2017

Current developments in S corporations

EXECUTIVE
SUMMARY

  • A binding, nonjudicial settlement agreement, where available under state law, offers a practical alternative to a probate court ruling to revise a trust's terms to comply with requirements to be a qualified Subchapter S trust.
  • An extension of time to make a "closing of the books" election upon termination of an S election may be available under Regs. Secs. 301.9100-1 and 301.9100-3, a recent IRS letter ruling demonstrates.
  • If an S corporation has accumulated earnings and profits and excess passive investment income for each of three consecutive tax years, its S election terminates. The IRS waived an inadvertent termination under the facts and circumstances presented in a letter ruling request. Other letter rulings determined that certain rental income was not passive investment income.
  • The Tax Court ruled in several cases involving S corporation shareholder basis that taxpayers claimed was created or increased by debt obligations. Other court cases involved determining whether the S corporation or its employee-shareholder was required to recognize income from providing services, the effect on basis of shareholders' income inclusion under Sec. 83(b), and allocation to a bankruptcy estate of shareholders' passthrough items.

In 2016 and 2017, courts have decided several cases involving S corporations and their shareholders. In addition, the IRS has issued guidance that should be of interest to S corporation owners. The AICPA S Corporation Taxation Technical Resource Panel offers the following summary of the court decisions and IRS guidance affecting S corporations and their shareholders that the panel believes will be of interest to tax practitioners.

Final regulations under Sec. 385


The IRS and Treasury in 2016 issued proposed regulations under Sec. 385 addressing when a purported debt instrument would be recharacterized as equity for income tax purposes.1These proposed regulations caused significant concerns from an S corporation perspective because their effect on a corporation's ability to satisfy the small business corporation requirements2 was unclear. Specifically, the proposed regulations raised concerns about whether the recharacterization of a purported debt instrument as equity would cause the issuing corporation to be treated as having more than one class of stock and/or cause the holder to be treated as a shareholder of the issuing corporation. However, in the final and temporary regulations issued in October 2016, S corporations are exempt from all aspects of these regulations.3

Reforming a trust to qualify as a qualified Subchapter S trust


In two private letter rulings,4 the IRS ruled that a trust was a qualified Subchapter S trust (QSST) following its reformation pursuant to a binding, nonjudicial settlement agreement.

Under the facts of the letter rulings, the terms of a trust that provided for discretionary distributions to the descendants of the primary beneficiary during the primary beneficiary's lifetime were reformed pursuant to a binding, nonjudicial settlement agreement so that the QSST requirement limiting distributions to the current beneficiary during the beneficiary's lifetime would be satisfied.5 Under the laws of the state that governed the trust, interested parties could enter into a binding, nonjudicial settlement agreement with respect to the validity, interpretation, or construction of the terms of the trust that would be final and binding on the trustee, all current and future beneficiaries of the trust, and all other interested persons, as if ordered by a court.

These letter rulings highlight a practical alternative to a probate court ruling for modifying the terms of a trust to qualify it as a permissible S corporation shareholder. However, it is important to note that modifications to a trust, whether via a nonjudicial settlement agreement or a probate court ruling, will likely not be given retroactive effect for purposes of the trust's qualifying as an S corporation shareholder, even if effective retroactively under applicable state law.6

Extension of time granted to file a 'closing of the books' election


If an S election terminates on a date other than the first day of the corporation's tax year, an "S termination year" results, consisting of an "S short year" and a "C short year."7 Unless a closing of the books is required, the corporation's items of income, gain, loss, deduction, credit, etc., are allocated between the S short year and the C short year on a daily, pro rata basis.8 However, a corporation may elect to not have the pro rata allocation rule apply and instead assign the items of income, gain, loss, deduction, credit, etc., for the S termination year to the S short year and the C short year under normal tax accounting rules (the "closing of the books election").9 The election is made by filing a statement with the corporation's return for the C short year.10 In a recent letter ruling,11 the IRS granted the taxpayer an extension of time to file a closing-of-the-books election pursuant to Regs. Secs. 301.9100-1and 301.9100-3.

Passive investment income (Secs. 1362(d)(3) and 1375)


S election termination from excess passive investment income was inadvertent

Under Sec. 1362(d)(3), if, for three consecutive tax years, an S corporation has accumulated earnings and profits at the close of each tax year and has excess passive investment income12 for each tax year, then the corporation's S election terminates at the beginning the first day of the first tax year following the third consecutive tax year. Under Sec. 1375(a), if an S corporation has accumulated earnings and profits at the close of a tax year and has excess passive investment income for the tax year, a tax is imposed on the corporation's net passive investment income.

