In this newsletter you will find information on updates and changes in the law on both the Federal and State level. If you have any questions, please feel free to contact us at (504) 569-2900.
Year End Planning – The Wandry Case
In Wandry v. C.I.R., 103 T.C.M. (CCH) 1472 (T.C. 2012), the taxpayers created a limited liability company (LLC) to hold cash, securities and a family business. The taxpayers gifted interests in the LLC to their children and grandchildren. The gift documents specified the dollar value of each gift, rather than a fixed percentage interest in the LLC. The IRS issued a notice of deficiency and argued that the gifts represented a fixed percentage interest of the LLC. The amount of interest gifted well exceeded the annual exclusion and thus, the IRS argued, gift tax was due. The IRS further argued the clauses created a condition subsequent to a completed gift and were thus void as being contrary to public policy.
The Tax Court ruled in favor of the taxpayer and held that the adjustment clauses in the gift documents were valid formula clauses that transferred specified dollar values of LLC membership units, despite the fact that the clauses called for an adjustment to the number of units so as not to exceed taxpayers’ gift tax exclusions in the event the IRS determined the value of units to be higher than specified in documents.
As a result of the Health Care and Education Reconciliation Act of 2010, (the “HCERA,” H.R 4872, P.L. 111-152), IRC §1411(a) will impose a new 3.8% Medicare surtax on net investment income of certain individuals, estates and trusts for tax years beginning after 2012. The new surtax applies to: (i) married taxpayers filing a joint return with greater than $250,000 of income; (ii) individuals with greater than $200,000 of income; and, (iii) married taxpayers filing a separate return with greater than $125,000 of income.
For individuals, the new 3.8% tax applies to the lesser of: (i) the net investment income of the individual for such taxable year, or (ii) the excess of (x) the individual’s modified gross income for such taxable year, over (y) the threshold amount. For trusts and estates, the new 3.8% surtax applies to the lesser of: (i) the undistributed net investment income for such taxable year; or (ii) the excess of (x) the adjusted gross income for such taxable year, over (y) the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year.
IRC §1411(c)(1)(A)(i) defines net investment income as gross income derived from interest, dividends, annuities, royalties, and rents; unless such income is derived in the ordinary course of a trade or business that is not a passive activity under §469. IRC §1411(c)(1)(A)(ii) provides that net investment income further includes all gross income derived from a trade or business that is a passive activity under IRC §1411(c)(2), which states that passive activity is determined with respect to the taxpayer according to IRC §469.
Closely held C corporations, S corporations, and partnerships are activities for purposes of §469. Accordingly, income derived from these types of entities will be subject to the new surtax unless the members or shareholders of the organization materially participate under §469. The materially participation standard will have to be applied with respect to each individual. As such, business owners of these types of entities should explore the possibility of becoming “active” in the business to avoid such tax. Those considering the switch to active participation should also consider the possibility that becoming active may trigger self-employment tax. Also, investors in pass-through entities should make certain the language in their entity agreements is sufficient to account for the tax in future tax distributions.
Recharacterization of Rental Income as Active Under Self-Rental Rule
In Veriha v. Commisioner, 139 T.C. No. 3 (August 8, 2012), the Tax Court held that income that the taxpayers received must be characterized as active income under the “self-rental rule or the recharacterization rule” of Treas. Reg. §1.469-2(f)(6). The taxpayer was the sole owner of a trucking company that was structured as a C corporation. Two other entities leased equipment to the C corporation. One was an S corporation, 99% owned by the taxpayers, which generated net income from the leases, and the other was a single member LLC, reported on Schedule C, which reported a net loss. The taxpayers initially reported the net income from the S corporation as passive income, and the loss on Schedule C as a passive loss.
The IRS determined that, under Treas. Reg. §1.469-2(f)(6), each tractor and each trailer must be considered to be a separate “item of property” and that the income that the taxpayer received from the S corporation must be recharacterized as active income because it was received for the use of property in a business in which the taxpayer materially participates. The taxpayer argued that they were not individually leasing property, but rather that the entire fleet of tractors and trailers was leased to the corporation and should be treated as one item of property, thus resulting in a single net income or loss from the combined income of the two operations.
The court ruled in favor of the IRS on the issue of whether each item was a separate item, noting that the corporation had signed a separate lease for each tractor or trailer, thus treating each one as a single item. The court further held that the S corporation income must be characterized as active because of the self-rental rule.
Dollar Limitation Changes for 2013
The IRS has announced the 2013 cost of living adjustments (COLAs), which affect a variety of retirement savings vehicles, including defined contribution plans, defined benefit plans, employee stock ownership plans (ESOPs), and individual retirement arrangements (IRAs). The COLAs include:
• The limits on elective deferrals for employees who participate in 401(k)s, 403(b)s, certain 457s, and the federal government’s Thrift Savings Plan has increased from $17,000 for 2012 to $17,500 for 2013.
• The limitation for Sec. 415(c)(1)(A) defined contribution plans will increase from $50,000 for 2012 to $51,000 for 2013.
• The maximum deductible amount under Sec. 219(b)(5)(A) for an individual making qualified retirement contributions to IRAs and similar plans will increase to $5,500.
• The allowable IRA deduction will phase out when modified AGE is between $59,000 and $69,000 for single taxpayers who are active participants in an employer-sponsored retirement plan. For married couples filing a joint return, where the spouse making the IRA contribution is an active participant in an employer-sponsored retirement plan, the income phase-out range will be $95,000 to $115,000.
For a complete list of the cost of living adjustments see IRS News Release IR-2012-77.
IRS Eliminates Circular 230 Rules for Covered Opinions
On September 17, 2012, the IRS issued the much-anticipated proposed regulations titled: Regulations Governing Practice Before the Internal Revenue Service (Circular 230) to simplify the rules for covered opinions. Presently, covered opinions are governed by Circular 230 § 10.35 and include written advice concerning: a listed transaction; a transaction with the principal purpose of tax avoidance or evasion; or a transaction with a significant purpose of tax avoidance or evasion, if the advice is a reliance opinion, marketed opinion, subject to conditions of confidentiality, or subject to a contractual protection. Under the proposed regulations, the covered opinion rules in § 10.35 are eliminated.
With the elimination of the § 10.35 rules, all written tax advice would be governed under streamlined standards in § 10.37, which would generally require that practitioners base all written advice on reasonable factual and legal assumptions, exercise reasonable reliance, and consider all relevant facts that the practitioner knows or should know. A practitioner must also use reasonable efforts to identify and ascertain the facts relevant to written advice on a federal tax matter under the proposed regulations. Practitioners must not, in evaluating a federal tax matter, take into account the possibility that a return will not be audited or that an issue will not be raised on audit.
In addition to the change detailed above, the proposed regulations provide that a practitioner may rely on the advice of another practitioner only if the reliance on that advice is reasonable and in good faith considering the facts and circumstances. Reliance is not reasonable when the practitioner knows or should know that the opinion of the other practitioner should not be relied on, the other practitioner is not competent to provide the advice, or the other practitioner has a conflict of interest.
The Supreme Court has recently granted certiorari to decide whether the United Kingdom’s windfall profits tax is a creditable tax within the meaning of IRC §901. There is currently a split between the U.S. Courts of Appeals for the Third and Fifth Circuits. The Third Circuit denied the taxpayer a foreign tax credit for payment of the windfall profits tax, while the Fifth Circuit found that the windfall profits tax was creditable. This case should be heard some time in the beginning of 2013.
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