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Top 15 Tax Developments of 2013
(Parker Tax Publishing December 2013)

The biggest tax development in 2013 came barely a day into the new year, with the dramatic, last minute passage of the American Taxpayer Relief Act (ATRA). As a follow up to this bold development, a stalemated Congress went the rest of the year without passing a single piece of significant tax legislation.

With Congress effectively on the sidelines, the highest profile tax developments for the rest of 2013 came from (1) the IRS, which issued sweeping new regulations dealing with the Affordable Care Act and several other major topics, (2) the Supreme Court, which struck down a provision in the Defense of Marriage Act thus legalizing same-sex marriages and opening the floodgates for amended tax returns; and (3) the Washington D.C. district court, which rejected the IRS imposition of requirements on unregulated tax-return preparers, effectively shutting down the Tax Preparer Registration program.

Several other high profile court decisions and IRS rulings round out the top 15 tax developments for the year.

1. ATRA Raises Tax Rates, Fixes AMT Exemption, and Extends Dozens of Deductions and Credits

The year began with the passage of the American Taxpayer Relief Act of 2012 (ATRA). Probably the most important provision of ATRA for many taxpayers was the permanent extension of lower tax rates on individuals with income of $400,000 or less, heads of households with income of $425,000 or less, and married taxpayers with incomes of $450,000 or less. Individuals with incomes above those thresholds, however, saw tax rate increases of up to 39.6 percent.

ATRA also increased the alternative minimum tax exemption amounts and, for the first time, indexed the exemption and phaseout amounts, with the result that taxpayers can avoid the annual uncertainty regarding the exemption. ATRA extended the favorable capital gains and dividends rates on income at or below $400,000 (individual filers), $425,000 (heads of households), and $450,000 (married filing jointly) for tax years beginning after December 31, 2012. However, for taxpayers with incomes above those thresholds, the rate for both capital gains and dividends increased to 20 percent.

Many tax provisions that had expired or were scheduled to expire were extended by ATRA including (1) the child tax credit, which was permanently extended; (2) the American Opportunity tax credit, which was extended through 2018; (3) the increase in the earned income credit for families with three or more children, which was extended through 2017; (4) the deduction for certain expenses of elementary and secondary school teachers, which was extended through 2013; (5) the exclusion from gross income of the discharge of qualified principal residence debt, which was extended through 2013; (6) the extension of the state and local general sales tax deduction, which was extended through 2013; (7) the above-the-line deduction for qualified tuition and related expenses, which was extended through 2013; and (8) the deduction of mortgage insurance premium that are treated as qualified residence interest, which was extended through 2013.

For businesses, ATRA retroactively extended the $500,000 Section 179 expensing amounts, which had expired at the end of 2011, through 2013. Bonus depreciation was also retroactively extended for most businesses through 2013. Other business-related provisions affected by ATRA included (1), the work opportunity credit, which was extended through 2013; (2) the reduction in the S corporation recognition period for built-in gains, which was extended through 2013; and (3) favorable basis adjustments of S corporation stock for shareholders making charitable contributions.

2. Final Repair/Capitalization Regs Provide Numerous Safe Harbors for Taxpayers

In September, the IRS issued final regulations (T.D. 9636) regarding the deduction and capitalization of expenditures related to tangible property. Under these rules, a taxpayer must distinguish whether an amount paid is for a repair, in which case it may be currently deducted, or is for an improvement to a unit of property, in which case it must be capitalized. Under the regulations, a unit of property is considered improved if the amounts paid for activities performed after the property is placed in service by the taxpayer (1) are for a betterment to the unit of property; (2) restore the unit of property; or (3) adapt the unit of property to a new or different use.

The final rules contain numerous safe harbor and de minimis rules under which a taxpayer can avoid capitalizing an item. For example, there is a safe harbor for routine maintenance on property. Under that safe harbor, amounts paid for routine maintenance on a unit of tangible property, or on a building (leased or owned), condo, or cooperative, are deemed not to improve that unit of property and may thus be expensed. The final regulations expanded the definition of materials and supplies to include property that has an acquisition or production cost of $200 or less (increased from $100 or less in the temporary regulations), clarify the application of the optional method of accounting for rotable and temporary spare parts, and simplify the application of the de minimis safe harbor to materials and supplies.

