Federal Tax Bulletin - Issue 14 - July 6, 2012

Supreme Court Upholds PPACA; Refresher on Healthcare Law's Tax Provisions

Last week, in a 5-4 decision, the Supreme Court upheld the Patient Protection and Affordable Care Act (PPACA) passed in 2010. In National Federation of Independent Business et al. v. Sebelius, Secretary of Health and Human Services, et al, 2012 PTC 167 (S. Ct. 6/28/12), the Court concluded that the penalty imposed by PPACA on individuals who do not buy health insurance (i.e., the individual mandate) functions more like a tax than a penalty. Thus, because Congress has the authority to tax, the Court held the law was constitutional.

According to Chief Justice Roberts, the most straightforward reading of the individual mandate is that it commands individuals to buy insurance. The Court rejected the government's main argument that the Commerce Clause gave Congress the power to force individuals to buy health insurance. The individual mandate, the Court noted, does not regulate existing commercial activity. It instead compels individuals to become active in commerce by purchasing a product on the ground that their failure to do so affects interstate commerce. Construing the Commerce Clause to permit Congress to regulate individuals precisely because they are doing nothing, the Court stated, would open a new and potentially vast domain to congressional authority. According to the Court, allowing Congress to justify federal regulation by pointing to the effect of inaction on commerce would bring countless decisions an individual could potentially make within the scope of federal regulation and empower Congress to make those decisions for him. Thus, the Court concluded that the Commerce Clause does not give Congress the power to command individuals to buy insurance.

With respect to the government's alternative argument that the mandate could be upheld as within Congress's power to tax the Court said that the penalty imposed by PPACA on those without health insurance looks like a tax in many respects. First, it is paid into the Treasury by taxpayers when they file their tax returns. Second, for taxpayers who do owe the payment, its amount is determined by such factors as taxable income, number of dependents, and joint filing status. Third, the requirement to pay is found in the Internal Revenue Code and enforced by the IRS, which must assess and collect it in the same manner as taxes. This process, the Court stated, yields the essential feature of any tax: It produces at least some revenue for the government. Indeed, the Court noted, the payment is projected to raise about $4 billion per year by 2017. The Court stated that, while PPACA describes the payment as a penalty, not a tax, such labels are not controlling. In the end, the Court found that the penalty functions as a tax, and thus it is within Congress's power to assess such a tax.

Refresher on PPACA's Key Tax Provisions

In the wake of the Supreme Court's decision and expected media attention to the healthcare law throughout the election season, practitioners should be ready for increased inquiries from clients on the law's tax provisions. The following recap provides answers to the most frequently asked PPACA tax questions.

PRACTICE AIDS: For client letters explaining healthcare-related taxes and credits, go to the "Affordable Care Act" folder in the "Sample Client Letters" database.

With respect to individuals, the more significant provisions are:

(1) a penalty, assessed on tax returns, for not maintaining essential heathcare coverage;

(2) a premium assistance tax credit;

(3) additional hospital insurance tax for high income individuals;

(4) unearned income Medicare contribution tax;

(5) an increase in the threshold over which medical expenses are deductible; and

(6) a limitation on health FSAs.

With respect to employers, some of the more significant provisions are:

(1) a penalty on large employers not offering adequate health coverage;

(2) a small business tax credit; and

(3) an excise tax on high-cost employer-sponsored health coverage.

Individual Mandate (Penalty for Not Maintaining Minimum Essential Coverage)

The crux of PPACA is the requirement for almost all individuals to maintain minimum essential healthcare coverage (i.e., the individual mandate). Beginning in January 2014, nonexempt U.S. citizens and legal residents must maintain such coverage or be subject to a penalty. Minimum essential coverage includes coverage under government-sponsored programs, eligible employer-sponsored plans, plans in the individual market, grandfathered group health plans, and other coverage as recognized by the Secretary of Health and Human Services (HHS) in coordination with the Secretary of the Treasury.

Government-sponsored programs include Medicare, Medicaid, Children's Health Insurance Program, coverage for members of the U.S. military, veterans health care, and health care for Peace Corps volunteers. Eligible employer-sponsored plans include: governmental plans, church plans, grandfathered plans, and other group health plans offered in the small or large group market within a state. Minimum essential coverage does not include coverage that consists of certain HIPAA-excepted benefits (e.g., coverage only for accident, or disability income insurance; coverage issued as a supplement to liability insurance; workers' compensation or similar insurance, etc.). Other HIPAA-excepted benefits that do not constitute minimum essential coverage if offered under a separate policy, certificate, or contract of insurance include long-term care, limited scope dental and vision benefits, coverage for a disease or specified illness, hospital indemnity or other fixed indemnity insurance, or Medicare supplemental health insurance.

Once the penalty is fully phased in, individuals who fail to maintain minimum essential coverage are subject to a penalty equal to the greater of:

(1) 2.5 percent of household income in excess of the taxpayer's household income for the tax year over the threshold amount of income required for income tax return filing for that taxpayer under Code Sec. 6012(a)(1); or

(2) $695 per uninsured adult in the household.

The per-adult annual penalty is phased in as follows: $95 for 2014; $325 for 2015; and $695 for 2016. For years after 2016, the $695 amount is indexed to CPI-U, rounded to the next lowest $50. The percentage of income is phased in as follows: 1 percent for 2014; 2 percent in 2015; and 2.5 percent beginning after 2015. If a taxpayer files a joint return, the individual and spouse are jointly liable for any penalty payment.

The fee for an uninsured individual under age 18 is one-half of the adult fee for an adult. The total household penalty may not exceed 300 percent of the adult penalty ($2,085).

The penalty applies to any period the individual does not maintain minimum essential coverage and is determined monthly. The penalty is assessed through the Code and accounted for as an additional amount of federal tax owed. However, it is not subject to the enforcement provisions of the Code.

Individuals are exempt from the requirement to maintain minimum essential coverage for months they:

(1) are incarcerated;

(2) are not legally present in the United States; or

(3) maintain religious exemptions.

Those who are exempt from the requirement due to religious reasons must be members of a recognized religious sect exempting them from self employment taxes and adhere to tenets of the sect. Individuals living outside of the United States are deemed to maintain minimum essential coverage. If an individual is a dependent of another taxpayer, the other taxpayer is liable for any penalty payment with respect to the individual.

