Courtney Kopec

Z is for (opportunity) zone

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Posted by Courtney Kopec, CPA

If you are holding appreciated property that you are looking to offload, but don’t want to pay income tax on the appreciation right now, then Congress has a solution for you: Qualified Opportunity Zones. This is an incredibly taxpayer-friendly provision that was included in the Tax Cuts and Jobs Act.

Get in the Zone

Congress passed Subchapter Z to entice private investors to invest in low-income urban and rural areas by providing “temporary deferral of inclusion in gross income for capital gains reinvested in a qualified opportunity fund and the permanent exclusion of capital gains from the sale or exchange of an investment in the qualified opportunity fund.” Translation: under this law, an investor may defer any gains from the sale of property to an unrelated party by reinvesting the capital gains portion of the proceeds in a qualified opportunity fund (“QOF”) within 180 days of the sale. The gains are deferred until the QOF is sold or exchanged, with the tax benefits increasing substantially the longer the holding period of the fund (up until December 26, 2026, the law’s tax recognition date). The principal cost portion of the sale proceeds does not need to be reinvested, and there is no tax benefit in doing so.

The best-case tax savings scenario is where an investor reinvests realized capital gains in a QOF by December 31, 2019, and the QOF is held for 10 years. In this scenario, on December 31, 2026 the taxpayer holding the QOF recognizes and includes gain in gross income as calculated to that date. The original reinvested deferred gain is reported and 15% of that deferred gain is treated as additional or “stepped-up” basis. This reduces the amount of the original reinvestment to be taxed by the 15% stepped up basis. Thereafter, if the fund is held for the full 10 years, no additional capital gains will be recognized. But the law contains other requirements and lesser tax savings scenarios that make the Qualified Opportunity Zones a tax savings opportunity that should not be overlooked, even if a shorter holding period is desired.

What is a Qualified Opportunity Fund?

A QOF is an investment vehicle designated by IRS guidelines and qualifications. No approval or action by the IRS is required to establish a QOF. The fund self-certifies and can be a partnership, corporation, or limited liability company. QOF requirements do include some technical guidelines. For example, the fund must hold at least 90% of its assets in QOZ Property (“QOZP”). QOZP includes QOZ stock, a QOZ partnership interest, or QOZ business property in a Qualified Opportunity Zone. QOZP must be acquired after December 31, 2017 in exchange for cash.

A qualified zone business owns or leases substantially all of its tangible property in QOZ business property and generates 50% of its income from active trade or business with “less than 5% of the average of its aggregate unadjusted bases of the property of such entity attributable to nonqualified financial property.” Investments in certain “sin” businesses are not eligible investments. A penalty is assessed each month the QOF fails to meet compliance requirements referred to above.

What is a Qualified Opportunity Zone?

A QOZ is an economically-distressed area where under certain conditions, new investments may be eligible for preferential tax treatment. Governors were asked to nominate low income urban and rural areas for Treasury approval to become QOZs. The current list of designated QOZs can be found here: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx

Death and taxes? Perhaps not: deferral and abatement

The primary benefit of investing in an QOF is the deferral of reporting taxable gains. Because QOF investors are reinvesting the capital gains portion only and deferring the tax to a future date, their initial reinvestment has no cost basis. An investor who holds a fund for a minimum of five years and initiates the investment by December 31, 2021 will be deemed to have a basis equal to 10% of the reinvested funds on December 26, 2026, the law’s tax recognition date. In other words, by satisfying the investment date and holding period requirement, $100,000 invested in a qualified fund with no basis now qualifies for a deemed $10,000 stepped-up basis. And due to the deemed basis, the taxpayer pays tax on only $90,000, instead of $100,000. For an increase in the tax savings benefits to be considered, the reinvested capital gains must be invested in a QOF by December 31, 2019 and held for seven years. If the Fund invests by year end 2019 and satisfies the seven-year holding period requirement, the investment qualifies for a 15% stepped-up basis. If the fund is held ten years, the basis is stepped up, and deemed to be equal to the fair market value. Therefore, after ten years, no tax is paid on the appreciation of the gains reinvested in the fund. Sweet, sweet tax benefits!

