Tag: Tax

Illinois Adopts A New Remote Seller Nexus Law

We should have a Wayfair decision by then, but IL adopted a South Dakota remote seller nexus rule effective October 1, 2018.

For purposes of the Use Tax Act, the definition of “retailer maintaining a place of business in this state” is amended, and for purposes of the Service Use Tax Act, the definition of “serviceman maintaining a place of business in this state” is amended. Beginning October 1, 2018, such a retailer will include a retailer making sales of tangible personal property and a serviceman making sales of service to purchasers in Illinois from outside of Illinois if the cumulative gross receipts from sales of tangible personal property and sales of service to purchasers in Illinois are $100,000 or more, or the retailer or serviceman enters into 200 or more separate transactions for the sale of tangible personal property or sales of service to purchasers in Illinois. The retailer or serviceman will determine on a quarterly basis, ending on the last day of March, June, September, and December, whether he or she meets this criteria for the preceding 12-month period. If the criteria are met, the individual is considered a retailer or serviceman maintaining a place of business in this state and is required to collect and remit use tax or the service use tax, respectively, and file returns for one year. At the end of the 1-year period, the retailer or serviceman will determine whether he or she met the criteria during the preceding 12-month period, and, if so, the individual is considered a retailer or serviceman maintaining a place of business in this state and is required to collect and remit use tax or the service use tax, respectively, and file returns for the subsequent year. If at the end of a 1-year period a retailer or serviceman that was required to collect and remit use tax or service use tax, respectively, determines that he or she did not meet the criteria during the preceding 12-month period, the retailer or serviceman subsequently will determine on a quarterly basis, ending on the last day of March, June, September, or December, whether he or she meets the criteria for the preceding 12-month period.

 

© Horwood Marcus & Berk Chartered 2018. All Rights Reserved.

Following Repeal of the Individual Mandate, Twenty States Challenge the Affordable Care Act

On February 26, 2018, twenty states (the “Plaintiffs”) jointly filed a lawsuit[1] in the U.S. District Court for the Northern District of Texas requesting that the court strike down the Patient Protection and Affordable Care Act (“ACA”), as amended by the Tax Cuts and Jobs Act of 2017 (the “TCJA”), as unconstitutional. The Plaintiffs’ suit gained support from the White House last week, when Attorney General Jeff Sessions delivered a letter to House Speaker Paul Ryan on June 7, 2018 (the “Letter”), indicating that the Attorney General’s Office, with approval from President Trump, will not defend the constitutionality of the individual mandate – 26 U.S.C. 5000(A)(a) – and will argue that “certain provisions” of the ACA are inseverable from that provision.[2]The Letter indicates that this is “a rare case where the proper course is to forgo defense” of the individual mandate, reasoning that the Justice Department has declined to defend statutes in the past when the President has concluded that the statute is unconstitutional and clearly indicated that it should not be defended.

Acknowledging that such a position breaks from a longstanding tradition of defending the constitutionality of duly enacted legislation, the Letter offers support for both of the Plaintiffs’ main arguments: first, the Plaintiffs claim that the individual mandate is no longer constitutional, because individuals will no longer pay a penalty for being uninsured after December 31, 2018; second, if the individual mandate is unconstitutional, the ACA is also unconstitutional, because the ACA cannot continue to function without the individual mandate. These arguments are discussed in further detail below.

The Individual Mandate

The Plaintiffs argue that the individual mandate, which requires individuals to be insured under the ACA or pay a tax if uninsured, is no longer constitutional following passage of the TCJA. When the United States Supreme Court reviewed the constitutionality of the individual mandate in 2012, the Court determined that Congress could not direct people to buy insurance under the Commerce Clause or Necessary and Proper Clause, but requiring individuals to buy health insurance or pay a fee was a constitutional use of Congress’s taxing powers.[3]

The Plaintiffs argue that the individual mandate can no longer be considered a valid use of Congress’s taxing power, because the TCJA reduces the fee for being uninsured to $0 beginning January 1, 2019. Although the TCJA effectively eliminated the individual mandate’s tax provisions, the requirement for individuals to buy insurance remains unaffected. The Plaintiffs argue that the individual mandate cannot be interpreted as a tax, because it lacks the central feature of any tax – the ability to generate revenue for the government. The individual mandate, therefore, cannot be upheld as a use of Congress’s taxation powers, and the Supreme Court also determined that it could not be upheld under the Commerce Clause or the Necessary and Proper Clause. Absent a constitutional basis, the Plaintiffs argue that the individual mandate can no longer be upheld.

The ACA Without the Individual Mandate

The Plaintiffs go on to argue that, if the individual mandate is unconstitutional, so too is the entire ACA. Citing the ACA and the Supreme Court, the Plaintiffs claim that the individual mandate is essential to creating effective health insurance markets and, because it is so “closely intertwined” with the rest of the ACA, severing the individual mandate would cause the rest of the ACA to cease functioning.[4] The Plaintiffs assert several arguments in furtherance of the charge that the “unconstitutional individual mandate” and ACA significantly harm and impact State sovereignty:

  • The ACA imposes a “burdensome and unsustainable panoply of regulations” on markets that each State has sovereign responsibility to regulate, including requirements for States to offer health insurance exchanges and minimum coverage standards for health insurance products.[5] Forcing the Plaintiffs to comply with ACA rules and regulations harms the States in their sovereign capacity, because the States lose the ability to enact or enforce their own laws or policies that conflict with the ACA.

  • States are significantly harmed by ACA rules and regulations compelling them to take costly corrective actions to stabilize insurance markets. The Plaintiffs argue that ACA regulations of the individual insurance market caused insurers to pull out of State marketplaces due to unsustainable rising costs. This, in turn, leads to costs rising further, as less competition exists in the healthcare markets. To escape the cycle of rising costs, the Plaintiffs argue that the States have to expend significant sums of money to stabilize healthcare markets.

  • States are significantly harmed as Medicaid and Children’s Health Insurance Plan (CHIP) providers. The Plaintiffs argue that the individual mandate and the ACA caused millions of individuals to enroll in Medicaid and CHIP, either because the ACA expanded program eligibility or the individual mandate forced individuals to enroll in one of the programs if they could not afford to purchase insurance in the marketplace. The influx of new Medicaid and CHIP enrollees caused states to incur “significant monetary injuries,” because the States are obligated to “share the expenses of coverage with the federal government.”[6]

  • States are harmed in their capacity as large employers. The ACA requires States, as large employers, to offer health insurance plans to eligible employees. The plans must contain minimum essential benefits defined under the ACA. Additionally, the ACA imposes a 40% excise tax on high cost employer-sponsored health coverage.[7]To comply with these, and other, ACA requirements, States must expend significant amounts of money to provide health coverage to employees. Some states, including Wisconsin, restructured their employer-sponsored health insurance plans to avoid the ACA excise tax. Other states, including Missouri and South Dakota, have cut other parts of their budgets to account for increased employer-provided healthcare costs.

Based on the allegations discussed above, the Plaintiffs request that the District Court declare the ACA, as amended by the TCJA, to be unconstitutional either in part or in whole, declare unlawful all rules and regulations promulgated pursuant to the ACA, and enjoin the defendants from enforcing the ACA. A ruling in favor of the Plaintiffs could not only eliminate the requirement for individuals to purchase health insurance, but could disrupt or eliminate some or all of the healthcare programs and mandates established under the ACA.