In Letter Ruling 201710013, the IRS determined that the termination of the taxpayer's S election under Sec. 1362(d)(3) was inadvertent, even though the taxpayer had paid the tax imposed under Sec. 1375(a) for three consecutive tax years. The taxpayer represented that it was aware that having excess passive investment income could subject it to tax but was unaware that this could cause a termination of its S election. To obtain the ruling, the taxpayer agreed to distribute its accumulated earnings and profits by making a deemed dividend election under Regs. Sec. 1.1368-1(f)(3).

ObservationNote that the deemed dividend election under Regs. Sec. 1.1368-1(f)(3) may be made on a timely filed original or amended return. Thus, provided that the period of limitation on assessment has not closed for the third consecutive tax year in which a taxpayer has accumulated earnings and profits and excess passive investment income, the terminating event may be avoided by making this election on an amended return to distribute all of the corporation's accumulated earnings and profits.

Sharecropping revenue and rental income are not passive investment income

The IRS ruled in Letter Ruling 201722019 that sharecropping revenue and rental income were not considered passive investment income under Sec. 1362(d)(3)(C)(i).

Taxpayer X was engaged in a farming arrangement with another taxpayer for sharecropping purposes whereby direct expenses including processing expenses were allocated based on the percentage of crops to which each was entitled. Taxpayer X paid all utilities, maintenance, box rent, and inspection fees and was responsible for all decisions regarding the type of crops planted and marketing efforts. In a subsequent year, a new lease arrangement was signed, where X's expenses were a percentage of rental income within a fixed range, but all property taxes were to be paid byX.

The IRS held that, based on the facts and representations made, the revenue received under the sharecropping agreement and the rental income under the lease arrangement were not considered passive investment income under the rules in Sec. 1362(d), but the rental activity could still be subject to the passive activity rules of Sec. 469.

Rental income did not constitute passive investment income

The IRS ruled in Letter Ruling 201725022 that rental income received by a corporation intending to be treated as an S corporation did not constitute passive investment income for purposes of Sec. 1362(d)(3)(C)(i).

The taxpayer owned a series of commercial buildings that were leased for medical offices and support activities. The taxpayer contracted with an independent leasing agent to provide assistance with obtaining, negotiating, and renewing leases, which required significant time and attention. The taxpayer had a standard lease agreement with its tenants indicating that the landlord was responsible for maintenance and repair activities, including building systems, lighting, lawn care, walkways, and utilities. Furthermore, the taxpayer represented that these activities were performed daily by the taxpayer, its employees, its agent, and the agent's employees. The IRS ruled that the rental income received from these activities was not passive income for purposes of Sec. 1362 but could still be subject to the passive activity loss rules under Sec. 469.

Shareholder basis


In Hargis,13 the Tax Court ruled that the taxpayer, an S corporation shareholder, failed to establish that he had sufficient basis in S corporation stock and debt to deduct the losses allocated to him from the S corporation. The taxpayer relied on his position as "co-borrower" on notes from outside lenders to the S corporation and notes from related business entities to the S corporation to support his claim of sufficient basis to claim the losses.

The court determined that the loans were made directly between the lenders and the S corporation and that the S corporation was not directly obligated to the shareholder. The court noted that none of the proceeds from the loan agreements were advanced to the shareholder but rather were paid directly to the S corporation. In addition, the shareholder was not called upon to make any payment on the notes as a co-borrower, and he was not looked to by the lenders as the primary obligor on the notes. Without a direct indebtedness from the S corporation to the shareholder, the court declined to recognize basis and disallowed the lossdeductions.

The Franklin14 case is similar to Hargis in that the taxpayer was the sole shareholder of an S corporation, and he personally guaranteed the debt of his S corporation to an outside lender. Unlike Hargis, however, the shareholder in Franklin was required to make payment to the lender on the guaranteed debt when the S corporation defaulted. The Tax Court in Franklin accepted evidence that the lender did seize and sell property of the shareholder as payment on the debt of the S corporation.