The regulations added new deminimis safe harbor for expensing items, determined at the invoice or item level and based on the policies the taxpayer uses for its financial accounting books and records. A taxpayer with an applicable financial statement (AFS) may rely on the de minimis safe harbor where the amount paid for property does not exceed $5,000 per invoice, or per item as substantiated by the invoice. A taxpayer without an AFS may rely on the de minimis safe harbor only if the amount paid for property does not exceed $500 per invoice, or per item as substantiated by the invoice. If the cost exceeds $500 per invoice (or item), then no portion of the cost of the property will fall within the de minimis safe harbor.

The final regulations added a rule aimed at helping certain small taxpayers. Under that rule, a qualifying small taxpayer can elect to not apply the improvement rules requiring capitalization to an eligible building property if the total amount paid during the tax year for repairs, maintenance, improvements, and similar activities does not exceed the lesser of $10,000 or 2 percent of the unadjusted basis of the building.

While the final regulations made some accommodations for smaller taxpayers in an effort to ease the compliance burden of these new rules, the rules are fairly complex and businesses may need to revise their accounting procedures to accommodate the new rules. Because the rules are more favorable for businesses that have applicable financial statements, businesses without such statements may want to look at whether transitioning to AFSs would be worth their while.

3. IRS Clarifies Rules on 3.8% Net Investment Income Tax in Final and Proposed Regs

In late November, the IRS issued more than 300 pages of final (T.D. 9644) and proposed (REG-130843-13) regulations on the 3.8 percent net investment income tax. Instead of finalizing the proposed rules on how to calculate the gain or loss on the disposition of interests in partnerships and S corporations, the IRS went back to the drawing board and issued new proposed regulations which provide two methods of calculating gain or loss includible in net investment income upon the disposition of a partnership or S corporation interest a primary method and an optional simplified reporting method, as well as a list of exceptions as to who may use the optional simplified method. The IRS also issued proposed regulations which address for the first time the impact of the net investment income tax on various partnership items, such as guaranteed payments and Code Sec. 736 payments.

Additional substantial changes in the final regulations from the proposed regulations include: (1) a relaxation of the rule preventing the use of capital losses against other investment income such that capital losses may now reduce other investment income; (2) a safe harbor rule for real estate professionals so that rental income will not be included as net investment income of such professionals; (3) revising the method for computing properly allocable itemized deduction to a more simplified method; (4) partially allowing the use of net operating losses; and (5) allowing the regrouping of activities under the passive loss grouping rules on certain amended returns.

Because 2013 is the first year that the net investment income tax applies, it's reasonable to expect issues to arise particularly with respect to calculating the gain or loss on the disposition of an interest in a partnership or S corporation. The new proposed regulations in this area are not exactly the model of clarity. Similarly, the definition of a trade or business can be expected to cause issues for practitioners, as the regulations do not define what this means for purposes of the net investment income tax but say instead to follow case law. Another issue the rules did not resolve was how to determine if an estate or trust materially participates in an activity such that income from the activity is not included in net investment income. Practitioners can expect to see much guidance in this area as issues arise.

4. District Court Shuts Down Tax Preparer Registration Program in Loving Decision

In January, a district court, in Loving v. IRS, 2013 PTC 10 (D. D.C. 1/18/13), agreed with three independent tax return preparers that the IRS exceeded its authority in requiring all tax return preparers to pass a qualifying exam, pay an annual application fee, and take 15 hours of continuing-education courses each year. The court held that the tax-return preparer regulations were invalid and that the IRS could not enforce them.

Two months later, in March, in Loving v. IRS, 2013 PTC 37 (D.C. Cir. 3/27/13), the D.C. Court of Appeals rejected an IRS motion to stay the lower court's order. The IRS then suspended the requirements for tax-return preparers until the D.C. Circuit Court rules on the IRS appeal, which was heard on September 24. In an unusual move, five former IRS commissioners, appointed by Democratic and Republican Presidents, came together to file an amicus brief (2013 PTC 64) before the court. In that brief, the commissioners strongly disagreed with the D.C. district court's decision.

