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The IRS has announced a significant increase in enforcement actions for syndicated conservation easement transactions. This is a "priority compliance area" for the agency.

Throughout the IRS, coordinated examinations are being conducted in the Small Business and Self-Employed (SB/SE) Division, Large Business and International (LB&I) Division, and Tax Exempt and Government Entities (TE/GE) Division. The IRS Criminal Investigation (CI) Division has also been initiating investigations. The audits and investigations cover billions of dollars of potentially inflated deductions, as well as hundreds of partnerships and thousands of investors.

"We will not stop in our pursuit of everyone involved in the creation, marketing, promotion and wrongful acquisition of artificial, highly inflated deductions based on these aggressive transactions. Every available enforcement option will be considered, including civil penalties and, where appropriate, criminal investigations that could lead to a criminal prosecution," said IRS Commissioner Charles "Chuck" Rettig. "Our innovation labs are continually developing new, more extensive enforcement tools that employ advanced techniques. If you engaged in any questionable syndicated conservation easement transaction, you should immediately consult an independent, competent tax advisor to consider your best available options. It is always worthwhile to take advantage of various methods of getting back into compliance by correcting your tax returns before you hear from the IRS. Our continued use of ever-changing technologies would suggest that waiting is not a viable option for most taxpayers," he added.

Syndicated Conservation Easements

The IRS issued Notice 2017-10, I.R.B. 2017-4, 544, in 2016, which designated certain syndicated conservation easements as listed transactions. In these types of transactions, investors in pass-through entities receive promotional material which offer the possibility of a charitable contribution deduction worth at least two-and-a-half times their investment. The deduction taken in many transactions has been significantly higher than 250 percent of the investment.

Syndicated conservation easements were included on the IRS’s 2019 "Dirty Dozen" list of tax scams to avoid.

Not only do these transactions grossly overstate the value of the easement that was purportedly donated to charity, they often also fail to comply with the basic requirements for claiming a charitable deduction for a donated easement.

Taxpayers may avoid the imposition of penalties for improper contribution deductions if they fully remove the improper contribution and related tax benefits from their returns by timely filing a qualified amended return or timely administrative adjustment request.

Enforcement Actions

The IRS has prevailed in many cases involving the charitable deduction basic requirements, and has established a body of law that it believes supports disallowance of the deduction in a significant number of pending conservation easement cases. The IRS will soon be moving the Tax Court to invalidate the claimed deductions in all cases where the transactions fail to comply with the basic requirements, leaving only the final penalty amount to be determined.

In addition to auditing participants in syndicated conservation easement transactions, the IRS is pursuing investigations of promoters, appraisers, tax return preparers and others, and is evaluating numerous referrals of practitioners to the IRS Office of Professional Responsibility. The IRS will develop and assert all appropriate penalties, including:

penalties for participants (40 percent accuracy-related penalty);
penalties for appraisers (penalty for substantial and gross valuation misstatements attributable to incorrect appraisals);
penalties for promoters, material advisors, and accommodating entities (penalty for promoting abusive tax shelters, and penalty for aiding and abetting understatement of tax liability); and
penalties for return preparers (penalty for understatement of taxpayer’s liability by a tax return preparer).

Rettig, Desmond Highlight Heightened Focus

Rettig and IRS Chief Counsel Michael J. Desmond have each highlighted the IRS’s heightened, agency-wide focus on syndicated conservations easements.

While speaking at the American Institute of CPAs (AICPA) 2019 National Tax Conference in Washington, D.C., Rettig and Desmond both separately underscored the IRS’s increased enforcement efforts toward abuses of certain tax-advantaged land transactions under Code Sec. 170(h).

"We appreciate the value of conservation easements," Rettig said. "We do not appreciate the activities that have gone on with respect to the syndicated conservation easements—there are some artificial appraisals there… some fatal flaws."

Reiterating the IRS’s tough stance on the matter, Rettig said that the IRS is not going to "stand down." The information in IR-2019-182 issued on November 12 was "fair warning," Rettig said.

Likewise, Desmond stressed that the challenges surrounding syndicated conservation easements are an "institutional concern" for the IRS, "one that we will be responding to," he emphasized.

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Treasury and the IRS are expected to release proposed rules in "early 2020" that would clarify certain limitations on the carried interest tax break, according to David Kautter, Treasury’s assistant secretary for tax policy. Kautter briefly addressed the proposed regulations’ timeline while speaking at the American Institute of CPAs (AICPA) 2019 National Tax Conference in Washington, D.C.

Carried Interest Limitation

The forthcoming regulations are expected to restrict S corporations from taking advantage of a carried interest exemption provision under the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97). The TCJA requires certain money managers to hold investments for at least three years before becoming eligible for the lower, 20 percent capital gains rate. However, it exempted corporations from this holding period, which Treasury and many lawmakers on Capitol Hill say resulted in an unintended "loophole."

The proposed regulations are expected to clarify the law’s intent that S corporations are subject to the three-year holding period for carried interest, according to Treasury’s last press release on the matter issued in March 2018 (see "Treasury, IRS Issue Guidance On Carried Interest," at https://home.treasury.gov/news/press-releases/sm0302).

Legal Questions May Arise

Most notably, however, the TCJA does not expressly contain this limitation on S-corporations, which has left some on Capitol Hill questioning Treasury and the IRS’s authority to implement such a restriction via regulations. The IRS on November 15 directed Wolters Kluwer to Treasury for confirmation on this anticipated rule and projected timeline. As of press time, Treasury had not responded to Wolters Kluwer’s request for comment.

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Hopes for a year-end tax extenders package appear to be dwindling on Capitol Hill.

Tax Extenders Need a Legislative Vehicle

Over 30 expired or soon-to-be expired tax breaks known as tax extenders were originally considered a top contender for hitching a ride on a larger, must-pass government funding bill. Considering the lack of time left on the legislative calendar this year, a stand-alone tax bill has been considered an unlikely initiative. Thus, a must-pass appropriations bill was seen by several lawmakers as the likely legislative vehicle for tax extenders and other tax items such as technical corrections to Republicans’ 2017 tax reform law.

However, a spokesperson for Senate Finance Committee (SFC) Chair Chuck Grassley, R-Iowa, confirmed to Wolters Kluwer on October 28 that Grassley believes there is "no hope" for action this year on a tax extenders package if lawmakers do not move quickly with respect to its legislative driver. Many within the practitioner community following these developments have said that the chances of providing taxpayers with certain tax breaks retroactively significantly decrease if Congress moves into next year leaving them expired.