The Tax Court acknowledged that the shareholder increased his basis in the S corporation by the amount of the actual payment made under his debt guarantee. The additional basis allowed the shareholder to deduct tax losses allocated to him from the S corporation. However, no deduction was allowed in another year where the shareholder had claimed a loss but the corporation had not filed a return and there was no evidence as to the loss or anybasis.

Another debt basis case was Phillips,15 in which a 50% shareholder guaranteed debts of an S corporation. The corporation defaulted on loans, and the creditors sued the guarantors and obtained a judgment against the taxpayer. The taxpayer increased her basis for the amount of the judgments in the year that the courts awarded them to the creditors. However, she had not paid any of the judgments, and the IRS and Tax Court would not allow her to claim basis until she made payments.16

Income earned by shareholder, not S corporation


In Fleischer,17 at issue was whether an S corporation or its shareholder/employee earned income from the services provided by the shareholder/employee.

The taxpayer provided professional services to customers in exchange for commissions and fees that he assigned to his wholly owned S corporation. The taxpayer was then paid a salary from the S corporation, the remaining net income or loss of the corporation was allocated to him, and he received cash distributions.

The Tax Court's opinion in Fleischer notes a first principle of income tax: that "income must be taxed to him who earned it,"18 or, more specifically, to the person "who controls the earning of the income."19 The court noted that for a corporation, and not its service-provider employee, to be the controller of the income, two elements must be found:

  1. The individual providing the services (to the customer) must be an employee of the corporation whom the corporation can direct and control in a meaningful sense; and
  2. There must exist between the corporation and the person or entity using the services (customer) a contract or similar indicium recognizing the corporation's controlling position.

Under the facts of the case, the shareholder, in his personal capacity, entered into a contract with an unrelated party prior to forming the S corporation, and the contract indicated that the shareholder's relationship with the unrelated party was that of an independent contractor. Subsequent to the formation of the S corporation, the shareholder entered into a contract with another unrelated party in his personal capacity. There were no addendums or amendments to either of these contracts requiring the unrelated parties to begin paying the S corporation instead of the shareholder or to recognize the S corporation in any capacity.

The Tax Court held that there was no indicium for the unrelated parties to believe that the S corporation had any control over the shareholder, and therefore, the shareholder, not the S corporation, should have reported the income received under the contracts.

Inclusion of income under Sec. 83(b) creates basis for distribution


Although Austin 20 is probably most notable as an economic substance case, one of its issues involved the taxability of a "special dividend" to an S corporation's shareholders. The Tax Court determined that the S corporation "was always an S corporation" and had no accumulated earnings and profits. Thus, the "special dividend" to its shareholders qualified as a distribution under Sec. 1368(b) and was excluded from the shareholders' taxable income to the extent the distribution did not exceed their stock basis.

The shareholders had relied on certain promissory notes issued as payment for their shares to provide basis and argued that the distribution did not exceed basis. The court found that the notes lacked economic substance and rejected the argument that the shareholders had additional basis. However, as a result of other rulings in the case, the shareholders recognized income under Sec. 83(b) with respect to their shares of the S corporation's stock, increasing their basis in the stock. This increase was sufficient to absorb the distribution so that the distribution was tax-free under Sec. 1368(b).

Bankruptcy estate allocated S corporation income for entire tax year


Under Sec. 1377, generally, an S corporation must allocate its income and other tax items to its shareholders on a per-share/per-day basis. In Medley v. Citizens Southern Bancshares,21two shareholders in the same S corporation transferred their shares to bankruptcy estates in early 2014. Neither shareholder elected to split his own tax year between the pre- and post-petition period under Sec.1398(d)(2). The corporation was profitable in 2014. The trustee allocated income between the shareholders and the estates based on the number of days each shareholder had held the stock. However, the court determined that Sec. 1398(e)(1) entitled the bankruptcy estate to all of the debtor's income or loss from the bankruptcy date forward. Because income does not pass through from an S corporation to a shareholder until the final day of the corporation's tax year, and the estates were the owners of the stock on that final day, all of the debtors' passthrough items for 2014 would pass through to the estates. The Medley case followed the reasoning in Williams,22 in which a shareholder who had transferred his stock to a bankruptcy estate attempted to benefit from a portion of the S corporation's losses for the year.

