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Our news articles are posted on a regular basis to give our clients relevant and timely information about matters pertaining to our financial services. Browse through our current and archived articles to learn more.

Category: Business Accounting

Accounting & Tax :: Year-end planning: reducing exposure to the new 3.8% surtax on unearned income – Part I

Year-end tax planning for 2013 includes a new and unwelcome complication: the 3.8% surtax on unearned income. This two-part article takes a look at year-end moves that can be used to reduce or eliminate the impact of this surtax. Part I, in this article, highlights the new code regarding the surtax and overall year-end strategies for coping with it, and includes specific strategies for taxpayers with interests in passive activities.

 

Overview

For tax years beginning after Dec. 31, 2012, certain unearned income of individuals, trusts, and estates is subject to a surtax on “unearned income” (i.e., it’s payable on top of any other tax payable on that income). The surtax, also called the “unearned income Medicare contribution tax” or the “net investment income tax” (NIIT), for individuals is 3.8% of the lesser of:

 

(1) net investment income (NII), or

(2) the excess of modified adjusted gross income (MAGI) over an unindexed threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case).

 

MAGI is adjusted gross income (AGI) plus any amount excluded as foreign earned (net of the deductions and exclusions disallowed with respect to the foreign earned income).

 

For an estate or trust, the surtax is 3.8% of the lesser of (1) undistributed NII or the excess of adjusted gross income (AGI) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.

 

For 3.8% surtax purposes, NII is investment income less deductions properly allocable to such income. Examples of properly allocable deductions include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in NII.

 

Investment income is:

 

… gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the 3.8% surtax doesn’t apply,

… other gross income derived from a trade or business to which the 3.8% surtax contribution tax does apply, and

… net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the Medicare contribution tax doesn’t apply.

 

The 3.8% surtax applies to a trade or business only if it is a passive activity of the taxpayer or a trade or business of trading in financial instruments or commodities. Investment income doesn’t include amounts subject to self-employment tax), distributions from tax-favored retirement plans (e.g., qualified employer plans and IRAs), or tax-exempt income (e.g. earned on state or local obligations).

 

The surtax doesn’t apply to trades or businesses conducted by a sole proprietor, partnership, or S corporation (but income, gain, or loss on working capital isn’t treated as derived from a trade or business and thus is subject to the tax).

Gain or loss from a disposition of an interest in a partnership or S corporation is taken into account by the partner or shareholder as NII only to the extent of the net gain or loss that the transferor would take into account if the entity had sold all its property for fair market value immediately before the disposition.

The tax does not apply to: nonresident aliens (special rules apply to nonresident aliens married to U.S. citizens or residents); trusts all the unexpired interests in which are devoted to charitable purposes; trusts exempt from tax under; or charitable remainder trusts exempt from tax under. (Also exempt are trusts treated as “grantor trusts” and trusts that are not classified as “trusts” for federal income tax purposes (e.g., Real Estate Investment Trusts and Common Trust Funds).

Specific Year-End Moves to Reduce Exposure to Surtax

Reexamine passive investment holdings. The 3.8% surtax applies to income from a passive investment activity, but not from income generated by an activity in which the taxpayer is a material participant. One subject a “passive” investor should explore with a tax adviser knowledgeable in the passive activity loss (PAL) area is whether it would be possible (and worthwhile) to increase participation in the activity before year-end so as to qualify as a material participant in the activity.

 

In general,  a taxpayer establishes material participation by satisfying any one of seven tests, including: participation in the activity for more than 500 hours during the tax year; and participation in the activity for more than 100 hours during the tax year, where the individual’s participation in the activity for the tax year isn’t less than the participation in the activity of any other individual (including individuals who aren’t owners of interests in the activity) for the year. Special rules apply to real estate professionals.

 

Becoming a material participant in an income-generating passive activity wouldn’t make sense if the taxpayer also owns another passive investment that generates losses that currently offset income from the profitable passive activity.

