quarterly federal tax update – first quarter 2015 · quarterly federal tax update—first quarter...

Quarterly Federal Tax Update – First Quarter 2015

Copyright 2015–2016 AICPA • Unauthorized Copying Prohibited 1

QUARTERLY FEDERAL TAX

UPDATE—FIRST QUARTER 2015

Title:

Quarterly Federal Tax Update—First Quarter 2015

Field of Study:

Taxation

Course Description:

This course provides various tax update items and other federal tax highlights.

Objective:

Understand key recent developments that will affect many tax practitioners and their clients.

Target Participants:

CPAs in industry and public practice

2 Copyright 2015–2016 AICPA • Unauthorized Copying Prohibited

Quarterly Federal Tax Update—First Quarter 2015

HIGHLIGHTS FOR VARIOUS TYPES OF TAXPAYERS

Second Quarter 2015 Interest Rates on Federal Tax Overpayments and Underpayments: No Changes

Ordinary Loss Deduction Allowed for Securities Abandonment Loss

HIGHLIGHTS FOR INDIVIDUAL TAXPAYERS

Update on Tax Recordkeeping for Gamblers

Affordable Care Act Developments Affecting Individual Taxpayers

Alimony Deduction Developments

Passive Activity Loss (PAL) Developments

Mortgage Interest Deduction Developments

Internet Service Payments Were Deductible Business Expenses

NOL Carryover Cannot Be Used to Reduce Self-Employment Tax Bill

HIGHLIGHTS FOR BUSINESS TAXPAYERS

IRS Announces Luxury Auto Depreciation Limitations for 2015

How Reimbursing Employee Health Insurance Premiums Can Trigger Punitive Affordable Care Act

Penalty and New Penalty Relief Provisions

IRS Issues Updated Procedures for Accounting Method Changes to Comply With Tangible Property

Regulations and Relief for Small Businesses

IRS Issues FAQs on Tangible Property Regulations

IRS Issues Guidance on Penalties for Failure to File Partnership and S Corporation Returns

$2 Million Bonus Paid to C Corporation’s Sole Shareholder Failed Reasonable Compensation Test


Key Tax Developments Affecting Various Types of Taxpayers

SECOND QUARTER 2015 INTEREST RATES ON FEDERAL TAX OVERPAYMENTS

AND UNDERPAYMENTS: NO CHANGES

The interest rates that apply to federal tax overpayments and underpayments for the second quarter of

2015 are the same as for the first quarter (Revenue Ruling (Rev. Rul.) 2015-5 and Section 6621). In fact,

the interest rates have now been the same for 15 consecutive quarters. The rates for the second quarter

are as follows:

For overpayments and underpayments by unincorporated taxpayers and most corporate underpayments: 3 percent

For most corporate overpayments: 2 percent

For the portion of a corporate overpayment that exceeds $10,000: 0.5 percent

For large corporate underpayments (generally underpayments by C corporations in excess of $100,000): 5 percent

ORDINARY LOSS TREATMENT ALLOWED FOR SECURITIES ABANDONMENT LOSS

In a recent decision, the Fifth Circuit Court of Appeals reversed the Tax Court which had concluded that

the taxpayer’s abandonment of securities had to be treated as a capital loss pursuant to Section 1234A.

The taxpayer had voluntarily surrendered securities that were worth far less than their cost but that still

had significant value. The Fifth Circuit concluded that the capital loss treatment mandated by Section

1234A(1) applies to the termination of a contractual or derivative right but not to the abandonment of a

capital asset. In this case, the taxpayer abandoned securities as opposed to a right or an obligation with

respect to the securities. Therefore, the taxpayer was allowed to treat the abandonment loss as an

ordinary loss rather than a capital loss. (See Pilgrim’s Pride Corp., 115 AFTR 2d 2015-930 [5th Cir. 2015].)


Key Tax Developments Affecting Individual Taxpayers

UPDATE ON TAX RECORDKEEPING FOR GAMBLERS

All Winnings Must Be Reported (in Theory)

Technically speaking, a gambler must report the full amount of each and every win from each and every

roll of the dice or each and every spin of the slot machine on the miscellaneous income line (on page 1 of

Form 1040 [line 21] for an amateur gambler or on Schedule C for a professional gambler). In other

words, an individual’s gross wagering winnings must be included in gross income on his or her Form

1040. (In a profitable year, an individual cannot simply subtract losses from winnings and report the net

amount of winnings on page 1 of Form 1040 or on Schedule C.)

The fact that clients are technically required to report the sum total of each and every win as gross

income results in higher AGI, which may cause all sorts of phase-out rules to come into play. Even

clients who attempt to keep good records will probably record only their daily net winnings and daily net

losses. Reporting an amount of gross income equal to the sum total of the net winnings from all days

with net winnings will probably not get the client in trouble with the IRS, as long as the amount reported

as income equals or exceeds the sum total of any amounts reported as income on Forms W-2G.

IRS and Tax Court Move in Direction of More Realistic Approach to Recordkeeping

Along the lines suggested in the immediately preceding paragraph, a 2008 advice memo from the IRS

Chief Counsel’s office (AM-2008-011) says a casual slot player can simply keep a record of his or her net

win or net loss from each gambling session. A session is deemed to end when the player cashes in his or

her tokens, or runs out of tokens and is therefore able to figure out how much he or she won or lost

during that session. If the casual slot player then reports the sum total of the net wins from all winning

sessions as gross income on page 1 of Form 1040 and keeps track of the sum total of the net losses from

all losing sessions for purposes of applying the losses-cannot-exceed-winnings limitation to his or her

Schedule A itemized deduction, the IRS will consider that close enough to the theoretically required

recording of each win or loss from each spin of the slot machine. Presumably this concept of recording

net wins and losses from all gambling sessions is also considered sufficient for other forms of casual

gambling.

Key Point: In a 2009 decision, the Tax Court appeared to endorse the aforementioned per-session

approach to recording gambling wins and losses (Shollenberger, TC Memo 2009-306).

More Good News on the Recordkeeping Front

In Notice 2015-21, the IRS sets forth a proposed revenue procedure that, if issued in final form, would

establish a new optional safe-harbor method that both amateur and professional slot players (apparently)

could use to determine wagering gains and losses for federal income tax purposes. The proposed safe-

harbor rule is an acknowledgment that the IRS is aware that determining wagering gains and losses from

slot machine play is problematic. The issue is exacerbated by the increased use of electronic gambling.

For most slot players, the advent of electronic gambling has completely eliminated “old-school” physical

redemptions of slot machine tokens at the end of gambling sessions. The proposed revenue procedure


states that the IRS would not challenge a taxpayer’s use of the per-session method explained in the

following section to calculate wagering gains and losses from electronically tracked slot machine play if

the taxpayer meets the requirements in the proposed revenue procedure. Electronically tracked slot

machine play is defined as using an electronic player system that is controlled by the gaming

establishment (such as through the use of a player’s card or similar system) and that records the amount

that a player wagers and wins on slot machine play.

Session of Play

The proposed revenue procedure defines a session of play as a period that begins when the player places

the first wager on a particular type of game and ends when the player completes the last wager on the

same type of game before the end of the same calendar day. Thus a session of play is always determined

by reference to a specific calendar day (24-hour period from 12:00 AM through 11:59 PM), and the

session ends no later than the end of that calendar day.

The same session of play continues if the player stops and then resumes electronically tracked slot

machine play within a single gaming establishment during the same calendar day.

If, after engaging in slot machine play at one gaming establishment, the player leaves that establishment

and begins electronically tracked slot machine play at another gaming establishment, a separate session of

play would begin at the second establishment, even if the play at the second establishment is within the

same calendar day as the play at the first establishment.

If the player uses the aforementioned definition of a session of play for any day in a calendar year at a

particular gaming establishment, the player must use the same definition for all electronically tracked slot

machine play during the same tax year at that same gaming establishment.

Calculation of Wagering Gains and Losses

The proposed revenue procedure states that a player determines the wagering gain or loss from

electronically tracked slot machine play at the end of a session of play as follows:

1. The player recognizes a wagering gain if, at the end of a single session of play, the total dollar

amount of payouts from electronically tracked slot machine play during that session exceeds the

total dollar amount of wagers placed during that session.

2. The player recognizes a wagering loss if, at the end of a single session of play, the total dollar

amount of wagers placed during that session exceeds the total dollar amount of payouts during

that session.

Effective Date

The rules in the proposed revenue procedure would generally be effective for tax years ending on or after

the date of publication in the form of a final revenue procedure. The rules would apparently apply to

both amateur and professional slot players.


