1.         HOUSING

A.        Gradually repeal the mortgage interest deduction

B.        Limit the mortgage interest deduction

C.        Convert the mortgage interest deduction to an above-the-line deduction

D.        Convert the mortgage interest deduction to a credit

E.         Phase out exclusion for capital gains on sale of principal residence

F.         Make permanent the deduction for mortgage insurance premium payments

G.        Extend exclusion from income for cancellation of certain home mortgage debt

H.        Repeal the Low-Income Housing Tax Credit (LIHTC)

I.          Replace the LIHTC with an equivalent reduction in tax on rental income

J.          Reform or expand the LIHTC

K.        Create a non-refundable tax credit for low-income renters

2.         STATE AND LOCAL FINANCING

A.        Limit or eliminate the deduction for state and local taxes

B.        Permanently extend the deduction for state and local sales tax

C.        Repeal the tax exemption on all governmental and private activity bonds

D.        Modify existing tax-exempt bonds

E.         Create a new, permanent direct subsidy for bonds for financing governmental capital projects

F.         Replace the exclusion for interest on state and local bonds with a direct subsidy for the issuer or a non-refundable tax credit for the investor

3.         TRIBAL FINANCING

A.        Modify tribal tax-exempt bonds

B.        Exempt certain tribal activities from taxation

C.        Clarify the general welfare exclusion doctrine for certain benefits provided by tribes to members

D.        Make permanent or expand temporary provisions

E.         Conform the definition of Indian and reservation for tax purposes

F.         Modify the adoption tax credit to allow Tribal Governments to determine whether a child has special needs

4.         COMMUNITY DEVELOPMENT

A.        Repeal the New Markets Tax Credit

B.        Extend and modify the New Markets Tax Credit

C.        Modify or eliminate the Historic Preservation Tax Credit

D.        Create a permanent tax relief package for individuals and businesses in Presidentially-declared national disaster areas

5.         STATE AND LOCAL TAX UNIFORMITY

A.        Exercise Federal authority to establish uniform rules among the states

B.        Authorize states to require out-of-state vendors to collect sales tax

C.        Reform prohibitions on certain state or local taxes

Health Care Exchange Notice

One of the requirements of the Affordable Care Act for employers is to provide all employees with a notice about the new health care exchanges.  The notice is required for all new hires starting October 1 of this year, and must be provided within 14 days of hire.  For existing employees, the notice must also be given later this year (the date is expected to be set for late summer or early fall), but may be given now.  To facilitate employer compliance, the Department of Labor has just published a new model notice.  The model notice requires designation of a contact person on page 1 and information about your current health plan on the second and third pages.  According to the instructions, you may fill out the notice on-line and then print it out for reproduction and distribution.  Distribution may be accomplished in the same manner as initial COBRA notices are sent out, including electronically (if the requirements imposed by the DOL for electronic delivery are satisfied).

COBRA Election Notice

On a related note, the DOL has also published a new model COBRA election notice that includes a notification about the new health care exchanges as a possible alternative to electing COBRA coverage.  As with your current COBRA election notice, you’ll need to fill in the required information, and then print it out for reproduction and delivery.  Alternatively, if you are using a service company to administer COBRA for your health plans, you may want to contact the company to make sure that the most recent COBRA election notice is being used.

Further information about both notices is available from the DOL website.

REFORM OPTIONS

 I. BASE EROSION AND DEFERRAL

1. Tighten anti-base-erosion rules and reform the treatment of non-subpart F earnings

2. Strengthen the subpart F rules

3. Repeal deferral for CFCs

4. Strengthen thin-capitalization rules to limit base erosion through excessive debt financing

5. Strengthen rules against U.S. base erosion by foreign companies

II. FOREIGN TAX CREDIT AND SOURCING RULES 

1.    Further limit cross-crediting

2. Improve the sourcing of income rules

III. OTHER INTERNATIONAL BUSINESS REFORMS

1.    Repeal DISC provision

2. Reform passive foreign investment company (PFIC) rules

3. Reform effectively connected income rules

IV. NON-RESIDENT U.S. CITIZENS  

1. Provide an election to citizens who are long-term nonresident citizens to be taxed as nonresident aliens if they meet certain conditions

2.  Repeal the foreign-earned income exclusion

The Section 469 passive activity loss rules were enacted in 1986, but no regulations have ever been issued that describe how a non-grantor trust may materially participate in an activity owned by the trust.  The IRS’s position in the TAM is that the quantitative standards for participation (500 hours or 100 hours for certain significant participation activities, for example) only apply to individuals holding interests in an activity and are not available to a non-grantor trust.  Relying on legislative history, the IRS concludes that a non-grantor trust can only prove material participation in an activity by showing that the trustees of the trust, acting in their fiduciary capacities with respect to the trust, participated in the activity on a regular, continuous and substantial basis.  S. Rep. No. 99-313, at 735.  For this purpose, the IRS insists that activities of any employee or agent of the non-grantor trust must be ignored.

In The Mattie K. Carter Trust, the Court concluded that such a limited reading of the material participation test belied common sense and that, as an entity, the non-grantor trust could operate only through the activities of its trustees, employees and agents, all of whose activities should be taken into account in determining whether the trust met the regular, continuous and substantial basis criteria.  In that case, the Court held, in the alternative, that the trustees’ level of involvement as fiduciaries met the IRS’ regular, continuous and substantial criteria.  Thus, even ignoring the activities of employees and agents, the Court held that the trustees’ actions alone were sufficient in that case to meet the material participation standard.

  Presuming it passes the Senate it is expected to face more resistance in the House where the parallel bill is H.R. 684.   Similar legislation was introduced in 2011, but this 2013 version has gone farther than ever before and has led to a significant battle between Ebay and the team of Amazon and the brick-and-mortar retailers.

UPDATE:  This passed the full Senate on May 6 in a 69-27 vote and now moves to the House, where the prospects are less clear.

