The Service issued proposed regulations corresponding to IRC § 199A today. As discussed in a prior blog post, IRC § 199A potentially allows individuals, trusts and estates to deduct up to 20% of qualified business income (“QBI”) received from a pass-through trade or business, such as an S corporation, partnership (including an LLC taxed as a partnership) or sole proprietorship.
The deduction effectively reduces the new top 37% marginal income tax rate for business owners to approximately 29.6% (i.e., 80% of 37%) in order to put owners of pass-through entities on a more level playing field with owners of C corporations who now have the benefit of the greatly reduced 21% top corporate marginal tax rate under the Tax Cuts and Jobs Act (“TCJA”). The concept sounds simple, but the application is complex. The new Code provision contains complex definitions and limitations, requires esoteric calculations, and is accompanied by many traps and pitfalls.
The Tax Cuts and Jobs Act (“TCJA”) will significantly impact merger and acquisition (“M&A”) activity. Although billed as tax reform, the TCJA did not reform or simplify the Internal Revenue Code (“Code”).
Virtually none of the provisions of the TCJA directly impact M&A transactions. Rather, the TCJA added or modified several sections of the Code that indirectly impact transaction structuring, pricing, negotiations and due diligence. Making matters more complex, some of these provisions of the TCJA are temporary.
This blog post briefly highlights several key provisions of the TCJA and the impact on M&A.
Charitable organizations work hard to maintain exempt status. These organizations operate in a highly regulated landscape: In exchange for enjoying freedom from income taxes, they must comply with strict organizational and operational rules. Even before the Tax Cuts and Jobs Act (“TCJA”), adhering to these rules required constant oversight. The TCJA changes the rules, impacting both the operations and funding of these organizations.
On the operational side, we review below: Changes to the rules on unrelated business taxable income and employee fringe benefits, the new excise taxes imposed on executive compensation, and college and university endowments, and changes to substantiation requirements for certain donations.
On the funding side, we review below: How changes to the standard deduction (addressed in more detail in a prior blog post), cash contribution limits, deductions for payments to colleges and universities for the right to purchase athletic event tickets, and the estate tax may impact donors and charitable giving patterns.
The Tax Cuts and Jobs Act (“TCJA”) creates the need for tax planning with respect to several major life-changing activities individuals may encounter, including marriage, divorce, home ownership, casualty losses, medical expenses and parenting. More specifically, the TCJA makes major changes to the existing framework of personal exemptions and itemized deductions, the child tax credit, the tax treatment of alimony and spousal maintenance payments made as a result of divorce, and the alternative minimum tax (“AMT”).
The primary focus of this blog post is the provisions of the TCJA that significantly impact families and individuals. Many of these provisions have been exhaustively reviewed by other commentators in the past several weeks. In those instances, our discussion is brief. Rather, we decided to place the bulk of our discussion on the less obvious provisions of the TCJA that may have significant impact on families and individuals.
The Tax Cuts and Jobs Act (“TCJA”) creates, modifies or eliminates a number of employment and employee fringe benefit related provisions of the Code. Both employers and employees need to be aware of these changes. Accordingly, this installment of our ongoing review and analysis of the TCJA focuses on these employer and employee fringe benefit provisions.
“Neither a borrower nor a lender be…” or at least, if you insist on borrowing (and we understand the appeal), we are here to help you stay abreast of the new rules on deducting interest.
Interest on a business or investment related debt is, in most instances, a deductible expense of the borrower and taxed as income to the lender. With a few exceptions, such as mortgage interest on a personal residence, borrowers generally cannot deduct personal interest. A borrower’s deduction is subject to a number of limitations set forth in Code Section 163. The Tax Cuts and Jobs Act (“TCJA”) has changed some of these limitations.
Before the enactment of the TCJA, nondeductible interest included any interest on a taxpayer’s debt not arising from a trade or business, home mortgage, investment activity, or qualified student loans (in other words, interest arising from those debts was deductible).