AFFORDABLE CARE ACT DEVELOPMENTS AFFECTING INDIVIDUAL TAXPAYERS

IRS Releases Publication on Premium Tax Credit

The IRS has finally posted long-awaited Publication 974, Premium Tax Credit (PTC), to its website at

www.irs.gov. Publication 974 is repeatedly referenced in the instructions to new IRS Form 8962,

Premium Tax Credit (PTC), and provides detailed guidance and helpful worksheets for calculating the

amount of any excess advance premium tax credits (PTCs) that taxpayers received in 2014 and must now

repay. Publication 974 also supplies guidance on calculating the PTC for taxpayers who got married in

2014 and on the interaction between the Section 162(l) self-employed health insurance deduction and the

PTC. Publication 974 also supplies information on what qualifies as minimum essential coverage and the

availability of relief from the penalty for failing to comply with the individual health insurance mandate

(the shared responsibility payment under Section 5000A).

IRS Releases Publication on Reporting Individual Health Coverage

On their 2014 federal income tax returns, individuals are required to report whether they were covered by

minimum essential coverage for 2014 and were therefore exempt from the penalty for failing to comply

with the individual shared responsibility payment under Section 5000A. Newly released Publication 5187,

Health Care Law: What’s New for Individuals and Families, covers some of the tax provisions included in the

Affordable Care Act (ACA) and explains how taxpayers can satisfy the individual health insurance

mandate by obtaining minimum essential coverage. Publication 5187 also covers exemptions from the

penalty and the new-for-2014 PTC.

IRS Asking Some Taxpayers to Verify Premium Tax Credit Information

The IRS is now sending letters to some taxpayers who claimed the PTC on their 2014 Forms 1040. The

letters asks for verification of certain information entered on returns and in some cases for copies of

Forms 1095-A (Health Insurance Marketplace Statement) issued to taxpayers. Refunds claimed on

affected returns may be held until the IRS receives responses to the letters. According to the IRS website,

factors that can trigger a letter include (1) filing an incomplete Form 8962 (Premium Tax Credit) with

Form 1040, (2) having doubts about the taxpayer’s eligibility for the PTC, and (3) reporting inconsistent

information on Form 8962 and Form 1040.

Taxpayers Advised to Wait for Corrected Forms 1095-A Before Filing 2014 Returns

The Centers for Medicare and Medicaid Services (CMS) announced that incorrect Forms 1095-A (Health

Insurance Marketplace Statement) were issued to approximately 800,000 taxpayers who purchased

federally facilitated marketplace health coverage in 2014 and then received advance PTCs to lower their

monthly premium costs. Form 1095-A is issued by the applicable marketplace to calculate the taxpayer’s

allowable PTC under Section 36B. CMS recommends that affected taxpayers postpone filing their 2014

federal income tax returns until they receive corrected Forms 1095-A.

Relief for Taxpayers Who Received Incorrect Forms 1095-A and Have Not Yet Filed Their 2014 Returns

In a further response to the fact that many taxpayers have received erroneous Forms 1095-A for the 2014

tax year, the IRS will provide further relief to individuals who were unable to file their returns by the

April 15, 2015 deadline due to erroneous Forms 1095-A. Apparently, such taxpayers will not be charged

http://www.irs.gov/


with late-filing penalties if they file Form 4868 (Application for Automatic Extension of Time to File U.S.

Individual Tax Return) by the April 15, 2015 deadline and then file their returns based on corrected

Forms 1095-A by the extended April 15, 2015 deadline. The IRS stated that additional details on this

relief will be provided later.

Relief for Taxpayers Who Received Incorrect Forms 1095-A From Federally-Facilitated Health Insurance Marketplace and Already Filed Their 2014 Returns

The IRS announced that individuals who filed 2014 federal income tax returns based on erroneous

Forms 1095-A received from the federally facilitated health insurance marketplace are not required to file

an amended returns to correct the errors. CMS previously announced that about 20 percent of taxpayers

who purchased health insurance from the federally-facilitated marketplace received incorrect Forms

1095-A. As a result, some of these taxpayers under-reported excess advance PTC amounts that were

received in 2014. In theory, such excess advance PTC amounts must be repaid, but the IRS will not

attempt to collect excess PTC amounts that were calculated based on erroneous Forms 1095-A.

Relief for Taxpayers Who Received Incorrect Forms 1095-A From State-Operated Health Insurance Marketplaces and Have Already Filed Their 2014 Returns

Form 1095-A (Health Insurance Marketplace Statement) is issued by the marketplace where the taxpayer

purchased his or her qualifying health insurance coverage and is necessary to compute the PTC under

Section 36B. Unfortunately, however, many incorrect Forms 1095-A have been issued by state-operated

health insurance marketplaces where individuals purchased their coverage. As a result, the IRS has now

expanded the relief announced earlier for taxpayers who enrolled in the federally facilitated marketplace

who received incorrect Forms 1095-A (see the immediately preceding discussion) to cover folks who

enrolled in state-operated marketplaces and received incorrect Forms 1095-A. Specifically, any individual

who (1) signed up for qualifying health coverage (either through the federally-facilitated marketplace or

through a state-operated marketplace), (2) received an incorrect Form 1095-A, and (3) filed his or her

federal income tax return based on that erroneous Form 1095-A does not need to file an amended return,

and the IRS will not attempt to collect excess PTC amounts that were calculated based on erroneous

Forms 1095-A. These individuals are off the hook.

Relief for Taxpayers With Tax Underpayments Caused by Excess Advance Premium Tax Credit Payments

The Affordable Care Act established the PTC, which is available to eligible individual taxpayers starting

in 2014 (Section 36B); therefore, client 2014 Forms 1040 are potentially affected. The PTC is a

refundable credit that is intended to make health insurance more affordable for individuals who do not

have access to other qualifying affordable coverage. The only problem is that some taxpayers will wind

up owing money to the government because advance PTC payments made on their behalf last year

exceeded their allowable credit, which was not known until tax return time. In such case, the taxpayer can

owe penalties in addition to the extra tax hit. However in recently released Notice 2015-9, the IRS offers

some penalty relief. The following information covers the necessary background information and then

explains the story.

Premium Tax Credit (PTC) and Advance Payment Basics

In general, a taxpayer is eligible for the PTC in 2014 if (1) household income was between 100 percent

and 400 percent of the federal poverty line, (2) access to affordable employer-sponsored coverage was

not available, and (3) qualifying coverage was obtained through a health insurance exchange. The

allowable credit amount can vary widely depending on the taxpayer’s specific circumstances. See IRS

Publication 974 (Premium Tax Credit) for more details.


A taxpayer who qualifies for the PTC for 2014 can (1) wait to claim the credit on his or her 2014 Form

1040, or (2) arrange for the credit to be paid in advance to the health insurance provider to lower last

year’s monthly premiums. If the advance payment option was chosen, any difference between the total

amount of advance credit payments and the allowable PTC amount is reconciled on the 2014 return by

filling out new Form 8962 [Premium Tax Credit (PTC)]. Form 8962 and its instructions add up to 17

pages.

In some cases, advance PTC payments will exceed the allowable PTC because the advance payments

were based on guesstimates, and the actual allowable credit is not known until tax return preparation

time. The calculation of the excess advance PTC payment amount, if any, is made on new IRS Form

8962, Premium Tax Credit (PTC). Subject to certain limitations, the excess advance PTC payment

amount is treated as an additional amount of tax due and is reported on line 46 of Form 1040 or line 29

of Form 1040A. Unfortunately, tax underpayments caused by excess advance PTC payments can also

trigger penalties. In Notice 2015-9, the IRS offers some penalty relief.

Key Point: If advance PTC payments were made on your client’s behalf last year, the amount of those

payments should be reported by the applicable health insurance exchange on new Form 1095-A (Health

Insurance Marketplace Statement). The client should have received Form 1095-A in early February.

Excess Advance PTC Payments Can Trigger Penalties

If excess advance PTC payments result in or increase the taxpayer’s balance due, the IRC Section 6654(a)

interest charge penalty on inadequate estimated tax payments can be triggered. However, Section

6654(e)(3) authorizes the IRS to waive the penalty in appropriate circumstances. For the first quarter of

2015 and for all previous quarters starting on or after October 1, 2011, the annual rate for the estimated

tax underpayment interest charge penalty is 3 percent (Section 6621 and Rev. Rul. 2014-29). This penalty

ceases to apply on the tax return due date without considering extensions (generally April 15 because

almost all individuals are calendar-year taxpayers).

