Newsroom

Pass-Through Entities Getting on the IRS' Radar?
(July 29, 2002)

Section 1031 & Tenants in Common Interests
(March 21, 2002)

Bush Signs Legislation - Substantial Depreciation Benefits
(March 10, 2002)

Impact Fees - IRS Ruling Released
(February 19, 2002)

The Supreme Court Allows Tax Assessment on Aggregate Estimated Tip Income
(August 15, 2002)

New Planning Strategies with Retirement Plans
(August 2002)

Charitable Remainder Trusts - Using a Trust Beneficiary
(August 2002)

There are more and more indications that the current reprieve from IRS examinations is about to end. Congressional hearings in 2001 and 2002 have highlighted the need for increased enforcement activities, IRS resources devoted to restructuring are being redeployed to examination, the IRS' reengineering of the audit process is well underway, and, for the first time in years, revenue agents are being hired. Recent indications are an IRS announcement regarding pass-through entities and a Treasury report targeting S corporations.

Schedule K-1 Matching Program

In News Release 2002-83, dated June 28, 2002, the IRS announced the launch of a Schedule K-1 matching program. The program is, at least in part, a response to some Congressional criticisms that the IRS has not devoted sufficient resources to matching Schedule K-1 information. The program starts with a computer matching of an individual's Form 1040 with Schedule K-1s from partnerships, S corporations, and trusts for tax year 2000. If a manual review cannot determine the cause of any discrepancy, a notice to the taxpayer will be generated. The IRS anticipates that the taxpayer or their representative will be able to resolve the issue with a letter or telephone call.

Recommendations: Because a Schedule K-1 can include multiple types of income and affected by other issues, such as passive loss limitations, this will be no easy task. Taxpayers should take care when preparing their tax returns. Taxpayers are recommended to disclose each separate amount from a Schedule K-1 and show the effect of any limitations in their tax return. Any response to an IRS notice should be clear and respond to the question(s) asked. It will be in the taxpayer's interest to make it easy for the IRS to understand how the Schedule K-1 ties into the taxpayer's Form 1040.

S Corporation Compensation of Shareholder-Employees

On July 5, the Treasury Inspector General for Tax Administration (TIGTA) issued a report titled "The Internal Revenue Service Does Not Always Address Subchapter S Corporation Officer Compensation During Examinations." The report includes a review of 84 cases. In these cases, the shareholders' reported an average of $5,300 in wages, while the S corporation reported an average of $349,323 in distributions. In 31% of the cases with distributions, the IRS did not sufficiently document a review of officer compensation.

At issue are employment taxes. Wages paid to shareholder-employees are subject to employment taxes whereas distributions are not. TIGTA wants IRS examiners to consider whether the wages to shareholder-employees are underreported when they are also receive distributions or loans. If case law is any guide, the risk will be that all of the payments to a shareholder-employee will be characterized as wages. TIGTA also recommended that distribution information from S corporation tax returns be input to the IRS' computer system to help identify returns for review and examination.

Recommendations: S corporations should review their compensation policies for shareholder-employees. Consideration should be whether their compensation is adequate and reasonable for their services. The payment of distributions to shareholder-employees should be independent of any salaries, both in methodology and timing. The treatment of distributions as bona fide distributions may be further strengthened if the corporation pays significant distributions to shareholders who do not provide any services to the corporation.

* * * * *
Both News Release 2002-83 and the report from TIGTA indicate that the level of IRS examination activity will be increasing. Now is the time for taxpayers to make sure documentation is in place to support the positions taken on their tax returns. Based upon prior audit experience, the ability to adequately and promptly respond to the IRS can save a lot of time and money. The inability to respond - even where taxpayers could be justified with their returns - can be very expensive.

The IRS issued Revenue Procedure 2002-22 specifying the conditions under which it will consider a ruling request that an undivided fractional interest in rental real property is an interest in real property and not an interest in a business entity. These undivided fractional interests are also referred to as Tenancy In Common (“TIC”) interests.

This issue is relevant to whether a TIC interest can be qualified replacement property for a Sec 1031 like-kind exchange of real property. Section 1031 requires that real property must be replaced with real property. You cannot replace real property with an interest in a partnership interest.