Inadvertent invalid QSub election highlights trap for the unwary


It has become increasingly common for an S corporation to restructure in connection with a sale or a third-party investment. A common form of this restructuring is for the S corporation's shareholders to form a new corporation (Newco), to which the stock of the S corporation (Oldco) is contributed. A qualified Subchapter S subsidiary (QSub) election is then made for Oldco, effective as of the date of contribution. Shortly after the contribution, Oldco is converted to a limited liability company (LLC) under state law. These steps are generally intended to qualify as a reorganization under Sec. 368(a)(1)(F). An unrelated party then purchases interests of the Oldco LLC or invests in it.

In Letter Ruling 201724013, the taxpayer implemented this type of restructuring; however, the QSub election for Oldco was not filed until after Oldco had been converted to an LLC under state law. Because Oldco did not satisfy all of the QSub requirements under Sec. 1361(b)(3)(B) at the time that the QSub election was filed for it, the QSub election was invalid. The IRS granted a waiver of the inadvertent invalid QSub election under Sec.1362(f).  

Footnotes

1 REG-108060-15.

2 Secs. 1361(b) and (c) and associated regulations.

3 T.D. 9790.

4 IRS Letter Rulings 201614002 and 201614003.

5 See Sec. 1361(d)(3).

6 See Rev. Rul. 93-79.

7 Sec. 1362(e)(1).

8 Sec. 1362(e)(2).

9 Sec. 1362(e)(3).

10 Regs. Sec. 1.1362-6(a)(5).

11 IRS Letter Ruling 201706013.

12 Passive investment income is excessive if it constitutes more than 25% of the corporation's gross receipts (Sec. 1362(d)(3)(A)(i)(II)).

13 Hargis, T.C. Memo. 2016-232.

14Franklin, T.C. Memo. 2016-207.

15 Phillips, T.C. Memo. 2017-61.

16 The years involved predated amendments to Regs. Sec. 1.1366-2 discussed in "Final Regulations Under Sec. 385" above, so there was no discussion of whether the arrangement created a bona fide debtor-creditor relationship between the S corporation and theguarantors.

17 Fleischer, T.C. Memo. 2016-238.

18 Lucas v. Earl, 281 U.S. 111 (1930).

19 Quoting Johnson, 78 T.C. 882 (1982), aff'd, 734 F.2d 20 (9th Cir. 1984).

20 Austin, T.C. Memo. 2017-69.

21 Medley v. Citizens Southern Bancshares, No. 13-12371 (Bankr. M.D. Ala. 5/17/16).

22 Williams, 123 T.C. 144 (2004).

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Phantom stock: Termination of right to buy or sell, treatment of asset and basis

In Hurford Investments No. 2, Ltd., No. 23017-11 (Tax Ct. 4/17/17) (order), the Tax Court considered whether the redemption of phantom stock was treated as a sale of a capital asset and what the tax basis in the redeemed phantom stock was.

Background

Gary Hurford owned "phantom stock" in Hunt Oil Co. The phantom stock was a form of deferred compensation that Hunt Oil paid to its employees; a share of phantom stock was valued at approximately the share price of Hunt Oil's common stock and would be adjusted for its increase or decrease in value at the end of each calendar year.

Under the terms of the phantom stock agreement, after Hurford's death, which was considered a "qualified termination of service," a five-yearcountdown was started. During this time Hunt Oil would continue to pay out dividends and adjust the stock for any growth or decline in value. At the end of the fifth year Hunt Oil would automatically redeem the stock; both parties had the right to liquidate the account at any time.

When Gary Hurford died in 1999, Thelma Hurford, his wife, inherited the phantom stock. Thelma decided to transfer the phantom stock into Hurford Investments No. 2 Ltd. (HI-2) in 2000, one of three limited partnerships Thelma's attorney formed as part of her estate plan after Thelma was diagnosed with cancer. On March 22, 2000, Hunt Oil formally recognized HI-2 as the holder of this stock. At the time of the transfer, the value of the stock was $6,411,000, and the receipt was reported on HI-2's Form 1065, U.S. Return of Partnership Income, as a short-term gain.

Thelma died in 2001, and the value of the stock on the date of her death was $9,639,588. In 2004, the five-year period that began on Gary's death was up, and Hunt Oil exercised its right to terminate the phantom stock. In 2006, Hunt Oil distributed $12,985,603 to HI-2. The IRS argued that the difference between the $12,985,603 distribution and $6,411,000 should be treated as ordinary income (deferred compensation) and argued that HI-2 should be considered an invalid partnership for federal income tax purposes since there was no transfer of phantom stock until after Thelma died. HI-2 and the estate argued the phantom stock should be treated as a long-term capital asset in HI-2's hands, which would also establish HI-2'svalidity as a holder and recognize it for income tax purposes.

