Holding real estate through an S corporation may seem like a good idea at first glance. Almost all professionals, however, recommend a partnership over an S corporation as the preferred vehicle to own real estate. S corporations and partnerships are both pass-through entities, meaning the income or loss generated by these entities flows through to the owners, who are responsible for paying the tax due. However, there are a number of disadvantages of owning real estate via an S corporation compared to a partnership.
First, although S corporations are often excellent for reducing self-employment taxes, income from passive real estate investments do not benefit from that because such income is not subject to self-employment taxes.
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For administrative convenience, federal and North Carolina law both provide that after a specific period of time, uncollected taxes are written off and released. This provides some relief for taxpayers who owe taxes for years long past as well as preventing tax agencies from fruitlessly pursuing old and cold liabilities.
Section 6502 provides the federal collection time limit, stating the collection statute expiration date (“CSED”) is 10 years after the assessment of the tax. There are certain events that extend the date as provided in Section 6503, including the taxpayer’s bankruptcy, spending time outside the United States, and filing a collection due process appeals hearing request. Before the expiration of the CSED, the IRS can seek to extend the 10-year period. However, it rarely does that.
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Limited liability companies can elect to be taxed under federal and state law in a number of different ways. One popular choice for small business owners is for an LLC to elect to be an S corporation.
The primary tax advantage of operating as an S corporation is minimizing self-employment taxes. When operating as a sole proprietorship (whether through a disregarded LLC or not), an individual’s profits are subject to a 15.3% self-employment tax in addition to the individual income tax. The same is true for wages paid to employees of the S corporation (although in that case 7.65% is paid by the employee while the other 7.65% is paid by the S corporation itself). The IRS requires owners of an S corporation to pay themselves a reasonable salary, and not doing so (or paying too small of a salary) is the subject of many employment division audits of S corporations. However, S corporations are not required to pay out all of their profits as salaries to their employees. Rather, the IRS (in publications such as FS-2008-25) requires only that the salary be reasonable.
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This is the second installment of this article. The first installment was previously posted on the Tax Section’s blog.
I. No Easement Charitable Contribution Deduction Allowed Where Form 8283 Did Not Include Cost Basis Information.
In yet another case of a failed charitable contribution donation deduction, in Oakhill Woods, LLC v. Commission, TC Memo 2020-24, the Tax Court disallowed an easement charitable contribution donation deduction because the taxpayer failed to include tax basis information on the Form 8283. That resulted in a disallowed deduction of almost $8 million.
On its tax return for the year of the donation, the taxpayer did not report its income tax basis in the donated easement but instead added an attachment to the Form 8283 stating that “the basis of the property is not taken into consideration when computing the amount of the deduction.” The Tax Court ruled, since the tax basis information was not included on the Form 8283 as originally filed for the year of the donation, the charitable deduction failed the substantiation requirements of Section 170.
The Tax Court noted the taxpayer may not qualify for the reasonable cause defense under Section 170(f)(11)(A)(ii)(II). The LLC argued it prepared and filed its Form 8283 in this manner based on advice of its CPA, who prepared the return, as well as the advice of a consulting firm named Forever Forests. Because Forever Forests was involved with the conservation donation, another court would have to determine, at a later date, whether it was a “competent and independent advisor unburdened with a conflict of interest” and whether the CPA was a competent tax professional who provided tax advice independent of that supplied by Forever Forests.
The decrease in the corporate tax rate by the 2017 Tax Act has made it more favorable for businesses to operate as C corporations. With more businesses opting to be C corporations, the gain exclusion of Section 1202 is more important. Section 1202 provides an exemption to eligible taxpayers of between 50% and 100% of the gain of the sale of Section 1202 stock.
