2012 FEDERAL INCOME TAX UPDATE FOR THE CONSTRUCTION INDUSTRY

2012 FEDERAL INCOME TAX UPDATE FOR THE CONSTRUCTION INDUSTRY Anthony F. Dannible, CPA/ABV, CVA, CFF, CDA Dannible & McKee, LLP Financial Plaza 221 Sou...
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2012 FEDERAL INCOME TAX UPDATE FOR THE CONSTRUCTION INDUSTRY Anthony F. Dannible, CPA/ABV, CVA, CFF, CDA Dannible & McKee, LLP Financial Plaza 221 South Warren Street Syracuse, New York 13202-2687 CONTRACTS - A MYRIAD OF TAX PLANNING IDEAS I.

TAX METHODS CHOICES?? A.

OF

CONSTRUCTION

ACCOUNTING



NUMEROUS

Overview of a contractor’s long-term contract accounting choices. 1.

The cash method;

2.

The accrual method;

3.

The accrual method, excluding retentions;

4.

The hybrid method; and

5.

Long-term contract methods (Internal Revenue Code Section 460).

B.

Depending on size of its revenues, a contractor may need to choose both an overall method of accounting and a method for long-term contracts.

C.

Long-term contracts under Internal Revenue Code Section 460.

D.

1.

Definition of a long-term contract (Code Section 460(b)).

2.

A “long-term” contract is a contract that is not completed within the same taxable year in which it is entered into.

3.

Thus, a contract need only span two (2) taxable years to be eligible for long-term contract accounting.

4.

In addition, the contract must either be a “building, installation, construction, or manufacturing contract” to qualify for long-term.

Generally, no book/tax conformity required.

-2II.

YEAR-END TAX PLANNING WITH THE SPECIAL TAX ACCOUNTING RULES FOR LONG-TERM CONTRACTS (Section 460). A.

Definition of a long-term contract (Internal Revenue Code Section 460(f)). 1.

Section 460(f) defines a “long-term contract” as: “…any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which the contract is entered into.” IMPORTANT A contract that starts and finishes in the same tax year is not a long-term contract under Section 460. The accrual or accrual less retainage can apply.

2.

Thus, a contract may only last a week, but if it goes beyond the end of the year, it is a long-term contract. OBSERVATION This negates the notion that a contract must be longer than 12-months to be a long-term contract for a construction contractor.

3.

4.

5.

Section 460(e)(4) defines a “construction contract” as any contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvement of, real property. a.

Applies to land, buildings, and inherently permanent structures such as roadways, dams, and bridges.

b.

An integral component to real property includes property not produced at the site, but intended to be permanently affixed to the real property.

Section 460(b) refers to any long-term contract rather than a contractor’s overall accounting method. a.

A contractor may report some contracts under the completed cost method (CCM) and may be required to use percentage-ofcompletion for others.

b.

The requirement to use a long-term contract method for some or all its contracts does not change the contractor’s elected method of accounting or the elected method of accounting for long-term contracts.

Construction Management Contracts are not long-term contracts. a.

In an Industry Specialization Program Settlement Guideline issued and the Revised Construction Industry Audit Guide, the Internal Revenue Service has indicated that construction management contracts generally requires the performance of personal services and does not put the construction management firm at risk for defects and mistakes in the construction.

-3-

6.

b.

The narrow and restrictive definition under Section 460(e)(4) denies long-term contract treatment to architects, engineers, industrial and commercial painters, as well as engineering services and construction management.

c.

Internal Revenue Service has clarified in the final Regulations that if a construction contract includes the performance of these services that are not incident to or necessary for a long-term contract, the contractor must allocate revenue and costs to that activity and the contractor must account for these activities under a permissible method of accounting other than a long-term contract method.

Under the Regulations, contracts with “de minimis” construction activity are not long-term contracts. a.

Regulation Section 1.460-1(b)(2)(ii) states that when a contract includes land and the total allocable costs are less than 10 percent of the contract total price, it is not a construction contract.

b.

Internal Revenue Service Non-Docketed Advice Review 200006.

c.

(i)

Addresses land development vs. construction.

(ii)

Provides guidance on home and residential construction.

Watch Dual-Purpose Contracts. (i)

Dual-Purpose Contract is when a contract requires the contractor to furnish land and land improvements to the land. The contract will not be classified as a construction contract if the construction activities are de minimis. EXAMPLE Dual-purpose contract Assume a customer and a contractor enters into a contract for the contractor to provide land and construct improvements to the land at a total contract price of $1 million. The cost of the land is $500,000 and estimated construction costs are $200,000. This contract would be considered a construction contract since total estimated costs allocable to construction activities are more than 10 percent of the total contract price. However, if estimated costs allocable to construction activities are only $95,000, the contract is not a construction contract and Section 460 would not apply.

-4B.

Long-Term Contract Methods.

Cash Method

Income as cash received/expensed when paid

≤ $1 million – Revenue Procedure 2001-10 ≤ $10 million – Revenue Procedure 2002-28

Accrual Method

When earned or incurred

Regulation Section 1.451-1(a)

Accrual with Deferral of Retainages Completed-Contract (CCM)

Same as accrual excludes retainage Billings or total contract price once contract is finished and accepted.

Revenue Ruling 69-314

Exempt Percentage-ofCompletion (EPCM)

Contract price (including change orders) multiplied by percent complete. Percent complete determined by various alternative methods, such as:  Cost-to-cost  Labor hours to total labor hours  Various other permitted input and/or output measurements. Revenues determined by only the cost-to-cost formula.

IRC §460(b) Percentage-of-Completion (PCM)

IRC §460(b)(3) Simplified Cost-to-Cost Method

Same formula as §460(b), except costs determined as outlined by §460(b)(4) or 1.460-5(c).

Reg. 1.460-4(e), §460(a) Percentage-of-Completion/ Capitalized-Cost Method (PCCM)

Use PCM formula as §460(b) with same type of costs for 70 percent, and use exempt contract method for the remaining 30 percent. Same as §460(b) above, except that revenues and billings on all contracts with less than 10 percent complete, determined by cost-to-cost formula, are deferred until greater than 10 percent complete.

IRC §460 10 percent Deferral Method

Costs are deferred as incurred. Specific costs are outlined in 1.460-5(d). Once completed, costs are closed out to expense. S,G&A costs are expensed as incurred. Based on economic performance regulations of §461(h). Costs determined by 1.460-5(d). All costs are expensed as incurred.

Based on economic performance regulations of §461(h). Costs determined by 1.460-5(b). All costs are expensed as incurred. Based on economic performance regulations of §461(h). Job costs are direct material, direct labor and depreciation, amortization, and cost recovery on equipment directly used. All costs are expensed as incurred. For 70 percent, same as the §460 PCM method, the balance of the contract is accounted for by the exempt-contract method. Based on economic performance regulations of §461(h). All costs are expensed as incurred. All costs on contracts less the 10 percent complete are not expensed as incurred, but rather are deferred in an account similar to an inventory account.

-5C.

III.

Code Section 460(a) mandates the percentage-of-completion method to account for long-term contracts. 1.

Section 460(b) measures revenue by determining the percentage of costs incurred to date compared to total estimated contract costs, as defined in Regulation Section 1.460-5(a) multiplied by the contract amount.

2.

Exceptions are provided in Code Section 460(e).

SPECIFIC EXEMPTIONS FOR CERTAIN CONSTRUCTION CONTRACTS (Section 460(E)). A.

The Small Contractor Exemption (Section 460(e)(1)(B)). 1.

For a contractor to be able to fall under this exemption, contracts must be for: (i) the construction or improvement of real property which are estimated to be completed within two (2) years from the commencement date of the contract and (ii) are performed by a contractor whose average gross receipts for the three (3) taxable years preceding the taxable year in which the contract is entered into do not exceed $10 million.

2.

For purposes of the $10 million limit, businesses under common control must be aggregated.

3.

a.

Gross receipts for purposes of this test are determined based on the principles found in Regulation 1.263A-3(b).

b.

In addition to the gross receipts from all of the taxpayer’s businesses, a proportionate share of construction related gross receipts from any person owning a 5 percent or greater interest in or in which the taxpayer owns a 5 percent or greater interest is included.

c.

Ownership is determined as of the first day of the tax year.

If a contractor meets this exemption, then the contractor may use accrual, accrual less retainage, completed contract (CCM), etc. a.

A small contractor must still capitalize production period interest.

b.

A small contractor must compute AMT under the percentage-ofcompletion method.

c.

The permissible methods for exempt contractors listed in Regulation Section 1.460-4(c)(1) does not include the cash receipts and disbursement method. IMPORTANT However, the Internal Revenue Service has issued Revenue Procedure 2001-10 and Revenue Procedure 2002-28 to continue the cash method or to automatically switch to it.

-6EXAMPLE Contract Status (A)

(B)

(C)

(D)

(E) (D-B) % of Comp.

Contr. No.