Many CPAs and attorneys who prepare tax returns for a living are hoping that the D.C. Circuit court overrules the district court and that the IRS reinstates the tax preparer registration program. They feel it's important to level the playing field for tax return preparers. Without regulations, anyone, regardless of their knowledge of the tax laws, can prepare a return. And many professional return preparers report seeing the disastrous results of returns prepared by incompetent tax return preparers.

OBSERVATION: While the IRS temporarily suspended the preparer tax identification number (PTIN) program as a result of the court decision, it reopened the program after a clarification from the court that the program was not affected.

5. Supreme Court Strikes Down DOMA, Leading to Numerous Amended Returns

On June 26, in yet another 5-4 decision, the Supreme Court struck down Section 3 of the Defense of Marriage Act (DOMA). The decision in U.S. v. Windsor, 2013 PTC 167 (S. Ct. 6/26/13) has broad tax implications for many same-sex couples. Couples legally married can no longer file as single. They must either file a joint return or file as married filing separately. For high-earner same-sex couples this can be a negative, as the threshold for applying the 3.8 percent net investment income tax to joint returns is $250,000, compared to a threshold of $200,000 for single taxpayers.

On the plus side, the DOMA decision allows taxpayers that might have benefited from filing a joint return to go back and file amended returns for any open tax year. In addition, same-sex couples can take advantage of the marital deduction for estate tax purposes, thus passing their estate tax-free to their partner. Refund claims can be made for estate taxes paid on property inherited from a same-sex partner to whom an individual was married under state law and on which estate taxes were paid. Additionally, employer-provided benefits that were previously taxable to partners in a same-sex marriage are now excludible from income, so refunds can be claimed on this basis also.

There are numerous opportunities here for amended returns and practitioners with same-sex couple clients should revise their year-end questionnaire to capture situations where amended returns may be warranted.

6. IRS Issues Final Regs on Individual Health Insurance Mandate Penalty

Under the Patient Protection and Affordable Care Act (PPACA), beginning in 2014, nonexempt U.S. citizens and legal residents of the United States must maintain minimum essential healthcare coverage. There has been a lot of controversy over this provision, referred to as the "individual mandate." A penalty in the form of a "shared-responsibility payment" is imposed upon individuals who do not have such healthcare coverage. The penalty is imposed under Code Sec. 5000A.

On August 30, the IRS issued final regulations under Code Sec. 5000A in T.D. 9632. One of the more favorable provisions of the final regulations is a rule that an individual is treated as having coverage for a month so long as he or she has coverage for any one day of that month. For example, an individual who starts a new job on April 30 and is enrolled in employer-sponsored coverage on that day is treated as having coverage for the month of April. Similarly, an individual who is eligible for an exemption for any one day of a month is treated as exempt for the entire month.

The statute provides an exemption for gaps in coverage of less than three months. It generally specifies that such gaps be measured without regard to the calendar years in which the gap occurs. For example, a gap lasting from November through February lasts four months and therefore generally would not qualify for the exemption. However, recognizing that many individuals file their tax returns as early as January, before the length of an ongoing gap may be known, the final regulations provide that if the part of a gap in the first tax year is less than three months and the individual had no prior short coverage gap within the first tax year, then no shared responsibility payment is due for the part of the gap that occurs during the first calendar year, regardless of the eventual length of the gap. For example, for a gap lasting from November through February, no payment would be due for November and December.

The final regulations provide that a taxpayer is liable for the shared responsibility payment imposed for any individual for a month in a tax year for which the individual is the taxpayer's dependent for that tax year. Whether the taxpayer actually claims the individual as a dependent for the tax year does not affect the taxpayer's liability for the shared responsibility payment for the individual. Special rules are also provided for determining liability for the shared responsibility payment attributable to children adopted or placed in foster care during a tax year. If a taxpayer legally adopts a child and is entitled to claim the child as a dependent for the tax year when the adoption occurs, the taxpayer is not liable for a shared responsibility payment attributable to the child for the month of the adoption and any preceding month. Conversely, if a taxpayer who is entitled to claim a child as a dependent for the tax year places the child for adoption during the year, the taxpayer is not liable for a shared responsibility payment attributable to the child for the month of the adoption and any following month.

