Category: Tax

A Year-End Estate and Financial Planning Checklist: Make Your List and Check it Twice

During the holidays, it can be hard to find the time (or desire) to review your finances and estate plan. To help with that effort, here is a short list of things that you can easily accomplish before the ball drops on New Years’ Eve.

1. Review required minimum distributions (“RMDs”). If you’re 70½ or older, you must take RMDs from certain retirement accounts by December 31 or face a penalty equal to 50% of the sum you failed to withdraw. If you turned 70½ this year, you have until April 1, 2019, to take your first RMD without penalty. (However, note that deferring your first RMD to 2019 will mean taking two RMDs in the same tax year, which could bump you into a higher income tax bracket). These rules also apply in the case of an inherited or “stretch” IRA. Generally, you must begin taking RMDs for inherited IRA assets by December 31 of the year after the year of the original owner’s death, but certain exceptions may apply. The IRS provides some helpful worksheets here.

2. Reduce taxable income and rebalance investments. Work with your financial advisors to sell losing positions in taxable investment accounts as necessary to offset gains. Then review your asset allocation and, if necessary, rebalance your investment portfolio.

3. Max out company retirement plan contributions. In 2018, you can contribute up to $18,500 in your employer-sponsored retirement plan (i.e., 401(k), 403(b), most 457 plans, and the Federal government’s Thrift Savings Plan). Employees aged 50 or older who participate in such plans can contribute an additional $6,000 in “catch-up” contributions. If you are not able to contribute the maximum, try to contribute enough to qualify for any matching contributions by your employer.

4. Review insurance coverage. Make sure you have adequate policies in place insuring your life, health, disability, business, and assets (home and auto), which can help protect you and your family from unforeseen liabilities and expenses.

5. Review estate plans and beneficiary designations. Estate planning should be reviewed holistically and periodically to be sure that the plan you have in place accomplishes your goals. See “So You Think You’re Done With Your Estate Plan” for a more in-depth discussion.

6. Make gifts. The 2018 annual gift tax exclusion is $15,000. This exclusion is the amount of money you can give away per person per year, tax-free. In addition, married couples can elect to “split gifts”. By utilizing this strategy, married taxpayers can gift up to $30,000 to an individual in 2018 before a gift tax return is required. On top of annual exclusion gifts, an unlimited gift tax exclusion is available for amounts paid on behalf of a person directly to an educational organization, but only for amounts constituting tuition payments. Amounts paid to health care providers for medical services on behalf of a person also qualify for an unlimited gift tax exclusion. Annual gifting is an excellent way to reduce the value of your gross estate over time, thereby lowering the amount subject to estate tax upon your date of death. Charitable and philanthropic gifts (whether outright, in trust, or through a donor advised fund or similar vehicle) should also be considered.

7. Fund your Health Savings Account (“HSA”). In 2018, those in high-deductible health-insurance plans can save as much as $3,450 in pre-tax dollars in a health savings account. For families, the figure is $6,900, and those aged 55 and older can contribute an additional $1,000. Unlike a Flexible Spending Account, your HSA balance rolls over from year to year, so you never have to worry about losing your savings. If you are over age 65 and enrolled in Medicare, you can no longer contribute to an HSA, but you can still use the money for eligible out-of-pocket medical expenses.

8. Use your flexible spending dollars. Unused funds in a Flexible Spending Account (“FSA”) are typically forfeited at year’s end, so make sure to spend them for eligible health and medical expenses by December 31. Some plans offer a “grace period” of up to 2 ½ months to use FSA money. Other plans may allow you to carry over up to $500 per year to use in the following year. Bottom line, check with your employer to confirm your plan’s deadlines.

9. Check your credit and identity. Under the Fair Credit Reporting Act, each of the national credit-reporting agencies is required to provide you with a completely free copy of your credit report, upon request, once every 12 months. Get yours at www.annualcreditreport.com.

10. Organize your records for 2019. Now is the time to gather and organize the documents and 2018 records that will be needed to prepare your tax returns in 2019. As part of that process, shred documents that no longer need to be retained.

© Copyright 2018 Murtha Cullina

ARTICLE BY

Lisa P. Staron
Murtha Cullina

2018 Recap: State Responses to the Repatriation Transition Tax in the Tax Cuts and Jobs Act

Since the Tax Cuts and Jobs Act (TCJA) passed in December 2017, over 100 bills were proposed by state legislatures responding to the federal legislation. Thus far in 2018, nearly half of states have passed legislation responding to the TCJA. With some exceptions, in this year’s legislative cycles the state legislatures were primarily focused on the treatment of foreign earnings deemed repatriated and included in federal income under IRC § 965 (965 Income).

The STAR Partnership has been very involved in helping the business community navigate the state legislative, executive and regulatory reaction to federal tax reform, and IRC § 965 in particular. The STAR Partnership’s message to states has been clear: decouple from IRC § 965 or provide a 100 percent deduction for 965 income. The STAR Partnership emphasized that excluding 965 Income from the state tax base is consistent with historic state tax policy of not taxing worldwide income and avoids significant apportionment complexity and constitutional issues.

