Eye on Washington: Quarterly Business Tax Update

Presented by

Stephen C. Henley, CPANational Tax Practice Leader, CBIZ MHM, LLC

William M. Smith, Esq.Managing Director, CBIZ MHM, LLC National Tax Office

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Circular 230 Notice

Any tax advice contained in this program is not intended to be used and cannot be used for the purposes of avoiding any penalties that may be imposed by the Internal Revenue Code.

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Agenda

• Tax Reform Update• Proposals to Reform Taxation of Small Businesses and

Passthrough Entities• Affordable Care Act Update• Cases• Regulatory Pronouncements

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Tax Reform Update

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• House – Of 232 House Republicans, 219 are from districts won by Romney

• Greater risk a challenger will emerge in primary than general election – Most sitting House members have little fear of losing seats

• 85% of 2012 House races had a margin of victory > 10% • 65% of 2012 House races had a margin of victory > 20%

– 145 Democratic winners; 140 Republican winners

• Senate – Since 2008, more than 40 new Senators have been elected

• Result – Bi-partisanship required to accomplish anything significant

Political Dynamics in Congress

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• Ranking Senate Finance Committee (SFC) members Max Baucus (D-MT) and Orrin Hatch (R-UT) sent letter to fellow Senators asking them which tax deductions should survive tax reform

• SFC’s approach will be to start with a “blank slate” – a tax code without any tax breaks – and then add back in worthy expenditures

• The blank slate is just a starting point, not the end product • Baucus and Hatch asked for proposals by July 26

Senate Looks to Start with “Blank Slate”

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• Tax deductions and credits will be restored only if they: – Help the economy grow, – Make the tax code fairer, or – Effectively promote other important policy objectives

• Exercise puts all special tax provisions in play, including: – Mortgage interest deduction – Charitable contribution deduction – Industry incentives (e.g., oil and gas, “green” industries)

• Goals of this process: – Clearly illustrate the effect of each tax expenditure – Determine which expenditures have broadest support – Give all Senators an opportunity to contribute to process

Senate Looks to Start with “Blank Slate”, cont’d.

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Tax Expenditure Lowest Quintile

Second Quintile

Third Quintile

Fourth Quintile

Highest Quintile

Employer provided health care exclusion 8% 14% 19% 26% 34% Retirement plan exclusions 2% 5% 9% 18% 66% Basis step-up at death 0% 3% 15% 17% 65% Social Security benefits exclusion 3% 15% 36% 33% 13% Mortgage interest deduction 0% 2% 6% 18% 73% Charitable contribution deduction 0% 1% 4% 11% 84%

Who Benefits from Individual Tax Expenditures?

Note: Income categories based on pre-tax income Source: Congressional Budget Office

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Proposals to Reform Taxation of Small Businesses and Passthrough Entities

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• Make $250,000 Section 179 limit permanent • Expand cash method to all businesses with gross receipts

less than $10 million – Increases 263A exemption to $10 million in gross receipts

• Due date changes: – Partnerships – 2 ½ months after year end – S corporations – 3 months after year end – C corporations – 3 ½ months after year end

• Unify deduction for start up and organizational expenses – Deduct up to $10,000 – Phase out beginning at $60,000 – Excess amortizable over 15 years

Core Components

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• S Corporations – Permanently reduce built-in gains recognition period to 5 years – Increase allowable passive income from 25% to 60% – Permit nonresident aliens to be shareholders through an ESBT

• Withholding required – Allow ESBT to deduct charitable contributions made by S corp

subject to limits applicable to individual donors – Make permanent rule reducing stock basis by adjusted basis of

charitable contribution vs. fair market value – Allow S election to be made on timely filed tax return

Passthrough Option 1: Revise Sub S and K

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• Partnerships – Mandate basis adjustments under §734 or §743 when property is

distributed to a partner or a partner sells his interest – Basis adjustments in lower tier partnership interest require

corresponding adjustment in basis of lower tier’s property – Repeal 7 year time limit for recognizing pre-contribution gain on

distributions to other partners – Repeal guaranteed payments rules so all payments a distribution

of income or capital (or payment in capacity as non-partner) – Apply §704(d) loss limitations to partner’s distributive share of

charitable contributions and foreign taxes – Treat all distributions of inventory as a sale regardless of whether

inventory is substantially appreciated

Passthrough Option 1: Revise Sub S and K

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• Repeals current Sub K and S and replaces with simplified, uniform regime – Allow contributions on tax-free basis – Allow for pass-through of income, losses, etc. – Permit only ordinary income, capital gains and tax credits to be

specifically allocated – Limit deductions for losses to owner’s basis with carryforwards – Limit tax-free distributions to owner’s basis – Require entity level withholding on pass-through income – Require pass-through businesses to recognize gain on distributions of

appreciated property – Require owners to take carryover basis in distributions of loss property – Allow owners basis for entity level debt (recourse and nonrecourse)