Contract Amount

Estimated Total Cost

Billings through 12/31/0X

Cost Incurred through 12/31/0X

1 2 3 4 5

$ 100,000 500,000 350,000 850,000 400,000 2,200,000

$ 65,000 400,000 265,000 660,000 330,000 1,720,000

$ 100,000 360,000 350,000 500,000 400,000 1,710,000

$

Income Recognition Analysis Contract PCM Accrual 1 2 3 4 5

$ 100,000 375,000 262,500 518,500 400,000 $ 1,656,000

$ 100,000 360,000 350,000 500,000 400,000 $ 1,710,000

65,000 300,000 200,000 400,000 330,000 1,295,000

100% 75% 75% 61% 100%

(F) (AxE) % of Contr. Revenue to Recognize $ 100,000 375,000 262,500 518,500 400,000 1,656,000

CCM

Cash

$ 100,000 N/A N/A N/A 400,000 $ 500,000

$ 100,000 N/A N/A N/A 300,000 $ 400,000

Operations PCM Fees billed to clients - net Direct costs of fees billed

Company Taxable Year Accrual CCM

Cash

$ 1,656,000 1,295,000

$ 1,710,000 1,295,000

$ 500,000 395,000

$ 400,000 345,000

Gross profit

361,000

415,000

105,000

55,000

Indirect expenses and overhead

205,000

205,000

205,000

205,000

Income/(loss) from operations

156,000

210,000

(100,000)

(150,000)

Other expenses/(income): Interest expense Interest income

32,000 (12,000)

23,000 (3,000)

28,000 (8,000)

28,000 (8,000)

20,000

20,000

20,000

20,000

136,000

190,000

(120,000)

(170,000)

54,000

76,000

(48,000)

(68,000)

82,000

$ 114,000

$ (72,000)

$ (102,000)

Income before income taxes Provision for income taxes (refund) Net income (loss)

$

-7B.

Specific exemptions (Section 460(e)). 1.

for

certain

“home”

construction

contracts

Any home construction contract (Section 460(e)(1)(A)). a.

In determining whether a contract is a home construction contract, Section 460(e)(6)(A) provides the following definition of a home construction contract: “Any construction contract that is 80 percent or more of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to (the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to or improvement of):

2.

(i)

Dwelling units (as defined in Section 168(e)(2)(A)(ii)) contained in buildings containing four or fewer dwelling units; and

(ii)

Improvements to real property directly related to such dwelling units and located on the site of such dwelling units.”

b.

A homebuilder, regardless of his annual receipts, may use an exempt contract method for home construction.

c.

The definition of a home construction contract uses the term “estimated total contract costs.”

d.

All of the direct and indirect costs of construction, including materials and raw land should be considered, as well as planning and design activities incurred before construction begins.

e.

In addition, Regulation Section 1.460-3(b)(2)(iii) provides that the estimated total contract costs for each dwelling unit should also include “their applicable share of the costs of any common improvements, such as service roads and clubhouses.”

The Small Contractor Exemption (Section 460(e)(1)(B)). a.

For a contractor to be able to fall under this exemption, contracts must be for: (i) the construction or improvement of real property which are estimated to be completed within two (2) years from the commencement date of the contract and (ii) are performed by a contractor whose average gross receipts for the three (3) taxable years preceding the taxable year in which the contract is entered into do not exceed $10 million.

b.

For purposes of the $10 million limit, businesses under common control must be aggregated.

-83.

If a contractor meets the home construction contract exemption, then the contractor may use accrual, accrual less retainage, completed contract method (CCM), etc. a.

A large or small contractor must still capitalize production period interest.

b.

The uniform capitalization rules in Section 263A do not apply.

c.

The permissible methods for exempt contractors listed in Regulation Section 1.460-4(c)(1) do not include the cash receipts and disbursement method. IMPORTANT However, the Internal Revenue Service has issued Revenue Procedure 2001-10 and Revenue Procedure 2002-28 to continue the cash method or to automatically switch to it.

4.

Internal Revenue Service challenges to Home Construction Contractors. a.

Internal Revenue Service Non Docketed Service Advice Review 20006. (i)

Internal Revenue Service addresses whether or not a developer who subdivides the property and installs roads, sewers, electric lines, etc. is involved in “home construction.”

(ii)

Internal Revenue Service points out that a contract is not a construction contract if it includes the provision of land and the total allocable contract costs are less than 10 percent of the total contract price.

(iii)

Internal Revenue Service points out that a construction contract is a home construction contract if 80 percent of the estimated contract costs are attributable to construction of a dwelling unit and improvements to real property directly related to such dwelling units.

(iv)

If there are no construction activities related to dwelling units, then there are no improvements to real property related to such dwelling units.

(v)

Q&A 44 in Notice 89-15 clarifies this off-site work such as roads, sewers and other common features are attributable to the dwelling units that the developer is developing.

(vi)

Internal Revenue Service points out that there must be some construction activity on a dwelling unit in order for a contract to qualify as a home construction contract.

(vii)

Internal Revenue Service concludes that a land developer is not involved in home construction.

-95.

6. C.

In TAM 200552012, the Internal Revenue Service concluded that a taxpayer who was involved in land development and who was required to provide common amenities and recreational facilities to be used by the homeowners was not entitled to use the completed contract method (CCM). a.

Internal Revenue Service concluded that Section 460 allows the more favorable CCM of accounting to be used only by taxpayers actively building the homes.

b.

Taxpayer realized its income pursuant to its sales contract with the builder, not the home construction contract with the consumer.

c.

Internal Revenue Service held taxpayer should use percentage-ofcompletion method (PCM).

Internal Revenue Service issued an Industry Audit Directive to all its field offices in 2007 challenging the use of CCM by land developers.

Date taxpayer completes a long-term contract (Section 1.460-1(c)(3)). 1.

The final Regulations indicate that a taxpayer’s contract is completed upon the earlier of: a.

Use of the subject matter of the contract by the customer for its intended purpose (other than for testing) and at least 95 percent of the total allocable contract costs attributable to the contract have been incurred; or

b.

Final completion and acceptance of the subject matter of the contract. EXAMPLE I In 2011, C, whose taxable year ends December 31, enters into a contract to construct a building for B. In November of 2012, the building is completed in every respect necessary for its intended use, and B occupies the building. In early December 2012, B notifies C of some minor deficiencies that need to be corrected, and C agrees to correct them in January 2013. C reasonably estimates that the cost of correcting these deficiencies will be less than 5 percent of the total allocable contract costs. C’s contract is complete under this section in 2012 because in that year, B used the building and C had incurred at least 95 percent of the total allocable contract costs attributable to the building. C must use a permissible method of accounting for any deficiency-related costs incurred after 2012.

- 10 EXAMPLE II In 2011, C, whose taxable year ends December 31, agrees to construct a shopping center, which includes an adjoining parking lot, for B. By October 2012, C has finished constructing the retail portion of the shopping center. By December 2012, C has graded the entire parking lot, but has paved only one-fourth of it because inclement weather conditions prevented C from laying asphalt on the remaining three-fourths. In December 2011, B opens the retail portion of the shopping center and the paved portion of the parking lot to the general public. C reasonably estimates that the cost of paving the remaining three-fourths of the parking lot when weather permits will exceed 5 percent of C’s total allocable contract costs. Even though B is using the subject matter of the contract, C’s contract is not completed in December 2012 because C has not incurred at least 95 percent of the total allocable contract costs attributable to the subject matter.

D.

2.

The final Regulations clarify that a subcontractor’s customer is the general contractor.

3.

For purposes of the look-back regulations, the final Regulations require a taxpayer to delay the first application of the look-back method until the taxable year in which the long-term contract is finally completed and accepted.

4.

Final completion and acceptance is determined without regard to whether a dispute exists.

Severing and aggregating contracts (Section 1.460-1(e)). 1.

The final Regulations allow a taxpayer to sever a long-term contract if necessary to clearly reflect income, but only if the taxpayer has obtained the Commissioner’s prior written approval.

2.

The ability to sever or aggregate will depend on the following factors: a.

Pricing – Independent pricing of items in an agreement is necessary for the agreement to be severed into two or more contracts. Similarly, interdependent pricing of items in separate agreements is necessary for two or more agreements to be aggregated into one contract. IMPORTANT The separate delivery or separate acceptance does not require an agreement to be severed.

- 11 -

3.

4.

b.

Separate Delivery or Acceptance – An agreement cannot be severed into two or more contracts unless it provides for separate delivery or acceptance of items that are the subject matter of the agreement.

c.

Reasonable Businessperson – Two or more agreements to perform manufacturing or construction may not be aggregated into one contract unless a reasonable businessperson would not have entered into one of the agreements for the terms agreed upon without also entering into the other agreement.

Exceptions. a.

Severance for PCM – A taxpayer may not sever a long-term contract that would be subject to PCM without obtaining the Commissioner’s prior written consent.

b.

For options and change orders, a taxpayer must sever an agreement that increases the number of units to be supplied to the customer, such as through the exercise of an option or the acceptance of a change order, if the agreement provides for separate delivery or separate acceptance of the additional units.

Statement required to be filed with return. a.

If a taxpayer severs an agreement or aggregates two or more agreements during the tax year, the taxpayer must attach a statement to its original tax return.

b.

The Statement must contain: (i)

The legend: “Notification of Severance or Agreement Under 1.460-1(e)l;”

(ii)

Taxpayer’s name; and

(iii)

Taxpayer’s identification number. NOTE A PCM contract cannot be severed under the change order exception.

