American Taxpayer Relief Act of 2012 (“ATRA”) and §1411 (Obama Care’s Income Tax)

Congress after much brinkmanship has finally passed ATRA.  I will assume that the readers of my blog already know the basics of ATRA; thus, I will not bore you with repetition of its major provisions.  Since the focus of this blog is the small, closely held family business,  I will review with you some of the traps for the unwary and  loopholes .  Additionally, I will discuss §1411’s provisions (the Obama Care law provision)  since they are somewhat inter- related due to the fact that they affect high income people.  All § references are to the Internal Revenue Code of 1986 as amended or modified. Due to the complexities of the provisions discussed below and the fact that this is generalized summary of the area, the readers of this blog should consult with their tax advisors before undertaking anything discussed below.

Congress refused to impose employment tax standards on S corporation shareholder- employees.  J. Radtke v US, DC Wis., 89-2 USTC ¶9466, 712 FSupp 143, aff’d per curiam CA-7, 90-1 USTC ¶50,113, 895 F2d 1196 established the concept that an S corporate shareholder must take a reasonable salary from his or her S corporation; the shareholder is not permitted to take all S corporate profits as a distribution free of employment taxes.  Neither Congress nor the courts have established what is a reasonable salary.  IRS has presented many surveys of S corporations to Congress showing that S corporations have been very aggressive in “pushing the window”on this salary issue with many S corporations not having their shareholder-employees take any salary. From a tax planning perspective, taking a minimal salary avoids the imposition of not only §3101(b)(1)’s Medicare Tax of 2.9% but §3101(b)(2)‘s additional medicare tax of .9% tax (note,§3101(b)(2)‘s additional medicare tax is imposed only once certain income thresholds are met, namely when covered wages, compensation or self-employment income exceed $200,000 for single individuals (heads of households [with qualifying person] and qualifying widows or widowers with dependent child); $250,000 for married couples filing jointly and $125,000 for married filing separately.  Assuming S corporate shareholders want to be aggressive with minimizing salary, what are the chances of being audited. First, lets look at the number of S corporations filing tax returns. The Government Accounting Office (“GAO”) reported that the IRS received almost 4.4 million S corp returns for 2008, up from 3.7 million for 2005.  However,  many S corporations are never audited. In fact, the GAO reported that audit coverage of S corp returns was low, hovering in the 0.38 to 0.45 percent range. (Audit coverage for partnerships was similarly low in recent years, ranging from 0.38 percent to 0.42 percent.). It is to be noted that partners have to pay self-employment tax and Medicare tax pursuant to §3101(b)(1).  It remains to be seen if Congress will close this loophole discussed above and  prescribe the same type of partnership self-employment  taxation on S corporate shareholders.

Means to minimize  the imposition of Section 1’s taxation for high income taxpayers.  §1 as of 1/1/13 imposes a  maximum income tax rate of 39.6% as well as 20% taxation for capital gains and dividends, with these high taxes kicking in when certain income thresholds are met ($400,000 for single taxpayers and $450,000 for married taxpayers; $225,000 for marrieds filing separately and $425,000 for heads of households). There are also other provisions which affect these high bracketed taxpayers such as §151(d)’s phase out of personal exemptions. §1411 imposes a 3.8% tax on net investment income for taxpayers who reach a certain threshold of income, namely $250,000 if married and $200,000 if single. Owners of  a closely held business facing this type of taxation may opt to handle their affairs through a C corporation rather than an S corporation or LLC.  The reason is simple: Congress did not change the maximum corporate income tax rate of  35%. Further, a C corporation can offer a medical reimbursement plan as a perk for the shareholder employees, something that an S corporation cannot offer.  (A one person LLC can offer a medical reimbursement plan providing the owner of the LLC employs his or her spouse and the spouse requests a medical reimbursement plan).  Naturally, there are some major drawbacks to operating as a C corporation.  One major one is double taxation of C corporate earnings. Unless the shareholder-employee takes earnings from the C corporation as salary; the distributions of earnings are subject to double taxation (first at the corporate level; then as tax on the dividends).  Of course, the shareholder-employee could borrow money “tax free” from his or her C corporation, but the interest on the loan is not tax deductible and the loan has to be repaid.

If Congress follows through with the tax reform proposals to enact lower corporate rates, closely held C corporations will become more attractive since the shareholders can control to some degree the compensation paid to these shareholder-employees to keep it below the taxable levels of ATRA, §141l and §3101(b)(1) and (2).  However, if this “game” of taking advantage of the discrepancy between the highest income tax bracket and corporate bracket becomes too egregious, IRS does have weapons to attack the situation such as §531’s Accumulated Earnings Tax provisions (currently 39.6% on 15% of accumulated taxable income).

A C corporation can defeat §531’s accumulated earnings tax by declaring dividends utilizing §561’s dividend paid deduction; however, if the shareholder-employee is in the 39.6% income tax bracket, §1’s 20% dividend rate will kick in as well as  §1411’s 3.8% tax, depending on the shareholder’s bracket, to make this type of abatement costly.

