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Tax News

CAN A DENTIST ALSO BE A REAL ESTATE PROFESSIONAL UNDER THE PASSIVE ACTIVITY LOSS RULES? – Posted April, 2017

In Zarrinnegar [2/13/17], a dentist’s case illustrates another aspect of the passive activity loss rules: Can a dentist also be a real estate professional and use the losses from his real estate business to offset his dental practice income? The taxpayer and his wife both were dentists who worked at their joint dental practice in shifts: she worked 9 - 2:30 Mondays, Wednesdays, Thursdays, and Fridays, and some Saturdays, and her husband worked 2:30 - 6:00 Mondays, Wednesdays, Thursdays, and Fridays. His real estate business consisted of his real estate brokerage activity and four rental properties that they owned and he managed. His wife did not participate in the real estate business. He spent hundreds of hours on brokerage-related activities (for example, brokers’ tours, listing searches, open houses, property viewings, and client meetings), and significant time managing the four rental properties. The taxpayers reported substantial income from their dental practice, and he reported losses from the real estate business that represented 47.4%, 63.3%, and 58.0% of the dental practice income for the three tax years, respectively, that were at issue in the case. The IRS disallowed the real estate business losses, contending they were passive activity losses, and not deductible. The Tax Court observed that generally rental activities are per se passive, regardless of how much the owner participates in the rental activity. But, the court noted the real estate professional rule excepts the taxpayer from the general rule if the taxpayer performs more than one-half of his personal services in a taxable year in a real property trade or business in which he materially participates, and he performs more than 750 hours during the year in real property trades or businesses in which he materially participates. Brokerage and rental real estate businesses are real property trades or businesses. For a joint return, the two requirements are met only if either spouse separately meets the two tests. As the husband’s wife did not participate in the real estate businesses, the court examined only the husband’s activities. The court first examined if the husband materially participated with respect to the rental properties and the brokerage business. It noted that regarding rental properties participation in each rental property must be examined unless the taxpayer makes the election to treat all interests in rental real estate as a single rental real estate activity, an election that the husband had not made. Then, for each rental, the court considered if the husband met any one of the seven tests that satisfy material participation. It concluded that the husband satisfied the test that provides for material participation if the individual’s participation constitutes substantially all of the participation in the activity of all individuals, including individuals who do not own interests in the activity. Secondly, the court examined if the husband met the two requirements under the real estate professional rule. It looked at the hours he spent in both his dental practice and his real estate business (brokerage and rental activities). It found his testimony credible that he worked at his dental practice on average 14 hours per week and, using 52 weeks a year if he worked every week, it arrived at 728 hours for his dental practice. For each of the three tax years, he produced logs that were prepared contemporaneously. He testified credibly and at great length about the logs’ contents, being able to recall extensive details relating to the log entries. Several other witnesses, including his wife, provided credible testimony that tended to corroborate the husband’s logs and testimony. The logs showed he spent more than 1,000 hours per year on real estate activities. Given the husband’s credible support for working more than 1,000 hours in real estate, and less than 1,000 hours in his dental practice, the Tax Court ruled he met the requirements for a real estate professional, and permitted the husband to deduct the losses from the real estate activities.  For copy of the complete Tax Court decision, click below. 

TAX COURT RULES THAT A FINANCIAL CONSULTANT’S COMMISSIONS COULD NOT BE RUN THROUGH HIS S CORPORATION – Posted March 20, 2017