The full 15-page report discusses various options such as eliminating, simplifying, or consolidating existing expenditures relating to child care and working parents.  The report also discusses ways to reduce work disincentives created by phase-outs of tax expenditures and means-tested transfer programs. On the marriage front, the report discusses options to reduce marriage penalties and/or bonuses for all, create parity for non-traditional households, or simply provide targeted marriage penalty relief.  Finally the report discusses seven different areas to reform education-related expenditures, including repealing, expanding, consolidating, and/or simplifying existing expenditures.

UPDATE: 

On May 6 the JCT released a 568-page Report To The House Committee On Ways And Means On Present Law And Suggestions For Reform Submitted To The Tax Reform Working Groups (the Report). The Report summarizes current law, selected tax reform proposals, findings of the working groups, and various comments submitted.

A taxpayer may establish the beginning of construction by either (1) starting physical work of a significant nature or (2) establish the beginning of construction by meeting the safe harbor provided in Notice 2013-29.  For example, in the case of a facility for the production of electricity from a wind turbine, on-site physical work of a significant nature (option 1) begins with the beginning of the excavation for the foundation, the setting of anchor bolts into the ground, or the pouring of the concrete pads of the foundation.  For the option 2 safe harbor construction of a facility will generally be considered as having begun before January 1, 2014, if (1) a taxpayer pays or incurs five percent or more of the total cost of the facility before January 1, 2014, and (2) thereafter, the taxpayer makes continuous efforts to advance towards completion of the facility (subject to limitations as provided under Notice 2013-29).

A representative sample of suggested reform options are listed below:

• Eliminate the requirement that smaller businesses depreciate and amortize investments
• Revise the depreciation rules for tangible assets to more closely track their economic lives
• Revise the amortization rules for intangible assets to more closely track the economic lives of intangible assets
• Repeal the domestic production deduction (Section 199)
• Allow the R&D credit to expire or make the R&D credit permanent, while simplifying and/or better targeting it
• Repeal last-in, first-out (LIFO) inventory accounting
• Repeal the lower of cost or market inventory rules
• Repeal, tighten or simplify the like-kind exchange deferral rules
• Match income and statutory accounting (life insurance companies)

The President highlighted several policy goals and related provisions including policies to:

• Jumpstart Growth by:
  • Providing a 10-percent tax credit for new jobs and payroll increases focused on small business through 2013.
  • Providing tax credits to support domestic clean energy manufacturing.
• Promote Investment in Infrastructure by:
  • Creating a new permanent America Fast Forward Bond program to help facilitate and reduce the cost of financing new projects for State and local governments.  
  • Exempting from the application of the Foreign Investment in Real Property Tax Act (FIRPTA) gains of foreign pension funds from the disposition of U.S. real property interests.
• Ask the Most Fortunate to Contribute to Balanced, Credible Deficit Reduction by:
  • Implementing the Buffett Rule by imposing a new “Fair Share Tax” on high-income taxpayers.
  • Limiting tax expenditures for the affluent by capping itemized deductions and certain other deductions and income exclusions at 28 percent.
  • Restoring the estate, gift, and generation skipping transfer taxes to 2009 levels.
  • Taxing carried interest profits as ordinary income.
  • Eliminating a special depreciation benefit for corporate jets.
• Level the Playing Field for American Business through Revenue-Neutral Business Tax Reform
  • Expand Manufacturing and Support Insourcing Jobs in America     
  • Establishing tax incentives for locating jobs and business activity in the United States and prohibiting tax deductions for shipping jobs overseas.
  • Providing a new manufacturing communities tax credit to encourage investments and job creation.  
  • Enhancing the research and experimentation credit and making it permanent.
• Tax Relief to Help Small Business Grow and Hire by:
  • Extend increased expensing for small business.
  • Permanently eliminating the capital gains tax on certain small business investments.
  • Doubling the amount of expensed start-up expenditures.
  • Expanding and simplifying the Small Business Health Care Tax Credit.  
  • Excluding certain assets of small taxpayers from the uniform capitalization (UNICAP) rules. 
  • Reduce Incentives to Shift Income and Assets Overseas by:
  • Closing loopholes and ending abuses—like transfer pricing abuses that shift intangible income and assets overseas—to produce $157 billion in savings over the next 10 years.

• Reduce the cost to taxpayers of complying with the tax code
• Improve the ability of the IRS to administer the tax law efficiently
• Reduce tax evasion and inadvertent mistakes
• Provide taxpayers with better service
• Protect taxpayers from identify theft and privacy invasions
• Ensure that all taxpayers are treated fairly and similarly situated taxpayers are treated similarly

Although this regulation has been a long-standing rule, presumably the taxpayer sought a ruling out of concern that the substance of the original partnership loan to the partner could be questioned as not a true loan since it was later cancelled.  If the original loan would have been disregarded, the potentially taxable distribution would have occurred on the date of the original purported loan and not the later cancellation date.  This difference in timing could directly affect whether the distribution is taxable, depending on the partner’s basis in their partnership interest on the different dates of the loan versus cancellation of the loan.  In the ruling the IRS notes that the original historical loans were documented as such, likely a critical fact to support their treatment as loans.

Excerpts from White House Press Release

• Giving State and Local Governments Flexible New Tools to Invest in Infrastructure:  The President’s new America Fast Forward Bonds program will build upon the successful example of the Build America Bonds program, broadening its use to include the types of projects that can be financed with qualified private activity bonds while also making the combined program more flexible.  In addition, the Administration is proposing changes to the Foreign Investment in Real Property Tax Act (FIRPTA) aimed at enhancing the attractiveness of investment in U.S. infrastructure and real estate to a broader universe of private investors.

• FIRPTA:  Infrastructure assets can be attractive investments for long-term investors such as pension funds that value the long-term, predictable, and stable nature of the cash flows associated with infrastructure.  Under current law, gains of foreign investors from the disposition of U.S. real property interests are generally subject to U.S. tax under FIRPTA, and foreign investors including large foreign pension funds regularly cite FIRPTA as an impediment to their investment in U.S. infrastructure and real estate assets.  With U.S. pension funds generally exempt from U.S. tax upon the disposition of U.S. real property investments, the Administration proposes to put foreign pension funds on an approximately equal footing:  exempting their gains from the disposition of U.S. real property interests, including infrastructure and real estate assets, from U.S. tax under FIRPTA. 