Most of the states that enacted legislation in response to the TCJA ultimately conformed to the recommendation of the STAR Partnership and did not tax a material portion of 965 Income. Of the states that enacted legislation in response to the TCJA, only one state explicitly decided to tax more than 20 percent of 965 Income. Below is a map prepared by the STAR Partnership illustrating the states’ responses to IRC § 965.

2018 STAR Partnership Success Stories Related to IRC § 965

Connecticut: Connecticut provides a dividends-received deduction for deemed dividends that, based on guidance from the Connecticut Department of Revenue Services, applies to 965 Income. A bill proposed by the Connecticut legislature would have deemed 10 percent of the dividend income to be a non-deductible expense attributable to such income. Due, in part, to advocacy efforts of the STAR Partnership and its members, the legislation that was ultimately adopted contained an expense attribution percentage of only 5 percent.

Hawaii: The STAR Partnership prepared policy and technical talking points and worked with local advocates to support Hawaii’s decoupling from IRC § 965. When legislation was passed, Hawaii did decouple from IRC § 965.

Indiana: The STAR Partnership prepared policy and technical talking points and worked with local advocates to support Indiana’s exclusion of 965 Income from the tax base. Indiana did enact legislation providing a 100 percent deduction for 965 Income, provided the taxpayer owns at least 80 percent of the foreign subsidiary.

Iowa: The STAR Partnership prepared policy and technical talking points and worked with local advocates to support Indiana’s decoupling from IRC § 965. Iowa did enact legislation effectively decoupling from IRC § 965.

Kentucky: The STAR Partnership prepared policy and technical talking points and worked with local advocates to support Kentucky’s decoupling from IRC § 965. Kentucky did enact legislation effectively decoupling from IRC § 965, at least with respect to taxpayers with calendar year CFCs.

Missouri: The STAR Partnership requested guidance from the Missouri Department of Revenue providing that 965 Income will be treated as a dividend and excluded from the state tax base under Missouri’s law, regardless of whether the taxpayer uses a three-factor or single-factor apportionment formula. The Department of Revenue issued the guidance that the STAR Partnership requested and, thus, pursuant to that guidance 965 Income is excluded from the Missouri state tax base for corporate taxpayers.

New Jersey: The New Jersey legislature proposed a special dividends tax on 965 Income, which would have resulted in tax being imposed on approximately 3 percent of total 965 Income. The STAR Partnership prepared talking points in opposition to the “special dividends tax” and sent a letter to the New Jersey legislature explaining that such tax was unconstitutional. Due to these efforts and the efforts of the STAR Partnership members, the legislature did not adopt the “special dividends tax.”

North Carolina: The STAR Partnership prepared policy and technical talking points and worked with local advocates to support North Carolina’s decoupling from IRC § 965. The legislature ultimately enacted legislation providing a 100 percent deduction for 965 Income.

Oklahoma: Due in part to the advocacy efforts of the STAR Partnership, the Oklahoma Tax Commission has stated that it will issue regulations that would effectively exclude 965 Income from the Oklahoma apportionable tax base for most taxpayers.

South Carolina: The STAR Partnership prepared policy and technical talking points and worked with local advocates to support South Carolina’s decoupling from IRC § 965. The legislature did pass a statute decoupling from IRC § 965.

© 2018 McDermott Will & Emery

IRS Issues Proposed Regulations for Qualified Opportunity Zone Funds

Treasury issued long-awaited Proposed Regulations and a Revenue Ruling today (October 19, 2018) regarding key issues involved with investing in and forming Qualified Opportunity Zone Funds (“OZ Fund”) and the OZ Fund’s investments in Opportunity Zone Businesses (“OZ Business”).  Although the Proposed Regulations do not answer all of our key questions, Treasury did provide generally taxpayer friendly guidance to the issues discussed below.  These Regulations are only proposed, and are therefore subject to further revisions based on comments received by Treasury.  However, Treasury has provided that taxpayers can rely on many of these proposed rules, provided that the taxpayer applies the rule in its entirety and in a consistent manner.

