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TAX MATTERS
Basis reporting for debt instruments and options is phased in  
July 2013

In final regulations (T.D. 9616), the IRS is phasing in basis reporting requirements under Sec. 6045(g) for debt instruments and options. The IRS took the action in response to comments about the complexity of complying with these rules and to give brokers ample time to develop and implement reporting systems. T.D. 9616 finalizes proposed regulations (REG-102988-11) released in November 2011. The final regulations were effective April 18.

Sec. 6045(g) requires securities brokers and other affected persons to report to the IRS and customers (on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions) the adjusted basis of covered securities sold and whether any gain or loss upon their sale is long- or short-term. It requires securities brokers to begin providing this information for corporate stock purchased in 2011 and later years, or beginning in 2012 for stock for which an average-basis method is permissible under Sec. 1012.

Reporting on all other specified securities, including debt instruments and options, was to begin with securities acquired or granted after Dec. 31, 2012, but that date was delayed in earlier guidance, so that reporting is required for debt instruments and options acquired on or after Jan. 1, 2014 (Notice 2012-34). The final regulations delay this date even further for certain debt instruments and options.

Debt instruments. The IRS received many comments suggesting that a narrower range of debt instruments and options be subject to reporting, such as debt instruments with a fixed yield and maturity date. However, the IRS noted that Sec. 6045(g) by its terms covers a broad range of instruments. For debt instruments with less complex features, the regulations retain the Jan. 1, 2014, effective date. These include:

  • Debt instruments that provide for a single fixed payment schedule for which a yield and maturity can be determined under Regs. Sec. 1.1272-1(b);
  • Debt instruments that provide for alternate payment schedules for which a yield and maturity can be determined under Regs. Sec. 1.1272-1(c) (such as a debt instrument with an embedded put or call option); and
  • A demand loan for which a yield can be determined under Regs. Sec. 1.1272-1(d).


The IRS did not agree to a request to delay reporting on instruments with embedded put or call options because, it said, too many securities would fall under that category.

Basis reporting applies to debt instruments acquired on or after Jan. 1, 2016, that are (1) a debt instrument that provides for more than one rate of stated interest (such as a debt instrument with stepped interest rates), (2) a convertible debt instrument, (3) a stripped bond or coupon, (4) a debt instrument that requires payment of either interest or principal in a non-U.S. dollar currency, (5) certain tax credit bonds, (6) a debt instrument that provides for a payment-in-kind feature, (7) a debt instrument issued by a non-U.S. issuer, (8) a debt instrument whose terms are not reasonably available to the broker within 90 days of the date the customer acquired the debt instrument, (9) a debt instrument issued as part of an investment unit, and (10) a debt instrument evidenced by a physical certificate unless the certificate is held (directly or through a nominee, agent, or subsidiary) by a securities depository or by a clearing organization. Non-fixed-yield and maturity date instruments, including contingent payment debt instruments, variable-rate debt instruments, and inflation-indexed debt instruments, will be subject to reporting only if issued after Jan. 1, 2016.

The final regulations retain the exemption from reporting in the proposed rules for debt instruments with principal subject to acceleration and add an exemption for short-term debt instruments (debt instruments with a fixed maturity date not more than one year from the date of issue). The IRS rejected a suggestion to exempt debt instruments with terms longer than one year that will mature in less than a year when transferred.

Another provision in the regulations concerns the consistency of reporting between different brokers when some permit their customers to make certain basis elections and others may not. Because this inconsistency could create problems when instruments are transferred between brokers, the final rules adopt default assumptions but require brokers to offer certain elections to customers. Under these rules, if a customer provides written notification, a broker must take into account the following elections for basis reporting purposes: the election to accrue market discount using a constant yield, the election to include market discount in income currently, the election to treat all interest as original issue discount (OID), and the spot rate election for interest accruals for a covered debt instrument denominated in a currency other than the U.S. dollar.

In addition, to improve consistency between income reporting and basis reporting for debt instruments, T.D. 9616 contains new temporary regulations requiring, under Sec. 6049, brokers to report interest (OID) income to reflect amounts of amortized bond premium or acquisition premium for a covered debt instrument.

Options. The reporting requirements apply to the following options granted or acquired after Jan. 1, 2014: an option on one or more specified securities, including an option on an index, substantially all the components of which are specified securities; an option on financial attributes of specified securities, such as interest rates or dividend yields; and a warrant or stock right on a specified security. The scope provisions in the final regulations are generally the same as in the proposed regulations, except that the final regulations explicitly exclude a compensatory option. The final regulations also apply to any over-the-counter option on a specified security.

