Copyright 1996 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
Subject to certain restrictions, a taxpayer can elect to expense, instead of depreciate, up to $17,500 in personal property in any one year. The new law increases this limit in stages until it reaches $25,000 in 2003. Here's the phasein:
Tax years beginning in: Maximum expensing:Remember, the expense election applies to property placed in service during the year. That's not necessarily the same as the purchase date.1997 $18,000 1998 18,500 1999 19,000 2000 20,000 2001 24,000 2002 24,000 2003 and subsequent 25,000
Example--At the end of 1997 Fred Flood buys and places in service a computer, printer and office furniture costing $22,000. He can elect to expense $18,000 of the total cost. The remaining $4,000 must be depreciated under the usual rules.
If Fred had ordered and paid for the equipment, but it was not delivered until 1998, it would not be considered placed in service in 1997 and he could only make the expense election for 1998.
The new law makes it clear that property outside the U.S., property used predominantly in connection with furnishing lodging, property used by a tax-exempt organization, and air conditioning and heating units do not qualify for the expense election. The definition of lodging does not include a hotel or motel used by transients. Thus, furniture used in a hotel or motel can be expensed; the same furniture used in a house you rent on annual basis can't be.
Even if you don't qualify for a home office deduction under the regular rules, you might be able to deduct the portion of your home used to store inventory for your trade or business of selling products at retail or wholesale, but only if the home is the sole fixed location of the business. The new law expands this rule to include product samples as well as inventory. This rule applies to tax years beginning after December 31, 1995.
Example--Susan Sanders is a manufacturer's rep for Madison Electronics. Since all of Susan's income is generated at customer's sites, she doesn't qualify for a regular home office deduction. However, she uses 400 square feet of her basement to store product samples. The space now qualifies for a home office deduction.
A 1993 law change provided a business tax credit on certain employer FICA taxes paid with respect to tips treated as paid by the employer. The credit applies to tips received from customers in connection with the provision of food or beverages for consumption on the premises of an establishment where tipping is customary.
The new law clarifies that the credit is available whether or not the employee reported the tips on which the employer FICA taxes were paid, and, effective with respect to taxes paid after December 31, 1993, regardless of when the services associated with the tips, were performed.
In addition, effective for services performed after December 31, 1996, the law also applies to tips received from customers in connection with the delivery or serving of food or beverages, regardless of whether the food or beverages are for consumption on the premises.
Tax-exempt organizations generally are subject to the unrelated business income tax (UBIT) on income derived from a trade or business not substantially related to the organization's tax-exempt functions.
Under the new law, if an agricultural or horticultural organization described in code section 501(c)(5) requires annual dues of $100 or less to be a member of the organization, then no portion of the dues will be subject to the UBIT. The $100 is to be indexed for inflation. The change applies to tax years beginning after December 31, 1986.
Generally, if business or investment property is destroyed in a casualty, you must use any insurance proceeds to purchase property similar or related in service or use within an applicable time period. If you don't meet these requirements, you must recognize any gain on the conversion. The similar or related in service or use requirement is important.
Under the new law, any tangible property acquired and held for productive use in a business is treated as similar or related in service or use to property held for investment or for productive use in a business. The modification only applies to Presidentially declared disaster areas, effective for declarations after December 31, 1994.
Comment--Under the old rule if a truck used in your business was destroyed in a hurricane, buying a computer for the business wouldn't qualify as replacement property. Under the new rule the computer does qualify and you can defer any gain.
While the provision above will benefit many taxpayers, this one plugs an obscure loophole. Instead of buying property to replace that destroyed in a casualty, you can purchase a controlling interest in the stock of a corporation that owns replacement property. Your basis in the replacement property (stock here) is generally the same as your basis in the destroyed ('converted' in tax parlance) property, decreased by the amount of any money or loss recognized and increased by the amount of any gain recognized.