Another Stopgap Spending Bill Appears Likely

Currently, the federal government is operating on a stopgap spending bill temporarily extending fiscal year (FY) 2019 funding levels through November 21. Previously, several lawmakers, in particular Grassley, had hoped that a tax extenders package would be attached to a larger, more comprehensive appropriations bill next month. However, Senate Appropriations Committee Chair Richard Shelby, R-Ala., told reporters that another short-term stopgap spending bill is the more likely option to keep the government open after November 21. "Unless a miracle happens around here with the House and Senate, we will have to put forth another [continuing resolution] CR," Shelby told reporters.

Notably, another short-term government funding bill is considered unlikely to have any policy riders. Generally, stop gap spending bills are usually considered "clean," for the most part. Also playing a role in tax extenders’ fate is whether President Trump would sign a more comprehensive appropriations bill. At this time, his support for a larger FY 2020 funding bill, apart from tax policy reasons, remains unclear.

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Senate Finance Committee (SFC) Chair Chuck Grassley, R-Iowa, and other top Senate tax writers are calling for Senate action on the bipartisan Setting Every Community Up for Retirement Enhancement Secure bill (HR 1994) (SECURE Act). The House-approved, bipartisan retirement savings bill has remained stalled in the Senate since May.

SECURE Act’s Route to Senate Floor Remains Unclear

Grassley’s communications director Michael Zona told Wolters Kluwer on October 21 that it remains "unclear at this point" whether the SECURE Act will move through committee, reach the Senate floor by unanimous consent, or be attached to a larger, year-end tax package. "Grassley supports the House-passed SECURE Act. There are several holds on the bill, and he is working to get them lifted," Zona said.

The SECURE Act cleared the House on May 23 by a 417-to-3 vote. The bipartisan measure, which proposes sweeping changes to retirement savings tax policy, was originally expected to quickly clear the Senate after its approval in the House. However, Sen. Ted Cruz, R-Tex., blocked the bill from reaching the Senate floor. Cruz blocked the bill in protest of House Democrats’ 11th hour-removal of a provision from the original bill that would have expanded tax-advantaged Section 529 education savings plans to include homeschooling and certain elementary and secondary expenses. Cruz and Sen. Patty Murray, D-Wash., are reportedly still holding up the measure from reaching the Senate floor.

Catch-All Tax Package

However, the SECURE Act, among other bipartisan tax-related items including tax extenders, could be attached to a catch-all tax package that is expected on Capitol Hill to hitch a ride on a year-end government funding bill. A "must-pass" appropriations bill, like the one currently being negotiated to keep the government open after funding expires on November 21, could serve as the tax package’s legislative vehicle, thus fast tracking its approval.

"As the economy continues to change, the way we approach retirement savings must change as well. Otherwise, too many Americans will be left behind," Grassley said on October 21, noting that the SECURE Act is under "active consideration."

Similar to Grassley’s push, Sen. Tim Scott, R-S.C., led a letter sent to Senate Majority Leader Mitch McConnell, R-Ky., urging immediate Senate consideration of the SECURE Act. "This bipartisan legislation would expand access to retirement plans for millions of Americans, allow older workers and retirees to contribute more to their retirement accounts, increase 401(k) coverage to part-time employees, prevent as many as 4 million people in private-sector pension plans from losing future benefits, protect 1,400 religiously affiliated organizations whose access to their defined contribution retirement plans is in jeopardy, and do the right thing for Gold Star families," according to Scott.

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The Senate blocked a Democratic resolution on October 23 to overturn Treasury rules preventing certain workarounds to the $10,000 state and local tax (SALT) federal deduction cap.

SALT Cap Workaround

Senate Democrats’ resolution, S.J. Res. 50, forced a vote on Wednesday to nullify Treasury regulations that block taxpayers from circumventing the SALT cap through certain states’ programs that convert state and local taxes into fully deductible charitable contributions. The resolution failed by a largely party-line vote of 43-to-52.

Sen. Michael Bennet, D-Colo., voted against the Democratic measure while Sen. Rand Paul, R-Ky., supported it. While the resolution would not repeal the SALT cap itself, House Democrats are reportedly crafting legislation to do so. Democrats and some Republicans, particularly from high-tax states, have criticized the SALT cap since its enactment in 2017 under the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97).

Debate on SALT Cap, Treasury Rules

"Without any clear authority to do so, the Treasury Department reversed a long-standing IRS position that had allowed taxpayers a full deduction for charitable contributions to state tax credit programs," Senate Finance Committee (SFC) ranking member Ron Wyden, D-Ore., said on the Senate floor before the vote. "My view is the Treasury Department should not be putting its thumb on the scale on behalf of Republican interests, and it shouldn’t be using phony regulatory justifications to fix Republicans’ extraordinarily poorly drafted law."

However, several Republicans cited to a recent report from the nonpartisan Joint Committee on Taxation (JCT), which estimated that repealing the SALT cap beginning in 2019 would result in over $40 billion of the associated tax cut going to taxpayers with incomes of at least $1 million ( JCX-35-19).

"It’s bad enough that my Democratic colleagues want to unwind tax reform, but it’s downright comical that their top priority is helping wealthy people in blue states find loopholes to pay even less," Senate Majority Leader Mitch McConnell, R-Ky., said from the Senate floor on October 23. "Repealing the SALT cap would give millionaires an average tax cut of $60,000. Meanwhile, the average tax cut for taxpayers earning between $50,000 and $100,000 would be less than ten dollars."

Vaping Tax

In other news, the House Ways and Means Committee approved a bipartisan vaping tax bill, ( HR 4742), on October 23 by a 24-to-15 vote. The bill would establish a $27.81 tax per gram of nicotine used in vaping devices.

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Treasury and the IRS on October 31 announced the release of a new, draft form implementing certain reporting requirements under the Tax Cuts and Jobs Act Opportunity Zone program.

The proposed Form 8996 for Qualified Opportunity Funds (QOFs) comes after numerous calls on Capitol Hill for more transparency within the Opportunity Zone program. "The form is designed to collect information on the amount of investment by opportunity funds in business property by census tract," according to a Treasury press release.

Opportunity Zones’ Architect Applauds Treasury’s Steps Toward Reporting Requirements

Ken Farnaso, press secretary for Sen. Tim Scott, R-S.C., chief architect of the TCJA’s bipartisan Opportunity Zone program, told Wolters Kluwer on October 31 that reporting requirements, "an important piece of the puzzle," were, in fact, originally in the bill. "Unfortunately, during the tax reform process, Senate Democrats blocked these requirements from being included in the Tax Cuts and Jobs Act. Since then, Senator Scott has continued working to restore those reporting requirements," Farnaso said.