The term Tenancy In Common describes the legal form of ownership – not the federal income tax form. Depending upon the activities associated with the real estate and the relationship of the various owners, a TIC interest may considered, for federal tax purposes, to be an interest in real property or an interest in a partnership. Such a determination is based on all facts and circumstances.

The IRS listed 15 conditions necessary to obtain a ruling. As more fully described in the Revenue Procedure these conditions relate to the following –

Tenancy in Common Ownership
Number of Co-Owners
No Treatment of Co-Ownership as an Entity
Co-Ownership Agreement
Voting
Restrictions on Alienation
Sharing Proceeds and Liabilities upon Sale of Property
Proportionate Sharing of Profits and Losses
Proportionate Sharing of Debt
Options
No Business Activities
Management and Brokerage Agreements
Leasing Agreements
Loan Agreements
Payments to Sponsor
A couple of observations

It was thought the IRS might issue a safe harbor ruling. Such ruling would have provided that if specified conditions were met, the TIC interest (or undivided fractional interest) would qualify as an interest in real property. A taxpayer could have assurance without the need for a ruling. Under Revenue Procedure 2002-22 a taxpayer must still request a ruling to have the assurance that your TIC interest will qualify.

Satisfying all of the conditions (without obtaining a ruling) may provide a taxpayer with some assurance that their TIC interest may qualify, but not the same level of assurance as a favorable ruling.

Just because the TIC interest does not satisfy all of the conditions outlined in the Revenue Procedure, the IRS may consider a request for a ruling where the facts and circumstances clearly establish that such a ruling is appropriate. Similarly, even without the ruling, such TIC interest does may qualify – but there is increased uncertainty and risk for the taxpayer.

This revenue procedure supersedes Rev. Proc. 2000-46, 2002-2 C.B. 438, which provided that the Service will not issue advance rulings or determination letters on the questions of whether an undivided fractional interest in real property is an interest in an entity that is not eligible for tax-free exchange under §1031(a)(1) of the Internal Revenue Code and whether arrangements where taxpayers acquire undivided fractional interests in real property constitute separate entities for federal tax purposes under §7701.

NOTE – These depreciation benefits may affect your 2001 tax returns (including those you have already signed)!

TAX PLANNING SUGGESTION – The additional 30% depreciation benefit is for property with a recovery property of 20 years or less. Thus, there is a much greater incentive for cost segregation analysis to identify additions that should not be characterized as real property subject to 27.5 (residential) or 39 (nonresidential) year recovery periods.

The Job Creation and Worker Assistance Act of 2002 (H.R. 3090) was signed by President Bush on Saturday, one day after the compromise bill was passed by Congress. The Act includes:

three-year, 30 percent depreciation boost for business, along with the requisite alternative minimum tax modification for the depreciation
increase in the two-year carryback for net operating losses to five years and a waiver of the 90 percent limitation against the AMT
bundle of targeted tax breaks to spur investment in the New York areas damaged September 11 (New York City Liberty Zone)
two-year fix for most of the expired and expiring provisions known as the "extenders”
five-year extension of the subpart F exception for active financing income for insurance companies operating abroad;
handful of technical tax corrections
base 13-week extension of UI benefits that can be automatically renewed for an extra 13 weeks should states require additional resources.

The additional depreciation benefits are for Qualified Property placed in service after 9/10/2001, including certain luxury autos.

Additional 30% Depreciation on Qualified Property Additions. For the tax years ending after 9/10/2001, the Act allows taxpayers to claim an additional first year depreciation deduction (for both regular tax and alternative minimum tax) equal to 30% of the adjusted basis of Qualified Property. Qualified Property meets the following conditions:

1. MACRS-eligible property with a recovery period of 20 years or less; water utility property (as defined in Sec. 168(e)(5); computer software other than software that must be amortized over 15 years under Sec. 197, or qualified leasehold improvement property (generally a non-structural, non-expansion improvement to an interior portion of an existing nonresidential building, provided certain requirements are met).