The Tax Court decision in Fleischer [12/29/16] is bound to cause a great deal of consternation for the insurance and financial planning industries. Typically, financial planners who sell insurance products and investment securities enter into broker contracts with a licensed broker/dealer. Many financial planners operate their business as an S Corporation. Generally, broker/dealers cannot pay commissions to an entity unless the entity formally registers as a licensed broker/dealer. Instead, the broker/dealer pays the commission to the financial planner and the financial planner assigns the commission to the S Corporation. This was the case in the current decision. On February 2, 2006, the taxpayer entered into a representative agreement with a financial services company whereby his relationship with the company was that of an independent contractor. Later he entered into a broker contract with another broker dealer. On February 7, 2006, the taxpayer formed an S Corporation but did not enter into an employment agreement with the S Corporation until February 28, 2006. The taxpayer was paid an annual salary to perform duties in the capacity of a financial advisor. The agreement included common provisions found in employment agreements, but it did not include a provision requiring the taxpayer to remit any commissions or fees from the financial services company to the corporation. During the taxable years 2009-2011, the S Corporation reported net income of $11,924, $147,642, and $115,327, respectively. During the same period, the taxpayer reported annual wages from the S Corporation of about $35,000. The IRS issued a notice of deficiency for nearly $42,000 for the three years in question claiming that the taxpayer should have reported the S Corporation‘s gross receipts as self-employment income on Schedule C. The Tax Court first noted that it has long been held that income is taxed to those who have earned it. However, when a corporation is involved, the question of who earned the income is not so easily answered. In this situation, this question has evolved to one “who controls the earning of the income.” Under a previous Tax Court decision (Johnson, 1982), the court held that for the corporation to be the controller of the income, two elements must be found: (1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense, and (2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation's controlling position. In the current case, the Tax Court observed that the S Corporation was not a party with either of the contracts between the taxpayer and broker/dealers. The taxpayer countered that it was impossible for the broker dealers to contract directly with the S Corporation because the S Corporation was not a registered entity under the securities laws and regulations. The Tax Court responded that the S Corporation was not prohibited from registering and the fact it had not registered did not allow the taxpayer to assign the income he earned in his personal capacity to the S Corporation. The court found no indicium for the broker dealers to believe that the S Corporation had any meaningful control over the taxpayer. Having failed the second test in the Johnson decision, the Tax Court ruled it was not necessary to determine whether the first element in the Johnson decision was satisfied. Accordingly, it ruled that the income earned under the representative agreement with the financial services company and broker contract with the broker dealer should have been reported by the taxpayer, not the S Corporation. Note: Unfortunately, the case does not provide any details regarding the S Corporation’s activities and expenses. If the S Corporation has employees providing substantial services in assisting the financial planner, the S Corporation’s “controlling position” could be established. To help establish this controlling position, the corporation should document through its employment contracts or otherwise the responsibilities of each employee and how the services of each employee including the financial planner are essential in earning the commission income. For a copy of the complete Tax Court decision

TAXPAYER DENIED LIKE-KIND EXCHANGE TREATMENT DUE TO RELATED PARTY PROVISION – Posted February 8, 2017

In Malulani [11/16/16], the taxpayer was a corporation whose primary operations consisted of leasing commercial property in various states. It filed consolidated returns with a wholly owned subsidiary corporation (sub). It also owned nearly 70% of a second corporation (C2) which also held real estate property throughout the country. On January 10, 2007, the sub through an intermediary sold one of its real estate properties to a third party resulting in a realized gain of $1.89 million. It desired to defer the gain under the deferred like-kind exchange provisions. In order for the sale to qualify for like-kind exchange treatment, the sub had to identify replacement property by February 24, 2007. Between October 31, 2006, the date the buyer expressed an interest in purchasing the relinquished property, and February 23, 2007, brokers presented the sub with numerous properties owned by unrelated parties as potential replacement properties, and the sub attempted to negotiate the purchase of an office building and an apartment building for that purpose. However, the purchase did not materialize and one day before the deadline, the sub identified three properties owned by C2. On July 3, 2007, barely within the 180-day replacement requirement, the sub purchased replacement property from C2. Although C2's realized gain was $3.13 million, it had sufficient net operating losses (NOLs) to offset the gain, resulting in no regular tax liability and an alternative minimum tax of $44,774. The taxpayer filed a consolidated tax return with its sub and pursuant to Section 1031 deferred the $1.89 million gain from the sale of the sub property.

The IRS denied like-kind exchange treatment on the basis of Section 1031(f). Section 1031(f)(1) generally provides that the like-kind exchange provisions will not apply if a taxpayer and a related person exchange like-kind property and within two years either one disposes of the property received in the exchange. This provision was enacted primarily to prevent the potential abuse where related parties engage in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property in order to reduce or avoid the recognition of gain on the subsequent sale.