 

Taxpayers that own interests in a number of passive activities also should reexamine the way they group their activities. A taxpayer may treat one or more trade or business activities or rental activities as a single activity (i.e., group them together) if based on all the relevant facts and circumstances the activities are an appropriate economic unit for measuring gain or loss for PAL purposes. A number of special “grouping” rules apply. For example, a rental activity can’t be grouped with a trade or business activity unless the activities being grouped together are an appropriate economic unit and a number of additional tests are met. And real property rentals and personal property rentals (other than personal property rentals provided in connection with the real property, or vice versa) can’t be grouped together.

 

Once the taxpayer has grouped activities, he can’t regroup them in later years, but if a material change occurs that makes the original grouping clearly inappropriate, he must regroup the activities.

 

Proposed reliance regs issued late last year provide a regrouping “fresh start” allowing qualifying taxpayers to regroup their activities for any tax year that begins during 2013 This would apply to the taxpayer without regard to the effect of regrouping (i.e., they have NII and the applicable income threshold is met). A taxpayer may only regroup activities once, and any regrouping will apply to the tax year for which the regrouping is done and all later years. (Reg. § 1.469-11(b)(3)(iv)) The regrouping must comply with the disclosure requirements.

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Healthcare & Benefit Service :: Healthcare Insurance Marketplace Deadline by October 1, 2013

The President announced on July 2nd of 2013, that certain key provision of the Healthcare Reform Law would be delayed until 2015. Businesses with 50 or more employees will not be penalized for declining to offer health insurance to their employees in 2014. This postponement provided a level of relief for many employers regarding Health Care.

 

However, other key provisions of the Law are still in effect with deadlines fast approaching. One such provision with an October 1, 2013 deadline includes Section 1512 of the Affordable Care Act, which creates a new Fair Labor Standards Act (FLSA) section requiring notifying employees of coverage options available through the new Healthcare Insurance Marketplace (http://www.dol.gov/ebsa/newsroom/tr13-02.html).

It doesn’t matter if an employer sponsors a health plan or not, the employer must still let employees know about their options that are available on January 1, 2014.

 
By October 1st 2013, employers must provide employees information related to:

 

1. The existence of the Marketplace (referred to in the statute as the Exchange) including a description of the services provided by the Marketplace, and the manner in which the employee may contact the Marketplace to request assistance;

 

2. If the employer plan’s share of the total allowed costs of benefits provided under the plan is less than 60 percent of such costs, the employee may be eligible for a premium tax credit if the employee purchases a qualified health plan through the Marketplace; and

 

3. If the employee purchases a qualified health plan through the Marketplace, the employee may lose the employer contribution (if any) to any health benefits plan offered by the employer and that all or a portion of such contribution may be excludable from income for Federal income tax purposes.

Model notices can be downloaded from the DOL at http://www.dol.gov/ebsa/healthreform/. There are two separate notices; one for those who currently offer health coverage and one for those who do not. The Department of Labor is recommending employers provide the forms either electronically or by certified mail to ensure receipt.

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Accounting & Tax :: Potential Tax Return Audit Red Flags-What They Are and How to Avoid Them

Millions of individuals file tax returns but only a small percentage of those returns are examined by the IRS or other taxing authorities. While there should be little reason to worry about an IRS examination, there are a few things that may lead to an increased chance of examination:

 

High Income Earners

The overall audit rate for individuals found during an IRS study conducted in 2012 is 1.03%. The individual audit rate for taxpayers making $200,000 or more is 3.70% or 1 out of every 27 returns. Make over $1,000,000? The rate jumps to 1-in-8 returns. The more income reflected on your tax return, the more likely it will be for you to have an IRS examination.

 

Failing to report taxable income

The IRS receives copies of all W-2 and 1099 forms. If your return is missing income that was reported to the IRS on a W-2 or 1099, it is likely that you will automatically receive a notice requesting an explanation.

