The IRS has released long-awaited guidance on new Code Sec. 199A, commonly known as the "pass-through deduction" or the "qualified business income deduction." Taxpayers can rely on the proposed regulations and a proposed revenue procedure until they are issued as final.

The IRS has released long-awaited guidance on new Code Sec. 199A, commonly known as the "pass-through deduction" or the "qualified business income deduction." Taxpayers can rely on the proposed regulations and a proposed revenue procedure until they are issued as final.

Code Sec. 199A allows business owners to deduct up to 20 percent of their qualified business income (QBI) from sole proprietorships, partnerships, trusts, and S corporations. The deduction is one of the most high-profile pieces of the Tax Cuts and Jobs Act ( P.L. 115-97).

In addition to providing general definitions and computational rules, the new guidance helps clarify several concepts that were of special interest to many taxpayers.

Trade or Business

The proposed regulations incorporate the Code Sec. 162 rules for determining what constitutes a trade or business. A taxpayer may have more than one trade or business, but a single trade or business generally cannot be conducted through more than one entity.

Taxpayers cannot use the grouping rules of the passive activity provisions of Code Sec. 469 to group multiple activities into a single business. However, a taxpayer may aggregate trades or businesses if:

• each trade or business is itself a trade or business;
• the same person or group owns a majority interest in each business to be aggregated;
• none of the aggregated trades or businesses can be a specified service trade or business; and
• the trades or businesses meet at least two of three factors which demonstrate that they are in fact part of a larger, integrated trade or business.

Specified Service Business

Income from a specified service business generally cannot be qualified business income, although this exclusion is phased in for lower-income taxpayers.

A new de minimis exception allows some business to escape being designated as a specified service trade or business (SSTB). A business qualifies for this de minimis exception if:

• gross receipts do not exceed $25 million, and less than 10 percent is attributable to services; or
• gross receipts exceed $25 million, and less than five percent is attributable to services.

The regulations largely adopt existing rules for what activities constitute a service. However, a business receives income because of an employee/owner’s reputation or skill only when the business is engaged in:

• endorsing products or services;
• licensing the use of an individual’s image, name, trademark, etc.; or
• receiving appearance fees.

In addition, the regulations try to limit attempts to spin-off parts of a service business into independent qualified businesses. Thus, a business that provides 80 percent or more of its property or services to a related service business is part of that service business. Similarly, the portion of property or services that a business provides to a related service business is treated as a service business. Businesses are related if they have at least 50-percent common ownership.

Wages/Capital Limit

A higher-income taxpayer’s qualified business income may be reduced by the wages/capital limit. This limit is based on the taxpayer’s share of the business’s:

• W-2 wages that are allocable to QBI; and
• unadjusted basis in qualified property immediately after acquisition.

The proposed regulations and Notice 2018-64, I.R.B. 2018-34, provide detailed rules for determining the business’s W-2 wages. These rules generally follow the rules that applied to the Code Sec. 199 domestic production activities deduction.

The proposed regulations also address unadjusted basis immediately after acquisition (UBIA). The regulations largely adopt the existing capitalization rules for determining unadjusted basis. However, "immediately after acquisition" is the date the business places the property in service. Thus, UBIA is generally the cost of the property as of the date the business places it in service.

Other Rules

The proposed regulations also address several other issues, including:

• definitions;
• basic computations;
• loss carryovers;
• Puerto Rico businesses;
• coordination with other Code Sections;
• penalties;
• special basis rules;
• previously suspended losses and net operating losses;
• other exclusions from qualified business income;
• allocations of items that are not attributable to a single trade or business;
• anti-abuse rules;
• application to trusts and estates; and
• special rules for the related deduction for agricultural cooperatives.

Effective Dates

Taxpayers may generally rely on the proposed regulations and Notice 2018-64 until they are issued as final. The regulations and proposed revenue procedure will be effective for tax years ending after they are published as final. However:

• several proposed anti-abuse rules are proposed to apply to tax years ending after December 22, 2017;
• anti-abuse rules that apply specifically to the use of trusts are proposed to apply to tax years ending after August 9, 2018; and
• if a qualified business’s tax year begins before January 1, 2018, and ends after December 31, 2017, the taxpayer’s items are treated as having been incurred in the taxpayer’s tax year during which business’s tax year ends.

Comments Requested

The IRS requests comments on all aspects of the proposed regulations. Comments may be mailed or hand-delivered to the IRS, or submitted electronically at www.regulations.gov (indicate IRS and REG-107892-18). Comments and requests for a public hearing must be received by September 24, 2018.

The IRS also requests comments on the proposed revenue procedure for calculating W-2 wages, especially with respect to amounts paid for services in Puerto Rico. Comments may be mailed or hand-delivered to the IRS, or submitted electronically to Notice.comments@irscounsel.treas.gov, with “ Notice 2018-64” in the subject line. These comments must also be received by September 24, 2018.

The IRS’s proposed pass-through deduction regulations are generating mixed reactions on Capitol Hill. The 184-page proposed regulations, REG-107892-18, aim to clarify certain complexities of the new, yet temporary, Code Sec. 199A deduction of up to 20 percent of income for pass-through entities. The new deduction was enacted through 2025 under the Tax Cuts and Jobs Act (TCJA), ( P.L. 115-97). The pass-through deduction has remained one of the most controversial provisions of last year’s tax reform.