While the litigation aims high, numerous legal scholars and stakeholders have blasted the merits of the DOJ’s latest intervention (or lack thereof). Republican Senator Lamar Alexander released a statement remarking that “[t]he Justice Department argument in the Texas case is as far-fetched as any I’ve ever heard.” Jonathan H. Adler, a law professor at Case Western Reserve University School of Law who helped develop the arguments against the ACA in prior litigation (most notably, King vs. Burwell), described the Department of Justice argument as “just absurd,” arguing that there “is no legal basis for applying severability doctrine in this way, and no precedent for the Justice Department to accept such an argument.” While the merits of the litigation appear to be dubious, it nonetheless represents a mortal threat to the ACA and its popular protections for pre-existing conditions. Over the coming months, we will observe how this plays out legally and politically.

[1] Complaint, Texas & Wisconsin, et al v. United States et al, (N.D. Tex. 2018) (No. 4:18-cv-00167-O).

[2] Jefferson Sessions, Re: Texas v. United States, NO. 4:18-cv-00167-O (N.D. Tex.), United States Office of the Attorney General, (June 7, 2018).

[3] Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519, 558, 574 (2012).

[4] 42 U.S.C. § 18091(2)(I); King v. Burwell, 135 S. Ct. 2480, 2487 (2015).

[5] Complaint at 16-17.

[6] Complaint at 22-23.

[7] 26 U.S.C. § 4980I.

Copyright © 2018, Sheppard Mullin Richter & Hampton LLP.

Tax Amnesties Popping up…and should be taken seriously!

Alabama, Connecticut and Texas are offering tax amnesty programs that have some huge benefits. Amnesty programs are a great way to resolve nexus issues and underpayment issues. As with most amnesty programs, you must not have been contacted by the respective state’s Department of Revenue to be eligible.

In Alabama, the amnesty period runs from July 1, 2018 through September 30, 2018. It includes most tax incurred or due prior to January 1, 2017 and includes a full waiver of interest and penalties.

Connecticut’s program is already open and runs through November 30, 2018. Connecticut’s amnesty program includes periods up through December 31, 2016. Connecticut will waive all of the penalty and 50% of any interest due.

Texas will offer an amnesty for most taxes due prior to January 1, 2018. The amnesty period runs from May 1, 2018 through June 29, 2018 and includes full penalty and interest waivers.

 

© Horwood Marcus & Berk Chartered 2018.
This post was written by Jordan M. Goodman of Horwood Marcus & Berk Chartered.

Navigating a Cook County Department of Revenue Audit and the Procedure for a Formal Protest

A recent national trend in the practice field of state and local tax has been the uptick in local jurisdictions’ audit activity. The Cook County Department of Revenue (“Cook County” or “Department”) is no exception to this trend where in recent years, the Department has increased its audit activity, and much to the chagrin of taxpayers, has taken aggressive positions in the interpretation of its tax ordinances. Consequently, this has led to increased litigation in the administrative proceedings before the Cook County Department of Administrative Hearings (“D.O.A.H.”). This post provides an overview of the Department’s audit and ensuing D.O.A.H. processes and will highlight some of the procedural differences compared to other jurisdictions such as Chicago and Illinois. This background should assist any taxpayer in navigating the pitfalls and traps they will likely face if they receive a notice of Tax Assessment and Determination (“Assessment”).

Authority to Tax

The Illinois Constitution grants a home rule unit, which includes a county that has a chief executive officer elected by electors of the county, with authority to exercise any power and perform any function pertaining to its government and affairs, including the power to tax.  Ill. Const. Art. VII, § 6(a), 55 ILCS 5/5-1009. For taxes that are measured by income or earnings or that are imposed upon occupations, Cook County only has the power provided by the General Assembly.  Ill. Const. Art. VII, § 6(e). Cook County, however, is not preempted from imposing a home rule tax on (1) alcoholic beverages; (2) cigarettes or tobacco products; (3) the use of a hotel room or similar facility; (4) the sale or transfer of real property; (5) lease receipts; (6) food prepared for immediate consumption; or (7) other taxes not based on the selling or purchase price from the use, sale or purchase of tangible personal property.  55 ILCS 5/5-1009.

Audit Overview

Cook County, like the Illinois Department of Revenue and the City of Chicago Department of Finance, initiates an audit by issuing an individual or business a notice of audit to the taxpayer. The notice will generally identify the taxes subject to review, the periods under audit, and the time and location where the Department will undertake the audit. The notice will likely also include document requests and/or questionnaires that the Department has requested to review as part of audit. In some instances, however, if the Department believes that a taxpayer is not reporting a tax that the Department believes it is subject to, the Department will skip the audit and issue a “jeopardy assessment.” A jeopardy assessment assesses liability based on the books and records of who the Department deems to be similarly situated taxpayers.

Additionally, as my colleague Samantha Breslow discussed in ” Navigating a Chicago Audit and the Procedure for a Formal Protest“, taxpayers should take the Department’s information requests seriously.  It is especially important that the taxpayer stays engaged and responsive to Department auditors as a failure to do so may result in the Department issuing a jeopardy assessment. Cook County Code of Ordinances (“C.C.O.”) § 34-63(c)(2).[1]

Protest

While the Department’s audit process is very similar to Illinois, Chicago, and most other jurisdictions for that matter, the Department’s tax appeals process differs significantly. Unlike the Chicago Department of Finance which affords taxpayers 35 days to protest a notice of tax assessment, and the Illinois Department of Revenuewhich affords taxpayers 30-60 days to protest a notice of tax assessment, a taxpayer subject to a Department tax assessment must file its protest within 20 days of the Department’s mailing the notice of tax determination and assessment. C.C.O § 34-80. The taxpayer must either personally serve the Department with its protest, or place its protest in an envelope, properly addressed to the Department and postmarked within twenty days of the Department’s mailing of the protest. C.C.O. 34-79. At a minimum, a protest must identify the date, name, street address of the taxpayer, tax type, tax periods, the amount of the tax determination and assessment, and the date the county mailed the notice of assessment. The protest should also include an explanation of reasons for protesting the assessed tax and penalties. The Department has published a ” Protest and Petition for Hearing” form which must be used by a protesting taxpayer.  The form must be signed, and must include a power of attorney if the taxpayer is represented by someone other than the taxpayer.

Taxpayers should pay attention to the extremely short time frame in which to a protest must be filed. When considering the Department is only required to serve this notice by United States registered, certified or first class mail, a taxpayer is often left with less than 15 calendar days to file its protest. This is especially true for corporate taxpayers whose headquarters may differ from the address of its tax or legal department or the individual responsible for protesting tax assessments.

Administrative Proceedings

Upon timely receipt of a taxpayer protest, the Department will determine whether any revisions to the Assessment are warranted. This stage may result in a continuation of the audit where the Department will request additional documentation from the taxpayer and the Director of the Department does have the authority to amend the Assessment. While nothing prohibits the Department from increasing the Assessment during this stage, generally if a revision to the Assessment is made, the result is a reduction in the Assessment.[2]

If the parties are unable to resolve the audit, the Department then institutes an administrative adjudication proceeding by forwarding a timely filed protest to the D.O.A.H. C.C.O. § 34-81; C.C.O. § 2-908. The Director of the D.O.A.H. is appointed by the President of the County Board, and is subject to approval by the County Board of Commissioners. C.C.O. § 2-901(b).The Director appoints hearing officers, or administrative law judges (“ALJ”), who are independent adjudicators authorized to conduct hearings for the Department.C.C.O. § 2-901(a). The ALJ has authority to hold settlement conferences, hear testimony, rule upon motions, objections and admissibility of evidence. C.C.O. § 2-904. Note, however, the ALJ is prohibited from hearing or deciding whether any ordinance is facially unconstitutional. C.C.O. § 34-81.

