to promote uniformity among the states, facilitate the proper determination of state and local taxes for multistate taxpayers, facilitate taxpayer convenience and compliance in the filing of tax returns, and avoid duplicative taxation. A key provision of the Compact was to provide taxpayers the option of utilizing the Uniform Division of Income for Tax Purposes Act (UDITPA) equally weighted apportionment formula or an alternative apportionment formula adopted by the state.

The Compact was drafted and adopted by numerous states in the late 1960s as a means to stave off federal encroachment in state taxation by providing multistate taxpayers a level of uniformity in apportioning their business income among the states. Until its enactment of legislation repealing, effective June 27, 2012 (2012 Stats., SB 1015 (ch. 37), the Multistate Tax Compact (Compact), California was a signatory to the Compact, a binding, multistate agreement that obligated member states to offer its multistate taxpayers the option of using either the Compact's 3-factor UDITPA formula to apportion and allocate income for state income tax purposes, or the state's own alternative apportionment formula.4 This is one of the Compact's key mandatory provisions designed to secure a baseline level of uniformity in state income tax systems, a central purpose of the agreement.

The FTB contended that: (1) the taxpayers lacked standing to complain of any purported violation of the Compact; (2) the plain language of Cal. Rev and TC §25128 mandated the exclusive use of the state's double-weighted sales apportionment formula, thereby eliminating use of the equally weighted 3-factor apportionment; and (3) under California statutory and contract law, the legislature had the power, and properly enacted legislation, to repeal Cal Rev and TC §38006 to the extent necessary to impose this mandatory apportionment formula on taxpayers. The Franchise Tax Board (FTB) contended that the 1993 amendment repealed the taxpayers’ option to elect to use the equally weighted formula and, therefore, denied the taxpayers’ refund claims. The taxpayers appealed the decision, and the lower court granted the

3 2012 Stats., S1015 (ch. 37). 4 Cal. Rev. and Tax Code 38006, art. III, subd. 1.


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FTB’s demurrer, finding that the state had the authority to repeal the provision allowing taxpayers to use the MTC equally weighted apportionment formula.

The court found that, as a signatory member of the Compact, California was bound by the

Compact’s provision providing taxpayers with an election to use the Compact’s apportionment formula or the state’s alternative apportionment formula. The court rejected the FTB’s contention that, because the Compact was an agreement between the signatory states, the taxpayers had no standing to challenge a violation of the Compact. California adopted the Compact as part of its statutory law, and the apportionment formula provision clearly provided taxpayers with an option as to how to determine the amount of their business income subject to California taxation. Taxpayers have a right to challenge how their tax is computed, and, because the FTB’s violation of the provision had an impact on how their tax liability was determined, the court held that the taxpayers had standing to challenge the violation of the Compact.

The court held that the Multistate Tax Compact was a valid compact and, therefore, the state could not enact subsequent legislation that altered, modified, or partially repealed the Compact’s provisions. The MTC was a valid compact as it did not encroach on a federal area of control and, therefore, did not require federal consent. The three primary components to indicate the existence of a valid interstate compact as laid out by the U.S. Supreme Court were satisfied. These requirements include an analysis of whether the pact purports to authorize the member States to exercise any powers that they could not exercise in its absence. The court concluded that the Compact did not authorize the states to do anything that enhanced the power of state government over federal government. Further, there is no delegation of sovereign power of the States to the Commission as each State retains the freedom to adopt or reject the rules and regulations of the Commission. Moreover, each State is free to withdraw at any time. 5

The FTB contended that the Compact was not a valid compact because it allows members

to unilaterally withdraw and, therefore, was not truly a binding agreement. However, the courts have upheld challenges to other interstate compacts with similar provisions. Furthermore, the FTB argued that the Compact was merely a model law and not really a true compact. The court agreed that the Compact did serve as a model law for the associate members who had not signed onto the Compact but who had enacted similar provisions. However, it held that for the signatory states, the Compact was indeed a binding contract. Finally, the court rejected the FTB’s contention that under California’s constitution the state could not surrender its power to tax by entering into a contract, finding that by signing onto the Compact the state retained its full power to tax, but it had agreed to allow taxpayers to elect to utilize the equally-weighted apportionment formula until it withdrew from the Compact.

Finding that the Compact was a valid compact that bound the signatory states, the court held that the state did not have the authority to unilaterally enact subsequent legislation that amended, modified, or partially repealed any provision of the Compact. The plain language of the Compact only allows for complete withdrawal from the Compact, and the withdrawal may only be made prospectively. The court rejected the FTB’s contention that the U.S. Supreme

5 See U. S. Steel Corp. v. Multistate Tax Comm’s (434 U.S. 453 (1978).


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Court had held that a compact cannot limit a state’s exercise of its right to withdraw from a compact, finding that the issue in the case cited by the FTB concerned the issue as to whether the state was withdrawing from the Compact in bad faith, not whether the state could make a piecemeal withdrawal from the Compact. Similarly, the court rejected the FTB’s argument that the Compact’s severability clause required a liberal construction of the withdrawal provision, finding that the severability clause and the provisions governing the withdrawal from the Compact involved two separate issues.

The court also refused to entertain the FTB’s position that the fact that 14 of the 20 signatory members had adopted similar legislation mandating the use of the state’s apportionment formula demonstrated that the Compact’s apportionment provision was nonbinding. The court reasoned that the plain language of the Compact clearly provided taxpayers with the option of using the MTC formula or the state’s alternative apportionment formula and refused to consider extrinsic evidence to the contrary. Furthermore, the court stated that to rule otherwise would contravene the very purpose of the Compact, which was to provide uniformity among the states.

Finally, the court found that the FTB’s interpretation would violate the federal and state constitutions’ prohibition against the impairment of contracts and the state constitution’s reenactment rule, which prohibits the Legislature from enacting a statute that changes the meaning of another provision unless the affected provision is also reenacted.

Subsequent to the issuance of the opinion described here, the California court of appeal vacated its decision in Gillette v. Franchise Tax Board and ordered a rehearing on the taxpayer’s challenge to the FTB’s position that despite California’s participation in the Multistate Tax Compact (MTC), California taxpayers were required to utilize the double-weighted sales tax formula to apportion their net business income for corporation franchise and income tax purposes.6

On October 3, 2012, the court issued its opinion upon rehearing and once again upheld the taxpayers’ right to utilize the Multistate Tax Compact’s (Compact) equally weighted apportionment formula to apportion net income for California corporation franchise and income tax purposes. 7 The revised opinion makes two clarifying points. The court removes itself from any debate over the implications of California’s enactment of legislation (SB 1015) that repeals the multistate Tax Compact from the state’s code and withdraws California from the compact. Further, the court clarifies that Cal. Rev & Tax Code 25128 is only unconstitutional to the extent that it denies taxpayers the right to elect to apportion their income under the compact election. These clarifications are in response to the FTB’s request for a rehearing filed in response to the July 24, 2012 decision.

The FTB appealed the decision to the California Supreme Court who heard oral

arguments on October 6, 2015. The case (The Gillette Company & Subs. v. California 6 The Gillette Co. v. Franchise Tax Board, Court of Appeal of California, First District, No. A130803, decision vacated and rehearing ordered, August 9, 2012. 7 The Gillette Co. v. Franchise Tax Board, Court of Appeal of California, First District, No. A130803, October 2, 2012.


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Franchise Tax Board) will determine whether California's membership in the Multistate Tax Compact (MTC) was a binding, reciprocal agreement between states that allowed multistate taxpayers to use the Compact's three-factor apportionment formula.

In 2015, the California Supreme Court held that, despite the Compact’s apportionment formula election provision, taxpayers could not use the Compact’s equally weighted three-factor formula to apportion net income for California corporation franchise and income tax purposes. Instead, said the court, taxpayers must use the apportionment formula required under California law ( i.e., a double-weighted sales factor formula for tax years beginning before 2013, or a single-sales factor formula for tax years beginning after 2012). ( The Gillette Company v. Franchise Tax Board, California Supreme Court, No. S206587, December 31, 2015,) In so holding, the court determined that (1) the Compact constitutes state law (without the force of federal law), (2) the Compact was not a binding contract between the signatory states, (3) the California Legislature had the authority to repeal the Compact’s election provision, (4) the California Legislature intended to repeal the election provision, and (5) the legislation repealing the election provision did not violate the state’s "reenactment rule." The case has been appealed by the taxpayer to the U. S. Supreme Court.

II. Throwback: Appeal of Craigslist Throwback is a concept adopted by 25 states to insure that 100% of the taxpayer’s income is subject to state taxation. 8 These states require that if a sale of tangible property is sourced to a state where the taxpayer does not pay tax, then the sale is thrown back and assigned to the state where the property is shipped from. If a state does not have throwback, then the income associated with this sale becomes “nowhere income” or income that is not taxed by any state. Throwback is not a new concept, but in light of recent changes in California’s definition of “doing business” and its adoption of single sales factor apportionment, the concept now offers new planning opportunities, as illustrated by the Appeal of Craigslist, Inc. Craigslist, Inc. lost its appeal, but only because it jumped the gun and attempted to apply the new law prior to the effective date. An alternative to throwback is throw-out. Only two states have adopted a throw-out rule, a provision that removes the sale from the numerator and denominator of the apportionment percentage. 9 Both states limit the application of throw-out to sales of tangible property. This methodology also has the effect of insuring that all of a taxpayer’s income is subject to tax in a state, albeit the result is to distribute the income of the taxpayer amongst all of the states where the taxpayer is taxable.

8 Alabama, Alaska, Arkansas, California, Colorado, District of Columbia, Hawaii, Idaho, Illinois, Indiana, Kansas, Kentucky and Maine (but only if tangible personal property is shipped from the state to the U. S. Government), Massachusetts, Mississippi, Missouri, New Hampshire, New Mexico, North Dakota, Oklahoma, Oregon, Rhode Island, Tennessee (but only if tangible personal property is shipped from the state to the U. S. Government) Utah, Vermont, Wisconsin. 9 These states include Maine and West Virginia.


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The issue in the, Appeal of Craigslist Inc.10 was throw-out and how the concept interacts with the “doing business” statute. Craigslist is a well-known web site (based in San Francisco) which allows users to post classified advertisements on its website, generally for free. Craigslist does charge a fee for job postings in certain areas, brokered apartments rental listings in New York City and therapeutic service advertisements. The year in question was 2007, a year when California used cost of performance to source service income. That put all of Craigslist’s income in California. After filing the return for 2007, Craigslist petitioned the FTB for permission to use a special apportionment formula (under Cal. Rev & TC sec. 25137). FTB partially granted their request, allowing Craigslist to use market base sourcing to source its gross receipts from advertising (placing the receipt in the state where the job posting was located). Under the alternative apportionment formula, FTB required receipts that were sourced to a location where the taxpayer did not pay tax be excluded from the sales factor. This meant that these receipts would be thrown out of the sales factor – i.e., removed from both the numerator and denominator of the sales factor. Craigslist filed an amended return in 2011 (for the tax year 2007) assuming that they were taxable in the destination state (and throw out was not required) if they had more than $500,000 of gross receipts sourced to that state using market based sourcing. For the five states that were at issue, sales of over $500,000 sourced to those states were not disputed.11 Craigslist left these sales in its denominator so that the effect was to significantly reduce its California apportionment factor. Craigslist argued that under Cal Rev and TC sec. 25122, a taxpayer is “taxable in another state” if the state has jurisdiction to subject the taxpayer to a net income tax regardless of whether they actually do subject the taxpayer to a net income tax. The regulations state that jurisdiction to impose a net income tax is present if the taxpayer’s business activity is sufficient to give the state jurisdiction to impose a net income tax by reason of such business activity under the Constitution and the statutes of the United States. 12 The FTB argued that the reason it included the throw-out provision in the alternative apportionment formula was to prevent income from being assigned to jurisdictions where the taxpayer was not subject to tax, thereby creating “nowhere” income. Further, the FTB argues that the current version of Cal Rev & TC sec. 23101 (California’s definition of “doing business”) did not become effective until 2011, and that prior to that time physical presence was required to be considered in the determination of doing business in the state. In 2007, Craigslist, Inc. did not have physical presence in any of the states in question, therefore the throw-out provision of the alternative apportionment formula applied. The issue in the case is proper application of Cal Rev. & TC sec. 25122 – the provision that defines when a taxpayer is subject to throwback. Section 25122 states that a taxpayer is “taxable” in a state if “that sate has jurisdiction to subject the taxpayer to a net income tax

10 SBE Case No.’s 725838 and 843070: Date of hearing:12/16/2015. Decision of Board not yet published. Case reported in Caltaxletter, Vol. XXVII, No. 40, December 18, 2015. Summary of briefs filed by both parties posted on SBE website. 11 The five states include Illinois, Massachusetts, New York, Oregon, Washington and District of Columbia. 12 Cal. Code Reg. tit. 18, sec. 25122( c)).


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regardless of whether in fact, the state does or does not (subject the taxpayer to a net income tax).” California Code of Regulations, title 18, section Reg. 25122( c) states that jurisdiction to tax is present if the taxpayer’s business activity is sufficient to give the state jurisdiction to impose a net income tax by reason of such business activity under the Constitution and statutes of the United States. Under Cal Rev & TC sec. 25135 shipments of tangible personal property from California to a state in which the taxpayer is not “taxable” (as defined in Sec. 25122) are thrown back to the state where the merchandise is shipped from. These sales are included in the numerator of the sales factor, which has the effect of increasing the overall percentage. In 2009, the California Legislature enacted amendments to Cal. Rev. & TC sec. 23101 which included a statutory nexus guideline for “doing business”. These rules now state that a taxpayer is “doing business” in the state if sales exceed the lesser of $500,000 or 25% of total sales sourced to California. 13 The new rules became effective for tax years beginning on or after January 1, 2011. FTB maintains that California authorities that interpreted the state’s jurisdiction to tax before 2011 required physical presence. Therefore, a taxpayer must demonstrate physical presence in the other state to avoid application of throwback rules under Sec. 25122. In FTB Chief Counsel Ruling 2012-03 the FTB concluded that on or after January 1, 2011 a taxpayer would be considered to be taxable in another state for purposes of throwback, if the taxpayer’s activities in that state exceeded any of the conditions set forth in Section 23101. This meant that if the taxpayer had more than $500,000 in sales in the other state, it would be considered taxable in that state under Cal. Rev. & TC sec. 23122, just as a taxpayer making sales into California would be considered taxable in California. This was something of a revelation in that typically upon audit, the agent would ask if the taxpayer had filed an income tax return in the other state. If the taxpayer could not produce a tax return as evidence of payment, then the sale would throwback to location where the merchandise had shipped from. It was also not clear whether the doing business standard of California or the destination state would apply. In addition, FTB issued Technical Advice Memorandum 2012-01 wherein the FTB states that for tax years beginning before January 1, 2011 that physical presence in another state is required to be considered taxable in that jurisdiction for purposes of throwback. The taxpayer argues that it is “taxable” in the states where it has over $500,000 in receipts as its connections with each of these states meets the minimum nexus standards under the U. S. Constitution for imposing a net income tax regardless of whether those jurisdictions impose a net income tax or not. Since California has concluded that it has jurisdiction under the U. S. Constitution to impose a tax on out of state taxpayers by virtue of the taxpayer having $500,000 of receipts sourced to a state during the tax year, it cannot now argue the same volume

13 Doing business is also defined to include real property and tangible personal property in excess of $50,000 or 25% of total property and compensation paid in the state that exceeds the lesser of $50,000 or 25% of total compensation. Cal. Rev and TC sec. 23101(b).


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of receipts sourced to another state does not also give that state the constitutional jurisdiction to assess a tax (whether they do or they do not). FTB argues that these arguments fail because Cal Rev and TC sec. 25122 defines “doing business” in the other state by reference to Cal Rev and TC sec. 23101. In 2007, Cal. Rev and TC sec. 23101 required physical presence in order for the State to have jurisdictional nexus over the out of state taxpayer. FTB states that since physical presence is required under Cal Rev & TC sec. 23101 for years prior to 2011, the same standard is required under Cal. Rev & TC 25122. Craigslist, Inc. did not have physical presence in the five states where it earned advertising income. The FTB reminded the taxpayer that the reason that the throw-out provision was included in the taxpayer’s Determination Letter was because of concern regarding income earned in states where the taxpayer was not taxable, i.e., nowhere income. To avoid this result and to more accurately reflect the taxpayer’s business activities, the special apportionment methodology included a throw-out rule. The State Board of Equalization voted unanimously to sustain the FTB’s position to throw out advertising revenue in the other jurisdictions under the alternative apportionment formula. The SBE did not agree that the taxpayer was taxable in the other states under Cal. Rev & TC sec. 25122 due to application of a statutory standard, which did not become effective until Jan. 1, 2011. FTB effectively argued that if the SBE ruled for the taxpayer by applying an economic presence standard retroactively, there would be unexpected results. Taxpayers could find that in those prior years, they were doing business in California and had a filing requirement in the state as if economic nexus rules applied. The holding in this case is no great surprise, but some of the discussion in the FTB’s brief is a bit more troubling. Currently in California we use a single sales factor for apportionment purposes, computed using market base sourcing rules for service income and income from intangibles. California has also adopted a statutory standard as a guideline for taxpayers to use to determine if they are doing business in the state. 14 We continue to apply Cal Rev. & TC sec. 25122 to determine if the taxpayer is “taxable in the other state”. Chief Counsel Ruling 2012-03 concludes for taxable years beginning on or after January 1, 2011 a corporation is doing business in California if its sales exceed the lesser of $500,000 or 25% of the taxpayer’s total sales. Just as an entity would be taxable in California for years beginning on or after January 1, 2011 by virtue of having sales of over $500,000 in the state, a taxpayer is considered to be taxable in a foreign jurisdiction where sales exceed $500,000. As a result of being deemed to be subject to tax in the foreign jurisdiction, the taxpayer is not required to throwback those sales to California under Cal. Rev. & TC sec. 23135(a)(2). The throwback rules apply only to sales of tangible personal property and do not apply to service income. The ruling goes on to clarify that the $500,000 threshold is determined under the sourcing rules set forth under Cal. Rev. and TC sec. 25136 (or the rules governing market based sourcing).

14 Cal. Rev & TC sec. 23101.


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Therefore, if the facts in the case involving Craigslist, Inc. arose after January 1, 2011 then the analysis of the taxpayer is correct. The revenue from the job postings would be sourced where the customer of Craigslist got the benefit of the service (which is logically the location where the advertisement ran). The income earned from the posting of ads is in the nature of advertising revenue and does not come under the throwback rules, therefore the sales would end up as nowhere income if Craigslist is not required to file a tax return in the destination state. 15 This leaves the FTB without statutory authority to challenge the Craigslist transaction after January 1, 2011. The brief filed by FTB in the Appeal of Craigslist includes an argument that throwback and throw-out are very similar in that they are designed to ensure that all of a taxpayer’s income, no more or less, is subject to taxation in the state in which it does business.16 The theoretical argument that the framework of defining nexus and apportionment adopted by the Uniform Division of Income for Tax Purposes Act (UDITPA) and also by California, is tenuous at best. If FTB wants to pursue the goals of UDITPA, then a statutory “fix” is the better alternative. Throw-out would be the most logical solution.

15 California has enacted a throw-out rule, which is effective for tax years beginning on or after January 1, 2011.15 Specifically excluded from the statutory definition of gross receipts, even if considered business income, are the following items:

• repayment, maturity, or redemption of the principal of a loan, bond, mutual fund, certificate of deposit, or similar marketable instrument;

• the principal amount received under a repurchase agreement or other transaction properly characterized as a loan;

• proceeds from issuance of the taxpayer's own stock or from sale of treasury stock; • damages and other amounts received as the result of litigation; • property acquired by an agent on behalf of another; • tax refunds and other tax benefit recoveries; • pension reversions; • contributions to capital (except for sales of securities by securities dealers); • income from discharge of indebtedness; • amounts realized from exchanges of inventory that are not recognized under the Internal

Revenue Code; • amounts received from transactions in intangible assets held in connection with a treasury

function of the taxpayer's unitary business and the gross receipts and overall net gains from the maturity, redemption, sale, exchange, or other disposition of those intangible assets; and

• amounts received from hedging transactions involving intangible assets.

Income earned by Craigslist is not subject to throwback either. 16 Citing William J. Pierce, The Uniform Division of Income for Tax Purposes Act, 35 Taxes 747, 748 (1957).


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The combination of market based sourcing, a nexus threshold based on a statutory standard and the application of throwback (when it applies) by looking at the entire combined reporting group all add up to the creation of nowhere income (and very little throwback) to California. 17

III. Throwback: CCR 2016-03.

A. Chief Counsel Ruling 2016-03 The California Franchise Tax Board issued a ruling to a designer-distributor that it must add proceeds from sales of tangible personal property with royalties received to verify it meets the "doing business" standard and that it should not throw back to its California sales factor numerator those sales from states where it has met the standard.