Additionally, Farnaso told Wolters Kluwer that Scott applauds Treasury’s steps to ensure a clearer picture of the impact the Opportunity Zones initiative can have on the country. "Senator Scott will also continue to push for his current bill restoring robust reporting requirements to create a holistic picture of how the initiative is functioning," Farnaso said. "Overall, today is a good day for Opportunity Zones. We look forward to the more than $44 billion in currently anticipated investment being deployed in distressed communities across the nation, and that number growing even larger in the future."

Opportunity Zones Tax Incentive

The Opportunity Zone Program enacted under TCJA ( P.L. 115-97) is considered on Capitol Hill as one of the most generous and ambitious tax incentives for investors in distressed communities. Under Code Sec. 1400Z-2, investors may defer taxation of capital gains that are invested in a QOF.

Generally, the following investor tax benefits were created under the Opportunity Zone program:

a temporary tax deferral for capital gains realized on the sale of appreciated assets and reinvested within 180 days in a QOF;
the elimination of up to 10 or 15 percent of the tax on the capital gain that is invested in the QOF and held between five and seven years; and
the permanent exclusion of tax when exiting a qualified opportunity fund investment held for at least 10 years.

Draft IRS Form 8996

Specifically, the new, draft Form 8996 for the 2019 tax year requires QOFs to report the following information:

the Employer Identification Number (EIN) of each business in which the QOF has an ownership interest;
the census tract location of the tangible property of the business;
the value of the QOF’s investment; and
the value and census tract location of qualified business property directly owned or leased.

"This is an important step towards a thorough evaluation of the Opportunity Zone tax incentive," Treasury Secretary Steven Mnuchin said. "We want to understand where Opportunity Zone investments are going and strengthening the economy so that investors and communities can learn from the successes of this bipartisan, pro-growth policy."

Generally, the collection of this information will play a role in allowing lawmakers and the public to evaluate the effects of the tax incentive and to understand why some locations may be more successful than others at attracting investment, according to Treasury.

Opportunity Zones Criticism

The Opportunity Zone program has not come to fruition without its share of criticism, however. Although lawmakers have called for reporting requirements related to QOFs since the TCJA’s enactment, the program has recently come under increased scrutiny and criticism. Senate Finance Committee (SFC) ranking member Ron Wyden, D-Ore., has said that the lack of reporting requirements are "inexcusable."

"Requiring taxpayers to prove they’re actually following the rules of the Opportunity Zone program is a positive first step, but it’s one that should have been taken two years ago…," Wyden said in an October 31 statement. "The Opportunity Zone program has been operating without any effort to ensure compliance and that’s inexcusable."

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A California-based medical marijuana dispensary corporation’s motion for summary judgment challenging the constitutionality of Code Sec. 280E was denied. The Tax Court also addressed whether Code Sec. 280E applies to marijuana businesses legally operating under state (California) law, and whether the prohibition on deductions is limited to ordinary and necessary business expenses.

Section 280E

Congress enacted Code Sec. 280E after the court had allowed certain deductions for expenses incurred in connection with an illegal drug trade. Generally, Code Sec. 280E disallows any deductions attributable to a taxpayer’s illegal drug related trade or business. Taxpayers may reduce their income by the cost of goods sold (COGS), and Code Sec. 280E does not generally disallow deductions attributable to a taxpayer’s non-drug-related business.

Constitutionality

The Eighth Amendment of the Constitution prohibits excessive fines or penalties. The dispensary in this case claimed that Code Sec. 280E is a punitive provision that violates the Eighth Amendment. However, because Congress generally has the power to levy taxes under the Sixteenth Amendment, the Tax Court found that the law’s denial of certain deductions cannot be construed as a penalty.

Legality Under State Law

The dispensary also argued that its actions could not be considered "trafficking" for purposes of Code Sec. 280E because its activities were not illegal under California law. The court noted that because marijuana is still considered a Schedule I controlled substance and is banned under federal law, the application of Code Sec. 280E does not depend on the legality of marijuana sales under California law.

Additional Deductions

Finally, the dispensary argued that Code Sec. 280E only applies to deductions under Code Sec. 162, and that other deductions such as those under Code Secs. 164 and 167 should be permitted. However, the text of Code Sec. 280E broadly states that "no deduction or credit shall be allowed." It does not limit the deductions to those claimed under Code Sec. 162.

Dissenting Opinions

The Tax Court decision included several concurring and dissenting opinions, which primarily addressed the issue as to whether Code Sec. 280E is in fact a penalty provision that would violate the Eighth Amendment.

The dissenting opinions found that Code Sec. 280E is punitive in nature. One dissenter noted that rather than specify a narrow range of disallowed expenses, Code Sec. 280E attacks the entire marijuana industry with a broad denial of otherwise allowable deductions. The opinion stated that Congress passed Code Sec. 280E order to deter the sale of controlled substances and to penalize the drug trade. That intent was found to be "clearly in the nature of a penalty." Both dissents concluded with two additional questions, which the dissenters felt need to be addressed:

Is the punitive nature of Code Sec. 280E excessive to the point where it violates the Eighth Amendment?, and
Does the Eighth Amendment apply to corporation taxpayers?

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The IRS has proposed regulations that define an eligible terminated S corporation (ETSC), and provide rules relating to distributions of money by an ETSC after the post-termination transition period (PTTP). The proposed regulations also extend the treatment of distributions of money during the PTTP to all shareholders of the corporation, and update and clarify the allocation of current earnings and profits to distributions of money and other property.

Code Sec. 1371(f), as added by the Tax Cuts and Jobs Act ( P.L. 115-97) extends the period during which C corporation shareholders can benefit from the corporation’s accumulated adjustment account (AAA) generated during its former status as an S corporation. Specifically, the provision allows the C corporation to source qualified distributions of money to which Code Sec. 301 would otherwise apply to in whole or part to AAA. The provision only applies if the corporation is an ETSC as defined in Code Sec. 481(d).

Under the proposed regulations, the revocation of S corporation status may be made during the two-year period beginning on December 22, 2017, even if the effective date for the revocation occurs after the conclusion of the two-year period.

Shareholder Identity Requirement

A former S corporation is not an ETSC unless the owners of its stock are the same owners (and in identical proportions) on December 22, 2017, and on the date of the S corporation revocation. The proposed regulations identify various categories of stock transfers that are not considered an ownership change for purposes of this rule.

ETSC Proration

A distributing ETSC’s AAA is allocated to qualified distributions and the distributions are chargeable to the ETSC’s accumulated earnings and profits (AE&P) based on the ETSC proration. The ETSC proration is implemented in a manner that facilitates the prompt distribution of AAA and full transition to C corporation status. Specifically, the proposed regulations:

specify the time at which amounts of AAA and AE&P are determined for purposes of the ETSC proration;
provide AAA and AE&P ratios used to the implement the proration; and
describe in detail the method of characterizing qualified distributions.