Passthrough Option 2: Unified Rules

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• Employment taxes • Transition rules • Foreign partners and partnerships • Mergers, divisions, reorganizations • Conforming changes in option 2 to integrate into related

tax rules • Effect of proposed changes to cash method on other

provisions not directly related to accounting methods

Unaddressed Issues

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Affordable Care Act (ACA) Update

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• Mandate for large employers to provide qualifying health coverage to full-time employees originally was effective in 2014

• Nondeductible excise tax assessed on large employers who do not provide to their full-time employees (i.e., work 30+ hours/week) – minimal essential coverage, and – affordable coverage

• “Large Employers” generally employers with at least 50 full-time employees or equivalents

Employer Mandate Postponed Until 2015

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• ACA imposes new information reporting requirements on employers and insurers beginning in 2014

• The Obama Administration had yet to issue proposed rules implementing those requirements or test reporting systems to compile that information

• The Administration acknowledged that both the Government and employers needed more time to implement the reporting requirements and thus delayed those requirements until 2015

• With the reporting requirements delayed until 2015, the Administration had no choice but to delay imposition of the excise tax as well

Employer Mandate Postponed Until 2015, cont’d.

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• Employers cannot ignore other ACA provisions as a result of this delay; they are still in effect

• Examples include (not all inclusive): – Mandatory employee notice regarding health exchanges – Mandatory provision of Summary of Benefits and Coverage to

group plan participants – Form W-2 reporting of group health benefits – 0.9% Medicare tax withholding on high wage earners – Health flexible spending account limits – Medical device tax

• This delay does not impact the individual mandate also scheduled for 2014

All Other ACA Provisions Remain in Effect

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• ACA created the Patient-Centered Outcomes Research Institute (PCORI) to compare the effectiveness of different health care services

• The PCORI is funded by fees imposed on health insurance providers and employers with self-funded health plans

• Self-funded plans are plans that provide for health coverage if any portion of the coverage is provided other than through an insurance policy – Self-funded plans could include health reimbursement arrangements

(HRAs) and flexible spending accounts (FSAs)

• A plan could be subject to the fee even if the employer did not have a Form 5500 filing requirement

PCORI Fee on Self-funded Plans Due July 31

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• The fee is imposed for plan years ending on or after October 1, 2012, and before October 1, 2019

• The fee is based on the average number of covered lives under the plan for the year

PCORI Fee on Self-funded Plans Due July 31, cont’d.

Plan Years Ending on or After PCORI Fee per Covered Life

October 1, 2012 $1 October 1, 2013 $2 October 1, 2014 – September 30, 2019 $2*

* Increased by percentage increases in projected per capita amount of National Health Expenditures 20

• One of several methods may be used to calculate the average number of covered lives under the plan during the year – Consult your tax or benefits advisor to determine which calculation

method results in the lowest fee

• The first annual fee is due by July 31, 2013 for plan years ending between October 1, 2012, and December 31, 2012

• The fee is reported on Form 720, Quarterly Excise Tax Return

• The fee is tax deductible

PCORI Fee on Self-funded Plans Due July 31, cont’d.

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Cases

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• Windsor v. U.S., S.Ct., 6/23/13, 2013-2 USTC ¶50,400 • U.S. Supreme Court in a 5-4 decision found Section 3 of

the Defense of Marriage Act (DOMA) violates the equal protection clause of the Fifth Amendment for same sex couples legally married under the laws of their state

• Section 3 of DOMA served to deny federal benefits to same sex couples that are available to opposite sex couples

• The Windsor case involved an estate tax issue where the estate could not claim the unlimited marital deduction on property transferred to the decedent’s same sex spouse

Supreme Court Strikes Down Sec. 3 of DOMA

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• The decision specifically applies to same sex couples who are legally married under state law – The status of civil unions and domestic partnerships is unclear

• The case did not consider Section 2 of DOMA which allows states to not recognize same sex marriages from other states – Will a same sex married couple qualify for federal benefits if they

were legally married in a state that recognizes same sex marriage but currently live in a state that doesn’t?