E.

Percentage-of-completion (Section 1.460-4(b)(4)).

method

(PCM)



The

contract

price

1.

In general, revenue earned on a contract during the tax year is calculated by multiplying the total contract revenue by the ratio of costs incurred on the contract by the total estimated costs, and then subtracting from that result any revenue recognized in prior tax years.

2.

The costs used to calculate the completion factor can be computed using two (2) different methods. a.

Simplified cost-to-cost method.

b.

The cost-to-cost method.

- 12 3.

The Simplified Cost-to-Cost Method. a.

Contractors using the PCM for income tax purposes can elect under Internal Revenue Code Section 460(b)(3)(A) to use a simplified cost-to-cost method to compute revenue. This election is also available to any cash basis contractor who must use the percentage-of-completion/capitalized cost method.

b.

If the simplified cost-to-cost method is used, the 10 percent election is not available.

c.

This method determines the contract’s completion factor using only

d.

(i)

direct material costs;

(ii)

direct labor costs; and

(iii)

tax depreciation, amortization, and cost recovery allowances on equipment and facilities directly used to manufacture or construct property under the contract.

Subcontracted costs represent either direct material or direct labor costs and must be allocated to a contract under the simplified costto-cost method. EXAMPLE Using the simplified cost-to-cost method for income ABC is a building contractor that started one contract with a value of $1,000,000 in 2012. As of December 31, 2012, ABC had incurred the following costs:

Direct labor Direct materials Depreciation/amort.

Cost To Date

Total Estimated Cost

$ 100,000 200,000 50,000 $ 350,000

$ 200,000 400,000 100,000 $ 700,000

PCM 50% ($350 ÷ $700) 4.

Cost-to-cost method. a.

Under the cost-to-cost method, all direct and indirect costs that directly benefit a long-term contract are compared with the direct and indirect estimated costs for that contract.

b.

Direct costs include direct materials, direct labor, and subcontract expenses. There are many indirect costs that must be considered.

c.

Some additional costs, such as construction period interest, must also be allocated to contracts.

- 13 d.

Costs become allocable to a contract once they have been specifically used in the job.

e.

An important issue involves the treatment of materials purchased for a job but not yet included in the subject matter of the contract.

f.

Tax cost accounting allows the contractor to treat the cost as incurred if the materials have been specifically purchased and dedicated to the job.

g.

GAAP requires that these stored materials be pulled out of contract costs and treated as inventory at the balance sheet date. IMPORTANT Subcontractor costs must be included in the contract costs in determining the completion factor under the PCM. The Internal Revenue Service Appeals Settlement Guideline concludes that a contractor cannot postpone the recognition of subcontractor costs that have been incurred but not yet paid for to reduce gross income. This applies to materials, equipment and labor. EXAMPLE

Computing Gross Profit Under the Percentage of Completion ABC is a general contractor that has one contract uncompleted at the end of 2012. The contract price is $1,200,000, costs incurred to date totaled $600,000, and ABC estimates that another $400,000 in costs will be incurred to complete the contract. In 2011, the first year of the contract, ABC recognized $250,000 in contract revenue and incurred $200,000 of costs. ABC will recognize $70,000 of gross profit in 2012, computed as follows: Costs incurred through the 2012 year-end Estimated costs to complete

$ 600,000 400,000

Total estimated costs

$1,000,000

Percentage of completion = $600,000 ÷ $1,000,000 = Revenue earned through 2012 = 60% x $1,200,000 =

60% $ 720,000

- 14 2012 Gross Revenue: Revenue earned through 2012 Less: Revenue previously recognized in 2011

$ 720,000 (250,000)

Gross revenue to be recognized in 2012 Cost of contract through 2012 Less: Costs previously deducted

$ 470,000 $ 600,000 (200,000)

Costs to be deducted in 2012 Gross profit in 2012 5.

IV.

(400,000) $

70,000

A taxpayer can reasonably estimate that an amount of contingent income will be earned not later than the year when the taxpayer includes that amount in income for financial purposes under generally accepted accounting principles.

NEW INTERNAL REVENUE SERVICE REGULATIONS PROVIDE GUIDANCE ON DEDUCTION AND CAPITALIZATION OF TANGIBLE PROPERTY EXPENDITURES (I A.

B.

Overview. 1.

Under the new Temporary Regulations, as a general rule, all costs that facilitate the acquisition or production of such property must be capitalized, with exceptions, for employee compensation and overhead costs.

2.

Investigation costs related to the acquisition of realty do not have to be capitalized unless they are inherently facilitation.

3.

A new rule requires taxpayers to capitalize repair-type expenses made to assets before they are placed in service.

4.

A de minimus rule allows taxpayers to expense the acquisition of some assets, if the acquisition cost is expensed on the taxpayer’s financial statements and certain other conditions are met.

The Temporary Regulations Rewrite the Rules on Deduction Versus Capitalization of Tangible Property Costs. 1.

The Regulations create all-encompassing guidelines on what constitutes an improvement and creates a “BAR Test.”

2.

Does the expenditure: a.

Result in a “Betterment” to the unit of property?

b.

Does it “Adapt” the unit of property to a new or different use?

c.

Does it “Restore” the unit of property?

- 15 IMPORTANT Much of the guidance in the Temporary Regulations revolves around what constitutes a “unit of property” (UOP). The definition of a UOP for capitalization purposes may be the same as, or radically different from, the definition of a UOP for other purposes. For example, the definition of a UOP for nonbuilding assets for capitalization purposes is very similar to the definition of a unit of tangible personal property for UNICAP purposes in Regulation Section 1.263A-10. By contrast, the definition of the UOP for a building is completely different from the definition of a unit of real property for purposes in Regulation Section 1.263A-10. C.

Building Improvements. 1.

In general, each building and it structural components are one UOP – the “building.”

2.

Amounts are treated as paid for an improvement to a building they improve: a.

The building structure; or

b.

Any designated building system.

3.

A building structure consists of a building and its structural components as defined in Regulation Section 1.48-1(e) (unless the component is a building system) and includes “structural components” that include such parts of a building as walls, partitions, floors, and ceiling, as well as any permanent coverings therefore, such as paneling or tiling; windows and doors; as well as other components relating to the operation or maintenance of a building.

4.

A building system consists of the following nine structural components that is separate from the building structure, and to which the improvement rules must be separately applied: a.

HVAC systems (including motors, compressors, boilers, furnace, chillers, pipes, ducts, radiators);

b.

Plumbing systems (including pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste to and from the property line and between buildings and other permanent structures);

c.

Electrical systems (including wiring, outlets, junction boxes, lighting fixtures and associated connectors, and site utility equipment used to distribute electricity from property line to and between buildings and other permanent structure);

- 16 d.

All escalators;

e.

All elevators:

f.

Fire-protection and alarm systems (including items such as sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, and alarm control panels);

g.

Security systems that protect the building and its occupants (including items such as locks, security cameras, motion detectors, security lighting, and alarm systems);

h.

Gas distribution system (including associated pipes and equipment used to distribute gas to and from property line and between buildings or permanent structures); and

i.

Other structural components identified in published Internal Revenue Service guidance that are not part of the building structure and are specifically designated as building systems. OBSERVATION The division of a building into components is a significant change from prior law where taxpayers would likely have treated all components of a building as one collective asset. With the new Temporary Regulations, taxpayers should consider capitalizing the different systems of buildings as separate assets.

5.

The new Temporary Regulations permit taxpayers to treat the retirement of a structural component as a disposition so taxpayers can recognize a “loss” before the disposition of the entire building.

6.

Notwithstanding the above UOP rules, a component of a UOP must be treated as a separate UOP if, when the UOP is initially placed in service by the taxpayer. a.

The taxpayer properly treated the component as being within a different class of property under Code Section 168(e) for MACRS depreciation purposes than the class of the UOP of which the component is a part; or

b.

The taxpayer properly depreciated the component using a different depreciation method than the depreciation method of the UOP of which the component is a part. NOTE In any year after a UOP is initially placed in service, if the taxpayer changes the treatment to a proper MACRS class or method, then the taxpayer must change UOP for the property.

- 17 7.

Repairs undertaken contemporaneously with improvements. a.

New Regulations set aside the judiciously developed plan of rehabilitation doctrine whereby a taxpayer must capitalize otherwise deductible repair costs if they are incurred as part of a general plan of renovation.

b.

Regulations specifically provide that indirect costs made at the same time as an improvement but that do not directly benefit or are not incurred by reason of the improvement do not have to be capitalized.

c.

Taxpayer must still capitalize all the direct costs of an improvement and all indirect costs that directly benefit or are incurred by reason of an improvement (such as otherwise deductible repair or component removed costs). OBSERVATION The Regulations make particular reference to removal costs and do not prescribe how to treat such costs. However, while reiterating that costs of removing a component of a UOP must be capitalized if they are incurred by reason of an improvement, the Regulations indicate that the cost of removing an “entire UOP” would not have to be capitalized.

D.

E.

F.

UOP for Assets Other than Buildings. 1.

For real or personal property that is not classified as a building, all components that are functionally interdependent comprise a single UOP.

2.

