Our Tax Advice Hotline helps policyholders gain a better understanding of the federal tax issues and potential problems associated with high-risk estate, gift, and corporate tax work, which bring about the most severe tax claims. The following five scenarios are examples of some of the calls the hotline receives and responds to with reviews and guidance.
Scenario 1My client is a partnership that operates a retail establishment. The retail establishment has inventory under $500,000. All the partners are individuals.
Question: Can the partnership utilize the cash basis of accounting, or is it required to use the accrual method of accounting?
The following is based on the respective revenue procedures which should be consulted for authoritative guidance.
Generally, unless Rev. Proc. 2001-10 or Rev. Proc. 2002-28 applies, a partnership that maintains inventory must use the accrual method to account for purchases and sales.
Exception for Gross Receipts $1 Million or Less – Rev. Proc. 2001-10
According to Rev. Proc. 2001-10 (modified by Rev. Proc. 2015-13), a “small business” with average annual gross receipts of $1 million or less can use the cash method of accounting even if the business would otherwise be required to use the accrual method of accounting because it maintains inventory. The average annual gross receipts is based on a three-year average ending with the prior tax period. If a partnership has not been in existence for three prior tax years, it must determine its average annual gross receipts for the number of years it has been in existence (including annualized short tax years). Once the three-year average for a tax year exceeds $1 million, the partnership will fail the gross receipts test beginning with the following tax year and will need to change to the accrual method of accounting. All businesses under “common control” [as defined in Treas. Reg. § 1.52-1(b)-(e)] must be aggregated when performing the gross receipts test.
Exception for Gross Receipts $10 Million or Less – Rev. Proc. 2002-28
According to Rev. Proc. 2002-28, a “qualifying small business” with average annual gross receipts of $10 million or less can use the cash method of accounting even if the business would otherwise be required to use the accrual method of accounting because it maintains inventory. The average annual gross receipts is based on a three-year average ending with the prior tax period. If a partnership has not been in existence for three prior tax years, it must determine its average annual gross receipts for the number of years it has been in existence (including annualized short tax years). Once the three-year average for a tax year exceeds $10 million, the partnership will fail the gross receipts test beginning with the following tax year and will need to change to the accrual method of accounting. All businesses under “common control” [as defined in Treas. Reg. § 1.52-1(b)-(e)] must be aggregated when performing the gross receipts test.
Qualifying Small Business
In order for business to be deemed a qualifying small business, gross receipts must be from an “eligible trade or business.” A business whose principal business activity is from a retail trade described in NAICS codes 44-45 is one of the activities excluded from the definition of an eligible trade or business.
Based on the above, a partnership operating a retail establishment would be required to use the accrual method of accounting once its average gross receipts exceed $1 million.
Scenario 2We have been engaged to prepare the Federal tax return for an LLC taxed as a partnership and to prepare each of the six members’ individual tax returns. Two of the members reside outside of the U.S. and visit the U.S. for a few weeks each year.
Question: Are there any issues with this engagement?
First, recognize that you have seven different clients (i.e. the entity and six individuals). Although related through the LLC, each individual represents a separate engagement, even if the LLC is paying the fees associated with the preparation of the six individual tax returns. Best practice would be to have each individual sign a separate engagement letter which would address the scope and limits of the services to be provided, and other important terms and conditions. As for the LLC, the engagement letter in addition to all of the standard required language should clearly identify who will be acting as the tax matters partner for the engagement. In addition, if the LLC is paying for the preparation of the tax returns for each of the six members, the fee language should be modified as appropriate and additional language should be added to the engagement letter regarding the confidentiality of the information with respect to each of the six members. Also, in some situations, it may be advisable to obtain signed waivers where there exists the potential of a conflict between members.
The following information provided by the IRS highlights some of the tax issues related to your inquiry:
- Partnerships with foreign partners: Helpful Hints for Partnerships with Foreign Partners
- Withholding of Tax on Nonresident Aliens and Foreign Entities: IRS Publication 515
Scenario 3My client is 76 years old and is considering taking two sizable distributions from her IRA this year.
