Chapter 8 - Belk College Of Business

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Chapter 8 - Belk College Of Business Powered By Docstoc
					                                         Chapter 8

                      Latest Developments
           Federal Tax Update – First Quarter 2010

Highlights
     Tax changes in the Worker, Homeownership, and Business Assistance Act of 2009.

     First quarter 2010 interest rates on federal tax overpayments and underpayments.

     IRS announces 2010 standard mileage rates.

     Federal estate tax is dead for now, but stayed tuned.

     IRS releases new form for claiming homebuyer credit.

     Tax Court rules again that MBA expenses can be deducted.

     Update on tax treatment of gambling activities.

     Taxpayer failed to qualify for IRS levy exception to 10% premature withdrawal penalty
      tax.

     No deductions for Ponzi losses inside IRAs.

     New regulations provide tax rules for operating employee stock purchase plans (ESPPs).

     New regulations cover reporting requirements when employer shares are acquired via
      incentive stock options (ISOs) and employee stock purchase plans (ESPPs).

     IRS says no year-of-accrual deduction when deferred employee bonuses were subject to
      continued employment requirement.

     New regulations on S corporation cancellation of debt (COD) income.




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        Tax Changes in the Worker, Homeownership,
            and Business Assistance Act of 2009

On November 6, 2009, the Worker, Homeownership, and Business Assistance Act of 2009 (the
Act) was signed into law. The two tax centerpieces of this legislation are: (1) the extension and
expansion of what is now inaccurately called the first-time homebuyer credit and (2) the
extension and expansion of the five-year NOL carryback privilege. Other less-important changes
are included as well. Here is the story, starting with changes that affect individual taxpayers.


Homebuyer Tax Credit Is Extended and Expanded

Purchase Deadline Extended into 2010
The so-called first-time homebuyer credit was previously scheduled to expire on November 30,
2009. The Act extends the deal to cover purchases of U.S. principal residences that close by
April 30, 2010. However, if a home is under contract on April 30, 2010, the deadline for closing
the deal is extended to June 30, 2010. [See IRC Sec. 36(h).]

Existing Homeowners Can Qualify for Smaller Credits
The Act creates a new but less-generous credit for so-called longtime homeowners who buy a
replacement U.S. principal residence after November 6, 2009. The new longtime homeowner
credit equals the lesser of (1) $6,500, or (2) 10% of the replacement principal residence purchase
price, or (3) $3,250 for a buyer who uses married filing separate status.

To qualify, the buyer must have owned and used the same home as a principal residence for at
least five consecutive years during the eight-year period ending on the purchase date for the
replacement principal residence. If the buyer is married, both spouses must pass this test,
whether or they file jointly or not. [See IRC Sec. 36(b)(1) and (c)(6).]

Key Point. The new longtime homeowner credit is only available for purchases that close after
November 6, 2009 and by no later than April 30, 2010 (or by June 30, 2010 if the replacement
principal residence is under contract on April 30, 2010).

Key Point. The new longtime homeowner credit can be claimed on 2009 returns, for qualifying
purchases that close between November 7, 2009 and December 31, 2009. As explained later, it
can also be claimed on 2009 returns for qualifying purchases that close in 2010.

Larger Credits Still Allowed for First-Time Buyers
Before the Act, the homebuyer credit was only available to so-called first-time homebuyers,
which means someone who had not owned a U.S. principal residence during the three-year
period ending on the purchase date for the home that will serve as the buyer’s new principal

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residence. If the buyer is married, both spouses must pass the three-year test, whether or not they
file jointly.

After the Act, the first-time homebuyer credit still equals the lesser of (1) $8,000, or (2) 10% of
the new principal residence purchase price, or (3) $4,000 for a buyer who uses married filing
separate status. [See IRC Sec. 36(b)(1) and (c)(1).]

Key Point. The familiar first-time homebuyer credit remains available for purchases that close
by no later than April 30, 2010 (or by June 30, 2010 if the home is under contract on April 30,
2010).

Higher-Income Folks Now Qualify
Both the familiar first-time homebuyer credit and the new longtime homeowner credit are phased
out (reduced or completely eliminated) as income goes up. However, the Act significantly raises
the phase-out ranges so that many more higher-income buyers will qualify.

      For purchases after November 6, 2009, the phase-out range for unmarried individuals and
       married folks who file separately is between modified adjusted gross income (MAGI) of
       $125,000 and $145,000 (way up from the old-law range of $75,000-$95,000).

      The phase-out range for married joint filers is between MAGI of $225,000 and $245,000
       (way up from the old-law range of $150,000-$170,000).


Key Point. Buyers who closed during 2009 before the new liberalized MAGI phase-out ranges
kicked in on November 7, 2009 are stuck with the much stricter old-law ranges. Too bad for
them!

Key Point. As before, MAGI for this purpose means the adjusted gross income figure reported
on the last line on page 1 of the client’s Form 1040 increased by income from outside the U.S.
that is exempt from taxation under IRC Secs. 911, 931, or 933. These income add-backs only
apply to a relatively few folks. [See IRC Sec. 36(b)(2).]

New $800,000 Purchase Price Limit
For purchases after November 6, 2009, the homebuyer credit can only be claimed for a principal
residence that costs $800,000 or less. So if your client’s new residence costs $800,001, the credit
is completely off limits. [See IRC Sec. 36(b)(3).]

No More Credits for Kids or Dependents
For purchases after November 6, 2009, the homebuyer must be at least 18 years old on the
purchase date to qualify for the credit. Also, no credit is allowed for a buyer who can be claimed
as a dependent on someone else’s Form 1040 for the year of the purchase. These new rules are
intended to shut down the practice of claiming the credit for youngish buyers who really do not

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even have incomes of their own (like college students who use money from their parents to buy a
pad near the campus). [See IRC Sec. 36(b)(4) and (d)(3).]

Anti-Fraud Measures (Finally) and Updated Tax Form
As you may know, a recent TIGTA report said the IRS has already identified about 100,000
returns with potentially fraudulent homebuyer credits. This is not surprising when the
government is willing to give away up to $8,000 in free money to anyone who files a return,
even when that person reports no income, thanks to the fraud-friendly refundable credit concept.
Believe it or not, absolutely no documentation was required to claim the credit before the Act.
Now, for credits claimed on returns for tax years ending after November 6, 2009 (meaning
calendar-year 2009 and 2010 returns), buyers must attach properly executed real estate
settlement sheets (HUD-1 forms) to their returns.

Key Point. The updated version of IRS Form 5405 (First-Time Homebuyer Credit) has been
revised to reflect this new requirement, and the revised form must be used to claim the credit for
(1) any purchases closed after November 6, 2009 and (2) any credits claimed on 2009 Forms
1040, even if the purchase date was before November 7, 2009. The 2008 version of Form 5405
can still be used to claim credits on 2008 returns for 2009 purchases that closed before
November 7, 2009. (See IRS Information Release IR 2009-18.)

Also, for returns for tax years ending after April 8, 2008 (meaning calendar-year returns for
2008-2010), the IRS can now treat apparent errors in claiming credits and apparent failures to
repay credits under the recapture rules (see below) as mathematical or clerical errors and thereby
automatically deny credits or assess additional tax without issuing a deficiency notice. [See IRC
Secs. 36(d)(4) and 6213(g)(2).]

Credits Can Still Be Claimed on Prior-Year Returns
As under prior law, a buyer can still claim the credit for a 2009 purchase on his 2008 Form 1040
(although he would usually have to file an amended return to do so at this late date). A buyer can
also claim the credit for a 2010 purchase on his 2009 Form 1040. This allows the buyer to cash
in on the credit sooner rather than later, and it may also allow him to claim a credit, or a larger
credit, if his MAGI is higher in the year of purchase than in the preceding year. [See IRC Sec.
36(g).]

Credits Must Still Be Repaid (Recaptured) in Some Cases
Under old-law rules for homes purchased between April 9, 2008 and December 31, 2008, buyers
are generally required to repay (recapture) their credits over 15 years, starting in 2010. For post-
2008 purchases, this 15-year repayment rule is eliminated in most cases. However under the
rules for post-2008 purchasers, your client might still have to repay the credit if she sells the
home within three years of the purchase date or stops using it as her principal residence during
that period. [See IRC Sec. 36(f).]




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Looser Rules for Members of the Military, Foreign Service, and
Intelligence Communities
For military service members, foreign service members, and employees of the intelligence
community on qualified official extended duty service outside the U.S., the Act lengthens the
deadline for closing on home purchases for an extra year to April 30, 2011 (or June 30, 2011 for
homes under contract on April 30, 2011). The new law also completely waives the credit
repayment rules (including the 15-year repayment rule for credits claimed for 2008 purchases)
when these individuals are forced to move, after 2008, due to receiving new orders for qualified
official extended duty service (including when orders are received by the taxpayer’s spouse).
[See IRC Sec. 36(h)(3) and (f)(4)(E).]

Tighter Restrictions on Related-Party Purchases
The homebuyer credit cannot be claimed for a home the buyer purchases from certain related
parties. For purchases after November 6, 2009, the Act tightens the related-party restriction by
providing that the restriction also applies when a home is purchased from certain parties related
to the buyer’s spouse. [See IRC Sec. 36(c)(3)(A)(i).]

No DC Homebuyer Credit for Those Eligible for National Credit
For purchases after 2008, the Act disallows the IRC Section 1400C DC homebuyer credit when
an individual or an individual’s spouse is eligible for the national homebuyer credit under IRC
Sec. 36. [See IRC Sec. 1400C(e)(4).]


Tax-Free Treatment for Stimulus Act Military Base Realignment and
Closure Payments
Under the Department of Defense Homeowner Assistance Program (HAP), eligible military
personnel and employees can receive payments intended to reimburse them for home value
losses due to base realignments and closures. HAP payments were expanded by the American
Recovery and Reinvestment Act of 2009 (better known as the Stimulus Act). The Worker,
Homeownership, and Business Assistance Act of 2009 grants tax-free fringe benefit treatment to
HAP payments that were authorized by the Stimulus Act, effective for payments made after
February 17, 2009. [See IRC Sec. 132(n).]


Five-Year NOL Carryback Deal Is Extended and Expanded

Background on Earlier Five-Year Carryback Deal for Small Business
NOLs Generated in 2008 Tax Years
As you recall, the American Recovery and Reinvestment Act of 2009, which we will call the
Stimulus Act, allows an eligible taxpayer to elect to carry back an applicable 2008 net operating

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loss (NOL) for either three, four, or five years in order to claim refunds of federal income taxes
paid for those years. This is a beneficial exception the two-year carryback rule that usually
applies to NOLs. [See IRC Sec. 172(b)(1)(A)(i) and IRC Sec. 172(b)(1)(H) before all the
amendments included in the Worker, Homeownership, and Business Assistance Act of 2009.]

         For a calendar-year taxpayer, the applicable 2008 net operating loss is one that was
          generated in calendar year 2008.

         For a fiscal-year taxpayer, the applicable 2008 net operating loss is one that was
          generated in either (1) the tax year that began in 2008 or (2) the tax year that ended in
          2008 (some such years just ended late in 2009). The expanded NOL carryback election
          can be made for one year or the other, but not both.


Eligible Taxpayers

The expanded NOL carryback election allowed by the Stimulus Act, which we will call the old-
law election, is only available to an eligible small business (ESB), as defined by IRC Sec.
170(b)(1)(H)(iv). An ESB can be a C corporation, a partnership (including a multi-member LLC
treated as a partnership for federal income tax purposes), an S corporation, or a sole
proprietorship (including a single-member LLC treated as a sole proprietorship for federal
income tax purposes). An ESB must have average annual gross receipts of no more than $15
million for the applicable three-year period, which means the three-year period that ends with
the NOL year for which the election is made.

Again, the old-law election can only be made for calendar year 2008 or for a fiscal tax year that
begins or ends in 2008. In determining if an entity (including an S corporation or partnership) is
an ESB, the aggregation rules found in IRC Sec. 448(c)(2) must be followed. (See Rev. Proc.
2009-26.)

Losses from S Corps, Partnerships, and Sole Proprietorships

In the case of an ESB that is a partnership an S corporation, or a sole proprietorship, the old-law
election allowed under the Stimulus Act is made at the owner level. The election can be made for
the owner’s applicable 2008 net operating loss, including passed-through items of income, gain,
loss, and deduction from an ESB that are allowed in calculating the owner’s NOL. The owner’s
applicable 2008 net operating loss equals the lesser of (1) the owner’s entire NOL for that year or
(2) the portion of the owner’s NOL for that year that is attributable to one or more ESB S
corporations, partnerships, or sole proprietorships. (See Rev. Proc. 2009-26.)

NOL Calculations for Individuals

An individual taxpayer’s NOL does not simply equal the negative taxable income amount shown
on the return for that year. Certain add-backs and adjustments must be made. These include
(among other things): (1) adding back personal exemption deductions, (2) adding back the excess
of non-business deductions over non-business income, (3) adding back the excess of non-


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business capital losses over non-business capital gains, (4) adding back gains excluded under
IRC Sec. 1202 (the qualified small business corporation stock rules), (5) adding back the
domestic producer deduction under IRC Sec. 199, and (6) adding back any NOL carried into the
year in question. (See IRC Sec. 172.) See Schedule A of Form 1045 for a worksheet that can be
used to calculate an individual’s NOL.

NOL Calculations for C Corporations

Similarly, a C corporation’s NOL does not simply equal the negative taxable income amount
shown on that year’s Form 1120. Certain adjustments must be made here too. Specifically, any
NOL carried into the year must be added back, and the dividends received deduction (if any)
may have to be recomputed. (See IRC Sec. 172.)

Election and Carryback Procedures

The old-law election allowed under the Stimulus Act generally must be made by the due date
(including any extension) of the return for the loss year for which the election is made. As
mentioned earlier, the old-law election for a calendar-year taxpayer can only be made for the
2008 tax year. The election deadline for that year has long since passed. If the taxpayer has a
fiscal tax year, however, the old-law election can be made for the tax year that begins or ends in
2008. The election deadline may not have yet passed for some fiscal tax years that began in
2008. For example, the deadline has not yet passed for a tax year that began on November 1,
2008 and ended on October 31, 2009 if the return for that year was extended.

The claim for a tax refund from carrying back an NOL for which the election is made generally
must be filed – typically using Form 1045 for individuals, estates, and trusts and Form 1139 for
corporations – by no later than 12 months after the end of the loss year for which the election is
made. The instructions to Forms 1045 and 1139 have been revised to accommodate the old-law
expanded NOL carryback election privilege.

Key Point. Rev. Proc. 2009-26 provides specific instructions on how to make the old-law
election for an applicable 2008 net operating loss.

New Law Gives Similar Deal to Almost All Businesses for NOLs
Generated in Tax Years Ending after 2007 and before 2010
Thanks to the new Worker, Homeownership, and Business Assistance Act of 2009 (the Act),
businesses of any size can generally elect to carry back NOLs for either three, four, or five years.
This is a beneficial exception to the two-year carryback rule that usually applies to NOLs.

This new expanded NOL carryback election is allowed for NOLs that arise in tax years that end
after 2007 and begin before 2010. However, the taxpayer in question can only make the election
for one such year. [See IRC Sec. 172(b)(1)(H)(ii) and (iii).]

For purposes of this discussion, we will call the extended and expanded NOL carryback election
allowed by the Act, the new election.

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Key Point. A calendar-year taxpayer can make the new election for either 2008 or 2009. A
fiscal-year taxpayer can make the new election for the tax year beginning in 2007, or the tax year
beginning in 2008, or the tax year beginning in 2009.

Key Point. The taxpayer’s status as an ESB (or not) does not affect eligibility for the new
election.

New Law Also Gives Small Businesses Second Bite of the Five-Year
NOL Carryback Privilege Apple
If the taxpayer properly made an old-law for an NOL attributable to ESBs for a 2008 tax year,
the taxpayer can now make the new election for an NOL arising in different tax year that ends
after 2007 and begins before 2010. [See IRC Sec. 172(b)(1)(H)(v)(I).]

Therefore, a small business taxpayer can potentially benefit twice from the expanded carryback
privilege: first for an NOL attributable to ESBs for a 2008 tax year (under the old-law election)
and again for an NOL from a different tax year that ends after 2007 and begins before 2010
(under the new election).

Key Point. Once again, the taxpayer’s status as an ESB (or not) does not affect eligibility for the
new election.

                                             Example 1

Danny Corp (DC) is a calendar-year C corporation ESB that made the old-law election
for the NOL from its 2008 tax year. Assume DC generates another NOL in 2009. DC
can make the new election for 2009. Note that DC’s status as an ESB is not relevant for
the new election.

                                             Example 2

Florida Corp (FC) is a fiscal-year C corporation ESB that made the old-law election for
the NOL from its tax year ending in 2008. FC continues to generate NOLs. FC can
make the new election for its tax year ending in 2009 or for its tax year beginning in
2009 (but not for both years). Note that FC’s status as an ESB is not relevant for the
new election.

Limitation on NOL Carried Back to Fifth Preceding Year
When the taxpayer chooses under the new election to carry back an NOL to the fifth preceding
tax year, the amount carried back to that year is limited to 50% of the taxable income for that
year. The remaining NOL amount (if any) can then be used to offset income in more-recent
carryback years without any such restriction. Note that this 50%-of-taxable-income limitation
applies whether the taxpayer is an ESB or not, because ESB status (or lack thereof) is irrelevant
for purposes of the new election. [See IRC Sec. 172(b)(1)(H)(iv)(I).]


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                                              Example 3

Georgia Corp (GC) is a calendar-year C corporation and is not an ESB. GC had taxable
income of $50 million for each year in 2004-2008. In 2009, GC runs up a whopping $90
million NOL. Under the new election privilege, GC can carry back the 2009 NOL to 2004
(the fifth preceding tax year). However, only 50% of the 2004 taxable income ($25
million) can be offset with the carryback. The remaining $65 million of the 2009 NOL
($90 million – $25 million utilized in 2004) can be used to offset all of GC’s 2005 taxable
income and $15 million of GC’s 2006 taxable income. At that point, the 2009 NOL will
be all used up.

Deadline for Making the New Election
The new expanded NOL carryback election must be made by the due date (including any
extension) of the return for the taxpayer’s last tax year that begins in 2009. There will only be
one such year except in the unusual case where the taxpayer has two short years that begin in
2009. Once made, the election is irrevocable. [See IRC Sec. 172(b)(1)(H)(iii)(II).]

AMT Limitation on NOL Carrybacks Is Suspended for NOLs for Which
Old-Law and New Elections Are Made
For NOLs for which either the old-law election or the new election is made, the Act suspends the
AMT rule that limits the carryback of a alternative tax NOLs (ATNOLs) to 90% of the
alternative minimum taxable income (AMTI) for the year to which the ATNOL is carried back.
This change is effective for tax years ending after 2002. [See IRC Sec. 56(d)(1)(A)(ii)(I).]