Section 1202 applies only to qualified small business stock held for more than five years. Qualified small business stock is stock of a C corporation that was issued on or after August 10, 1993, if (a) as of the date of issuance, the corporation was a qualified small business, and (b) the stock was acquired by the taxpayer at its original issue (subject to narrow exceptions). A qualified small business is a U.S. corporation that is a C corporation and the aggregate gross assets of which at all times after August 10, 1993, and before and immediately after issuance did not exceed $50 million. Additionally, the corporation must meet an active business requirement. At least 80% by value of the assets of the corporation must be used in the active conduct of one or more qualified trades or businesses. A qualified trade or business is any trade or business other than the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, or financial services, any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, banking, insurance, financing, leasing, investing, or similar business, any farming business (including raising or harvesting trees), any business involving the production or extraction of products to which a deduction is allowable under Section 613 or 613A, or operating a hotel, motel, restaurant, or similar business.
This is the first of two installments of this article. The second installment will be posted soon on the Tax Section’s blog.
I. Audit Statistics; What Are Your Chances of Being Audited?
In early 2020, the IRS published its 2019 data book, which contained audit statistics for the fiscal year that ended September 30, 2019. Here are the audit statistics for tax returns filed in calendar year 2018 (“CY 2018”):
A. Audit Rates for Individual Income Tax Returns.
Only 0.6% of individual income tax returns filed in CY 2018 were audited (about the same as in CY 2017). Of those audited returns, only 25% were conducted by revenue agents (down from 29%), and the rest were correspondence audits.
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Dec. 2, 2020, marked the annual meeting between the Tax Section and the IRS, along with our invited guests from the Tax Committee for the North Carolina Association of Certified Public Accountants. As with most meetings these days, it was held virtually. We were fortunate to have representatives from the IRS from locations other than just in Greensboro. Speakers included representatives from IRS Chief Counsel’s office, the Examination Division, Collections Division, Appeals Collection, Appeals Exam, and we ended with a brief discussion by our local IRS stakeholder liaison. Click here for the speakers’ contact information.
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Nonprofit organizations generally must file a Form 1023 with the IRS to obtain federal tax-exempt status under Section 501(c)(3). However, such status may not be eternal. Tax-exempt status is automatically revoked when a charity does not file the required Form 990 series return or notice for three consecutive years. The IRS publishes a list of charities whose tax-exempt status has been revoked. As one can imagine, that can be overwhelming for a charity that needs to assure its donors their donations are eligible for the charitable tax deduction. Luckily, the IRS has established four procedures in Revenue Procedure 2014-11 for the reinstatement of an organization’s tax-exempt status.
The first is streamlined retroactive reinstatement. That is available only for organizations that should have filed Form 990-EZ or Form 990-N (ePostcard) for the three years for which returns were not filed. These charities are eligible to file Form 1023 or 1023-EZ and mark the appropriate box to have their exempt status retroactively reinstated. Such charities will be treated as if they never lost their exempt status.
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Whole life insurance, when distinguished from term life insurance, has several qualities that may create surprising tax results. One of these potential pitfalls can arise when taxpayers take out policy loans on their whole life policies. These loans, when received by the taxpayer, are not taxable income so long as they do not exceed the amount paid in premiums and a termination event does not occur. Prepaying such a loan is usually not mandatory, as any debt outstanding upon the insured’s death will be deducted from the policy payout to beneficiaries.
While these are helpful benefits, they can be double-edged if the taxpayer is forced to surrender the policy or if it lapses. In either of these cases, the loan (plus accrued interest) is taxable, and a Form 1099-R will be issued. This income is cancellation of indebtedness income consistent with Tufts and its progeny, as explained by the Tax Court in Mallory v. Commissioner, T.C. Memo 2016-110.
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Single-member LLCs and grantor trusts are both entities that exist for state law purposes but are disregarded for federal income tax purposes. These entities are commonly known as disregarded entities or DREs. The ownership of partnership interests by a disregarded entity creates the question of who the partner really is.
A limited liability company has great flexibility in federal and state tax treatment under Treas. Reg. § 1.7701-3. The default treatment of an LLC that has a single owner is for the LLC to be disregarded as an entity separate from its owner. So, who is the partner if a disregarded LLC owns a partnership interest? The IRS answered that in Rev. Rul. 2004-77, which confirms an entity disregarded under federal tax law is ignored under federal partnership law. Thus, the disregarded entity’s owner is treated as the partner.
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