The regulations apply different reporting rules to Sec. 1256 options and non-Sec. 1256 options. For a nonequity option described in Sec. 1256(b)(1)(C) on one or more specified securities, brokers must use the Regs. Sec. 1.6045-1(c)(5) reporting rules that apply to a regulated futures contract. For an option on one or more specified securities that is not described in Sec. 1256(b)(1)(C), a broker will report gross proceeds and basis using the rules in the final regulations for a non-Sec. 1256 option.

For a cash-settled non-Sec. 1256 option, the regulations require a broker to adjust gross proceeds related to an option transaction by increasing gross proceeds by the amount of any payments received for issuing the option and decreasing gross proceeds by the amount of any payments made on the option. These rules for a cash-settled option are based on the idea that costs related to the acquisition of a position affect basis, while the costs related to the sale or closeout of a position affect gross proceeds.

In a change from the proposed regulations, the final regulations do not permit brokers to adjust basis to account for the exercise of a compensatory option that is granted or acquired on or after Jan. 1, 2014. The IRS says this approach will eliminate confusion and uncertainty for an employee who has exercised a compensatory option.


TAX MATTERS
IRS finds widespread noncompliance by colleges and universities  
By Charles J. Reichert, CPA
July 2013

The IRS published its final report concerning its Colleges and Universities Compliance Project, finding compliance issues related to unrelated business taxable income (UBTI) and compensation practices. The IRS conducted the study to find out why colleges and universities had so much unrelated business activity but owed so little tax and to examine their compensation practices. The IRS examined tax returns from 34 colleges and universities it selected from among 400 it surveyed by questionnaire. The examined schools were divided almost evenly between private and public institutions, with about two-thirds reporting enrollments greater than 15,000 students.

Unrelated business taxable income. An exempt organization, including exempt colleges and universities, must pay tax on income from an unrelated trade or business, defined as an activity not substantially related to the accomplishment of the organization’s exempt purposes, even if the income from the business is used to support those purposes. Losses from one activity can offset income from another; however, continuing losses can indicate a lack of profit motive, which would disqualify the activity’s losses from the netting process.

The IRS found that UBTI was underreported at 90% of the institutions examined, with a total understatement of more than $90 million from 30 unrelated activities. The majority of the activities with unreported UBTI were fitness and recreation centers, sports camps, advertising, facility rentals, arenas, and golf courses. Nearly half of the institutions had adjustments to UBTI from advertising and/or facility rentals, and about one-third had adjustments from fitness and recreation centers and sports camps, arenas, and/or golf courses. The report identified four primary reasons for understated UBTI: (1) lack of profit motive, (2) improper expense allocation, (3) misclassification of certain activities as exempt, and (4) miscalculated or unsubstantiated net operating losses.

The IRS reported that nearly 70% of the institutions examined reported losses from activities that lacked a profit motive since the activities had losses for many years. These activities should not have been classified as a trade or business, and the institutions improperly used the losses to offset income from unrelated trade or business activities. In addition, nearly 60% of the institutions reduced their UBTI by improperly allocating expenses to an unrelated trade or business activity that did not have the required proximate and primary relationship to the activity. Also, the IRS determined that more than 40% of the institutions incorrectly omitted income from activities they believed to be related to their tax-exempt purpose that were actually unrelated activities subject to tax.

Compensation. Sec. 4958 imposes an excise tax on unreasonable compensation paid by exempt organizations (in this case, private colleges and universities) to a disqualified person, namely, an officer, director, trustee, or key employee (ODTKE). An institution’s compensation is presumed to be reasonable if the college or university (1) uses an independent body to review and determine the amount of compensation, (2) relies on appropriate comparability data to set the compensation amount, and (3) contemporaneously documents the compensation-setting process. The IRS found that the compensation of 94% of ODTKEs examined in the study was determined using a process intended to satisfy the rebuttable presumption requirement; however, 20% of the examined institutions failed to meet the requirement due to the use of inappropriate comparability data. The data was inappropriate because it was (1) from another institution not comparable to the examined school, (2) obtained from an independent firm but used without any adjustments to make it comparable to the examined school, or (3) obtained from a survey that did not precisely define compensation.

The IRS also examined the employment tax returns of 11 schools and found problems in all of them, resulting in increased taxable wages of more than $35 million. The adjustments were due to failure to include the value of the personal use of autos, houses, social club memberships, and travel as wages; failure to include the value of graduate tuition waivers as wages; failure to withhold taxes on wages of nonresident aliens; and misclassification of employees as independent contractors. Also, the retirement plans at eight schools were examined, resulting in wage adjustments at four institutions totaling $1,115,007 due to excess deferrals, additions, and loans related to Sec. 403(b) plans, and nonqualifying contributions to Sec. 457 plans.