7. Obama Administration Delays Employer Healthcare Mandate Until 2015

In July, the Treasury Department announced that two key parts of the Affordable Care Act, the mandatory employer and insurer reporting requirements, would not take effect until 2015, one year later than originally planned. As a result, businesses to which the law applies (generally those with 50 or more full-time employees or full-time equivalents) are not required to provide healthcare to employees until 2015.

The delay in implementing these provisions is designed to meet two goals: (1) give the IRS time to consider ways to simplify the new reporting requirements; and (2) provide employers time to adapt health coverage and reporting systems while moving toward making health coverage affordable and accessible for their employees.

8. Supreme Court Reverses Third Circuit in Foreign Tax Credit Case

In May, the Supreme Court issued a unanimous opinion in a case dealing with foreign tax credits. The decision has broad implications for entities doing business abroad because the Court declined to accept the notion that U.S. courts must take the foreign tax rate as written and accept whatever tax base the foreign tax purports to adopt.

In PPL Corporation v. Comm'r, 2013 PTC 108 (S. Ct. 5/20/13), the Supreme Court reversed a Third Circuit opinion and held that a United Kingdom (U.K.) windfall tax was creditable for U.S. tax purposes under Code Sec. 901. In doing so, it rejected the IRS's rigid construction of the foreign tax rules, saying that such rigid construction could not be squared with the black-letter principle that tax law deals in economic realities, not legal abstractions.

The important take away from this decision is that it's not important how a foreign government characterizes its own tax in determining whether a foreign tax credit is available for U.S. tax purposes. Given the artificiality of the U. K.'s calculation method, the Court followed substance over form and held that the windfall tax was nothing more than a tax on actual profits above a threshold.

9. S Corp Procedure Expands Time for Applying Corrective Procedures to Late Elections

Late S corporation elections, such as the election to become an S corporation or the election by certain trusts to become an eligible S corporation shareholder, can result in additional taxes if not properly corrected. In August, the IRS issued Rev. Proc. 2013-30, which will greatly simplify obtaining relief for various late S corporation elections. The procedure is more liberal in that it expands the time period taxpayers have in which to request relief from late S corporation elections.

Rev. Proc. 2013-30 provides corrective actions for various late S corporation elections and eliminates compliance with a number of prior procedures that taxpayers had to navigate to obtain such relief. The guidance is in lieu of requesting an IRS ruling and, thus, there is no user fee for requests filed under Rev. Proc. 2013-30. While there may still be some taxpayers that do not fall within the new procedure and will have to request an IRS ruling and pay a user fee, the number of such taxpayers is minimized under the new procedure.

10. IRS Provides Taxpayer-Friendly Guidance on Residential Energy Tax Credits

In November, the IRS issued 2013-70 which expanded guidance on tax credits for residential energy property and provided new insights into the types of property that qualify. Taxpayers that place certain nonbusiness energy property in service before 2014 or before 2017 may be eligible for tax credits under Code Sec. 25C and Code Sec. 25D, respectively. Each credit has different requirements and covers different types of property. The credits, which are aimed at homeowners installing energy efficient improvements such as insulation, new windows (including skylights), certain roofs, furnaces, and hot water boilers, range from $50 to $1,500, depending on the type of property placed in service.

Notice 2013-70 includes taxpayer-friendly guidance in several areas, including (1) expressly allowing taxpayers to claim a Code Sec. 25D credit for certain qualifying property installed in a second home or a vacation home, (2) allowing for the inclusion of sales tax paid on qualifying property when calculating credits under Code Sec. 25C or Code Sec. 25D, and (3) providing that window sash replacement kits may be eligible for the Code Sec. 25C credit even though they are not whole windows.

To the extent the notice provides new insight into the types of property that qualify, practitioners may be able to use this guidance to take credits on a client's 2013 tax return or file amended returns for prior years in which their clients placed such property in service.

11. Inappropriately Signed Return Keeps Statute of Limitations Open

The importance of knowing when the statute of limitations begins and ends is central in assessing a client's tax liability. Generally, under Code Sec. 6501, the IRS has three years from the date a return is filed in which to assess additional tax due. In Chapman Glen Limited v. Comm'r, 140 T.C. No. 15 (5/28/13), the Tax Court held that the three-year statute of limitations period remained open because the taxpayer's Form 990 was not signed by one of the taxpayer's corporate officers and thus was not a valid return.