2. The property is acquired by the taxpayer (1) after 9/10/2001, and before 9/11/2004 (but only if there was no written binding contract in effect before 9/11/2001, for the acquisition of the property), or (2) under a written binding contract entered into after 9/10/2001, and before 9/11/2004.

3. The original use of the property (that is, the first use to which the property is put) commences with the taxpayer after 9/10/2001. Qualifying improvements made after 9/10/2001, and before 9/11/2004, to property that isn't original-use property would qualify for the additional first-year depreciation allowance.

4. The property is placed in service by the taxpayer before 2005 (before 2006, for certain property with longer production periods).

The additional first-year depreciation allowance is not available for:

1. Property that must be depreciated under the alternative depreciation system (e.g., tangible personal property used predominantly outside the US).

2. Listed property (such as a passenger auto) that isn't used more than 50% for business; and

3. New York Liberty Zone qualified leasehold improvement property.

Example. Assume that on March 1, 2002, a calendar year taxpayer acquires and places in service qualified property that costs $50,000. In addition, assume that the property qualifies for the expensing election under Sec. 179. The taxpayer is first allowed a $24,000 deduction under Sec 179. The taxpayer then is allowed an additional first-year depreciation deduction of $7,800 based on $26,000 ($50,000 original cost less the Sec 179 deduction of $24,000) of adjusted basis. Finally, the remaining adjusted basis of $18,200 ($26,000 adjusted basis less $7,800 additional first-year depreciation) is to be recovered in 2002 and subsequent years pursuant to the depreciation rules of present law.

Luxury Autos. The first year depreciation dollar cap for a passenger auto (defined in Sec. 280F(d)(5)) that is also Qualified Property (defined above) is increased by $4,600. Therefore, the first year allowance for such luxury auto that is placed in service in 2001 is $7,660. That is, the regular first year depreciation allowance of $3,060 (for autos placed in service in 2001 or 2002) plus $4,600.

This settles the concern that the impact fees created an intangible asset with an unlimited useful life which would be nondepreciable and only recoverable when the property is sold. Also, developers and operators of low-income housing may include such fees in the computation of the low-income housing credit.

ISSUE
Are "impact fees" incurred by a taxpayer in connection with the construction of a new residential rental building capitalized costs allocable to the building under §§263(a) and 263A of the Internal Revenue Code?

FACTS
Taxpayer is in the business of developing, owning, and leasing residential rental property. Taxpayer purchased unimproved land located in County on which Taxpayer will construct a new residential building that it will rent to tenants. The development plan submitted by Taxpayer to County indicates that the building is expected to have x number of rental units. County imposes "impact fees" on new and expanded development.

HOLDING
"Impact fees" incurred by a taxpayer in connection with the construction of a new residential rental building are capitalized costs allocable to the building under §§263(a) and 263A.

The impact fees incurred by Taxpayer are not direct costs within the meaning of §263A because they are neither direct material nor direct labor costs. However, the impact fees are indirect costs under §263A because they directly benefit, and are incurred by reason of, Taxpayer's production activity. Similar to the costs at issue in Von-Lusk, the impact fees were assessed by County because of Taxpayer's plans to construct the new residential building, and thus are "as much a part of a development project as digging a foundation or completing a structure's frame." Thus, in accordance with §1.263A-1(f), Taxpayer must allocate the impact fees to the property produced based on all the facts and circumstances. Because the impact fees are assessed as a result of Taxpayer's plans to construct the building, the amount of the impact fees is calculated based upon the characteristics of the building, and the impact fees generally would be refundable if Taxpayer decides not to construct the building as planned, the impact fees are allocable to the building. Accordingly, the impact fees must be capitalized under §263A as indirect costs allocable to the new residential rental building.

The Supreme Court Allows Tax Assessment on Aggregate Estimated Tip Income
By Barbara S. Borczak, CPA

The Internal Revenue Service scored a victory in the Supreme Court decision in United States v. Fior D'Italia, Inc. which conceded the Service the authority to assess an employer with FICA taxes on its employees' aggregate estimated unreported tip income. The taxpayer, Fior D'Italia, Inc., operated a restaurant whose employees' compensation included tips. Seemingly in complete compliance with its responsibilities as an employer, the taxpayer routinely calculated and remitted its share of FICA tax based on 7.65% of each employee's salary and reported tip income. Using the same information, the Company filed Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, each year.