The proposed regulations adopt a "snapshot" approach under which amounts of AAA and AE&P are determined on a specified date. As a result, the same ETSC proration is applied to all qualified distributions. Under the proposed regulations, the determination date is the date when the S corporation revocation election is effective. A "dynamic" approach that recalculated the amounts before each qualified distribution was rejected as administratively cumbersome.

The proposed regulations provide two ratios for determining the part of a qualified distribution that is sourced from AAA and from AE&P. The AAA ratio is the ratio of historical AAA to the sum of historical AAA and historical AE&P. The AE&P ratio is the ratio of historical AE&P and the sum of historical AAA and historical AE&P. The qualified distribution is multiplied by these ratios to determine the amount sourced from AAA and AE&P.

The proposed regulations provide a priority rule under which ETSC proration first applies to qualified distributions during the tax year. The rules of Code Sec. 301 and allocation rules of Code Sec. 316 then apply to any nonqualified distributions that are not fully accounted for by the ETSC proration because the corporation’s AAA or AE&P are exhausted.

Effective Date

The proposed regulations will be effective in tax years beginning after the date they are published as final regulations. A taxpayer may apply the regulations in their entirely to tax years that begin on or before the date of publication as final regulations.

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The small business health insurance tax credit, created by the health care reform package, rewards employers that offer health insurance to their employees with a tax break. The credit is targeted to small employers; generally employers with 25 or fewer employees. In May 2010, the IRS issued Notice 2010-44, which describes the steps employers take to determine eligibility for the credit and how to calculate the credit.

Initial steps

1. Determine the employees taken into account for purposes of the credit.

Generally, any employee who performs services for you during the tax year is taken into account in determining your full-time employees (FTEs), average wages, and premiums paid. However partners and certain business owners are excluded. Additionally, family members of these owners and partners are also not taken into account as employees.

Example. A partnership employs five individuals, including one of the partners, Elise, and her spouse, Ron. For purposes of the credit, Elise and Ron are not taken into account as employees in determining the number of FTEs for purposes of the credit.

2. Determine the number of hours of service performed by those employees.

An employee's hours of service include (1) each hour for which an employee is paid, or entitled to payment, for the performance of duties for the employer during the employer's tax year; and (2) each hour for which an employee is paid, or entitled to payment, by the employer on account of vacation, holiday, illness, and similar events. The IRS allows you to use one of three alternative methods to calculate hours of service: (1) actual hours of service; (2) days-worked equivalency; or (3) weeks-worked equivalency.

Example. Priscilla is an employee of ABC Co. ABC's payroll records show that Priscilla worked 2,000 hours and was paid for an additional 80 hours on account of vacation, holiday and illness in 2010. Priscilla performed 2,080 hours of service.

3. Calculate the number of full-time equivalent (FTE) employees.

Employers use a formula to calculate the number of FTEs. Total hours of service credited during the year to qualified employees (but not more than 2,080 hours for any employee) are divided by 2,080. The result, if not a whole number, is then rounded to the next lowest whole number.

Example. An employer pays five employees wages for 2,080 hours each, pays three employees wages for 1,040 hours each, and pays one employee wages for 2,300 hours. The employer's FTEs would be calculated as follows:

(1) Total hours of service not exceeding 2,080 per employee is the sum of:

(a) 10,400 hours of service for the five employees paid for 2,080 hours each (5 x 2,080);

(b) 3,120 hours of service for the three employees paid for 1,040 hours each (3 x 1,040); and

(c) 2,080 hours of service for the one employee paid for 2,300 hours (the lesser of 2,300 and 2,080).

The sum of (a), (b) and (c) equals 15,600 hours of service.

(2) The hours of service -- 15,600 -- are divided by 2,080, which equals 7.5. That number is rounded to the next lowest whole number, which is seven. The employer has seven FTEs.

4. Determine the average annual wages paid per FTE.

Employers also use a formula to determine average annual wages paid for a tax year. The amount of total wages paid to qualified employees is divided by the number of the employer's FTEs for the year. The result is then rounded down to the nearest $1,000 (if not otherwise a multiple of $1,000).

Example. XYZ Co. has 10 FTEs and pays average annual wages of $224,000 for the 2010 tax year. The amount of XYZ's average annual wages is $224,000 divided by 10, which equals $22,400. When rounded down to the nearest $1,000, is $22,000.

5. Determine the amount of premiums paid by the employer.

Only premiums paid by the employer for health insurance coverage are counted in calculating the credit. If an employer pays only a portion of the premiums for the coverage provided to employees (with employees paying the rest), only the portion paid by the employer is taken into account.

However, an employer's premium payments are not taken into account for purposes of the credit unless the payments are for health insurance coverage under a qualifying arrangement. Generally, this is an arrangement under which the employer pays premiums for each employee enrolled in health insurance coverage offered by the employer in an amount equal to a uniform percentage (not less than 50 percent) of the premium cost of the coverage.

Additionally, the amount of an employer's premium payments taken into account in calculating the credit is limited to the premium payments the employer would have made under the same arrangement if the average premium for the small group market in the state (or an area within the state) in which the employer offers coverage were substituted for the actual premium.

Example. MNO Co. offers a health insurance plan with single and family coverage to its nine FTEs with average annual wages of $23,000 per FTE. Four employees are enrolled in single coverage and five are enrolled in family coverage.

MNO pays 50 percent of the premiums for all employees enrolled in single coverage and 50 percent of the premiums for all employees enrolled in family coverage. The premiums are $4,000 a year for single coverage and $10,000 a year for family coverage. The average premium for the small group market in employer's State is $5,000 for single coverage and $12,000 for family coverage.

MNO's premium payments for each FTE ($2,000 for single coverage and $5,000 for family coverage) do not exceed 50 percent of the average premium for the small group market in employer's state ($2,500 for single coverage and $6,000 for family coverage).

The amount of premiums paid by the employer for purposes of computing the credit equals $33,000 ((4 x $2,000) + (5 x $5,000) = $33,000).

Calculating the credit

After determining eligibility for the credit, employers calculate the amount of their credit. The maximum credit is 35 percent for employers with 10 or fewer FTEs paying average annual wages of not more than $25,000. The maximum credit for a tax-exempt employer is 25 percent. The maximum 35 percent and 25 percent credits are available for 2010 through 2013. The maximum amounts rise for 2014 and 2015, but at that time the credit is linked to an employer's participation in a state insurance exchange.

The credit is subject to phase-out. The credit is reduced by 6.667 percent for each FTE in excess of 10 employees and by four percent for each $1,000 that average annual compensation paid to an employee exceeds $25,000.