Example--Fred Flood owns a factory with an adjusted basis of $100,000. The property is destroyed in a fire and Fred receives $500,000 in insurance. Instead of purchasing a similar building, he buys all the stock of Madison Inc. which owns a similar building. Madison's adjusted basis in the building is also $500,000. The purchase of stock qualifies as replacement property. Fred's basis in the stock is $100,000. Madison's basis in the building is $500,000. Thus, if Madison sells the building for $500,000, it will report no gain or loss.
Under the new law, Fred's basis in the replacement stock would be the same, but, in addition, the corporation must reduce its basis in its assets by the amount by which the taxpayer reduces its basis in the stock. The corporation's adjusted basis in the assets will not be reduced below the taxpayer's basis in its stock (determined after the appropriate basis adjustment). The basis reduction is applied first to property that is similar or related in service or use to the converted property, then to other depreciable property, and finally to other property.
Example--Assume the facts are the same as in the example above. Only now the new law applies. Fred must reduce his basis in the stock to the same amount, $100,000. In addition, Madison Inc. must reduce its basis in the building to $100,000 also. That means that Madison must reduce its depreciation and has a lower basis for gain or loss. Now if Madison sells the building for $500,000, it'll have to report a gain of $400,000.
Comment--You'll have to work through the numbers, but now buying stock instead of assets as replacement property could be a big mistake. The gain of $400,000 in the second example is just the tip of the iceberg. If the cash remaining after the sale and taxes is distributed to the shareholder, they'll be another tax due. Buying stock may make sense if (1) you can get a bargain because the selling shareholders will avoid the double tax on their sale and (2) you have no intention of liquidating the corporation or selling the assets in the near term.
This provision is effective for involuntary conversions after August 20, 1996.
Under prior law an employee could exclude from gross income amounts paid by the employer for educational assistance provided to the employee if made pursuant to an educational assistance program that met certain requirements. The exclusion was limited to $5,250 per calendar year. The exclusion applied whether or not the education was job related.
The new law retroactively extends the exclusion for tax years beginning after December 31, 1994. The exclusion is now scheduled to expire June 30, 1997. Thus, for 1997 only expenses paid for courses beginning on or before that date will qualify.
There is one major change in the law. Payments for graduate level courses beginning after June 30, 1996 are not excludable.
Many employers thought the law was going to be extended and excluded educational assistance from employees' W-2s. The IRS has been directed to develop expedited procedures for refunding any interest and penalties that might have been imposed.
On the other hand, if an employer filed forms W-2 reporting the amount of educational assistance as taxable wages, they must file forms W-2c with the IRS and the employee must file a 1040X (amended return) to secure a refund. Employers will also have to request a refund of employment taxes paid. The IRS has been directed to establish expedited procedures for the refund of any overpayment of taxes paid in 1995.
Comment--The IRS will probably issue a revenue ruling or announcement shortly specifying the exact procedures to be used in both the above situations. We suggest waiting until that's done. Filing before any announcement could delay refunds.
Tax Tip--The educational assistance exclusion can be applied to any courses that meet the requirements of the prior law. Thus, assistance provided to a secretary who's taking electrical engineering courses is excludable under this provision. Even without this provision, you can exclude assistance provided in the employee's field. For example, you can exclude a reimbursement for an engineering course taken by an engineer. The course qualifies under a different section of the law and there is no maximum on the amount that can be excluded. Furthermore, graduate courses can qualify under that section.
Nonresidential buildings must generally be depreciated over 39 years. Property used in the retail gasoline trade can generally be depreciated over 15 years using an accelerated method. The IRS has taken a more limited view of the law than many taxpayers, holding that many convenience stores associated with gas stations must be depreciated over 39, not 15 years.
Under the new law a retail motor fuels outlet, whether or not food or other convenience items are sold at the outlet, qualifies for the more rapid depreciation as long as either 50% or more of the gross revenue from the property is from petroleum sales or 50% or more of the floor space in the property is devoted to petroleum marketing sales. The determination of whether or not the property meets the requirement will generally be made in the year the property is placed in service.