Excess advance PTC payments can also trigger the IRC Section 6651(a)(2) penalty for failure to pay the

amount of tax shown on a return on or before the tax return due date. However, the failure-to-pay

penalty is not imposed if the taxpayer can show that the failure was due to reasonable cause and not

willful neglect. The failure-to-pay penalty is imposed at the rate of 0.5 percent per month, and the penalty

starts running on the tax return due date without considering extensions (generally April 15). It ends

when the taxpayer pays the tax underpayment.

Finally, excess advance PTC payments can trigger the IRC Section 6601 interest charge penalty on tax

underpayments. The tax underpayment penalty starts running on the tax return due date without

considering extensions (generally April 15) and ends when payment is made.

Notice 2015-9 Offers Limited Penalty Relief

In Notice 2015-9, the IRS provides a procedure under which many taxpayers with excess advance PTC

payments for the 2014 tax year can obtain relief from the penalty for inadequate estimated tax payments

and the failure-to-pay penalty.

Relief from the penalty for insufficient estimated tax payments for the 2014 tax year is available for

taxpayers who (1) have underpayments attributable to excess advance PTC payments, (2) are otherwise

current with their federal income tax filing and payment obligations, and (3) report the amount of the

excess advance PTC payments on their timely filed (including extensions) 2014 return (using line 46 of

Form 1040 or line 29 of Form 1040A).


Relief from the failure-to-pay penalty is available to taxpayers who (1) are otherwise current with their tax

filing and payment obligations, (2) have a balance due for the 2014 tax year due to excess advance PTC

payments, and (3) report the amount of excess advance PTC payments on their timely filed (including

extensions) 2014 return (using line 46 of Form 1040 or line 29 of Form 1040A).

Taxpayers will be treated as current with their federal income tax filing and payment obligations if, as of

the date they file their 2014 returns, they (1) have filed all currently required federal tax returns or have

filed extensions for such returns; and (2) have paid the tax due or entered into an installment agreement

(which is not in default), an offer in compromise, (or both) to satisfy any unpaid tax liability. If the

taxpayer has not paid because there is a legitimate dispute regarding the existence of or proper amount of

the tax liability, the amount in dispute will be treated as being current until the dispute is resolved.

Warning: Notice 2015-9 offers no relief from the Section 6601 interest charge penalty on tax

underpayments. Therefore, the Section 6601 penalty on unpaid balances will start running on April 15,

even if the taxpayer qualifies for relief from the other two penalties under Notice 2015-9.

Procedures for Claiming Notice 2015-9 Relief

To take advantage of the penalty relief offered by Notice 2015-9, taxpayers should follow the following

procedures.

Relief From Estimated Tax Penalty

To request a waiver of the Section 6654(a) penalty for inadequate estimated tax payments pursuant to

Notice 2015-9, taxpayers should check box A in Part II of Form 2210, complete page 1 of Form 2210,

and include Form 2210 with their return along with the statement: Received excess advance payment of

the premium tax credit. Taxpayers need not attach documentation for the amount of advance payments

or explain the circumstances under which they received excess advance payments. Taxpayers also need

not calculate the amount of the estimated tax penalty caused by the excess advance PTC payments. Just

fill out Form 2201 as instructed, and that is it.

Relief From Failure-to-Pay Penalty

In general, the IRS will automatically assess the Section 6651(a)(2) failure-to-pay penalty and send a

notice demanding payment. To claim the penalty relief offered by Notice 2015-9, an eligible taxpayer

should respond to the notice by submitting a letter to the address listed in the notice that contains the

following statement: “I am eligible for the relief granted under Notice 2015-9 because I received excess

advance payment of the premium tax credit.” Taxpayers who file their 2014 returns by April 15, 2015, are

entitled to relief under Notice 2015-9 even if they have not paid the tax liability caused by the excess

advance PTC payments by the time they request relief. Taxpayers who file their returns after April 15,

2015, must pay that liability by April 15, 2016, to be eligible for relief under Notice 2015-9.

Key Point: The Section 6601 interest charge penalty on tax underpayments will accrue from April 15,

2015, until the liability is paid. Notice 2015-9 offers no relief from this penalty.

IRS Issues 2015 Monthly Bronze Plan Premium Amount

Non-exempt individuals who do not maintain required minimum essential healthcare coverage during

2015 may be liable for the individual mandate penalty (also known as the shared responsibility payment)

under Section 5000A. One factor in calculating the penalty is the amount of bronze-level plan premiums

for the shared responsibility family. For 2015, the monthly national average bronze plan premium

amount is $207 per individual, with a maximum bronze plan premium amount of $1,035 for a shared


responsibility family with five or more members. These amounts are up from $204 and $1,020,

respectively, for 2014. (See Revenue Procedure 2015-15).

ALIMONY DEDUCTION DEVELOPMENTS

When a divorce or separation happens, one spouse or ex-spouse is often legally required to make

payments to the other party. Payments that meet the tax-law definition of alimony can be deducted by the

payer for federal income tax purposes and the payments must be reported as gross income by the

recipient (Sections 71(a) and 215(a)).

More specifically, deductible alimony payments can be written-off above-the-line on the payer’s Form

1040, which means the payer does not have to itemize to benefit. Here is the issue: a list of specific tax-

law requirements must be satisfied for payments to meet the definition of deductible alimony. Because

we see litigation on this issue year-after-year, these tax-law requirements are apparently unknown to, or

poorly understood by, quite a few divorce attorneys throughout the country.

When payments to an ex fails to meet the tax-law definition of alimony, they are generally treated as either

child support payments or as payments to divide the marital property. Such payments represent

nondeductible personal expenses for the payer and tax-free income for the recipient. This is not good news

for individuals who are making the payments; it is good news for folks who are receiving the payments).

The remainder of this analysis briefly summarizes the rules for tax-deductible alimony and some recent

developments regarding what kinds of payments can qualify as deductible alimony and what kinds cannot.

Requirements for Tax-Deductible Alimony

Whether payments qualify as tax-deductible alimony or not is determined strictly by applying the

applicable language in the Internal Revenue Code and related federal income tax regulations. In general,

what the divorce decree might say and what the divorcing couple might intend does not matter. The lone

exception to the preceding general rule is when divorcing individuals stipulate in their divorce papers that

certain amounts that would otherwise qualify as deductible alimony will not be deducted by the payer and

will not be included in the payee’s gross income (Temporary Regulation Temp. Reg. 1.71-1T(b), Q&A-8).

Note that it is possible (although unlikely) for payments that are not intended to be alimony to meet the tax-

law definition of alimony. In such case, they are deductible by the payer and taxable income to the recipient.

Now we are ready for the specifics. For a particular payment to qualify as deductible alimony for federal

income tax purposes, all the following requirements must be met for that payment (Sections 71(b) and 215).

1. Written Instrument Requirement

The payment must be made pursuant to a written divorce or separation instrument. This term includes

(1) divorce decrees, (2) separate maintenance decrees, and (3) separation instruments (Section 71(b)(2)).

After a decree of separate maintenance is issued by a court, the couple is considered legally separated, but the marriage is not yet considered to be legally dissolved. For tax purposes, however, this status is equivalent to being divorced.

The purpose of a separation instrument is to settle certain marital rights in advance of obtaining a divorce decree or a separate maintenance decree.


Other written court orders and decrees (such as temporary support orders which cover the time after a divorce petition is filed but before divorce or legal separation occurs) can also qualify as divorce or separation instruments. For example, temporary alimony payments made pursuant to temporary support orders can qualify as deductible alimony if all the other tax-law requirements are met (Treasury Regulation (Treas. Reg.) 1.71-1(b)(6), Example 4).

Key Point: It is possible to have deductible alimony payments before a couple is divorced or legally

separated. However, payments made in advance of signing a written divorce or separation instrument or

before the effective date of a court order or decree cannot be deductible alimony. Such payments are

considered voluntary and are therefore nondeductible. The same is true for payment of amounts in

excess of what is required under a divorce or separation instrument or court order or decree.

2. Payment Must Be to or on Behalf of Spouse or Ex-Spouse

To qualify as deductible alimony, a payment must be to or on behalf of a spouse or an ex-spouse.

Payments to third parties, such as attorneys and mortgage lenders, are permitted if they are made on

behalf of a spouse or an ex-spouse and pursuant to a divorce or separation agreement or at the written

request of the spouse or ex-spouse. (See Temp. Reg. 1.71-1T, Q&A-6 and -7 and Alan Zinsmeister, TC

Memo 2000-364.)

3. Payment Cannot Be Stated to Not Be Alimony

The divorce or separation instrument cannot state that the payment in question is not alimony or

effectively stipulate that it is not alimony because it is not deductible by the payer or not includable in the

payee's gross income. This seemingly simple requirement has spawned disputes between taxpayers and

the IRS. One example is the Tax Court’s 2011 Shelton decision in which the divorce agreement said the

ex-wife would receive $25,000 for her share of the ex-husband’s military separation pay. Each party

waived any claim for maintenance payments from the other. The Tax Court denied the ex-husband’s

attempt to claim an alimony deduction for the $25,000 because the divorce agreement clearly stated that

neither party would receive any alimony. (See Andrew Shelton, TC Memo 2011-266.)

