Archive for Depreciation

How to calculate stock and loan basis in an S Corp for tax purposes

February 27, 2013 Basis, Corporation, Cost Basis, Depreciation, Self Employ, Small Business, Sole Proprietor, Sub-chapter S, Tax Guidance & Preparation, Tax Problems & Requests

If you are a shareholder of an S corporation you are responsible for keeping track of your own basis (investment value) in the S corporation of which you own shares.  Tracking shareholder basis is usually not the S corporation’s responsibility.

You can have stock basis and loan basis, which are usually adjusted each year based on the S corporation’s operations. 

It is important to annually calculate your shareholders basis in the S corporation stock you own for the following reasons:

• You can claim losses and deductions passed through on Schedule K-1 to the extent of their stock and loan basis [§1366(d)(1)].

• If you receive a non-dividend distribution from the S corporation, it’s nontaxable to the extent of you stock basis [§1368(b)(1)].

• When you disposes of the S corporation stock, gain or loss on the disposition is calculated using you stock basis.

Stock basis starts with your initial contribution of capital to the S corporation’s capital account or the price paid for the stock. This amount is adjusted annually, as of the last day of the S corporation year, in the following order [Reg. §1.1367-1(f)]:

(1) Increased by all income including tax-exempt income reported on Schedule K-1 and excess depletion.

(2) Decreased by property distributions including cash made by the S corporation that are reported on Schedule K-1 in Box 16 with code D.

(3) Decreased by nondeductible non capital expenses, such as illegal bribes, kickbacks, fines and penalties, expenses and interest related to tax-exempt income, and the nondeductible portion of meals and entertainment.

(4) Decreased by deductible losses and deductions reported on Schedule K-1.

Stock basis can never go below zero.

If non dividend distributions exceed stock basis, the excess is taxed as capital gain on your personal return [§1368(b)(2)].

If deductible losses and deductions exceed stock basis, they can be deducted to the extent you have loan basis and any amount in excess of loan basis is suspended and carried over to the succeeding tax year.

You can elect to reduce your stock basis by deductible losses and deductions before decreasing their basis by non deductible expenses [Reg. §1.1367-1(g)]. If this election is made and nondeductible expenses exceed your stock and loan basis, the excess retains its character and is carried over to the succeeding tax year. If the election is not made, any excess nondeductible expenses are lost, not suspended and not carried over.

Loan basis starts with a loan substantiated with loan documentation from you the shareholder of the S corporation to the S corporation. In other words, it includes a traditional, written note with a reasonable stated rate of interest. It does not include third party loans to the S corporation that you guarantee or co-signs.

Loan basis is adjusted as follows:

• Losses and deductions (deductible and nondeductible) passed through on Schedule K-1 reduce stock basis before they reduce loan basis.

• Loan basis can never go below zero. If deductible losses and deductions exceed your stock and loan basis, the excess is suspended and carried over.

• If there are different types of losses and deductions, the allowable loss and deduction items must be prorated.

• If loan basis has been reduced by pass-through losses and deductions, any net increase in a subsequent year restores the reduced loan basis before it increases your stock basis [Reg. §1.1367-2(c)].

A net increase is the amount by which the increases to stock basis exceed the decreases to stock basis including non dividend distributions.

• Non dividend distributions are not taxable if there is a “net increase” for the year, even if you have no stock basis.

• Reduced loan basis is restored by any “net increase” for the year before any loan repayments during the year are taken into account [Reg. §1.1367-2(d)(1)].

These loan repayments must be allocated in part to a return of your basis and in part to the receipt of income. If the loan is a written note, the note is a capital asset and the income will be capital gain.

As an S corporation shareholder you must establish that you have enough basis in the S corporation before you can claim any pass-through losses or deductions. Basically S corporation shareholders usually tend to get into trouble when they assume that non dividend distributions from an S corporation are entirely nontaxable. Be sure to verify that the distribution does not exceed your stock basis. Also be sure to be aware of the various ordering rules for adjusting stock and loan basis in an S corporation.

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IRS Form 1040 Schedule C: Profit or Loss from Business

February 7, 2012 Accounting Method, Business Expense, Business Income, Car expense, Depreciation, Disallowed Expenses, Employee Business Expense, Entity Classification, FICA, Health Insurance, Hobby, Home Office, Husband/Wife, Medicare, Net Operating Loss, NOL, Passive Activity, Self Employ, Small Business, Social Security, Social Security Tax, Sole Proprietor, Start up costs, Sub-chapter S, Tax Guidance & Preparation, Tax Problems & Requests

The sole proprietorship or Limited Liability Corporation (LLC) is in my opinion the easiest type of business entity to set up and begin operating. It is not separate from its owner with the income and expenses reported on IRS Form 1040 Schedule C.

