On February 21, 2014, then House Ways and Means Committee Chairman Dave Camp (R-Michigan) issued a discussion draft of the “Tax Reform Act of 2014.” The proposed legislation spanned almost 1,000 pages and contained some interesting provisions, including repealing IRC § 1031, thereby prohibiting tax deferral from like-kind exchanges. Not only would taxpayers have been impacted by this proposal, but it would have turned the real estate industry upside down. Qualified intermediaries would have been put out of business. Likewise, title and escrow companies, as well as real estate advisors specializing in exchanges, would have been adversely affected by the proposal.
On November 2, 2015, the Bipartisan Budget Act (“Act”) was signed into law by President Barack Obama. One of the many provisions of the Act significantly impacts: (i) the manner in which entities taxed as partnerships will be audited by the Internal Revenue Service (“IRS”); and (ii) who is required to pay the tax resulting from any corresponding audit adjustments. These new rules generally are effective for tax years beginning after December 31, 2017. As discussed below, because of the nature of these rules, partnerships need to consider taking action now in anticipation of the new rules.
The Current Landscape
Entities taxed as partnerships generally do not pay income tax. Rather, they compute and report their taxable income and losses on IRS Form 1065. The partnership provides each of its partners with a Schedule K-1, which allows the partners to report to the IRS their share of the partnership’s income or loss on their own tax returns and pay the corresponding tax. Upon audit, pursuant to uniform audit procedures enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), examinations of partnerships are conducted generally under one of the following scenarios:
- For partnerships with ten (10) or fewer eligible partners, examinations are conducted by a separate audit of the partnership and then an audit of each of the partners;
- For partnerships with greater than ten (10) partners and/or partnerships with ineligible partners, examinations are conducted under uniform TEFRA audit procedures, whereby the examination, conducted at the partnership level, is binding on the taxpayers who were partners of the partnership during the year under examination; and
- For partnerships with 100 or more partners, at the election of the partnership, examinations may be conducted under uniform “Electing Large Partnership” audit procedures, whereby the examination, conducted at the partnership level, is binding on the partners of the partnership existing at the conclusion of the audit.
Lawmakers believed a change in TEFRA audit framework was necessary for the efficient administration of Subchapter K of the Code. If a C corporation is audited, the IRS can assess an additional tax owing against a single taxpayer—the very taxpayer under examination—the C corporation. In the partnership space, however, despite the possible application of the uniform audit procedures, the IRS is required to examine the partnership and then assess and collect tax from multiple taxpayers (i.e., the partners of the partnership). In fact, the Government Accountability Office (the “GAO”) reported in 2014 that, for tax year 2012, less than one percent (1%) of partnerships with more than $100 million in assets were audited. Whereas, for the same tax year, more than twenty-seven percent (27%) of similarly-sized corporations were audited. The GAO concluded the vast disparity is directly related to the increased administrative burden placed on the IRS under the existing partnership examination rules.
As reported in my November 2014 blog post, President Obama’s administration wants to limit taxpayers’ ability to defer income under IRC § 1031. In response to former House Ways and Means Committee Chairman David Camp’s proposed Tax Reform Act of 2014, which would have eliminated IRC § 1031 altogether, the Obama administration proposed to retain the code section, but limit deferral with regard to real property exchanges to $1 million per taxpayer each tax year. Personal property exchanges, under the President’s proposal, would go unscathed.
In 2015, President Obama expanded his proposal relative to IRC § 1031 to limit personal property exchanges by excluding certain types of property from the definition of “like kind.” The excluded personal property included items such as collectibles and art. The President’s proposed $1 million real property exchange limitation was left intact.
Fast forward to today. No tax reform legislation has gained enough traction to even come close to being enacted into law. Nevertheless, President Obama’s attack on IRC § 1031 continues. In the administration’s 2017 budget proposal (released a few months ago), the White House expands its quest to limit the application of IRC § 1031. This proposal is identical to President Obama’s original response to former Chairman Camp’s 2014 tax reform proposal, but it goes further. Now, the President is proposing that the $1 million limitation apply to both personal and real property exchanges. In addition, like his 2015 proposal, President Obama wants to exclude certain personal property, collectibles and art, from the definition of “like kind.”
I am not sure any real logic or significant tax policy supports the White House’s latest proposal to limit the application of IRC § 1031. Rather, the proposal appears to be solely aimed at tax revenue generation. According to the Treasury, the proposal, if enacted into law, would increase tax revenues by $47.3 billion over 10 years.