Special New Election for Life Insurance Companies
The Act allows life insurance companies to elect a four or five-year NOL carryback (instead of
the usual three-year carryback) for an NOL that arises in a tax year that ends after 2007 and
begins before 2010. The election can only be made for one such year. Also, the NOL carried
back to the fifth preceding tax year cannot exceed 50% of the taxable income for that year. [See
IRC Sec. 810(b)(4).]

Some Businesses Are Ineligible for New Election
The new expanded NOL carryback election privilege is not allowed for taxpayers that receive
certain financial assistance from the federal government under the Emergency Economic
Stabilization Act of 2008 (better known as the Bailout Bill). [See Section 13(f)(1) of the Act.]

Rev. Proc. 2009-52 Supplies New Election Specifics
In Rev. Proc. 2009-52, the IRS provided guidance on how to make the new expanded NOL
carryback election and how to claim the resulting federal income tax refunds. Here are the three
most important things to know.


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   1. Under Rev. Proc. 2009-52, there are two ways to make the new election. First, it can be
      made with the original or amended federal income tax return for the loss year (the year
      the applicable NOL was generated). As a second and simpler alternative, the new election
      can also be made with the NOL carryback refund claim (using Form 1045 for individuals,
      estates, and trusts or Form 1139 for corporations) or with the amended return for the year
      to which the NOL is being carried back. Regardless of which way the new election is
      made, it must be done by no later than the due date (including any extension) of the
      return for the last tax year that began in 2009 (even if the new election is being made for
      an NOL generated in some other tax year). Similarly, the refund claim from carrying
      back the NOL for which the new election is made must be filed (using Form 1045 for
      individuals, estates, and trusts or Form 1139 for corporations or via an amended return
      for the year to which the NOL is being carried back) by no later than the due date
      (including any extension) of the return for the last tax year that began in 2009.

   2. Rev. Proc. 2009-52 also explains how to revoke an earlier election to forgo carrying back
      an NOL in order to allow the taxpayer to make the new expanded NOL carryback
      election for that NOL. The revocation must be made by no later than the due date
      (including any extension) of the return for the last tax year that began in 2009.

   3. Rev. Proc. 2009-52 also explains what to do if the taxpayer has already filed a carryback
      claim or amended return to carry back an NOL for which the new election is now being
      made.


Extension of FUTA Tax Surcharge
Through 2009, the Federal Unemployment Tax Act (FUTA) imposes a maximum tax rate of
6.2% on the first $7,000 of an employee’s annual wages. The 6.2% rate is comprised of a
permanent 6% rate and a .2% temporary surtax. The Act extends the .2% surtax for another 18
months, through June 30, 2011. (See IRC Sec. 3301.)


Higher Failure-to-File Penalties for Partnerships and S Corps
The Act increases the monthly penalty for failing to file a partnership return (on Form 1065) or
failing to provide required information on a return from $89 per partner to $195 per partner. The
penalty can be assessed for a maximum of 12 months. For example, the maximum penalty for a
partnership with five partners is $11,700 (5 × $195 × 12 = $11,700). Ouch! The increased
penalty applies to Forms 1065 required for tax years beginning after December 31, 2009. (See
IRC Sec. 6698.)

Key Point. It seems like the partnership penalty could be a pretty big deal if the Feds really get
serious about trying to identify unfiled partnership returns. Taxpayers often enter into
arrangements that can be classified as partnerships for federal income tax purposes without even
realizing it.



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The Act also increases the monthly penalty for failing to file an S corporation return (on Form
1120S) or failing to provide required information on a return from $89 per shareholder to $195
per shareholder. The penalty can be assessed for a maximum of 12 months. For example, the
maximum penalty for an S corporation with four shareholders is $9,360 (4 × $195 × 12 =
$9,360). The increased penalty applies to Forms 1120S required for tax years beginning after
December 31, 2009. (See IRC Sec. 6699.)


Estimated Tax Bump for Large Corporations
The Act jacks up by another 33% the 2014 corporate estimated tax payments that were already
jacked up by the little-noticed Corporate Estimated Tax Shift Act of 2009. This change only
affects corporations with assets over $1 billion. (See Section 18 of the Act and IRC Sec. 6655.)

Key Point. This budget accounting gimmick has been used so often that it has become a bad
habit.


Beneficial Worldwide Interest Allocation Rules Delayed
The Act postpones the pro-taxpayer worldwide interest allocation rules, which would benefit
consolidated groups that own foreign corporations and some financial institutions. The rules now
will not take effect until tax years beginning after 2017. Frankly, our beloved Congress may
never actually allow these rules to kick in. [See Section 15 of the Act and IRC Sec. 864(f).]


More Preparers Must File Electronic Returns (in Theory)
Why this is considered a revenue raiser is a mystery, but the Act stipulates that the IRS will
require electronic filing by all preparers except those who reasonably expect to prepare a total of
less than ten income tax returns for individuals, trusts, and estates in a calendar year. However,
there is no penalty for failing to comply with this requirement, which is scheduled to take effect
in 2011. [See Section 17 of the Act and IRC Sec. 6011(e).]




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                       Key Developments Affecting
                       Various Types of Taxpayers

First Quarter 2010 Interest Rates on Federal Tax Overpayments and
Underpayments Are Unchanged
The interest rates that apply to federal tax overpayments and underpayments for the first quarter
of 2010 are the same as for the previous three quarters. (See Rev. Rul. 2009-37 and IRC Sec.
6621.) The first quarter 2010 rates are as follows:

      4% for overpayments and underpayments by unincorporated taxpayers and most
       corporate underpayments.

      3% for most corporate overpayments.

      1.5% for the portion of corporate overpayments that exceed $10,000.

      6% for large corporate underpayments (generally underpayments by C corporations in
       excess of $100,000).


IRS Announces 2010 Standard Mileage Rates
In Rev. Proc. 2009-54, the IRS announced that the standard mileage deduction allowances listed
below will apply for 2010.

      50 cents per mile for business driving (down from 55 cents per mile for 2009). The 50
       cents per mile allowance for 2010 includes 23 cents per mile for depreciation.

      16.5 cents per mile for driving for medical or moving purposes (down from 24 cents per
       mile for 2009).

      14 cents per mile for charitable driving (this amount is fixed by statute and does not
       change from year to year).




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    Key Developments Affecting Individual Taxpayers

Federal Estate Is Dead (for Now)
Washington, we have a problem. You just let the federal estate tax die, and we lowly citizens out
here are confused about what it means. No wonder, because nobody saw this coming. Here is a
brief discussion of how we arrived at this strange destination along with some common-sense
advice for clients.

The Federal Estate Tax Was Programmed to Die in 2010 (and It Did
Die) but the Story Is Not Over
Ever since the Economic Growth and Tax Relief Reconciliation Act of 2001 became law, the
federal estate tax has always been scheduled to be repealed this year. But it has also always been
a two-part story. In part two, the tax is scheduled to come roaring back in 2011 and beyond. In
those years, estates worth as little as $1 million are lined up for a tax whipping (versus only
estates worth over $3.5 million last year), and the maximum federal estate tax rate is poised to
rise to the confiscatory percentage of 55% (versus “only” 45% last year). No informed person
ever thought our beloved Congress would allow this two-part story to be played out because,
taken together, the two parts make no sense. Duh!

So we all sleepily assumed Congress would step in and continue the relatively generous (by
historical standards) $3.5 million federal estate tax exemption that we had last year with a
maximum tax rate of no more than 45% (same as last year). More optimistic observers were
hopeful the exemption would be bumped up to $5 million or so with a maximum rate well below
45%.

No such luck! Our pals in Congress did absolutely nothing about the estate tax last year, and it
could be months before they get around to tackling it this year. By then, the issue may be so
contentious that all previous predictions about what might happen get tossed out the window.
Meanwhile, the tax will stay repealed for 2010 until something changes.

So to sum it up so far, we are in a very weird place where there is no federal estate tax on those
who happen to die right now, but there is a harsh federal estate tax looming over those who
happen to die next year. This bizarre situation will continue until the law gets changed, which it
undoubtedly will. Until then, however, clients want advice about what to do (or not do) today.
Fair enough. Here goes.

Observation. The author still believes Congress will resurrect the federal estate tax sometime in
2010 and that the effective date of the new rules (whatever they turn out to be) will be sometime
in 2010. Some commentators believe that making the new rules retroactively effective all the
way back to January 1, 2010, would be unconstitutional. It remains to be seen whether Congress
shares that concern.



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Client Is Married with Joint Estate Worth Over $3.5 Million
If your client falls into this category, we hope she already has a tax-saving estate plan in place. If
so, she should probably leave it alone unless she has one of the two problems explained below.

Problem No. 1: Too Much Goes to the Kids

Your client’s existing estate plan may be fatally flawed (so to speak) if it calls for giving as much
money as possible (as opposed to a specific dollar amount) to the kids and/or grandkids without
triggering a federal estate tax bill, with the rest then going to the surviving spouse.

Last year, this plan would have directed $3.5 million to the kids. That $3.5 million bequest
would have been federal-estate-tax-free because it matched last year’s federal estate tax
exemption.

But with the federal estate tax now missing in action, the current exemption is infinity.
Therefore, dying today would mean all the client’s assets go to the kids with absolutely nothing
left for the surviving spouse. If this is not what your client intends (and it probably is not), his
estate planning documents need to be fixed ASAP.

One simple-and-easy fix is to amend the documents to provide that the surviving spouse gets a
specific dollar amount or percentage of the client’s estate with the rest going to the youngsters.
The plan may have to be retooled later on when Congress finally does whatever it does. Oh well.
We will cross that bridge when we come to it.

Problem No. 2: Not Enough Goes to the Kids

The second potential problem is less serious, and some folks might decide it is even not worth
worrying about. Say the client’s current estate plan calls for leaving the specific amount of $3.5
million to the kids and/or grandkids (last year’s federal estate tax exemption amount), with the
rest then going to the surviving spouse. In 2009, this was a good plan. It would have avoided any
federal estate tax hit by taking full advantage of last year’s $3.5 million exemption.

As of today, however, the client can leave as much as she wants to the youngsters with no federal
estate tax due. So if her existing plan gives her spouse more than he really needs, the client can
change the deal and leave more to the youngsters and less to the spouse. Once again, the client
may very well have to retool her plan yet again when Congress finally takes action. Sorry about
that!

Client Is Married with Joint Estate Worth Less Than $3.5 Million
There will not be any federal estate tax hit if this client dies today, and there would not have been
one if he had died last year. We can only hope the same will be true if he dies next year. In any
case, this client does not need any tax-saving estate plan right now. But if the plan was set up
several years ago, it is still a good idea to revisit it to make sure it reflects the client’s current
wishes.


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Client Is Single with Estate Worth Over $3.5 Million
Last year, this client could not have left more than $3.5 million to loved ones without triggering
a federal estate tax liability. The existing plan might still call for the estate to make enough
charitable donations to whittle its net worth down to $3.5 million, before giving that $3.5 million
to the client’s loved ones.

Since the client can now leave an unlimited amount to loved ones with no federal estate tax due,
she might want to make a change to leave more to loved ones and less to charities. Of course,
another fix might be necessary after Congress finally makes its move.

Client Is Single with Estate Worth Less Than $3.5 Million
There will not be any federal estate tax hit if this client dies today, and there would not have been
one if he had died last year. We can only hope the same will be true if he dies next year. This
client does not need any tax-saving estate plan right now. But if the plan was set up several years
ago, it is still a good idea to revisit it.

New Modified Carryover Basis Rule Replaces (for Now) Old Stepped-
Up Basis Rule for Inherited Assets
In conjunction with the 2010 repeal of the federal estate tax, we also get a new rule for
determining the federal income tax bases of inherited assets. Under the old rule, the bases of
inherited assets were generally stepped up (or stepped down) to equal their date-of-death FMVs.
However, there was no basis step-up for an amount attributable to income in respect of a
decedent (IRD). Basically, IRD is ordinary income that was accrued as of the decedent’s death
but that had not yet been included in the decedent’s gross income for federal income tax
purposes. The two most common examples of IRD assets are tax-deferred retirement accounts
and CDs and taxable bonds with accrued interest that had not been paid as of the decedent’s
death.

Under the new basis rule that exists today, the federal income tax bases of inherited assets can
still be stepped to reflect their date-of-death FMVs, but there is a limit on this tax-saving benefit.
In a nutshell, the new rule says the bases of inherited assets start off equal to the decedent’s
carryover basis amounts (generally equal to cost). Then those carryover basis amounts can be
stepped up by as much as $1.3 million to reflect date-of-death FMVs, or by as much as $4.3
million for assets inherited by a surviving spouse. As under prior law, there is no basis step up
for an amount attributable to IRD. To sum up, the new modified carryover basis rule for
inherited assets is complicated, and very few tax pros have bothered to learn exactly how it
works. [See IRC Sec. 1014(a)(1) and (f) for the old stepped-up basis rule and IRC Sec. 1022 for
the new modified carryover basis rule.]

Key Point. When Congress gets around to resurrecting the federal estate tax, the author expects
the old stepped-up basis rule for inherited assets will also be resurrected as part of the deal.
Fingers crossed!


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Generation-Skipping Transfer Tax Is Gone Too (for Now) but Gift Tax
Lives On
As part and parcel of the one-year repeal of the federal estate tax, the dreaded generation-
skipping transfer tax (GSTT) was also repealed for 2010. We do not miss it! The GSST is a
super-confiscatory extra tax that is added on top of the “regular” gift or estate tax liability when
generation-skipping transfers in excess of the GSTT exemption amount are made. Generation-
skipping transfers are those made via gifts while alive or via bequests after death to individuals
who are deemed to be two or more generations below the giver. For 2009, the GSTT exemption
was a relatively generous $3.5 million, and the maximum tax rate was “only” 45%. Next year,
the GSTT is scheduled to come roaring back with an exemption of only $1 million, and the
maximum tax rate is scheduled to balloon to the confiscatory percentage of 55%.

Despite the one-year death of the federal estate tax and GSTT, the federal gift tax lives on in
2010 with the familiar $1 million lifetime exemption still in place. However, the maximum gift
tax rate drops to 35% in 2010 (versus 45% in 2009). That is the end of the good news. For 2011
and beyond, the maximum gift tax rate is scheduled to soar to the confiscatory percentage of
55%. The exemption is scheduled to stay at $1 million.

Observation. Just because the GSTT is currently missing in action is no reason to make big
generation-skipping gifts. Our beloved Congress will probably resurrect the GSTT, along with
the federal estate tax, sometime in 2010. Congress may try to make both taxes retroactive to
January 1, 2010.


New Form for Homebuyer Credit
To claim the IRC Section 36 homebuyer credit on a return for a tax year ending after November
6, 2009 (meaning a calendar-year 2009 or 2010 return), the buyer must attach a properly
executed real estate settlement sheet (HUD-1 form) to her return. The updated version of IRS
Form 5405 (First-Time Homebuyer Credit) has been revised to reflect this new requirement. The
revised form must be used to claim the credit for (1) any purchase closed after November 6, 2009
and (2) any credit claimed on a 2009 Form 1040, even if the purchase date was before November
7, 2009. The 2008 version of Form 5405 can still be used to claim the credit on a 2008 return for
a 2009 purchase that closed before November 7, 2009. (See IRS Information Release IR 2009-
18.)


Tax Court Rules Again That MBA Expenses Can Be Deducted
Individual taxpayers can deduct what we will call, for purposes of this discussion, qualified
education expenses. The taxpayer has qualified education expenses if (1) the education is
expressly required by his employer or by applicable law or regulations in order for him to retain
his current employment relationship, status, or compensation level or (2) the education maintains
or improves skills needed in the taxpayer’s current employment or business. [See IRC Sec.
162(a) and Reg. 1.162-5(a).]

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In contrast, the taxpayer does not have qualified expenses if the education (1) prepares her for a
new profession or business or (2) occurs before the taxpayer’s employment or shortly thereafter
in order to meet pre-existing minimum educational requirements for his employment, profession,
or business. [See Reg. 1.162-5(b).]

The IRS says an undergraduate degree automatically prepares you for a new profession, so costs
to obtain a BA or BS are not qualified education expenses, and you cannot deduct them.
Unfortunately, the Tax Court has repeatedly agreed with the IRS on this score. [See for example
Malek, Theresa (TC Memo 1985-428, 1985); Meredith, Judith (TC Memo 1993-250, 1993); and
Fields, Edward M. (TC Summary Opinion 2001-35, 2001).]

The IRS has made the same argument about MBAs. Thankfully, the Tax Court has repeatedly
disagreed by concluding that MBA costs are qualified education expenses in the common
situation where the MBA program improves the taxpayer’s general business knowledge and
skills and thereby improves knowledge and skills needed in the taxpayer’s current job. For the
latest decision along this line, see Singleton-Clarke, Lori (TC Summary Opinion 2009-182,
2009).

Key Point. The Tax Court reached the same conclusion in three earlier cases. See Allemeier,
Daniel Jr. (TC Memo 2005-207, 2007); Beatty, Robert C. (TC Memo 1980-196, 1980); and
Blair, Frank S. III (TC Memo 1980-488, 1980). So you would think the Tax Court must be
getting a little cranky that IRS keeps bringing up the same losing argument.


Update on Tax Treatment of Gambling Activities
Gambling is always popular. Perversely enough, it may be even more popular when the economy
stinks. Here is the updated story on the tax implications of gambling.

Tax Basics for Gamblers
Loss Deductions Are Limited to Winnings

The most important thing to know is you can only deduct gambling losses for the year (from all
types of gambling) to the extent of gambling winnings for the year (from all types of gambling).
If you have excess gambling losses for the year, they go up in smoke without delivering any tax
benefit. [See IRC Sec. 165(d).]

After applying this losses-cannot-exceed-winnings limitation, the allowable loss amount for a
client who is not a professional gambler is then claimed as a Schedule A itemized deduction (on
line 28 of the 2009 version of Schedule A). So if the client does not itemize, he is out of luck in
the gambling loss deduction game.

Now for some good news. Allowable itemized gambling losses are not subject to the 2%-of-AGI
floor that applies to most other types of miscellaneous itemized deductions. Also, allowable
itemized gambling losses are not subject to the phase-out rule that applies to certain other

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itemized deductions (this phase-out rule disappears for 2010 before reappearing with a
vengeance in 2011). Finally, allowable itemized gambling losses are fully allowed for AMT
purposes too, unlike some other itemized deductions. [See IRC Secs. 56(b)(1)(A)(i), 67(b)(3),
and 68(c)(3).]

