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The IRS has released new proposed rules related to charitable contributions made to get around the $10,000/$5,000 cap on state and local tax (SALT) deductions. The proposed regulations:

incorporate the safe harbor in Notice 2019-12 for individuals who have any portion of a charitable deduction disallowed to the receipt of SALT benefits;
incorporate the safe harbor in Rev. Proc. 2019-12 for business entities to deduct certain payments made to a charitable organization in exchange for SALT benefits; and
clarify the application of the quid pro quo principle under Code Sec. 170 to benefits received or expected to be received by the donor from a third party.

SALT Limit

An individual’s itemized deduction of SALT taxes is limited to $10,000 ($5,000 if married filing separately) for tax years beginning after 2017. Some states and local governments have adopted laws that allowed individuals to receive a state tax credit for contributions to certain charitable funds. These laws are aimed at getting around the SALT deduction limit by creating a charitable deduction for federal income tax purposes.

The IRS issued final regulations in June 2019 that provide that the receipt of a SALT credit for a charitable contribution is the receipt of a return benefit (quid pro quo benefit). Thus, the taxpayer must reduce any contribution deduction by the amount of any SALT credit received or expected to receive in return. The regulations contain a de minimis exception if the SALT credit does not exceed 15 percent of the taxpayer’s charitable payment.

A taxpayer is not required to reduce the charitable contribution deduction because of the receipt of SALT deductions. However, the taxpayer must reduce the charitable deduction if it receives or expects to receive SALT deductions in excess of the taxpayer’s payment or the fair market value of property transferred.

Payments by Individuals

A safe harbor was provided in Notice 2019-12 for individuals who have a portion of a charitable deduction disallowed due to the receipt of a SALT credit. Under the safe harbor, any disallowed portion of the charitable contribution deduction may be treated as the payment of SALT taxes for the purposes of deducting taxes under Code Sec. 164.

The new proposed regulations incorporate the safe harbor in Notice 2019-12. The safe harbor is allowed in the tax year the charitable payment is made, but only to the extent that the SALT credit is applied as provided under state or local law to offset the individual’s SALT liability for the current or preceding tax year. Any unused credit may be carried forward as provided under state and local law.

Payments by Business Entities

The IRS also provided a safe harbor in Rev. Proc. 2019-12 that business entities may continue to deduct charitable contributions in exchange a SALT credit. A business entity may deduct the payments as ordinary and necessary business expenses under Code Sec. 162 if made for a business purpose.

The new proposed regulations incorporate the safe harbor in Rev. Proc. 2019-12. If a C corporation or specified pass-through entity makes the charitable payment in exchange for a SALT credit, it may deduct the payment as a business expense to the extent of any SALT credit received or expected to be received. In addition, the new proposal provides that if the charitable payment bears a direct relationship to the taxpayer’s business then it may be deducted as a business expense rather than a charitable contribution regardless of whether the taxpayer receives or expects to receive a SALT credit.

Benefits Received from Third Party

If a taxpayer receives any goods, services, or other benefits from a charitable organization in consideration for a contribution, then the charitable deduction must be reduced by the value of those benefits. If the contribution exceeds the fair market value of the benefits received, then only the excess is a deductible as a charitable contribution.

The new proposed regulations clarify that this quid pro quo principal applies regardless of whether the party providing the goods, services, or other benefits is the charitable organization or not. A taxpayer will be treated under the proposal as receiving goods and services in consideration for the taxpayer’s charitable contribution if, at the time the taxpayer makes the payment or transfer, the taxpayer receives or expects to receive goods or services in return.

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Final regulations provide rules on the attribution of ownership of stock or other interests, for determining whether a person is a related person with respect to a controlled foreign corporation (CFC) under the foreign base company sales income rules. The regulations also provide rules to determine whether a CFC receives rents in the active conduct of a trade or business, for determining the exception from foreign personal holding company income.

The regulations adopt without change, proposed regulations published on May 20, 2019 ( NPRM REG-125135-15).

Attribution of Ownership

The regulations provide specific rules for applying principles similar to those in the Code Sec. 958(b) constructive ownership rules when determining related person status under the foreign base company sales income rules. The determination of related person status is relevant for many purposes, including whether certain types of income can be characterized as subpart F foreign base company sales or service income.

A person is a related person with respect to a CFC if the person is:

an individual who controls the CFC,
an entity that controls or is controlled by the CFC, or
an entity that is controlled by the same person that controls the CFC.

Rules similar to those for determining stock ownership in Code Sec. 958 apply for purposes of determining whether a person is a related person. The regulations limit the application of the downward attribution rules in Code Sec. 318(a)(3), which apply by reference to the Code Sec. 958 stock ownership rules, and which attribute ownership downward from the owner of an entity to an entity. The downward attribution rules are applied regardless of the size of the ownership interest in a partnership, estate, or trust, but are applied to corporations based on a 50-percent or more ownership interest.

The regulations address concern that application of the downward attribution rules could inappropriately treat entities (including CFCs) that do not have significant relationships with each other as related persons. Accordingly, the regulations provide that the downward attribution rules of Code Sec. 318(a)(3) and Reg. §1.958-2(d) will not apply for purposes of determining related person status under the foreign base company sales income rules.