Components are functionally interdependent if placing one component in service depends on placing the other component in service.

3.

New Regulations do not require that taxpayer to treat functionally interdependent components as a separate unit of property if the taxpayer initially assigns a different economic life to the component for financial reporting or regulatory purposes.

4.

The Regulations have a safe-harbor from capitalization for certain routine maintenance costs.

Definition of Repairs and Maintenance. 1.

A component acquired to maintain, repair or improve a unit of tangible property owned, leased or serviced by the taxpayer and that is not acquired as part of any single unit of property.

2.

A unit of property that had an economic useful life of 12-months or less, beginning when the property was used or consumed; or

3.

A unit of property that had an acquisition or production cost of $100 or less.

Factors Determining Routine Maintenance. 1.

Recurring nature of the activity.

- 18 2.

Industry practice.

3.

Manufacturer’s recommendations.

4.

Taxpayer’s experience (history).

5.

Taxpayer’s treatment on its applicable financial statement. NOTE Routine maintenance does not include amounts paid to return a unit of property to its ordinary efficient operating condition – if the property has deteriorated to a state of disrepair and is no longer functional for its intended use.

6. G.

Betterments. 1.

Improves a material condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property.

2.

Results in a material addition.

3. H.

If the routine maintenance involves a “betterment,” the cost of routine maintenance is required to be capitalized.

a.

Enlargement.

b.

Expansion.

c.

Extension.

Results in a material increase in capacity, productivity, efficiency, strength or quality of the unit or the output of the unit of property.

De Minimus Rule of Expensing. 1.

If a taxpayer expenses the purchase price of tangible property for financial reporting purposes and has a “formal written accounting policy” for expensing those amounts, the taxpayer can now deduct the amount for tax purposes – up to a threshold.

2.

Safe-Harbor Threshold. a.

The aggregate amount expensed must be less than or equal to 0.1 percent of the gross receipts; or

b.

Two percent of the total depreciation and amortization expense for the tax year. CAUTION The De Minimus Rule is only available to taxpayers who have a financial statement filed with the SEC, a certified audited financial statement, or a financial statement required to be filed with the Federal or state government or agency (other than a tax return).

- 19 I.

Large Business & International (LB&I) Division has Issued a Directive to Field Agents in Examinations of Repair Versus Capitalization Issues. 1.

Internal Revenue Service issued Revenue Procedure 2012-19 and Revenue Procedure 2012-20 which provide procedures for taxpayers to obtain automatic consent to change to the accounting methods in the Temporary Regulations.

2.

For pre-2012 audits, the LB&I Directive provides that for examination of tax years beginning before January 1, 2012, the Internal Revenue Service Examiner should: a.

Discontinue current exam activity with regard to the Issues;

b.

Not begin any new exam activity with regard to the Issues;

c.

Risk assess the Form 3115 and determine, in consultation with the Change in Accounting Method Issue Practice Group, whether to examine the Form 3115 where a taxpayer files a Form 3115 with regard to the Issues on or after December 31, 2011 (i.e., the date the Temporary Regulations were issued) for a tax year not covered by the Temporary Regulations.

d.

Take the following steps to discontinue exam activity with regard to the Issues: (i)

Withdraw Forms 4564, Information Document Request.

(ii)

Withdraw all Forms 5701, Notice of Proposed Adjustment, which propose an adjustment to repair expenses related to whether costs incurred to maintain, replace, or improve tangible property must be capitalized under Code Section 263(a), and any correlative adjustments involving the disposition of associated assets.

(iii)

Develop and issue a Form 5701 with a Form 886-A, Explanation of Adjustments, containing specified language indicating that Internal Revenue Service neither accepts not rejects the position taken in the tax return related to the method to determine the proper treatment of amounts incurred to repair tangible property, but that the taxpayer has a two-year period to adopt the appropriate accounting method in Revenue Procedure 2012-19 or Revenue Procedure 2012-20.

3.

For post-2011 audits, the LB&I Directive provides that for examination of a return for a tax year beginning on or after January 1, 2012 but before January 1, 2014, Internal Revenue Service Examiners should perform a risk assessment regarding the method change if the taxpayer has filed a Form 3115, Application for Change in Accounting Method, in accordance with Revenue Procedure 2012-19 or Revenue Procedure 2012-20.

4.

For examination for tax years beginning on or after January 1, 2014, the Internal Revenue Service Examiner should apply the Regulations in effect and follow normal exam procedures.

- 20 IMPORTANT The Internal Revenue Service, on November 20, 2012, released an advance copy of Notice 2012-73 (Notice). The Notice indicates the Internal Revenue Service intends to issue final regulations regarding the deduction and capitalization of expenditures related to tangible property in 2013, with an effective date beginning on or after January 1, 2014, rather than January 1, 2012, as provided when the temporary regulations were introduced. But, that does not mean that taxpayers should put plans to implement changes on hold. The Notice permits taxpayers to apply the temporary regulations for taxable years beginning on or after January 1, 2012, and before the effective date of the final regulations. Taxpayers electing to adopt the temporary regulations prior to taxable years beginning on or after January 1, 2014, may continue to obtain the automatic consent under Revenue Procedure 2012-19 and Revenue Procedure 2012-20. V.

FOR 2012 TAX RETURNS, THERE IS ENHANCED EXPENSING FOR CERTAIN DEPRECIABLE ASSETS BUT IT IS REDUCED (Internal Revenue Code Section 179). A.

The Small Business Jobs Act of 2010 increased the maximum regular Code Section 179 tax deduction to $139,000 in 2012. 1.

The $139,000 limitation is reduced by the excess amount of Section 179 property placed in service during the year that exceeds $560,000.

2.

Unlike regular depreciation, the full expensing is not limited by the midquarter or half-year convention and is allowed in full no matter when the property is placed in service, even on the last day of the tax year.

3.

Applies to new or used property additions, including off-the-shelf software.

4.

The increased Section 179 deduction and phase-out levels available for qualified property placed in service in: a.

An empowerment zone;

b.

A renewal community; or

c.

Gulf Opportunity Zone

continue to be available in addition to the enhanced regular Section 179 maximum expense deduction.

- 21 EXAMPLE ABC, an empowerment zone taxpayer, places qualified zone property of $1,120,000 in service in 2012. ABC can expense $174,000 in 2012 under Section 179. The $139,000 under the Small Business Act is increased by $35,000 for the cost of qualified zone property. In addition, when determining whether or not the phaseout of $560,000 is exceeded, only one-half of the value of the cost of zone property is considered. 5.

There is no alternative minimum tax (AMT) adjustment for property expensed under Section 179.

6.

Effective for property placed in service prior to January 1, 2013. IMPORTANT H.R. 3476 of the American, Growth, Recovery, Empowerment and Entrepreneurship Act proposes to extend the $500,000 to 2015.

B.

Under the Small Business Jobs Act, the limitation was $500,000 in 2010 and 2011 and a $2 million phase-out and allowed taxpayers to expense up to $250,000 of the $500,000 for qualified leasehold property.

C.

No amount attributable to qualified real property can be carried over to a tax year beginning after 2011. 1.

Regardless of the general carryover rule for Section 179, there is no carryover for unused expensing for real property placed in service in 2011.

2.

To the extent that any amount is not allowed as a carryover to a tax year beginning after 2011 due to the carryover limitation, the Internal Revenue Code is applied as if no Section 179 election had been made. OBSERVATION Thus, any disallowed Section 179 deduction for real property placed in service in 2011 that is carried over to 2012 is treated as if the property was placed in service on the first day of the taxpayer’s last tax year beginning in 2012. EXAMPLE X, a calendar year taxpayer, has no carryovers and places $500,000 of qualified leasehold improvements property in service in 2011. The maximum Section 179 is $250,000. Assuming X has taxable income of $100,000, X’s unused Section 179 would be $150,000 ($250,000 - $100,000) which cannot be carried over. X can depreciate the excess $150,000 in 2012.

- 22 VI.

FOR 2012 TAX RETURNS, THERE IS THE ENHANCED 50 PERCENT ADDITIONAL BONUS DEPRECIATION (I 168( )). A.

Qualified property is eligible for the 50 percent additional first-year depreciation deduction if: 1.

Qualified property is acquired before January 1, 2013;

2.

Taxpayer places the qualified property in service before January 1, 2013; and

3.

The original use of the qualified property commences with the taxpayer. IMPORTANT Qualified property that a taxpayer manufactures, constructs or produces in its trade or business is acquired by the taxpayer when the taxpayer begins manufacturing or construction. However, there is a special election for “components” constructed or produced.

B.

In order for property to qualify for the additional depreciation, property must fall under one of the following classes of property: 1.

Property to which Code Section 168 with a MACRS recovery period of twenty (20) years or less;

2.

Water utility property;

3.

Computer software except for non-Section 197 computer software amortized over fifteen (15) years; or

4.

Qualified leasehold improvements. PLANNING POINT Based on the Hospital Corporation of America & Subsidiaries vs. Commissioner, (1997) 109 T.C. 21 case, the new bonus depreciation rule provides even greater incentive to allocate a portion of the new twenty-seven and one-half (27.5) or thirty-nine (39) year realty to a five (5) or seven (7) year “fixture” where the 100 percent cost can be written-off up-front. The Internal Revenue Service has issued a MSSP guide on cost segregation.