However, case law under § 537 regarding “reasonable needs of the business” may come to the rescue to provide a  means to avoid the imposition of § 531’s accumulated earnings tax.  Usually, if IRS wants to impose § 531’s tax, a case or two can be found which resembles the fact pattern of the taxpayer under audit or it can be harmonized to the situation; thus, forcing the government to consider the cost and consequences of litigation.    Besides case law, there is also the question of burden of proof where the corporation can shift the burden to the Internal Revenue Service under Reg. Section 1.534-2.

Another alternative is to spread income out utilizing a family partnership assuming there are family members in a lower tax bracket than the parents (ie, children and grandchildren sometimes  referred to as “minority partners”). The first step is to transfer income producing assets to the family partnership; then give the low bracket taxpayers a minority interest in the partnership utilizing valuation discounts such as “lack of marketability” to value the gifts for gift tax return purposes. Then, follow the rules enunciated for family partnerships such as found in Strangi, T.C. Memo. 2003-145 so that the partnership will be sustained for tax purposes, namely that § 2036 does not apply to strike down the partnership. Besides reducing  § 1’s imposition of 20% tax on dividends and capital gains for high income taxpayers on the income producing assets transferred to the family partnership, § 1411’s 3.8% tax on net investment income is also reduced.

There are some major downside risks with family partnerships; namely, the minority partners now have rights to challenge the majority no matter how many restrictions are placed on them such as not being able to vote their interests, etc. For instance, the minority partners still have the right to see the partnership books and  records to determine if the majority is mis-appropriating partnership assets as well as sue the majority for “waste” of partnership assets if they are not receiving a fair return on their partnership interest.  The family partnership concept can be utilized with an S corporation; however, because of the limited tax planning possibilities with S corporations, partnerships are preferred.

§ 179’s Bonus Depreciation

Congress’ extension for one year of bonus first year depreciation indicates that Congress still believes that the economy needs a boost.  In simple terms, § 179 allows most taxpayers to expense the purchase of assets, both new and used,  in connection with operation of a business subject to certain limits.

Congress is also trying to help the real estate community by expanding the definition of assets covered, namely, qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property. Unfortunately, while Congress wants to stimulate the economy, it still has not put parity into the law for purposes of utilization of § 179’s expense provisions. A classic example of disparity is § 179(d)(4)’s provision which prevents estates and trusts from utilizing § 179.

Where this prohibition is painfully illustrated is with S corporations.   If an S corporation has an estate and/or a trust for a shareholder, Reg. Section 1.179-1(f)(3) provides that the trust or estate  may not deduct its allocable share of the §179 expense elected by the S corporation and the S corporation’s basis in § 179 property shall not be reduced to reflect any portion of the § 179 expense that is allocable to the trust or estate. However, the S corporation may claim a depreciation deduction under § 168 or a § 38 credit (if available) with respect to any depreciable basis resulting from the trust or estate’s inability to claim its allocable portion of the § 179 expense.

Other examples which require planning due to Congress’ restrictions are:

– Congress only extended § 179’s expanded expense provisions through 2013.  So, careful planning must occur because for § 179 to apply, there must be sufficient taxable  income to operate.  If there is  not  sufficient taxable income, then taxpayers are trapped by § 179 (b)(3)’s carryforward provisions which in a nutshell provide that any unused deductions can be carried forward but the amount to be expensed in a carried forward year is limited to the maximum annual dollar cost ceiling, investment limitation, or, if lesser, § 179 (b)(3)’s income limitation.  Thus, in 2014, unless Congress changes the provisions, §179(b)(1)’s  expense dollar limitation cannot exceed $25,000 instead of the current $500,000 and the beginning of § 179(b)(2)’s phase out starts at $200,000, not $2,000,000 as it is currently.

– If an S corporate shareholder plans to dispose of his or her stock where gain or loss is not recognized in whole or in part (including transfers of an S corporate interest at death) and the shareholder has not been able to fully utilize his or her § 179 deduction due to § 179’s income limitation, Reg. Section 1.179-3(h)(2) states that immediately before the transfer of the shareholder’s stock in the S corporation, the shareholder’s basis  is increased by the amount of the shareholder’s outstanding carryover of disallowed deduction with respect to his or her S corporate interest.