Some people have instant success with a venture that is profitable from the very beginning. However it is more common to be unprofitable in the first 24 to 36 months of operation. If you are loosing money it is important to remember that you MUST REPORT A PROFIT IN 2 OUT OF THE PREVIOUS 5 TAX YEARS TO AVOID BEING CONSIDERED BY THE IRS TO BE REALLY ENGAGED IN A HOBBY. For more details on the specifics of hobby versus business see my post at: http://johnrdundon.com/how-to-determine-what-is-a-business-vs-what-is-a-hobby/

When it comes to losses the other thing to keep in mind is that they can be limited basically in three different ways:

1. By the amount of your investment or basis limitation;
2. By the amount you have at risk or at-risk limitation; and
3. By the passive activity loss limitation.

Basis limitations do not apply to sole proprietors as they would with an S corporation shareholder or partner in a partnership. A sole proprietorship is predominantly financed by the proprietors own assets. Two obstacles must be overcome before a Schedule C loss is deductible as addressed in this particular order:

1. The at-risk limitations of IRC Sec. 465; and
2. The passive activity loss limitations of IRC Sec. 469.

The at-risk limitations apply before any loss is limited due to lack of material participation which is a threshold criteria of a passive activity. The proprietor’s at-risk limitation is calculated on IRS Form 6198. If a taxpayer cannot verify a material-participation level with respect to the Schedule C activity, then being at-risk for the loss is essentially immaterial. The at-risk concept is one that looks at the source of funds for the business. Usually sole proprietors would not be at-risk when:

• The business was financed with non-recourse loans – except for holding real property;
• A valid guarantee or stop-loss agreement is in force; or
• Amounts borrowed for use in the business are from a person with an interest in the business, other than a creditor, or who is
related to a person having an interest in the business under IRC Sec. 465(b)(3)(C).

Most all small businesses with gross receipts of $1 million or less are allowed to use the cash method of accounting (Rev. Proc. 2001-10). New proprietors generally begin using the cash method of accounting immediately. An existing business may qualify to change its accounting method by filing IRS Form 3115 – Application for Change in Accounting Method with its tax return under the automatic consent procedures. When changing from an accrual to a cash method of accounting usually a negative IRC Sec. 481(a) adjustment is deducted in the year of the change and a positive IRC Sec. 481(a) adjustment is generally reported in income over a four-year period.

Items withdrawn for contributions to charitable organizations are reported via to IRS Form 8283 Non-cash Charitable Contributions and finally to Schedule A Itemized Deductions.

Office-in-home deduction items are detailed separately on IRS Form 8829 Expenses for Business Use of Your Home rather than on the expense lines for rent, utilities, interest, etc.

Proper deduction of vehicle expenses includes a decision for utilizing the cents-per-mile deduction or the actual method. Both methods require maintaining a mileage log and an understanding
of which miles are business miles.

Additionally, an understanding of depreciation methods available, which includes knowing the weight of the vehicle, are important. IRC Sec. 179 deductions are limited to income, but regular depreciation, including bonus depreciation, can actually assist in creating or increasing an net operating loss (NOL).

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100% Bonus Depreciation – Revenue Procedure 2011-26

April 8, 2011 Depreciation

For those of you fortunate enough to have actually invested in your operations through the purchase of certain ‘qualified property’ last year you are going to want to read IRS Revenue Procedure 2011-26 which provides guidance on the new 100 percent bonus depreciation from the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

Specifically it explains the eligibility requirements for qualified property to qualify for the 100 percent additional first year depreciation deduction. Also, Revenue Procedure 2011-26 provides the method for a taxpayer who already timely filed the 2009 tax return to amend it to include qualified property.

This can be a huge deduction not to be over looked.  It is worth your time to check and see if the property you purchased for your trade or business qualifies for this deduction.  Read the link to Revenue Procedure 2011-26 and feel welcome to contact me with questions.

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Application of Asset Classification Rules When Determining Cost Segregation Depreciation

February 15, 2011 Cost Segregation, Depreciation

Okay this is pretty huge in regards to some of the IRS Examination Appeals work I have been doing lately.  The bottom line is that you need to follow the asset classification rules if you are going to engage in cost segregation depreciation.  The following text is taken directly from the IRS’ Audit Techniques Guide for depreciation……Be realistic in your initial determinations and resist the urge to change an assets classification mid life.

Asset classification pursuant to the rules in Rev. Proc. 87-56 is not always a straight-forward determination, particularly where the taxpayer is involved in a number of related business activities. The proper steps to follow in assigning assets to the appropriate asset or activity or class may be summarized as follows:

    1. Ascertain and understand the primary business activity of the taxpayer.

  1. Determine the function and use of the assets in the taxpayer’s business.

  2. Apply the clear and plain language contained in the asset guideline classes of Rev. Proc. 87-56 with respect to the assets in question.