At all proceedings before the ALJ, the Department will be represented by the State’s Attorney. The ALJ will set the matter for an initial pre-hearing status where the parties should be prepared to provide the ALJ with a brief overview of the facts and issues in dispute. The parties will then work to narrow the issues for presentment of findings by the ALJ. This will likely be accomplished by pre-hearing motion practice and the parties’ attempt to stipulate to facts and legal issues to be decided by the ALJ. Ultimately, the taxpayer and the Department will participate in a hearing, or trial, before the ALJ prior to the ALJ issuing a final order with findings of fact and conclusions of law. C.C.O. §  2-904.

Most taxpayers and practitioners are surprised to learn that the D.O.A.H. has no formal discovery. In fact, the parties are only entitled to conduct discovery with leave of the ALJ. Cook County D.O.A.H. General Order No. 2009-1 (“General Order”), Rule 6.3.In our experience,the ALJ will occasionally permit limited interrogatories and requests to admit, but requests to produce have been denied, and depositions arestrictlyprohibited. This is true even where a party intends on introducing an expert witness at the hearing.  Notably, because the Illinois Supreme Court rules do not apply, there is also no corresponding requirement that an expert submit its conclusions and opinions of the witness and bases thereof to the adverse party. See  Ill. S. Ct. R. 213(f). The ALJ may subpoena witnesses and documents which the ALJ deems necessary for the final determination. General Order, Rule 6.4. The lack of procedure naturally increases the likelihood of surprise at final hearing.

After the completion of any pre-hearing motions and the narrowing of the issues, the parties proceed to a hearing where each party will present its case. This is where the record is made for purposes of appeal. No additional evidence is permitted to be introduced at the Circuit Court. The Petitioner, often the Department, must present its case first and bears the initial burden.[3] However, the Department’s Assessment is deemed to be prima facie correct. C.C.O. § 34-64.Thus, a taxpayer has the burden of proving with documentary evidence, books and records that any tax, interest or penalty assessed by the Department is not due and owing.  C.C.O. § 34-63. The formal and technical rules of evidence do not apply at the hearing. C.C.O. § 2-911. A taxpayer can also present fact and expert witnesses in support of its position and may wish to call Department personnel such as the auditor and supervisor as adverse witnesses to support its case.

After both parties have concluded their case, each may request an opportunity to present a closing argument. General Order, Rule 9.4. In lieu of, or in addition to a closing argument, the ALJ may request the parties to file post hearing briefs. It is during the closing argument and/or brief, that the parties will have the opportunity to present its legal and factual defense to the Assessment.

After the hearing and review of post-trial briefs, the ALJ will issue a final order which includes findings of fact and conclusions of law. The findings of the ALJ are subject to review in the Circuit Court of Cook County pursuant to the Administrative Review and the aggrieved party has 35 calendar days to file an appeal. C.C.O. 2-917.

Conclusion and Takeaways:

The D.O.A.H. presents some unique litigation and procedural challenges for a taxpayer wishing to protest a Department Assessment. The major takeaways for a taxpayer protesting an assessment are (1) a taxpayer must file its protest within 20 days of the Department’s mailing of the assessment; (2) the D.O.A.H. has limited discovery rules and prohibits the use of depositions which can inhibit a taxpayer’s ability to build a case. Accordingly, a taxpayer must present adequate witnesses and documentation to support its case at hearing; and (3) a taxpayer must build a record at the administrative proceeding because it will be foreclosed from doing so at the circuit court if an appeal is necessary. These takeaways can go a long way in assisting a taxpayer’s chances of success in what is at times, an unpredictable venue.

[1] If a Taxpayer believes that it has paid a prior amount of tax, interest, or penalty in error to the department, in addition to amending its return, the taxpayer must file a claim for credit or refund in writing on forms provided by the Department. Cook County Code of Ordinances (“C.C.O.”) § 34-90.  The claim for refund must be made not later than four years from the date on which the payment or remittance in error was made. Id.  

[2] If the assessment is revised, the Taxpayer should determine whether the revisions are documented in an official “Revised Notice of Assessment and Determination” or alternatively, whether the revisions were documented in something less formal such as revised schedules or workpapers.  If it is the former, while the Ordinance does not expressly require an Amended Protest to be filed, the issue of whether a revised protestmust be filedwithin 20 daysof the Revised Assessment has been raised in administrative proceedings before the Department. 

[3] We have seen instances where the Taxpayer is identified as the Petitioner in the captioned matter.  In fact, the Taxpayer is identified as Petitioner in the Department’s Protest and Petition for Hearing Form.  However, because the Department submits the matter to DOAH, the taxpayer has no choice on whether it is identified as Petitioner or Respondent in the proceeding, and the Department’s inconsistency often leads to confusion regarding burden of proof issues.

 

© Horwood Marcus & Berk Chartered 2018. All Rights Reserved.
This post was written by David W. Machemer of Horwood Marcus & Berk Chartered 2018.

Overview of the Tax Cuts and Jobs Act

On December 27th, 2017 President Trump signed into law what is the most consequential tax reform in thirty years, by signing the Tax Cuts and Jobs Act (the “Act”). Most business changes took effect after December 31, 2017, some changes were effective immediately and others, like expensing of capital expenditures, had specialized retroactive effective dates. The following is an overview of the Act:

Individual Income and Transfer Taxes

For individuals, the new law reduces tax brackets, curbs the effect of the Alternative Minimum Tax, alters some tax credits, simplifies many returns by increasing the standard deduction, and increases the amount of property that can pass free of the estate, gift and generation skipping transfer tax. One area untouched by the new law is the adjustment to tax basis for capital assets upon death, allowing for “step-up” or “step-down” depending upon the cost basis vs. the value at date of death. Please see the following summary explanations:

  • Rates. Beginning in 2018, the highest individual income tax rate was reduced from 39.6% to 37%. Other rate adjustments are illustrated in this table:

Rate

Unmarried Individuals, Taxable Income Over

Married Individuals Filing Jointly, Taxable Income Over

Heads of Households, Taxable Income Over

10%

$0

$0

$0

12%

$9,525

$19,050

$13,600

22%

$38,700

$77,400

$51,800

24%

$82,500

$165,000

$82,500

32%

$157,500

$315,000

$157,500

35%

$200,000

$400,000

$200,000

37%

$500,000

$600,000

$500,000

  • Standard Deduction and Personal Exemptions. Beginning in 2018, the doubling of the standard deduction and curtailment of state and local taxes and mortgage interest deductions have the effect of simplifying many returns by eliminating the complexity associated with the preparation of Schedule A. Elimination of personal exemptions and limits on deductions for those who itemize will dramatically change the benefit to individuals of the deductions for mortgage interest, state income and property taxes and charitable contributions.

  • Credits. The new legislation creates a patch-work quilt of how many tax credits are treated. For example, the American Opportunities Tax Credit for education remained untouched, but other credits were modified.

  • Alternative Minimum Tax. Fewer individual taxpayers will be subject to this tax as a result of the increase of the exemption to just over $109,000 (indexed).

  • Estate, Gift and Generation Skipping Tax Exemptions. Beginning in 2018 and through 2025, these exemptions have been doubled to $11.2 million per person, and indexed to inflation.

Basis Adjustment at Death. This adjustment, often mistakenly referred to as “step-up basis”, remains unchanged. Property owned at death will be afforded a new basis equal to the value of such property at date of death. Adjusting the basis at date of death may mean the basis is increased, but can also result in a decrease in basis as happened for some deaths occurring during our last recession.