Key Point. When a married couple files jointly, the winnings of both spouses are combined for
purposes of determining the deductible losses incurred by both spouses. (See Reg. 1.165-10.)

No Deductions for Amateur’s Out-of-Pocket Expenses

The IRS and the Tax Court agree that only the cost of an amateur gambler’s actual wagering
transactions are considered gambling losses. Other out-of-pocket expenses such as
transportation, meals, and lodging do not count as gambling losses and therefore cannot be
written off at all. Such outlays are considered nondeductible personal expenses, under IRC Sec.
262. Note that Section 262 treatment also negates any possibility of deducting out-of-pocket
expenses under the IRC Section 183 hobby loss rules or as IRC Section 212 expenses for the
production of income. [See Whitten, Stanley, TC Memo 1995-508 (1995) and PLR 9808002.]

All Winnings Must Be Reported (in Theory)

Technically speaking, an amateur gambler must report the full amount of each and every win on
the miscellaneous income line on page 1 of Form 1040 (line 21 on the 2009 version of Form
1040). So in a profitable year, you cannot simply subtract losses from winnings and report the
net amount of winnings on page 1 of Form 1040.

The fact that clients are technically required to report the sum total of each and every win as
gross income on page 1 of Form 1040 results in higher AGI, which may cause all sorts of nasty
phase-out rules to come into play. But let us be realistic: even clients who attempt to keep good
records will probably only record their daily net winnings and daily net losses. Reporting an
amount of gross income on page 1 of Form 1040 equal to the sum total of the net winnings from
all days with net winnings will probably not get the client into trouble with the IRS, as long as
the amount reported as income equals or exceeds the sum total of any amounts reported as
income on Forms W-2G (more on Form W-2G later).

Key Point. Along the lines suggested in the immediately preceding paragraph, IRS Chief
Counsel Advice (CCA) EMISC 2008-011 (dated December 12, 2008) says a casual slot player
can simply keep a record of his net win or net loss for each gambling session. If the casual slot
player then reports the sum total of all his net winnings from all winning sessions as gross
income on page 1 of Form 1040 and keeps track of the sum total of all his net losses from all
losing sessions for purposes of applying the losses-cannot-exceed-winnings limitation to his
Schedule A itemized deduction, the IRS will consider that close enough to the theoretically
required recording of each win or loss from each spin of the slot machine. Thank you IRS!
Presumably this procedure of recording all net wins and losses from all gambling sessions would
also be considered adequate recordkeeping for other forms of casual gambling. (See the
following example.)



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                                              Example 4

Floyd likes occasional casino action. Assume he is not a professional gambler. Early in
2009, Floyd had a gambling session where he won $20,000 playing poker. Later in
2009, he had a gambling session where he lost $30,000 playing roulette. On Floyd’s
2009 Form 1040, the $20,000 of net winnings from the winning poker session should be
reported on page 1 on the other income line (line 21). His $20,000 deductible loss
amount from the losing roulette session (equal to his reported winnings for the year)
should be reported as an itemized deduction on Schedule A (line 28). Floyd’s $20,000
deduction is unaffected by the 2%-of-AGI floor. It is also exempt from the itemized
deduction phase-out rule, and it is fully allowed for AMT purposes. However, Floyd’s
$10,000 excess loss ($30,000 of losses – $20,000 of winnings) simply vanishes. It
cannot be deducted in 2009, nor can it be carried forward to future years. Bad luck!

Professional Gamblers
Although it is relatively rare, a taxpayer can sometimes rightly claim to be a professional
gambler for income tax purposes. In this case, his winnings should be reported as business
income on Schedule C, and his losses should be reported as business expenses on Schedule C of
Form 1040, just like for any other business activity. [See Rusnak, Charles (TC Memo 1987-249,
1987).] Schedule C deductions equate to above-the-line treatment for the taxpayer’s allowable
gambling losses, which is beneficial because the allowable losses will reduce AGI dollar for
dollar.

Key Point. As you can see, it is really only necessary to keep track of annual nets wins and
losses in some reasonable fashion (like on a daily basis) to arrive at the correct bottom line
amount on a professional gambler’s Schedule C.

In a number of cases, the courts have considered what it takes to be a professional gambler. To
summarize the decisions, the taxpayer must devote substantial time to gambling on a regular
basis and must depend on winnings as a meaningful source of income. [See for example
Panages, Pansy (TC Summary Opinion 2005-3, 2005) and Pias, Thomas (TC Summary Opinion
2005-138, 2005).] It also helps when the taxpayer conducts gambling activities in a businesslike
fashion by keeping detailed records and developing and evaluating strategies. [See for example
Castagnetta, James (TC Summary Opinion 2006-24, 2006) and Groetzinger, Robert (87-1 USTC
9191, 1987).]

Loss Limitation Rule Still Applies

Unfortunately, several court decisions have also concluded that IRC Section 165(d) limits a
professional gambler’s wagering losses to the amount of his winnings. In other words, the
dreaded losses-cannot-exceed-winnings limitation applies equally to professional gamblers and
amateurs alike. This may not seem very fair, but it is true. [See for example Kent, John (83
AFTR 2d 99-2850, 9th Cir., 1999) and Valenti, Pete (TC Memo 1994-483, 1994).]



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In a more-recent decision, the Tax Court confirmed that a professional tournament poker player’s
wagering losses are subject to the losses-cannot-exceed-winnings limitation. The taxpayer
argued that playing poker in tournaments was not a “wagering activity” and that her losses were
therefore not subject to the gambling loss limitation rule. No dice said the Tax Court. [See
Tschetschot, George E (TC Memo 2007-38, 2007).]

                                              Example 5

Assume the same basic facts as Example 4, except this time assume Floyd is a
professional gambler. Despite his professional status, the dreaded losses-cannot-
exceed-winnings limitation still applies to Floyd. Therefore, the $20,000 allowable loss
amount is the same as in Example 4. The difference is the $20,000 allowable loss in
this example is reported on Schedule C.

Watch Out for SE Tax Too

So far, so bad. An additional negative consideration is the fact that a professional gambler’s net
Schedule C income in profitable years is subject to the dreaded self-employment (SE) tax. (See
IRC Sec. 1402.) Therefore, in some cases, exposure to the SE tax may actually make claiming
professional gambler status more expensive than not.

IRS Says Out-of-Pocket Expenses Get Favorable Treatment

A professional gambler can deduct out-of-pocket non-wagering expenses under the normal rules
that apply to Schedule C business expenses (including the 50% disallowance rule for meal costs).
However, several court decisions concluded that a professional gambler’s out-of-pocket
expenses must be combined with his wagering losses and then subjected to the dreaded losses-
cannot-exceed-winnings limitation under IRC Sec. 165(d). [See for example Kozma, Michael
(TC Memo 1986-177, 1986); Valenti, Pete (TC Memo 1994-483, 1994); and Praytor, William
(TC Memo 2000-282, 2002).]

Despite these anti-taxpayer decisions, the IRS has decided that a professional gambler’s out-of-
pocket expenses should not be combined with wagering losses for purposes of applying the
Section 165(d) losses-cannot-exceed-winnings limitation. Instead, the Service now says the
limitation only applies to wagering losses. In other words, a professional gambler’s deductions
for wagering losses are indeed limited to her wagering winnings under the limitation. But a
professional gambler’s out-of-pocket non-wagering expenses can be deducted as garden-variety
Schedule C business expenses without regard to the limitation. (See IRS Office of Chief Counsel
Memorandum EMISC 2008-013, dated December 19, 2008.) This is good news in years when
the client’s gambling losses exceed gambling winnings, because her out-of-pocket expenses will
result in a Schedule C loss that can be used to offset income from other sources.




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Forms W-2G Help Keep Winning Taxpayers Honest
For most types of gambling at a legitimate gaming facility, your client will be issued a Form W-
2G (Certain Gambling Winnings) if she wins $600 or more and that amount is also more than
300 times the amount wagered. Of course, the IRS gets a copy too! However a $1,200 tax
reporting threshold applies to winnings from slots and bingo, and a $1,500 tax reporting
threshold applies to winnings from keno. Since the IRS gets a copy of Form W-2G, the client
better make darn sure to report an amount of gross gambling winnings on page 1 of Form 1040
(or on Schedule C if the client is a professional gambler) that at least equals the winnings
reported on Forms W-2G. When winnings exceed $5,000, federal income tax withholding is
generally required (but not for winnings from slots, bingo, or keno). [See the Form W-2G
instructions and IRC Sec. 3402(q).]

Recordkeeping Issues
Whether the taxpayer is an amateur or a professional gambler, she must adequately document the
amount of her gambling losses in order to claim her rightful deductions. According to Rev. Proc.
77-29, taxpayers must compile the following information in a log or similar record:

      The date and type of each specific wager or wagering activity.

      The name and address or location of the gambling establishment.

      The names of other persons (if any) present with the taxpayer at the gambling
       establishment (obviously this requirement cannot be met at a public venue such as a
       casino or race track).

      The amount won or lost. Substantiation of winnings and losses from wagering on table
       games can done by recording the number of the table played and keeping statements
       showing casino credit issued to the player. See also IRS Publication 529 (Miscellaneous
       Deductions).


Per-Session Recordkeeping Is Apparently OK

To reiterate what was said earlier, the IRS in Chief Counsel Advice (CCA) EMISC 2008-011
(dated December 12, 2008) indicated that it is permissible for a casual slot player to simply keep
a record of his net win or net loss amount for each gambling session. In other words, the
determination of the net win or loss amount can be made when the gambler redeems his tokens at
the end of each session or determines that he lost all the tokens he started off with at the
beginning of that session. If the casual slot player then reports the sum total of all the net
winnings from all winning sessions as gross income on page 1 of Form 1040 and keeps track of
the sum total of the net losses from all losing sessions for purposes of applying the losses-cannot-
exceed-winnings limitation to his Schedule A itemized deduction, the IRS will consider that
close enough to the theoretically required recording of each win or loss from each spin of the slot
machine. Thank you IRS! Presumably this concept of recording all net wins and losses from all


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gambling sessions would also be considered sufficient recordkeeping for other forms of casual
gambling.

In Dire Circumstances No Recordkeeping May Be Required

In a 2009 Summary Opinion, the Tax Court allowed a taxpayer to use a common-sense approach
to establish that his gambling losses, for which he had no records, were more than enough to
offset gambling winnings reported on Forms W-2G. The evidence showed the taxpayer was a
compulsive gambler who lost so habitually that he did not own a car and had to depend on
relatives to help pay his living expenses. Therefore, the Tax Court concluded that all his reported
gambling winnings (more than $70,000) had obviously been gambled away, even though he had
no records to prove it. [See Caro, Jose D. (TC Summary Opinion 2009-184, 2009).]


Taxpayer Failed to Qualify for IRS Levy Exception to 10% Premature
Withdrawal Penalty Tax
Withdrawals before age 59½ from a tax-deferred retirement account (including an IRA) are
subject to the dreaded 10% premature withdrawal penalty tax unless an exception applies. [See
IRC Sec. 72(t).] One such exception applies to premature withdrawals taken to satisfy IRS levies
against the account. [See IRC Secs. 72(t)(2)(A)(vii) and 6331.] Unfortunately, the Tax Court
says this exception is not available when the IRS levies against the account owner or participant,
as opposed to the account itself, or when the IRS has merely issued a Notice of Intent to Levy
against an account but has not yet put the levy in place. In these scenarios, the 10% penalty tax
still applies to premature retirement account withdrawals even when the withdrawn funds are
used to pay amounts owed to the IRS. [See Willhite, James (TC Memo 2009-263, 2009).]


No Deductions for Ponzi Losses Inside IRAs
In information letter INFO 2009-0154, the IRS pointed out that when IRA funds are lost in Ponzi
investment schemes, the losses do not in and of themselves give rise to deductible losses.
Instead, the following rules apply.

Losses from Traditional IRAs
Losses from traditional IRAs can only be claimed when both of the following conditions are met:

   1. The taxpayer liquidates all traditional IRAs set up in her name.

   2. The taxpayer’s total tax basis in those accounts exceeds the total proceeds from
      liquidating those accounts. The excess equals the tax loss amount. [See IRS Publication
      590 (Individual Retirement Arrangements) and IRS Notice 89-25, Q&A-7.]




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Even when there is a tax loss, another hurdle must be cleared. The IRS says the loss is classified
as a miscellaneous itemized deduction. (See IRS Publication 590.) As such, the loss gets thrown
in the pot with other miscellaneous itemized deduction expenses (e.g., unreimbursed employee
business expenses, investment expenses, and fees for tax advice and preparation). Only the
excess of total miscellaneous itemized deductions over 2% of AGI can be claimed as a write-off
on Schedule A of Form 1040. (See IRC Sec. 67.) If the account owner clears the 2%-of-AGI
hurdle, she is still not home free. She may lose part of his miscellaneous itemized deduction
write-off due to the deduction phase-out rule for higher-income individuals. (See IRC Sec. 68.)
Finally, miscellaneous itemized deduction write-offs are completely disallowed for AMT
purposes. So if the account owner is an AMT victim, some or all of the anticipated tax savings
from IRA losses will go up in smoke. [See IRC Sec. 56(b)(1)(A)(i).]

Losses from Roth IRAs
For tax loss determination purposes, taxpayers must treat Roth IRAs separately from traditional
IRAs. Losses from Roth IRAs can only be claimed when both of the following conditions are
met:

   1. The taxpayer liquidates all Roth IRAs set up in his name.

   2. The taxpayer’s total tax basis in those accounts exceeds the total proceeds from
      liquidating those accounts. The excess equals the tax loss amount. [See IRS Publication
      590 (Individual Retirement Arrangements); IRS Notice 89-25, Q&A-7; and IRC Sec.
      408A(d)(4)(A).]


Unfortunately, the other hurdles mentioned above in the context of traditional IRA tax losses
apply equally to Roth IRA tax losses, because the IRS says Roth losses must also be treated as
miscellaneous itemized deductions. (See IRS Publication 590.)




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       Key Developments Affecting Business Taxpayers

New Regulations Provide Tax Rules for Operating Employee Stock
Purchase Plans (ESPPs)
In newly released final Regs. 1.423-1 and 1.423-2 (in TD 9471), the IRS explains the federal
income tax rules applicable to ESPPs. The rules are quite similar to those that apply to incentive
stock option (ISO) programs. The new final regulations apply to ESPP options granted after
2009, but they can also be relied upon for options granted earlier.


New Regulations Cover Information Reporting Rules When Employer
Shares Are Acquired via Incentive Stock Options (ISOs) and
Employee Stock Purchase Plans (ESPPs)
In newly released final Regs. 1.6039-1 and 1.6039-2 (in TD 9470), the IRS explains how
employers must file information returns and supply information to employees when company
shares are acquired by exercising ISOs or participating in ESPPs. Returns must be filed using
new Form 3921 for ISO shares and new Form 3922 for ESPP shares. The return-filing
requirement does not apply to shares that were acquired in 2007-2009. For those years, however,
employees must still be given certain information including (among other things) the option
exercise date, the exercise price, and the FMV of the shares on the exercise date.


No Year-of-Accrual Deduction for Deferred Bonuses Subject to
Continued Employment Requirement
In Chief Counsel Advice (CCA) 200949040, the IRS opined that an accrual-method corporation
could not claim a Year 1 deduction for deferred employee bonuses that were accrued in Year 1
and paid in the first 2½ months of Year 2. In this case, the employees could only collect their
bonuses if they were still employed on the Year 2 bonus payment date. Therefore, the IRS
concluded the employer’s deferred bonus liability was subject to a contingency as of the end of
Year 1, and the liability did not become fixed until the bonus payment date in Year 2. The IRS
also concluded that economic performance with respect to the deferred bonus liability had not
occurred as of the end of Year 1, because the deferred bonus plan required employees to
continue to provide services until the Year 2 bonus payment date. Therefore, the employer could
not deduct the deferred bonus liability until Year 2, when the contingency was removed and
economic performance had occurred.




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New Regulations on S Corporation Cancellation of Debt (COD) Income
In newly released final amendments to Reg. 1.108-7 (in TD 9469), the IRS explains how to
reduce certain S corporation shareholder tax attributes (such as NOL carryovers) when an S
corporation has COD income that is excluded from gross income under IRC Sec. 108(a)(1).




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          Federal Tax Update – Second Quarter 2010

Highlights
      Tax changes in the healthcare legislation

      Tax changes in the Hiring Incentives to Restore Employment Act

      Tax Freedom Day is April 9th this year

      Second quarter 2010 interest rates on federal tax overpayments and underpayments

      COBRA subsidy extended again

      Whether severance payments will be exempt from FICA tax or not

      IRS says golf cart tax credit is not for golf carts

      New Form 3115 for requests to change accounting methods

      Employers get postcards from IRS about new health insurance tax credit

      IRS announces 2010 luxury auto depreciation limits

      PAL groupings must be disclosed on tax returns (but not yet)

      Yet another court decision says LLC members are general partners for PAL purposes

      Certain 2010 Haiti relief donations can be deducted on 2009 returns




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           Tax Changes in the Healthcare Legislation

For purposes of this analysis, the Patient Protection and Affordable Care Act and the related
Health Care and Education Reconciliation Act will be collectively referred to as the healthcare
legislation. The two pieces were signed into law on March 23, 2010, and April 30, 2010,
respectively, and they include lots of tax changes, some of which have nothing to do with
healthcare.

This section summarizes what we think are the most important new tax provisions. Frankly, it
will take time to make much sense out of some of them, because we have two different laws
going on here, plus poorly drafted language to boot. What is included is what we can say right
now.


Retroactive Changes Taking Effect Before 2010

New Exclusion for Certain Forgiven Student Loans
The healthcare legislation creates a new and retroactive federal income tax exclusion for student
loan amounts paid off or forgiven under certain state loan repayment and forgiveness programs
that are intended to increase the availability of healthcare in underserved areas.

Effective Date: Amounts received or forgiven in tax years beginning after 2008. [See IRC Sec.
108(f)(4).]

New Credit for Therapeutic Discovery Projects
The healthcare legislation creates a new and retroactive tax credit for qualified investments in
therapeutic discovery projects, as defined. The credit is only available to taxpayers with 250 or
fewer employees.

Effective Date: For eligible expenses paid or incurred in 2009 and 2010, subject to a $1 billion
limit on total allowable credits. (See IRC Sec. 48D.)


