House Ways and Means Committee Chairman Dave Camp (R-Michigan) issued a discussion draft of the “Tax Reform Act of 2014” last week. The proposed legislation spans almost 1,000 pages and contains some interesting provisions, including, without limitation, the following:
Individual Taxpayer Provisions
- Consolidation and simplification of individual income tax brackets. The current seven tax brackets would be consolidated into three brackets—namely, a 10% bracket, a 25% bracket and a 35% bracket. High-income taxpayers would be subject to a phase-out of the tax benefit of the 10% bracket. In addition, the special rate structure for net capital gains would be repealed. In its place, non-corporate taxpayers could claim an above-the-line deduction of 40% of adjusted net capital gain.
- Expand the standard deduction (to $22,000 for joint filers and $11,000 for individuals) and modification of available itemized deductions, including:
- Repeal of the 2% floor on itemized deductions and the overall limitation on itemized deductions.
- Reduce the itemized deduction for home mortgage interest to $500,000.
- Repeal of the deduction for personal casualty losses.
- Repeal of the deduction for unreimbursed medical expenses.
- Repeal of the deduction for state and local taxes not paid in connection with business or investment.
- Simplification of the rules surrounding charitable deductions.
- Repeal of the exclusion for employee achievement awards.
- Repeal of the deduction for moving expenses.
- Reinstating the former provision allowing the cost of over-the-counter medications to be reimbursed through tax-favored health accounts.
- Consolidation and simplification of tax benefits for higher education. A single educational tax credit of up to $2,500 annually would be made available that could be used for up to 4 years; however, the current deductions for educational expenses and interest on student loans would be repealed.
- Elimination of the income limitations on Roth IRAs and prohibiting new contributions to traditional IRAs and non-deductible traditional IRAs—effectively forcing all new IRA contributions to be Roth contributions.
- Repeal of the exception to the 10% early withdrawal penalty for withdrawals from retirement plans and IRAs used to pay first-time home buyer expenses (capped at $10,000).
- Elimination of the deduction by the payor for the payment of alimony and elimination of the inclusion in income by the recipient.
- Repeal of the individual AMT.
- IRC Section 1031 would be repealed. Consequently, tax deferral from like-kind exchanges would no longer be permitted.
- Simplification of rules surrounding in-service distributions, hardship withdrawals and required minimum distributions from retirement plans.
- Encouraging Roth contributions in 401(k) plans by requiring all 401(k) plans to offer Roth accounts and requiring larger plans to treat all employee contributions as Roth contributions once an employee had contributed one-half of the annual contribution limit.
Business & Corporate Taxpayer Provisions
- Repeal of the corporate AMT.
- Creation of a flat corporate tax rate of 25% (phased in over 5 years), applicable to business and personal service corporations alike.
- Code Section 351 would be amended so that contributions of capital to a corporation in excess of the fair market value of the stock issued would be taxable to the recipient corporation. This provision would also extend to any non-corporate entity.
- Limitations on the deductibility of NOLs by C corporations would be implemented.
- Code Section 179 expensing would be made permanent at the 2008-2009 levels.
- Code Section 197 amortization of goodwill would be extended from 15 years to 20 years.
- The deductions for meals and entertainment expenses, which are currently limited to 50%, would be eliminated with respect to entertainment. A 50% deduction for meals directly related to the conduct of a trade or business would remain intact.
- Repeal of a significant number of business tax credits.
- Simplify accounting method rules—businesses with average annual gross receipts of $10 million or less would be allowed to use the cash method of accounting, while businesses with average annual gross receipts over $10 million would be required to use the accrual method of accounting. The large portion of the current array of exceptions and nuances relative to adopting an accounting method would be eliminated.
- Interest charge rules would attach to all installment sales in excess of $150,000.
- The LIFO inventory method of accounting would be eliminated.
- Dividends received from a foreign subsidiary would be excluded from the definition of personal holding company income.
- The S corporation built-in gains tax recognition period would be permanently set at five (5) years.
- The passive income threshold for the application of Code Sections 1362(d)(3) and 1375 would be increased from 25% to 60%.
- Non-resident aliens would be allowed to be beneficiaries of ESBTs.
- The time for making an S election would be extended until the due date of the Form 1120s (with extensions).
- The rules relating to guaranteed payments from a partnership to a partner would be repealed.
- The technical termination of a partnership by the transfer of 50% or more of the interest in the partnership would be repealed.
- “Carried interest” in investment partnerships would be treated as ordinary income.
- A worker classification safe harbor would be created based upon objective criteria. Limited withholding obligations on the part of the service recipient would be required.