Premium Assistance Tax Credit

PPACA enacted Code Sec. 36B. This provision, which is effective for tax years ending after December 31, 2013, creates a refundable tax credit, called the premium assistance credit, for eligible individuals and families who buy health insurance through an insurance exchange. The premium assistance credit, which is refundable and payable in advance directly to the insurer, subsidizes the purchase of certain health insurance plans through an exchange. The premium assistance credit is generally available for individuals (single or joint filers) with household incomes between 100 and 400 percent of the federal poverty level (FPL) for the family size involved.

Additional Hospital Insurance Tax

Beginning in 2013, the employee portion of the hospital insurance (HI) portion of FICA taxes is increased by an additional tax of 0.9 percent on wages received in excess of the threshold amount. However, unlike the general 1.45 percent HI tax on wages, this additional tax is on the combined wages of the employee and the employee's spouse, in the case of a joint return. The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case.

As under present law, the employer is required to withhold the additional HI tax on wages. However, in determining the employer's requirement to withhold and liability for the tax, only wages the employee receives from the employer in excess of $200,000 for a year are taken into account, and the employer must disregard the amount of wages received by the employee's spouse. Thus, the employer is only required to withhold on wages in excess of $200,000 for the year, even though the tax may apply to a portion of the employee's wages at or below $200,000, if the employee's spouse also has wages for the year, they are filing a joint return, and their total combined wages for the year exceed $250,000.

For example, if a taxpayer's spouse has wages in excess of $250,000 and the taxpayer has wages of $100,000, the employer of the taxpayer is not required to withhold any portion of the additional tax, even though the combined wages of the taxpayer and the taxpayer's spouse are over the $250,000 threshold. In this instance, the employer of the taxpayer's spouse is obligated to withhold the additional 0.9-percent HI tax with respect to the $50,000 above the threshold with respect to the wages of $250,000 for the taxpayer's spouse.

Expanded Medicare Contribution Tax (3.8% Tax on Unearned Income)

For tax years beginning after 2012, in the case of an individual, estate, or trust, an additional tax is imposed on income over a certain level. The Joint Committee on Taxation's Technical Explanation of PPACA refers to this tax as the unearned income Medicare contribution tax. Others have referred to it as a tax on investment income, although it can apply to individuals, estates, and trusts that do not have investment income.

In the case of an individual, this tax is 3.8 percent of the lesser of:

(1) net investment income; or

(2) the excess of modified adjusted gross income over the threshold amount.

The threshold amount is $250,000 in the case of taxpayers filing a joint return or a surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case. Modified adjusted gross income is adjusted gross income increased by the amount excluded from income as foreign earned income under Code Sec. 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income).

For purposes of the unearned income Medicare contribution tax, net investment income is investment income reduced by the deductions properly allocable to such income. Investment income is the sum of:

(1) gross income from interest, dividends, annuities, royalties, and rents (other than income derived in the ordinary course of any trade or business to which the tax does not apply);

(2) other gross income derived from any trade or business to which the tax applies; and

(3) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply.

Investment income does not include distributions from a qualified retirement plan or amounts subject to self-employment tax.

OBSERVATION: Investment income does not include items that are excludible from gross income under the tax rules, such as interest on tax-exempt bonds, veterans' benefits, and any gain excludible from income upon the sale of a principal residence.

In the case of a trade or business, the tax applies if the trade or business is a passive activity with respect to the taxpayer, or the trade or business consists of trading financial instruments or commodities. The tax does not apply to other trades or businesses. Income, gain, or loss on working capital is not treated as derived from a trade or business.

In the case of an estate or trust, the tax is 3.8 percent of the lesser of:

(1) undistributed net investment income or

(2) the excess of adjusted gross income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.

OBSERVATION: There is no provision for the indexing of the threshold amounts that apply to individuals. However, there is a provision for indexing the tax calculation for estates and trusts, since their tax brackets are indexed annually for inflation. However, the highest tax bracket that applies to estates and trusts is so low that the indexing provision won't provide much benefit.

The tax is subject to the individual estimated tax provisions and is not deductible in computing any income tax. Thus, for example, there is no deduction allowed for this tax under Code Sec. 164(f) (relating to the deduction for one-half of self-employment taxes).

Increase in Medical Expense Deduction Threshold

A taxpayer can deduct on Schedule A (Form 1040), Itemized Deductions, only the amount of the taxpayer's medical and dental expenses that is more than 7.5 percent of the taxpayer's adjusted gross income (AGI) for the year. Thus, in effect, a taxpayer must subtract 7.5 percent of the taxpayer's AGI from his or her medical expenses to figure the medical expense deduction.

Under PPACA, for 2013 and later years, the deduction floor is increased to 10 percent. However, for any tax year ending before January 1, 2017, the floor will be 7.5 percent if the taxpayer or the taxpayer's spouse has attained age 65 before the end of that year.

FSA Limitation

Under PPACA, for a health flexible spending arrangement (FSA) to be a qualified benefit under a cafeteria plan, the maximum amount available for reimbursement of incurred medical expenses of an employee, the employee's dependents, and any other eligible beneficiaries with respect to the employee, under the health FSA for a plan year (or other 12-month coverage period) must not exceed $2,500. This provision is effective for tax years beginning after 2012. The $2,500 limitation is adjusted for inflation, with any increase that is not a multiple of $50 rounded to the next lowest multiple of $50 for years beginning after December 31, 2013.

A cafeteria plan that does not include this limitation on the maximum amount available for reimbursement under any FSA is not a cafeteria plan within the meaning of Code Sec. 125. Thus, when an employee is given the option under a cafeteria plan maintained by an employer to reduce his or her current cash compensation and instead have the amount of the salary reduction be made available for use in reimbursing the employee for his or her medical expenses under a health FSA, the amount of the reduction in cash compensation pursuant to a salary-reduction election must be limited to $2,500 for a plan year.

Shared Responsibility for Employers

Under PPACA, certain employers have a responsibility to supply their workers with health care or be subject to a penalty. An applicable large employer that does not offer coverage for all its full-time employees, offers minimum essential coverage that is unaffordable, or offers minimum essential coverage that consists of a plan under which the plan's share of the total allowed cost of benefits is less than 60 percent, is required to pay a penalty if any full-time employee is certified to the employer as having purchased health insurance through a state exchange with respect to which a tax credit or cost-sharing reduction is allowed or paid to the employee.