The Tax Cuts and Jobs Act (“TCJA”) adopted a new 20% deduction for non-corporate taxpayers. It only applies to “qualified business income.” The deduction, sometimes called the “pass-through deduction,” is found in IRC § 199A. There has been a significant amount of media coverage of this new deduction. Rather than repeat what you have undoubtedly already read or heard, we chose to focus this blog post on the not so obvious aspects of IRC § 199A—the numerous pitfalls and traps that exist for the unwary.
As indicated at the end of 2017, I intend to provide our readers with an in-depth review of the Tax Cuts and Jobs Act (“TCJA”). With the help of two of my colleagues, Steven Nofziger and Miriam Korngold, we will do this in a series of bite-size blog posts. Our goal is to not only review the technical elements of the new law, but to offer practical insights that will be helpful to tax practitioners and their clients.
Many of the provisions of the TCJA have already received significant attention by the media. Rather than start our multi-part series with any of those provisions, we decided to commence the journey with a discussion about a rather obscure provision of the new law. This provision, while it may not have received any media attention, could be a huge trap for the unwary. It also highlights several aspects of the new law that have received little discussion.
Earlier this week, United States Tax Court Judge Richard T. Morrison ruled, in the case of Emmanuel A. Santos v. Commissioner, T.C. Memo 2016-100 (May 17, 2016), that the government will not pay the cost of a taxpayer obtaining a law degree.
This is a pro se case. While the record was not very clear, the taxpayer, Emmanuel A. Santos, claimed he earned a degree in accounting from Indiana University in 1988. Thereafter, he began a career as a tax return preparer. In 1996, he obtained a master’s degree in taxation. Eventually, Mr. Santos expanded his tax return preparer practice to include accounting and financial planning services.
Mr. Santos attended a law school in California, graduating in 2011. He was admitted to the California Bar Association and the United States Tax Court in 2014. In 2015, Mr. Santos and his father started Santos & Santos Law Offices LLP, a law firm offering attorney, tax planning, accounting and financial planning services.
On his 2010 federal income tax return, Mr. Santos deducted, in addition to various expenses, including laundry costs, $20,275 for law school tuition and fees. On audit, many of these deductions were denied.
After likely losing at the IRS Office of Appeals, Mr. Santos headed to the United States Tax Court. The sole issue in dispute was whether the deduction of $20,275 for law school tuition and fees was allowable under Code § 162 as an ordinary and necessary business expense.
When Educational Expenses Are Considered Deductible (and When They Are Nondeductible)
Treas. Reg. § 1.162-5(a) is clear—educational expenses that either: (i) maintain or improve skills required by the taxpayer in his or her current employment; or (ii) are required by the taxpayer’s employer (or applicable law) as a condition to continued employment or rate of compensation, are deductible. On the other hand, certain types of educational expenses are expressly nondeductible, including expenses for education that qualify the taxpayer for a new trade or business. Treas. Reg. § 1.162-5(b)(1) provides examples of these nondeductible educational expenses. One of the examples set forth in the regulations specifically references a taxpayer practicing accounting who pursues a law degree. The costs of attending law school are nondeductible because the course of study qualifies the taxpayer for a new trade or business. The law degree is not required to continue practicing accounting.
Previous Tax Court Holdings
Judge Morrison cited numerous cases where the courts have held, consistent with the Treasury Regulations, a law degree qualifies a taxpayer for a new trade or business, and thus the cost of the degree is a nondeductible educational expense. This is true, even if the degree improves the taxpayer’s accounting and tax skills, and the taxpayer remains practicing accounting (i.e., never practices law). See e.g., Taubman v. Commissioner, 60 T.C. 814 (1973).
Despite the clear language of the Treasury Regulations and the numerous cases supporting the government’s position, Mr. Santos brought his case to the United States Tax Court. He appears to have argued that the holdings in the cases where the court relied upon the Treasury Regulations are incorrect because the regulations are invalid. Mr. Santos’s argument, at first blush, appeared intriguing to me. By gosh, I recently won an Oregon Tax Court case invalidating a long-existing administrative rule (which is akin to Treasury Regulations).
Shortly after Treasury promulgated Treasury Regulation § 1.162-5, the United States Tax Court ruled that it was valid. The Ninth Circuit Court of Appeals affirmed the tax court’s conclusion. See Weiszmann v. Commissioner, 52 T.C. 1106 (1969), aff’d 443 F.2d 29 (9th Cir. 1971).