The application of these steps may be illustrated by the analysis used in a sampling of court cases, private letter rulings, and revenue rulings, which are summarized below. The analysis in each citation is based on a strict reading of Rev. Proc. 87-56, including historical reference to original asset and activity class descriptions from which later classes have been derived. Note that, for those instances in which a taxpayer was permitted to use an asset class that was different from its primary business activity, the taxpayer was able to demonstrate that it did, in fact, have a separate trade or business for that property item.

Revenue Ruling 77-476, 1977-2 C.B. 5 - Conclusion: The primary business activity of the taxpayer determines the appropriate activity class.

Analysis: An oil pipeline owned by an electric utility company and used to transport oil between the company’s dock and its inland generating facility is “public utility property” (Asset Guideline Class 49.13, Electric Utility Steam Production Plant). Since the taxpayer is not in the trade or business of transporting oil by pipeline, the pipeline should not be classified as “pipeline transportation property” (Asset Guideline Class 46.0, Pipeline Transportation).

Revenue Ruling 80-127, 1980-1 C.B. 53 – Conclusion: Assets specifically excluded from a certain activity class must be classified in the appropriate asset class.

Analysis: The taxpayer leases shipping containers to a shipping company. The containers are designed to transport cargo over the road on trailers and by water on cargo ships and should be classified in Asset Guideline Class 00.27, which includes “trailer-mounted containers.” Activity Guideline Class 44.0, Water Transportation, which describes assets used in the commercial and contract carrying of freight by water, specifically excludes assets included in classes with a 00.2 prefix. (Note: the result would be the same if the shipping company owned the containers.)

Private Letter Ruling 9101003 (Sept. 25, 1990) – Conclusion: Property is classified according to the primary business activity of the taxpayer, even though the activity in which such property is primarily used is insubstantial in relation to all the taxpayer’s activities. In determining the primary business activity included in a current activity class, it is helpful and appropriate to analyze the historic business activities included in the classes from which it is derived.

Analysis: The taxpayer’s business activities include the acquisition, processing, and sale of various types of scrap materials. Asset Guideline Class 57.0, Distributive Trades and Services, includes assets used in wholesale and retail trade. The description for this class includes no further detail. However, the predecessor to Asset Guideline Class 57.0 included Asset Guideline Class 50.0, Wholesale and Retail Trade, which included assets used in the acquisition and processing of goods at both the wholesale and retail level. The description for Asset Guideline Class 50.0 also specifically referenced the brokerage of scrap metal and various pre-sale processing activities.

Private Letter Rulings 9502001, 9502002, and 9502003 (June 30, 1994) - Conclusion: Property is included in the asset class in which the property is primarily used, even if it is used in more than one activity or the activity is not specifically defined.

Analysis: The taxpayer uses a factory trawler to harvest and process various species of fish. There is no specific Asset Guideline Class for the fishing industry. Asset Guideline Class 20.4 covers the Manufacture of Other Food and Kindred Products, but does not specifically list water vessels. However, Asset Guideline Class 00.28 includes Vessels, Barges, Tugs, and Similar Water Transportation. Accordingly, the trawler is a specific asset described in Asset Guideline Class 00.28, which includes all water vessels without regard to the business activity.

Private Letter Ruling 9548003 (July 31, 1995) – Conclusion: Assets engaged in more than one activity must be classified to the activity in which they are primarily used.

Analysis: The taxpayer is a public utility company supplying electric and gas utility service. Through a number of subsidiaries, the taxpayer also owns and operates several natural gas gathering systems, processing plants, and pipeline systems. Most of the pipelines are not connected to the taxpayer’s processing plants; thus, the taxpayer is engaged in two separate business activities. The gathering pipelines are appropriately included in Asset Class 46.0 (Pipeline Transportation), while the processing plants are included in Asset Class 49.23 (Natural Gas Production Plant).

Duke Energy Natural Gas Corporation v. Commissioner, 109 T.C. 416 (1997), rev’d, 172 F.3d 1255 (10th Cir. 1999), nonacq., 1999-2 C.B. xvi. – Conclusion: The class life of an asset is based on the asset’s primary use in relationship to the classes in question.

Analysis: The taxpayer was a natural gas corporation. At issue was the classification of its natural gas gathering systems as either assets used in the production of gas or assets used in the transportation of gas. It was determined that the plain language of the asset descriptions supported the contention that the gathering systems constituted assets used in the taxpayer’s production of natural gas.

Saginaw Bay Pipeline Co., et al v. United States, 124 F. Supp. 2d 465 (E.D. Mich. 2001), rev’d and rem’d, 2003 FED App. 0259P (6th Cir.) (No. 01-2599) – Conclusion: The proper asset class is determined by the use of the property rather than the activity of the owner of the property.

Analysis: The 6th Circuit held that, because the taxpayer’s underground natural gas pipelines were used primarily by natural gas producers and functioned as gathering pipelines in the natural gas production process, the taxpayer’s underground natural gas pipelines are includible in Asset Class 13.2. The 6th Circuit reached this result, even though the taxpayer was not a producer of natural gas (that is, not engaged in the activity described in Asset Class 13.2).