An employer is an applicable large employer with respect to any calendar year if it employed an average of at least 50 full-time employees during the preceding calendar year. For purposes of this rule, the term employer includes any predecessor employer. An employer is not treated as employing more than 50 full-time employees if the employer's workforce exceeds 50 full-time employees for 120 days or fewer during the calendar year and the employees that cause the employer's workforce to exceed 50 full-time employees are seasonal workers. A seasonal worker is a worker who performs labor or services on a seasonal basis, including retail workers employed exclusively during the holiday season and workers whose employment is, ordinarily, the kind exclusively performed at certain seasons or periods of the year and that, from its nature, may not be continuous or carried on throughout the year.

Small Business Tax Credit

PPACA enacted Code Sec. 45R, which provides a tax credit for a qualified small employer for nonelective contributions to buy health insurance for its employees. While the credit took effect in 2011, the amount of the credit increases from 35 percent of eligible premium payments to 50 percent in 2014. A qualified small business employer for this purpose generally is an employer with no more than 25 full-time equivalent employees (FTEs) employed during the employer's tax year, and whose employees have annual full-time equivalent wages that average no more than $50,000. The credit phases out gradually (but not below zero) for eligible small employers if the number of FTEs exceeds 10 or if the average annual wages exceed $25,000. These wage limits are indexed for inflation for years beginning in 2014.

Excise Tax on High-Cost Employer-Sponsored Health Coverage

Beginning after December 31, 2017, an excise tax is imposed on certain health insurance providers for any excess benefit provided by an employer to an employee with respect to employer-sponsored health coverage. An excess benefit is the amount, if any, by which the aggregate cost of such coverage exceeds a threshold amount. The excess benefit is determined on a monthly basis and the amount of the excise tax is equal to 40 percent of the sum of the monthly excess benefits for the tax year. For 2018, the threshold amount is $10,200 for individual coverage and $27,500 for family coverage, multiplied by a health cost adjustment percentage increased by an age and gender adjusted excess premium amount.

The excise tax is imposed pro rata on the issuers of the insurance. In the case of a self-insured group health plan, a health FSA or a health reimbursement arrangement (HRA), the excise tax is paid by the entity that administers benefits under the plan or arrangement (plan administrator). Where the employer acts as plan administrator to a self-insured group health plan, a health FSA or an HRA, the excise tax is paid by the employer. Where an employer contributes to a health savings account (HSA) or an Archer MSA, the employer is responsible for payment of the excise tax, as the insurer.

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New Guidance on Correct Tax Treatment of Service Charges May Necessitate Changes to Service Industry Reporting Systems

For practitioners with clients in service industries, a recent IRS ruling and announcement provide updated guidance relating to tips and service charges. In Rev. Rul. 2012-18 and Announcement 2012-25, the IRS clarifies and updates guidance on FICA taxes on tips and provides administrative guidelines to examiners auditing a business where tipping is customary and/or where a business adds service charges to customers' bills, and then distributes the service charges to employees. Services charges are properly characterized as regular (i.e., non-tip) wages and not as tips, and thus are not subject to the special reporting rules that apply to tips. The ruling states, for example, that if a restaurant adds an 18 percent gratuity to a check for a table of six or more, that amount is a service charge and not a tip. As a result, some businesses that have been treating such amounts as tips may have to change automated or manual reporting systems in order to comply with the proper treatment of service charges.

Practice Aid: See ¶320,697 for a client letter on service charge reporting.

In addition, in a separate memorandum, the IRS said it is considering significant changes to the Tip Reporting Alternative Commitment (TRAC) program and other variations of TRAC agreements.

Background

Code Secs. 3101 and 3111 impose FICA taxes on employees and employers, respectively, equal to a percentage of the wages received by an individual with respect to employment. FICA taxes consist of two separate taxes, the Old Age, Survivors, and Disability Insurance (social security) tax and the Hospital Insurance (Medicare) tax. The amount of wages subject to social security tax is limited by an annual contribution and benefit base; however, all wages are subject to Medicare tax.

Code Sec. 3121(a) defines wages for FICA tax purposes as all remuneration for employment, with certain exceptions. Subject to certain exceptions (e.g., noncash tips and tips under $20 in a month), tips are considered wages.

Employer FICA Obligations

Under Code Sec. 3121(q), tips received by an employee in the course of the employee's employment are considered remuneration for that employment and are deemed to have been paid by the employer for purposes of the employer share of FICA taxes imposed by Code Sec. 3111(a) and (b) that is, social security tax and Medicare tax, respectively. The tip amount is deemed to be paid when the employee gives the employer a written statement reporting the tips.

The employer is required to pay social security tax on the amount of cash tips received by the employee up to and including the contribution and benefit base and to pay Medicare tax on the total amount of cash tips received by the employee. However, if the employee either did not furnish the statement under Code Sec. 6053(a) or if the statement furnished was inaccurate or incomplete, then, in determining the employer's liability for FICA taxes with respect to the tips, Code Sec. 3121(q) provides that the remuneration is deemed to be paid on the date on which the IRS sends the employer a notice and demand for the taxes.

Employee FICA Obligations

Under Code Sec. 3121(q), for purposes of the employee share of FICA taxes, tips that are properly reported to the employer under Code Sec. 6053(a) are deemed to be paid at the time a written statement is furnished to the employer. Unreported tips received by the employee are deemed to be paid to the employee when actually received by the employee.

Code Sec. 6053(a) requires every employee who, in the course of the employee's employment by an employer, receives in any calendar month tips that constitute wages (as defined in section 3121(a) for FICA tax purposes or Code Sec. 3401(a) for federal income tax withholding purposes) to report all those tips in one or more written statements furnished to the employer on or before the 10th day of the following month. The employee is to furnish the statements in the form and manner prescribed by the IRS.

Credit for Employer Share of FICA Taxes Paid on Tips

Code Sec. 45B(a) provides that, for purposes of the general business credit, the credit for employer social security and Medicare taxes paid on certain employee tips is an amount equal to the "excess employer social security tax" paid or incurred by the employer. The term "excess employer social security tax" means any tax paid by an employer under Code Sec. 3111 (both social security tax and Medicare tax) on its employees' tip income without regard to whether the employees reported the tips to the employer pursuant to Code Sec. 6053(a). Consequently, the Code Sec. 45B credit is available with respect to unreported tips in an amount equal to the "excess employer social security tax" paid or incurred by the employer. No credit, however, is allowed to the extent tips are used to meet the federal minimum wage rate. The credit is available with respect to FICA taxes paid on tips received from customers in connection with the providing, delivering, or serving of food or beverages for consumption, if it is customary for customers to tip the employees.