In the current case, Section 1031(f)(1) is not applicable because it does not involve direct exchanges between two related parties. That is, only one of the property transactions in this case involved related parties (the sale of the property from C2 to the sub). However, Section 1031(f)(4) provides that like-kind exchange treatment will not apply to any related party exchange which is part of a transaction or series of transactions "structured to avoid the purposes of" Section 1031(f). Because C2 paid little tax on the transaction and the sub deferred a sizable gain from the exchange, the IRS argued that they structured the exchanges for tax avoidance purposes. The taxpayer countered that Section 1031(f)(2) provides that any disposition of the relinquished or replacement property within two years of the exchange is disregarded if the taxpayer establishes that neither the exchange nor disposition had as one of its principal purposes the avoidance of tax. It argued that it had no preconceived plan to conduct an exchange with C2 and it diligently sought a replacement property held by an unrelated party and only turned to the property held by C2 when the deadline to complete a deferred exchange was imminent. The Tax Court did not buy the taxpayer’s arguments. It noted that C2 essentially cashed out its investment virtually tax-free while significant tax savings resulted from the sub’s acquisition of the replacement property from C2. The Tax Court concluded that the taxpayer failed to demonstrate that the avoidance of tax was not one of the principal purposes of the exchange with C2. Consequently, it ruled that Section 1031 did not apply. Note: We believe the decision was harsh for several reasons. First, the transactions were not consistent with the so-called abuses that Congress was concerned with – the stepping up of basis of appreciated property using the like-kind exchange rules and then selling it a short time later. Second, C2's realized gain of $3.13 million from the sale of its property to the sub was offset by large NOLs unrelated to any tax benefits derived from Section 1031. Third, the very purpose of Section 1031 is tax avoidance. So it is nearly impossible in this case to satisfy Section 1031(f)(2) – that the like-kind exchange did not have as one of its purposes the avoidance of tax. Click Here for a copy of the complete Tax Court decision.

WHAT IS YEAR OF DEDUCTION FOR AN S CORPORATION’S DISTRESSED PROPERTIES? – Posted January 24, 2017

In Tucker [11/21/16], a single-owner S Corporation was in the business of real estate acquisition, development, and sales. It was solvent at the beginning of 2008, when it had bank recourse mortgages which it used to buy real property. In 2007 and 2008, the local residential real estate market sharply declined, and it had no sales or revenue in 2008. At the end of 2008, it closed its office, dismissed its employees, and stopped making payments on its mortgages, insurance premiums, and taxes. At that time, it owned 13 mortgaged properties with an aggregate FMV of around $6.8 million, and an aggregate mortgage balance of around $8.6 million. Six of the properties were under water. A real estate appraiser stated that there was value to all properties, and some demand for them. During 2009 - 2010, the corporation was relieved of a number of the liabilities under foreclosure lawsuits through varying cash payments it made or through sale of the properties. For two of the properties, the corporation completed a residence on the property and sold the property to help lessen damages. The corporation reported a loss of about $10.8 million on its 2008 federal income tax return, around $8.9 million of which was attributable to a write down of its real estate inventory to its 12/31/08 current market value. Its owner claimed a $6.78 flowthrough loss on his 2008 individual income tax return, generating a 2008 NOL of more than $6.7 million which he carried back to generate almost $2 million of refunds. The IRS asserted that the corporation’s loss was only $1.5 million.

Section 165 allows deductions for losses from “closed and completed transactions,” which include an asset’s being abandoned or becoming worthless. The Tax Court applied the general rule that, when a taxpayer’s real property is secured by a recourse obligation, the taxpayer is not entitled to a loss deduction until the year of the foreclosure sale, regardless of abandonment or worthlessness. The 11th Circuit agreed with the Tax Court. It also agreed that even though the corporation had closed its office, dismissed its employees, and stopped making payments on its obligations by 12/31/08, the record showed it continued to develop and sell the properties throughout 2009 and 2010. The 11th Circuit stated that Section 165 law permits a loss claim in the year that the amount of the loss becomes readily ascertainable. It stated that the corporation’s total losses were not ascertainable or fixed at the end of 2008, as none of the homes had been formally foreclosed upon or sold. The corporation was not entitled to a loss deduction on its real estate properties secured by recourse loans until the year of the foreclosure sale of a property. Click here for a copy of the complete 11th Circuit Court decision.