 

Charitable deductions

If charitable deductions reported on a return are disproportionately large compared to income, the IRS is likely to investigate. Therefore, it is important to keep all charitable donation receipts. Audit exposure also exists if valuable property is donated without appraisals, or if Form 8283 is not filed when a property donation over $500 is made and the deduction is claimed.

 

Home office deductions

The home office deduction consists of a portion of rent, mortgage interest, real estate tax payments, insurance, utilities, phone bills and other costs allocated proportionately to an area of an individual’s home used regularly and exclusively for business purposes. The space used to claim the home office deduction cannot also be used as a guest bedroom or play room, nor can the office computer be sometimes used for homework. Therein lays the difficulty in substantiating the deduction. The IRS is aware of the difficulty a taxpayer may have in substantiating a home office deduction and is often successful in knocking down the deduction in part or all together during an audit. (The IRS recently issued new non substantiation guidelines on this deduction, but the amounts are very low.)

 

Rental Losses

In general, most real estate losses are not currently recognized and are suspended until such time as the taxpayer can recognize real estate rental income. This is known as the passive loss rule. If a taxpayer actively participates in the rental real estate property, an up to $25,000 of losses could be available to offset income, however the deduction begins to fade out as individual’s income reaches $100,000, and is completely phased out at $150,000. Real estate losses are fully deductible for those individuals who are deemed to be real estate professionals. In order to be considered a real estate professional you must spend more than 50% of your working hours and at least 750 hours a year participating in real estate as a developer, broker or landlord. The IRS may pull your return for review to substantiate the claim of real estate professional, especially if your day job is not in real estate.

 

Deducting business meals, travel and entertainment

Historically, self-employed individuals understate income and overstate deductions. Large deductions for travel, meals and entertainment, especially when compared to income, can cause a closer look from an IRS agent.

 

100% business vehicle use

Similar to the home office deduction, which requires regular and exclusive use of an area for business use, it is difficult to maintain that a vehicle is used for business and only business purposes. If you are going to be claiming a 100% business vehicle deduction, be sure to maintain detailed mileage logs including details of where and when you went on each trip.

 

Writing off hobby losses

If you have wage income in addition to large Schedule C losses, there is a high chance your return will be pulled for inspection. Horse breeding and car racing are two such hobbies moonlighting as businesses that can cause scrutiny from an IRS agent. In order for a business to be considered legitimate by the IRS, it must be entered into with the intention of making a profit. If your business reflects profits for 3 out of 5 years (2 out of 7 for horse breeding) it is generally considered a legitimate business intended to make money. If you are audited, you will have to prove you have a legitimate business and not a hobby. Make sure you can support for all expenses.

 

Running a cash business

Small business owners in cash intensive industries such as taxi drivers, car washes, bars, hair salons and restaurants have historically been a target for IRS examination. Agents are aware that when a good portion of revenue is cash based, there is an opportunity for a taxpayer to underreport income as there is no trail (ie. credit card receipts.)

 

Failing to report a foreign bank account:

In recent years, there has been greater IRS interest in taxpayers with offshore bank accounts or signature authority, specifically in tax haven countries. In the past, the IRS has set up programs for taxpayers to come forward with previously undisclosed accounts with the incentive of reduced penalties for not reporting sooner, as failure to report a foreign bank account leads to significant penalties.

 

Engaging in currency transactions

The IRS receives reports of cash transactions in excess of $10,000 involving banks, casinos, car dealerships and other businesses. Banks and other institutions also file reports on suspicious activities such as $9,000 deposits several days in a row. These currency transactions are known to lead to undisclosed income, creating a greater risk of audit examination for those engaging in them.

 

Taking higher-than-average deductions

If you have deductions that are disproportionately large compared to your income, your return has a higher chance of being reviewed.
While the areas outlined above do present items that will provide greater audit exposure, if you have proper documentation, there should be nothing to worry about in the case of an IRS examination.