  • Treatment of Land. Land is excluded from the requirement that the original use of opportunity zone property commence with the OZ Fund or that the OZ Fund substantially improve the property, alleviating fears that land could only be a “bad” asset. Very favorably, if the OZ Fund purchases an existing building and the underlying land, the OZ Fund is only required to substantially improve (“double the basis”) the building.  The cost of the land is disregarded for this purpose.
  • Treatment of Capital Gains of Partnerships and other Pass-Thru Entities. Partners have 180 days from the end of the partnership’s taxable year to invest in an OZ Fund. Accordingly, capital gains recognized by a partnership early in 2018 (or even very late 2017) may still be eligible for investment in OZ Funds, even if 180 days have passed. A partnership has the option of either investing capital gains in an OZ Fund itself or allocating the gain to its partners, thereby permitting the partners the opportunity to invest their distribute share of the gain in an OZ Fund. If desired, the partner has the option to select the 180-day period starting from the date of the partnership’s sale of the property.
  • Treatment of Working Capital. The Proposed Regulations provide a working capital safe harbor for investments in OZ businesses that acquire, construct, or rehabilitate tangible business property. An OZ business can hold the working capital for a period of up to 31 months if there is a written plan that identifies the working capital as held for the acquisition, construction, or substantial improvement of tangible property in an opportunity zone and such written plan identifies a schedule of expenditures. This alleviates the concern that cash invested by an OZ Fund in an OZ business would be a “bad asset” for the OZ business.  Working capital can be held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
  • Only 70% of an OZ Business’ Tangible Assets Need to be OZ Property. An OZ Fund that invests directly in assets must have 90 percent of its assets be qualifying OZ Property. Qualifying property includes an investment into an OZ Business. An OZ Business only needs to have “Substantially all” of its tangible assets consist of qualifying OZ Property. The Proposed Regulations define, for this purpose only, “substantially all” as 70 percent of the OZ Business’ tangible assets. This is critical in allowing investors in non-real estate businesses to take advantage of the opportunity zone benefits. The Proposed Regulations provide alternative methods for determining compliance with the “substantially all” test, based either on the values in an applicable financial statement of the OZ business, or, if the business does not have an applicable financial statement, applying the methodology used by its Fund investors (who hold at least 5 percent of the OZ business) for determining their compliance with the 90 percent asset test.
  • The OZ Fund Can Borrow Money. The Proposed Regulations provide that deemed contributions of money derived from a partner’s share of partnership debt do not create a separate, non-qualifying investment in the OZ Fund. There had been concern that the proportion of the investment relating to money borrowed by the Fund would result in a non-qualifying investment. The Proposed Regulations do indicate that Treasury is considering an anti-abuse rule for investments that may be considered abusive. In addition, the Proposed Regulations imply that partners in OZ Funds do get outside basis for amounts borrowed by the OZ Fund, thereby potentially permitting the investors to take advantage of OZ Fund losses.
  • “Gains” are Limited to Gains Treated as Capital Gain. Treasury has specifically limited the OZ Fund benefits to gain that “is treated as a capital gain” for Federal income tax purposes.  Although this provision could have been clarified better, we think that “treated as a capital gain” is intended to include Section 1231 gains (special rules apply gains from hedging/straddles).
  • Special Allocations are Permitted. Investors must receive an equity interest in an OZ Fund.  For OZ Funds organized as partnerships, the Proposed Regulations specifically permit special allocations. Depending on whether additional limits are placed on special allocations, this may permit a certain amount of “carried interest” to be paired with an equity investment for OZ Fund service providers.
  • Early Disposition of OZ Fund interest. If an OZ Fund investor sells all of its interest in an OZ Fund before the end of deferral in 2026, the OZ Fund investor can maintain the original gain deferral by reinvesting the proceeds into a new OZ Fund within 180 days.  This allows an investor to get out of a bad deal without losing the deferral benefits. Note that the Proposed Regulations specifically deferred until future Regulations issues involved when the OZ fund itself sells OZ Fund property. These issues include what a “reasonable period of time” is for the OZ Fund to reinvest in qualifying assets and what the potential income tax consequences to the Fund and its investors of such a sale of OZ Fund property by the OZ Fund.
  • Valuation of Assets for Purposes of the 90% Test. For purposes of determining whether a Fund holds 90 percent of its assets in qualified opportunity zone property, the Proposed Regulations require the Fund to use asset values reported on an applicable financial statement of the Fund. Applicable financial statements are prepared in accordance with U.S. GAAP and either: (1) filed with a federal agency besides the IRS (which includes the SEC); or (2) are audited and used to make decisions by the taxpayer.  If a Fund does not have an applicable financial statement, the Fund must use its cost in acquiring the assets for the calculation. Treasury is seeking comments as to whether adjusted basis or another valuation method is a better measurement than cost.
  • 90% Asset Test Testing Dates. The Proposed Regulations provide for the possibility that an OZ Fund formed late in the taxable year could have to fully comply with the asset tests by the end of that year.  The law requires that an Oz Fund invest 90 percent of its assets in qualified opportunity zone business property, measured as the average of two Testing Dates. The first testing date is the last day of the 6th month following formation, and the second Testing Date is the last day of the taxable year.  For example, if a calendar-year fund selects April as its first month as an OZ Fund, then its first testing dates are the end of September and the end of December.  However, if a Fund is formed in the last half of the taxable year, then it will have only one testing date, which may be soon after formation. This creates the possibility that an OZ Fund formed in December only has until the end of December to fully comply. We are hoping that the final Regulations will provide more time for the OZ Fund to initially comply.
  • Limited Liability Companies (LLCs) Can Be OZ Funds. So long as the LLC is taxed as a partnership or a corporation, an LLC can be an OZ Fund.