C.

The original use must begin with the taxpayer (Regulation 1.168(k)-1(b)(3)). 1.

Original use means the first use to which the property is put, whether or not that use corresponds to the use of the property by the taxpayer.

2.

Additional capital expenditures incurred by the taxpayer to recondition or rebuild the property satisfy the “original use” requirement.

3.

Under Internal Revenue Service Regulation 1.168(k)-1(b)(3)(i) indicates that property that contains used parts will be treated as new and will not be treated as used if the cost of the reconditioned or rebuilt property is not more than 20 percent used.

- 23 D.

The new property must be purchased within the applicable time period. 1.

The applicable time period for acquired property is after September 8, 2010, and before January 1, 2013, but only if no binding written contract for the acquisition is in effect before September 8, 2010; or IMPORTANT An important exception is available for “components” of self-constructed assets started prior to September 8, 2010.

E.

2.

With respect to property that is manufactured, constructed, or produced by the taxpayer for use by the taxpayer, the taxpayer must begin the manufacture, construction, or production of the property after September 8, 2010, and before January 1, 2013.

3.

Property that is manufactured, constructed, or produced for the taxpayer by another person under a contract that is entered into prior to the manufacture, construction, or production of the property is considered to be manufactured, constructed, or produced by the taxpayer.

4.

An extension of the placed-in-service date of one year (i.e., to January 1, 2013) is provided for certain property with a recovery period of ten years or longer and certain transportation property.

No overall ceiling on bonus depreciation. 1.

Unlike the Section 179 first-year depreciation that is phased-out, if more than $560,000 in additions is placed in service in 2012, the new 50 percent bonus depreciation has no such requirement.

2.

Unlike the Section 179 expense deduction, all taxpayers can take advantage of this new provision. EXAMPLE On July 1, 2012, ABC purchases and places in service construction equipment that is five-year MACRS property costing $10 million. ABC can elect 50 percent bonus depreciation of $5 million for tax year 2012.

3.

The amount of the 50 percent bonus depreciation deduction is not affected by a short tax year.

4.

The 50 percent bonus depreciation deduction is not allowed for purposes of computing earnings and profits. IMPORTANT Most states disallow the increased expensing allowance and/or first year bonus depreciation deductions.

F.

In 2013, the Section 168(k) bonus depreciation is eliminated.

- 24 IMPORTANT For planning purposes, current law allows taxpayer to expense 50 percent of new qualified additions acquired before January 1, 2013. Taxpayers should review their capital expenditures and consider accelerating additions into 2012. G.

Comparison of Section 179 versus the 50 percent bonus depreciation.

Types of Activities

Section 179

50% Bonus Depreciation**

Active trade or business only

All activities (rentals)

Yes Big Advantage

Generally-No

$500,000 in 2010-2011 $139,000 in 2012 $25,000 in 2013

No limit

New cash only

50% of basis Consider trade-ins

$2,000,000 in 2010-2011

None

Modify Election Deduction Limited

1031 basis Purchase Amount Limits

** For property acquired after September 8, 2010, and prior to January 1, 2012, 100 percent bonus depreciation was allowed. VII.

FIRST-YEAR DEPRECIATION LIMIT FOR PASSENGER AUTOMOBILES IS INCREASED BY $8,000 IF THE AUTOMOBILE IS “QUALIFIED PROPERTY” (Internal Revenue Code Section 168(k)(2)(F)(i)). A.

For 2012, an additional $8,000 is added to the first year cap for new luxury automobiles, trucks and vans.

B.

For 2012, the following Table shows the depreciation limitation: PASSENGER AUTOMOBILES TAX YEAR 1st Tax Year 2nd Tax Year 3rd Tax Year Each Succeeding

NO BONUS

WITH BONUS

$3,160 5,100 3,050 1,875

$11,160 5,100 3,050 1,875

TRUCKS AND VANS TAX YEAR

NO BONUS

WITH BONUS

1st Tax Year (2009) 2nd Tax Year 3rd Tax Year Each Succeeding

$3,360 5,300 3,150 1,875

$11,360 5,300 3,150 1,875

IMPORTANT The Internal Revenue Service has provided owners and lessees with Tables detailing limitations on the above deductions in Revenue Procedure 2011-26.

- 25 EXAMPLES $

(A)

(B) (A)+(B) $

60,000 -060,000 (8,000) 52,000 20% 10,400 3,160

Purchase price Section 179 (limited)

11,160

2012 deduction

Bonus depreciation (no limit other than autos) Remaining basis Year 1 rate Year 1 depreciation Luxury auto limit

50% Bonus

Section 179 and Bonus

$ 60,000 -060,000 (30,000)

Purchase price Section 179 (limited)

$ 60,000 (25,000) 35,000 (30,000)

Purchase Price Section 179 (limited)

$ 6,000

Year 1 depreciation

$

Year 1 depreciation

$ 36,000

2012 deduction

$ 56,000

Bonus depreciation (no limit) 30,000 Remaining basis 20% Year 1 rate

$

$

60,000 (60,000) -0-0-020% 60,000

Bonus depreciation (no limit) 5,000- Remaining basis 20% Year 1 rate 1,000-

2012 deduction

Purchase price Section 179 (up to $139,000) *Bonus depreciation (no limit) Year 1 rate 2012 deduction

*Could also have claimed 50% bonus if truck was a new truck. C.

Unlike the Section 179 deduction, the purchase of a “used vehicle” does not qualify for the additional 50 percent first year deduction.

D.

There is no AMT depreciation adjustment for qualified property for the entire period.

- 26 E.

F.

There is an important exception where a passenger vehicle with an enclosed body that is built on a truck chassis is not considered to be a passenger auto if it has a gross vehicle weight rating (GVWR) – the manufacturer’s maximum weight rating when loaded to capacity – above 6,000 pounds. 1.

“Heavy” passenger vehicles that meet the preceding definition are considered trucks under the Internal Revenue Code and are thus eligible for the favorable depreciation rules outlined above – as opposed to the stingy luxury auto rules that apply to passenger autos.

2.

Quite a few SUVs, pickups, and vans qualify as heavy.

Reduced Section 179 deduction for heavy SUVs. 1.

VIII.

A lower $25,000 limit exists on Section 179 deductions for heavy SUVs with GVWRs of 14,000 pounds or less.

CONSTRUCTION GROSS RECEIPTS THAT QUALIFY FOR THE DOMESTIC PRODUCTION ACTIVITIES DEDUCTION ( ). A.

B.

A contractor is allowed a deduction under Internal Revenue Code Section 199(a)(1) against gross income equal to 9 percent of qualified production activities income (QPAI). 1.

Contractor must be engaged in a qualified production activity (QPA).

2.

Qualified production activity includes construction performed in the United States.

3.

Contractor must determine qualified domestic production gross receipts.

Domestic Production Gross Receipts (DPGR). 1.

The Regulations define DPGR from construction activities as a taxpayer’s gross receipts from construction activities that are directly related to erection or substantial renovation of real property located in the United States. a.

Includes residential or commercial buildings.

b.

Includes infrastructure improvements such as roads, power lines, water systems, etc.

2.

Gross receipts from the sale of tangible property may be included in DPGR (at the election of the taxpayer) if they are less than 5 percent of total receipts.

3.

Construction does not include activities performed by others that are secondary to the construction, such as hauling or delivery materials.

4.

Painting and land improvements are considered to be construction activities only if performed in connection with other activities that constitute erection or substantial renovation of real property.

5.

The Standard for determining whether there has been a substantial renovation of real property is the Standard applied under Internal Revenue Code Section 263(a) to determine whether a taxpayer’s activities result in permanent improvements or betterments of property, such that the cost must be capitalized.

- 27 C.

D.

E.

On February 24, 2011, the Tax Court ruled in Gibson & Associates v. Commissioner, 136 TC10 that the taxpayer receipts were domestic production gross receipts to the extent the taxpayer erected or substantially renovated real property. 1.

This is the first Court decision on Section 199.

2.

Provides important guidance in two important areas: a.

What constitutes an “item” or a “unit” of real property under Section 199; and

b.

What constitutes “substantial renovation” of real property.

Court Addressed an Item or Unit of Real Property (UOP) under Section 199. 1.

In defining real property, the Section 199 Regulations use the Section 263(a) Regulations.

2.

Regulation Section 1.199-3(m)(3) defines real property to mean: a.

Buildings (including structural components);

b.

Inherently permanent structures other than machinery;

c.

Inherently permanent land improvements; and

d.

Infrastructure.

3.

Regulation Section 199-3(m)(4) defines “infrastructure” in part to include such things as roads, power lines, water systems, etc.

4.

The Court cited Regulation 1.263(a)-10(b)(1) stating “a unit of real property includes any components of real property owned by the taxpayer that are functionally interdependent.”

5.

Court concluded that the relevant item to analyze was each bridge that Gibson worked on, not each component part.

The Court defined “substantial renovation” of real property. 1.

Regulation Section 1.199-3(m)(5) defines substantial renovation as: a.

Materially increasing the value of the real property;

b.