Supreme Court Strikes Down Sec. 3 of DOMA, cont’d. – Many Unanswered Questions

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States Recognizing Same Sex Marriage

State Date of Recognition

Massachusetts 5/17/04 Connecticut 11/12/08 Iowa 4/27/09 Vermont 9/1/09 New Hampshire 1/1/10 District of Columbia 3/9/10 New York 7/24/11

State Date of Recognition

Washington 12/6/12 Maine 12/29/12 Maryland 1/1/13 Delaware 7/1/13 Rhode Island 8/1/13 Minnesota 8/1/13 California* 6/26/13

* Via Supreme Court decision on California Proposition 8

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• Filing Status – Same sex couples now must file as Married Filing Joint or Married

Filing Separately – filing as Single no longer an option – Couples with comparable incomes will receive a marriage penalty – Couples where one spouse has majority of income will receive a

marriage bonus

• Inherited IRA Payments to Surviving Spouse – Surviving spouse has flexibility with respect to required minimum

distributions not afforded to other beneficiaries

• Family Attribution Rules – Same sex couples would now constructively own each other’s

business interests for purposes of applying loss and other limitations

Supreme Court Strikes Down Sec. 3 of DOMA, cont’d. – Income Tax Implications

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• Unlimited Marital Deduction – Same sex couples may now pass property to each other upon

death or during their lifetimes without using any of their lifetime exclusion or paying estate or gift tax

• Portability of Estate Tax Exclusion Amount – Any unused estate tax exclusion should now pass to the surviving

same sex spouse

• Gift Splitting – Same sex couples may now elect to split their gifts to take

advantage of the double annual exclusion ($14,000 each for 2013)

Supreme Court Strikes Down Sec. 3 of DOMA, cont’d. – Estate and Gift Tax Implications

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• Exclusion of Employer Provided Health Benefits – Previously, if an employee added a same sex spouse to the

company health plan, the employer had to impute income to the employee equal to the fair market value of the health coverage provided to the same sex spouse

– This resulted in additional taxes to both the employee and the employer since the additional income was subject to FICA and Medicare taxes

• Benefits from other Tax Favored Vehicles – Same sex spouses can now benefit from cafeteria plans, health

flexible spending accounts and health savings accounts

Supreme Court Strikes Down Sec. 3 of DOMA, cont’d. – Employee Benefits Implications

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• Wells Fargo v. U.S., 2013-1 USTC ¶50,368, 6/5/2013 • In Textron v. U.S., First Circuit Court of Appeals found

that work product privilege did not protect tax accrual workpapers because the work was performed in conjunction with preparing financial statements, not in anticipation of litigation

• In Wells Fargo, the workpapers in question were those used to identify uncertain tax positions (UTPs) and the subsequent recognition and measurement analysis

Portion of Tax Accrual Workpapers Protected

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• Conclusion: – Workpapers prepared in identifying UTPs were not protected

• They often were prepared in the ordinary course of business around the time the transactions were entered into

• Mere identification of positions that should be analyzed under FIN 48 is too far removed from any litigation to be protected

– The recognition and measurement analysis was protected as it was prepared in anticipation of litigation • Wells Fargo was actively in litigation or appeals on many UTPs • Legal analysis was not created merely for FIN 48 – included settlement

figures, assessment of chances in litgation, etc. • Material developed in anticipation of litigation can be incorporated into

an audit document without sacrificing privilege

Portion of Tax Accrual Workpapers Protected, cont’d.