Changes Taking Effect in 2010

New Health Insurance Tax Credit for Small Employers
Qualifying small employers can claim a new tax credit to help cover the cost of providing
employee health coverage. A qualifying small employer is one that (1) has no more than 25 full-
time-equivalent (FTE) workers, (2) pays an average FTE wage of no more than $50,000, and (3)
pays on a uniform basis at least 50% of the cost of employee health coverage (meaning the
employer must pay the same percentage of the cost for all employees). For 2010 only, the IRS


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intends to issue transition rules that will allow the credit, even if the employer does not pay for
coverage on a uniform basis.

Health premiums paid under a Section 125 cafeteria benefit plan salary-reduction arrangement
do not count as employer-paid premiums for purposes of the credit.

The maximum credit equals 35% of the lesser of (1) the actual cost of providing qualifying
health coverage, or (2) the cost of “benchmark” coverage as determined on a state-by-state basis
by the Department of Health and Human Services. For tax-exempt employers, the maximum
credit percentage is reduced to 25%.

The maximum credit percentage (35% or 25%) is only allowed to qualifying small employers
with 10 or fewer FTE employees and an average FTE wage of no more than $25,000. For
qualifying small employers with more employees and/or higher wages, the credit percentage is
effectively reduced under complicated phase-out rules.

Finally, the credit for the year cannot exceed the sum of (1) federal income tax and 1.45%
Medicare tax withheld from employee wages, plus (2) the employer’s 1.45% Medicare tax on
wages.

See the IRS website at www.irs.gov for some helpful information and examples of how to
calculate the credit.

The credit is apparently allowed to all types of employers, including C and S corporations,
partnerships, LLCs, and sole proprietorships. However, the credit cannot be claimed for
healthcare expenditures to cover sole proprietors, partners, more-than-2% shareholder-employees
of S corporations, more-than-5% owners of businesses, and certain related employees. For credit
calculation purposes, these excluded individuals are not counted in determining how many FTE
employees a business has or the average FTE wage.

The credit is classified as a general business credit. Therefore, it can be used to offset both
regular federal income tax and any AMT. Unused credits can be carried back for one year (but
not to any pre-2010 year) and ahead for 20 years.

Finally, the employer’s deduction for health insurance premium costs is reduced by the amount
of the credit.

Observation. In this economy, it is exceedingly doubtful that the new credit will induce many
small businesses to suddenly start providing employee health coverage. The fact that the credit
rules are too complicated to be easily explained does not help matters. Presumably, a fair number
of small businesses that already provide health coverage will qualify for the credit, but that
remains to be seen.

Effective Date: Tax years beginning in 2010-2013. Note that eligible costs incurred in 2010
before the healthcare legislation was enacted can still qualify for the credit. [See IRC Secs. 45R
and 280C(h) and Section 1421 of the healthcare legislation.]

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Healthcare-Related Tax Breaks Granted to Adult Children
Effective for plan years beginning after September 23, 2010, health plans that cover dependent
children must continue to cover adult children until they turn 26.

In conjunction with the new coverage requirement, employer-provided health coverage for an
employee’s adult child is now treated as a tax-free fringe benefit, as long as the child has not
reached age 27 by the end of the year. It does not matter if the adult child is the employee’s
dependent or not.

Key Point. In Notice 2010-38, the IRS concluded that tax-free treatment also applies to
reimbursements from a cafeteria plan, healthcare FSA, or HRA to cover an under-age 27 adult
child’s qualified medical expenses.

If you are self-employed and pay for your own health coverage, the cost of covering an adult
child is eligible for the above-the-line deduction for self-employed health insurance premiums,
as long as the adult child has not reached age 27 by the end of the year. It does not matter if the
adult child is your dependent or not.

The discrepancy between the until-age-26 coverage requirement and the until-age-27 tax breaks
is apparently an unintended glitch.

Effective Date: March 30, 2010. [See IRC Secs. 105(b) and 162(l).]

Liberalized Adoption Tax Breaks
Strangely enough, the healthcare legislation also increases the annual cap on tax-free employer
adoption assistance payments by $1,000 and extends the new deal through 2011. For 2010, this
change increases the cap to $13,170 (up from $12,170).

Similarly, the healthcare legislation increases the maximum annual adoption credit by $1,000
and extends the new deal through 2011. For 2010, this increases the maximum credit to $13,170
(up from $12,170).

Finally, for 2010 and 2011, the adoption credit is transformed into a refundable credit that can be
collected in full, even if you do not owe any federal income tax.

Effective Date: Tax years beginning in 2010 and 2011. (See IRC Secs. 36C and 137.)

Economic Substance Doctrine Is Codified
In what is sure to open up a giant can of worms, the healthcare legislation attempts to provide a
home within our beloved Internal Revenue Code for the so-called economic substance doctrine.
Economic substance will be deemed to exist only if the transaction in question (1) changes the
taxpayer’s economic position in a meaningful way without regard to tax consequences, and (2) is
entered into for a substantial non-tax purpose. A 20% penalty can be assessed on tax

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underpayments attributable to transactions that are disallowed because they lack of economic
substance. The penalty rises to 40% for “undisclosed economic substance transactions.” Other
penalties may also apply.

Effective Date: For transactions entered into after March 30, 2010, and tax underpayments,
understatements, refunds, and credits attributable to transactions entered into after that date. [See
IRC Secs. 7701(o), 6662(i), and 6676(c).]

New Rules for Nonprofit Hospitals
The healthcare legislation establishes new rules for hospitals to qualify for tax-exempt nonprofit
status.

Effective Date: Tax years beginning after March 23, 2010. [See IRC Secs. 501(r) and 6033(b).]

No More Biofuel Tax Credit for Black Liquor
The healthcare legislation disallows the cellulosic biofuel producer credit for so-called black
liquor fuels.

Effective Date: For fuels sold or used after 2009. [See IRC Sec. 40(b)(6)(E).]

New Loss Ratio Rule for Health Organizations
The healthcare legislation requires a medical loss ratio of at least 85% for health organizations to
qualify for certain insurance company tax breaks.

Effective Date: Tax years beginning after 2009. [See IRC Sec. 833.]

New Tanning Excise Tax
The healthcare legislation imposes a new 10% excise tax on indoor tanning services.

Effective Date: For services performed after June 30, 2010. (See IRC Sec. 5000B.)


Changes Taking Effect in 2011

Employer Costs to Provide Health Insurance Must Be Reported on
Forms W-2
The healthcare legislation requires employers to report to employees on their annual Forms W-2
the value of employer-provided health insurance coverage (not including salary-reduction
amounts contributed to healthcare FSAs).



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Effective Date: Tax years beginning after 2010. [See IRC Sec. 6051(a)(14).]

No More Tax-Free Reimbursements for Non-Prescription Drugs
If you participate in an employer-sponsored healthcare FSA or HRA, or have your own HSA or
MSA, current rules allow you to take tax-free withdrawals to pay for non-prescription drugs such
as pain and allergy relief medications. Starting next year, this tax-favored treatment will only be
available for prescription drugs, insulin, and doctor-prescribed over-the-counter medications.

Effective Date: For expenses incurred in tax years beginning after 2010. [See IRC Secs. 106(f),
220(d), and 223(d).]

Stiffer Penalty on Nonqualified HSA and MSA Withdrawals
If you take money out of your HSA or MSA for any reason other than to cover qualified medical
expenses, you usually owe federal income tax, plus a 10% penalty tax on HSA account earnings
included in the payout, or a 15% penalty tax for an MSA. The healthcare legislation increases the
penalty tax rate to 20% for nonqualified withdrawals of earnings.

Effective Date: Withdrawals in tax years beginning after 2010. [See IRC Secs. 220(f) and
223(f).]

New Simple Cafeteria Plans for Small Employers
The healthcare legislation establishes a new and simpler type of Section 125 cafeteria benefit
plan for employers with 100 or fewer employees. These simplified plans will be deemed to
automatically satisfy all applicable cafeteria benefit plan nondiscrimination rules if they satisfy
certain minimum standards for eligibility, participation, and contributions.

Effective Date: Tax years beginning after 2010. [See IRC Sec. 125(j).]

New Tax on Drug Companies
The healthcare legislation imposes a new nondeductible fee (we will call it a tax) on
manufacturers and importers of branded prescription drugs. Each targeted company must pay an
allocable portion of the total annual fee, which is $2.5 billion for 2011. The fee is apportioned
among targeted companies, based on each company’s share of sales in the preceding year.

Effective Date: Calendar year 2011. (See Section 9008 of the Patient Protection and Affordable
Care Act.)




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Changes Taking Effect in 2012

New Form 1099 Reporting Requirement for Business Payments to
Corporate Providers of Property and Services
Businesses that pay over $600 a year to a corporate provider of property or services must supply
the provider with a Form 1099 and file a copy with the IRS.

Effective Date: For payments made after 2011. [See IRC Sec. 6041(h).]

New Tax on Health Insurance Policies
Health insurers and sponsors of applicable self-insured health plans will have to pay an annual
fee of $2 per covered life ($1 per life for affected policy or plan years that end by September 30,
2013).

Effective Date: Policy years ending after September 30, 2012. (See IRC Secs. 4375, 4376, and
4377.)


Changes Taking Effect in 2013

Additional 0.9% Medicare Tax on Salaries and Self-Employment
Income Earned by “Rich” Folks
Right now, the Medicare tax on salary and/or self-employment (SE) income is 2.9%. If you are
an employee, 1.45% is withheld from your paychecks, and the other 1.45% is paid by your
employer. If you are self-employed, you get to pay the whole 2.9% yourself.

Starting in 2013, an extra .9% Medicare tax will be charged on (1) salary and/or SE income
above $200,000 for an unmarried individual, (2) combined salary and/or SE income above
$250,000 for a married joint-filing couple, and (3) salary and/or SE income above $125,000 for
those who use married filing separate status. More good news: these thresholds will not be
adjusted for inflation.

For self-employed individuals, the additional .9% Medicare tax hit will come in the form of a
higher SE bill. However, the additional .9% Medicare tax will not qualify for the above-the-line
deduction for 50% of SE tax.

The additional .9% Medicare tax must be taken into account for estimated tax payment purposes.

Effective Date: Tax years beginning after 2012. [See IRC Secs. 164(f), 1401(b), 3101(b), 3102,
and 6654.]




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Additional 3.8% Medicare Tax on Net Investment Income Collected by
“Rich” Folks and Trusts
Right now, the maximum federal income tax rate on long-term capital gains and dividends is
15%. Starting in 2011, the maximum rate is scheduled to go up as the so-called Bush tax cuts
expire. The president repeatedly promised that 20% would be the maximum rate for 2011 and
beyond, but he changed his mind. Starting in 2013, all or part of the net investment income,
including long-term capital gains and dividends, collected by higher-income folks can get socked
with a 3.8% “Medicare contribution tax.” Therefore, the maximum federal rate on long-term
gains and dividends for 2013 and beyond will actually be 23.8% (assuming it is not increased yet
again) instead of the promised 20%.

The additional 3.8% Medicare tax will not apply unless modified adjusted gross income (MAGI)
exceeds (1) $200,000 for an unmarried individual, (2) $250,000 for a married joint-filing couple,
or (3) $125,000 for those who use married filing separate status. These MAGI thresholds will not
be adjusted for inflation.

MAGI means regular AGI plus the excess of the amount excluded from gross income under the
IRC Section 911(a)(1) foreign earned income exclusion over any deductions or exclusions that
are disallowed under IRC Sec. 911(b)(6) with respect to such excluded foreign earned income.

The additional 3.8% Medicare tax will apply to the lesser of (1) net investment income or (2) the
amount of MAGI in excess of the applicable threshold. For instance, a married joint-filing couple
with MAGI of $265,000 and $60,000 of net investment income would pay the 3.8% tax on
$15,000 (the amount of excess MAGI). If the same couple has MAGI of $350,000, they would
pay the 3.8% tax on $60,000 (the entire amount of net investment income).

Net investment income includes interest, dividends, royalties, annuities, rents, gross income from
passive business activities, gross income from trading in financial instruments or commodities,
and net gain from property held for investment (but not property held for business purposes)
reduced by deductions allocable to such income.

The additional 3.8% Medicare tax must be taken into account for estimated tax payment
purposes.

Key Point. For a trust, the additional 3.8% Medicare tax will apply to the lesser of (1)
undistributed net investment income, or (2) the amount of AGI in excess of the threshold for the
top trust federal income tax bracket.

Effective Date: Tax years beginning after 2012. [See IRC Secs. 1411 and 6654.]

New $2,500 Cap on Healthcare FSA Contributions
Right now, there is no tax-law limit on salary-reduction contributions to an employer’s
healthcare FSA arrangement. Starting in 2013, the maximum annual FSA contribution by an
employee will be capped at $2,500. For post-2013 years, the cap will be indexed for inflation.

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Effective Date: Tax years beginning after 2012. [See IRC Sec. 125(i).]

Higher Threshold for Itemized Medical Expense Deductions
Right now, you can claim an itemized deduction for medical expenses paid for you, your spouse,
and your dependents, to the extent the expenses exceed 7.5% of AGI. Starting in 2013, the hurdle
is raised to 10% of AGI. However, if you or your spouse is age 65 or older at year-end, the new
10%-of-AGI threshold will not take effect until 2017. The medical expense deduction threshold
for AMT purposes remains at 10% of AGI.

Effective Date: Tax years beginning after 2012 (tax years beginning after 2016, if taxpayer or
spouse is 65 or older at year-end). [See IRC Sec. 213(a) and (f).]

No More Deductions for Retiree Drug Plan Subsidies
Employers that sponsor qualified retiree prescription drug plans are entitled to collect tax-free
federal subsidies for a portion of the cost. Employers are currently allowed to deduct the full cost
of retiree drug plans without any reduction for the tax-free federal subsidies. In effect, deductions
are allowed for amounts that are actually paid by the government. The healthcare legislation
reduces deductions by the amount of tax-free federal subsidies.

Effective Date: Tax years beginning after 2012. (See IRC Sec. 139A.)

New Excise Tax on Medical Device Manufacturers
Manufacturers will have to pay a 2.3% excise tax on taxable sales of medical devices intended
for humans. However, devices commonly retailed to the general public will be exempt. The tax
will not apply to eyeglasses, contact lenses, hearing aids, and the like.

Effective Date: Sales after 2012. (See IRC Sec. 4191.)

New Deductible Compensation Limit for Health Insurers
Affected health insurance providers will face a $500,000 per-person deduction limit on
compensation paid to “applicable individuals,” which can include officers, employees, directors,
and certain other service providers, such as consultants.

Effective Date: Tax years beginning after 2012. [See IRC Sec. 162(m)(6)(A).]


Changes Taking Effect in 2014
New Penalties on Individuals without “Adequate” Coverage
In general, U.S. citizens and legal residents of this country will be required to pay penalties if
they do not obtain (one way or the other) “adequate” health insurance coverage.

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The tentative penalty amount will equal the greater of (1) the applicable percentage of household
income above the income threshold that requires the filing of a federal income tax return, or (2)
the applicable dollar amount, times the number of uninsured individuals in the household.

The applicable percentage of income is 1% for 2104, 2% for 2015, and 2.5% for 2016 and
beyond.

The applicable dollar amount is $95 for 2104, $325 for 2015, and $695 for 2016. For post-2016
years, the applicable dollar amount will be $695, adjusted for inflation. For an under-age-18
household member, the applicable dollar amounts will be 50% of the aforementioned amounts.

The final penalty amount for each household will be limited to 300% of the applicable dollar
amount. For example, the maximum penalty for 2016 will be $2,085 (3 × $695). However, if the
national average cost of “bronze coverage” (a new term of art) for the household is less, the
maximum penalty will be limited to the cost of bronze coverage.

If an affected individual is uninsured for only part of the year, the penalty amount will be
calculated on a monthly basis using pro-rated annual figures. We can hardly wait to see how that
calculation will work.

Observation. Although the penalty is supposed to be reported on your federal income tax return,
there is apparently no enforcement mechanism other than subtracting the penalty from your
federal income tax refund (if any). Therefore, it is hard to see how the penalty will scare very
many scofflaws into buying “adequate” health insurance.

Effective Date: Tax years beginning in 2014. (See IRC Sec. 5000A.)

New Penalties on Employers
Employers with at least 50 full-time employees who do not provide all employees with
affordable health coverage that meets certain minimum standards of generosity will be charged a
penalty if even one employee purchases his own government-subsidized coverage through a
state-run exchange.

Government-subsidized coverage means coverage for which a federal cost-sharing subsidy
(explained above) is available.

The penalty will be $167 per month ($2,000 per year) for each employee who is not provided
with “adequate” coverage for that month (whether or not that particular employee purchases
subsidized coverage from a state-run exchange). However, no penalty is charged for the first 30
employees.

Alarmingly enough, an employer can be charged a penalty even when employees are offered the
opportunity to enroll in a plan that provides minimum essential coverage, but one or more
employees choose to buy subsidized coverage through a state-run exchange. In this case, the


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penalty is $250 per month for each applicable employee, but the total penalty cannot exceed the
penalty that would be charged for outright failure to offer “adequate” coverage. Good grief!

Employers cannot deduct these penalties as a business expense.

Effective Date: Coverage months beginning in 2014. (See IRC Sec. 4980H.)

New “Cost-Sharing Subsidies” for Eligible Individuals
Government paid “cost-sharing subsidies” will be provided to help individuals who are ineligible
for Medicaid, employer-provided coverage, or other “adequate” coverage. This deal has been
advertised as a benefit for low-income folks, but you can be eligible with income up to 400% of
the federal poverty level. For 2009, 400% of the poverty level was $43,320 for one person or
$88,200 for a family of four, so middle-income folks will be able to cash in.

Key Point. The cost-sharing subsidy is sometimes called a “premium assistance tax credit,”
mainly because the enabling language is found in the Internal Revenue Code. In most cases,
however, the cost-sharing subsidy will simply be paid in advance directly to the insurer. If that
does not happen, the amount of the subsidy can be claimed as a refundable tax credit on the
eligible individual’s federal income tax return.

Effective Date: Tax years beginning in 2014. (See IRC Sec. 36B.)

More Generous Health Insurance Tax Credit for Small Employers
As explained in the 2010 changes, qualifying small employers can claim a new tax credit to help
cover the cost of providing employee health coverage. For 2010-2013, the maximum credit
percentage is 35% or 25% for tax-exempt employers. Starting in 2014, the maximum credit
percentage increases to 50% or 35% for tax-exempt employers. However, employers must
purchase qualifying health coverage from state-run insurance exchanges to be eligible for the
higher credit percentages. Also, the FTE wage caps for credit qualification and calculation
purchases are indexed for inflation, starting in 2014.

Effective Date: Tax years beginning in 2014. (See IRC Sec. 45R and Section 1421 of the
healthcare legislation.)