Miscellaneous Administrative Changes
- A C corporation would be required to file its tax return on or before April 15. On the other hand, partnerships and corporations would be required to file their tax returns on or before March 15.
- Most compliance penalties are increased.
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The above summary is not exhaustive. It does, however, illustrate the types of broad-sweeping changes Chairman Camp has in mind. Most lawmakers do not expect a tax overhaul of this nature to become law this year. Rather, the consensus in Washington is that discussions on tax reform will continue into 2015 before any bill is presented for a vote in either the House or the Senate. It is doubtful that we will see any proposed legislation enacted into law until 2016. Stay tuned! I expect we will see a great deal of commentary on tax reform in the upcoming months.
For a discussion of Chairman Camp’s proposal, please read here.
I Won the Gold Medal in Sochi. Awesome! Do I Owe Taxes on the Value of My Prize?
As a general rule, in accordance with IRC § 61, the value of any prize or award a taxpayer receives is subject to taxation. IRC §§ 74 and 117 provide limited exceptions to this general rule.
IRC § 74 specifically excludes from the income of the recipient certain employee achievement awards and certain prizes or awards transferred to charitable organizations prior to receipt. IRC § 117 specifically excludes from the income of the recipient “qualified scholarship” proceeds. These exceptions are subject to rigid qualifications.
The value of prizes and awards which do not come within the parameters of these limited exceptions are subject to taxation. Consequently, as we know, the winning ticketholder of the lottery is taxed on his or her winnings. The recipient of the Nobel Prize is subject to taxation on the cash prize he or she receives. Likewise, the value of the ring received by each of the members of the Seattle Seahawks this year for winning the Super Bowl is subject to taxation. Also, the value of the rings received by each member of the Miami Heat for winning the NBA championship in 2012 and 2013 is subject to taxation.
The logic behind taxing prizes and awards makes perfect sense. The recipient received something of value from the contest sponsor. Consequently, the recipient should pay tax on the value of the prize or award. The exceptions to the general rule are well thought out and are supported by public policy. For example, public policy dictates excluding from taxation “qualified scholarship” proceeds, certain employee achievement awards (limited in value), and certain prizes or awards which the recipient donates to charity.
Senator John Thune, from South Dakota, would like to expand the limited exceptions to this general rule. Senator Thune is the ranking member of the United States Committee on Commerce, Science and Transportation (“Commerce Committee”). The Commerce Committee oversees the U.S. Olympic Committee. Senator Thune is also a member of the United States Senate Finance Committee (the committee which writes tax laws).
On February 12, 2014, Senator Thune introduced legislation (SB 2026) that would expand the prize and award exceptions to medals and the cash prizes awarded to participants in the “Olympic Games” or the “Paralympic Games.” The bill appears to have strong bipartisan support, including support of Senator Charles Schumer and Senator Kirsten Gillibrand.
Senator Thune’s attempt to exempt Olympic athletes from taxation relative to medals and cash prizes is not the first legislative proposal we have seen of this nature. Representative Blake Farenthold introduced similar legislation this month in Congress (i.e., the Tax Exemptions for American Medalists Act—HB 3987). Senator Thune’s proposed bill, however, is a little broader in application than Representative Farenthold’s proposed bill in that it specifically extends to medals or cash prizes received by both Olympians and Paralympians.
President Barack Obama is very familiar with the tax treatment of prizes and awards. In 2009, when he was the recipient of the Nobel Prize, he avoided paying tax on the prize money because he assigned the money to a charity prior to the award presentation.
President Obama likely supports Senator Thune’s proposed legislation. In 2012, Senator Marco Rubio and Congressman Aaron Schock introduced similar legislation. At that time, the President expressed strong support. Despite that support, however, the 2012 legislation failed to become law.
Most commentators believe Senator Thune’s proposal will become law. He has been a strong advocate of the bill as exemplified by his recent statement in support: “Winning an Olympic medal should be a source of great pride for our athletes and the federal government should celebrate their achievement rather than tax their success.”
Is Senator Thune’s legislative proposal opening up a can of worms? Should Olympic athletes be treated differently than the members of a championship NBA team, members of a Super Bowl team, members of a World Series championship team, medal winners of the FIS World Skiing Championship, medal winners of the World Figure Skating Championship, or recipients of the Nobel Prize? Prior to the Tax Reform Act of 1986, many prizes and awards were exempt from taxation as long as no significant services were involved. Should the Code revert back to pre?1986 law on this subject? Shouldn’t the Code treat all prize and award recipients the same? In the case of athletes, should cash prizes be excluded from taxation? Olympic medalists receive a cash prize, along with a medal. The cash prize is currently $25,000 for each gold medal, $15,000 for each silver medal, and $10,000 for each bronze medal.