• Bonus Expensing.  The draft makes permanent section 179 expensing at pre-stimulus levels, allowing small businesses to deduct immediately investments in new equipment and property up to $250,000, with the deduction phased out for investments exceeding $800,000 (both amounts indexed for inflation).
• Limitation on Cash Method Accounting. To be eligible for the favorable cash method accounting, under current law most businesses must have average annual gross receipts of less than $5M (professional service businesses are exempt from the revenue cap).  The proposal increases the cap to $10M, but eliminates the professional service exception, effectively forcing many law firms and accounting firms to apply for a change in method of accounting to switch to the accrual method.  Although these service firms will not be required to accrue income that is not anticipated to be collected, the net result of converting to the accrual method of accounting could create a significant acceleration of income for many service firms.
• Streamlining Start-Up and Organizational Expense Deduction Rules.  The proposal would consolidate into a single provision the rules for start-up expenditures and organizational expenditures.  It would also combine the baseline immediate deduction amount to $10,000 (phased out starting at $60,000), with the remainder amortizable over same 180-month period available under current law.
• Changing Tax Return Due Dates.  With the stated goal of simplifying tax compliance, the due date for calendar-year returns would be (1) March 15 for partnerships; (2) March 31 for S corporations; and (3) April 15 for C corporations and individuals.
• Pass-through Entities – Option 1 (limited reform)
  • S Corporation Rules.  The proposal effectively adopts the S Corporation Modernization Act of 2013, with the centerpiece being the reduction of the Section 1374 built-in gain tax period from 10 to 5 years.  This reduction would likely incentive C corporation conversions to S corporations or REITs.  Other provisions would make S corporation qualification less cumbersome.
  • Eliminate Guaranteed Payments Rules.  The proposal would eliminate Section 707(c) guaranteed payments entirely, forcing such payments to be treated either as a Section 707(a) non-partner capacity payment or a Section 704(b) distributive share of income.  The special tax treatment of guaranteed payments has caused much tax uncertainty over the years and repeal is consistent with the prior recommendation of the ABA.
  • Eliminate Special Retirement Payment Rules.  Under current law, Section 736 provides rules for the treatment of payments made in the liquidation of a retiring or deceased partner’s partnership interest – treating them either as an effectively deductible payment or subjecting them to the general partnership distribution rules.  The proposal cites an academic article on why Section 736 is arguably no longer necessary and would simply make such payments subject to the more general partnership distribution rules.
  • Mandatory Inside Basis Adjustments.  Under current law, if there is a transfer of partnership interest or a partnership distribution that would otherwise result in a disparity between a partner’s inside and outside basis, the inside basis is only adjusted if either there is a Section 754 election in effect or if there would otherwise be a “substantial built-in loss”. The proposal would simply make such Section 743(b) and Section 734(b) inside-basis adjustments mandatory in all events, dispensing with the current requirement to make a Section 754 election.  Further, corresponding inside-basis adjustments would be required through successive tiers of partnerships.
  • Clean Up “Hot Asset” Rules.  Under current law, a sale of partnership interest is capital gain except to the extent of the selling partner’s share of Section 751 “hot” assets (inventory and unrealized receivables).  Similarly, the Section 751 rules police the shifting of ordinary income hot assets between partners that could otherwise result from partnership distributions.  The proposal would create a consistent definition of “inventory” for purposes of both transfers of partnership interests and partnership distributions and would also more simply define a section 751 unrealized receivable as only the ordinary income component in an asset, determined as if the partnership had sold such asset.  Further the IRS would be directed to only take into account only the income component of a hot asset for purposes of Section 751(b) distributions.  This is consistent with the IRS request for simplification in this area.
  • Repeal 7-Year Limit on Mixing Bowl Rules.  Under the so-called “mixing bowl” rules of Sections 704(c)(1)(B) and 737, a deemed taxable sale may occur if a partner contributes appreciated property to a partnership and within 7 years either (1) the contributed property is distributed to another partner, or (2) the partnership distributes other property to the contributing partner.  Under the proposal, the seven year limit would be repealed such that the mixing bowl rules would apply indefinitely.
• Pass-through entities – Option 2 (major reform).  This includes many of the concepts discussed in Option 1, plus others including the following:
  • Single Pass-Through Tax Regime for Partnerships and S Corporations.  This regime would more closely resemble the current partnership rules.  Eligible pass-through entities would not include any publicly-traded entities or any ineligible corporations under present law subchapter S.
  • Require Partnership Withholding on Partner’s Share of Taxable Income.  Except as otherwise provided in regulations or guidance, the withholding tax is treated as a tax imposed under section 11 (relating to corporate income tax) and any pass-through required to pay the tax is treated as a corporation for purposes of the rules relating to failure by a corporation to pay estimated income tax.
  • Disallow Most Special Allocations Among Partners.  The proposal would disallow differing tax allocation amounts among partners within a particular class of income (ordinary, capital, or credits).  The distributive share must be consistent with the owner’s economic interest in the pass-through (determined by taking into account all facts and circumstances).  If the distributive share under the ownership agreement is inconsistent with the owner’s economic interest in the pass-through, the distributive share of each owner is adjusted accordingly.
  • Contributions Still Tax-Deferred; Distributions Trigger Asset Appreciation.  Principles similar to Section 721 would continue to apply to in-kind contributions to a partnership.  However, on the distribution of property other than money, for purposes of determining gain recognized by the pass-through, the pass-through is treated as having sold the distributed property for its fair market value immediately before the distribution of the property to the owner.

