Q: Assessor Authority Over Change In Ownership Decisions

ASSESSOR AUTHORITY OVER CHANGE IN OWNERSHIP DECISIONS. An assessor or any person employed by the office of the county assessor must possess a valid assessment analyst certificate issued by the State Board of Equalization (SBE) in order to make decisions regarding change in ownership. [Cal. Rev. & Tax. Cd. §674(a) .] The SBE will not issue a certificate to an applicant who has not attained a passing examination grade and demonstrated to the SBE that he or she is competent to make such change in ownership decisions. If an applicant is denied a certificate, the applicant has a right to a review of the denial. In order to retain a valid certificate, every certified assessment analyst will complete at least 24 hours of SBE approved training in each one-year period or risk certificate revocation. [Cal. Rev. & Tax. Cd. §674(c) ; Cal. Rev. & Tax. Cd. §675 .] The assessment analyst certificate provisions will only apply in counties or cities and counties that have passed a resolution upon the recommendation of the assessor to require certification pursuant to such provisions. [Cal. Rev. & Tax. Cd. §680 .]

Q: Administrative Remedies

ADMINISTRATIVE REMEDIES. Taxpayers must exhaust their administrative remedies when appealing the assessor's determination that a change in ownership occurred by either: (1) filing with the appeals assessment board (AAB) a timely application for changed assessment that is also designated as a claim for refund as provided by Sec. 1603; or (2) filing a timely application for changed assessment with the AAB and a separate, timely claim for refund under Sec. 5907. The failure to seek such remedies will result in the taxpayer being precluded from challenging the new base year value. Further, the transfer of a life estate and remainder interests upon the death of the trustor of a revocable trust constitutes a change in ownership. Cal. Code Regs. 18 §462.060 remains valid and the creation of a life estate in real property is a change in ownership unless the estate is for the transferor or the transferor's spouse, regardless of whether additional interests are also transferred. [California State Board of Equalization Letter to Assessors No. 2010/034, 07/12/2010.]

Question 1

IRS Appeals

Accepted Answer

If you are involved in a dispute with IRS or are currently undergoing an audit, you should be aware of your rights to appeal tax determinations within IRS. This approach tends to be less costly and formal than litigating the matter in court, and often results in satisfactory resolution of the issues involved.

You can file an appeal with the IRS Office of Independent Appeals (Independent Appeals) in your region if you disagree with the result of your tax examination (audit). The appeal can be filed before you file a Tax Court petition, or even after one is filed (but before litigation). You can also file an appeal to contest certain penalties, or after rejection of a refund claim or compromise offer in a collection case. Under special procedures, you can also appeal a lien, levy, or seizure by IRS, as well as an IRS rejection of, or attempt to terminate, an installment arrangement for tax payments.

A taxpayer can request early referral of certain eligible unresolved issues from IRS?s Examination Division to Independent Appeals.

It is also possible to resolve a tax dispute through a mediation process in limited situations. The tax law requires IRS to prescribe procedures under which either taxpayers or Independent Appeals can request nonbinding mediation on any issue that is still unresolved after the conclusion of either: (1) appeals procedures or (2) unsuccessful attempts to enter into a closing agreement or a compromise. IRS has established procedures for requesting mediation of certain issues, for cases that are already in the Independent Appeals administrative process.

IRS also has ?fast track? programs under which certain taxpayers that are already under examination can get an expedited resolution of their cases.

An administrative appeal can also be made by filing an application with the office of the National Taxpayer Advocate. The Taxpayer Advocate or his or her designee can issue a Taxpayer Assistance Order based on a determination that the taxpayer is suffering or is about to suffer a significant hardship as a result of the way in which the tax laws are being administered by IRS.

What?s important to keep in mind, is that there are procedures that represent a middle ground between merely giving in to IRS, or waging a costly all-out war through litigation.

Please contact us if you wish to discuss these issues further.

Trust Fund Penalty for Unpaid Payroll Taxes

Sometimes, when businesses get in financial trouble, they are tempted to pay creditors or others instead of paying the government the income and employment taxes it has withheld from employees? wages. This is a big mistake and can lead to large penalties against business owners or others who are responsible for paying over such taxes. In such situations, the IRS can levy on the individual assets of the responsible person. The IRS may even criminally prosecute the ?responsible persons? who make this decision.

To encourage prompt payment of withheld income and employment taxes, including social security taxes, railroad retirement taxes, or collected excise taxes, Congress passed a law that provides for a trust fund recovery penalty (TFRP). Income and employment taxes are called trust fund taxes because you actually hold the employee?s money in trust until you make a federal tax deposit in that amount. The TFRP may apply to you if these unpaid trust fund taxes cannot be immediately collected from the business.

The amount of the penalty is equal to the unpaid balance of the trust fund tax. The penalty is computed based on the unpaid income taxes withheld, plus the employee?s portion of the withheld FICA taxes. For collected taxes, the penalty is based on the unpaid amount of collected excise taxes.

The TFRP may be assessed against any person who is responsible for collecting or paying withheld income and employment taxes, or for paying collected excise taxes, and willfully fails to collect or pay them.

For purposes of the TFRP, a responsible person includes, but is not limited to an officer or employee of a corporation, a partner or employee of a partnership, a member or employee of an LLC, a corporate director or shareholder, another corporation, or a surety or lender.

The IRS does not need to use the TFRP to assert liability against the owner of a sole proprietorship or a general partner of a general partnership, because the individual owner or the general partners are already personally liable for trust fund taxes. In fact, sole proprietors and general partners are liable for the WHOLE amount of unpaid payroll taxes, not only the trust fund portion withheld from employee wages. However, the IRS can use the TFRP to assert liability against an employee or other non-owner who exercises control over a sole proprietorship?s finances.

Regardless of a person?s corporate title, a person will not be held liable for the TFRP unless he or she is considered a ?responsible person? (i.e., an individual who has the duty to account for, collect, and pay over the trust fund taxes to the government). There may be more than one responsible person in a business.

Most trust fund recovery cases involve corporate officers. A director who is not an officer or employee of the corporation may be responsible for the trust fund recovery penalty if he or she was responsible for the corporation?s failure to pay taxes that were due and owing.

I cannot over emphasize the importance of paying over to the IRS taxes that are withheld from your employees? wages. As an officer/owner of your business, you are the first person the IRS will look to, to collect any unpaid withholdings. I cannot emphasize enough this point: If found to be the person responsible for withholding, collecting, and paying these taxes over to the IRS, you will be personally liable for any nonpayment that is considered to be willful. This means that you will have to pay the taxes out of your own pocket. In addition, there is the possibility of criminal prosecution for this failure, if you are found to be a ?responsible person?.

Under the system established for withholding taxes, your employees are credited for any taxes withheld from their wages. Your company is deemed to hold the withheld taxes ?in trust? for the federal government. This is why withholding taxes are referred to as ?trust fund taxes.? Often times, businesses that experience financial trouble will use taxes withheld from employees? wages to pay creditors and suppliers in order to keep the business afloat. However, if the business eventually fails, the employees are not liable for the unpaid taxes, and the business probably doesn?t have sufficient funds to satisfy the trust fund tax liability.

By enacting §6672 of the Internal Revenue Code, Congress made sure that the government would have the means to recover trust fund taxes if, for whatever reason, they are not paid. Section 6672 imposes personal liability on any person who is required to collect, truthfully account for, and pay over trust fund taxes but who willfully fails to do so. In the past,this has been referred to as the ?100%Penalty? because the amount of liability is equal to 100% of the taxes withheld from the employees? wages. More recently, the IRS calls this the ?Trust Fund Recovery Penalty.?

Let us look at the elements for liability under §6672. First, to be liable, a person must be a ?responsible person.? There is no one factor that makes an individual a responsible person. Generally, a responsible person is the one who has the power and authority to control the business?s decision-making process regarding the payment of creditors. In most cases, the IRS looks to officers and owners of a business as responsible persons because they are the ones who make the decision concerning which creditors to pay and which ones not to pay. Courts have found stockholders, directors, managers, bookkeepers, and people outside the business to be responsible persons because they had the ultimate authority over the disbursements of the business?s funds. More than one person can be held liable, too.

Still, there is a second element without which a responsible person is not liable for the Section 6672 penalty: Willfulness. Willfulness does not mean that there is some bad motive or intent. Rather, for these purposes, willfulness can be established if there is evidence that the responsible person(s) knew that payments were being made to other creditors or suppliers at a time when withheld taxes were not being paid to the IRS. In some cases, the responsible person does not actually have to be aware that the taxes are not being paid in a specific instance if there is a history of nonpayment of trust fund taxes at times of financial crisis.

It?s called the ?trust fund recovery penalty? (or simply the ?trust fund penalty?) because it applies to the Social Security and income taxes required to be withheld by a business from its employees? wages. Since the taxes are considered property of the government, the employer holds them in ?trust? on the government?s behalf until they are paid over. It?s also called the ?100% penalty? because the person liable for the taxes (the ?responsible person? described below) will be penalized 100% of the taxes due. Accordingly, the amounts IRS seeks when the penalty is applied are usually substantial, and IRS is very aggressive in enforcing this penalty.

The trust fund recovery penalty is among the more dangerous tax penalties because it applies to a broad range of actions and to a broad range of persons.

What actions are penalized? The penalty applies to any willful failure to collect, or truthfully account for and pay over Social Security and income taxes required to be withheld from employee wages.

Who is at risk? The penalty can be imposed on any person ?responsible? for collection and payment of the tax. This has been broadly defined to include a corporation?s officers, directors, and shareholders under a duty to collect and pay the tax as well as a partnership?s partners, or any employee of the business under such a duty. Even voluntary board members of tax-exempt organizations, who are generally excepted from responsibility, can be subject to this penalty under certain circumstances. Responsibility has even been extended in some cases to family members close to the business, and to attorneys and accountants.

IRS says responsibility is a matter of status, duty, and authority. Anyone with the power to see that the taxes are paid may be responsible. There is often more than one responsible person in a business, but each is at risk for the entire penalty. Although a taxpayer held liable may sue other responsible persons for contribution, this is an action he or she must take entirely on his or her own after he or she pays the penalty. It cannot be part of the IRS collection process. Note how broadly the net can be cast: You may not be directly involved with the withholding process in your business. But if you learn of a failure to pay over withheld taxes and have the power to have them paid and instead make payments to creditors, etc., you become a responsible person.

What is ?willfulness?? For actions to be willful, they don?t have to include an overt intent to evade taxes. Simply bowing to business pressures and paying bills or obtaining supplies instead of paying over withheld taxes due the government is willful behavior for these purposes. And just because you delegate responsibilities to someone else doesn?t necessarily mean you are off the hook. Your failure to take care of the job yourself can be treated as the willful element.

Avoiding the penalty. Absolutely no failure to withhold and no ?borrowing? from withheld amounts should ever be allowed?regardless of the circumstances. All funds withheld must also be paid over.

You can see from this brief discussion that it is not difficult for the IRS to impose personal liability for unpaid trust fund taxes on the person responsible for making the financial decisions in a business. Moreover, this liability never goes away. For instance, it would survive a personal bankruptcy. Yet, there are ways to structure business holdings to protect the family?s assets and home. I hope that your business will continue to enjoy its success, but I think it is a good idea for us to meet and make sure that you or your professional advisors are doing everything possible to protect you and your personal holdings from liability in the event something should go wrong.

If you have any questions regarding this penalty or have any concerns relating to any potential personal liability, please give us a call at your earliest convenience so we can discuss your situation.

Question 2

Audit Reconsideration Process

Accepted Answer

IRS Audit Reconsideration Process

There are times following a tax audit you don't like, you may be able to ask for a re-audit. Below, are the conditions for obtaining this 'audit reconsideration'.

When you can obtain Audit Reconsideration

The IRS audit reconsideration process is an IRS procedure designed to help taxpayers when they disagree with the results of:

(1) an IRS assessment made because of an audit of a taxpayer's tax return, or

(2) a return IRS created for the taxpayer, under Code Sec. 6020(b), because the taxpayer did not file a tax return (IRS Pub. 3598, The Audit Reconsideration Process).

The IRS audit reconsideration process allows the IRS to reconsider a taxpayer's information informally. If the taxpayer has paid the amount due in full, the taxpayer must file a formal claim (Form 1040X, Amended U.S. Individual Income Tax Return).

Tip: The IRS audit reconsideration process should be considered where a taxpayer misses a deadline for filing a petition with the Tax Court, thus negating any consideration by the Tax Court of the taxpayer's case.

Steps to obtain an Audit Reconsideration

The IRS will accept an audit reconsideration request if:

(1) The taxpayer submits information that the IRS has not considered previously which might change the amount of tax owed, or credit the taxpayer may be entitled to.

(2) The taxpayer filed a return after IRS completed a return for the taxpayer.

(3) The taxpayer believes the IRS made a computational or processing error in assessing the taxpayer's tax.

(4) The liability is unpaid or credits are denied.

When IRS will not agree to an Audit Reconsideration

The IRS will not accept an audit reconsideration request if:

(1) The taxpayer previously agreed to pay the amount of tax owed by signing an agreement such as:

(a) a Closing Agreement (Form 906) that is final and conclusive;

(b) a Compromise agreement; or

(c) an agreement on Form 870-AD with the Appeals Office,

(2) The amount of tax owed is a result of final partnership item adjustments under the Tax Equity Fiscal Responsibility Act of 1982 known as TEFRA.

(3) The U.S. Tax Court, or another court, has issued a final determination on the taxpayer's tax liability.

How to Start the Audit Consideration Process

In order to start the audit reconsideration process, the taxpayer must:

(1) have filed a return

(2) write to the IRS to inform them which changes the taxpayer wants the IRS to consider;

(3) include documentation that supports the taxpayer's position (including a copy of the taxpayer's examination report, Form 4549, along with any new documentation that supports the taxpayer's position);

(4) include a daytime and evening telephone number and the best time for the IRS to call.

IRS Response to Audit Reconsideration Request

Upon receiving the taxpayer's documentation, the IRS may delay collection activity. However, if the documentation is not sufficient to support the taxpayer's position and the taxpayer does not respond to any request for additional information within 30 calendar days, the IRS may resume collection activity.

Observation: If the taxpayer has an installment agreement, he or she must continue making payments during the audit reconsideration process.

Question 3

In Depth Discussion of IRS Audit Reconsiderations

Accepted Answer

What is an Audit Reconsideration?

An audit reconsideration is defined by the Internal Revenue Manual (IRM) as the process the IRS uses to reevaluate the results of a prior audit where additional tax was assessed and remains unpaid, or a tax credit was reversed.

If the taxpayer disagrees with the original determination, they must provide information not previously considered during the original examination. IRS uses this process when the taxpayer contests a Substitute for Return (SFR) determination by filing an original delinquent return. [IRM §4.13.1.2(1)]

Audit Reconsideration Authorization

The Internal Revenue Code does not explicitly authorize the IRS to offer audit reconsideration as a relief provision to taxpayers. Nevertheless, the Code generally authorizes the IRS to abate the unpaid portion of the assessment of any tax or liability with respect to it that is one of the following:

(1) excessive in amount,
(2) assessed after expiration of the applicable period of limitation, or
(3) erroneously or illegally assessed (Sec. 6404(a)).

This means IRS has 'discretionary authority' to evaluate a prior audit conducted by an IRS auditor. This evaluation is a form of review of a previous audit where some issues remain unresolved. For a usual audit reconsideration situation, the taxpayer believes that the audit resulted in an inappropriate or unsupported increase in tax liability. As result, the taxpayer objects to pay the additional tax assessed. Many times, the taxpayer was not present at the audit, either because

(1)the taxpayer was unaware of it (did not receive the notice) or
(2)decided not to respond to the IRS notice.

Whatever the circumstances causing the disagreement with the tax assessment, need arises to have IRS take a second look at the prior audit findings.

Audit Reconsideration Effectiveness

Audit reconsideration can amount to a highly effective tool available to when the taxpayer

(1)is dissatisfied with the results of a prior audit,
(2)as well as when clients have not filed tax returns and the IRS has filed returns for them through the SFR process.

The SFR process allows the IRS to file tax returns on behalf of taxpayers in situations when taxpayers fail to make a return or file (willfully or otherwise) a false or fraudulent return. IRC section 6020(b) authorizes the IRS to use information gathered through the mandatory reporting processes (e.g., the Form 1099 series) and any other information available to it. IRC Sec. 6020(b)(2) states that any return prepared by the IRS "shall be prima facie good and sufficient for all legal purposes." Once the IRS files a SFR on behalf of a non filing taxpayer, it can be an uphill battle to obtain relief. Usually, the taxpayer then needs to engage tax counsel.

Important Factors

There are several important concerns when choosing the audit reconsideration tool.

(1) audit reconsideration is not available during an original IRS examination.
(2) Audit Reconsideration is an administrative process, and is discretionary. As a result, the IRS has the power to decide which cases it will approve for audit reconsideration.

By comparison, the IRS Appeals Unit generally grants taxpayers the right to have their case mediated by an 'independent representative' of the IRS.

(3)The additional tax assessed by the IRS must remain unpaid; otherwise, the taxpayer will need to consider other options for seeking a refund such as a formal "Claim for Refund" which has it own labyrinthian rules.

(4)The taxpayer must have something "new" to offer the IRS for consideration, that usually is new evidence, e.g., supporting documentation that was not previously considered by the examining agent, for example.

Audit Reconsideration Goals

The stated goals of the audit reconsideration process are to ensure that:

The amount of assessed tax is correct;
The collection process is suspended while the reconsideration request is being considered;
Procedures support the abatement of assessments in appropriate situations; and
Cases are handled in a consistent manner.

Learning

What lessons can be derived from these goals?

(1)IRS is willing to work with taxpayers to help resolve tax disputes in a cost-efficient, timely manner.
(2)IRS is interested in ensuring that the amount of tax assessed is correct.
(3)Taxpayers benefit from having the tax collection process suspended while the IRS considers their requests.
(4)The goals support the notion of fairness and consistency on the part of the IRS when considering an audit reconsideration request.

Reasons for Seeking Audit Reconsideration

Frequent and common reasons for seeking relief through audit reconsideration include:

The taxpayer did not receive some or all of the correspondence mailed by the IRS to the taxpayer. For example, the taxpayer moved and the IRS does not have the taxpayer's current address;
The taxpayer did not appear for an audit; Interestingly, even if the taxpayer decided to ignore the notice;
The IRS did not consider some or all of the information submitted by the taxpayer in response to an IRS inquiry;
The taxpayer disagrees with an assessment from an earlier audit and now has new information related to the dispute; or
The taxpayer disagrees with an assessment based on a return filed by the IRS through the SFR process.

Example

Married taxpayers' jointly filed return was audited by the IRS. Subsequently, the IRS mailed a notice of deficiency (90-day letter) that stated that as a result of the audit, an additional tax was being assessed. Additionally, the notice stated that (1) the taxpayers had 90 days from the date of the notice to file a petition with the Tax Court; (2) the Tax Court cannot consider a late petition; (3) the time to file a petition with the Tax Court cannot be extended or suspended; and (4) the receipt of other information or correspondence from the IRS will not change the period for filing a petition.

Upon receipt of the 90-day letter, the taxpayers, through their accountant, submitted a request for audit reconsideration based on new information they had related to the audit. The IRS granted their request, stating in its letter that the taxpayers' case would be returned to the examination group for evaluation. At the bottom of the letter, the following handwritten statement appeared: "Time to file a petition with the U.S. Tax Court has expired." Nonetheless, the taxpayers filed a petition with the Tax Court. In response to the taxpayers' petition, the IRS filed a motion to dismiss for lack of jurisdiction, on the grounds that the petition was not timely filed. The Tax Court found that the taxpayers did not file their petition for redetermination with the court within the time prescribed by Secs. 6213(a) and 7502. Accordingly, the court determined that it lacked jurisdiction to redetermine the tax liability and granted the IRS's motion to dismiss for lack of jurisdiction.

Bad news if the taxpayers want to have their day in Tax Court and not have to pay the tax first. However, hope remains. The taxpayers were still able to have their case reconsidered by the IRS through the audit reconsideration process. The Court in Wong, T.C. Memo. 2000-88, "Petitioners did not even begin to discuss audit reconsideration with respondent until after the 90-day period had expired." Takeaway: Given the discretionary nature of audit reconsideration, the taxpayer should view audit reconsideration as a possible remedy for resolving a dispute with the IRS, even when other strategies are unavailable, such as filing a petition with the Tax Court.

Factual Situations whee the IRS Views a Request for Audit Reconsideration Favorably

The IRM lists the following circumstances as examples of when it is likely to view a request favorably (IRM §4.13.1.7):

The taxpayer requests the abatement of an assessment based on information that was not previously considered and that, if considered, would have resulted in a change to the assessment;
An original delinquent return is filed by the taxpayer after an assessment was made as a result of a return executed by the IRS under Sec. 6020(b) or another SFR procedure; or
There was an IRS computational or processing error in assessing the tax.

As a Tax Attorney, I have personally utilized situation one above to obtain a second look at a tax assessment that was several years old by the time the taxpayer came to see me.

Oppositely, the IRS has indicated it will not consider a request for audit reconsideration in the following situations (IRM §4.13.1.8):

The taxpayer has already been afforded a reconsideration request and did not provide any additional information with the current request that would change the audit results;
The assessment was made as a result of
- a closing agreement entered into under Sec. 7121 using Form 906, Closing Agreements on Final Determination Covering Specific Matters, and/or
- Form 866, Agreement as to Final Determination of Tax Liability;
The assessment was made as a result of a compromise under Sec. 7122;
The assessment was made as the result of final TEFRA administrative proceedings;
The assessment was made as a result of the taxpayer entering into an agreement on Form 870-AD, Offer of Waiver of Restrictions on Assessment and Collection of Deficiency in Tax; or
The Tax Court has entered a decision that has become final, or a district court or the Court of Federal Clams has rendered a judgment on the merits that has become final.

Requirements for Submitting an Audit Reconsideration

The taxpayer should send a written audit reconsideration request to the appropriate IRS office. Typically, the following documents should be submitted:

A statement about the issues the taxpayer contends should be corrected;
Information that supports the taxpayer's position, including necessary documents such as Forms 1099, canceled checks, bank statements, and loan documents; and
Copies of letters and reports the IRS sent the taxpayer (including, if available, a copy of the examination report, Form 4549, Income Tax Examination Changes).

Notice: The taxpayer should submit a request for audit reconsideration only if other options, such as filing a petition in Tax Court, have expired and are unavailable.

The audit reconsideration package should be prepared and presented in the same manner as an Appeals notebook. A cover letter is included with the audit reconsideration.

IRS Actions Following Audit Reconsideration Request

After it review of the taxpayer submission, the IRS normally advises the taxpayer whether it will change the assessed tax. Normally, IRS provides explanations for its conclusions. If a taxpayer does not agree with the IRS's position, taxpayer may do the following:

request a conference with the Appeals Office by filing a written protest.
pay the tax in full and then file a formal claim for refund. If the IRS subsequently disallows the claim in full or in part, the taxpayer may request an Appeals conference or file a refund suit in U.S. district court or the Court of Federal Claims.

Usually, it takes several months prior to the time the IRS takes action on audit reconsideration requests.

Note: If a taxpayer is suffering an economic hardship or immediate threat of adverse action such as forced collection or has experienced a significant systematic delay in the IRS's processing of a reconsideration request, the taxpayer can contact the Taxpayer Advocate's Office and ask to expedite resolution of the request by filing Form 911, Request for Taxpayer Advocate Service Assistance.

Question 4

Partnership audit procedures may affect your Partnership or LLC

Accepted Answer

How the partnership audit procedures may affect your partnership

There are specific partnership audit procedures that apply for partnership tax years beginning after 2017. As under the pre-2018 partnership audit rules, the IRS audits partnerships at the partnership level. However, under the post-2017 partnership audit procedures, the adjustments are ordinarily imposed at the partnership level and partners do not have the opportunity to opt out of the partnership procedures. Partnerships must designate a partnership representative with a substantial presence in the U.S. The partnership representative will have the authority to bind the partnership; if no partnership representative is appointed, the IRS will designate one. In general, it makes sense for partnership to designate their partnership representatives when they are formed.

A partnership may elect out of the partnership audit procedures if (i) the partnership is required to furnish 100 or fewer statements to partners or nominees for the year, treating each statement that must be furnished to an S corporation shareholder as a separate statement and (ii) each statement the partnership is required to furnish for the year is furnished to an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were a domestic entity, an S corporation, or an estate of a deceased partner. Thus, if statements have to be furnished to partnerships, trusts, foreign entities not described above, disregarded entities, estates of individuals other than a deceased partner and any person that holds an interest on behalf of another person, the partnership cannot make the election. A partnership must make the election on its timely filed return for the tax year to which the election applies and must notify its partners of the election within 30 days of the day it makes the election.

Under the partnership audit procedures, the IRS may make adjustments to (i) any item or amount relating to the partnership that is relevant in determining the income tax liability of any person and (ii) any partner's distributive share of any such item or amount. In general, an imputed underpayment will be determined (a) by netting all partnership adjustments for the reviewed year and (b) applying the highest individual or corporate tax rate to the adjustments. Special rules apply so that items of different characters aren't netted against each other.

The partnership audit procedures provide partnerships with the opportunity to suggest modifications to imputed underpayments. Thus, a partnership that receives a notice of proposed partnership adjustment (NOPPA) may request a modification of the imputed underpayment based on various grounds, including the character of its partners (e.g., a tax-exempt organizations). The IRS may file a notice of a final partnership adjustment (FPA) no earlier than 270 days after the NOPPA is filed. Thus, a partnership has at least 270 days to request a modification of an imputed underpayment.

Although imputed underpayments, and interest and penalties, are ordinarily imposed at the partnership level, the partnership may elect to have imputed underpayments taken into account at the partner level. If the election is made, the partnership must provide statements to each of its partners notifying the partner of its portion of the imputed underpayment and the partners would have to pay their portions of the imputed underpayment and the interest and penalties.

An FPA is the equivalent of a notice of a deficiency and gives the partnership the right to file a readjustment petition in Tax Court within 90 days of the FPA. The partnership may also file a readjustment petition in a district court or the Court of Federal Claims, but it must pay the tax before it files a petition in those courts. A partnership is also allowed to file an administrative adjustment request (AAR) to adjust partnership-related items unless it has received a notice of an administrative proceeding from the IRS.

Question 5

Common Errors That Can Waive the Practitioner/Taxpayer Confidentiality Privilege

Accepted Answer

Common Errors That Can Waive the Practitioner/Taxpayer Confidentiality Privilege

1. Including privileged information in the tax return or other filings with the IRS or state.
2. Disclosing privileged information in non-governmental filings, such as financial statements.
3. Mixing privileged communications with non-privileged communications or discussions.
4. Including third parties not critical to the subject of the privileged communication in the discussions.
5. Permitting access to privileged files by staff not engaged in the privileged engagement.
6. Permitting an engagement involving privileged communications to be managed by a staff member who is not an attorney, CPA, or enrolled agent or actuary.
7. Not segregating written privileged communications in separate files.
8. Not segregating electronic privileged communications from other files.
9. Not obtaining the written consent of the client before releasing any privileged information.
10. Failing to claim the privilege when the IRS requests privileged documents or other communications.
11. Allowing the privileged information to be used for non-tax matters.
12. Disclosing the privileged information to third parties, including governmental bodies and private businesses (such as banks).
13. Failing to educate clients about the fundamentals of the privilege, thus increasing the chances that the client can inadvertently waive the privilege.
14. Not marking every privileged communication as privileged.
15. Not billing separately for privileged engagements.

Question 6

IRS Audit Survival Tips

admin · Accepted Answer

Surviving an IRS Audit

- Objective. you must convince the IRS that you reported all of your income and were entitled to any credits, deductions, and exemptions that are questioned.

- Request Audit Delay when possible. Postponing the audit usually works to your advantage. Request more time whenever you need it to get your records in order, or for any other reason.

- Do not allow IRS to conduct the audit at your home or place of business. Keep the IRS from holding the audit at your business or home. Instead, go to the IRS or have YAHNIAN LAW CORPORATION handle it. Field audits (at your place) are used mainly when there is business income; consult YAHNIAN LAW CORPORATION before hosting a field audit. If you retain us, it is most likely that you will not even have to appear at the audit.

- Record Preparation. If you are missing receipts or other documents, you are allowed to reconstruct records.

- Manage your expectations. Don't expect to come out of the audit without owing something. . Don't try to compromise on the amount of taxes to be paid; instead, negotiate the tax issues with the auditor.

- Don't Elaborate on auditor questions. Give the auditor no more information than he is entitled to. Do not speak any more during the audit than is absolutely necessary. Don't give copies of other years' tax returns to the auditor. In fact, don't bring to an audit any documents that do not pertain to the year under audit or were not specifically requested by the audit notice.

- Research. Research tax legal issues by using free IRS publications and commercial tax guides. If you are still unclear about the tax law or how to present your documents to an auditor, consult YAHNIAN LAW CORPORATION before the audit. Better yet, have YAHNIAN LAW CORPORATION handle the audit for you. Know your rights. Review IRS Publication 1, explaining the Taxpayers' Bill of Rights, prior to your audit. If the audit is not going well, demand a recess to consult YAHNIAN LAW CORPORATION. Ask to speak to the auditor's manager if you think the auditor is treating you unfairly. If the subject of tax fraud comes up during an audit, don't try to handle it yourself. At that point, you most definitely need legal counsel. Don't even talk to your accountant. There is no accountant client privilege for criminal tax matters.

- Time is on your side. The IRS must complete an audit within three years of the time the tax return is filed, unless the IRS finds tax fraud or a significant underreporting of income.

- Appeal the results. When you get the examination report, call the auditor if you don't understand or agree with it. Meet with him or his manager to see if you can reach a compromise. If you can't live with an audit result, you may appeal within the IRS or go on to tax court.

Question 7

Lawyer Tax Audits

Accepted Answer

When the IRS examines returns of attorneys, there are specific issues they look for. Thus, if you should be chosen for an audit, it's important that we appropriately document your compliance with these issues. This will help reduce additional costs to you in the future should an audit arise.

1. IRS prior 3 year analysis

If you are chosen for an audit, the IRS will perform a comparative analysis of at least three years during the pre-audit planning phase. During this phase, they will determine if there are any unusual changes in income, expenses and taxes paid for those prior years. Thus, it is important that I review your last three year tax returns so we can document any unusual changes such as I just described.

2. Attorney Specialties

The IRS will also build its audit around an attorney's specialty. For example, criminal and immigration attorneys may receive more cash for services than other types of lawyers, as their clients may not use U.S. banks. Thus, the IRS will look at Currency Transaction Reports posted to the Information Returns Program (IRP) transcripts to see if an attorney has received large cash payments. They will then track those payments back to the attorney's tax return. IRP transcripts provide information about payments an attorney receives that are reported to the IRS. For example, these transcripts provide information about reported Forms 1099, Currency Banking Retrieval System report summaries, social security payments, rental income, property sales, and interest and dividend payments.

3. Costs Advanced on Client Behalf

If you pay litigation expenses on behalf of your clients, the IRS will verify whether or not these payments have been deducted. Courts have determined that costs paid on behalf of a client are to be treated as in the nature of loans for tax purposes. They are not deductible as a current cost of conducting business. The costs are those of the client and not the attorney since there is an expectation of reimbursement. A bad debt deduction may be taken in the year that any costs are determined to be uncollectible.

4. Bookkeeping System Review and Analysis

The IRS will also want a thorough understanding of your bookkeeping system and internal controls, especially as they relate to any trust accounts that you control. Your business should have a written accounting manual which describes these procedures. If you have one, I will want to review it. If you do not have one, I can help you prepare one.

5. Earned Income Contained in Trust Accounts

If you control trust accounts into which settlement and award proceeds have been deposited, the IRS will check to see if you have attempted to defer earned income by allowing fees to remain in the trust account until the following year. Generally, once a settlement is received, the attorney's fee is both determinable and available and therefore includible in income. However, if there are some extenuating circumstances which preclude income recognition, we need to appropriately document those circumstances.

6. Non cash Transactions

If you receive noncash compensation, for example in a bartering transaction, the IRS will want to see documentation of how such compensation has been valued and recorded in income.

7. Entertainment and Meals Deductions

The IRS pays particular attention to deductions for entertainment and meals. Generally, to be deductible, entertainment must meet either a "directly related" or "associated with" test. The "directly related" test generally cannot be met where there was little or no possibility of engaging in the active conduct of trade or business. This would apply, for example, in situations where you were not present. However, even if you were present, the rules state that there is little or no possibility of engaging in business where distractions are substantial, such as when the meetings or discussions occur at nightclubs, theatres, sporting events, cocktail parties, or social gatherings. In one instance, an attorney gave a party at a country club that was attended by some clients, persons who referred clients, and other business associates. The attorney could not deduct the expense incurred for the party because no business was discussed. The business purpose and business discussions must be properly substantiated. Any expenses rejected by the IRS because of improper, ill-kept, or non-existent records can result in substantial penalties.

8. Personal Service Corporations (PSCs)

When an attorney works for a personal service corporation, the IRS will scrutinize whether or not there are any constructive dividends or additional wages as a result of the corporation paying the attorney's travel, meal, entertainment, and other personal expenses. If you have received a lot of reimbursements of such expenses, we need to ensure that the business purpose is appropriately documented.