Some Employers Must Give Employees “Free Choice Vouchers”
The gist of this change is that an affected employer must give a so-called free choice voucher to
any eligible employee who chooses to buy her own coverage instead of participating in the
company plan. The amount of the voucher equals the amount the employer would have
contributed to the company plan on behalf of the employee if she had participated. As long as the
employee spends at least the amount of the voucher on qualified health coverage, the voucher is
tax-free to the employee. However, an employee who takes advantage of the free choice voucher
deal is ineligible to receive any cost-sharing subsidy for buying coverage from a state-run
exchange.

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Effective Date: 2014. (This change was supposed to be set forth in IRC Sec. 139D, but that
section was already devoted to something else. See Section 10108 of the healthcare legislation.)

New Excise Tax on Health Insurance Providers
The healthcare legislation imposes a new fee (we will call it a tax) on health insurance providers.
Each targeted company must pay an allocable portion of the total annual fee, which is $8 billion
for 2014. The fee is apportioned among targeted companies based on each company’s share of
applicable net premiums.

Effective Date: Calendar year 2014. (See Section 9010 of the Patient Protection and Affordable
Care Act.)


Change Taking Effect in 2018
New Excise Tax on “Cadillac Health Plans”
Starting in 2018, health insurance companies that service the group market and administrators of
employer-sponsored health plans (if any are left by then) will get socked with a 40% excise tax
on premiums that exceed the applicable threshold of $10,200 for self-only coverage, or $27,500
for family coverage. For retired individuals and plans that cover employees in high-risk
professions, the thresholds will be $11,850 and $30,950, respectively. All these thresholds may
be increased to reflect higher than expected inflation in health premiums. Plans sold in the
individual market will be exempt, except for coverage that is eligible for the above-the-line
deduction for self-employed health premiums.

Effective Date: Tax years beginning in 2018. (See IRC Sec. 4980I.)




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                Tax Changes in the Hiring Incentives
                    to Restore Employment Act

The Hiring Incentives to Restore Employment Act (the HIRE Act) was signed into law on March
18, 2010. It received relatively little notice because the healthcare reform soap opera was still
dominating the nation’s attention at that time.

Despite the lack of fanfare, the HIRE Act is significant. It includes three meaningful business tax
breaks, and a daunting array of changes intended to clamp down on taxpayer attempts to avoid or
evade U.S. taxes by taking assets and transactions offshore. The HIRE Act also makes a few
changes that fall into the miscellaneous category.

This section summarizes the new provisions, starting with the taxpayer-friendly changes for
business.


Favorable Business Tax Changes
Generous Section 179 Deduction Limits Extended Through 2010
The HIRE Act extended the $250,000 maximum Section 179 deduction allowance by one year,
to cover tax years beginning in 2010. Without this retroactive change, the 2010 maximum
deduction would have been only $134,000.

Key Point. For tax years beginning in 2011, the maximum Section 179 deduction will take a
drastic fall to only $25,000, unless our beloved Congress takes further action (which it probably
will).

The HIRE Act also extended the $800,000 threshold for the Section 179 deduction phase-out
rule by one year, to cover tax years beginning in 2010. Without this retroactive change, the 2010
phase-out threshold would have been only $530,000.

Key Point. For tax years beginning in 2011, the phase-out threshold will plummet drastically, to
only $200,000 unless Congress takes further action (which it probably will).

Temporary Social Security Tax Exemption for Wages Paid to New
Hires
Another HIRE Act provision exempts wages paid by a qualified employer to a qualified new
employee for work performed between March 19, 2010, and December 31, 2010, from the 6.2%
employer’s portion of the Social Security tax. [See IRC Sec. 3111(d).]

The maximum amount of Social Security tax savings for an employer is $6,621.60 for each
qualified new employee (6.2% × the $106,800 Social Security tax ceiling for 2010). Savings are

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less if the qualified new employee’s wages during the exemption period are below the Social
Security tax ceiling (which will almost always be the case).

Key Point. There is no exemption for the employee’s 6.2% portion of the Social Security tax,
and there is no change in the Medicare tax component of the FICA tax. Finally, there is no
exemption for self-employed folks who pay Social Security tax (and Medicare tax) via the self-
employment tax. Sorry!

Definition of Qualified Employer

Qualified employers are defined as private sector employers, tax-exempt not-for-profit outfits,
and eligible public higher education institutions. Other public sector employers do not meet the
definition. [See IRC Sec. 3111(d)(2).]

Definition of Qualified New Employee

Qualified new employees are defined as full-time or part-time workers who begin work after
February 3, 2010, and by no later than December 31, 2010, and who were not employed for more
than 40 hours during the 60-day period ending on the start date.

To be a qualified new employee, a newly hired worker cannot replace another worker, unless
that other person exited voluntarily or was discharged for cause.

Key Point. The new worker must certify to the employer that she was not employed for more
than 40 hours during the 60-day period ending on her start date. [See IRC Sec. 3111(d)(3).] This
is done by having the new worker sign new IRS Form W-11 (HIRE Act Employee Affidavit).
The signed Form W-11 is not filed with the IRS, but it should be kept with the employer’s tax
records.

No Exemption for Wages Paid to Certain Related Parties

The Social Security tax exemption is disallowed for wages paid to new employees who are
related to employers under the same related party disallowance rules that apply to the IRC
Section 51 Work Opportunity Tax Credit (WOTC). [See IRC Sec. 51(i)(1).] For example, say the
employer is a closely held corporation. Wages paid to a new hire who would otherwise be a
qualified new employee, but who is a brother or sister of a more-than-50% owner of the
corporation, are ineligible for the exemption. [See IRC Sec. 3111(d)(3)(D).]

Implementation Rules

The benefit of the Social Security tax exemption for any eligible wages paid during March of
2010 (for work performed between March 19, 2010, and March 31, 2010) will show up as a
credit on the employer’s second quarter Form 941, Employer’s Quarterly Federal Tax Return,
which has been revised to reflect this change. The first quarter Form 941 is completely
unaffected. The benefit of the exemption for any eligible wages paid during the last three



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quarters of 2010 will show up as reduced employer Social Security tax obligations on the
employer’s Forms 941 for those quarters. [See IRC Sec. 3111(d)(5).]

Employers Can Elect Out of Exemption and Claim WOTC Instead

Employers have the option of electing out of the Social Security tax exemption. Then, they can
use wages paid during the one-year period beginning on the qualified new employee’s hiring
date to claim the Work Opportunity Tax Credit (WOTC), assuming the qualified new
employee’s wages are also eligible for the WOTC. Without the election out, wages paid to the
qualified new employee are automatically ineligible for the WOTC.

Key Point. When a lower-paid qualified new employee’s wages could be used to claim either
break, electing out of the Social Security tax exemption will often be beneficial, because the
value of the WOTC will often exceed the value of the exemption. [See IRC Secs. 3111(d)(4) and
51(c)(5).]

Temporary Tax Credit for Retaining New Hires
In addition to the Social Security tax exemption explained above, the HIRE Act also gives
employers a temporary new tax credit of up to $1,000 to help offset wages paid to each qualified
new employee, using the same definition as for the Social Security tax exemption.

The new credit comes in the form of an increase in the employer’s general business credit [under
IRC Sec. 32(b)]. Interestingly enough, the provisions for the new credit are found in Section 102
of the HIRE Act rather than in the Internal Revenue Code itself (more government transparency
in action).

Eligibility Rules and Credit Amount

In order to claim the credit, the qualified new employee must be kept on the payroll for at least
52 consecutive weeks. In addition, wages paid to the new employee during the second 26 weeks
of the 52-week period must equal at least 80% of wages paid during the first 26 weeks of that
period. Otherwise, no credit is allowed.

The credit equals the lesser of 6.2% of wages paid to the qualified new employee during the 52-
consecutive-week period or $1,000. To claim the maximum $1,000 credit, the worker must be
paid at least $16,130 during the 52-week period (6.2% × $16,130 = $1,000). The credit can only
be claimed for the tax year during which the 52-week requirement is first met for the qualified
new employee in question.

Key Point. Understand this: the credit is a one-time break for each qualified new employee
based on wages paid to him during the 52-week period that starts with his employment date.




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No Instant Gratification for Employers

Unfortunately, the credit can only be claimed for the tax year ending after March 18, 2010,
during which the 52-week requirement is first met for the qualified new employee. As you can
see, the 52-week requirement cannot be met until February of 2011 at the earliest – for a worker
who started on the earliest possible date of February 4, 2010. Therefore, a calendar-year
employer can claim the credit on the 2011 federal income tax return, but there is no way to claim
it on the 2010 return. Rats!

If the qualified new employee begins work on the latest possible date of December 31, 2010, the
52-week requirement cannot be met until the bitter end of 2011. Once again, this translates into
having to wait until the calendar-year 2011 return to claim the credit.

Another provision prevents employers from carrying back any portion of an unused Section
38(b) credit attributable to the qualified new employee credit to any tax year beginning before
March 18, 2010. For a calendar-year taxpayer, this provision prevents carrying the credit back to
the 2010 tax year. The bottom line is that calendar-year taxpayers cannot possibly benefit from
the credit until they file their 2011 returns. Sorry!

The timing rules are even more complicated when the employer uses a fiscal tax year. In such
case, the credit cannot be claimed any sooner than on a return for a fiscal tax year that began on
March 1, 2010.

Key Point. Despite the preceding unfavorable timing rules, hiring a qualified new employee as
soon as possible and retaining that person for at least 52 weeks will indeed generate a credit that
will eventually cut the employer’s federal income tax bill by up to $1,000. Clients just need to
understand that the tax savings will not show up anytime soon.


Unfavorable Changes Affecting Taxpayers with Offshore Assets and
Transactions
If you have clients with foreign assets and transactions, watch out, because those clients are now
in the government’s crosshairs more than ever before, thanks to changes in the HIRE Act. Here
is a quick summary of the new provisions.

New Disclosures Required for Foreign Financial Assets Owned by
Individuals
The HIRE Act added new IRC Section 6038D which requires new tax return disclosures from
individuals with interests in “specified foreign financial assets,” if the aggregate value of such
assets exceeds $50,000. Future regulations or IRS guidance may add more disclosure rules to
cover domestic entities used to hold (directly or indirectly) specified foreign financial assets in
the same manner as if the entities were individuals.



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Affected Assets

Specified financial assets are defined to include depository and custodial accounts at foreign
financial institutions; stocks and securities issued by foreign persons that are not held in such
accounts; certain other financial instruments and contracts that are held for investment but that
are not held in such accounts; and interests in foreign entities that are not held in such accounts.

Stiff Penalties for Noncompliance

Failure to provide required tax return disclosures can trigger a $10,000 penalty for each
applicable tax year. Failure to provide disclosures for more than 90 days after the IRS notifies
the taxpayer of a failure can result in additional penalties of $10,000 per 30-day period, or any
part of a 30-day period. If the IRS discovers a failure to make disclosures, the $50,000 threshold
is presumed to be exceeded, and penalties will be assessed accordingly. (Note that the statutory
language appears to allow total Section 6038D penalties of up to $60,000 for each applicable tax
year, but the legislative history seems to indicate that total penalties for a tax year were not
meant to exceed $50,000.)

Effective Date: Tax years beginning after March 18, 2010. (See IRC Sec. 6038D.)

New 40% Accuracy-Related Penalty on Tax Understatements from
Undisclosed Foreign Financial Assets
The HIRE Act establishes a new 40% accuracy-related penalty on any tax understatement that is
attributable to an undisclosed foreign financial asset. Ouch!

Affected Assets

The new 40% penalty covers assets for which taxpayer disclosures are required under IRC Sec.
6038 (dealing with U.S. persons that control foreign corporations or partnerships); IRC Sec.
6038B (dealing with U.S. persons that make certain outbound transfers to foreign entities); IRC
Sec. 6038D (new rules for individuals with interests in specified foreign financial assets, as
explained immediately above); IRC Sec. 6046A (dealing with U.S. persons with interests in
foreign partnerships); and IRC Sec. 6048 (dealing with U.S. persons that have interests in foreign
trusts or make certain transactions with them).

Broad Definition of Tax Understatement

Alarmingly enough, a tax understatement is deemed to be attributable to an undisclosed foreign
financial asset if it is attributable to any transaction involving such an asset. Yikes!

Effective Date: Tax years beginning after March 18, 2010. [See IRC Sec. 6662(b)(7) and (j)(1).]




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New Six-Year Statute of Limitations Period for Tax Understatements
from Foreign Financial Assets
The HIRE Act amends IRC Section 6501 to establish a new six-year assessment period (statute
of limitations period) for tax understatements attributable to certain understated income from
foreign financial assets. This is bad news for affected taxpayers, because the “normal” statute of
limitations period is only three years. For the much harsher six-year statute of limitations rule to
apply, the understated income attributable to foreign financial assets must exceed $5,000.

Effective Date: For returns filed after March 18, 2010, and earlier returns for which the IRC
Section 6501 assessment period had not expired as of March 18, 2010. [See IRC Secs.
6501(e)(1) and 6629(c)(2).]

New Tax Withholding Requirements for Payments to Foreign
Financial Institutions and Other Foreign Entities
The HIRE Act adds new IRC Sections 1471-1474. Together, the new provisions require 30% tax
withholding on affected payments from U.S. sources to foreign financial institutions (such as
interest paid on loans from such institutions) and on “withholdable payments” (as defined) to
certain other foreign entities. Affected foreign financial institutions and withholding agents can
avoid the new 30% withholding requirement by following applicable IRS disclosure, reporting,
and compliance rules.

Effective Date: The new 30% withholding rules generally apply to payments made after
December 31, 2012, but they do not apply to payments on obligations that are already
outstanding as of March 18, 2012. (See IRC Sec. 1471-1474.)

Passive Foreign Investment Company (PFIC) Shareholders Must File
Information Returns
The HIRE Act requires U.S. persons that are shareholders in PFICs to file annual returns to
report whatever information the IRS requires.

Effective Date: March 18, 2010. [See IRC Sec. 1298(f).]

Statute of Limitations Is Suspended by Failures to File Passive
Foreign Investment Company (PFIC) Information Returns or Make
Required Disclosures of Foreign Financial Assets
Another provision in the HIRE Act suspends the IRC Section 6501 assessment period (the statute
of limitations period) for as long as the taxpayer fails to make (1) timely filings of information
returns required for a PFIC pursuant to IRC Secs. 1295(b) or 1298(f) (see immediately above), or
(2) required tax return disclosures of specified foreign financial assets pursuant to the new IRC
Section 6038D rules (explained earlier). This is bad news for affected taxpayers because the
statute of limitations normally runs out after only three years.

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Effective Date: For returns filed after March 18, 2010, and earlier returns for which the IRC
Section 6501 assessment period had not expired as of March 18, 2010. [See IRC Sec.
6501(c)(8).]

Dividend Equivalents Treated as Dividends for Tax Withholding
The HIRE Act mandates that U.S. source “dividend equivalents” (as defined) which are paid to
foreign recipients are treated the same as garden-variety U.S. source dividends, for purposes of
dividend tax withholding rules.

Effective Date: For payments made on or after September 19, 2010. [See IRC Sec. 871(l).]

Unfavorable New Provisions for Unregistered Foreign Targeted
Obligations
Under provisions that pre-date the HIRE Act, “registration-required obligations” (as defined)
must be issued in registered form (as opposed to unregistered “bearer bond” form), in order for
bond issuers to deduct interest payments and in order for interest paid on state and local
municipal bonds to be classified as tax-exempt interest. Certain unfavorable provisions
(including an excise tax) can also apply to issuers when registration-required obligations are not
registered. Under pre-HIRE Act law, “foreign targeted obligations” were exempt from the
aforementioned rules. In a nutshell, foreign targeted obligations are unregistered obligations
(bearer bonds) that satisfy tax-law requirements intended to discourage them from being sold to
U.S persons who might be sorely tempted to use them to evade taxes on the interest payments.
The HIRE Act generally repeals an exemption that previously allowed interest to be deducted by
an issuer of an unregistered foreign targeted obligation. However, the repeal does not apply to an
obligation issued by a natural person that matures in one year or less and is not of a type offered
to the public.

Effective Date: For obligations issued after March 18, 2012. [See IRC Secs. 149(a), 163(f), and
4701(b).]

Another change in the HIRE Act generally repeals a provision that previously allowed tax-
exempt treatment for interest paid on unregistered foreign targeted municipal bonds (certain
bearer bonds that satisfy tax-law requirements intended to discourage them from being sold to
U.S persons). However, the repeal does not apply to bonds that mature in one year or less and
that are not of a type offered to the public.

Effective Date: For bonds issued after March 18, 2012. [See IRC Secs. 149(a), 163(f), and
4701(b).]

Note. The HIRE Act also includes some other technical changes to the rules for foreign targeted
obligations. [See IRC Secs. 149(a), 163(f), and 4701(b).]




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New Withholding Tax Requirement for Unregistered Foreign Targeted
Obligations
Under pre-HIRE Act law, an exception to the general 30% withholding tax requirement for
interest paid to foreign persons was allowed for unregistered foreign targeted obligations (bearer
bonds) that satisfied certain requirements intended to discourage them from being sold to U.S
persons who might have been sorely tempted to use them to evade taxes. The HIRE Act
generally repeals the exemption from the 30% withholding requirement for unregistered foreign
targeted obligations.

Effective Date: For bonds issued after March 18, 2012. [See IRC Sec. 871(b), (c), and (h).]

New 180-Day No-Interest Rule for Tax Refunds from Over-Withholding
on Certain Offshore Payments
Normally, the government is required to pay interest on tax overpayments that are not refunded
within 45 days after the tax return due date (without regard to any extensions) or the tax return
filing date, whichever is later. The HIRE Act increases the no-interest period on certain refunds
of tax overpayments to 180 days. Ouch! This unfavorable change applies to overpayments that
are attributable to taxes withheld under Chapter 3 of the Internal Revenue Code (dealing with
withholding on nonresident aliens and foreign corporations) and Chapter 4 (new withholding
rules for payments to foreign financial institutions and certain other foreign entities, pursuant to
new IRC Secs. 1471-1474, as explained earlier in this analysis).

Effective Date: For overpayments shown on returns due after March 18, 2010, without regard to
any extensions and refund claims filed after March 18, 2010. [See IRC Sec. 6611(e)(4).]

New Electronic Filing Requirement for Foreign Financial Institutions
The HIRE Act allows the IRS to require a foreign financial institution to file electronic returns to
report taxes withheld by the institution pursuant to IRC Sec. 1461 (which deals with withholding
by withholding agents) or IRC Sec. 1474(a) (which deals with withholding on foreign accounts).
The IRS can assess the IRC Section 6721 penalty for failure to file information returns if an
institution fails to comply.

Effective Date: For returns due after March 18, 2010, without regard to any extensions. [See
IRC Secs. 6011(e)(4) and 6724(c).]