IRC § 1031 is clearly on lawmakers’ radar screens as a means to increase tax revenues. Time will tell whether IRC § 1031 will be repealed or significantly curtailed in its application. Nevertheless, one thing is for sure: IRC § 1031 remains a potential target. Stay tuned!
Late this afternoon, President Obama signed into law the tax extenders legislation referenced in my blog earlier today. Hopefully, we can now complete our client year-end tax planning.
The Protecting Americans from Tax Hikes Act of 2015 Passes Both the U.S. House of Representatives and the U.S. Senate
Late in the day on December 15, 2015, the U.S. House of Representatives passed the Protecting Americans from Tax Hikes Act of 2015 (the “Act”). The Act, which represents a $622 billion tax package, revives many taxpayer-friendly provisions of the Code that expired a year ago.
The Act passed the House with a vote of 318 to 109. Voting in favor of the Act were 77 Democrats and 241 Republicans.
The Act moved to the U.S. Senate, where it was presented along with a comprehensive spending bill. As expected, the Senate voted in favor of the legislation today by a vote of 65 to 33. Consequently, the Act moves from Congress to the desk of President Obama. Most commentators expect that he will promptly sign the Act into law, as his administration has shown strong support.
In anticipation of President Obama signing the Act into law, the following is a brief overview of some of the most important provisions:
Business Provisions of the Act
The Act includes several business taxpayer provisions, including:
- Built-In Gains Tax Recognition Period Reduced. The Act retroactively and permanently sets the recognition period under Code Section 1374(d)(7) at five years.
- S-Corporation Charitable Contributions. The Act retroactively and permanently extends Code Section 1367(a)(2) that had expired on December 31, 2014. Consequently, if an S-Corporation contributes money or property to a charity, each shareholder may take into account his or her pro-rata share of the fair market value of the contributed property in determining his or her income tax liability. In other words, the contribution flows through to the shareholders. Likewise, the shareholder gets to reduce the basis in his or her stock by his or her pro-rata share of the corporation’s adjusted basis in the contributed property (rather than by the amount of the charitable deduction that flowed through to him or her). This provision should be a benefit to charities.
- Research Credit. The research credit allowed under Code Section 41(h) was retroactively and permanently extended. It had already expired as of December 31, 2014.
- RIC Interest and Related Dividends and Short-Term Capital Gain Dividends. The Act retroactively and permanently extends the rules contained in Code Section 871(k), exempting from gross income and the withholding tax the interest-related dividends and short-term capital gain dividends received from a regulated investment company. These provisions had expired as of December 31, 2014.
- Small Business Stock. Under Code Section 1202(a)(4), assuming certain requirements were met, a taxpayer prior to this year was allowed to exclude all gain from the disposition of qualified small business stock acquired after September 27, 2010, but before January 1, 2015. The exclusion applied for both regular income tax and alternative minimum tax purposes. The Act permanently and retroactively extended this provision for stock acquired after December 31, 2014.
- New Markets Tax Credit. The Act retroactively extends the new markets tax credit under Code Section 45D(f) through the end of 2019. Unless extended or made permanent, it will expire on December 31, 2019.
- 15-Year Straight-Line Cost Recovery for Qualified Leasehold Improvements. The Act permanently extends the 15-year recovery period for qualified leasehold improvements, qualified restaurant property and qualified retail improvement property.
- Section 179 Expensing. The Act permanently and retroactively extends the small business expensing limitation and phase-out amounts that were in effect from 2010 to 2014. Consequently, for 2015 forward, the Code Section 179 deduction limit is $500,000. Likewise, the deduction phase-out commences at $2 million. Both the limitation and the phase-out threshold will be indexed for inflation beginning next year. This provision of the Act also extends 50% bonus depreciation through the end of 2019.
Individual Provisions of the Act
The Act includes several individual taxpayer provisions, including:
- Enhanced child tax credit. The Act makes the child tax credit, with a $3,000 un-indexed threshold, permanent. The threshold was scheduled to rise to $10,000 and be indexed for inflation. The Act eliminates the threshold increase and the index for inflation.
- American Opportunity Tax Credit. The Act makes the American Opportunity Tax Credit permanent.
- Mass Transit. The Act permanently extends the employee exclusion for employer-provided mass transit. Now, the exclusion ceiling is equivalent to the employer-provided parking exclusion (i.e., $250 per month).
- State and Local Sales Tax Deduction. The Act permanently extends the life of Code Section 164(b)(5) so that a taxpayer who itemizes his or her deductions may elect to deduct state and local general sales and use taxes in lieu of state and local income taxes. Under Code Section 164(b)(5)(I), this provision, absent the Act, expired on December 31, 2014.
