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The Federal Research & Development Tax Credit

Chances are that you or companies you know are not taking advantage of a valuable tax credit.

John Williams is our director of tax services and recently was published on this topic.

Northern Nevada Weekly

Small Business Jobs Act of 2010

On September 23, the House passed the Small Business Jobs Act of 2010 (H.R. 5297) and signed into law by President Obama on September 27, 2010.

The following are some of the key provisions of the 2010 Act:

• Section 179 Expense Election expanded: For tax years beginning in 2010 and 2011, expense limit is increased to $500,000 and phase-out threshold increased to $2 million;
• Section 179 for (some) real estate: For tax years beginning in 2010 and 2011, taxpayers can elect to treat certain real estate as Section 179-eligible. Qualifying real estate includes:
  • Qualified leasehold improvements;
  • Qualified restaurant property; and
  • Qualified retail improvement property.
• Bonus depreciation extended: Available for property purchased through December 31, 2010;
• Luxury auto depreciation increased: As a result of the extension of bonus depreciation, first-year depreciation of automobiles is bumped up $8,000;
• Deduction for start-up expenditures increased: Under Section 195, increased from $5,000 to $10,000 for taxable years beginning in 2010 (only);
• Exclusion for small business stock: For purchases made after the date of enactment and before January 1, 2011, the exclusion for small business stock under Section 1202 is increased to 100%;
• Five-year carryback for general business credits: Effective for credits determined in the taxpayer’s first taxable year beginning after December 31, 2009 (one year only), the carryback period for an “eligible small business” is increased from one to five years. In addition, the credit is not subject to the AMT limitation;
• Built-in gain period shortened to five years: For taxable years beginning in 2011 (only), the recognition period for the BIG tax is shortened to five years;
• Deduction for health insurance for SECA purposes: For 2010 (only), the deduction for self-employed health insurance is also a deduction for purposes of the SE tax;
• Cell phones removed from listed property: Permanent and effective for tax years ending after 2009;
• Information reporting required for rental property: Effective for payments made after December 31, 2010, rental real estate is treated as a trade or business for information reporting purposes. IRS to prescribe de minimis exceptions;
• Higher information return penalties: Penalties under Section 6721 are substantially increased beginning in 2011;
• Section 457 plans can include Roth accounts: For tax years beginning after December 31, 2010; and
• Rollovers from elective deferral plans to in-plan Roth accounts allowed: Effective on the date of enactment. Will allow a two-year deferral (2011 and 2012) for rollovers done in 2010.

If you would like to know how these new provisions may specifically impact your 2010 taxes, please contact us at Mark Bailey & Co.  The IRS has included the provisions of the 2010 Act on its website. To view, click here.

 

Foreign Bank Account Reporting – 2011 Offshore Voluntary Disclosure Initiative

Does the date June 30, 2011, mean anything to you?

It should – especially if you’re a “U.S. person” (US citizen, Green Card holder and/or a non-resident alien if you are physically present in the US over a prescribed number of days and hold foreign assets with an aggregate value of $10,000 or more.

June 30th is the deadline for filing  “Form TD F 90-22.1″ for 2010;  this  “foreign bank account report” (FBAR) gives the Treasury a look at your  foreign “bank, brokerage, or ‘other’ financial accounts” you held during 2010 .  If you have a financial interest in, or signature or other authority over foreign bank, securities or “other” financial accounts with an aggregate value exceeding $10,000, you must file the FBAR. That’s true even if the account contains only precious metals or other non-cash assets, or generates no income.

The FBAR is not the only reporting obligation for your offshore investments.  Additionally, you must also report your foreign accounts each year on Schedule B of your Form 1040, federal income tax return. Moreover, the IRS has created a special reporting regime for Americans with more than $50,000 in non-U.S. assets.

FUBAR – ‘Fouled Up Beyond All Recognition’

The FBAR offshore reporting regime truly is FUBAR. The tax penalties for failing to file FBAR forms are draconian. You could end up paying a $10,000 fine per unreported account for each year you neglect to file the FBAR. Far worse, if you “willfully” fail to file the form, you face a fine up to $500,000, five years imprisonment . . . or both.  In addition, if you own more than 50% of the shares of a corporation (by value, U.S. or foreign) with a foreign account, the corporation must file a FBAR. You must also file a separate FBAR in your own name acknowledging the same account.  Similar rules apply to partnerships. Even a single-member LLC, taxed as a “disregarded entity,” is a “U.S. person” for FBAR purposes.