Chapman Glen Limited is a cautionary tale of the importance of meeting return reporting requirements and the severe repercussions that can result if those requirements are not followed.

12. Court Upholds Right of Shareholder to Revoke S Status of Bankrupt QSub

In re Majestic Star Casino, LLC, 2013 PTC 109 (3d Cir. 5/21/13), a court was asked to decide for the first time whether or not the sole shareholder of an S corporation was entitled to revoke an S corporation election with the result being that the S corporation's QSub, which was in a Chapter 11 bankruptcy, lost its QSub election. The Third Circuit rejected conclusions reached by several lower courts that S corporation status was "property" and vacated a bankruptcy court order compelling the parent corporation to rescind its S revocation. The case reinforces the rule that filing a bankruptcy petition is not supposed to expand or change a debtor's interest in an asset; it merely changes the party who holds that interest.

Had the Third Circuit affirmed the bankruptcy court's holding, a QSub in bankruptcy could stymie legitimate transactions of its parent as unauthorized property transfers, even though the QSub would have had no right to interfere with any of those transactions before filing for bankruptcy.

13. Payroll Tax Fraud by Accountant Keeps Employer's Statute of Limitations Open

In City Wide Transit, Inc. v. Comm'r, 2013 PTC 27 (2d Cir. 3/1/13), the Second Circuit reversed the Tax Court and held that a CPA impersonator that filed fraudulent tax returns on behalf of a company in order to embezzle money that the company otherwise owed the IRS for employment taxes, was found to have intentionally evaded that company's taxes, thereby triggering the tolling provision of the statute of limitations. Accordingly, the IRS was free to assess the company's taxes at any time.

The case is notable because the company itself did not commit the fraud; rather, as a result of an employee's fraud, the company was subject to an unlimited statute of limitations. Thus, it's a cautionary tale for what can happen when an employee with access to filing a company's tax returns is not properly vetted.

14. Fourth Largest Tax Prep Firm in U.S. Shut Down for Fraudulent Conduct

Calling the repeated fraudulent and deceptive conduct by the fourth largest tax preparation firm in the United States "astonishing" and the evidence of such conduct "overwhelming," an Ohio district court judge permanently barred the organization, as well as its CEO and owner, from operating, or being involved with in any way, any business relating in any way to the preparation of tax returns.

In U.S. v. ITS Financial, LLC, 2013 PTC 349 (S.D. Ohio 11/6/13), the judge found the company's repeated attempts to downplay the gravity of their lawlessness "stunning" and said the injunction was necessary to protect the public and the Treasury. One of the more heinous acts committed by the owner of the company involved forging customers' signatures on duplicate refund checks that subsequently caused collection proceedings against the customers for a situation they knew nothing about. Several clients saw their credit ratings ruined. In all, the district court devoted 173 pages of its opinion to detailing a mind-boggling array of abuses perpetrated by ITS.

15. Tax Court Reverses Course on Gift Tax Issue and Rules for Taxpayer

In Steinberg v. Comm'r, 141 T.C. No. 8 (9/30/13), the Tax Court determined that it will no longer follow its decision in McCord v. Comm'r, a 2003 case in which it held that a couple had improperly reduced their gross gift value by the actuarial value of the donees' obligation to pay potential estate taxes. In reversing course, the court held that a donee's assumption of estate tax liability may reduce a gift's value.

In Steinberg, the 89 year old taxpayer gifted securities and cash to her daughters and, in exchange, the daughters agreed to assume and pay, among other things, any estate tax liability imposed under Code Sec. 2035(b) as a result of the gifts (an arrangement commonly known as a "net gift agreement"). The Tax Court rejected the IRS's request for summary judgment and held that, because the value of the obligation assumed by the daughters was not barred as a matter of law from being consideration in money or money's worth, the fair market value of mother's taxable gift could possibly be reduced by the daughters' assumption of the potential Code Sec. 2035(b) estate tax liability.

Although the Steinberg litigation is ongoing, the Tax Court's reversal of its own McCord precedent opens the door to broader application of the taxpayer-friendly "net gift rationale".

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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