4. Ex-Spouses Cannot Live in Same Household or File Jointly

After divorce or legal separation has occurred (meaning the couple is considered divorced for federal

income tax purposes), the ex-spouses cannot live in the same household or file a joint return for

payments to an ex to qualify as deductible alimony.

5. Cash or Cash Equivalent Requirement

To be deductible alimony, a payment must be made in cash or cash equivalent.

6. Cannot Be Child Support

To be deductible alimony, a payment cannot be classified as fixed or deemed child support under the

alimony tax rules. The rules regarding what constitutes child support—especially what constitutes

deemed child support—for this purpose are complicated and represent a nasty trap for unwary taxpayers

and tax professionals. These rules are beyond the scope of this analysis. For additional information, see

IRS Publication 504 (Divorced or Separated Individuals).

7. Payee's Social Security Number Requirement

For the payer to claim an alimony deduction for a payment, the payer’s return must include the payee’s

Social Security number (Section 215; Temp. Reg. 1.215-1T).


8. No Payments After Recipient's Death

The obligation to make payments (other than payment of delinquent amounts) must cease if the recipient

party dies. If the divorce papers are unclear about whether or not payments must continue, state law

controls. If under state law, the payer must continue to make payments after the recipient’s death, the

payments cannot be alimony. In other words, the payment obligation must cease if the recipient party

dies in order for the payment to qualify as deductible alimony. Relying on state law to support deductible

alimony treatment is an act of faith that may be unwise. Therefore, divorce papers should always

explicitly state whether a payment obligation (whether lump-sum or recurring) continues to exist after the

death of the recipient party. Failing to meet the requirement for payments to cease if the recipient dies is

probably the most common reason for lost alimony deductions.

Key Point: In the context of planning for deductible alimony payments, it is not a problem if the payer’s

estate is required to continue making payments after the payer’s death.

Recent Court Decisions

Child-Related Contingency Rule Precludes Alimony Deduction

The taxpayer and his ex-wife entered into a divorce agreement that required the taxpayer to pay 75

percent of the monthly mortgage payments on the ex-wife’s residence until (1) the mortgage was paid off,

or (2) their oldest child no longer lived with the ex-wife. The taxpayer claimed alimony deductions for the

payments. However, because the payments would cease upon the occurrence of a child-related

contingency, the Tax Court correctly concluded that the full amount of the payments represented

nondeductible child support rather than deducible alimony, pursuant to Section 71(c)(2).

(See George Resnik, Jr., TC Summary Opinion 2015-11.)

Nondeductible Child Support Has Priority Over Deductible Alimony

Under the terms of his divorce agreement, the ex-husband was required to pay to his ex-wife monthly

child support of $8,307 and monthly alimony of $8,205 (total of $16,512 per month) for the tax year in

question. However, the ex-husband actually paid only $9,688 per month and claimed the entire amount as

deductible alimony. Unfortunately for the ex-husband, Section 71(c)(3) stipulates that when a payment is

less than the full amount of the required child support plus the required alimony, the partial payment is

treated as first consisting of nondeductible child support. Any amount in excess of the required child

support constitutes deductible alimony (assuming all the aforementioned requirements are met).

Therefore, the Tax Court in this case correctly concluded that the ex-husband’s monthly alimony

deduction was only $1,381 ($9,688 -$8,307). (See Joseph Becker, TC Summary Opinion 2015-2.)

PASSIVE ACTIVITY LOSS (PAL) DEVELOPMENTS

Taxpayer’s Increased Participation in Family Businesses Met Material Participation Standard

In a recent decision, the Tax Court concluded that the taxpayer, who was formerly only a passive investor

in several related family businesses, met the passive activity loss (PAL) material participation standard for

the businesses when he stepped in to rescue them. As a result, the taxpayer’s losses from the businesses

were exempt from the PAL rules and could be deducted in full. Specifically, the Tax Court determined

that the taxpayer qualified as a material participant after considering the following factors: (1) the related

businesses qualified as a single activity under the activity grouping rules set forth in Treas. Reg. 1.469-


4(c)(2), (2) the taxpayer worked at least 691 hours for 2 of the businesses during the tax year on question,

and (3) the taxpayer did not do the work to avoid the PAL rules. Bottom line, the taxpayer materially

participated in the businesses, so his tax losses from them were exempt from the PAL rules. He was

therefore allowed to carry back large losses from the businesses to earlier tax years and obtain significant

federal income tax refunds. (See Jose A. Lamas, TC Memo 2015-59.)

Temp. Reg. 1.469-5T(a) prescribes seven tests to determine if a taxpayer can meet the material

participation standard with respect to a particular business activity. If one or more of these tests are

passed for the tax year in question, then the taxpayer meets the material participation standard for that

activity for that year, which means the PAL rules are inapplicable to that activity for that year. The seven

tests can be summarized as follows:

1. More-Than-500-Hours Test: This test is passed if the taxpayer participates in the activity for

more than 500 hours during the year.

2. Substantially-All Test: This test is passed if the taxpayer’s participation in the activity during

the year constitutes substantially all the participation by all individuals (including those who are

not owners of interests in the activity) during that year.

3. More-Than-100-Hours Test: This test is passed if the taxpayer participates in the activity for

more than 100 hours during the year, and no other individual participates more than the taxpayer

during that year.

4. Significant Participation Activity (SPA) Test: This test is passed if the activity is a SPA (as

defined in Temp. Reg. 1.469-5T) in which the taxpayer participates for more than 100 hours

during the year, and the taxpayer’s total participation in all SPAs during the year exceeds 500

hours.

5. Prior-Year Material Participation Test: This test is passed for the year if the taxpayer

materially participated in the activity for any 5 of the 10 immediately preceding years.

6. Personal Service Activity Test: This test is passed for the year if the activity is a personal

service activity, and the taxpayer materially participated in the activity for any three preceding

years.

7. Facts and Circumstances Test: This test is passed if consideration of relevant facts and

circumstances dictate that the taxpayer materially participated in the activity on a regular,

continuous, and substantial basis. The taxpayer must participate for more than 100 hours to be

eligible for this test.

Mortgage Broker Did Not Qualify for Real Estate Professional Exception to PAL Rules

Losses from rental real estate activities are generally subject to the PAL rules, which can limit your ability

to claim current federal income tax deductions for the losses. That is because under the general PAL rule,

you can deduct only passive losses to the extent you have passive income from other sources. If you have

no passive income, your passive losses are suspended and cannot be deducted until you have some

passive income or you dispose of the loss-producing rental activities (Section 469). A favorable exception

to the aforementioned general rule allows individuals who devote a substantial amount of time to real

property businesses to be considered to materially participate in certain rental real estate activities. Losses

from rental real estate activities in which you are considered to materially participate are exempt from the

PAL rules. That means you can generally deduct the losses in the year when they are incurred. This is the

real estate professional exception (Section 469(c)(7) and Treas. Reg. 1.469-9).


In a recent Chief Counsel Advice (CCA), the IRS distinguished services performed by state-licensed real

estate agents from services performed by mortgage brokers for purposes of qualifying for the real estate

professional exception to the PAL rules. A real estate agent brings together real property buyers and sellers

and negotiates contracts of sale between them while a mortgage broker merely brings together lenders and

borrowers for purposes of financing real property transactions. According to the CCA, Congress did not

intend for financing operations to meet the definition of a real property business for purposes of

qualifying for the real estate professional exception. Therefore, the CCA concluded that a mortgage

broker, who is a broker of financial instruments, is not engaged in a real property business for purposes

of qualifying for the real estate professional exception. (See CCA 201504010.)

MORTGAGE INTEREST DEDUCTION DEVELOPMENTS

Under the qualified residence interest rules, an unmarried individual or a joint-filing married couple can

claim an itemized federal income tax deduction for the interest on up to $1 million of acquisition debt to

buy, construct, or improve a first or second residence and up to $100,000 of home equity debt on a first

or second residence (these limits are halved for folks who selected “married filing separate” status).

Therefore, interest on a total of up to $1.1 million of home mortgage debt can potentially be treated as

deductible qualified residence interest. (See Section 163(h)(3).)

Quick Summary of Qualified Residence Interest Rules

Unlike most other types of personal interest, qualified residence interest can be claimed as an itemized

deduction thanks to Section 163(h)(3). Qualified residence interest is defined as interest on up to $1

million of acquisition debt plus interest on up to $100,000 of home equity debt.