The Proposed Regulations are generally favorable to investors, and so we expect that Opportunity Zone investments will really take off. Based on the 70 percent “substantially all” rule for OZ Businesses, we expect that Opportunity Zone investments will not be limited to real estate investors. In addition, we think Opportunity Zone investments are more likely to be structured with OZ Funds owning OZ businesses rather than the OZ Fund owning assets directly, because of the working capital safe harbor, the substantially all test, and the testing dates for OZ Funds.

© Polsinelli PC, Polsinelli LLP in California

This post was written by Korb Maxwell Jeffrey A. Goldman and S. Patrick O’Bryan of Polsinelli PC.

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.

Incentive Compensation That is Never Subject to Income Tax – Too Good to Be True?

Clients frequently ask if they can provide incentive compensation to their employees and executives in a manner that gives them flexibility and drives performance, but receives coveted capital gains treatment. This usually sounds too good to be true. In most cases, you can defer or sometimes minimize income tax for employees (retirement plans, deferred compensation arrangements, stock appreciation rights, non-qualified stock options), but there is one tool that enables employees to skip income tax, FICA, and withholding altogether – well-designed and-well managed incentive stock options or “ISOs.”

Incentive stock options – sometimes called statutory options because they are established and governed by Internal Revenue Code 422 – are a kind of stock option that can provide “special” tax treatment to the recipients if certain requirements are satisfied. There are two key differences between incentive stock options and their more common cousin – the non-qualified stock option:

  • First, executives will not recognize any ordinary income tax at exercise of an ISO (as compared to a non-qualified option – which requires executives to recognize ordinary income on the spread – or difference between the exercise price and the value of the option on the date of exercise – and come up with money to pay their withholding on that amount). This can be a big benefit as long as the exercise does not end up triggering the AMT (which has historically been an issue for many incentive stock option holders, but is less likely now in light of changes made to the AMT by the Tax Cuts & Jobs Act).

What is AMT?  At a very high level, the Alternative Minimum Tax (AMT) is simply an alternative tax structure to the more well-understood and more often used regular income tax method. In order to determine which tax to apply, taxpayers must calculate taxes under the regular income tax method and the alternative minimum tax and then pay whichever amount is greater. This does not come up particularly often for most normal taxpayers, but is relevant for most ISO recipients because the value of the spread at exercise is not taken into account under the regular tax method, but it is considered as a preference item in the AMT method. The larger the spread, the more likely ISOs will trigger the AMT.

  • Second, if all of the statutory requirements are satisfied, then the gain – the difference between the incentive stock option’s exercise price (generally, the fair market value of the stock on the date of grant) and the amount the holder will receive when she ultimately sells the stock after exercise – will all be taxed at the lower capital gains rate (currently, 15 percent or 20 percent, depending on income level), rather than income tax (the top tax bracket is currently at 37 percent), and no FICA or withholding obligations will apply. That is a tax savings of more than 17 percent!

The flipside is that ISOs are less tax advantageous to employers because, if all goes as planned, they will never be permitted to take a deduction for the compensation. However, because the corporate tax rate was reduced with the Tax Cuts & Jobs Act, some employers are taking a second look at whether to issue ISOs now, considering that the deduction is now less valuable.

To receive this special treatment, the plan document, award agreement, and management of the incentive stock option award must meet certain requirements:

Plan and Award Agreement

  • Incentive stock options must be issued pursuant to an equity incentive plan.
  • The plan must provide the number of shares reserved for issuance as ISOs.
  • The plan must be approved by the company’s shareholders within 12 months before or after it is adopted by the company, and re-approved at least every 10 years thereafter.
  • The award agreement must provide an exercise price that is no less than the fair market value of the stock underlying the options on the date of grant (100 percent of the fair market value for 10 percent owners). [This will also help with Code Section 409A compliance.]
  • Each award must have a stated term of no more than 10 years (five years for 10 percent owners).

Eligibility and Operation

  • ISOs may only be issued to employees – not to consultants or non-employee directors.
  • ISOs may only be issued by corporations.
  • No more than $100,000 of ISOs may become exercisable in any given calendar year (based on the fair market value on the grant date). [This seems straightforward until companies add fancy features like accelerated vesting on a change in control event.]
  • Certain limits on post-termination exercise apply, notably ISOs must be exercised within three months of a standard termination (longer periods apply in the event of death or disability).
  • After the option is exercised, and stock is actually purchased, the stock must be held until the later of (i) the second anniversary of the grant date or (ii) one year from the exercise date. [This tends to be one of the most difficult requirements to satisfy because many employees want to wait to exercise until a liquidity event – or change in control – but will not satisfy the holding period if they sell their stock shortly after exercise.]
© 2018 Foley & Lardner LLP
This post was written by Casey K Fleming of Foley & Lardner LLP.
Please find more tax legal news on the National Law Review tax type of law page.