9. Employee Status of Independent Contractors

Finally, if you treat receptionists, secretaries, paralegals, or law clerks as independent contractors, there may be some potential employment tax exposure. If this is the situation in your case, we need to document the facts that support such treatment.

Question 8

Bankruptcy Discharge of Taxes-Introduction

admin · Accepted Answer

Contrary to what you may believe or have heard, most tax debts cannot be discharged in bankruptcy. Instead, you will still owe them at the end of a Chapter 7 bankruptcy case, or you'll have to repay them in full in a Chapter 13 bankruptcy repayment plan. If you need to discharge tax debts, Chapter 7 bankruptcy will probably be the better option -- but only if your debts qualify for discharge (see below) and you are eligible for Chapter 7 bankruptcy. When You Can Discharge a Tax Debt You can discharge (eliminate) personal debts for federal income taxes in Chapter 7 bankruptcy only if all of the following conditions are true:

The taxes are income taxes. Taxes other than income, such as payroll taxes or fraud penalties, can never be eliminated in bankruptcy. There may be an exception for California Sales taxes under certain conditions.
You did not commit fraud or willful evasion. If you filed a fraudulent tax return or otherwise willfully attempted to evade paying taxes, such as using a false Social Security number on your tax return, bankruptcy can't help.
The debt is at least three years old. To eliminate a tax debt, the tax return must have been originally due at least three years before you filed for bankruptcy.
You filed a tax return. You must have filed a tax return for the debt you wish to discharge at least two years before filing for bankruptcy. (In most courts, if you file a late return (meaning your extensions have expired and the IRS filed a substitute return on your behalf), you have not filed a "return" and cannot discharge the tax. In some courts, you can discharge tax debt that is the subject of a late return as long as you meet the other criteria.)
You satisfy the "240-day rule." The income tax debt must have been assessed by the IRS at least 240 days before you file your bankruptcy petition, or must not have been assessed yet. (This time limit may be extended if the IRS suspended collection activity because of an offer in compromise or a previous bankruptcy filing.)

Federal Tax Liens are Not dischargable If your taxes qualify for discharge in a Chapter 7 bankruptcy case, your victory is somewhat limited if the IRS filed its tax lien before you filed your bankruptcy petition. This is because bankruptcy will not wipe out prior recorded tax liens. A Chapter 7 bankruptcy will wipe out your personal obligation to pay the debt, and prevent the IRS from going after your bank account or wages. However, if the IRS recorded a tax lien on your property before you file for bankruptcy, the lien will remain on the property. In effect, this means you'll have to pay off the tax lien in order to sell the property.

Question 9

Choosing a Form of Business Entity-Tax Strategies

Accepted Answer

Factors in Choosing a Form of Business Entity

Question 10

Qualified Business Income Deduction-Introduction

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New deduction for pass-through income. Generally for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, the Act adds a new section, Code Sec. 199A, “Qualified Business Income,” under which a non-corporate taxpayer, including a trust or estate, who has qualified business income (QBI) from a partnership, S corporation, or sole proprietorship is generally allowed a deduction equal to the lesser of 20% of QBI (not including net capital gains) or 50% of W-2 wages paid by the partnership, S corporation, or sole proprietorship. But the deduction can’t exceed the taxpayer’s taxable income, reduced by net capital gain. This is a significant tax deduction taking effect in 2018 under the TCJA. It should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship. This income is sometimes referred to as “pass-through” income. The deduction is 20% of your “qualified business income (QBI)” from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business. The deduction is taken “below the line,” i.e., it reduces your taxable income but not your adjusted gross income. But it is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. If QBI is less than zero it is treated as a loss from a qualified business in the following year. Rules are in place (discussed below) to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction. For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. Here’s how the phase-in works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, viz., $415,000.) If your taxable income is between $157,500 and $207,500, you would exclude only that percentage of income derived from a fraction the numerator of which is the excess of taxable income over $157,500 and the denominator of which is $50,000. So, e.g., if taxable income is $167,500 ($10,000 above $157,500), only 20% of the specified service income would be excluded from QBI ($10,000/$50,000). (For joint filers, the same operation would apply using the $315,000 threshold, and a $100,000 phase-out range.) Additionally, for taxpayers with taxable income more than the above thresholds, a limitation on the amount of the deduction is phased in based either on wages paid or wages paid plus a capital element. Here’s how it works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50% of taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if your QBI were $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000. And if your taxable income were between $157,500 and $207,500, you would only incur a percentage of the $4,000 reduction, with the percentage worked out via the fraction discussed in the preceding paragraph. (For joint filers, the same operations would apply using the $315,000 threshold, and a $100,000 phase-out range.) Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships. Obviously, the complexities surrounding this substantial deduction can be formidable, especially if your taxable income exceeds the threshold discussed above. If you wish to work through the mechanics of the deduction with me, with particular attention to the impact it can have on your specific situation, please give me a call.

Question 11

Qualified Business Income Deduction-Detailed Discussion

Accepted Answer

Individuals who are sole proprietors, partners in partnerships, members in LLCs taxed as partnerships (hereafter, "partners"), or shareholders in S corporations, may be able eligible to claim a deduction for qualified business income (QBI) under new Code Section 199A, beginning with the 2018 tax year. Trusts and estates are also eligible for the deduction.

The amount of the deduction (QBI deduction) is generally 20 percent of the taxpayer's qualifying business income from a qualified trade or business.

Example: In 2018, Joe receives $100,000 in salary from his job at XYZ Corporation and $50,000 of qualified business income from a side business that he runs as a sole proprietorship. Joe's QBI deduction for 2018 is $10,000 (20% of $50,000).

The QBI deduction is claimed by individual taxpayers on their personal tax returns. The deduction reduces taxable income, and is not used in computing adjusted gross income. Thus, it does not affect limitations based on adjusted gross income.

An explanation of the main rules for the QBI deduction follows.

Different Rules Apply at Different Levels of Taxable Income

One of the most important things to understand about the QBI deduction is that the rules that apply to individuals with taxable income below certain thresholds in a given tax year are simpler and more permissive than the ones that apply to income above those thresholds. For 2018, the threshold amount is $315,000 for married taxpayers filing a joint return, and $157,000 for all others.

There are actually only two rules that are waived for taxpayers with income below the threshold, but the impact can be profound. These are: (1) a rule that disqualifies income from a broad range of service businesses (referred to as "specified service trades or businesses") from the QBI deduction; and (2) a rule that limits the QBI deduction to a percentage of W-2 wages paid by a business. Both are discussed below.

Other rules, such as one preventing individuals from claiming the QBI deduction for employment income, apply to all taxpayers, regardless of their level of taxable income.

Qualified Trades or Businesses

The QBI deduction can only be claimed for income from a qualified trade or business.

A qualified trade or business means any trade or business other than:

(1) a specified service trade or business; or

(2) the trade or business of being an employee.

Specified service trade or business. A "specified service trade or business" is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Engineering and architecture services are specifically excluded from the definition of a specified service trade or business.

Some of the categories and fields listed in the previous paragraph are fairly clear in their meaning. Others - such as "consulting" and "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees" - are vague, and will be difficult to apply until the IRS provides guidance.

Special rule where taxpayer's income is below a specified threshold. The rule disqualifying specified service trades or businesses from being considered a qualified trade or business does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the restriction is phased in over a range of $50,000 in taxable income ($100,000 for joint filers). If an individual's income falls within the range, he or she is allowed a partial deduction. Once the end of the range is reached, the deduction is completely disallowed.

Employees vs. independent contractors. The rule that taxpayers cannot claim a QBI deduction on their employment income is clear. But it isn't always clear when an individual is an employee versus being an independent contractor - and unlike employees, independent contractors are eligible for the QBI deduction. The more favorable treatment of independent contractors for purposes of the new deduction creates new opportunities, but also new pitfalls. If you're currently an employee and find yourself considering a switch to becoming an independent contractor, we should discuss the implications for both employment taxes and any potential QBI deduction.

Qualified Business Income

Qualified business income (QBI) means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer.

Compensation paid to partners and S corporation shareholders. QBI does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer, or any guaranteed payment (or other payment) to a partner for services rendered with respect to the trade or business.

Example: Monica is a shareholder in, and sales manager for ABC, an S corporation that is a qualified trade or business. During the tax year, she receives reasonable compensation of $250,000 from ABC for her services as its sales manager. In addition, her pro rata share of ABC's net income, its only item of income or loss, is $175,000. Monica's qualified business income from ABC is $175,000. This is the amount eligible for the 20% QBI deduction.

'Domestic' requirement. Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States.

Investment income. Qualified items do not include specified investment-related income, deductions, or losses, such as capital gains and losses, dividends and dividend equivalents, interest income other than that which is properly allocable to a trade or business, and similar items.

REIT dividends, cooperative dividends, and publicly traded partnership income. Qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income are not included in the definition of QBI, but these items are eligible for a separately calculated 20 percent deduction.

Calculating the QBI Deduction for Each Trade or Business

The QBI deduction for a qualified trade or business is the lesser of:

(1) 20 percent of qualified business income; or

(2) the greater of: (a) 50 percent of the business's W-2 wages (applies to most businesses), or (b) an amount based on a more complex formula involving the business's W-2 wages and its depreciable property (see "Alternative limitation for rental real estate activities", below).

The amount in (2), above, is referred to as the "W-2 wage limitation".

Example: Susan, a single taxpayer, owns and operates a sole proprietorship that sells cupcakes. The cupcake business pays $100,000 in W-2 wages and has $350,000 in qualified business income. For the sake of simplicity, assume the business has no depreciable property, so the W-2 wage limitation is based on 50 percent of the business's W-2 wages (not the more complex formula involving wages and property). Susan's QBI deduction is $50,000, which is the lesser of (a) 20 percent of $350,000 in qualified business income ($70,000), or (b) 50 percent of $100,000 of W-2 wages ($50,000).

Alternative limitation for rental real estate activities. The more complex formula referred to in (2), above, which typically applies mainly to rental real estate activities, calculates the W-2 wage limitation by adding 25 percent of the business's W-2 wages to 2.5 percent of the original tax basis of the business's depreciable property that's still within its depreciable period at the end of the tax year.

Phase-in of W-2 wage limitation. The W-2 wage limitation does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the W-2 limitation is phased in over a range of $50,000 in taxable income ($100,000 for joint filers).

Calculating the QBI deduction for multiple business. If you own more than one qualifying trade or business, the QBI deduction must be calculated separately for each business. This requirement can sometimes reduce the overall deduction by preventing W-2 wages or qualified property from one business from being used to increase the deductible amount from another business.

Loss carryovers. If the net amount of qualified business income from all qualified trades or businesses during the tax year is a loss, it is carried forward as a loss from a qualified trade or business in the next tax year (and reduces the qualified business income for that year).

Special Rules for Partnerships and S Corporations

In the case of a partnership or S corporation, the business income deduction applies at the partner or shareholder level. Each partner in a partnership takes into account the partner's allocable share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the taxable year equal to the partner's allocable share of W-2 wages of the partnership. Similarly, each shareholder in an S corporation takes into account the shareholder's pro rata share of each qualified item and W-2 wages.

Taxable Income Limitation on the QBI Deduction

If your taxable income (reduced by any income taxed at capital gain rates and before applying any QBI deduction) is less than your qualified business income, the QBI deduction is limited to 20 percent your taxable income (reduced by any income taxed at capital gain rates).

Example: Cynthia owns and operates LittleCo, a sole proprietorship that is a qualified trade or business. Cynthia has $100,000 in qualified business income from LittleCo, and no other items of income or loss. She has a total of $25,000 in above-the-line and itemized deductions. Her taxable income, prior to applying any QBI deduction, is $75,000. Cynthia's QBI deduction is $15,000, which is the lesser of her QBI deduction for LittleCo ($20,000 = 20% x $100,000 QBI) or 20 percent of her taxable income taxed at regular tax rates ($15,000 = 20% x $75,000 taxable income).

The effect of this limitation is to ensure that the 20 percent QBI deduction rate isn't applied to more income than the amount taxed at regular tax rates. The limitation mainly applies in situations where most or all of a taxpayer's income is qualified business income. Taxpayers with a significant amount of non-QBI income taxed at regular rates (e.g., salary or wage income, spousal salary or wage income, taxable interest income, etc.) will generally not see their QBI deduction reduced by the taxable income limitation.

Concluding Thoughts

As you can see, even the main rules for the QBI deduction are quite complicated.

If you'd like to discuss the availability of the QBI deduction for an existing business, or for one you are considering starting or investing in, please don't hesitate to call.

Question 12

QBI Rental Real Estate Safe Harbor

Accepted Answer

Section 199A - Rental Real Estate Safe Harbor

The availability of the 20 percent deduction for qualified business income (QBI deduction) with respect to a rental real estate activity.

If all the general requirements (which vary based on your level of taxable income) are met, the deduction can be claimed for a rental real estate activity - but only if the activity rises to the level of being a trade or business. An activity is generally considered to be a trade or business if it is regular, continuous, and considerable.

Because determining whether a rental real estate enterprise meets the applicable criteria for a trade or business can be difficult, the IRS has provided a safe harbor under which such an enterprise will be treated as a trade or business for purposes of the QBI deduction. For this purpose, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.

Generally, you may either treat each interest in similar property held for the production of rents as a separate rental real estate enterprise or treat interests in all similar properties held for the production of rents as a single rental real estate enterprise. For purposes of applying the safe harbor, properties held for the production of rents are similar if they are part of the same rental real estate category. The two types of rental real estate categories for the purpose of combining properties into a single rental real estate enterprise are residential and commercial. Thus, commercial real estate held for the production of rents may only be part of the same enterprise with other commercial real estate, and residential properties may only be part of the same enterprise with other residential properties.

Once you treat interests in similar commercial properties or similar residential properties as a single rental real estate enterprise under the safe harbor, you must continue to treat interests in all similar properties, including newly acquired properties, as a single rental real estate enterprise. However, if you choose to treat an interest in each residential or commercial property as a separate rental real estate enterprise, you may choose to treat your interests in all similar commercial or all similar residential properties as a single rental real estate enterprise in a future year.

While commercial and residential real estate may not be part of the same enterprise, you have the option of treating an interest in mixed-use property as a single rental real estate enterprise or bifurcating the interest into separate residential and commercial interests.

Under the safe harbor, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the tax year with respect to the rental real estate enterprise:

(1) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.

(2) For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive tax years that end with the tax year, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise.

(3) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. If services with respect to the rental real estate enterprise are performed by employees or independent contractors, the taxpayer may provide a description of the rental services performed by such employee or independent contractor, the amount of time such employee or independent contractor generally spends performing such services for the enterprise, and time, wage, or payment records for such employee or independent contractor. These records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement does not apply to tax years beginning before January 1, 2020.

For purposes of the safe harbor, rental services include:

· advertising to rent or lease the real estate;

· negotiating and executing leases;

· verifying information contained in prospective tenant applications;

· collecting of rent;

· daily operation, maintenance, and repair of the property, including the purchase of materials and supplies

· management of the real estate; and

· supervision of employees and independent contractors.

Some types of rental real estate are not eligible for the safe harbor. Real estate used by a taxpayer (including an owner or beneficiary of passthrough entity) as a residence for any part of the year is generally not eligible for the safe harbor. Nor is real estate rented or leased under a triple net lease.

Question 13

Tax Free Corporate Formation

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Tax-free formation of a corporation A corporation’s initial shareholders often wish to transfer property to the corporation upon its formation. General Rule-No Gain This transfer may qualify for an exception to the general rule that a taxpayer must recognize gain or loss on the disposition of property. A taxpayer recognizes no gain or loss on the transfer of property to a corporation solely in exchange for common stock of the corporation (and certain types of preferred stock) if the taxpayer (and other transferors of property, if any) is in control of the corporation immediately after the exchange. Exceptions to Gain Recognition The taxpayer-transferor may, however, be required to recognize gain if, in addition to receiving qualifying stock, he also receives other property (called “boot”), such as cash, a promissory note, or nonqualified preferred stock. The transferor may also recognize gain if the transferee corporation assumes liabilities of the transferor. In that case, the transferor recognizes gain if the total amount of liabilities assumed exceeds the transferor’s total adjusted basis in transferred assets. This situation may arise if, for example, property was depreciated (for tax purposes) at a rate faster than the rate of repayment of the debt that the property secured. Tax Free Incorporation Requirements To qualify for nonrecognition treatment, a transferor must transfer “property.” Thus, if a transferor provides services for the stock received, he must recognize compensation income. If both property and services are transferred, a reasonable allocation must be made between the stock received in exchange for property and the stock received for services. The stock received in the exchange may generally be either common or preferred, and either voting or nonvoting. However, “nonqualified preferred stock” is treated as boot and triggers gain recognition. In certain cases, the stock received may be either contingent stock or escrowed stock. To qualify for nonrecognition treatment, the transferors must also have “control” of the transferee corporation “immediately after the exchange.” “Control” generally means ownership of stock having at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of each other class of stock outstanding. Furthermore, the transferors must have a valid business purpose for the exchange of property for stock — otherwise, the transaction may be treated as a taxable exchange. Deferred Gain Recognition even in ‘Non Taxable’ Corporate Formations Nonrecognition treatment does not mean that the transferor’s gain escapes taxation. Rather, it means only that the taxation of the gain is deferred until the stock received in the exchange is disposed of in a recognition transaction (e.g., sold). The transferor takes a substituted basis in the qualifying stock received (decreased by the amount of boot received and increased by any gain recognized). Corporate Tax Effect The transferee-corporation does not recognize gain or loss on its issuance of stock. The corporation takes a “carryover basis” in the property received in the exchange, meaning that its tax basis in the property is the same as that of the property’s transferor (increased by the gain, if any, that the transferor recognized on the exchange). Investment Company Exception Nonrecognition treatment is not applicable to the transfer of property to an “investment company,” which include, for example, a corporation more than 80% of the value of whose assets are held for investment. Nonrecognition may be similarly unavailable in other exceptional cases (e.g., if the corporation is bankrupt).

Question 14

C Corporation Characteristics

Accepted Answer

Characteristics of a C Corporation

The following is a brief explanation of the most important nontax and tax aspects of this kind of business organization.

General.

A C corporation is a corporate entity (either U.S. or non-U.S.).

A U.S. corporation is organized in a single state, although the corporation may do business in many states. Ownership of a corporation is in the form of stock. There is no limit to the number of shareholders that can own a single C corporation. In addition, there is no limit on the number of classes of stock that can be issued. A corporation comes into being when its organizers file articles of incorporation with a state (or country, in the case of a foreign corporation).

Assets and liabilities.

A corporation owns its assets and is liable for its debts. Shareholders are not liable for corporate debt. The fact that the shareholders are not liable for corporation debt is one of the primary advantages of the corporation as a form of business.

Management and employees.

The C corporation is managed by its employees, who are hired by the corporation's board of directors. The members of the board of directors are elected by shareholders. The shareholders do not have a right to directly manage the affairs of the C corporation. Instead, they exercise indirect control over the corporation by electing the board, which then appoints corporate managers.

Shareholders who provide services to a C corporation are treated either as employees or independent contractors, depending on the specific circumstances, and are taxable on compensation received. When shareholders are employees of a C corporation they are eligible to receive tax-free fringe benefits, such as health care benefits. They can also participate in company-sponsored retirement plans.

Taxation of a C corporation.

A C corporation is taxable on the income it earns. Shareholders of a C corporation are not directly taxable on this income. A C corporation is the only business form where this is the case. All other forms of business are pass-through entities, where owners are taxed directly on entity-level income.

Although shareholders are not taxed directly on corporation income, they can be indirectly taxable on the income. If a C corporation distributes the income in the form of dividends, then the shareholders pay tax.

Transfers of assets and liabilities to a C corporation.

When a C corporation is formed shareholders contribute cash, property, or services to the corporation in exchange for stock; and sometimes the corporation assumes shareholder liabilities (such as debt to which property is subject). Contributions of property and debt in exchange for stock are usually tax-free; however, there are exceptions. When the corporation assumes debt, and the debt exceeds the basis of property transferred in exchange for stock, then the excess debt triggers gain recognition. In addition, transfers of appreciated property to a corporation in exchange for its stock are tax-free only if the transferors of property own at least 80% of the corporation after the transfer.

When stock is received in exchange for services provided to a C corporation, the receipt of stock is usually taxable.

Distributions of property to shareholders.

Although the transfer of property to a C corporation is tax-free, the distribution of appreciated property by a corporation to a shareholder is usually taxed. When appreciated property is distributed by a C corporation to a shareholder, either as a dividend or as consideration for the repurchase of stock, the corporation ordinarily recognizes gain as if it sold the property to the shareholder; and, the shareholder recognizes gain equal to the excess of the value of the property received over the shareholder's stock basis.

Estate planning.

The C corporation is a useful device for minimizing estate and gift tax. In general, stock in a C corporation is often valued (for estate and gift tax purposes) at a discount to the value of assets owned by the corporation.

Question 15

California FTB Offers in Compromise

admin · Accepted Answer

California Franchise Tax Board Income Tax Offers in Compromise.

In order for the FTB to process an OIC application, the taxpayer must file all of the required tax returns, fully complete the OIC application, provide all supporting documentation, and agree with the FTB on the amount of tax owed.

File an OIC application using:

Form FTB 4905PIT for personal income tax (which may be filled in online but must be mailed);
Form FTB 4905BE for business income tax (which must be printed and prepared manually); or
Form DE 999CA, Multi-Agency Form for Offer in Compromise, for individuals who owe taxes to the FTB, EDD, and/or CDTFA.

Criteria

Generally, the FTB will approve an OIC when the amount offered represents the most the FTB can expect to collect within a five-year period. The FTB does not have a set formula for determining the amount of an OIC. They consider, among other things, the taxpayer’s age, health, and future earning potential along with the amount of the liability versus the taxpayer’s net assets.

The FTB gives strong consideration to these factors in its evaluation:

The taxpayer’s ability to pay;
The amount of equity in the taxpayer’s assets;
The taxpayer’s present and future income;
The taxpayer’s present and future expenses;
The potential for changed circumstances; and
Whether the offer is in the best interest of the state.
The IRS’s acceptance of an OIC does not mean the FTB will automatically grant a California offer. The FTB will conduct an independent evaluation.

Collateral agreements

The FTB often requires a taxpayer to enter into a collateral agreement for a term of five years, particularly if the taxpayer has significant potential for increased earnings.

A collateral agreement requires a taxpayer to pay the FTB a percentage of future earnings that exceeds an amount agreed upon by the taxpayer and the FTB.

The collateral agreement is one of the tools you can use to negotiate the payment down.

Joint returns

Acceptance of an offer by one debtor on a joint liability does not automatically relieve the remaining spouse from payment of the compromised liability.

Installment agreements

Being on an installment agreement will not prevent a taxpayer from being approved for an OIC. But the FTB will want all cash paid up front in an amount the taxpayer would pay on the installment agreement over the next five years.

Required documentation

Submit the following documentation with the offer in compromise application:

Verification of income: Pay stubs for the past three months or financial statements for the past two years if the taxpayer is self-employed. Include any investment or ownership in any business entity or trust and income derived from these sources (dividends, K-1 income, distributions, etc.);
Verification of expenses: Billing statements for the past three months (include copies of revolving charge card statements, bills from other creditors, and personal loan statements);
Bank information: Bank statements for savings and checking accounts for the past six months. If the taxpayer is self-employed, you must provide bank statements for the past 12 months. Include any accounts that have been closed;
Securities: Investment account statements showing the value of stocks, bonds, mutual funds, and/or retirement or profit sharing plans (IRA, 401(k), Keogh, annuity);
Housing: Current lease or rental agreements;
Real property information: Mortgage statements and escrow statements for property the taxpayer currently owns, sold, or gifted in the past five years;
IRS information: If applicable, copy of an IRS OIC and acceptance letter or other IRS arrangements;
Legal documents: Marital settlement agreements, divorce decrees, marital property settlements, trust documents, and bankruptcy documents;
Medical information: Physician’s letter including diagnosis and prognosis and/or other documents to show any medical condition that should be considered; and
Power of attorney: Power of attorney form if you are submitting the offer on behalf of your client.

No advance payment

The FTB does not follow the federal requirement that a taxpayer make a nonrefundable payment when making an OIC. Once the offer is approved, a taxpayer will then be required to pay the agreed amount by cashier’s check or money order.

How long does the process take?

Generally, the FTB will make a decision within 120 days of the account being assigned to a specialist. More complex accounts might take longer.

Ralite

Entities and shareholders/members who qualify for Ralite are perfect candidates for an OIC, and the FTB will accept an offer for these businesses because there are no assets to pay the outstanding liabilities.

The process will be the same as other OICs. Most importantly:

All outstanding returns must be filed. Remember that in those cases involving entities that never commenced operations, this means that they would only need to file no activity returns for all relevant tax years and mark the final return box on the last return;
The FTB requires a fully completed OIC application, Form FTB 4905BE, Offer In Compromise for Business Entities; and
There must be a payment offered. You may not make an OIC with no payment. We suggest you offer a minimal amount. You can always increase this amount.

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Question 16

Assessor Authority Over Change In Ownership Decisions

Accepted Answer

ASSESSOR AUTHORITY OVER CHANGE IN OWNERSHIP DECISIONS.

An assessor or any person employed by the office of the county assessor must possess a valid assessment analyst certificate issued by the State Board of Equalization (SBE) in order to make decisions regarding change in ownership. [Cal. Rev. & Tax. Cd. §674(a) .] The SBE will not issue a certificate to an applicant who has not attained a passing examination grade and demonstrated to the SBE that he or she is competent to make such change in ownership decisions. If an applicant is denied a certificate, the applicant has a right to a review of the denial. In order to retain a valid certificate, every certified assessment analyst will complete at least 24 hours of SBE approved training in each one-year period or risk certificate revocation. [Cal. Rev. & Tax. Cd. §674(c) ; Cal. Rev. & Tax. Cd. §675 .] The assessment analyst certificate provisions will only apply in counties or cities and counties that have passed a resolution upon the recommendation of the assessor to require certification pursuant to such provisions. [Cal. Rev. & Tax. Cd. §680 .]

Question 17

Change in Ownership Rules-Introduction

admin · Accepted Answer

Overview The California Constitution requires the reappraisal of property in the event of a change of ownership. Under Proposition 13, the full cash value of property that changed ownership after the 1975 lien date is its current value as of the date the change in ownership occurred. [Cal. Constitution Art. XIIIA §2(a) .] What is a change of ownership? A “change of ownership” means the transfer of interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of the fee interest. [Cal. Rev. & Tax. Cd. §60 ; Cal. Code Regs. 18 §462.001 .] A change in the name of an owner of property that does not involve a change in the right to beneficial use is not a change of ownership for reassessment purposes. [Cal. Code Regs. 18 §462.001 .] Change of ownership inclusions. Change in ownership includes, but is not limited to: (1) Oil and gas leases—The creation, renewal, sublease, assignment or other transfer of the right to produce or extract oil, gas and other minerals is a change of ownership, regardless of period during which the right may be exercised; the balance of property will not be reappraised. [Cal. Rev. & Tax. Cd. §61(a) .] (2) Possessory interest in exempt property—The creation, renewal, extension, or assignment of a taxable possessory interest in tax exempt real property for any term is a change of ownership. Assignment of a possessory interest means the transfer of all rights held by the transferor. “Renewal” and “extension” do not include the granting of an option to renew or extend an existing agreement pursuant to which the term of possession of the existing agreement would, upon exercise of the option, be lengthened, whether the option is granted in the original agreement, or later. [Cal. Rev. & Tax. Cd. §61(b) ; Cal. Code Regs. 18 §462.080 .] The renewal or extension of a possessory interest will not be reassessed as a change of ownership until the end of the reasonably anticipated term of possession. At the end of the reasonably anticipated term of possession, a new base year value, based on a new reasonably anticipated term of possession, will be set. [Cal. Rev. & Tax. Cd. §61(b)(2) .] (3) Leases in taxable property—The creation of a leasehold interest in taxable real property for a term of 35 years or more, including renewal options; the termination of leasehold interest in taxable real property that had an original term of 35 years or more, including renewal options; any transfer of a leasehold interest having a remaining term of 35 years or more, including renewal options; or any transfer of the lessor’s interest in taxable real property subject to a lease with a remaining term of less than 35 years, including renewal options. Only that portion of property subject to the lease or transfer will be considered to have undergone a change of ownership. For this purpose, it will be presumed that all homes eligible for homeowner’s exemption, other than mobile homes subject to personal property tax and floating homes located on leased or rented land have renewal option of 35 years or more on the lease of such land, whether or not in fact such renewal option exists in any contract or agreement. [Cal. Rev. & Tax. Cd. §61(c) ; Cal. Code Regs. 18 §462.100 .] (4) Subleases in exempt property—A change of ownership includes sublease of possessory interest in tax-exempt real property for a term, including renewal options, that exceeds half the length of the remaining term of the leasehold, including renewal options; termination of a sublease of possessory interest with an original term, including renewal options, that exceeds half the length of the remaining term of the leasehold, including renewal options; transfer of a sublessee’s interest with a remaining term, including renewal options, exceeding the half of the remaining term of the leasehold; and transfer of a possessory interest in tax-exempt property (subject to a sublease with a remaining term, including renewal options) that does not exceed half the remaining term of the leasehold, including renewal options. [Cal. Rev. & Tax. Cd. §61(d) ; Cal. Code Regs. 18 §462.080 .] (5) Joint tenancies—The creation, transfer or termination of any joint tenancy interest is a change of ownership, unless the transferor or spouse is one of joint tenants, or the transfer is to the spouse. [Cal. Rev. & Tax. Cd. §61(e) ; Cal. Code Regs. 18 §462.040(a) .] (6) Tenancies in common—The creation, transfer or termination of any tenancy-in-common interest is a change of ownership, unless the change is in the method of holding title without a change of the proportionate interest, or the transfer is to the spouse. [Cal. Rev. & Tax. Cd. §61(f) ; Cal. Code Regs. 18 §462.020 .] (7) Life estates—Any vesting of the right to possession or enjoyment of the remainder or the reversionary interest occurring at end of a life estate, or other precedent interest is a change of ownership, except for transfers by the trustor, or the spouse, or between spouses, or between registered domestic partners. [Cal. Rev. & Tax. Cd. §61(g) ; Cal. Code Regs. 18 §462.060(a) ; see Steinhart v. County of Los Angeles, Cal. S. Ct., Dkt. No. S158007, 02/04/2010; 47 Cal 4th 1298, 223 P3d 57, 104 Cal Rptr 3d 195, (2010) reversing Cal. Ct. App. (2007) 66 Cal Rptr 3d 458, Dkt. No. B190957, 09/28/2007.] (8) Trusts—Any interests in real property that vests in persons other than the trustor or spouse when the trust becomes irrevocable, is a change of ownership. [Cal. Rev. & Tax. Cd. §61(h) ; Cal. Code Regs. 18 §462.160 .] (9) Housing cooperative stock—The transfer of stock in a cooperative housing corporation, as defined, giving the transferee exclusive right to the occupancy and possession of property, or part thereof, is a change of ownership. [Cal. Rev. & Tax. Cd. §61(i) ; Cal. Code Regs. 18 §462.180(d)(3) .] (10) Legal entities—The transfer of any interest in real property between a corporation, partnership or other legal entity and a shareholder, partner or any other person is a change of ownership (see “Transfers of interest in corporations, partnerships, or limited liability companies or other legal entities, below). [Cal. Rev. & Tax. Cd. §61(j) ; Cal. Code Regs. 18 §462.180(a) .]

Question 18

DIRECT REAL PROPERTY OWNERSHIP CHANGE IN OWNERSHIP REPORTING REQUIREMENTS

Accepted Answer

DIRECT REAL PROPERTY OWNERSHIP CHANGE IN OWNERSHIP REPORTING REQUIREMENTS

A change in ownership statement must be filed for each transfer of real property and on the death of the owner. Rev & T C §§480?480.2. The transferee must file a preliminary change of ownership report concurrent with recordation of any document effecting a change in ownership of the property. Rev & T C §§480.3?480.4.

PRACTICE TIP: If the transfer is excluded from reassessment, explain on the preliminary change of ownership report form (using an attachment, if necessary) what transfers are occurring, and why the transfers are excluded from reassessment. Although a claim for refund based on an erroneous change of ownership can always be filed, the property tax must be paid as a condition of filing the claim for refund, and it takes 1 year or longer to obtain a hearing date. Consequently, a preliminary change of ownership report form that clearly states the reasons for the exclusion and convinces the assessor of the basis for the exclusion will be of substantial benefit to the client.

Transfers on Death

The personal representative must file a change in ownership statement with the county recorder or assessor in each county in which the decedent owned real property before or at the time the inventory and appraisal is filed; in all other cases, including a transfer through a trust, the form is to be filed by the trustee or transferee within 150 days of the decedent's death. Rev & T C §480(b).

PRACTICE TIP: Send a copy of the form, with the original to the assessor, with a self-addressed, stamped envelope, and ask for a date-stamped copy.

The change in ownership statement must be filed in order to file the property tax certification required under Prob C §8800(d).

PRACTICE TIP: Whenever a document is recorded that changes who manages the trust (e.g., a resignation of trustee and acceptance of nomination of successor trustee), no matter how innocuous, use a preliminary change of ownership report form. See Rev & T C §480.4. The recorder usually will insist on identification of the affected real property by assessor's parcel number and often will require a reference (by instrument number and date) to the recorded deed that places title to the property in the trustee.