New Guidance Relating to Service Charges

In Rev. Rul. 2012-18, the IRS states that an employer's characterization of a payment as a tip is not determinative. For example, an employer may characterize a payment as a tip, when in fact the payment is a service charge. The IRS is advising examining agents to apply the criteria of Rev. Rul. 59-252 to determine whether a payment made in the course of employment is a tip or non-tip wages. Rev. Rul. 2012-18 provides that the absence of any of the following factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge:

(1) the payment is made free from compulsion;

(2) the customer has the unrestricted right to determine the amount;

(3) the payment is not the subject of negotiation or dictated by employer policy; and

(4) generally, the customer has the right to determine who receives the payment.

According to the IRS, all of the surrounding facts and circumstances must be considered. For example, Rev. Rul. 59-252 holds that the payment of a fixed charge imposed by a banquet hall that is distributed to the employees who render services (e.g., waiter, busser, and bartender) is a service charge and not a tip. Thus, to the extent any portion of a service charge paid by a customer is distributed to an employee, it is wages for FICA tax purposes.

Example: Grapeseed Restaurant's menu specifies that an 18 percent charge will be added to all bills for parties of six or more customers. Dave's bill for food and beverages for his party of eight includes an amount on the tip line equal to 18 percent of the price for food and beverages and the total includes this amount. Grapeseed distributes this amount to the waitresses and bussers. Under these circumstances, Dave did not have the unrestricted right to determine the amount of the payment because it was dictated by employer policy. Also, Dave did not make the payment free from compulsion. The 18 percent is not a tip. The amount included on the tip line is a service charge dictated by Grapeseed.

Tips that Must Be Reported to Employers

All cash tips received by an employee are wages for FICA tax purposes and, therefore, must be reported to the employer, unless the cash tips received by the employee during a single calendar month while working for the employer total less than $20. For these purposes, cash tips include tips received from customers, charged tips (e.g., credit and debit card charges) distributed to the employee by his or her employer, and tips received from other employees under any tip-sharing arrangement. Thus, both directly and indirectly tipped employees must report tips received to their employer. Non-cash tips (i.e., tips received by an employee in any other medium than cash, such as passes, tickets, or other goods or commodities) from customers are not wages for FICA tax purposes and are not reported by the employee to the employer. However, all cash tips and non-cash tips are includible in an employee's gross income and subject to federal income taxes.

The IRS notes that an employee is required to give the employer a written statement (or statements) of cash tips by the 10th day of the month after the month in which the tips are received. Form 4070, Employee's Report of Tips to Employer, is used for this purpose.

Unreported Tips

If an employee fails to report tips to his or her employer, the employee is liable for the employee share of FICA taxes on the unreported tips. The employee pays his or her share of FICA taxes by completing Form 4137, Social Security and Medicare Tax on Unreported Tip Income, and filing it with Form 1040 (or other applicable return in the Form 1040 series) for the year in which the tips are actually received by the employee.

With respect to computing the employee's FICA tax liability on unreported tips, the IRS provides that the social security and Medicare rates and the social security contribution and benefit base applicable to the calendar year in which the tips were actually received apply. Form 4137 includes the applicable social security and Medicare rates and social security contribution and benefit base. The employer is not liable to withhold and pay the employee share of FICA taxes on the unreported tips.

An employee who fails to report tips required to be reported to an employer is subject to a penalty equal to 50 percent of the employee share of FICA taxes on those tips, unless the employee can provide a satisfactory explanation showing that the failure was due to reasonable cause and not due to willful neglect. The explanation must be made in the form of a written statement setting forth all the facts alleged as a reasonable cause. This statement can be attached to the employee's Form 1040 (See Form 4137). If the statement is submitted in response to a notice regarding a proposed penalty assessment, the statement must contain a declaration that it is made under the penalties of perjury.

With respect to the employer, Rev. Rul. 2012-18 notes that if an employee fails to report tips to his or her employer, the employer is not liable for the employer share of FICA taxes on the unreported tips until notice and demand for the taxes is made to the employer by the IRS. The employer is not liable to withhold and pay the employee share of FICA taxes on the unreported tips.

The notice and demand is made under Code Sec. 3121(q). However, there is no specific form or procedure prescribed for a Code Sec. 3121(q) notice and demand. According to the IRS, notice and demand is made by the IRS when it advises the employer in writing of the amount of tips received by an employee (or employees) who failed to report or underreported tips to the employer. Although no specific form is prescribed, the IRS states that a document will constitute a Code Sec. 3121(q) notice and demand if it (1) includes the words "notice and demand" and "section 3121(q), (2) states the amount of tips received by the employee (or employees), and (3) states the period to which the tips relate. However, a document including such information will not constitute a Code Sec. 3121(q) notice and demand if it states that it is not a notice and demand.

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IRS Explains Effect of Code Sec. 83(b) Election; Provides Sample Election Language

The IRS reviews the tax implications of making a Code Sec. 83(b) election to include restricted property in income prior to it becoming vested and provides sample language that may be used for making the election. Rev. Proc. 2012-29.

Generally, under Code Sec. 83(a), if a service provider receives property in connection with the performance of services, the service provider must include all or a portion of the property's fair market value in income in the year he or she receives the property. However, if the property is subject to certain restrictions for example, restricted stock its value is generally not included in income until it becomes "substantially vested." When the property becomes substantially vested, the service provider generally must include its fair market value, minus any amount the service provider paid for it, in income for that year.

However, under Code Sec. 83(b), a taxpayer may elect to include in gross income, for the tax year in which the property is transferred, the excess of the fair market value of the property at the time of transfer (determined without regard to any restriction other than a restriction that by its terms will never lapse) over the amount paid for the property. The taxpayer may make this election even if he or she paid full value for the stock at the time of the transfer, and thus realized no bargain element in the transaction.

