President Obama’s 2016 budget proposal includes provisions which, in the aggregate, increase income tax revenues by approximately $650 billion over 10 years. At least three of the proposed tax increases will be of concern to a broad spectrum of taxpayers:
1. President Obama proposes to increase both capital gains and dividend tax rates to 28%. This rate hike will apply to many taxpayers. It represents an increase of approximately 40% over the previous rate of 20% that came into play in 2013, and an increase of approximately 87% over the previous rate of 15% that we enjoyed from 2003 to 2013.
2. President Obama proposes to abolish a taxpayer’s ability to obtain a basis step-up upon receipt of an asset from a bequest. Also, he proposes that bequests and gifts be treated as realization events, triggering a capital gains tax. His proposal also provides that decedents would be allowed a $200,000 per couple ($100,000 per individual) exclusion for capital gains. There would be a separate exclusion of $500,000 per couple ($250,000 per individual) for personal residences. The President proposes to exclude tangible personal property and family-owned and operated businesses from this tax change.
3. President Obama proposes to return the estate tax rules to the 2009 laws. This would result in the unified credit being reduced from the current $5.43 million level (indexed for inflation) to a $3.5 million level (without an inflation index).
These three changes to the income tax code alone would raise $208 billion over 10 years. Time will tell whether lawmakers will enact this part of the President’s budget proposal. While these provisions will certainly raise tax revenues, they appear to be counter to the administration’s goal of creating a “simpler, fairer and more efficient tax system.” If these proposals are pushed forward, the President’s budget proposal will likely face significant turbulence.
I was recently interviewed by Ama Sarfo, a reporter for Law360 (a national legal publication of LexisNexis). I discussed some of the audit risks Subchapter S corporations and their shareholders face these days. Below is an excerpt of the Article.
Audit Risk: It's estimated that the U.S. has a $450 billion gap between taxes that are owed to the government and taxes that are actually paid on time. This staggering number, despite significant budgetary constraints, has put taxpayer compliance back in the forefront for the IRS. In the 1990s, the Service was forced to move its focus from the audit function to information and technology as its systems were terribly out of date. Taxpayers need to be on their game because the IRS is back in the audit business, and noncompliance penalties are stronger than they've ever been before.
Compensation Documentation: Subchapter S corporation exams often lead to a review of shareholder compensation. The focus is generally on whether the compensation is unreasonably low — an amorphous label that lacks a uniform standard within the courts and instead depends on questions of facts and circumstances. I advise S corporation clients, among other things, to annually document their compensation decisions and their rationale for establishing shareholder employee compensation. This would include developing a compensation methodology based on qualifications, nature of work and information about what other like companies pay similar employees. It's an art.
Loss Deductions: Shareholder basis calculations used for the purpose of absorbing losses passed through from the corporation are often reviewed in S corporation examinations. S corporations aren't required to track and report shareholder basis on IRS Form K-1 issued to shareholders each year. According to IRS studies, in a large number of cases, errors are made in this computation (it is usually user error). So, the IRS is closely scrutinizing this issue in its audits. Don’t be surprised if, in the future, S corporations are required to track and report basis calculations on IRS Form K-1, just like partnerships are required to track and report capital account changes.
The law governing S corporations is ever changing. As tax practitioners, we need to keep abreast of these developments. I try to report important developments in this area of tax law on the blog.
If you would like to read the complete Article, it is available at www.Law360.com.
Barnes v. Commissioner, 712 F.3d 581 (D.C. Cir. 2013) aff’g T.C.M. 2012-80 (2012) is illustrative of the point that understanding the basis adjustment rules is vital.
If this case was made into a movie, the name of the movie would tell the entire story – S corporation shareholders are not allowed to just make up the basis adjustment rules! Also, as I have repeatedly stated, poor records lead to disastrous results. The DC Circuit affirmed the US Tax Court in April of 2013 to finally put an end to the case.
Marc and Anne Barnes, husband and wife, are entrepreneurs. They were engaged in several businesses, including restaurants, nightclubs and entertainment promotion. These businesses were operated through a sole proprietorship and several entities they owned 100% of, including two S corporations and a C corporation.