Clajon Gas Co. LP, et al v. Commissioner, 119 T.C. 197 (2002), rev’d, 2004 U.S. App. LEXIS 284 (8th Cir. Mo. Jan. 12, 2004) – Conclusion: Classification of property as to the proper asset class is based on the use of the property in a manner as described in an asset class.

Analysis: The taxpayer was not a natural gas producer and the taxpayer used the gathering lines to transport gas. At issue was the classification of taxpayer’s gathering lines as either assets includible in Asset Class 13.2 (Exploration for and Production of Petroleum and Natural Gas Deposits), which has a MACRS recovery period of 7 years, or Asset Class 46.0 (Pipeline Transportation), which has a MACRS recovery period of 15 years. The 8th Circuit determined that Clajon primarily used the gathering system in a manner consistent with the description of Asset Class 13.2 (i.e., as gathering pipelines). The descriptive language of the asset class does not require that the producer be the owner of the gathering system assets. The result is that there is no distinction between the gathering system assets of producers and nonproducers, for purposes of depreciation deductions.

Revenue Ruling 2003-81, 2003-2 C.B. 126 – Conclusion: An asset included in both an asset category and an activity category is placed in the asset category, unless it is specifically excluded from the asset category or specifically included in the activity category. [Reference is to Norwest Corporation & Subsidiaries v. Commissioner, 111 T.C. 105 (1998).]

Analysis: The taxpayer was engaged in the business activity of producing and selling electricity generated from steam, which is described in activity class 49.13, Electric Utility Steam Production Plant.

A workbench used to repair machinery and equipment damaged during the production of electricity was classified in activity class 49.13, because it was used in the activity described in that class and not specifically included in another asset class.

A bookcase used to hold training manuals and operation protocols was classified in asset class 00.11 (even though it was used in connection with the taxpayer’s business activity of producing electricity) because it is not specifically excluded from asset class 00.11 or specifically included in asset class 49.13.

Parking Lot A, located outside the plant facility and used by employees at the plant, was classified in asset class 49.13, because that asset class specifically includes land improvements that are related to assets used in the production of electricity from steam. Although asset class 00.3, Land Improvements, also includes parking lots, it specifically excludes land improvements that are explicitly included in any other asset class.

Parking Lot B, located 100 miles away from the plant and adjacent to the corporate headquarters, was classified in asset class 00.3. This parking lot was used by employees at the headquarters office and was not related to the activity of producing the electricity. Therefore, it did not constitute a land improvement related to assets used in the production of electricity from steam and the proper classification was in the asset category, rather than the activity category.

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Capital Equipment Expense example – Bonus Depreciation

January 16, 2011 Depreciation

If in December 2010 you purchased and placed in service a new piece of capital equipment to use in your business – say for example a farmer buys a new tractor and placed it in service in his farming business. The tractor cost $300,000. The farmer can expense the entire cost of the tractor even if he has no taxable income.

Note: You cannot claim a deduction on your 2010 tax return using §179 if you have no taxable income. However, you can use bonus depreciation. Under the 2010 Tax Relief Act, qualified property purchased after September 8, 2010, and before January 1, 2012, and placed in service before January 1, 2012 (January 1, 2013, for certain aircraft and certain property having longer production periods), is eligible for 100% bonus depreciation [§168(k)(5)]. There is no taxable income limitation for bonus depreciation. Thus, you can deduct the entire cost of the tractor using bonus depreciation. Bonus depreciation can also create a net operating loss (NOL); whereas, §179 cannot.

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New reporting rules for passive activities force group decisions

August 26, 2010 Cost Segregation, Depreciation, Like/Kind Exchange, Mortgage, Net Operating Loss, NOL, Passive Activity, Rental Real Estate, Tax Deductible Expenses, Tax Guidance & Preparation, Tax Problems & Requests, Taxable Income

As part of the IRS’s continuing efforts to require greater disclosure of tax positions and strategies on returns, it recently released new, mandatory disclosure rules for grouping passive activities. Rev. Proc. 2010-13 for the first time mandates that passive-activity groupings and regrouping, as required under Code Sec. 469 regulations, be disclosed on the taxpayer’s return.

The IRS, of course, puts a positive spin on this new reporting requirement, claiming that it will help taxpayers “more easily verify their historical groupings.” It also seems clear, however, that the IRS will not put this new information in a drawer, but will use it as an effective audit and compliance tool.

MANDATORY DISCLOSURE AUTHORITY

Sec. 469 generally prohibits losses incurred in a passive activity from being used to reduce income from an activity that is not a passive activity. A limited exception applies upon the disposition of an activity. Unused passive losses may be carried forward only. A passive activity for these purposes is generally any activity involving the conduct of a trade or business in which the taxpayer does not materially participate, and any rental activity. Grouping activities can be especially significant when determining whether material participation exists.