Sales of tangible personal property and royalties must be aggregated because both are sales for tax purposes, and the taxpayer should not throw back its sales of tangible personal property to its California sales factor numerator because the third-party licensee's use of the taxpayer's trademarks that gave rise to royalties was neither a protected activity nor a de minimis one.

IV. Proposed Regulations: Market Based Sourcing For taxable years beginning on or after January 1, 2013, Revenue and Taxation Code (RTC) Section 25136 provides the rules for assignment of sales of other than tangible personal property for taxpayers that file a combined report. California Code of Regulations (CCR) section 25136-2 interprets and makes specific the market-based sourcing assignment rules of RTC section 25136. In March 2012, the FTB held the initial Interested Parties Meeting (IPM) to discuss amendments to CCR 25136-2. Possible amendments (in the order of their appearance in the regulation) included (1) a definition of "marketable securities," (2) assignment rules for asset management fees, (3) assignment rules for dividends and goodwill, (4) assignment rules for interest, and (5) assignment rules for marketable securities. Finally there were various minor cleanup fixes. Other proposed amendments were discussed at the initial IPM, but were not pursued because both the FTB and the public agreed that such amendments are not necessary at this time. In October 2013, the FTB proposed initial draft language at the second IPM. In July 2014, a second discussion draft language was presented at the third IPM. The second discussion draft included additional amendments as well as changes to and deletions of amendments provided in the initial discussion draft for the IPM of October 2013. Since the July 2014 IPM, additional public input has been received in connection with the definition of "marketable securities," assignment rules for receipts that come in the form of interest and marketable securities, as well as a request for clarifying language in the asset management fee examples.

17 Also see Eric J. Coffill, Throwback Sales Issues in California, 2015 STT 197-11.


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The new draft language based on the latest public input since July 2014 is explained below.

A. General Definition Section. The July 2014 proposed draft amendments included a stand-alone definition for the term "marketable securities" as used in RTC Section 25136(a)(2) for securities dealer type taxpayers. The subsection provided definitions for a "securities dealer" and "marketable securities" incorporating various subsections of Internal Revenue Code (IRC) Section 475. Additional public feedback since July 2014 has been that (1) a commodities dealer should be treated as a securities dealer under the securities dealer definition if the commodities dealer has made an IRC Section 475(e) election, and (2) all contracts to which IRC Section 1256(a) applies should be treated as marketable securities. Language incorporating these two suggestions has been added. Lastly, a sentence was inserted in the definition of "marketable securities" applicable to securities dealer type taxpayers to indicate that transactions specifically excluded under RTC Section 25120(f)(2)(L) from gross receipts are likewise not included in the gross receipts factor for securities dealers. (CCR Section 25136- 2(b)(6).)

B. Benefit of the Service Section.

Since the July 2014 IPM, public input that the asset management fee examples should be clarified to reflect that the taxpayers in those examples are not subject to the provisions of CCR Section 25137-14 has been addressed. (CCR Section 25136-2(c)(1)(C)5. and 6.)

Example:

Asset Management Corp, which is not subject to California Code of Regulations section 25137-14 because the taxpayer is not providing services to at least one Regulated Investment Company, provides administration, distribution and management services for pension plans, retirement accounts, or other investment accounts, by contracting with third party entities to provide these services on behalf of shareholders, beneficial owners, or investors of the pension plans, retirement accounts or other investment accounts. Since the benefit of the services is received by the shareholders, beneficial owners, or investors, the sale of these services shall be assigned to the location of the shareholders, beneficial owners, or investors. If Asset Management Corp, through its books and records kept in the normal course of business, can determine the domicile of the shareholders, beneficial owners, or investors, then the gross receipts shall be assigned to this state by the ratio of shareholders, beneficial owners, or investors in this state over the shareholders, beneficial owners, or investors everywhere. Example:

Same facts as prior example, except that Asset Management Corp cannot determine through its books and records kept in the normal course of business the domicile of the shareholders, beneficial owners, or investors. Asset Management Corp shall assign the


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sales by reasonably approximating the domicile of the shareholder, beneficial owner, or investor by utilizing information based on zip codes or other statistical data. If Asset Management Corp cannot reasonably approximate a method for determining the domicile of the shareholders, beneficial owners, or investors, then those receipts shall be disregarded for purposes of the sales factor.

C. Sales from Intangible Property Section. The only changes to this section are to the section addressing the sale of intangible property where there has been a complete transfer of all property rights. During and subsequent to the July 2014 IPM, public input indicated that there needed to be a substantial rewrite of the provision for the assignment of receipts in the form of interest. It was ultimately decided that the interest should be divided into three (3) different categories with three (3) different assignment methods. First, interest from investments, other than loans, shall be assigned to California if the investment is managed in California. Second, interest from loans secured by real property shall be assigned to California if the real property is located in California. Third, interest from loans which are not secured by real property shall be assigned to California if the borrower is located in California. Loans are defined under the provisions of CCR Section 25137-4.2(b)(7). (CCR Section 25136- 2(d)(1)(A)2.) In addition, the regulation provides that receipts from dividends or goodwill are assigned according to the sale of stock rules. (18 CCR sec. 25136-2(d)(1)(A)(2)(b)).

D. Assignment of marketable securities section. Subsequent to the July 2014 IPM, several stakeholders argued that for sales of marketable securities to corporations or business entities, taxpayers that use the commercial domicile of a purchaser as indicated from the taxpayer's books and records should not be subject to audit. This draft creates a presumption for taxpayers that use the commercial domicile of purchasers in accordance with the taxpayer's books and records. In such cases, the assignment will be accepted by the FTB as long as the assignment is consistent with the books and records of the taxpayer. The taxpayer may overcome this presumption with credible documentation that the commercial domicile of a purchaser is in a state other than the commercial domicile that is reflected in the taxpayer's books and records. The Franchise Tax Board may examine the taxpayer's alternate method. The language of this safe harbor rule is based on the safe harbor rule contained in the assignment rules for sales of services to individuals set forth in CCR Section 25136-2(c)(1)(A). (CCR Section 25136-2(e)(2)(A).) These same stakeholders also stated that if the location of the commercial domicile of the taxpayer's corporate or business entity customer was not readily apparent in the taxpayer's books and records, the taxpayer should be able to use the billing address of its corporate or business entity customer to assign those receipts. Based on Chief Counsel Ruling 2011-01, which provides for similar relief, an example was inserted indicating that this method is permissible. (CCR Section 25136-2(e)(3)(A).)


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E. Operative Dates. A new subsection was added to reflect the applicable date of the original regulation is for taxable years beginning on or after January 1, 2011 but only if the taxpayer had made an election for a single sales factor formula. That same subsection also notes that the original regulation is applicable to all taxpayers for taxable years beginning on or after January 1, 2013. A second subsection was added to provide that the amendments proposed herein will be applicable to taxable years beginning on or after January 1, 2015. A third subsection was added to provide that notwithstanding the previous two subsections, a taxpayer may elect to have the amendments proposed herein apply retroactively to taxable years beginning on or after January 1, 2012, but only if those taxable years are open to adjustment under applicable statutes of limitation. (CCR Section 25136-2(i).)

V. Apportionment and Startups.

A. Apportionment and No Sales.

Startups often have losses in the early years but they may have no revenue (sales). The question is how should such losses be apportioned? These corporations will need to know how much of their current year net operating loss (NOL) to apportion to California for use in future years when the company is expected to have sales and income. The FTB has answered this question in the October, 2016 edition of Tax News.

If a taxpayer has no sales and its business activity takes place entirely within California in a taxable year, it is not an apportioning taxpayer and its losses would be sourced to California and carried forward into future taxable years. If the trade or business of a taxpayer is conducted partly within California and partly elsewhere such that the taxpayer is subject to tax in more than one jurisdiction, the taxpayer must apportion its income under the Uniform Division of Income for Tax Purposes Act, R&TC Section 25120-25137.

For taxable years beginning on or after January 1, 2013, R&TC Section 25128.7 requires all business income of an apportioning trade or business, other than an apportioning trade or business under R&TC Section 25128(b), to be apportioned using the single-sales factor formula. Under the single sales factor apportionment formula now applicable to most taxpayers, a company that has no sales does not have a sales factor. Thus, although such taxpayers will likely be responsible for filing a return and paying the minimum franchise tax based on their business activity in this state, the question arises as to how losses generated by such companies should be apportioned (sourced) so they may be properly applied in future taxable years.

An apportionment result must fairly reflect the extent of a taxpayer's business activity in California. R&TC Section 25137 states that when the standard allocation and apportionment provisions of the Uniform Division of Income for Tax Purposes Act (R&TC Sections 25120-


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25139) do not fairly represent the extent of a taxpayer's business activity in California, the taxpayer may petition for the use of an alternative method to accomplish an equitable allocation or apportionment of income to California.

Because a taxpayer with no sales has no sales factor, such a result would not fairly reflect its business activity in California. For this reason, an alternative apportionment methodology might be appropriate. In such situations, a taxpayer with no sales should file a petition with us for relief under R&TC Section 25137. The petition should set forth the facts demonstrating that the taxpayer has no sales for the taxable year in question and should suggest a reasonable alternative to single sales factor apportionment that will result in sourcing its losses in a manner that fairly reflects the extent of the taxpayer's business activity in California.


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CHAPTER 3 THE ELECTION


II. Upcoming Ballot Measures ............................................................................................................................ 1 A. State and Local Measures on the Ballot. .............................................................................................................. 1

II. Upcoming Ballot Measures

A. State and Local Measures on the Ballot.

The November 8 election will require voters to decide not only 17 statewide measures, but also 228 local tax measures representing a cumulative tax increase of more than $3 billion per year, along with 193 bonds that would dramatically increase annual property taxes, according to a report released September 20 by the California Taxpayers Association.

The 17 statewide measures represent another $5.3 billion to $10.6 billion in potential annual tax increases, according to the state’s fiscal estimates.

The 180 school bonds (totaling $24.63 billion) and 13 bonds for other uses (totaling $7.27 billion), if approved and issued, will have to be repaid – with significant interest – through higher annual property taxes.

The table contains a summary of the top three state tax/fee-related initiatives that we feel might be of particular interest to you and your clients.

2016 Tax-Related Initiatives Proposition 55, Tax Extension to Fund Education and Healthcare

Proposition 55 would extend for an additional 12 years the “temporary” 1% to 3% surtax imposed on incomes above $250,000 that voters approved when they passed Proposition 30 in 2012. The revenues would be directed to K-12 education, community colleges, and government healthcare programs

Proposition 64, Marijuana Legalization

Proposition 64 would legalize recreational marijuana for use by adults age 21 or older. Excise taxes of 15% would be imposed on retail sales of recreational marijuana, as well as state cultivation taxes of $9.25 per ounce of flowers and $2.75 per ounce of leaves. Most of these funds would be required to be spent for specific purposes such as youth programs, environmental protection, and law enforcement. Allows for local regulation and taxation of marijuana. Also allows for resentencing and expungement of records for prior marijuana convictions

Proposition 67, Ban on Proposition 67 would implement SB 270 (Ch. 14-850), which prohibits


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Single-Use Plastic Bags

grocery and other stores from providing customers with single-use plastic or paper carryout bags and would require these stores to charge at least 10 cents for any other carryout bag provided for customers at checkout. Revenues would be used by the stores to cover compliance and educational outreach.


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CHAPTER 4 INCOME


II. Crowdfunding. ........................................................................................................................ 1

II. Crowdfunding.

On June 25, 2016, the IRS recently released Information Letter 2016-0036 that explains their thinking on the tax treatment of crowdfunding. The FTB has stated in Tax News that the IRS’s letter concurs with their prior statement “Without an analysis of the facts and circumstances, you can tell your client in most cases that amounts raised are included in your taxable income unless it is specifically exempted by law.” The Information Letter states:

“In general, money received without an offsetting liability (such as a repayment obligation), that is neither a capital contribution to an entity in exchange for a capital interest in the entity nor a gift, is includible in income. The facts and circumstances of a particular situation must be considered to determine whether the money received in that situation is income.

What that means is that crowdfunding revenues generally are includible in income if they are not:

1. Loans that must be repaid. 2. Capital contributed to an entity in exchange for an equity interest in the entity. 3. Gifts made out of detached generosity and without any “quid pro quo.”

However, a voluntary transfer without a “quid pro quo” is not necessarily a gift for federal income tax purposes. In addition, crowdfunding revenues must generally be included in income to the extent they are received for services rendered or are gains from the sale of property.


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CHAPTER 5 DEDUCTIONS

Table of Contents

I. Casualty Losses. .................................................................................................................................................. 1 A. Porter Ranch Gas Leak. .............................................................................................................................................. 1 B. Fires. ................................................................................................................................................................................. 2

II. Real Estate Tax Deduction. ............................................................................................................................ 3 A. Energy Saving Projects. ............................................................................................................................................. 3

I. Casualty Losses.

A. Porter Ranch Gas Leak.

On January 6, 2016, the Governor issued a proclamation of a state of emergency in Porter Ranch in Los Angeles County due to the Aliso Canyon gas leak. For tax years beginning on or after January 1, 2014, and before January 1, 2024, California law now provides immediate benefits for any loss attributable to a disaster for which only the Governor has declared a state of emergency. This means loss victims won’t have to wait for California legislation to be enacted to get the throwback election. (Cal Rev and TC §§ 1 7207.14; 24347.14).

Under the new law, Taxpayers may claim an IRC §165(i) throwback election on the California return for any disaster loss:

• Declared by the President (current law); or • Declared by the Governor for any city, county, or city and county that is proclaimed by

the Governor to be in a state of emergency.

In addition:

• A taxpayer may make the election on or before the extended due date of the tax return for the year of the loss. Federal law requires the election to be made on or before the original due date, not including extensions; and

• Unused disaster losses may create a net operating loss (NOL), which may be carried back two years from the year the disaster loss is recognized and carried forward for 20 years.

Therefore, unreimbursed casualty losses (primarily property damage) can be carried back and claimed on the prior year state tax return. The same treatment is not available on the federal tax return until Congress declares the area a federal disaster as well.


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In Announcement 2016-25 the IRS stated that disaster relief payments from the state or Southern California Gas Company would not be taxable (if used to reimburse the taxpayer for living expenses. (See discussion under Federal Update.). Residents near a gas storage facility in Southern California who were forced to vacate their homes won't have to pay taxes on compensation paid to them by Southern California Gas Co., according to an announcement by the IRS. This means that payments made by SoCal Gas to reimburse victims for a variety of expenses are excluded. These expenses could include:

• Hotel expenses and/or expenses incurred in temporarily leasing another home; • Expenses for staying with family and friends ($150/day); • Cleaning expenses; • Meal reimbursements; • Mileage expenses; and/or • Pet boarding fees.

Payments received from state and local governmental agencies are excludable under IRC §139(b)(4) and (c)(4). However, if only the Governor and the local governments declare a state of emergency, payments received from private entities such as SoCal Gas are not excludable unless the President also declares the area a disaster area or the disaster is determined by the Secretary to be of a catastrophic nature (IRC sec. 139( c)(3)).

In Announcement 2016-15, the IRS has concluded that they will not require SoCal Gas payments and reimbursements paid directly to the gas leak victims to be included in the victims’ gross income (on the basis that the event is of a catastrophic nature). Because the California Revenue and Taxation Code conforms to the federal definition of gross income in IRC §61, to the extent that the IRS is taking the position that the relief payments are not included in gross income, it is probably safe to assume that the FTB will follow that interpretation.

The IRS guidance states that family and friends who received payments under the relocation plan for housing affected area residents must include these payments in gross income, unless these amounts are properly excludable from gross income under IRC §280A (relating to the exclusion for rental income from a taxpayer’s residence for less than 15 days during the taxable year).

B. Fires.

On July 27th, the Governor declared a state of emergency in Los Angeles and Monterey counties for the Sand and Sobranes fires. So taxpayers living in these counties now qualify for these disaster tax benefits.

The Governor declared a state of emergency on June 24, 2016, for the Erskine fire in Kern County.

With the recent State of Emergency Proclamations issued in July and August by Governor Brown for fires, here is how to claim a disaster loss in 2016. Beginning on or after January 1, 2014, and before January 1, 2024, your clients may deduct a disaster loss for any loss


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sustained in California that is proclaimed by the Governor to be in a state of emergency. California law generally follows federal law regarding the treatment of losses incurred as a result of a casualty or a disaster.

Casualty loss: If taxpayers’ property is lost or damaged due to an earthquake, fire, flood, or similar event that is sudden, unexpected, or unusual, and insurance or other reimbursements do not repay them for the damage to their property, they will usually qualify for a casualty loss deduction.

Disaster loss: For California purposes, a casualty loss becomes a disaster loss when both of the following occur:

• Sustained the loss in an area the President of the United States or the Governor of California declares a state of emergency.

• Sustained the loss because of the declared disaster.

Your client can claim a disaster loss in the taxable year the disaster occurred or in the taxable year immediately before the disaster occurred. The advantage of claiming a loss in the preceding year is that the loss will generally reduce that year’s tax liability generating a refund that FTB can issue quickly.

If they e-file, they will need to use the appropriate disaster code from the Qualified Disasters chart.

If they file a paper return, they will need to print the following information in red ink across the top:

• Disaster. • Name of disaster in Governor’s State of Emergency Proclamation. • The year the loss occurred: year from Governor’s proclamation.

II. Real Estate Tax Deduction.

A. Energy Saving Projects.

The issue is whether energy-saving projects paid through one's property tax bill qualify as deductible real estate taxes. These energy-saving projects include solar panels, air conditioning, roofing, windows, lighting controls, and landscape-related products. Often these projects are financed through the property assessed clean energy (PACE) program.

California conforms to federal law regarding real estate tax deductions. On May 25, 2016, the Internal Revenue Service issued "Topic 503 - Deductible Taxes" which provides specific guidance on this issue, including the following:


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There are popular loan programs that finance energy saving improvements through government-approved programs. You sign up for a home energy system loan and use the proceeds to make energy improvements to your home. In some programs, the loan is secured by a lien on your home and appears as a special assessment on your real estate property tax bill over the period of the loan. The payments on these loans may appear to be deductible real estate taxes; however, they are not deductible real estate taxes. Assessments associated with a specific improvement benefitting one home are not deductible. However, the interest portion of your payment may be deductible as home mortgage interest. Refer to Publication 936, Home Mortgage Interest Deduction, to see whether you might qualify for a home mortgage interest expense deduction.

Therefore, under the above federal guidance, which appears consistent with federal guidance issued in 2013 (see Chief Counsel Advice 201310029), neither the principal nor interest amounts paid on a taxpayer's property tax bill for energy saving projects are deductible real estate taxes. However, taxpayers may be able to deduct some or all of the interest as a home mortgage interest deduction.


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CHAPTER 6 CALIFORNIA CREDITS

Table of Contents

I. Update on California Film Credit ............................................................................................................. 1 A. Assignable Credits. .............................................................................................................................. 2

II. SB 837 (CH. 32 June 27, 2016). Donated Fruits and Vegetables Credit. ............................................... 3

III. SB. 836 (Ch. 31; June 27, 2016) California Competes Credit. .............................................................. 4 IV. SB 836 (Ch. 31; June 27, 2016) Advanced Strategic Aircraft Credit. ................................................... 5

V. SB 837 (CH. 32 June 27, 2016). Low Income Housing Credit. .............................................................. 5 VI. Earned Income Tax Credit. .................................................................................................................... 7

A. AB 1847 Advising Clients. .................................................................................................................. 7

I. Update on California Film Credit On September 18, 2014, Governor Brown signed bipartisan legislation to more than triple the size of California's film and television production incentive, from $100 million to $330 million annually. Aimed at retaining and attracting production jobs and economic activity across the state, the California Film and TV Tax Credit Program 2.0 also extends eligibility to include a range of project types (big-budget feature films, TV pilots and 1-hr TV series for any distribution outlet) that were excluded from the state's first-generation tax credit program. Other key changes include replacing the prior lottery system with a "jobs ratio" ranking system that selects projects based on wages paid to below-the-line workers, qualified spending (for vendors, equipment, etc.) and other criteria. Program 2.0 also offers an additional five percent tax credit for non-independent projects that shoot outside the Los Angeles 30-mile zone or have qualified expenditures for visual effects or music scoring/track recording. Projects approved for California tax credits are selected based on their jobs ratio score, which ranks each project by wages to below-the-line workers, qualified spending for vendors, equipment, etc., and other criteria. The top 200% ranked projects in each round (i.e., those that would qualify if double the amount of funding was available for the current allocation round) are evaluated, and those with the highest-ranked jobs ratios receive tax credits. Those not selected are placed on the waiting list. The program allocates funding in "buckets" for different production categories, including non-independent feature films, independent films, TV projects and relocating TV series. This enables applicants to compete for credits directly against comparable projects. As has been the case since the state launched its first-generation tax credit program in 2009, the California Film Commission awards tax credits only after each selected project: 1) completes post-production, 2) verifies that in-state jobs were created, and 3) provides all required documentation, including audited cost reports.