Provisions of Tax Cuts and Jobs Act Affecting Businesses

In addition to the changes impacting individual taxpayers, the Act included a substantial revision to the tax laws governing businesses. These changes begin with a reduction of the corporate tax rate to a flat 21% (down from a maximum of 35%) and permit unlimited expensing of capital expenditures, repeal the corporate Alternative Minimum Tax and change the deductions available to businesses. A substantial difference between the individual and business tax law changes is that some of the business changes are permanent (i.e. corporate tax rate), while others are temporary (immediate expense treatment for capital expenditures).

  • Tax Rate. The new law creates a flat 21% income tax rate for C Corporations to replace the marginal rate bracket system which had imposed tax rates between 15% and 35%.

  • Corporate Dividends. The dividends received deduction which allowed a C corporation to deduct 70 or 80 percent of dividends received from another C corporation has been reduced to a deduction of either 50 or 65 percent (the higher rate is available where the stock of the dividend paying corporation is owned at least 20% by the corporation receiving the dividend).

  • AMT. The corporate Alternative Minimum Tax has been repealed for tax years beginning after December 31, 2017.

  • Section 179 Expensing Business Capital Assets. Internal Revenue Code Section 179 allows a business to deduct the cost of certain “qualifying property” in the year of purchase in lieu of depreciating the expense over time. The Act allows a year of purchase deduction of up to an inflation indexed $1 million (increased from $500,000) with a total capital investment limitation of $2.5 million. While these changes provide businesses with increased deductions, they have little meaning given the new 100% year of purchase deduction for capital expenditures available under amended Code Section 168(k).

  • Section 168(k) Accelerated Depreciation. The Act allows a 100% deduction of the basis of “qualifying property” acquired and placed in service after September 27, 2017 and before January 1, 2023. Qualifying property generally includes depreciable tangible property with a cost recovery period of 20 years or less, computer software not acquired upon purchase of a business and nonresidential leasehold improvements.

    The bonus depreciation deduction is then reduced to 80% in 2023 and drops by an additional 20% after each subsequent two year period until disappearing entirely for periods beginning January 1, 2027. The allowed deduction percentages are applied on a slightly extended time frame for certain property with longer production periods. In addition to increasing the available deduction, the Act also allows used property to qualify for the deduction. After a phase-out beginning in 2023, this provision lapses after December 31, 2026.

  • Business Interest. Net business interest will not be deductible in excess of 30% of the “adjusted taxable income” of a business. For 2018 through 2021, adjusted taxable income will be determined without consideration of depreciation, amortization, depletion or the 20% qualified business income deductions. In 2022 and thereafter, the 30% limit will be applied to taxable income after deductions for depreciation and amortization. An exemption from the 30% limitation exists for taxpayers with annual gross receipts (determined by reference to the three preceding years) of $25 million or less. Disallowed business interest can be carried forward indefinitely. If a taxpayer’s full 30% adjusted taxable income limit is not met with respect to one business, the unused limitation amount can be applied to another business of the taxpayer which otherwise would have excess interest that is nondeductible after application of the 30% adjusted taxable income limit to that business.

  • Net Operating Losses. Generally, the two year NOL carryback has been repealed. While the losses can be carried forward indefinitely, the deduction will generally be limited to 80% of taxable income.

  • Other.

    • Domestic Production Activities Deduction has been repealed.

    • Like Kind Exchanges are limited to real property.

    • Fringe Benefits. Entertainment expenses and transportation fringe benefits (including parking) are no longer deductible. The 50% meals expense deduction is expanded to include on premises cafeterias of employers.

    • Penalties and Fines. Certain specifically identified restitution payments may be deductible.

    • Sexual Harassment Payments. No deduction will be allowed for amounts paid for or in connection with settlement of sexual harassment or abuse claims if such payments are subject to nondisclosure agreements.

Provisions of Tax Cuts and Jobs Act Affecting Pass-Through Entities and Sole Proprietorships

Before the Act passed, the pass-through of business income from a partnership or S corporation meant a lower overall tax rate would be paid on company income (compared to C corporations) as such income was not subject to double taxation and a lower overall income tax rate generally applied. However, with the reduction of the corporate income tax rate to a flat 21%, and individual rates that reach up to 37%, pass-through entities and sole proprietorships could face a higher tax burden than their C corporation counterparts.

To address the disparate effects of the flat 21% C corporation income tax rate, the Act allows owners of pass-through entities and sole proprietorships a deduction equal to 20% of their “qualified business income” subject to certain limitations. The calculation of what constitutes the qualified business income deduction amount is complex as are the applicable limitations. For example, upon sale of substantially all of the assets of a business, it is likely the 20% qualified business deduction will be significantly limited. Going forward, an analysis of the comparative tax savings as a C corporation or a pass-through entity will be appropriate for all businesses looking to maximize tax savings.

One further complication of the 20% qualified business deduction is that it is currently not applicable in calculating the state tax liability of most businesses. For example, the 20% deduction is currently inapplicable to the state income tax liabilities of Wisconsin businesses.

Family Owned Businesses

With the higher estate and gift tax exemptions and retention of the basis adjustment at death provisions of the tax law, the transfer of family owned businesses will need to re-focus, as follows:

  • Entrepreneurial families may prioritize family governance issues over estate tax issues for many businesses in transition. The changes to the valuation rules from August of 2016 have now been neutralized, and higher exemptions allow more effective estate tax freeze types of transactions.

  • Changes to how pass-through entities are taxed will re-position family businesses to place more emphasis on leasing entities, intellectual property licensing and real estate rental arrangements.

  • With corporate income tax rates reduced, the resurgence of a “management company” or “family office” may take center stage to house key employees who desire different classes of equity and debt ownership, unique compensation arrangements and generous employee benefits. However, IRS rules regarding how management agreements are negotiated and operate will need to be addressed before venturing into this area.

Buying and Selling Businesses

For those clients engaged in buying or selling businesses, the most powerful aspects of the bill have to do with changes to how capital expenditures are taxed, the loss of state and local tax deductions (individuals) and the lower corporate tax rates. We are making the following general observations on the effect of the new law on business sale transactions:

  • Even after the so-called “double tax” stigma associated with the regular corporate tax regime, when all aspects are considered, pass through entities are less attractive for many buyers and sellers. For example, a C corporation can deduct state and local taxes, while shareholders of S corporations, non-corporate owners of LLCs and individual sole proprietors cannot. This negative consequence is amplified by the fact that the 20% qualified business income deduction will not be available for state income tax purposes in most states, including Wisconsin.

  • Because many business valuations are based on income streams that do not consider taxes, those valuations do not reflect the effect of the now lower income tax rates for those businesses. However, lower tax rates should result in more cash flow to the buyers of those businesses, thereby increasing their internal rate of return on invested capital. The result will be that higher valuations will apply in the future because of the tax benefits of the new tax law.

  • Under the new law, buyers of tangible business assets, certain software and leasehold improvements can deduct their cost, in full, in the year of purchase. This means capital intensive businesses will enjoy significantly reduced effective tax rates and, therefore, higher values than previously applicable. More important, however, is that the buyer of a business can fully deduct the cost of all tangible assets in the year of purchase. The result will be that buyers of substantially all of the assets of a business will likely have little taxable income (and therefore less tax liability) for several years after the purchase of the business.

  • As a result of the 100% deduction of tangible assets purchased on the sale of a business and the lack of any changes to the capital gain and qualifying dividend tax rates, we believe that asset purchases will become more beneficial than stock purchases to buyers who seek to minimize transactional taxes, while stock sales will be more beneficial to sellers.