Is phantom stock a capital asset?

In Thelma Hurford's hands, the termination of phantom stock generated ordinary income (deferred compensation), but it is pertinent to note that the character of property may change depending on who holds it, e.g., a laptop is inventory for a retailer but a capital asset for most buyers. "Capital asset" has a broad definition under Sec. 1221, which defines the term as all property that is not specifically excluded in a list of exceptions. The types of property excepted from Sec. 1221 are (1) stock in trade; (2) depreciable property used in a trade or business; (3) a copyright or other similar item; (4) an account or note receivable acquired in the ordinary course of business; (5) a U.S. government publication; (6) a commodities derivative financial instrument; (7) a hedging transaction; or (8) supplies used or consumed in the ordinary course of business.

Because HI-2's interest in the phantom stock does not fit into one of the exceptions listed in Sec. 1221, the Tax Court found that it was a capital asset. This designation makes more sense when one thinks about the nature of the asset. HI-2acquired an asset that had its value linked to the stock value of Hunt Oil, and HI-2 had no influence over the underlying Hunt Oil common stock, holding it in the hope that it would appreciate. According to the Tax Court, this distinguishing characteristic is enough to conclude that the phantom stock was a capital asset.

Does Hunt Oil's redeeming the phantom stock constitute a sale?

Under Sec. 1234A(1), the gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation for property that is a capital asset in the taxpayer's hands is treated as a gain or loss from the sale of a capital asset. HI-2 argued and the Tax Court agreed that when Hunt Oil liquidated the phantom stock and distributed the proceeds to HI-2, it ended HI-2's right to sell the phantom stock. Thus, under Sec. 1234A, there was a termination of a right to buy or sell a capital asset, and HI-2 was entitled to capital gain treatment.

What is the basis of the stock?

The IRS argued the basis of the stock should be $6,411,000, which was HI-2's original interest in the phantom stock upon Gary Hurford's death; the difference between the value at termination of $12,986,603 and $6,411,000 would be the long-term gain. HI-2 argued that the basis in stock should be stepped-up to the value of $9,639,588 as of Thelma's death. Because the phantom stock was included in Thelma's estate, the Tax Court found that HI-2 was entitled to a step-up in basis under Secs. 1014(a) and 1014(b)(9). The court noted that Sec. 1014(c) specifically excludes from step-up in basis "property which constitutes a right to receive an item of income in respect of a decedent under section 691." However, it concluded that Sec. 1014(c) did not apply because the phantom stock had been converted into a capital asset in HI-2'shands and as such was no longer an item of income in respect of a decedent.

'Appreciation' is a hallmark of a capital asset

According to the Tax Court, the phantom stock was a capital asset in HI-2's hands as determined by Sec. 1221; it was treated as long-term capital gain when Hunt Oil terminated the program and liquidated the phantom stock account. The partnership could not affect the value of the stock in any way and could only hope for the phantom stock value to appreciate; this characteristic was enough to classify the stock as a capital asset. Per Sec. 1234(A), it was also determined that Hunt Oil's liquidation of the stock was a termination of HI-2's right to sell the phantom stock and constituted a sale of an asset. Lastly, the partnership had basis in the phantom stock equal to its fair market value as of Thelma's death. The fair market value of $9,639,588 was included in Thelma's estate, and under Sec. 1014(b)(9), that was the partnership's basis in the stock.

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IRS simplifies procedure to request relief for late portability elections

Estate tax rules can be tricky for executors, especially when dealing with provisions they may have to face only once in a lifetime. A case in point is the portability of the deceased spousal unused exclusion (DSUE) amount, which, if elected, allows the estate exclusion amount ($5.49 million in 2017) to pass from a deceased spouse to the survivingspouse.

To make the exclusion portable, the executor must timely file an election. What happens if the executor, unaware of the necessity of the election, misses the filing? Fortunately, there may be relief. The rules for applying for this relief have changed again under Rev. Proc. 2017-34.

A brief history of the estate tax exclusion

Few taxes have caused as much debate as the estate tax. For years it has served as a lightning rod for tax reform, with those objecting to it calling it a form of double taxation, while defenders point to the tax revenue it generates and the oversized fortunes that pass from generation to generation.