Statute of Limitations

The statute of limitations on supplemental assessments is 4 years (6 years for penalty assessments under Rev & T C §504) if a change in ownership statement is filed, or a preliminary change of ownership report is filed under Rev & T C §480.3, and unlimited if a statement or report is not filed. Rev & T C §75.11. The statute of limitations on escape assessments is 4 years if any document evidencing a change of title or ownership is recorded (8 years for penalty assessments under Rev & T C §504), and 8 years for any unrecorded change for which a statement or report was not filed. Rev & T C §532.

Question 19

Reporting Requirements-Entity Change in Ownership

Accepted Answer

Form BOE-100-B, Statement of Change in Control and Ownership of Legal Entities, is used by the BOE to obtain information to determine whether a transfer of interest in a legal entity has triggered a change in control or ownership that results in the reassessment of the California real property owned by the entity, and whether an exclusion from change in ownership applies. Failure to file in either circumstance noted above will result in application of penalty pursuant to Revenue and Taxation Code section 482(b).

Whenever there is a change in ownership or a change in control of a legal entity and the legal entity owned an interest in California real property as of that date, the person or legal entity acquiring ownership control or the legal entity that has undergone a change in ownership must file a statement with the Board. (See Revenue and Taxation Code sections 480.1 and 480.2.)
When an entity is requested by the BOE to file regardless of whether or not a change in control or ownership of the legal entity has occurred or whether the legal entity owned an interest in real property.

The acquiring person or legal entity is required to file form BOE-100-B within 90 days of the change in control or the legal entity that has undergone a change in ownership must file. However, any person or legal entity that receives a form BOE-100-B must complete and file the BOE-100-B with the BOE. Note: If a written request to file is made by the BOE, form BOE-100-B must be filed within 90 days, regardless of whether a change in control or ownership of the legal entity has occurred. (See Revenue and Taxation Code sections 480.1 and 480.2.)

Question 20

Administrative Remedies

Accepted Answer

ADMINISTRATIVE REMEDIES.

Taxpayers must exhaust their administrative remedies when appealing the assessor's determination that a change in ownership occurred by either: (1) filing with the appeals assessment board (AAB) a timely application for changed assessment that is also designated as a claim for refund as provided by Sec. 1603; or (2) filing a timely application for changed assessment with the AAB and a separate, timely claim for refund under Sec. 5907. The failure to seek such remedies will result in the taxpayer being precluded from challenging the new base year value. Further, the transfer of a life estate and remainder interests upon the death of the trustor of a revocable trust constitutes a change in ownership. Cal. Code Regs. 18 §462.060 remains valid and the creation of a life estate in real property is a change in ownership unless the estate is for the transferor or the transferor's spouse, regardless of whether additional interests are also transferred. [California State Board of Equalization Letter to Assessors No. 2010/034, 07/12/2010.]

Question 21

Entity Changes in Ownership

Accepted Answer

(25)Transfers of interest in corporations, partnerships, or limited liability companies or other legal entities. Except as discussed below or elsewhere on this page, the transfer of or purchase of ownership interests in legal entities, such as corporate stock, partnership, or limited liability company interests, is not considered a transfer of the real property of the legal entity. [Cal. Rev. & Tax. Cd. §64(a) ; Cal. Code Regs. 18 §462.180(c) .] When an owner of a majority ownership interest in a partnership gets all the remaining ownership interests in the partnership or otherwise becomes the sole partner, the purchase of the minority interests, subject to the application of the step?transaction doctrine, is not a change of ownership of the partnership's real property. It is immaterial whether the partnership is a continuing or dissolved partnership. [Cal. Rev. & Tax. Cd. §64(c)(2) .] Interspousal transfers of ownership interest in legal entities are not changes of ownership. [Cal. Code Regs. 18 §462.220 .]

PARTNERSHIP TRANSFERS. The amendment of the statute providing that no change of ownership of partnership real property results from the acquisition by a majority partner of the ownership interests of minority partners reverses Zapara v. County of Orange, Cal. Ct. App., (1994) 26 Cal App 4th 464. An uncodified provision of L. 1995, ch. 497 (SB722) (§40) states that the amendment of the statute is declaratory of, not a change in, existing law.

In addition, a reorganization of members of an affiliated group of corporations or of farm credit institutions does not result in a change of ownership for reassessment purposes if the reorganization qualifies as an IRC § 368 reorganization and is accepted as a nontaxable event under California law. Transfers of property among members of an affiliated group of corporations similarly does not result in transfer of ownership.

?Affiliated group? means one or more chains of corporations connected through stock ownership with a common parent corporation if:

(1) 100% of the voting stock, exclusive of any share owned by directors, of each of the corporations, except the parent, is owned by one or more of the other corporations; and
(2) the common parent owns directly 100% of the voting stock, exclusive of any shares owned by directors, of at least one of the other corporations.

[Cal. Rev. & Tax. Cd. §64(b) ; Cal. Code Regs. 18 §462.180(b)(1) .]

Further, no change of ownership occurs from the transfers of stock, partnership interests, limited liability company interests, or any other interests in legal entities between legal entities or by an individual to a legal entity (or vice versa) that result solely in a change in the method of holding title and in which proportional ownership interests of the transferors and transferees, in each and every piece of property represented by the interests transferred, remain the same after the transfer. Also, no change of ownership results from a statutory conversion or merger of a partnership into an LLC or other partnership (or vice versa) when the law of the jurisdiction of the converted or surviving entity provides that it remains the same entity or it succeeds to the assets of the converting or disappearing entity without another act or transfer and the partners or members of the converting or disappearing entity maintain the same ownership interest in profits and capital of the converted or surviving entity that they previously held in the converting or disappearing entity. [Cal. Code Regs. 18 §462.180(d)(4) .]

But the following transfers of interest in a legal entity are considered as transfers of ownership that will trigger a reassessment:

If a corporation partnership, limited liability company, or other legal entity obtains control through direct or indirect ownership or control of more than 50% of the voting stock of a corporation or obtains a majority ownership interest of a partnership, limited liability company, or other legal entity, through the purchase or transfer of corporate stock, partnership, or limited liability company interest or ownership interest, including the purchase or transfer of 50% or less of the ownership interest through which control or a majority ownership interest is obtained. [Cal. Rev. & Tax. Cd. §64(c) ; Cal. Code Regs. 18 §462.180(d)(1) .]
Transfers by the original owner(s) (in one or more transactions) of shares or other ownership interests representing more than 50% of the total interests in an entity that was previously involved in an exempt transfer of property under Cal. Rev. & Tax. Cd. §62(a)(2) . This statutory provision exempts a transfer between an individual and entity or between entities that results only in the method of holding title to the property and in which the proportional interests of the transferor and transferee remain the same after the transfer. [Cal. Rev. & Tax. Cd. §64(d) ; Cal. Code Regs. 18 §462.180(d)(2) .]

Question 22

Trusts: Change in Ownership and Reassessment

Accepted Answer

Trusts: Irrevocable and Revocable

1. Transfer of Property to Trust

Generally, a transfer of real property from trustor A into a trust is a change of ownership at the time of the transfer. Rev & T C §62(d)(1); 18 Cal Code Regs §462.160(b)(1).

2. Transfer of Property to Irrevocable Trust

Transfer of real property to an irrevocable trust in which trustor A is the sole present beneficiary is not a change in ownership. However, a similar transfer by trustor A to a trust naming A and B as beneficiaries would require reappraisal of the property to the extent that B is a beneficiary. Rev & T C §62(d)(1); 18 Cal Code Regs §462.160(b)(1).

3. Third Party Beneficiary

A transfer of property from A to C as trustee under a trust naming B as the sole beneficiary triggers reappraisal of the interest transferred to B. Rev & T C §§60, 61(h); 18 Cal Code Regs §462.160(a).

4. Reversion of Beneficial Interest Within 12 Years

The transfer of property from A to a trust for the benefit of B for a term of 12 years or less with a subsequent reversion to A will not require reappraisal of the property at either creation or termination of B's beneficial interest. The beneficial interest transferred must exceed a term of 12 years to be deemed a change in ownership. Rev & T C §62(d); 18 Cal Code Regs §462.160(d)(3).

NOTE: A person who holds a beneficial interest to a property (i.e., the beneficial owner), as opposed to legal title, has the right to possess and use the property to the exclusion of all others. Mayhew Tech Ctr., Phase II v County of Sacramento (1992) 4 CA4th 497, 505.

5. Assignment of Beneficial Interest

When A, as beneficiary of a trust owning real property, assigns his or her beneficial interest to B, reappraisal of the property is triggered if the beneficial interest reverts back to A after a term exceeding 12 years. Rev & T C §60; 18 Cal Code Regs §462.001.

There is no reappraisal based on transfer of a future beneficial interest to B. Rev & T C §60; 18 Cal Code Regs §462.001. In that case, the property is reappraised at the time that B receives the interest in the property. Rev & T C §63; 18 Cal Code Regs §462.220.

6. Income Beneficiaries With Remainder

In a transfer of property from A to B as trustee of a trust naming A and C as income beneficiaries with a remainder to D, a reappraisal is triggered to the extent that C and D are present beneficiaries of the trust. Rev & T C §62(d)(1); 18 Cal Code Regs §462.160(b)(1). A is not the sole beneficiary of the trust.

EXAMPLE 1: Should A die, then A's interest in the property is reappraised. Rev & T C §61(g); 18 Cal Code Regs §462.160(c).

EXAMPLE 2: If A and C die and the property goes to D, then the property is reappraised. Rev & T C §61(g); 18 Cal Code Regs §462.160(c). The interspousal exception will apply only if D is A's spouse. Rev & T C §63; 18 Cal Code Regs §§462.160(b)(3), 462.220.

7. Transfer From Joint Tenants to Irrevocable Trust

No reappraisal is triggered following a transfer of real property from A and B as joint tenants to A and B as trustees and life beneficiaries of an irrevocable trust, with a remainder to C. The transfer does not involve a transfer of a present interest or beneficial use. Rev & T C §62(d)(1); 18 Cal Code Regs §462.160(b)(1). The property will be reappraised after the deaths of both A and B, as there is then a termination of the precedent interest when the right of possession vests in C. Rev & T C §61(g); 18 Cal Code Regs §462.160(c).

8. Transfer of Property to Revocable Trust

When A is both the transferor of property to a revocable trust and the trustor, there is no reappraisal of the property triggered. Rev & T C §62(d)(2); 18 Cal Code Regs §462.160(b)(2). If and when the trust becomes irrevocable (e.g., on the death of A), a reappraisal is triggered. Rev & T C §61(h); 18 Cal Code Regs §462.160(b)(2).

a. Revocable Trust Involving Spouses

When spouses create a revocable trust and transfer real property into it, naming themselves as trustees and life beneficiaries, and granting a remainder to C, no reappraisal of the property is triggered because there has not been a transfer of a present interest or beneficial use of the property. Rev & T C §§60, 62(d); 18 Cal Code Regs §462.160(b)(2).

EXAMPLE 1: If both spouses revoke the trust, then again there is no reappraisal required, because no present interest or beneficial use has been transferred. The property is still held by both spouses. Rev & T C §§60, 62(d); 18 Cal Code Regs §462.160(d)(2).

EXAMPLE 2: If both spouses die without revoking the trust and the property transfers to C, then the reappraisal is triggered. The termination of the spouses' precedent interest and the vesting of the right of possession in C are a change in ownership. Rev & T C §61(g); 18 Cal Code Regs §462.160(c).

EXAMPLE 3: If one spouse dies and then the other spouse revokes the trust, no reappraisal is warranted because there is no present interest transferred. Rev & T C §62(d); 18 Cal Code Regs §462.160(d)(2).

EXAMPLE 4: If one spouse dies and remainderman C dies prior to the surviving spouse, with the surviving spouse as sole heir of both, reappraisal of the property is not triggered. If the remainderman predeceases the surviving spouse, the present interest remains in the surviving spouse as life beneficiary. Rev & T C §60; 18 Cal Code Regs §462.160(d)(1).

Question 23

Gift Taxes-Introduction

admin · Accepted Answer

When does the Gift Tax Apply? A gift tax is a tax imposed on the transfer of ownership of property during the giver’s life. The United States Internal Revenue Service says that a gift is “Any transfer to an individual, either directly or indirectly, where full compensation (measured in money or money’s worth) is not received in return.” Who is liable for the Gift Tax? When a taxable gift in the form of cash, stocks, real estate, or other tangible or intangible property is made, the tax is usually imposed on the donor (the giver) unless there is a retention of an interest which delays completion of the gift. A transfer is “completely gratuitous” when the donor receives nothing of value in exchange for the given property. A transfer is “gratuitous in part” when the donor receives some value but the value of the property received by the donor is substantially less than the value of the property given by the donor. In this case, the amount of the gift is the difference. US Gift Tax Law In the United States, the gift tax is governed by Chapter 12, Subtitle B of the Internal Revenue Code. The tax is imposed by section 2501 of the Code. For the purposes of whether or not a ‘gift’ is taxable income, courts have defined a “gift” as the proceeds from a “detached and disinterested generosity.” Gifts are often given out of “affection, respect, admiration, charity or like impulses.” Estate Tax Effect of Gifts Generally, if an interest in property is transferred during the giver’s lifetime (often called an inter vivos gift), then the gift or transfer would not be subject to the estate tax because it would not be owned by the Donor when they die. In 1976, Congress unified the gift and estate tax regimes, thereby limiting the giver’s ability to circumvent the estate tax by giving during his or her lifetime. Some differences between estate and gift taxes remain, such as the effective tax rate, the amount of the credit available against tax, and the basis of the received property. There are also types of gifts which will be included in a person’s estate, such as certain gifts made within the three-year window before death and gifts in which the donor retains an interest such as gifts of remainder interests that are not either qualified remainder trusts or charitable remainder trusts. The remainder interest gift tax rules impose the tax on the transfer of the entire value of the trust by assigning a zero value to the interest retained by the donor. Non-taxable gifts Generally, the following gifts are not taxable gifts:

Gifts that are not more than the annual exclusion for the calendar year (last raised to $15,000 per recipient for any one donor, beginning for 2018)
Gifts to a political organization for its use
Gifts to charities
Gifts to one’s (US Citizen) spouse (non taxable because of something called the gift tax marital deduction)
Tuition or medical expenses one pays directly to a medical or educational institution for someone. Donor must pay the expense directly. If donor writes a check to donee and donee then pays the expense, the gift may be subject to tax.

Exemptions There are two levels of exemption from the gift tax. Annual Exclusion First, gifts of up to the annual exclusion ( $15,000 for 2018 thru 2020) incur no tax or filing requirement. Gift Splitting by Spouses By splitting their gifts, married couples can give up to twice this amount tax-free. Each giver and recipient pair has its own annual exclusion; a giver can give to any number of recipients and the exclusion is not affected by other gifts that recipient may have received from other givers. Lifetime Exemption for taxable gifts and estates Second, gifts in excess of the annual exclusion may still be tax-free up to the lifetime estate basic exclusion amount ($11.58 million for 2020). For estates over that amount, however, such gifts might result in an increase in estate taxes. Taxpayers that expect to have a taxable estate may sometimes prefer to pay gift taxes as they occur, rather than saving them up as part of the estate because gift taxes reduce the size of the taxable estate if paid more than 3 years prior to death, and also because lifetime gifts can shift future appreciation in value out of the estate for estate tax purposes. Generation Skipping Transfer Taxes Beware of the GST when doing gifting. Exemptions to some extent can apply. Careful planning and reporting is crucial. Non Residents For gift tax purposes, the test is different in determining who is a non-resident alien, compared to the one for income tax purposes (the inquiry centers around the decedent’s domicile). This is a subjective test that looks primarily at intent. The test considers factors such as the length of stay in the United States; frequency of travel, size, and cost of home in the United States; location of family; participation in community activities; participation in U.S. business and ownership of assets in the United States; and voting. It is possible for a foreign citizen to be considered a U.S. resident for income tax purposes but not for gift tax purposes. If a person is a non-resident alien for purposes of gift tax, taxation of gifts is determined in a different way. If the property is not located in the U.S., there is no gift tax. If it is intangible property, such as shares in U.S. corporations and interests in partnerships or LLCs, there is no gift tax. Non-resident alien donors are allowed the same annual gift tax exclusion as other taxpayers . Non-resident alien donors do not have a lifetime unified credit. Non-resident alien donors are subject to the same rate schedule for gift taxes. U.S. citizens and residents must report gifts from a non-resident alien that are in excess of $100,000 on Form 3520. Noncitizen spouse According to 26 USC section 2523(i), gifts to a non-U.S.-citizen spouse are not generally exempt from gift tax. Instead, they are exempt only up to a specified amount foreseen by 26 USC section 2503 (b) U.S. Federal gift tax contrasted with U.S. Federal income tax treatment of gifts Pursuant to 26 USC 102(c), the receipt of a gift, bequest, devise, or inheritance is not included in gross income. Thus, a taxpayer does not include the value of the gift when filing an income tax return. Although many items might appear to be gift, courts have held the most critical factor is the transferor’s intent. The transferor must demonstrate a “detached and disinterested generosity” when giving the gift to exclude the value of the gift from the taxpayer’s gross income.The courts have defined “gift” as proceeds from a “detached and disinterested generosity.” “Gifts” received from employers that benefit employees are not excluded from taxation. 26 U.S.C. § 102(c) clearly states employers cannot exclude as a gift anything transferred to an employee that benefits the employee. Consequently, an employer cannot “gift” an employee’s salary to avoid taxation. Gifts from certain parties will always be taxed for U.S. Federal income tax purposes. Under Internal Revenue Code section 102(c), gifts transferred by or for an employer to, or for the benefit of, an employee cannot be excluded from the gross income of the employee for Federal income tax purposes. While there are some statutory exemptions under this rule for de minimis fringe amounts, and for achievement awards, the general rule is the employee must report a “gift” from the employer as income for Federal income tax purposes. The foundation for the preceding rule is the presumption that employers do not give employees items of value out of “detached and disinterested generosity” due to the existing employment relationship. Under Internal Revenue Code section 102(b)(1), income subsequently derived from any property received as a gift is not excludable from the income taxed to the recipient. In addition, under Internal Revenue Code section 102(b)(2), a donor may not circumvent this requirement by giving only the income and not the property itself to the recipient. Thus, a gift of income is always income to the recipient. Permitting such an exclusion would allow the donor and the recipient to avoid paying taxes on the income received, a loophole Congress has chosen to eliminate.

Question 24

Gift Taxes-Medical and Tuition Planning Strategy

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If you or a well-off relative are facing the gift and estate tax, here’s a planning opportunity often overlooked: pay tuition and medical expenses for loved ones. Such payments, structured correctly, do not represent gifts for gift tax purposes. The monies spent by you on the qualified medical and tuition payments reduce your net worth and taxable estate, but they do no harm to your income, gift, or estate taxes. Further, the loved one who benefits from your help does not incur any tax issues. As unusual as this sounds, with the tuition and medical payments, you operate in a tax-free zone. Gift and Estate Tax Exclusion If you die this year, your heirs won’t pay any estate or gift taxes if your estate and taxable gifts total less than the sizeable estate tax exemption. If you are married and have done some planning, you and your spouse can avoid estate and gift taxes on to twice the exemption amount. Lawmakers set the current rates with the Tax Cuts and Jobs Act and also set them to drop by 50 percent in 2026. Gifts made now continue as excludable should they exceed the upcoming 50 percent drop. Avoiding the Gift Tax with Tuition The tuition exception to the normal gift tax rules involves direct payment of tuition (money for enrollment) made to an educational organization on behalf of another individual. You may not two-step this. For example, you can’t write a check to grandson Dave for $50,000 that he in turn uses for his tuition. Here, you made a $50,000 gift. But if you write the $50,000 check directly to the educational organization to pay for Daves’s tuition, you are in the tax-free zone. The $50,000 does not use up any of your annual gift exclusion amount or your gift and estate tax exemptions, because it’s for tuition. The unlimited benefit here applies only to tuition for full-time and part-time students. You can’t use it for items such as dorm fees and books. You can’t pay the money to a trust and then require the trust to pay a grandchild’s future tuition costs (this fails the test for direct to the institution). Qualifying Educational Organization The tax code defines “educational organization” as “an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.” The regs elaborate by explaining that the term “educational institution” includes primary, secondary, preparatory, or high schools, and colleges and universities. Example. You have four children, ages 7, 8, 9, and 10, at a private school where the tuition is $17,000 per year per student. Grandma Grace pays directly to the school the tuition for each of the children. Grandma Grace has no gift tax or other tax issues. Her payments are in the tax-free zone. You can also pay the tuition to a foreign university. That tuition payment is in the tax-free zone just as if you had paid it to the University of California or Harvard. Irrevocable prepaid tuition meets the rules and offers planning opportunities. Grampa Zeke has four grandchildren all in the first and second grades. He sets up and funds an irrevocable plan with each of the schools to pay the tuition at their respective schools. The plans qualify for tax-free zone treatment. Planning note. Prepaid tuition can be a great death-bed strategy. Avoiding the Gift Tax with Medical The tax-free zone treatment of medical expenses requires that you pay the money directly to the medical care provider or insurance company (when paying for health insurance). Under this plan, you avoid gift taxes when you pay directly to the provider any medical expense that would qualify as an itemized deduction on your Form 1040. Here are the basics: • Qualifying medical expenses are limited to those expenses defined in Section 213(d) and include expenses incurred for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body or for transportation primarily for and essential to medical care. (See IRS Pub. 502, Medical and Dental Expenses for an easy-to-understand list of itemized medical deductions—note this link produces a PDF of the publication.) • In addition, the unlimited exclusion from the gift tax includes amounts paid for medical insurance on behalf of any individual. • The unlimited exclusion from the gift tax does not apply to amounts paid for medical care that are reimbursed by the donee’s insurance. Thus, if payment for a medical expense is reimbursed by the donee’s insurance company, the donor’s payment for that expense, to the extent of the reimbursed amount, is not eligible for the unlimited exclusion from the gift tax, and the gift is treated as having been made on the date the reimbursement is received by the donee. Example. Sam, your buddy, takes a big fall while climbing Mount Everest. You pay $67,000 of his medical bills directly to the medical providers. You are in the tax-free zone and face no gift tax. Say that the insurance company reimburses Sam for $31,000 of the medical bills that you paid, and Sam keeps the money. Now, you have the following tax situation: • You have $36,000 of medical bills that you paid directly to the provider that are in the tax-free zone and not subject to gift taxes ($67,000 – $31,000). • You can avoid $15,000 of gift taxes because of the 2020 annual exclusion. Thus, of the $31,000 reimbursed to Sam by the insurance company, you pay gift taxes on $16,000 and avoid taxes on the remaining $15,000 because of the annual exclusion. Final Thoughts The primary rule to remember when using the tuition and medical gift tax-free strategy is that you must make the payments directly to the institutions and providers. Commit this rule to memory as rule one for this strategy. Don’t violate it. If you have a loved one who needs tuition or medical help from you, use the tax-free zone method. For example, you have an estate tax problem, but Uncle Jimmy needs help with his medical bills. Don’t make a monetary gift to Jimmy to help him. Even if you don’t have a gift tax problem today, use the tax-free method because, who knows, you could win the lottery tomorrow. And don’t forget this strategy. Sure, you have an $11.58 million estate and gift tax exemption this year (2020). In 2026, that’s scheduled to drop by 50 percent (adjusted for inflation). But the current deficit issues could trigger a drop to, say, the 2008 exemption amount of $2 million, or lower.

Question 25

Gift Taxes-Even More Detail

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The Gift Tax OVERVIEW If you give people a lot of money, you might have to pay a federal gift tax. But the IRS also allows you to give up to $15,000 in 2020to any number of people without facing any gift taxes, and without the recipient owing any income tax on the gifts. Why it pays to understand the federal gift tax law If you give people a lot of money or property, you might have to pay a federal gift tax. But most gifts are not subject to the gift tax. For instance, you can give up to the annual exclusion amount ($15,000 in 2020) to any number of people every year, without facing any gift taxes. Recipients generally never owe income tax on the gifts. In addition to the annual gift amount, your can give a total of up to $11.5 million in 2020 in your lifetime before you start owing the gift tax. If you give $17,000 each to ten people in 2019, for example, you’d use up $20,000 of your $11.5 million lifetime tax-free limit—ten times the $2,000 by which your $17,000 gifts exceed the $15,000 per-person annual gift-free amount for 2019. The general theory behind the gift tax The federal gift tax exists for one reason: to prevent citizens from avoiding the federal estate tax by giving away their money before they die. The gift tax is perhaps the most misunderstood of all taxes. When it comes into play, this tax is owed by the giver of the gift, not the recipient. You probably have never paid it and probably will never have to. The law completely ignores 2020 gifts of up to $15,000 per person, per year, that you give to any number of individuals. (You and your spouse together can can make joint gifts up to $30,000 per person, per year to any number of individuals.) If you have 1,000 friends on whom you wish to bestow $15,000 each, you can give away $15 million a year without even having to fill out a federal gift-tax form. That $15 million would be out of your estate for good. But if you made the $15 million in bequests via your will, the money would be part of your taxable estate and, depending on when you died, might trigger a large estate tax bill. The interplay between the gift tax and the estate tax Your estate is the total value of all of your assets at the time you die. The rules for 2020 tax estates over $11.5 million at rates as high as 40%. That $11.5 million is an exclusion meaning the first $11.5 million of your estate does not get taxed. So why not give all of your property to your heirs before you die and avoid any estate tax that might apply? The government is ahead of you. As noted above, you can move a lot of money out of your estate using the annual gift tax exclusion. Go beyond that, though, and you begin to eat into the exclusion that offsets the bill on the first $11.5 million of lifetime gifts in 2020. Go beyond the $11.5 million and you’ll have to pay the gift tax—at rates that mirror the individual income tax, up to 40% in 2019. The tax basis issue As you consider making gifts, keep in mind that very different rules determine the tax basis of property someone receives by gift versus receives by inheritance. For example, if your son inherits your property, his tax basis would be the fair market value of the property on the date you die. That means all appreciation during your lifetime becomes tax-free. However, if he receives the property as a gift from you, generally his tax basis is whatever your tax basis was. That means he’ll likely owe tax on appreciation during your life if he sells it, just like you would have if you sold the asset yourself. The rule that “steps up” basis to date of death value for inherited assets can save estate beneficiaries billions of dollars every year. An income tax basis example Your father has a house with a tax basis of $600,000 (what they payed for it). The fair market value of the house is now $900,000. If your father gives you the house as a gift, your tax basis would be $600,000. If you inherited the house after your father’s death in 2020, the tax basis would be $900,000, its fair market value on the date of his death. What difference does this make? If you sell the house for $950,000 shortly after you got it: Your gain on the sale is $350,000 ($950,000 minus $600,000) if you got the house as a gift. Your gain on the sale is $50,000 ($950,000 minus $900,000) if you got the house as an inheritance. At a combined federal and state tax rate of 30%, that is a tax savings of $90,000 (350,000 – 50,000 x 30%) What is a gift? For tax purposes, a gift is a transfer of property for less than its full value. In other words, if you aren’t paid back, at least not fully, it’s a gift. In 2020, you can give a lifetime total of $11.5 million in taxable gifts (that exceed the annual tax-free limit) without triggering the gift tax. Beyond the $11.5 million level, you would actually have to pay the gift tax. Gifts not subject to the gift tax Here are some gifts that are not considered “taxable gifts” and, therefore, do not count as part of your 2020 $11.5 million lifetime total. Present-interest gift of $15,000 in 2020 “Present-interest” means that the person receiving the gift has an unrestricted right to use or enjoy the gift immediately. In 2020 you could give amounts up to $15,000 to each person, gifting as many different people as you want, without triggering the gift tax or using any of your lifetime exemption of 11.5 million. Charitable gifts Unlimited gifts can be made to a qualifying charity without any gift tax liability and without using any of your lifetime 11.5 million dollar exemption. Gifts to a spouse who is a U.S. citizen. No gift tax due to something called the gift tax marital deduction. However, Gifts to foreign spouses are subject to an annual limits. This amount is indexed for inflation and can change each year. Gifts for educational expenses. To qualify for the unlimited exclusion for qualified education expenses, you must make a direct payment to the educational institution for tuition only. Books, supplies and living expenses do not qualify. If you want to pay for books, supplies and living expenses in addition to the unlimited education exclusion, you can make a 2020 gift of $15,000 to the student under the annual gift exclusion. Example: In 2019, an uncle who wants to help his nephew attend medical school sends the school $17,000 for a year’s tuition. He also sends his nephew $15,000 for books, supplies and other expenses. Neither payment is reportable for gift tax purposes. If the uncle had sent the nephew $30,000 and the nephew had paid the school, the uncle would have made a reportable (but maybe not taxable) gift in the amount of $15,000 ($30,000 less the annual exclusion of $15,000) which would have reduced his $11.4 million lifetime exclusion by $15,000. The gift tax is only due when the entire $11.5 million lifetime gift tax amount has been surpassed. Payments to 529 state tuition plans are gifts, so you can exclude up to the annual $15,000 amount n 2019. In fact, you can give up to $75,000 in one year, using up five year’s worth of the exclusion, if you agree not to make another gift to the same person in the following four years. Example: A grandmother contributes $75,000 to a qualified state tuition program for her grandchild in 2019. She decides to have this donation qualify for the annual gift exclusion for the next five years, and thus avoids using a portion of her $11.4 million gift tax exemption. Gifts of medical expenses.

Medical payments must be paid directly to the person providing the care in order to qualify for the unlimited exclusion. Qualifying medical expenses include:
- Diagnosis and treatment of disease
- Procedures affecting a structure or function of the body
- Transportation primarily for medical care
- Medical insurance, including long-term care insurance

In addition to these gifts that are not taxable, there are some transactions that are not considered gifts and, therefore, are definitely not taxable gifts. Adding a joint tenant to a bank or brokerage account or to a U.S. Savings Bond. This is not considered to be a gift until the new joint tenant withdraws funds. On the other hand, if you purchased a security in the names of the joint owners, rather than holding it in street name by the brokerage firm, the transaction would count as a gift. Making a bona fide business transaction. Even if you later find out that you paid more than the item was worth based on its fair market value, the transaction is not a gift; just a bad business decision. Gifts subject to the gift tax The following gifts are considered to be taxable gifts when they exceed the annual gift exclusion amount. Remember, taxable gifts count as part of the $11.4 million in 2019 you are allowed to give away during your lifetime, before you must pay the gift tax. Checks. The gift of a check is effective on the date the donor gives the check to the recipient. The donor must still be alive when the donor’s bank pays the check. This rule prevents people from making “deathbed gifts” to avoid estate taxes. Adding a joint tenant to real estate. This transaction becomes a taxable gift if the new joint tenant has the right under state law to sever his interest in the joint tenancy and receive half of the property. Note that the recipient only needs to have the right to do so for the transaction to be considered a gift. Loaning $10,000 or more at less than the market rate of interest. The value of the gift is based on the difference between the interest rate charged and the applicable federal rate. Applicable federal rates are revised monthly. This rule does not apply to loans of $10,000 or less. Canceling indebtedness Making a payment owed by someone else. This is a gift to the debtor. Making a gift as an individual to a corporation. Such a donation is considered to be a gift to the individual shareholders of the corporation unless there is a valid business reason for the gift. Such a donation is not a present-interest gift, and thus does not qualify for the annual per person per year exclusion. Example: A son owns a corporation worth $100,000. His father wants to help his son and gives the corporation $1 million in exchange for a 1 percent interest in the company. This is a taxable gift from father to son in the amount of $1 million less the value of one percent of the company. A gift of foreign real estate from a U.S. citizen. For example, if a U.S. citizen gives 100 acres he owns in Mexico to someone (whether or not the recipient is a U.S. citizen), it is subject to the gift tax rules if the land is worth more than annual gift exclusion amount. Giving real or tangible property located in the United States. This is subject to the gift tax rules, even if the donor and the recipient are not U.S. citizens or residents. Nonresident aliens who give real or tangible property located in the United States are allowed the 2019 year’s $15,000 annual present-interest gift exclusion and unlimited marital deduction to U.S. citizen spouses, but are not allowed the $11.4 million lifetime gift tax exemption. How gifts to minors are taxed If you give an amount up to $15,000 to each child each year, your gifts do not count toward the $11.4 million of gifts you are allowed to give in a lifetime before triggering the gift tax in 2019. But what counts as a gift to a minor? Gifts made outright to the minor Gifts made through a custodial account such as that under the Uniform Gifts to Minors Act (UGMA), the Revised Uniform Gifts to Minors Act, or the Uniform Transfers to Minors Act (UTMA) Note: One disadvantage of using custodial accounts is that the minor must receive the funds at maturity, as defined by state law (generally age 18 or 21), regardless of your wishes. A parent’s support payments for a minor are not gifts if they are required as part of a legal obligation. They can be considered a gift if the payments are not legally required. Example: A father pays for the living expenses of his adult daughter who is living in New York City trying to start a new career. These payments are considered a taxable gift if they exceed $15,000 during 2019. However, if his daughter were 17, the support payments would be considered part of his legal obligation to support her and, therefore, would not be considered gifts. Advantages of making a gift Giving a gift may earn you more than gratitude: Reduced estate taxes. Moving money out of your estate via lifetime gifts can pay off even if those gifts trigger the gift tax. How? By removing future appreciation on the asset from your estate. Say, for example, that you give your daughter real estate worth $11,385,000, using up your $15,000 exclusion and your entire $11,400,000 2019 lifetime gift exclusion. If the property were to become worth $20,000,000 when you die, that’s $8,600,000 less to be taxed in your estate. Reduced income taxes. If you give property that has a low tax basis (such as a rental house that has depreciated way below its fair market value), or property that generates a lot of taxable income, you may reduce income taxes paid within a family by shifting these assets to family members in lower tax brackets. Teaching your family to manage wealth. Giving family members assets now allows you to monitor their ability to handle their future inheritance. Disadvantages of making a gift Reduces your net worth. You need to keep enough assets to care for yourself throughout a long or extended retirement or illness. The Kiddie Tax. Giving funds to children may subject them to the Kiddie Tax, which applies the parents’ tax rates to investment earnings of their children that exceed a certain amount. For 2019, the Kiddie Tax applies to investment income exceeding $2,200 for a child under age 19 or in certain instances age 19 to under 24 if a full-time student. How to report and pay the gift tax If you make a taxable gift, you must file Form 709: U.S. Gift (and Generation-Skipping Transfer) Tax Return, which is due April 15 of the following year. Even if you do not owe a gift tax because you have not reached the 2019 $11.4 million limit, you are still required to file this form if you made a gift that exceeds the $15,000 annual gift tax exclusion level. The IRS needs to keep a running tab of your lifetime exemption. Example 1 In 2019, you give your son $16,000 to help him afford the down payment on his first house. This is a gift, not a loan. You must file a gift tax return and report that you used $1,000 ($16,000 minus the $15,000 2019 exclusion) of your $11.4 million lifetime exemption. Example 2 Same facts as above, except that you give your son $15,000 and your daughter-in-law $1,000 to help with the down payment on a house. Both gifts qualify for the annual exclusion. You do not need to file a gift tax return. Example 3 Same facts in Example 1, but your spouse agrees to “split” the gift—basically this means he or she agrees to let you use part of his or her exclusion for the year. One spouse, for example, could give $30,000 to his son without triggering the gift tax if the other spouse agrees not to give the son any gift that year. Although no tax is due in this situation, the first spouse would be required to file a gift tax return indicating that the second spouse had agreed to split the gift. Forms, publications and tax returns Only individuals file Form 709: U. S. Gift (and Generation-Skipping Transfer) Tax Return—there’s no joint gift tax form. If a both spouses each make a taxable gift, each spouse has to file a Form 709. On a gift tax return you report the fair market value of the gift on the date of the transfer, your tax basis (as donor) and the identity of the recipient. You should attach supplemental documents that support the valuation of the gift, such as financial statements in the case of a gift of stock in a closely-held corporation or appraisals for real estate. If you sell property or family heirlooms to your child for full fair market value, you don’t have to file a gift tax return. But you may want to file one anyway to cover yourself in case the IRS later claims that the property was undervalued, and that the transaction was really a partial gift. Filing Form 709 begins the three-year statute of limitations for examination of the return. If you do not file a gift tax return, the IRS could question the valuation of the property at any time in the future.