– Reg. Section 1.179-2(b)(4) states that § 179’s dollar limitation (§ 179(b)(1)’s current limit is $500,000)  applies to the S corporation as well as to each S corporate shareholder. In applying the dollar limitation to a taxpayer that is a S corporate shareholder in one or more S corporations, the S corporate shareholder’s share of § 179 expenses allocated to the S corporate shareholder from each S corporation is aggregated with any non-S corporation § 179 expenses of the taxpayer for the taxable year. So, assume that a calendar year S corporation owned equally by two individual shareholders, Mike and Laurie, purchases $800,000 of § 179 property on January 1, 2013 and elects to expense all of it.  On December 31, 2013, Mike individually for his sole proprietorship purchases $200,000 of § 179 property.  Mike cannot take a § 179 deduction of $600,000 ($400,000 from the passthrough of 50%  of the S corporation’s § 179 deduction and $200,000 from his proprietorship) on his 2013 Form 1040; rather, he can only take under § 179(b)(1) a maximum of $500,000.  Accordingly, $100,000 of a § 179 deduction is wasted due to bad timing of purchases (½ x 800,000 +200,000 =600,000; 600,000 – 500,000 [§ 179’s limitation of 500,000] = $100,000 to be carried over).

– § 179(d)(6) prescribes that members of a controlled group cannot expense totally more than $500,000 in a taxable year.  § 179(d)(7) states that for purposes of determining a control group for § 179 purposes, the group is determined using a “more than 50%” ownership test rather than “at least an 80%” one.  So, if an S corporation owns more than 50%  of the stock of another corporation, then care must be practiced so as not to run afoul of §179(b)(1)’s dollar limitation.

Charitable Contributions.  Congress basically left  charitable contribution provisions alone; however, it did not extend all provisions regarding charitable situations, eg, the enhanced deduction for charitable contribution of books.  Accordingly, creative tax planning can continue. Case law provides an illustration of such tax planning in the area of conservation easements. §170(f)(3)(B)(iii) permits a charitable deduction for the value of a qualified conservation contribution. §170(h) and Reg. §1.170A-14(a) define a “qualified conservation contribution” as a contribution of a qualified real property interest made to a qualified organization or that is exclusively for conservation purposes that are protected in perpetuity. Normally, one thinks of conservation easements involving undeveloped pieces of land. However, the homeowners in Glass v. Comm.,  2007 -1 USTC ¶ 50111 (6th Cir. 2006)proved it could apply to personal residences. In Glass, the homeowners claimed charitable deductions for two conservation easement donations of undeveloped lakefront property to a non-profit nature conservancy, much of it a high, undeveloped bluff on the shoreline of a lake.  The taxpayers’ property had 3 buildings on it, a log cabin which was used as a vacation home, a guest house and a garage. The easements did not restrict the taxpayers from developing the property providing they followed zoning requirements. The easements covered  approximately 2.64 acres of the property consisting of the width of the property at M-119 and 250 feet inland towards Lake Michigan with the easement generally restricting the building, construction, development, or removal of trees on the” encumbered property but “allow[ing] for the building of (and removal of trees for) a 3,200-square-foot garage/work space/studio and related access road.  The taxpayers’ property was relatively small but there was no evidence that the plant and wildlife habitat couldn’t exist on an area of that size. Although the county itself imposed a 60-foot setback requirement, the easements doubled that protection. The easements allowed taxpayers to continue living on the property, but prevented them from building on the lakefront lots, though they could still develop the rest of the property. The easement provided the homeowners the right to selectively prune, trim, or cut trees, shrubs, or vegetation with the limited purposes of preserving the scenic view or for safety. The taxpayers also carved out a right to build a shed, boathouse, or deck but this right had to be exercised in a way that minimized interference with the habitat. They also had the  right to maintain and establish foot paths providing they enhanced the ability of the plant and wildlife habitats to flourish.  With the respect to the easement property it was a relatively natural habitat for threatened plant species, bald eagles, and other wildlife.  The Taxpayers were allowed a charitable deduction for the easements created.  In reaching its decision the court noted that the protection of the natural habitat needn’t be pursuant to a clearly delineated government policy or further a specific conservation project. Rights retained by the donor of the conservation easements didn’t preclude the deduction where each right was limited to ensure that the plant and wildlife habitats were protected.  Thus, the right to selectively prune, trim, or cut trees, shrubs, or vegetation was for the limited purposes of preserving the scenic view or for safety. Likewise, the charitable deduction would be sustained if the taxpayer kept the  rights to (a)  build a shed, boathouse, or deck providing it was exercised in a way that minimized interference with the habitat; and (b) to maintain and establish foot paths providing it enhanced the ability of the plant and wildlife habitats to flourish. The court noted that there is no minimum size for a qualified conservation contribution. The relatively small size of property subject to two conservation easements (150 and 260 feet of shoreline, extending inland for 120 feet) did not preclude a deduction where there was no evidence that the plant and wildlife habitat could not exist on an area of that size.

§1411s tax on capital gains

§1411 is designed to tax capital gains as part of Net Investment Income once the income thresholds are reached, namely $250,000 if married and $200,000 if single.  §1411(c)(1)(A)(iii) prescribes that capital gain will be taxed at 3.8% , BOTH LONG and SHORT TERM GAIN. There is no special treatment.  Thus, once §1411 applies, long term capital gain will be taxed at maximum of  23.8% and short term gain at a maximum of 43.4%.  What effect this discrepancy of approximately 20% will have on the market is difficult to predict.