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On August 2, 2016, the Film Commission announced that the expanded Film & Television Tax Credit Program 2.0 has scored its first big-budget film project, signaling a milestone in the state's effort to combat runaway production.

Disney's "A Wrinkle in Time" is among the 28 projects selected as part of the first feature film allocation for year-two of the program. It is the type of "tentpole" film previously ineligible under the state's first-generation tax credit program (Program 1.0), which did not accept projects with budgets greater than $75 million. In contrast, Program 2.0 is open to film projects of any budget (though credits are capped to each studio-produced film's first $100 million in qualified spending).

Adapted from the classic 1963 fantasy novel by Madeleine L'Engle, the film is set on multiple planets across the universe. Disney plans to shoot much of the film outside the Los Angeles 30-Mile Zone.

The first feature film application period for year-two of Program 2.0 was held June 27 -- July 8. It drew 91 applications vying for $109 million in tax credits. A total of 28 projects -- 18 from studios and 10 from independent production companies -- were selected. Based on data provided with each application, these projects are on track to spend a total of $880 million in state, including $326 million in qualified wages to more than 5,900 crew and cast members.

The next application period for California's Film & Television Tax Credit Program 2.0 will be held November 14-29 for television projects.

A. Assignable Credits.

FTB recently revised form FTB 3541, California Motion Picture and Television Production Credit, for all years with an open statute (i.e. 2012 to 2015). Now you will be able to include prior year assignable credit carryovers to determine the total amount of credit available for assignment in the current year.

Step 1. Include prior year "assignable" credit to compute the total amount of credit available for assignment in the year being reported. (Credits that are purchased or received via assignment are not assignable.)

Step 2. If the total amount of credit available for assignment is greater than the amount assigned on the original return, then file an amended return.

Step 3. Complete form FTB 3541. List both, the originally reported credit assignments and the additional assignments. Attach the completed FTB 3541 to the amended return.

In addition, motion picture credit that is in excess of current year tax liability is available for assignment.

Example:


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Taxpayer has $300,000 of old credit. They have $200,000 of new credit. Current year tax liability is $100,000.

Solution 1

Old credit New credit Amount of credit available $300,000 $200,000 Amount of tax liability reduced by credit $100,000 0 Credit available for assignment $200,000 $200,000

Solution 2

Old credit New credit Amount of credit available $300,000 $200,000 Amount of tax liability reduced by credit 0 $100,000 Credit available for assignment $300,000 $100,000

II. SB 837 (CH. 32 June 27, 2016). Donated Fruits and Vegetables Credit. Under current federal law, in general, a deduction is permitted for charitable contributions, subject to certain limitations that depend on the type of taxpayer, the property contributed, and the donee organization. The amount of any deduction generally equals the fair market value of the contributed property on the date of the contribution.

A donor making a charitable contribution of inventory must make a corresponding adjustment to the cost of goods sold by decreasing the cost of goods sold by the lesser of the fair market value of the property or the donor's basis with respect to the inventory. Accordingly, if the allowable charitable deduction for inventory is the fair market value of the inventory, the donor reduces its cost of goods sold by such value, and the donor's basis may still be recovered by the donor as a business deduction other than as a charitable contribution.

To use the enhanced deduction, the taxpayer must establish that the fair market value of the donated item exceeds basis. The valuation of food inventory has been the subject of disputes between taxpayers and the IRS.

California’s PITL generally conforms to the federal rules relating to charitable contributions as of the specified date of January 1, 2015, but specifically does not conform to the enhanced deduction for a contribution of food inventory. The deduction under the PITL for charitable contributions of inventory is limited to the taxpayer‘s basis in the inventory, generally its cost. Additionally, the state’s CTL does not adopt the general federal rules that allow enhanced deductions for C-corporation contributions of inventory, and does not adopt the enhanced deduction for a contribution of food inventory. The deduction under the CTL for contributions of inventory is limited to the taxpayer‘s basis in the inventory (generally its


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cost), and may not exceed ten percent of the corporation‘s net income. Any excess may be carried forward for up to five years.

For taxable years beginning before January 1, 2017, current state law allows a credit of 10 percent of the qualified donation of fresh fruits and vegetables made to a qualified nonprofit by a qualified taxpayer. For taxable years beginning on or after January 1, 2017, and before January 1, 2022, a new corporation franchise and income and personal income tax credit is allowed to qualified taxpayers who donate fresh fruits or vegetables to a food bank in California. The credit allowed is equal to 15% of the qualified value of the fresh fruits and vegetables donated. For taxable years beginning before January 1, 2017, current state law provides a similar credit for 10% of the qualified cost of fresh fruits and vegetables donated to a food bank in California. For purposes of the new credit, a "qualified taxpayer" is a person responsible for planting, managing, and harvesting the crop from the land. "Qualified value" must be calculated by using the weighted average wholesale price based on the taxpayer’s total like grade wholesale sales of the donated item within the calendar month of the donation. If no wholesale sales of the donated item have occurred in the calendar month of the taxpayer’s donation, the "qualified value" will be equal to the nearest regional wholesale market price for the calendar month of the donation based upon the same grade products as published by the U.S. Department of Agriculture’s Agricultural Marketing Service or its successor. Any deduction allowed for the cost paid or incurred by the taxpayer for the donated items must be reduced by the amount of the credit allowed. A donor must provide to the nonprofit organization the qualified value of the donated fresh fruits or fresh vegetables and information regarding where the fruits or vegetables were grown. Upon receipt of the donated fresh fruits or fresh vegetables, the nonprofit organization must provide a certificate to the donor. Upon request, a taxpayer must provide a copy of the certificate to the Franchise Tax Board (FTB). The credit may be claimed only on a timely filed original return. Excess credit may be carried over for up to seven years until the credit is exhausted. The FTB must report to the Legislature on or before December 1, 2019, and each December 1 thereafter regarding the utilization of the credit. The FTB must also include in the report the qualified value of the fresh fruits and fresh vegetables donated, the county in which the products originated, and the month the donations were made. The reporting requirement becomes inoperative on January 1, 2021.

III. SB. 836 (Ch. 31; June 27, 2016) California Competes Credit.


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SB 836 clarifies that when determining whether to enter into a written agreement with a taxpayer eligible for the California Competes credit, GO-Biz may now consider the following additional factors:

• The financial solvency of the taxpayer and the taxpayer’s ability to finance its proposed expansion;

• The taxpayer’s current and prior compliance with federal and state laws; • Current and prior litigation involving the taxpayer; • The reasonableness of the fee arrangement between the taxpayer and any third party

providing any services related to the credit; and • Any other factors GO-Biz deems necessary to for the purposes of accountability,

transparency, and effectiveness.

IV. SB 836 (Ch. 31; June 27, 2016) Advanced Strategic Aircraft Credit.

To allow taxpayers to claim the advanced strategic aircraft credit for the entire 15 years of the project, the specific operative date is changed from taxable years beginning on or after January 1, 2015, and before January 1, 2030, to taxable years beginning on or after January 1, 2016, and before January 1, 2031.

V. SB 837 (CH. 32 June 27, 2016). Low Income Housing Credit. Current federal tax law allows an LIHC for the costs of constructing, rehabilitating, or acquiring low-income housing. The credit amount varies depending on several factors, including when the housing is placed in service and whether it is federally subsidized; and, varies between 30 and 70 percent of the present value of the qualified low-income housing. The credit is claimed over ten years.

The California Tax Credit Allocation Committee (Allocation Committee) allocates and administers the federal and state LIHC Programs.

Current state tax law generally conforms to federal law (Internal Revenue Code section 42) with respect to the LIHC, except that the state LIHC is claimed over four taxable years (versus 10 years for federal purposes), is limited to projects located in California, must be allocated and authorized by the Allocation Committee, rents must be maintained at low-income levels for 30 years (versus 15 years for federal purposes), and the Allocation Committee must have authorized a federal credit to the taxpayer or the taxpayer must qualify for the federal credit. The LIHC is allocated in amounts equal to the sum of all the following:

• $100 million, • The unused housing credit ceiling, if any, for the preceding calendar years, and • The amount of housing credit ceiling returned in the calendar year.


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Prior law required allocation of the LIHC, on or after January 1, 2009, and before January 1, 2016, to partners based upon the partnership agreement, regardless of how the federal LIHC was allocated to the partners, or whether the allocation of the credit under the terms of the agreement had substantial economic effect, as specified.

The Allocation Committee certifies the amount of tax credit amount allocated. In the case of a partnership or an S Corporation, a copy of the certificate is provided to each taxpayer. The taxpayer is required, upon request, to provide a copy of the certificate to the Franchise Tax Board (FTB).

Any unused credit may continue to be carried forward until the credit is exhausted.

Existing federal and state laws provide that gross income includes all income from whatever source derived, including gains from property, unless specifically excluded. The sale of a credit is a sale of property; therefore, the seller is required to report gain from the sale. The gain from the sale of the credit is the excess of the total consideration received over the basis. The total amount of consideration received is the sum of any money received plus the fair market value of the property (other than money) received. Because the seller’s basis in the credit is zero, the seller will recognize and report gain on the full amount of consideration received.

For a project that receives a preliminary reservation of the state low-income housing credit before January 1, 2020 (previously, 2016), the credit may be allocated among partners based upon the partnership agreement, regardless of how the federal credit is allocated to the partners, or whether the allocation under the terms of the partnership agreement has substantial economic effect. Also, for a project that receives a preliminary reservation beginning on or after January 1, 2016, and before January 1, 2020, a taxpayer may make an irrevocable election in its application to the California Tax Credit Allocation Committee to sell all or any portion of the credit allowed to one or more unrelated parties for each taxable year in which the credit is allowed. The credit must be sold for consideration that is not less than 80% of the amount of the credit. Furthermore, the unrelated party purchasing the credit must be a taxpayer allowed the state or federal credit for the taxable year of the purchase or any prior taxable year in connection with a project located in the state. The credit generally may not be resold by the unrelated party to another taxpayer or other party. However, the credit may be resold once by an original purchaser to one or more unrelated parties, subject to all the requirements for the credit. The taxpayer that originally receives the credit that is sold remains solely liable for all obligations and liabilities imposed on the taxpayer with respect to the credit, none of which will apply to any party to whom the credit is sold or subsequently transferred. Parties that purchase a credit are entitled to utilize the purchased credit in the same manner as the taxpayer that originally received the credit. A taxpayer may not sell the credit if the taxpayer was allowed the credit on a tax return. A taxpayer, with the approval of the Executive Director of the California Tax Credit Allocation Committee, may rescind the election to sell all or any portion of the credit if the consideration for the credit falls below 80% of the amount of the credit after the California Tax Credit Allocation Committee reservation.


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VI. Earned Income Tax Credit.

A. AB 1847 Advising Clients.

Governor Brown signed Assembly Bill 1847 (Stone), which requires employers to let employees know they may be eligible for California's Earned Income Tax Credit (EITC). AB 1847, which takes effect on January 1, 2017, updates the Earned Income Tax Credit Notification Act, which already requires that employers alert employees that they may be eligible for the federal Earned Income Tax Credit. The Act calls on employers to send a notice to employees at about the same time that W-2 forms are delivered.

Governor Brown and the Legislature created the state's first refundable EITC in 2015 in an effort to assist the state's low-income families. The California EITC is designed to supplement the federal EITC.


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CHAPTER 7 FLOW THROUGH ENTITIES

Table of Contents

I. Legal Ruling 2016-01 LLC Fee Computation. ......................................................................... 1 II. Sourcing gain on Sale of Partnership Interest. ........................................................................ 3

III. LLC Statement of Information. ............................................................................................. 4 IV. Update on Flow Through Entities .......................................................................................... 5

A. Doing Business: Flow Through Entities. ........................................................................... 5 B. General partnerships. ........................................................................................................... 6 C. Limited Liability Companies. .............................................................................................. 7 D. Limited Partnerships. .......................................................................................................... 9 E. Sourcing gain on sale of flow through entity ownership interest. ..................................... 11

V. Corrigan v. Testa: Taxation of Nonresident Capital Gain ................................................... 12

I. Legal Ruling 2016-01 LLC Fee Computation.

Legal Ruling 2016-01 addresses the issue whether for purposes of calculating the limited liability company (LLC) fee, does the cost of goods sold include the adjusted basis of real property held for sale to customers in the ordinary course of business? In other words does the LLC fee computation include gross receipts for sales in the ordinary course of business or gross income (net of cost of goods sold). The Forms instructions were conflicting and unclear. Legal Ruling 2016-01 concludes that if the sale is made in the ordinary course of a taxpayer’s trade or business, then the adjusted basis of the property sold should be added back. In the alternative where the property might be held for investment purposes, the amount included will be gross income (or net of cost of goods sold.

Revenue and Taxation Code (R&TC) Section 17942 imposes a fee on LLCs based on "total income from all sources derived from or attributable to this state.” Total income for purposes of calculating the LLC fee is defined in R&TC Section 17942 as "gross income…plus the cost of goods sold that are paid or incurred in connection with the trade or business of the taxpayer." In other words, the costs of goods sold is added back to trade or business gross income and the LLC fee is then calculated based on gross receipts. For other items of income, the LLC fee is calculated based on gross income.

Many LLCs sell investment real property for which the LLC fee is calculated based on gross income. This generally includes (among other investments) real property held for rental purposes. However, a dealer in real property sells both real property held for sale to customers in the ordinary course of business, as well as investment real property. The legal ruling clarifies


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"the cost of goods sold that are paid or incurred in connection with the trade or business of the taxpayer:"

1. Includes the adjusted basis of real property held for sale to customers in the ordinary course of business and

2. Does not include the adjusted basis of real property held for investment purposes.

This ultimately means a dealer in real property calculates the LLC fee based on gross receipts amounts for sales of real property held for sale to customers in the ordinary course of business, but calculates the LLC fee based on gross income (i.e. gain amounts) for sales of real property held for investment. This result is consistent with the calculation of the LLC fee for other industries.

The legal analysis on this issue was undertaken because of long-standing practitioner concerns regarding the instructions to FTB Form 568. Those instructions told taxpayers the cost of goods sold did not include the adjusted basis of real property held for sale to customers in the ordinary course of business. The FTB has agreed to update the forms instructions for 2016 and subsequent forms to include the legal ruling's conclusions. In the meantime, the FTB has no plan to commit audit resources to identify prior year tax returns that did not conform to this legal ruling's conclusions.

Finally, the FTB recognizes that LLCs' reliance on FTB's existing instructions regarding the calculation of the LLC fee may subject some LLCs to a potential underpayment penalty per R&TC Section 17942(d). While R&TC Section 17942(d) does not contain an abatement provision, the FTB recommends that impacted LLCs should contact the FTB’s Taxpayer Advocate, whose office has the authority to consider and abate this penalty under R&TC Section 21004.

Example:

X is a California LLC with two or more members that is classified as a partnership for federal and California income tax purposes. X holds real property for sale to customers in the ordinary course of its trade or business. X owns Blackacre, a parcel of unimproved real property, for sale to customers in the ordinary course of its trade or business, and sells Blackacre during its 2016 taxable year. As a result, X’s adjusted basis in Blackacre will be added back to X’s gross income for purposes of calculating X’s 2016 LLC fee under RTC section 17942.

Example:

Assume the same facts as in prior example, except that instead of selling Blackacre, X sold Whiteacre, a parcel of unimproved real property held by X for investment purposes, during its 2016 taxable year. Since X held Whiteacre for investment purposes, rather than for sale to customers in the ordinary course of its trade or business, X’s adjusted basis in Whiteacre will not be added back to X’s gross income for purposes of calculating X’s 2016 LLC fee under RTC section 17942.


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II. Sourcing gain on Sale of Partnership Interest.

In the Appeal of Bills (Case No. 610028 and 782397, August 26, 2016) two issues were raised: One was related to residency and the second related to the sourcing of gain on the sale of a partnership interest. Michael and Mary Bills had moved to Washington, bought a house but kept their home in California for use by their daughter. For the years in question (2004 and 2005) there was some travel back and forth between the two locations. But sufficient contacts were established in Washington for the SBE to determine that the date of the move was in January, 2005. Therefore, when Mr. Bills received the first of five payments from the partnership where he had worked in March of 2005, he was determined to be a nonresident. That meant that the issue in the case became an issue of sourcing payments for partnership interest received by a nonresident. Mr. Bills tendered his written resignation and retirement from the Brandes Partnership effective December 31, 2004, and, thereafter, pursuant to the Brandes partnership agreement, received Partnership Interest payments from Brandes from 2005 through 2009. The partnership agreement provided that those payments would be treated as payments under IRC section 736(b), calculated by a formula under which the amount of each payment for each year was dependent upon Brandes's earnings from the prior year. Brandes treated the amounts paid as payments under IRC section 736(b) in accordance with the partnership agreement and did not deduct those payments as expenses on its returns. . Bills received his first payment of $7,553,083 on March 15, 2005, and subsequent payments in the amounts of $7,774,548, $9,205,847, $9,697,337, and $5,138,423 for the years 2006 through 2009, respectively.

With respect to partnership distributions made in liquidation of a retiring partner's interest, IRC section 736(a) provides, in relevant part, that such payments shall, except as provided in subsection (b), be considered—

(1) as a distributive share to the recipient of partnership income if the amount thereof is determined with regard to the income of the partnership, or (2) as a guaranteed payment described in section 707(c) if the amount thereof is determined without regard to the income of the partnership.

IRC section 736(b) provides, in relevant part, that payments in liquidation of a retiring partner's interest “shall, to the extent such payments (other than payments described in paragraph (2)) are determined, under regulations prescribed by the Secretary, to be made in exchange for the interest of such partner in partnership property, be considered as a distribution by the partnership and not as a distributive share or guaranteed payment under subsection (a).” Payments made in liquidation of a retiring partner's interest must be allocated between payments for a partner's interest in partnership property and all other payments. (Int.Rev. Code, §736(a) & (b); Treas. Reg. §1.736-1(a)(3).) Amounts paid for a partner's interest in partnership assets are treated in the same manner as a distribution in complete liquidation, and the partnership is allowed no deduction for such payments. (Treas. Reg. §§1.736-1(a)(2), 1.736-1(b)(2).)


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For purposes of computing the taxable income of a nonresident or part-year resident as defined by R&TC section 17041, subdivision (i)(1), R&TC section 17951, subdivision (a) provides that “in the case of nonresident taxpayers the gross income includes only the gross income from sources within this state.” Regulation 17951-4, subdivision (a) provides, in part, that if “the nonresident's business, trade or profession is conducted wholly within the state, the entire net income therefrom is derived from sources within this state.” R&TC section 17952 provides that “income of nonresidents from stocks, bonds, notes, or other intangible personal property is not income from sources within this state unless the property has acquired a business situs in this state ….” With respect to business situs, subdivision (c) of Regulation 17952 provides that:

[i]ntangible personal property has a business situs in this State if it is employed as capital in this State or the possession and control of the property has been localized in connection with a business, trade or profession in this State so that its substantial use and value attach to and become an asset of the business, trade or profession in this State. For example, if a nonresident pledges stocks, bonds or other intangible personal property in California as security for the payment of indebtedness, taxes, etc., incurred in connection with a business in this State, the property has a business situs here…. If intangible personal property of a nonresident has acquired a business situs here, the entire income from the property including gains from the sale thereof, regardless of where the sale is consummated, is income from sources within this State, taxable to the nonresident.

In the Appeals of Amyas and Evelyn P. Ames, et al., (87-SBE-042) (hereafter Appeals of Ames), decided on June 17, 1987, this Board decided that the operation of a partnership in California did not create a business situs for the partnership interests in California and, thus, the gain on the sale of partnership interests was not taxable by California. The Board reasoned that the gain was not the result of partnership operations, but rather the result of the sale of intangible property and, therefore, the gains would be sourced to California only if the intangible property had a business situs in the state. Because the taxpayers did not integrate those partnership interests into business activities in California, the gain was sourced to the taxpayers' states of residence.

III. LLC Statement of Information.

Every California and registered foreign limited liability company must file a Statement of Information with the Secretary of State, within 90 days after the filing of its original Articles of Organization or Application for Registration, and every two years thereafter during a specific 6-month filing period based on the original file date, as described in the chart below. Changes to information contained in a previously filed Statement of Information can be made by filing a new Form LLC-12, completed in its entirety. If there has been no change in any of the information contained in the previous complete Statement of Information filed with the California Secretary of State, and if filing within the required 6-month filing window listed below, a Statement of No Change (Form LLC-12NC) may be used in lieu of the Statement of


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Information (Form LLC-12). Type of Filing Description Form to Use Fee Initial Filing The initial filing is due 90 days from the

entity’s registration date.