Question 26

Gift Taxes-Detailed Discussion

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The Federal Gift Tax If you make very large gifts during your lifetime, you may owe federal gift tax. But don’t worry too much about gift tax: the vast majority of Americans never need to pay it, because most ordinary gifts aren’t taxed. How the Federal Gift and Estate Tax Work Together The federal gift tax is part of what’s called the “unified” federal gift and estate tax. Gift tax applies to lifetime gifts; estate tax applies to assets left at death. The idea is that whether you give assets away while you’re alive, or leave them at your death, they’re taxed the same way, at the same rate. (If there were no gift tax, then anyone could completely avoid the estate tax by giving everything away just before death.) Under current law (for deaths in 2020), each of us can give away or leave up to $11.58 million without owing federal gift and estate tax. So, for example, if during your life you give your children your house, worth $1 million, plus another $4 million in stocks and bonds, no federal gift tax will be due. If the stocks and bonds were worth $12 million, then your estate would owe gift and estate tax on the amount over $11.58 million. The exemption amount is indexed for inflation and goes up each year. In addition to the $11.58 million exemption, many other gifts are not subject to the gift tax—for example, gifts to a spouse. So if you give your $1 million house and $10 million of other property to your children, and another $7 million to your spouse, you still won’t owe any gift tax because the taxable gifts to your children did not exceed $11.58 million. Gift Tax Basics If a gift is taxable, the person who makes the gift—not the recipient—must file a gift tax return and pay any tax owed. However, very few people end up paying gift tax during life because gift tax is not owed until your cumulative taxable gifts exceed the $11.58 million exemption. Very few people give away that much money during their lives. At someone’s death, federal estate tax is calculated. In addition to the property left behind (the estate), the amount of taxable lifetime gifts is included in the total that may be subject to estate tax. Again, no tax is due unless the taxable estate exceeds the exempt amount. What’s a gift? A gift is any transfer for which you receive nothing, or less than “fair market value,” in return. For example, if you hand someone a check for $1,000, that’s a gift. And if your house would fetch $100,000 on the open market but you sell it to your son for $10,000, you’ve made a $90,000 gift to him. What’s “fair market value?” The fair market value is the price at which an asset would sell when there’s a willing and knowledgeable buyer and seller. What’s a taxable gift? Lots of ordinary gifts are NOT taxable, including:

Gifts that are not more than the annual exclusion amount, $15,000 in 2020 (you can give this amount to any number of different recipients; you and your spouse can give $30,000 per year per recipient)
Tuition, if you pay it directly to the school (other expenses related to education, such as books, supplies and living expenses, do not qualify for this exemption)
Medical expenses you pay directly
Gifts to your spouse (if your spouse is a U.S. citizen)
Gifts to a political organization for its use
Gifts to certain charities

What’s the gift tax rate? The current federal gift/estate tax rate is 40%. Filing a Federal Gift Tax Return If you make a taxable gift—for example, you give your son $25,000 to help him buy a house—then you’ll need to file a gift tax return (IRS Form 709). This isn’t a do-it-yourself project; hire an experienced attorney, enrolled agent (EA), or certified public accountant (CPA). (Or better yet, structure the gift so it isn’t taxable. See “Reduce Estate Tax by Making Gifts.”)

Question 27

Tax Litigation Courts

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If a civil tax dispute is not settled in IRS appeals, taxpayers have two types of litigation processes from which to choose:

Deficiency Litigation in U.S. Tax Court
Bankruptcy Court to challenge the assessment before payment; and
Refund Litigation in of the following:
- U.S. Court of Federal Claims or
- U.S. District Court.

Question 28

Tax Free Employer Provided Meals and Lodging (IRC 119)

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Introduction Federal income tax law provides that, unless otherwise excluded, gross income includes compensation for services, including fringe benefits. A taxpayer may exclude the value of employer-provided meals and lodging from gross income if the meals and lodging are furnished “for the convenience of the employer” on the employer’s “business premises,” and, in the case of lodging, the employee is required to accept the lodging as a “condition of employment.” Definitions Each of these terms has a precise meaning under the federal income taxation system. For example, the term “convenience of the employer” has a special meaning for purposes of the meals and lodging exclusion that differs somewhat from its customary sense. Although “convenience” suggests a subjective test within the discretion of a particular employer, under the tax law, “convenience” is determined under an objective “business necessity” test. Under the convenience of the employer standard, an exclusion for employer-provided meals or lodging is appropriate only if an objective evaluation of all pertinent facts and circumstances shows that the primary reason for providing the meals or lodging is a bona fide business necessity. Where this objective test is satisfied, the employee is entitled to exclude the meals or lodging from income even if an employment contract or law states that they are furnished as compensation. IRC 119 Exclusion This statutory exclusion is provided under §119 of the Internal Revenue Code, which is entitled “ Meals or Lodging Furnished for the Convenience of the Employer.” It applies to employees only and is not allowed to independent contractors or tenants. Taxpayers are bound by the form of the transactions into which they enter. The IRS asserts that meals and lodging furnished by a sole proprietorship to the proprietor or by a partnership to a partner who is actively involved in the partnership’s business do not qualify for the exclusion because there is no employment relationship between the business and its owner. The IRS will not issue a ruling or a determination letter under §119 with regard to whether the value of meals or lodging is excludible from gross income by an employee who is a controlling shareholder of the employer. Meals Meals are considered provided for the “convenience of the employer” if they are furnished for a “substantial noncompensatory business reason.” This test is satisfied only if, based on an objective examination of all the circumstances, there is a primary business reason for furnishing the meals. For example, where meals are provided to employees who must be available during their meal period to attend to urgent business, the test is satisfied. Lodging Lodging is considered to be furnished for the convenience of the employer if it is furnished for a primary noncompensatory business reason. Generally, this test is satisfied if it is established that the employee could not properly perform his duties without being furnished lodging. Employer Business Premises To qualify for exclusion from gross income, meals and lodging must also be furnished on the employer’s “business premises.” For example, in the case of the employees at a remote mining project, the lodging must be furnished on, or contiguous to, the work-site; a camp several miles away would not qualify. However, it is not necessary in all cases that the meals or lodging be furnished on property owned by the employer, such as an office building or plant. The business premises test is satisfied if the meals or lodging are furnished at a place where the employee performs a significant amount of services. Condition of Employment In addition to the “convenience of the employer” and “business premises” tests, the exclusion for lodging also requires the employee to demonstrate that he is required to accept the lodging “as a condition of employment.” Generally, this test is satisfied if, as a practical matter, the employee must accept the lodging in order to properly perform his duties. This test is essentially the same as the convenience of the employer test. It is a fact intensive inquiry. In kind only Only meals and lodging that are furnished to the employee in kind qualify for the exclusion from gross income. Cash allowances or reimbursements for meals and lodging must be included in gross income by the employee. Camps and Campus Lodging Special rules are provided for employees who are furnished lodging in a camp in a foreign country and for the value of “qualified campus lodging” furnished to employees of certain educational institutions. Employer Deductibility Employer deductibility of meals and lodging provided to employees is limited under current law. Consult with us before deducting those expenses. Conclusion The discussion above outlines the general rules governing the excludability from gross income of the value of meals and lodging provided by an employer. Many of the rules in this area are complex and may also be affected by other tax laws. The correct tax treatment of a particular situation, however, can be made only after a careful examination of the facts and circumstances.

Question 29

How to beat the reduced federal tax deduction for state taxes

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C corporations cause double taxation for business owners, so you probably think you want to avoid them at all costs. And for many of you, this is true, as the S corporation often provides the lower overall tax outcome. But for some of you, the C corporation could provide the best tax outcome, especially since you can bypass the $10,000 state and local tax (SALT) deduction cap, which was introduced by the Tax Cuts and Jobs Act (TCJA), with a C corporation. Prior to the TCJA, you could deduct as itemized deductions on your Form 1040, Schedule A—without limit—the following foreign, state, and local taxes: • Income taxes • Real property taxes • Personal property taxes • Foreign income and real property taxes Tax reform took two direct actions against your itemized deductions for foreign, state, and local taxes. Beginning in tax year 2018, • you can’t deduct foreign real property taxes, and • your combined state and local income, real property, and personal property tax deductions may not exceed $10,000 ($5,000 on a married filing separate return). If you operate your business as an S corporation, the S corporation passes its net income to your individual tax return. This causes you, the individual, to pay state income taxes on the S corporation income. Those state income taxes are subject to the $10,000 cap. C Corporation Loophole But there is an exception: This $10,000 limit applies only to individuals—meaning, taxes deducted on your Schedule A. The limit does not apply to C corporations. If you operate your business as a C corporation, then your C corporation pays state income taxes on its net income and deducts those taxes on its corporate income tax return.

Question 30

Non Resident Aliens

admin · Accepted Answer

Two Tests If you are an alien (not a U.S. citizen), you are considered a nonresident alien unless you meet one of two tests. You are a resident alien of the United States for tax purposes if you meet either (1) the green card test or (2)the substantial presence test for the calendar year (January 1-December 31). Certain rules exist for determining the Residency Starting and Ending Dates for aliens. Elections In some cases aliens are allowed to make elections which override the green card test and the substantial presence test, as follows:

Nonresident Spouse Treated as a Resident
Closer Connection To a Foreign Country
Tax Treaties

Dual Status You can be both a nonresident alien and a resident alien during the same tax year. This usually occurs in the year you arrive or depart from the United States. If so, you may elect to be treated as a Dual Status Alien for this taxable year and a Resident Alien for the next taxable year if you meet certain tests. Tax Treaties A resident alien who is required to establish his/her U.S. residency for the purpose of claiming a tax treaty benefit with a foreign country should refer to Certification of U.S. Residency for Tax Treaty Purposes.

Question 31

Residency

Accepted Answer

Residency

Two Different Tax Regimes: US persons and Non-US persons

U.S. persons are taxed on their Worldwide Income (Income from US and Foreign sources). They are entitled to a Foreign Tax Credit to the extent of their Foreign Source Income.

Foreign person are mostly taxed only on their U.S. source income.

Because of this distinction, we need to ask two questions whenever dealing with any International Tax issue:

1 - What is the residence of the taxpayer?

2 - What is the source of the income?

In week 1 we will focus on answering Question 1

In week 2 we will focus on answering Question 2

RESIDENCY

The most useful approach is to determine if a person or entity is a U.S. person, if not, you can assume they are a non-US person.

An individual can obtain US person status if ANY of the following 4 methods applies:

Citizenship ? Person is a US citizen

Legal Residency ? Person holds a Green Card

Permanent Resident under Substantial Presence Test 1 (SPT 1)

Permanent Resident under Substantial Presence Test 2 (SPT 2)

Substantial Presence Tests

SPT1: If a person is present in the US for 183 days or more in a given year, they are a US person. This is an objective test because you are jus counting the days.

SPT 2: This test is met if the following elements are met:

1 - a person is present in the US for 31 days or more in a current year AND

2 - they are present in the US for 183 days or more over the last 3 years using a weighed systems AND

3- they do not have a Closer Connection to a Foreign Tax Home in the current year, then they are a U.S. person.

Note that SPT2 contains objective elements (1 & 2) and a subjective element (3). All of them must be met for SPT2 to apply. Let?s look at them in more detail.

Element 1 is straight forward: count the days they are in the US in the current year, if it?s less than 31 days then SPT2 will not apply.

Element 2 is tricky. You need to count all the days the person was in the US over the last three years. Let?s say they are contemplating their tax position for 2004. You must look at the days they were in the US for 2004, 2003 and 2002. The days in 2004 will count as one full day. The days in 2003 will count as 1/3 of a day and the days in 2002 will count as 1/6 of a day. Add them up using this weighted measure, if it is 183 or more you can go to Element 3.

Element 3 is a subjective element. You first have to determine if they have a Foreign Tax Home. To determine if they have a Foreign Tax Home you must ask the question ?what is their home for purposes of taking travel expense deductions?? Then you have to determine if they have a Closer Connection to that Foreign Tax Home. This is a subjective test where you look at a number of variables: where they are employed, where their family lives, where they belong to clubs, etc? There is no right or wrong answer, it is an issue of fact.

Days that don?t count in the calculation: For purposes of SPT1 and SPT2 you do not include certain days in your calculation, these exempted days apply for days for commuting, medical emergencies, charitable sports events, teachers, and students.

Corporations: The residence of a corporation is based on where it is incorporated.

Some countries define residence based on central place of management. So It is possible to have a dual-resident corporation.

For further clarification I will elaborate on the following two areas:

The difference between the tax regime for U.S. persons and non-U.S. persons, and

The exceptions to the Substantial Presence Test.

The difference between the tax regime for U.S. persons and non-U.S. persons

Let?s assume that a Taxpayer, T, earned $500 in 2004 with $100 of expenses. His tax calculation would be as follows:

Gross Income: $500

Expenses: ($100)

Taxable Income: $400

Tax Rate 35%

Tax Liability $140

Now let?s assume that of the $500 of income, $200 was from services performed in the U.S. (US source income) and $300 was from services performed in France (foreign source income). Also assume that a French tax of 30% was imposed on the $300.

If T is a non-U.S. person (i.e. not a US citizen, green card holder and fails both Substantial Presence Tests), then his tax calculation would be as follows:

Gross Income: $200 (foreign source income is not taxable)

Expenses: ($100)

Taxable Income: $100

Tax Rate: 35%

Tax Liability: $35

If T is a U.S. person, then his tax calculation would be as follows:

Gross Income: $500 (Worldwide income is subject to US tax)

Expenses: ($100)

Taxable Income: $400

Tax Rate: 35%

Tax Liability: $140

Foreign Tax Credit: ($90) 30% French tax on the $300 French income

Tax Due: $50

As you can see, for a Non-US person foreign source income is not even included in the tax calculation. For a US person, the foreign source income is included in Gross Income. However, the US person may get a Foreign Tax Credit for taxes paid on foreign source income.

There are exceptions, but this is the general framework of the two different tax regimes. We will be exploring both of these in greater detail as the course develops. Starting next week, we will only be looking at Non-US persons and how they are taxed on their US activities (referred to as Inbound Transactions). After the midterm we will focus on US person and how they are taxed in the US on their foreign activities (referred to as Outbound Transactions).

The exceptions to the Substantial Presence Test

Generally, when performing the Substantial Presence Test calculation you count every day that the Taxpayer was present in the US. However, the following days are not included in the SPT calculation even though the Taxpayer was physically present in the US:

Commuters from Canada & Mexico: If a person returns home at least once during each 24 hour period they are not considered to have spent a day in the US for SPT purposes.

Short stopovers: Presence in the US while in transit between two points outside the US does not count as a day spent a day in the US for SPT purposes. This is relevant if an Irish person, for instance, was in the US 182 days in a given a year and she also spent 1 day at Miami International Airport on a layover to Brazil. That extra day won?t put her over the 183 day threshold. However, if she conducts a business meeting at the Miami airport, then that day would count.

Medical emergencies: If a person is unable to leave the US because of a medical emergency, those days are not counted for SPT purposes. However, if the taxpayer came to the US with the intent of pursuing a medical treatment, those days would count for SPT purposes.

Teachers, trainees and students: Teachers and trainees who are in the U.S. for the purpose of teaching with a J visa are not required to count their days in the US for SPT purposes. Students are also exempt if they are in the US with a F, J or M visa.

Diplomats, employees of international organizations and their families.

Participants in charitable sports events.

Crew members of foreign vessels.

With all areas we will be discussing, it is most important to remember the general rule. Exceptions rarely apply, however it is important to know they exist and run a check just in case.

Question No. 1

W and H, wife and husband, are citizens of Canada. They do not have U.S. citizenship nor do they hold a U.S. green card. They maintain homes in both Quebec and Florida. W and the couple?s minor children spend about nine months each year at the Florida home, and the children attend school in Florida public schools. W and the children spend the summer months (80 days) in Quebec. H, who owns a construction company in Quebec, spends most of the year in Quebec, but makes several trips to Florida each year, aggregating 70 days annually. H?s income comes from the construction business. W owns several farms in Quebec which are rented to tenants and produce a significant amount of rental income. H & W do not file a joint return in the U.S.

How are H and W taxed by the U.S.?

W is present in the U.S. for about 285 days (in Canada for 80 days). This is sufficient for W to be a resident under SPT1 since she is present in the US for more than 183 days.

H?s presence in the U.S. does not meet the thresholds of SPT1 or SPT2:

Current year: 70 X 1 = 70 days

Prior year: 70 X 1/3 = 23.3

Two years prior: 70 X 1/6 = 11.6

Total days in the US using the weighted method: 105 days which is less than the 183 day threshold.

How does the analysis of H?s situation change if he stays in the U.S. a total of 125 days annually.

Now H would be the threshold of SPT2:

Current year: 125 X 1 = 125 days

Prior year: 125 X 1/3 = 41.6

Two years prior: 125 X 1/6 = 20.8

Total days in the US using the weighted method: 187.5 days which is more than the 183 day threshold.

In order for H to be a US person under SPT 2, he must also satisfy the subjective element of the test (i.e. closer connection to a foreign tax home). Since this is a subjective test and you only have limited facts to work with your answer could go either way.

Question No. 2

Nelson is a citizen of Brazil. He has a full-time job in that country and generally lives there with his family in a home he has owned for over 20 years. In 2015, Nelson comes to the United States for the first time. The sole purpose of the trip is business. Nelson intends to stay in the U.S. for only 180 days, but he runs into problems with his business and is required to stay 300 days.

In 2016, Nelson comes to the U.S. again on business and stays for 90 days. He returns to Brazil as planned.

Early in 2017, Nelson comes to the United States on business and stays for 170 days. Later in 2017, he returns to the U.S. to take his 6 year old son to Disney World for 10 days and then return to Brazil. On the last day of the planned visit, Nelson breaks his leg in an automobile accident. He is checked into the hospital for treatment, where he remains for five days. Nelson and his son leave the U.S. as soon as possible after he is released from the hospital.

Under these facts, discuss Nelson?s residence status in the U.S. in 2015, 2016 and 2017.

2015

Nelson is a US person for 2015:

He is present in the US for 300 which meets SPT1 (note that his intention to stay less is irrelevant)

2016

Nelson is probably not a US person for 2016 despite the fact that he satisfies the first two elements of SPT2.

2016: 90 X 1 = 90 days in the US

2015: 300 X 1/3 = 100 days in the US

Total days in the US: 190 days, which is greater than the 183 day threshold. However, Nelson can make a reasonable argument that he has a closer connection to a foreign tax home since he has many associations with Brazil. Since he does not meet the subjective element of SPT2, he would not be a US person for 2016.

2017

Nelson is probably not a US person for 2017

2017: 180 days (don?t count the 5 days he is in the US for the medical emergency).

2016: 90 X 1/3 = 30 days

2015: 300 X 1/6 = 50 days

Total days in the US: 260 days. However, since he probably has a closer connection to a foreign tax home, he does not meet the subjective element of SPT2 and he would not be a US person for 2017.

Question 32

Controlled Foreign Corporations (CFCs)

admin · Accepted Answer

Controlled Foreign Corporations Now we are going to switch focus from the tax consequences for non-US persons to the tax consequences for US persons. As we discussed at the beginning of the course, US persons are taxed on their worldwide income. Their ultimate tax liability may be reduced by a foreign tax credit but all income, US source and foreign source, is included in the US taxpayer’s gross income. We will discuss the application of the Foreign Tax Credit in more detail in 2 weeks. First we will look at Anti-Deferral Legislation. Purpose of the Controlled Foreign Corporation / Subpart F Rules Consider the following two scenarios: Scenario 1 Ted, a US individual, has a portfolio of foreign stocks that pay annual dividend payments of $100,000. Although the income is foreign source income (since a foreign corporation is making the distributions) Ted must include the full amount in his US gross income. If no foreign tax was imposed on the dividend income, Ted would not be entitled to a foreign tax credit. Scenario 2 Ted creates a newly formed corporation in Bermuda, BerCo, and transfers his portfolio of foreign stocks to BerCo. Now the only asset that Ted owns is stock in BerCo. When BerCo earns the $100,000 dividend payments, it will not be subject to US tax because BerCo is a non-US person (it is incorporated outside the US) and non-US persons with no US trade/business are not subject to US tax on foreign source income. Meanwhile, Ted is also not subject to US tax since he did not receive any payments. Only when BerCo makes a dividend payment to Ted will he be subject to tax. Hence, Ted was able to defer US tax on the foreign stock dividends indefinitely. Meanwhile, BerCo can reinvest the dividend proceeds and grow the portfolio offshore without being affected by US tax. You should note how easily it was for Ted to make the switch from Scenario 1 to Scenario 2. All he had to do was file some paperwork (incorporate BerCo and transfer his shares to BerCo) and his tax consequences were drastically altered. Consider another similar strategy for abuse: Scenario 1 USCo has an export business in which it purchases baseball caps in the US for $500,000 and sells them to retailers in Japan for $600,000, resulting in a gain of $100,000. USCo also has a branch in Japan that negotiates and concludes the sales. Title transfers in Japan making the gain from the sales foreign source. Nonetheless, USCo is subject to US tax on the $100,000 even though it’s foreign source income because USCo is a US person. Scenario 2 USCo creates a newly formed corporation in Bermuda, BerCo, and sells the baseball caps to BerCo for a small but reasonable mark-up of $40,000. BerCo resells the baseball caps to the Japanese retailers for $600,000. In this scenario, USCo only has $40,000 of gain and the remaining $60,000 of gain is earned by BerCo. Since BerCo is not a US person the $60,000 would not be subject to US tax until it is distributed to USCo as a dividend. USCo was able to defer US tax on the income indefinitely while BerCo reinvests the sales proceeds offshore without being affected by US tax. As in the earlier example, the shift from Scenario 1 to Scenario 2 merely requires some paperwork: incorporating BerCo and drafting sales agreements between USCo and BerCo and another agreement between BerCo and the Japanese retailers. Other than the documentation no real changes have occurred. USCo may still ship the baseball caps directly to Japan and all sales activities continue to be performed in Japan. The employment contracts of the sales force in Japan may be redrafted so that BerCo is their employer instead of USCo. Basically, the form of the transaction has been changed but the underlying substance of the transaction remains unchanged. The Controlled Foreign Corporation (CFC) and Subpart F legislation was enacted in order to control these abuses. The intent of the legislation is to prevent US persons from accumulating wealth in low-tax jurisdictions. However, they also did not want to cause US corporations to be less competitive abroad. So when you have a foreign corporation with US shareholders you must ask two questions: 1) Is the foreign corporation controlled by US shareholders (is it a CFC)?; and, if so 2) Is the income earned by Foreign Corporation tainted income (does it earn Subpart F income)? Tainted income (commonly referred to as Subpart F income) is income that was shifted to the Foreign Corporation strictly for tax reasons and not really for business reasons. Consequences of a CFC with Subpart F Income Assume you have a Foreign Corporation that is a CFC (which we will define later) and that CFC earns $1000 of Subpart F income (which we will define next week) and $2000 of non-Subpart F income. The consequence is that the US shareholders of the CFC must include the $1000 of Subpart F income in their Gross Income in the year it was earned by the Foreign Corporation. The $2000 of non-Subpart F income does not need to be included in the US shareholder’s Gross Income until such time that the Foreign Corporation distributes the income. Basically, if a CFC earns Subpart F income you treat it as if the CFC distributed that income to the US shareholder in the year it was earned by the CFC. When a real distribution of the $1000 of Subpart F income is made to the US Shareholders, you ignore the transaction and there is no need to include it in the US Shareholders’ Gross Income again since it was already included earlier. What is a CFC? A CFC is a Foreign Corporation that is controlled by US Shareholders. First we must define a “US shareholder.” There are two criteria that must be met for a taxpayer to be a US shareholder: 1) The taxpayer must be a US person (as defined by the residence rules), and 2) The taxpayer must own 10% or more of the Foreign Corporation. So if you have a Foreign Corporation where no single shareholder owns more than 9.99% of the stock, none of the shareholders would be “US shareholders” and as a result the corporation could not be a CFC. Under the pre-2017 law you only looked to the percentage of voting shares that the shareholder owned to determine if the 10% threshold was met. Under the post-2017 law you can also be a US shareholder by owning 10% of the value of the corporation regardless of ownership of voting shares. Once you have identified all the US shareholders of a Foreign Corporation, you must add up all of their shares and determine if together they own MORE than 50% of the Foreign Corporation’s stock. So if you have 5 US persons that each own 10% of the stock of a Foreign Corporation and the remaining 50% is owned by Foreign persons, you do not have a CFC, because only 50% (not more than 50%) is owned by US persons. Direct Ownership, Indirect Ownership & Constructive Ownership When we calculate the number of shares that a US shareholder owns there are three forms of ownership that we look at, direct, indirect and constructive ownership. Direct Ownership Direct Ownership is straight forward, if a US shareholder owns shares in her name then she owns those shares directly. Indirect Ownership If a US shareholder owns shares in a Foreign Corporation (FC1) that owns shares in a Foreign Subsidiary (FC2), then the US shareholder owns shares in FC2 indirectly. So if T, a US shareholder, owns 20% of FC1 and FC1 owns 50% of FC2, then T owns 20% of FC1 directly and 10% of FC2 indirectly. Note that indirect ownership can only occur through Foreign Corporations. If FC1 was a US corporation, there would be no indirect ownership of FC2. Constructive Ownership Constructive Ownership is ownership through family members or related entities (such as parent corporations and their subsidiaries). Assume that a Foreign Corporation has 100 shares, 9 shares are owned by H, a US person, 9 other shares are owned by W, H’s wife who is also a US person, 33 shares are owned by X, an unrelated US person and the remaining 49 shares are owned by a foreign shareholder. If we just rely on Direct Ownership, W and H are not US shareholders since they both hold less than 10% of the Foreign Corporation. As a result we only have one US shareholder (X) and he owns less than the requisite “more than 50%” threshold. However, spouses are required to attribute their shares to each other. So for purposes of determining whether or not a person is a US shareholder, we include their shares and shares of closely related family members. So H is deemed to own 18% of the shares (making him a US shareholder) and W is deemed to own 18% of the shares (making her a US shareholder). So now we have three US shareholders H, W, X. If we add up their shares (9+9+33 = 51), it exceeds the “more than 50% threshold” and the Foreign Corporation is a CFC. Note that Constructive ownership is only used to determine whether or not a person is a US shareholder. It is not used to determine how much Subpart F they must include in Gross Income. For instance, assume that the Foreign Corporation in the above example earned $5000 of Subpart F income. H would include $450 (9%) in his Gross Income, not $900 (18%). The same would be true for W. X would include $1,650 (33%). The close family members that attribute shares to each other are the following: Spouses attribute shares to each other Siblings DO NOT attribute shares to each other Parents attribute their shares to their Children and Children attribute their shares to their Parents Grandchildren attribute their shares to Grandparents but Grandparents do not attribute their shares to Grandchildren (this is a tricky one) So if you had the following family that owned the following number of shares, here’s how it would break down: X Corp. has 100 shares outstanding owned by: Actual Constructive Total Ownership Ownership Ownership Husband 10 40 (Wife and Child) 50 Wife 20 60 (Husband, Child and Father) 80 Child 20 30 (Husband and Wife) 50 Wife’s Father 30 60 (Wife, Wife’s Sister, Child) 90 Wife’s Sister 20 30 (Father) 50 Note that a Non-US person can never attribute shares to a US person. So if a US person is married to a Non-US person, they do not constructively own each other’s shares. To sum up, in order to identify US shareholders we consider Direct, Indirect and Constructive ownership. However, in order to determine the amount of Subpart F inclusion, we only consider Direct and Indirect ownership. Now that we’re able to identify whether a Foreign corporation is a CFC or not, next week we will learn to determine if the CFC earns Subpart F income.

Question 33

Expatriates

Accepted Answer

Expatriates & Sourcing
Expatriates

The tax code provides an exemption for expatriates to encourage US employees to work abroad and to ease the complications of being taxed in two jurisdictions. The first step is to determine if a US person qualifies as an expatriate. The second step is to determine how much they can exempt.

Step 1:

A U.S. person is an expatriate if they have a tax home in a foreign country. The concept of ?tax home? was introduced in the discussion on Residency. If a person takes travel deductions when traveling away from their home in France, for instance, then you can conclude that their ?tax home? is in France.

In addition to having a foreign ?tax home?, a US person must ALSO meet one of the following requirements to be considered an expatriate. The US person must

- Spend 330 days of the year abroad, OR

- Be a Bona Fide resident of a foreign country (this is a subjective test where you look at intentions, activities, physical presence?)

Step 2:

Once we?ve determined that the taxpayer is an expatriate, we have to determine what exclusions are available to them. There are two exclusions available:

1/ Foreign Earned Income Exclusion (FEI): $102,100 of wages, salaries, fees...for services performed in foreign countries (it will be $104,100 in 2018).

- Where the services are performed is what matters, not where the income is paid to.

- The exemption only applies to Personal Services. Not gain on sale of property (unless property was created by taxpayer ? art, royalties for writer).

2/ Foreign Housing Expenses (FH):

Applies to a reimbursement or stipend provided by the employer.

- Includes rent, fair rental value provided by employer, utilities repair, parking, insurance on property.

- Not included: purchase of house, capital improvements, mortgage, property tax. Furniture.

Excludes housing expenses to the extent they exceed 16% of the FEI exclusion, or $16,336. The theory here is that $16,336 is the amount that the average worker in the US would spend on housing. Anything above that is the additional cost the employee had to incur for working abroad, and therefore exempted to create a level playing field between US workers abroad and US workers in the US.

Example 1:

Jones has lived and worked in Peru from 2/1/15 to 12/31/15. He received a salary of $102,100 and housing cost reimbursements of $21,336.

He can take FEI exemption for the full $102,100 and a $5,000 FH exemption ($21,336 - $16,336).

Example 2:

Same as above but Jones? housing cost reimbursement is $40,336.

He can take a $102,100 FEI exemption, and a FH exemption of only $14,294. The maximum amount of the FH exemption is $14,294 ((30% x $102,100) ? $16,336). Even though his housing cost exceeds $16,336 by $24,000, only $14,294 is eligible for the FH exemption due to the 30% cap.

If Jones was living and working in Germany instead of Peru, he may be able to take a FH exemption of the full amount, because the 30% cap does not apply in high cost countries such as those in Europe or Japan.

Law Changes

Note that the addition of the 30% cap is fairly recent. Prior to 2006, there was no such limitation so long as the housing costs were reasonable.