 The Act would also eliminate the Section 1362(d) rule that terminates S corporation status if there is excess passive income, which is consistent with the recent AICPA tax simplification recommendation (page 29).  Similarly the Act would increase the amount of eligible passive investment income from 25% to 60% of gross receipts before imposing the corporate-level tax under Section 1375.  Other modernization provisions include (i) allowing a non-resident alien to be a beneficiary of an Electing Small Business Trust (ESBT), (ii) allowing IRAs as S corporation shareholders; (iii) allowing ESBTs the benefit of S corporation charitable deductions; and (iv) making permanent the favorable S corporation stock basis reduction rule to not penalize S corporations from making charitable deductions (as compared to if the shareholders had made the contributions directly).

In reaching its conclusion, the Tax Court found that “[t]he STARS transaction was structured to meet the relevant requirements in the Code and the regulations for claiming the disputed foreign tax credits. The STARS transaction in essence, however, was an elaborate series of pre-arranged steps designed as a subterfuge for generating, monetizing and transferring the value of foreign tax credits among the STARS participants.”  The court looked to the detailed economics of the transaction to understand whether the complex steps performed any significant banking, commercial or business function with respect to the loan. In sum the court found that STARS structure did not bear a reasonable relationship to the loan, and that the true motivation was tax avoidance.

For the May 2, 2013 update to the business plan click here.

For the current and cumulative lists of IRS Prioirty Business Plans click here.

• Tax-free treatment does not apply to the extent the partnership is issuing equity to satisfy any unpaid interest component of convertible debt.  However, the partnership is effectively treated as satisfying this obligation with cash so there is no tax to the partnership through a deemed sale of a portion of its underlying assets used to satisfy the obligation.
• The strike price can be satisfied with cash or property with similar tax treatment.
• The favorable section 721 treatment does not apply to the exercise of options in disregarded entities, such as an option issued by a single-member LLC taxed as a partnership.
• A cash-settled option is treated as the sale or exchange of the option (not a deemed exercise followed by sale of partnership interest).
• Related proposed regulations treat the lapse of an option as subject to section 1234(a) (treating the partnership interest as a security).
• Various accounting clarification are provided regarding the treatment of options and partnership “book ups”, including capital account adjustments and “corrective allocations”.
• The final regulations retain the general rule of not treating the option holder as a partner prior to exercise, but clarified the circumstances that would overcome this presumption.  One of the factors to recast an option holder as a partner is if the holder has rights that are substantially similar to the rights afforded to a partner, defined as when the option is reasonably certain to be exercised or the option holder possesses regulatory-described “partner attributes”.

On January 24 the chair of the House Ways & Means Committee released proposals to reform the taxation of financial products.  The reforms include:

• Mark-to-market taxation for speculative financial investments.  Specifically the draft would require taxpayers engaged in speculative financial activity—but not business hedging against common risks—to mark certain financial derivative products to fair market value at the end of each tax year, thus triggering the recognition of gain or loss for tax purposes.  The proposal would apply to property acquired and positions established after December 31, 2013.
• Eliminate the requirement for many common business transactions to separately “identify” hedges for tax purposes.  For taxpayers that are engaged in hedging business risks, the draft would allow transactions that are properly treated as hedges for financial accounting purposes to be treated as hedges for tax purposes.  This taxpayer-favorable proposal would minimize inadvertent failures to identify a transaction as a hedge for tax purposes, even though the transaction satisfies all of the substantive requirements for hedging transaction tax treatment.  The proposal would be effective for hedging transactions entered into after December 31, 2013.
• Eliminate phantom income on non-write-down debt restructurings.  The draft would reform the tax rules that apply to debt restructurings that do not involve a forgiveness of principal. This change would reduce the prevalence of “phantom” cancellation-of-indebtedness income when debt is restructured—a common practice during economic downturns—thereby creating a more taxpayer-favorable rule.  The discussion draft would eliminate the phantom taxable income problem associated with many debt restructurings by generally providing that the issue price of the modified debt instrument cannot be less than the issue price of the debt instrument prior to modification.  The proposal would be effective for debt modifications that occur after December 31, 2013.
• Harmonize the Tax Treatment of Bonds Traded at a Discount or Premium on the Secondary Market. The draft would require the holder of the bond to recognize taxable income on the discount over the remaining life of the bond.  Further the amount of discount to be recognized for tax purposes would be limited to the discount that typically reflects an increase in interest rates that has occurred since the date the bond was originally issued—as opposed to steeper discounts that often reflect deterioration in the creditworthiness of the borrower.  The proposal would be effective for bonds acquired after December 31, 2013.
• Require average cost basis for securities.  The draft would require the cost basis of the security to be based on the average cost basis of all other shares or units of the identical security held by the taxpayer.  The proposal would be effective for sales of securities occurring after December 31, 2013.
• Tighten “wash sale” rules.  The draft would reform the wash sale rule (i.e., sell to recognize tax loss but buy back the security) so that it applies to transactions involving closely related parties.  Specifically the draft would expand the scope of the wash sale rules to include acquisitions of replacement securities by certain closely related parties, including spouses, dependents, controlled or controlling entities (such as corporations, partnerships, trusts or estates), and certain qualified compensation, retirement, health and education plans or accounts.  The proposal would be effective for sales of securities occurring after December 31, 2013.

The release includes (1) an overview of the proposals, (2) a summary description of the specific legislative proposals, (3) proposed legislative text, and (4) a 27-page detailed technical explanation of the proposals. Many of these proposals are also found in a 2011 ABA report recommending tax reform in this area.

What is FATCA?

In 2010 new sections 1471-1474 enacted FATCA to prevent noncompliance with U.S. tax rules by U.S. taxpayers that use foreign accounts.  In general, the rules require U.S. withholding agents to withhold 30% tax on certain payments to foreign financial institutions (FFIs) that do not agree to report certain information to the IRS regarding their U.S. accounts.  The rules also extend to payments to certain nonfinancial foreign entities.  FATCA reporting will be made on Form 8938, which taxpayers attach to their federal income tax return, starting this tax filing season.  Also, FATCA will require FFIs to report directly to the IRS with information about financial accounts held by U.S. taxpayers, or held by foreign entities in which U.S. taxpayers hold a substantial ownership interest.