IRS REPORTS ON NEW SCAM ATTACKING TAX PROFESSIONALS – Posted October 20, 2016

In News Release 2016-103 [8/11/16], the IRS warned tax professionals of an emerging phishing scam that goes after the tax data of tax professionals. The email scheme requests the recipient to download and install an important software update via a link included in the e-mail. Considering that over the next few months, tax software providers will be sending tax professionals updated tax software for the upcoming 2017 filing season, tax professionals need to be extra careful to assure they are not falling for this scam. Once recipients click on the embedded link, they are directed to a website prompting them to download a file appearing to be an update of their software package. The file has a naming convention that uses the actual name of their software followed by an ".exe extension." Upon completion, tax professionals believe they have downloaded a software update when in fact they have loaded a program designed to track the tax professional's key strokes, which is a common tactic used by cyber thieves to steal login information, passwords and other sensitive data. At the date of the news release, the IRS only knew of a few cases where tax professionals were victimized by this scam. However, in News Release 2016-119 [9/2/16], the IRS reports that it is aware of another 2 dozen cases where this scam was successful in gaining access to sensitive information. The IRS urges all tax preparers to take the following steps: (1) run a security "deep scan" to search for viruses and malware; (2) strengthen passwords for both computer access and software access; (3) make sure their password is a minimum of eight digits with a mix of numbers, letters, and special characters, and change them often; (4) be alert for phishing scams: do not click on links or open attachments from unknown senders; (5) educate all staff members about the dangers of phishing scams in the form of emails, texts and calls; and, (6) review any software that a tax professional’s employees or IT support vendors use to remotely access the professional’s network, and/or IT support vendor uses to remotely troubleshoot technical problems and support the tax professional’s systems. The IRS notes that remote access software is a potential target for bad actors to gain entry and take control of a machine. The IRS also noted that tax professionals should review Publication 4557, “Safeguarding Taxpayer Data, a Guide for Your Business,” which provides a checklist to help safeguard taxpayer information and enhance office security. For taxpayers that become victims of this or similar scams, the IRS provides several recommendations at its website at the link below. Note: The link contains a misspelling (profesionals) and correcting the link will not get you to the proper site.

https://www.irs.gov/individuals/data-theft-information-for-tax-profesionals

IRS PROVIDES VEHICLE LIMITATIONS FOR 2016 PURCHASES – Posted May, 2016

In Revenue Procedure 2016-23 [4/1/16], the IRS specifies the inflation-indexed depreciation deduction limitations for owners of passenger vehicles and the income inclusion amounts for lessees of passenger vehicles first purchased or leased in calendar year 2016. There are separate limitations for trucks and vans. “Trucks and vans” refers to passenger vehicles built on a truck chassis, including minivans and sport utility vehicles that are built on a truck chassis. The amounts for passenger automobiles placed in service in 2016 are: 2016 – $3,160; 2017 – $5,100; 2018 – $3,050; and, each succeeding year – $1,875. All four amounts are the same limits as 2015. For trucks and vans placed in service in 2016, the amounts are: 2016 –$3,560; 2017 – $5,700; 2018 – $3,350; and, each succeeding year – $2,075. Except for the 2018 truck and van limit, each of the other three limits increased $100 from the 2015 limits. The PATH Act extended bonus depreciation through 2019 but only extended the $8,000 increase in the first year vehicle limit for 2015-2017. For 2018, the increase is $6,400 and for 2019 it is $4,800. If taxpayers claim bonus depreciation in 2016, the first-year depreciation limitations are $11,160 for passenger automobiles and $11,560 for trucks and vans. Click here for a complete copy of Revenue Procedure 2016-23.

