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Tax Alerts

Tax Alerts

CBO reports on top tax incentives/expenditures

The Congressional Budget Office (CBO) issued a report in mid-March about current tax incentives. Tax expenditures, CBPO explained, reduce the amount of revenue that is collected for any given set of statutory tax rates. Tax incentives also affect the distribution of the tax burden in ways that may not always be recognized, both among people at different income levels and among people who have similar income but differ in other ways, CBO reported.

CBO identified the top five largest tax expenditures in 2017 as:

  • The exclusion from workers’ taxable income of employers’ contributions for health care, health insurance premiums, and premiums for long-term care insurance;
  • The exclusion of contributions to and the earnings of pension funds (minus pension benefits that are included in taxable income);
  • Preferential tax rates on dividends and long-term capital gains;
  • The deferral for profits earned abroad, which certain corporations may exclude from their taxable income until those profits are returned to the U.S.; and
  • The deductions for state and local taxes (on nonbusiness income, sales, real estate, and personal property).

Other significant tax expenditures include the earned income tax credit (EITC), the deduction for mortgage interest, the immediate deduction for investments in certain business property, and the deduction for charitable contributions, according to CBO. Watch for all of these scores to play a role in the upcoming debate on tax reform.

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IRS updates 401(k) hardship distributions exam materials

The IRS Tax Exempt and Government Entities Division (TE/GE) has updated guidance used to determine whether a Code Sec. 401(k) plan hardship meets the safe-harbor standards set forth in applicable regulations. Specifically, the memorandum, TE/GE-04-0217-008, sets out the substantiation guidelines that IRS auditors are to use in conducting related examinations.

Under Code Sec. 401(k), plans may provide hat an employee can receive a distribution of elective contributions from the plan on account of hardship. Generally, a hardship distribution form a retirement account can only be made for immediate and heavy financial need of the employee and is in an amount necessary to satisfy the financial need of the applicable.

Under Reg. §1.401(k)-1(d)(3)(iii)(B), the safe harbor provides that a distribution is deemed to be as a result of immediate and heavy financial need if made for the following reasons:

  • Expenses for medical care deductible under Code Sec. 213(d);
  • Costs directly related to the purchase of a principle residence;
  • Payment of tuition, related educational fees, and room and board expenses for up to the next 12 months of post-secondary education for the employee or employee’s spouse, children or dependents;
  • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure of the mortgage on that residence;
  • Payments for burial or funeral expenses for the employee’s deceased parent, spouse, children or other dependent; or
  • Expenses for the repair of damage to the employee’s principal residence that would qualify for the Code Sec. 165 casualty deduction.

The TE/GE guidance details the steps that an examiner is to take in substantiation that a distribution is made for one of the enumerated reasons. Firstly, the examiner is to determine whether the employer or a third-party administrator had the requisite source documents or summary of source documents prior to making a distribution to an affected employee. In addition, the examiner may need to ensure that the employee was given the relevant notifications prior to a hardship distribution, to include being told that the hardship is taxable, and that the amount of the distribution may not exceed the immediate and heavy financial need.

Next, the IRS examiner is to review the provided documentation to determine if they substantiate the requested hardship distribution. If they do not, the examiner is to ask the employer or the third-party administrator to substantiate that a hardship distribution is deemed to be on account of an immediate and heavy financial need. If an examiner determines that the requirements of the first and second steps are met, the plan is to be treated as satisfying the substantiation requirement for making hardship distributions deemed to be for an immediate and heavy financial need.

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Employee consent requirements for employer refund claims released

The IRS recently issued the employee consent requirements that an employer need to adhere to in order to support a claim for refund of overpaid taxes under the Federal Insurance Contributions Act (FICA) and the Railroad Retirement Tax Act (RRTA). The guidance clarifies the basic requirements for both a request for employee consent and the content needed for the employee consent. It also permits employee consent to be requested, furnished and retained in electronic format. In addition, the procedure contains guidance concerning what constitutes “reasonable efforts” if employee consent is not secured in order to permit the employer to claim a refund of the employer share of overpaid FICA and RRTA taxes.

The new guidance applies to employee consents requested as of June 5, 2017. It does not require employers to solicit new employee consents and will not affect the validity of any employee consent received pursuant to a request made prior to June 5, 2017, that was provided in accordance with existing law. For employee consents requested before June 5, 2017, employers may rely on the proposed revenue procedures set forth in Notice 2015-15.

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New Offers in Compromise policy starts April 27

The IRS informed taxpayers and tax professionals of its updated policy with regards to the Offer in Compromise (OIC) application process. OIC applications received on or after March 27, 2017, will now be returned without further consideration in instances where the taxpayer has not filed all required tax returns, the Service explained. In addition, the associated application fee will also be returned. Further any required initial payment submitted with the OIC will be applied to the outstanding tax debt. The agency also noted that taxpayers continue to be required to make nonrefundable partial payments with the submission of any OIC, the IRS noted. The new policy will not apply to current year tax returns so long as a valid extension is on file.