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.

Tax Reform – Consolidated Appropriations Act Provides Added Bonus for LIHTC Projects

On March 23, the President signed the Consolidated Appropriations Act, 2018 (H.R. 1625), a $1.3 trillion dollar spending bill that funds the federal government through September 30, 2018. In addition to preventing a government shutdown, this omnibus spending bill incorporated the following key provisions that help to strengthen and expand the Low Income Housing Tax Credit (LIHTC):

  • A 12.5% increase in the annual per capita LIHTC allocation ceiling (after any increases due to the applicable cost of living adjustment) for calendar years 2018 to 2021.
  • An expansion of the definition of the minimum set-aside test by incorporating a third optional test, the income-averaging test. Pursuant to the Code, a project meets the 40-60 minimum set aside test when 40% of the units in the project are both rent restricted and income restricted at 60% of the area median income. Under the new law, the income test is also met if the average of all the apartments within the property, rather than every individual tax credit unit, equals 60% of the area median income. Notwithstanding, the maximum income to qualify for any tax credit unit is limited to 80% of area median income.

This legislation is a great win for affordable housing advocates who have been pushing for LIHTC improvements through the Affordable Housing Credit Improvement Act, introduced in both the Senate (S. 548 sponsored by Senators Cantwell and Hatch) and the House (H.R. 1661 now sponsored by Congressmen Curbelo and Neal) in 2017, as discussed previously in a prior blog post.

We will continue to provide updates on legislation related to Tax Reform.

Read more coverage on tax reform on the National Law Review’s Tax page.

Copyright © by Ballard Spahr LLP
This post was written by Maia Shanklin Roberts of Ballard Spahr LLP.

Reduction in U.S. Corporate Tax Rates Will Significantly Impact Outbound Tax Planning by U.S. Individuals

The Tax Cuts and Jobs Act (“TCJA”) represents the most significant tax reform package enacted since 1986. Included in this reform are a number of crucial changes to existing international tax provisions.  While many of these international changes relate directly to U.S. corporations doing business outside the United States, they nevertheless will have a substantial impact on U.S. individuals with the same overseas activities or assets.

One notable change under the new law was the reduction of the maximum U.S. corporate income tax rate from 35% to 21%. Not surprisingly, this change will have a corresponding impact on the ability of U.S. shareholders (both corporations and individuals) of controlled foreign corporations (“CFCs”) to qualify for the Section 954(b)(4) “high-tax exception” from Subpart F income.  This is because the effective foreign tax rate imposed on a CFC that is needed to qualify for this purpose must be greater than 90% of the U.S. corporate tax rate.  Therefore, this exception now will be available when the effective rate of foreign tax is greater than 18.9% (as opposed to 31.5% under prior law).

In addition to the reduction in corporate tax rates, the TCJA includes a partial shift from a worldwide system of taxing such U.S. corporate taxpayers to a semi-territorial system of taxation.  This “territorial” taxation is achieved through the creation of a dividends received deduction (“DRD”) for such domestic corporate taxpayers under Section 245A.[1]  This provision will allow a U.S. C corporation to deduct the “foreign-source portion” of any dividends it receives from a 10%-or-more-owned foreign corporation (other than a PFIC), as long as the recipient has owned the stock of the payor for more than one year during the prior two year period.  Assuming the foreign payor has no income that is effectively connected to a U.S. trade or business (“ECI”) and no dividend income from an 80%-owned U.S. subsidiary, the entire dividend generally will be exempt from U.S. federal income tax under this provision.[2]  In a corresponding change to Section 1248, when the relevant stock of a CFC is sold or exchanged, any amount of gain that is recharacterized as a dividend to a corporate U.S. shareholder under Section 1248 also is eligible for this DRD assuming the stock has been held for at least one year.

Despite these shifts toward partial territoriality, the new law retains the Subpart F rules that apply to tax currently certain income earned by CFCs (i.e., foreign corporations that are more than 50% owned by 10% U.S. shareholders (under the new law, both the 10% and 50% standards are measured by reference to either vote or value), as well as introducing a new category of income puzzlingly called “global intangible low-taxed income” (GILTI), though it has almost nothing to do with income from intangibles.[3]  GILTI will include nearly all income of a CFC other than ECI, Subpart F income (including Subpart F income that is excludible under the Section 954 (b)(4) high-tax exception), or income of taxpayers with very significant tangible depreciable property used in a trade or business.