 

 

EXCHANGED PROPERTY HELD IN NOT-FOR-PROFIT ACTIVITY QUALIFIES AS LIKE-KIND EXCHANGE – Posted March, 2016

A partnership (lessor) owns multiple aircraft that it leases to another partnership (lessee). The aircraft are used principally by two of lessee’s senior executives. They use the aircraft for business purposes and personal purposes. The executives report the value of personal use as compensation. The executives own interests in lessee, and each also owns 50% of lessor. The lessor exchanges a relinquished aircraft for a replacement aircraft. Both aircraft were leased under a so-called “dry” lease – the lessee provides flight crew and other services pertaining to the aircraft. As to the relinquished aircraft, the lease payments approximated the fair market rental value of the aircraft. As to the replacement aircraft, the lease payments were below fair market rental value. The lease payments were designed to cover the aircraft’s carrying costs, but were not designed to generate meaningful economic profit. The issue in Chief Counsel Advice 201601011 was whether the lessor held the relinquished and replacement aircraft “for productive use in a trade or business” under the like-kind exchange rules of Section 1031. The IRS’s field position was that “held for productive use in a trade or business” is not defined in the Code or Treasury regulations. The field relied on the not-for-profit (hobby rules) law of Section 183. IRS Chief Counsel found no authority suggesting that Section 183 law should be used to evaluate whether property is held for productive use under Section 1031. Chief Counsel stated that property could be held for productive use in a business even though the business holds and uses property in a way that, if the use of the property were viewed as an activity, did not and could not generate a profit. Chief Counsel stated that the lessor’s lack of intent to make a economic profit on the aircraft rental does not establish that the aircraft fails the productive use in a trade or business standard of Section 1031. It noted that for many reasons businesses opt to hold property, especially aircraft, in a separate entity. It observed that the related lessee operated a legitimate business enterprise that required the private aircraft to be available to its senior executives both for business travel and as an employment perk. Chief Counsel stated that were it to disallow Section 1031 treatment based on the entity structure here, businesses would be forced to structure similar transactions in inefficient and potentially risky ways to achieve Section 1031 treatment. Chief Counsel ruled against the IRS field position in concluding that the aircraft are held for productive use in a trade or business.

IRS ISSUES NUMBER OF ITEMS WITH RESPECT TO TAX-RELATED IDENTITY THEFT – POSTED FEBRUARY 2016

The IRS is serious about identity theft, and wants tax professionals and their clients to be also. In IR-2015-129 [11/19/15], the IRS announced its “Taxes. Security. Together.” campaign. The educational campaign, represents a collective effort of the IRS, the states, and the tax industry. The IRS encourages all of us to: (1) use security software to protect our computers, including a firewall and anti-virus protection; also, if tax returns are stored on computers, files should be encrypted, and strong passwords used; (2) beware of phishing emails and phone scams; and, (3) protect personal information, e.g., by not routinely carrying one’s social security numbers, shredding old tax returns that are disposed of, checking credit reports and social security administration accounts at least annually, and not oversharing on social media. The IRS notes that for the 2016 filing season, there will be new standards for logging onto all tax software products, e.g, minimum password requirements, new security questions, and standard lockout features. The software industry will provide more than 20 additional elements from the tax return submission to the IRS and, in turn, to the states to help identify fraudulent returns. The IRS notes in the release that since 2013 nearly 2,000 identity thieves have been convicted, with the average sentence for those convicted running well over 3 years. In fact sheet FS-2016-3 [January 2016], the IRS outlines very specific procedures that will apply if the taxpayer tells the IRS he or she may be a tax-related identity theft victim, or the IRS tells the taxpayer that a suspicious return has been received with the taxpayer’s name on it. If the taxpayer’s e-filed return is rejected because of a duplicate tax filing with the taxpayer’s social security number, the IRS advises the taxpayer to complete Form 14039, complete a paper return, and file the paper return with Form 14039. Its “Identity Theft Victim Assistance” organization will specifically work the taxpayer’s case. Generally, the case is resolved within 120 days, with complex cases taking 180 days or longer. If the taxpayer is notified by the IRS about a suspicious return filed with the taxpayer’s name on it, the taxpayer will be asked to verify his or her identity at IDVerify.irs.gov. In IR-2016-12 [2/1/16], the IRS highlights that identity theft is the first scam listed in its most recent annual “Dirty Dozen” list of tax scams to avoid. The IRS also has published IRS Publications 4524 (covering its “Taxes.Security.Together.” campaign) and 4557 (giving very detailed procedures for tax professionals and their clients to follow to safeguard taxpayer data). Checklists included in Publication 4557 include administrative activities, facilities security, personnel security, information systems security, media security, and certifying information systems for use. Also, reporting incidents, laws and regulations, and standards and best practices are included in Publication 4557.