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• Peek et al v. Commissioner, 140 T.C. No. 12, 5/9/2013 • Taxpayer formed self-directed IRA • IRA bought company formed by taxpayer • Taxpayer guaranteed loan taken by company • Court deemed guarantee was indirect extension of credit

between IRA and disqualified person • IRA was disqualified and liquidated

Guarantee of Loan to IRA-Owned Company a Prohibited Transaction

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• Elick et al v. Commissioner, TC Memo 2013-139, 6/3/2013 • Dentist sets up separate company (Mgmt Co) to manage

his dental practice’s (Dental Co) operations • Mgmt Co has no employees, except Dentist is a “co-

employee” of Mgmt Co and Dental Co • Dentist was Mgmt Co’s only officer and board member • ESOP benefitting Dental Co’s employees purchases Mgmt

Co’s stock from Dentist • Dental Co pays over $700,000 in management fees to

Mgmt Co • Mgmt Co uses fees to fund ESOP

Deduction for Purported Management Fee Disallowed

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• Court disallowed deduction for entire management fee • Reasoning:

– Taxpayer never established that Mgmt Co rendered any services – Taxpayer never provided any documentation corroborating that any

services were provided – Management agreement established only what Mgmt Co agreed to

provide; not what it actually did provide – Most terms of the management agreement (e.g., monthly billing)

were ignored – Third parties provided services that Mgmt Co was to provide – Dental Co’s office manager performed same functions as before – Neither Dentist nor office manager were compensated by Mgmt Co

Deduction for Purported Management Fee Disallowed, cont’d.

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• Davis v. Com’r., 2013-1 USTC ¶50,330 (CA-11) • Taxpayer owned 23% of S corporation • Spouse demanded half of Taxpayer’s shares in a divorce • Taxpayer declared he would stop working for the company

if his ownership percentage was not restored • Spouse issued Taxpayer an option to repurchase shares • S Corp redeemed Spouse’s shares and assumed

obligation under the option • Modifications to the option:

– Cashless exercise provision – Notification requirement if Taxpayer makes 83(b) election

Exercise of Stock Options Taxable under Sec. 83

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• Taxpayer exercised option in cashless exercise – S Corp took compensation deduction for value of shares exercised – Taxpayer recognized no income, claiming:

• Option was from Spouse, not S Corp • No gain is recognized on transfer of property incident to divorce

• Court of Appeals disagreed – Testimony proved that Taxpayer structured transaction this way to

avoid income recognition; intent was always for Taxpayer to receive the shares from S Corp, not Spouse

– The non-recognition provision on transfer of property pursuant to divorce would have only applied to the grant of the option itself, not the shares received upon exercise

Exercise of Stock Options Taxable under Sec. 83, cont’d.

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• Issue: Are severance payments made to employees pursuant to a reduction in work force subject to FICA tax?

• In Quality Stores v. U.S., the district court and 6th Circuit Court of Appeals say “No!” – Conclusion: Supplemental unemployment compensation benefits

(SUBs) paid because of an employee’s involuntary separation resulting directly from a reduction in force, discontinuance of operations, etc. are not wages for FICA purposes

– IRS tried to extend the federal income tax withholding requirement on SUBs to FICA taxes

• 6th Circuit’s opinion in direct contrast to Federal Circuit Court of Appeals’ decision in CSX Corp v. U.S.

FICA Treatment of Severance Payments

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• IRS asking Supreme Court to settle the split between the appeals courts

• Employers that withheld FICA on severance payments resulting from a reduction in force should file protective refund claims before the statute of limitations expires – Statute to file refund claim for payments made in 2010 expires on

April 15, 2014 – Unless employer is in 6th Circuit, IRS will deny the claim – Employer then has 2 years to file a refund suit or file Form 907 to

extend time to file suit • IRS has informally said that it will agree to sign Form 907

FICA Treatment of Severance Payments, cont’d.

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Regulatory Pronouncements

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• Extending taxpayers who file returns containing certain delayed forms are not subject to late payment penalty if: – a good faith effort was made to properly estimate the tax liability

on the extension application; – the estimated amount is paid by the original due date of the return;

and – any balance of tax owed on the return is fully paid by no later than

the extended due date of the return.

• Common forms include Form 4562 and Form 8582 • Taxpayer needs to respond to notice assessing penalty

with a letter explaining how he qualifies for relief

Late Payment Penalty Relief (Notice 2013-24)

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• §1.263(a)-5(a) – Amounts paid to facilitate a business acquisition or reorganization

must be capitalized • §1.263(a)-5(f)

– Amount contingent on successful closing of a transaction (“success based fee”) presumed to facilitate the transaction

– Taxpayer may rebut presumption with sufficient documentation

• Rev Proc 2011-29 (4/8/11) – Safe harbor allows taxpayer to treat 70% of success based fee as

not paid to facilitate transaction (i.e., deductible)

