Small business:

Recent Depreciation Developments

T wo recent depreciation developments will affect small businesses that write off office furniture and equipment.

In Norwest Corporation v. Commissioner (TC Memo, 1995-390), the Tax Court said all industries could treat office furniture, fixtures and equipment as 5-year property for depreciation purposes. Prior to this ruling, Internal Revenue Code section 168 said that under the modified accelerated cost recovery system, property with a class life of 4 to 10 years could not be written off before 5 years and property with a class life of 10 to 15 years could not be written off before 7 years. In recent years, generally all office equipment has been considered 7-year property.

Revenue procedure 96-31 allows taxpayers that erroneously claim less than they are entitled to correct their depreciation errors. Although there are some exceptions, 96-31 creates an automatic consent to change the accounting method for property that previously was underdepreciated. Taxpayers must file Form 3115, Application for Change in Accounting Method, with the Washington office of the IRS on or before the 180th day in the year of change. There is no fee.

Observation: The Norwest ruling gives small businesses the opportunity to use the 5-year recovery period for office furniture, fixtures and equipment. Practitioners who wish to consider such use should review the Norwest decision for more details. Also, revenue procedure 96-31 gives both taxpayers and CPAs the opportunity to review past depreciation methods to see if property was underdepreciated and to change it to the correct amount without IRS consent. It is important to note that this ruling does not cover the prior year's overdepreciation. Such requests for change must still be made under the provisions of revenue procedure 92-20.

—Stanley Person, CPA, partner of Person & Co., New York City.


Loan Fees in LBOs

I n a leveraged buyout (LBO), the debt incurred to finance the payments to the target company's shareholders almost always is assumed by the target company. The Internal Revenue Service treats the transaction as a redemption-the target company is considered to have redeemed its own stock.

For redemption treatment, Internal Revenue Code section 162(k) disallows a deduction for amounts paid by a corporation in connection with the reacquisition of its own stock, including loan acquisition costs and advisory fees. Accordingly, these expenses, normally deducted through amortization over the term of the loan, would not be deductible at all. In Fort Howard v. the Commissioner (107 TC no. 12, 1996), the Tax Court supported the IRS's position.

Now, under the Small Business Job Protection Act of 1996, Congress has overturned the IRS's position. Moreover, it has done so retroactively to the 1986 inception of section 162(k). Loan fees and other amounts properly allocable to indebtedness can be amortized over the term of the loan notwithstanding IRC section 162(k).

Observation: In the case of Fort Howard and for other taxpayers in this situation, loan fees can be deducted in an LBO without a challenge by the IRS.


Planning After Death

T he Internal Revenue Service recently allowed a taxpayer to plan his estate after he died. The taxpayer died on March 2, 1994, with a substantial balance in his individual retirement account (IRA) and before he had began receiving distributions. On March 21, 1990, he had executed a trust that was the beneficiary of the IRA; his wife, mother and three daughters were beneficiaries of the trust. The taxpayers spouse and mother predeceased him, and one of his daughters died on June 6, 1995. According to the trust instrument, the IRA was to be divided equally between the two surviving daughters. The bank trustee elected to have distributions made to the surviving daughters over the life expectancy of the deceased daughter because she was the eldest and the one with the shortest life expectancy.

Heres where the postmortem planning began. In order to avoid Internal Revenue Code section 408 (d)(3)(C) regulations, which prohibit rollover treatment for inherited IRAs, the bank trustee asked the IRA custodian to separate the IRA into two subaccounts. The bank assigned its beneficial interests as successor trustee in the two subaccounts to the two daughters, and the IRA remained in the taxpayers name. The creation of the subaccounts provided both daughters with the freedom to direct their own investment activities, to select their own custodian or investment adviser and to receive distributions from the IRA in an amount independent of the actions of the other.

In private letter ruling 9641031, the IRS sanctioned the taxpayers plan and issued the following five statements to help clear up regulations dealing with IRA distributions.

  1. The trust beneficiaries qualified as beneficiaries of the IRA for purposes of determining the distribution period under IRC section 401(a)(9)(B)(iii).
  2. The bank trustee could make the election to receive distributions over the deceased daughters life even though the bank was not the designated beneficiary of the IRA.
  3. The designated beneficiary was determined when the taxpayer died. If there were multiple beneficiaries, the one with the shortest life expectancy would be the designated beneficiary for purposes of determining the distribution period under Treasury regulations section 1.401 (a)(9)(1), E-5 (a)(1).
  4. The two subaccounts could be established without affecting the IRAs tax-deferred status.
  5. The transfer of funds from the main IRA to the subaccounts would not be treated as a taxable distribution under section 408(d)(1).