Acquisition debt is debt of up to $1 million that is (1) incurred to acquire, construct, or substantially improve a qualified residence; and (2) secured by such residence.

Home equity debt is debt (other than acquisition debt) of up to $100,000 that is secured by a qualified residence, to the extent the aggregate amount of the debt does not exceed the fair market value (FMV) of the residence after subtracting any acquisition debt secured by that residence. (See Section 163(h)(3)(C)(i).) Unlike acquisition debt, the proceeds from home equity debt can be used for any purpose without affecting the deductibility of the interest under the regular tax rules. However, interest on home equity debt is deductible only under the AMT rules to the extent the debt proceeds are used to acquire, construct, or improve substantially a qualified residence. (See Section 56(b)(1)(C) and (e)(1).)

The definition of a qualified residence includes the taxpayer’s principal residence and up to one additional personal residence owned by the taxpayer. If the taxpayer owns two or more additional residences, the taxpayer can specify which one is treated as the second residence for each tax year for purposes of applying the qualified residence interest rules. (See Section 163(h)(4)(A).)

Mortgage Interest Was Qualified Residence Interest Even Though Taxpayer Did Not Hold Formal Title to Property and Was Not Named on Mortgage

A taxpayer’s home mortgage interest can meet the aforementioned definition of qualified residence

interest if the taxpayer is the legal or equitable owner of the mortgaged property, even though the

taxpayer is not directly liable for the mortgage (Treas. Reg. 1.163-1(b)). In the facts underlying a recent

Tax Court summary opinion, the taxpayer did not hold legal title to the mortgaged property, and his

name did not appear on the mortgage. However, he was under an oral agreement to purchase the

property from family members. On his 2010 federal income tax return, the taxpayer reported deductible


home mortgage interest of $35,880. The Tax Court concluded that he provided clear and convincing

evidence that he was an equitable owner of the property. He paid the mortgage, taxes, insurance, and

other bills associated with the property; maintained it; and made improvements. Therefore, he was

entitled to deduct the mortgage interest under the qualified residence interest rules. (See Qui Van Phan,

TC Summary Opinion 2015-1.)

Deducting Interest on Mortgage Owed by More Than One Homeowner

In a recent Chief Counsel Advice (CCA), the IRS addressed three fact patterns: (1) when one of the

mortgage obligors is a deceased spouse and the bank issues Form 1098 (Mortgage Interest Statement)

using the deceased spouse’s tax ID number; (2) when the two obligors are unmarried, and the bank issues

Form 1098 using the tax ID number(s) of one or both obligors; and (3) when related individuals are both

liable on the mortgage, and the bank issues Form 1098 using the tax ID numbers(s) of one or both.

According to the CCA, mortgage interest paid from a joint account with two equal owners is presumed

to be paid equally by each co-owner (barring evidence to the contrary). However, when mortgage interest

is paid from separate funds, each individual is entitled to deduct all of the interest (and only the interest)

paid with his or her separate funds. (See CCA 201451027.)

ESTATE TAX DEVELOPMENTS

Estate Not Entitled to Charitable Income Tax Deduction

In a recent decision, the Tax Court concluded that an estate did not qualify for a federal income tax

deduction for an amount the decedent left under the terms of her will to a charitable organization. In this

case, the estate became embroiled in a legal dispute with the decedent’s brother regarding his ownership

rights in a condominium in which he resided that had been left a charity. After paying its legal fees and

administrative costs, the estate was short of funds. Although the decedent’s will permanently set aside a

designated amount for charity, the Tax Court held that the estate fell under Treas. Reg. 1.642(c)-2(d),

which disallows a charitable deduction unless there is only a remote possibility that the amount intended

for charity will not actually be turned over to charity. Because the estate was aware that a prolonged legal

battle was more than just a remote possibility at the time it claimed the charitable deduction, the

deduction was disallowed pursuant to Treas. Reg. 1.642(c)-2. (See Estate of Eileen S. Belmont, 144 TC No. 6

[Tax Court, 2015].)

Estate Executor Was Personally Liable for Unpaid Estate Tax

If the assets of an estate are insufficient to pay the decedent’s federal estate, gift, and income liabilities,

the executor can be held personally liable. This happens when (1) other debts of the estate are paid or

beneficiary distributions are made before paying the federal tax bill(s) (or both), and (2) the executor

knows (or constructively knows) that the estate’s assets will be rendered insufficient to pay the federal tax

bill(s). In this case, an executor made distributions from the estate to himself and his sisters, even though

he was aware that a federal estate tax bill of over $2 million was due. Because he depleted the estate’s

assets before paying the tax liability, he was held personally liable for the tax bill. Therefore, a

Pennsylvania District Court upheld an IRS lien that was placed against other property owned by the

executor. (See David Stiles, 114 AFTR 2d 2014-6809 [DC PA, 2014].)


INTERNET ACCESS FEES WERE PARTLY DEDUCTIBLE AS BUSINESS EXPENSES

In the facts underlying a recent Tax Court Summary Opinion, a self-employed financial adviser paid a

monthly fee that included telephone service, Internet access, and cable television for his residence. On his

Schedule C for the year in question, he treated $1,371 of those fees as deductible business expenses. The

IRS disallowed the entire amount, claiming it was a non-deductible personal expense under Section 262.

However, the Tax Court concluded that because Internet access fees are tantamount to utility expenses,

strict substantiation is not required. Instead, taxpayers can estimate the deductible amount based on

reasonable evidence. In this case, the taxpayer stated that he used his Internet service about 75 percent of

the time for business purposes (for example, to send and receive business-related emails). Therefore, the

Tax Court allowed a $477 deduction, which was 75 percent of the amount he paid for Internet access.

(See James E. Kaminski, TC Summary Opinion 2015-7.)

NOL CARRYOVER CANNOT BE USED TO REDUCE SELF-EMPLOYMENT TAX

BILL

In the facts underlying a recent Tax Court summary opinion, the taxpayer operated a sole proprietorship

business that incurred a net operating loss (NOL). The taxpayer carried the NOL over to the following

tax year and deducted it in calculating his net self-employment (SE) income for SE tax purposes. The Tax

Court disagreed, based on Section 1402(a)(4) which states that a taxpayer’s net SE income cannot be

reduced by an NOL deduction allowed in calculating the taxpayer’s “regular” federal income tax bill. (See

Joshua J. Stebbins, TC summary opinion 2015-10.)


Key Tax Developments Affecting Business Taxpayers

IRS ANNOUNCES LUXURY AUTO DEPRECIATION LIMITATIONS FOR 2015

In Rev. Proc. 2015-19, the IRS announced the luxury auto depreciation limitations for passenger autos,

light trucks, and light vans that are placed in service during calendar year 2015. As the tax law currently

stands, additional first-year bonus depreciation is allowed for new (not used) vehicles placed in service in

2015. However, we expect that bonus depreciation will be restored for 2015. If that happens, the

maximum first-year amounts will be increased by $8,000. The following tables include first-year

depreciation amounts for new vehicles with and without bonus deprecation.

New and Used Autos Assuming No Bonus Depreciation1

Year 1 $ 3,160

Year 2 5,100

Year 3 3,050

Year 4 and beyond 1,875 until fully depreciated

New Autos Assuming Bonus Depreciation1

Year 1 $ 11,160

Year 2 5,100

Year 3 3,050


New and Used Light Trucks and Light Vans Assuming No Bonus Depreciation2

Year 1 $ 3,460

Year 2 5,600

Year 3 3,350


New Light Trucks and Vans Assuming Bonus Depreciation2

Year 1 $ 11,460

Year 2 5,600

Year 3 3,350


1 These amounts are unchanged from 2014. 2 Except for the year 2 dollar amount (which increased by $100), these amounts are unchanged from 2014.


Key Point: If a vehicle’s business-use percentage is less than 100 percent, the amounts in the tables must

be proportionately reduced. If the business-use percentage is 50 percent or less, the amounts in the tables

cannot be used to calculate depreciation because they are based on MACRS accelerated depreciation.

Straight-line depreciation must be used when business use does not exceed 50 percent.

HOW REIMBURSING EMPLOYEE HEALTH INSURANCE PREMIUMS CAN

TRIGGER PUNITIVE AFFORDABLE CARE ACT PENALTY AND NEW PENALTY

RELIEF PROVISIONS

The Affordable Care Act (ACA) legislation established a number of market reform restrictions on

employer-provided group health plans, starting with the 2014 plan year. These restrictions generally apply

to all employer-provided group health plans—including those furnished by small employers with fewer

than 50 workers. Even worse, there is a punitive penalty for running afoul of the market reform

restrictions. The penalty equals $100 per-day, per-employee, which can amount to up to $36,500 per-

employee over the course of a full year (Section 4980D). In fact, according to the IRS and the

Department of Labor (DOL), the market reform restrictions can penalize employers for offering plans

that simply reimburse employees for premiums paid by employers for individual health insurance policies.