There has also been a law change in 2006 regarding the tax rate that applies to the income that exceeds the FEI exemption amount.

Prior to 2006, if an expatriate worker earned $107,100, the excess amount over the FEI exemption of $5000 ($107,100 - $102,100) would be subject to the tax bracket of someone making $5000 which is 10%, resulting in a tax liability of $500 (10% of $5000). Under the new law, the tax bracket would be the same as someone earning $107,100, which is 28%, resulting in a tax liability of $1400 (28% of $5000).

Note that the amount that exceeds the FEI exemption may still be offset by a foreign tax credit. Typically, if the tax rates of the foreign country are higher than the US tax rates, the foreign tax credit would eliminate US tax liability. We will be discussing the details of the foreign tax credit later in the class.

Sources of Income

Relevance

Now that we?ve determined the residence of the taxpayer, the next step is to establish whether the taxpayer?s income is US source or Foreign source.

The source of income is important for Foreign Residents because, for the most part, Foreign Residents are not subject to US tax on Foreign Source income (there are some exceptions that we?ll get into later).

Although US persons are subject to US tax on Worldwide income (i.e. both US and Foreign Source income), the source of income is still important since the amount of Foreign Tax Credit available to US persons will be based on the amount of the taxpayer?s Foreign Source income.

Methodology

The way to approach a Source analysis is to take the following three step approach:

1- Identify the type of income: Interest, Dividend, Royalty, Compensation for Services, Gain from the Sale of Property, Inventory Gain)

2- Identify the General Rule for sourcing the income: For example, for Interest Income the general rule is that the income is sourced according to the residence of the debtor. For Income Compensating Services the general rule is that the income is sourced according to the location where the service was performed.

3- Determine if any of the Exceptions apply. For every rule there is usually an exception. For example, the General Rule for Interest Income is that the income is sourced according to the residence of the debtor (the party who is paying the interest). So if you have a US corporation paying interest to the Taxpayer, under the General Rule the Income would be US source. However, if more than 80% of the US corporation?s income is from ?active foreign business income? then the interest income is Foreign source.

Assignment 2 will require you to make an outline using this methodology. This will serve as a valuable tool for the exams and for professional uses. It will also allow me to assess how well you understand the Sourcing rules.

A note on sourcing income from the Sale of Property

The General Rule for Gain from the sale of property is that it is sourced according to the Residence of the Seller. So if the taxpayer is a US resident, her gain from the sale of a car would be US source income.

Here?s the tricky part: So far we?ve determined that the residence of a taxpayer is determine by using one of the following tests: Citizenship, Legal Residency (green card), SBT1 and SBT2. However, for the purposes of determining source of gain from the sale of property, there is a different definition of residence. Here, Residence is determined based on the ?Tax Home? of the taxpayer. So if Tom, a US citizen, has a home and operates a business in Hungary, Tom would be a US person under the General Residence rules. However, if Tom sold his car and realized gain of $1000, that income would be Foreign source income because his Tax Home is not in the US.

A note on sourcing income from the Sale of Inventory

The general sourcing rule for gain from the sale of property does not apply for inventory (i.e. goods that are held for resale).

Inventory is sourced based on where title (ownership) is transferred). To determine where title is transferred you must look at where risk of loss is transferred.

For example: Assume a contract specifies that a US Seller sells bicycles to a German Buyer and the German buyer will receive title when the goods arrive in Germany. However, the contract also specifies that the goods are transferred F.O.B. Long Beach (free-on-board Long Beach, means that if anything happens to the goods after they leave the port of Long Beach, the Seller is not responsible for any risk of loss). Hence, if the boat carrying the bicycles sinks, the German Buyer would still have to pay for them. Although the FORM of the contract stated that ownership was transferred in Germany, the SUBSTANCE of the agreement implies that ownership is really transferred in the US. The source of the gain is therefore US source. This is an example of the doctrine of Substance over Form.

A note on sourcing income from the Sale of Manufactured Inventory

Although gain from the sale of inventory is sourced according to where title is transferred, gain from the sale of inventory that is manufactured in the US will be sourced in the US. So if title is transferred outside the US but the goods are manufactured in the US, the gain is sourced in the US. Likewise, gain from the sale of inventory that is manufactured outside the US will be foreign source income.

This is a new rule as a result of the Tax Cuts and Jobs Act of 2017. For years prior to 2018, the gain in such situations would be divided into foreign source and US source income according to one of the following methods (the taxpayer was able to choose among the three methods):

50/50 Method: 50% of the gain is sourced in the US and 50% of the gain is sourced outside the US.

Independent Factory Price Method (IFP): Requires sales to independent distributors.

Books and Records Method: the gain is sourced based on how it is recorded in the taxpayer?s Books and Records (this method requires approval from the IRS).
A note on Interest Expense

Prior to 2018, the taxpayer could choose to allocate interest expense based on basis of assets or based on the Fair Market Value (FMV) of assets. This is covered in the reading on the second paragraph of page 67.

Under the Tax Cuts and Jobs Act of 2017, only allocation can only be made according to the basis of the assets and not the FMV.

Question 34

Corporations and Branches

admin · Accepted Answer

I will elaborate on the following areas: Difference between a Corporation and a Branch Exceptions to the General Rule for Sourcing Interest and Exceptions to the General Rule for Sourcing Dividends. The Distinction between a Corporation and a Branch A Corporation is a distinct legal entity. It must satisfy specific requirements in order to be recognized as an organization that is independent from its shareholders. So when a Corporation enters into contracts or takes on a loan, it is on its behalf and not on behalf of its shareholders, directors or employees. If a US Corporation (USCo) has a subsidiary in Korea (KorCo), it means that we have two distinct legal entities that act on their own behalf. USCo owns all of KorCo’s shares but when KorCo is independent of USCo. If USCo is to buy goods from KorCo it would have to enter into an agreement with KorCo. USCo would be a US resident because it is incorporation in the US and KorCo would be a non-US resident because it is incorporated outside the US. A Branch is not a distinct legal entity. There are no formal legal requirements to create and maintain a branch. For instance, if USCo sent some employees to start a sales office in Korea (but did not formally incorporate that office), then USCo would have a Korean branch. If employees in the Korean branch obtained a loan or entered into a contract, they would be doing so on behalf on USCo since the branch is not a separate entity. Consequently, interest payments made by the Korean branch would be US source to the party receiving the interest. The distinction between a Corporation and a Branch may be rudimentary to some students in this class. However, it is a distinction that everyone should understand since the differing treatment of Corporations and Branches arises in many areas of international tax. Exceptions to the General Rule for Sourcing Interest The General Rule for sourcing interest payments is to base it on the residence of the payor. So if a foreign corporation (ForCo) makes a loan to a US corporation (USCo) and USCo makes interest payments on that loan, then that interest is US source income. Remember from the Residence rules that a corporation is sourced based on where it is incorporated. So when a US corporation is making interest payments, that interest is US source. Exception No. 1: Foreign Branch of a US bank As we just saw, the payment of interest by a foreign Branch of a US Corporation will be US source income. However, there is an exception for US banks with foreign branches. In order to encourage the competitiveness of US banks abroad, interest payments by foreign branches of US banks are foreign source income. If a Korea resident made a deposit with the foreign branch of Wells Fargo Bank, the interest received on that deposit would not be US source income and not subject to the 30% tax. Note that most US banks incorporate their foreign branches so this exception is rarely applied. Exception No. 2: 80/20 Rule If a US Corporation (USCo) performs 80% or more of its activities outside the US, then ALL interest paid by the USCo would be foreign source income even though USCo is a US resident. So regardless of whether USCo performs 85% or 99% of its activities abroad, 100% of its interest payments will be foreign source. However, if USCo pays the interest to a “related person”, it is necessary to apportion the sourcing of interest according to the percentage of foreign activities. A “related person” is one that owns 10% or more of the interest payor. Assume that all of USCo’s shares are owned by a Korean corporation (KorCo) and KorCo makes a $100,000 loan to USCo with interest payments of $10,000. Also assume that 90% of USCo’s business activities occur in China. In this case, $9,000 (90%) of the interest would be foreign source and $1,000 would be US source. Exception No. 3: Foreign Corporations with a US trade/business When a Foreign Corporation (ForCo) is engaged in a US trade/business it basically has a branch in the US. As we saw earlier, a branch is not a distinct legal entity. Under the General Rule, if the US trade/business of ForCo makes interest payments, those payments would be foreign source since the corporation is incorporated outside the US. However, there is an exception in this case, and the US trade/business is treated as if it is an independent corporation for purposes of the interest sourcing rules. As a result, such payments would be US source income. Exception to the General Rule for Sourcing Dividends The General Rule for sourcing dividends is not unlike the rule for sourcing interest: it is based on the residence of the party making the payment. Since only corporations pay dividends, all you have to do is determine where the corporation was incorporated. There is only one exception to the General Rule and it concerns the scenario where a Foreign Corporation is paying a dividend AND that corporation is engaged in a US trade/business. In this case, if 25% or more of foreign corporation’s income is from the US trade/business, then at least a portion of the dividend will be US source income despite the fact that the corporation was not incorporated in the US. Assume, for instance, that a Belgian corporation has $1,000,000 in sales and $300,000 of those sales are from a US trade/business. Also assume that the Belgian corporation pays a dividend of $5,000 to its shareholders. In this case, 30% of the Belgian corporation’s income is from a US trade/business so 30% of its dividend will be deemed to be US source income to the recipient. Hence, $1,500 of the dividend is US source income and the remaining $3,500 is foreign source income.

Question 35

Sourcing Rules Examples

admin · Accepted Answer

Source Rules for Income I/ Interest: Rule: Residence of Payor of Interest Exceptions: 80% or more of U.S. debtor’s gross income is from “active foreign business income.” Look to 3 taxable years prior to year of interest payment. (Look-thru subsidiaries’ dividends and look at their activities). All interest is foreign source unless lender and borrower are related parties (10% or more ownership), then split according to U.S./foreign source. Interest paid by foreign branches of U.S. banks is foreign source. Foreign corporations with U.S. trade or business: income paid by a U.S. T/B of a foreign corporation (e.g. paid by the U.S. branch of foreign co.) is U.S. source income. II/ Dividends Rule: Residence of corporation issuing the dividend Exception: 25% or more of foreign corporation’s income is from U.S. TB. U.S. source portion of dividend equals portion of U.S. TB income. Look at last three years. III/ Services Rule: Where services are performed. Exceptions: De Minimis Exceptions: Services income is foreign source income if the taxpayer was in the U.S. no more than 90 days AND earned no more than $3000 from performing services in the U.S., AND performed the services on behalf of a foreign party or foreign branch of U.S. corp. AND the recipient is a non-resident alien. Treaty: No more 183 days. IV/ Rents Rule: Where property is located. V/ Royalties Rule: Where intangible property is used. VI/ Gain from the Sale of Real Estate: Rule: Where property is located. VII/ Gain from the Sale of Personal Property: Rule: Residence of the seller. Residence for this purpose = location of a “tax home” (i.e. taxpayer takes travel deductions when traveling from this location). U.S. citizens and residents with a foreign tax home will only have foreign source income if they pay a tax of at least 10% of gain in the country… Exceptions: U.S. resident may have foreign source income from sale of personal property if: – office/fixed place of business in foreign country – gain is attributable to that office – foreign tax of 10% is PAID, and – property is not inventory, depreciable, intangible or stock of foreign affiliate. VIII/ Personal Property that is Depreciable/Amortizable Property: US source to the extent depreciation/amortization deductions were taken against U.S. source income. IX/ Intangible Property Rule: Residence of the Seller Exception: Sourced as a royalty if income is contingent on productivity of property. VIII/ Inventory: Where the sale occurred: site of property when title was transferred. IX/ Inventory manufactured in one jurisdiction and sold in another: Where the inventory is manufactured. Source Rules for Deductions A/ General Rule 1 – Allocate to income item (factual relationship between income and deduction). Source is the same as the associated income item. 2- Ratable apportionment for non-related deductions (e.g. charitable contributions, medical expenses…) B/ Interest Expense Allocation is based on the basis assets, not income (i.e. assets producing US source income and assets producing foreign source income). Exceptions: Non-recourse loan for specific property.

Question 36

Inbound Transactions - Non-Business Income

admin · Accepted Answer

Inbound Transactions – Non-Business Income Now that we’ve distinguished between US persons and non-US persons we will focus strictly on non-US persons and how their activities in the US cause them to be subject to US taxation. From the reading you will note that when we are looking at the activities of non-US persons, we distinguish between Business Income and Non-Business Income (or Investment Income): Business Income will be taxed according the usual tax regime where we start with Gross Income, reduce it by Deductions and tax the Net Income at graduated tax rates (this is called a Net Tax). Non-Business/Investment Income will be subject to a withholding tax of 30% on the Gross amount. In this case there is only one tax rate, 30%, and no deductions are offered (this is called a Gross Tax). Non-Business/Investment Income is basically passive income such as interest, dividends, royalties, rents and capital gain. In other words, it is the type of income that one earns strictly from ownership of property. This income is also referred to as Fixed, Determinable, Annual & Periodic income (FDAP income), although it need not be fixed, determinable, annual or periodic. The primary reason that the Tax Code makes a distinction between tax regimes for Business Income and Non-Business Income is because of the practicality of collecting the income. Since Investment Income merely requires ownership, it is possible for a foreign individual to own US debt, equities, intangibles or other property without having any physical presence or activities in the US. It would therefore be very difficult to collect this tax from the foreign person since they would be beyond the jurisdiction of the US. As a result, the Tax Code imposes a fixed withholding rate of 30% on this type of income. The payor of the income is responsible for withholding the amount and since the payor is within the jurisdiction of the US, they have an incentive to make these payments of the payee’s behalf. If Investment Income is US source income it may be subject to the withholding tax. Note however, that sometimes Investment Income may be US source income but it will not be subject to the withholding tax because it falls under one of the exceptions to FDAP Income. A Note on Tax Treaties The US has entered into a number of Income Tax Treaties with other foreign countries. These treaties have a number of provisions that we will be discussing throughout the course. There are provisions that operate to reduce or eliminate the withholding tax on FDAP Income. Instead of requiring a 30% withholding tax, many Tax Treaties override the Code and allow for a reduced rate such as 10% withholding for dividends or no withholding for interest income (the specific reductions vary from treaty to treaty). A Note on Capital Gain Capital Gain is earned from the disposition or exchange of a capital asset. Capital Assets may be Personal Property or Real Property. Stocks and other securities are examples of Personal Property that generate Capital Gain. Generally, Capital Gain from Personal Property is not subject to withholding tax. Hence, a non-US person who earns Capital Gain on the disposition or exchange of Personal Property will not be subject to any US withholding tax on that gain. Capital Gain from Real Property is taxed under a different tax regime under FIRPTA (Foreign Investment in Real Property Tax Act) which we will be discussing in two weeks. Unlike personal property, Capital Gain from the sale of US real property by a non-US person will be subject to US tax. Summary To recap, when you are dealing with a non-US person conduct the following analysis: – Distinguish between business and non-business/investment income, – Identify the non-business/investment income that is US source income, – Determine if the income falls under one of the exceptions to FDAP, – Apply the withholding tax of 30%, or a lower rate provided by a tax treaty. Next week we will focus on the tax consequences of Non-US persons earning Business Income in the US.

Question 37

In Bound Transactions-Business Income

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Inbound Transactions – Business Income “Business Income” is income that is earned through an active business in the US rather than merely through ownership of investments. In order to be subject to US tax on business income, the non-US person must have a “US trade/business” and the income must be “Effectively Connected with that US trade/business.” We will refer to US trade/business as “USTB” and to Effectively Connected Income as “ECI”. You will note that generally tax law is heavily codified and a great deal of clarification can usually be obtained by reading the Internal Revenue Code and the Treasury Regulations. Unfortunately, the definitions of USTB and ECI are not very clearly defined in the statutes. When confronted with USTB and ECI issues it is necessary to look at them on a fact-by-fact basis to reach a decision. Because of the lack of clarity it is always best to err on the side of caution when conducting tax planning in this area. US Trade/Business A USTB is generally defined as regular, continuous and considerable business activities in the US. As you have seen in the reading, case law has set a low threshold as to what constitutes a USTB. There are many examples that are clearly a USTB such as manufacturing in the US, maintaining a research & development facility, carrying inventory, maintaining a sales force that actively sells and negotiates deals in the US, or performing services in the US. A physical office in not necessary to create a USTB, if a foreign corporation has a sales force in the US that may be sufficient. Agency It is possible that a Foreign person (or corporation) has no presence in the US but will still be deemed to have a USTB as a result of an agent in the US that acts on its behalf. In order to determine whether a US party is an agent to a Foreign person you should look for three things in the arrangement between the parties: Does the Foreign Person have control over the US party’s activities? Does the US party need approval from the Foreign Person in order to take important actions? Does the Foreign Person maintain Risk of Loss with respect to the activities in the US? Does the US party act exclusively on the Foreign Person’s behalf? Consider the facts of Revenue Ruling 70-424: ForCo and USCo enter into an agreement under which ForCo conveys to USCo sole agency for sale of its products in the US. USCo will receive a commission of the sales price. [Exclusivity] USCo agrees not to make sales of the same kind of products of any other company without ForCo’s permission. [Exclusivity] USCo agrees not to sell ForCo’s products outside the US without permission. [Approval/Control] USCo will secure yearly contracts with US end-buyers, subject to the approval of ForCo [Approval/Control] USCo assumes full responsibility for the sale of ForCo’s products and acts as guarantor. [Risk] ForCo will share equally any loss incurred by USCo. [Risk] The IRS concluded that this created an agency relationship and ForCo was deemed to have a USTB even though it wasn’t directly conducting activities in the US. In short, what you’re asking is whether the US party is acting more like an employee of the Foreign Person than an independent third party acting on its own behalf. So if there is a legitimate Buy-Sell arrangement between the Foreign Person and the US party, then the US party would not be an agent but merely a business partner acting on its own behalf. Effectively Connected Income Once you’ve determined that there is a US trade/business, you must now look at that business’ income and determine whether that income is Effectively Connected with the US trade/business. The short answer is: If a Foreign Person has a USTB and he/she earned US source income that is not FDAP income, then that income is ECI. Income that is Effectively Connected with a US trade/business is taxed under a Net Tax regime in much the same way US persons are taxed: – Start with Gross Income that is Effectively Connected with the US trade/business – Reduce it by deductions – Apply the marginal tax rate to the net amount There are certain situations in which FDAP income and Foreign Source income can be ECI as well: FDAP income that is ECI FDAP-type income (interest, dividends, royalties, rent, capital gain) are generally taxed under the withholding tax regime as we discussed last week. However, if the FDAP income passes the Asset-Use test or the Business Activities test, then it will be taxed according to the USTB regime. Asset-use test: If the asset that is producing the FDAP income is used in the USTB, then the FDAP income will be ECI. Examples of a FDAP asset used in a USTB include the following: – Plant, equipment or vehicle used in the daily conduct of the business, – Securities and investments if they are held to meet the present cash needs of the business, – FDAP-type assets acquired with the funds of the USTB and actively managed by the USTB. Business Activities test: If the USTB consists of making investments or licensing then, under the Business Activities test, any dividends, interest and royalties would be ECI and taxed accordingly. Foreign Source Income that is ECI Foreign source income will only be ECI if the foreign source income is attributable to a US office or fixed place of business. If a Foreign Corporation has a sales force present in the US, then it would have a USTB but not necessarily a US office or fixed place of business. With respect to the sale of inventory, even if the Foreign Corporation has a US office/fixed place of business, and foreign source income is attributable to that office, the foreign source income may still avoid being ECI if a foreign office materially participates in the sale and that inventory is not used in the US. Treaty Modifications: Replace the USTB analysis with the PE analysis The ECI/USTB standard of analysis only applies if the Foreign Person is from a country that does not have an Income Tax Treaty with the US. If there is an Income Tax Treaty in effect, then a similar, but more lenient standard is applied: In order to be subject to US tax on business income, the Foreign Person/Corporation would need to have a Permanent Establishment (PE) in the US rather than merely a US trade/business. The threshold for having a PE is must higher than for having a USTB. There are generally two types of PEs, a physical PE or an agency PE: Physical PE In order to have a physical PE, you need a fixed place of business. So, unlike a USTB, it is not enough to have a sales force roaming the US, they actually need to be working out of an office. Unless you have some type of physical structure like an office, factory, laboratory, a warehouse, etc…you do not have a PE. Basically, you are looking for a distinct place with some degree of permanence. Most treaties also list a number of activities that do not constitute a PE including a facility in the US that is used merely for storing, purchasing, displaying and delivering goods, collecting information or other auxiliary or ancillary functions. Agency PE Earlier we saw that an agent can create a USTB for a foreign person. Similarly, under a tax treaty an agent can create a PE. In order for an agent to create a PE, the agent must be a Dependent Agent of the Foreign Person (as opposed to an Independent Agent). A Dependent Agent is one with the authority to conclude contracts in the name of the Foreign Person and habitually exercises that authority. If a Foreign Person has a Dependent Agent in the US, they would have a PE even though the Foreign Person or the Dependent Agent has no physical structure in the US.

Question 38

Other In Bound Rules

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I will elaborate on the following four areas: Capital Gains Received by Non-US Persons The Mechanics of the Withholding Tax Foreign Source ECI and the Consequences of Having a US Subsidiary Capital Gains Received by Non-US Persons Generally, if a Non-US Person receives US source capital gain AND the capital gain is not effectively connected with a US trade/business, then the Non-US Person is not subject to US tax on that gain. If the non-US person has no US trade/business, then no taxes will be imposed on the capital gain earned by such a person. If the non-US person has a US trade/business, then capital gain may be subject to US tax if it is ECI. In order for it to be ECI it must meet the asset-use test or the business activities test (see Lecture 4). The policy behind the limitations on taxation of capital gains received by non-US persons is to encourage foreign investment in the US. Typically, when an intangible asset is sold, the gain constitutes capital gain and it would not be subject to withholding tax. However, if the sales price is contingent on the property’s productivity, use or disposition then it will be sourced as a royalty and subject to withholding tax accordingly. Mechanics of the Withholding Tax The reason the Tax Code imposes a withholding tax on investment revenue received by non-US persons is because it is the most practical way of collecting the tax. Generally, the withholding agent must withhold 30% of the revenue (or a lesser amount directed by a Treaty). The withholding agent is the person in the US who last handles the item of income before it is remitted to the taxpayer or a foreign intermediary. So if a corporation pays a dividend to a foreign person, the corporation is the withholding agent. However, if the corporation pays a dividend to a US stock broker who then remits it to a foreign person, then the stock broker is the withholding agent. The withholding agent has an obligation to withhold if they have been notified that the payee is foreign or if they have reason to assume that the payee is foreign. For instance, if the payee provides a foreign address or does not present a Taxpayer Identification Number, the withholding agent should assume the payee is foreign. A foreign person should notify the withholding agent of their foreign status by providing them with a withholding certificate (Form 8233). If there is an Income Tax Treaty that reduces the rate, it is the payee’s obligation to inform the withholding agent that a lower rate applies. Foreign Source ECI Last week we saw that when you’ve established that a non-US person has a US trade/business, all US source income will be ECI except FDAP income that does not meet the “Asset-Use” test or the “Business Activities” test. Foreign Source income may also be ECI with a USTB; however there are a number of restrictions for it to be included as such. First, you need an office or fixed facility in the US. Remember it is possible to have a USTB without an office or fixed facility. However, it is not possible to have Foreign Source ECI without an office or fixed facility. So if a Foreign Corporation has a sales force present in the US without an actual office, no Foreign Source income would be ECI no matter how related it is to the activities in the US. Also, be aware that if the Foreign Corporation merely has a US subsidiary with an office that, in and of itself, will not create an office for the Foreign Corporation. If the US subsidiary is acting as the Foreign Corporation’s agent, then its office may create an office for the Foreign Corporation (more on the consequences of having a US subsidiary later). Once you’ve determined that there is a USTB with an office or fixed facility it is time to ask the second question: Is the item of Foreign Source income ATTRIBUTABLE to the US office? In other words, does the US office MATERIALLY PARTICPATE in the production of the item of Foreign Source income? This is where things get tricky. Establishing that there is an US office if pretty straight forward. But it’s harder to determine if the US office materially participates in the production of an item of Foreign Source income. The standard of “materially participates” is difficult to grasp. It is necessary to apply it on an item-by-item basis: Royalties and Rents We can conclude that a US office materially participates in the production of Foreign Source Royalties and Rents if that office actively participates in soliciting, negotiating, or performing other activities required to arrange or service the lease/license. General supervision by the US office of such activities is insufficient to constitute materially participation. The US office’s personnel must actually perform such services. The following activities alone will not constitute material participation: Creation, development or purchase of licensed property, Collecting or accounting for royalties or rents, Performing clerical functions Exercising final approval over the execution of licenses/leases Dividends and Interest In order for dividends and interest to be attributable to a US office, the dividends/interest must be derived in the active conduct of a banking, financing or similar business in the US. This is not unlike the “business activities” for FDAP income. Basically, if you are not dealing with a banking or financing business then Foreign Source dividends/interest will not be ECI. Sales Income The General Rule is that Foreign Source income from the sale of personal property is ECI if it is made through the taxpayer’s office. Assume that a Foreign Corporation (ForCo) has a sales office in the US that sells encyclopedias. There is a sales force in the US that calls individuals in the US and Canada and sells them the encyclopedias. The terms of the contract state that title transfers upon receipt by the customer. Since title transfers to the Canadian customers upon receipt in Canada, such income is foreign source income (the sourcing rule for inventory is based on where title is transferred). Because the sale was made through the US office, the foreign source income from the sale is ECI. There is an exception to the above rule. Even if the sale is made through a US office, the Foreign Source income will NOT be ECI if an office of the taxpayer in a foreign country participates materially in the sale. So back to our example: Assume the same facts as above except that ForCo also has an office in Canada that produces marketing material for the encyclopedias sold in Canada. One may argue that the Canadian office also materially participates in the sale and therefore the Foreign Source income from the sale of encyclopedias in Canada is not ECI. Consequences of Having a US Subsidiary A general rule that you should remember is that if a Foreign shareholder (or a Foreign Corporation) owns shares in a US corporation, that alone is not enough to create a US trade/business. Assume that a Foreign Corporation, a foreign corporation, (ForCo) owns 100% of the shares of a US Corporation (USSub). ForCo makes bicycles and sells them in France directly to retailers. ForCo also sells the bicycles to USCo and USCo sells them to retailers in the US. The fact that ForCo owns 100% of USCo is not enough to create USTB for ForCo. Remember that mere ownership is not enough to create a USTB. Since ForCo does not have any of its own employees in the US (the US sales force is employed by USCo), the only way that ForCo could have a USTB is if USCo was acting as ForCo’s agent. In the facts above, there is an arm’s length Buy-Sell arrangement between ForCo and USCo. USCo assumes all risk on the sales of the bikes and concludes contracts on its own behalf. Since USCo is acting independently of ForCo, USCo is not ForCo’s agent and ForCo does not have a USTB. Note that USCo will be subject to US tax on the sale of the bikes just as any other US person would be, however ForCo would not be subject to US tax. Now assume that the terms of the agreement between ForCo and USCo are different. Assume that instead of a buy-sell arrangement, ForCo commissions USCo to sell the bikes for it and compensates USCo with a percentage of the sale. ForCo maintains ownership of the inventory and has final approval of all contracts. In this case USCo is not acting independently of ForCo. We can conclude that since USCo is ForCo’s agent, ForCo has a USTB through USCo and ForCo will be subject to US tax on its ECI. Assume that ForCo also had a wine business that was wholly unrelated to the bike business and ForCo sold wine through mail-order directly to US consumers (without the involvement of USCo). If title to the wine passes upon receipt by the customers in the US the income would be US source income. Even though it has nothing to do with the bike business and USCo played no role in the wine sales, the wine income would be ECI because it is US source income and ForCo had a USTB (through USCo). I know this is complicated but here are some simple rules that you should remember: Ownership of a US corporation is not enough to create a USTB. You should analyze the relationship between a Foreign person/corporation and its US corporation the same way you would analyze the relationship between the Foreign person/corporation and an unrelated agent in the US. If you have a USTB, all non-FDAP US source income earned by the non-US person will be ECI even if it is entirely unrelated to the USTB. Planning Note: It is generally preferable for a Foreign Person to incorporate its US activities and to have the US corporation act on its own behalf in order to prevent the Foreign Person from having ECI. The only time a Foreign Person would want to conduct activities in the US directly (i.e. without incorporating) is if it had losses in the US.

Question 39

Decision Tree

Accepted Answer

Decision Tree 1: Inbound Transactions

Analysis for Foreign Persons or Foreign Corporations

Step 1: Is there a Tax Treaty between the Foreign Person/Corporation?s jurisdiction and the U.S. If so, go to Step 4, if not, go to Step 2.

Step 2: If there is not a Tax Treaty in effect, determine if there is a U.S. Trade or Business. If there is no U.S. Trade/Business, go to Step 6. If there is a U.S. Trade/Business, go to Step 3.

Question 1: Are there Regular, Continuous & Considerable Business Activities in the U.S.? (Consider the presence of employees or a fixed place of business).
Question 2: Is there an Active Business or Mere Ownership?
Question 3: Is there an agent in the U.S.? (Consider exclusivity, risk of loss, approval requirements, extent of agent?s responsibility).
Question 4: Is there a Buy-Sell arrangement with parties in the U.S. or a Consignment arrangement?

Step 3: If there is a U.S. Trade or Business, determine if there is Effectively Connected Income. If there is U.S. source income that is not ECI, go to Step 6. If there is ECI go to Step 8.

Question 1: Is there U.S. source income that would not be considered FDAP? If so, it is likely that this income is ECI.
Question 2: If there is U.S. source income that would be considered FDAP, does it satisfy the Asset-Test or the Material Factor Test?
Question 3: Is there any Foreign source income that is ATTRIBUTABLE to an OFFICE OR FIXED PLACE OF BUSINESS in the U.S. and does that office MATERIALLY PARTICIPATE in the production of income?

- Sub Question A: Is there an Office or Fixed Place of Business? If not, do not include any Foreign Source income as ECI.

- Sub Question B: If there is an Office or Fixed Place of Business, does it provide significant contribution (essential factor) to earning the income? If not, do not include any of that Foreign Source income as ECI.

- Sub Question C: If the income is from the use, consumption or disposition of goods outside the U.S., does a Foreign Office also materially participate? If so, do not include that income as ECI.

Step 4: If there is a Tax Treaty in effect, determine if there is a Permanent Establishment in the U.S. and if there are Business Profits attributable to that Permanent Establishment? If there is U.S. source income and there is no Permanent Establishment, go to Step 7. If there are Business Profits attributable to a Permanent Establishment, go to Step 9.

Question 1: Is there a Fixed Place of Business (other than those that qualify as exceptions: purchasing, storing, displaying & delivering goods, collecting information or other auxiliary or ancillary task).
Question 2: If there is not a direct Fixed Place of Business, is there a Permanent Establishment through a Dependent Agent?

- Sub Question A: Does the agent habitually exercise the authority to make contracts on the principal?s behalf?

Step 5: If there is a Permanent Establishment, determine the Business Profits attributable to the Permanent Establishment (profits derived from the assets or activities of the Permanent Establishment).

Step 6: If there is not a U.S. Trade or Business, or if there is U.S. source income that is not ECI, determine if withholding tax applies to the U.S. source income.

Question 1: Is the income U.S. source Dividend, Interest, Royalty, Rental, Services Income or other FDAP Income that is not ECI? If so, determine if any exceptions apply and apply the withholding tax to the gross amount?
Question 2: Is there is U.S. source Capital Gain that is not ECI and is not from the sale of Real Property? If so, no tax applies.

Step 7: If there is not a Permanent Establishment but there is U.S. source income, determine if a withholding tax applies to the U.S. source income under the Treaty.

Question 1: Is the income U.S. source Dividend, Interest, Royalty, Rental, Services Income or other FDAP Income that is not ECI? If so, determine if these types of income are subject to tax under the Treaty and apply the appropriate withholding tax to the gross amount?
Question 2: Is the income U.S. source Capital Gain that is not ECI and is not from the sale of Real Property? If so, no tax applies.

Step 8: If there is ECI, include it as income on the U.S. tax return and deduct allocated expenses. Apply appropriate tax credits, including foreign tax credits, to reduce the tax liability. Apply the Branch Profits Tax withholding tax to any Effectively-Connected E&P adjusted by Changes in Net Assets.

Step 9: If there are Business Profits attributable to a Permanent Establishment, include it as income on the U.S. tax return and deduct allocated expenses. Apply appropriate tax credits, including foreign tax credits, to reduce the tax liability. Apply the Treaty-Prescribed Branch Profits withholding tax to any Effectively-Connected E&P adjusted by Changes in Net Assets.