The IRS’s proposed pass-through deduction regulations are generating mixed reactions on Capitol Hill. The 184-page proposed regulations, REG-107892-18, aim to clarify certain complexities of the new, yet temporary, Code Sec. 199A deduction of up to 20 percent of income for pass-through entities. The new deduction was enacted through 2025 under the Tax Cuts and Jobs Act (TCJA), ( P.L. 115-97). The pass-through deduction has remained one of the most controversial provisions of last year’s tax reform.

A legislative package that would make permanent the pass-through deduction, as well as other individual tax cuts, is expected to move though the House this fall. However, the House’s legislative efforts are not expected, at this time, to pass muster in the more narrowly GOP-controlled Senate.

Criticism

Several Democratic lawmakers and tax policy experts have already started to weigh in on the proposed regulations, which were released on August 8 while Congress remained in its annual August recess. Democrats have criticized the new deduction for primarily benefiting the wealthy. Meanwhile, several tax policy experts have taken to Twitter to note that the deduction is overly complex and administratively burdensome.

Senate Finance Committee (SFC) ranking member Ron Wyden, D-Ore., has reportedly said that the proposed regulations "confirm that the fortunate few win," under the new tax law. "Tax planners are already scouring through the nearly 200 pages of regulations in search of new ways to keep wealthy clients from paying their fair share."

Compliance Burdens

The pass-through deduction could add 25 million hours to taxpayers’ annual reporting burden, according to the proposed regulations. Additionally, the IRS has estimated that gross reporting annualized costs to taxpayers will total approximately $1.3 billion over 10 years.

Furthermore, the IRS has estimated that the compliance burden will vary between taxpayers, averaging between 30 minutes and 20 hours. The administrative burden on smaller pass-through entities is anticipated to be on the lower end of the estimate, according to the IRS.

Comment. Ryan Kelly, partner at Alston & Bird LLP, told Wolters Kluwer on August 13 that the IRS’s 25 million-hour estimate, whether accurate or not, suggests that there will be a significant increase in administrative compliance costs. "There is a real cost to tax compliance in lost time and productivity for taxpayers," Kelly said. However, Kelly predicted that taxpayers’ Code Sec. 199A compliance burden will eventually decrease. "Time will reveal the extent of taxpayers’ administrative burden to comply; however, it is likely that as time goes on the taxpayers’ compliance burden will fall as taxpayers, tax practitioners, and the Service all become more familiar with section 199A and how it is intended to operate."
Meanwhile, the chairs of the House and Senate tax writing committees have both praised Treasury and the IRS for quickly releasing the much anticipated regulations. Additionally, several tax policy experts have also praised the proposed regulations for alleviating confusion, as well as taxpayer anxiety, about ambiguous provisions of the law.

"This first-ever 20 percent deduction for small businesses allows our local job creators to keep more of their money so they can hire, invest, and grow in their communities," House Ways and Means Committee Chairman Kevin Brady, R-Tex., said in a statement. "These proposed regulations are intended to provide certainty and flexibility for Main Street businesses in this historic new small business deduction."

Improvements to the proposed regulations are expected in the coming months as stakeholders submit comments. A public hearing at IRS headquarters in Washington, D.C., has been scheduled for October 16. "Evolution of tax regulations is generally never a pretty process, but it is a necessary process that in this case will hopefully happen sooner rather than later," Kelly told Wolters Kluwer.

The House’s top tax writer has unveiled Republicans’ "Tax Reform 2.0" framework. The framework outlines three key focus areas:.

The House’s top tax writer has unveiled Republicans’ "Tax Reform 2.0" framework. The framework outlines three key focus areas:

• making permanent the individual and small business tax cuts enacted under the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97);
• promoting family savings by streamlining retirement savings accounts and creating a new Universal Savings Account; and
• spurring business innovation by allowing new businesses to write off more initial start-up costs.

Tax Reform 2.0

The GOP’s tax reform "phase two" framework—otherwise known as "Tax Cuts 2.0"—was released by House Ways and Means Committee Chairman Kevin Brady, R-Tex. on July 24. The outline is expected to be used for GOP "listening sessions" to be held among lawmakers.

Brady has said that making permanent the TCJA’s individual and small business tax cuts, enacted last December temporarily through 2025, will be the "centerpiece" of the next tax reform package. Further, Brady told reporters on July 24 that he anticipates Tax Reform 2.0 to move forward as three separate tax bills. A House vote on the package is expected sometime in September.

Preliminary Analysis

Republicans’ Tax Reform 2.0 framework is a "good start," according to a July 24 report released by the independent, yet widely-considered conservative-leaning, think tank Tax Foundation. The report praised the framework’s proposal to streamline retirement savings accounts and make permanent the TCJA’s individual tax cuts. Additionally, the Tax Foundation estimates that making permanent the individual tax cuts set to expire in 2026 would grow the U.S. economy by 2.2 percent while reducing federal revenue by $165 billion annually on a static basis.

Democrats Disagree

However, several Democratic lawmakers began issuing statements criticizing the Tax Reform 2.0 framework shortly after its release. Democrats have remained united in their disapproval of the TCJA, criticizing last year’s tax code overhaul for primarily benefiting the wealthy and corporations.