TREASURY DEPARTMENT ISSUES FORM REMINDERS ABOUT HEALTH INSURANCE UNDER THE AFFORDABLE CARE ACT – POSTED FEBRUARY 2016

In a recent Treasury Department News Release [TDNR JL-10326; 1/21/16], the Treasury provides some information on the ACA’s impact on returns filed during the 2016 filing season. It reminds that, while most Americans will simply need to check a box on their tax return indicating they had health coverage all year, some may not. For those who chose not to buy health insurance, they may have to pay a fee, for others who could not afford coverage or meet other conditions, they may claim an exemption if they qualify. The Treasury reminds about 3 forms forthcoming during this filing season, 2 new ones, and one that was sent out during the 2015 filing season. Form 1095-A: Also sent last year, this form contains information that will help the recipients reconcile financial assistance received through the premium tax credit with the actual amount they should have received. Treasury notes that taxpayers who do not file a tax return to reconcile will not be eligible to receive financial help in future years. The deadline for the Marketplace to provide individuals with Form 1095-A was February 1, 2016. If the taxpayer expects to receive this form, he or she should wait to file the 2015 return until the form is received. Form 1095-B: Health insurance providers send this form to individuals that they cover, with information about who was covered and when. Form 1095-C: Certain employers send this form to certain employees, with information about what coverage the employer offered. Employers that offer “self-insured coverage” send this form to individuals they cover, with information about who was covered and when. The deadline for insurers, other coverage providers, and certain employers to provide Forms 1095-B and C is March 31, 2016. Some taxpayers may not have received Form 1095-B or C when they otherwise are ready to file. The IRS notes [HCTT 2016-13; 2/2/16] that, while the information on these forms may assist in preparing the return, the forms are not required, that is the taxpayer does not have to wait for Form 1095-B or C in order to file the return.

CONGRESS MAKES PERMANENT MANY “TEMPORARY” TAX PROVISIONS AND ENHANCES SEVERAL MORE – POSTED JANUARY 2016

The “Protecting Americans from Tax Hikes Act of 2015" (PATH Act), signed by President Obama on December 18, 2015, makes 22 temporary provisions permanent, including the following: (1) state sales tax deduction; (2) American Opportunity Tax credit; (3) the reduced earnings threshold ($3,000) for the additional child tax credit; (4) the EITC rate of 45 percent for taxpayers with three or more qualifying children and the higher EITC phase-out thresholds for married couples filing joint returns ($5,520 for 2015, adjusted for inflation after 2015); (5) $250 above-the-line deduction for educators, which is adjusted for inflation after 2015; (6) tax-free retirement plan distributions made to qualified charitable organizations; (7) increased percentage limits and extended carryforward period for qualified conservation contributions; (8) the Section 179 immediate expense deduction of $500,000; (9) the modified research tax credit; (10) 15-year straight-line cost recovery for qualified leasehold improvements and qualified restaurant buildings; and, (11) 100% gain exclusion on certain small business stock. Four other provisions have been extended through 2019, which include bonus depreciation. The bonus percentages are 50% for 2015-2017, 40% for 2018, and 30% for 2019. For taxpayers who claim bonus depreciation on passenger vehicles, the $8,000 increase in the limitation on the depreciation deductions has been extended for 2015-2017, and is reduced to $6,400 in 2018 and $4,800 in 2019. Thirty other provisions, generally more narrow in scope, have been extended through 2016. Two of these extensions affecting a larger number of taxpayers are (1) mortgage insurance premiums treated as qualified residence interest, and (2) above-the-line deduction for tuition and fees. There are a number of other tax provisions involving family tax relief, real estate investment trusts, and tax administration. Note: The PATH Act is a welcome relief to tax planners who have had to wait until the end of the year to find out whether provisions affecting their clients would be extended. Making incentive provisions such as bonus deprecation permanent may be more effective. For example, how effective can the bonus depreciation provision be in stimulating the current economy if the taxpayer does not know whether it will apply to the current year until the last two weeks of the year? The PATH Act also should be welcomed by the IRS, which previously was unable to finalize tax forms for the upcoming tax season until Congress decided whether to extend many temporary provisions.

Click here for a copy of the complete technical explanation of the PATH Act by the Joint Committee on Taxation.