Question 40

Branch Profits and FIRPTA

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Branch Profits Tax and FIRPTA Where we are to date: Now would be a good time to review the different concepts we covered and how they all fit together. Question 1: Is the taxpayer a US person or a non-US person? For any issue you are faced with in international tax, this is always the first issue you must resolve. Question 2: What is the source of the income? The source of income is also relevant to further analysis you will be conducting. If you’ve determined that you are dealing with a non-US person, there are 2 important questions you must ask: 1- Is the non-US person a resident of a country that has a tax treaty with the US? 2- Does the non-US person have a US trade/business or a Permanent Establishment (if there is a Treaty in effect)? I have created a decision tree that will help you get through the various questions that arise for non-US persons. Branch Profits Tax The Branch Profits Tax (BPT) was created to create parity between the situation when a non-US person has a US subsidiary and when a non-US person has a US branch. Consider the following two scenarios: Scenario 1: A foreign corporation (ForCo) owns 100% of the shares of a US corporation (USSub) USSub earns $1000 of income that is subject to corporate tax at the normal marginal rates (let’s assume the applicable rate is 35%), resulting in $350 of tax. The remaining $650 is distributed to ForCo as a dividend. Since the $650 dividend is FDAP income (and no exception applies), it is subject to the 30% withholding tax. After $195 is withheld, ForCo receives a payment of $455 from USSub. Scenario 2: A foreign corporation (ForCo) is engaged in a US trade/business. Since the US business is unincorporated it is a branch. The US branch earns $1000 of income which is ECI. The income is therefore subject to tax at normal marginal rates (let’s assume it’s taxed at 35%), resulting in $350 of tax. When the remaining $650 is remitted to ForCo, the income is not characterized as FDAP income. In this case the $650 does not constitute a dividend payment (since it is not a distribution of earnings from a corporation to a shareholder); it is merely an inter-company payment that is only reflected on the company’s internal books. After the inter-company is payment is made ForCo would have $650 from the US branch. As you can see, by having a US branch instead of a US subsidiary ForCo was able to bypass the 30% withholding tax. The BPT steps in to remedy this difference. Essentially, the BPT treats a branch as if it was a subsidiary by imposing a 30% withholding tax on a branch’s earnings that are deemed to be distributed to the foreign corporation. The difficulty is in determining the “deemed dividend amount.” A US subsidiary has the discrepancy of distributing any amount it chooses to its shareholders. So if USSub earned $650 after-corporate taxes, it could choose to pay a dividend anywhere from $0 to $650. It would therefore be too simple to assume that the “deemed dividend amount” of a branch was merely its after-tax ECI. We have to account for the potential that the branch may have re-invested some of its earnings into the US operations. As a result, the “deemed dividend amount” is reached by performing the following calculation: Determine the US trade/business’ ECI ($1000 in our example) Subject the ECI to the appropriate marginal tax rate (35% in our example) Post-tax ECI is Effectively Connected Earnings & Profits ($650 in our example) In order to account for reinvestments in the US operations, we need to adjust the Effectively Connected Earnings & Profits by changes in the branch’s Net Assets. So we need to look at the branch’s balance sheet for the prior year and the current year and determine whether the Net Assets increased or decreased. Assume that at the end of the prior year, the branch’s Net Assets were at $450 and at the end of the current year the branch’s Net Assets were at $500. We can conclude that the Change in Net Assets was $50. When there is an increase in Net Assets, we assume that there was a reinvestment into the branch’s operations. Hence, we assume that of the $650 of Effectively Connected E&P, $50 was reinvested into the branch, leaving only $600 to be distributed to the Foreign Corporation. In this example, a 30% withholding tax would be imposed on $600. FIRPTA We discovered in the last two weeks that non-US persons are generally not subject to US tax on their US source capital gains unless they are ECI with a US trade/business. The major exception to this rule is in the case of Real Property. Capital gain realized by non-US persons from the sale of Real Property is subject to tax at normal tax rates (i.e. ordinary income rates for short-term capital gain and capital gains rates for long-term capital gain). However, imagine that a non-US person created a US corporation (USCo) and the only asset that the USCo owned was US real property. At first, it would appear that if the non-US person sold shares in USCo, it would not be subject to any tax because shares of stock are personal property, not real property. In order to curtail this abuse, the tax code will treat a US corporation as a US Real Property Holding Company (USRPHC) if 50% or more of its assets are a US Real Property Interest (USRPI). The sale of shares of a USRPHC is treated the same as the sale of Real Estate. A USRPI includes most forms of Real Estate (e.g. buildings, land, etc…) as well as other USRPHCs. So if a US corporation’s (USCo1) only asset is stock in another US corporation (USCo2), and USCo2’s only asset is a building, then both USCo1 and USCo2 are USRPHCs. To determine if you reached the 50% threshold for a USRPHC perform the following formula: USRPI (including other USRPHCs) / USRPI (including other USRPHCs) + Foreign Real Property + All other assets used in a trade/business Note that passive assets are not included in the formula. So if a US corporation owned $100 worth of US Real Property and $300 of bonds and $50 of trade/business assets, it would be a USRPHC because the USRPI would be more than 50% of the RELEVANT assets: USRPI ($100) / USRPI ($100) + trade/business assets ($50) = $100/$150 = 67% The investment assets of $300 are NOT included in the denominator of the formula.

Question 41

Subpart F Income

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Subpart F Income When a US person owns shares in a Foreign Corporation you must ask two questions: 1/ Is the Foreign Corporation a CFC? 2/ If so, did the Corporation earn Subpart F income? Last week we reviewed the test to establish whether a Foreign Corporation is a CFC. This week we will focus on the second question: Did the Foreign Corporation earn Subpart F income? Subpart F income is income that was probably shifted offshore strictly for tax purposes. If there is a legitimate business purpose for earning income offshore, it is usually not characterized as Subpart F income. Subpart F income includes several different categories of income, we will focus on Foreign Base Holding Company Income (FBHC) and Foreign Base Company Sales Income (FBC Sales Income). Foreign Base Holding Company Income FBHCI is investment income that is moved offshore. Remember the first example in Lecture 6 where a US person transferred the ownership of his international portfolio to a Foreign Corporation. This is the type of transaction that typically creates FBHCI. Generally, whenever a CFC earns dividends, interest, royalties or rent or capital gain from the sale of investment income producing property, such income is FBHCI. This is because this type of income is easy to move offshore and there is no reason for it to be earned offshore as opposed to in the US. There are some exceptions: Rents and Royalties from an Active Trade/Business and received from a Non-Related Party When the CFC has active rental or licensing income from an unrelated party there is more evidence that the offshore company is located there for legitimate business reasons rather than tax reasons alone. Regular Dealer or Active Banking Business Exception When the CFC is conducting an active banking business or when the CFC is a regular dealer in investment properties (e.g. stock brokerage business) there is more evidence that the offshore company is located there for legitimate business reasons rather than tax reasons alone. Same Country and from a Related Party Exception When a CFC receives investment income from a related party from the country in which the CFC is incorporated, there is a legitimate business reason for the existence of the CFC. For instance, assume that Ted, a US shareholder, owns 100% of a Dutch holding company (HoldCo). The Dutch holding company owns shares in other companies throughout Europe including a company in the Netherlands (DutchCo). Also assume that DutchCo only earns non-Subpart F income (see Scenario B in the attachment). Dividend payments from DutchCo to HoldCo would normally be considered FBHCI since they are dividends received by a CFC. However, since the dividend was from a related party in the same country (both HoldCo and DutchCo are Dutch), an exception applies and the income is not Subpart F income. The legislators saw no reason to tax US shareholders on dividends received by a CFC (HoldCo) from a related party in the same country where the US shareholder would not have been taxed if he had owned the stock of the related party (DutchCo) directly (in Scenario A, the dividend payment would not exist). The conclusion is that there must be a legitimate business reason for creating HoldCo since the taxpayer could have avoided the dividend income altogether by not creating HoldCo in the first place. There is an exception to this exception (and this is where it gets tricky). Assume the same facts as above, a Dutch company (HoldCo) owning 100% of another Dutch company (DutchCo). However, this time assume that DutchCo earns $500 of Subpart F income and $500 of non-Subpart F income. DutchCo received a loan from HoldCo and makes interest payments of $1000 (see Scenario C). Both HoldCo and DutchCo are CFCs so we need to determine if either one has Subpart F income that Ted needs to include currently in his gross income. DutchCo had $500 of Subpart F income and $500 of non-Subpart F income, however it made an interest payment of $1000, so DutchCo’s net income is $0 and there is no income for Ted to include in his gross income. HoldCo had $1000 of interest income which would normally be Subpart F income. However, since it was received from a related party in the same country the exception applies. As a result Ted does not include this amount in his gross income either. You will note that Ted does not include anything in his gross income even though DutchCo had $500 of Subpart F income. This income was reduced to $0 as a result of the interest payment from DutchCo to HoldCo. Since $500 of the interest payment from DutchCo to HoldCo served to reduce Ted’s Subpart F inclusion, the exception will not apply to that amount. As a result of the exception to the exception HoldCo is deemed to have $500 of Subpart F income since the payment from DuthCo to HoldCo served to reduce Ted’s overall Subpart F income inclusion by $500. example.png Foreign Base Sales Income Sales income earned by a CFC is Subpart F income when the buyer or seller are related parties. If a CFC buys goods from unrelated parties and then sells them to unrelated parties, there is no Subpart F income. There are two exceptions to FBC Sales Income: Same Country Exception If the goods that are being sold were manufactured in the CFC’s country or if they were sold in the CFC’s country, the income is not Subpart F income. Example 1: A US shareholder owns 100% of the shares of a CFC in Hong Kong (HKCo) and 100% of the shares of a US corporation (USCo). HKCo buys goods from USCo and sells them to retailers in Hong Kong. The income received is not Subpart F income even though the seller is a related party because the goods were sold in the CFC’s country. Example 2: Same as above except instead of selling the goods to retailers in Hong Kong, HKCo sells the goods to a distributor in Hong Kong that resells them to retailers throughout Asia (outside Hong Kong). If HKCo knows, or has reason to know, that the end user of the goods is outside of the CFC’s country of incorporation (Hong Kong), then the exception does not apply and the income is Subpart F income. Manufacturing Exception If the goods sold by the CFC were manufactured by the CFC, the income is not Subpart F income. Manufacturing is defined as Substantial Transformation of the product. So merely packaging or labeling will not qualify as a product. Assembly may qualify as manufacturing if an entirely different product results after the assembly occurs. Note that the manufacturing does not need to occur in the CFC’s country of incorporation for this to apply. Example 1: A US shareholder owns 100% of the shares of a CFC in the Netherlands (DutchCo). DutchCo owns a manufacturing operation in Ireland (since the operation is not independently incorporated it is a branch of DutchCo). DutchCo sells the goods manufactured by the Irish branch throughout Europe. The income received is not Subpart F income because the goods were manufactured by the CFC (in its Irish branch). Example 2: A US shareholder owns 100% of the shares of a CFC in the Netherlands (DutchCo). DutchCo enters into an agreement with an unrelated third party (MfgCo) to perform manufacturing on its behalf. Under the agreement, DutchCo retains all risk of loss and owns the raw materials used in the manufacturing. MfGCo performs the manufacturing services for a cost plus mark-up fee. DutchCo sells the goods manufactured by the contract manufacturer throughout Europe. The income received is not Subpart F income because the goods are deemed to be manufactured by the CFC. Even though the CFC does not manufacture the goods itself, if it enters into a contract manufacturing agreement with a third party manufacturer it is deemed to have performed the manufacturing. Note: Even though Rev. Rul. 97-48 appears to invalidate this position, tax planners have successfully relied on general agency law to argue that manufacturing performed by a contract manufacturer may be deemed to be performed by a CFC. Relief Provisions High-Tax Exception If the CFC’s income is subject to an effective tax rate that is greater than 90% of the maximum US corporate tax rate, none of the Subpart F income is included in the taxpayer’s gross income. If the maximum US corporate tax rate is 35%, then the CFC’s Subpart F income will not be included in the taxpayer’s gross income if its income is subject to a rate of 32% since this is higher than 31.5% (90% of 35%). The theory is that the CFC was not set up for tax avoidance purposes if its income is subject to a rate of tax that is about as high, or higher, than the US tax rate. DeMinimis Exception If the proportion of Subpart F income to total income (Subpart F and non-Subpart F) falls below a certain threshold, then NONE of the income is Subpart F income. The threshold is the lesser of $1,000,000 or 5% of the CFC’s gross income. If the CFC had $900,000 of Subpart F income and $19,000,000 of non-Subpart F income, the $900,000 of Subpart F income would not be included in the taxpayer’s gross income since it is less than 5% of the CFC’s gross income. ($900,000 is 4.5% of $19,900,000). If a CFC had $700,000 of Subpart F income and $10,000,000 of non-Subpart F income, the $700,000 of Subpart F income would be included in the taxpayer’s gross income since it is greater than 5% of the CFC’s gross income ($700,000 is 6.5% of $10,700,000). If the CFC had $2,000,000 of Subpart F income and $45,000,000 of non-Subpart F income, the $2,000,000 of Subpart F income would be included in the taxpayer’s gross income since it is more than $1,000,000 (even though it is less than 2,350,000 – 5% of $47M). Full Inclusion Rule This is the opposite of the DeMinimis Exception. Basically, if most of the CFC’s income is Subpart F income (70% or more), then all of it will have to be currently included in the taxpayer’s gross income. So if a CFC had $800,000 of Subpart F income and $200,000 of non-Subpart F income, the entire $1,000,000 would be currently included in the taxpayer’s gross income because $800,000 is 80% of the CFC’s total income. Non-Subpart F Income With regard to non-Subpart F income, the CFC is treated as a regular foreign corporation and the income is not subject to US tax until such time that the income is repatriated to a US person as a dividend. So if a CFC receives $1,000,000 of non-Subpart F income in Year 1 and the income is not distributed to a US person until Year 4, that $1,000,000 will not be subject to US tax until Year 4 when it will be taxed at US tax rates to the shareholder. New Law: However, under the Tax Cuts and Jobs Act of 2017 there is an exception to the general rule above for 2017. At the end of 2017, all non-Subpart F income that has been retained by a CFC is deemed to distribute that income to its US shareholders. The tax rate for this undistributed income is 15.5% to the extent that it is attributable to cash and 8% to the extent it is attributable to other assets. For example, assume that in 2016 a CFC had $400,000 of Subpart F income and $500,000 of non-Subpart F income and in 2017 the CFC has no income. Also assume that of that $500,000, $300,000 is cash and $200,000 is non-cash assets. In 2016, the US shareholders would be subject to tax on the $400,000 as if it was distributed to them. Because of the new law, in 2017 the CFC will be deemed to have distributed the $500,000 to its US shareholders and they would be taxed at 15.5% on the $300,000 of accumulated cash and 8% on the $200,000 of non-cash assets. Note that this deemed distribution is a one-time event for the end of 2017. For subsequent years the default law will apply whereby non-Subpart F income is not deemed to be distributed to US shareholder and is therefore not subject to US tax until such time that it is acutally distributed. A Brief Note on PFICs PFICs can be complicated but here are the essential issues you should understand: Once you’ve conducted a thorough CFC/Subpart F analysis and determined that the taxpayer does not have to currently include any of the Foreign Corporation’s income in his gross income, you then need to conduct a PFIC analysis. Generally, when a US Person owns shares of a Foreign Corporation the PFIC rules could potentially apply. The key distinction between PFICs and CFCs is that CFCs only have consequences for US Shareholders (i.e. 10% or more owners) whereas PFICs have consequences for any US Person who owns shares of a Foreign Corporation (even a US person who owns 1 share of a Foreign Corporation needs to be concerned). So once we’ve identified a Foreign Corporation that is owned in some part by a US person, we need to determine if that Foreign Corporation is a PFIC. It will be a PFIC if it meets either of the two following tests: Income Test: If 75% or more of the Foreign Corporation’s income is FPHCI (i.e. passive investment income or investment capital gain), then it is a PFIC. Asset Test: If 50% or more of the Foreign Corporation’s assets produce FPHCI, then it is a PFIC. If the Foreign Corporation is a PFIC the US person taxpayer will face one of the following consequences: 1 – Excess Distribution: When the PFIC makes an excess distribution (125% of previous year’s distribution) or when the PFIC stock is sold, the taxpayer is taxed on the income as if it was earned in the year the PFIC earned the income (applying the tax rate of that year and interest due). This is the default rule and will apply unless the taxpayer makes an election otherwise. 2 – QEF Election: If a QEF election is made, the PFIC is treated as if it distributed all its income in the year it was earned (this is a similar treatment that Subpart F income receives in the CFC regime). 3- Mark-to-Market Election: Current inclusion of the difference between the taxpayer’s basis in the PFIC stock and its market value on a public exchange at the end of the year (the PFIC’s stock must be publicly trade for this election to apply). It is possible that a corporation can be a CFC and a PFIC at the same time. If this is the case, only the CFC regime will apply for US shareholders. The PFIC regime will continue to apply for non-US shareholders who are US persons.

Question 42

Transfer Pricing and Transfer of Property Outside the US

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Transfer Pricing and Transfer of Property Outside the US Transfer Pricing Transfer Pricing is one of the most well known areas of International Tax (probably because it often results in high-profile litigation). In practice, Transfer Pricing issues are more often within the domain of economists than tax professionals since, ultimately, the questions that need to be resolved are economic questions rather than legislative ones. Transfer Pricing rules were introduced to control the following abuses: Assume that a multinational corporation, WorldCo, has two subsidiaries, one in the US (USCo) and one in Hong Kong (HKCo). Hong Kong taxes HKCo at a rate of 10% whereas the United States taxes USCo at a rate of 35%. USCo manufactures radios and sells them to HKCo. HKCo distributes the radios to retailers in Hong Kong. The cost to manufacture the radios is $5 per unit and the sales price to retailers is $20 per unit. The $15 of gain is realized by the WorldCo enterprise regardless of the portion earned by USCo or HKCo. It is therefore in WorldCo’s interest to set the intercompany price between USCo and HKCo as low as possible. For example, if USCo sold the radios to HKCo for $7, there would be $2 of gain attributed to USCo that would be taxed at 35%. Meanwhile, $13 of gain would be attributed to HKCo and taxed at only 10%. By shifting more of the gain to HKCo, which is in a lower tax jurisdiction, WorldCo can minimize the amount of tax it pays on the transaction. It does not matter to USCo that it is being short-changed since it is part of the same enterprise as WorldCo and, ultimately, WorldCo’s shareholders will receive the entire $15 of gain (no matter how it is spread between USCo and HKCo). If HKCo was unrelated to USCo, USCo would never tolerate a price as low as $7 since $2 gain is well below the acceptable mark-up for radios. The IRS aims to ensure that the prices in intercompany transactions do not deviate from the prices that would exist between unrelated parties. The purpose of the Transfer Pricing rules is to require related parties to charge each other “arm’s length” prices for goods and services (i.e. prices that would be excepted if the transactions were between unrelated parties). Transfer Pricing Methods The tricky part is to determine what the appropriate intercompany price should be – what price would reflect a transaction between independent parties. There are three generally accepted methods to establish the proper transfer price: Comparable Uncontrolled Price (“CUP”) Method Under this method, you find comparable transactions between unrelated parties and look at the price that is charged between those parties. For instance, if another US company manufactured similar radios for $5 and sold them to an unrelated distributor in Hong Kong for $10, the CUP Method would require USCo to charge $10 to HKCo for the radios it sells. Since it is difficult to find exact comparables, certain adjustments must often be made. Resale Price (“RSP”) Method In this case we are not looking at comparable products, but comparable distribution functions. We look at the gross profit margin that is realized by an unrelated distributor and apply that gross profit margin to our distributor (HKCo). If no other company in the US manufactures radios we could not use the CUP method. However, assume that we identify a Hong Kong company that distributes televisions. Assume that this other Hong Kong company buys the TVs from an unrelated party for $20 per unit and sells them to retailers for $45 per unit. The gross profit margin is 56% (($45-$20) / $45). Using the RSP method, we can conclude that the gross profit margin realized by HKCo should also be 56%. Since HKCo charges the retailers $20, a 56% gross profit margin would be $11.20. In order to receive $11.20 of profit it must have paid USCo $8.80 for the radios. Hence, using the RSP method $8.80 should be the appropriate intercompany price. Notice two things: 1/ We don’t need comparable goods using this method, only comparable distribution services, 2/ We work backwards from the sale price to the retailers (remember we can be assured that the $20 charged to retailers is a fair market price since the retailers are unrelated to HKCo and wouldn’t tolerate a higher price). Cost Plus Method (“CPM”) This method is appropriate where there are no comparable products or any comparable distribution services (e.g. HKCo does more than just distribute the goods, it also provides unique services). In this case we apply an appropriate gross-profit mark-up to the manufacturer’s costs to determine the intercompany price. Assume that we determine that there is a manufacturer selling MP3 players to unrelated parties for a mark-up of 80%. We can therefore apply this mark-up to USCo’s radios: since it costs USCo $5 to manufacture the radios, an 80% mark-up would result in a distributor sales price of $9 ($5 + (80% x $5)). Notice that in this case we are working forward, starting with the costs and adding a mark-up. The appropriate method to be selected depends on the comparable information that is available. Generally, the Cost-Plus method appears to be the method that is most commonly used. Transfer of Property Outside the US Section 367 of the Tax Code, which discusses the transfer of property outside the US, is where corporate tax meets international tax. Those of you who have already taken corporate tax will be familiar with some of the concepts we will discuss. For those of you who don’t have experience with corporate tax here is a brief primer: Non-recognition Transactions in Corporate Tax Generally, when one party transfers property to another party in exchange for cash or property, the transferor is subject to tax on the difference between her amount realized and her basis. Assume that T owns a car. T’s basis in the car is $5,000 and the car’s fair market value is now $12,000. If T transfers her car to XCorp, a US corporation, and, in exchange, XCorp gives T a painting worth $12,000, T has realized a gain of $7000. T must pay tax on the amount of this gain. Now assume that instead of the painting, XCorp transfers $12,000 worth of XCorp to stock T. Once again, T has received property valued at $12,000 for a car with a basis of $5,000, BUT Section 351 of the tax code permits T not to be subject to tax on this gain at the time of the transfer. So even though T has a “Realized Gain” of $7000 (i.e. the FMV of the amount realized is $7000 more than T’s basis in the property), T does not have “Recognized Gain” (i.e. T is not subject to tax on the gain). The reason for this Non-recognition treatment is that T continues to own the car indirectly through XCorp. Since T received XCorp stock, T is now a shareholder of XCorp which owns the car. Although T does not recognize gain, T’s basis in the XCorp remains at $5,000. So if XCorp stock did not appreciate and T sold the XCorp stock in one year, T would have to recognize $7,000 at that time. Meanwhile, XCorp’s basis in the car is also $5,000. So if XCorp sold the car, XCorp would have Recognized Gain of $7,000 at that time. This non-recognition treatment is permitted for various transactions in corporate tax such as mergers, spin-offs and liquidations. The logic is that these transactions do not change the ownership of the property by T, only the manner in which T owns the property (i.e. indirectly through another entity rather than directly). International Tax Implications The problem occurs when the transferee corporation is a foreign corporation rather than a US corporation. So if XCorp is a foreign corporation instead of a US corporation, it is not enough to rely on the non-recognition treatment provided by Section 351. We must now consider the implications of Section 367. As we saw above, when XCorp is a US corporation, taxation of the gain is deferred until such time as T sells the XCorp shares or XCorp sells the car. However, if XCorp was a foreign corporation, XCorp would be beyond the jurisdiction of the US. Hence, when T transfers the car to XCorp, she is in fact transferring the property outside the US’s jurisdiction. Even though T still owns the car indirectly through XCorp, the IRS believes it is necessary to disallow deferment of the gain because the property moves beyond the US’s jurisdiction. So the rules are as follows: 1- Section 351 operates to allow for non-recognition when a taxpayer transfers property to a corporation in exchange for the corporation’s stock. 2- When the transferee corporation is a Foreign Corporation, Section 367 trumps Section 351 and gain must be recognized upon the transfer of the property. Exceptions to Section 367: Active Trade/Business If the assets that are transferred to the foreign corporation are used by that corporation in an Active Trade/Business, then Section 367 does not apply. As a result, non-recognition (under Section 351) is permitted when the assets that are transferred are used in an Active Trade/Business. Exception to the Exception Tainted Assets Even if the foreign corporation is using the assets in an active trade/business, gain must nonetheless be recognized for the following assets: Accounts Receivable Inventory Intangible Assets The Active Trade/Business exception applies to all other assets such as Equipment, Real Property and Goodwill. Depreciation Recapture Rule Even if a transferred asset is used in an Active Trade/Business and the asset is NOT a tainted asset, gain must be recognized to the extent depreciation was taken on the asset against US income (this should remind you of the sourcing rule regarding depreciable personal property that we discussed in week 2). Consider the following example: T buys an airplane for $500,000. She depreciates the plane to zero (so her basis in the plane is now zero). When the plane has a value of $700,000 she transfers it to ForCo, a foreign corporation, in exchange for stock in ForCo. ForCo will use the plane in an air-taxi business. The Active Trade/Business exception applies since the asset will be used in an active business by ForCo. There is $700,000 of Realized Gain. However, $500,000 of that gain must be recognized (T must pay taxes on it) since $500,000 of depreciation was taken against US income. The remaining $200,000 of Realized Gain need not be recognized. So T’s basis in the ForCo stock will be $500,000. The $200,000 of built-in gain (difference between T’s basis in ForCo stock and the Fair Market Value) won’t be recognized until T sells the ForCo stock. Branch Loss Recapture Rule If the transferred assets are part of a branch operation that has sustained a net loss at the time of the transfer, gain on those assets must be recognized at the time of the transfer. The objective is to prevent taxpayers from operating as a branch during the early period of a new business when it sustains losses and then transferring the branch assets to an offshore corporation just before the operation becomes profitable. The theory is that if the start-up’s losses offset US income, then the recapture of those losses must be recognized when the assets of the operation are transferred outside the US. Assume that T operates a new start-up and the operation sustains losses in 2001 of $12,000 and losses in 2002 of $5,000. If T transfers the assets of the operation to a foreign corporation in 2003, then, to the extent that the assets produce $17,000 of realized gain, such gain must be recognized at the time of transfer. Now assume instead that in 2002 the operation made a profit of $14,000 instead of a loss of $5,000. Here there is a net gain (of $2,000) at the time of the transfer so no gain must be recognized. Transfers of Stock and Intangible Assets The Section 367 rabbit hole runs quite deep and we’ve only touched the surface. We have not discussed the consequences of transferring stock or intangible property to foreign corporations. Such transfers are subject to another set of rules and the discussion of those rules could be an entire course in itself.

Question 43

Introduction to IRC 1031 Exchanges

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A 1031 Exchange (Tax-Deferred Exchange) Is One Of The Most Important Tax Deferral Strategies Remaining Available For Taxpayers. Section 1031 of the Internal Revenue Code is the basis for tax-deferred exchanges. Taxpayers will avoid or minimize income taxes on the sale of property if they reinvest the proceeds in similar or like-kind property. The 1031 Exchange Advantage permits a taxpayer to sell income, investment or business property and replace the same with like-kind Replacement Property but without having to pay federal or state income taxes on the transaction. A sale of property and subsequent purchase of a Replacement Property does not work; there must be an Exchange. The legal documents and the form of the transaction will determine if there is a 1031 exchange. The party's intent is only one aspect. The sale and purchase escrows must be related in some aspect. The Disadvantages of a Section 1031 Exchange include a reduced basis for depreciation deductions on the Replacement Property. The tax basis of Replacement Property will be the purchase price of the Replacement Property minus the gain which was deferred on the sale of the Relinquished Property as a result of the exchange. As a result, the Replacement Property includes a deferred gain that will be taxed in the future if the taxpayer cashes out of their investment. Exchange Techniques. There is more than one way to structure a tax-deferred exchange under Section 1031 of the Internal Revenue Code. However, the 1991 "safe harbor" Regulations established procedures which include the use of an Intermediary, direct deeding, the use of qualified escrow accounts for temporary holding of "exchange funds" and other procedures which have Congressional and IRS approval. Therefore, the exchange needs to be structured to comply with IRS regulations. As a result, exchanges commonly use the services of a facilitator known as a Qualified Intermediary. Exchanges can also occur without the services of an Intermediary when parties to an exchange are willing to exchange deeds or if they are willing to enter into an Exchange Agreement with each other. However, two-party exchanges are uncommon since, in the typical Section 1031 transaction, the seller of the Replacement Property is not the buyer of the taxpayer's Relinquished Property.

Question 44

Like Kind Exchanges-Overview

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If you are thinking of selling real property that you use in your trade or business or that you are holding for investment, you should consider the benefits of a like-kind exchange. What is a like kind exchange? In a like-kind exchange, you do not recognize any gain or loss on the disposition of real property held for the productive use in a trade or business or for investment if you dispose of the property by exchanging it solely for property of like kind that is to be held either for productive use in a trade or business or for investment. Gain Recognized if ‘Boot’ If, in addition to receiving like-kind property, you receive cash or other property that does not qualify as like-kind property (so-called “boot”), you must recognize gain to the extent of the boot received. Gain Deferral In a like-kind exchange, the gain realized on the exchange of real property for replacement property does not escape tax – the tax on the gain is merely deferred until you sell the replacement property. However, by deferring the tax, you’ll have more money available to invest in another property. In effect, you receive an interest-free loan from the federal government, in the amount you would have paid in taxes. Also, any gain from depreciation recapture is postponed except to the extent you receive boot as part of the exchange and recognize gain. Further, because of the way the term “like kind” is defined, you may use the acquisition and disposition of properties to reallocate your investment portfolio (e.g., moving from commercial rental property to residential rental property) without paying tax on any gain. IRC 1031 Qualification To qualify as a like-kind exchange, both the property you give up (the relinquished property) and the property you receive (the replacement property) must be held for

investment or
productive use in your trade or business.

While taxpayers were able to use the like-kind exchange rules for exchanges of personal property in years beginning before 2018, such exchanges are no longer available for federal income tax purposes. Only real property is eligible for the like-kind exchanges rules. Examples of property that may qualify include land, farm property, commercial and rental houses. The like-kind exchange rules do not apply to real property held primarily for sale. Unproductive real estate held by someone other than a dealer for future use or future realization of the increment in value is considered held for investment and not primarily for sale. Like Kind Also, to qualify as a like-kind exchange, the replacement property must be of a “like kind” to the relinquished property. “Like kind” refers to the nature and character of the property and not to its grade or quality. An exchange of one kind or class of property for a different kind or class is not a like-kind exchange. All qualifying real property located in the United States, improved or unimproved, is considered to be of like kind. Deferred Exchanges Additional requirements apply to deferred like-kind exchanges in which you do not receive the replacement property immediately upon your transfer of the relinquished property.

Question 45

Like Kind Exchanges-Basics

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The Basic Rules for a 1031 Exchange The Relinquished Property The Relinquished Property or Properties and the Replacement Property or Properties Must Be Qualifying Property. Qualifying Property Qualifying property is property held for: investment purposes or used in a taxpayer's trade or business. Investment property includes real estate, improved or unimproved, held for investment or income producing purposes. Property used in a taxpayer's trade or business includes office facilities or place of doing business. Real estate must be replaced with like-kind real estate. This means agricultural real property can be exchanged for residential real or commercial real properties or a combination of real properties. All that matters is that the property give up and the property or properties received must be real property as that term is defined under state law. Non Qualifying Real Property Property Which Does Not Qualify For A 1031 Exchange includes:

A personal residence
Land under development for resale
Construction or fix/flips for resale
Property purchased for resale
Inventory property
Corporate stock
Partnership interests
LLC membership interests
Bonds
Notes

Same Taxpayer Replacement Property Title Must Be Taken In The Same Name As The Relinquished Property Was Titled. If a husband and wife own property in joint tenancy or as tenants in common, the Replacement Property must be deeded to both spouses, either as joint tenants or as tenants in common. Corporations, partnerships, limited liability companies and trusts must be in title on the Replacement Property the same as they were on the Relinquished Property. The Replacement Property Must Be Like-Kind

Improved real estate can be replaced with unimproved real estate.
Unimproved real estate can be replaced with improved real estate.
A 100% interest can be exchanged for an undivided percentage interest with multiple owners and vice versa.
One property can be exchanged for two or more properties.
Two or more properties can be exchanged for one Replacement Property.
A duplex can be exchanged for a four-plex.
Investment property can be exchanged for business property and vice versa.
Agricultural property can be exchanged for commercial and/or residential property and vice versa

Personal Residences As referenced above, a taxpayer's personal residence cannot be exchanged for income property and income or investment property cannot be exchanged for a personal residence which the taxpayer will reside in. However, in some circumstances, vacation property can qualify if certain conditions are met. Seek professional advice from us before going that route. Boot Boot Received In Addition To Like-kind Replacement Property Will Be Taxable (to the extent of gain realized on the exchange). This is acceptable when a seller desires some cash or debt reduction and is willing to pay taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be completely tax free. The term "boot" is not used in the Internal Revenue Code or the Regulations. But, it is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange. Boot received is the money, debt relief or the fair market value of "other property" received by the taxpayer in an exchange. Money includes all cash equivalents received by the taxpayer. Debt relief is any net debt reduction which occurs as a result of the exchange taking into account the debt on the Relinquished Property and the Replacement Property. "Other property" is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or "non-qualified property." "Other property" also includes such things as a promissory note received from a buyer (Seller Financing). A Rule Of Thumb for avoiding "boot" is to always replace with property of equal or greater value than the Relinquished Property. Never "trade down." Trading down always results in boot received, either cash, debt reduction or both. Boot received is mitigated by exchange expenses paid.