Observation: This new ruling allowed for some postdeath decision making, but taxpayers should establish multiple IRAs during their lifetimes to provide for beneficiaries with special needs. Each separate IRA can be tailored to the specific needs of each beneficiary. Trusts can be used when needed, but generally only individuals can be designated as beneficiaries.

—Michael Lynch , CPA, Esq., Associate professor of accounting at Bryant College, Smithfield, Rhode Island.


Sourcing Losses

T he Internal Revenue Service issued proposed regulations for sourcing losses from the sale of foreign affiliate stock. Although they would be effective 60 days after they are finalized, taxpayers could apply them retroactively to stock losses for all open taxable years after 1986.

The sourcing of income and losses is used when (1) U.S. resident companies determine their foreign tax credit limitations and (2) foreign taxpayers determine their U.S. taxable income. Internal Revenue Code section 865 provisions on how gains should be sourced were enacted in 1986; however, with the exception of certain rulings on bank losses, the IRS has not provided rules for sourcing losses.

Section 865 generally bases the sourcing of gains from sales of personal property, including stock, on the taxpayers residence. One exception applies when the sale is made through a branch office. For U.S. residents, gains from sales made through a foreign office generally are considered foreign source gains if they are subject to at least 10% foreign income tax. Another exception allows gains from sales of foreign affiliate stock by a U.S. resident to be considered foreign sourced if the sales occur in a foreign country where the affiliates business generates more than half of its gross income.

Proposed regulations section 1.865-2(a) provides sourcing rules for losses from affiliate stock sales that generally mirror the gains rules. However, a U.S. residents losses attributable to a foreign office would be foreign sourced if a gain would have been taxable by a foreign country where the highest marginal tax rate is at least 10%.

The provisions dividend recapture rule would require allocation of a loss to the same income source as well as the same foreign tax credit limitation category as any dividend inclusion within 24 months of the loss sale. This recapture rule would not apply if the sum of all recapture amounts was less than 10% of the realized loss. The loss rules generally do not incorporate the special rule for gains from sales of foreign affiliate stock. However, a consistency rule would require a loss recognized on the sale of an 80%-owned foreign affiliate to reduce foreign source passive income if, within the past five years, the seller had recognized gain on the sale of a foreign affiliate sourced under the foreign affiliate stock rule. The five-year look-back would apply only to gains recognized after September 6, 1996.

Observation: The proposed regulations generally mirror the rules for gains from sales of affiliate stock and prevent potential whipsawing that could occur if, for example, losses from a sale of a block of affiliate stock could not be netted against gains from a sale of another block of the same stock. They also are favorable for U.S. multinationals because they generally result in U.S. source losses, which do not reduce the foreign tax credit limitation.

— Kenneth Kral, CPA, international tax partner ; Jack Serota, Esq., international tax manager ; Sophie Young, international tax associate, Price Waterhouse, New York City.

  • The Internal Revenue Service issued a model amendment for employee plan sponsors to use when amending their plans to comply with the requirements of the Uniformed Services Employment and Reemployment Rights Act of 1994 and the Small Business Job Protection Act of 1996. Designated sponsors adopting the model language do not have to apply to the IRS for permission or pay a user fee, but they are required to file Form 8837 Notice of Adoption of Revenue Procedure Model Amendments.
  • In private letter ruling 9640003, the IRS said farmers are precluded from using the installment method of accounting for alternative minimum tax (AMT) purposes. A farmer had sold his crop and was paid $0.75 on the dollar upon inspection and delivery, with the balance received in the next taxable year. The IRS ruled that, for AMT purposes, farmers must treat the full fair market value of the deferred payment as received in the year of sale.

    —Michael Lynch, CPA, Esq., Associate professor of accounting at Bryant College, Smithfield, Rhode Island.

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This comprehensive report looks at the changes to the child tax credit, earned income tax credit, and child and dependent care credit caused by the expiration of provisions in the American Rescue Plan Act; the ability e-file more returns in the Form 1040 series; automobile mileage deductions; the alternative minimum tax; gift tax exemptions; strategies for accelerating or postponing income and deductions; and retirement and estate planning.