Tax planning considerations

Subchapter Z presents real estate developers an opportunity to establish a fund in order to generate third-party investment capital for their projects. But! QOFs that choose real estate as a primary holding in the fund must meet mandated rehabilitation requirements. For real estate investors with large gains considering a 1031 exchange, the opportunity fund is a viable alternative option in that it requires only gain to be reinvested. However, additional cash invested will be treated separately and will not be eligible for the capital gain exclusion.

Bottom line? The alternative capital gain tax deferral option offered by the fund vehicle is more liquid than reinvesting in another real estate property. In the least favorable scenario, if an investment is held fewer than five years, the gain is deferred until the sale, but no gain is excluded.

Is Subchapter Z right for you? Contact your CPA or trusted advisor to make that determination.

Further reading

Self-employment tax: the other tax reform

 
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Posted by Courtney Kopec, CPA

While the headlines parsed the effects of the Tax Cuts and Jobs Act of 2017, other important tax issues affecting the owners of pass-through entities were being scrutinized. Over the past year, the U.S. Tax Court modified self-employment (“SE”) tax guidelines to firm up the limited partner and LLC pass-through rules previously used to avoid self-employment tax on income earned by certain taxpayers.

S corporation ordinary income is not subject to SE tax

In Fleischer v Commissioner (TC Memo 2016-238), the taxpayer created an S corp entity to report non-employee compensation from a service provider contract he entered into with MassMutual as a financial services provider. The intended result was to exclude self-employment income tax because S-corp pass-through income is not subject to SE tax. The Court determined the income should have been reported on Schedule C and subject to SE tax. The Court applied two tests to determine whether the corporation was the controller of the income: first, the individual providing the services must be an employee of the corporation; and second, a contract must exist recognizing the corporation’s controlling position. The Court determined that the taxpayer, not his S corporation, had earned all the income.

A partner’s power is either general or limited, but not both

In Castigliola v Commissioner (TC Memo 2017-62), a law practice that was incorporated as a professional limited liability company by three attorneys had a compensation agreement that was reasonable based on average salaries in their area. The partners reported the guaranteed payments they received as subject to self-employment tax. However, the net profits distributed in excess of the guaranteed payments were reported as not subject to SE tax. The taxpayers argued that the guaranteed payments reflected reasonable compensation for their services and the earnings in excess were attributable to the partner’s investment and were akin to the items of income or loss of a limited partner. The Court determined that in the absence of a written operating agreement that identified a general partner, all three attorneys had equal management power that was in no way limited. None of the partners could be considered as limited and classify their additional income as limited partner income. Therefore, all three attorneys were general partners and all income was subject to SE tax.

A surgeon successfully separates out his passive activities

In Hardy v Commissioner (TC Memo 2017-16), a surgeon (Hardy) performed surgeries at a facility in which he held a 12.5% minority interest and so considered himself a limited partner. He held no management authority at the facility and his distributions were not related to his performance. Hardy reported the income as passive and, at first, also paid self-employment tax on the income. The core issue was whether Hardy properly reported the income as passive and the activities should treated as a single activity and “constitute an appropriate economic unit for the measurement of gain or loss for the purposes of Section 469.” The IRS argued that Hardy’s payment of SE tax implied that the activities were non-passive and should be grouped as a single activity. The Court rejected the IRS argument and held that Section 1.469-4(c)(2) permits a taxpayer to use any reasonable method of “applying the relevant facts and circumstances” to group activities and, therefore, the taxpayer was not liable for the SE tax. He would have been liable for SE tax and could not use the passive losses if the Court determined the activities were to be grouped as a single activity.