Substantially prolonging the useful life of the real property; and/or

c.

Adapting the property to a new or different use.

2.

Critical issue was substantial renovation versus repair.

3.

Court reported the Internal Revenue Service argument that the rehabilitation of one or more components of real property would be a repair unless all the property’s major components were replaced. IMPORTANT If a contractor is making a repair, the repair will not be domestic production gross receipts (DPGR).

- 28 IX.

PRE-CONTRACTING YEAR COSTS ( ). A.

In CCA 201111006, the Chief Counsel’s Office addressed a situation where a taxpayer entered an agreement requiring the taxpayer to incur design and development costs.

B.

Taxpayer asserted that the design and development costs were currently deductible.

C.

1.

The taxpayer asserted that the design and development costs arise from its operational activities rather than a “long-term contract activity.”

2.

The taxpayer maintained that its design and development costs represent allocable contract costs only when the design and development benefit an existing long-term contract.

3.

The taxpayer referred to Regulation Section 1.460-1(d), which provides that if the performance of a non-long-term contract activity is incident to or necessary for the manufacture, building, installation, or construction of the subject matter of one or more of the taxpayer’s long-term contracts, the costs attributable to that activity must be allocated to the long-term contracts benefitted.

The Chief Counsel’s Office maintained that Section 460 does not expressly impose the condition that allocable contract costs arise only where they will benefit an existing long-term contract. 1.

The Chief Counsel’s Office found the statutory definition of independent research and development expenses in Section 460 to be germane to the analysis.

2.

Two categories of independent research and development expenses are established in Section 460. a.

The first category includes only those costs incurred to benefit existing long-term contracts.

b.

The second category of allocable research and developments costs, however, includes costs performed under an agreement without requiring the contemporaneous existence of a benefitted long-term contract. IMPORTANT For construction companies engaged in “design build,” the design and development costs for a particular contract will be pre-construction costs that are not currently deductible. Keep in mind that these costs will qualify for the research and development credit under Internal Revenue Code Section 41(b).

- 29 X.

ACCRUED BONUSES – THE YEAR OF DEDUCTION ( ). A.

Generally, compensation that is accrued to an employee is deductible by the accrual basis employer provided the compensation is received by the 15 th day of the third calendar month after the employer’s year end.

B.

Internal Revenue Service issued Chief Counsel Advice 200949040 that denied deduction until year paid.

C.

XI.

1.

Under taxpayer’s incentive compensation plan, employees are required to be employed by the taxpayer on the date bonuses are paid to receive compensation.

2.

Internal Revenue Service concluded that liability was not fixed at year end and was contingent.

3.

Even though the bonuses were based on company performance in prior year, economic performance did not occur and the liability is not fixed until the date bonuses are paid since service had to continue.

Internal Revenue Service recently issued Revenue Ruling 2011-29 that permits the taxpayer to deduct accrued bonuses if the employer can establish “the fact of the liability” under Section 461, even though the employer does not know the identity of any particular bonus recipient and the amount payable to that recipient until after the end of the year.

SHAREHOLDERS COULD INCREASE BASIS IN S CORPORATIONS TO DEDUCT LOSSES ( ). A.

B.

The Tax Court in Maguire, TCM 2012-160, held that shareholders in two related S corporations were not prohibited from receiving a distribution from one S corporation and then contributing the assets to another to increase their tax basis to deduct losses. 1.

Taxpayer distributed accounts receivable to shareholders.

2.

Taxpayers executed a separate written shareholder resolution.

3.

Adjusting journal entries were made in the books.

Internal Revenue Service contended no economic outlay. 1.

Court took exception and held that funds lent to an S corporation that originates with another entity owned by the shareholders does not preclude that the loan lacks economic substance.

2.

Related cases. a.

Ruckriegel, TCM 2006-78.

b.

Yates, TCM 2001-280.

c.

Culnen, TCM 2000-139. OBSERVATION The Internal Revenue Service’s position is also reflected in the recent Internal Revenue Service Proposed Regulations on back-to-back loans.

- 30 XII.

LONG-AWAITED PROPOSED REGULATIONS ISSUED ON “BACK-TOBACK LOANS” ( ). A.

B.

On June 12, 2012, the Internal Revenue Service released the much anticipated proposed regulations addressing basis increases for back-toback loans made by S corporation shareholders. 1.

A back-to-back loan in the S corporation context refers to an arrangement in which an S corporation shareholder borrows funds from an unrelated or related third party, and then lends such funds to the S corporation.

2.

A loan can be structured as a back-to-back loan at the outset to enable the shareholder to obtain a basis increase immediately on the infusion of funds into the corporation, or a back-to-back loan may arise later when a loan that originally was structured as a direct loan from the third party to the S corporation is restructured as a back-to-back loan in order to increase basis.

3.

Section 1366(d)(1)(B) does not specifically define what is indebtedness of the S corporation to the shareholders.

4.

Cases and rulings interpreting Section 1366(d)(1)(B) have established two requirements that generally must be met in order for a loan to constitute “indebtedness of the S corporation to the shareholder” within the meaning of Section 1366(d)(1)(B): a.

A debt must run directly from the S corporation to the shareholder.

b.

The shareholder must have made an “actual economic outlay.”

5.

Cases and rulings interpreting Section 1366(d)(1)(B) generally have held that debt of the S corporation must be owed to the shareholder, and not to a related entity, for the debt to increase the shareholder’s basis available to absorb losses from the S corporation.

6.

Thus, shareholders have been denied an increase in basis with respect to loans made to their S corporations by other corporations.

The Proposed Regulations Under Section 1366-2. 1.

Proposed Regulation 1.1366-2(a)(2)(ii) specifically provides that a shareholder does not obtain a basis increase merely by guaranteeing a loan or acting as a surety, accommodation party, or in any similar capacity relating to a loan.

2.

The proposed regulation provides that when a shareholder makes a payment on bona fide debt for which the shareholder has acted as guarantor or in a similar capacity, based on the facts and circumstances, the shareholder may increase its basis of debt to the extent of such payment. NOTE This is consistent with the overwhelming majority of courts that have considered whether shareholders may increase their basis as the result of guarantees of S corporation debt.

- 31 3.

Under the proposed regulations, an incorporated pocketbook transaction increases basis of debt only where the transaction creates a bona fide creditor-debtor relationship between the shareholder and the borrowing S corporation. NOTE The Preamble to the proposed regulations also emphasizes that they do not address how to determine the basis of the shareholder’s stock in an S corporation for purposes of Section 1366(d)(1)(A). Consequently, left unchanged is the conclusion found in published guidance that a shareholder of an S corporation is not allowed to increase his or her basis in an S corporation under Section 1366(d)(1)(A) upon the contribution of the shareholder’s own unsecured demand promissory note to the corporation. Unfortunately, this also leaves the door open for the Internal Revenue Service to still apply the actual economic outlay test, as it did recently in Maguire.

C.

Proposed Regulation 1.1366-2(a)(2)(iii) provides four examples of how the regulations operate: Example 1 A is the sole shareholder of S, an S corporation. A makes a loan to S. The example provides that if the loan is bona fide debt from S to A, A’s loan to S increases A’s basis under Section 1366(d)(1)(B). Example 1 goes on the provide that the result is the same if A made the loan to S through an entity that is disregarded as an entity separate from A under Regulation 301.7701-3. Example 2 A loan made to S directly from Bank. A guarantees Bank’s loan to S. Example 2 provides that no basis increase is allowed as a result of the guarantee until A makes actual payments on the guarantee to the Bank Example 3 The classic back-to-back loan transaction. A is the sole shareholder of two S corporations, S1 and S2. S1 loans $200,000 to A, who then loans $200,000 to S2. Example 3 provides that if A’s loan to S2 is a bona fide debt from S2 to A, A’s back-to-back loan increases his basis under Section 1366(d)(1)(B).

- 32 Example 4 A is the sole shareholder of S1 and S2. S1 makes a loan directly to S2, and subsequently S1 assigns its creditor position in the note to A by making a distribution to A of the note. The example provides that under local law, after S1 distributed the note to A, S2 was relieved of its liability to S1 and was directly liable to A. Example 4 concludes that if the note is bona fide debt from S2 to A, the note increases A’s basis under Section 1366(d)(1)(B). XIII.

DON’T BE PASSIVE WITH PASSIVE ACTIVITY LOSSES – REAL ESTATE PROFESSIONAL ( ). A.

Generally, Section 469 disallows any passive losses from offsetting any other types of income, such as interest, dividends and compensation. 1.

A rental activity is generally treated as passive regardless of whether or not the taxpayer materially participates.

2.

There is a special exception to the annual passive activity loss rules.

3.

The key to this exception is meeting the two requirements for a “real estate professional.”

4.

a.

More than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates; and

b.

Such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

An individual taxpayer materially participates in an activity if he or she meets any one of the following tests: a.

He or she participates more than 500 hours during the year;

b.

His or her participation is substantially all of the participation of individuals in that activity for the year (including individuals who are not owners of interests in the activity);

c.

He or she participates more than 100 hours and no other individual participated more;

d.

The activity is a significant participation activity and his or her aggregate participation in all significant participation activities exceeds 500 hours;

e.