• LB&I 04-0511-012 (7/28/11) – Examiners instructed not to challenge treatment of success based

fee if at least 30% is capitalized

Success Based Fees

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• CCA 201234027 – $10 million fee on successful transaction – $2 million nonrefundable fee paid at various milestones

• Would be applied towards $10 million fee if successful transaction – Chief Counsel ruled $2 million fee nondeductible since not

contingent on successful transaction

• LB&I 04-0413-002 – IRS directs examiners not to challenge a taxpayer’s treatment of

eligible milestone payments if: • Taxpayer qualified and properly elected 70% safe harbor • Taxpayer did not deduct more than 70% of eligible milestone payment • Taxpayer is not contesting liability for milestone payment

Success Based Fees – Milestone Payments

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• C corporation elects S corporation status (S Corp) • S Corp wants to sell assets (“target assets”) to Buyer but

would incur built-in gains (BIG) tax • S Corp and Buyer form a partnership (P-ship)

– S Corp contributes target assets – Buyer contributes notes

• P-ship borrows from bank and distributes cash to S Corp – Collateral: P-ship’s assets & Buyer’s equity interest – Guaranty: Debt guaranteed by P-ship and Buyer – Indemnification: S Corp indemnifies Buyer for amounts Buyer

actually pays under the guarantee

Attempt to Avoid BIG Tax Deemed Disguised Sale

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• Generally, a transfer of property to a partnership followed by a distribution within 2 years presumed to be a disguised sale

• However, a debt-financed distribution only considered for disguised sale rules to extent it exceeds partner’s allocable share of debt

• S Corp attempted to use indemnification to allocate entire debt to itself, thus avoiding disguised sale income

• IRS disregarded the indemnification: – Lacked important features of a commercial indemnity – No practical risk that indemnity would be enforced – Buyer merely used P-ship as a conduit to accommodate S Corp

Attempt to Avoid BIG Tax Deemed Disguised Sale, cont’d.

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• Two corporations (“A” and “B”) entered into collaboration agreement to develop and commercialize a product

• A and B each maintained records of transactions • A submitted records to B and B calculated enterprise’s

profits and losses and A’s allocable share • A and B did not file partnership tax return or elect out of

Subchapter K • Side agreements between A and B indicated they did not

intend for collaboration to be a partnership or joint venture

Collaboration Must Be Treated as Partnership

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• IRS concluded that collaboration was a partnership or joint venture – Was not merely a cost sharing arrangement but an attempt to use

each other’s know-how to make a profit from selling the product

• Could not elect out of Subchapter K as it was not an investment partnership but an active business

• Each partner was eligible to claim the Sec. 199 deduction on its separate corporate return, if applicable, on its allocable share of the activity

Collaboration Must Be Treated as Partnership, cont’d.

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• Tax Reform Update – Political dynamics necessitate bi-partisanship for agreement – Senate looking to start with “blank slate” – Many key individual tax expenditures largely benefit top quintile

• Proposals to Reform Taxation of Small Businesses and Passthrough Entities – Core components – Sec. 179, expanded cash method, due dates – Option 1: Tweak partnership and S corporation rules – Option 2: Scrap current partnership/S corporation rules in favor of

unified, simplified regime

Summary/Key Takeaways

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• Affordable Care Act Update – Employer mandate postponed until 2015 – Other ACA provisions remain in effect – PCORI fee on self-funded plans due July 31

• Cases – Supreme Court strikes down Sec. 3 of DOMA

• Many income tax, estate/gift tax & benefit implications • Many unanswered questions

– Limited tax accrual workpaper protection – Protective refund claims on FICA from severance payments

• Regulatory Pronouncements – Late payment penalty relief

Summary/Key Takeaways

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QUESTIONS?

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Upcoming Webinars – Save the Date

Exit Strategies for Contractors on Wednesday, July 31st from 2:00 – 3:00 ET

California as a Backdrop for recent State Tax Developments on

Wednesday, August 21st from 2:00 – 3:00 ET Eye on Washington: Quarterly Business Tax Update (3rd Quarter) on

Wednesday, October 30th from 2:00 – 3:00 ET Registration will be available closer to webinar date.

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CBIZ MHM, LLC Contact Information Stephen C. Henley National Tax Practice Leader 770.858.4443 shenley@cbiz.com William M. Smith Managing Director 301.951.3636 billsmith@cbiz.com

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Thank You

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