General Approach of the Final Regulations

The final regulations attempt to reduce burdens through three avenues.  The regulations first adopt a risk-based approach to address policy considerations while eliminating unnecessary burdens.  Second, the IRS is collaborating with foreign governments to develop an alternative intergovernmental approach to implementing the FATCA rules. Third, the regulations develop administrative approaches to simplify the process for registering and entering into an agreement with the IRS in order to minimize operational costs associated with collecting and reporting FATCA information.

The risk-based approached reduces compliance burdens in a number of ways including (i) expanding grandfathering rules, (ii) providing exemptions for certain financial institutions and passive non-financial foreign entities; (iii) expanding categories of FFIs that are deemed to comply with FATCA without the need to enter into an agreement with the IRS; (iv) exempting smaller accounts; (v) reducing diligence and documentation rules for lower-value preexisting accounts; (vi) expanding the ability of FFIs to rely on a self-certification from an account holder; (vii) extending the time to review existing accounts; and (viii) phasing in implementation of certain reporting and withholding requirements.  

According to the Treasury Department, the issuance of the final regulations marks a key step in establishing a common intergovernmental approach to combating tax evasion and provides important clarity for foreign and U.S. financial institutions.

A LILO is a Lease-In Lease-Out transaction where a U.S. taxpayer enters into a long-term “Headlease” to acquire depreciable property from a non-U.S. taxpaying entity — the lease-in, followed by a shorter term “Sublease” of the same property back to the original owner — the lease-out.  The U.S. taxpayer then borrows a significant sum to make an up-front payment on the Headlease.  The U.S. taxpayer claims net tax deductions for rent and interest expense on the loan.  In this particular transaction Consolidated Edison was the U.S. taxpayer and the underlying property was a Dutch Utility’s energy plant held by EZH. 

The government’s primary argument was that the EZH was reasonably likely to exercise the sublease purchase option, and that, as a result, the purported Headlease should not be treated as a true lease.  Consolidated Edison argued that the legal standard was instead that the option should only be a problem if it was “certain” to be exercised.  The Appeals Court disagreed with Consolidated Edison, concluding that the relevant standard was “reasonable likelihood” to be exercised.  Specifically, the 2011 Wells Fargo case standard requires an assessment of whether a prudent investor in Consolidated Edison’s position would have reasonably expected that EZH would exercise the purchase option.  The Appeals Court also held that Consolidated Edison was denied the interest deductions from the purported loan, concluding that “it is clear that the loan is not genuine.”

Highlights of the H.R. 8 legislation are described in general terms below:

General Provisions

• Income Tax Rates.  Making the 2001 and 2003 Bush tax cuts permanent except for Individuals and Married-Filing Jointly whose income equals or exceeds $400,000 or $450,000, respectively (indexed for inflation).  For incomes in excess of the thresholds, the ordinary income rates rise to 39.6% and the long-term capital gain and Qualified Dividend rates rise to a maximum of 20%.
• Itemized Deduction Haircut.  The Section 68 reduction of individual itemized deductions returns. In general, deductions are reduced by 3% of the amount by which an individual’s or couple’s Adjusted Gross Income exceeds thresholds of $250,000 and $300,000, respectively. The threshold amounts are indexed for inflation.
• Personal Exemption Phase-Out.  The personal exemption phase-out returns. Exemptions are phased out at the rate of 2% of Adjusted Gross Income in excess of the new Section 68 thresholds.
• Estate, Gift, and Generation-Skipping Transfer Taxes.  Estate, gift, and generation-skipping transfer tax exemptions are set at $5M and indexed annually for inflation for 2012 and subsequent years.  Maximum tax rate set at 40%.  Portability, which allows the estate of the first spouse to die to transfer his or her unused estate tax exemption to the surviving spouse, is made permanent.
• AMT.  Permanent extension of the 2012 Alternative Minimum Tax exemption amounts, indexed for inflation.
• Roth Conversions.  The legislation expands the scope of qualified plans that can be converted to a Roth IRA in a taxable conversion. Specifically it allows an individual to elect any amount in a non-Roth account to be converted to a Roth account in the same plan, whether or not the amount is otherwise distributable because the individual is not at least age 59 ½ or has not separated from service.

Extenders

• Individual Extenders.  Nine individual “extenders” provisions generally extended to cover 2012 and 2013 including (i) exclusion for cancellation of debt on qualified principal residence; (ii) special conservation easement deductions; and (iii) use of IRAs for charitable donations.
• Business Extenders.  Thirty-one business extenders provisions generally extended to cover 2012 and 2013 including (i) research credit; (ii) new market tax credit; (iii) 15-year depreciation for qualified leasehold, restaurant, and retail improvements; (iv) continue the $500,000 limit for expensing and 50% bonus depreciation; and (v) continue 100% gain exclusion for section 1202 small business stock.
• Low Income Housing.  The 9% floor for Section 42 low income housing tax credits is extended for credit allocations made before January 1, 2014 and no longer requires the housing to be placed in service before December 31, 2013.
• Energy Tax Extenders.  Twelve energy-tax extenders provisions generally extended to cover 2012 and 2013 including (i) cellulosic bio-fuel producer credit; (ii) incentives for biodiesel; and (iii) wind and certain renewable energy production credit.
• International.   The look-through rule under Section 954(c)(6) has been extended to include subsidiary taxable years beginning before January 1, 2014.  This rule will generally allow US corporations with foreign subsidiaries to move active business income among those subsidiaries without immediate US tax
• S Corporations.  S corporation charitable contributions made before December 31, 2013 will continue to only reduce a shareholder’s basis by their pro rata share of the S corporation’s basis in the donated property (rather than by their share of fair market value of the donated property).  For determining whether the C corporation “sting” tax applies to gains recognized in 2012 and 2013, the built-in gain period is reduced from 10 to 5 years.

Other new tax items for 2013

• Payroll Tax Holiday Ended.  The 2% reduction in employee’s share of Medicare taxes from 2011 and 2012 was not extended.  
• Higher Medicare Tax.  The Patient Protection and Affordable Care Act of 2010, established a new “Additional Medicare Tax” of 0.9%, effective January 1, 2013.
• 3.8% Net Investment Income Tax.  The Patient Protection and Affordable Care Act of 2010, also created a new 3.8% tax on net investment income, effective January 1, 2013.