Unfavorable Changes Affecting Foreign Trusts and Beneficiaries
We are not done yet. If you have clients that are involved with foreign trusts, you too have to
watch out, because those clients are also targeted by unfavorable changes in the HIRE Act. Here
is a quick summary of the new provisions.



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Broader Definition of U.S. Beneficiary of Foreign Trust
The HIRE Act establishes a broader definition of what constitutes a beneficiary for purposes of
determining when a foreign trust is treated as a grantor trust that is owned by a U.S. beneficiary.
This is a significant change, because said U.S. beneficiary must then report its share of income
from the foreign trust.

Effective Date: March 18, 2010. [See IRC Sec. 679(c).]

Transfer to Foreign Trust Creates Presumption of U.S. Beneficiary
The HIRE Act establishes a rebuttable presumption that a foreign trust is a grantor trust owned
by a U.S. beneficiary (under the IRC Section 679 grantor trust rules), when property is
transferred to the trust by a U.S beneficiary. This is a significant change, because said U.S.
beneficiary must then report its share of income from the foreign trust. This unfavorable
presumption can be rebutted by submitting such information as the IRS may require proof that
none of the trust’s income or corpus has accrued to the benefit of a U.S. person.

Effective Date: For property transfers after March 18, 2010. [See IRC Sec. 679(d).]

New Reporting Requirement for Foreign Trust Grantors
The HIRE Act dictates that U.S. persons treated as grantors (owners) of foreign trusts under the
grantor trust rules (IRC Sections 671 through 679) must report such information as the IRS may
specify.

Key Point. This new requirement is over and above the pre-existing requirement that U.S.
grantors must ensure that their foreign trusts comply with return filing and information reporting
rules.

Effective Date: Tax years beginning after March 18, 2010. [See IRC Sec. 6048(b)(1).]

Increased Minimum Penalty for Failure to Meet Foreign Trust
Reporting Rules
The HIRE Act imposes a new $10,000 minimum penalty for failures to file required foreign trust
returns and notices pursuant to the IRC Section 6048 rules. Previously, the minimum penalty was
based on percentages of amounts that were required to be reported. The new $10,000 minimum
penalty can be imposed even when amounts required to be reported are not known by the IRS.

Effective Date: For failures to file returns and notices due after December 31, 2009. [See IRC
6677(a).]




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Below-Market Deals with Foreign Trusts Treated as Distributions
The HIRE Act treats uncompensated use of foreign trust property by a U.S. grantor, a U.S.
beneficiary, or a U.S. person related to such a grantor or beneficiary as a distribution by the trust
to the grantor or beneficiary. In addition, below-market loans made by foreign trusts to U.S.
persons and discounted uses of foreign trust property by U.S. persons are treated as distributions
that cause the trusts to be considered grantor trusts owned by U.S. persons under the IRC Section
679 rules.

Key Point. The new rules are aimed at discouraging foreign trusts from providing interest-free
loans, and other freebies and discounted goodies, to U.S. persons without any U.S. tax
consequences for those persons.

Effective Date: For uses of property and loan transactions after March 18, 2010. [See IRC Sec.
643(i).]


Miscellaneous Changes
Worldwide Interest Allocation Rules Postponed Again
The HIRE Act postpones the effective date for beneficial rules that would allow interest expense
to be allocated among domestic and foreign corporations on a worldwide basis. The rules are
delayed for another three years, until tax years beginning in 2020. [See IRC Sec. 864(f).]

More Estimated Tax Increases for Large Corporations
For large corporations (those with assets over $1 billion), the HIRE Act increases estimated tax
payments due in July, August, or September of 2014 to 157.5% of the amounts that would
otherwise be required to avoid the IRC Section 6655 interest charge penalty. Estimated payments
due in July, August, or September of 2015 are increased to 121.5% of the amounts that would
otherwise be required. Estimated payment due in July, August, or September of 2019 are
increased to 106.5% of the amounts that would otherwise be required. For an affected
corporation, the next estimated tax payment due after these dates is reduced accordingly. (See
IRC Sec. 6655 and Section 561 of the HIRE Act.)

Issuers of Certain Tax-Credit Bonds Can Elect to Receive Federal
Subsidy
State and local governmental entities have the option of issuing tax-credit bonds instead of
traditional tax-exempt interest bonds. Flipping the coin to the other side, the HIRE Act allows
issuers of certain tax-credit bonds to elect to receive direct payments from the IRS. Bondholders
are then paid taxable interest instead of receiving allocations of tax credits. To clarify, a bond
issuer that makes the new election is given a direct federal subsidy that covers part of the interest
paid to bondholders. The election must be made by no later than the bond issue date.


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Effective Date: For new clean renewable energy bonds (new CREBs), qualified energy
conservation bonds (QECBs), qualified zone academy bonds (QZABs), and qualified school
construction bonds (QSCBs) issued after March 18, 2010. [See IRC Sec. 6431(f).]




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                        Key Developments Affecting
                        Various Types of Taxpayers

Tax Freedom Day Is April 9th This Year
The Tax Foundation announced that Tax Freedom Day for 2010 fell on April 9th. As you know,
Tax Freedom Day is the estimated day when the average taxpayer’s income finally equals her
total tax obligations for the year to federal, state, and local government. Put another way, it is the
day the taxpayer starts working for herself, instead of working to pay the government. With that
thought in mind, it would be very interesting to know what the Tax Freedom Day over/under bet
is in Las Vegas right now for 2011 and beyond.


Second Quarter 2010 Interest Rates on Federal Tax Overpayments
and Underpayments Are Unchanged
The interest rates that apply to federal tax overpayments and underpayments for the second
quarter of 2010 are the same as for the previous four quarters. (See Rev. Rul. 2010-9 and IRC
Sec. 6621.) The second quarter 2010 rates are as follows:

      4% for overpayments and underpayments by unincorporated taxpayers and most
       corporate underpayments

      3% for most corporate overpayments

      1.5% for the portion of corporate overpayments that exceed $10,000

      6% for large corporate underpayments (generally, underpayments by C corporations in
       excess of $100,000)


COBRA Subsidy Extended Again
The Continuing Extension Act of 2010 extended the 65% subsidy for COBRA health insurance
premiums to cover workers who are involuntarily terminated though May 31, 2010. As a result,
the subsidy now covers terminations that occur during the 21-month period extending from
September 1, 2008, and May 31, 2010. The period during which the subsidy can available for a
terminated worker can now be as long as 15 months. (See IRS News Release IR-2010-52 and the
COBRA guidance available at www.irs.gov.)




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Severance Payments Exempt from FICA Tax?
According to a Michigan District Court, severance payments to terminated employees are not
subject to the FICA tax, because they meet the IRC Section 3402(o)(2) definition of
supplemental unemployment compensation benefits. Therefore, they are not wages for FICA tax
purposes. [See U.S. v. Quality Stores, Inc., 105 AFTR 2d 2010-1110 (DC MI).]


IRS Says Golf Cart Tax Credit Is Not for Golf Carts
Last year’s stimulus legislation included a new business and personal tax credit of up to $2,500
for buying a four-wheeled, plug-in electric vehicle that weighs no more than 3,000 pounds when
fully loaded and has a top speed of 20-25 MPH. Although the vehicle must be “primarily for use
on public streets,” the only thing that seems to meet the description is an electric golf cart with a
little bumper sticker that says “intended for street use.” The statutory language for this credit is
buried in a heaping pile of zany tax incentives that were supposed to create all those “green jobs”
that nobody can find. When this goofy break got some press and became a public
embarrassment, the IRS quickly issued a requirement that qualifying vehicles must come with
certifications saying they are not mainly intended for golf course transportation. Fair enough, but
we are still trying to figure out what the credit is meant to cover, if not golf carts. However that
turns out, you will be happy to know the credit is scheduled to remain on the books through
2011. [See IRC Sec. 30(d)(1) and (d)(2) and IRS Notice 2009-58.]




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    Key Developments Affecting Business Taxpayers

New Form 3115 for Accounting Change Requests
The IRS has released an updated version of Form 3115, Application for Change in Accounting
Method. The new form shows a December 2009 revision date. In general, the new form must be
used for requests to change tax accounting methods that are filed after May 31, 2010. (See IRS
Announcement 2010-32.)


Employers Get Postcards from IRS about New Health Insurance Tax
Credit
As explained at the beginning of this chapter, the healthcare legislation created a new tax credit
intended to encourage small employers to provide health insurance coverage to employees. The
credit is one of a relatively few changes that are effective this year. The IRS is publicizing the
credit by issuing postcards to about four million potentially eligible small businesses and tax-
exempt employers.


IRS Announces 2010 Luxury Auto Depreciation Limitations
For vehicles that fall under the dreaded luxury auto depreciation limitation rules, the expiration
of the 50% first-year bonus depreciation break has translated into a $7,900 decrease in maximum
first-year depreciation deductions for new vehicles placed in service in 2010 compared to those
placed in service last year (assuming 100% business use). For affected vehicles placed in service
during 2010, the maximum depreciation deductions for 100% business use are listed below. (See
Rev. Proc. 2010-18.)

New and Used Cars
Year 1                                                    $3,060
Year 2                                                     4,900
Year 3                                                     2,950
Year 4 and thereafter until cost is recovered              1,775

New and Used Light Trucks and Light Vans
Year 1                                                    $3,160
Year 2                                                     5,100
Year 3                                                     3,050
Year 4 and thereafter until cost is recovered              1,875




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Key Point. When vehicles are not used 100% for business, the numbers shown above must be
proportionately reduced to account for the non-business usage. Also, the numbers shown above
only apply when business use exceeds 50%.

Key Point. If 50% first-year bonus depreciation is retroactively reinstated for new vehicles
placed in service in 2010, the first-year amounts shown above will be approximately $8,000
higher.


PAL Groupings Must Be Disclosed on Tax Returns (but Not Yet)
For purposes of applying the dreaded passive activity loss (PAL) rules, Rev. Proc. 2010-13
requires taxpayers to make tax return disclosures of (1) activity groupings and regroupings that
occur during the tax year, and (2) additions of new activities to existing groupings that occur
during the tax year. The new disclosure requirements are effective for tax years beginning on or
after January 25, 2010. Therefore, they will not impact calendar-year 2009 or 2010 returns.
However, calendar-year 2011 returns will be impacted.




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    Key Developments Affecting Individual Taxpayers

Yet Another Court Decision Says LLC Members Are General Partners
for PAL Purposes
In Newell, the Tax Court concluded that a member of a California multi-member LLC was
allowed to use all seven of the passive activity loss (PAL) material participation tests that are
available to general partners, rather than just the three stricter tests that are available to limited
partners. [See Lee Newell, 132 TC Memo 2010-23 (2010).]

The Tax Court and Court of Federal Claims already came to the same conclusion in three earlier
decisions. [See Paul Garnett, 132 TC No. 19 (2009); James Thompson, 104 AFTR 2d 2009-
5381, Court of Federal Claims (2009); and Sean Hegarty, TC Summary Opinion 2009-153
(2009).]

In effect, these decisions all say that interests in multi-member LLCs that are treated as
partnerships for tax purposes are general partner interests, rather than limited partner interests for
purposes of applying the PAL material participation tests. The common thread is the fact that
LLC members are allowed to be heavily involved in LLC activities, under applicable state LLC
laws. In contrast, when a limited partner becomes too involved in a partnership’s affairs, his
limited partner status may be lost under applicable state partnership laws. According to the
courts, this important distinction makes it impossible to conclude that LLC interests are
equivalent to limited partner interests for PAL purposes.

Bottom Line. The courts say LLC members are general partners for PAL purposes, even though
LLC members have limited liability similar to what limited partners have. Period! While some
tax advisers may have adopted this position long ago, it is reassuring to know that the courts
agree. In particular, the Tax Court’s agreement is very reassuring, because it is the law of the
land on this subject, until further notice. In Action on Decision (AOD) 2010-001, the IRS
acquiesced to the outcome in Garnett, but has not yet thrown in the towel, altogether. It should!




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Certain 2010 Haiti Relief Donations Can Be Deducted on 2009 Returns
The so-called Haiti Relief Act (Public Law 111-126) allows calendar-year 2009 tax return
deductions for certain 2010 cash donations to assist Haiti relief efforts. Individuals must itemize
deductions to benefit. Specifically, 2009 tax return deductions can be claimed for Haiti relief
donations made between January 12, 2010, and February 28, 2010, to help victims in areas
affected by the January 12th earthquake. For this purpose, cash donations include contributions
made via check, money order, credit card, charge card, debit card, or phone. For donations under
$250, the taxpayer needs either a bank record (like a cancelled check or credit card statement) or
a receipt from the charity to support the deductible amount. For donations of $250 or more, the
taxpayer must have a receipt from the charity. For donations made by phone or text message, the
IRS says that a service provider bill showing the name of the charity, the donation date, and the
amount is sufficient proof. Beyond that, the normal rules for charitable donation deductions
apply. (See IRS News Releases 2010-12 and 2010-21 and IRC Sec. 170.)




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           Federal Tax Update – Third Quarter 2010

Highlights
     Third quarter 2010 interest rates on federal tax overpayments and underpayments

     2011 inflation-adjusted amounts for HSAs (same as for 2010)

     Guidance on new requirement for health plans to cover adult children

     Guidance on new healthcare-related tax breaks for adult children

     Homebuyer credit fraud runs rampant

     Federal tax consequences for California Registered Domestic Partners

     Instructions for tip credit form revised to reflect temporary employer Social Security tax
      exemption

     Guidance on small business healthcare credit

     Detailed explanation of new small business healthcare credit

     Small business alert: detailed explanation of temporary payroll tax breaks for hiring
      relatives of business owners

     Detailed explanation of burdensome new Form 1099 reporting requirements starting in
      2012




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                       Key Developments Affecting
                       Various Types of Taxpayers

Third Quarter 2010 Interest Rates on Federal Tax Overpayments and
Underpayments Are Unchanged
The interest rates that apply to federal tax overpayments and underpayments for the third quarter
of 2010 are the same as for the previous five quarters. (See Rev. Rul. 2010-14 and IRC Sec.
6621.) The third quarter 2010 rates are as follows:

      4% for overpayments and underpayments by unincorporated taxpayers and most
       corporate underpayments

      3% for most corporate overpayments

      1.5% for the portion of corporate overpayments that exceed $10,000

      6% for large corporate underpayments (generally underpayments by C corporations in
       excess of $100,000)


2011 Inflation-Adjusted Amounts for HSAs Unchanged from 2010
Deductions for HSA contributions can cut your client’s federal income tax bill starting with the
year he obtains coverage under a qualifying high-deductible health plan (HDHP).

      For tax years beginning in 2011, an HDHP must have a deductible of at least (1) $1,200
       for self-only coverage or (2) $2,400 for family coverage (same as for 2010).

      For tax years beginning in 2011, an HDHP cannot have an annual limit on total out-of-
       pocket costs for covered benefits in excess of (1) $5,950 for self-only coverage or (2)
       $11,900 for family coverage (same as for 2010).


Key Point. Having HDHP coverage is the initial hurdle that must be cleared for an individual to
be eligible for HSA contributions.

      For tax years beginning in 2011, the maximum HSA contribution amounts are generally
       (1) $3,050 for self-only coverage or (2) $6,150 for family coverage (same as for 2010).

      If an account owner will be age 55 or older as of 12/31/11, an additional $1,000 can be
       contributed (same as for 2010).


These 2011 amounts were announced in Rev. Proc. 2010-22.

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Guidance on New Requirement for Health Plans to Cover Adult
Children
Pursuant to this year’s healthcare legislation, health plans must cover a participant’s adult child
until he reaches age 26 if the participant is signed up for dependent child coverage. This new
coverage requirement is effective for plan years or policy years that begin after 9/22/10. (See
IRC Sec. 9815.) The IRS has now issued temporary regulations on the new requirement. (See
Temp. Reg. 54.9815-2714T.) Among other things, the guidance clarifies that health plans cannot
condition eligibility for coverage of an under-age-26 child on anything other than the
relationship between the participant and the child. For example, eligibility cannot be conditioned
on the child’s financial dependency, place of residence, income, employment status, or status as
a student. Enrollment of under-age 26 children for which coverage previously ended or was
previously denied (before such things were illegal) must be opened up for at least 30 days on the
first day of the first plan year or policy year that begins after 9/22/10.


Guidance on New Healthcare-Related Tax Breaks for Adult Children
In conjunction with the aforementioned health plan coverage requirement for under-age-26 adult
children, the healthcare legislation also stipulates that employer-provided health coverage for an
employee’s adult child is now treated as a tax-free fringe benefit as long as the child has not
reached age 27 by the end of the year. It does not matter if the adult child is the employee’s
dependent or not. When a self-employed person pays for her own health insurance, the cost of
covering an adult child is eligible for the above-the-line deduction for self-employed health
insurance premiums, as long as the adult child has not reached age 27 by the end of the year. It
does not matter if the adult child is a dependent or not. These changes are effective as of 3/30/10.
[See IRC Secs. 105(b) and 162(l).] In Notice 2010-38, the IRS concludes (among other things)
that tax-free treatment also applies to reimbursements from an employer-provided cafeteria plan,
healthcare flexible spending account (FSA) plan, or health reimbursement arrangement (HRA) to
cover an under-age 27 adult child’s qualified medical expenses.

Key Point. The discrepancy between the until-age-26 coverage requirement and the until-age-27
tax breaks is apparently intended to allow tax breaks for adult children who are covered by health
plans all the way through the end of the plan year or policy year during which they turn age 26
(at which point they could be as little as one day short of hitting age 27).




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    Key Developments Affecting Individual Taxpayers

Homebuyer Tax Credit Fraud Runs Rampant (No Big Surprise)
Before the Worker, Homeownership, and Business Assistance Act of 2009 became law,
absolutely no documentation was required to claim the homebuyer tax credit, which can be up to
$8,000 (the credit has now expired except for certain buyers who are in the military). Since it is a
“refundable” credit, the homebuyer credit can be collected in cash even when the “taxpayer” has
no federal income tax liability. So you can get up to $8,000 in free money just for filling out
some forms. Not surprisingly, tons of fraudulent homebuyer credit claims have already been
filed with many, many more sure to follow.

A recent Treasury Inspector General for Tax Administration (TIGTA) report on IRS efforts to
monitor credits claimed on 2008 returns is illuminating. The IRS discovered that over 10,000
“taxpayers” had received credits for allegedly purchasing the same homes that other “taxpayers”
had also claimed credits for. In one case, 67 different “taxpayers” claimed credits for the same
home. But that is not all. Over $9 million in credits went to prisoners who were incarcerated
when they allegedly made qualifying home purchases.