The new policy can be read on the Offer in Compromise page located on the IRS website and the newly updated Offer in Compromise Booklet, Form 656-B, available as of March 27.

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Tax refund offsets may be used toward unpaid debts

A taxpayer who incurs an unpaid debt may notice a reduction in his or her federal tax refund. The Treasury Offset Program is allowed to use all or part of a taxpayer’s federal refund to settle unpaid federal or state debts, to include unpaid individual shared responsibility payments.

For example, the IRS is prohibited from using liens or levies to collect any individual shared responsibility payment, if a taxpayer owes a shared responsibility payment, the IRS may offset the taxpayer’s tax refund against the liability.

The Department of Treasury’s Bureau of the Fiscal Service, or BFS, runs the Treasury Offset Program. The BFS may use part or all of a taxpayer’s tax refund to pay certain debts such as federal tax debts, federal agency debts (e.g. a delinquent student loan), state income tax obligations, past-due child and spousal support, and certain unemployment compensation debts owed to a state.

The BFS mails a taxpayer a notice if it offsets any part of the taxpayer’s refund to pay the debt incurred. The notice lists the original refund and the offset amount. It also includes the agency that received the offset payment, as well as the agency's contact information.

A taxpayer may dispute the offset by contacting the agency that received the offset payment. Note that taxpayers should only contact the IRS if the offset was applied to a federal tax debt.

Taxpayers who filed a joint tax return with their spouse may be entitled to part or the entire offset. However, this rule only applies if the spouse is solely responsible for the debt. For the taxpayer to obtain his or her part of the refund, he or she should file Form 8370, Injured Spouse.

Further, although the IRS is prohibited from using liens or levies to collect any individual shared responsibility payment, if a taxpayer owes a shared responsibility payment, the IRS may offset the taxpayer’s tax refund against the liability.

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Passport certifications will begin in early 2017, IRS posts on website

The IRS has informed taxpayers via its website that the agency will begin, in early 2017, to remit certifications to the U.S. State Department for individuals who are seriously delinquent in paying their tax debt. Such certification could impact an individual’s ability to obtain or keep a U.S. passport. At this time, the IRS has not started certifying tax debt to the State Department, the agency reported on its website.

On its website, the IRS explained that seriously delinquent tax debt is an individual's unpaid, legally enforceable federal tax debt totaling more than $50,000 (including interest and penalties) for which a notice of federal tax lien has been filed and all administrative remedies under Code Sec.6320 have lapsed or been exhausted, or a levy has been issued.

However, the IRS explained, some tax debt is not included in determining seriously delinquent tax debt. Such tax debt includes:

  • Being paid in a timely manner under an installment agreement entered into with the IRS.
  • Being paid in a timely manner under an offer in compromise accepted by the IRS or a settlement agreement entered into with the U.S. Justice Department.
  • For which a collection due process hearing is timely requested in connection with a levy to collect the debt.
  • For which collection has been suspended because a request for innocent spouse relief under Code Sec. 6015 has been made.

Before an applicant’s passport is denied, the State Department will hold the application for 90 days. During the 90 days, an individual can resolve any erroneous certification issues; make full payment of the tax debt; and/or enter into a payment alternative, such as an installment agreement. There is no grace period for resolving the debt before the State Department revokes a passport, the IRS added.

The IRS will notify taxpayers in writing if the agency makes a certification to the State Department. The agency will also notify taxpayers in writing if it reverses a certification. In addition, the IRS will provide notice within 30 days of the date the debt is fully satisfied, becomes legally unenforceable or ceases to be seriously delinquent tax debt.

Taxpayers may seek judicial review of certifications. If the Tax Court or a federal district court finds the certification was erroneous, the court may order the IRS to notify the State Department. There is no administrative process before filing suit in court, the IRS explained.

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Tax returns lacking ACA coverage status will not be rejected

The IRS has announced that it will continue to process individual returns that do not report the taxpayer’s health coverage status under the Affordable Care Act (ACA). The IRS will accept returns that fail to indicate coverage, an exemption or a shared responsibility payment. The IRS had planned to reject these returns (known as "silent returns") this filing season after having accepted them in past years. Taxpayers may, however, be contacted later, the IRS cautioned.

The IRS left open the question of whether it would revise other aspects of ACA compliance during the balance of this filing season. The IRS announcement on processing silent returns began with the statement, without elaboration: "The IRS is currently reviewing the January 20, 2017, Executive Order on the ACA to determine the implications. Taxpayers should continue to file their tax returns as they normally would."

Executive order. Shortly after taking office, President Trump announced that it is the policy of his administration to seek "prompt repeal" of the ACA. In Executive Order 13765, the President instructed the heads of federal agencies "to waive, defer, grant exemptions from or delay the implementation of any provision or requirement of the ACA that would impose any cost, fee, tax, penalty, or regulatory burden on individuals."

Return processing. Processing silent returns means that returns are not systemically rejected by the IRS at the time of filing, allowing the returns to be processed and minimizing burden on taxpayers, including those expecting a refund,” the agency reported.