• Limiting the use of pass-through taxation,
• Integrating the individual and corporate income taxes, and
• Unifying taxes on businesses in a new entity-level tax.

Section 1411 imposes a 3.8% tax on Net Investment Income of individuals, estates, and trusts that have income over specified threshold amounts ($250,000 for married filing jointly) and applies to the first tax year beginning on (or after) January 1, 2013.  The guidance addresses questions such as (1) what types of trusts are subject to the tax; (2) what types of income and net gain are subject to the tax; (3) what expenses are deductible in computing Net Investment Income; (4) how is Net Investment Income reported and paid; (5) is the Net Investment Income tax subject to withholding or included in estimated tax payments; and (6) the treatment of real estate professionals. 

The detailed regulations also address more complex Section 1411 questions such how the rules apply to pass-through entities and the scope of the exception for trade or business income if the taxpayer materially participates in the business.  The regulations generally look to the existing Section 469 rules for determining material participation, but allow taxpayers a one-time “fresh start” in grouping activities for this purpose and also apply a more narrow Section 162 definition of trade or business (limiting certain passive activities, including certain passive real estate rental activities, from qualifying for the trade or business exception).

The guidance provides detailed rules as to when disclosure under Schedule UTP or Schedule M-1 or M-3 is adequate for this purpose and also lists circumstances when a separate Form 8275 or Form 8275-R is required (such as if an entry may present a legal issue or controversy because of a related-party transaction).  Further, the guidance explains when disclosure under Rev. Proc. 2012-51 is not sufficient, such as for an item attributable to a tax shelter. The guidance applies to any income tax return filed on 2012 tax forms for a taxable year beginning in 2012, and to any income tax return filed on 2012 tax forms in 2013 for short taxable years beginning in 2013.

The IRS has updated the effective date of these regulations.

Among other modifications, the Bill (i) expands the availability of Section 179D from commercial buildings to also include multifamily housing (defined as five more dwelling units), (ii) increases the amount of deduction from $1.80 to $3.00 per square foot for the full deduction or from $1.00 to $2.20 per square foot for the partial deduction, (iii) updates the ASHRAE standard for determining the energy efficiency of a building to 90.1-2004, and (iv) creates a framework for owners that may not otherwise be able to take the deduction (e.g., REITs and non-profits) to allocate the deductions to parties that can take the deductions such as lenders, tenants, architects and contractors. Further, an important change in the law is to include energy efficiency improvements measured based on energy usage reduction for existing buildings.  Finally, this Bill creates a new tax code Section 179F, which provides for the deduction of retrofits of existing commercial and multifamily buildings.

Although the prospect of passage of this legislation is uncertain given the overall legislative climate, this marks a very important development in green building incentives for the long run.  This legislation is consistent with the President’s Better Buildings Initiative.

(1)    are non-resident U.S. taxpayers who have resided outside of the U.S. since January 1, 2009

(2)    have not filed a U.S. tax return since January 1, 2009

(3)    present a low level of compliance risk (generally simple returns with little or no U.S. tax due (e.g., if the submitted returns and application show less than $1,500 in tax due in each of the years)

The streamlined procedures require filing the appropriate income tax returns for the past three years and FBARs for the past six years, the payment of any tax and interest due, and the submission of a signed questionnaire.  Additional information is required for taxpayers seeking late election relief from certain retirement or savings plans (generally Canadian retirement plans where Form 8891 was not timely filed).  Although the new procedures allow the avoidance of civil penalties, the IRS warns that criminal penalties could still apply.  More detail on Canadian pension plan procedures can be found under IRS Q&A 54 with more general Offshore Voluntary Disclosure Initiative information also available on the IRS website.

The court relied heavily on the decisions in Castle Harbour and Virginia Historic Tax Credit Fund, both of which held for the IRS in reclassifying a purported partnership interest of an investor.  The Third Circuit Court seemed particularly troubled by the various contractual rights to limit the investor’s downside and upside, including a guarantee of tax benefits and an investor right to put its interest for a fixed 3% annualized profit return.  The court was also bothered by the economic projections, saying,“[t]o put it mildly, the parties and their advisors were imaginative in creating financial projections to make it appear that [the credit partnership] would be a profit-making enterprise.”

For purposes of substantiation and disclosure rules, the parent charity is treated as the recipient.  However, the parent should include a statement in its acknowledgement of the gift that the SMLLC is wholly-owned by the parent charity and treated by the parent charity as a disregarded entity.

While this Notice may not be a surprise to many, it was necessary to address the deductibility questions raised in the IRS Continuing Professional Education materials from 2000 and 2001 on the topic, indicating that the IRS was “considering” the issue.  This Notice should provide comfort and opens the way for greater use of SMLLCs by U.S. charitable organizations.

More recently, OTR issued Notice 2012-06 (the “Notice”) clarifying and superseding prior guidance regarding the recordation tax treatment of refinanced and modified security instruments.  The Notice clarifies that effective for security instruments recorded after June 19, 2012, the legislation imposes a recordation tax on:

(i)  a refinanced security interest equal to the excess of the principal amount of the refinance instrument over the principal balance due on the existing debt under the prior security instrument; and

(ii)  a modified, amended or restated security instrument equal to the excess of the principal amount of the modified instrument (including amounts paid to the borrower on the existing security instrument during the preceding 12 months) over the principal balance on the existing debt (without including such payments).

This approach represents a departure from the prior guidance which assessed the recordation tax on the amount equal to the difference between the principal amount of the refinanced or modified instrument and the outstanding principal amount of existing debt under the prior security interest instrument.  The Notice also provides details about what documentation a taxpayer must provide in order to substantiate the amount of tax due, which includes the amount of tax previously paid or any exemptions.