Sec. 469 defers to regulations the formation of the requirements for grouping activities. The regs, in turn, leave the rules for identifying particular groupings to the IRS. Notice 2008-64, which proposed certain reporting requirements, was the IRS’s first pass at following through on that authority. Rev. Proc. 2010-13 now spells out final reporting requirements.

WHAT THE REGS ALREADY DO

Passive-activity loss regs (Reg Sec. 1.469-4 et seq.) treat one or more trade or business activities or rental activities as a single activity if the facts and circumstances indicate that they constitute an appropriate economic unit for the measurement of gain or loss. Facts and circumstances in making that assessment include “any reasonable method,” but generally should consider certain nonexclusive factors set out in the regs, including: similarities and differences in types of businesses; the extent of common control; the extent of common ownership; geographical location; and interdependencies between the activities.

The regs recognize that the same facts and circumstances may result in more than one permissible grouping of activities, and there may be more than one reasonable method for grouping a taxpayer’s activities. However, multiple options do not remain open-ended.

  1. Lock in. Once the taxpayer decides on a grouping, the regs limit change. Reg Sec. 1.469-4 (e) provides that:

    “(1) Original groupings. – Except as provided in paragraph (e)(2) …, once a taxpayer has grouped activities under this section, the taxpayer may not regroup those activities in subsequent taxable years … .”

    “(2) Regroupings. If it is determined that a taxpayer’s original grouping was clearly inappropriate or a material change in the facts and circumstances has occurred that makes the original grouping clearly inappropriate, the taxpayer must regroup the activities … .”

  2. Tax avoidance override. The regs also empower the IRS to regroup a taxpayer’s activities if any activity is not an appropriate economic unit, and if a principal purpose of the grouping is “to circumvent the underlying purposes of Section 469″ (Reg Sec. 1.469-4(f)). Moreover, the IRS is specifically authorized to impose 6662 penalties in addition to regrouping under such circumstances. The IRS indicated back in 1994 when issuing this reg that it would not exercise its regrouping authority often. Whether having the advantage of disclosures under the new reporting regime will change this dynamic, however, is yet to be determined.

NOTICE 2008-64 PROPOSALS

The regulations under Reg Sec.1.469-4 mandate that taxpayers comply with disclosure requirements “that the commissioner may prescribe with respect to both their original groupings and the addition and disposition of specific activities within those chosen groupings in subsequent taxable years.”

In floating reporting requirements for comments in Notice 2008-64, the IRS noted that at that time it had not previously prescribed requirements for Sec. 469 groupings, despite this long-time option to do so. It added, however, that, “as a result, the IRS and taxpayers have had difficulty verifying taxpayers’ historical groupings.” Rev. Proc. 2010-13 now fills that void with a reporting regime similar, but not identical to, that proposed in 2008.

REV. PROC. 2010-13 DISCLOSURES

First, the good news. There are two tax-friendly differences between the Notice 2008-64 proposals and Rev. Proc. 2010-13′s requirements. Disclosure will not be required whenever there is a disposition of an activity within a chosen grouping. And a taxpayer with an incorrect grouping has a chance to fix the problem without being forced to forego grouping entirely. As a bonus, Rev. Proc. 2010-13 provides that groupings that are made for tax years beginning before Jan. 25, 2010, are required to be disclosed only upon the addition of new activities to existing groups or regroupings. For calendar-year taxpayers, original groupings therefore need not be disclosed until the 2012 tax-filing season on 2011 returns.

Despite backing off a bit on Notice 2008-64 proposals, however, Rev. Proc. 2010-13 nevertheless, for the first time, will provide the IRS with a significant amount of information heretofore unavailable to assess the necessity and effectiveness of a possible audit on passive-activity groupings.

Taxpayers now must file a written statement with their original income tax returns for the first tax year in which two or more trade or business activities or rental activities are originally grouped as a single activity. The statement must identify the names, addresses and employer ID numbers for the activities that are being grouped. It must contain a declaration that the grouped activities constitute “an appropriate economic unit.”

Statements also are required for the addition of new activities to existing groupings and for regroupings of original groupings:

  1. Additions. The taxpayer is required to report on their annual return those changes that occur during the tax year in which the taxpayer adds a new trade or business activity or a rental activity to an existing grouping.

  2. Regroupings. Original groupings that were or have become “clearly inappropriate” must be regrouped and reported as such with the taxpayer’s original tax return for the tax year in which the regrouping occurs. This statement must contain a declaration that the regrouped activities constitute an appropriate economic unit and an explanation of why the original grouping was or is now clearly inappropriate. The new reporting rules do not alter the restrictions placed under the regs on a taxpayer for regrouping. As discussed, once the taxpayer has grouped activities, they normally may not be regrouped in subsequent years unless the original grouping was “clearly inappropriate” or a material change in facts and circumstances now makes it “clearly inappropriate.” In the case of “clearly inappropriate,” the regs require the taxpayer to make the regrouping and the new procedure sets out the information that must be reported.