Offshore Voluntary Disclosure Initiative

If for whatever reason you failed to satisfy the FBAR requirements anytime during the past eight years – now is your chance!  A  new IRS initiative allows certain taxpayers to voluntarily disclose hidden offshore accounts (accounts outside of the US) without the risk of criminal prosecution and also provides for reduced civil penalties for prior noncompliance with offshore account reporting requirements. The initiative, known as the 2011 Offshore Voluntary Disclosure Initiative (OVDI), was announced by the IRS on February 8, 2011. Taxpayers participating in the 2011 OVDI must file all original and amended tax returns and include payment for taxes, interest and accuracy-related penalties by August 31, 2011.

Penalty Framework

The 2011 OVDI provides the following penalty framework during the eight-year look-back period:

• an “off-shore” penalty of 25% on the highest annual aggregate balance in the unreported accounts;
• an “accuracy-related” penalty of 20% for unpaid taxes; and
• late filing and/or late payment penalties in certain cases.

A taxpayer with offshore accounts or assets that, in the aggregate, did not exceed $75,000 in any calendar year during the look-back period will qualify for a reduced 12.5% rate instead of the standard 25% rate. A 5% rate (instead of the standard 25% rate) will apply in certain limited circumstances (e.g., in the case of foreign residents who were unaware that they were U.S. citizens).

Under the 2011 OVDI, taxpayers will not be required to pay a penalty greater than what they would otherwise be liable for under the maximum penalties imposed under existing statutes. The 2011 OVDI also offers a modified mark-to-market election for taxpayers with interests in passive foreign investment companies (e.g., foreign mutual funds) to determine the income from such investments.

Eligibility

Taxpayers, including entities such as corporations, trusts and partnerships, who have undisclosed offshore accounts or assets are eligible to apply for the 2011 OVDI. However, taxpayers under criminal or civil investigation by the IRS or who participated in the 2009 Offshore Voluntary Disclosure Program (predecessor to the 2011 OVDI) are ineligible.

Procedure

There is a fairly simple process to make a voluntary disclosure under the 2011 OVDI. A taxpayer may either submit basic personal information by fax letter to the IRS or submit a more detailed disclosure letter from the outset. Either way, a detailed package of information must ultimately be provided to the IRS to secure acceptance into the program. Mark Bailey & Co. has taken several clients through this process and can assist you.

Webpage

The IRS has launched a new webpage that includes the full terms and conditions of the 2011 OVDI, as well as the necessary forms and documents for making a disclosure.  Additionally, the webpage contains information regarding the procedure for making a voluntary disclosure and a comprehensive FAQ. For more information regarding the 2011 OVDI, click here .

 

 

Why You Shouldn’t Kill Your Rich Uncle Just Yet: Things You May Not Know About the Estate Tax Repeal

The day is finally here. After hearing about it for the past nine years, the estate tax is repealed as of January 1, 2010. Yet, many questions remain. For example, one may wonder what will happen next year when the estate tax (presumably) returns and one is puzzled why U.S. Congress did not address the “estate tax issue” during the 2009 tax year.

The one-year repeal of the “death tax” was a typical congressional compromise. It involved the gradual decrease in marginal tax rates and increase in tax free amount (unified credit) through 2009 and the repeal of the tax for just one year in 2010. The current law reads that in 2011 the rates from 2001 will apply again (P.L. 107-16, 115 Stat 38 (June 7, 2001)).

What does this mean for taxpayers? Let’s assume Uncle Joseph’s taxable estate is valued at $5 million. If he died in 2001, $675,000 of the estate would have been tax free and the rest would have been taxed with a top marginal rate of 55%. Tax liability would have been about 2.17 million and effective tax rate about 43%. Had Uncle Joseph died in 2009, his tax due would have been $675,000 and his effective tax rate around 14% while a 2010 death would mean zero liability (see Table).

Year	Top Marginal Tax Rate	Unified Credit (Exemption Equivalent)	Tax due after credit on $5 million estate	Effective Tax Rate
2001	55%	$220,550 ($675,000)	$ 2,170,250	43%
2002	50%	$345,800 ($1,000,000)	$ 1,930,000	39%
2003	49%	$345,800 ($1,000,000)	$ 1,905,000	38%
2004	48%	$555,800 ($1,500,000)	$ 1,665,000	33%
2005	47%	$555,800 ($1,500,000)	$ 1,635,000	33%
2006	46%	$780,800 ($2,000,000)	$ 1,380,000	28%
2007	45%	$780,800 ($2,000,000)	$ 1,350,000	27%
2008	45%	$780,800 ($2,000,000)	$ 1,350,000	27%
2009	45%	$1,455,800 ($3.5 million)	$    675,000	14%
2010	NA	NA	No tax	N/A
2011	55%	$220,550 ($675,000)	$ 2,170,250	43%

Questionable Policy Incentives

The stated policy reason for estate taxes has been that too much concentration of wealth is not good for a society. Aside from the fact that the estate tax has not done much in terms of reducing income and wealth inequality, the fact that Congress did not change the one-year repeal before January 1 of 2010, is an example of implementing quite questionable incentives. As the situation above shows, all else equal, the best year for Joseph to die is 2010. His heirs will receive the entire $5 million instead of only $4.3 million if he died in 2009 or $2.8 million if he dies in 2011. Of course, death of natural causes cannot be timed. What happens though if Joseph was in a serious accident in late 2009 without a DNR order in place? Would his heirs insist that he’d be kept alive until January 1 and then taken off life support? What if Joseph has an accident in December of 2010?