"Republicans’ first tax bill exposed the party’s real priorities: big corporations and people at the top," House Ways and Means Committee ranking member Richard Neal, D-Mass., said in a July 24 statement. "This new framework is more of the same – it rewards the well-off and well-connected, fails to reinstate the state and local tax deduction, and leaves the middle class behind."

Corporate Tax Cuts

The Tax Reform 2.0 framework did not include a proposal to further reduce the corporate tax rate. President Trump has called for lowering the corporate tax rate to 20 percent. The corporate tax rate was lowered from 35 to 21 percent last December under the TCJA. Brady previously told reporters that House Republicans and the White House are continuing discussions on the idea.

Tax Reform 3.0, 4.0

"Tax Reform 2.0 is a new commitment to improve the tax code each and every year for American families and local businesses," the framework says. Congress will examine the tax code each year to identify areas of needed improvement, according to the outline. Additionally, Brady has said he hopes to see a Tax Reform 3.0, 4.0, and so on.

Senate

At this time, the Tax Reform 2.0 package is not expected to clear the Senate in its entirety. It is thought on Capitol Hill that Democrats may support measures that focus on retirement and education savings and business innovation. However, several lawmakers view it as unlikely that Democrats would support a bill that makes permanent the individual tax cuts under the TCJA.

Brady has reportedly said that extending TCJA’s individual provisions would increase the deficit by $600 billion over 10 years but would be offset, at least in part, by beneficial economic factors. Several Senate Democrats and Republicans have said they would not vote for extending or creating tax cuts that increase the federal deficit.

The IRS faces numerous challenges, most of which are attributable to funding cuts, the National Taxpayer Advocate Nina Olson told a Senate panel on July 26. "The IRS needs adequate funding to do its job effectively," Olson told lawmakers.

The IRS faces numerous challenges, most of which are attributable to funding cuts, the National Taxpayer Advocate Nina Olson told a Senate panel on July 26. "The IRS needs adequate funding to do its job effectively," Olson told lawmakers.

IRS Funding

Olson, while testifying at a Senate Finance Committee (SFC) Taxation and IRS Oversight Subcommittee hearing, placed blame on both congressional appropriations and IRS management for the Service’s challenges. "While some of the IRS’s struggles can be addressed by better management, much of the IRS’s challenges are attributable to funding cuts," Olson said.

The IRS has simultaneously seen an increased workload and budget reduction of 20 percent when accounting for inflation between fiscal years 2010 and 2018, according to Olson. "Because of these reductions, the IRS does not have enough employees to answer the phones, to conduct outreach and education, or to provide basic taxpayer service," she added.

Further, Olson noted that the IRS answered only 29 percent of telephone calls received on the Accounts Management lines during this year’s filing season. Additionally, IRS compliance and enforcement efforts have also struggled, Olson said, adding that the audit rate is at its lowest level in "memory."

Likewise, Phyllis Jo Kubey, testifying on behalf of the National Association of Enrolled Agents, IRS Advisory Council, remarked on decreased IRS funding. "The agency is handicapped by budgeting that is not only insufficient to meet its large and growing portfolio, but also inefficiently structured," Kubey told lawmakers.

IRS Reform

The SFC subcommittee hearing came just days after the 20-year anniversary of the IRS Restructuring and Reform Act of 1998. The House and Senate are currently working toward approving bipartisan legislation that would significantly reform the IRS for the first time in 20 years.

SFC Taxation and IRS Oversight Subcommittee Chairman Rob Portman, R-Ohio, and Sen. Ben Cardin, D-Md., unveiled on July 26 the bipartisan Protecting Taxpayers Bill. The measure aims to reform a number of IRS functions and administrative practices, according to a joint press release issued the same day.

"It has been 20 years since the last significant IRS reform, and it is time to update the agency once again," Portman said in the press release. Similarly, Cardin praised the bill for including needed updates to modernize the IRS. "Americans of all income levels deserve a responsive, effective IRS, and the updates contained in this bipartisan bill will help keep the IRS on that path," Cardin said.

Additionally, SFC Chairman Orrin G. Hatch, R-Utah, and ranking member Ron Wyden, D-Ore., recently introduced the bipartisan Taxpayer First Bill ( Sen. 3246). The measure would also reform certain administrative practices at the IRS.

To that end, the House approved its bipartisan IRS reform package, the Taxpayer First Bill ( HR 5444) last April. The House package contains several proposals, which would, among other things:

• establish a single point of contact for tax-related identity theft victims;
• expand the use of Low-Income Taxpayer Clinics (LITCs); and
• require electronic filing for certain tax-exempt organizations

Path Forward

Hatch previously told Wolters Kluwer that the House’s IRS reform proposals are a "welcomed step forward." Additionally, Hatch told Wolters Kluwer that he will work with his "colleagues in Congress to find a path forward that reflects both the House and Senate views."

Senate Finance Committee (SFC) Republicans are clarifying congressional intent of certain tax reform provisions. In an August 16 letter, GOP Senate tax writers called on Treasury and the IRS to issue tax reform guidance consistent with the clarifications.

Senate Finance Committee (SFC) Republicans are clarifying congressional intent of certain tax reform provisions. In an August 16 letter, GOP Senate tax writers called on Treasury and the IRS to issue tax reform guidance consistent with the clarifications.