Statement of Information - Form LLC-12

$20.00 Required Periodic Filing

• The periodic filing is due every two years based on the entity’s registration date. • If the registration occurred in an even- numbered year, the periodic filing is due every even year. • If the registration occurred in an odd- numbered year, the periodic filing is due every odd year. • The filing period includes the registration month and the immediately preceding five (5) months.

Statement of No Change - Form LLC-12NC, if no changes since the last complete Statement of Information or Statement of Information - Form LLC-12, if changes have been made

$20.00

No Fee Statement

A Statement of Information is submitted after the initial or required filing requirements have been met to update information including changes to the agent for service of process.

Statement of Information - Form LLC-12

No Fee

IV. Update on Flow Through Entities California’s 2011 changes in defining doing business, apportionment and sourcing certain types of income have had major implications for a wide variety of taxpayers. This new dimension of complexity might more than override any tax benefit that taxpayer’s thought they might have experienced by electing to be taxed as a flow through entity. Prior to January 1, 2011, nexus in California was largely determined by physical presence in the state. This changed in 2011 when a statutory standard was added to the definition of doing business.1 The statutory standard was determined by looking to the sourcing rules used for apportionment, which also changed as of the same date. As of January 1, 2011, California adopted market based sourcing rules for service income and income from intangibles and as a result economic nexus was here to stay. The last piece of the new state structure was a mandatory use of a single sales factor apportionment. This dramatic departure from prior rules coupled with aggressive enforcement by FTB has resulted in a very different tax landscape now brimming with uncertainty.

A. Doing Business: Flow Through Entities.

Under Cal Rev. and TC sec. 23101, "doing business" means actively engaging in any transaction for the purpose of financial or pecuniary gain or profit. This definition was amended for taxable years beginning on or after 1/1/2011, to expand the scope of “doing business” to include the following situations if any of the following conditions are satisfied:

• The taxpayer is organized or commercially domiciled in California. 1 Cal. Rev. and TC sec. 23101(b).


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• Sales, as defined in Cal. Rev. and TC sec. 25120 (e) or (f)2, of the taxpayer in California, including sales by the taxpayer’s agents and independent contractors, exceed the lesser of $500,000 (indexed for inflation) or 25 percent of the taxpayer's total sales. For purposes of Cal. Rec & TC sec. 23101, sales in California are determined using the rules for assigning sales under Cal. Rev. and TC sec. 25135 (the sales factor sourcing rule for sales of tangible property)…

• Real and tangible personal property of the taxpayer in California exceed the lesser of $50,000 (indexed for inflation) or 25 percent of the taxpayer's total real and tangible personal property.

• The amount paid in California by the taxpayer for compensation, as defined in Cal. Rev. and TC sec. 25120 exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.

• For the conditions above, the sales, property, and payroll of the taxpayer include the taxpayer's pro rata or distributive share of pass-through entities. "Pass-through entities" means partnerships, LLCs treated as partnerships, or S corporations.

For taxable years beginning on or after 1/1/2015, the inflation indexed amounts are for sales $536,446, for property $53,644 and for payroll $53,644, respectively.

Applying these rules to flow through entities creates a new wrinkle in that the rules have to be applied twice – once at the entity level and again at the owner level. The impact of these new rules varies by type of entity.

B. General partnerships.

California does not tax general partnerships at the entity level, but if the general partnership is doing business in the state then the general partners will be deemed to be doing business in the state. 3 In the Appeal of CFL.LP the SBE held that an Arizona limited partnership that served as a general partner in a California general partnership was doing business in California as the business of the partnership is the business of each partner. Therefore, wherever the partnership does business, the activities are attributed to the partner, with the consequence that the partner is doing business in the same locations as the partnership does business. 4

Example:

2 "Gross receipts" means the gross amounts realized (the sum of money and the fair market value of other property or services received) on the sale or exchange of property, the performance of services, or the use of property or capital (including rents, royalties, interest, and dividends) in a transaction that produces business income, in which the income, gain, or loss is recognized (or would be recognized if the transaction were in the United States) under the Internal Revenue Code, as applicable for purposes of this part. Amounts realized on the sale or exchange of property shall not be reduced by the cost of goods sold or the basis of property sold. Gross receipts, even if business income, shall not include (certain items subject to a “throwout rule”.) 3 Appeal of CFL. LP (SBE No. 764609, Oct. 14, 2014). 4 Legal Ruling 2014-01, July 22, 2014.


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GP (general partnership doing business in California) is owned by three equal general partners – ABC Corporation, DEF LLC and Sammy (an individual). GP owns and operates two hotels in California and both hotels lost money in 2015. ABC Corporation receives one-third of the loss, but still has to file and pay $800 (the minimum franchise tax) because ABC is doing business in California through their status as a general partner. DEF LLC also receives one-third of the loss and will have to file and pay $800 because the LLC is deemed to be doing business in the state through their ownership of a 1/3rd interest in ABC. DEF might also have to pay the fee based on gross receipts if they have over $250,000 of gross receipts sourced to California for the year.5 Assume DEF LLC is solely owned by XYZ Corporation. Since XYZ is the manager of DEF LLC, XYZ is deemed to be doing business in the state and will also have to file and pay the $800 minimum franchise tax. If, in the alternative, DEF LLC is owned by GHI LLC then the $800 assessments continue, with GHI owing $800 to California. The liability for the minimum franchise tax continues down the chain of ownership until we reach an owner, which is not a flow through entity and/or not subject to the minimum franchise tax. Sammy (who pays tax under the Personal Income Tax) will have to pay tax on his share of the flow through income when GP makes money, but is not required to pay the minimum franchise.

C. Limited Liability Companies. LLC’s apparently come under a special rule that focuses on the rights of the members under the state’s LLC statute. In Legal Ruling 2014-01, the FTB addressed when a business entity with a membership interest in a multiple-member LLC that is classified as a partnership for tax purposes is required to file a California return and pay taxes and fees that are imposed on the basis of doing business in the state. According to the FTB, if an LLC is classified as a partnership for tax purposes and the entity is “doing business” in California under Section 23101, the members of the LLC are themselves “doing business” in California. This is true even in the case of “manager-managed” LLCs. Members of LLCs generally have the right to participate in the management of the business.6 Part of that power necessarily includes the right to delegate the power to manage the business in favor of a manager, and the power to revoke that delegation at any time. This analysis is not affected by whether or not members participate in the management of an LLC or appoint a manager to do so because the members' rights to participate in the management of the business arise out of the statutory relationship between an LLC and its members. Partners are considered co-owners of the partnership enterprise and the partnership acts as a conduit through 5 Cal. Rev. and TC. Sec. 17942. 6 Cal. Corp. Code sec. 17704.07(b).


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which the enterprise is operated. “The courts have recognized that the execution of an agreement relinquishing control is itself an exercise of the requisite right of control over the conduct of the partnership business.”7 Thus, according to the FTB, the distinction between “manager-managed” LLCs and “member-managed” LLCs is not relevant for purposes of determining whether a member of an LLC, which is “doing business” in California and is classified as a partnership for tax purposes, is “doing business” here within the meaning of Cal. Rev. and TC sec. 23101. Swart Enterprises, Inc. v. Franchise Tax Board 8 is an example of the extreme result that can accrue under the above analysis. Swart is an Iowa corporation with no business activities or physical presence in California. Swart’s sole connection with California is a $50,000 investment in an investment Fund which represented a 0.2% interest. At the time that Swart invested in the Fund, the Fund had appointed a manager and the Fund’s operating agreement prohibited members (other than the manager) from taking part in the control or operation of the fund. In due course, the Fund lost money and FTB demanded that Swart file a tax return and pay the minimum tax ($800) on the basis that Swart was doing business in California through their ownership interest in in the LLC that was operating in California. The California Superior Court held that the taxpayer was not doing business in California and, therefore, was not subject to the $800 minimum franchise tax. The Franchise Tax Board (FTB) took the position that an entity owning an interest in an LLC operating in California is doing business in California per Cal. Rev. and TC Sec. 23101 (actively engaging in any transaction for the purpose of financial or pecuniary gain or profit) and, therefore, is subject to the minimum franchise tax, even if owning the interest in the LLC is the entity’s sole connection with California. The Court did not agree holding that "actively " requires active participation. Therefore, holding an investment in the LLC did not constitute actively engaging in a transaction for gain or profit. FTB has appealed the decision in the case (which is still listed on the FTB’s Litigation Roster as awaiting a date for oral argument.) The lower court decision is of only limited value, as Superior Court decisions cannot be cited as precedent. Aggressive enforcement has also accompanied the expansive interpretation of the LLC statute discussed above. This may be partly due to the extension of a $2,000 per year penalty for failure to file a tax return in the state if the entity has been conducting business in the state.9 This penalty has been assessed for many years against non-filing foreign or suspended corporations, and has now been extended to foreign or suspended LLCs. Although the penalty was extended to LLCs as of January 1, 2013, it applies to all prior tax years that receive a Notice and Demand to File letter after January 1, 2013. In other words, the penalty could be assessed for all prior years. The penalty is not assessed if the taxpayer files a return within 60 days after the FTB sends the Notice and Demand letter. Although the discussion so far has dealt with out of state members doing business in the state through their ownership interest, the long arm of California’s definition of “doing business” does not stop there. If an LLC member lives in California and performs functions in California

7 Moulin v. Der Zakarian (1961) 191 Cal. App. 2d 184. 8 No. 13CECG02171 (Cal. Super. Ct. (Fresno) Nov. 13, 2014. 9 Cal. Rev. and TC sec. 19135.


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on behalf of the out of state LLC, then the out of state LLC might very well be deemed to be doing business in California through the activities of its owner. This argument is most persuasive where the LLC has only a single California resident as an owner.

Example: Jerry, a California resident, owns a 60% interest in LLC1 which owns a rental property in Montana. The LLC owns rental property located in Montana which is managed by a property management company (also located in Montana). The LLC used a California address on the tax returns filed in Montana, used a California CPA and opened a bank account in San Francisco. Jerry also owns a 100% interest in LLC 2 which owns a second home on the Nevada side of the state line in Lake Tahoe. Jerry has never rented this property and keeps it for his own use. LLC1 is deemed to be doing business in California. This is because of the activity conducted on behalf of the LLC by Jerry (a California resident) in California.10 The LLC that owns the second home in Lake Tahoe, is not deemed to be doing business in California because it is not used for trade or business purposes. Joey (Jerry’s brother) lives in Nevada but owns a vacation home in Monterey, California through a single member LLC which is organized in Nevada. In this case, the Nevada LLC is doing business in California as the value of the California residence is $600,000 (significantly above the statutory threshold of $53,644 which applies to property owned in the state).

D. Limited Partnerships. What further muddies the waters is limited partnerships – which operate under old case law which holds that the nonresident limited partners are not doing business in the state. 11 The Appeal of Amman & Schmid Finanz AG held that foreign corporations were not subject to the minimum franchise tax where their only connection with California was limited partnership interests in partnerships engaged in business in California, from which they received distributive shares of California sourced income. The SBE based its decision on its application of the law of limited partnerships in California. It noted that limited partners were inactive participants in the partnerships and, therefore, not “actively engaging” in profit-seeking transactions. As limited partners, the foreign corporations had no interest in specific limited partnership property, had no right to participate in partnership management, were powerless to bind the partnership, and were not liable for the obligations of the partnerships. Thus, the decision of the Board hinged on the right to manage or control the decision making process of the entity, not whether a partner enjoys

10 Appeal of Mockingbird Partners, LLC, 06-SBE- 306061. 11 Appeal of Anman & Schmid Finanz AG (1996) 96-SBE-008.


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limited liability. The case is still good law and provides a limited exception to the broad definition of “doing business” for corporate out of state limited partners.

Example:

Corporation E, an out-of-state corporation, has no property, payroll or sales in California. Corporation E owns a 30 percent limited partnership interest in Limited Partnership X which is doing business in California. For tax year 2016, Limited Partnership X has $30,000, $50,000 and $200,000 in property, payroll, and sales in California, respectively. Is Corporation E considered doing business in California?

No, Corporation E is considered to have the following distributive shares of property, payroll, and sales from Limited Partnership X: Flow through Partnership property = $9,000 ($30,000 x 30%) Flow through Partnership payroll = $15,000 ($50,000 x 30%) Flow through Partnership sales = $60,000 ($200,000 x 30%) Corporation E is not doing business in California because it does not have any activity in California and its share of the factors that flow through to it from Limited Partnership X do not exceed the statutory standards. Corporation E will still be subject to California’s corporate income tax on its proportionate share of the California source income that flows through to it from Limited Partnership X. Although Corporation E is exempt from the minimum franchise tax (currently $800), it is still subject to the income tax which is assessed on all California sourced income which flows through to Corporation E on the Schedule K-1. The California income tax is assessed at the same rate as the franchise tax (i.e., 8.84%), however there is no minimum. Therefore, Corporation E will pay the income tax on the California source income even if it is less than $800.

Example:

Assume in the alternative, that Corporation E owns multiple interests in several pass-through entities in California. How should it compute the amounts of property, payroll, and sales in California?

Corporation E computes its property, payroll, and sales in California by aggregating the property, payroll, and sales from all sources, including all distributive shares of property, payroll, and sales from each pass-through entity. If the combined property, payroll, or sales exceed the threshold amounts, Corporation E is considered doing business in California. Note that the factor presence test applies on an entity-by-entity basis rather than on a unitary group basis. That being the case, regardless of whether the flow through entity interests are unitary with Corporation E or not, they are aggregated for the purpose of applying the doing business standard.


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E. Sourcing gain on sale of flow through entity ownership interest.

An out of state corporation might also find that it is unexpectedly doing business in California when it sells its interest in the LLC/partnership. Under these rules (included in the market based sourcing regulations)12 where the sale of intangible property is the sale of shares of stock in a corporation or the sale of an ownership interest in a pass-through entity, other than sales of marketable securities, then in the event that fifty (50) % or more of the amount of the assets of the corporation or pass-through entity sold, determined on the date of the sale and using the original cost basis of those assets, consist of real and/or tangible personal property, the sale of the stock or ownership interest will be assigned by averaging the payroll and property factors of the corporation or pass-through entity in California for the most recent twelve (12) month taxable year. Special rules apply if the flow through entity’s assets consist of intangible property. The out of state corporate owner might find that although it has never filed in California, that upon sale of the ownership interest in the flow through entity which is doing business in California, it now has a filing requirement in the state.

Example:

The ABC Corporation (ABC) is a Nevada corporation that sells widgets. ABC owns a limited partner (5 percent interest) in XYZ Limited Partnership. ABC Corporation and XYZ Limited Partnership are not unitary. ABC has $1,000,000 in property and $150,000 payroll in Nevada, but no property or payroll in California. ABC received all of its requests for widgets by phone, mail, or its website (over the internet) at its office in Nevada. In 2015, ABC reported net income of $500,000 (all business income). ABC shipped via common carrier $350,000 worth of its $5,000,000 in widget sales to California customers. XYZ does business wholly within California. ABC acquired and maintained the limited partnership interest primarily for investment purposes, but in 2015 decided to sell the ownership interest for $200,000 and realized a gain of $100,000. For taxable years beginning on or after January 1, 2013, sales of intangibles are assigned to the California sales factor numerator using market assignment. Under Regulation Section 25136-2(d)(1)(A)(1), for sales of shares of stock in a corporation or sale of an ownership interest in a pass-through entity, other than sales of marketable securities, the taxpayer needs to consider when the sale occurred and what type of assets were held by the entity represented by the shares/interest sold. Generally, the Regulation provides that if the corporation or pass-through entity held assets consisting more than 50 percent real and/or tangible personal property, the amount of California sales receipts from the sale of the shares/interest is based on the average of

12 18 CCR 25136-2(d)(1)(A)(1).


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the corporation or pass-through entities' property and payroll factors. In this case, since XYZ does business wholly within California, regardless of the date of sale or the asset values, 100 percent of the receipts from the sale ($200,000) is assigned to California. Therefore, ABC Corporation is doing business in California and must file and pay the franchise tax. ABC’s California gross receipts exceed the statutory threshold ($350,000 of widget sales and $200,000 from the sale of the XYZ limited partnership interest).

Not only do the sourcing rules add complexity, but also require that the limited partners have access to the books and records of the partnership to compute the property and payroll factors of the business being sold. This is the fundamental problem faced by all taxpayers who find themselves subject to a state’s “look through” rules.

V. Corrigan v. Testa: Taxation of Nonresident Capital Gain

In Corrigan v. Testa (2016 WL 2341977 (May 4, 2016) the Ohio Supreme Court held that Ohio’s attempt to tax a nonresident on the gain from the sale of an ownership interest in an Ohio LLC violated the Due Process Clause. As convoluted as the California process of sourcing gain on the sale of an ownership interest in a flow through entity appears to be (see above analysis), it does appear to be the methodology which was recommended by the Ohio Supreme Court in this case.

Mansfield Plumbing (Mansfield) specialized in selling sanitary ware in all 50 states and maintained its corporate headquarters in Perrysville, Ohio. In November 2000, Connecticut resident Kevin Corrigan purchased a 79% share in Mansfield. As part of his purchase, Corrigan became a “manager” of Mansfield—i.e., a member of the company's board of managers.

Corrigan's duties as a manager included visiting the company's Ohio headquarters to attend board meetings, provide management presentations, and address other matters dedicated to growing Mansfield. He estimated his time spent in these manager duties as “easily a hundred hours per year.”

However, Corrigan asserted that his role did not involve active “management” of the Mansfield business but rather “stewardship.” Indeed, the court pointed out that the tax commissioner did not assert that Corrigan was “operating or managing the business of Mansfield Plumbing.”

In 2004, Corrigan sold his 79% interest in Mansfield as part of a sale of a 100% interest in the company to a Colombian sanitary-ware business hoping to gain a foothold in North America. Corrigan's capital gain from the sale was approximately $27.5 million, and he allocated all of that income outside of Ohio based on his non-Ohio domicile.

In 2009, Ohio assessed tax liability from 2004 of nearly $675,000 based on the capital gain from the sale, plus $150,000 in interest. Corrigan paid $100,000 of the assessment and filed a refund claim in March 2010 with the Ohio tax commissioner.


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The tax commissioner denied the refund claim in August 2012, and Corrigan appealed to the Ohio Board of Tax Appeals (BTA). The BTA upheld the commissioner's determination on statutory grounds but declined to reach Corrigan's constitutional arguments, reasoning that it lacked jurisdiction to do so. Corrigan appealed directly to the Ohio Supreme Court.

During the tax period, Ohio law provided that capital gains—like royalties, rents, and compensation—were considered “nonbusiness income” subject to allocation based on their situs.3 As a result, capital gains were not generally apportionable and instead were required to be assigned to only one state. Ohio law further provided specifically that capital gains from the sale of intangible personal property were statutorily allocated to the taxpayer's domicile.4

At the time, R.C. 5747.212 provided that any investor owning at least 20 percent of the equity voting rights of a passthrough entity during the prior three years must treat any gain or loss from the sale of those rights as though it was business income, apportioned using the standard three-factor formula. This statute clearly applied to Corrigan because he owned 79% of Mansfield, and he sold his interest in 2004.

Based on Mansfield Plumbing's headquarters and substantial sales in Ohio, the Department of Taxation calculated that Corrigan should have paid about $675,000 on the sale, and it issued an assessment for nearly $850,000 in unpaid taxes and interest in 2009.

Corrigan paid $100,000 and requested a refund. The commissioner denied the refund and rejected Corrigan's challenges on due process, commerce clause, and equal protection grounds. The Ohio Board of Tax Appeals rejected Corrigan's appeal, noting in its decision that it lacked jurisdiction to rule on his constitutional arguments.

That brought the case to the Ohio Supreme Court, where Corrigan again raised constitutional challenges, saying that section 5747.212 impermissibly "attempts to tax a non-resident on income that is not earned within Ohio."

The state argued that even though Corrigan was not managing Mansfield Plumbing, Ohio still had the constitutional authority to tax the proceeds of his sale of the LLC simply because it conducted business in Ohio.

But the court disagreed, finding that although section 5747.212 was not facially unconstitutional, it was unconstitutional as applied to Corrigan's situation. "Due process predicates taxation of a nonresident's income on Ohio's connection to both the taxpayer and the transaction," the court wrote, distinguishing its authority to tax people within its borders from its authority to tax income-producing activities in the state.

The court acknowledged that Corrigan had subjected himself to taxation by acquiring a controlling interest in an Ohio-based passthrough under its 1999 decision in Agley v. Tracy ( 719 N. E. 951 (Ohio 1999) but it said that holding was not applicable in Corrigan, in which the state had only an indirect connection to the sale of Corrigan's shares. The court in Agley reasoned that the decision to invest in an Ohio entity and make pass-through elections for federal tax purposes satisfied the purposeful-availment requirement of the Due Process Clause. Thus, the court noted,


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any income Corrigan gained from Mansfield's regular business activities in Ohio would be properly taxable in Ohio.