In order to prevent anybody of literally making life or death decisions in order to save taxes, Congress should have addressed the estate tax in 2009 before the repeal-year started. There were several proposals on the table. Considering the current budget shortfall and the Democratic majorities in both the House and the Senate it is not unlikely that the legislators will pass a law retroactively changing the 2010 repeal. Since tax returns are not due until nine months after the decedent’s death, a retroactive change is possible. For example, it may be possible that a “patch” (i.e., keeping rates and credit like it was in 2009) will pass for 2010. Thus, contemplating death in light of a possible tax free year would be unwise considering the irreversibility of such action.

Other Negative Consequences

During 2001–2011 inflation was relatively low (around 2.3% on average). Using consumer price index measures, the value of a dollar in 2001 is about 1.25 more than in 2011. Given that in 2001, over 108,000 estate tax returns were filed, compared to only 38,000 in 2008 , we can assume that reverting back to 2001 law would mean that at least 130,000 returns will be due in 2011. This is good news to tax accountants but bad news for many individuals who did not expect to be subject to estate taxes.

In addition, the repeal of the estate tax for 2010 means that assets transferred at death during this year do not get a stepped-up basis. Thus, beneficiaries will have to pay larger amounts in income taxes when they sell the inheritance.

Last, the one-year repeal is also bad news for estates below the exemption equivalent. For these estates, the tax savings are zero while the elimination of the step-up in basis increases beneficiaries’ income tax when they sell the assets received. One can make the argument that this is a rule against the middle class and upper middle class since presumably most of these individuals would have never paid estate tax anyway but their heirs would benefit from the step-up in basis. If the law reverts back to 2001 law in 2011, the step-up will be back next year. Thus, while individuals with large estates have an incentive to die in 2010, others (most middle and upper middle class taxpayers) who have an estate below the exemption equivalent should not die in 2010.

Say Goodbye to the Bonus

Accrual basis taxpayers are generally permitted to deduct accrued compensation if it’s paid out within 2 1/2 months after year end.  In a recent Chief Counsel Advice, the IRS announced that they would not permit deductions for accrued bonuses if payment is contingent upon continued employment at the date the bonus is actually paid.  If you haven’t finalized your year-end bonus plan and expect a deduction, you should ensure that employees are not required to be employed at the payment date.  This may be difficult for many companies, as bonus policies are usually established well in advance of the year-end, but there’s still time to change it if you can.

Tax Help for All Businesses Great and Small

In February the normal two year carryback period for Net Operating Losses (NOL’s) was extended to 3, 4 or 5 years for electing small businesses. Earlier this month, the 3, 4 or 5 year NOL carryback election was extended to all business (except taxpayers receiving help from the Federal government under the Emergency Economic Stabilization Act). The carryback is valid for any years ending after December 31, 2007 and commencing before January 1, 2010 – you can even make the election if you previously elected to forego the 2 year carryback period.

What’s the catch? Well, you can only make the election once (qualifying small businesses who were previously eligible now get to make the election twice). Also, if you elect the 5 year carryback, you can only offset 50% of that year’s income with the NOL. Other guidelines, including details for how to elect the carryback were issued by the IRS last week.

Extended carryback periods have been used by the IRS before, and should help many businesses who were profitable by expediting the tax benefit from recent losses. We certainly hope it helps more businesses to keep going during tough economic times, and keep more people employed.

S Corporation Pitfalls – Part 1

S Corporations are a popular business entity - they allow for limitation of liability, may reduce self-employment taxes, and income is passed through to the owners, resulting in only one level of taxation, while providing a “corporate veil” for liability protection.  There are a number of possible pitfalls for the unwary, particularly if the company operated as a C Corporation prior to electing S Corporation status.  This series on S Corporation pitfalls will discuss some of the more common issues, and some of the more serious… pitfalls that can have costly results without proper planning…

First, as a rule of thumb, do not hold appreciable assets, such as real estate or passive investments in an S Corporation. Why not? You probably know that there is generally no resulting tax when cash is distributed from S Corporation earnings. What many people fail to realize is that the distribution of appreciated property will result in a taxable transaction. When property is distributed from any type of Corporation (S Corporation or C Corporation) the distribution is made at the property’s Fair Market Value. This means that there is a realized taxable gain on the difference between the Fair Market Value at the date of distribution and the tax basis. You will pay tax on the transaction, and your resulting tax basis in the asset after distribution will be its Fair Market Value at the date of distribution.