The letter, addressed to Treasury Secretary Steven Mnuchin and Acting IRS Commissioner David Kautter, identifies three sections of the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97) needing clarification:

• Section 13204 – qualified improvement property expensing;
• Section 13302 – net operating losses (NOLs) deduction; and
• Section 13307 – sexual misconduct settlement deduction.

Real Property Depreciation

Congressional intent for Section 13204 under the TCJA was to provide a 15-year modified accelerated cost recovery system (MACRS) recovery period for qualified improvement property, the lawmakers wrote. Additionally, the letter states that the new law should also provide a 20-year alternative deprecation system (ADS) recovery period for qualified improvement property.

NOLs

The TCJA contains a typographical error in Section 13302. The law should state that the NOL carryforward and carryback modifications are effective for NOLs arising in tax years beginning after December 31, 2017, the lawmakers noted. Currently, the legislative text states the effective date is for tax years ending after December 31, 2017.

Attorney’s Fees

Generally, section 13307 of the TCJA denies a deduction for attorney’s fees related to a settlement or payment stemming from a sexual harassment/abuse nondisclosure agreement (NDA). Congressional intent was that attorney’s fees would not be subject to the rule prohibiting the deduction, the letter states.

Technical Corrections

SFC Republicans intend to introduce a technical corrections bill addressing other needed clarifications of the TCJA, the letter notes. The intended technical corrections bill is not expected to be a part of Republican "Tax Reform 2.0" efforts.

"While this letter focuses on these three important provisions, we are continuing a thorough review…to identify other instances in which the language as enacted may require regulatory guidance or technical corrections to reflect the intent of the Congress. After this review, we intend to introduce technical corrections legislation to address any items identified in the on-going review."

Taxpayers and practitioners need clarity on certain S corporation issues by next tax filing season, the American Institute of CPAs (AICPA) has said. In an August 13 letter sent to Treasury and the IRS, the AICPA requested immediate guidance on certain S corporation provisions under the Tax Cuts and Jobs Act (TCJA) (P.L. 115-97).

Taxpayers and practitioners need clarity on certain S corporation issues by next tax filing season, the American Institute of CPAs (AICPA) has said. In an August 13 letter sent to Treasury and the IRS, the AICPA requested immediate guidance on certain S corporation provisions under the Tax Cuts and Jobs Act (TCJA) (P.L. 115-97).

S Corporations

S corporations elect to pass corporate income, losses, deductions, and credits through to shareholders for federal tax purposes. Thus, S corporations are considered a pass-through entity. This election allows S corporations to avoid double taxation on the corporate income, according to the IRS.

"Taxpayers and practitioners need clarity on S corporation issues in order to comply with their 2018 tax obligations and to make informed decisions regarding cash-flow, entity structure, and tax planning issues," Annette Nellen wrote in the letter on behalf of the AICPA. Generally, the letter noted the following three areas for which guidance is needed:

• application of the new laws on loss carryforwards;
• clarification of certain provisions relating to the post-termination transition period (PTTP) and the eligible terminated S corporation period (ETSC Period); and
• treatment of deferred foreign income upon transition to participation exemption system of taxation for S corporation trust shareholders.

Earlier this year, the AICPA also called for guidance on the Code Sec. 199A new pass-through deduction.

You have carefully considered the multitude of complex tax and financial factors, run the numbers, meet the eligibility requirements, and are ready to convert your traditional IRA to a Roth IRA. The question now remains, however, how do you convert your IRA?

Conversion basics

A conversion is a penalty-free taxable transfer of amounts from a traditional IRA to a Roth IRA. You can convert part or all of the money in your regular IRA to a Roth. When you convert your traditional IRA to a Roth, you will have to pay income tax on the amount converted. However, a traditional IRA may be converted (or rolled over) penalty-free to a Roth IRA as long as you meet the requirements for conversion, including adjusted gross income (AGI) limits in effect until 2010. You should have funds outside the IRA to pay the income tax due on the conversion, rather than taking a withdrawal from your traditional IRA to pay for it - those withdrawals are subject to an early withdrawal penalty and they cannot be put back at a later time to continue to accumulate in the tax-free environment of an IRA.

Big news for 2010 and beyond

Beginning in 2010, you can convert from a traditional to a Roth IRA with no income level or filing status restrictions. For 2008, Roth IRAs are available for individuals with a maximum adjusted gross income of $116,000 ($169,000 for joint filers and heads of household). These income limits have prevented many individuals from establishing or converting to a Roth IRA. Not only is the income limitation eliminated after 2009, taxpayers who convert to a Roth IRA in 2010 can recognize the conversion amount in adjusted gross income (AGI) ratably over two years, in 2011 and 2012.

Example. You have $14,000 in a traditional IRA, which consists of deductible contributions and earnings. In 2010, you convert the entire amount to a Roth IRA. You do not take any distributions in 2010. As a result of the conversion, you have $14,000 in gross income. Unless you elect otherwise, $7,000 of the income is included in income in 2011 and $7,000 is included in income in 2012.

Conversion methods

There are three ways to convert your traditional IRA to a Roth. Generally, the conversion is treated as a rollover, regardless of the conversion method used. Any converted amount is treated as a distribution from the traditional IRA and a qualified rollover contribution to the Roth IRA, even if the conversion is accomplished by means of a trustee-to-trustee transfer or a transfer between IRAs of the same trustee.