Due process, the court stated, “requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” The court explained that this link must exist between the state and the taxpayer, as well as between the state and the activity subject to tax. The link between a taxpayer and the state requires that the taxpayer “purposefully availed” himself or herself of the benefits within the taxing state. The link between the activity and the state requires “a connection to the activity itself, rather than a connection only to the actor the State seeks to tax.


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CHAPTER 8 RETIREMENT PLANS

Table of Contents

I. California Security Choice Retirement Program. ..................................................................... 1

I. California Security Choice Retirement Program.

The California Security Choice Retirement Program was signed into law by Governor Jerry Brown on September 29, 2016 and will go into effect on January 1, 2017. This proposal has been several years in the making. On September 28, 2012, Governor Jerry Brown signed into law S. B. 1234, the California Secure Choice Retirement Savings Trust Act. The bill, which was sponsored by Senator de Leon, authorized the state to study the proposal and determine if the idea was viable. The 2012 legislation did not set up the program, and required the enactment of implementing legislation. The bill signed by the Governor on September 29, 2016 implements the program.

SB 1234 requires all employers within California with five or more employees who do not offer their employees another retirement savings option to participate in the California Secure Choice Retirement Program. The requirement is phased-in over a three-year period based on the employer’s size. Beginning 12 months after the opening of enrollment, employers of 100 or more employees must have an arrangement to allow employees to participate in the plan. Beginning 24 months after enrollment opens, employers of 50 or more employees must participate, and beginning 36 months after enrollment, the size of employer covered by the mandate drops to those with 5 or more employees. Employees will be automatically enrolled in the program, but will have the right to opt-out. An employer that offers a defined benefit plan or a 401(k), Simplified Employee Pension Plan (SEP), or Savings Incentive Match Plan for Employees (SIMPLE) plan, or that offers automatic enrollment payroll deduction IRA plans are exempt. An employer has the right to set up any one of these plans after the Secure Choice opens.

Employers will have administrative responsibilities. They will be required to: � Enable employees to make an automatic contribution from their paycheck into their Secure Choice Account. � Transmit the payroll contribution to a third party administrator to be determined by the Board. � Potentially provide state developed informational materials about the program to their employees. However the Board is working with industry to figure out if a third party could provide the materials to employees, eliminating this responsibility from the employer.

The employer is not, however, responsible for the plan or liable as a plan sponsor. Other employer safeguards include:


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� Employers would not have any liability for an employee’s decision to participate in, or opt out of, the Program; � Employers would not have any liability for the investment decisions of participating employees; � Employers would not be a fiduciary of the Program; � Employers would not bear responsibility for the administration, investment, or investment performance of the Program; � Employers would not be liable with regard to Program design, investment returns, and benefits paid to participating employees; � Employers would not be able to contribute to the employee account unless there was a change in federal law that permitted contributions without triggering ERISA requirements.

The program fund is also not guaranteed by the State.

Like a standard individual retirement account or 401(k), the investments would be subject to the ups and downs of financial markets, including the potential for losses.

Secure Choice, as the program is known, is overseen by a board with authority to make decisions about investment options, the default savings rate and benefit payouts in retirement. Financial consultants recommended a default savings rate of 5 percent, which would rise by 1 percent a year until it reaches 10 percent of pay.

The cost to the state is unclear, as it depends how many employees participate, but it could reach up to $134 million over the first several years, according to the legislative analysis. The program is expected to eventually fund itself with fees on workers' deposits.

Objections to the program include concern over the opt out provision. Lower-income workers, are more likely to opt out or withdraw their balances early, and the cost to administer millions of small accounts would be higher than proponents assume. Moreover, the state's obligations under securities law are uncertain, and the political pressure for taxpayers to backfill investment losses would be intense.

To date, the State has established the California Secure Choice Retirement Savings Investment Board and the California Secure Choice Retirement Savings Trust, as required by the 2012 statute. The Board has been meeting monthly since 2013, collected information on retirement issues, and reviewed market and legal analyses of the program. On March 28, 2016, the Board voted unanimously to recommend approval of the Program, and sent letters to state leaders outlining the Board’s recommendations for legislation implementing the Secure Choice Program. The Board’s recommendations for inclusion in the legislation include:

• Establishing managed accounts that would be invested in U.S. Treasuries or similarly safe investments within the first three years of the program, with the expectation that during that period the Board would begin to develop investment options that address risk-sharing and smoothing of market losses and gains. Options could include, but not be


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limited to, custom pooled, professionally managed funds that minimize management costs and feels, the creation of a reserve fund, or the establishment of investment products

• Providing for the Board to conduct an annual peer review to compare California Security Choice funds with similar funds on performance and fees.

• Requiring the Board to seek to minimize participant fees • Requiring the Board to establish an initial automatic contribution rate of between 2% and

5% of salary • Allowing the Board to implement automatic escalation of participant’s contribution rates

up to 10% of salary, with the option for participants to stop automatic escalation and change their contribution rates.

• Establishing a fiduciary duty in the Board and its contracted administrators and consultants toward the participants of the program.

• Permitting the inclusion of quasi-public and quasi-private workers to be enrolled if found legally permissible

• Requiring communication and education on the Program, including the inherent risks of its investment strategies, making clear that the state does not have liability for the investment performance or payment of benefits to participants

• Directing that a default payout method to retirees be determined • Clearly defining the ‘ministerial duties’ expected of employers in the implementation of

the program, and limiting liability for all employers if an employer inadvertently provides more than ministerial duties.

• Fully determining all necessary costs for administration of the program and ensuring all investment options are appropriately considered by the Board.

• Making determinations on how to structure the Program to ensure the state is prohibited from incurring liabilities associated with administering the Program.

Employees will be automatically enrolled in the program, with the opportunity to opt-out. If an employee does not select a contribution amount, 3 percent of salary will be contributed to their Secure Choice account. The Board has the authority to change the default contribution from 2 percent of salary to 5 percent. Employee contributions will be subject to automatic escalation of up to 8 percent of salary, with no more than 1 percent of salary increases per year. Employees have the opportunity to opt-out of automatic escalation and to select their own escalation percentage.

Employers will be allowed to make contributions to the accounts on behalf of their employees but only if these contributions are permitted by the Internal Revenue Code and do not subject the Secure Choice Program to the Employee Retirement Income Security Act. The U.S. Department of Labor gave the green light in August to retirement plans run by states and large cities or counties, putting to rest questions about their legality and removing a major hurdle.

For up to the first three years of the Program, contributions will be invested in United States Treasury bonds or similarly safe investments. During this time, the Board will develop other options that appropriately balance risk and strive to minimize participant fees. During start-up and for the first year of operation, administrative funds will be appropriated from the state’s General Fund. These amounts are to be repaid, with interest, and subsequent costs will be


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paid from the Program’s administrative account. Administrative expenditures for the program are limited to 1 percent of the program fund.

Other states which have adopted state-based retirement plans for the private sector include Arizona, Colorado, Connecticut, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Hampshire, New Jersey, New York, North Carolina, North Dakota, Ohio, Oregon, Rhode Island, Utah, Vermont, Virginia, Washington, West Virginia and Wisconsin.


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CHAPTER 9 RESIDENCY

Table of Contents

I. Residency: Gilbert Hyatt litigation update. ............................................................................. 1 A. Brief Background. ............................................................................................................... 2 B. Nevada v. Hall. .................................................................................................................... 3 C. Damages. ............................................................................................................................. 3 D. The Residency Audit ........................................................................................................... 4

II. Sale of a Partnership Interest: Appeal of Bills. ...................................................................... 6

I. Residency: Gilbert Hyatt litigation update. The most recent update on the Gilbert Hyatt litigation is the U. S. Supreme Court decision released on April 19, 2016.1 In a nutshell, the Supreme Court did not overrule Nevada v. Hall,2 but did agree with the Franchise Tax Board that the award of damages (even though substantially reduced from the initial jury award) reflected a policy of hostility to the public Acts’ of a sister State (i.e., California) by allowing greater damages to be levied against California, than a private citizen could obtain in a similar suit against Nevada’s own agencies. This means that Hyatt can recover damages of no more than $50,000 for each of his two remaining causes of action, the same amount that he would be awarded if the issue involved a Nevada employee. The Full Faith and Credit Clause prohibits a state from adopting a “policy of hostility to the public Acts” of another state. According to Justice Breyer, writing for the majority, Nevada’s "special rule" allowing damages awards of over $50,000 against foreign states and local governments is “not only ‘opposed’ to California law [which provides total immunity], it is also inconsistent with the general principles of Nevada immunity law” [which grants the state immunity over $50,000]. Even the most recent U. S. Supreme Court decision does not bring an end to the Hyatt saga in Nevada court. Hyatt can petition for a rehearing and there is still the retrial on his emotional distress damage claim.3 In addition, “Round two” has not even started yet. “Round Two” involves the residency determination which is still pending before the SBE.

1 Franchise Tax Board v. Gilbert P. Hyatt 578 U. S. _____(2016). 2 440 U. S. 410 (1979). 3 Slip Opinion at pp. 6-7, 578 U. S. ______(2016).


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A. Brief Background.

Gilbert Hyatt is an inventor who claims to have discovered the microprocessor chip for computers. Hyatt entered into multiple licensing agreements that began to pay out in 1991. In September of 1991, Hyatt claims to have moved to Nevada, which led to an audit by the Franchise Tax Board regarding whether and when he actually moved. The FTB proceeded with their typical audit procedures, requesting information from Hyatt regarding connections to California and Nevada for the audit period such as location of bank accounts, medical providers, attorneys, and accountants -- not to mention information that might confirm physical presence such as credit card statements, utility bills, telephone bills, subscriptions to publications, and club memberships. This information was requested not only from Hyatt, but also from third parties. Interviews were conducted with relatives, neighbors, and others to determine physical presence. All audit procedures were within the state's residency audit guidelines and were typical of most residency audits.

The FTB determined that Hyatt had changed his residence from California to Nevada in April 1992 rather than October 1, 1991, as claimed. (Hyatt later changed his claimed California nonresidency date to September 26, 1991, attempting to avoid California's nine-month residency presumption.) 1 The FTB then determined that Hyatt owed California approximately $4.5 million in additional state income taxes plus penalties. The audit findings were then expanded to include 1992, and an additional $6 million was assessed.

Hyatt protested the audit findings and filed a complaint in Nevada court alleging seven intentional torts and negligence against the FTB. In 2003, the U. S. Supreme Court granted Hyatt the right to proceed in Nevada court, unanimously holding that Nevada was not required to apply California law (which would have provided full immunity to the Franchise Tax Board.)4 The jury trial found in favor of Hyatt and awarded a multimillion-dollar damage award to Mr. Hyatt for his claims of fraud, invasion of privacy, intentional infliction of emotional distress and punitive damages.

The FTB appealed this verdict and the Nevada Supreme Court significantly reduced the award to $1 million of damages for fraud and remanded the claim for emotional distress, however they refused to apply the statutory cap on damages that would have applied to Nevada agencies (i.e., $50,000 per claim).

The FTB filed a petition for writ of certiorari with the U.S. Supreme Court, requesting that it undertake a review of the Nevada Supreme Court's rulings. In June of 2015, the Court granted the FTB's petition with respect to the following two issues:

• Whether Nevada v. Hall5, which permits a sovereign State to be haled into the courts of another State without its consent, should be overruled; and

• Whether Nevada may refuse to extend to sister States haled into Nevada courts the same immunities Nevada enjoys in those courts.

4 Franchise Tax Board v. Hyatt, 538 U. S. 488 (2003) 5 440 U.S. 410 (1979).


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B. Nevada v. Hall. The Justices split 4 to 4 on the issue of overruling Nevada v. Hall and therefore the lower court decision stands (which upheld the decision that allows States to be sued in the courts of another state). This marked the third time since the death of Justice Antonin Scalia in February that the Supreme Court voted 4-4 on a case. A recent article suggests that had Justice Scalia's initial vote counted, FTB would have succeeded in overruling Nevada v. Hall.6

In Nevada v. Hall, California residents brought an action in California court for damages against the State of Nevada and others for injuries they sustained when a Nevada-owned vehicle on official business collided on a California highway with a vehicle occupied by these California residents. The California Supreme Court, reversing the trial court, held Nevada subject to suit in the California courts. Nevada, on the basis of the Full Faith and Credit Clause of the Federal Constitution, unsuccessfully invoked a Nevada statute limiting to $25,000 any tort award against the State. California has no such limitation, but rather allowed both residents and nonresidents who are negligently injured on its highways to secure full compensation for their injuries. Ultimately, damages were awarded to the California drivers for $1,150,000, and the judgment in their favor was affirmed on appeal.

The U. S. Supreme Court decision held that a State is not constitutionally immune from suit in the courts of another State. The doctrine that no sovereign may be sued in its own courts without its consent does not support a claim of immunity in another sovereign's courts. The result of this finding is that a private citizen can bring a lawsuit against another State without the other State’s consent, which is what happened in the Hyatt litigation. In addition, the Court held that the Full Faith and Credit Clause does not require a State to apply another State’s law in violation of its own legitimate public policy. Since California allows those negligently injured on its highways to secure full compensation for their injuries in California courts, the State is not required to surrender jurisdiction to Nevada or to limit recovery to the $25,000 Nevada statutory maximum at the time. Applying the holding on this issue to the Hyatt matter, Nevada should apply its own law in its own courts as it would be applied to a Nevada state agency.

California (along with 45 other states who had filed briefs in this case) had asked the Supreme Court to reverse Nevada v. Hall and declare that one state cannot be haled in the courts of another state without its consent. The Justices split four to four on that issue and therefore the Nevada Supreme Court (which allowed the litigation to go forward) stands. Nevada v. Hall remains good law and must await a future case (and a ninth justice) to address the issue again.

C. Damages.

The U. S. Supreme Court did hand California a big win on the damages issue. The Court held that under the Full Faith and Credit clause the states are not free to discriminate against another state when applying their own law against another state. The Court stated that the Full

6 www.bna.com. Datlowe, Nicholas, April 21, 2016. “Minor Error, Major Effect” (“The means that, had Scalia lived, the Franchise Tax Board would have won, 5-4 on the initial question of overruling Nevada v. Hall.”)


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Faith and Credit Clause does not require a State to substitute for its own statute the statute of another State – particularly if it reflects a conflicting and opposing policy. However, the Court noted that when a State declines to apply another State’s statute on this ground, then it must do so without exhibiting any hostility towards the statutes of that other State. Therefore, the Court concluded that it would not require that Nevada apply California law, but it would require that Nevada apply the principles of Nevada law in the same way that the law would be applied against Nevada’s own agencies.

Nevada law limits damages for similar actions against Nevada officials to $50,000 per claim or cause of action. Although the Nevada Supreme Court set aside most of the damages awarded to Hyatt, it did affirm $1 million of the award and remanded for retrial the question of damages for intentional infliction of emotional distress. The U. S. Supreme Court stated that a State that disregards its own ordinary legal principles (such as what the Nevada Supreme Court did here) is acting in a manner that is hostile to another state. The U. S. Supreme Court went on to state that Nevada has not offered sufficient policy considerations to justify the application of a special rule of Nevada law that discriminates against California. The U. S. Supreme Court called the actions of the Nevada Supreme Court reflective of a policy of hostility to the public Acts’ of another state.

FTB should be happy with the result, in that it looks like when the dust settles damages will be limited to $100,000 (two remaining claims) (having been reduced from over $600 million to approximately $1,000,000 and now down to $100,000 assuming a new Nevada jury awards emotional distress damages in the ordered retrial on that issue).

D. The Residency Audit Throughout all of the litigation described above, we still don’t know if the State Board of Equalization will decide if Mr. Hyatt was a California resident until April 1992 or not. This proceeding is now moving forward. California law states that a resident includes every individual who is in the state for other than a temporary or transitory purpose and every person who is domiciled in the state but who is outside the state for a temporary or transitory purpose. 7 This is a facts and circumstances analysis that requires scrutiny of both subjective intent and objective facts. As facts were uncovered in the residency audit of Mr. Hyatt, the auditor became more suspicious, raised more questions and asked for an increasing volume of documentation. Essentially, when Mr. Hyatt decided to move to Nevada, he used his son’s trailer and loaded it up with his worldly possessions. They drove to Las Vegas where they unloaded the van and stored Hyatt’s possessions in the Continental Hotel (now bankrupt). All this occurred in September 1991. In October, Hyatt rented an apartment in Las Vegas and the evidence indicates that he moved into the unit in October. Subsequently, Hyatt purchased a home in Las Vegas in April 1992. Numerous detailed facts related to this time period are what are in dispute. The SBE will be charged with the responsibility of sifting through the volumes of evidence and depositions to determine where Hyatt actually lived during this period. If the SBE holds in favor

7 Cal. Rev & TC sec. 17014.


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of the FTB and determines that the date of Hyatt’s change of residency is actually April 1992, then Hyatt owes approximately $10 million in California taxes (plus interest). Due to the intensely factual nature of a residency case, the outcome is far from certain. A second argument can, however, be made with these facts, and that is the issue of sourcing. Mr. Hyatt had been a long time California resident before moving to Nevada, coming to California on or around 1954. Beginning in the late 1960’s Hyatt began filing patent applications with the U. S. patent office on inventions and technologies that he had developed while a resident of California. Hyatt was granted many of these patents, including U. S. patent 4,942,516 (the 516 patent) for the single chip integrated circuit computer architecture (or microprocessor), granted in July 1990. Hyatt then sought as many patent infringement litigation settlement agreements from electronics companies that he could negotiate either directly or indirectly. Several companies paid the amounts demanded by Hyatt in return for his agreement not to sue for patent infringement. These are the payments that are in question in the residency audit, and most of these payments appear to be derived primarily from the 516 patent, which was developed in California.

Cal Rev & TC sec. 17952 states that taxable income of a nonresident from bonds, stocks, notes or other intangible personal property is not income from sources within the state unless the property has acquired a business situs within the state. Regulation sec. 17952( c) states that intangible personal property has a business situs in the State if it is employed as capital in this State or the possession and control of the property has been localized in connection with a business, trade or profession in this State so that its substantial use and value attach to and become an asset of the business, trade or profession in this State. If intangible personal property of a nonresident has acquired a business situs here, the entire income from the property including gains from the sale thereof, regardless of where the sale is consummated, is income from sources within this State, taxable to the nonresident.

The definition of the business situs concept is discussed in Holly Sugar Corp. v. Johnson 8 which states that business situs arises from the act of the owner of the intangibles in employing the wealth represented as an integral portion of the business activity of the particular place, so that it becomes identified with the economic structure of that place. In the Appeal of Neuschotz9 the SBE held that the concept of business situs involves location of the intangible property itself in the business situs state as an asset of a business there.

During the period 1990 and 1991 Hyatt entered into a series of agreements for which Hyatt received payment related to intellectual property developed during the period that Hyatt worked and lived in California. Under these agreements, Hyatt did not transfer any technology to the other party, but rather received payments in return for his agreement not to sue for patent infringement. All of the work (and technology) that resulted in the patents was done in California. His business (conducted from California) was exploiting his patents. Therefore, the often-overlooked argument of business situs might present a stumbling block for Mr. Hyatt if he

8 18 Cal. 2d 218, 115 P.2d 8 (1941). 9 68 SBE 017 (March 25, 1968).


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is in fact found to be a nonresident of the state during the crucial time period of September, 1991 to April 1992.

II. Sale of a Partnership Interest: Appeal of Bills.

California residents became residents of Washington state two months before receiving an initial payment on the $40 million paid for the sale of the husband’s California partnership interest. Because the sale of the husband’s partnership interest was a sale of an intangible, it was sourced to their new state of residence and not taxable by California. (Appeal of Bills (April 28, 2016) Cal. St. Bd. of Equal., Case Nos. 610028, 782397

Michael and Mary Bills had been California residents since the late 1990s and owned a home in Rancho Santa Fe in Southern California. Michael was the managing partner of Brandes Investment Partners, LP until his retirement at the end of 2004. In anticipation of the retirement, the taxpayers bought a completely furnished, 5,635 square foot home in November 2004 in Washington, for $2.8 million. Rather than selling their California home, they allowed their adult daughter to reside there. In November/December they turned on the electric and gas utility service. In December 31 2004 Mr. Bills retired from Brandes Investment, LP.

From January 10 to the 16, 2005 the Bills stayed in their Washington home, registered to vote, Michael obtained a Washington driver’s license, and the Bills received household furnishings and personal items at their Washington home. The Bills also registered three of their seven cars in Washington during this period, although all the cars remained in California. Sometime later the Bills registered four other vehicles in Washington, although none of the cars were driven up to Washington until April 2005, when one car was driven up, followed by another car in June 2005. The Bills also opened a local bank account in Washington and saw local doctors and dentists.

