Please join me at the NYU Summer Institute in Taxation this July in New York City. This year, I will be presenting "Entity Classification – Another Look at the Check-the-Box Regulations" on Day 2 (July 27) of the Institute’s Advanced Income Tax and Wealth Planning Conference, where I will discuss recent developments, flexibility and planning opportunities created by the regulations, traps that exist for the unwary, and practical tax practitioner guidance.
As reported in my November 2013 blog post, for tax years beginning in 2015 or later, under ORS 316.043, applicable non-passive income attributable to certain partnerships and S corporations may be taxed using reduced tax rates. The reduced tax rates are as follows:
- 7 percent for taxable income of $250,000 or less;
- 7.2 percent for taxable income greater than $250,000 but less than or equal to $500,000;
- 7.6 percent for taxable income greater than $500,000 but less than or equal to $1,000,000;
- 8 percent for taxable income greater than $1,000,000 but less than or equal to $2,500,000;
- 9 percent for taxable income greater than $2,500,000 but less than or equal to $5,000,000; and
- 9.9 percent for taxable income greater than $5,000,000.
In accordance with ORS 316.037, the Oregon income tax rates that would otherwise apply to individual taxpayers are 9 percent on taxable income over $5,000 (up to $125,000), and 9.9 percent on taxable income over $125,000. At first blush, the reduced tax rates offered under ORS 316.043 look desirable. An understanding of the statute, however, is needed before jumping in head first.
- Election. To qualify for this reduced rate structure, which is subject to adjustment as provided by ORS 316.044, taxpayers must make an election on their original return by checking Box 22c and completing and attaching Oregon Department of Revenue Schedule OR-PTE, OR-PTE-PY or OR-PTE-NR. The election cannot be made on an amended return. Does the original return have to be timely filed? The statute is silent. Caution is advised!
- Material Participation. The reduced rate structure is only available to taxpayers who materially participate in day-to-day operations of a partnership or an S corporation that constitutes a trade or business.
- Non-Passive Income Only. The reduced rate structure only applies to “non-passive” income that flows through to the taxpayer from the partnership or S corporation.
- One or More Non-Owner Employees. The S corporation or partnership must employ at least one non-owner and an aggregate of at least 1,200 hours of work must be performed in Oregon during the taxable year by the non-owner employee(s). For the purpose of computing the number of hours worked in Oregon during the taxable year, only hours during weeks in which the non-owner worker(s) performed 30 hours or more of services may be counted.
- Irrevocable. Per the statute, once made, the election is irrevocable—it cannot be amended or revoked. Does this mean that once an election is made, the taxpayer is required to use the reduced rate structure for all future tax years, or does it simply mean that the taxpayer cannot revoke the election for the particular tax year the election is made? Logic dictates that the election is made for each tax year, so the later should be true. The statute, however, does not provide a clear answer to this question. Caution is advised! The Oregon Department of Revenue has not yet written administrative rules to accompany ORS 316.043. I suspect, it will address this question in any rules it drafts.
- No Disregarded Entities. The owner of a disregarded entity (e.g., a single-member limited liability company or a sole proprietorship) is not eligible for the reduced tax rates.
- Limited Deductions. For purposes of computing the taxpayer’s income, which is subject to the regular income tax rates, the taxpayer is allowed to use all subtractions, deductions or additions otherwise allowable under the Oregon tax laws set forth in ORS Chapter 316. For purposes of computing the non-passive income to which the reduced tax rates apply, however, the taxpayer is only allowed to take into consideration depreciation deductions or adjustments directly related to the partnership or S corporation. Consequently, before making the election to use the reduced tax rates, an analysis of the impact of the limited use of subtractions, deductions and additions against the non-passive income needs to be undertaken.
- Composite Returns. A taxpayer who uses the reduced income tax rates may not join in the filing of a composite return under ORS 314.778.
Until the Oregon Department of Revenue drafts administrative rules to accompany ORS 316.043, the questions discussed above will remain unanswered. Consequently, caution is advised. Careful review and consideration is required before tax practitioners jump into an election under this alternative tax rate regime. Unfortunately, traps exist for the unwary.
A California couple was recently walking their dog when they noticed a rusty tin container protruding from the soil next to a tree in their garden. Upon investigating the matter, they discovered several tin cans buried in the soil. The cans contained 1,400 gold coins. The coins, which are said to be in mint condition, date back to the 19th century. Experts have placed a preliminary value on the coins of more than $10 million. For obvious reasons, the couple is keeping their identity and the location of their home out of the media.
It appears the couple is legally entitled to retain the treasure trove. A law professor from the University of North Carolina, John Orth, recently told TIME Magazine, because the coins were found on the couple’s own property, they will likely be able to retain them.
Like the winner of a lottery, the California couple will be required to declare their new fortune as gross income for income tax purposes. This is not the first time a person has been faced with good fortune and a corresponding tax bill.
In Cesarini v. U.S., 23 AFTR 2d 69-997 (Northern District of Ohio, 1969), a couple purchased a piano in 1957 for $15. In 1964, while cleaning the piano, they discovered almost $4,500 in U.S. currency.
On the Cesarinis’ 1964 joint income tax return, they reported the money found in the piano as ordinary income from other sources. About six months later, however, they had a change of heart. Consequently, they filed an amended return, seeking a refund of the tax paid on the treasure trove, claiming it was excludable from income. The Internal Revenue Service reviewed the claim for refund, but eventually denied it. So, the Cesarinis filed a refund lawsuit in the U.S. District Court for the Northern District of Ohio.
The taxpayers asserted three arguments (without offering legal support):
- IRC § 61 does not include money found in a piano;
- If the money found in the piano is includible in income, it should be included in the year the piano was purchased (i.e., 1957), rather than the year of discovery (i.e., 1964). Since tax year 1957 was closed, the Internal Revenue Service is out of luck; and
- If the money found in the piano is includible income, it is capital gain rather than ordinary income.
The Internal Revenue Service’s position was equally simple and, in some respects, lacking proper legal support. It asserted:
- IRC § 61 is broad sweeping—it includes income from all sources. Consequently, unless specific provisions of the Code exclude an item of income, it is includable. Since no provision of the Code specifically excludes treasure trove, the money found in the Cesarinis’ piano is includible in their gross income;
- It is ordinary income; and
- It is includible in income in the year of discovery.
Section 61 of the Code provides: “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following…”
Both the Cesarinis and the Internal Revenue Service appear to have failed to
“Treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession.”
Judge Young, however, did review the Treasury Regulations. Based upon this regulation, he held the Cesarinis had income in the year of discovery. As there was no sale or exchange of a capital asset, the income is properly characterized as ordinary income. Consequently, their request for refund was properly denied.
In the present case, assuming the value of the gold coins is $10 million, and further assuming the California couple has an undisputed right to the gold coins, they will have a combined federal and state income tax liability of approximately $5 million. Despite the Cesarinis’ argument, the income to the California couple is ordinary income. It is hard to debate this result. The California couple reportedly had an increase in wealth by $10 million. Good fortune found them!
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
- "Entity Classification – Another Look at the Check-the-Box Regulations," New York University Summer Institute in TaxationNew York, NY, 7.27.17
- New York, NY, 10.22.17-10.27.17
- San Francisco, CA, 11.12.17-11.17.17