In Rev. Proc. 2012-29, the IRS provides sample language that may be used (but is not required to be used) for making an election under Code Sec. 83(b). The procedure also provides examples of the income tax consequences of making such an election.

As the procedure notes, if the election is made, the substantial vesting rules do not apply with respect to the property, and any subsequent appreciation in the value of the property is generally not taxable as compensation to the person who performed the services. Thus, the value of property with respect to which the Section 83(b) election is made is included in gross income as of the time of transfer, even though the property is substantially nonvested at the time of transfer, and no compensation is includible in gross income when such property becomes substantially vested. In computing the gain or loss from a subsequent sale or exchange of Code Sec. 83(b) property, the basis of the property is the amount paid (if any) increased by the amount included in gross income under Code Sec. 83(b). If property for which a Code Sec. 83(b) election was filed is forfeited while substantially nonvested, no deduction is allowed with respect to the forfeiture. The forfeiture is treated as a sale or exchange upon which there is realized a loss equal to the excess (if any) of (1) the amount paid (if any) for such property, over (2) the amount realized (if any) upon such forfeiture. If such property is a capital asset in the hands of the taxpayer, the loss is a capital loss.

Example: ABC Corporation is a privately held corporation and no ABC stock is traded on an established securities market. On April 1, 2012, in connection with the performance of services, ABC transfers to Ethan, its employee, 25,000 shares of substantially nonvested ABC stock. In exchange for the stock, Ethan pays ABC $25,000, representing the fair market value of the shares at the time of the transfer. The restricted stock agreement provides that if Ethan stops providing services to ABC as an employee before April 1, 2014, ABC will repurchase the stock from Ethan for the lesser of the then current fair market value or the original purchase price of $25,000. Ethan's ownership of the 25,000 shares of stock is not treated as substantially vested until April 1, 2014, and will be treated as substantially vested only if Ethan continues to provide services to ABC as an employee until April 1, 2014. On April 1, 2012, Ethan makes a valid election under Code Sec. 83(b) with respect to the 25,000 ABC shares. Because the excess of the fair market value of the property ($25,000) over the amount Ethan paid for the property ($25,000) is $0, Ethan includes $0 in gross income for 2012 as a result of the stock transfer and related Code Sec. 83(b) election. The 25,000 ABC shares of stock become substantially vested on April 1, 2014, when the fair market value of the shares is $40,000. No compensation is includible in Ethan's gross income when the shares become substantially vested on April 1, 2014. In 2015, Ethan sells the stock for $60,000. As a result of the sale, Ethan realizes $35,000 ($60,000 sale price - $25,000 basis) of gain, which is a capital gain.

For a discussion of the Code Sec. 83(b) election, see Parker Tax ¶124,525.

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House Donated to Fire Department Was a Contribution of a Partial Interest and Thus Not Deductible

Taxpayers who grant a fire department the right to conduct training exercises on their property and destroy a building thereon during the exercises do not donate any ownership interest in property, and Code Sec.. 170(f) (3) denies them a charitable contribution deduction for the donation of the use of their property regardless of the value of that use. Patel v. Comm'r, 138 T.C. No. 23 (6/27/12).

At the end of May 2006, Upen and Avanti Patel purchased property Virginia, with the intention to demolish the house situated thereon and construct a new one on the site. Their realtor told them about the Fairfax County Fire and Rescue Department (FCFRD) Acquired Structures Program, where a property owner allows FCFRD to conduct live fire training exercises on his or her property. As part of the exercises, FCFRD destroys, by burning, the designated building on the owner's property. Within a few weeks of purchasing the Virgina property, the Patels contacted FCFRD and obtained information about the requirements for participating in the program. After the Patels obtained a demolition permit and completed all the other requirements, they executed documents granting FCFRD the right to conduct training exercises on the property and to destroy the house by burning it during the exercises. During October 2006, FCFRD, along with six other fire departments, used the Virginia property to conduct live fire training exercises, during which the house was destroyed.

On their 2006 federal income tax return, the Patels reported a noncash charitable contribution of $339,504 on Schedule A, Itemized Deductions, for the donation of the house to FCFRD. Because they were subject to certain charitable limitations under Code Sec. 170(b), the Patels deducted $92,865 as a noncash charitable contribution for 2006. The IRS disallowed the deduction, asserting that the Patels' donation to FCFRD was a contribution of a partial interest in property and, under Code Sec. 170(f)(3), was not deductible. The IRS also assessed an accuracy-related penalty.

A sharply divided Tax Court held that a landowner's grant to a fire department of the right to conduct training exercises on his property and destroy a building thereon during the exercises is a mere license that permits the fire department to do an act that, without such a grant, would be illegal and that conveys no interest in the property to the fire department. The Tax Court also held that taxpayers who grant a fire department the right to conduct training exercises on their property and destroy a building thereon during the exercises do not donate any ownership interest in property to the fire department, and Code Sec.. 170(f) (3) denies them a charitable contribution deduction for the donation of the use of their property regardless of the value of that use. As a result, the court concluded that the Patels donated only the use of the Virginia property and the house to FCFRD. That donation, the court stated, was a donation of a partial interest in the property, and under Code Sec. 170(f)(3), was not deductible. However, the court also concluded that the Patels acted with reasonable cause and in good faith and, thus, were not liable for any accuracy-related penalty.

While eight judges agreed with the end result on the charitable donation issue, seven judges dissented. In the dissenting opinion, those judges said that the Patels gave more than the use of their house and retained no substantial interest therein by virtue of their grant of permission to destroy. According to those judges, where the interest retained by the taxpayer is so insubstantial that he has, in substance, transferred his entire interest in the property, the tax treatment should so reflect. Such a taxpayer, the dissenting opinion noted, satisfies the original congressional purpose behind Code Sec. 170(f)(3). These dissenting judges concluded that Code Sec. 170(f)(3) did not apply to limit the Patels' deduction. They did note, however, that while Code Sec. 170(f)(3) did not bar the Patels' charitable contribution deduction, the Patels still had to satisfy the sine qua non of a charitable contribution, namely, a transfer of money or property without adequate consideration in return. Thus, the Patels would have to show that the value of the house, taking into account the conditions on its donation, exceeded the value of the benefit they received from the fire department in the form of demolition services.