- Nontaxable IRA Transfers to Eligible Charities. The Act makes Code Section 408(d)(8)(F) permanent. Consequently, individuals who are at least 70½ years of age may exclude from gross income qualified charitable distributions from IRA’s, subject to an annual cap of $100,000.
- Home Mortgage Debt Discharge Exclusion. Under Code Section 108(a)(1)(E), prior to this year, an individual taxpayer could exclude from gross income the discharge of indebtedness from a qualified personal residence, up to $2 million for married taxpayers filing jointly, and $1 million for single taxpayers or married taxpayers filing separately. This provision of the Code expired on December 31, 2014. The Act, however, gives it new life, albeit for a brief period of time. The provision will now expire on December 31, 2016, unless extended or made permanent.
Many taxpayers and tax advisors feared that no extenders act would not be passed by the end of 2015. Fortunately, lawmakers were able to reach a compromise. We expect President Obama will sign the Act into law well before the end of the year. Stay tuned!
As reported in my January 20, 2015 blog post, the IRS continues to take strong blows to its body in terms of budget setbacks. President Obama, however, as part of his administration’s 2016 budget proposal issued on February 2, 2015, plans to end some of the pain being imposed on the Service. His budget proposal, if enacted, would infuse over $12.9 billion into the Service’s coffers during fiscal year 2016. This represents an increase of approximately $2 billion over the fiscal year 2015 IRS budget.
The budget enhancement proposed by President Obama is targeted to be used for many worthy efforts, including enhancing taxpayer service, enhancing information technology (e.g., creating and implementing a new online tax filing system and taxpayer payment options), and improving the Service’s tax compliance/enforcement capabilities.
These budget expenses are clearly worthy. Consequently, it is difficult to debate enhancing the IRS budget in this manner. The $2 billion query that follows, however, is where our government will get the additional revenue to fund this cause. Unless other government agency budgets get slashed, the answer to this question most certainly has to be tax increases. This is not an acceptable answer for most taxpayers and lawmakers. It will be interesting to see what lawmakers do with this portion of the President’s budget proposal.
Stay tuned for further commentary on the President’s 2016 fiscal year budget proposal.
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.
On February 2, 2015, President Obama published his 2016 budget proposal. It proclaims that “[a] simpler, fairer, and more efficient tax system is critical to achieving many of the President’s fiscal and economic goals.” While some tax practitioners may debate the claim that the tax provisions embedded in the President’s budget proposal make the tax system simpler, it is a certainty that a significant number of tax practitioners will question the fairness of these provisions.
As in the past, the President’s budget proposes that “wealthy millionaires” pay no less than 30% of their income in federal income taxes. To facilitate accomplishing that goal, President Obama suggests these taxpayers be prevented from making charitable contributions to reduce their tax liability. He states: “…this proposal will act as a backstop to prevent high-income households from using tax preferences to reduce their total tax bills to less than what many middle class families pay.”
This provision of the budget proposal will definitely not receive broad support from the charitable organization community. Taking away the tax deduction resulting from charitable contributions certainly does not motivate taxpayers to transfer their wealth to charities.
Whether a charitable contribution deduction is a tax preference item is open to debate. A charitable contribution certainly does not seem to be “a tax preference” item. All taxpayers generally benefit in the same manner by this deduction. Shouldn’t taxpayers receive a tax deduction for wealth transfers to charities? Don’t we want to incentivize taxpayers to fund charitable needs through contributions? Eliminating this deduction for certain taxpayers may generate billions of dollars of tax revenues, but it will definitely impair charitable organizations from obtaining much needed funding. For this reason alone, hopefully lawmakers will resist removing the charitable contribution deduction from the tax code.
Contributions To College Athletic Programs
College sports fans—whether you are wealthy or not—buried in the President’s budget proposal is a provision that eliminates the deductibility of the charitable contribution you are required to make as a pre-requisite to purchasing tickets for college sporting events. Most colleges will not be pleased with this proposal! While President Obama has talked about this type of tax reform in the past, this is the first time we have seen it in one of his budget proposals. The provision, if enacted into law, is estimated to generate over $2.546 billion in tax revenues during the period of 2016-2025. Like the elimination of the charitable deduction for “wealthy” taxpayers, this provision will result in charities being the biggest losers.
Stay tuned! Time will tell whether lawmakers will adopt these proposals.
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
- "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
- "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