The following examples illustrate calculation of the credit:

Small for-profit employer

PRS Co. employs nine FTEs with average annual wages of $23,000 per FTE for the 2010 tax year. PRS pays $72,000 in health insurance premiums for those employees (which does not exceed the average premium for the small group market in the employer's state) and otherwise meets the requirements for the credit. PRS's credit for 2010 is $25,200 (35 percent x $72,000).

Small tax-exempt employer

TUV employs 10 FTES with average annual wages of $21,000 per FTE for the 2010 tax year. TUV pays $80,000 in health insurance premiums for its employees (which does not exceed the average premium for the small group market in the employer's state) and otherwise meets the requirements for the credit. The total amount of the employer's income tax and Medicare tax withholding plus the employer's share of the Medicare tax equals $30,000 in 2010.

The credit is calculated as follows: (1) The initial amount of the credit is determined before any reduction: (25 percent x $80,000) = $20,000; (2) The employer's withholding and Medicare taxes are $30,000; (3) the total 2010 tax credit equals $20,000 (the lesser of $20,000 and $30,000).

We've covered a lot of material. Please contact our office if you have any questions about the small employer health insurance tax credit.

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The health care reform package (the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010) imposes a new 3.8 percent Medicare contribution tax on the investment income of higher-income individuals. Although the tax does not take effect until 2013, it is not too soon to examine methods to lessen the impact of the tax.

Net investment income

"Net investment income" includes interest, dividends, annuities, royalties and rents and other gross income attributable to a passive activity. Gains from the sale of property not used in an active business and income from the investment of working capital are also treated as investment income. Further, an individual's capital gains income will be subject to the tax. This includes gain from the sale of a principal residence, unless the gain is excluded from income under Code Sec. 121, and gains from the sale of a vacation home. However, contemplated sales made before 2013 would avoid the tax.

The tax applies to estates and trusts, on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute.

However, the tax will not apply to nontaxable income, such as tax-exempt interest or veterans' benefits.

Deductions

Net investment income is gross income or net gain, reduced by deductions that are "properly allocable" to the income or gain. This is a key term that the Treasury Department expects to address in guidance, and which we will update on developments. For passively-managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.

For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property's basis. It also focuses on investment expenses that may reduce net gains: interest on loans to purchase investments, investment counsel and advice, and fees to collect income. Other costs, such as brokers' fees, may increase basis or reduce the amount realized from an investment. As such, taxpayers may want to consider avoiding installment sales with net capital gains (and interest) running past 2012.

Thresholds

The tax applies to the lesser of net investment income or modified AGI above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married filing separately. MAGI is your AGI increased by any foreign earned income otherwise excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not work overseas.

Example. Jim, a single individual, has modified AGI of $220,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($220,000) over the threshold amount for an individual ($200,000), or $20,000. The tax is 3.8 percent of $20,000, or $760. In this case, the tax is not applied to the entire $40,000 of investment income.

Exceptions to the tax

Certain items and taxpayers are not subject to the 3.8 percent Medicare tax. A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. There is no exception for distributions from nonqualified deferred compensation plans subject to Code Sec. 409A. However, distributions from these plans (including amounts deemed as interest) are generally treated as compensation, not as investment income.

The exception for distributions from retirement plans suggests that potentially taxable investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities, and IRAs, or to 409A deferred compensation plans. Increasing contributions will reduce income and may help you stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, if they have not yet established a plan, and should consider increasing their contributions to existing plans.

Another exception is provided for income ordinarily derived from a trade or business that is not a passive activity under Code Sec. 469, such as a sole proprietorship. Investment income from an active trade or business is also excluded. However, SECA (Self-Employment Contributions Act) tax will still apply to proprietors and partners. Income from trading in financial instruments and commodities is also subject to the tax.

The additional 3.8 percent Medicare tax does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity's property would be from an active trade or business. The tax also does not apply to business entities (such as corporations and limited liability companies), nonresident aliens (NRAs), charitable trusts that are tax-exempt, and charitable remainder trusts that are nontaxable under Code Sec. 664.

Income tax rates

In addition to the tax on investment income, certain other tax increases proposed by the Obama administration may take effect in 2011. The top two marginal income tax rates on individuals would rise from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum tax rate on long-term capital gains would increase from 15 percent to 20 percent. Moreover, dividends, which are currently capped at the 15 percent long-term capital gain rate, would be taxed as ordinary income. Thus, the cumulative rate on capital gains would increase to 23.8 percent in 2013, and the rate on dividends would jump to as much as 43.4 percent. Moreover, the thresholds are not indexed for inflation, so more taxpayers may be affected as time elapses.

Please contact our office if you would like to discuss the tax consequences to your investments of the new 3.8 percent Medicare tax on investment income.

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The answer is no for 2010, but yes, in practical terms, for 2014 and beyond. The health care reform package (the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010) does not require individuals to carry health insurance in 2010. However, after 2013, individuals without minimum essential health insurance coverage will be liable for a penalty unless otherwise exempt.

Shared responsibility

The health care reform package describes health insurance coverage as "shared responsibility." Individuals, employers, the federal government, and the states all have roles to play in guaranteeing that individuals do not lack minimum essential health insurance coverage.

The health care reform package assumes that employer-provided health insurance will continue to be the primary means of delivering coverage after 2013. The health care reform package includes measures that lawmakers hope will keep premium costs down along with tax incentives, so employers continue to offer health insurance. For larger employers (those with 50 or more employees), that "encouragement" is also combined with penalties if alternate health insurance is not offered.

Millions of Americans are also currently covered by Medicaid, Medicare and other government programs. They will continue to be covered by these programs after 2013. Indeed, some of these government programs will be expanded between now and 2013, covering more individuals.

Individual responsibility

Beginning in 2014, the health care reform package imposes a penalty on individuals for each month they fail to have minimum essential health insurance coverage for themselves and their dependents. Another name for the penalty is "shared responsibility payment."

As a baseline, all individuals without minimum essential health insurance coverage will be liable for the penalty. However, the health care reform package expressly excludes certain individuals from liability for the penalty. They include:

Individuals whose household income is below their income thresholds for filing a federal income tax return;
Individuals who are exempt on religious conscience grounds;
Individuals whose contribution to employer-provided coverage exceeds a threshold percentage;
Hardship cases;
Native Americans;
Undocumented aliens;
Incarcerated individuals;
Individuals with short lapses of minimum essential coverage;
Individuals covered by Medicare, Medicaid and other government programs; and
Certain individuals outside the U.S.

Amount of penalty

The monthly penalty after 2013 is 1/12 of the flat dollar amount or a percentage of income, whichever is greater. For 2014, the flat dollar amount is $95 and the percentage of income is one percent. The flat dollar amount rises to $695 in 2016 (indexed for inflation thereafter) and the percentage of income increases to 2.5 percent.