In 1994, after finding that the taxpayer's reported tip income was significantly less than the tips recorded on its customers' credit card receipts, the Service assessed the taxpayer with additional FICA tax. The Service based its assessment on a simple calculation. First, it established the "tip rate" as the ratio of tips reported on customers' credit card receipts to the total credit card charges. Next it applied the tip rate to the taxpayer's total receipts to determine total estimated tips. Finally, the tips that had already been reported to the IRS were deducted from the estimated total to determine the taxpayer's estimated unreported tips. The Service applied its formula to all of the taxpayer's employees in total - it made no attempt to determine the amount of each individual employee's unreported tip income.

The question brought before the Court was whether the Service was legally authorized to make an assessment based on a collective estimate of the tips received by the taxpayer's employees, or whether it must determine total tip income by separately estimating each employee's tip income and summing the estimates together. Although the Ninth Circuit and Circuit Court of Appeals decided for the taxpayer, the Supreme Court ruled that the Service was correct in using an aggregate estimate of tip income to calculate the employer's FICA liability.

The taxpayer's primary argument rested on the statutory language that imposes the FICA tax. It asserted that because §3121(q) speaks in a singular voice of "tips received by an employee in the course of his employment," it should be interpreted to mean that the employer's liability is attached to the individual employee, not the summation of all employees. The Court rebuffed that argument, pointing out that the tax is actually imposed on the employer by §3111(a) and (b), which speaks in terms that an employer's liability should be imposed on the earnings of the whole group of employees. It went on to explain that in giving the Service the authority to assess tax, §6201(1) also grants it the ability to decide how to determine the amount of the assessment, as long as the method is reasonable. The Court concluded that although certain elements of the aggregate estimate approach could result in certain inaccuracies and misstatements, that alone does not make the method so unreasonable that it is unlawful.

The taxpayer in this case did not challenge the accuracy of the Service's calculation; it challenged the Service's authority to apply such a calculation. In forming its decision, the Court left no doubt that the Service is statutorily empowered to make a collective estimate, but the taxpayer is free to present evidence to challenge the accuracy of its calculation. Some of the features of a collective estimate that may make it unreasonable include: the erroneous inclusion of tips that should not be counted (for individuals receiving less than $20 in tips per month or total earnings in excess of the annual Social Security wage base); the possibility that cash tips are generally lower than credit card tips; and the need for an allowance for poor tippers. For this reason, it is imperative that the employer maintain complete and accurate records related to these matters.

The Supreme Court's decision is clearly a blow to every employer in an industry whose workforce receives tip income. The only way for them to limit their exposure under this ruling is by enlisting the cooperation of their employees. The Service has established programs to encourage this approach. They guarantee to protect an employer from an aggregate assessment if the employer demonstrates a willingness to work with the Service to educate their workforce about their own potential tax liability and the necessity of providing accurate information. Currently these programs are only available for restaurants but employers in other affected fields may earn the Service's support and increased tolerance by establishing their own employee education programs.

New Planning Strategies with Retirement Plans
By Roger W. Lusby, III, CPA, CMA, AEP
August 2002

One of the factors that influence the decision of an employer, particularly a small employer, to adopt a retirement plan is the extent to which the owners of the business, the decision-makers, will benefit under the plan. Recognizing this fact, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (the Act) which increased the maximum annual amount an employer may contribute to a defined contribution plan from the lesser of $35,000 or 25% of compensation in 2001 to the lesser of $40,000 or 100% of compensation in 2002. The new $40,000 threshold will be indexed in $1,000 increments. The Act also increased the annual compensation that may be taken into account for purposes of determining contributions and benefits under a plan and for nondiscrimination testing from $170,000 in 2001 to $200,000 in 2002. This new $200,000 threshold will be indexed in $5,000 increments.