  • The new tax law limits the deductibility of business interest to 30% of adjusted taxable income. This means buyers using debt financing may not be able to fully deduct interest on the debt used to purchase a business. As a rule of thumb, the interest limitation will become applicable whenever the debt to cash flow ratio is higher than the ratio of the effective interest rate to 30%. Note that starting in 2022, the 30% limitation is applied to adjusted taxable income after deducting depreciation and amortization. Therefore, if you are going to buy a business, the time to do it is before the 30% limit becomes more stringent in 2022.

Compensation and Benefits Changes in the Tax Cuts and Jobs Act

  • Section 162(m). Internal Revenue Code Section 162(m) imposes a $1 million cap on the deduction for compensation paid to certain officers of public companies. Before the Act, there was an exception to the deduction limit for compensation that was “performance-based” if certain conditions were met. The Act eliminates the exception for performance-based compensation. Performance-based compensation paid pursuant to a written binding contract in effect on November 2, 2017 will continue to be outside of the $1 million deductibility cap, if the contract is not materially modified on or after that date.

  • Excise Tax on Excess Compensation for Executives of Tax-Exempt Organizations. The Act imposes a new excise tax on “excessive” compensation paid to certain employees of certain tax-exempt organizations. The excise tax is 21% of the sum of:

    • any excess parachute payment paid to a covered employee; and

    • remuneration (other than an excess parachute payment) in excess of $1 million paid to a covered employee for a taxable year (remuneration is treated as paid when there is no longer a substantial risk of forfeiture).

Covered employees are the five highest compensated employees for the year, and any other person who was a covered employee for any prior tax year beginning after 2016. Certain payments to licensed nurses, doctors and veterinarians are excluded.

A “parachute payment” is a payment that is contingent on the employee’s separation from service, the present value of which is at least three times the “base amount” (i.e., average annual compensation includible in the employee’s gross income for five years ending before the employee’s separation from employment). If a parachute payment is paid, the excise tax applies to the amount of the payment that exceeds the base amount.

  • Extended Rollover Deadline for “Qualified Plan Loan Offsets.” Prior to the Act, a participant in a qualified retirement plan who wanted to roll over a “plan loan offset” (an offset to his or her plan account due to a default on a loan taken from the account) to another plan or IRA had only 60 days to do so. The Act gives a longer period of time to roll over a “qualified plan loan offset,” which is a plan loan offset that occurs solely because of the termination of the plan or failure to make payments due to severance from employment. Participants will have until the due date of the tax return for the year in which the qualified plan loan offset occurs.

  • Reduction of Individual Mandate Penalty. The Affordable Care Act generally imposes a penalty (the “individual shared responsibility payment”) on all individuals who can afford health insurance but who do not have coverage. The Act reduces the amount of the individual shared responsibility payment to $0, effective January 1, 2019.

  • Section 83(i) – Taxation of Qualified Stock. The Act adds a new Section 83(i) to allow certain employees of non-publicly traded companies to defer the tax that would otherwise apply with respect to “qualified stock.” Qualified stock is stock issued in connection with the exercise of an option or in settlement of a Restricted Stock Unit (“RSU”), if the options or RSUs were granted during a calendar year in which the corporation was an “eligible corporation.” An eligible corporation is a non-publicly traded company with a written plan under which at least 80% of its U.S. employees are granted options or RSUs with the same rights and privileges. Certain employees, including any current or former CEO or CFO, and anyone who is (or was in the prior 10 years) a 1% owner or one of the four highest paid officers of the company, are excluded from the ability to elect a Section 83(i) deferral.

©2018 von Briesen & Roper, s.c.

Impact of final Tax Reform Legislation on the Historic Tax Credit, New Markets Tax Credit, Low-Income Housing Tax Credit and Renewable Energy Tax Credits

On Dec. 22, 2017, President Donald Trump signed into law “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” – widely referred to as the Tax Cuts and Jobs Act, or simply, the Tax Reform Legislation. As has been widely reported, the Tax Reform Legislation makes sweeping and extensive changes to federal tax law on a scale not seen since 1986. Here, we will focus on the impact of the Tax Reform Legislation on certain federal project-based income tax credits, including the Low-Income Housing Tax Credit (LIHTC), the New Markets Tax Credit (NMTC), the Historic Tax Credit (HTC), and the Production Tax Credit (PTC) and Investment Tax Credit (ITC) for renewable energy projects.

Unlike the tax reform bill passed by the House of Representatives, which would have significantly altered many of these project-based tax credits, the final Tax Reform Legislation generally leaves the credits in place, although with some modifications.

The HTC endured the most adjustment under the Tax Reform Legislation. Prior to the enactment of that legislation, the HTC provided a taxpayer who rehabilitated a historic structure with a tax credit equal to 20% of the taxpayer’s “qualified rehabilitation expenditures” if the structure was listed on the National Register or was otherwise certified by the Secretary of the Interior as being historically significant, or 10% of the taxpayer’s qualified rehabilitation expenditures if the structure did not meet those criteria but was originally placed in service prior to 1936; the tax credit was claimed in its entirety in the year the building was placed in service, subject to a five-year recapture period. The newly revised law eliminates the 10% credit for pre-1936 buildings not listed on the National Register or otherwise certified by the Secretary of the Interior and restructures the 20% credit so that it is claimed ratably over a five-year period beginning in the year the building is placed in service. (A transition rule allows taxpayers who own historic buildings as of Dec. 31, 2017, to take advantage of the pre-amendment version of the HTC for a period of time.)

While the other project-based tax credits were left in place unchanged, the shift, under the Tax Reform Legislation, in how multi-national corporations are taxed will likely impact their relative value. These credits are rarely of value to the developers of the projects to which they apply, as those developers typically do not have sufficient tax liability to fully utilize the credits. Instead, developers will typically shift the benefit of these tax credits to investors, in exchange for cash infusions into the underlying projects. Historically, these investors have been banks and other large corporations with significant tax liability; in many cases, these investors have significant overseas operations. One of the more significant changes the Tax Reform Legislation makes to the taxation of corporations is the imposition of a Base Erosion and Anti-Abuse Tax (BEAT), which is designed to counteract efforts by multi-national corporations to shift income from the United States to lower-tax jurisdictions. In calculating their BEAT liability, corporations may claim none of their HTCs and NMTCs, and only 80% of their LIHTCs and PTCs and ITCs for renewable energy projects, reducing the value of those credits to those corporations and presumably reducing the amount investors will be willing to contribute to projects in exchange for them (either due to investors’ BEAT liability, or due to the decreased demand for the credits among investors). Moreover, beginning in 2026, LIHTCs and PTCs and ITCs for renewable energy projects will be treated like HTCs and NMTCs, and corporations will not be able to use any portion of these credits against their BEAT liability, effectively eliminating the value of those credits to investors subject to the BEAT.

Similarly, the change to the HTC – which is also generally shifted from developers of historic projects to investors in them – from a credit claimed all at once to a credit claimed ratably over five years will likely reduce the value of that credit to investors and/or impact the timing of investors’ cash infusions into the underlying projects, potentially amplifying the need for bridge financing and increasing developers’ borrowing costs.

Further, the reduction, under the Tax Reform Legislation, in the top corporate tax rate from 35% to 21% will reduce the value of depreciation deductions that are sometimes allocated to investors in low-income, historic and renewable energy projects, further reducing the tax benefits available to investors in those projects and likely further reducing the amount that investors are willing to deploy into those projects in exchange for those tax benefits.

While the actual impact of the Tax Reform Legislation on the market for these project-based tax credits will only become clear over time, it is safe to assume that the Tax Reform Legislation will negatively impact the sources of funds available to developers of low-income housing, historic rehabilitation and renewable energy projects, and projects located in disadvantaged areas eligible for the NMTC.