  3. Passthroughs. Special disclosure rules apply to partnerships and S corporations. These entities already must comply with the disclosure instructions for grouping activities found on Form 1065, U.S. Return of Partnership Income, and Form 1120S, U.S. Income Tax Return for an S Corporation. In general, the entity’s groupings must be disclosed to the partners or shareholders by separately stating the income or loss from each grouping on an attachment to the entity’s annual Schedule K-1. The new reporting procedure makes clear that activities that are grouped together by these Sec. 469 entities may not be treated as separate activities by the shareholder or partner.

SANCTIONS

The failure to report whether activities have been grouped as a single activity will generally result in the unreported activities being treated as separate activities under a default rule. The IRS, however, is not bound by this “separate activities” default rule if it would aid in tax avoidance. Specifically, the IRS may regroup activities to prevent tax avoidance.

A taxpayer who discovers a failure to disclose, too, is not necessarily locked into separate activities treatment. The taxpayer will be deemed to have made a timely disclosure, provided all affected income tax returns have been made consistent with the claimed grouping and the disclosure is made on the return for the year that the failure to disclose is first discovered. In addition, reasonable cause for the failure to make a timely disclosure must be demonstrated by the taxpayer if the IRS first discovers the failure to disclose.

CONCLUSION

Grouping and regrouping of passive activities will be rising to a new level of scrutiny as the IRS gains easy access to information on how closely taxpayers are following the rules under the regs. Taxpayers, too, should take this as a wake-up call to make careful decisions on initial grouping elections and then substantiate those decisions through documentation to show “an appropriate economic unit.” Documentation also should be collected contemporaneously when changed circumstances make an original grouping “clearly inappropriate,” or “reasonable cause” is raised as a reason for a failure to report.

By George G. Jones and Mark A. Luscombe

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Cost Segregation Depreciation

July 27, 2010 1031 Exchange, Audit Reconsideration, Business Expense, Cost Segregation, Deductible Expense, Depreciation, Disallowed Expenses, Rental Real Estate, Tax Guidance & Preparation, Tax Problems & Requests, Tax Relief

For income tax depreciation purposes there are two major types of assets: Sec. 1250 real property and Sec. 1245 personal property. When owners acquire commercial property or tenants invest in leasehold improvements, many only allocate the purchase price between land (non-depreciable) and building (depreciated as a 39-year asset over 40 years).

However, by taking advantage of IRS sanctioned rules in the tax law, property may be further segregated within these two sections by identifying 5-year and 7-year personal property, 15-year land improvements, and 27.5-year residential and 39-year nonresidential real property.

For example the IRS allowable 5 and 7 year personal property items include electrical service and distribution to dedicated computer equipment and appliances; plumbing that services dedicated kitchen equipment; and many types of nonstructural furniture, finishes, fixtures and equipment. 15 year land improvements include site utilities, some pools, landscaping, paving, curbs and gutters.

As a direct result of segregating these IRS allowable categories, depreciation expense increases in the first several years of the property’s life. The increase in depreciation expense applied against generated revenues decreases taxable earnings in those years, resulting in substantial present-value tax savings for building owners who purchased their buildings after 1986.

Cost segregation is applicable and cost effective for buildings of varying cost basis, starting in value at $250,000 as well as tenant leasehold improvements starting in value at $80,000.

BENEFITS OF COST SEGREGATION DEPRECIATION

Calculating Cost Segregation Depreciation involves not only knowledge of tax law but of construction methodology and an understanding of which construction components apply to which 5, 7, 15 year, etc category. To generate the maximum amount of tax savings requires a detailed Cost Segregation Engineering Study. Specialized companies employ construction engineers and tax professionals to document and prepare these Cost Segregation Engineering Studies.

Naturally these firms charge a fee for their services. But the benefits of a proper fixed-fee cost segregation study will pay for the fee several times over, giving a healthy upward push to the owner’s cash flow and a significant ROI on the investment in the Study. Additionally, many of these firms will provide free estimates to review before committing to any course of action.

As a note, IRS guidelines prohibit a fee based pricing structure derived from the amount of tax benefit gained from the study.

“LOST” DEPRECIATION FROM EARLIER FILINGS CAN BE RECOUPED

Section 481(a) of the Internal Revenue Code enables property owners to “catch up” past years’ understated depreciation with a one-year lump-sum adjustment.

Therefore, if a property was acquired in 2003 and a Cost Segregation Engineering Study finds that $400,000 more could have been depreciated from 2003 to 2007, the owner can apply that additional amount to 2008 depreciation, in effect making up for the four years of increased depreciation that was lost.