Tax Tip--This provision is retroactive. Check with your tax advisor. You may be able to claim extra depreciation for prior years.
Prior law was unclear on what happens when a lessor disposes of a leasehold improvement that the lessor made. The law now makes it clear that a lessor that disposes of (or abandons) a leasehold improvement (made for a lessee) at the end of a lease, may take a tax deduction for any unadjusted basis remaining. The lessor must be able to separately account for the adjusted basis of the leasehold improvement abandoned. This is effective for leasehold improvements disposed of after June 12, 1996.
Example--Madison Inc. owns a commercial building that it leases to tenants. It made certain improvements costing $10,000 to a tenant's space that were specifically designed for the tenant's needs. At the expiration of the lease the tenant left and the improvements were disposed of. The remaining basis was $9,000. The lessor received $500 for the scrap value. The lessor can take a $8,500 deduction.
The new law liberalizes the rules with respect to classification of workers as employees or independent contractors. It amends section 530 of the Revenue Act of 1978 which allows employers to avoid employment tax liability if the employer filed the required returns (1099s) and had a reasonable basis for treating the worker as an independent contractor. (We discussed the revised IRS audit procedures in our June 15, 1996 issue.)
The revisions are technical in nature. Here are the important points.
Prior audits. This one is the one change that is not good news. A taxpayer cannot rely on the outcome of an audit that starts after December 31, 1996 unless it included an examination for employment tax purposes of the worker involved or one holding a substantially similar position. This doesn't affect the rule for audits started before January 1, 1997.
Significant segment. In order to rely on industry practice you don't need to show that any more than 25% of the industry treats similar workers as independent contractors. A lower percentage may even be sufficient, depending on the facts and circumstances.
Long-standing practice. You will not be required to show industry practice has continued for any more than 10 years. Again, a shorter period may be sufficient, based on the facts.
Burden of proof. The new law modifies the burden of proof by providing that if a taxpayer establishes a prima facie case that it was reasonable not to treat the worker as an employee, the burden of proof shifts to the IRS. In order to shift the burden of proof the taxpayer must fully cooperate with reasonable IRS requests for information.
Reclassification. If you later reclassify a worker as an employee and pay employment tax, it will not compromise your classification of a worker for prior years.
IRS Notice. The IRS must provide notice to taxpayers at (or before) commencing an audit involving worker classification issues.
The new law replaces the Targeted Jobs Tax Credit that expired at the end of 1994 with the Work Opportunity Tax Credit for wages paid to a qualified individual who begins work after September 30, 1996 and before October 1, 1997. (Of course, it's possible the credit could be extended again.) Here are the highlights:
Credit percentage. The credit is equal to 35% of qualified first-year wages, but only the first $6,000 of wages are eligible. That translates to a maximum credit of $2,100. For qualified summer youth employees, the maximum eligible wages are $3,000. As with the prior credit, the deduction for wages is reduced by the amount of any credit taken.
Minimum employment. No credit is allowed for wages paid unless the eligible individual is employed for at least 180 days (20 days in the case of a summer youth employee) or 375 hours (120 hours for summer youth).
Targeted groups. The old credit had 10 targeted groups; the new law has 7. In addition, the definition of even the groups retained has changed in most cases.
Certification. An employer must obtain a written certification from the designated local agency that the individual is a member of a specific targeted group on or before the day an individual begins work. Alternatively, on or before the day the individual is offered work, a pre-screening notice is completed by the employer and within 21 days after the employee begins work the employer submits the notice to the designated local agency. The pre-screening notice contains the information provided to the employer that forms the basis of the employer's belief the individual is a member of a targeted group.
Comment-- The plus side here is that certification under the new law is somewhat easier. The negative is that, once again, the rules have changed and the credit is only available for a limited time. In addition, the range of individuals that are eligible for the credit is even narrower than before.