From January 16 through April 23 the Bills drove back to California and stayed in their California home until February 3, 2005, when they left on a series of trips, which ended on April 23, 2005. They returned to the California home in between trips. In March, 2005 the Bills received the first of five payments for the partnership interest totaling approximately $7.5 million. In April, 2005 they drove back to Washington and discovered that the well required repairs. They returned to California while the repairs were in process. In June, 2005 the Bills returned to their Washington home.

The Board found that the evidence showed that the Bills abandoned their California domicile when they arrived at their Washington home on January 10, 2005. They had purchased a fully furnished home and undertook all the various activities that one would undertake to establish a new domicile during the one week they were in Washington. This included registering to vote, opening a bank account, visiting doctors and dentists, etc.

Once their new domicile was established in Washington in January 2005, the next question was whether their return visits to California were for other than a temporary or transitory purpose. In evaluating the Bills’ contacts with California to determine whether their


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contacts were for more than a temporary or transitory purpose, the Board utilized the residency factors as set forth in the Appeal of Stephen D. Bragg ((May 28, 2003) 2003-SBE-002). This included registering to vote, registering vehicles, etc. These were all done in Washington during the Bills’ one-week stay in January, demonstrating a “strong” connection to Washington. Further, the Bills saw dentists/doctors in Washington. As Michael had retired, there were no occupational contacts in either state. These demonstrated a stronger connection to Washington; and the home in Washington was purchased fully furnished. Other furnishings were shipped from the Bills’ California home and New York apartment. Their adult daughter resided in their California residence. The days spent in California were “brief sojourns” between trips. The Board ruled there was a closer connection to Washington and that they became residents of Washington on January 10, 2005, and remained so thereafter.

Then the Board turned to the question of sourcing the gain on sale of the partnership interest. The Board ruled that the sale of Michael Bill’s partnership interest sourced to Washington, the state of the Bills’ residence at the time of receipt.

The FTB argued that the payments for Mr. Bills 99% membership interest in the partnership were made in exchange for the property owned by Brandes and therefore should be treated as a sale of the partnership’s property and not the sale of an intangible partnership interest. However, based on previous rulings of the Board, the sale of a partnership interest is considered a sale of an intangible. (Appeal of Ames et al. (June 17, 1987) 87-SBE-042).

The sale of an intangible is sourced to the nonresident’s state of residence unless the intangible personal property has a business situs in California. A business situs in California may be established in California if the property is employed as capital in California or if the possession and control of the property has been localized in connection with a business or profession in California, such as using the partnership interest as a security for debt incurred in connection with a California business. (18 CCR sec. 17952.)


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CHAPTER 10 PROCEDURE


II. Tax Return Filing Dates. ................................................................................................................................. 1 A. Federal Tax Return Filing Dates. ............................................................................................................................ 1 B. California Tax Return Filing Dates. ....................................................................................................................... 2 C. Status of State conformity to Federal Filing Dates. ........................................................................................... 4 D. Other new filing requirements in California. ...................................................................................................... 5

III. Sec. 1031 Like Kind Exchange ................................................................................................................... 5 A. Exchanges Out of California ..................................................................................................................................... 5 B. Exchanges into California .......................................................................................................................................... 6 C. Exchanges out of California – Multiple Exchanges ........................................................................................... 7

IV. ITax Scams, Identity Theft and Tax Fraud. ......................................................................................... 10

V. Revivor. ......................................................................................................................................................... 11 II. Tax Return Filing Dates.

A. Federal Tax Return Filing Dates.

In an effort to minimize taxpayers' timing difficulties with filing dates for several common types of returns and reporting forms, Congress included provisions in the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, P.L. 114-41, revising original and extended due dates for tax years starting after Dec. 31, 2015 (e.g., 2016 returns prepared during 2017).

Federal law requires persons to file income tax returns in the manner prescribed by the

Secretary, in compliance with due dates established in the Internal Revenue Code (IRC), if any, or by regulations.

For taxable years beginning on or after January 1, 2016, Congress shortened the due date for partnership returns by one month and extended the due date for C corporation returns by one month so that, unlike prior law, the filing deadline for partnerships would precede the due dates of their individual and corporate investors.

Under federal law, for taxable years beginning on or after January 1, 2016: Partnership returns are due by the 15th day of the third month following the close of the taxable year (generally March 15th)—instead of the 15th day of the fourth month under prior law (generally April 15th). C corporation returns are generally due by the 15th day of the fourth month following the close of the taxable year—instead of the 15th day of the third month under prior law


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(March 15th in the case of a calendar year taxpayer).

However, a special rule delays the due-date change for C corporations with a fiscal year ending on June 30 until taxable years beginning on or after January 1, 2026; until then, returns for such corporations are due by the 15th day of the third month following the close of the fiscal year.

Federal law treats a limited liability company (LLC) as a partnership, corporation, or a disregarded entity1 depending on the rules governing the classification of business entities.

B. California Tax Return Filing Dates. State law, rather than conforming to the federal due dates for filing tax returns of

partnerships and C corporations, has stand-alone law that provides return due dates for partnerships and C corporations that are similar to the federal due dates that were in effect prior to the federal changes described above.

Under California law Partnership returns are due by the 15th day of the fourth month following the close of the taxable year (generally April 15th), and C corporation and S corporation returns are due by the 15th day of the third month following the close of the taxable year (March 15th in the case of a calendar year taxpayer).

An LLC may be classified as a corporation, partnership, or disregarded entity, and the return due dates of LLC returns depend on how the LLC is classified. LLCs classified as corporations that organize in California, register in California, conduct business in California, or receive California source income, must file a corporation return by the 15th day of the third month following the close of the taxable year (March 15th in the case of a calendar year taxpayer).

LLCs classified as partnerships that organize in California, register in California, or conduct business in California, must file a California Form 568 LLC Return of Income by the 15th day of the fourth month following the close of the taxable year (generally April 15th). • LLCs that are disregarded as separate entities (SMLLCs) must file a Form 586 LLC return by the same due date as the owner.

AB 1775 (Ch. 16-348) conforms to most of the federal changes outlined above. For taxable years beginning on or after January 1, 2016, this bill modifies the California return due dates of partnerships and C corporations to be similar to federal law. • Partnership returns are required to be filed on or before the 15th day of the third month following the close of the taxable year, and C corporation returns would be due on or before the 15th day of the fourth month following the close of the taxable year.


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This bill also makes corresponding changes to the due dates of returns of LLCs: LLCs classified as partnerships will have a return due date of the 15th day of the third month following the close of the taxable year. LLCs classified as corporations would have a return due date of the 15th day of the fourth month following the close of the taxable year; and LLCs that are SMLLCs will generally have a return due date based on the return due date of the owner:

SMLLCs owned by an S corporation, partnership, or LLC classified as a partnership, will

have a return due date of the 15th day of the third month following the close of the taxable year. All other SMLLCs, including those owned by a corporation, would have a return due date of the 15th day of the fourth month following the close of the taxable year of the owner.

S corporation returns will continue to be due on or before the 15th day of the third month following the close of the taxable year, consistent with federal law.

The extensions to file under state law remains unchanged; partnerships would continue to have up to a six-month extension, and C corporations will continue to have up to a seven- month extension. FTB has indicated that they plan to change the seven-month extension to six-months for C and S Corporations. They believe that they can do this by notice rather than legislative action. • California has not conformed to the federal delay in the due date change for C corporations with a fiscal year ending on June 30. For federal purposes, these C corporations will continue to file their returns by the 15th day of the third month following the close of the fiscal year until taxable years beginning after December 31, 2025. For California purposes, these corporations are not required to file their returns until the 15th day of the fourth month following the close of their fiscal year. What follows is a concise summary of these rules:

March 15 (Extensions Until Sept. 15)

Federal Income Tax Returns: Form 1065, U.S. Return of Partnership Income; and Form 1120S, U.S. Income Tax Return for an S Corporation. Note: This is the due date for the tax return and also for the Schedules K-1 that the entity must provide to its owners. Extension requests (Form 7004 must be filed by the original due date.) California Income Tax Returns: FTB Form 565 California Partnership Income Tax Return, and FTB Form 100S California S Corporation Income Tax Return. Note: Extensions are automatic, but must file FTB Form 3529 with any payment due.

April 15 (Extensions Until Oct. 15, Unless Noted Below)


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Federal Income Tax Returns: Form 1040, U.S. Individual Income Tax Return; Form 1041, U.S. Income Tax Return for Estates and Trusts (extensions until Sept. 30); Form 1120, U.S. Corporation Income Tax Return (extensions until Sept. 15 until 2026, see note below); and FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR) (any late filing penalty for a first-time filer may be waived). FBARs are filed with the Treasury Department, not the IRS. They should not be filed with or attached to federal tax returns. Note: Calendar-year C corporations can get extensions until Sept. 15 until tax years beginning after 2025, when the extended due date will be Oct. 15. June 30 fiscal-year-end C corporations (returns due Sept. 15) can get extensions to April 15 until tax years beginning after 2025; after 2025, June 30 fiscal-year-end C corporations will have an Oct. 15 due date and can get extensions until April 15. California Income Tax Returns. FTB Form 540 California Individual Income Tax Return. FTB Form 541 California Income Tax Return for Estates and Trusts FTB Form 100 California Corporate Income Tax Return

May 15 (Extensions Until Nov. 15) Federal Tax Returns.

Form 990, Return of Organization Exempt From Income Tax (series). State Tax Returns. FTB Form 109 Note: For California purposes, exempt organizations subject to tax on unrelated business taxable income must file an exempt organization business income tax return. This is in addition to filing an exempt organization annual information return. FTB Form 109 California Business Income Tax Return, is due on or before the 15th day of the fifth month following the close of the taxable year. The FTB may grant an extension of time for filing a Form 109 for a period of up to seven months or December 15.

July 31 (Extensions Until Oct. 15)

Form 5500 for employee benefit plans. Note: The Form 5500 extension due date of Oct. 15 remains unchanged (or at 2 ½ months). C. Status of State conformity to Federal Filing Dates.

As of this writing, conformity legislation with respect to due dates had been enacted in

Alabama, Arizona, Florida, California, Georgia, Maryland, Mississippi, New Hampshire, New


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Mexico, New York, Oklahoma, Oregon, South Carolina, Utah, and West Virginia.

D. Other new filing requirements in California.

For taxable years beginning on or after January 1, 2016, California conforms to the Foreign Account Tax Compliance Act (FATCA) information reporting requirements for individuals with foreign financial assets, including the minimum $10,000 penalty for failure to file Form 8938, Statement of Specified Foreign Financial Assets, without reasonable cause.1 This requirement applies to all individuals required to file California income tax returns (not just California residents). The information required to be filed with the FTB is a copy of the information filed with the IRS. This means taxpayers who are required to file California returns may be subject to penalties of $20,000 ($10,000 federal and $10,000 California) for failures to comply with these information reporting requirements. FTB will also follow P. L. 114-113, Division Q, Section 201 which requires Form 1099 MISC to be filed on or before January 31, 2017 when reporting nonemployee compensation payments in box 7. This means that effective January 31, 2017, 1099-MISC Information Returns must be filed with FTB by January 31st. Taxpayers are permitted to file all other 1099 Information Returns by February 28, 2017 if filed on paper or by March 31, 2017 if filed electronically. III. Sec. 1031 Like Kind Exchange The FTB has opened a regulation project to address several issues related to swapping property into and out of the state of California. The regulations will address: (1) the sourcing of gains/losses from IRC section 1031 exchanges; and (2) which year's apportionment factor(s) should be applied to such gains/losses for apportioning taxpayers.

A. Exchanges Out of California

1. Exchange out of California followed by sale of out-of-state property (appreciation in

value) Taxpayer ("TP") purchased California property for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into property located in State A which is later sold in a taxable transaction for $20.

Question:

• How much of the $15 federal gain ($20 sales price minus $5 basis) is

California source gain? 2. Exchange out of California followed by sale of out-of-state property (appreciation


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followed by depreciation in value) TP purchased California property for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into property located in State A which is later sold in a taxable transaction for $8.

Questions:

• How much of the $3 federal gain ($8 sales price minus $5 basis) is California

source gain? • Does TP have California source gain in excess of the federal gain reported in

the year the State A property is sold? 3. Exchange out of California followed by sale of out-of-state property (appreciation

followed by loss on the ultimate sale of the property) TP purchased California property for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into property located in State A which is later sold in taxable transaction for $4.

Questions:

• How much of the $1 federal loss ($4 sale price minus $5 basis) is California

source loss? • Does TP have California source gain in the year the State A property is sold

even though a federal loss is reported?

B. Exchanges into California 4. Exchange into California followed by sale of California property (appreciation in value)

TP purchased property in State A for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into California property which is later sold in a taxable transaction for $20.

Question:


California source gain? 5. Exchange into California followed by sale of California property (appreciation

followed by depreciation in value) TP purchased property in State A for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into California property which is later sold in a taxable transaction for $8.


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Questions:


source gain? • Does TP have California source loss even though TP is reporting a federal gain

in the year the California replacement property is sold? 6. Exchange into California followed by sale of California property (appreciation

followed by loss on ultimate sale) TP purchased property in State A for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into California property which is later sold in a taxable transaction for $4.

Questions:

• How much of the $1 federal loss ($4 sale price minus $5 basis) is California

source loss? • Does TP have California source loss in excess of the federal loss reported in

year the California replacement property is sold?

C. Exchanges out of California – Multiple Exchanges 7. Exchange out – Multiple exchanges (insufficient deferred gain)

TP purchased California property for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into State A property which is later sold for $15 and again defers the gain by performing a second IRC section 1031 exchange. TP exchanges into State B property which is later sold for $20 and again defers the gain by performing a third IRC section 1031 exchange. TP exchanges into State C property which is later sold for $8.

Questions:


source gain? • Does TP have California source gain in excess of the federal gain reported in

the year the State C property is sold? NEW FACT: The State C property is sold for $15 instead of $8.


California source gain? 8. Exchange out – Multiple exchanges (loss on ultimate sale)


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TP purchased California property for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into State A property which is later sold for $15 and again defers the gain by performing a second IRC section 1031 exchange. TP exchanges into State B property which is later sold for $20 and again defers the gain by performing a third IRC section 1031 exchange. TP exchanges into State C property which is later sold for $4.

Questions:

• How much of the $1 federal loss ($4 sales price minus $5 basis) is California

source loss? • Does TP have California source gain in the year the State C property is sold

even though a federal loss is reported? Exchanges into and back out of California

9. Exchange into and back out of California (appreciation, followed by more

appreciation, followed by depreciation in value) TP purchases property in State A for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into California property which is later sold for $20 and again defers the gain by performing a second IRC section 1031 exchange. TP exchanges into a property located in State B which is later sold in a taxable transaction for $10.

Questions:


California source gain? • Does TP have California source gain in excess of the federal gain reported in

the year the State B property is sold? NEW FACT: The State B property is sold for $15 instead of $10.


California source gain? 10. Exchange into and back out of California (appreciation, followed by more

appreciation, followed by loss on the ultimate sale of the property) TP purchased property in State A for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into California property which is later sold for $20 and again defers the gain by performing a second lRC section 1031 exchange. TP exchanges into a property located in State B which is later sold in a taxable transaction for $4.


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Questions:

• How much of the $1 federal loss ($4 sales price minus $5 basis) is California source loss?

• Does TP have California source gain in the year the State B property is sold even though a federal loss is reported?

11. Exchange into and back out of California (appreciation, followed by depreciation,

followed by appreciation in value) TP purchased property in State A for $5 and sells the property for $10, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into California property which is later sold for $8 and again defers the gain by performing a second lRC section 1031 exchange. TP exchanges into a property located in State B which is later sold in a taxable transaction for $20.

Questions:


California source gain? • Does TP have California source loss in the year the State B property is sold

even though TP reported a federal gain on the sale? 12. Exchange into and back out of California (appreciation, followed by depreciation,

followed by loss on the ultimate sale of the property) TP purchased property in State A for $5 and sells the property for $15, deferring the gain by performing an IRC section 1031 exchange. TP exchanges into California property which is later sold for $8 and again defers the gain by performing a second lRC section 1031 exchange. TP exchanges into a property located in State B which is later sold in a taxable transaction for $4.

Questions:

• How much of the $1 federal loss ($4 sales price minus $5 basis) is California

source loss? • Does TP have California source loss in excess of the federal loss reported in

the year the State B property is sold? 13. Apportioning

Taxpayers Questions:

• Should the FTB develop a regulation addressing which year's apportionment factor(s) should be applied to the deferred gain/loss from an IRC section 1031 exchange when such deferred gain/loss is ultimately recognized?

• What should the scope of this regulation be?


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IV. ITax Scams, Identity Theft and Tax Fraud.

Effective July 1, 2016, the FTB has a new Identity Theft Hotline. Although the hotline number has changed, the ID theft fax number remains the same for submission of ID theft correspondence and forms, such as the ID Theft Affidavit, FTB 3552.

The contact numbers to use are:

Phone: (916) 845-7088 Fax: (916) 843-0561

In general, if a taxpayer knows or even just suspects that he or she is a victim of identity theft, it’s important to immediately file Form FTB 3552, Identity Theft Affidavit. The taxpayer should also be prepared to send copies of the following documents to the FTB:

• Passport; • Driver’s license or Department of Motor Vehicles identification card; • Social Security card; • Police report; and • IRS letter of determination, if applicable.

Reporting the theft will place a notice on the account. Because of the “ID Theft status” on the account, the FTB will stop and review any returns filed under the victim’s name and Social Security number to confirm if the return was filed by the real taxpayer or if it’s fraudulent. The FTB will use information from their files and may also contact the taxpayer for confirmation. If the victim is expecting a refund, the refund could be delayed 60 days due to the high volume of identity theft cases.

You should be suspicious of anyone that contacts you by email, mail, or phone who:

• Asks for passwords or information about your credit cards and bank accounts. FTB never ask for this kind of information and you should never disclose it.

• Threatens to contact local police or other law-enforcement groups to have you arrested if a tax debt is not paid.

• Demands payment by third-party issued or pre-paid debit cards. FTB does not accept these forms of payment.

• Claims that there is a problem with your account.

If you receive a suspicious email that claims to be from us requesting personal information, it may be a phishing email. Phishing occurs when an email is received requesting personal information such as:

• Social Security number


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• User name • Password • Credit card or bank account information

Phishing emails look legitimate since they often use real logos and phone numbers. In addition to requesting personal information, the email may also direct you to a fake website which looks like the FTB website and asks you for personal information. Once you enter your personal information, it can be used to steal your identity. FTB will never redirect you to another website from FTB emails. These scams entice the user to click on an email attachment, which contains malicious software that tracks keystrokes and may identify password information. You can minimize exposure to phishing scams by not opening messages from unknown senders. Make sure your staff members are trained on the dangers of phishing scams in the form of e-mails, texts, and calls.

Whether you have a large or small practice, there are measures to reduce the likelihood of a successful attack. Employ appropriate security controls for your environment based on the size, complexity, nature and scope of your activities. Security controls are necessary to protect the confidentiality, integrity and availability of your clients’ sensitive information.

Other ways to protect your business from cyber criminals: range from locking doors to restricting access to paper or electronic files to installing antivirus software with automatic updates to recognize viruses and malware on all computers on your business network. Frequently back up and secure data on a flash drive or external hard drive and store in a fireproof safe. Use strong passwords and don’t share them including your MyFTB password. These are only a few examples of ways to reduce ID theft from your office.

If you receive a suspicious email:

• Don’t click or follow any links as they can contain malicious code that may infect your computer or mobile phone.

• Don't reply to the email with personal information. • Delete the email from your inbox and from your trash folder.

Typically, FTB contacts you by mail—several times, if necessary—prior to calling you directly. FTB also uses their automated dealer program to make collection calls to taxpayers that are not current with their tax obligations.

V. Revivor. Beginning Friday, July 1, 2016, business entities can submit an online request for revivor assistance on the FTB website.

FTB’s goal is to revive business entities as quickly as possible once they meet their tax compliance obligations to ensure the business is promptly and legally able to conduct business in California. When a business is suspended or forfeited, the entity must properly revive in order to be placed back in good standing.