PROPERTY IMPROVEMENT BY BUILDING OWNERS AND TENANTS CAN BENEFIT AS WELL

Cost Segregation Engineering Studies often are performed on capital projects in existing commercial property with even more beneficial results. Because large-scale renovations include repairs to and replacements of structural and nonstructural items, they normally are depreciated as a 39-year asset. However, it is not uncommon for a Cost Segregation Engineering Study to enable accelerated depreciation of more than half of the total renovation cost. Using a $6- million renovation as an example, this translates into more than $1 million in tax savings during the first four years and more than $500,000 present value tax savings.

There are certain circumstances where initiating Cost Segregation Depreciation is of no benefit. Building owners who plan to sell their property in 2-5 years; properties nearing the end of their depreciable life; owners who cannot use any more tax deductions; and non-profits would not benefit from Cost Segregation Depreciation.

COST SEGREGATION CAN BE APPLIED WITHOUT RE-FILING PREVIOUS YEARS TAXES. Re-filing is not necessary. In order to bring this new depreciation forward you will submit a 31.15 Change in Accounting Form. Court rulings allows for an “automatic approval protocol”. In other words all you have to do is complete the form and send it in with the client’s financials. Additionally the IRS ruled there would be no filing fee for the Change in Accounting Form.

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Recapture 179 Depreciation Expense Deduction – example

July 16, 2010 Depreciation

Robert purchased a new heavy duty pick-up truck (rated over 6,000 lbs.) for use in his landscaping business. The vehicle is used 100% for business and Robert elected to expense $15,000 of the cost under §179. In 2009, Robert sold his landscaping business and now uses the truck 100% in his residential rental activity. Is Robert required to recapture any of the §179 expense deduction?

Yes. Recapture is triggered when the use of the property in a trade or business drops to 50% or less in any year during the recovery period (generally five years for a truck). For purposes of applying the recapture rules, converting the use of the property from use in a trade or business to use in an income producing activity, such as a residential rental activity where no extraordinary personal services are rendered, is considered a conversion to personal use. The §179 expense deduction subject to recapture is taxed as ordinary income in 2009 [Reg. §1.179-1(e)(2)].

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HIRE – Depreciation and Section 179 Expense

May 26, 2010 Deductible Expense, Depreciation

HIRE and Section 179 Deduction – A qualifying taxpayer can choose to treat the cost of certain property as an expense and deduct it in the year the property is placed in service instead of depreciating it over several years. This property is frequently referred to as section 179 property.

The Hiring Incentives to Restore Employment (HIRE) Act of 2010 extends the dates of the IRC Section 179 temporary increase in limitations on expensing of depreciable business assets. Under HIRE, qualifying businesses can continue to expense up to $250,000 of section 179 property for the 2010 tax year. Without HIRE, the 2010 expensing limit for section 179 property would have been $125,000. The $250,000 amount provided under the new law is reduced, but not below zero, if the cost of all section 179 property placed in service by the taxpayer during the tax year exceeds $800,000.

2009 Section 179 limits. The maximum section 179 expense deduction you can elect for qualified section 179 property you placed in service in tax years that begin in 2009 remains at $250,000 ($285,000 for qualified enterprise zone property and qualified renewal community property). This limit is reduced by the amount by which the cost of section 179 property placed in service in the tax year exceeds $800,000

Depreciation limits on business vehicles. The total depreciation deduction (including the section 179 expense deduction) you can take for a passenger automobile (that is not a truck or a van) you use in your business and first placed in service in 2009 is $2,960 ($10,960 for automobiles for which the special depreciation allowance applies). The maximum deduction you can take for a truck or van you use in your business and first placed in service in 2009 is $3,060 ($11,060 for trucks or vans for which the special depreciation allowance applies).

Caution. These limits are reduced if the business use of the vehicle is less than 100%.

John R. Dundon, EA – 720-234-1177

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Cost Basis

May 20, 2010 1031 Exchange, Cancelled Debt, Capital Gain, Capital Loss, Charitable Contribution, Cost Basis, Cost Segregation, Deductible Expense, Depreciation, Estate Tax, Like/Kind Exchange, Passive Activity, Rental Real Estate, Tax Guidance & Preparation, Tax Problems & Requests

On October 3, 2008, President George W. Bush signed the Emergency Economic Stabilization Act of 2008. Tucked away in the Act is a provision that moves the responsibility of basis determination from the shoulders of the taxpayer to the shoulders of the securities industry. After December 31, 2010, every broker that is required to file an information return reporting the gross proceeds of a ‘covered security’ must include in the return the customer’s adjusted basis in the security and whether any gain or loss with respect to the security is short term or long term under Code Sec. 1222, Sec. 403(3)(1)DivB, PL 110-343, 10/3/2008.