He or she materially participates for 5 out of 10 years immediately preceding the year in issue;

- 33 -

5. B.

The activity is a personal service activity and he or she materially participated for any three years preceding the year in issue; or

g.

On all the facts and circumstances, he or she participated on a regular, continuous, and substantial basis during the year.

Rather than attempt to substantiate “material participation” for each rental property, an election can be made to “aggregate the properties.”

Real Estate Professional Status. 1.

2.

C.

f.

In Bosque v. Commissioner, TC Memo 2011-79, the Court held that an attorney did not qualify as a real estate professional, but did actively participate in real estate rental. a.

Taxpayer kept daily logs.

b.

Taxpayer held to materially participate.

c.

Taxpayer failed the 750 hours test and held not to be a real estate professional.

In Anyika v. Commissioner, TC Memo 2011-69, the Tax Court held that a Pennsylvania engineer was not a real estate professional and his real estate rental activities were passive activities. a.

Taxpayer worked as an engineer 7.5 hours per week for 48 weeks or 1800 hours per year.

b.

Taxpayer alleged that he worked 800 hours as a real estate professional.

c.

Court explained that he would have had to work more than 1800 hours engaged in the real estate business to attain the “more than one-half of the personal services in real property trades and businesses.”

Losses from Real Estate Rentals are Passive and Limited. 1.

2.

Irvine v. Commissioner, TC Memo 2012-32. a.

Taxpayer failed to elect to treat all interests in rental real estate as a single rental unit.

b.

The Court evaluated each of their properties separately in order to determine whether or not the taxpayer materially participated in real estate activities for each property.

c.

Taxpayer showed he spent over 812 hours in real estate business which included the hours he spent as a pilot.

d.

However, while the hours claimed in the real estate activities were more than half of his personal services, not all his hours counted towards “material participation.”

Donald W. Task vs. Commissioner, TC Memo 2010-78. a.

Task owned 33 rental properties.

b.

Task showed via work logs that he was a real estate professional.

- 34 -

D.

E.

c.

Task failed to elect to aggregate the properties as a single activity under Section 469(c)(7)(A).

d.

He failed to prove he materially participated in each activity.

e.

Taxpayer had aggregated his rental activities, but had failed to make a formal election.

f.

Court concluded that Task failed to satisfy the material participation test.

Internal Revenue Service Revenue Procedure 2010-13, 2010-4. 1.

Internal Revenue Service has finalized system for reporting groupings and regrouping of passive activities.

2.

Taxpayers, including partnerships and S corporations, must report on their annual tax returns, certain changes to the taxpayer’s groupings of passive activities.

3.

A statement is required for new groupings that are grouped as a single activity. a.

Statement must identify names, addresses and EIN.

b.

Must contain a declaration that the grouped activities constitute an appropriate economic unit.

4.

Statement is required for regrouping.

5.

Failure to report means that each trade or business activity or rental activity will be treated as a separate activity.

6.

Effective for 2011.

Real Estate Professionals Allowed Late Election to Aggregate Rental Real Estate Interests under Revenue Procedure 2011-34. 1.

Under Revenue Procedure 2011-34, a taxpayer is treated as having made a timely election under Section 469(c)(7)(A) to treat all interests in rental real estate as a single rental real estate activity.

2.

Taxpayer is eligible for this extension, if he represents that he:

3.

a.

Failed to make the election solely because he failed to timely meet the requirements in Regulation 1.469-9(g);

b.

Filed all prior year tax returns consistent with the election;

c.

Timely filed each prior year tax return; and

d.

Had reasonable cause for having not made the election.

Taxpayer must attach the required statement under Regulation 1.469-9(g) to an “amended” return for the most recent year.

- 35 XIV.

TAXPAYER WAS PROHIBITED FROM DEDUCTING MANAGEMENT FEES PAID BY ONE RELATED ENTITY TO ANOTHER ( ). A.

B.

The Tax Court in Fuhrman, TC Memo 2011-236 held that the Taxpayer was not entitled to deduct management fees it paid to its wholly-owned C corporation. 1.

Tax Court found that Fuhrman failed to establish that the amounts charged for management fees were “ordinary and recurring.”

2.

Tax Court challenged whether the amounts charged were at arm’s-length.

3.

Fuhrman had no support to demonstrate how the management fees were determined.

4.

There was no written contract.

5.

No documentation as to provide contemporaneous support.

Related Tax Court Cases. 1.

2.

XV.

In ASAT, Inc., 108 TC 147, the Tax Court held that the Taxpayer could not deduct consulting fees it paid to its subsidiary when the Taxpayer failed to establish how the fees were determined. a.

No written contract.

b.

No detail or invoices.

c.

No evidence of the provider’s skills to support the charges.

In Trailers, Inc., TC Memo 2011-105, the Tax Court held that a taxpayer’s wholly-owned S corporation was not entitled to deduct management fees paid to another of his wholly-owned S corporations where the evidence did not adequately support the services and who performed them.

EXPENSE REIMBURSEMENT REGULATIONS ( ). The Service has issued proposed regulations to clarify the definition of reimbursement or other expense allowance arrangements and how the deduction limitations apply to reimbursement arrangements between three parties. A.

Deductions for certain expenses for entertainment, amusement, or recreation activities and for facilities used in connection with entertainment, amusement, or recreation activities are limited. 1.

The amount allowable as a deduction for any expense for food, beverages, entertainment activities, or entertainment facilities is generally limited to 50 percent of the amount otherwise allowable.

2.

However, these limitations do not apply to an expense a taxpayer pays or incurs in performing services for another person under a reimbursement or other expense allowance arrangement with the other person.

- 36 3.

The exception applies if the taxpayer is an employee performing services for an employer and the employer does not treat the reimbursement for the expenses as compensation and wages to the taxpayer.

4.

In that case, the employee is not treated as having additional compensation and has no deduction for the expense. The employer bears and deducts the expense and is subject to the deduction limitations.

5.

If the employer treats the reimbursement as compensation and wages, the employee may be able to deduct the expense as an employee business expense. a.

6.

The employee bears the expense and is subject to the deduction limitations, and the employer deducts an expense for compensation, which is not subject to the deduction limitations under Section 274.

The exception also applies if the taxpayer performs services for a person other than an employer and the taxpayer accounts (substantiates, as required) to that person. NOTE In a reimbursement or other expense allowance arrangement in which a client or customer reimburses the expenses of an independent contractor, the deduction limitations do not apply to the independent contractor to the extent the independent contractor accounts to the client by substantiating the expenses as required. If the independent contractor is subject to the deduction limitations, the limitations do not apply to the client.

B.

In the case of any expenditure for entertainment, amusement, recreation, food, or beverages made by one person in performing services for another person (whether or not the other person is an employer) under a reimbursement or other expense allowance arrangement, the limitations on deductions apply either to the person who makes the expenditure or to the person who actually bears the expense, but not to both. 1.

C.

If an expenditure of a type described herein properly constitutes a dividend paid to a shareholder, unreasonable compensation paid to an employee, a personal expense, or other nondeductible expense, nothing in this exception prevents disallowance of the expenditure to the taxpayer under other provisions of the Code.

In the case of an employee’s expenditure for entertainment, amusement, recreation, food, or beverages in performing services as an employee under a reimbursement or other expense allowance arrangement with a payor (the employer, its agent, or a third party), the limitations on deductions apply: 1.

To the employee to the extent the employer treats the reimbursement or other payment of the expense on the employer’s income tax return as originally filed as compensation paid to the employee and as wages to the employee for purposes of withholding; and

- 37 2.

D.

In the case of an expense for entertainment, amusement, recreation, food, or beverages of a person who is not an employee (referred to as an independent contractor) in performing services for another person (a client or customer) under a reimbursement or other expense allowance arrangement with the person, the limitations on deductions apply to the party expressly identified in an agreement between the parties as subject to the limitations.

E.

If an agreement between the parties does not expressly identify the party subject to the limitations, the limitations apply:

F.

XVI.

To the payor to the extent the reimbursement or other payment of the expense is not treated as compensation and wages paid to the employee in the manner provided in the preceding paragraph.

1.

To the independent contractor (which may be a payor described in the preceding paragraph) to the extent the independent contractor does not account to the client or customer; and

2.

To the client or customer if the independent contractor accounts to the client or customer.

The term reimbursement or other expense allowance arrangement means: 1.

For these purposes, an arrangement under which an employee receives an advance, allowance, or reimbursement from a payor (the employer, its agent, or a third party) for expenses the employee pays or incurs; and

2.

For these purposes, an arrangement under which an independent contractor receives an advance, allowance, or reimbursement from a client or customer for expenses the independent contractor pays or incurs if either: a.

A written agreement between the parties expressly states that the client or customer will reimburse the independent contractor for expenses that are subject to the limitations on deductions; or

b.

A written agreement between the parties expressly identifies the party subject to the limitations.

WORKER CLASSIFICATION ISSUES UNDER ATTACK BY INTERNAL REVENUE SERVICE. A.

B.

Employers should evaluate whether workers are properly classified as independent contractors and not as employees. 1.

Internal Revenue Service enforcement under the Employment Tax National Research payment.

2.