Now for the good news, if you can call it that. The IRS has supposedly blocked nearly 400,000
bogus claims. The question is, how many bogus claims sailed right through, and how much did
they cost the public?

As this publication went to press, there was talk in some quarters of Congress about resurrecting
the credit because it was such a great idea. Good grief!


IRS Addresses Federal Tax Consequences for California Registered
Domestic Partners
In Private Letter Ruling (PLR) 201021048 and related Chief Counsel Advice (CCA) 201021050,
the IRS addressed the federal income and gift tax consequences of a 2007 California state law
change that mandates community property treatment for income earned by California Registered
Domestic Partners (RDPs). As of 1/1/07, said community property treatment applies for both
California property law purposes and California state income tax purposes.

Accordingly, in PLR 201021048, the IRS concluded that each member of a California RDP
couple must report on his or her separate federal income tax return 50% of the couple’s
combined income from the performance of personal services and 50% of the couple’s combined
income from community property assets. The IRS also concluded that each member is entitled to
50% of the credit for the combined amount of federal income taxes withheld from the couple’s
wages. Finally, the IRS concluded that there are no federal gift tax consequences for any
transfers of wealth from one RDP member to the other that could be construed to occur as a
result of the state-law community property treatment of the couple’s income.


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In CCA 201021050, the IRS indirectly states that the aforementioned 50/50 federal income tax
treatment for an RDP couple’s income is mandatory for tax years beginning after 5/31/10. For
tax years that began before 6/1/10, the 50/50 treatment is not mandatory because California RDP
couples were expected to follow contrary guidance in CCA 200608038. The earlier CCA
concluded that each RDP member should report 100% of his or her income from the
performance of personal services on his or her separate federal income tax return. For open tax
years that began after 12/31/06 and before 6/1/10, RDPs also have the option of filing amended
federal income tax returns (using Form 1040X) to reflect the new 50/50 treatment deal.

Key Point. Although the IRS does not explicitly say so, California RDPs should apparently file
their separate federal income tax returns as unmarried taxpayers rather than using the less-
favorable married filing separate status.




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       Key Developments Affecting Business Taxpayers

Instructions for Tip Credit Form Revised to Reflect Temporary Social
Security Tax Exemption for Employers
The IRS has issued revised instructions for Form 8846 (Credit for Employer Social Security and
Medicare Taxes Paid on Certain Employee Tips) to reflect the new temporary employer Social
Security tax exemption for wages paid between 3/19/10 and 12/31/10 to eligible new hires who
were previously unemployed.

Key Point. See the discussion on claiming the Social Security tax exemption for newly-hired
relatives of small business owners later in this chapter.


Guidance on New Small Business Healthcare Tax Credit
In Notice 2010-44, the IRS issued guidance on the new tax credit for small employers that
provide health insurance coverage for their employees.

In Rev. Rul. 2010-13, the IRS announced the state-by-state benchmark premium amounts that
must be used for credit calculation purposes.

Key Point. Later in this chapter, we cover how the healthcare credit works in detail, including
some of what is discussed in Notice 2010-44 and Rev. Rul. 2010-13.




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                Detailed Explanation of New Small
               Employer Health Insurance Tax Credit

The healthcare legislation enacted in March of 2010 includes a new tax credit for qualifying
small employers. The credit can cover up to 35% of employee health insurance costs. It is
available for tax years beginning in 2010, and it can be claimed for eligible costs that were
incurred before the healthcare legislation became law.

Key Point. The rules explained in this analysis apply to tax years beginning in 2010-2013.
Different rules are scheduled to take effect in 2014.


Basics on How the Credit Works
A qualifying small employer is one that (1) has no more than 25 full-time-equivalent (FTE)
employees, (2) pays an average FTE wage of no more than $50,000, and (3) has a qualifying
healthcare arrangement in place. (See IRC Sec. 45R.)

The credit is quickly phased out when the number of FTE employees exceeds 10 and when the
average FTE wage exceeds $25,000. Phase-out is complete when the number of FTE employees
hits 25 or when the average FTE wage hits $50,000. Therefore, it is inaccurate to imply (as the
statute does) that an employer can have 25 FTE employees or an average wage of $50,000 and
still qualify for the credit.

Anyway, a qualifying healthcare arrangement is one that requires the employer to (1) pay at least
50% of the cost of each enrolled employee’s qualifying health insurance coverage and (2) pay
same cost percentage for all enrolled employees. However for tax years beginning in 2010, this
uniform cost percentage requirement does not apply. Instead, a favorable transition rule
published in IRS Notice 2010-44 allows the employer to pay an amount equal to at least 50% of
the cost of single coverage for all enrolled employees (including those with more-expensive
family or self-plus-one coverage). To be eligible for the credit in later years, however, the
employer must pay the same cost percentage for all enrolled employees, including those with
more expensive coverage.

According to IRS Notice 2010-44, qualifying health insurance coverage includes (1) major
medical coverage; (2) limited scope coverage for dental care, vision care, long-term care, nursing
home care, home health care, community-based care, or any combination of these; (3) hospital
indemnity coverage (such as so-called daily hospital insurance) or other fixed indemnity
coverage; and (4) Medicare supplemental health insurance and certain other types of
supplemental coverage.

In the usual situation where the employer pays less than 100% of the cost of coverage (with
employees picking up the balance), the credit can only be claimed for the percentage of the cost
that is paid by the employer.

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Healthcare premiums paid under a section 125 cafeteria benefit plan salary-reduction
arrangement do not count as an employer-paid cost.

The credit is allowed for all types of qualifying small employers including C and S corporations,
partnerships, LLCs, and sole proprietorships. However, certain workers who are also owners of
the employer are classified as excluded workers, and costs to cover them are ineligible for the
credit. Specifically, sole proprietors, partners, more-than-2% S corporation shareholder-
employees, and more-than-5% C corporation shareholder-employees are excluded workers. Most
employees who are members of such an owner’s family, including in-laws and dependents, are
also classified as excluded workers, and costs to cover them are also ineligible for the credit.
[See IRC Sec. 45R(e)(1)(A).]

Key Point. It is clear that an employee who is married to a more-than-2% S corporation
shareholder or a more-than-5% C corporation shareholder is an excluded worker. However, it
appears that an employee who is married to a sole proprietor or a partner is not an excluded
worker. We await IRS guidance on this issue, but we may not get any.


Calculating FTE Employees and FTE Wages
As you will see, a complicated phase-out rule quickly reduces the credit if the business in
question has over 10 FTE employees or an average FTE wage above $25,000. Phase-out is
complete when the number of FTE employees hits 25 or when the average FTE wage hits
$50,000. Therefore, the FTE employee and FTE wage calculations are super-important. Here is
the drill.

The number of FTE employees for the year is calculated by dividing total paid employee hours
for the year by 2,080. However, if a worker is paid for more than 2,080 hours, the excess hours
are excluded from the calculation. Hours worked by seasonal employees who work 120 days or
less during the year (counting all days that any hours are worked) are also excluded from the
calculation. The calculated number of FTE employees is then rounded down to the next whole
number.

The average FTE wage for the year is calculated by dividing total employee wages for the year
by the number of FTE employees for the year. Wages paid to seasonal employees who work 120
days or less (counting all days that any hours are worked) are excluded from the calculation. The
calculated FTE wage amount is then rounded down to the next multiple of $1,000.

Because the credit cannot be claimed for costs to cover excluded workers (certain owners and
their relatives, as explained earlier), their hours and wages are not counted in determining the
number of FTE employees or the average FTE wage.

See Notice 2010-44 for additional details on how to calculate the number of FTE employees and
the average FTE wage.




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Key Point. A business can have more than 25 workers and still be eligible for the credit when
some of the workers are part-time employees, seasonal employees, or excluded workers.


Calculating the Tentative Credit before the Phase-Out Rule
The maximum possible credit, which we will call the tentative credit, equals 35% of the lesser of
(1) the employer’s real-world cost of providing employee health coverage under its qualifying
arrangement or (2) the imaginary government-world cost to obtain “benchmark” coverage in the
small-group market as determined on a state-by-state basis by the Department of Health and
Human Services (HHS).

In the usual situation where the employer pays less than 100% of the real-world cost of coverage
under its qualifying arrangement, the tentative credit is calculated by multiplying the real-world
cost or the imaginary benchmark cost (whichever is less) by the percentage of real-world cost
paid by the employer.

                                              Example

Epsilon Corporation is a qualifying small employer. The real-world cost of Epsilon’s
qualifying healthcare arrangement is $150,000, and the company pays 60% of the cost.
Assume the imaginary benchmark cost in Epsilon’s state is $175,000. Epsilon’s
tentative credit is $31,500 (60% × $150,000 × 35%).


                                              Example

Friendly LLC is a qualifying small employer. The real-world cost of Friendly’s qualifying
healthcare arrangement is $150,000, and the company pays 75% of the cost. Assume
the imaginary benchmark cost in Friendly’s state is $130,000. Friendly’s tentative credit
is $34,125 (75% × $130,000 × 35%).

The initial stab at providing imaginary benchmark costs for tax years beginning in 2010 was
published in Rev. Rul. 2010-13. The benchmark cost for single coverage ranges from a high of
$6,204 (Alaska) to a low of $4,215 (Idaho). The benchmark cost for family coverage ranges from
a high of $14,138 (Massachusetts) to a low of $9,365 (Idaho). For higher-cost areas within
certain states, HHS may provide additional 2010 imaginary benchmark amounts later on.


Calculating the Allowable Credit after the Phase-Out Rule
An employer’s allowable credit (the amount that can actually be claimed on the employer’s
federal income tax return) equals the tentative credit (based on 35% of the applicable healthcare
cost figure) only when the employer has (1) 10 or fewer FTE employees and (2) an average FTE
wage of $25,000 or less.


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If the employer has more employees and/or a higher average wage, the allowable credit is
quickly reduced under a complicated two-tiered phase-out rule. Here is the drill.

Tier 1 Phase-Out Factor
The tentative credit amount is reduced by a phase-out factor that depends on the number of FTE
employees in excess of 10. Specifically, the tentative credit is reduced by 6.667% for each excess
employee. For instance, say your client’s business has 15 FTE employees. It has five excess
employees, and the tier 1 phase-out factor is therefore 33.335% (5 × 6.667%). Once a business
hits 25 FTE employees, the allowable credit is reduced to zero because the tier 1 phase-out factor
is 100%. However, if the business has 10 or fewer FTE employees, the tier 1 phase-out factor is
inapplicable.

Tier 2 Phase-Out Factor
The tentative credit amount is also reduced by a second phase-out factor that depends on the
average FTE wage in excess of $25,000. Specifically, the tentative credit is reduced by 4% for
each $1,000 of excess wage. For instance, say your client’s business has an average FTE wage of
$35,000. The excess wage is $10,000, and the tier 2 phase-out factor is therefore 40% (10 × 4%).
Once the business hits an average FTE wage of $50,000, the allowable credit is reduced to zero
because the tier 2 phase-out factor is 100%. However, if the average FTE wage is $25,000 or
less, the tier 2 phase-out factor is inapplicable.

                                              Example

Gentle Partnership is a qualifying small employer with 15 FTE employees and an
average FTE wage of $35,000. Assume Gentle’s tentative credit is $37,800 (35% ×
$108,000 of real-world healthcare costs). Since Gentle has five excess employees, the
tier 1 phase-out factor reduces the tentative credit by 33.335%, or $12,600 (33.335% ×
$37,800). Since Gentle has $10,000 of excess FTE wage, the tier 2 phase-out factor
reduces the tentative credit by another 40%, or $15,120 (40% × 37,800). Therefore,
Gentle’s allowable credit is only $10,080 ($37,800 - $12,600 - $15,120). This amounts
to an effective credit rate of only 9.33% (credit of $10,080 for $108,000 of healthcare
costs) versus the maximum rate of 35%.

When all is said and done, the credit will only provide truly meaningful benefits to truly small
employers that pay truly modest wages. In the real world, however, such employers are the least
likely to have any interest in providing company-paid health coverage.


Impact of Offering Several Types of Healthcare Coverage
Some small employers may offer several different types of qualifying health insurance coverage
such as major medical coverage, dental coverage, and vision care coverage. Each type of
coverage must be tested separately for purposes of meeting the requirement to pay at least 50%


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of the cost. For instance, say the employer pays 50% of the cost for major medical coverage and
25% of the cost of dental and vision care coverage. Only the cost of the major medical coverage
can be taken into account for purposes of calculating the credit.

In addition, offering several types of coverage has no impact on the imaginary benchmark cost
limitation rule. For instance, say an especially generous employer pays 50% of the cost for major
medical, dental, and vision care coverage. Costs for dental and vision care coverage are not
included in the state-by-state imaginary benchmark cost figures. If 50% of the applicable
imaginary benchmark cost is less than the employer’s real-world cost to provide the more-
generous coverage, the credit calculation will be based on 50% of the applicable imaginary
benchmark cost. Sorry about that!


Special Rules for Tax-Exempt Small Employers
For qualified small employers that happen to be tax-exempt not-for-profit organizations, the
maximum credit percentage is 25%, and the phase-out rule explained above applies to them too.
In addition, the allowable credit amount for the year cannot exceed the sum of (1) federal income
tax and 1.45% Medicare tax withheld from employee wages for that year plus (2) the employer’s
1.45% Medicare tax on wages for that year. Since there is no federal income tax liability to
offset, the allowable credit amount for a tax-exempt employer is refunded to the employer in
cash.


Other Considerations
As we said earlier, the credit can be claimed for eligible healthcare costs incurred in tax years
beginning in 2010 before the healthcare legislation was enacted. (See Notice 2010-44.)

An employer’s federal income tax deduction for employee healthcare costs is reduced by the
amount of the credit. [See IRC Sec. 280C(h).]

The credit is classified as a specified general business credit, under IRC Sec. 38(b) and (c). As
such, the credit can be used to offset both regular federal income tax and any AMT. It cannot be
used to offset federal employment tax liabilities. Any unused credit amount can be carried back
for one year (but not to any pre-2010 year) and ahead for 20 years. Therefore, unused credits for
tax years beginning in 2010 can only be carried forward. (See Notice 2010-44.)

See Notice 2010-44 for guidance on how state health insurance credits and subsidies impact the
credit.

Last but not least, we make the observation that in this economy, it is exceedingly doubtful that
the credit will induce many small businesses to suddenly start providing employee health
coverage. The fact that the credit rules are too complicated to be easily explained does not help
matters. Presumably, a fair number of small businesses that already provide health coverage will
qualify for the credit, and we hope some of your clients fit into that category.

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                Small Business Alert: Temporary
              Payroll Tax Breaks for Hiring Relatives

In a weak economy, keeping more money within the family unit is a worthy goal. For small
business clients, one way to accomplish that goal is to hire family members instead of outsiders
when additional workers are needed. Great idea! As a bonus, your client might qualify for two
temporary payroll tax breaks. As you will see, the odds of collecting these breaks are much better
if the newly hired relative happens to be the business owner’s spouse rather than some other
relative. Here is the story.


Temporary Social Security Tax Break for Wages Paid to New Hires
The Hiring Incentives to Restore Employment (HIRE) Act, which became law in March of 2010,
grants a temporary employer Social Security tax exemption for wages paid by a qualified
employer to a qualified new employee between 3/19/10 and 12/31/10. Specifically, such wages
are exempt from the 6.2% employer portion of the Social Security tax. [See IRC Sec. 3111(d).]

We will call this new break the Social Security tax exemption.

Key Point. There is no change in the 6.2% employee portion of the Social Security tax on wages
that are collected via FICA tax withholding from employee paychecks. There is also no change
in the 2.9% Medicare tax on wages (1.45% is paid in via FICA tax withholding from employee
paychecks, with the other 1.45% paid by the employer).

For each qualified new employee, the employer’s 2010 Social Security tax bill can be cut by a
maximum of $6,621.60 (6.2% × $106,800 Social Security tax ceiling = $6,621.60). The tax
savings will be less if the qualified new employee’s wages paid during the exemption period
(3/19/10 through 12/31/10) are below the $106,800 Social Security tax ceiling (which will
usually be the case). Hiring a qualified new employee sooner rather than later will usually result
in more tax savings.

Key Point. According to FAQs About Claiming the Payroll Exemption on the IRS website, the
Social Security tax exemption applies to wages paid between 3/19/10 and 12/31/10 as opposed to
wages paid for work performed between those dates. (See PE7.)

Qualified Employers Include All Private-Sector Businesses
Qualified employers include private-sector businesses as well as tax-exempt not-for-profit
organizations and certain public higher-education institutions (other public employers are
ineligible). [See IRC Sec. 3111(d)(2).]




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Qualified New Employees Can Include Owner’s Spouse (Maybe Other
Relatives Too)
A qualified new employee is a worker who begins employment between 2/4/10 and 12/31/10 and
who was not employed for more than 40 hours during the 60-day period ending on the start date.
Both part-time and full-time workers can meet this description. However, the Social Security tax
exemption is not allowed for wages paid to a worker who is hired to replace another worker,
unless that person quit voluntarily or was discharged for cause. According to updated
instructions to Forms W-2 and W-3, being discharged in a downsizing counts as being
discharged for cause.

The new worker must certify with a signed affidavit that he or she was not employed for more
than 40 hours during the 60-day period ending on the start date. [See IRC Sec. 3111(d)(3).] The
certification can be made by completing and signing new IRS Form W-11 (Hiring Incentives to
Restore Employment (HIRE) Act Employee Affidavit). The Form W-11 is not turned in to the
IRS, but it should be kept with the employer’s tax records.

Mind the Related-Party Disallowance Rules
Here is where it gets interesting for small employers. The Social Security tax exemption is
disallowed for wages paid to any person who fits the general description of a qualified new
employee but who has a prohibited relationship to the employer under the same related-party
disallowance rules that apply for purposes of the Work Opportunity Tax Credit (WOTC). [See
IRC Secs. 3111(d)(3)(D) and 51(i)(1).] We will call such workers ineligible employees.

Related-Party Rule for Employers Treated as Individuals
When the employer is a sole proprietorship or (presumably) a single-member LLC that is treated
as a sole proprietorship for tax purposes, the employer is considered to be an individual taxpayer
for purposes of the Social Security tax exemption. In this case, ineligible employees are defined
by reference to the list of persons who can potentially be qualifying relatives of the taxpayer
(employer) for purposes of claiming dependent exemption deductions. These persons include (1)
the taxpayer’s (employer’s) child, including a stepchild, adopted child, eligible foster child, or
descendant of the taxpayer’s child (most often a grandchild); (2) the taxpayer’s (employer’s)
brother, stepbrother, half brother, sister, stepsister, half sister, or a descendent of one of these
individuals (most often a niece or nephew); (3) the taxpayer’s (employer’s) son-in-law, daughter-
in-law, father, stepfather, father-in-law, mother, stepmother, mother-in-law, brother-in-law,
sister-in-law, aunt, or uncle; and (4) any non-relative who is classified as the taxpayer’s
(employer’s) dependent because the person lives in the same household. [See IRC Sec. 51(i)(1)
and IRC Sec 152(d)(2)(A) through (H).]