Question: Can she make a $100,000 charitable contribution from each distribution and exclude the $200,000 from gross income?
Pursuant to IRC § 408(d)(8), an individual who has reached age 70 ½ may distribute otherwise taxable IRA amounts of up to $100,000 to tax-exempt charities and exclude the amount from her income. The limitation can be found in IRC § 408(d)(8) and applies to the aggregate amount of qualified charitable distributions made during the tax year. Moreover, the distribution must be made directly from the IRA to the tax-exempt charities.
Scenario 4My client, an LLC taxed as a partnership, wishes to provide a 401(k) plan to its members and employees.
- May an LLC member participate in a 401(k) plan, and if so, how should it be reported?
- How should 401(k) contributions made by the LLC on behalf of its members be treated for federal tax purposes?
- Does the $18,000 maximum 401(k) elective deferral limitation for 2016 apply to the employer’s contribution?
IRC § 415 provides for an annual limit on the amount of contributions that can be made to an individual participant’s qualified retirement plan. This limit is the sum of (1) the employee’s elective deferral and (2) the employer’s contribution. For 2017, the IRC § 415 annual limitation is the lesser of $54,000 ($53,000 for 2015-2016) or 100% of the participant’s compensation (limited partner’s net earnings from self-employment). So, were an individual member to properly elect to defer $18,000 to her retirement plan, the maximum the LLC could contribute to the plan would be the lesser of $35,000 ($53,000 minus $18,000) or 100% of the participant’s compensation. Although the employer contribution limit is different from the employee’s maximum contribution limit, the employer must take into account the employee’s contribution when computing the IRC § 415 limitation.
The defined contribution and the IRC § 415 plans allow participants age 50 or older to defer an additional $6,000 in 2015-2017.
Scenario 5I have the following questions:
- Is a surviving spouse entitled to a step-up to FMV for rental property jointly owned with deceased spouse? The decedent passed away five years ago and the rental property was never stepped-up.
- If the rental property was entitled to a stepped-up basis, is it possible for the taxpayer to obtain the benefit of the missed depreciation that would result from the stepped-up basis given the allowed or allowable rule.
Surviving Spouse’s Basis in Property Inherited from Decedent
A threshold question involves how the property was held (e.g. qualified joint-tenants or as community property). For purposes of the explanation below, it is assumed that the decedent’s share of the property was included in his/her estate.
- Qualified joint interest property – a surviving spouse's basis in qualified joint interest rental property is determined by adding one-half of the cost basis of the property to the one-half of the fair market value included in the gross estate and adjusting for depreciation previously allowed to the surviving spouse in computing taxable income. (see IRS Pub. 559 p.14 for definitions and further guidance).
- Community property – pursuant to IRC § 1014(b)(6), a surviving spouse's share in community property is treated as property acquired from the decedent spouse if at least one-half of the community property was includible in the deceased spouse's estate. In such case, 100% of community property asset receives a step up in basis.
Depreciation - Allowed or Allowable
Generally, a taxpayer must reduce the basis of property by the depreciation allowed or allowable, whichever is greater. Allowed depreciation is depreciation actually deducted by the taxpayer while allowable depreciation is depreciation that the taxpayer is entitled to deduct. Whether or not the deduction is actually taken, the taxpayer is required to reduce the basis of the asset by the full amount of allowable depreciation.
Depreciation of an asset for two or more consecutive tax years establishes an accounting method which may not be corrected for under-reporting on an amended return. However, according to Rev. Proc. 2007-16, the taxpayer may be able to make an accounting method change and correct for under reported depreciation, but only upon disposition of the asset.
Rev. Proc. 2007-16 provides that an automatic accounting method change is permitted to correct depreciation on disposed property when the taxpayer did not claim the full amount of depreciation allowable. That is, permanent loss of the benefit from previously understated depreciation deductions may be avoidable. The guidelines for obtaining automatic consent is contained in Rev. Proc. 2015-13, as modified by Rev. Proc. 2015-33 and Rev. Proc. 2015 -14.
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