The GILTI tax, imposed under Section 951A, applies to U.S. shareholders (both corporate and individual) of CFCs at ordinary income tax rates. Accordingly, U.S. individual shareholders of CFC typically will be subject to tax on GILTI inclusions at a 37% rate (the new maximum individual U.S. federal income tax rate).   U.S. C corporations that are shareholders of CFCs, on the other hand, are entitled under new Section 250 to deduct 50% of the GILTI inclusion, resulting in a 10.5% effective tax rate on such income.  Additionally, such corporate shareholders are permitted to claim foreign tax credits for 80% of the foreign taxes paid by the CFC that are attributable to the relevant GILTI inclusion.  Accounting for the 50% deduction and foreign tax credits, if any, a corporate U.S. shareholder’s GILTI inclusion that is subject to a rate of foreign income tax of at least 13.125% should result in no further U.S. federal income tax being due.[4]

In addition to the above GILTI provisions, Section 250 also permits U.S. corporations to deduct 37.5% of “foreign-derived intangible income” (FDII), resulting in an effective U.S. federal income tax rate of 13.125% on such income. FDII is the portion of the U.S. corporation’s net income (other than GILTI and certain other income) that exceeds a 10% rate of return on the U.S. corporation’s tangible depreciable business assets and is attributable to certain sales of property (including leases and licenses) to foreign persons or to the provision of certain services to any person located outside the United States.

Impact on Individual U.S. Taxpayers

While the TCJA substantially reduced the top U.S. corporate tax rate from 35% to 21%, individual U.S. income tax rates were not materially altered (i.e., the maximum individual U.S. federal income tax rate was reduced from 39.6% to 37%).  Nevertheless, the reductions in corporate tax rates and other relevant entity-level changes should be expected to have a dramatic impact on outbound U.S. tax planning for individual shareholders of CFCs.

Planning Using Section 962

Section 962, which has been a part of the Code since 1962, allows an individual (or trust or estate) U.S. shareholder of a CFC to elect to be subject to corporate income tax rates on amounts which are included in income under Section 951(a) (i.e., subpart F inclusions and amounts included under Section 956). The purpose behind this provision is

…to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. This provision gives such individuals assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad.[5] (emphasis added).

The U.S. federal income tax consequences of a U.S. individual making a Section 962 election are as follows. First, the individual is taxed on amounts included in his gross income under Section 951(a) at corporate tax rates. Second, the individual is entitled to a deemed-paid foreign tax credit under Section 960 as if the individual were a domestic corporation. Third, when an actual distribution of earnings is made of amounts that have already been included in the gross income of a U.S. shareholder under Section 951(a), the earnings are included in gross income again to the extent they exceed the amount of U.S. income tax paid at the time of the Section 962 election.[6]

Historically, elections under Section 962 were made infrequently. Under the new law, however, this is likely to change as such elections will have much more significance to many more U.S. individual shareholders of CFCs.  As noted above, the new GILTI provisions will cause U.S. individual shareholders of CFCs to be subject to U.S. federal income tax at a 37% rate on a new category of income, which will be taxed in the same manner as Subpart F income (including with respect to eligibility to make a Section 962 election as to such income).[7]

The lower 21% corporate income tax rate under the new law coupled with the inability of individual shareholders to claim indirect foreign tax credits under Section 960 mean that, in some cases, U.S. individuals investing in CFCs through U.S. corporations will be better off from a tax perspective under the TCJA than U.S. individual shareholders making such investments in CFCs directly. For this reason, individual U.S. shareholders should consider whether it is beneficial to make Section 962 elections going forward, which would allow them to claim indirect foreign tax credits on any amounts included under subpart F, as well as under the GILTI provisions.[8]

Some of the unanswered questions facing taxpayers in this context are, first, whether individuals owning their CFC interests through S corporations or partnerships may make a Section 962 election at all. The IRS previously refused to issue a requested private letter ruling confirming the availability of the election in such cases,[9] though it appears based on informal discussions with Treasury and IRS officials as well as a footnote in the legislative history to Section 965 that the IRS may have since adopted a different view.[10]

Another issue that is not clear is whether an individual U.S. shareholder who makes a Section 962 election is eligible to claim the 50% GILTI deduction under Section 250 (which would have the effect of reducing the effective U.S. tax rate on such income to 10.5%). Based on the clear intent behind Section 962, which is to ensure that an individual U.S. shareholder who has an inclusion under Subpart F (including for this purpose, inclusions under Section 951(A) is subject to tax under Section 11 as if the shareholder invested abroad through a U.S. C corporation, such deduction should be allowed.  The IRS seems to have agreed with this logic in FSA 200247033, when it cited to the legislative history behind Section 962 and calculated the tax on a U.S. individual shareholder who made a Section 962 election as if the taxpayer actually invested through a separate U.S. C corporation doing business abroad.  The IRS noted that “…section 962 was enacted to relieve a U.S. individual shareholder of a CFC from a hardship that might otherwise result from a section 951(a) inclusion by ensuring that the tax burden for such individual would be ‘no heavier’ than it would be if the individual had instead invested in a U.S. corporation doing business abroad. If the amount included in income under Section 951(a) were derived by a taxpayer’s domestic corporation, such amount would have been subject to tax at the applicable corporate rates.” It also should be pointed out that while the regulations under Section 962 specifically state that the hypothetical corporate taxpayer may not reduce its taxable income by any deductions of the U.S. shareholder[11] the regulations make no mention of any prohibition against corporate level deductions, such as the 50% GILTI deduction allowable under Section 250 (emphasis added).