In September of 2011, the Internal Revenue Service entered into a memorandum of understanding with the Department of Labor and “states to share information regarding employee classifications.”

Section 530 under the Revenue Act of 1978 offers relief. 1.

Taxpayers must consistently treat the workers in question as nonemployees;

- 38 -

C.

2.

The inconsistent treatment of even one employee can cause this requirement to not be met;

3.

It must report the compensation on Form 1099 for all years; and

4.

It must have a reasonable basis for treating the workers as nonemployees.

Internal Revenue Service announced a “Voluntary Classification Settlement Program” (VCSP) for employers to voluntarily re-classifying workers as employees. 1.

The program applies to taxpayers who are currently treating their workers (or a class or group of workers) as independent contractors or other nonemployees and want to prospectively treat the workers as employees.

2.

To be eligible:

3.

a.

The taxpayer must have consistently treated the workers as nonemployees, and must have filed all required Forms 1099 for the workers for the previous three years.

b.

The taxpayer cannot currently be under audit by the Internal Revenue Service.

c.

The taxpayer cannot be currently under audit concerning the classification of the workers by the Department of Labor or by a state government agency. A taxpayer who was previously audited by the Internal Revenue Service or the Department of Labor concerning the classification of the workers will only be eligible if the taxpayer has complied with the results of that audit.

A taxpayer who participates in the VCSP will agree to prospectively treat the class of workers as employees for future tax periods. In exchange, the taxpayer: a.

Will pay 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Section 3509 of the Internal Revenue Code;

b.

Will not be liable for any interest and penalties on the liability; and

c.

Will not be subject to an employment tax audit with respect to the worker classification of the workers for prior years. NOTE Additionally, a taxpayer participating in the VCSP will agree to extend the period of limitations on assessment of employment taxes for three years for the first, second, and third calendar years beginning after the date on which the taxpayer has agreed under the VCSP closing agreement to begin treating the workers as employees.

- 39 4.

The amount due under the VCSP is calculated based on compensation paid in the most recently closed tax year, determined at the time the VCSP application is being filed. EXAMPLE In 2010, employer paid $1,500,000 to workers that are the subject of the VCSP. All of the workers that are the subject of the VCSP were compensated at or below the Social Security wage base (e.g., under $106,800 for 2010). Employer submits the VCSP application on October 1, 2011, and Employer wants the beginning date of the quarter for which Employer wants to treat the class or classes of workers as employees to be October 1, 2012. Employer looks to amounts paid to the workers in 2010 for purposes of calculating the VCSP amount, since 2010 is the most recently completed tax year at the time the application is being filed. Under Section 3509(a), the employment taxes applicable to $1,500,000 would be $160,200 (10.68 percent of $1,500,000). Under the VCSP, the payment would be 10 percent of $160,200, or $16,020.

5.

XVII.

The 10.68 percent effective rate applies under the VCSP in 2011 since the most recently closed tax year is 2010. The 10.28 percent effective rate applies under the VCSP in 2012 since the most recently closed tax year is 2011. The rate of 3.24 percent applies to compensation above the Social Security wage base in both situations. These effective rates constitute the sum of the rates as calculated under Section 3509(a).

LOOK-BACK INTEREST – ANOTHER INTERNAL REVENUE SERVICE AUDIT ISSUE (Internal Revenue Code Section 460(b)(1)(B) and Internal Revenue Service Regulation 1.460-6(a)(1)). A.

B.

Application of look-back. 1.

In the year of completion, income from certain long-term contracts accounted for under either the percentage-of-completion method or percentage-of-completion-capitalized-cost method is allocated among the prior taxable years on the basis of actual contract price and costs instead of estimated contract price and costs.

2.

The underpayment or overpayment of tax that results from this reallocation of income, for each affected prior taxable year, is determined and the taxpayer must either pay look-back interest if the reallocation reveals a deferral of tax liability, or is entitled to a refund of interest if the reallocation shows an acceleration of tax liability.

Post-completion revenue and expenses. 1.

In addition to the year of completion, look-back applies to any postcompletion year for which the taxpayer must adjust the total contract price or total allocable contract costs.

- 40 2. C.

D.

However, the taxpayer may elect not to have look-back method apply in de minimus cases.

Alternative minimum tax (AMT). 1.

Look-back not only applies to long-term contracts reported under the percentage-of-completion method for regular income tax purposes but also applies to long-term contracts that must be reported under the percentage-of-completion method for alternative minimum tax purposes.

2.

Includes CCM contracts used for regular tax.

Percentage-of-completion-capitalized-cost method (PCCM). For long-term contracts reported under the percentage-of-completion-capitalizedcost method, look-back applies to the portion of the contract that is subject to percentage-of-completion. In the case of long-term residential contracts (buildings with four or more dwelling units), the portion is 70 percent. Lookback may also apply to the remaining 30 percent portion for alternative minimum tax purposes.

E.

F.

Exceptions from the application of look-back. 1.

Home construction contract – The look-back method does not apply to home construction contracts (defined in Internal Revenue Code Section 460(e)(6)(A)).

2.

Mandatory de minimus exception – The look-back method does not apply to any long-term contract that is completed within two years of the contract commencement date and has a gross contract price that does not exceed the lesser of $1,000,000 or 1 percent of the average annual gross receipts for the three tax years preceding the tax year of completion.

3.

Elective de minimus discrepancies exception – A taxpayer may elect not to apply look-back if the cumulative taxable income under the contract for each prior year is within 10 percent of the cumulative look-back income for each prior year.

Filing and reporting look-back interest. 1.

The computation of the amount of deferred or accelerated tax liability under the look-back method is hypothetical and it does not result in amending prior years’ tax liability.

2.

Definitions:

3.

a.

Filing year – The taxable year in which long-term contracts are completed or adjusted (post-completion adjustments).

b.

Redetermination year – Each prior tax year that is affected by income from contracts completed or adjusted in the filing year.

Form 8697 is used to compute and report look-back interest due or to be refunded. a.

For each filing year, the taxpayer will either owe look-back interest or be entitled to a refund as the “net” result of computing look-back interest on one or more redetermination years.

- 41 -

G.

Thus, a current filing year may contain both hypothetical overpayments and underpayments for prior years, but the net result determines whether look-back interest is owed by the taxpayer or should be refunded.

c.

The Form 8697 consists of two methods, represented as Part I and Part II, for computing look-back interest. (i)

Form 8697, Part I – Regular Method.

(ii)

Form 8697, Part II – Simplified Marginal Impact Method.

New Changes to the Look-Back Form. 1.

2.

3. H.

b.

The filing year has been added as a column. a.

Income tax liability is recomputed in the filing year for the effect of the filing year look-back adjustment.

b.

Line 3 of the filing year column becomes the line 1 entry of the subsequent year look-back redetermination

c.

Line 4 of the filing year column is used instead of actual tax in line 5 of the redetermination year.

Line 2 – The total column (2(c)) has been opened up. a.

All line 2 columns when added should result in “0.”

b.

Look-back does not increase or decrease income – it only reallocates it from year to year.

Signature – There is now a second signature line for the spouse for joint returns.

Common errors made in look-back. 1.

For refunds requested by individuals, failure to include both signatures on the Form 8697. If the related income tax return (Form 1040) is a joint return, both signatures are required on the Form 8697.

2.

Improperly computing interest from the NOL carryback year. The tax liability is hypothetically re-determined in the tax year the NOL carryback is absorbed, but interest to be computed for that carryback year is only from the due date (not including extensions) of the tax year that generated the NOL to the due date of the filing year (not including extensions).

3.

Simplified marginal impact method incorrectly applied at the flowthrough entity level for those taxpayers electing this method. There are only two instances in which look-back interest is applied at the entity level of a flow-through entity (Form 1120-S or Form 1065). a.

The pass-through entity is widely-held and required to use SMIM.

b.

Following the conversion of a C corporation into an S corporation the look-back method is applied at the entity level with respect to contracts entered into prior to the conversion. See Treasury Regulation Section 1.460-6(g)(3)(iv).

- 42 4.

For taxpayers electing SMIM, the overpayment ceiling is not being applied – the net hypothetical overpayment of tax should be limited to the taxpayer’s total Federal income tax liability as adjusted (i.e., prior applications of look-back, NOL carrybacks, etc.). The overpayment ceiling does not apply to widely-held pass-through entities; taxpayers who are required to use SMIM. See Treasury Regulation Section 1.4606(d)(2)(iii).

5.

Separate members of a consolidated group erroneously file Form 8697. The consolidated entity must file the Form 8697 using the consolidated entity’s EIN.

6.

The interest rate for computing look-back interest is incorrectly being changed as the quarterly rates change. The quarterly rate that is in effect on the date after the due date of a taxpayer’s return should be applied to the entire “interest accrual period” (an annual period), and it does not change quarterly during the year.

7.

Forms 8697 claiming refunds are improperly attached to the tax return reducing the current year’s tax liability. Forms 8697 refunds that must be filed separately from the income tax return.

8.

Schedules of contract income reallocation are not attached to the Form 8697 – only owners of pass-through entities are exempt from this requirement.

9.

The cumulative changes to look-back taxable income and look-back tax liability for each redetermination year are not being properly reported on the Form 8697. *

*

*