Tax planning considerations

The implications of the three cases presented are clear: the IRS wants to subject pass-through entity income to self-employment tax, where appropriate. The owners of S corps who do not take reasonable compensation are easy prey for IRS auditors. If you are an entrepreneurial owner of an S corporation and are not taking salary, or if you are a managing partner in a partnership entity, you should consult your CPA tax advisor to review your tax exposure under these types of situations.

Further reading

The Multistate Tax Commission’s sales tax amnesty for internet sales has closed

Posted by Courtney Kopec, CPA

Recently, the states have signaled that their sales tax regulations for sellers of online goods will change yet again.

First, the window has closed on the Multistate Tax Commission Online Marketplace Seller Voluntary Disclosure Initiative’s offer for sales tax amnesty.  Twenty-five states offered to waive all past tax, interest, and penalties for companies that agree to register for and collect sales tax for online sales going forward. 

 
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Second, South Dakota has filed a petition to have the Supreme Court overturn the landmark Quill case because the proliferation of internet sales has too much appetizing tax revenue on the table left uncollected by the states.  And so going forward the states’ goal is to force out-of-state-sellers to collect sales tax by expanding the definition of nexus, data sharing, and enforcement which have been the factors that would allow states to compel taxpayers to comply.

When must I collect sales tax?

Taxing authorities require businesses to pay or collect tax based on nexus, which is their connection to the state.  The 1992 Supreme Court case Quill Corp v North Dakota limited the burden of businesses required to collect sales tax to those with a physical presence:  in general, an office, employee, salesperson, or inventory physically present in the state creates physical presence nexus.  However, physical presence is just the starting point and not the only determining factor.  The state’s narrow application of the physical presence test allowed for the creation of economic nexus that is generally triggered when a company has a purposeful direction of its business activities within a state rising to a substantial level.

New York State has been said to lead the way in proposed legislation defining economic nexus.  In 2008, New York State amended the definition of vendor and created “click through nexus” (sometimes referred to as the “Amazon laws”) with the intention that large internet retailers with no physical presence in the state be required to collect sales tax if they pay commissions to in-state residents and gross receipts exceeded $10,000 during the preceding 12 months.  Then in 2015 New York proposed that “marketplace providers” collect and pay New York State sales tax at the point of sale when the transaction takes place whether the actual seller is located within or outside the State.   In October 2017, the state of South Dakota filed a petition for certiorari in the U.S. Supreme Court urging it to "abrogate Quill's sales-tax-only, physical-presence requirement."  In its appeal South Dakota noted that advances in computer technology have made it easier to determine appropriate sales tax based on the purchaser's location and requiring such "poses a minimal obstacle."  For a foreign seller of goods:  “Tax treaties do not cover the taxing activities of the States” (1983 Supreme Court, Container Case).   Therefore, because no international treaty provisions apply to sales tax, foreign sellers are subject to the same rules as domestic sellers.

Cover your bases

If you engage in internet sales and this is confusing to you, join the club.  The statutes are evolving continually in reaction to the changing landscape of retail sales.  However, the evolving concept of nexus may also apply to income and franchise tax, so being aware of and understanding the regulations is critical.

Another important thing to keep in mind is that when a transaction is complete, it is impossible to go back later and collect sales tax for which the taxpayer may be responsible.  Under audit, what should have been a tax collection process becomes an expense to the seller.

The analysis and interpretation of these changing laws is challenging. If your business has transactions out-of-state and you would like to review whether your business has compliance requirements in another state, contact your CPA or trusted advisor to review the latest guidelines.

Is it time for you to make the mark-to-market election?

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Investors and traders are treated differently by the IRS

If the markets reach a tipping point and crash, how will you be affected? The tax implications will depend on whether you're an investor or a trader who has made a mark-to-market election under Section 475 of the Internal Revenue Code. Traders who seek treatment under Section 475 can gain advantages in a down market, and here's why.