In an attempt to lessen the blow of the estate tax, Congress long ago added an exclusion, allowing anything below that exclusion amount to be passed down to the next generation tax-free. This compromise has generally worked as long as both sides of the political spectrum were content with the size of the exclusion amount.

That "just right" exclusion amount has been a moving target. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, P.L. 107-16, put the exemption on a continuing growth chart from 2001 through 2010, when the exclusion amount in effect became unlimited. Then, in 2011, the exclusion was scheduled to drop to $1 million after EGTRRA's sunset.

Neither side of the political spectrum was happy with this cliff, so Congress addressed the issue in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (Tax Relief Act) of 2010, P.L. 111-312. The exclusion amount was set at $5 million plus annual inflation adjustments (after 2011), with the hope that this would prevent future fighting over the exclusion amount.

To make the $5 million exclusion even more palatable to those opposed to the estate tax, Congress temporarily passed, then later made permanent, a provision allowing any unused exclusion of a decedent to pass to a surviving spouse. This portability of the DSUE amount effectively allows a couple to pass up to $10 million (plus inflation) to their heirs tax-free.

Electing portability

Rules regulating exclusion portability to the surviving spouse are found in Sec. 2010(c)(5)(A), which states:

Election required. A deceased spousal unused exclusion amount may not be taken into account by the surviving spouse . . . unless the executor of the estate of the deceased spouse files an estate tax return on which such amount is computed and makes an election on such return.

In other words, for DSUE portability to be claimed, the executor must elect portability on the deceased spouse's estate taxreturn.

The IRS, thankfully, has made electing portability easy. If the executor timely files the decedent's Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, which generally is due nine months after the decedent's date of death, portability is automatically elected. If a return is timely filed, to decline to make or not be considered to have made a portability election, the executor must make an affirmative statement to that effect on the return or an attachment, which few executors will choose to do.

Extension of the portability election

Executors are most likely to run into problems if Form 706 is not timely filed. Under Regs. Sec. 20.2010-2(a)(1), estates electing portability are considered to be required to file Form 706 under Sec. 6018(a), with a due date of nine months after the decedent's death or the last day of any period covered by an extension obtained under Regs. Secs. 20.6075-1 and 20.6081-1.

The rules for missed elections go down two possible paths. Path A is followed by those who are required to file Form 706 under Sec. 6018(a) without regard to Regs. Sec. 20.2010-2(a)(1). In this situation, no further extension is available under Regs. Sec. 301.9100-3. In other words, if the executor was required to file a Form 706 under Sec. 6018(a) without regard to portability within nine months of the decedent's death (plus any period covered by an extension other than under Regs. Sec. 301.9100-3) but failed to do so, a portability election is not allowed.

Executors who did not timely file a Form 706 and the portability election who were not required to file Form 706 under Sec. 6018(a) may go down Path B, which allows extension relief.

Rev. Proc. 2014-18, issued in February 2014, provided a simplified method for executors on Path B to extend the filing period for portability under Regs. Sec. 301.9100-3 for estates of decedents who died between Dec. 31, 2010, and Dec. 31, 2013, which was available until Dec. 31, 2014. After that, executors seeking relief had to use the letter ruling process. Consequently, the IRS was flooded with private letter ruling requests for portability extension relief, most of which came from executors who did not discover the need to file for the portability election until the surviving spouse passed away. Due to the large influx of letter ruling requests, the IRS again decided to allow a simplified method of extending the election and did so in Rev. Proc. 2017-34, issued in June 2017.

Extensions under the new simplified method

Under Rev. Proc. 2017-34, if an executor missed the original election date and was not required to file Form 706 under Sec. 6018(a) without regard to the portability election, for decedents dying after Dec. 31, 2010, the executor may file a complete and properly prepared Form 706, by Jan. 2, 2018, or the second anniversary of the decedent's death, whichever is later, to obtain an extension of time to elect portability. The return must include a note at the top stating that it is "filed pursuant to Rev. Proc. 2017-34 to elect portability under Sec. 2010(c)(5)(a)." No user fee is required.