Due to the compliance issues related to UBTI and compensation found at the colleges and universities examined, the IRS concluded that similar problems may exist across the tax-exempt sector and plans to look at these issues more broadly.

  IRS, Colleges and Universities Compliance Project Final Report, available at tinyurl.com/brkhfz3

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.


TAX MATTERS
Proposed rules address minimum value of health coverage for premium tax credits  
July 2013

The IRS issued proposed regulations for determining whether an eligible employer-sponsored health plan provides minimum value for purposes of the Sec. 36B health insurance premium tax credit (REG-125398-12). Individuals do not receive the credit if they are eligible for affordable coverage under an eligible employer-sponsored plan that provides minimum value. Employers whose employees receive the health insurance premium tax credit may be liable for the Sec. 4980H “assessable payment.”

When the final regulations for Sec. 36B were issued in May 2012, they did not cover the definition of minimum value; the IRS requested comments on that issue (T.D. 9590, Notice 2012-31). In drafting the proposed rules, the IRS considered the comments it received.

Prop. Regs. Sec. 1.36B-6(a) states that a plan provides minimum value only if the plan’s share of the total allowed costs of benefits provided to an employee is at least 60%. Minimum value may be calculated using one of four methods: (1) the minimum value calculator provided by the IRS and the Department of Health and Human Services (HHS) (calculated with adjustments provided in the regulations); (2) one of the safe harbors established by the IRS and HHS (generally, plans that provide certain benefits within specified co-pay, deductible, and cost-sharing limits); (3) actuarial certification for nonstandard plans; or (4) for plans in the small group market (employers with a maximum of 100 employees or, in years before 2016, in states that elect, 50 employees), conforming with a level of coverage defined in 45 C.F.R. Section 156.140(b) (bronze, silver, gold, or platinum).

The proposed regulations also explain how wellness incentives (where a premium or other cost is reduced to encourage certain behaviors) are included in calculating minimum value. If the wellness incentives are tobacco-related, they are included in determining affordability (i.e., they would reduce the premium); otherwise, they are not included. The rules also explain how payments into health savings accounts and health reimbursement arrangements are included in calculating affordability.

The proposed regulations also:

  • Define the term “rating area” used to determine costs of plans in the area in which the taxpayer lives;
  • Define how retiree coverage is included as minimum essential coverage;
  • Define coverage months for newborns and new adoptees;
  • Explain how to calculate the adjusted monthly premium for family members not enrolled a full month (e.g., for a newborn child);
  • Explain how to calculate the premium assistance amount when coverage is terminated before the last day of a month;
  • Explain that premiums for family members residing in different states who enroll in different health plans can be added together; and
  • Require taxpayers who receive advance payments of premium tax credits to file an income tax return to reconcile the payments by the due date for the return (including extensions) for the year they received the advance payments.


The regulations are proposed to apply to tax years ending after Dec. 31, 2013 (the first year the credit will be in effect).


TAX MATTERS
Salary was partially reasonable  
By Laura Jean Kreissl, Ph.D. and Darlene Pulliam, CPA, Ph.D.
July 2013

Relying on standards set by the Ninth Circuit, the Tax Court found that a sole shareholder’s compensation from a wholly owned corporation for the year in question was partially deductible as reasonable compensation. The deductible compensation included catch-up payments for prior years’ services.

Arthur Astor was the president and CFO of his wholly owned corporation, Aries Communications Inc. Since the company’s formation in 1983, Astor was very involved in day-to-day operations and was a major factor in its success. In 2003 and 2004, Aries reported large sales of radio station assets through its subsidiaries, which resulted in large taxable income for those years. In the years before and after these sales, the company reported negative taxable income.

In 2004, Aries claimed a deduction of $6,896,974 for compensation to Astor. The IRS disallowed most of the 2004 deduction—$6,086,753—and determined a deficiency of $2,676,002 and an accuracy-related penalty under Sec. 6662(a).

The Tax Court relied on six factors to determine how much of the compensation was reasonable. The specific factors selected are those used by the Ninth Circuit, to which the case would be appealed (see Elliotts, Inc., 716 F.2d 1241 (9th Cir. 1983), and Metro Leasing & Dev. Corp., 376 F.3d 1015 (9th Cir. 2004)).