The new law revives the credit for increasing research expenditures, but only from July 1, 1996 through May 31, 1997. (The credit is generally equal to 20% of the amount by which a taxpayer's qualified research expenditures for a year exceeded its base amount for that year.)
There are three important changes to the old law. First, the definition of a start-up company has been expanded. Second, a taxpayer can elect an alternative 3-tiered approach instead of the standard 20% credit. Third, 75% of amounts paid to a qualified research consortium for qualified research can be treated as qualified research expenditures.
Comment-- If you think the credit is applicable to your business, check with your tax advisor regarding the election and details of the new rules.
Pluses and minuses here. The tax is extended for three years, through December 31, 2002. On the other hand, the tax rate has been reduced to 9% for 1996 and will fall to 8% in 1997; 7% in 1998; 5% in 2000; 4% in 2001; and 3% in 2002.
Comment--The reduced 9% rate applies to sales on or after August 27, 1996.
Tax Tip--Since the rate falls on January 1 in 1997 and 1998, consider making any luxury car purchases after the first of the year.
The new law also makes a technical change that corrects a error in the indexing of the threshold for the tax. For 1996 the tax applies to cars costing $34,000 or more.
State and local governments can issue bonds to finance loans to first-time farmers for the acquisition of land (and limited amounts of related depreciable farm property) if the purchasers will be the principal user of the property and will materially participate in the farming operation.
Under the new law the definition of a first-time farmer is expanded to include an individual who has at no time owned farm land in excess of 30% of the median size farm in the county. Second, these bonds may be used to finance purchases between related parties provided that (1) the price paid reflects the fair market value of the property and (2) the seller has, in general, no more than a 10% interest in the farming operation conducted on the land after the bond-financed sale occurs.
This provision is effective for financing provided with bonds after the date of enactment.
Is a person who delivers newspapers an employee, an independent contractor or a direct seller? The classification is important for tax purposes and usually depends on the facts and circumstances.
The new law clarifies the treatment of qualifying newspaper distributors and carriers as direct sellers. A person engaged in the business of delivery or distribution of newspapers or shopping news (including services directly related to the business such as solicitation of customers) qualifies as a direct seller, provided substantially all the remuneration for the performance of services is directly related to sales or other output rather than the number of hours worked and the services are performed pursuant to a written contract that provides that the person will not be treated as an employee for federal tax purposes. The rule applies even if the distributor hires others to assist in the delivery and applies to both a buy-sell or agency distribution system.
This provision is effective with respect to services performed after December 31, 1995.
The income forecast method is an allowable method for calculating depreciation for certain property. Under this method, the depreciation deduction for a year is determined by multiplying the cost of the property (less estimated salvage value) by a fraction, the numerator of which is the income generated by the property during the year and denominator of which is the total forecasted or estimated income to be derived from the property during its useful life. The method has been held to be applicable for computing depreciation deductions for motion picture and television films, and taped shows, books, patents, master sound recordings and video games. The total forecasted income to be derived from a property is to be based on the conditions known to exist at the end of the period for which depreciation is claimed.
Example--Madison Inc. introduces a new video game in early 1996. The game cost $1,000,000 to develop. It anticipates the total revenue to be $5,000,000 over a 5-year period. In 1996 the game produces $2,000,000 in revenue. Madison can take depreciation equal to 2/5ths of the $1,000,000 cost, or $400,000 in 1996.
Obviously, since depreciation for a year is ultimately dependent on an estimate, there is considerable room for 'error' in these calculations.
Because this depreciation method is so specialized, we won't discuss the changes in detail. Here are the highlights:
Comment--In general, the changes will have the effect of stretching the depreciation recovery over a longer period of time.
These provisions generally apply to property placed in service after September 13, 1995.
The Revenue Reconciliation Act of 1990 had inadvertently make a change in the depreciation rules. The new law clarifies that solar or wind property owned by a public utility qualifies as 5-year MACRS property.