Rev. Proc. 2017-34 also notes that this portability extension relief does not extend the period available to the surviving spouse or surviving spouse's estate to claim a credit or refund for the overpayment of taxes under Sec. 6511(a). It also does not extend the time the surviving spouse's estate has to file a Form 706 upon the surviving spouse's death. However, if the claim for credit or refund on the surviving spouse's return is filed within the time required by Sec. 6511(a) in anticipation of the decedent spouse's executor's making a late portability election, it will be considered a protective claim for credit or refund of tax.

If, subsequent to the grant of relief under the simplified method, it is determined that, based on the value of the gross estate and taking into account any taxable gifts, an executor of an estate was required to file an estate tax return for the estate under Sec. 6018(a), the grant of an extension under the simplified method is deemed null and void ab initio.

The takeaway

If the decedent passed away on or after Jan. 1, 2011, and the executor missed electing portability of the DSUE due to not being otherwise required to file a Form 706, extension relief is available under Rev. Proc. 2017-34. However, this relief will soon disappear for estates of decedents who died before Jan. 2, 2016, leaving the private letter ruling process as the only recourse for their executors.

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Senate tax reform bill contains more changes

The Senate Finance Committee on Thursday evening approved its version of the Tax Cuts and Jobs Act, sending the bill to the full Senate for debate and a vote. The committee had spent the week amending the bill, and the final version includes some changes beyond those included in the chairman’s mark released on Tuesday. 

The Senate is expected to take up the bill after it returns from its Thanksgiving recess.

Here are notable changes in the final version approved by the Senate Finance Committee.

Individuals

Free File program: The Senate bill would codify and make permanent the IRS’s Free File program.

Whistleblower awards: The Senate bill would provide an above-the-line deduction for attorneys’ fees and court costs paid in connection with any action involving claims under a state false claims act, the SEC whistleblower program, and the Commodity Futures Trading Commission whistleblower program.

The bill would also modify Sec. 7623 to expand the definition of collected proceeds eligible for whistleblower awards.

Carried interests: The Senate bill would impose a three-year holding period requirement before certain partnership interests transferred in connection with the performance of services would qualify for long-term capital gain treatment.

Businesses

Excessive compensation: Sec. 162(m) limits the deductibility of compensation paid to certain covered employees of publicly traded corporations. Current law defines a covered employee as the chief executive officer and the four most highly compensated officers (other than the CEO). The Senate bill would revise the definition of a covered employee under Sec. 162(m) to include both the principal executive officer and the principal financial officer and would reduce the number of other officers included to the three most highly compensated officers for the tax year. The bill would also require that if an individual is a covered employee for any tax year (after 2016), that individual will remain a covered employee for all future years. The bill would also remove current exceptions for commissions and performance-based compensation.

The bill includes a transition rule, so that the proposed changes would not apply to any remuneration under a written binding contract that was in effect on Nov. 2, 2017, and that was not later modified in any material respect.

Dividends paid: Under the Senate bill, corporations that pay dividends would be required to report the total amount of dividends paid during the tax year and the first 2½ months of the succeeding year, effective for tax years beginning after 2018. Corporations would not be allowed to deduct dividends paid when computing taxable income.

Dividends received: The Senate bill would also reduce the current 70% dividends-received deduction to 50% and the 80% dividends-received deduction to 65%.

Net operating losses: The Senate bill would limit the net operating loss deduction to 80% of taxable income (as determined without regard to the deduction). Net operating losses would be allowed to be carried forward indefinitely, but not carried back (except for certain farming losses). This change would apply to tax years beginning after 2022.

Orphan drug credit: The Senate bill would reduce the current Sec. 45C 50% orphan drug credit to 27.5% and would institute reporting requirements similar to the required for the Sec. 48C qualifying advanced energy project credit and the Sec. 48D qualifying therapeutic discovery project credit.

Employer-provided meals: The Senate bill would disallow an employer’s deduction for expenses associated with meals provided for the convenience of the employer on the employer’s business premises, or provided on or near the employer’s business premises through an employer-operated facility that meets certain requirements. However, the final version of the bill delays this change until tax years starting after 2025.

Amortization of research and experimental expenditures: The Senate bill would require specified research or experimental expenditures to be capitalized and amortized over a five-year period, effective for amounts paid or incurred in tax years beginning after 2025. Specified research and experimental expenditures attributable to research conducted outside the United States would be amortized over a 15-year period. The bill would also institute a new reporting requirement, for tax years beginning after 2024.