OBSERVATION: The facts in this case are similar to those in Rolfs v. Comm'r, 135 T.C. No. 24 (2010), aff'd, 2012 PTC 19 (7th Cir. 2012), where the Tax Court denied the taxpayers a charitable deduction based on a quid pro quo argument advanced by the IRS. That court concluded that the taxpayers anticipated a substantial benefit in exchange for their donation of a house to a local fire department, in the form of demolition services worth approximately $10,000, and that the fair market value of the donated house did not exceed that figure. As a result, the court in Rolfs did not address the IRS's alternative argument that Code Sec. 170(f)(3) operated to deny the taxpayer's a deduction. In the Patel case, the Tax Court decided the issued based on Code Sec. 170(f)(3).

For a discussion of the rules relating to contributions of partial interests in property, see Parker Tax ¶84,155.

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Taxpayer Can't Deduct Lodging and Meals During Transitional Period Relating to Job Change

The taxpayer's theory that his tax home changed only when he established an apartment in the city of his new job was unpersuasive to the Tax Court, which disallowed deductions for meals, lodging, and lease cancellation fees. Newell v. Comm'r, T.C. Summary 2012-57 (6/18/12).

Darren Newell worked as a restaurant general manager for LGO Hospitality. During the first eight months of 2008, Darren managed a restaurant in Phoenix, Arizona. While working at the Phoenix restaurant, Darren lived in an apartment with his wife and daughter in the nearby adjacent city of Scottsdale, Arizona. In August 2008, Darren's supervisor offered him a permanent position as general manager of LGO's restaurant in Pasadena, California. Darren accepted the position and around September 1, 2008, he started working at the Pasadena restaurant. Darren and his family moved to Pasadena around the same time period. The Newells terminated their apartment lease in Scottsdale and paid expenses associated with that early cancellation. They used a rented moving truck and their personal car to move their personal belongings to Pasadena. Because they didn't have an apartment before moving, the Newells paid for hotel accommodations and storage for their personal belongings in Pasadena. Darren and his family lived in hotel until the beginning of October 2008 while he worked at the Pasadena restaurant.

On October 10, 2008, the Newells executed a lease and moved into an apartment in Pasadena. They lived in the Pasadena apartment through the end of 2008 and into the following year. In February 2009, Darren transferred from the Pasadena restaurant to a newly constructed LGO restaurant located in Santa Monica, California. When Darren moved his family to Santa Monica in 2009, the Newells terminated the lease with respect to the Pasadena apartment and again paid expenses associated with that early lease cancellation. Darren worked as the general manager of the Santa Monica restaurant until approximately February 2010.

The Newells timely filed a 2008 joint federal income tax return, which was prepared by a commercial tax return preparer. Darren provided the return preparer with information regarding his move from Phoenix to Pasadena in 2008, including receipts for the expenses he paid. The same tax return preparer had prepared the Newells' tax returns for at least seven years before 2008 without incident. On their tax return, the Newells claimed a deduction for moving expenses of $9,433. The IRS denied the deduction and assessed an accuracy-related penalty under Code Sec. 6662.

The Newells subsequently conceded that the expenses originally claimed on their tax return were not deductible as moving expenses. Instead, they said, the amounts were deductible under Code Sec. 162 as business expenses. Those expenses included lodging, meals, and lease cancellation fees. According to the Newells, these expenses are not personal living expenses but deductible business expenses related to Darren's employment with LGO. Before the Tax Court, the Newells acknowledge that Darren's tax home changed from Phoenix to Pasadena in 2008. The Newells contended, however, that although Darren moved his family to Pasadena and began work at the Pasadena restaurant on or about September 1, 2008, his tax home did not shift to Pasadena until October 10, 2008, when he and his family moved into the Pasadena apartment. According to the Newells, the time period between September 1 and October 10, 2008, was a transitional period within which Darren's tax home remained in Phoenix. In the Newells' view, the expenses Darren paid for hotel lodging and meals in Pasadena during that transitional period constituted business travel expenses or temporary living expenses incurred while Darren was away from his tax home in Phoenix and were thus deductible under Code Sec. 162(a)(2).

The IRS argued that Darren's tax home shifted from Phoenix to Pasadena no later than September 1, 2008, when he moved his family to Pasadena and began working at the Pasadena restaurant. According to the IRS, the lodging and meal expenses Darren paid between September 1 and October 10, 2008, were therefore not incurred while he was away from his tax home. Consequently, the disputed lodging and meal expenses were nondeductible personal living expenses.

The Tax Court agreed with the IRS and held that the Newells expenses were not deductible personal living expenses. The court noted that the Newells provided no legal authority to support their transitional theory of deductibility. With respect to the Newells point that a hotel generally does not constitute a tax home, the Tax Court agreed. However, it said, the Newells' theory that Darren's tax home changed only when he established an apartment in Pasadena on October 10, 2008, was unpersuasive and contrary to well-established precedent.

After considering the totality of the facts and circumstances, and the fact that the Newells used a tax return preparer, the court was satisfied the Newells acted in good faith and came within the reasonable cause exception of to the accuracy-related penalty. Thus, they were not liable for the penalty.

For a discussion of deductible travel expenses while away from home, see Parker Tax ¶91,105.

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IRS Strengthens ITIN Application Requirements; Notarized Copies of Documents No Longer Accepted

Interim changes have been made to the procedures for issuing individual taxpayer identification numbers. IR-2012-62 (6/22/12).

The IRS announced important interim changes to its procedures for issuing individual taxpayer identification numbers (ITINs) from now through the end of 2012. Designed specifically for tax-administration purposes, ITINs are only issued to people who are not eligible to obtain a social security number.

During this interim period, the IRS will issue ITINs only when applications include original documentation, such as passports and birth certificates, or certified copies of these documents from the issuing agency. During this interim period, ITINs will not be issued based on applications supported by notarized copies of documents. In addition, ITINs will not be issued based on applications submitted through certifying acceptance agents unless they attach original documentation or copies of original documents certified by the issuing agency. According to the IRS, the changes, which are effective immediately, are designed to strengthen and protect the integrity of the ITIN process while minimizing the impact on taxpayers.

The procedures apply to most applicants submitting Form W-7, Application for IRS Individual Taxpayer Identification Number. ITINs for most individuals generally are issued during the tax filing season with the submission of a Form 1040, U.S. Individual Income Tax Return. Because the April 17 filing deadline has passed, the IRS anticipates that a small number of taxpayers will need ITINs between now and the end of the year for these purposes. According to the IRS, it will issue final rules before the start of the 2013 filing season when most ITIN requests come in.