Three of the factors were not favorable for allowing the full compensation deduction claimed by Aries. After reviewing expert reports submitted by both Aries and the IRS that determined Astor’s reasonable compensation based on compensation information from similar companies, the court found that the amount claimed by Aries for fixed compensation for the current and prior years was less than that paid by similar companies. However, the court rejected both experts’ opinion on the reasonable part of Astor’s bonus compensation and independently determined that only $2 million of the nearly $6.7 million bonus payment for 2004 was reasonable. Second, the company’s character and condition indicated that Aries was thinly capitalized and in poor financial condition, supporting a much smaller deduction. Third, Astor had a potential conflict of interest in characterizing his economic reward for his work as salary rather than dividends, especially when he had been well-compensated for his efforts for the prior year’s asset sale.

The court determined the factor of internal consistency in the treatment of payments to employees was neutral. Astor’s compensation was not awarded under a structured, formal, consistently applied program; however, in 2004, it included amounts for prior years of hard work for which he had been undercompensated. Also, Astor’s compensation could not be compared with other nonowner Aries’ employees because the company had no employees with duties similar to Astor’s.

The court determined two factors were favorable: Astor’s role in the company was obviously significant. He was very involved and important in the company’s success and in the asset sales. Also, under the independent-investor standard (whether corporate profits, after paying the compensation, would provide a satisfactory return on equity for a hypothetical independent investor), the court found that Aries had sufficient net income and retained earnings to support Astor’s compensation.

The court concluded that Aries could deduct $2,660,899, which consisted of $461,625 for prior years’ underpayments, current annual salary of $199,274, and a $2 million bonus. The accuracy-related penalty was allowed.

Taxpayers should take steps to support the deduction of a large salary. The factors important to the appropriate court of appeals should be supported and documented. A record of dividends should be established, even if the amounts are relatively small.

  Aries Communications, Inc., T.C. Memo. 2013-97

By Laura Jean Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.


TAX MATTERS
GAO: Foreign account “quiet disclosures” may be much higher than detected  
July 2013

More than 10,000 taxpayers showed signs of having avoided offshore penalties by making “quiet disclosures” of foreign bank accounts for tax years 2003 through 2008, the U.S. Government Accountability Office (GAO) reported, a period for which the IRS has detected several hundred quiet disclosures. Filing data also suggest many more taxpayers may have begun reporting previously reportable foreign accounts on a recent current-year return without entering the government’s offshore voluntary disclosure program (OVDP) or making a quiet disclosure for prior open years, the GAO said. While these taxpayers may have come into voluntary compliance going forward, they also thereby may have evaded all penalties and past-due taxes and interest on the accounts and income generated by them.

In the report, Offshore Tax Evasion: IRS Has Collected Billions of Dollars, but May Be Missing Continued Evasion (GAO-13-318), released April 26, the GAO gave results of its study of the effectiveness of the IRS’s 2009 OVDP, which was the IRS’s second OVDP and the most recent one with enough closed cases for analysis. The IRS also conducted OVDPs in 2003 and 2011, and has had one ongoing since 2012. In each, taxpayers have been allowed to apply to the IRS and, if they qualify, disclose their foreign accounts and pay taxes, interest, and tax-related penalties due for open years. In exchange, the IRS waives any criminal prosecution and limits the penalty for failing to disclose the accounts (“offshore penalty”) to, in the 2009 OVDP, 20% of the highest aggregate value of the unreported accounts between 2003 and 2008 (the years covered by the 2009 OVDP). The penalty otherwise applicable to failing to properly file a Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), is, for each year of violation, the greater of $100,000 or 50% of the balance in the account at the time of the violation.

The GAO identified 19,337 participants in the 2009 OVDP in 10,439 closed cases. The average offshore penalty assessed was about $376,000. Almost half the participants had accounts in Switzerland (a “John Doe” summons in 2008 for the names of U.S. account holders in Swiss bank UBS was a major factor driving participation in the 2009 OVDP). About half of the $4.1 billion in total revenues collected (as of the end of 2012) was from 378 cases. All the OVDP programs together have resulted in more than 39,000 disclosures and more than $5.5 billion in revenue as of December 2012.

Quiet disclosures. To identify potential quiet disclosures for years covered by the 2009 OVDP, the GAO identified taxpayers that had filed amended or late returns and FBARs for one or more of those years and excluded OVDP participants from this total. It found that 10,595 taxpayers met these criteria, indicating possible quiet disclosures. Of those, 3,386 taxpayers made the late or amended filings for multiple tax years—94 of them for all six years.