1. Rollover conversion. Amounts distributed from a traditional IRA may be contributed (i.e. rolled over) to a Roth IRA within 60 days after the distribution.

2. Trustee-to-trustee transfer. Amounts in a traditional IRA may be transferred in a trustee-to-trustee transfer from the trustee of the traditional IRA to the trustee of the Roth IRA. The financial institution holding your traditional IRA assets will provide directions on how to transfer those assets to a Roth IRA that is maintained with another financial institution.

3. Internal conversions. Amounts in a traditional IRA may be transferred to a Roth IRA maintained by the same trustee. Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, in lieu of opening a new account or issuing a new contract. As with the trustee-to-trustee transfer, the financial institution holding the traditional IRA assets will provide instructions on how to transfer those assets to a Roth IRA. The transaction may be simpler in this instance because the transfer occurs within the same financial institution.

Failed conversions

A failed conversion has significant negative tax consequences, and generally occurs when you do not meet the Roth IRA eligibility or statutory requirements; for example, your AGI exceeds the limit in the year of conversion or you are married filing separately (note: as mentioned, the AGI limit for Roth IRAs will no longer be applicable beginning in 2010).

A failed conversion is treated as a distribution from your traditional IRA and an improper contribution to a Roth IRA. Not only will the amount of the distribution be subject to ordinary income tax in the year of the failed conversion, it will also be subject to the 10 percent early withdrawal penalty for individuals under age 59 1/2, (unless an exception applies). Moreover, the Tax Code imposes an additional 6 percent excise tax each year on the excess contribution amount made to a Roth IRA until the excess is withdrawn.

Caution - financial institutions make mistakes

The brokerage firm, bank, or other financial institution that will process your IRA to Roth IRA conversion can make mistakes, and their administrative errors will generally cost you. It is imperative that you understand the process, the paperwork, and what is required of you and your financial institution to ensure the conversion of your IRA properly and timely. Our office can apprise you of what to look out for and what to require of the financial institutions you will deal with during the process.

Determining whether to convert your traditional IRA to a Roth IRA can be a complicated decision to make, as it raises a host of tax and financial questions. Our office can help you determine not only whether conversion is right for you, but what method is best for you, too.

In a period of declining stock prices, tax benefits may not be foremost in your mind. Nevertheless, you may be able to salvage some benefits from the drop in values. Not only can you reduce your taxable income, but you may be able to move out of unfavorable investments and shift your portfolio to investments that you are more comfortable with.

First, you should keep in mind that gain and loss on a sale of stock or mutual fund shares depends on the fair market value of the shares when sold or disposed of, compared to the cost basis of the stock. Your investments may have lost substantial value over recent periods. Nevertheless, if the stock's value when sold is higher than the basis, you still have a gain.

Example. You purchased X Corp stock in 2004, when it cost $5. At the end of 2007, the stock is worth $12. In November, 2008, you sell the stock when its value is $8 a share. Even though your investment has declined in value by 33 percent, you have a gain of $3 a share on the sale ($8 sales price less $5 cost).

The same tax-basis situation that may cause capital gain on the sale of shares that have dropped significantly in value over the past year also is causing many owners of mutual funds that have declined in value to be surprised with a capital gains distribution notice from their fund managers. If you own the mutual fund shares at the time of the capital gain distribution date, you must recognize the gain. Of course, that gain may be netted against your losses from stock or other capital asset sales.

If you realize a profit on a stock sale, the long-term capital gains tax is a maximum of 15 percent, while taxes on wages and other ordinary income can be taxed as high as 35 percent. For taxpayers in the 10 or 15 percent rate brackets, there is no capital gains tax. These reduced capital gains rates are scheduled to expire after 2010. Short-term capital gains (investments held for one year or less) are taxed at ordinary income rates up to 35 percent.

Capital losses can offset capital gains and ordinary income dollar for dollar. Capital gains can be offset in full, whether short-term or long-term. Ordinary income can be offset up to $3,000. If net capital losses (capital losses minus capital gains) exceed $3,000, the excess can be carried forward without limit and can offset capital gains and $3,000 of ordinary income in each subsequent year.

Because a capital loss can offset income taxed at the 35 percent rate, it can be advantageous to sell stock that yields capital gains in one year, while delaying the realization of capital losses until the following year.

Example. Mary has two assets. One asset would yield a $6,000 long-term capital loss when sold. The other would yield a $6,000 long-term capital gain. If Mary sells both assets in the same year, she has a net capital gain of zero. If she realizes the gain in 2008 and the loss in 2009 (by selling the assets in different years), she will increase her 2008 taxes by a maximum of $900 ($6,000 X 15 percent), but will reduce her taxes in 2009 and 2010 by a maximum of $2,100 ($3,000 X 35 percent X 2 years). She will reduce her taxes by $1,200 merely by shifting the timing of the sales.

Worthless securities. You can write off the cost of totally worthless securities as a capital loss, but cannot take a deduction for securities that have lost most of their value from stock market fluctuations or other causes if you still own them and they still have a recognizable value. You do not have to sell, abandon or dispose of the security to take a worthless stock deduction, but worthlessness must be evidenced by an identifiable event. An event includes cessation of the corporation's business, commencement of liquidation, actual foreclosure and bankruptcy. Securities become worthless if the corporation becomes worthless, even if the corporation has not dissolved, liquidated or ceased doing business.