According to the IRS press release:

• The guidance represents a series of common-sense steps to help U.S. citizens abroad get current with their tax obligations and resolve pension issues.
• The IRS will provide a new option to help some U.S. citizens and others residing abroad who haven’t been filing tax returns and provide them a chance to catch up with their tax filing obligations if they owe little or no back taxes.
• The guidance includes new procedures that will allow resolution of certain issues related to certain foreign retirement plans (such as Canadian Registered Retirement Savings Plans).  In some circumstances, tax treaties allow for income deferral under U.S. tax law, but only if an election is made on a timely basis.  The streamlined procedures will be made available to resolve low compliance risk situations even though this election was not made on a timely basis.

Although the details of the IRS guidance is still forthcoming, the IRS issued a general overview of the proposed new procedure, including how the IRS determines if a taxpayer is a low compliance risk and how taxpayers can take advantage of the procedure.   In related guidance, the IRS also announced that they closed a technical loophole for taxpayers in the OVDI program.

The guidance is effective for COD from discharged debt on or after June 15, 2012.  However, the guidance also allows taxpayers to apply the guidance to COD attributable to any taxable year in which the statute of limitations is open.  This subject of this guidance had been on the IRS Business Plan as a top priority guidance item.

The text of the sample election follows.

Section 83(b) Election

The undersigned taxpayer hereby elects, pursuant to § 83(b) of the Internal Revenue Code of 1986, as amended, to include in gross income as compensation for services the excess (if any) of the fair market value of the shares described below over the amount paid for those shares.

1. The name, taxpayer identification number, address of the undersigned, and the taxable year for which this election is being made are:

TAXPAYER’S NAME: _______________________________________

TAXPAYER’S SOCIAL SECURITY NUMBER: _____________________

ADDRESS: _______________________________________________

TAXABLE YEAR: Calendar Year 20__

2. The property which is the subject of this election is __________ shares of common stock of __________________________.

3. The property was transferred to the undersigned on [DATE].

4. The property is subject to the following restrictions: [Describe applicable restrictions here.]

5. The fair market value of the property at the time of transfer (determined without regard to any restriction other than a nonlapse restriction as defined in § 1.83-3(h) of the Income Tax Regulations) is: $_______ per share x ________ shares = $___________.

6. For the property transferred, the undersigned paid $______ per share x _________ shares = $______________.

7. The amount to include in gross income is $______________. [The result of the amount reported in Item 5 minus the amount reported in Item 6]

The undersigned taxpayer will file this election with the Internal Revenue Service office with which taxpayer files his or her annual income tax return not later than 30 days after the date of transfer of the property. A copy of the election also will be furnished to the person for whom the services were performed. Additionally, the undersigned will include a copy of the election with his or her income tax return for the taxable year in which the property is transferred. The undersigned is the person performing the services in connection with which the property was transferred.

Dated: _________________

Taxpayer: _________________

The court carefully analyzed 11 debt-equity factors based on the law in the 9th Circuit, in which the case can be appealed.  Although there was a mixture of debt and equity factors, on balance, the court concluded that the instruments were properly classified as debt.   Although the lender later recapitalized the floating-rate debt as equity, the court did not use this hindsight as a determinative factor in its debt-equity analysis.  Further, in determining whether the terms of the related-party loans were comparable to similar third-party loan terms, the court also favorably noted that related-party loans may offer more flexible terms and that the test is whether “the terms of the purported debt were a ‘patent distortion of what would normally have been available’ to the debtor in an arm’s-length transaction.”  The court also favorably concluded on issues such as subordination to other creditors, the ability to repay the debt when due, and whether the peak 82% debt-to-equity ratio was too high.

Background

Like partnerships, S corporations allow the pass-through of losses and deductions to the extent of a shareholder’s basis.  However, unlike partnerships, S corporation shareholders do not receive tax-basis for entity-level debt unless that debt is owed to the specific shareholder and the shareholder is treated as making an “actual economic outlay”.  This has led to significant litigation, addressing questions such as circular flow of cash in determining whether there has been such required shareholder economic outlay.  The most recent decision was published June 6, 2012 when the Tax Court allowed a shareholder to achieve basis through a loan to an S corporation when the funds were derived from a distribution from another related S corporation.  Because of the uncertainty and varied tax treatment of similarly situated taxpayers, practitioners have requested that the IRS replace the current actual economic outlay test with more uniform rules and related examples.

Practical Effect of Proposed Regulations

The proposed regulations provide some needed clarity, although still leave taxpayers without bright lines as to what satisfies the new “bona fide indebtedness” test.  The regulations are helpful in that they bring in more general tax principles that are arguably more certain than the highly litigated “actual economic outlay” test that currently exists.  Moreover, the examples provide some helpful guidance, specifically allowing shareholder basis for bona fide indebtedness involving (1) shareholder loans made directly or through a tax-disregarded entity; (2) shareholder payments on personal guarantees of a S corporation loans (but no basis for the guarantee itself until paid); (3) bona fide back-to-back loans where the shareholder borrowed from S corp 1 to loan to S corp 2; (4) a shareholder assumption of a bona fide loan that was formerly directly between S corp 1 and S corp 2.

• Expand dealer property exception on a limited basis.  To avoid the 100% tax on dealer property (inventory), REITs prefer to rely on the 2-year holding period safe harbor.  However, a major limit to this safe harbor is that a REIT cannot sell more than 10% of its property in a single year (measured by value or basis).  The legislation would allow a REIT to elect an alternative test that would apply this 10% restriction using an average value/basis of properties sold over a 3-year window, with a cap of 20% in any single year.  The changes would also clarify that the special REIT rules are inapplicable for inventory determinations for other tax purposes.

• Expand role of Taxable REIT Subsidiary (TRS) and expand re-determined rent.  The legislation would also clarify that the TRS can perform some of the same roles that now require an independent contractor.  For example, a TRS would be able to market or develop property that is sold under the 10% dealer property safe harbor described above and also operate foreclosure property without losing foreclosure status.  The legislation would also extend the current 100% excise tax applicable to “re-determined” income and deductions between a REIT and its affiliated TRS to include any re-determined TRS service income.