This problem is most commonly avoided by distributing cash from the S Corporation to the owners, who then use the funds to purchase real estate, or other passive investments.  These assets are frequently purchased through a limited liability company (LLC) to preserve pass through treatment of the income.  If the real property is used by the S Corporation in its business, the property is then rented back to the S Corporation. The difference is that distributions from LLC’s (and partnerships) are made at the asset’s tax basis, with no gain or loss recognized on the distribution (resulting in a deferral of tax until the property is actually disposed of). Your basis in the distributed asset will be the same as it was in the hands of the LLC.

Placing appreciable assets into LLC’s instead of S Corporations will provide greater flexibility for future tax planning, and possibly defer the payment of income tax.

Taking the Life out of LIFO

For many companies the transition to IFRS will not result in a major change… the big exception is in the manufacturing and retail industries, as IFRS does not allow the use of LIFO (the Last In First Out method of accounting for inventory). Because LIFO treats the last item to be purchased as the first item to be sold, the use of LIFO generally increases the cost of goods sold during periods of inflation.  This reduces a company’s assets and earnings, but can result in large tax savings. It is because of this dichotomy that the IRS requires businesses to use LIFO for their book accounting records and financial statements if they wish to use it for tax purposes. Additionally, use of LIFO is generally restricted to mid-to-large sized companies, as it requires additional administrative work to track multiple LIFO layers for each type of inventory, and to prepare tax Uniform Capitalization adjustments on each layer.

Enter IFRS (from 2014 to 2016 for publicly traded companies – transition dates for privately held businesses have not yet been announced). Exit LIFO.  If companies can no longer use LIFO for book accounting purposes, they will not be able to use it for tax accounting. This will give rise to a flood of paperwork to the IRS, as each company requests permission to change accounting method (which must be formally requested, even though the change is required and unwanted). More importantly, it will  result in a huge income tax liability for nearly all companies required to make the transition.

So far the IRS has not offered any hint of resolution on this matter… and it looks like our manufacturers and retailers may pay the price.

A Matter of Trust

A number of countries don’t allow foreign people (including foreign business entities) to own land in certain areas. The most well known of these countries is Mexico, but I have recently come across a similar situation in Canada, and know of cases in Great Britain. As a work-around, the land is usually held in trust for the foreign owner. This may not seem as though it creates any tax issues, but it does. Unfortunately foreign trusts have at times been used to try to shelter income off-shore in foreign tax havens, so the IRS has strict reporting requirements for foreign trusts… and the penalties for not filing the related forms are huge! (In some cases 35% of the trust assets per year).  Even if you don’t think of the trust as a “real trust” – the IRS probably will (they are commonly referred to as “Land Trusts” or “Mexican Land Trusts”). We recently enlisted the services of tax attorney, Jean Ryan at Sideman Bancroft, LLP, to analyze a Canadian land trust.  Although the client “never thought of it as being a real trust,” her answer was that it the IRS may treat it as trust, because of the language in the document. So if you own beachfront property in Mexico – lucky you, but in all seriousness, talk to your tax advisor to make sure that you don’t lose it all in penalties.

Get Out of Jail Free

Oversight of seemingly insignificant, immaterial assets such as bank balances could cost you big money in penalties.

The IRS has disclosure reporting requirements for ownership or control over foreign assets.  The disclosures relate to control over a foreign business entity or trust, receipt of gifts or inheritances from foreign sources, and ownership in (or signing authority for) a foreign bank or investment account.  The penalties for not filing the disclosure forms on time, or incomplete filings, include both civil and criminal penalties, with civil penalties starting start at a minimum of $10,000 per person, per year, per failure to file.

The IRS recently announced a reduction in the Foreign Bank Account Reporting (FBAR) penalties and disclosure penalties for those with an interest in foreign entities (foreign companies, foreign trusts, etc.) if they voluntarily disclose previously unreported information prior to September 23, 2009.  This sounds great, but penalties are still being assessed at 20% of the maximum value in the bank account at any point during the last 6 years (or 20% of the maximum value of the assets held by a business), which may be substantial.  In certain circumstances the penalty may be reduced to 5%, but these cases are very limited.  Even worse, an IRS memorandum directs examiners that “no reasonable cause exception may apply” – so there is no getting out of these penalties because of an innocent mistake.  This can be unfair, as many of those failing to file these forms don’t know that the requirement exists.  The commissioner also threatened in a statement that “the situation will only become more dire” for those who do not self-correct, directing examiners to pursue both civil and criminal penalties that are available for non-compliance.  The good news is that if you self-correct in time, a “get out of jail free card” is still available.