If you would like to discuss these issues, please contact our office. We can help you consider your options.

The high cost of energy has nearly everyone looking for ways to conserve and save money, especially with colder weather coming to many parts of the country. One surprising place to find help is in the financial markets rescue package (the Emergency Economic Stabilization Act of 2008) recently passed by Congress. Overshadowed by the financial provisions are some very important energy tax incentives that could save you money at home and in your business.

While the energy tax incentives in the new law are generous, they are also complex. The names of the tax credits and deductions themselves can be daunting. Don't be put off by all the complex rules. Our office can help you navigate them and take advantage of their benefits.

Individuals

Improvements. If you are thinking of installing insulation or new energy-efficient windows and doors, you may be eligible for the residential energy property credit. This credit (also known as the Code Sec. 25C credit) gives eligible taxpayers a lifetime credit of up to $500 for making energy-efficient improvements to their residences. Up to $200 of the credit can be taken for the cost of windows. Besides insulation and energy-efficient windows and doors, some electric heat pump water heaters, natural gas, propane and oil furnaces, and other items qualify. The credit limits and energy-efficiency ratings are very complex so please contact our office before you make a purchase. We don't want you to miss out on a potentially valuable tax break. However, because of a quirk in the new law, the residential energy property credit is not available for 2008. However, you can take advantage of it in 2009.

Alternative energy. This credit (also known as the Code Sec. 25D credit) sounds a lot like the credit for energy efficient property but it is different. The key word in the title of the credit is "alternative." This credit rewards individuals who install certain types of alternative energy systems in their homes, particularly systems that utilize solar power and wind energy. These include solar electric, solar water heating, small wind energy, and geothermal heat pump property. Generally you must install the property before the end of 2016.

Businesses

Solar and wind power. Businesses are also eligible for some valuable energy tax breaks. Businesses that install solar energy and small wind energy property can take advantage of special tax credits that can reach as high as 30 percent. Generally, the solar or wind energy property must be used to generate electricity that heats, cools or lights a building.

Improvements. There is also a special tax deduction for energy efficient improvements made to commercial buildings. Generally, the improvements to heating, cooling, ventilation, lighting, and other qualifying systems must significantly reduce annual energy costs. Many of the new heating, cooling and lighting systems currently on the market meet these standards. If you recently installed new heating, cooling or lighting systems, you may have qualified for a tax break without even knowing it.

Manufacturers and builders. Manufacturers of energy efficient appliances, such as washing machines and refrigerators, are eligible for special tax credits. Additionally, contractors that build energy efficient homes can take advantage of tax breaks.

Transportation

In the not too distant future, you may be able to purchase a plug-in electric vehicle. In anticipation of that day, Congress created a new plug-in electric vehicle tax credit. The credit is available to everyone: individuals and businesses. Electric plug-in vehicles could be on the market as soon as 2010 so keep this tax break in mind if you shop for one.

These are just the highlights of some of the many energy tax incentives in the new law. Please contact our office for more details.

Nonbusiness creditors may deduct bad debts when they become totally worthless (i.e. there is no chance of its repayment). The proper year for the deduction can generally be established by showing that an insolvent debtor has not timely serviced a debt and has either refused to pay any part of the debt in the future, gone through bankruptcy, or disappeared. Thus, if you have loaned money to a friend or family member that you are unable to collect, you may have a bad debt that is deductible on your personal income tax return.

The fact that the debtor is a family member or other related interest does not preclude you from taking a bad debt deduction, provided that the debt was bona fide and that worthlessness has been established. A direct or indirect transfer of money between family members may create a bona fide debt eligible for the bad debt deduction. However, these transactions are closely scrutinized to determine whether the transfer is a bona fide debt or a gift.

Bona-fide debt and other requirements for deductibility

You may only take a bad debt deduction for bona-fide debts. A bona-fide debt is a debt arising from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money. You must also have the present intention to seek repayment of the debt. Additionally, for a bad debt you must also show that you had the intent to make a loan, and not a gift, at the time the money was transferred. Thus, there must be a true creditor-debtor relationship.

Moreover, nonbusiness bad debts are only deductible in the year they become totally worthless (partially worthless nonbusiness bad debts are not deductible).

To deduct a bad debt, you must also have a basis in it, which means that you must have already included the amount in your income or loaned out your cash (for example, if your spouse has not paid court-ordered child support, you can not claim a bad debt deduction for the amount owed as this amount was not previously included in your gross income).

Reporting bad debts

You can deduct nonbusiness bad debts as short-term capital losses on Schedule D of your Form 1040. On Schedule D, Part I, Line 1, enter the debtor's name and "statement attached" in column (a). Enter the amount of the bad debt in parentheses in column (f). If you are reporting multiple bad debts, use a separate line for each bad debt. For each bad debt, attach a statement to your return containing the following:

•  A description of the debt, including the amount and date it became due;
• The name of the debtor, and any business or family relationship between you and the debtor:
• The efforts you made to collect the debt; and
• An explanation of why you decided the debt was worthless (for example, you can show the debtor has declared bankruptcy or is insolvent, or that collection efforts such as through legal action will not likely result in the debt being paid).

If you did not deduct a bad debt on your original income tax return for the year it became worthless, you can file a refund claim or a claim for a credit due to the bad debt. You must use Form 1040X to amend your return for the year the debt became worthless. It must be filed with 7 years from the date your original return for that year had to be filed, or 2 years from the date you paid the tax, whichever is later.