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Accounting & Tax :: Partnerships and LLC’s: The Basics of Making a 754 Election

The basis of the assets of a partnership or LLC may not reflect the basis of the interest in the hands of the partners(s). If a Section 754 election is made, by the entity, certain events can trigger an equalization of basis without waiting until the assets are sold. Utilizing this election can accelerate deductions into earlier years, which may be beneficial for owners of LLC’s and partnerships.

 

What is a 754 election?
Section 754 allows a partnership to make an election to “step-up” the basis of the assets within a partnership when one of two events occurs: distribution of partnership property or transfer of an interest by a partner. This “step-up” in basis is used to make the outside basis (basis of the partnership in the hands of the owner) equal to the inside basis (the basis of the assets in partnership) for tax purposes. This equalization of basis can be beneficial to an owner when the “step-up” is deemed to be related to depreciable or amortizable property. It will allow for depreciation and amortization deductions, starting in the year the election is made, rather than recouping basis when the interest or property is transferred.

The election is made by filing a written statement with the tax return. It is important to note that the election is in effect for the year filed and all years thereafter. It can only be revoked with IRS consent. All distributions and transfers of interests will be subject to the election and the “step-up” or “step-down” must be calculated when one of these events occurs.

 

How does the election work in the case of a distribution?
In general, there is no effect on the basis of the undistributed pass-through entity’s assets when a current distribution is made. However, if a 754 election is made or is in place, there may be a “step-up” or “step-down” of the remaining assets. Any gain recognized by the distributee (because his outside basis is less than the basis of the property he received) increases the basis of the remaining assets in the partnership. Since current distributions cannot result in a loss to the distributee, there will only be a “step-down” of assets if the distribution is made in complete liquidation of the distributee’s interest.

The “step-up” or “step-down” is allocated to the other pass-through entity owners. This equalizes the other owners by providing them with a tax asset equal to the asset that the distributee partner received.

 

Example 1:
ABC partnership distributes real estate with a value of $100,000 to partner A. Partner A’s outside basis in ABC is $90,000. The $10,000 difference (gain to be recognized by A) is allocated to partners B and C and any related depreciation/amortization deductions are specially allocated to B and C. No entry is made to record the $10,000 754 asset on the books of the partnership: the $10,000 is reflected in partner B and C’s outside bases. Additional depreciation/amortization deductions will be specifically allocated to these partners in the future.

 

How does the election work when there is a transfer of an interest?
When a new partner acquires an interest from a former partner, the price paid is based on the fair market value of the interest (which is based on the underlying value of assets of the partnership). However, if the assets of the partnership are greater in value than the outside basis, there is a distortion between the new partner’s outside basis and the proportionate value of the assets of the partnership. If a 754 election is made, the incoming partner receives a “step-up” or “step-down” for any difference in what he paid and the former partner’s previously taxed capital (essentially, the proportionate basis of the assets of the partnership). The “step-up” and any related depreciation or amortization deductions are allocated to the incoming partner.

 

Example 2:
Z owns 50% of XYZ partnership and has previously taxed capital of $25,000. Z sells his 50% interest to W for $50,000. The $25,000 difference is allocated to incoming partner W and any related depreciation/amortization deductions are specially allocated to W. No entry is made to record the $25,000 754 asset on the books of the partnership: the $25,000 is reflected in partner W’s outside basis. Additional depreciation/amortization deductions will be specifically allocated to this partner in the future.

 

What is the downside to the election?
As mentioned before, this is a permanent election that is only revocable with IRS consent. In one year there may be a “step-up”, making the election beneficial. However, if a “step-down” occurs in a subsequent year, it too must be calculated. Accounting for the election can be complicated as there will be special allocations of inside basis and related deductions to specific partners which will need to be tracked and disclosed on the partner’s form K-1. Furthermore, the election is an entity level election and all partners are subject to the rules (as they pertain to that specific partnership). It would be wise to check the operating agreement (if applicable) to see if a 754 election is allowed and how the determination to make it is made between the partners.