Question 46

When to Use a Like Kind Exchange

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When to Use a Like-kind Exchange

Nontaxable like-kind exchanges should be considered by taxpayers in any of the following situations:

When a taxpayer intends to replace the real property with similar property.
When the real property being disposed of has appreciated in value enough that a sale would result in a significant tax liability.
When a taxpayer has nondepreciable, nonincome-producing property and wants to obtain depreciable, income-producing property. This may be particularly beneficial for taxpayers needing additional after-tax income during retirement.
When a taxpayer wants to convert from trade or business real property (e.g., active in management) to investment real property (e.g., triple net lease property), or vice-versa.

Question 47

When Not to Use a Like Kind Exchange

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However, in other situations taxpayers may benefit more from a taxable disposition, and should intentionally avoid or disqualify a property exchange since the nontaxable provisions are mandatory when the statutory requirements are met. These situations include the following:

When a taxpayer has current year losses or loss carryovers (capital, net operating, charitable, etc.) that can be used to offset gain resulting from a taxable disposition.
When a taxpayer has a built-in loss in the property being disposed of. Nontaxable exchanges not only defer taxable gains, but also losses. In such case, a nontaxable exchange would prevent the taxpayer from recognizing the loss currently.
When a wide disparity exists between the capital gains and ordinary tax rates. Here, some taxpayers may benefit from a step-up in basis in the replacement property when a taxable sale at capital gain rates is followed by the purchase of depreciable property.
When the gain is passive income that can be used against current or suspended passive activity losses.
When paying tax on the gain in the current year may be more beneficial than deferring the tax because of events (such as increases in the taxpayer’s future taxable income, rising tax rates, or changes in the tax treatment of capital gains) that would produce future additional tax.

Normally, the disparity between the capital gain and ordinary income tax rates make a taxable sale followed by a reinvestment of the net proceeds a practical strategy, assuming the sale results in long-term capital gain treatment. In addition, the more the basis in the replacement property can be allocated to depreciable property and the shorter the related recovery period, the more likely a taxable sale will be a favorable alternative since it allows the taxpayer to step up basis in the replacement property.

Question 48

Reasons and how to Avoid IRC 1031

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AVOIDING LIKE-KIND TREATMENT Situations When Like-Kind Treatment Not Advantageous Before entering into an exchange under Code Sec. 1031, an exchanger should review the specific tax status of the property being received and the property being relinquished in order to determine the actual effects of Code Sec. 1031. Although exchangers often presume that Code Sec. 1031 is advantageous, there are situations when this presumption is not correct. Examples of situations in which an exchanger may wish to avoid like-kind treatment include: Where there is built-in capital loss in the property being transferred that the exchanger could recognize in a sale, but not an exchange; EXAMPLE: Abel owns Whiteacre with a cost basis of $20,000 and a fair market value of $10,000. Baker owns Blackacre with an adjusted tax basis of $2,000 and a fair market value of $10,000. Baker wants to acquire Whiteacre from Abel in a like-kind exchange. Abel does not want to acquire Blackacre but he wants to recognize a capital loss with respect to Whiteacre. If he enters into a simple like-kind exchange with Baker, Abel cannot recognize the built-in loss. Thus, it is more advantageous for Abel to sell Whiteacre, which results in recognizable loss. Note that both parties can reach their desired result by entering into a four-party exchange. Where the exchanger has a current capital loss or net operating loss carryforward that can be used to offset all or part of the gain generated by a sale of the property; EXAMPLE: Abel owns Blackacre with a fair market value of $10,000 and an adjusted loss basis of $5,000. Abel also has a current capital loss of $5,000. Baker owns Whiteacre and wants to acquire Blackacre in a like-kind exchange. If Abel enters into a like-kind exchange, the gain realized on the exchange is not recognized and, therefore, cannot be used to offset his current capital loss. If Abel sells the property and recognizes a gain, however, he can offset the capital loss with the gain recognized. NOTE: If a sale generates capital gain in excess of an exchanger's current capital loss carryforward, the exchanger may use such loss to offset the gain. This is an important factor to the extent that the property acquired is depreciable since the basis of the acquired property would be $10,000 in the case of a purchase using the proceeds of the sale, as opposed to $5,000 in the case of an exchange. When the payment of tax in the current year is preferable to the deferral of tax. In this regard, exchangers should consider potential changes in their income, any anticipated changes in tax rates or capital gain benefits, and the anticipated holding period for replacement property received in the exchange; and EXAMPLE: Abel wants to dispose of Whiteacre (which has appreciated in value) and obtain replacement property. Abel is not sure, however, if it is more advantageous to enter into a like-kind exchange, or a sale. If he enters into an exchange, he can defer paying tax on the gain until he disposes of the property received in the exchange. If he sells Whiteacre, he must pay a tax on the gain currently. At the time of disposition, Abel is in the 15% marginal tax bracket. If Abel believes that in future years he will be in a higher marginal tax bracket, it may be advantageous for Abel to sell the property in the current year (the proceeds of which can be used to purchase replacement property) rather than subjecting the deferred gain to an anticipated higher tax rate. Abel must consider the time period that he plans to hold onto the replacement property and assumptions as to future tax rates. Depreciation benefits from the purchase of the replacement property are more beneficial than the cost of the tax on the capital gain from the sale of the property. EXAMPLE: Abel has an adjusted tax basis of $60,000 in Property B which has a fair market value of $100,000. At an assumed capital gains rate of 20%, the current tax on the sale of B is $8,000 ($40,000 gain × 20%). If Abel exchanges B for Property W pursuant to Code Sec. 1031, he has a carryover basis in W of $60,000. If, on the other hand, Abel sells B and purchases W for $100,000, he will have a cost basis of $100,000. This creates additional depreciation deductions of $40,000 assuming all of W is depreciable. This depreciation is deductible against ordinary income in future years. Thus, the cost of the tax paid upon the sale of the property is clearly less than the benefit derived from the potential increased depreciation deduction. This is particularly important if there is a preferential capital gains rate. In that case, the deferred depreciation deductions will offset income subject to tax at ordinary income rates, while Abel pays tax currently on the gain at a preferential capital gains rate. NOTE: Lost depreciation benefits are also a factor in the event the property being transferred in a Code Sec. 1031 exchange was acquired before the accelerated cost recovery system rules were adopted in 1981. In that event, the exchanger not only takes a carryover basis in the replacement property, but under Code Sec. 168, will be unable to use any accelerated cost recovery method. Recapture: Notwithstanding the general deferral of taxes on an exchange, Code Sec. 1245 and Code Sec. 1250 include provisions requiring the recapture of any depreciation involved in the event gain is realized in the exchange. This issue may be particularly troublesome with respect to nonresidential real property subject to recapture under Code Sec. 1245. Methods of Avoiding Like-Kind Treatment Lack of Mutual Dependency Avoiding the mandatory nature of Code Sec. 1031 requires breaking the "mutual dependency" of the transaction. For example, many exchangers enter into a deferred exchange agreement as a matter of course when selling property that may qualify for exchange treatment. In the event that it is determined after the agreement is executed that exchange treatment would not be beneficial, the exchanger may attempt to avoid Code Sec. 1031 by allowing the time periods contained in the agreement to identify and close on the replacement property to lapse. This allows the exchanger to then gain unrestricted control of the proceeds and use those proceeds to acquire suitable property, thereby destroying the mutual dependency of the agreement. Substance Versus Form In order to receive like-kind exchange treatment, an exchanger must satisfy both the formalistic and substantive requirements of Code Sec. 1031 . Thus, an exchanger can avoid exchange treatment by structuring the transaction as something other than a like-kind exchange. If an exchanger purposely fails to meet the formal requirements under Code Sec. 1031 , but the substance of the transaction still resembles a like-kind exchange, the IRS and the courts generally will treat the transaction as an exchange and the exchanger will receive nonrecognition treatment. Rev. Rul. 61-119, 1961-1 C.B. 395 ; Greene, Joanne, (1991) TC Memo 1991-403, PH TCM ¶91403, 62 CCH TCM 512 . See Redwing Carriers Inc v. Tomlinson, (1968, CA5) 22 AFTR 2d 5448, 399 F2d 652, 68-2 USTC ¶9540 ; Biggs, Franklin B., (1978) 69 TC 905, affd (1980, CA5) 47 AFTR 2d81-484, 47 AFTR 2d 81-484, 632 F2d 1171, 81-1 USTC ¶9114. But see Young, Robert G., (1985) TC Memo 1985-221, PH TCM ¶85221, 49 CCH TCM 1439 ; Swaim, Emsy H. v. U.S., (1979, DC TX) 45 AFTR 2d 80-1276, 79-2 USTC ¶9462, affd & revd (1981, CA5) 48 AFTR 2d 81-5653, 651 F2d 1066, 81-2 USTC ¶9575.

Question 49

Non Tax Considerations in Real Estate Like-Kind Exchanges

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NONTAX CONSIDERATIONS IN REAL ESTATE LIKE-KIND EXCHANGES It is axiomatic that undertaking a like-kind exchange of real property means that the taxpayer will continue to own real property when the exchange is completed. Taxpayers who intend to sell property should consider many tax and nontax factors before deciding whether a like-kind exchange is the best option. The following are examples of nontax reasons for continuing to invest in real property following a sale:

Consolidating investments by exchanging several small properties for one larger replacement property;
Diversifying investments by exchanging one property for several smaller replacement properties in different locations;
Eliminating property management problems on one property by acquiring either a problem-free property or an interest in a larger property that employs a third party property management company;
Replacing property having limited potential for appreciation with property having greater potential for appreciation;
Realigning some or all of a real estate investment portfolio by exchanging high-risk, high-yield property for low-risk, low-yield property, or vice versa;
Increasing cash flow by exchanging property with limited cash flow for property with greater cash flow;
Relocating a business by exchanging the property on which it is located for property in a different area;
Replacing an aging commercial facility with a modern, newly constructed commercial facility;
Increasing investment leverage by acquiring property with a smaller ratio of equity to fair market value; and
Terminating a problem joint ownership by exchanging joint interests for separate properties.Non tax considerations may also lead the taxpayer to liquidate, rather than continue, an investment. The taxpayer may need cash liquidity or wish to invest in another form of investment. The taxpayer may be willing to pay the tax on the gain to obtain steady income with less risk. For example, a taxpayer may prefer a passive investment such as bonds or treasury bills rather than real estate.

Question 50

Like Kind Exchanges of Real Property

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Like Kind Exchanges of Real Property

Question 51

Qualifying Types of Real Property

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Real Estate Interests Which Qualify as Like-Kind for a 1031 Exchange There a surprising number of property types that are deemed 'like kind' under the tax free exchange rules. As examples, the following types of real estate interests are deemed by Congress and the IRS to qualify as like-kind to each other for a 1031 Exchange:

Fee interest
Fractional (tenancy-in-common) interest
Leasehold interest, 30-year plus lease
Easements for conservation
Easements for right of way
Water rights
Mineral Rights
Oil & Gas interests
Transferrable Development Rights
Mutual Irrigation Ditch Stock
City real property for a ranch or farm. See Treas Reg §1.1031(a)?1(c); Hubert Rutland, TC Memo 1977?8.
Rental income property (house and land) for farmland and improvements but not farm machinery. See Rev Rul 72?151, 1972?1 Cum Bull 225.
Improved real property for unimproved real property. See Treas Reg §1.1031(a)?1(b)?(c); Earlene T. Barker (1980) 74 TC 555. See §2.65 for further discussion of improvements.
An exchange among cotenants of two or more parcels of real property so that each ends up with sole ownership of one of the parcels. See Rev Rul 79?44, 1979?1 Cum Bull 265; Rev Rul 73?476, 1973?2 Cum Bull 300; IRS Letter Ruling 9525038. See also IRS Letter Ruling 9609016.take care, however, in evaluating exchanges of property held in cotenancy because the interests exchanged may be treated as partnership interests, precluding nonrecognition treatment. See M.H.S. Co., TC Memo 1976?165, aff'd per curiam (6th Cir 1978) 575 F2d 1177.
A 50 percent tenant-in-common interest in old-growth timberlands for a 100 percent interest in half of such timberlands. See IRS Letter Ruling 199926045. See also IRS Letter Ruling 199945046.
A fee for a fee subject to an unexercised option. See Boise Cascade Corp., TC Memo 1974?315. See also Cary A. Everett, TC Memo 1978?53.
A fee for the contractual right to purchase real property or equitable fee title subject to conditions precedent. See Biggs v Commissioner (5th Cir 1980) 632 F2d 1171; Starker v U.S. (9th Cir 1979) 602 F2d 1341.
A remainder interest in one property for a remainder interest in another property. See Rev Rul 78?4, 1978?1 Cum Bull 256.
A remainder interest in one property for a life estate in another property when the life tenant has a life expectancy of at least 30 years. See Rev Rul 72?601, 1972?2 Cum Bull 467.
An agricultural conservation easement in perpetuity in a farm, found to be real property under state law, for a fee simple interest in real property. See IRS Letter Ruling 9232030. See also IRS Letter Ruling 200201007 and companion IRS Letter Rulings 200203033 and 200203042.
Agricultural conservation easements over two farms for fee simple title in a different farm. See IRS Letter Ruling 9851039.
A perpetual conservation easement encumbering real property for a fee simple interest in either farm land, ranch land, or commercial real property. See IRS Letter Ruling 9601046 (the conservation easement in question was granted by the taxpayer to the federal government over real property the taxpayer had held for many years for productive use in the business of cattle grazing and duck hunting).
A scenic conservation easement, found to be real property under state law, for a fee simple interest in timberland, farmland, or ranch land. See IRS Letter Ruling 9621012.
Raw land acquired by taxpayers for future use as a mobilehome park, on which taxpayers operated sand mining business under a nontransferable mining permit, for land and buildings. See Larry L. Beeler, TC Memo 1997?73.
Transferable development rights associated with real property for a fee interest in real property. IRS Letter Rulings 200805012, 200901020.
A utility easement for another utility easement. See IRS Letter Ruling 9814019.
Replacement property for involuntarily converted outdoor advertising displays, which the taxpayer elected to treat as real property under an IRC §1033(g)(3)(C) election. See IRS Letter Ruling 200041027.
Standing timber to be severed by the buyer, found to be a transfer of real property under state law, for a fee interest in land. D. G. Smalley (2001) 116 TC 450.
The conversion of a stock cooperative into a condominium. See IRS Letter Rulings 200137032 and 200631012.
An exchange of old growth timber for reproductive timber. See IRS Letter Ruling 200541037.
Coal supply contracts for a fee interest in a gold mine. See Peabody Natural Resources Co. (2006) 126 TC 261. For discussion of supply contracts, see §2.68.
An exchange of a perpetual stewardship easement for fee interest in real property. IRS Letter Rulings 200649028, 200651018, and 200651025.

Question 52

Exchange Types

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The Basic Types of Exchanges

Simultaneous Exchanges

A Simultaneous Exchange is an exchange in which the closing of the Relinquished Property and the Replacement Property occur on the same day, usually back to back. There is no interval of time between the two closings. This type of exchange is covered by the Safe harbor Regulations.

Delayed Exchanges

A Delayed Exchange is an exchange where the Replacement Property is acquired at a later date than the closing of the sale of the Relinquished Property. The exchange is not simultaneous or on the same day. This type of exchange is sometimes referred to as a "Starker Exchange" after the well known Supreme Court case which ruled in the taxpayer's favor for a delayed exchange before the Internal Revenue Code provided for such exchanges. There are strict time frames established by the Code and Regulations for completion of a delayed exchange, namely the 45-Day Clock and the 180-Day Clock (see detailed explanation below).

Reverse Exchanges

A Reverse Exchange (Title-Holding Exchange) is an exchange in which the Replacement Property is purchased and closed on before the Relinquished Property is sold. Usually the Intermediary takes title to the Replacement Property and holds title until the taxpayer can find a buyer for the Relinquished Property and close on the sale under an Exchange Agreement with the Intermediary. Subsequent to the closing of the Relinquished Property (or simultaneous with this closing), the Intermediary conveys title to the Replacement Property to the taxpayer. The IRS has issued safe harbor guidance on Reverse Exchanges (see below).

Improvement Exchanges

An Improvement Exchange (Title-Holding Exchange) is an exchange in which a taxpayer desires to acquire a property and arrange for construction of improvements on the property before it is received as Replacement Property. The improvements are usually a building on an unimproved lot, but can also include enhancements made to an already improved property in order to create adequate value to close on the Exchange with no boot occurring. The Code and Regulations do not take into account for exchange purposes improvements made to a property after the closing on the Replacement Property has occurred. Therefore, it is necessary for the Intermediary to close on, take title and hold title to the property until the improvements are constructed and then convey title to the improved property to the taxpayer as Replacement Property. Improvement Exchanges are done in the context of both Delayed Exchanges and Reverse Exchanges, depending on the circumstances. The IRS has issued safe harbor guidance on Reverse Exchanges (including title-holding exchanges for construction or improvement)

Question 53

The "Held For" Requirement for 1031 Property Received or Exchanged

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The "Held For" Requirement for 1031 Property Received or Exchanged In order to qualify for a 1031 Exchange, the Relinquished and the Replacement Properties must both have been acquired and "held for" investment or for use in a trade or business. The amount of time that the property must be "held for" use in a trade or business is not specified in either the Code or the Regulations. The position of the IRS has been that if a taxpayer's property was acquired immediately before an exchange, or if the Replacement Property is disposed of immediately after an exchange, it was not held for the required purpose and the "held for" requirement was not met. There is no safe harbor holding period for complying with the "held for" requirement. The IRS interprets compliance based on their view of the taxpayer's intent. Intent is demonstrated by facts and circumstances surrounding the taxpayer's acquisition of ownership of the property and what the taxpayer does with the property. The courts have been more liberal than the IRS on these issues. Here are some examples of transactions that should be considered to have potential for a finding by the IRS that the "held for" requirement has not been met:

The taxpayer acquires Replacement Property and immediately lists the property for sale. The IRS will interpret the intent to acquire the property for resale instead of for investment purposes.
The taxpayer receives the Relinquished Property by deed from a partnership and immediately proceeds to sell/exchange it (aka "drop and swap").
The taxpayer acquires Replacement Property and immediately converts the property to a personal residence.
The taxpayer acquires Replacement Property and immediately transfers the property to a corporation, partnership or LLC.

A cushion of time between events such as these is desirable to reduce the risk of possible "held for" issues in an exchange. Exchange Professionals recommend one year for the Replacement Property. The IRS has ruled that two years was adequate in a private letter ruling (Ltr Rul 8429039) but this was not made mandatory. In any event, the burden is on the taxpayer to support compliance with the "held for productive use in investment or a trade or business" requirement.

Question 54

Delayed Exchanges

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Delayed Exchanges - The Exchange Process and Time Clocks A taxpayer desiring to do a 1031 Exchange lists and/or markets the property for sale in the normal manner without regard to the contemplated 1031 Exchange. A buyer is found and a contract to sell the property is executed. Accommodation language is usually placed in the contract securing the cooperation of the buyer to the seller's intended 1031 Exchange, but such accommodation language is not mandatory. When contingencies are satisfied and the contract is scheduled for a closing, services of an Intermediary are arranged. The taxpayer enters into an Exchange Agreement with the Intermediary, which permits the Intermediary to become the "substitute seller" in accordance with the requirements of the Code and Regulations. The Exchange Agreement usually provides for:

An assignment, to the Intermediary, of the seller's Contract to Buy and Sell Real Estate.
A closing where the Intermediary receives the proceeds due the seller at closing. Direct deeding is used. The Exchange Agreement will comply with the requirements of the Code and Regulations wherein the taxpayer can have no rights to the funds being held by the Intermediary until the exchange is completed or the Exchange Agreement terminates. The taxpayer cannot touch the funds.
An interval of time where the seller proceeds to locate suitable Replacement Property and enter into a contract to purchase the property. The interval of time is subject to the 45-Day and 180-Day rules.
An assignment, to the Intermediary, of the contract to purchase Replacement Property.
A closing where the Intermediary uses the exchange funds in its possession and direct deeding to acquire the Replacement Property for the seller.

The 45-Day Rule for Identification. The first timing restriction for a delayed Section 1031 exchange is for the taxpayer to either close on the purchase of the Replacement Property or to identify the potential Replacement Property within 45 days from the date of transfer of the Relinquished Property. The 45-Day Rule is satisfied if Replacement Property is received before 45 days have expired. Otherwise, the identification must be by written document (the identification notice) signed by the taxpayer and hand delivered, mailed, faxed, or otherwise sent to the Intermediary. The identification notice must contain an unambiguous description of the Replacement Property. This includes, in the case of real property, the legal description, street address or a distinguishable name. The 45-Day Rule for Identification imposes limitations on the number of potential Replacement Properties, which can be identified and received as Replacement Properties. More than one potential Replacement Property can be identified by one of the following three rules:

The Three-Property Rule - Any three properties regardless of their market values.
The 200% Rule - Any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate FMV of all of the exchanged properties as of the initial transfer date.
The 95% Rule - Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified.

Although the Regulations only require written notification within 45 days, it is recommended practice for a solid contract to be in place by the end of the 45-day period. Otherwise, a taxpayer may find himself unable to close on any of the properties which are identified under the 45-day letter. After 45 days have expired, it is not possible to close on any property which was not identified in the 45-day letter. Failure to submit the 45-Day Letter causes the Exchange Agreement to terminate and the Intermediary will disburse all unused funds in his possession to the taxpayer. The 180-Day Rule for Receipt of Replacement Property. The Replacement Property must be received and the exchange completed no later than the earlier of

180 days after the transfer of the exchanged property or
The due date of the income tax return, including extensions, for the tax year in which the Relinquished Property was transferred.

The Replacement Property received must be substantially the same as the property that was identified under the 45-day rule described above. There is no provision for extension of the 180 days for any circumstance or hardship. There are provisions for extensions for presidentially declared disaster areas. As noted above, the 180-Day Rule is shortened to the due date of a tax return if the tax return is not put on extension. For instance, if an Exchange commences late in the tax year, the 180 days can be later than the April 15 filing date of the return. If the Exchange is not completed by the time for filing the return, the return must be put on extension. Failure to put the return on extension can cause the replacement period for the Exchange to end on the due date of the return. This can be a trap for the unwary.

Question 55

Reverse Exchanges

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Reverse Exchanges - The Exchange Process and Time Clocks Safe Harbor Reverse Exchanges - Rev. Proc. 2000-37 issued by the IRS on September 15, 2000 established recognition of and "safe harbor" guidance for Reverse Exchanges complying with the guidelines. These are known as "Safe Harbor Reverse Exchanges." Reverse Exchanges which are not in compliance with the guidelines are not prohibited by Rev. Proc. 2000-37 but must stand or fall on their own merits and are referred to as "Non-Safe Harbor Reverse Exchanges." Reverse Exchanges of either type are common and occur when a taxpayer arranges for an Exchange Accommodation Titleholder (EAT) (usually the Intermediary) to take and temporarily hold title to Replacement Property before a taxpayer finds a buyer for his Relinquished Property. Sometimes the exchange accommodation titleholder will take and hold title to the Relinquished Property until a buyer can be found for it. Reverse Exchanges of either type are useful in circumstances where a taxpayer needs to close on the purchase of Replacement Property before a Relinquished Property can be sold or where the taxpayer desires ample time to search for suitable Replacement Property before selling a Relinquished Property which starts the 45-day and 180-day clocks for Delayed Exchanges. Reverse Exchanges are also common where a taxpayer wants to acquire a property and construct improvements on it before taking title to the property as Replacement Property. This is necessary if the value of the improvements is important for replacing with property of equal or greater value in order to avoid a taxable "trade-down." Rev. Proc. 2004-51 issued in 2004 added an additional requirement for Reverse Exchanges to be under the safe harbor "umbrella." Any property which has been previously owned by the taxpayer within the prior 180 days is declared ineligible for protection under the Rev. Proc. 2000-37 safe harbor procedures. The Safe Harbor Reverse Exchange Time Clocks. The safe-harbor procedures impose compliance requirements which require analysis for impact and planning that can be summarized as follows: The 5-Day Rule. A "Qualified Exchange Accommodation Agreement" must be entered into between the taxpayer and the exchange accommodation titleholder (Qualified Intermediary in most cases) within five business days after title to property is taken by the exchange accommodation titleholder in anticipation of a Reverse Exchange. The 45-Day Rule. The property to be "relinquished" (the Relinquished Property) must be identified within 45 days. More than one potential property to be sold can be identified in a manner similar to the rules of delayed exchanges (i.e., the three-property rule, the 200% rule, etc.) The 180-Day Rule. The Reverse Exchange must be completed within 180 days of taking title by the exchange accommodation titleholder. The 180-Day Clock. as with Delayed Exchanges, Reverse Exchanges must be completed within 180 days. Prior to the issuance of Rev. Proc. 2000-37 there was no statutory limitation of time in which to be in title. It was common for the Exchange Accommodation Titleholder to be in title on the parked property for a year or more. The taxpayer would search for a buyer for his Relinquished Property or have improvements constructed on the property being held by the Titleholder. 180 days may be a suitable time for a buyer to be found for the Relinquished Property. However, 180 days is a problem with respect to construction/improvement exchanges. The 180 day time limit within which to complete a Safe Harbor Reverse Exchange is probably insufficient for most large "build to suit" exchanges. What if the taxpayer has not yet found a buyer for his Relinquished Property by the end of 180 days? In this case, the taxpayer can discontinue his attempt to accomplish a Reverse Exchange and take deed to the Replacement Property. The taxpayer may decide to extend his Reverse Exchange outside of the protection of the safe harbor procedures. The safe harbor guidance issued by the IRS is not mandatory. Reverse Exchanges that do not comply with the requirements of Rev. Proc. 2000-37 stand or fall on their own merits and should be considered to have a higher degree of audit risk. Rev. Proc. 2000-37 imposes responsibilities and burdens on the Exchange Accommodator Titleholder. The Accommodator is required to report, for federal income tax purposes, the "tax attributes" of ownership of the property it is in title on. Rents and expenses attributed to ownership of the property may have to be reported by the Accommodator. It is unclear if the Accommodator has to also report depreciation on the property it is in title on just as a true owner would be compelled to do.

Question 56

Qualified Intermediaries

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The Role Of the Qualified Intermediary The role of the Qualified Intermediary is essential to completing a successful and valid delayed exchange. The Qualified Intermediary is the glue that puts the buyer and seller of property together into the form of a 1031 Exchange. Where such an intermediary (often called an exchange facilitator) is used, the intermediary will not be considered the agent of the taxpayer for constructive receipt purposes notwithstanding the fact that he may be an agent under state law and the taxpayer may gain immediate possession of the money or property under the laws of agency. In order to take advantage of the qualified intermediary "safe harbor" there must be a written agreement between the taxpayer and intermediary expressly limiting the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the intermediary. A Qualified Intermediary is formally defined as a person who is not the taxpayer or a disqualified person and who enters into a written agreement (the "exchange agreement") with the taxpayer. The Qualified Intermediary acquires the Relinquished Property from the taxpayer, transfers the Relinquished Property to the buyer, acquires the Replacement Property and transfers the Replacement Property to the taxpayer. The Qualified Intermediary does not actually have to receive and transfer title as long as the legal fiction is maintained. The Intermediary can act with respect to the property as the agent of any party to the transaction and further, an Intermediary is treated as entering into a contract for sale if the rights of a party to the contract are assigned to the Intermediary and all parties to the contract are notified in writing of the assignment on or before the date of the relevant transfer of property. This provision allows a taxpayer to enter into a contract for the transfer of the Relinquished Property and thereafter to assign his rights in the contract to the Intermediary. Providing all parties to the agreement are notified in writing of the assignment on or before the date of the transfer of the Relinquished Property, the intermediary is treated as having entered into the contract and after completion of the transfer, as having acquired and transferred the Relinquished Property. There are no licensing requirements for Intermediaries established by the IRS. They need merely be not an unqualified person as defined by the Internal Revenue Code in order to be qualified. The Code prohibits certain "agents" of the taxpayer from being qualified. Accountants, attorneys and realtors who have served taxpayers in their professional capacities within the prior two years are disqualified from serving as a Qualified Intermediary for a taxpayer in an exchange. Related parties are also disqualified. Criteria for Selecting a Qualified Intermediary Intermediaries serve as a limited purpose depository institution and hold all of the Exchange Cash during the course of a 1031 Exchange. As a result, Intermediaries usually hold substantial sums of money on behalf of their exchange clients. With the exception of a few states, including Nevada, California, Idaho, Colorado and Arizona, there are no federal or state regulations or supervision of Intermediaries. Taxpayers are unsecured creditors when an Intermediary becomes bankrupt or insolvent. Funds held by Intermediaries are invested in a variety of ways, including pooled cash funds with stock brokerages and segregated liquid asset money market accounts. Obviously, the selection of an Intermediary who will be entrusted with the funds of a 1031 Exchange is an important matter. Intermediaries offer widely varying services and have widely varying professional training, skills and competence. Intermediaries are usually attorneys, tax accountants, bank affiliates, title company affiliates or realtors. Many Intermediaries have no training as a tax professional or as an exchange professional and offer no consultation to a taxpayer on tax issues related to the exchange or on the technical requirements for completion of a successful exchange. Some Intermediaries simply bank funds. Intermediaries take their fees or compensation in a variety of ways. Some Intermediaries charge little or no fees for their services and retain all or a portion of the interest earned on the funds in their possession. Some Intermediaries charge higher fees for their services and forward all interest earned on funds in their possession to the client at the end of the exchange. Some do a little of both. Interest earned on funds held by an Intermediary can vary widely also, depending on where the funds are invested or held on deposit. Here are some of the things taxpayers should consider when engaging the services of an Intermediary:

Does the Intermediary have tax professionals or Certified Exchange Specialists capable of consulting you on 1031 tax issues?
Does the Intermediary deposit Exchange Funds in segregated and FDIC insured accounts?
Is the Intermediary a member of the Federation Of Exchange Accommodators, a professional organization that expects its members to perform services at the highest level of competence and trust?
Does the Intermediary have experience and a verifiable reputation?
Is the Intermediary willing to meet with you, consult with you on exchange strategies, issues and execution of exchange documents?
Is the Intermediary bonded with a fidelity bond?
Are Exchange Funds available for disbursement within 24 hours?
Does the Intermediary manage closings in order to avoid inadvertent boot and related taxes, which can cost you more than the fees they charge?

Question 57

Boot Rules

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The Rules of “Boot” in a Section 1031 Exchange A Taxpayer Must Not Receive “Boot” from an exchange in order for a Section 1031 exchange to be completely tax free. Any boot received is taxable (to the extent of gain realized on the exchange). This is acceptable when a seller desires some cash and is willing to pay some taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be tax free. The term “boot” is not used in the Internal Revenue Code or the Regulations, but is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange. Boot received is the money, debt relief or the fair market value of “other property” received by the taxpayer in an exchange. Money includes all cash equivalents received by the taxpayer. Debt relief is any net debt reduction which occurs as a result of the exchange taking into account the debt on the Relinquished Property and the Replacement Property. “Other property” is property that is non-like-kind such as personal property received in an exchange of real property, property used for personal purposes, or “non-qualified property.” “Other property” also includes a promissory note received from a buyer (Seller Financing). Boot can be in advertent and result from a variety of factors. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided. The most common sources of boot include the following:

Cash boot received during the exchange. This will usually be in the form of “net cash received” at the closing of either the Relinquished Property or the Replacement Property.
Debt reduction boot which occurs when a taxpayer’s debt on Replacement Property is less than the debt which was on the Relinquished Property. As with cash boot, debt reduction boot can occur when a taxpayer is “trading down” in the exchange.
Sale proceeds being used to service costs at closing which are not closing expenses. If proceeds of sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to bring cash to the closing of the sale of their Relinquished Property to pay for the following non-transaction costs:
- Rent prorations.
- Utility escrow charges.
- Tenant damage deposits transferred to the buyer.
- Property tax prorations? Possibly, see explanation below.
- Any other charges unrelated to the closing.

Tax prorations on the Relinquished Property settlement statement can be considered as service of debt based on PLR 8328011. Under this rationale exchange cash used to service tax prorations should not result in taxable boot. However, taxpayers may want to bring cash to the Relinquished Property closing anyway in order to resolve this issue. Excess borrowing to acquire Replacement Property. Borrowing more money than is necessary to close on Replacement Property will cause cash being held by an Intermediary to be excessive for the closing. Excess cash held by an Intermediary is distributed to the taxpayer, resulting in cash boot to the taxpayer. Taxpayers must use all cash being held by an Intermediary for Replacement Property. Additional financing must be no more than what is necessary, in addition to the cash, to close on the property. Loan acquisition costs for the Replacement Property, which are serviced from exchange funds being brought to the closing. Loan acquisition costs include origination fees and other fees related to acquiring the loan. Taxpayers usually take the position that loan acquisition costs are being serviced from the proceeds of the loan. However, the IRS may take a position that these costs are being serviced from Exchange Funds. There is no guidance which is helpful in the form of Treasury Regulations on this issue at the present time. Non-like-kind property which is received from the exchange, in addition to like-kind property (real estate). Non-like-kind property could include the following:

Seller financing, promissory note.
Furniture and fixtures acquired with purchase of real estate.
Sprinkler equipment acquired with farm land.