Note. If you deduct a bad debt and in a later year collect all or part of the money owed, you may have to include this amount in your gross income. However, you can exclude from your gross income the amount recovered up to the amount of the deduction that did not reduce your tax in the year you deducted the debt.

With the U.S. and world financial markets in turmoil, many individual investors may be watching the value of their stock seesaw, or have seen it plummet in value. If the value of your shares are trading at very low prices, or have no value at all, you may be wondering if you can claim a worthless securities deduction for the stock on your 2008 tax return.

Capital or ordinary loss treatment

When stock you own in a corporation becomes totally worthless during the tax year, you may be able to report a loss in the stock equal to its tax basis. Generally, a worthless stock loss is characterized as a capital loss because securities like stock that become worthless are usually treated as capital assets. When a security that is not a capital asset becomes wholly worthless, the loss is deductible as an ordinary loss. For example, if worthless stock is Code Sec. 1244 stock, ordinary loss treatment applies. Worthless stock is treated as if it was sold on the last day of the tax year.

Note. You may only deduct a loss on worthless securities if the loss is incurred in a trade or business, in a transaction entered into for profit, or as the result of a fire, storm, shipwreck, another casualty, or theft. It is generally assumed that an individual acquires securities for profit (although this assumption may be refuted).

Your stock is trading at $1.08 a share: Is it "worthlessness?"

A worthless stock deduction may only be taken when your securities have become totally worthless. You can not take the deduction for stock that has become only partially worthless. The Internal Revenue Code, however, does not define "worthlessness." Nonetheless, in the IRS's eyes, a company's stock is not going to be automatically considered worthless simply because the stock or security has plummeted in value and is now trading at mere dollars and cents.

With the current market turmoil, many stocks have taken big hits and dropped significantly in value, perhaps even trading for a $1.08 per share, but are nonetheless still alive and trading on an exchange. Therefore, you can not take a worthless stock deduction for a mere decline in value of stock caused by a fluctuation in market price or other similar cause, no matter how steep the decline, if your stock has any recognizable value on the date you claim as the date of loss. Even if a company in which you have stock files for bankruptcy, or lawsuits are filed against it, does not automatically qualify the stock or securities as worthlessness.

More hurdles to overcome

Even if you can establish that the stock you own has become totally worthless, the loss must be (1) evidenced by a closed and completed transaction, (2) fixed by identifiable events and (3) actually sustained during the tax year. First, you may only claim the deduction on your return for the tax year in which the stock has become completely worthless, and you must be able to show that the year in which you are claiming the loss is the appropriate tax year.

Generally, a worthless stock loss deduction can be taken in the year in which you abandon the stock. To abandon a security, you must permanently surrender and relinquish all rights in the security and receive no consideration in exchange for the security. But, whether the transaction qualifies as abandonment, and not an actual sale or exchange, is a facts and circumstances test.

If you would like to know whether the stock or other securities you own have become worthless, please contact our office. We can help you navigate these complex rules.

The Housing Assistance Tax Act of 2008 (2008 Housing Act) gave a boost to individuals purchasing a home for the first time with a $7,500 first-time homebuyer tax credit. The credit was enhanced from $7,500 to $8,000 and extended for certain purchases under the American Recovery and Reinvestment Act of 2009 (2009 Recovery Act). This article explains how to determine the credit for eligible first-time homebuyers.

The $7,500 credit

The first-time homebuyer tax credit is a refundable, but temporary, tax credit equal to 10 percent of the purchase price of the residence, up to $7,500 for single individuals and married couples filing jointly, and $3,750 for married individuals who file separately. The $7,500 credit is only available for first-time purchases of primary residences (i.e. no second homes) made on or after April 9, 2008 and before July 1, 2009. To be eligible to claim the credit, however, an individual (or his or her spouse) must not have had any type of ownership interest in a principal residence during the three-year period before the date that the principal residence, for which the credit is to be taken, is purchased. You can claim a credit of up to either $7,500, or 10 percent of the purchase price, whichever is less.

The $8,000 credit under the 2009 Recovery Act

The 2009 Recovery Act raised the $7,500 maximum credit to $8,000, and extended that level through 2009 for eligible home purchases. The new law also eliminates any required repayment to the IRS after 36 months in the home. However, the enhanced $8,000 credit only applies to purchase of a principal residence made by a "first-time" homebuyer after December 31, 2008. Purchases on or after April 9, 2008 and before January 1, 2009 continue to be governed by the original first-time homebuyer credit enacted in the 2008 Housing Act.

The credit must be repaid in equal installments over the course of 15 years; the credit is interest-free. Repayments start two years after the year in which the residence is purchased. If the taxpayer sells or no longer uses the home as his or her principal residence before repaying the credit, the unpaid amount accelerates and becomes due on the return for the year in which the residence is sold or no longer used as a principal residence. The credit does not need to be repaid if the taxpayer dies. Special rules also exist for an involuntary conversion and a residence transferred in a divorce.

Example. Jim and Marsha, a married couple, are new homebuyers. They have never owned any other real property as a primary residence. Their combined modified adjusted gross income (AGI) is $74,600. They purchase their home in June 2009. Their first-time home purchase qualifies for the full $7,500 credit. They may file an amended 2008 return to claim the credit. Repayments of the $7,500 credit would begin in 2011.