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CHAPTER 11 WATER’S EDGE ELECTION


II. Water’s Edge Election ............................................................................................................. 1 A. Treatment of Elections .......................................................................................................... 2 B. Conditions for Treatments in this Notice to Apply .................................................................. 2

II. Water’s Edge Election During the 2009-2010 third extra session, the California Legislature amended Revenue and Taxation Code section 23101, adding subdivisions (b) through (d), operative for taxable years beginning on or after January 1, 2011. Subdivision (b) outlines additional circumstances that constitute doing business in California. Corporations that are doing business in California are subject to the franchise tax, i.e., they are taxpayers. (Rev. & Tax. Code, § 23151(a) et seq.) Consequently, a corporation that was not subject to the franchise tax (i.e., was not a taxpayer) could become subject to the franchise tax, (i.e., become a taxpayer) due to the addition of subdivision (b) of section 23101. Section 25110 provides that a qualified taxpayer may elect to determine its income derived from or attributable to sources within California pursuant to a water's-edge election. Section 25113 provides that a water's-edge election shall be effective only if every member of the self-assessed combined reporting group that is subject to taxation (i.e., all taxpayer members) make a water's-edge election. A unitary foreign affiliate of a water's-edge combined reporting group that, at the time of an election, was not doing business in California under the provisions of section 23101(a) and thus, was not a taxpayer, could not make a water's-edge election for taxable years beginning before January 1, 2011 because that entity was not a taxpayer in California. However, beginning on January 1, 2011, if a unitary foreign affiliate is doing business in California due solely to the addition of section 23101, subdivision (b), the foreign entity is subject to the franchise tax, and thus, is a taxpayer. Depending on whether a unitary foreign affiliate is a corporation whose income and apportionment factors would have been properly considered in computing the income of the taxpayers making a water's-edge election, the foreign affiliate may have been required by section 25113, subdivision (b), to make an election for the election to be effective.

This Notice addresses the treatments the FTB will apply in situations where a unitary foreign affiliate of a water's-edge combined reporting group could not make an election at the time of a water's-edge election because the affiliate was not subject to tax in California; but after the addition of section 23101, subdivision (b), the affiliate would have been required to make a water's-edge election for the election to remain effective.


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A. Treatment of Elections Section 25113 and the regulation thereunder address the effect on water's-edge elections resulting from changes in the composition of water's-edge combined reporting groups due to corporate events such as acquisitions, mergers, consolidations, or disaffiliations between electing and non-electing affiliates that occur after an election is made. However, neither the statute nor the regulation addresses the effect on an election due entirely to a change of law resulting in a change of status of a non-electing unitary foreign affiliate from non-taxpayer to taxpayer as outlined above.

The water's-edge election statute, and the regulation promulgated thereunder, were drafted to give effect to taxpayers' objective manifestations of intent to elect or terminate an election to the greatest extent possible. Therefore, consistent with this approach and subject to all of the conditions outlined below, the FTB will treat the existing water's-edge elections in the situations described below as follows: (1) When a unitary foreign affiliate has income derived from or attributable to sources

within the United States as described in section 25110, subdivision (a)(2)(A)(i) ("United States Income") both before and after the beginning of a taxable year in which the affiliate becomes a taxpayer solely due to the addition of section 23101, subdivision (b), the deemed election provisions of section 25113, subdivision (b)(4) shall apply.

(2) When a unitary foreign affiliate does not have United States Income either before or after the beginning of a taxable year in which the unitary foreign affiliate becomes a taxpayer solely due to the addition of section 23101, subdivision (b), the affiliate would never have been includable in the water's-edge combined report under section 25110(a)(2)(A)(i) despite its status as a taxpayer under section 23101, subdivision (b). However, in order to give effect to the objective intent of the taxpayers' unitary group to maintain an effective water's-edge election, the unitary foreign affiliate shall be deemed to have made an election as of the taxable year in which it became a taxpayer. The commencement date of the deemed water's-edge election shall be the same as the commencement date of the electing taxpayers of the existing water's- edge combined reporting group. In such circumstances, the foreign affiliate may be included in the group return of the existing water's-edge combined reporting group for administrative convenience.

When a unitary foreign affiliate does not have United States Income before, but has United States Income after, the beginning of a taxable year in which the affiliate becomes a taxpayer solely as a result of the addition of section 23101, subdivision (b), the unitary foreign affiliate will be deemed to have made an election as of the taxable year in which it becomes a taxpayer. The commencement date of the deemed water's-edge election shall be the same as the commencement date of the electing taxpayers of the existing water's-edge combined reporting group.

B. Conditions for Treatments in this Notice to Apply The treatment of elections outlined above is limited to situations in which all of the


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following conditions apply: (A) a group of taxpayers made a valid water's-edge election before the date of this

Notice, and

(B) at the time the water's-edge election described in condition (A) was made, a foreign affiliate that was unitary with the electing water's-edge combined reporting group members could not make a water's-edge election because the affiliate was not subject to tax in California, and

(C) the unitary relationship between the members of the water's-edge combined reporting group and the foreign affiliate remained continuously in effect between the time the valid water's-edge election was made and the time the unitary foreign affiliate became a taxpayer, and

(D) the unitary foreign affiliate of the water's-edge combined reporting group became a taxpayer in a taxable year ending on or before December 31, 2016 due solely to the addition of subdivision (b) of section 23101, such that, had the foreign affiliate been a taxpayer member of a self-assessed combined reporting group at the time the water's-edge election described in condition (A) was made, the foreign affiliate would have been required by statute or regulation to make a waters-edge election in order for the water's-edge election to have been valid.

If all of these conditions are satisfied, the FTB will not seek to terminate the water's-edge election of the water's-edge combined reporting group that is unitary with the foreign affiliate that is now a taxpayer, but will apply the treatments outlined in paragraphs (1) through (3), above.

Except as provided in this Notice, all other provisions of law relating to the determination of the income derived from or attributable to sources within California pursuant to a water's- edge election remain in full force and effect. The deemed election provisions of this Notice shall apply only to taxable years beginning within 84 months of the date of this Notice.


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CHAPTER 12 OTHER LEGISLATIVE DEVELOPMENTS

Table of Contents

I. Crowdfunding ........................................................................................................................... 1 A. Income Tax Consequences. ................................................................................................. 3 B. Is Crowdfunding Taxable Income? ..................................................................................... 3 C. Activity as a Hobby versus Trade or Business. ................................................................... 4 D. Startup Expenses. ................................................................................................................ 4 E. Nontaxable Gift. .................................................................................................................. 5 F. Nonshareholder Contribution .............................................................................................. 5 G. Sales Tax. ............................................................................................................................ 6

1. Nexus. ............................................................................................................................... 6 H. SEC Regulations. ................................................................................................................ 7

II. Termination of Community Property. ..................................................................................... 8

III. SB 2 (CH. 2-March 1, 2016). New Managed Care Organization Provider Tax Imposed (Mar. 3, 2016) ............................................................................................................................... 10 IV. “No Tax” States. ............................................................................................................................. 11

A. Tennessee. .......................................................................................................................... 11

V. Fantasy Sports ....................................................................................................................... 11 VI. Minimum Wage and Paid Family Leave. ............................................................................ 12

I. Crowdfunding

Crowdfunding has grown into a prominent internet-based vehicle for raising money from a large number of people who may have little in common other than a desire to contribute to the success of the project or other endeavor. On websites such as kickstarter.com and indiegogo.com, "creators" or initiators of a fundraising campaign seek contributors, or "backers," to finance their projects. Other sites, such as gofundme.com or causes.com, feature fundraisers for personal or charitable endeavors.

Crowdfunding is the practice of funding a project or venture by raising monetary contributions from a large number of people, typically through the internet. Generally, three parties are involved in crowdfunding: a project initiator that is seeking project funding, contributors that fund the projects, and a moderator, usually a website, that brings the initiator and contributors together. Besides Kickstarter, crowdfunding moderators include Indiegogo ( indiegogo.com) and other sites that host forums for project initiators to present their projects or ventures and for contributors to make pledges to the initiators' causes.

Crowdfunding participants include:


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Host – The host is usually a website or online platform. This site is where individuals and companies can place and describe the project. The host receives the donated money from backers. Once the project meets its financial goal, the host keeps some of the money for providing online services. Then, the rest of the money is given to the project creators. If the project doesn’t meet its financial goal, some hosts require that the project creators return the money to the backers. Other hosts give project creators whatever money was raised.

Project creator – The project creators are the people who create the project. A project creator can be an individual or a business. The project creator post the project ideas on the host website and asks backers for money. Project creators set the goal, and a deadline. They may also provide the backers with rewards for funding the project.

Backer – A backer is a business or individual who offers money to project creators. This group is usually made up of the general public, friends, family, etc. In exchange for giving money to a project, backers can get rewards from the project creators. These rewards can be anything from a thank you note to books, dinners, tickets, or anything else.

Crowdfunding in the United States falls into three distinct types: for creative enterprises, which can be characterized as reward-based crowdfunding; as a means of personal fundraising, or donation-based crowdfunding; and equity-based crowdfunding, which raises capital for companies and for which the SEC issued final rules earlier this year (and which are summarized below.

Example:

You are a book author. You want to turn one of your books into a movie so you decide to use crowdfunding to raise money for your project. You decide to reward your backers in the following ways:

Backer donates $1: You write the backer a thank you note.

Backer donates $5: You write the backer a thank you note and list their name online as a supporter.

Backer donates $25: You give the backer a signed copy of your book.

Backer donates $100: You invite the backer to a private screening of your movie.

Backer donates $250: You invite the backer to a private screening of your movie, and to a cast dinner.

Backer donates $500: You invite the backer and two guests to a cast dinner and private screening of your movie. Backer also gets a cameo appearance in the movie.

Backer donates $1,000: You buy the backer a plane ticket and movie tickets to see the movie opening in Los Angeles, CA.


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As the project creator, you are responsible to make sure backers get their rewards.

There are few, if any, definitive guidelines, especially in view of the variety of types of arrangements and transactions that crowdfunding has taken so far, with still more options likely to come. Still, applying common tax principles and common sense may help tax preparers and advisers in talking through the issues with their clients who have taxable crowdfunding income and deciding how to report and pay taxes on it.

The IRS has recently stated informally that donations will not qualify for a charitable contribution deduction if they are earmarked for a single person or a small group. This would also include contributions to assist with a persons medical costs or to help a family who lost their home in a fire. But gifts to charities who solicit donations on a fund raising site can be deducted if the group is a IRC sec. 501( c)(3) organization.

A. Income Tax Consequences.

The Internal Revenue Code and IRS guidance do not address crowdfunding, leaving several possibilities for how it should be treated for tax purposes. Accordingly, the following should not be regarded as a definitive guide but only as considerations in exploring each taxpayer's situation to assess possible tax treatments and, hopefully, settle on a well-reasoned and substantiated position. Also, note that crowdfunded activities may be subject to other taxes, notably, sales and use taxes. See "Tax Clinic: Crowdfunding Contributions and State Sales and Use Taxes," The Tax Adviser, June 2015, page 420.

B. Is Crowdfunding Taxable Income?

Amounts received through reward-based crowdfunding campaigns most likely are taxable income under Sec. 61, to be reported by the creator in the year of receipt. In August 2013, the Canadian Revenue Authority interpreted Canadian tax law as generally requiring inclusion of reward-based crowdfunding in Canadian taxable income where receipts are "by virtue of a profession or ... carrying on a business".

The websites that facilitate crowdfunding do not guarantee the completion of the project or the delivery of the reward. This means that once creators receive the funds, they have complete control over them, even if they do not complete the project and deliver the reward. Therefore, under both the cash and accrual method of accounting, this income is taxable in the year of receipt. These situations also create the timing problem associated with many creative endeavors and that is timing of income/expense recognition. If the income is taxable immediately upon receipt, then the expenses will generally not follow until a later year which might create cash flow problems.

If tax practitioners conclude that a client's crowdfunding income is includible in U.S. federal gross income, a number of other questions and issues arise, including what expenses, if any, should be deductible against it. That depends on several factors, including:

Whether the crowdfunding activity is deemed a trade or business or a hobby;


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Whether the activity is deemed a startup business; or Whether the contribution is nontaxable (gift or nonshareholder contribution to capital).

C. Activity as a Hobby versus Trade or Business.

If the activity is deemed a trade or business, all otherwise allowable trade or business expenses should be deductible against the income (Sec. 62). If, however, the activity is deemed to be a hobby, only expenses to the extent of the income will be deductible (Sec. 183).

Whether an activity is a trade or business or a hobby is a facts-and-circumstances determination. The Sec. 183 limit can apply to individuals, partnerships, S corporations, estates, and trusts; it does not apply to C corporations. Nine factors are generally considered when making this determination, including whether the business is run in a businesslike fashion, whether the owner had any experience or knowledge in the business area, and whether the activity is carried on for recreation or personal purposes.

D. Startup Expenses.

If the crowdfunding activity is a new business, creators may have startup costs or, in the case of an activity set up as a corporation or partnership, organizational costs. The general tax treatment applied to start-up expenses applies here. A taxpayer must capitalize these costs unless the taxpayer makes an election under Sec. 195 for startup costs or Sec. 248 (corporations) or Sec. 709 (partnerships) for organizational costs to deduct up to $5,000 of these costs (reduced by the amount by which they exceed $50,000). The deduction is taken in the year the trade or business becomes active (for startup costs) or the partnership or corporation begins business (for organizational expenses), and the remainder of the startup costs are amortized over a 15-year period beginning in the month in which the trade or business becomes active or the corporation or partnership begins business. A taxpayer is deemed to make the election to deduct and amortize these expenses unless it affirmatively elects to capitalize them on the return in which the trade or business activity begins or the entity begins business.

For startup or organization costs to be deducted at all, the activity must be considered an active business. A taxpayer is not deemed to be carrying on a trade or business until the regular activities for which the business was formed are under way. No deduction is allowed for expenses incurred in the planning or preparatory stages of an activity. Conducting a crowdfunding activity alone may not be considered engaging in an active business, so crowdfunding expenses may not be deductible until a later year, when the business begins its active business.

The discussion above presupposes that the backer receives something of value in exchange for a contribution to a campaign. Some of the rewards offered on the crowdfunding campaigns, however, might be difficult to value. See “Example” above.

If the value of any of the rewards offered cannot be determined, or if a reward is determined to have no value or a value less than the pledge amount, additional evaluation may be required to determine whether all or part of the contribution can be classified as a nontaxable gift or some other type of contribution.


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E. Nontaxable Gift.

A gift is generally defined for federal income taxes as an amount transferred out of "detached and disinterested generosity" (Duberstein, 363 U.S. 278 (1960)). Gift treatment would be disallowed where the reward has a value approximately equal to or greater than the contribution in return for the payment (American Bar Endowment, 477 U.S. 105 (1986)).

Therefore, amounts received as a reward-based crowdfunding campaign that promises a reward that has some value is unlikely to be considered a gift. Contributions from backers who choose to forgo the reward might be treated as nontaxable gifts, particularly if the recipient cannot offer a charitable contribution deduction.

F. Nonshareholder Contribution In the case of corporations, Sec. 118 allows certain receipts to be treated as nontaxable contributions to capital by a nonshareholder. This is unlikely to apply to most reward-based crowdfunding, as most creators do not operate their campaigns through corporations. Corporations are generally exempt from tax on contributions made to corporate capital under section 118(a), which states that "in the case of a corporation, gross income does not include any contribution to the capital of the taxpayer." United States v. Chicago, Burlington & Quincy Railroad Co., 412 U.S. 401 (1973), is the case that clarified the Supreme Court's position on non-shareholder contributions to capital. In CB&Q, the taxpayer operated a railroad that needed safety improvements. The taxpayer agreed to make those improvements if the government would pay for their installation, and it argued that it could depreciate the cost of some safety-related improvements that had been required and funded by the federal government. It said it received no taxable income and incurred no tax liability when it received those improvements at governmental expense. The Court held that the governmental subsidies did not constitute contributions to the taxpayer's capital under IRC section 118, that the assets in the hands of the taxpayer had a zero basis, and that the taxpayer was precluded from claiming a depreciation allowance for those assets. The improvements were constructed primarily for the benefit of the public's safety, the need of the railroad for capital funds was not considered, and no substantial incremental benefit in terms of the production of income was foreseeable.

CB&Q helped clarify the Court's position by outlining five characteristics to be considered in testing the motive and intent of the transferor when determining if a transfer meets the requirements for being considered a non-shareholder contribution to capital. The contribution must:

• become a permanent part of working capital; • not be compensation for specific quantifiable services; • be bargained for; • provide a foreseeable benefit to the corporation in an amount commensurate with its

value; and • ordinarily be used to generate additional income.


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While a crowdfunding contribution may meet some of the criteria, the last factor will likely prove problematic. Due to the nature of a crowdfunding campaign, creators simply post a project and hope backers will choose to contribute. Websites that support crowdfunding will not provide backer information to a creator until after a project is funded and contributions are received by the creator, so negotiation is not possible.

G. Sales Tax.

Not many states have addressed taxability of the funds raised through crowdfunding under the sales tax. Washington did issue guidance (Tax Topics: Crowdfunding, Washington Dept. of Revenue , December 17, 2014). In Washington project creator is required to collect sales tax on donations if it provides retail services, digital products, or tangible personal property as rewards. Donations must be reported in the reporting period in which the project is fully funded. The sales tax rate is based on the location where the backer receives the retail services or goods. An individual electing to use crowdfunding must register with the department if the annual gross income from crowdfunding, including the host fee, exceeds $12,000 or if he/she is required to collect sales tax on a reward. The project creator is required to collect sales tax on donations if you provide retail services (such as meals), digital products or tangible personal property (books, videos, copies of games, etc.) as rewards. You don’t have to collect sales tax on items exempt from sales tax (such as prepackaged food items). Therefore, rewards such as a thank-you note or listing the contributor's name online as a supporter are not taxable, and, therefore, the related contributions are considered donations.

The sales tax rate is based upon where the backer receives the goods or retail services. For example, if a backer in Spokane receives taxable, tangible personal property then you would use Spokane’s sales tax rate and location code.

1. Nexus.

Another question for whether a project initiator is responsible for collecting sales or use taxes is whether the state has jurisdiction over the initiator to require collection and remittance. For a state to have jurisdiction over an out-of-state seller, the seller must meet the state's statutory requirements for "doing business" or being a "vendor" in the state, and the out-of-state seller's activities must have a "substantial nexus" with the taxing state. The U.S. Supreme Court in Quill v. North Dakota, 504 U.S. 298 (1992), ruled that "substantial nexus" for sales and use tax collection means that a seller has "physical presence" in the state, which requires more than a connection through the U.S. mail or common carrier within the state. Many project initiators may be individuals or small startups with a physical presence in one or a few states; however, they may be deemed to have substantial nexus in additional states through the crowdfunding moderator.

Several states have enacted provisions termed “click through” nexus which impose an agency relationship on the out-of-state seller if they pay a commission to an in-state person who, through an internet link, refers customers to the out-of-state seller, if the referral results in a sale and the seller's annual sales from the referrals reach a certain dollar threshold. Since the crowdfunding host is receiving a fee for providing an internet link for contributors to make


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contributions, these click-through nexus provisions may create nexus for the project initiator if the host has substantial nexus in a click-through nexus state.

H. SEC Regulations.

The new rules update and expand Regulation A, an existing exemption from registration for smaller issuers of securities. The rules are mandated by Title IV of the Jumpstart Our Business Startups (JOBS) Act.

The updated exemption will enable smaller companies to offer and sell up to $50 million of securities in a 12-month period, subject to eligibility, disclosure and reporting requirements.

The final rules, often referred to as Regulation A+, provide for two tiers of offerings: Tier 1, for offerings of securities of up to $20 million in a 12-month period, with not more than $6 million in offers by selling security-holders that are affiliates of the issuer; and Tier 2, for offerings of securities of up to $50 million in a 12-month period, with not more than $15 million in offers by selling security-holders that are affiliates of the issuer. Both Tiers are subject to certain basic requirements while Tier 2 offerings are also subject to additional disclosure and ongoing reporting requirements.

In addition to the limits on secondary sales by affiliates, the rules also limit sales by all selling security-holders to no more than 30 percent of a particular offering in the issuer’s initial Regulation A offering and subsequent Regulation A offerings for the first 12 months following the initial offering.

For offerings of up to $20 million, the issuer could elect whether to proceed under Tier 1 or Tier 2. Both tiers would be subject to basic requirements as to issuer eligibility, disclosure, and other matters, drawn from the current provisions of Regulation A. Both tiers would also permit companies to submit draft offering statements for non-public review by Commission staff before filing, permit the continued use of solicitation materials after filing the offering statement, require the electronic filing of offering materials and otherwise align Regulation A with current practice for registered offerings.

In addition to these basic requirements, companies conducting Tier 2 offerings would be subject to other requirements, including:

• A requirement to provide audited financial statements. • A requirement to file annual, semiannual and current event reports. • A limitation on the amount of securities non-accredited investors can purchase in a Tier 2

offering of no more than 10 percent of the greater of the investor’s annual income or net worth.

The exemption would be limited to companies organized in and with their principal place of business in the United States or Canada. The exemption would not be available to companies that:


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• Are already SEC reporting companies and certain investment companies. • Have no specific business plan or purpose or have indicated their business plan is to

engage in a merger or acquisition with an unidentified company. • Are seeking to offer and sell asset-backed securities or fractional undivided interests in

oil, gas or other mineral rights. • Have been subject to any order of the Commission under Exchange Act Section 12(j)

entered within the past five years. • Have not filed ongoing reports required by the rules during the preceding two years. • Are disqualified under the “bad actor” disqualification rules.