The IRS identified “several hundred” taxpayers (the report did not give a more specific number) as making quiet disclosures by similarly looking at amended returns for the period and screening out those with adjustments unrelated to offshore accounts. It also looked at amended returns with increased tax assessments over a certain threshold. The IRS also looked at FBARs filed or amended with amended returns, but only for those processed in 2009 and for the limited purpose of detecting movement of taxpayer assets from “non-secrecy” jurisdictions to those with financial secrecy laws.

New reporting. To estimate potential numbers of taxpayers newly reporting existing foreign financial accounts without making any disclosure concerning or amending prior returns, the GAO also looked at the overall increase between tax years 2003 and 2011 in FBAR filings and from fiscal 2003 to 2010 in returns that reported “yes” to the question on Schedule B, Interest and Ordinary Dividends, about whether the taxpayer owned or controlled a foreign financial account. The latter more than doubled in that period to 515,635 (see related graphic). As a percentage of all taxpayers filing Schedule B, they rose from approximately 1% in 2003 through 2007 to more than 2.5% in 2010. Similarly, the number of FBARs filed more than tripled to 618,134 from fiscal 2003 to 2011, and more than doubled between 2009 and 2010. Reasons for the increase could include taxpayers who had complied with income reporting requirements previously but only belatedly realized the need to also answer the question on Schedule B affirmatively and file an FBAR, the GAO noted.

“However,” it added, “such a sharp increase … amidst the global economic recession and the publicity surrounding IRS’s offshore programs raises the question whether some of these taxpayers may have attempted to circumvent some of the taxes, interest, and penalties that would otherwise be owed.” 

The IRS agreed with the GAO’s recommendations that it use similar methods to more effectively detect and pursue quiet disclosures and previously unreported foreign financial accounts and to use offshore data to educate taxpayers about compliance.


TAX MATTERS
Line items  
July 2013

Tokyo, Hong Kong Again Top IRS High-Cost Housing List

Housing CostTokyo and Hong Kong have the highest allowable housing costs for 2013 for purposes of the foreign housing exclusion under Sec. 911(c). The limitation for Tokyo is $320.82 per day, or $117,100 for the year. For Hong Kong, it is $313.15 a day, or $114,300 for the year. The cities are followed, in order, by Moscow; Geneva; Osaka-Kobe, Japan; and Singapore (see chart).

The cities are among 288 places the IRS identified in Notice 2013-31, an annual update, as having allowable foreign housing exclusions above the otherwise applicable limitation for 2013 of $29,280. The top five high-cost cities are the same as in the 2012 list (see Notice 2012-19).

Subject to limitations, qualified individual taxpayers may elect to exclude from gross income under Sec. 911(a) their foreign earned income and foreign housing costs. The individual must meet the bona fide residence or physical presence test. The income exclusion and housing cost exclusion together may not exceed the taxpayer’s foreign earned income for the year.

The foreign housing cost exclusion is further limited to 30% of the foreign earned income limitation, as adjusted for inflation, or, for all of 2013, $29,280 of qualifying housing costs above a threshold amount of 16% of the foreign earned income exclusion limitation, or, for 2013, $15,616. The IRS is authorized by Sec. 911(c)(2)(B) to adjust the 30% limitation amount based on geographical differences in housing costs relative to those in the United States, which it does annually.

Five locations in France took ninth through 13th places in 2013: Paris and its suburbs of Garches, Sèvres, Suresnes, and Versailles. All were just behind Luanda, the capital of Angola, which is undergoing an oil-related economic boom but whose per capita GDP of $6,200 remains less than one-eighth that of the United States (CIA, The World Factbook).

Notice 2013-31 is effective for tax years beginning on or after Jan. 1, 2013; however, taxpayers may elect to apply it to their 2012 tax return instead of the otherwise applicable adjusted limitation in the 2012 notice.

HSA Figures for 2014 Announced

For calendar 2014, the inflation-adjusted limitations on deductible or excludible contributions to a health savings account (HSA) under Sec. 223 will be:

  • Individual with self-only coverage under a high-deductible health plan (HDHP): $3,300.
  • Individual with family coverage under an HDHP: $6,550.


The amounts are slightly higher than for 2013 ($3,250 and $6,450, respectively). The additional contribution amount for individuals 55 and older remains unchanged at $1,000.

An HDHP’s minimum annual insurance deductible for 2014 will be unchanged from 2013 at $1,250 for self-only coverage and $2,500 for family coverage. Maximum out-of-pocket expenses allowable under an HDHP (other than premiums) will be $6,350 for self-only coverage and $12,700 for family coverage (up from $6,250 and $12,500, respectively, in 2013).

The updated amounts are in Rev. Proc. 2013-25


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