Giving It the Old College Try
Mr. Santos argued that the court in Weiszmann employed the wrong standard to examine the validity of the regulation at issue. Unfortunately for him, the tax court quickly dismissed the argument without much discussion. Then, Mr. Santos asserted that Treasury failed to adequately respond to public comments before finalizing the regulations at issue, thus making the regulations invalid. Unfortunately, Mr. Santos did not raise that issue until after the trial had concluded. Consequently, the trial court record contained no evidence upon which the tax court could even evaluate his assertion. While his argument was creative and certainly intriguing, it never gained any traction. If he had offered evidence on the issue at trial, the tax court’s opinion would have been a much more interesting read. Who knows if any evidence exists to support his assertion of invalidity – Mr. Santos lost!
The clear take-away from this case is that: educational expenses are generally only deductible if they are incurred to maintain or improve the skills required for current employment or to retain current employment or current compensation. The costs of education required to prepare for a new trade or business are generally nondeductible.
The outcome of these cases is generally dependent upon the facts and circumstances. For example, if Mr. Santos had been a practicing tax lawyer (i.e., had already obtained his J.D. degree, had already passed the bar examination and was practicing as a tax lawyer), the costs of obtaining his LL.M. (taxation) may have been deductible.
Many nuances exist in this area of tax law. Consequently, careful analysis is required.
As reported in my November 2015 blog post, in accordance with Internal Revenue Code (“Code”) Section 280E, taxpayers (for purposes of computing federal taxable income) are prohibited from deducting expenses related to the production, processing or sale of illegal drugs, including marijuana.
A Bit of Welcome Relief?
Measure 91, officially called the Control, Regulation, and Taxation of Marijuana and Industrial Hemp Act, passed by Oregon voters, appears to have alleviated some of the impact of Code Section 280E as it relates to Oregon taxable income. Specifically:
- Section 71 of Measure 91 provides that Code Section 280E does not apply for purposes of determining Oregon taxable income or loss under our corporate income tax regime. This provision sets forth no specific effective date. So, in accordance with Sections 81 and 82 of Measure 91, it became effective on July 1, 2015.
- Section 74 of Measure 91 provides that Code Section 280E does not apply for purposes of determining Oregon taxable income or loss under our individual income tax regime. This provision of Measure 91 specifically provides that the change became effective for tax years beginning on or after January 1, 2015.
So, following the passage of Measure 91, were there any Oregon tax problems plaguing the cannibals industry? The short answer is: Maybe.
Measure 91 generally only applies to the recreational marijuana industry. Even though nothing in Measure 91 says Sections 71 and 74 are limited to recreational marijuana, maybe an argument could be made that these provisions did nothing to alleviate the Code Section 280E issue for medical marijuana business activities.
Don’t despair; Oregon lawmakers came to the rescue. The law is now clear (at least as clear as a law can be) that, with respect to the Oregon individual income tax regime, folks in both medical and recreational marijuana businesses may deduct (for Oregon purposes only) expenses that would be otherwise be nondeductible under Code Section 280E.
House Bill 4014 Is Signed Into Law
On March 3, 2016, Oregon Governor Kate Brown signed House Bill 4014 into law. The bill, which spans numerous pages, deals with several issues related to the Oregon cannabis industry, including the application of Code Section 280E to both the recreational and the medical marijuana industries.
The provisions of House Bill 4014 relating to Oregon income taxation are contained in: Sections 28, 28a and 29.
SECTION 28 of House Bill 4014 amends ORS 316.680 by adding subsection (i) providing that there shall be subtracted from federal taxable income:
“Any federal deduction that the taxpayer would have been allowed for the production, processing or sale of marijuana items authorized under ORS 475B.010 to 475B.395 but for section 280E of the Internal Revenue Code.”
SECTION 28a of House Bill 4014 amends ORS 316.680 by adding subsection (i) providing that there shall be subtracted from federal taxable income:
“Any federal deduction that the taxpayer would have been allowed for the production, processing or sale of marijuana items authorized under ORS 475B.010 to 475B.395 or 475B.395 or 475B.400 to 475B.525 but for section 280E of the Internal Revenue Code.”