 

Is it right for my partnership?
If there is a transfer of an interest or a distribution in property and the inside and outside basis has a disparity, the election can be beneficial to accelerate deductions, if there is greater inside basis than outside basis. Before making the election, the partners should consider the likelihood of the assets declining in value and the extent of separate accounting they are willing and able to handle.

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Safeguarding Tax Records During Hurricane Season

Each year on the East Coast of the United States, an intense cycle of storms roll through the Atlantic, in a period commonly known as “Hurricane Season.” These natural disasters can occur anytime during the months of June to November when hurricane season is upon us. While memories of Hurricane Irene and Superstorm Sandy are still clear in our minds, it’s too early to know what is in store for 2013. 

But, if we have learned anything from the past,
it’s that we need to be proactive
in our emergency planning efforts and
one of the most important ways we can do this
is by the safeguarding of our
financial assets and tax documentation.

In order to understand the importance of safeguarding tax documentation, it is important to first understand the importance of recordkeeping in general. One of the most financially beneficial things you can do is keep adequate financial records. Keeping adequate records helps to monitor the progress of your business or personal financial situation, and can be useful when it comes to important decision making. It also helps in the preparation of yearly tax returns. With adequate documentation you can identify sources of income, separate what is taxable from what isn’t, and determine which expenses are deductible. Finally, it supports the information on your tax return, should the IRS choose to conduct an audit. The IRS does not require you to keep your records in a particular way, and different systems are suited for different people or businesses. However, these records should always include a summary of business transactions or checkbook activity, and all supporting documentation that may be needed to back up these transactions.

The IRS describes three ways in which we can safeguard our tax documents and prepare ourselves for the upcoming hurricane season.

First, they encourage the electronic back up of all documentation. This includes your previously filed tax returns and all supporting workpapers. If you already file tax returns electronically, save a PDF copy to an external hard drive or flash drive. Another great way to back up these files is to send yourself a copy via email, so you can remotely access it. If you manually process or paper file your tax returns, scan them in and make sure to have a copy saved in PDF form that you can back them up the same way. In addition to your previously filed tax returns, you should keep supporting documentation such as bank statements, brokerage statements, homeowner’s expenses, retirement contributions, and credit statements. Many of these records are already stored online and can be found on the website of your bank or broker. However, you can make your own digital back up of these, in addition to other records that may not readily be available online, such as receipts for equipment and other major purchases or expenses. Any back up or extra set of electronic records should be kept in a safe place separated from the originals.

Another way the IRS encourages the safeguarding of records during hurricane season is the documentation of assets, with an emphasis on higher value items. This could be as easy as taking photographs or videotapes of your home and as difficult as documenting it in list form. The IRS has released Publication 584, which is a workbook that is designed to help you determine what you have or what you’ve lost when it comes to your personal-use property. It allows you to list personal-use property from each room and determine what you have prior to a hurricane and then what you may have lost in the event of a hurricane. Another great resource can be found on the Insurance Information Institute’s website knowyourstuff.org. This site allows you to create an online inventory of your possessions and list the value of each item. When documenting your valuables online or electronically, it is important to store the list or photos outside of the home and, either send them to yourself via email or put them on an external hard drive in a safe location separate from the valuables themselves.

In addition to electronically backing up your information and documenting your valuables, it is strongly suggested that you

• Update your emergency plan annually before each hurricane season. Each year our businesses and personal lives may change. It is important to continually update your emergency plan to correspond with these changes. Emergency plans should be reviewed each year prior the start of hurricane season and changed accordingly.

Finally, the IRS has many resources available to both prepare for a hurricane and recover from one. You can always contact the IRS and order transcripts online or request previously filed returns by filing form 4506. In addition, the IRS is constantly releasing publications that provide further information on how to report casualty losses, keep adequate records, or inquire about what tax relief is being provided for victims of natural disasters.