Exempt organizations

Excise tax on private college investments: Under current law, private colleges and universities are generally treated as public charities rather than private foundations, and thus they are not subject to the Sec. 4940 private foundation excise tax on net investment income. However, the Senate bill would impose a 1.4% excise tax on net investment income of private colleges and universities that have at least 500 students and aggregate assets of at least $250,000 per student. The assets-per-student threshold will be determined by including amounts held by related organizations, but only to assets held by the related organization for the education institution and to investment income that relates to assets held for the institution

Source: https://www.journalofaccountancy.com/

A Detailed Look at Tax Reform: Changes to Deductions and Credits

Tax reform cleared its first major hurdle in Congress on November 16 when the House passed its version of the bill by a 227-to-205 vote mainly along party lines. (No Democrats voted for it.) But the legislation, which would generally be effective for tax years beginning after 2017, still has a long way to go around the track before it hits the finish line.

The bill approved by the House contains many of the measures proposed during the past year by the Trump administration and GOP lawmakers. The following provisions may be of particular interest to your clients.

Individual Tax Provisions

Tax rates: The current tax rate structure of seven brackets would be replaced by just four brackets of 12%, 25%, 35% and 39.6%. (Note that the top rate will remain at 39.6%.)  In addition, a “bubble tax” of 6% would apply to a portion of adjusted gross income (AGI) above $1 million.

Standard deduction: The bill essentially doubles the standard deduction from $6,350 to $12,200 for single filers and from $12,700 to $24,400 for joint filers. Combined with other proposed tax law changes, many more taxpayers will be claiming the standard deduction in lieu of itemizing deductions.

Personal exemptions: Currently, a taxpayer is entitled to claim a personal exemption of $4,050 for himself or herself, a spouse and each qualified dependent. The bill eliminates all personal exemptions.

Itemized deductions: The bill repeals most itemized deductions while preserving tax breaks for charitable donations and disaster-area casualty losses. The deduction for mortgage interest would be reduced to cover $500,000 of acquisition debt, down from $1 million, but interest deductions for existing loans would be grandfathered. The state and local tax deduction, a lightening rod for controversy in high-tax states, would be limited to property taxes of up to $10,000.

Child tax credit: The child tax credit for children under age 17, which is currently $1,000, would be increased to $1,600, subject to certain restrictions. However, the extra $600 would not be refundable, unlike the $1,000 base credit.

Alternative minimum tax: The alternative minimum tax (AMT), which was designed to affect only the wealthiest taxpayers but has been a thorn in the side of millions of others, would be completely repealed.

Family tax credit: The new legislation would create a new $300 nonrefundable tax credit for each taxpayer as well as any non-child dependent such as an older child or an elderly relative. However, the credit would have a short shelf life and would expire after five years.

Recharacterizations: Although most retirement plan rules would remain intact, the House bill repeals the rule allowing a taxpayer to recharacterize a Roth IRA back into a traditional IRA. Typically, recharacterizations are used when the value of the taxpayer’s account drops. 

Business Tax Provisions

Corporate tax rates: One of the main tent poles in the new legislation is a reduction in the top corporate tax rate from 35% to 20%. After much debate, lawmakers made the corporate tax rate permanent.

Repatriation tax: Under the House-approved bill, a one-time tax of 14% would apply to existing foreign profits being held in offshore accounts. In addition, foreign profits invested in non-cash assets offshore would be taxed at the rate of 7%. The law gives companies up to eight years to pay up.

Pass-through entities: Currently, profits funneled through pass-through entities like S corporations and partnerships are taxed at individual tax rates as high as 39.6%. The new bill would limit the top tax rate on these earnings to 25%. It would also provide a lower rate of 9% for businesses earning less than $75,000.

Business deductions and credits: The new bill would add several key tax benefits for businesses while removing certain deductions and credits. For instance, it would effectively allow 100% Section 179 expensing of business property for a five-year period, but repeal the Section 199 manufacturing deduction and Work Opportunity Tax Credit (WOTC).

Finally, the new law would repeal the federal estate tax, a long-time target of GOP legislators, but not in one shot. The repeal would not completely take effect until 2024 and would be combined with a doubling of the estate tax exemption. Under current law, the exemption is $5 million (indexed to $5.49 million in 2017).

It’s still too early for your clients to take action based on these provisions, but the proceedings should continue to be monitored closely. Keep your clients informed about any significant developments.

Source: http://www.cpapracticeadvisor.com/