 

Copyright © 2018 Godfrey & Kahn S.C.
This post was written by Jed A. Roher of Godfrey & Kahn S.C.
Read more Tax News on the National Law Review.

Tax Bill Causes Alarm for Some Charities and Tax-Exempt Organizations

The Tax Cuts and Jobs Act, which has been renamed the Amendment of 1986 Code, was signed into law by President Trump on December 22, 2017. Many are calling it the most sweeping overhaul to the United States tax system in decades. The Act positively impacts many sectors, including corporations with the significant reduction in corporate rates. In the case of tax-exempt organizations, however, the Act may have a significant negative impact.

Impact on Charitable Giving

An increase in the standard deduction amount for individual filers and the increase in the estate tax exclusion are predicted to cause a meaningful decrease in overall charitable giving. A higher standard deduction means fewer taxpayers will itemize deductions, reducing their incentive to make charitable donations. Only taxpayers who itemize their deductions receive a tax benefit from charitable contributions. The Tax Policy Center has estimated that before the Act, more than 46 million tax filers would itemize their 2018 returns, but with the passage of the Act, this number could drop to less than 20 million. In the short-term, donors are advised to consider making additional charitable contributions in 2017 since it is uncertain whether their charitable gifts will create a tax benefit in future years. Similarly, the doubling of the estate tax exclusion will reduce the incentive to make testamentary gifts to charities.

New Excise Tax on Executive Compensation Paid by Certain Tax-Exempt Organization; Medical Services Excluded

The Act imposes a 21 percent excise tax on most tax-exempt organizations (defined as “applicable tax-exempt organizations”) on the sum of compensation paid to certain employees in excess of $1 million plus any excess parachute payments paid to that employee (defined as a “covered employee”).

An applicable tax-exempt organization means any organization that:

  • is exempt from tax under Section 501(a) (such as Section 501(c)(3) charitable organizations),
  • is a Section 521(b)(1) farmers’ cooperative organization,
  • has income excluded from tax under Section 115(1) (this includes certain governmental entities), or
  • is a political organization described in Section 527(e)(1) for the taxable year.

A “covered employee,” is any current or former employee who:

  • is one of the tax-exempt organization’s five highest compensated employees for the current taxable or
  • was a covered employee of the organization (or any predecessor) for any preceding tax year beginning after December 31, 2016.

Compensation is referred to as “remuneration” under the new provision and is defined as “wages” for federal income tax withholding purposes. It also includes remuneration paid by related organizations of the applicable tax-exempt organization.

There are certain exceptions to the inclusion in remuneration under the definition including compensation attributable to medical services of certain qualified medical professionals and any designated Roth contribution.

The new Section 4960 is effective for taxable years beginning after Dec. 31, 2017. Year-end compensation planning, such as accelerating incentive compensation, should be considered to help avoid or reduce the 2018 excise tax. Calendar year taxpayers have only a few days to engage in this planning while fiscal year-end taxpayers may have a few more months to plan.

Separate Computation of UBTI for Each Trade or Business Activity

Certain tax-exempt organizations are subject to income tax on their unrelated business taxable income (“UBTI”). Under the current unrelated business income (“UBI”) rules, an organization that operates multiple UBI activities computes taxable income on an aggregate basis. As a result, the organization may use losses from one UBI activity to offset income from another, thus reducing total UBI. The Act requires tax-exempt organizations with two or more UBI activities to compute UBI separately for each activity. Accordingly, the losses generated by UBI activities computed on a separate basis may not be used to offset the income of other UBI activities. Under the new provision, a net operating loss deduction will be effectively allowed only with respect to the activity from which the loss arose. The inability to offset losses from one UBI activity against income from another may increase an organization’s overall UBI, but the lower corporate tax rate may otherwise reduce the amount of tax paid.

Provisions Affecting Tax-Exempt Bonds

The Act provides some welcome certainty for many tax-exempt organizations relative to tax-exempt bond financing. The House version of the Act had proposed an elimination of the ability of entities to issue “private activity bonds” Section 501(c)(3) bonds that are issued for the benefit of many tax-exempt Section 501(c)(3) organizations. This proposed elimination did not make it into the final bill. The Act does, however, adversely affect many tax-exempt organizations by eliminating their ability to undertake “advance refunding” transactions, where new tax-exempt bonds are issued to refinance existing tax-exempt bonds more than 90 days in advance of the redemption date or maturity date of such existing tax-exempt bonds.Under current law, tax-exempt Section 501(c)(3) organizations could undertake one “advance refunding” transaction, but the Act eliminates all “advance refundings” after Dec. 31, 2017.

Other Noteworthy Provisions

  • The Act imposes a new 1.4 percent excise tax on the investment income of private colleges and universities and their related organizations with at least 500 students and which have investment assets, including those of related entities, of at least $500,000 per student.
  • The existing income tax deduction for donations made in exchange for college athletic event seating rights will be repealed.
  • The charitable contribution deduction of an electing small business trust will be determined by the rules applicable to individuals, rather than those applicable to trusts.
  • The Act modifies the partnership rules to clarify that a partner’s distributive share of loss takes into account the partner’s distributive share of charitable contributions for purposes of the basis limitation on partner losses.
  • The top corporate tax rate for UBI is reduced to 21 percent.
  • The Act increases the annual limit on cash contributions to most public charities from 50 percent to 60 percent.
  • UBI will be increased by the amount of certain qualified transportation fringe benefit expenses for which a deduction is disallowed.
  • The Act repeals the deduction for local lobbying expenses which could impact Section 501(c)(6) rules.
  • The contribution limitation as to ABLE accounts is increased under certain circumstances.
  • The Act now allows for rollovers between qualified tuition programs and qualified ABLE programs.

The Act could have a significant impact on your tax-exempt organization.

© Polsinelli PC, Polsinelli LLP in California
For more Breaking Legal News go to the National Law Review.

BREAKING NEWS: Congress Sends Tax Cuts and Jobs Act to President Trump’s Desk for Signing

The Tax Cuts and Jobs Act (TCJA) has been passed by both houses of Congress and is now set to be signed into law by President Trump. The vote was 224-201 in the House with all the Democrats joined by twelve Republicans voting “no” and 51-48 in the Senate along party lines. Although the TCJA isn’t exactly great news for the renewable energy industry, it is far better than what was originally proposed in the House and Senate bills. Here are the main takeaways:

  • PTC Inflation Adjustment – The TCJA preserves the current 2.4¢/kWh PTC amount for wind with an annual inflation adjustment. The House bill would have reduced the PTC to 1.5¢/kWh with no annual inflation adjustment.

  • ITC Phase-out Schedule – The TCJA does not eliminate the permanent 10% solar ITC beginning 2023.

  • Continuous Construction Requirement – The TCJA does not include the statutory continuous construction requirement that was included in the House bill. Despite clarification from the House there was some concern as to whether the House bill would eliminate the four-year safe harbor that wind developers rely on under IRS guidance.

  • Orphaned Technologies – The TCJA does not include the ITC extension for orphaned technologies (e.g., fuel cell, small wind, micro turbine, CHP, and thermal energy) that were left out of the 2015 PATH Act. However, the Senate Finance Committee is proposing to include an extension for these technologies in its tax extenders package.

  • 100% Bonus Depreciation – The TCJA provides 100% bonus depreciation through 2022 for both new and used property. 100% bonus applies to property acquired and placed in service after September 27, 2017 with a transition rule permitting taxpayers to elect 50% bonus instead during the taxpayer’s first taxable year ending after September 27, 2017. This provides a big incentive to place projects in service this year in order to take advantage of depreciation deductions at the current 35% corporate tax rate.