For individuals under age 18, the flat dollar amount is 50 percent of the amount for adults. Generally, a family's total penalty cannot exceed $285 for 2014 (rising to $2,085 by 2016) or the national average annual premium for the "bronze" level of coverage through a state insurance exchange. By 2014, each state must establish an insurance exchange where individuals can shop for health insurance coverage. The exchanges will have four levels of coverage: bronze, silver, gold, and platinum.

Example. Ana, age 38, is self-employed with a modified adjusted gross income (AGI) of $68,500 for 2014. Ana does not have minimum essential coverage for all 12 months of 2014 and is not exempt from carrying minimum essential coverage because of income or other qualifying reasons. Ana will be liable for a penalty of the greater of $95 or one percent of her modified AGI.

Example. Ana's mother, Barbara, is enrolled in Medicare. Barbara has minimum essential coverage because she is enrolled in Medicare and is not liable for a penalty.

Health insurance tax credits

At the same time the individual responsibility requirement kicks in, the health care reform package provides a refundable health insurance premium assistance tax credit to qualified persons. The premium assistance credit will operate on a sliding scale based on an individual's relationship to the federal poverty level (between 100 and 400 percent).

The healthcare reform package makes the premium assistance tax credit refundable and also provides for advance payment of the credit. Advance payment will be made to the health plan in which the individual is enrolled.

Adult children

There is one important change regarding individual coverage for 2010. Effective September 23, 2010, the health care reform package enables more young adults to remain on their parents' health insurance policies. Generally, employer-sponsored group health plans will be required to provide coverage for adult children up to age 26 if the adult child is ineligible to enroll in another employer-sponsored plan. The health care reform package also extends the employer-provided health coverage gross income exclusion to coverage for adult children under age 27 as of the end of the tax year.

Guidance

The IRS, the U.S. Department of Health and Human Services and other federal agencies are expected to issue extensive guidance on the individual responsibility mandate. Our office will keep you posted on developments.

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On March 18, 2010, President Obama signed the Hiring Incentives to Restore Employment (HIRE) Act. The $18 billion HIRE Act is expected to be the first of several "jobs" bills out of Congress in 2010. The new law encourages companies to hire unemployed workers and also retain existing workers by providing two key tax incentives: payroll tax relief and a worker retention tax credit. Employers can take a tax credit of up to $1,000 for the year if they hire an unemployed worker and retain the new worker for at least one year.

Payroll tax forgiveness

The Federal Insurance Contributions Act (FICA) is made up of two taxes: Old-Age, Survivors and Disability Insurance (OASDI) (Social Security) and hospital insurance (HI)(Medicare). Employers pay OASDI tax equal to 6.2 percent of an employee's taxable wages up to $106,800. The HIRE Act temporarily lifts the employer's 6.2 percent OASDI tax.

The covered employee must be on the employer's payroll after February 3, 2010 and before January 1, 2011. However, payroll tax forgiveness applies only to wages paid to covered employees after March 18, 2010 and before January 1, 2011.

Example #1. Ann is hired as a full-time employee working 40 hours each week by ABC Co. Ann's hire date is January 31, 2010. On March 19, ABC Co. hires Nate as a full-time employee working 40 hours each week. On April 30, ABC Co. hires Cai as a full-time employee working 40 hours each week. Ann is not a covered employee for purposes of the HIRE Act because she began employment with ABC Co. before February 3, 2010. Cai and Nate are covered employees under the HIRE Act because their start dates are after February 3, 2010 and they are on the company's payroll after March 18, 2010.

The HIRE Act requires that employees certify they had not been employed for more than 40 hours during the 60-day period ending on the date their employment with the qualified employer began. The IRS is developing a form that employers can use to obtain the certification from covered employees.

Example #2. In example #1, Cai and Nate were covered employees under the HIRE Act because their start dates with ABC Co. were after February 3, 2010 and they were on the payroll after March 18, 2010. Before coming to work for ABC Co., Cai was employed full-time (40 hours per week) by XYZ Co. between November 1, 2002 and April 29, 2010 (one day before her date of hire by ABC Co.). Consequently, Cai cannot certify that she had not been employed for more than 40 hours during the 60-day period ending on the date of her employment with ABC Co.

A covered employee must not replace another employee of the employer, with some exceptions. The exceptions cover employees who voluntarily quit and employees who are fired for cause. Additionally, the covered employee must not be related to the employer or own a certain share of the employer's business. Some employees, for example household employees, are expressly excluded from the HIRE Act.

Retained worker tax credit

As part of the general business credit, the HIRE Act allows employers to claim a worker retention credit. For each qualified employee, the employer's general business credit is increased by the lesser of $1,000 or 6.2 percent of the retained worker's wages paid during a 52-week consecutive period.

The covered employee must be on the employer's payroll after March 18 and continue in employment for at least 52 consecutive weeks. Additionally, the covered employee's wages during the last 26 weeks of the 52 consecutive week period must equal at least 80 percent of the wages paid during the first 26 weeks of that period.

Example #3. In example #1, Nate was a covered employee under the HIRE Act because his start date with ABC Co. was after February 3, 2010. Additionally, Nate qualified his employer for payroll tax forgiveness because he was on the company's payroll after March 18, 2010. At the close of business on September 24, 2010, Nate resigns from ABC Co. Consequently, ABC Co. may claim payroll tax forgiveness for Nate for the period between March 19, 2010 and September 24, 2010 but ABC Co. cannot claim the retained worker tax credit because Nate did not remain employed with the company for at least 52 consecutive weeks.

Employers will need to maintain careful records with respect to each new employee hired in order to show that the new worker qualifies the employer for the credit. It is presumed that the IRS will begin crafting a form to be used by employers in order to claim the credit.

Please contact our office if you have any questions about the HIRE Act. The business incentives are temporary, so don't delay.

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Health care reform is now law and many employers are asking how does it affect my business and my employees? The first thing to keep in mind is that reform is gradual. The health care reforms and tax provisions in the new health care reform package play out over time, with some taking effect this year or next year but others not until 2014 and beyond. However, the health care package imposes significant new responsibilities and taxes on employers and individuals so it is not too early to start preparing.

Two new laws

Health care reform is actually made up of two new laws. The first is the Patient Protection and Affordable Care Act of 2010, signed by President Obama on March 23. The second is the Health Care and Education Reconciliation Act of 2010, signed by the president on March 26. The Patient Protection Act, which reflects the Senate's original health care reform bill, provides the overall framework for reform. The Reconciliation Act was drafted in the House to make changes to the Patient Protection Act, especially in the area of cost-sharing and in some of the revenue raisers.