Living on the East Coast and experiencing hurricane season each year certainly has its risks. It is important to understand the risks associated with losing all of your financial documentation. All of the documentation you would need for insurance and recovery purposes should be easily obtainable in the aftermath of a natural disaster. Safeguarding your financial information should be part of your overall emergency plan, and you can use the tips discussed above to hope for the best but prepare for the worst.

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Accounting & Tax :: IRS Reminds Those with Foreign Assets of Their U.S. Tax Obligations

The Internal Revenue Service is reminding U.S. citizens, resident aliens, and those with dual citizenship who have lived or worked abroad during all or part of 2012 that they may have U.S. tax liability and filing requirements in 2013. With the possibility of large penalties for failure to comply, it is important to know the foreign asset filing requirements.

U.S. citizens and resident aliens are required to report all worldwide income, including income from foreign trusts and foreign bank and securities accounts. Affected taxpayers need to fill out Part III, Foreign Accounts and Trusts, of Schedule B, Interest and Ordinary Dividends. This section asks about the existence of foreign accounts, such as bank and securities accounts, and requires U.S. citizens to report the country in which the account is located.

Certain taxpayers may also have to fill out and attach to their return Form 8938, Statement of Foreign Financial Assets. U.S. citizens, resident aliens, and certain nonresident aliens who have an interest in specified foreign financial assets where the value of those assets is more than the applicable reporting threshold must file this form. If you are required to file this form, you must report the specified foreign financial assets in which you have an interest, even if none of the assets affects the tax liability for the year. Instructions for Form 8938 explain the thresholds for reporting, what constitutes a specified foreign financial asset, how to determine the total value of relevant assets, what assets are exempted and what information must be provided. If applicable, Form 8938 is due with your individual income tax return. An extension to file the tax return is also applied to the filing of Form 8938.

Taxpayers that have a financial interest in or signature authority over foreign financial accounts must file Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts, if the aggregate value of the foreign financial accounts exceeded $10,000 at any time during 2012. This is not a tax form and is due to the Treasury Department by June 30, 2013. There is no extension of time to file this form.

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Accounting & Tax :: The House and Senate Finally Agree on Something – The Marketplace Fairness Act of 2013

Last week the Marketplace Fairness Act of 2013 (the “Act”) was introduced in both the House and Senate by sponsors of both the Republican and Democratic parties. Indeed, a remarkable turn of events, given the ongoing conflicts between the House and Senate, and their Republican and Democratic members. But finally lawmakers appear to be in agreement – the time has come for the States to be permitted to collect sales and use taxes from remote sellers.

The proposed legislation permits States to enforce collection of sales and use taxes from internet retailers, placing them on a par with brick and mortar businesses. The bills introduced in the House and Senate are substantially similar in all material respects. Each provides an important exception, the “Small Seller Exception”, for businesses with less than $1 million dollars in annual domestic remote sales.

This Act permits States to require qualifying Sellers to collect and remit sales and use taxes on remote sales, but the States must implement certain simplification requirements. Some of these requirements include:

  • Specific identification of the applicable taxes,
  • Establishment of a single entity within the State responsible for sales and use tax administration, returns, audits and overall compliance,
  • Provision of a uniform sales and use tax base,
  • Compliance with certain definitions, provision of information, and
  • Availability and use of compliance software provided free of charge.

Since 1992 when the Quill case was decided by the Supreme Court, States have been prohibited from collecting sales taxes on purchases made by in-state customers from out-of-state sellers who lack sufficient physical presence. Quill has, however, been watered down by subsequent cases and creative legislation, as well as agreements between states and remote sellers, such as Amazon, facilitating the collection of local sales and use taxes in limited circumstances.

Whenever Republicans and Democrats, in both the House and Senate, act together to introduce legislation, passage is assured. We must therefore assume, that the age of sales tax free internet sales by remote sellers is rapidly coming to a close.

While States and local jurisdictions will clearly benefit from significantly increased tax revenue, internet purchasers will find their bargain purchases much reduced in value, and businesses will find their compliance costs increased.

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