We will call such plans employer payment arrangements. The following analysis explains what employers need

to know to avoid the punitive market reform penalty on such arrangements. But first, we will cover some

necessary background information

Employer Payment Arrangement Basics

Employer payment arrangements have long been a popular way for smaller employers to help their

employees to obtain health coverage without the hassle and expense of furnishing a full-fledged company

health insurance plan. Another advantage is that employees are free to select coverage that meets their

specific needs instead of being stuck with a one-size-fits-all company plan. Under an employer payment

arrangement, the employer reimburses participating employees for premiums paid for their individual

health insurance policies. To qualify for tax-free treatment under the federal income tax rules, the

employer must (1) make the reimbursements under a written Section 105 medical reimbursement plan,

and (2) verify that the reimbursements are spent for health insurance coverage (Sections 105 and 106 and

Revenue Ruling 61-146).

ACA Market Reform Penalty Generally Applies to Employer Payment Arrangements

IRS Notice 2013-54 states that tax-free employer payment arrangements are generally considered to be

group health plans that are subject to the ACA market reform restrictions and the Section 4980D market

reform penalty. With a few limited exceptions, such plans fail to meet ACA requirements because, among

other reasons, group health plans that are used to purchase coverage in the individual market cannot be

integrated with individual market policies. However, many observers had hoped that plans that reimburse

employees on an after-tax basis (instead of on a before-tax basis) would not be treated as employer plans

that are subject to the market reform restrictions and the punitive penalty. Those hopes have been

dashed. According to Notice 2015-17, an employer arrangement that pays for or reimburses employee

individual market health insurance premiums is considered to be a group health plan and is subject to the

market reform restrictions and the punitive penalty, whether the reimbursements are treated by the

employer as before-tax (tax-free) or after-tax (taxable). Bottom line: an employer payment arrangement


can trigger the punitive Section 4980D market reform penalty whether the arrangement is treated by the

employer as tax-free or taxable.

Impact on S Corporation Employer Payment Arrangements for a More-Than-2% Shareholder-Employee

Many S corporations have set up employer payment arrangements to reimburse employees who own

more than 2 percent of the company stock (also known as more-than-2-percent shareholder-employees)

for their individual health insurance premiums. Under longstanding IRS rules, such reimbursements are

treated as additional taxable wages that are not subject to the Social Security or Medicare taxes.

Qualifying more-than-2-percent shareholder-employees can then deduct their premiums above-the-line

on their individual federal income tax returns under the provision for self-employed health insurance

premiums. The company can deduct the reimbursements as compensation expense. (See Notice 2008-1,

Announcement 92-16, and Section 162(l).) Unfortunately, such S corporation arrangements now run

afoul of the ACA market reform restrictions and can therefore trigger the punitive Section 4980D market

reform penalty.

Impact on One-Employee Employer Payment Arrangements

About the only good news here is that that the ACA market reform restrictions do not apply to employer

payment arrangements, including S corporation arrangements, with only one participating employee

(Notice 2013-54). Therefore, such arrangements can still be used to reimburse one employee for his or

her individual health insurance premiums without triggering the disastrously expensive Section 4980D

market reform penalty. Notice 2015-17 seems to confirm that this one-employee exception applies even

if the employee has family coverage that covers a spouse or dependent who is also an employee (see

answer 2 in Notice 2015-17).

Warning: Employer payment arrangements generally must cover all full-time employees in order to

avoid running afoul of IRS nondiscrimination rules (Section 105(h)). However, the nondiscrimination

rules allow employers to exclude workers who (1) have fewer than three years of service, (2) have not

reached age 25, or (3) meet the definition of part-time or seasonal employees (Treas. Reg. 1.105-11(c)).

Reimbursements for Medicare Insurance Premiums

Notice 2015-17 states that an employer that reimburses or pays directly for some or all of employee

Medicare Part B or Part D premiums has created a group health plan that is potentially subject to the

Section 4980D market reform penalty. However, Notice 2015-17 provides a method for integrating

Medicare premium reimbursement arrangements with ACA-compliant employer-provided group health

plans. Such integration avoids exposure to the penalty.

IRS Offers Temporary Penalty Relief

In Notice 2015-17, the IRS granted temporary relief from the Section 4980D market reform penalty for

two categories of employers.

Relief for S Corporations That Pay or Reimburse Health Premiums for More-Than-2% Shareholder-Employees

Relief applies to health premiums paid or reimbursed by S corporations between January 1, 2014, and

December 31, 2015, for more-than-2-percent shareholder-employees. Therefore, S corporations can

continue to rely on the longstanding guidance in Notice 2008-1 and Announcement 92-16 for payments

or reimbursements to such employees made in 2014 and 2015 without triggering the Section 4980D


market reform penalty. As explained earlier, Notice 2008-1 and Announcement 92-16 allow an S

corporation to report health premium payments or reimbursements for more-than-2-percent

shareholder-employees as W-2 wages that are not subject to the Social Security or Medicare taxes.

Notice 2015-17 also clarifies that S corporations that qualify for this relief provision for employer

payment arrangements that benefit more-than-2 percent shareholder-employees are not required to file

Form 8928 (Return of Certain Excise Taxes Under Chapter 43 of the Internal Revenue Code), which is

used to self-assess the Section 4980D market reform penalty, for payments or reimbursements that

benefit those employees. Bottom line: there is no risk of incurring the market reform penalty for S

corporation employer payment arrangements that benefit only more-than-2-percent shareholder-

employees during 2014 and 2015. However, S corporation employer payment arrangements that benefit

other employees during those years are still exposed to the penalty.

Relief for Small Employers (Fewer Than 50 Employees)

Notice 2015-17 also offers penalty relief to small employers that pay or reimburse employee health

premiums between January 1, 2014, and June 30, 2015. A small employer is defined as one with fewer

than 50 full-time employees (including full-time equivalent employees) during the prior year. The relief

also applies to small employer reimbursements for Medicare Part B or Part D insurance premiums.

During the temporary relief period, there is no requirement for the employer to file Form 8928 for

employee health premium reimbursements.

Warning: Unless something changes, the relief for small employers will expire on June 30, 2015. It is

hoped that the IRS will relent and extend the relief through the end of 2015 (if for no other reason than

to be consistent with the relief for S corporations).

Compliance Remedies for Eligible Employers

Employers that reimbursed employee health premiums during 2014 and that now find themselves eligible

for Notice 2015-17 relief probably reported the 2014 premium reimbursements as taxable wages to their

employees. Such employers should consider amending 2014 Forms W-2 (using Form W-2C) and 2014

federal payroll tax returns (using Form 941-X or 943-X) to remove the reimbursements from taxable

wages. State income tax Form W-2 copies may also need to be amended to provide maximum tax savings

to employees.

IRS ISSUES UPDATED PROCEDURES FOR ACCOUNTING METHOD CHANGES TO

COMPLY WITH TANGIBLE PROPERTY REGULATIONS AND RELIEF FOR SMALL

BUSINESSES

In Rev. Procs 2015-13 and 2015-14, the IRS supplied updated guidance on making accounting method

changes to comply with the final tangible property regulations (also sometimes called the final repair

regulations). The final tangible property regulations are generally effective for tax years beginning in 2014.

Perhaps more importantly, Rev. Proc. 2015-20 supplies some accounting method change relief provisions

for eligible small businesses. Following is what you need to know about the small business relief, starting

with some necessary background information.


Accounting Method Change Basics

As you know, accounting method changes generally require filing Form 3115 to obtain IRS consent.

Completing the eight-page Form 3115 is a daunting project at best, especially for small businesses and

their tax preparers who are typically familiar with the task.

Method changes also generally require calculating a Section 481(a) adjustment to recognize the

cumulative effect of the changes on taxable income and to avoid the duplication of deductions or the

omission of income after the changes.

Because businesses that were in existence before 2014 will usually be required to make accounting

method changes to comply with the final tangible property regulations, many of these businesses must

also file Form 3115 and calculate the Section 481(a) adjustment. For small businesses, this can be a very

burdensome and expensive procedure (even though they may qualify to file a “Short-Form 3115" that

requires less information).

Accounting Method Change Relief for Small Businesses

Recognizing the obvious difficulties faced by small businesses and their tax preparers in dealing with

method changes to comply with the final tangible property regulations, the IRS has provided some relief

in the form of Revenue Procedure 2015-20. It establishes a simplified accounting method change

procedure for qualifying small businesses.