The Act clarifies that any credit attributable to a working interest in an oil and gas property, in a taxable year in which the activity is no longer treated as being a nonpassive activity, will not be treated as attributable to a passive activity to the extent of any tax allocable to the net income from the activity for the taxable year. Any credits from the activity in excess of this amount of tax will continue to be treated as arising from a passive activity and will be treated under the rules generally applicable to the passive activity credit.
The Act clarifies the rule relating to the computation of the overall loss allowed upon the disposition of a passive activity. In a transaction in which all gain or loss is recognized on the disposition of a passive activity, any loss from the activity for the taxable year (taking into account all income, gain, and loss, including gain or loss recognized on the disposition) in excess of the net income or gain from other passive activities for the taxable year is treated as a nonpassive loss.
Example--In 1997 Fred Flood sells his shares in an S corporation where he was a passive investor. At the time of the sale he had suspended losses of $12,000 he could not use because of the passive loss limitations. Fred sells the shares for a $9,000 gain. In addition, Fred has $2,000 in passive income. The first step is to offset the $12,000 in suspended losses against the $9,000 gain. That leaves $3,000 in unused losses. Those must be offset against the $2,000 in passive income. As a result of the disposition, the remaining $1,000 of passive losses can be used to offset Fred's wages, interest or dividend income, etc.
The Act provides three new rules for determining the alternative minimum taxable income of a taxpayer that holds a residual interest in a REMIC.
First, the alternative minimum taxable income (AMTI) of the taxpayer is computed without regard to the REMIC rule that taxable income cannot be less than the amount of excess inclusions. This provision prevents a taxpayer from having to include in alternative minimum taxable income preference items for which it received no tax benefit.
Second, the AMTI for a taxable year cannot be less than the excess inclusions of the residual interests for that year. In effect, this provision prevents nonrefundable credits from reducing the taxpayer's income tax below an amount equal to what the tentative minimum tax would be if computed only on excess inclusions.
Third, the amount of any alternative minimum tax net operating loss deduction is computed without regard to any excess inclusions. This provision insures that the net operating losses will not reduce any income attributable to any excess inclusions.
These provisions are effective for all taxable years beginning after December 31, 1986, unless the taxpayer elects to apply the rules of the Act only to taxable years beginning after August 20, 1996.
Under prior law, banks, insurance companies, regulated investment companies, and corporations actively engaged in the business of lending money could exclude 50% of the interest income received on loans to an employee stock ownership plan (ESOP) or to an employer corporation if the proceeds were used by the plan to acquire employer securities.
The new law repeals this 50% exclusion. However, the repeal does not apply to loans made pursuant to a written binding contract in effect prior to June 10, 1996. In addition, the new law provides an exception for refinancings. The interest exclusion will apply to a refinanced loan if the refinancing loan meets the old rules, and, immediately after the refinancing, the outstanding principal amount is not greater, and the term of the new loan does extend beyond the term of the original loan.
Comment--This provision could result in an increase in the cost of financing stock purchases by an ESOP. How much additional interest a bank or other lender will require to offset the higher taxes on the interest depends on the lender.
Code section 162(k) generally denies a deduction for any expenses related to redemption of a corporation's stock. The new law clarifies that the rules apply to any acquisition of its stock by a corporation or by a related party. In general, a related person is one with more than a 10% interest. (For details see Code Sec. 465(b)(3)(C).)
Thus, the denial of a deduction applies to any reacquisition (i.e., any transaction that is an acquisition of previously outstanding stock) regardless of whether the transaction is treated as a redemption for purposes of subchapter C of the Code, regardless of whether it is treated for tax purposes as a sale of the stock or as a dividend, and regardless of whether the transaction is a reorganization or other transaction.
On the other hand, the Act clarifies that amounts properly allocated to debt on which interest is deductible and properly amortized over the term of that debt are not subject to the disallowance provision of section 162(k).
Comment--Thus, while the new law tightens the rules for deducting most expenses associated with a stock redemption, or a similar transaction, it does allow an interest deduction for debt incurred in connection with the reacquisition.