  • BEAT Provision – The TCJA provides a Base Erosion Anti-Abuse Tax (BEAT) whereby a bank that makes 2% (or 3% for companies) of its deductible payments to a foreign affiliate is subject to the BEAT when those payments reduce its U.S. tax liability to less than 10% (12.5% beginning in 2025). The good news is that the TCJA provides that tax equity investors can use the PTC and ITC to off-set up to 80% of their tax liability under the BEAT. The bad news is that the 80% offset expires in 2025, so tax-equity investors in wind projects that generate PTCs over a 10-year time horizon could potentially have all of their credits clawed-back in the future.

  • Interest Deductibility – The TCJA generally limits the amount of interest that can be deducted to 30% of the business’s adjusted taxable income. In the case of partnerships, this limitation would apply at the entity level. Deductions that are disallowed are carried forward and used as a deduction in subsequent years. As we discussed in our blog post here on the House bill, this limitation could have an adverse impact on back leveraged transactions, which developers utilize to reduce their cost of capital and free up cash to invest in new projects.

  •  Corporate Tax Rate/AMT – The TCJA slashes the corporate tax rate from 35% to 21%, effective for tax years beginning after 2017, with no sunset. The TCJA does not include the corporate AMT that was in the Senate bill and which would have had a negative impact on projects generating PTCs after four years in operation. It remains to be seen whether the lower corporate rate will reduce demand for renewable energy credits among tax-equity investors in the market, which now have less tax liability to offset with credits.

© 2017 Foley & Lardner LLP
For more on Tax, go to the Tax Practice Group page.

Hurricane Harvey Client Alert: Tax Filing and Payment Deadlines Extended for Victims

Victims of Hurricane Harvey in some designated areas now have until January 31, 2018 to file certain federal tax returns and make payments.

On August 28, 2017, the US Internal Revenue Service (IRS) announced in a news release that it would postpone various individual and business federal tax return filing and payment deadlines that were to occur on or after August 23, 2017 until January 31, 2018 for certain persons affected by Hurricane Harvey. Specifically, this extension applies to taxpayers located in areas designated by the Federal Emergency Management Agency (FEMA) as qualifying for individual assistance.[1] Any taxpayer with an IRS address of record located within these designated areas will automatically receive the extension. Taxpayers in areas that are later added as qualifying for individual assistance by FEMA will automatically receive the extension as well. Additionally, taxpayers who are outside of the designated area but have necessary records needed to meet deadlines located in a designated area may qualify for the extension, but must contact the IRS to determine eligibility for relief.

As noted above, the specific relief announced by the IRS extends federal tax return filing and payment deadlines for individuals and businesses with original deadlines that would have occurred starting on August 23, 2017 to January 31, 2018. In other words, individuals and businesses will have until January 31, 2018 to file federal tax returns and make federal tax payments that have either an original or extended due date during this period. For individuals, the extension covers 2016 income tax returns that received “automatic” filing extensions until October 16, 2017; however, tax payments associated with these returns are not eligible for the extension because the payments were originally due on April 18, 2017. Additionally, the extension applies to the September 15, 2017 and January 16, 2018 deadlines for making quarterly estimated tax payments. For businesses, the extension covers the October 31, 2017 deadline for quarterly payroll and excise tax returns. Notably, the IRS announcement also states that the IRS will waive late-deposit penalties for federal payroll and excise tax deposits that are normally due on or after August 23, 2017 and prior to September 7, 2017, as long as the deposits are made by September 7, 2017.

[1] When the IRS news release was originally issued on August 28, there were 18 counties in areas designated by FEMA as qualifying for individual assistance. By August 30 (and as of August 31), FEMA had designated another 11 counties, bringing the total counties eligible for this relief up to 29.

This post was written by Donald-Bruce Abrams, Casey S. August, Jennifer Breen and William P. Zimmerman of Morgan, Lewis & Bockius LLP. All Rights Reserved. Copyright © 2017
For more legal analysis go to The National Law Review 

The Malta Pension Plan – A Supercharged, Cross-Border Roth IRA

Relevant US Tax Principles

In the cross border setting, two of the principal goals in international tax planning are (i) deferral of income earned offshore and (ii) the tax efficient repatriation of foreign profits at low or zero tax rates in the United States. For U.S. taxpayers investing through foreign corporations, planning around the controlled foreign corporation (CFC) rules typically achieves the first goal of deferral, and utilizing holding companies resident in treaty jurisdictions generally accomplishes the second goal of minimizing U.S. federal income tax on the eventual repatriation of profits (for U.S. corporate taxpayers, the use of foreign tax credits may be used to achieve this latter goal).

In a purely domestic setting, limited opportunities exist to defer paying U.S. federal income tax on income or gain realized through any type of entity, and fewer opportunities, if any, exist for the beneficial owners of such entities to receive tax-free distributions of the accumulated profits earned by these entities. A Roth IRA may be the best vehicle available to achieve these goals.

A Roth IRA (hereafter, “Roth”) is a type of tax-favored retirement account, under which contributions to the Roth are not tax deductible (like contributions to a traditional IRA would be), but all earnings of the Roth accumulate free of U.S. tax. In addition, qualified distributions from a Roth are not subject to U.S. federal income tax. In other words, once after-tax funds are placed in a Roth, those funds generally are not taxed again. As with traditional IRAs, however, the tax benefits of Roth IRAs are restricted to certain taxpayers who fall below certain modified adjusted gross income thresholds, and even then, such persons are limited in the amounts that can be contributed each year. Additionally, those who are eligible to contribute to such Roth accounts are limited to a maximum contribution of $5,500 per year ($6,500 for taxpayers age 50+). Any “excess contributions” beyond the stated limitations trigger an annual 6 percent excise tax until the excess contributions are eliminated. Finally, because of the “prohibited transaction” provisions, it is not possible for U.S. taxpayers to transfer property (whether appreciated or not) to a Roth without triggering certain taxes (i.e., excise tax as well as income tax on any built-in gain). Therefore, while the benefits of Roths are significant, they are not widely available, particularly to high-income taxpayers.

Relevant Maltese Principles Relating to Malta Pensions

Since 2002, Maltese legislation has been in existence which allows for the creation of cross-border pension funds (although these pension funds have become more relevant to U.S. taxpayers since the effective date of the U.S.-Malta income tax treaty (the “Treaty”) in November of 2010). In contrast to the stringent limitations imposed on contributions to Roths under U.S. law, unlimited contributions may be made to a Malta pension plan. This is true also for U.S. citizens and tax residents, regardless of whether such persons are resident in or have any connection at all to Malta (though no U.S. deduction is permitted for contributions to such Maltese plans). A Maltese pension plan generally is classified as a foreign grantor trust from a U.S. federal income tax perspective because of the retained interest of the grantor/member in the pension fund. Thus, contributions to such a pension fund (including contributions of appreciated property) generally are ignored from the U.S. income tax perspective and should not trigger any adverse U.S. tax consequences.[1]

There also appears to be almost no limitation on what types of assets can be contributed tax-free to a Malta pension, including, for example, stock in private or publicly-traded companies (including PFICs), partnership and LLC interests (including so-called “carried interests”), and interests in U.S. or non-U.S. real estate. While the specific terms of each pension plan vary, Malta law generally permits distributions to be made from such plans beginning at age 50.