Boot Offset Rules – Only the net boot received by a taxpayer is taxed. In determining the amount of net boot received by the taxpayer, certain offsets are allowed and others are not, as follows:

Cash boot paid offsets cash boot received (but only at the same closing table).
Cash boot paid at the Replacement Property closing table does not offset cash boot received at the Relinquished Property closing table (Reg. section 1.1031(k)-1(j)(3) Example 2). This rule probably also applies to inadvertent boot received at the Relinquished Property closing table because of prorations, etc. (see above).
Debt incurred on the Replacement Property offsets debt-reduction boot received on the relinquished property.
Cash boot paid offsets debt-reduction boot received.
Debt boot paid never offsets cash boot received (net cash boot received is always taxable).
Exchange expenses (transaction and closing costs) paid offset net cash boot received.

Rules of Thumb:

Always trade “across” or up. Never trade down (the “even or up rule”). Trading down always results in boot received, either cash, debt reduction or both. The boot received is mitigated by exchange expenses paid.
Bring cash to the closing of the Relinquished Property to pay for charges which are not transaction costs (see above).
Do not receive non-like-kind property (or if you do, pay for it).
Do not over finance Replacement Property. Financing should be limited to the amount of money necessary to close on the Replacement
Property in addition to exchange funds which will be brought to the Replacement Property closing.

Question 58

Related Party Exchanges

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Related Party Exchanges (Two-Year Holding Period Requirement) Exchange of property between related parties. There is a special rule for exchanges between related parties (IRC §1031(f)), which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years following the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two-year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs. Sale to an unrelated party, replacement from a related party. A taxpayer will often desire to sell to an unrelated party and receive Replacement Property from a related party. This type of related party transaction does not work, according to the IRS, if the related party receives cash (Rev. Rul. 2002-83). The IRS reasons that if the taxpayer or a related party “cashes out” of property in this manner, IRC §1031(f)(4) “kicks in” and the exchange is disallowed. However, if the related party is also doing an exchange (and is not “cashing out”) then it is okay to receive Replacement Property from a related party according to PLR 200440002 and PLR 200616005. Sale to a related party, replacement from an unrelated party. A taxpayer will often sell to a related party but receive Replacement Property from an unrelated party. This is OK but it has been unclear whether the related party was required to hold the property it acquired from the taxpayer for two years. Instructions to Form 8824 seem to imply that the two-year rule applies. However, PLR 200706001, PLR 200712013 and PLR 200728008 released in 2007 say that the two-year rule does not apply to a related party who purchased the Relinquished Property from the taxpayer. Related parties under the rules are the following:

Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.);
An individual and a corporation when the individual owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
Two corporations that are members of the same controlled group as defined in IRC §1563(a), except that “more than 50%” is substituted for “at least 80%” in that definition;
A trust fiduciary and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation;
A grantor and fiduciary, and the fiduciary and beneficiary, of any trust;
Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts;
A tax-exempt educational or charitable organization and a person who, directly or indirectly, controls such an organization, or a member of that person’s family;
A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital interest, or profits interest, in the partnership;
Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation;
Two corporations, one of which is an S corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; or
An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.
Two partnerships if the same persons own directly, or indirectly, more than 50% of the capital interests or profits in both partnerships, or
A person and a partnership when the person owns, directly or indirectly, more than 50% of the capital interest or profits interest in the partnership.

A disqualifying disposition does not include dispositions by reason of the death of either party, the compulsory or involuntary conversion of the exchanged property if the exchange occurred before the threat or imminence of the conversion, or dispositions where it is established to the satisfaction of the IRS that neither the exchange nor the disposition had as one of their principal purposes the avoidance of federal income tax.

Question 59

Multiple Asset Exchanges Involving Like Kind and Non Like Property

Accepted Answer

Multiple-Asset Exchanges

A Multiple-Asset Exchange occurs when a taxpayer is selling/exchanging a property which includes more than one type of asset. A common example is a farm property including a personal residence.

The Treasury Department has issued Regulations, which govern how multiple-asset exchanges are to be reported. The Regulations establish "exchange groups" which are separately analyzed for compliance with the like-kind replacement requirements and rules of boot. Farmland must be replaced with qualifying like-kind real property. A personal residence is not 1031 property and is accounted for under the rules applicable to the sale of a personal residence.

The Multiple-Asset Regulations are ambiguous concerning how the personal residence portion of a multiple-asset exchange should be accounted for. However, it is common practice for the closing on the Relinquished Property to be bifurcated into two separate closings; one for the personal residence and the other for the remainder of the property. The proceeds applicable to the sale of the personal residence are usually disbursed to the taxpayer and not retained by the Intermediary in the exchange escrow. The balance of the proceeds is retained by the Intermediary for use in acquiring like-kind Replacement Property under the Exchange Agreement.

Another common example of multiple-asset exchanges is a real property sale that includes personal property (i.e. furniture and appliances). Hotel properties are a good example of a multiple-asset exchange including real and personal property.

Even a sale/exchange of a rental property includes a combination of real and personal property. In practice, the value of the personal property that is transferred with a rental property is commonly disregarded for calculation and income tax reporting purposes. However, there is no de minimus rule which permits a taxpayer to disregard the value of personal property, even if it is nominal.

The Multiple-Asset Regulations are complex and require the services of YAHNIAN LAW CORPORATION for analysis purposes and income tax reporting. The tax professional is essential and will help in determining values, allocations of sale price and purchase prices to the elements of the transaction. Exchanges that include personal property of significant value should be referenced in the contract as it is non-qualifying property.

Question 60

Partnership and Co Ownership Issues

Accepted Answer

Partnership And Co-Ownership Issues

Investment real estate is commonly owned by co-owners in a partnership containing two or more partners or by co-owners as tenants in common. An exchange of a tenant in common interest in real estate poses no problems and is eligible for 1031 Exchange treatment. However, an exchange of an interest in a partnership is not permitted under the Code and Regulations.

If a partnership owns property and desires to sale/exchange the property, then the partnership is the entity that is the Exchanger and party to the Exchange Agreement. The partnership will take title to the Replacement Property.

Frequently, individual partners in a partnership desire to take their share of the proceeds of sale of the partnership property, replace with qualifying 1031 Replacement Property in their own names and end their relationship with the partnership. This presents problems that require careful planning and is not without tax risk.

If a partnership involving two or more partners wishes to discontinue the partnership, sell the property, and go their separate ways with either the cash or a 1031 Exchange, it is necessary for the individual partners to receive deed to the property in advance of the sale. This is done in the context of a distribution of property from the partnership to its partners who then hold the property as tenants in common. Each individual partner then is positioned to sell or exchange his tenancy in common ownership in the real estate. This is known in the industry as a "drop and swap" and is often done at the same closing table. However, it is better for the "drop" to be performed some time before the "swap" is done in order to comply with the "held for investment" rule by the individual partners. Simultaneous "drop and swaps" have been challenged in past years by the IRS. The courts have been more lenient.

If a partnership with multiple partners wishes to exchange property in the name of the partnership but some of the partners want to "cash out" or go separate ways, it is common for the partnership to do a "split-off." The partnership distributes tenancy in common title to a portion of the partnership property to those individual partners who wish to proceed in separate directions, and the partnership (and its remaining partners) proceed with an exchange in the name of the partnership.

The services of YAHNIAN LAW CORPORATION are essential for tax planning and structuring for successful exchanges of partnership and co-ownership interests in real estate.

Question 61

Tenancy in Common Interests (TICs)

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What is a TIC? (Tenancy In Common Investments) Tenancy in common investments (“TIC” or “TIC Investments”) have become a booming industry in the United States in recent years. A tenancy in common investment (better known as a TIC) is an investment by the taxpayer in real estate which is co-owned with other investors. Since the taxpayer holds a deed to real estate as a tenant in common, the investment qualifies under the like-kind rules of IRC §1031. TIC investments are typically made in projects such as apartment houses, shopping centers, office buildings, etc. TIC sponsors arrange TIC syndications to comply with the limitations specified by the IRS with Rev Proc 2002-22 which, among other things, limits the number of investors to 35. This type of an investment can appeal to taxpayers who are tired of managing real estate. TICs can provide a secure investment with a predictable rate of return on their investment. Management responsibilities are provided by management professionals. Cash returns on these types of investments are typically in the 6% to 7% range. Syndicators of TICs are called “sponsors.” Investment offerings can be made directly by the sponsor or by brokers who can assist taxpayers with an assortment of offerings currently on the market. TIC investments are treated by most sponsors as securities because they meet the definition of securities either in the state where the property resides or in the various states where the sponsor intends to offer the investment for sale. The SEC has not ruled on this issue but most states are quite clear in their statutes that these investments are securities under state law. This means that only licensed security dealers may market these investments. However, even though the investments may be securities under state law, the investment is a real estate investment for purposes of §1031. Some sponsors of TIC investments structure their TIC so that the investment is a real estate investment not subject to state security laws. Usually this means that the TIC sponsor will not be responsible for management of the investment and independent management will be employed. TIC investments are commonly structured in one of the following ways:

A single-tenant property with an established credit rating,
Multiple tenants subject to a single master lease with the TIC sponsor who subleases to the tenants,
Multiple tenants each with separate leases managed by professional management.

Taxpayers considering a TIC investment should be prepared for an investment which may last for several years with limited liquidity. As with any other real estate investment, an investment in a TIC can be subject to various business risks. Taxpayers should research track records and management performance of sponsors who are offering TIC investments. They should also carefully review any available proforma operating statements and prospectus. A financial advisor should be consulted when necessary.

Question 62

Attorneys, CPAs, Financial Planners and Realtors Information

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What Attorneys, CPAs, Financial Planners and Realtors Should Know About 1031 Exchanges Business Advisors, including Attorneys, CPAs and Financial Planners as well as Realtors are Often the First to Recognize the Potential Benefits of a Section 1031 Exchange to a seller of real estate. When a seller is going to replace qualifying real estate with replacement real estate, a Section 1031 Exchange should be suggested. It is possible for a seller to employ the services of an Exchange Intermediary at any time after a contract is executed up to the day of closing on the contract. It is too late after the closing has occurred. Accommodation Language in the Contract. Accommodation language is usually placed in the Contract to Buy and Sell Real Estate wherein the other party to the contract is informed and agrees to cooperate with the 1031 exchange. Typical accommodation language might read as follows:

For a Seller – “A material part of the consideration to the seller for selling is that the seller has the option to qualify this transaction as a tax deferred exchange under Section 1031 of the Internal Revenue Code. Purchaser agrees to cooperate in the exchange provided purchaser incurs no additional liability, cost or expense.”
For a Buyer – “This offer is conditional upon the seller’s cooperation at no cost to allow the purchaser to participate in an exchange under Section 1031 of the Internal Revenue Code at no additional cost or expense. Seller hereby grants buyer permission to assign this Contract to an Intermediary not withstanding any other language to the contrary in this Contract”.

Accommodation language is not mandatory and can be omitted if it puts the taxpayer at a disadvantage for other parties to know about his plan to sell and replace property under IRC §1031 and related closing pressures under the exchange ’time clocks.” Assignment of Contracts. If a Realtor knows that a buyer intends to assign the contract to an Intermediary in connection with an exchange, it is helpful to reference the buyer as “John Doe or Assigns” on the contract. Another way to make the contract “assignable” is for an addendum to the contract to be prepared by the Realtor making the contract “assignable.” Settlement Statements. Section 1031 of the Internal Revenue Code imposes no requirements and provides no guidance with respect to preparation of settlement statements for an exchange of property. The Colorado Real Estate Commission has no special requirements concerning exchanges involving an Intermediary. Intermediaries often instruct closers to name the Intermediary as the seller of a property on behalf of their client. This is not required by IRC §1031 and creates additional closing burdens since it requires the Intermediary to sign the settlement statements. An occasional (but unnecessary) practice is for the title company closing on the transaction to prepare a second set of settlement statements in which the Intermediary is shown as a buyer and seller. The Intermediary’s set of statements “mirror” each other as to debits and credits. The thinking here is that the settlement statements should reflect a “chain of title.” This practice is not required by IRC §1031. Recommendation: prepare one set of settlement statements in the normal manner which total to zero proceeds due to or from the Exchanger. The settlement statements should be made to total to zero proceeds due to or from the Exchanger by showing a debit or credit for “Exchange Funds – 1031 Corporation” as a transaction item “above the bottom line”. The amount of “Exchange Funds” is the amount of funds being transferred to or from the Intermediary in connection with the closing.

Question 63

Vacation Homes

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Vacation Homes and 1031 Exchanges Can a vacation home qualify for a 1031 Tax-Deferred Exchange? Most tax and exchange professionals think so to the extent that the vacation home is used partly for rental purposes. For instance, if the vacation home is used 50% for personal use and 50% for rental or investment purposes, then 50% of the property is qualifying property held for investment purposes under IRC § 1031. The personal use portion of the vacation home will not be eligible for 1031 Exchange treatment. If the vacation home is used 100% for personal use, forget it _ it does not qualify under IRC §1031. What if the vacation home is used partly for personal use and partly for investment purposes but is never rented out? In this case, the answer is “it depends.” It depends on the amount of personal use of the property by the taxpayer. Property held for personal use does not qualify as investment property (IRC § 1031(a)). However, mere incidental personal use of property that is otherwise considered investment property does not disqualify the property from 1031 Exchange treatment (PLR 8103117). “Incidental personal use” is not defined by the Code, Regs. or by other guidance issued by the IRS. Personal use of a vacation home for anything other than “incidental personal use” will disqualify a property if it is never rented out by a taxpayer. Under what circumstances can all of the vacation home (100%) qualify for a 1031 Exchange? Code Section 280A(d) provides that a taxpayer’s dwelling is a 100% rental property (and not a “residence”) if the taxpayers personal use of the property is less than the greater of -

15-days, or
10% of the number of days during the year for which the dwelling is rented (at fair market value rents).

Personal use includes use by members of the taxpayer’s family. Personal use does not include work-days a taxpayer is at the residence. The purpose of IRC §280A is to limit deductions with respect to the rental use of a residence. Does 280A also define a property for purposes of a 1031 Exchange? Most tax and exchange professionals do not think so. However, compliance with the minimal personal use provisions under IRC §280A could be considered to be a “good bet” for qualification of the property as a 100% eligible property for 1031 Exchange treatment. Also, see (below) the new “safe-harbor” Rev. Proc. Issued by the IRS in March 2008 which uses language similar to IRC §280A. If none of these rules will work for a taxpayer because of disqualifying personal use of the vacation home, then the taxpayer should consider converting the property to a qualifying investment property by discontinuing all personal use for a year or more to position the property for a 1031 Exchange. At the same time, be sure to report all of expenses related to the property as “investment related expenses.” Renting the property will be a definite help for this purpose but is not mandatory. Safe Harbor - The IRS issued Rev. Proc. 2008-16 in March, 2008 for taxpayers who want assurance that their vacation home is a qualifying investment. The Rev Proc applies to any residence owned by the taxpayer in addition to a primary residence so it is broader in its application than to mere “vacation homes.” It is effective for exchanges of homes occurring after March 9, 2008. The IRS says they will not challenge whether a residence qualifies as property held for use in a trade or business or for investment for purposes of §1031 if the following requirements are met: The relinquished residence is owned by the taxpayer during the 24-month period ending on the day before the date of the exchange, The replacement residence is owned by the taxpayer during the 24-month period beginning on the day after the date of the exchange, and Within each of the two 12-month periods immediately before the exchange and within each of the two 12-month periods immediately after the exchange – the residence is rented to another person or persons at a fair rental for at least 14 days, and the period of personal use does not exceed the greater of 14 days or 10% of the days the residence is rented at a fair rental. Personal Use - Rev Proc 2008-16 provides that personal use occurs on any day on which a taxpayer is treated as having used the dwelling unit for personal purposes under §280A(d)(2) (taking into account §280A(d)(3) but not §280A(d)(4)). Therefore, a taxpayer is generally treated as using a residence for personal purposes for a day if the unit is used for personal purposes by: The taxpayer or any other person who has an interest in the dwelling unit or by a member of the family of the taxpayer or the other person; Any individual who uses the unit under a reciprocal use arrangement; or By any individual (other than an employee whose use is excludable from income under §119-Use for the convenience of the employer) unless, for that day, the dwelling unit is rented for a fair rental. Fair Rental - A “fair rental” is determined based on all the facts and circumstances when entering the rental agreement Failure to meet the new safe-harbor requirements does not mean that the exchange automatically does not qualify for §1031 treatment. But it does mean that the IRS could challenge the taxpayer’s exchange. IRS Issues Safe Harbor for 1031 Exchanges of Residences (Including Vacation Homes) Rev Proc 2008-16 provides a “safe harbor” for dwelling units given and received in an exchange will qualify for §1031 treatment. This Rev Proc is only a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies as property held for use in a trade or business or for investment for purposes of §1031. Failing to meet the safe harbor should not mean that the exchange automatically does not qualify for §1031 treatment. A dwelling unit is real property with a house, apartment, condominium, or similar improvement that provides basic living accommodations, including sleeping space, bathroom and cooking facilities. Therefore, a dwelling unit is a residence. Safe-Harbor - The IRS says they will not challenge whether a dwelling unit qualifies as property held for use in a trade or business or for investment for purposes of §1031, if the following requirements are met:

The relinquished residence is owned by the taxpayer during the 24-month period ending on the day before the date of the exchange,
The replacement residence is owned by the taxpayer during the 24-month period beginning on the day after the date of the exchange, and
Within each of the two 12-month periods immediately before and after the exchange, the residence is rented to another person or persons at a fair rental for at least 14 days, and
the period of personal use does not exceed the greater of 14 days or 10% of the days the residence is rented at a fair rental.

Personal Use - Rev Proc 2008-16 provides that personal use occurs on any day on which a taxpayer is treated as having used the dwelling unit for personal purposes under IRC §280A(d)(2) (taking into account §280A(d)(3) but not §280A(d)(4)). Therefore, a taxpayer is generally treated as using a residence for personal purposes for a day if the unit is used by: The taxpayer or any other person who has an interest in the dwelling unit or by a member of the family of the taxpayer or the other person; Any individual who uses the unit under a reciprocal use arrangement; or By any individual (other than an employee whose use is excludable from income under §119-Use for the convenience of the employer) unless, for that day, the dwelling unit is rented for a fair rental.

Question 64

Like Kind Exchange Glossary, Terms and Vocabulary

Accepted Answer

Basic §1031 Exchange Vocabulary

Code Sec. 1031 practitioners commonly use the following words when advising regarding Code Sec. 1031 exchanges or discussing Code Sec. 1031 issues.

(g)(6) Restrictions:

Restrictions imposed by the Income Tax Regulations and the exchange agreement that prohibit the early distribution of the exchange proceeds. The (g)(6) restrictions help avoid the exchanger's constructive receipt of the exchange proceeds.

Accommodation Titleholder:

An individual or other legal entity engaged by the exchanger to hold title to replacement property or in rare cases, relinquished property, to facilitate a parking transaction. This term is generally used to define the accommodator in non-safe harbor parking transactions.

Adjusted Tax Basis:

The adjusted tax basis of property used to compute gain or loss on the disposition of property and to compute depreciation. As a general rule, the adjusted tax basis is the acquisition cost, plus the cost of capital improvements, less depreciation.

Boot:

Money or non like-kind property consideration received in connection with an exchange.

Constructive Receipt:

A technical federal income tax concept that treats an exchanger as receiving property or cash even though such payment of cash is not legally transferred to the exchanger. Generally, an exchanger is in constructive receipt of property or cash if the exchanger has the unrestricted use of the property or cash. Receipt by a qualified intermediary of the exchange proceeds should avoid constructive receipt.

Dealers and Developers:

Dealers and developers are individuals or other legal entities that generally hold property for resale. Such property does not qualify for Code Sec. 1031 treatment. Dealer and developers may, however, exchange property held for investment or use in a trade or business if certain requirements are satisfied.

Exchange Accommodation Agreement:

A contract entered into between the exchanger and an exchange accommodation titleholder providing that the exchange accommodation titleholder will take title to either the replacement property or relinquished property and hold it under the exchanger's supervision.

Exchange Accommodation Titleholder:

An individual or other legal entity engaged by the exchanger to hold title to replacement property or, in rare cases, relinquished property, to facilitate a parking transaction. This term is generally used to define the accommodator in safe harbor parking transactions.

Exchange Agreement:

A contract entered into between an exchanger and a qualified intermediary providing, among other things, that the qualified intermediary will facilitate the exchange and hold the Exchange Proceeds subject to the (g)(6) Restrictions.

Exchange Clauses or Cooperation Clause:

The earnest money contract or purchase and sale agreement begin the paper trail that distinguishes the transaction as a Code Sec. 1031 exchange. An exchange or cooperation clause helps establish the exchanger's intent to make an exchange and further seeks cooperation from the other party to accept an assignment of the sales contract.

Exchange Facilitator:

A general term used to refer to those individuals or other legal entities that facilitate Code Sec. 1031 exchanges. The term exchange facilitator is broad enough to include qualified intermediaries and exchange accommodation titleholders.

Exchange Period:

That period ending 180 days following the date the relinquished property is transferred. The exchange period will be cut short if the exchanger files the tax return for the taxable year of the exchange prior to the 180th day. The first day of the exchange period is the day after the transfer of the relinquished property.

Exchange Proceeds:

Consideration received for the relinquished property. Generally, in a deferred multi-party exchange, a qualified intermediary receives exchange proceeds.

Exchanger:

An individual or entity pursuing a Code Sec. 1031 exchange.

Identification Period:

That period ending forty-five (45) days following the date the relinquished property is transferred by the exchanger. The first day of the identification period is the day after the transfer of the relinquished property.

Qualified Intermediary:

An individual or other legal entity that satisfies several requirements in the Income Tax Regulations. Qualified intermediaries are often used to facilitate Code Sec. 1031 exchanges.

Realized Gain:

The realized gain is the difference between the sales price received for a property and its adjusted tax basis.

Recognized Gain:

That portion of the realized gain that is required to be reported as income on a federal income tax return.

Related Parties:

The parties related to the exchanger as defined by Code Sec. 267(b) and Code Sec. 707(b)(1) . The definition of related party includes, but is not limited to, a spouse, ancestors, descendants, and brothers and sisters. Not related to the exchanger are aunts, uncles, cousins, nieces and nephews, in-laws, ex-spouse, employees, business associates, and friends. Further, corporations and partnerships are related to the exchanger if the exchanger owns more than a fifty percent (50%) interest in such entity. As discussed in the section on related parties, the group of persons treated as related parties is quite large and sometimes complicated to determine.

Relinquished Property:

Property an exchanger transfers in an exchange.

Replacement Property:

Property an exchange identifies and ultimately receives in an exchange.

Safe Harbor:

Structure approved by the IRS, which if followed, will produce a foreseeable tax consequence. For example, the use of a qualified intermediary or exchange accommodation titleholder under the Income Tax Regulations and Rev. Proc. 2000-37 creates safe harbors. Following the rules pertaining to these safe harbors allows an exchanger to know the tax consequences of a transaction. Structuring a transaction outside the safe harbors creates some uncertainty regarding the tax consequences of the transaction.

Sales Price:

The contract price of the property less closing costs. Also referred to as the net sales price.

Seller Financing:

A financing arrangement under which the seller of property provides the buyer with the financing needed to acquire the property. The financing is often a note from the buyer secured by the property without money changing hands.

At-risk limitations: The at-risk limitations are provisions of IRC §465 that limit a taxpayer's deductible loss for income tax purposes to the amount that the taxpayer has at risk in the activity generating the loss. Because the at-risk limitations apply to real property, a taxpayer can deduct losses from a real property investment only to the extent of the amounts personally invested or for which the taxpayer is personally liable (recourse debt).

Buyer: In this book, buyer refers to the party that ultimately acquires the relinquished property on completion of the exchange transaction.

Buyer cooperating three-party exchange: A buyer cooperating three-party exchange is one in which the buyer of the relinquished property acts as the intermediary in the exchange by acquiring the replacement property from the seller and conveying it to the taxpayer in exchange for the relinquished property.

Chief Counsel advice: Chief Counsel advice refers to written guidance issued by the National Office of the Chief Counsel of the Internal Revenue Service to the IRS and Treasury (IRC §6110(i)). This guidance takes a variety of forms including Chief Counsel memorandums (CCM), general counsel memorandums (GCM), field attorney advice (FAA), and field service advice (FSA). The purpose of Chief Counsel advice is to advise IRS personnel on legal matters at varying stages of development. Chief Counsel advice cannot be cited as precedent (see IRC §6110(k)(3)), although it may influence an agent or appellate conferee's evaluation of a matter. See §1.13. See also General counsel memorandum; Field service advice.

Chief Counsel memorandum: See Chief Counsel advice.

Escrow agents or officers: In real property transactions, the escrow agent or officer is the entity or person that receives documents and funds from the principals in the transaction (e.g., the buyer, seller, and exchanger), holds the documents and funds, and delivers them on the occurrence of specified conditions in accordance with instructions from the principals. In some regions, escrow agents are employed to structure the exchange itself.

Exchange counterparty: In all exchange transactions, the taxpayer actually does or is deemed to swap properties with another party referred to as the exchange counterparty. In a deferred exchange, when the buyer of relinquished property and the seller of replacement property are different parties, an intermediary generally serves as the exchange counterparty.

Exchange equity credit: Exchange equity credit is the amount held by the intermediary in a deferred exchange, for the benefit of the exchanger, after selling the relinquished property. The intermediary applies the exchange equity credit to one or more items of replacement property.

Exchange escrow: An exchange escrow is the escrow through which properties are exchanged between two parties. In a seller-cooperating three-party exchange, the taxpayer and the seller are the parties to the exchange escrow. See §1.40. In a buyer-cooperating three-party exchange, the buyer and the taxpayer are the parties to the exchange escrow. In a four-party exchange, there is typically no exchange escrow; rather, the deeds for transferring the properties between the taxpayer and the intermediary are recorded as an accommodation in the sale escrows.

Exchanger: Exchanger is a term often used in exchange agreements to describe the taxpayer, i.e., the party intending to complete an exchange to obtain nonrecognition treatment under IRC §1031. See also Taxpayer.

Facilitator: See Intermediary.

Field attorney advice: See Chief Counsel advice.

Field service advice: A field service advice is a memorandum prepared by the National Office of the Chief Counsel of the Internal Revenue Service, analyzing issues presented by an agent relating to an ongoing audit. Unlike letter rulings and technical advice memorandums, a field service advice is not binding, although it generally influences an agent or appellate conferee's evaluation of a case. Field service advice may not be cited as authority or precedent in any tax controversy. See also Chief Counsel advice; Letter rulings; Technical advice memorandum.

Four-party exchange: A four-party exchange involves the taxpayer, the buyer, the seller, and an independent intermediary to facilitate the exchange. The taxpayer transfers the relinquished property to the intermediary, who sells it to the buyer, uses the proceeds to purchase the replacement property from the seller, and then transfers the replacement property to the taxpayer. A four-party exchange can be simultaneous or nonsimultaneous.

General counsel memorandums: General counsel memorandums (GCM) are legal memorandums prepared by the National Office of the Chief Counsel to provide legal advice to branches of the Internal Revenue Service. GCMs cannot be cited as precedent. IRC §6110(k)(3). See also Chief Counsel advice; Letter rulings, Technical advice memorandum.

Intermediary: A party who receives and transfers a taxpayer's relinquished property to a buyer and receives and transfers a taxpayer's replacement property from a seller, thus facilitating an exchange transaction by eliminating the need for buyer or seller cooperation in the exchange. See also Four-party exchange; Deferred exchange.

Letter rulings: Letter rulings are written advice issued by the Internal Revenue Service, on written request from taxpayers, regarding the tax treatment of their specific proposed transactions. Letter rulings may be relied on by the taxpayers involved but may not be used or cited as precedent by anyone else, unless the IRS establishes otherwise by regulation. IRC §6110(j)(3). Letter rulings are also called private letter rulings and private rulings.. See also Revenue ruling; Technical advice memorandum.

Like-kind exchange: Exchanges under IRC §1031 are alternatively referred to as "like-kind," "tax-deferred," "tax-free," and "nontaxable" exchanges. "Like-kind exchange" is the most accurate term used to refer to transactions that are the subject of IRC §1031.

Nonqualifying property: As used in this book, nonqualifying property is any property that is excluded property ( property not held for the required business or investment purpose, or non-like-kind property ). .

Nonrecourse financing: If a loan is secured by specified collateral and, under the terms of the loan or the antideficiency laws, the lender's only recourse in the event of default is to foreclose against the security, that financing is called nonrecourse financing. See also Qualified nonrecourse financing.

Other property: Other property consists of nonqualifying property received by the taxpayer in the exchange. . See also Nonqualifying property.

Passive loss rules: Losses from a passive activity generally may be offset only against gains from passive activities?not gains from other types of activities. The rules governing these offsets are known as the passive loss rules. Passive activity includes the conduct of a trade or business in which the taxpayer does not materially participate, or engaging in rental activity above a certain dollar threshold regardless of the taxpayer's participation. IRC §469.

Private letter ruling: See Letter rulings.

Private rulings: See Letter rulings.

Qualified nonrecourse financing: Qualified nonrecourse financing is financing on real property that is (1) borrowed from a qualified person (generally someone actively and regularly engaged in the business of lending money, but not the seller of the property), (2) borrowed from a government entity, or (3) guaranteed by a government entity, which the taxpayer is not personally liable to repay and which is not convertible debt. IRC §465(b)(6). As an exception to the at-risk limitations, a borrower who receives qualified nonrecourse financing is still considered at risk in terms of qualified nonrecourse financing. IRC §465(b)(6)(A). . See also At-risk limitations; Nonrecourse financing.

Relinquished property: Relinquished property is the property given up by the taxpayer in an exchange.

Replacement property: Replacement property is the property ultimately received by the taxpayer in an exchange.

Revenue procedure: A revenue procedure is a statement of procedure issued by the National Office of the Internal Revenue Service that affects the rights or duties of taxpayers or other members of the public under the Internal Revenue Code and related statutes, or information that, although not necessarily affecting the rights and duties of the public, should be a matter of public knowledge. Treas Reg §601.601(d)(2)(i)(b).

Revenue ruling: A revenue ruling is a statement of the Internal Revenue Service's conclusion on the application of the law to a specific set of facts. Taxpayers and IRS personnel are expected to rely on these published rulings as precedent. Rev Proc 89?14, 1989?1 Cum Bull 814. Courts generally do not regard revenue rulings as binding on them.

Reverse exchange: A reverse exchange is a form of nonsimultaneous exchange in which the taxpayer receives the replacement property before transferring the relinquished property.

Round-robin exchange: A round-robin exchange is a type of three-party exchange in which each party has contractual obligations to transfer his or her relinquished property to a different party than the one from whom the replacement property will be received.

Seller: In this article, the seller is the party that owns the replacement property before the exchange transaction occurs. The seller sells the replacement property to the buyer in a buyer-cooperating three-party exchange or to an intermediary in a four-party exchange. In a seller-cooperating three-party exchange, the seller transfers the replacement property to the taxpayer in exchange for the relinquished property and then sells the relinquished property to the buyer.

Seller cooperating three-party exchange: A three-party exchange in which the taxpayer transfers the relinquished property to the seller of the replacement property in exchange for the replacement property, and the seller of the replacement property then sells the taxpayer's relinquished property to the buyer of the relinquished property.

Substance-over-form doctrine: Under the substance-over-form doctrine, the courts and the Internal Revenue Service determine tax consequences based on the substance of a transaction rather than its form, if the form chosen by the taxpayer is a legal construct that does not reflect the economic realities of the transaction. Commissioner v Court Holding Co. (1945) 324 US 331, 334, 65 S Ct 707.

Suspended loss: For any taxable year, a taxpayer generally may not deduct the excess of losses from passive activities over income from passive activities sustained or earned during that year. IRC §469(a). The net losses from passive activities that are disallowed are carried over and treated as losses from passive activities in the next taxable year. IRC §469(b). The net passive losses that are carried over are referred to as suspended losses. When the passive activity that generated suspended losses is disposed of by the taxpayer in an otherwise taxable transaction, the suspended losses are treated as a loss that is not from a passive activity. . See also Passive loss rules.

Tax-deferred exchange: See Like-kind exchange.

Taxpayer: All exchanges and their tax ramifications are analyzed from the point of view of a specific taxpayer. For example, if party A to a two-party exchange owns property 1 and party B to that exchange owns property 2, the relinquished property (i.e., the property given up by the taxpayer) will be property 1 if party A is viewed as the taxpayer but property 2 if party B is viewed as the taxpayer. Attorneys normally think of their client as the "taxpayer" for these purposes, but all parties to an exchange transaction are likely to have tax consequences resulting from the transaction. . See also Exchanger; Relinquished property.

Technical advice memorandum: A technical advice memorandum (TAM) is a written statement issued to a district director of the Internal Revenue Service on a closed and completed transaction in connection with the examination of a taxpayer's return or consideration of a taxpayer's refund claim. A TAM may not be used or cited as precedent by anyone other than the taxpayer involved unless the IRS establishes otherwise by regulation. IRC §6110(b)(1), (k)(3).

Three-party exchange: A three-party exchange is one in which three principal parties are involved. It may be structured as a buyer cooperating, seller cooperating, or round-robin exchange. A three-party exchange does not involve an independent intermediary. . See also Round-robin exchange; Buyer cooperating three-party exchange; Seller-cooperating three-party exchange.

Two-party exchange: A two-party exchange is a reciprocal transfer of properties in which each party is both a transferor of relinquished property and a recipient of replacement property.. See also Relinquished property; Replacement property.

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