There is a three-stage phase-in with the first effective date of January 1, 2011, as follows: Stock acquired on or after January 1, 2011; Mutual fund and dividend investment plan (DRIP) shares acquired on or after January 1, 2012; and Other specified securities [principally debt securities (bonds) and options] acquired on or after January 1, 2013. Because cost basis reporting only applies to securities acquired on or after the applicable effective date, brokers must sort and separate post-effective-date acquired securities from the pre-effective date securities. As customers sell their positions, brokers must have the ability to identify whether pre-effective-date or post-effective-date securities were sold in order to determine whether cost basis reporting is required. The software and accounting system mechanics of such an exercise could be difficult. Similarly, because of the three-stage phase-in of effective dates, brokers’ systems must correctly sort securities into the various categories in order to apply the proper basis rules to each and to determine correctly whether a security is a pre-effective or post-effective-date acquisition.

This effort began with the National Taxpayer Advocate’s report about the tax gap based on the 2001 filing season. The report stated that the tax gap was $345 billion. Of this amount, individual taxpayers accounted for $197 billion, mostly unreported or under reported income rather than overstated deductions or improperly claimed credits. Of that $197 billion, under reported capital gains accounted for $11 billion.

In 2006, the investigative arm of Congress, the General Accounting Office (GAO), estimated that 38 percent of all reported capital gains are erroneous. This was also verified by the work of the IRS in conjunction where 46,000 random taxpayers were audited. Net Basis was used to verify reported cost basis information on the Schedules D for the 2001 National Research Program Random Study. Hundreds of thousands of investment transactions were processed through the NetBasis system. NetBasis not only identified a significant number of Schedules D that yielded improper reporting, but it also identified $11 billion dollars in under reported capital gains taxes, which was then included in the 2006 Tax Gap Report.

Since 2005, a renewed effort has been underway to change the rules to shift this responsibility from the taxpayer to the broker. At the heart of the matter is that cost basis of securities, real estate, or other items sold was not required to be reported to the IRS by anyone except the taxpayer. According to Nina Olson, the National Taxpayer Advocate, “When information is reported to the IRS, the compliance rate is 90 percent. When it’s not reported, only 50 percent shows up on a tax return. In another statement, Olson said, “Where taxable payments are not reported to the IRS by third parties, compliance drops precipitously to a range from about 20 percent to about 68 percent depending on the type of transaction.”

Congress decided to take the responsibility from the shoulders of the individual taxpayer and place the responsibility upon the securities industry primarily brokerage firms which was spelled out in the 2008 Emergency Economic Stabilization Act.

In early 2009, the IRS released Notice 2009-17, Information Reporting of Customer’s Basis in Securities Transaction, requesting comments for guidance with respect to the reporting of a customer’s basis in securities transactions. The notice contained 36 specific issues under 8 categories. The categories included:

1. Applicability for reporting requirements. The IRS addresses concerns about who is a “middleman” subject to the broker reporting and transfer reporting statement requirements and how to minimize duplication of reporting by multiple brokers.

2. Basis method election. There are many basis method elections
(FIFO, specific identification, single-category and double-category averaging for mutual funds, and dividend reinvestment plans (DRIPs) for determining the basis of securities sold. How will these methods be applied uniformly? Will the taxpayer retain the various elections or will the brokers force a single method to simplify their reporting?

3. Dividend reinvestment plans. Can the average cost basis frequently used by mutual funds be expanded to include DRIPs? How will shares of stock acquired prior to the effective date for DRIPs (January 1, 2012) be melded into a suitable report after the effective date of basis reporting for stocks (January 1, 2011)?

4. Reconciliation with customer reporting. How will the taxpayer’s
Form 1040 Schedule D be reconciled by a broker’s basis reporting if the basis method elections are different? If a workable solution is not found, the objectives of taxpayer help and audit administration could be defeated.

5. Special rules and mechanical issues. This category deals with the variety of issues associated with wash sales, options, changes in timing for reporting proceeds from short sales, adjustments to basis for original issue discount (OID), market premium, discount and additional special basis adjustment rules.

6. Transfer reporting. When a taxpayer transfers his or her account from one broker to another, what information is required to be in the customer account transfer (ACAT) reporting? Due to the staggered effective dates, what will be the cost basis computation and reporting obligations for brokers under the law? What is the proper period for furnishing transfer reporting statements? How soon will the transfer information be required to be available to the successor broker?

7. Issuer reporting. When a corporation merges, splits, spins off, etc., there is generally a notice advising the taxpayer of any taxable consequences of the corporate action. Now that brokers are responsible for cost basis information, who will ultimately be responsible for providing the taxpayer with a tax opinion or a tax disclosure statement? How soon?

8. Broker practices and procedures. The cost basis reporting law presents some additional obligations and potential penalties to brokers. What responsibility does a brokerage firm or mutual fund have to make sure that the cost basis numbers they send are as accurate as possible? When does a broker have to start correcting numbers or looking for more information?

What initially appeared to be a simple solution to provide cost basis following the sale of a security really isn’t because the effective dates of the new law are staggered, the fact that acquisitions prior to the effective dates are not part of the solution, and that mutual funds, stocks, and bonds are only a part of the assets that can be acquired or sold.

John R. Dundon, EA – 720-234-1177

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