The relevant Maltese pension rules allow an initial lump sum payment of up to 30% of the value of the member’s pension fund to be made free of Maltese tax. This initial payment must be made within the first year of the retirement date chosen by that member. Additional periodic payments generally must then be made from the pension at least annually thereafter, and while such payments may be taxable to the recipient, they are usually significantly limited in amount (generally being tied to applicable minimum wage standards in the recipient’s home jurisdiction). Beyond those minimum wage amounts, excess lump sum distributions of up to 50 percent of the balance of the plan generally can be made free of Malta tax.

U.S.-Malta Income Tax Treaty Provisions

As noted above, when the Treaty became effective in late 2010, Maltese pension plans became more attractive to U.S. taxpayers. The Treaty contains very favorable provisions that can result in significant tax benefits to U.S. members of a Maltese pension. In order for such U.S. members to take advantage of these benefits, the pension must qualify as a resident of Malta under the Treaty and also satisfy the limitation on benefits (LOB) article of the Treaty.

Article 4, paragraph 2 of the Treaty provides that a pension fund established in either the United States or Malta is a “resident” for purposes of the Treaty, despite that all or part of the income or gains of such a pension may be exempt from tax under the domestic laws of the relevant country. Under Article 22(2)(e) of the Treaty, a pension plan that is resident in one of the treaty countries satisfies the LOB provision as long as more than 75% of the beneficiaries, members, or participants of the pension fund are individuals who are residents of either the Unites States or Malta.[2]

Thus, as long as a Maltese pension is formed pursuant to relevant Maltese law and more than 75% of its members are U.S. and/or Maltese residents, the pension plan should be eligible for Treaty benefits.

Pursuant to Article 18 of the Treaty, income earned by a Maltese pension fund cannot be taxed by the United States until a distribution is made from that fund to a U.S. resident. This article of the Treaty contains no restrictions on the types of income that are covered, and thus is generally believed to apply broadly to all income (including, for example, income arising in connection with interests in U.S. real estate, PFIC stock, and assets connected to a U.S. trade or business).[3]

Article 17(1)(b) of the Treaty further provides that distributions from a pension arising in one country, and which would be exempt from tax in that country if paid to a resident of that country, must also be exempt from tax in the other country when paid to a  resident of the latter country.  The U.S. Treasury’s Technical Explanation to the Treaty further clarifies that, for example, “a distribution from a U.S. Roth IRA to a resident of Malta would be exempt from tax in Malta to the same extent the distribution would be exempt from tax in the United States if it were distributed to a U.S. resident.”[4]

As mentioned above, pursuant to Maltese law, the initial lump sum payment from a Maltese pension (up to 30% of the value of the relevant pension fund) generally is not taxable in Malta. Thus, based on Article 17(1)(b) of the Treaty, such amounts likewise must not be taxed in the United States when made to a U.S. resident beneficiary. Additionally, this same Maltese exemption generally applies to further lump sum payments received by Maltese resident beneficiaries in certain subsequent years (generally, such distributions may be made tax-free beginning three years after the initial lump sum distribution is received). Notably, any required annual (or more frequent) periodic payments would be taxable in Malta if made to a Maltese resident, and therefore also are taxable in the United States under Section 72 when received by a U.S. resident member of the pension fund.[5]

Finally, while under the so-called “savings clause” the United States generally reserves the right under its income tax treaties to tax its citizens and “residents” as though the treaty did not exist, this savings clause contains certain exceptions. Under the Treaty, Article 1(5) provides that Articles 17(1)(b) and 18 are excepted from the savings clause (found at Article 1(4)). Consequently, the savings clause of the Treaty should not prevent a U.S. citizen or resident member of a Maltese pension from qualifying for Treaty benefits under relevant provisions of Articles 17 and 18.

Example

Assume a U.S. resident individual 49-years of age owns both highly-appreciated U.S. real estate and founders’ shares of a technology start-up that is about to go public. In combination, the interests are worth approximately $100 million, and the aggregate tax basis of the assets is $10 million. As part of her retirement planning, this U.S. individual decides to contribute these assets to a Maltese pension fund.[6] During this same tax year, the real estate is sold for fair market value and the technology company goes public, though she is required to hold the shares for at least six months before disposing of them.  During the following tax year, after her lockup period expires, she sells her shares for fair market value, leaving her portion of the pension plan holding proceeds of $100 million. Since at this time she is at least 50 years of age, assuming the terms of the pension plan permit her to begin withdrawing assets at age 50, the U.S. individual can cause the pension plan to distribute to her during that tax year $30 million of the pension plan funds without the imposition of any tax, either in Malta or the United States.

At this point, the pensioner would need to wait until year 4 to be able to extract additional profits tax-free (pursuant to Maltese law, three years must pass after the initial lump sum distribution before additional lump sum distributions could be made to a resident of Malta tax-free). Thus, in year 4, additional assets can be distributed to the member without triggering tax liability. To calculate how much can be distributed free of tax, it is necessary to first determine the pension holds “sufficient retirement income.” This amount in turn is based, pursuant to Maltese law, on the “annual national minimum wage” in the jurisdiction where the member is resident. To the extent the pension plan balance exceeds the member’s “sufficient retirement income” (on a lifetime basis), 50% of the excess can be withdrawn tax-free each year. Assuming the $70 million remaining assets (after accounting for the initial lump sum distribution) had increased in value to $85 million by year 4, and further assuming it was determined that the individual needed $1 million as her sufficient retirement income, 50% of the $84 million excess, or $42 million, could be distributed to her that year free of tax. Such calculations could likewise be performed in each succeeding tax year, with 50% of the excess being available for tax-free receipt by the beneficiary each year. Consequently, while it is not possible to distribute 100% of the proceeds of such a pension tax-free, a substantial portion of any income generated in the pension (including gains realized with respect to appreciation accrued prior to contribution of assets to the pension fund) may be distributed without any Maltese or U.S. tax liability.

Conclusion

Some commentators have suggested that the purported benefits of Maltese pensions in this context were not intended by Treasury in negotiating the Treaty and that therefore the use of such pensions in this manner is “too good to be true.” The underlying legal principles, however, are not so different from those that apply to Roths in the United States. Like participants in Roths, participants in Maltese pensions can contribute after-tax dollars to the plan and never pay future tax on profits realized with respect to assets held in the plan. Admittedly, the biggest differences relate to the unlimited amounts that may be contributed to Maltese pensions and the fact that prior appreciation in assets that are contributed to the plan also may avoid being subjected to any U.S. tax. Regardless, these distinctions result from features of domestic Maltese law (not U.S. law), and make the use of such pension plans by U.S. residents so potentially attractive.

[1] Note, however, that U.S. information filing obligations may be triggered to the U.S. transferor member pursuant to Section 6048. Unless otherwise noted, all Section references are to the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury regulations promulgated under the Code.

[2] For this purpose, the term resident includes a U.S. citizen.  Article 4(1) of the Treaty.

[3] It should be noted that the FIRPTA provisions of Section 897 and Section 1445 should not be applicable because the pension plan is treated as a foreign grantor trust for U.S. federal income tax purposes.

[4] Treasury Technical Explanation of the U.S.-Malta Income Tax Treaty, signed 8/8/2008, Article 17, paragraph 1.

[5] Under Section 72, a portion of each payment represents tax-free return of basis.

[6] Note that, as discussed above, there should be no U.S. tax implications on contribution of the assets (for example, under Section 684), as the pension plan should be classified as a grantor trust for U.S. federal income tax purposes.

This post was written by  Jeffrey L. Rubinger and Summer Ayers LePree of  Bilzin Sumberg Baena Price & Axelrod LLP.
Read more on the National Law Review.