During this interim period, people who need ITINs to get their tax return processed can do so by submitting by mail their original documentation or certified copies of their documentation. Documentation will be accepted at IRS walk-in sites but will be forwarded to the ITIN centralized site for processing. The IRS also has an additional set of questions and answers for ITIN applicants available.

Some categories of applicants are not affected by these interim changes, including spouses and dependents of U.S. military personnel who need ITINs. People who should follow the current procedures outlined in the Form W-7 instructions include:

(1) Military spouses and dependents without an SSN who need an ITIN (Military spouses use box e on Form W-7 and dependents use box d). Exceptions to the new interim document standards will be made for military family members satisfying the documentation requirements by providing a copy of the spouse or parent's U.S. military identification, or applying from an overseas APO/FPO address.

(2) Nonresident aliens applying for ITINs for the purpose of claiming tax treaty benefits (use boxes a and h on Form W-7). Nonresident alien applicants generally need ITINs for reasons besides filing a U.S. tax return. This is necessary for nonresident aliens who may be subject to third-party withholding for various income, such as certain gaming winnings or pension income, or need an ITIN for information reporting purposes. While existing documentation standards will be maintained only for these applicants, scrutiny of the documents will be heightened. ITIN applications of this category that are accompanied by a US tax return will be subject to the new interim document standards.

The IRS may require some taxpayers who have already filed applications to furnish additional documentation directly to the IRS. No additional action is required for people who have already filed ITIN requests unless they are contacted by the IRS.

For a discussion of ITINs, see Parker Tax ¶250,135.

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IRS Did Not Abuse Its Discretion When It Charged Hot Interest on Corporate Tax Underpayment

A notice of a balance due on Form 4340 is sufficient to presumptively establish that notice and demand was sent on the date listed on the form and, as a result, the taxpayer was liable for the higher large corporate underpayment rate of interest. JTK Masonry Company v. Comm'r, T.C Memo. 2012-175 (6/20/12).

In 2009, the IRS denied JTK Masonry Company's request for interest abatement for fiscal years ending March 31, 2003 and 2005. When JTK filed its 2003 Form 1120 for the fiscal year ending March 31, 2003, it had unpaid tax due of approximately $577,000. The tax, delinquency penalties, and interest relating to the 2003 return were assessed on August 4, 2003. Form 4340, Certificate of Assessments, Payments, and Other Specified Matters, reflects that a notice of balance due was issued to JTK on August 4, 2003, the date of assessment of the liabilities. The IRS did not retain a copy of the notice of balance due. JTK's president did not recall receiving the notice of balance due, which the Form 4340 reflects as having been issued on August 4, 2003.

On September 3, 2003, the IRS began charging interest using the higher large corporate underpayment (LCU) rate under Code Sec. 6621(c). JTK made a $200,000 payment on January 16, 2004. On June 15, 2004, JTK's 2004 net operating loss was carried back and applied to reduce its 2003 liability by $521,000, resulting in full satisfaction of the outstanding 2003 balance due. Upon a subsequent audit of JTK's 2003 return, a deficiency was assessed by the IRS and the IRS assessed interest on the deficiency, addition to tax, and penalty using the LCU rate.

There was no dispute that interest was due. The only issue in dispute was whether the IRS abused his discretion in determining that the higher LCU rate of interest should apply to all tax, additions to tax, and penalties assessed with respect to JTK's underpayment of its 2003 income tax.

Under Code Sec. 6404(e)(1), the IRS can abate the assessment of interest in some situations. To prevail, the taxpayer must show that the IRS abused its discretion. The IRS is considered to have abused its discretion if it exercised that discretion arbitrarily, capriciously, or without sound basis in fact or law. Interest on underpayments of tax is generally imposed at the normal underpayment rate of the federal short-term rate plus 3 percentage points. Code Sec. 6621(c) imposes an additional 2 percent interest rate, called hot interest, on any large corporate underpayment. The term large corporate underpayment means any underpayment of a tax by a C corporation for any tax period if the amount of such underpayment for such period exceeds $100,000. The so-called hot interest or LCU rate applies only to periods after the applicable date.

The applicable date for hot interest is determined by taking into account any letter or notice provided by the IRS that notifies the taxpayer of the assessment or proposed assessment of the tax. After 30 days have passed from the date upon which the initial notice is issued, large underpayments due for that tax period are subject to the LCU rate. JTK conceded that it had a large corporate underpayment upon the filing of its 2003 fiscal year corporate income tax return. However, JTK argued that it was not liable for the hot interest rate because that rate does not apply until 30 days after the taxpayer is given notice of its opportunity for administrative review under Code Sec. 6621(c)(2)(A)(i), and JTK never received such notice. JTK asserted that absent proper notice sent to the taxpayer, the hot interest rate does not apply, even where a large corporate underpayment exists.

The Tax Court rejected JTK's argument and held for the IRS. The court noted that, under Code Sec. 6621(c)(2)(B)(i), the applicable date for hot interest where the underpayment is one to which the deficiency procedures do not apply is determined by taking into account any letter or notice provided by the IRS that notifies the taxpayer of the assessment or proposed assessment of the tax. The Form 4340, the court stated, clearly showed that tax due, as shown on JTK's delinquent 2003 corporate income tax return, was assessed on August 4, 2003. The Form 4340 reflected that a notice of balance due was issued upon the assessment of tax on August 4, 2003. Accordingly, the applicable date was 30 days from August 4, 2003, which was September 3, 2003.

According to the Tax Court, a notice of balance due entry on Form 4340 is sufficient to presumptively establish that notice and demand was sent on the date listed on the form. Moreover, the court stated, JTK failed to provide any credible evidence to rebut the presumption that the IRS provided such notice. Therefore, the court concluded that the IRS issued to JTK the notice on August 4, 2003, and that the IRS was therefore correct in assessing interest using the Code Sec. 6621(c) LCU rate as of September 3, 2003. Consequently, the IRS did not abuse its discretion in denying JTK's request to abate the hot interest assessed under Code Sec. 6621(c).

For a discussion of the large corporate underpayment rate of interest, see Parker Tax 261,520.