Finally, a third potential issue that may arise in this context is the tax characterization of an actual distribution of earnings and profits that were previously included in the U.S. shareholder’s gross income under Section 951(a). This issue arises whenever the CFC is located in a non-treaty jurisdiction, such that dividends paid by such a CFC could not qualify for the reduced “qualified dividend” rate under Section 1(h)(11).  When an actual distribution is made from such a company, the question is whether the distribution should be treated as coming from the CFC (and therefore be classified as ordinary income), or instead as coming from the deemed C corporation created by the Section 962 election (and thus be classified as qualified dividends). As explained above, the objective behind Section 962 is to tax the individual U.S. shareholder in the same amount that she would have been taxed had the investment in the CFC been made through a domestic C corporation. To achieve this objective and avoid exposing the shareholder to a significantly higher rate of tax in the United States, where962 election is in place, any distribution of earnings and profits by the CFC must be treated as coming from a domestic C corporation.  This issue is currently pending in the United States Tax Court.

Impact Under Section 1248(b)

Another outbound provision that should become more relevant to U.S. individual shareholders of CFCs is the limitation imposed under Section 1248(b) when a U.S. shareholder, directly or indirectly, sells the shares of a CFC. Under Section 1248(a), gain recognized on a U.S. shareholders’ disposition of stock in a CFC is treated as dividend income to the extent of the relevant earnings and profits accumulated while such person held the stock.  Significantly, where the U.S. seller is a C corporation, under the new quasi-territorial system, this conversion of gain into a dividend triggers an exemption from tax pursuant to the Section 245A dividends received deduction.

With respect to individual U.S. shareholders who sell stock in a CFC, recharacterization under Section 1248(a) also remains significant due to the rate differential between the taxation of qualified dividends and long-term capital gains (which are subject to a maximum federal income tax rate of 23.8% under Section 1(h)(11)), and non-qualified dividends (which are subject to a maximum federal income tax rate of 40.8%).

Section 1248(b), however, provides for a ceiling on the tax liability that may be imposed on the shareholder receiving a Section 1248(a) dividend if the taxpayer is an individual and the stock disposed of has been held for more than one year. The Section 1248(b) ceiling consists of the sum of two amounts.  The first amount is the U.S. income tax that the CFC would have paid if the CFC had been taxed as a domestic corporation, after permitting a credit for all foreign and U.S. tax actually paid by the CFC on the same income (the “hypothetical corporate tax”).  For example, assume a Cayman Islands CFC has $100 of income and pays $0 of foreign taxes.  Also assume the Cayman CFC would be in the 21% income tax bracket for U.S. federal income tax purposes under Section 11 based on its taxable income levels if it were a domestic corporation.  In this case, the hypothetical corporate tax would be $21 ($21 U.S. tax minus $0 of foreign tax credits).

The second amount is the addition to the taxpayer’s U.S. federal income tax for the year that results from including in gross income as long-term capital gain an amount equal to the excess of the Section 1248(a) amount over the hypothetical corporate tax (the “hypothetical shareholder tax”). Continuing with the same example and assuming the shareholder’s gain on the sale is $100, this hypothetical shareholder tax would be 23.8% of $79 ($100 Section 1248(a) amount less the hypothetical corporate tax of $21), or $18.80.

Adding together the hypothetical corporate tax and the hypothetical shareholder tax in this example thus yields $39.80 in U.S. tax on the $100 gain, for an effective tax rate of 39.8%. Given that the CFC in this example is not resident in a treaty country (i.e., the United States does not have an income tax treaty with the Cayman Islands), the amount of gain that is recharacterized as a dividend under Section 1248(a) (i.e., $100) would be taxable at a maximum federal rate of 40.80%, resulting in $40.80 of tax. Because this is greater than the Section 1248(b) ceiling of $39.80, the ceiling will apply, and the U.S. shareholder will pay U.S. tax of $39.80.  As a consequence of the significant reduction in U.S. corporate tax rates, it appears that the Section 1248(b) limitation will now always yield a lower effective tax than the tax that would be imposed under Section 1248(a).  While this may seem somewhat odd, it makes sense given that the U.S. corporate tax rate (which the hypothetical corporate tax rate is based on) was reduced from 35% to just 21%.