Despite these questions, I suspect the proposed legislation will become law. Senator Thune’s timing is superb. We are in the midst of the winter Olympics and our Olympians are ever present on our minds. Stay tuned!
On January 27, 2014, Judge Haines of the United States Tax Court issued a decision in Ydney Jay Hall v. Commissioner, TC Memo 2014-6. This case illustrates that a taxpayer’s failure to retain adequate business records to substantiate income and expenses will lead to disastrous results.
The taxpayer, Ydney Jay Hall, is a practicing attorney admitted to practice before the United States Tax Court. His law practice income was reported on Schedule C of his Individual Income Tax Return. Upon examination of Mr. Hall’s 2008 return, the Service asked to review his books and records relating to the law practice. The Service, believing Mr. Hall did not fully respond to its request for information, summoned bank records. With that information, it reconstructed his business income for the tax year. The results of the audit reconstruction were not pretty.
The IRS issued a deficiency notice to the taxpayer, asserting he had underreported his income by $76,681 for the tax year. In addition, the Service disallowed deductions for travel and other expenses listed on Schedule C totaling $63,542 as the taxpayer did not maintain any books or records for his business activities and failed to provide proof he actually paid the expenses (e.g., receipts, invoices, cancelled checks or other evidence of payment). To put salt on the wound, the Service assessed an accuracy related penalty against the taxpayer.
Mr. Hall filed a petition in the United States Tax Court challenging the notice of deficiency and the assessment of taxes and penalty. He represented himself in the case.
In the Ninth Circuit, the Service is required to show minimal evidence supporting its conclusion a taxpayer underreported income. Then, the burden shifts to the taxpayer who must prove by a preponderance of the evidence that the Service’s determination is incorrect.
In this case, the Service in its brief conceded the correct amount of underreported income was $61,014 (rather than $76,781). It based this amount on a reconstruction of the taxpayer’s bank deposits. In response to the taxpayer’s challenge to the government using this method to recreate his income, the court said: “If a taxpayer has not maintained business records or the taxpayer’s business records are not adequate, the Commissioner is authorized to reconstruct the taxpayer’s income by any method that, in the Commissioner’s opinion, clearly reflects that taxpayer’s income. The Commissioner’s reconstruction need not be exact, but it must be reasonable in the light of all the surrounding facts and circumstances (citations omitted).”
The taxpayer provided no documentation or other evidence supporting the income reported on his Schedule C other than his testimony which the court classified as “self-serving and uncorroborated.” Consequently, the court found for the government and concluded Mr. Hall failed to report income of $61,014 in 2008.
Unfortunately for the taxpayer, the case did not get any better when the court turned its attention to the disallowed business deductions. The court stated: “Deductions are a matter of legislative grace, and the taxpayer bears the burden of proving he is entitled to the deductions claimed.” In accordance with IRC Section 162, “there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” The court then went on to reiterate the well established rule of law that taxpayers, however, are required to maintain records to support these deductions and to enable the Service to determine the correct tax liability.
In the instant case, the taxpayer did not maintain any books or records of his business activities. He also failed to produce any receipts, invoices, bills, cancelled checks or other documents to support payment of the business expenses reported on the tax return.
In accordance with IRC Section 274(d), no deduction is allowed for travel, entertainment or gifts unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement as to: (1) the amount of the expense; (2) the time and place of the travel or entertainment, or the date and description of the gift; (3) the business purpose of the expense; and (4) in the case of entertainment or gifts, the business relationship between the taxpayer and the persons entertained.
If a taxpayer establishes he paid or incurred an otherwise deductible expense other than travel, entertainment, or gift expenses (“non-274(d) expenses”), but does not establish the amount of the expense, the Court has authority to estimate the amount of the expense but it can weigh heavily against the taxpayer. In order to estimate the amount of the expense, the court, however, must be presented with some reasonable basis upon which an estimate may be made.
In the instant case, the taxpayer failed to offer any evidence to support any of the expenses in question other than his own uncorroborated testimony. The court reiterated that it is not required to accept such testimony. Consequently, it concluded that the taxpayer failed to meet his burden to substantiate the business expenses in question. The court upheld the Service’s disallowance of the business expenses.
Last, the court looked at the 20% accuracy related penalty imposed under IRC Section 6662 for the taxpayer’s negligence or disregard of rules or regulations. Failure to maintain adequate books and records or provide substantiation of items reported on a tax return constitutes negligence. IRC Section 6662(c); T. Reg. Section 1.6662-3(b)(1). A taxpayer may obtain reprieve from the imposition of the penalty if he establishes he acted with reasonable cause and in good faith.