Under the simplified method, qualifying small businesses can change their accounting methods to comply

with the final tangible property regulations for the first tax year beginning in 2014 without having to file

Form 3115 and without having to calculate a Section 481(a) adjustment. Instead, the new rules under the

final regulations are simply applied “cold turkey” starting with the first tax year beginning in 2014.

A qualifying small business is a business with one or more separate and distinct businesses that has (1)

total assets of less than $10 million on the first day of the year the taxpayer first applies the final tangible

property regulations (for example, January 1, 2014, for a calendar-year taxpayer); or (2) average annual

gross receipts of $10 million or less for the prior three years. These eligibility rules apply separately to

each business. So if a taxpayer operates several businesses, some may qualify for the relief offered by Rev.

Proc. 2015-20 and some may not.

Qualifying small businesses can use the simplified procedures for the following accounting method

changes and designated change numbers (DCNs) described in section 10.11(3)(a) of Rev. Proc. 2015-14:

Tangible Property DCNs 184, 185, 186, 187, 188, 189, 190, 191, 192, and 193(3)(a). Identifying the asset

or portion of an asset sold (DCN 200 in Section 6.38); dispositions of a building or structural component

(DCN 205 in Section 6.39); dispositions of tangible depreciable assets other than a building or its

structural components (DCN 206).

If the simplified method is used, it must be used consistently. For example, if the changes under section

10.11(3)(a) of Rev. Proc. 2015-14 are made using the simplified method without any Section 481(a)

adjustment (in other words, without taking into account amounts paid or incurred in prior tax years), any

changes in accounting for tangible property dispositions under sections. 6.38 or 6.39 of Rev. Proc. 2015-

14 must also be made without any Section 481(a) adjustment, and vice versa. Finally, taxpayers who use

the simplified method for a business cannot make a late partial disposition election under section 6.33

Rev. Proc. 2015-14.

Key Point: Some small business taxpayers that now qualify for Rev. Proc. 2015-20 relief may have

already filed Form 3115 for one or more of these accounting method changes. Such taxpayers can


withdraw Form 3115 by filing an amended return using the simplified method. The amended return must

be filed by the extended due date of the return for the 2014 tax year.

Some Small Businesses Might Not Want to Use Relief Provisions

In limited circumstances, a qualifying small business may find it beneficial to follow the “regular”

procedure for making accounting method changes to comply with the final tangible property regulations.

Of course, following the regular procedure will entail filing the Form 3115. For instance, following the

regular procedure might be beneficial for a qualifying small business if the method changes produce a

whopping negative Section 481(a) that reduces taxable income or if the business wants to take advantage

of the late partial disposition election allowed by section 6.33 Rev. Proc. 2015-14.

CONCLUSION

Rev. Proc. 2015-20 is great news for many small business taxpayers, but stay tuned because we expect

further guidance in this area. For instance, the IRS has already released some new frequently asked

questions (FAQs) dealing with accounting method changes to comply with the tangible property

regulations.

IRS ISSUES FAQS ON TANGIBLE PROPERTY REGULATIONS

The IRS has released a batch of FAQs and answers on the final tangible property regulations, including

information on the aforementioned simplified accounting method change procedures for small business

taxpayers. The FAQs also provide guidance on the de minimis safe-harbor election, which allows

businesses to immediately deduct the cost of certain low-cost assets such as furniture, equipment, and

computers. The FAQs also clarify that the de minimis safe-harbor election is not an accounting method

change and therefore does not require filing of Form 3115 (Application for Change in Method of

Accounting). Additionally, the FAQs explain how to treat material and supply costs.

IRS ISSUES GUIDANCE ON PENALTIES FOR FAILURE TO FILE PARTNERSHIP

AND S CORPORATION RETURNS

In a 2015 development, IRS Program Manager Technical Advice (PMTA) 2013-015 provided some

questions and answers regarding the penalties for failure to file S corporation and partnership federal

income tax returns on time. Here is the scoop, along with some necessary background information.

Failure-to-File Penalty Basics

General Failure-to-File Penalty

The general failure-to-pay penalty is imposed when a federal income tax return is not filed on time, unless

the taxpayer can show that the failure was due to reasonable cause and not willful neglect. The penalty

equals 5 percent of the amount of unpaid tax for each month that the return is delinquent, for up to a


maximum of five months. So the maximum penalty equals 25 percent (5 percent x 5 months) of the

unpaid tax. (See Section 6651(a)(1) and (b).)

While it is relatively unusual, S corporations and partnerships can sometimes owe federal income tax at

the entity level (for example, this can occur when an S corporation owes the Section 1374 built-in gains

tax). In such cases, the general Section 6651(a)(1) failure-to-file penalty can potentially be imposed on an

S corporation or partnership. However, the following separate failure-to-file penalties were created in

recognition that S corporations and partnerships typically do not owe any federal income tax at the entity

level.

Separate S Corporation Failure-to-File Penalty

When an S corporation fails to (1) file its federal income tax return (Form 1120S) on time, or (2) include

required information on the return, then the S corporation can be charged a failure-to-file penalty even

when the entity does not owe any federal income tax. The penalty equals

$195 x [number of shareholders in place at any time during specified S corporation tax year] x

[number of months (or fractions of months) for which the failure continues]

However, the penalty can be imposed for a maximum of only 12 months. (See Section 6699.)

Separate Partnership Failure-to-File Penalty

When a partnership fails to (1) file its federal income tax return (Form 1065 or Form 1065-B for an

electing large partnership) on time, or (2) include required information on the return, then the

partnership can be charged a failure-to-file penalty even when the entity does not owe any federal income

tax. The penalty equals

$195 x [number of partners in place at any time during specified partnership tax year] x [number

of months (or fractions of months) for which the failure to file continues] (See Section 6698.)

However, the penalty can be imposed for a maximum of only 12 months. (See Section 6698.)

Key Point: As previously mentioned in Part 11, Rev. Proc. 84-35 provides a limited exemption from the

Section 6698 failure-to-file penalty. The exemption is available only to domestic partnerships with 10 or

fewer partners when all the partners have reported their proportionate shares of income and deductions

on timely filed returns. When income or deductions are not allocated proportionately, the Rev. Proc.

84-35 exemption is unavailable.

Question-and-Answer Guidance in PMTA 2013-015

PMTA 2013-015 deals with several S corporation and partnership failure-to-file issues in a question and

answer format. Following are summaries of the most important issues.

Issue 1a: If an S corporation return is filed late, can the corporation be hit with both the general Section

6651(a)(1) failure-to-file penalty and the separate Section 6699 failure-to-file penalty?

Answer: No. Although the Section 6651(a)(1) penalty can potentially apply to an S corporation return,

the IRS concluded that it is unlikely that a court would uphold the imposition of both penalties for the

same late-filed return. According to the PMTA, the Section 6699 penalty was created to fill a gap in the

penalty regime. There is no indication in the legislative history that Congress intended for S corporations

to be penalized twice for the same misconduct.


Issue 1b: If an Electing Large Partnership Return (Form 1065-B), is filed late, can the partnership be hit

with both the general Section 6651(a)(1) failure-to-file penalty and the separate Section 6698 failure-to-file

penalty?

Answer: No. Only one penalty should be imposed with respect to any one late-filed return. According to

the PMTA, charging two penalties would be inconsistent with the IRS policy that penalties exist to

encourage voluntary compliance. Moreover, the IRS concluded that it is unlikely that a court would

uphold the imposition of two penalties for the same late-filed return. While the PMTA doesn’t actually

say so, the answer would presumably be the same if we were talking about a “regular” partnership that

files Form 1065 or a multi-member LLC that is treated as a partnership for tax purposes and files Form

1065.

Issue 1c: If a late-filed S corporation or partnership return fails to include required information, the

Section 6699 and 6698 penalties for such failure begin running on the return due date. Can an S

corporation or partnership be hit with the both the penalty for failure to file (under Sections 6699(a)(1) or

6698(a)(1)) plus another penalty for failure to include required information (under Sections 6699(a)(2) or

6698(a)(2))?

Answer: This answer comes in the form of the following example, which has been adapted for this

analysis.

Assume that Ess Corp (EC), which has two shareholders, filed its Form 1120S for calendar year 2013 on

December 10, 2014, without including the required Schedules K-1 for the two shareholders. EC did not

obtain an extension of time to file its 2013 return, so the return due date was March 15, 2014. Therefore,

the return (without the required Schedules K-1) was filed nine months late. EC finally gets around to

filing the Schedules K-1 on August 1, 2015. The Section 6699(a)(1) penalty for filing late is $3,510 (9

months x 2 shareholders x $195 = $3,510). The Section 6699(a)(2) penalty for failure to include required

information on the return begins running on the return due date (March 15, 2014) and ends when the

missing information is provided (August 1, 2015). However, the penalty cannot be charged for more than

12 months. So the Section 6699(a)(2) penalty is $4,680 (12 months x 2 shareholders x $195 = $4,680).