As illustrated in the above example, going forward, even where no foreign corporate income taxes are paid, the Section 1248(b) limitation will result in a lower tax liability than the tax that would be imposed under Section 1248(a). As the foreign tax burden increases, the Section 1248(b) limitation becomes more significant.  In fact, as long as the foreign corporate tax rate is at least 21%, the Section 1248(b) limitation will yield an effective tax rate of 23.8%, which is equal to the maximum individual U.S. federal income tax rate on qualified dividends.  Therefore, if a U.S. individual shareholder sells shares of stock in a CFC that is tax resident, for example, in Ecuador (a non-treaty country which currently has a corporate tax rate of 22%), the effective tax rate imposed on such shareholder based on the Section 1248(b) limitation will be the same as if the CFC were resident in a treaty country.

Even more interesting is the fact that it would appear to be possible to qualify for the reduced qualified dividend rates caused by the Section 1248(b) limitation even in situations where the foreign tax rate is less than 21%. This is due to the ability of such shareholders to take deductions for purposes of the hypothetical U.S. tax computations that may not be available under relevant foreign law. At least one federal court has confronted this issue. In Hoover v. the United States,[12] for purposes of determining the amount of corporate taxes that would have been paid if the CFC had been a domestic corporation, the U.S. District Court for the Central District of California allowed the hypothetical corporation to claim the former deduction available under Section 922 for Western Hemisphere Trade Corporations. This special deduction is available only to domestic corporations all of the business of which was conducted in North, Central, or South America, or in the West Indies, if, among other items, at least 95 percent of the company’s gross income was derived from foreign sources during a three-year testing period.  Clearly this deduction is not available for U.S. federal income tax purposes when computing the earnings and profits of a CFC, so it is noteworthy that the court allowed the taxpayer in Hoover to claim this special deduction in calculating the hypothetical corporate tax under Section 1248(b).

While the Section 922 deduction for Western Hemisphere Trade Corporations no longer exists, other relevant provisions are available that may provide a benefit to U.S. taxpayers in calculating the hypothetical corporate tax under Section 1248(b). For example, as noted above, Section 250 now provides a 37.5% deduction on FDII. This provision could provide a major income tax benefit to a U.S. taxpayer that owns a CFC that sells goods or provides services to non-U.S. persons when calculating the hypothetical corporate income tax under Section 1248(b).  This results from the fact that FDII is subject to an effective corporate tax rate of only 13.125% (which is much lower than the current 21% corporate tax rate).

Conclusion

As illustrated above, despite the negligible reduction of maximum U.S. individual tax rates from 39.6% to 37%, individual shareholders of CFCs nevertheless will benefit greatly from the more significant reduction in U.S. corporate tax rates. While there are a number of unanswered questions relating to the interaction between Section 962, GILTI, and qualified dividends, direct or indirect U.S. individual shareholders of CFCs now, more than ever, should seriously consider the impact of making a Section 962 election, especially where the CFC is tax resident in a treaty country and/or is subject to a relatively high rate of tax.

[1] All Section references are to the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury Regulations promulgated under the Code.

[2] No foreign tax credits are permitted as to such dividends for which a foreign-source DRD is allowed.

[3] Unlike subpart F inclusions, there is no high-tax exception to GILTI inclusions under Section 951A. Instead subpart F income that is excluded from a U.S. shareholder’s gross income under the Section 954(b)(4) high-tax exception also is excluded from the GILTI provisions.  Query whether it makes sense to cause certain non-subpart F income that is otherwise subject to an effective foreign tax rate greater than 18.9% to be recharacterized as subpart F income in order to avoid GILTI (e.g., by creating a related party transaction).

[4] For tax years after 2025, the deduction is scheduled to decrease from 50% to 37.5%, resulting in an effective tax rate of 13.125% rather than 10.5% assuming corporate rates remain capped at 21%.

[5] S. Rep. No. 1881, 87th Cong., 2d Sess. (1962), reprinted at 1962-3 C.B. at 798.

[6] Section 962(d); Treas. Reg. Section 1.962-3. The most obvious reason why a taxpayer would choose to make a Section 962 election is the ability to defer the U.S. federal income tax on the actual distribution from the CFC, as well as the possibility of obtaining “qualified” dividends under Section 1(h)(11) on the subsequent distribution.

[7] Section 951A(f)(1)(A).

[8] Section 951A(f)(1)(A). See also TCJA Conference report at p. 517

[9] See Rubinger and LePree, “IRS Takes Flawed Approach to Inclusion under Subpart F,” Tax Notes, v.123, no.7, 2009 May 18, p.903-910.

[10] Section 965(a) imposes a one-time deemed repatriation tax on any deferred earnings of certain “specified foreign corporations.” This tax applies to C corporations as well as U.S. individual shareholders of these corporations.  A Section 962 election also may be useful when calculating the tax due under Section 965 for an individual.

[11] Treas. Reg. Section 1.962-1(b)(1)(i).

[12] Hoover v. United States, 348 F. Supp. 502, 504 (CD Cal. 1972).

© 2018 Bilzin Sumberg Baena Price & Axelrod LLP

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.

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