In this case, the taxpayer failed to address his liability for the penalty assessment other than including a brief statement in his brief that he was not liable for an accuracy related penalty. Despite his failure to present any additional argument to support an abatement of the penalty, the court looked to see if any evidence in the record supported that the taxpayer acted in good faith and with reasonable cause. Finding no such evidence, the court upheld the penalty assessment.
This case leaves us with a few obvious take-aways. First, taxpayers must maintain adequate records. Failure to do so could lead to a finding by the Service that the taxpayer misreported income and expenses. Second, as Mr. Hall encountered firsthand, it will likely lead to the imposition of an accuracy related penalty. Last, for tax return preparers, it could lead in egregious situations to the imposition of a tax preparer penalty under IRC Section 6694(b)(2). Caution is advised.
On December 17, 2013, the United States District Court for the Northern District of Georgia issued its decision in United States v. Morris Legal Group, LLC, 113 AFTR 2d, 2014-XXXX (D.C. Georgia). Gilbert Greenburg, a disbarred attorney, was employed as the office manager of Morris Legal Group, LLC, a law firm in Atlanta, Georgia. He helped set up and manage the law firm’s personal injury practice. Interestingly, Mr. Greenburg had no written agreement with the law firm relative to the amount of compensation he was entitled to receive. Rather, he wrote himself payroll checks from time to time based upon the level of the firm’s profits. His compensation generally ranged from $4,000 to $8,000 per month.
Mr. Greenburg owed the IRS over $100,000 in unpaid income taxes, interest and penalties. On May 26, 2011, the IRS sent the law firm a Notice of Levy and formally requested it surrender Mr. Greenburg’s wages until the levy was released. Morris Legal Group, LLC appears to have ignored the levy and continued paying Mr. Greenburg compensation.
The law in this area is fairly straightforward. IRC §§ 6331 and 6332 generally allow the government to collect delinquent taxes from a person by levy upon any property or property rights of that person, including salary and wages. The Eleventh Circuit in United States v. Ruff, 78 AFTR 2d, 96-7274 (11th Cir. 1996) clearly articulated a party’s obligations upon receipt of a Notice of Levy as follows:
“Upon receipt of a notice of levy, such third parties are required to surrender that property to the IRS. The notice of levy ‘gives the IRS the right to all property levied upon…and creates a custodial relationship between the person holding the property and the IRS so that the property comes into constructive possession of the government.’ Those individuals who fail to honor the levy incur liability to the government equal to the full value of the property not surrendered.” [Citations omitted].
There are generally two defenses that excuse a party’s failure to comply with a Notice of Levy. The first defense is where it can be shown the party was not in possession of any of the delinquent taxpayer’s property or rights to property at the time it received the Notice of Levy. The second defense is where the party can show, when it received the Notice of Levy, the property or property rights in question were already subject to attachment or execution under judicial process.
In this case, the law firm, Morris Legal Group, LLC, failed to honor the Service’s levy. It had no defenses. Consequently, the Eleventh Circuit held it was liable for amounts it continued to pay Mr. Greenburg following receipt of the Notice of Levy (up to the amount owing by Mr. Greenburg to the IRS), plus interest on these unpaid amounts. In addition, under IRC § 6332(d)(2), it was subject to a 50% penalty (i.e., 50% of the amount owing by the person failing to honor the levy). The law firm ended up being liable to the IRS for its failure to comply with the levy for more than $200,000. Ouch!
The moral to the story is simple: You cannot ignore a Notice of Levy. Unless one of the two defenses discussed above are clearly applicable, ignoring the Notice of Levy may be costly. If one of these defenses could apply, before asserting the defense, have a qualified tax practitioner review the matter. As Morris Legal Group, LLC learned, a mistake in this area of tax law can be costly.
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "Developments in the World of IRC Section 1031 Exchanges Including the TCJA," Oregon Society of Certified Public Accountants (OSCPA) Forest Products ConferenceEugene, OR, 6.22.18
- "Evaluating the Built-in Gains Tax for C to S Conversions After TCJA," New York University Summer Institute in Taxation – Advanced Conference on Subchapter SNew York, NY, 7.26.18-7.27.18
- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationNew York, NY, 10.21.18-10.26.18
- "The Tax Cuts and Jobs Act – What It May Mean to Your Clients," Estate Planning Council of Portland Mini-SeminarPortland, OR, 11.7.18
- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationSan Diego, CA, 11.11.18-11.16.18