Employer responsibility

The final health care package, unlike earlier versions, does not include an employer mandate. However, any employer with more than 50 full-time employees that does not offer health insurance and has at least one full-time employee receiving a premium assistance tax credit or cost-sharing will pay a per-employee penalty. An employer with more than 50 full-time employees that offers coverage that the government deems unaffordable or fails to meet minimum standards and has at least one full-time employee receiving a premium assistance tax credit or cost-sharing also will pay a per-employee penalty. Small employers with less than 50 employees will not be penalized in any case. The penalty rules apply starting in 2014.

Small employers that provide health insurance coverage are eligible for a new tax credit. A sliding scale tax credit is available immediately in 2010 for qualified small employers. The IRS is expected to make guidance for the new credit a priority. If your small business offers or is thinking of offering health insurance to your workers, the credit could generate significant cost-savings. Please contact our office and we can discuss the details of the credit in depth.

Individual responsibility

Unlike employers, individuals have a mandate under the health care reform package. Beginning in 2014, most individuals will be responsible for maintaining health insurance coverage for themselves and their dependents. If they do not have minimum essential coverage, they will be liable for a penalty.

The health care package excludes many individuals from the mandatory coverage requirement. Any individual or family who currently has coverage can retain that coverage under a "grandfather" provision. Individuals with incomes below the federal filing threshold, religious objectors, individuals covered by Medicaid and Medicare and others are also exempt.

The health care package provides a premium assistance tax credit and cost-sharing to help make coverage more affordable. The premium assistance tax credit is calculated on a sliding scale based on the individual's income in relation to the federal poverty level. Cost-sharing reduces the cost of coverage for qualified individuals. The premium assistance tax credit and cost-sharing generally will be available after 2013.

High-dollar plans

One of the principal revenue raisers to fund health care reform is a new excise tax on high-dollar health insurance plans. The health care reform package imposes an excise tax of 40 percent on insurance companies or plan administrators for any health insurance plan with an annual premium in excess of $10,200 for individuals and $27,500 for families. The excise tax applies to the amount in excess of the $10,200/$27,500 levels. The thresholds are higher for individuals in high-risk occupations and individuals over age 55. The excise tax will not kick in until 2018.

Medicare additional tax and surtax

Changes to the hospital insurance (HI)(Medicare) tax also fund health care reform. These changes impact higher-income individuals and families.

The health care reform package increases the Medicare tax by 0.9 percent for individuals who receive wages in excess of $200,000 (the threshold increases to $250,000 for married couples who file a joint federal income tax return). Additionally, the new law imposes a 3.8 percent surtax (called the Unearned Income Medicare Contribution) on investment income for individuals with adjusted gross incomes above $200,000 ($250,000 for married couples filing jointly). Investment income includes income from interest and dividends.

The additional Medicare tax on wages and the additional Medicare contribution on investment income take effect in 2013, so taxpayers have some time to prepare. Please contact our office for more details about how these tax changes may impact you.

Flexible spending arrangements

Flexible spending arrangements (FSAs) are a very popular way to save and pay for health care expenses. One of the most attractive features is the ability to use FSA dollars for over-the-counter medications. The health care reform package ends that feature after 2010.

In 2011 and subsequent years, FSA dollars can only be used to pay for prescription medications (with some limited exceptions). In 2013, the health care reform package limits the amount of contributions to health FSAs to $2,500 per year. The $2,500 amount will be indexed for inflation after 2013.

More provisions

The health care reform package als

Increases the AGI threshold for claiming the itemized deduction for medical expenses for regular tax purposes to 10 percent after 2012 with a delayed effective date for seniors;
Extends dependent coverage up to age 26;
Expands Medicaid eligibility;
Requires states to establish insurance exchanges to help individuals and small employers obtain coverage;
Increases the additional tax on distributions from health savings accounts (HSAs) not used for qualified medical expenses;
Eliminates the employer deduction for Medicare Part D;
Imposes annual fees on pharmaceutical manufacturers and health insurance providers;
Imposes an excise tax on medical device manufacturers;
Requires more corporate information reporting;
Imposes new requirements on non-profit hospitals;
Accelerates some corporate estimated income taxes in 2014;
Imposes an excise tax on indoor tanning services;
Codifies the economic substance doctrine; and
Modifies the biofuel credit.

In the coming months and years, the IRS and other federal agencies will issue many new rules and regulations to implement health care reform. Our office will keep you posted of developments, and, as always, please contact us if you have any questions.

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As 2010 unfolds, small businesses are confronted with tax challenges and opportunities on many fronts. Lackluster consumer spending, combined with tight credit, has many small businesses in a holding pattern. Congress may respond with a new tax credit to encourage hiring. Small businesses are also faced with uncertainty over many temporary provisions in the federal Tax Code. Many of these incentives have expired. At the same time, small businesses are uncertain how health care reform, the fate of the federal estate tax and proposed retirement savings initiatives may impact them.

Hiring and retention tax credit

To encourage businesses to hire more workers, the Senate has passed a hiring and retention tax credit (Hiring Incentives to Restore Employment Act). The credit exempts employers from paying the 6.2 percent Social Security tax for qualified new hires up to the Social Security wage base of $106,800. The new hire must have been unemployed for at least 60 days and added to the employer's payroll before January 1, 2011. Employers would also be eligible for an additional $1,000 tax credit for each new hire that they keep on the payroll for at least 52 consecutive weeks.

The House has not scheduled a vote on the Senate's hiring and retention credit and it is unclear if it will. The House approved a jobs bill late last year (Jobs for Main Street Act, H.R. 2847), which does not include a hiring and retention credit.

Extenders

Businesses may be surprised that some of the tax breaks they took in 2009 are not available in 2010. That's because many of these popular business tax incentives are temporary and they expired at the end of 2009. They include the research tax credit, 15-year recovery periods for qualified leasehold improvement, restaurant, and retail improvement property, enhanced corporate contributions to qualified organizations, special incentives for producers of alternative energy, and others.

In December 2009, the House approved legislation extending these temporary business incentives through December 31, 2010 (Tax Extenders Act of 2009, H.R. 4213). The Senate, however, has yet to act on the House bill or vote on its own version of an extenders package. Traditionally, the extenders have been renewed but this year there is a chance that renewal may be later rather than sooner. High unemployment numbers have Congress focused on job creation. A growing number of lawmakers view many of the extenders as having little if any impact on immediate job creation in the private sector.

Expensing/bonus depreciation

Under a temporary provision expiring at the end of 2009, taxpayers could expense up to $250,000 in annual investment expenditures for qualified property. The maximum amount that could be expensed for property placed in service in 2009 was reduced by the amount that the qualified property exceeded $800,000. The Obama administration has proposed extending enhanced Code Sec. 179 expensing, with the $250,000/$800,000 threshold, through December 31, 2010. The Senate approved an extension in its jobs bill and the House approved an extension last year but the chambers have yet to approve the extension in a common bill that they can send to the White House for the president's signature.