As a result of the above increases, much attention has been drawn to the fact that employees can now reach the maximum contribution level through a defined contribution plan, meaning that any existing money purchase pension plan could be terminated in 2002 without sacrificing contribution levels. Conversions of money purchase pension plans are popular with employers/plan sponsors since they require annual contributions of a set percentage of participants' compensation. Contributions to profit-sharing plans, on the other hand, are discretionary and can be based on whether the employers/plan sponsors can afford to make contributions to the plan. Given the current economic turmoil, this flexibility could prove valuable to employers/plan sponsors. In fact, the Internal Revenue Service recently clarified some of the tax issues relating to a merger or conversion of a money purchase pension plan into a profit-sharing plan with Rev. Rul. 2002-42.

However, little attention has been given to the change in percentage of the compensation level. The Act effectively increased this percentage from 25% in 2001 to 100% in 2002. With the family aggregation rules repealed, closely-held businesses should consider putting spouses or other family members on the payroll at $40,000 and amend their defined contribution plan to allow for 100% of salary, or $40,000, to be contributed to their defined contribution plan in 2002. This strategy could really benefit a number of profitable, closely-held businesses with few employees who want to increase their retirement savings while generating significant tax deductions.

The Internal Revenue Service recently amplified an earlier decision that annuity or unitrust amounts paid to a trust by a charitable remainder trust (CRT) for the life of a "financially disabled" individual will not disqualify the CRT. In Rev. Rul. 2002-20, IRB 2002-17, issued on April 29, 2002, superseding Rev. Rul. 76-270, the Internal Revenue Service stated that "a trust will qualify as a CRT if:

The separate trust's sole function is to receive and administer the (annuity or) unitrust amounts for the benefit of the disabled beneficiary; and
Upon the beneficiary's death, the separate trust's remaining assets will be distributed to the beneficiary's estate or, after reimbursing the state for any Medicaid benefits provided to the beneficiary, will be subject to the beneficiary's general power of appointment."

By meeting these requirements, the trust mirrors the actions of the beneficiary, i.e. the trust assets are controlled by the beneficiary. Thus, the Internal Revenue Service takes the position that the annuity or unitrust amounts are considered to go directly to the beneficiary for purposes of §664(d)(2)(A) since the only function of the trust is to receive and administer the payments it receives from the CRT for the benefit of the beneficiary. The Internal Revenue Service also concluded that the term of the CRT under these circumstances "can be for the life of the beneficiary and is not limited to a term of years."

Reg. §1.664-3(a)(5)(i) provides that the beneficiary of the annuity or unitrust amounts must be either an individual or a charitable organization. In order to qualify as a CRT with a beneficiary other than those named in Reg. §1.664-3(a)(5)(i) under the exception in Rev. Rul. 2002-20, the beneficiary of the trust which receives the annuity or unitrust

amount must qualify as a "financially disabled" individual under §6511(h)(2)(A). This requires the individual to be unable to manage his or her financial affairs due to a "medically determinable physical or mental impairment" which will result in the death of the individual or which has or is expected to last for at least one year. If the individual has a person acting on his or her behalf for financial matters, he or she is not considered financially disabled for purposes of §6511(h)(2)(A).

Reg. §1.664-2(a)(5)(i) also states that the annuity or unitrust amount must continue either for the life or lives of a named individual(s) or for a term not to exceed twenty years and can only be paid to an individual or charitable organization. However, under the situation described in Rev. Rul. 2002-20, the term of the CRT can be for the life of the "financially disabled" individual and is not limited to a term of years.

Rev. Rule. 2002-20 also describes a situation where an individual creates a CRT and Trust B to benefit individual C. The CRT will pay annual unitrust amounts to Trust B for the life of C, who is "financially disabled." Trust B is to pay a portion of the unitrust amount to C each month. If this amount is not sufficient to provide proper care, maintenance, support and general welfare for C, the trustee of Trust B can authorize additional payments to C. Upon the death of C, the balances remaining in the CRT and Trust B will be distributed subject to C's general power of apportionment.

This ruling provides an excellent tax planning strategy for high net worth individuals who care for an incompetent individual. By utilizing the ruling, wealthy individuals can reduce their estates, avoid gift tax implications, benefit an incompetent individual, and produce a charitable contribution.

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