SECTION 29 of House Bill 4014 provides that the amendments to ORS 316.680 by Section 28 apply to conduct occurring on or after July 1, 2015 but before January 1, 2016, and to tax years ending before January 1, 2016. The amendments to ORS 316.680 by section 28a apply to conduct occurring on or after January 1, 2016, and to tax years beginning on or after January 1, 2016.
Implications for the Oregon Cannabis Industry
What this means for the cannabis industry in Oregon is twofold:
- For Oregon personal income tax purposes only (for tax years beginning on or after July 1, 2015 but before January 1, 2016), the prohibition contained in Code Section 280E does not apply to the non-medical production, processing or sale of marijuana. In other words, a subtraction from Oregon personal income tax is permitted by folks in a recreational marijuana business for any federal deduction a taxpayer would have been allowed for expenses related to the production, processing or sale of marijuana had there been no prohibition under Code Section 280E.
- For Oregon personal income tax purposes only (for tax years beginning on or after January 1, 2016), the prohibition contained in Code Section 280E does not apply to the production, processing or sale of marijuana (medical and non-medical marijuana). In other words, on or after January 1 of this year a subtraction from Oregon personal income tax is permitted by folks in both a medical and recreational marijuana business for any federal deduction a taxpayer would have been allowed for expenses related to the production, processing or sale of marijuana had there been no prohibition under Code Section 280E.
Interestingly, House Bill 4014 does not appear to address the Oregon corporate excise or income tax regimes. Remember, Section 71 of Measure 91 clearly tells us that, after July 1, 2015, Code Section 280E does not apply to the computation of Oregon corporate taxable income.
Why did Oregon lawmakers feel the need to make it clear that Code Section 280E does not apply to the computation of Oregon individual taxable income in the case of both medical and recreational marijuana business activities (as of January 1, 2016), but did not do the same for the computation of Oregon corporate taxable income?
Oregon law clearly contemplates corporations and other entities will be used to operate marijuana related businesses. In fact, both Measure 91 and the Oregon regulations governing the local marijuana industry allow businesses to be organized as corporations (and other entities). The definition of "person" in Measure 91 includes corporations (Section 5(24)), and various parts of the regulations contemplate that marijuana licenses will be issued to corporations and other entities (e.g., OAR 845-025-1045(3).
Was this apparent omission intentional or simply as oversight by Oregon lawmakers? It certainly seems Measure 91 covers (for purposes of Code Section 280E) recreational and medical marijuana activities at both the Oregon corporate and individual income tax levels. Was House Bill 4014 necessary to clarify the elimination of the application of Code Section 280E for Oregon income tax purposes?
It will be interesting to see how the Oregon Department of Revenue interprets House Bill 4014 and Measure 91 in this regard. Time will tell.
One interesting observation about Measure 91 is that the clear language eliminating the application of Code Section 280E for Oregon individual and corporate taxation is not expressly limited to marijuana activities. Arguably, it eliminated the application of Code Section 280E for Oregon income tax purposes in all instances (including the sale or distribution of illegal drugs). It appears House Bill 4014 removes that interpretation of the law in the instance of the Oregon individual tax regime as it expressly limits the application to marijuana, but its silence as to the Oregon corporate tax regime leaves that interpretation alive. I hope this was not the legislature’s intent.
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
- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationNew York, NY, 10.21.18-10.26.18
- "Developments in the World of IRC Section 1031 Exchanges, including the Impact of the Tax Cuts and Jobs Act," IRS Tax Practitioners ForumPortland, OR, 10.31.18
- Portland, OR, 11.5.18
- "The Tax Cuts and Jobs Act – What It May Mean to Your Clients," Estate Planning Council of Portland Mini-SeminarPortland, OR, 11.7.18
- "What a Family Law Practitioner Needs to Know About the Tax Cuts and Jobs Act," Clackamas County Bar Association Fall ConferenceOregon City, OR, 11.8.18
- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationSan Diego, CA, 11.11.18-11.16.18