Somewhat surprisingly, the taxpayer’s (employer’s) spouse does not appear on the list of
ineligible employees. This means that wages paid to a newly hired spouse are eligible for the
Social Security tax exemption if the spouse fits the general description of a qualified new
employee (previously unemployed, hired between the magic dates, and so on).


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Key Point. Most other new hires who are related to the taxpayer (including in-laws) will be on
the list of ineligible employees.

                                               Example

Hank operates his business as a sole proprietorship. Therefore, he is treated as the
employer if the business has any employees. Assume Hank hires his unemployed wife,
Helen, who meets the description of a qualified new employee. Hank can take
advantage of the Social Security tax exemption for wages paid to Helen between
3/19/10 and 12/31/10. However, if Hank also hires his unemployed son, Harry, he is an
ineligible employee because of his prohibited relationship (son) with the employer
(Hank).

Related-Party Rule for Corporate Employers
When the employer is a corporation, ineligible employees include (1) any relatives (as defined
earlier) of an individual who owns [directly or indirectly under IRC Sec. 267(c)] more than 50%
of the employer’s stock and (2) any dependents of any relatives (as defined earlier) of a more-
than 50%-shareholder. [See IRC Sec. 51(i)(1).]

Under this rule, the spouse of a majority shareholder will not be an ineligible employee except in
highly unusual circumstances. This means that wages paid to a majority shareholder’s spouse
will almost always be eligible for the Social Security tax exemption if the spouse fits the general
description of a qualified new employee (previously unemployed, hired between the magic dates,
and so on).

Most other new hires who are related to a majority shareholder (including in-laws) will be
ineligible employees.

However, new hires who are only related to minority shareholders (taking into account both
direct and indirect stock ownership) can be eligible if they fit the description of a qualified new
employee. This can include relatives who are students hired to work over the summer.

                                               Example

Donald, Enid, and Floyd each own one-third of the shares in DEF, Inc. They are not
related. Assume DEF hires Enid’s unemployed husband, Edward, who meets the
description of a qualified new employee. DEF can take advantage of the Social Security
tax exemption for wages paid to Edward between 3/19/10 and 12/31/10.

Assume DEF also hires Donald’s unemployed son, Dale, and Floyd’s unemployed
daughter, Fern. They both meet the qualified new employee description. DEF can take
advantage of the Social Security tax exemption for wages paid to Dale and Fern
between 3/19/10 and 12/31/10, because being related to minority shareholders does not
disqualify them.


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Warning. With family corporations, the related-party rule can be tricky, as the following
example illustrates.

                                              Example

Joe owns 60% of the shares in Joeco, Inc. Assume Joeco hires Joe’s unemployed wife,
Jill, who meets the description of a qualified new employee. Joeco can take advantage
of the Social Security tax exemption for wages paid to Jill between 3/19/10 and
12/31/10.

Assume Joe’s daughter June owns the other 40% of Joeco’s stock. If Joeco hires
June’s unemployed husband, Jeff, he is an ineligible employee because he has a
prohibited relationship (son-in-law) with Joe, who is the employer’s majority
shareholder. However, if June was unrelated to Joe, her husband Jeff could meet the
description of a qualified new employee because being related to a minority shareholder
(June) would not disqualify him.

Related-Party Rule for Partnership Employers
When the employer is a partnership or (presumably) a multi-member LLC that is treated as a
partnership for tax purposes, ineligible employees are any relatives (as defined earlier) of an
individual who owns [directly or indirectly under IRC Sec. 267(c)] more than a 50% interest in
the partnership’s capital and profits. [See IRC Sec. 51(i)(1).]

Under this rule, the spouse of a majority partner will not be an ineligible employee. This means
that wages paid to a majority partner’s spouse will be eligible for the Social Security tax
exemption if the spouse fits the general description of a qualified new employee (previously
unemployed, hired between the magic dates, and so on).

Most other new hires who are related to a majority partner (including in-laws) will be ineligible
employees.

However, new hires who are only related to minority partners (taking into account both direct
and indirect ownership) can be eligible if they fit the description of a qualified new employee.
This can include relatives who are students hired to work over the summer.




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                                              Example

Glenda, Hank, and Ingrid are equal one-third partners in the GHI Partnership. They are
not related. Assume GHI hires Glenda’s unemployed husband, Glen, who meets the
description of a qualified new employee. GHI can take advantage of the Social Security
tax exemption for wages paid to Glen between 3/19/10 and 12/31/10.

Assume GHI also hires Hank’s unemployed daughter, Helen, and Ingrid’s unemployed
son, Irving. They both meet the qualified new employee description. GHI can take
advantage of the Social Security tax exemption for wages paid to Helen and Irving
between 3/19/10 and 12/31/10, because being related to minority partners does not
disqualify them.

Warning. With family partnerships, the related-party rule can be tricky, as the following
example illustrates.

                                              Example

Rich is a 51% partner in the RS Partnership. Assume RS hires Rich’s unemployed wife,
Rowena, who meets the description of a qualified new employee. RS can take
advantage of the Social Security tax exemption for wages paid to Rowena between
3/19/10 and 12/31/10.

Assume Rich’s daughter Rylee owns the other 49% of RS. If RS hires Rylee’s
unemployed husband, Ron, he is an ineligible employee because he has a prohibited
relationship (son-in-law) with Rich, who is the employer’s majority partner. However, if
Rylee was unrelated to Rich, her husband Ron could meet the description of a qualified
new employee because being related to a minority shareholder (Rylee) would not
disqualify him.


Temporary Tax Credit for Retaining New Hires
In addition to the temporary Social Security tax exemption, the HIRE Act also grants a
temporary tax credit of up to $1,000 for wages paid to each qualified new employee, using the
same definition as for the Social Security tax exemption (the worker must begin employment
between 2/4/10 and 12/31/10, have been unemployed during the 60-day period ending on the
start date, and so on). However, the employer must meet two additional requirements to claim
the credit: (1) the new hire must be retained for at least 52 consecutive weeks, and (2) wages
paid during the second 26 weeks of the 52-week period must equal at least 80% of wages paid
during the first 26 weeks of that period. (See Section 102 of the HIRE Act.)

We will call this new break the employee retention credit.




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To be clear, the employer can claim the Social Security tax exemption for wages paid to a
qualified new employee between 3/19/10 and 12/31/10, and the employer can also claim the
employee retention credit if the two additional requirements are met for the worker in question.
Claiming one break does not prevent claiming the other.

Calculating and Claiming the Credit
The employee retention credit amount equals the lesser of (1) 6.2% of wages paid to the
qualified new employee during the 52-consecutive-week period or (2) $1,000. To claim the
maximum $1,000 credit, the new hire must be paid at least $16,130 during the 52-week period
(6.2% × $16,130 = $1,000).

In contrast to the Social Security tax exemption, hiring an eligible worker any sooner than
12/31/10 will not result in a larger tax benefit for the employer. That is because the full $1,000
employee retention credit can potentially be claimed for a new hire who starts work any time
between 2/4/10 and 12/31/10.

Key Point. To summarize so far, the credit is a one-time tax benefit for each eligible worker, and
the credit amount is based on wages paid during the 52-week period that begins with that
worker’s employment date.

The credit is allowed for the tax year during which the 52-week requirement is first met for the
worker in question. Since that requirement cannot possibly be met any sooner than February of
2011, the credit cannot be claimed for tax years that end in 2010 (for calendar-year employers,
the credit can be claimed on calendar-year 2011 returns). The credit is implemented via an
increase in the general business credit under IRC Sec. 38(b). No portion of any unused Section
38(b) credit that is attributable to the retained employee credit can be carried back to any tax year
that begins before 3/18/10. Taken together, these timing rules ensure that the credit will not
result in any immediate tax-saving gratification for employers.

Qualified New Employees Can Include Owner’s Spouse (Maybe Other
Relatives Too)
When a business owner’s newly-hired spouse or relative fits the description of a qualified new
employee for purposes of the Social Security tax exemption, that person is also a qualified new
employee for purposes of the employee retention credit, assuming the two additional
requirements for the credit are satisfied. See the earlier discussion and examples regarding when
spouses and other relatives can be qualified new employees for purposes of the Social Security
tax exemption. The exact same considerations apply for purposes of the employee retention
credit (assuming the two additional requirements for the credit are met for the person in
question).




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Work Opportunity Tax Credit (WOTC) Considerations
When wages paid to a qualified new employee are eligible for both the Social Security tax
exemption and the WOTC, the employer can “elect out” of the Social Security tax exemption
and instead claim the WOTC. For lower-paid workers, the WOTC will often be more lucrative.
Without an election out, however, the WOTC cannot be claimed for wages paid during the one-
year period beginning on the qualified new employee’s hiring date. [See IRC Secs. 3111(d)(4)
and 51(c)(5).]

The election out can be made on an employee-by-employee basis by simply not claiming the
Social Security tax exemption for the employee in question. (See PE8 and PE9 in FAQs About
Claiming the Payroll Exemption on the IRS website.)

When wages paid to a qualified new employee are eligible for both the employee retention credit
and the WOTC, both breaks can be claimed. In other words, claiming one does not prevent
claiming the other. (See PE11 in FAQs About Claiming the Payroll Exemption on the IRS
website.)

Key Point. The WOTC can only be claimed for wages paid to newly hired members of targeted
groups (such as qualified veterans, qualified felons, qualified summer youth employees, long-
term family assistance recipients, and so on). Spouses and other relatives of small business
owners are not terribly likely to be members of targeted groups, so the WOTC coordination issue
may be irrelevant in most real-life situations.


The Bottom Line
The availability of the two temporary tax breaks explained in this section do not make the case
for hiring a spouse or relative. That said, these breaks can be meaningful for small business
owners who were going hire spouses or relatives anyway. If so, great! But watch out for the
related-party loss disallowance rules. They are tricky, especially in situations where businesses
are owned by several related individuals.




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  Healthcare Legislation Imposes Burdensome New
 Form 1099 Reporting Requirements (Starting in 2012)

Businesses have grown accustomed to existing requirements to report certain types of payments
on annual Form 1099 information returns. However, the healthcare legislation enacted in March
of 2010 adds new Form 1099 reporting requirements. Complying with them may add
significantly to your small business clients’ paperwork burdens. While the new rules do not
apply to payments made before 2012, it may not be too soon to start helping clients gear up to
deal with them. This section gives you a quick summary of what you need to know right now.

Key Point. The healthcare legislation does not require Form 1099 reporting of payments that are
made for non-business reasons.


Current Form 1099 Reporting Rules in a Nutshell
For many years, businesses have been required to report various types of payments on various
versions of Form 1099. For instance, when a business pays $600 or more during a calendar year
to an independent contractor for services, the business must issue the contractor a Form 1099-
MISC that reports the total amount paid in that year. The business must also furnish a copy of the
Form 1099-MISC to the IRS. This reporting procedure helps the contractor remember to include
the payments as income on his tax return, and it helps the IRS to make sure that happens. Fair
enough.

Under the current rules, other types of payments that businesses must report on Forms 1099
include (1) commissions, fees, and other forms of compensation paid to a single recipient when
the total amount paid in a calendar year is $600 or more; and (2) interest, rents, royalties,
annuities, and other income items paid to a single recipient when the total amount paid in a
calendar year is $600 or more.

When a Form 1099 is required, it must show the total amount of payments in the calendar year,
the name and address of the payee, the tax ID number (TIN) of the payee (for privacy reasons, it
is okay to show a truncated TIN on a 1099 issued to an individual payee), contact information for
the payer, and the payer’s TIN.

If the business does not have a payee’s TIN, it may be required to institute backup federal
income tax withholding at a 28% rate on payments to that payee. (See IRC Sec. 3406.)

In most cases, the rules summarized above apply equally to payments made by non-profit
organizations, because they are generally considered to be businesses for Form 1099 reporting
purposes.

If a payer inadvertently fails to issue a proper Form 1099, the IRS can assess a $50 penalty. The
penalty for each intentional failure can be $100 or more. (See IRC Secs. 6721, 6722, and 6723.)

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Most Payments to Corporations Need Not Be Reported under Current
Rules
Under the rules that apply right now, most payments to corporations are exempt from any Form
1099 reporting requirements. Naturally, there are a few exceptions. For instance, payments of
$600 or more in a calendar year to a corporate law firm must be reported on a Form 1099-MISC
for that year.

                                              Example

Billco, LLC makes monthly payments to rent office space from a corporate lessor. Under
the current rules that apply through the end of 2011, there is no Form 1099 reporting
requirement for the payments, because they are made to a corporation.

Payments for Property Need Not Be Reported under Current Rules
Under the rules that apply right now, there is generally no requirement to issue Forms 1099 to
report payments for property (merchandise, raw materials, equipment, and just about anything
else you can put your hands on).

                                              Example

Retail Associates, LLC buys a delivery van, display shelving, and computer equipment.
Under the current rules that apply through the end of 2011, there is no Form 1099
reporting requirement for these payments, because they are for property.


Healthcare Legislation Changes the Deal for 2012 and Beyond
The healthcare legislation makes two big changes to the existing Form 1099 reporting rules and a
third change that is hard to assess without further guidance. [See IRC Sec. 6041(a), (i), and (h).]

Change No. 1: Payments to Corporations Must Be Reported
Starting in 2012, if a business pays a corporation $600 or more in a calendar year, it must report
the total amount of the payments on an information return for that year. Presumably, Form 1099-
MISC will be used for this purpose, or a new type of Form 1099 will be developed. (Payments to
corporations that are tax-exempt organizations will be exempt from this new requirement.)




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                                               Example

Bizco, Inc. pays $30,000 to rent office space from a corporate lessor. Under the new
rule that will take effect in 2012, the $30,000 must be reported on a Form 1099. Before
2012, most payments to corporations are exempt from any Form 1099 reporting
requirements.

In 2012, Bizco pays $2,000 for four employees to attend a seminar put on by a
corporation in the seminar business. Under the new rule that will take effect in 2012, the
$2,000 must be reported on a Form 1099.

In 2012, several of Bizco’s employees go on a business trip, and Bizco pays $1,500 to a
hotel operated by a corporation. Under the new rule that will take effect in 2012, the
$1,500 must be reported on a Form 1099.

In 2012, Bizco spends $1,000 at a local restaurant for a modest holiday gathering for
employees. The restaurant is operated by a corporation. Under the new rule that will
take effect in 2012, the $1,000 must be reported on a Form 1099.

As you can see, the new requirement to report payments to corporations will undoubtedly result
in the issuance of many millions of additional Forms 1099 each year. (Presumably, payments
between related corporations will not be exempted.)

Also, businesses must obtain a TIN from each corporate payee to avoid the requirement for
backup withholding of federal income tax.

On the other side of the coin, if your client runs a corporate business, it will have to supply
customers with the company’s TIN to avoid backup withholding on payments to it.

Change No. 2: Payments for Property Must Be Reported
Starting in 2012, if a business pays $600 or more in a calendar year to any payee (including an
individual) as “amounts in consideration for property,” the total amount of such payments must
be reported on an information return for that year. Once again, the term “property” means
equipment, merchandise, raw materials, and just about anything else you can put your hands on.
Presumably, Form 1099-MISC will be used to reported affected payments, or a new type of
Form 1099 will be developed for this purpose.




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                                               Example

Fargo, Inc. buys equipment from a supplier for $25,000. Under the new rule that will
take effect in 2012, the $25,000 must be reported on a Form 1099. Before 2012,
payments for property are exempt from any Form 1099 reporting requirements.

In 2012, Fargo buys inventory from a supplier for $20,000. The $20,000 must be
reported on a Form 1099.

In 2012, Fargo buys an old pickup truck from an individual for $1,500. The $1,500 must
be reported on a Form 1099.

In 2012, Fargo spends $1,000 at a specialty food and liquor store to buy food and
beverages for a company party. The $1,000 must be reported on a Form 1099.

In 2012, Fargo spends $750 at an office supply store for supplies. The $750 must be
reported on a Form 1099.

As you can see, the new requirement to report payments for property will undoubtedly result in
the issuance of many millions of additional Forms 1099 each year.

For each payee that must be issued a Form 1099, the payer must obtain a TIN in order to avoid
the requirement to institute backup withholding of federal income tax.

On the other side of the coin, if your client’s business sells property, it will have to supply
customers with its TIN to avoid backup withholding on payments to it.

Change No. 3: Payments of “Gross Proceeds” Must Be Reported
In general, the current Form 1099 reporting rules do not attempt to cover payments where the
payer cannot determine the payee’s taxable profit or gain. One exception is for payments to a
non-corporate service provider, such as an independent contractor. Under the current rules, when
the gross amount of payments to a non-corporate service provider in a calendar year add up to
$600 or more, the total must be reported as non-employee compensation on a Form 1099 for that
year. We understand that.

Now it gets a little confusing. Under a third new rule that will take effect in 2012, payments of
$600 or more in “gross proceeds” to a payee in a calendar year must be reported on an
information return for that year. Perhaps this new gross proceeds rule is intended to force
businesses to issue 1099s for payments to non-corporate payees such as restaurants, motels, gas
stations, repair shops, and seminar providers. We await IRS clarification on this issue.




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Action Plan
Dealing with the new Form 1099 reporting rules is not going to be any fun. The more you think
about it, the more this truth becomes self-evident.

Your client’s business may have to modify its accounting procedures to capture payee
information that will be needed to comply with the new rules.

One key point to remember is that TINs must be obtained from vendors to avoid having to
institute backup federal income tax withholding on payments made to them. By the same token,
your client’s business will have to make sure that its customers have its TIN to avoid backup
withholding on payments made to it. And if backup withholding does occur on payments made
to your client’s business, it must be prepared to track the withheld amounts so credit can be
claimed for them at tax return time. [See IRC Sec. 31(c).]

If your client’s business winds up on either side of the backup withholding rules, it can be a real
mess. And with lots more 1099s flying around, the odds rise proportionately for TIN screw-ups
that will result in backup withholding messes.

Fortunately, the new Form 1099 reporting rules (including any backup withholding implications)
do not cover payments made before 2012. So there is still plenty of time to help clients plan for
what may be a daunting compliance task. Do not waste that time!

Key Point. The IRS Commissioner has informally stated that businesses will not have to issue
1099s for payments made with credit or debit cards, because those payments are already covered
by existing information reporting requirements.




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