Example--In 1997 Madison Inc. redeems 100 shares of stock from a shareholder. Legal costs amount to $10,000; Madison pays $100,000 for the shares. It borrows $100,000 to finance the purchase and pays $11,000 in interest during the year. The $10,000 in legal fees are not deductible, but the $11,000 in interest is.
The rule clarifying that interest to finance the reacquisition are deductible are effective as if included in the Tax Reform Act of 1986. The other clarifications apply to amounts paid or incurred after September 13, 1995.
Under prior law a public utility customer can exclude up to 50% of any energy subsidy received for energy conservation measures with respect to property that is not a dwelling unit. For example, Madison Inc. operates a heat treatment plant. The local utility provides it with a $5,000 subsidy to install a waste heat boiler. Madison could exclude $2,500 from income.
The new law repeals this exclusion, effective for amounts received after December 31, 1996, unless received pursuant to a binding written contract in effect on September 15, 1995.
The Act creates a new type of entity called a financial asset securitization investment trust (FASIT) that facilitates the securitization of debt obligations such as credit card receivables, home equity loans, and auto loans. A FASIT generally will not be taxable; the FASIT's taxable income or net loss will flow through to the owner of the FASIT.
The ownership interest of a FASIT generally will be required to be entirely held by a single C (regular) corporation. In addition, a FASIT generally may hold only qualified debt obligations, and certain other specified assets. An entity that qualifies as a FASIT can issue instruments that meet certain specified requirements and treat those instruments as debt for federal income tax purposes. Instruments issued by a FASIT bearing yields to maturity over 5 percentage points on specified U.S. government obligations must be held, directly or indirectly, only by a C corporation that is not exempt from income tax.
Comment--A FASIT may be attractive investment vehicle for a regular (C) corporation. The main advantage of a FASIT is that it's clear that instruments it issues will be characterized as debt for income tax purposes and interest paid will be deductible. The financial implications could be far reaching. Since the original holders of credit card debt, auto loans, etc. can now sell off the debt, interest rates on these loans could decline.
Transfers between trust funds, mutual funds, etc. are all taxable, even if within the same family. The Act permits a common trust fund to transfer substantially all of its assets to one or more RICs (regulated investment company) without gain or loss being recognized by the fund or its participants. The fund must transfer its assets to the RIC solely in exchange for shares of the RIC and the fund must then distribute the RIC shares to the fund's participants in exchange for the participant's interests in the fund. This provision is effective for transfers after December 31, 1995.
Service as a crew member on a fishing vessel is generally excluded from the definition of employment for purposes of income tax withholding on wages and for FICA and FUTA taxes if the operating crew normally consists of fewer than 10 individuals, the individuals receive a share of the catch and the individual receives no cash remuneration.
The new law clarifies that a boat is treated as normally made up of fewer than 10 individuals if the average size of the operating crew on trips made during the preceding 4 calendar quarters consisted of fewer than 10 individuals. In addition, the exemption applies even if the crew member receives certain cash payments. The cash cannot exceed $100 per trip, must be contingent on a minimum catch, and is paid solely for additional duties (e.g., as mate, engineer, or cook). The provision applies to remuneration paid after December 31, 1994. In addition, it applies to remuneration paid after December 31, 1984 unless the payer treated it when paid as subject to FICA wages.
This provision requires persons engaged in the trade or business of purchasing fish for resale who pay more than $600 in cash in a calendar year for fish or other forms of aquatic life from a seller engaged in the business of catching fish to file a 1099 on such purchases. A copy of the report must be provided to the seller. The provision is effect for purchases after December 31, 1997.
Under prior law an exclusion from FUTA was provided for labor performed by an alien admitted to the U.S. to perform agricultural labor under section 214(c) and 101(a)(15)(H) of the Immigration and Nationality Act. The new law permanently extends the FUTA exemption for alien agricultural workers for labor performed on or after January 1, 1995.