• Partial repeal of preferential dividend rule.  The legislation would repeal the preferential dividend rule to “publicly offered REITs” that have to register their securities, and provide regulatory authority to cure inadvertent failures of the preferential dividend rules for other REITs.

• No Foreign-investor withholding on interest dividends.  The legislation would exempt interest-related dividends of a publicly offered REIT that is not 50 percent or more owned by a non-U.S. investor based upon the similar temporary (but expired) provision for mutual funds (assuming the mutual fund provision is extended).

• Modifications to income and asset tests.  The legislation would (1) classify debt securities of a publicly offered REIT as a “real estate asset”; (2) treat personal property leased in connection with real property as a qualifying real estate asset if the value does not exceed 15% of the associated real property; (3) include as qualifying hedges those entered into to counteract a qualifying hedge; and (4) provide specific qualifying income rules for timber sales and mineral/gas royalties.

• E&P Disallowance Rule.  The legislation would modify the rule for calculating Earnings & Profits (E&P) for REITs to avoid a mismatch that occurs because of the longer depreciation lives for E&P purposes as compared to taxable income purposes.  The change would allow for a reduction of E&P by deductions that were allowable to reduce taxable income in either the current year or prior years.

• A substantial risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer.
• In determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered.
• Restrictions on the transfer of property, whether contractual or by operation of applicable law, will not result in a substantial risk of forfeiture except as provided in section 83(c)(3) and Reg. §1.83-3(j) or (k) (generally relating to sales of property that could give rise to a lawsuit under section 16(b) of the Securities Exchange Act of 1934)).
• The proposed regulations incorporate the holdings in Rev. Rul. 2005-48 which relates to transfer restrictions, such as from lock-up agreements or restrictions relating to insider trading, that do not prevent property from being “substantially nonvested”.

The proposed regulations apply to property transferred on or after January 1, 2013.

Background

Section 108 excludes COD income from tax to the extent the debt discharge occurs while the taxpayer is insolvent.  Because insolvency is measured at the partner level for discharged partnership debt, the next question is how to measure partner insolvency if the partner was not personally liable for the partnership debt.  Previously, Rev. Rul. 92-53 concluded that in the aggregate the partners can take into account discharged partnership nonrecourse debt to the extent such debt exceeds the fair market value of the underlying property securing the debt.  For example, if the partnership property was “underwater” by $200 and the bank cancelled $220 of debt, $200 of the cancelled debt could be taken into account in determining the partners’ insolvency.  If all of the COD and debt was allocated to a partner with $80 of net assets, the partner would be insolvent by $120 ($200 share of partnership discharged debt over partner’s $80 of net worth).

What Rev. Rul. 2012-14 resolves

New Rev. Rul. 2012-14 answers the question of how discharged partnership nonrecourse debt is allocated among the partners for purposes of applying the insolvency exception on a per-partner basis.  The basic choices were (1) follow the section 752 debt allocation rules that otherwise apply for determining partner basis or (2) allocate the debt in the same ratio as the COD income from the discharged debt is allocated.  The IRS chose the second option, which generally has the effect of matching up potential insolvency with the underlying COD income in the hopes of qualifying for the insolvency exception.

The Tax Court held in favor of the taxpayers based on their treatment of the house as investment property at the time of the exchange.  The couple placed fliers throughout town where the house was located, showed the house to potential renters, and only decided to use the house as their personal residence almost eight months after the purchase.  Given how the taxpayers treated the house, the Tax Court held that their sale of the apartment building and subsequent purchase of the house qualifies as a Section 1031 like-kind exchange.

The IRS relied on Goolsby v. Commissioner for its position that making the purported replacement property a personal residence causes the taxpayer to lack the requisite investment motive.  The court noted that Goolsby was distinguishable because in that case, the taxpayers made their purchase of the replacement property contingent on the sale of their former personal residence, and their only rental efforts consisted of taking out a single advertisement in the local newspaper.  Moreover, they moved into the replacement property within two months of purchasing it.  The taxpayers in Reesink showed much more effort to rent out the property and only made the property a personal residence after eight months of failure to rent the property.

In PLR 201214007, the IRS treated facility-specific power purchase agreements (PPAs) as part of their related energy production facilities, and that such PPAs are therefore eligible for favorable five-year depreciation.  In the PLR, the taxpayer acquired both a wind facility and the related PPA and the question was whether the favorable five-year depreciation life for wind equipment also applied to the value attributable to the PPAs.  The PPAs in the ruling were directly tied to the output of a specific wind energy facility such that energy from other facilities could not fulfill the terms of the PPAs.  As a result, the IRS ruled that the facility-specific PPAs should not be treated as assets separate from the wind energy facilities to which they relate, and that the PPAs should therefore be included in the tax basis of the wind energy facility for depreciation purposes.

PLR 201214007 did not address the more interesting question of whether the costs related to creating the PPA is also treated as part of the alternative energy property eligible for the 30% Section 48 credit or the “Section 1603″ grant.  It would be consistent with this PLR to allow such credit, but previous Treasury guidance, at least as it relates to the Section 1603 grant, generally did not treat such PPA costs as eligible for the 30% grant.

The regulations address comments from the American Bar Association and the National Association of REITs.  The primary change in the proposed regulations is to make clear that a RIC or REIT is not subject to the section 1374 built-in gain rules to the extent that a C corporation transfers property with a built-in gain to a RIC or REIT and the C corporation’s gain is not recognized by reason of either section 1031 or 1033 (relating to like-kind exchanges or involuntary conversions).  For example, if a REIT enters into a tax-deferred like-kind exchange with a C corporation, there is not a new built-in gains tax period on the like-kind asset received by the REIT.

The regulations make other clarifying changes including adding a special exemption to the indirect partnership rule for C corporation partners that are tax-exempt entities.  This exemption applies only to the extent that the tax-exempt would not have been taxable on the gain had it made a gain recognition election at the time the property was transferred (e.g., the gain would not have been subject to the unrelated business income tax).  The proposed regulations are effective when finalized, but taxpayers are allowed to rely on the regulations back to the effective date of the original 2003 regulations.