The Dow Industrial Average is on an unprecedented rally, exceeding 22,000 and continuing for more than eight years. But the simple truth is that bull market streaks always come to an end. The extended low-interest rate policy and quantitative easing program set by the Fed have assisted the climb of the market indices, but authorities are now debating how to end these programs and normalize economic policy. Looking forward, both investors and traders need to employ the best investment and tax strategies to maximize gains and minimize the damage from the impending bear market.

Whether you’re defined as an investor or a trader by the IRS, it’s critical to use advanced tax planning and good record-keeping.

Are you an investor or a trader?

Investors are defined as individuals who seek to profit from capital appreciation, dividends, and interest. When they hold assets longer than a year and a day are rewarded with preferential tax rates (generally 15%-23.6%). Otherwise, the gain is taxed at the ordinary rate (as high as 39.6%). Excess losses can be used against ordinary income from other business activities, limited to only $3,000 per year; the remainder is carried forward. Investment expenses incurred, such as trading programs, software, and conferences are limited to an amount that exceeds 2% of adjusted gross income and are not deductible at all for alternative minimum tax purposes. In a volatile or bear market, managing losses can be tricky for the investor. Under Sec. 1901, losses are further limited: the investor’s repurchase of a security that would otherwise be reported as a loss within 30 days of sale (a “wash sale”) is disallowed and added to the basis of the security, which will only be allowed upon ultimate disposition of said security.

Trader status is less clearly defined, but court decisions offer some guidance. Traders are individuals who seek to profit from daily market movements; their activity must be substantial; and it must occur with continuity and regularity. The trader treats the buying and selling of securities as if carrying on a business activity.

Here’s where traders can tip the scales in their favor: individuals who qualify as traders may make a Sec. 475 mark-to-market election. The timing is important to understand: the election must be filed by April 15 with the preceding year’s tax return or extension (e.g., to be effective for 2017, a statement must have been filed with your 2016 tax return or extension by April 15, 2017). Relief is technically available for late elections, but taxpayers are not frequently successful in receiving that relief. Form 3115 should be filed with the 2017 tax return to change accounting methods.

Advantages of the mark-to-market election

Taxpayers who have made the mark-to-market election benefit in several ways:

  • Losses are unlimited (as opposed to the $3,000 limit)
  • Investment expenses are 100% deductible
  • No self-employment tax
  • Wash sale rules don’t apply

Keep in mind, though, that traders report all gains and losses as ordinary income or loss, so there is the potential for an increase in rate on those gains from the preferential tax rates previously mentioned.

No self-employment tax              

There is no IRC section or regulation dealing specifically with self-employment tax on traders, but case law findings now support the position that traders are not subject. This is a tax issue that has shifted over time. As an example, the $8.1 million first prize for the Main Event World Series of Poker that was captured by a New Jersey accountant was subject to both income and self-employment (Social Security and Medicare) taxes, which added up to a staggering 47.11% tax bite. The IRS reasoned that there was no distinction between a gambler or active trader who devotes his full-time on the exchanges for his livelihood. Trading should be regarded as a trade or business and subject to self-employment taxes. However, the IRS more recently advised that individuals who qualified for trader status “occupy an unusual position under tax law because they engage in a trade or business [that] produces capital gains and losses.” In 1999, an IRS letter stated that “self-employment tax does not apply since the sale of a capital asset is involved and is only ordinary because of the mark-to-market election.”

Bottom line

If you engage in short-term trading and qualify for trader status, you can take advantage of some significant tax treatments. Don’t forget traders can have it both ways and take advantage of the investor’s preferential long-term capital gains rates on securities in held-for-investment accounts, but proper records must be kept. A trader who seeks this benefit must separate the respective brokerage activities into different accounts. Contemporaneous records should document how the trader intends to treat each security at the time of purchase.

The analysis and interpretation of IRS rulings and court decisions is critical in helping taxpayers decide if their activities will qualify for trader status. Before making the Sec. 475 election, talk to a CPA.

Further reading