According to the PMTA, Sections 6698 and 6699 do not impose two different penalties: one for filing a

return late and another for failing to include required information on a return. Instead, Sections 6698 and

6699 charge one penalty for two different miscues: (1) filing late, and (2) failing to include required

information. When the taxpayer is guilty of both miscues, the miscue that results in the larger penalty is

the one that is taken into account. Therefore, the penalty due in this example is $4,680, based on EC’s

failure to include required information with its return.

$2 MILLION BONUS PAID TO C CORPORATION’S SOLE SHAREHOLDER FAILED

REASONABLE COMPENSATION TEST

In the facts underlying a recent Tax Court decision, a C corporation operated an eye-care center that had

five eye surgeons on board. The corporation’s sole shareholder and medical director was one of the

surgeons. He was paid a $2-million bonus after he had to substantially increase his workload when one of

the other surgeons departed unexpectedly and another began working reduced hours. The corporation

deducted the entire $2 million as compensation expense. After an audit, the IRS disallowed $1 million

and assessed an accuracy-related penalty of $62,000 based on the argument that half of the purported

bonus was actually a disguised dividend rather than compensation. The Tax Court agreed because the

corporation failed to provide any evidence of comparable salaries or offer a methodology to show that


the entire bonus represented reasonable compensation in light of the shareholder’s increased

responsibilities. (See Midwest Eye Center, S.C., TC Memo 2015-53.)

How Much Compensation Can Be Justified as Reasonable?

When C corporation shareholder-employees are provided with generous salaries and benefits, the

corporation should be prepared to fight IRS claims that some or all of the purported compensation

payments are actually disguised taxable dividends that were paid according to stock ownership (Treas.

Regs. 1.162-7(b)(1) and 1.162-8). The IRS will argue that the corporation cannot justify compensation

amounts that exceed what is ordinarily paid by similar companies to workers who supply similar services

(Treas. Reg. 1.162-7(b)(3)). When allegedly excessive amounts of compensation and benefits are

provided, the IRS will treat the excess as dividends, with the resulting negative tax effects listed earlier. In

summary, corporations must be prepared to pass a “reasonable” test for compensation and benefits

provided to shareholder-employees.

In the real world, the reasonable test is often not so easy to apply to closely held companies. The

shareholder-employees in question are often the founders of the business who made great personal

sacrifices over the years, were grossly underpaid in at least some of those years, and have been the driving

force behind the company’s growth and profitability.

With all the preceding thoughts in mind, the following checklist summarizes what the author feels are the

relevant factors to consider when determining how much compensation can be paid to shareholder-

employees while still passing the reasonable test.

Reasonable Compensation Checklist

“Yes” answers are suggestive of reasonable compensation; “no” answers indicate the opposite. However,

having some “no” answers is not fatal. Each factor’s importance depends on the facts in the particular

case at hand. In other words, assessing the reasonable compensation issue is more of an art than a

science.

Tax Motivation Factors

1. Would a hypothetical outside investor conclude that return on shareholder equity has not been

reduced to unacceptably low levels because of excessive compensation payments to shareholder-

employees? Based on the trend in court decisions, this hypothetical outside investor standard

now appears to be the single most important factor in assessing the reasonableness of

compensation paid to shareholder-employees. The concept is that—except for small operations

and personal service businesses—compensation paid to shareholder-employees should not be so

high as to reduce corporate earnings to unacceptably low levels because this would eliminate any

reasonable return on shareholder equity. Put another way, when the return on shareholder equity

is inadequate, the IRS is likely to suspect that unreasonably high compensation may be the cause.

Key Point: Common sense dictates that it should always be acceptable to zero out a professional C

corporation’s income with deductible compensation payments (no matter how large) to shareholder-

employees, unless significant income is attributable to (1) services provided by employees who are not

shareholders, (2) merchandise sales, (3) specialized equipment (such as expensive diagnostic medical

equipment), or (4) some other factor beyond the value of the personal services provided by the

shareholder-employees. For example, see Law Offices—Richard Ashare P.C., v. Commissioner and Pediatric

Surgical Associates, P.C. (TC Memo 2001-81).

2. Is it clear that compensation levels are not determined simply by percentage of stock ownership?


Key Point: It is important to document in the corporate minutes that compensation is based on the

value of the services provided by shareholder-employees.

3. Does the company have a history of paying at least some dividends? However, the mere fact that

no dividends have been paid does not prove that compensation is unreasonable (Rev. Rul. 79-8).

Key Point: A dividend history cannot possibly hurt, but the trend in court decisions seems to show this

is not a critical factor.

Company-Specific Factors

1. Are sales and profits healthy and growing?

2. Are key financial ratios favorable?

3. Is the company performing above average for the industry?

4. Is the nature of the business itself unique, difficult, or highly specialized?

Employee-Specific Factors

1. Has the shareholder-employee in question demonstrated commitment by his or her length of

service and by making measurable contributions in the past?

2. Does the individual handle multiple functions (marketing, personnel, financial management, and

so forth) for one salary?

3. Does the individual have extensive experience in the company’s line of business?

4. Does the individual possess unique skills or education or possess a unique “package” of

attributes?

5. Does the individual have an exceptionally high workload?

6. Are the other fringe benefits (retirement plan, medical insurance, and so forth) modest?

Key Point: Do not forget to take advantage of fringe benefit programs, which can provide great value to

shareholder-employees while remaining virtually invisible to the IRS. The IRS seems to obsess about

salary and bonuses while paying less attention to other forms of compensation that can be just as valuable

(or more) to shareholder-employees.

7. Has the shareholder-employee been underpaid in the past?

Key Point: Progressive annual increases in compensation are easier to explain to the IRS than explosive

increases. However, it is well-established that very large increases can be justified if they are intended to

make up for under-compensation in earlier years. In other words, reasonable compensation is measured

over a period of years rather than just one year at a time. See Lucas v. Ox Fibre Brush Co. (281 US 115

(1930)).

Compensation Policy Factors

1. Can the corporation document that it has established compensation policies and that they have

been followed? This factor is especially important when it appears that large year-end bonuses

have been paid out to reduce the company’s annual taxable income at the last minute.


Key Point: Bonuses should be paid pursuant to written plans, and such plans should be followed

consistently over the years. Annual bonus amounts, and the considerations used in awarding them,

should be documented in the corporate minutes. The timing of bonuses does not appear to be a big deal.

Large year-end payments are generally acceptable if the preceding advice is followed.

2. Was an outside adviser (for example, a CPA or compensation planning expert) engaged to design

and oversee the bonus plan?

3. Can the company show that compensation levels for at least some non-shareholder employees

have been set using similar guidelines to those used to determine salaries for the shareholder-

employees?

Comparability Factors

1. Is there evidence that the compensation paid to the shareholder-employee is comparable to that

received by employees rendering similar services to similar businesses?

Key Point: When favorable comparable salary data is available, it is helpful to include this information in

the corporate minutes.

2. Is the shareholder-employee’s role with the company unique (in other words, is it unrealistic to

compare this person to employees of other similar businesses)? For instance, the shareholder-

employee may be an incredible innovator and a marketing genius who also founded the

company.

KNOWLEDGE CHECK

1. For a payment to an ex-spouse to qualify as deductible alimony for federal income tax purposes:

a. At least four out of seven specific requirements must be met.

b. Eight specific requirements must be met.

c. The payment must be made directly to the ex and not to any third party.

2. If your client has a plan that reimburses more than one employee for his or her individual policy health

insurance premiums:

a. There is no cause for alarm because this arrangement benefits rank-and-file employees;

Washington, D.C. politicians and the IRS always approve of such arrangements.

b. Watch out because this arrangement could trigger a significant penalty hit under the Affordable

Care Act’s “market reform” restrictions (Section 4980D).

c. There is no cause for alarm as long as the employer is an unincorporated business or an S

corporation.


3. The penalty for failing to file a partnership return on time is:

a. $195 per tax-return year.

b. $195 times the number of partners that were in place at any time during the partnership tax year

in question times the number of months (or fractions of months) for which the failure to file

continues up to an unlimited number of months.

c. $195 times the number of partners that were in place at any time during the partnership tax year

in question times the number of months (or fractions of months) for which the failure to file

continues up to a maximum of 12 months.

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