Follow-up. Taxpayers may receive follow-up questions and correspondence at a future date, about their coverage status, after the filing process is completed, the IRS reported. The IRS also emphasized that its revised treatment does not change the underlying legislative provisions of the ACA that remain in force at this time, including penalty payments, until changed by Congress.

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Dentist persuades Tax Court of material participation in real estate business

The Tax Court determined, in Zarrinnegar v. Commissioner, TC Memo. 2017-34, that a dentist by profession, was a real estate professional, and therefore could deduct rental real estate losses. As such, the losses were not barred by the passive activity rules.

The taxpayer was a dentist married to another dentist with whom he shared a dental practice. The two worked in shifts, often with the wife working the morning shift and the husband working the afternoon shift. The couple also owned a real estate brokerage firm and four rental properties. The husband managed the properties, while the wife did not. The husband reported that he spent over 1,000 hours every year on the real estate business.

For several years, the couple reported income from the dental practice on their returns, and losses from their real estate business. The IRS disallowed the deductions for the losses after characterizing them as passive activity losses.

In general, losses from the rental activities of a real estate professional are not considered passive losses. One requirement to be classified as a real estate profession, among many, is that an individual perform more than 750 hours of services during the tax year in real property trades or businesses in which he or she materially participates.

The Tax Court held that a passive activity is trade or business in which the taxpayer does not materially participate. Material participation requires regular, continuous and substantial involvement in business operations. Rental activities are generally considered passive in nature, regardless of a taxpayer’s material participation. However, there is an exception for rental activities of taxpayers who are real estate professionals.

A taxpayer is a real estate professional if more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

The court determined that the husband had worked more than 1,000 hours each year on the real estate business, as he substantiated this claim with credible time logs. Witness testimony also substantiated the amount of time the husband spent on the real estate business. In addition, the court found that the husband worked less than 1,000 hours every year at the dental practice. As such, the court concluded that the couple was not bared from claiming the losses from their real estate business.

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IRS confirms automatic six-month extension for C corporations

The IRS has confirmed that a new revision of the Instructions for Form 7004 correctly reflects that calendar year C corporations are eligible for an automatic six-month extension. Code Sec. 6081(a) provides that the IRS may grant a reasonable extension of time for filing returns, so long as the extension is not more than six months, the IRS explained.

Domestic corporations are required to annually file Form 1120, U.S. Corporation Income Tax Return, to report the income, credits, gains, losses, deductions, and income tax liability of the corporation unless it elects, or is required to file, a special return. Corporate income tax returns are usually filed on Form 1120, but specified types of corporations are required to file on specialized forms.

The automatic extension provided by Reg. §1.6081-3(a) to C corporations filing Form 1120 was codified by the Surface Transportation Act and changed to six-months. This change applies to returns for tax years beginning after December 31, 2015. However, a special rule under Code Sec. 6081(b) provides that in the case of any calendar-year C corporation with a tax year beginning before January 1, 2026, the maximum extension allowed is five months. In the case of a C corporation with a fiscal year ending on June 30 and beginning before January 1, 2026, the maximum extension allowed is seven months.

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Future pension payouts not counted as asset in determining insolvency exclusion

The Tax Court, in Schieber v. Commissioner, TC Memo. 2017-32, found that the right to a continuing monthly payment state pension plan was not an asset in determining insolvency for purposes of exclusion from cancellation of indebtedness income. The court rejected the IRS’s argument that the ability of the taxpayers to use their monthly pension payments to continue to pay off existing tax indebtedness was sufficient to disprove insolvency.

The taxpayer-husband’s public employees’ defined benefit pension provided monthly payments with cost of living increases. Other than the monthly amounts as they became payable, the husband and his wife could not access the value in the plan. They could not convert their interest into a lump-sum cash amount, sell their interest, assign their interest, borrow against their interest or borrow from the plan. The plan withheld federal income tax from the payments.

A mortgage lender cancelled $418,000 of the taxpayers’ debt. The taxpayers claimed that their liabilities exceeded their asset by $293,000, and that should be excluded from cancellation of indebtedness income under the insolvency exception provided in Code Sec. 108. The IRS, however, claimed that the taxpayers were not insolvent since the income stream from the pension should be counted as an asset.

The Tax Court observed that although the Tax Code does not define assets, case precedent did find that an asset exempt from creditors could still be an asset for purposes of Code Sec. 108 because such an asset can give the taxpayer the ability to pay an immediate tax on income from the canceled debt. The IRS argued that the taxpayers’ interest in the pension plan should be considered an asset because they could use their monthly payments to pay liabilities.

However, the Tax Court appeared to view the insolvency test to be one predicated on whether the asset gives the taxpayer the ability to pay an “immediate tax on income” from the canceled debt, not to pay the tax gradually over time. Here, the taxpayers’ interest in the pension plan could not be used to immediately pay the income tax on canceled-debt income. Therefore, the court found that it could not be considered an asset within the meaning of Code Sec. 108.

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