II. Termination of Community Property.

On February 18, 2016, Senator John Moorlach introduced SB 1255 which amends Sections 771, 910, 914, and 4438 of, and … adds Section 70 to, the Family Code, relating to family law. According to the Legislative Counsel’s Digest:

Under existing case law, a spouse is required to be living in a separate residence in order to be considered living separate and apart from the other spouse, for purposes of characterizing the earnings of the spouse. SB 1255 adds Section 70, which reads:

(a) “Date of separation” means the date that a complete and final break in the marital relationship has occurred, as evidenced by both of the following: (1) The spouse has expressed his or her intent to end the marriage to the other spouse. (2) The conduct of the spouse is consistent with his or her intent to end the marriage. (b) In determining the date of separation, the court shall take into consideration all relevant evidence. (c) It is the intent of the Legislature in enacting this section to abrogate the decisions in In re Marriage of Davis (2015) 61 Cal.4th 13 846 and In re Marriage of Norviel (2002) 102 Cal.App.4th 1152.

SB 1255 was signed by the Governor on July 25, 2016 (CH 114-2016) and will apply retroactively to cases pending on January 1, 2017.

Before October 25, 2013, no reported case had ever held that parties could be separated while they lived under the same roof. The only case to have considered that issue held that "living apart physically is an indispensable threshold requirement to separation, whether or not it is sufficient, by itself, to establish separation."

On October 25, 2013, the First District Court of Appeal published its subsequently overturned decision in Marriage of Davis. The First District disagreed with Norviel and held that


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"a spouse who continues to live in the family home but who, in every meaningful way, has abandoned the marital relationship" could still be separated.

The California Supreme Court reversed the First District, holding that " living in separate residences 'is an indispensable threshold requirement' [citation omitted] for a finding that spouses are “living separate and apart” for purposes of section 771(a)." After a lengthy historical legislative analysis, the Supreme Court concluded that the Legislature had intended the phrase "living separate and apart" in Section 771 to mean "a situation in which spouses are living in separate residences and at least one of them has the subjective intent to end the marital relationship, which intent is objectively evidenced by words or conduct reflecting that there is a complete and final break in the marriage relationship."

SB 1255 overrules the Davis case. Although this may be the better result to achieve the objective of protecting the non wage earning spouse, it does take California further away from federal tax law governing this issue.

In general, federal law will use the same characterization as state law to determine if community property applies, but it is possible that community income under state law will be separate property for federal tax purposes (or vice versa). This is because of IRC sec. 66 which addresses the termination of community property for federal tax purposes. IRC sec. 66 states that if the following conditions are met, then community property will not apply:

1. The spouses are married to each other at any time during the calendar year; 2. The spouses live apart at all times during the calendar year. Note that living apart requires that spouses maintain separate residences. Spouses who maintain separate residences due to temporary absences are not considered to be living apart.; 3. The spouses do not file a joint return with each other for a taxable year beginning or ending in the calendar year; 4. One or both spouses have earned income that is community income for the calendar year; and 5. No portion of such earned income is transferred (directly or indirectly) between such spouses before the close of the calendar year. Note that transferred income does not include a de minimis amount of earned income that is transferred between the spouses. In addition, any amount of earned income transferred for the benefit of the spouses' child will not be treated as an indirect transfer to one spouse. Additionally, income transferred between spouses is presumed to be a transfer of earned income.

California has not incorporated IRC sec. 66. This provision is distinguishable from Family Code sec. 771 in that the California provision has no requirement that the parties live apart for the entire year. If, however, the parties do live apart for the entire year they have met one but not all of the requirements of Family Code sec. 771.

Example:

H and W are married, domiciled in California, a community property state, and have lived apart the entire year of 2015. H and W are estranged and intend to live apart indefinitely. H


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and W do not file a joint return for taxable year 2015. H occasionally visits W and their two children, who live with W. When H visits, he often buys gifts for the children, takes the children out to dinner, and occasionally buys groceries or new clothes for school. H and W have recently been attending marriage-counseling sessions in an attempt to reconcile differences. Both W and H have earned income in the year 2015 that is community income under the laws of California (not much objective intent to terminate the marriage). For federal purposes, H and W may report their own income on separate returns under IRC sec. 66.1

III. SB 2 (CH. 2-March 1, 2016). New Managed Care Organization Provider Tax Imposed (Mar. 3, 2016)

For fiscal years 2016-17, 2017-18, and 2018-19, a new California managed care organization provider tax is imposed on licensed health care service plans, managed care plans contracted with the Department of Health Care Services to provide Medi-Cal services, and Alternate Health care Service Plans (AHCSPs), except for specifically excluded plans. Health plans that provide only specialized or discount services, certain international plans, and plans owned and operated by nonprofit hospitals or health systems that are headquartered in have a substantial amount of enrollment in Sacramento or San Diego County are excluded. An "AHCSP" is defined as a nonprofit health plan with at least four million enrollees statewide, that owns or operates pharmacies and provides professional medical services to enrollees in specific geographic regions through an exclusive contract with a single medical group in each specific geographic region in which it is licensed.

The tax will be imposed at various taxing tiers and per enrollee amounts, with the base year, for purposes of assessing the tax, being the 12-month period from October 1, 2014, through September 30, 2015. Medi-Cal taxing tiers I, II, and III consist of all countable Medi-Cal enrollees in a health plan from zero to 2 million, 2,000,001 to 4 million, and greater than 4 million, respectively. Other taxing tiers I, II, and III consist of all countable other enrollees in a health plan from zero to 4 million, 4,000,001 to 8 million, and greater than 8 million, respectively. The AHCSP taxing tier consists of all countable AHCSP enrollees in a health plan from zero to 8 million. The applicable tax rates are as follows:

• Medi-Cal per enrollee tax for Medi-Cal taxing tier I - $40 for 2016-17, $42.50 for 2017-18, $45 for 2018-19

• Medi-Cal per enrollee tax for Medi-Cal taxing tier II - $19 for 2016-17, $20.25 for 2017-18, $21 for 2018-19

• Medi-Cal per enrollee tax for Medi-Cal taxing tier III - $1 for all three fiscal years • Other per enrollee tax for other taxing tier I - $7.50 for 2016-17, $8 for 2017-18, $8.50

for 2018-19 • Other per enrollee tax for other taxing tier II - $2.50, $3 for 2017-18, $3.50 for 2018-19 • Other per enrollee tax for other taxing tier III - $1 for all three fiscal years • AHCSP per enrollee tax for the AHCSP taxing tier - $2, $2.25 for 2017-18, $2.50 for

2018-19 1 Reg. 1.66-2(a).


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The department may modify or make adjustments to any methodology, tax amount, taxing tier, or other similar provision to the extent necessary to meet the requirements of federal law or regulations, obtain federal approval, or ensure federal financial participation is available, as long as the modification or adjustment does not otherwise conflict with the purposes of the new law.

The department must not start collecting the tax until it receives approval from the federal Centers for Medicare and Medicaid Services that the tax is a permissible health care-related tax, as specified in federal regulations, and is eligible for federal financial participation. The department must collect the annual tax in four equal installments and establish the payment due dates. Late tax payments will be subject to interest and penalties.

IV. “No Tax” States.

A. Tennessee. Tennessee has enacted legislation that will allow it to join the ranks of states without an individual income tax. It now imposes a tax only on interest from notes and bonds and dividends. A recently enacted law lowers the tax rate to 5% (from 6%) for 2016 and cuts it further for later years, until the tax is eliminated beginning in 2022. Currently, seven states have no individual income tax: Alaska, Fla., Nev., S.D., Texas, Wash. and Wyo.

V. Fantasy Sports

Fantasy sports is a game in which players pick teams based on an individual athlete's playing statistics and other factors. They come with a salary cap, that is, a player has only so much play money to spend on acquiring a team. These teams compete based on the statistical performance of those players in actual games. This performance is converted into points that are compiled and totaled according to a roster selected by each fantasy team's manager. These point systems can be simple and manually calculated by a "league commissioner" who coordinates and manages the overall league, or more complicated and calculated using computers tracking actual results of the professional sport. In fantasy sports, team owners draft, trade, and cut players, analogous to real sports. Traditional fantasy sports games last for an entire season.

Daily fantasy sports (DFS) is a subset of fantasy sports. As with traditional fantasy sports games, players compete against others by building a team of professional athletes from a particular league or competition while remaining under a salary cap and earning points based on the actual statistical performance of the players in real-world competitions. DFS games are an accelerated variant of traditional fantasy sports that are conducted over short-term periods, such as a week or single day of competition, as opposed to those that are played across an entire season. DFS games are typically structured in the form of paid competitions referred to as a "contest"; winners receive a share of a predetermined pot funded by their entry fees. A portion of entry-fee payments goes to the provider as rake revenue or commission fees. The DFS industry is dominated by two players, New York-based FanDuel, and Boston-based DraftKings. Each company is worth about $1 billion and together control roughly 95 percent of the market.


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The Fantasy Sports Trade Association is a game of skill or gambling depends on who you talk to. Managers (players) must be aware of much more than "simple depth charts and statistics." They must also take into account "injuries, coaching styles, weather patterns, prospects, home and away statistics," and many other pieces of information to be successful. The association asserts that top players routinely win more games than if the contests were based on chance. In other words, the highly skilled fantasy player wins more often than if the games were based solely on chance alone. Indeed, some observers think that there may be such a thing as being too skilled. The element of skill in DFS may be so high "that DFS pros will wipe out recreational players in short order," possibly resulting in the casual player dropping out of the games entirely. Seven states passed laws this year: Colo., Ind., Miss., Mo., N.Y., Tenn. and Va. Also mulling new laws: Ill. and Texas, two big markets for fantasy sports competition. A summary of the provisions enacted by each of these state follows:

1. Colorado: No tax provision; DFS operators must be licensed by the state.

2. Indiana: No tax provision; DFS operators must pay $50,000 licensing fee (which may be increased up to $75,000) with a $5,000 annual renewal fee.

3. Kansas: No tax provision; DFS operators must be licensed by the state.

4. Mississippi: No tax provision; DFS operators must be licensed by the state.

5. Missouri: No tax provision; DFS operators must pay a license fee and a yearly operating fee of 11.5 percent of net revenue, defined as gross revenue minus winnings paid out, multiplied by the resident percentage, which is the total entry fees collected from Missouri residents divided by the total entry fees collected from all players regardless of location.

6. New York: $50,000 annual fee; 15 percent tax on revenue.

7. Tennessee: Imposes a 6 percent privilege tax on adjusted revenues. Adjusted revenues is defined as gross entry fee amounts collected minus winnings multiplied by the resident percentage, which is defined as the total entry fees collected from Tennessee residents divided by the total entry fees collected from all players regardless of location.

8. Virginia: No tax provision; DFS operators must pay a $50,000 fee to register in the state.

VI. Minimum Wage and Paid Family Leave.

On Monday, April 4, 2016, California Governor Jerry Brown signed SB 3 (Ch. 16-4), which will eventually raise the statewide minimum wage to $15 per hour, into law. On the same day he


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signed AB 908 (Ch. 16-5) which increases paid family leave benefits. SB 3 provides for six stepped annual statewide increases of the current minimum wage of $10 an hour, starting on January 1, 2017, for employees working for employers of 26 or more employees. The increases are delayed for one year for employers of 25 or fewer employees.

The increases may be temporarily delayed by the Governor during the six-year phase-in period for state general economic, or state budgetary, reasons. The possible delays (called “off-ramps” in the committee reports) may be used only twice during the phase-in period, with the last increase occurring on January 1, 2023.

Starting August 1, 2022, the California Director of Finance will annually calculate the adjusted minimum wage to be implemented on January 1 of the following year. The calculation will be based on a specified formula, which includes a version of the consumer price index (CPI). SB 3’s indexing provision allows only increases to the minimum wage – no decreases.

There is no difference in the wage paid based on geographic location of the employer. Therefore, under SB 3’s provisions, employers in Fresno will be paying their minimum wage workers the same rate as employers in San Francisco.

Unlike laws passed by some other states, SB 3 does not bar counties and cities from enacting their own minimum wages that are higher than the state's minimum wage.

The scope of the minimum wage's application is set by the amended statute’s definition of “employer.” There are no carve-outs in the definition of an employer for this new amended statute; public sector employers are included.

The bill sets two minimum wage rates, depending on whether an employer has 26 or more, or 25 or fewer, employees. The increases are delayed for one year for employers of 25 or fewer employees.18

Date 26 or More Employees 25 or Fewer Employees January 1, 2017 $10.50 $10.00 (current rate) January 1, 2018 $11.00 $10.50 January 1, 2019 $12.00 $11.00 January 1, 2020 $13.00 $12.00 January 1, 2021 $14.00 $13.00 January 1, 2022 $15.00 $14.00 January 1, 2023 $15.00 $15.00

The Governor can trigger the off-ramps (or delays in increase of the minimum wage) but only from 2017-2023. In addition, the Governor can only do so twice, based upon specified economic factors and certifications by the California Director of Finance. If a minimum wage increase is suspended by this method, subsequent increase dates are postponed for an additional year.


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Beginning in 2022 for employers with 26 or more employees, and in 2023 for employers with 25 or fewer employees, potential annual increases in the minimum wage for the following calendar year will be calculated by August 1 of each year by the Department of Finance.

As the bill had no urgency clause, it takes effect on January 1, 2017.

In addition, SB 3 phases in sick leave for In-home Supportive Services. Existing law excludes In-Home Supportive Services (IHSS) employers from the requirement to provide at least three days of paid sick time to their employees.2 SB 3 phases in sick leave for IHSS workers as follows:3

8 hours or one paid sick day in each year of employment beginning July 1, 2018 16 hours or 2 paid sick days in each year of employment beginning when the minimum wage reaches $13/hour; and 24 hours or 3 paid sick days in each year of employment beginning when the minimum wage reaches $15/hour.

For this purpose, “year of employment” means either a calendar year or 12-month period.

On April 11, 2016, Governor Jerry Brown signed into law AB 908, which will, though effective January 1, 2017, increase, for periods of disability commencing on or after January 1, 2018, the benefits provided to individuals in the Paid Family Leave (PFL) and State Disability Insurance (SDI) programs. The new law will increase the level of benefits from the current level of 55 percent to either 60 or 70 percent, depending on the applicant’s income. The new law will also remove, effective January 1, 2018, the seven-day waiting period before which individuals would be eligible for family temporary disability benefits.

The PFL program provides up to six weeks of wage replacement benefits to workers who take time off work to care for a seriously ill or injured family member or to bond with a minor child with one year of birth or placement of the child in connection with foster care or adoption. The SDI program provides benefits to individuals who are unable to work because of their own illness or injury.

The Paid Family Leave program affected by this legislation was enacted in 2002. It is funded through worker contributions and is administered by the Employment Development Department in tandem with the State Disability Insurance program.


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7Forensic Services Section

Benefi ts of Membership

As a Forensic Services Section member, your added benefi ts include:

• Leadership Development—Working your way from the backof the room to the front and enhancing your ability to beselected as an expert;

• Networking with other forensic services professionalsincluding attorneys and judges;

• Full-day Education Meetings with speakers, case studies andpractice development tools;

• Leading-edge, practice specifi c articles in The Witness Chair;

• Breaking news in the forensic accounting, valuation,damages,family law, litigation and fraud practice areas; and

• Effective representation on credentials, standards, practiceaids, precedent-setting legal cases and other professionalguidance.

Learn more and join at calcpa.org/fss

For more information, contact:Marie Ebersbacher, Forensic Services Section Chair [email protected] Ku, Forensic Services Section Manager [email protected]

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VPE 80 is one of our most economical programs. Mix and match any of our offerings to earn your credit hours, like at our CPE weeks at luxury destinations.

CalCPA Members: $1,295

VPE 50 is a limited time offer in honor of CalCPA Education Foundation’s 50th anniversary. Get 10 bonus hours of CPE at the same great price. Available March 1, 2016 – April 30, 2017.

CalCPA Members: $795

VPE 24 is a practical option if you want to attend a staff training, or if you are interested in three of our specialty conferences.

Coupons are ideal for attending full and multi-day Conferences and Courses. They are fully transferable, making it easy to distribute to staff and/or clients.


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Save up to $1,955 per year with our exclusive member discount for Value-Priced Education (VPE).

CalCPA Education Foundation

Discount Programs

calcpa.org/discount | (800) 922 5272

Coupons Coupon holders can choose between any of our live and webcast CPE formats (self-study products not included).

All discount programs are valid for one year from date of purchase.

*Savings based on live/webcast conference costs.

Take advantage of these great savings for all your CPE needs with CalCPA Education Foundation discount programs. With more than 1,400 opportunities to choose from, you have the flexibility to tailor your education to your schedule, professional requirements and learning style.

CalCPA Education Foundation VPE programs can be used for all conferences, courses and self-study products (on demand and PDF).

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Post your accounting position today.Members pay just $195 for 30 days

CalCPA.org/classifieds(800) 922-5272

does finding the right employee seem like searching for a needle in a haystack?Bring your talent search into focus.

Earn CPE anywhere, anytime.Search our Online Self-Study Products.

Choose from more than 100 self-paced, skill building courses.

To search for self-study products, visit-calcpa.org/SelfStudy

Note: All Education Foundation self-study formats—including on demand and PDF—qualify for interactive self-study credit.

Connect with CalCPAcalcpa.org/Linkedin

calcpa.org/Twitter

calcpa.org/Facebook

calcpa.org/YouTube

calcpa.org/RSSfeedsVPE

80VPE

40 50VPE

24COUPON

10

VPE 80 is one of our most economical programs. Mix and match any of our offerings to earn your credit hours, like at our CPE weeks at luxury destinations.

CalCPA Members: $1,295

VPE 50 is a limited time offer in honor of CalCPA Education Foundation’s 50th anniversary. Get 10 bonus hours of CPE at the same great price. Available March 1, 2016 – April 30, 2017.


VPE 24 is a practical option if you want to attend a staff training, or if you are interested in three of our specialty conferences.

Coupons are ideal for attending full and multi-day Conferences and Courses. They are fully transferable, making it easy to distribute to staff and/or clients.


Coupon 10: $2,495

Save up to $1,955*80 hours of CPE

Save up to $1,235*Now 50 hours of CPE!

Save up to $300*24 hours of CPE

10 Couponseach valid for up to

8 hours of event CPE; excludes self study

Save up to $1,955 per year with our exclusive member discount for Value-Priced Education (VPE).

CalCPA Education Foundation

Discount Programs

calcpa.org/discount | (800) 922 5272

Coupons Coupon holders can choose between any of our live and webcast CPE formats (self-study products not included).

All discount programs are valid for one year from date of purchase.

*Savings based on live/webcast conference costs.

Take advantage of these great savings for all your CPE needs with CalCPA Education Foundation discount programs. With more than 1,400 opportunities to choose from, you have the flexibility to tailor your education to your schedule, professional requirements and learning style.

CalCPA Education Foundation VPE programs can be used for all conferences, courses and self-study products (on demand and PDF).

WHY ONSITE LEARNING?

It’s convenient, cost-eff ective and most importantly – a powerful educational experience! Whether you are looking to fi ll regulatory requirements, stay current with annual updates, introduce trending topics or delve into specifi c training needs, Onsite Learning provides a personal group learning environment where you can raise questions and have discussions that are directly related to your business.

We can bring over 100 courses directly to your organization.

Calcpa.org/Onsite

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ConferencesSEPTEMBERFarmers Tax and AccountingSept. 21: Fresno | Webcast

OCTOBERFamily LawOct. 27: Los Angeles Oct. 28: San Francisco | Webcast

NOVEMBERFederal, State, Local and International TaxationNov. 2-4: Burbank Area | Webcast

DECEMBERWine Industry ConferenceDec. 5: Napa | Webcast

APRIL 2017Accounting and Auditing April 24-25: San Francisco | Webcast

Women’s Leadership ForumApril 28: San Francisco | Webcast

MAY 2017Governmental Accounting and Auditing

Introduction to School Districts Auditing

Employee Benefit Plans Annual Audit

Not-for-Profit Organizations

JUNE 2017Entertainment Industry

Estate and Trust

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CPE WeeksSAN DIEGOHyatt Regency Mission BayJuly 11–15

MONTEREY Embassy Suites Monterey Bay - SeasideAug.1-5

SAN LUIS OBISPO Embassy Suites San Luis ObispoOct. 24-28

LAKE TAHOE Hyatt Regency Lake Tahoe Resort, Spa and Casino Nov. 7-9

PALM SPRINGS Omni Rancho Las Palmas Resort Nov. 28-Dec. 2

calcpa.org/conferences

calcpa.org/CPEWeeks

REGISTER NOW!

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• Your Voice Advocacy in Sacramento

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