Example. Mary and Tim are married joint filers who close title on a new home in February 2009. Their combined modified AGI is $100,000. They are entitled to claim the $8,000 first-time homebuyer tax credit. If they remain in the home for 36 months, they are not required to repay the credit to the government.

Phase-outs

The $7,500 and $8,000 credits both begin to phase-out for married couples with modified AGI between $150,000 and $170,000, and for single taxpayers with modified AGI between $75,000 and $95,000. However, the new credit benefits more than just single individuals and married couples, and can be taken by all co-owners, such as same-sex couples and family members who buy the residence together. However, the total amount of the credit allowed to such individuals, jointly, cannot exceed $7,500 (or $8,000).

Figuring the credit

If your modified AGI exceeds income threshold at which the credit begins to phase-out - $75,000 for single filers and $150,000 for joint filers - use the following steps to help determine the amount of the credit you can take.

1. Subtract the "phase-out amount" ($75,000 for single filers, or $150,000 for joint filers) from your (or you and your spouse's) modified AGI.
2. Take this dollar amount and divide it by $20,000.
3. Multiply this number by $7,500 (for single and joint filers), $3,750 for a married individual filing separately, or 10 percent of the purchase price of your home, whichever amount is applicable in your circumstances. (For example, if the purchase price of your home is $50,000, you would be able to claim the credit up to $5,000, since 10 percent of $50,000 (the purchase price) is less than $7,500). The resulting amount is the total amount of the credit that you may claim.

Note. This same formula will work for determining the $8,000 credit under the 2009 Recovery Act. Simply substitute $8,000 for $7,500 where applicable.

 Example. Jane, a single filer, is a first-time homebuyer. Her modified AGI is $80,000. She buys a home in October 2008 for $200,000. Because 10 percent of the purchase price ($20,000) is more than $7,500, the maximum credit amount she can claim is $7,500. However, because her modified AGI exceeds $75,000, she will not be able to claim the entire credit amount. Instead, she will be able to claim a credit of $5,625 ($80,000 - $75,000 = $5,000. $5,000 divided by $20,000 = .25. $7,500 multiplied by .25 = $1,875. $7,500 - $1,875 = $5,625).

Example. Michael is a single filer and first-time homebuyer. His modified AGI is $87,600. He buys a home in September 2008 for $50,000. Because 10 percent of the home's purchase price ($5,000) is less than the maximum amount of the allowable credit ($7,500), the maximum credit he can claim is $5,000. However, because his modified AGI exceeds the amount at which the credit phases out, his credit will be further reduced. Michael can claim a credit of $1,850 ($87,600-$75,000= $12,600. $12,600 divided by $20,000 = .63. $5,000 multiplied by .63 = $3,150. $5,000 - $3150 = $1,850.

Example. Linda and Ed, married joint filers, are first-time homebuyers. Their modified AGI is $162,400. They buy their first home in August 2008 for $300,000. Since their modified AGI exceeds the phase-out amount ($150,000 for joint filers), they will not be able to claim the entire credit amount of $7,500. Instead, they will be able to claim a maximum credit of $2,850 ($162,400 - $150,000 = $12,400. $12,400 divided by $20,000 = .62. $7,500 multiplied by .62 = $4,650. $7,500 - $4,650 = $2,850).

The credit amounts in every case will need to be repaid beginning two years after the date the home is purchased, in equal installments over the course of 15 years.

If you or anyone close to you is considering purchasing a first home as defined under the new law, the new tax credit may be able to make an otherwise difficult down payment sail through. Please contact this office for further details.

As you open the doors of your new business, the last thing on your mind may be the potential for loss of profits through employee oversight or theft - especially if you are the only employee. However, setting up some basic internal controls to guard against future loss before you hire others can save you headaches in the future.

As you open the doors of your new business, the last thing on your mind may be the potential for loss of profits through employee oversight or theft - especially if you are the only employee. However, setting up some basic internal controls to guard against future loss before you hire others can save you headaches in the future.

Soon after you start making money and the world realizes that they cannot live without your goods or service, you will probably need to hire employees. Although necessary for your growing company, hiring employees increases your risk of loss through errors, oversights and theft.

Implementing internal controls to help you monitor your business can decrease the need for constant supervision of your employees. Internal controls are checks and balances to prevent fraud, limit financial losses and reduce errors or oversights by employees. For example, the most basic internal control concept requires that certain tasks be handled by different people. This process, called "separation of duties", can greatly decrease the probability of loss.

The following basic internal control checklist includes suggestions that, once implemented, can help you and your employees avoid concerns about fraud or theft in the workplace:

• Have one person open the mail and list all the checks on the deposit slip while another enters cash receipts in your financial records.

• Make sure someone who does not handle the checkbook or purchasing is in charge of payments to suppliers and vendors.

• Have your bank reconciliation done by someone who does not have access to daily checkbook transactions.

• Make sure that you approve all vendors and that you count all goods received. Check all orders to make sure they are correct and of the quality you intended. Sign each check and review the invoice, delivery receipt and purchase order.

As your company grows, you may want to become less and less involved with the day-to-day operations of the business. The internal controls you put into place now will help keep the profits up, the losses down, and help you sleep better at night. If you need any assistance with setting up internal controls for you business, please feel free to contact our office.