Another expired pending incentive is bonus depreciation. Under a temporary provision, an additional first-year depreciation deduction equal to 50 percent of the adjusted basis of the property was provided for qualified property acquired and placed in service before January 1, 2010. The Obama administration has proposed extending bonus depreciation through December 31, 2010. The House approved an extension last year but the Senate has not. There is growing sentiment among some senators that the extension of bonus depreciation into 2010 would be an expensive "budget buster" not worth the price tag.

Health care reform

Health care reform, which dominated the news in recent months, has been on the back burner as lawmakers have switched their attention to jobs. However, health care reform remains a priority of the Obama administration. Some form of a reform package may be enacted in 2010 and it could impose new mandates on employers.

The House health care reform bill (Affordable Health Care for America Act, H.R. 3962) would require employers to satisfy certain minimum coverage requirements. Otherwise, the employer would be liable for an additional payroll tax. Small employers, generally businesses with annual payrolls below $500,000, would be exempt. The Senate health care reform bill (Patient Protection and Affordable Care Act, H.R. 3590) does not require employers of any size to provide health insurance coverage.

Estate tax

Many small business owners are reviewing their estate plans after the federal estate tax expired January 1, 2010. Effective for decedents dying on and after January 1, 2010 and on or before December 31, 2010 the federal estate tax is replaced with a carryover basis regime. Generally, the income tax basis of property acquired from a decedent is carried over from the decedent. Executors may partially increase the basis of property by up to $1.3 million ($3 million in the case of property passing to a surviving spouse).

The House passed a bill late last year extending the 2009 estate tax into 2010 (Permanent Estate Tax Relief Bill of 2009, H.R. 4154). However, the Senate has not acted on the House bill. Democratic leaders have said the Senate will vote on an extension but have not laid out a timetable. If you have not reviewed your estate plans in light of the expiration of the federal estate tax, please contact our office.

Retirement plans

The Obama administration proposes requiring employers that do not currently offer a retirement plan to offer their employees automatic enrollment in an individual retirement account (IRA). Small businesses (generally employers with 10 or fewer employees) would be exempt from the proposed requirement. The administration's proposal would be effective for tax years beginning after January 1, 2011. Qualified employers would be eligible for a temporary tax credit of $25 for each employee up to a total credit of $250 per year for a maximum of two years.

At the same time, the administration proposes to enhance the existing tax incentive for small employers that establish a retirement plan. Under current law, employers with 100 or fewer employees that adopt a new qualified retirement plan are entitled to a temporary tax credit equal to 50 percent of their expenses to establish and administer the plan. The credit is limited to $500 per year for three years. The administration has asked Congress to double the tax credit to $1,000 per year for three years. The administration's proposal would be effective for tax years beginning after January 1, 2011.

Employment tax audits

In addition to trying to cope with the changing tax laws, small businesses should be aware that the IRS has identified their group as a target for vigorous tax audits. Recent surveys have confirmed for the IRS that the small business environment presents easy opportunities for some "bad apples" to cheat on their taxes. Armed with those statistics as justification, the IRS is now aggressively looking to small businesses to help close "the tax gap," the difference between what taxpayers owe and what is actually collected. One initial area of concern involves employment taxes.

The IRS recently launched a special study of employment tax compliance. The IRS will randomly audit 2,000 taxpayers, including small businesses, each year for the next three years. Employers selected for the study will receive notices from the IRS. According to the IRS, these examinations will be comprehensive, will look at all aspects of employment tax compliance, and will be used to form more effective criteria for auditing many more small businesses.

If you have any questions about the tax opportunities and challenges we have discussed, please contact our office.

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People are buzzing about Roth Individual Retirement Accounts (IRAs). Unlike traditional IRAs, "qualified" distributions from a Roth IRA are tax-free, provided they are held for five years and are made after age 59 1/2, death or disability. You can establish a Roth IRA just as you would a traditional IRA. You can also convert assets in a traditional IRA to a Roth IRA.

Before 2010, only taxpayers with adjusted gross income of $100,000 or less were eligible to convert their traditional IRA (provided they were not married taxpayers filing separate returns). Beginning in 2010, anyone can convert a traditional IRA to a Roth IRA, regardless of income level or filing status.

Comment: While you can only contribute a maximum of $5,000 to a Roth IRA for 2010 (plus a $1,000 catch-up contribution if you are over age 50), you can convert an unlimited amount from a traditional IRA.

Conversion is treated as a taxable distribution of assets from the traditional IRA to the IRA holder, although it is not subject to the 10 percent tax on early distributions. While paying taxes on conversion is undesirable, the advantages of holding assets in a Roth IRA usually outweigh this disadvantage, especially if you will not be retiring soon. Furthermore, if you convert assets in 2010, you have the option of including them in income in 2011 and 2012 (50 percent each year) instead of 2010.

Comment: Generally, this income-splitting would be advantageous to any taxpayer who does not expect a sharp increase in income in 2011 or 2012. A wildcard factor is that the lower income tax rates that have been in effect since 2001 will expire after 2010 and could increase in 2011.

There are four ways to convert a traditional IRA to a Roth IRA:

A rollover - you receive a distribution from a traditional IRA and roll it over to a Roth IRA within 60 days;
Trustee-to-trustee transfer - you direct the trustee of the traditional IRA to transfer an amount to the trustee of a Roth IRA;
Same-trustee transfer - the trustee of the traditional IRA transfers assets to a Roth IRA maintained by the same trustee; or
Redesignation - you designate a traditional IRA as a Roth IRA, instead of opening a new Roth account.

Comment: The account holder does not have to convert all of the assets in the traditional IRA.

Another advantage of converting assets from a traditional IRA to a Roth IRA is that you can change your mind and put the assets back into the traditional IRA. This is known as a recharacterization. You have until the due date, with extensions, for the return filed for the year of conversion. Thus, if you convert assets in 2010, you have until mid-October in 2011 to undo the conversion.

This ability to recharacterize the conversion allows you to use hindsight to check whether your assets declined in value after the conversion. Since you are paying taxes on the amount converted, a decline in asset value means that you paid taxes on phantom income that no longer exists. However, if you convert assets into multiple Roth IRAs, you can choose to recharacterize the assets in a Roth IRA that decreased in value, while maintaining the conversion for a Roth IRA's assets that appreciated in value.

The use of a Roth IRA can be a savvy investment, but whether to convert assets is not an easy decision. If you would like to explore your options, please contact this office.

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