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IRS Finalizes Regs on Recapture of Overall Domestic Losses

The IRS has issued final regulations on the recapture rules for overall domestic losses. T.D. 9595 (6/24/12).

In 2007, the IRS issued proposed and temporary regulations under Code Sec. 904, relating to the foreign tax credit and the recapture rules for overall domestic losses. The IRS has now finalized those regulations with several changes.

The first change relates to dispositions under Code Sec. 904(f)(3), which provides that if a taxpayer disposes of certain property used or held for use predominantly without the United States in a trade or business, gain is recognized on that disposition and treated as foreign source income, regardless of whether the gain would otherwise be recognized. Under the regulations, gain is recognized to the extent of any overall foreign loss account in the separate category of foreign source taxable income generated by the property. Reg. Sec. 1.904(f)-2(d) provides separate rules for dispositions in which gain is recognized irrespective of Code Sec. 904(f)(3) and dispositions in which the gain would not otherwise be recognized.

The second change was the result of a question that arose on dispositions in which gain is recognized irrespective of Code Sec. 904(f)(3) and the recognized gain is otherwise treated as U.S. source income. In the preamble to the final regulations, the IRS said the language of Code Sec. 904(f)(3)(A) is clear that gain on such dispositions is recharacterized as foreign source income only to the extent of the applicable Code Sec. 904(f)(3) recapture amount. Thus, the final regulations clarify that this limit on recharacterization applies. The amount of gain recharacterized as foreign source is equal to the lesser of the total recognized gain or the balance in the overall foreign loss account remaining after any other overall foreign loss recapture under Code Sec. 904(f)(1) has been made.

A third change relates to the adjustments for capital gains and losses and qualified dividend income. The 2007 temporary regulations provided rules coordinating the application of Code Sec. 904(b), which addresses the effect of capital gains and losses on the foreign tax credit limitation, and Code Sec. 904(g), which addresses overall domestic losses and the recapture of such losses. The 2007 temporary regulations followed the approach of the coordination rules in Reg. Sec. 1.904(b)-1(h), which generally provides that adjustments under Code Sec. 904(b) to capital gains and losses and qualified dividend income (i.e., Code Sec. 904(b) adjustments) are taken into account first before applying the overall foreign loss provisions of Code Sec. 904(f). The final regulations retain that basic approach; however, they revise several provisions included in the 2007 temporary regulations and add new provisions to implement the mechanics of this coordination rule.

For a discussion of the treatment of overall foreign and domestic losses for purposes of calculating the foreign tax credit, see Parker Tax ¶101,925.

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IRS Rules on Criteria for Determining if Dividends and Dividend Equivalents Are Qualified Performance-Based Compensation

Where the rights to dividend and dividend equivalents of performance-based restricted stock or restricted stock units do not vest, and become payable solely on account of the attainment of preestablished performance goals, these amounts are not qualified performance-based compensation and are therefore included in determining applicable employee compensation for purposes of applying the $1 million cap on deductible compensation for a publicly held company. Rev. Rul. 2012-19.

The facts in Rev. Rul. 2012-19 deal with two publicly held corporations both in different situations. Both corporations maintain plans under which participating employees may be granted restricted common stock of the respective corporation or restricted stock units (RSUs) based on the common stock of the respective corporation. The restricted stock and RSUs granted under the plans vest upon the attainment of certain preestablished, objective performance goals and otherwise meet the applicable requirements of being deductible. Accordingly, the compensation received due to the vesting of the restricted stock and the vesting and payment of the RSUs is qualified performance-based compensation that is excluded from the applicable employee remuneration to which the deduction limitation under Code Sec. 162(m) applies.

In the first situation, Corporation X's plan provides that dividends and dividend equivalents otherwise payable to an employee during the period from grant through vesting with respect to performance-based restricted stock and RSU awards granted to the employee are accumulated and become vested and payable only if the related performance goals with respect to the restricted stock and RSUs are satisfied. All other applicable requirements are met with respect to the grant of rights to dividends and dividend equivalents.

In the second situation, Corporation Y's plan provides for payment to an employee during the period from grant to vesting of dividends and dividend equivalents with respect to performance-based restricted stock and RSU awards granted to the employee at the same time dividends are paid on common stock of Corporation Y regardless of whether the performance goals established with respect to the restricted stock and RSUs are satisfied.

The IRS was asked to rule on whether dividends and dividend equivalents relating to restricted stock and RSUs that are performance-based compensation must separately satisfy the requirements under Code Sec. 162(m)(4)(C) to be treated as performance-based compensation. Code Sec. 162(m)(4)(C) provides that applicable employee remuneration does not include compensation payable solely on account of the attainment of one or more performance goals, but only if (1) the performance goals are determined by a compensation committee of the board of directors of the taxpayer that is comprised solely of two or more outside directors, (2) the material terms under which the remuneration is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the vote in a separate shareholder vote before payment of such remuneration, and (3) before any payment of such compensation, the compensation committee certifies that the performance goals and other material terms were in fact satisfied.

The IRS ruled that, with respect to Corporation X, dividends and dividend equivalents paid under X's plan are qualified-performance based compensation and therefore are excluded from applicable employee remuneration for purposes of applying the $1 million limitation on deductibility. Under Corporation X's plan, the IRS stated, participants' rights to restricted stock and RSUs are subject to performance goals that meet the applicable requirements in Reg. Sec. 1.162-27(e) and are excluded from applicable remuneration for purposes of applying the excess compensation deduction limitation. Under the same plan, participants' rights to dividends and dividend equivalents vest and become payable only if the same performance goals that apply to the related grants of restricted stock and RSUs are satisfied. Therefore, the IRS concluded, dividends and dividend equivalents under X's plan are also excluded from applicable remuneration for purposes of applying the excess compensation deduction limitation.

However, the IRS ruled that in the second situation, with respect to Corporation Y, dividends and dividend equivalents paid under Y's plan are not qualified-performance based compensation and therefore are included in applicable employee remuneration for purposes of applying the $1 million limitation on deductibility. According to the IRS, the rights to these amounts do not vest and become payable solely on account of the attainment of preestablished performance goals. Thus, these amounts are not qualified performance-based compensation, regardless of whether the performance goals are met with respect to the related restricted stock and RSUs.

For a discussion of the $1 million cap on deductible compensation for publicly held companies, see Parker Tax ¶91,101.

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