The tax returns at issue were the 2003 returns. One of the Barnes’ S corporations was Whitney Restaurants, Inc. which operated a Washington DC restaurant and nightclub called Republic Gardens (Whitney has since sold Republic Gardens). Upon audit of the Barnes’ 2003 tax return, the Service pulled in the 1120S of Whitney Restaurants.
In addition to some smaller items, the Service disallowed a $123,006 loss stemming from Whitney on the ground the Barnes’ had insufficient basis to take the losses. In addition, the Service assessed an IRC Section 6662 accuracy related penalty and an IRC Section 6651 late filing penalty.
The Barnes’ contested the assessment, including the penalties, and filed a petition in the US Tax Court. Prior to the court’s ruling, however, they conceded liability for the late filing penalty. The return was eight months late. So, the Court was left to decide whether the assessment of taxes and the accuracy related penalty were appropriate.
The facts are a little convoluted. In 1995, the Barnes’ had a $22,282 loss from Whitney, suspended due to lack of basis. On their 1996 joint return, they reported the $22,282 loss even though their 1996 K-1 showed an additional $136,229 loss for the tax year. In 1997, they contributed $278,000 in capital to Whitney, enabling them to finally take the suspended losses from 1995 and 1996, which totaled $158,511, but in fact they only deducted the current 1997 loss of $52,594 on the 1997 return. USER ERROR!
To follow the story, we must fast forward to 2003. The taxpayers awake from the sleep they were in and with the help of a new accountant, they determine they should have deducted the losses on the 1997 return. Guess what; that year is closed. Ouch!
Sounds bad; but, the Barnes’ find a way to relieve some of the pain. They claim, since they did not use the basis for the losses from 1995 and 1996, they can take a deduction for the losses resulting from the current year on the current return – tax year 2003 -- using the unused basis from 1997. They make three arguments in favor of this position:
First, they argue IRC Section 1367(a)(2)(B) only requires you to reduce basis for losses you actually report on your return. So, since they did not take the losses on the 1997 return, there should be no reduction in basis. WRONG!
IRC Section 1367(a)(2)(B) requires an S corporation shareholder to reduce stock basis by any losses that a shareholder should have taken into account under IRC Section 1366(a)(1)(A), even if the shareholder did not actually claim the benefit of the pass-through of the losses on his/her return.
Next, the Barnes’ argued the tax benefit rule allowed them to claim a deduction in 2003 for the loss they should have deducted in 1997. WRONG AGAIN!
The tax benefit rule generally only applies when taxpayers recover amounts they deducted in a prior year. When that situation arises, the taxpayer may exclude the recovered income to the extent the prior deduction did not give rise to a tax benefit. The tax benefit was inapplicable in the Barnes case.
Last, the Barnes argued that their failure to properly deduct the losses in 1997 caused them to compute an incorrect amount of losses that could be used to offset income in 2003. I do not understand the argument. It makes no sense. Guess what, the Tax Court did not understand it either. The Barnes’ lose the battle!
The Barnes’ do not go down for the count. Instead, they turn on their CPA and claim they relied upon professional advice. So, no penalties for accuracy or negligence are appropriate. Unfortunately, the court concluded they did not provide evidence to show they acted in good faith in relying upon professional advice. In fact, the evidence showed the accounting firm’s advice was limited by the Barnes’ inadequate accounting records and erroneous basis information from prior years in which it did not represent the taxpayers.
The result is simple: The Barnes’ were stuck with the tax and penalty assessment and a boat load of interest as the case muddled through the IRS and the court system for over nine years.
There are two pearls of wisdom to take away from the case:
- You reduce stock basis by the losses allowable under IRC Section 1366 even if you fail to report the losses on your return; and
- If a taxpayer does not provide you with adequate records, they will not likely prevail in a dispute over negligence or accuracy related penalties.
CPAs and other tax advisors need to be careful. You want to resist the temptation to represent or continue to represent clients that do not maintain adequate records.
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
- "Planning Using IRC Section 1031 Exchanges," 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