The change does not preclude a corporation, partnership, trust, or estate from being treated as controlled by the same person or persons that control the CFC under other rules that remain applicable for the related person rules.

Additionally, an anti-abuse rule is provided with respect to the option attribution rule in Code Sec. 318(a)(4). The option attribution rule in Code Sec. 318(a)(4) and Reg. §1.958-2(e) will not be applied to treat a person with an option as owning the stock or an equity interest for purposes of the related person rule if the principal purpose of using the option was to cause a person to be treated as a related person.

The regulations also incorporate a similar rule issued in section 7(d) of Notice 2007-9, 2007-1 CB 401. The rule applies if the principal purpose for the use of an option is to qualify dividends, interest, rents or royalties paid by a foreign corporation for the Code Sec. 954(c)(6) CFC look-through exception from foreign personal holding company income. The rule applies to tax years of CFCs beginning after December 31, 2006, and ending before November 19, 2019, and to tax years of U.S. shareholders in which or with which such tax years end.

Personal Holding Company Income

The regulations modify the foreign personal holding company rules for amounts paid or incurred by a CFC in connection with the CFC’s rental income and the active rents exception. Rents are excluded from foreign personal holding company income if the rents are:

received from a person other than a related person, and
from the active conduct of a trade or business.

If rents are from leasing property as a result of marketing activities, there must be a substantial marketing organization in order to meet the active trade or business test. Under a safe harbor, an organization is substantial if active leasing expenses equal or exceed 25 percent of adjusted leasing profit. If the CFC receives rents from property it does not own, the substantiality of the organization is determined net of those rent payments.

The regulations extend the rule to apply to royalties in addition to rents. As a result, the substantiality of the organization is determined under the safe harbor net of the rents or royalties paid or incurred by the lessor CFC, for the right to use the property (or a component part of the property) that generated the rental income.

Applicability Date

The regulations generally apply to tax years of CFCs ending on or after November 19, 2019, and to tax years of U.S. shareholders in which or with which such tax years end. The regulations on the downward attribution rule, and the option anti-abuse rule for use of the option to treat a person as a related person with respect to a CFC, apply to tax years of CFCs ending on or after May 17, 2019, and to tax years of U.S. shareholders in which or with which such tax years end, with respect to amounts received or accrued by a CFC on or after May 17, 2019, to the extent the amounts are received or accrued in advance of the period to which such amounts are attributable with a principal purpose of avoiding application of the rules.

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The IRS has issued final and proposed regulations implementing the base erosion and anti-abuse tax (BEAT) under Code Sec. 59A. The BEAT is a minimum tax that certain large corporations must pay on certain payments made to foreign related parties, and was added by the Tax Cuts and Jobs Act ( P.L. 115-97).

The final regulations adopt proposed rules ( REG-104259-18) published on December 21, 2018 (2018 proposed regulations), with certain modifications. The proposed regulations ( REG-112607-19) (2019 proposed regulations) provide rules under Code Secs. 59A and 6031 regarding certain aspects of the BEAT.

Final Regulations

The 2018 proposed regulations provided guidance related to the mechanics of determining a taxpayer’s BEAT liability, and addressed application of the BEAT to partnerships, banks, registered security dealers, and consolidated groups. The final BEAT regulations retain the basic approach and structure of the 2018 proposed regulations, with certain revisions.

The final regulations continue to be exclude from the denominator of the base erosion percentage Code Sec. 988 losses with respect to transactions with foreign related parties that are excluded from the numerator of the percentage. The final regulations also retain the add-back method for computing modified taxable income and the computation of base erosion minimum tax amount (BEMTA) on a taxpayer-by-taxpayer basis.

Among some of the more significant changes to the proposed rules, the final regulations:

adopt the "with-or-within" method to determine the gross receipts and the base erosion percentage of an aggregate group;
disregard transactions between parties if both parties were members of the aggregate group at the time of the transaction;
exclude the base erosion tax benefits and deductions attributable to the tax year of a member of an aggregate group that begins before January 1, 2018;
clarify that payments resulting in a reduction to determine gross income are not treated as base erosion payments;
require that the determination of whether a payment or accrual is a base erosion payment be made under general U.S. federal income tax law;
clarify the definition of a "base erosion payment," and generally exclude amounts transferred to, or exchanged with, a foreign related party in certain corporate nonrecognition transactions from that definition;
clarify the rules for determining the portion of U.S. branch interest paid to foreign related parties;
provide rules for the treatment of an interest expense determined under a U.S. tax treaty;
include additional detail on the documentation required to satisfy the service cost method (SCM) exception;
modify the total loss-absorbing capacity (TLAC) exception;
provide that the additional one percent add-on to the BEAT rate will not apply to a taxpayer that is part of an affiliated group with de minimis banking and securities dealer activities;
provide that Code Sec. 15 applies only to the change in tax rate set forth in Code Sec. 59A(b)(2) and should not apply to the change in tax rate included in Code Sec. 59A(b)(1)(A) for tax years beginning in calendar year 2018;
change the Qualified Derivative Payments (QDP) exception;
clarify the rules regarding how partnerships and their partners are treated for purposes of the BEAT; and
clarify the anti-abuse rule and certain rules applicable to insurance companies and consolidated groups.

Applicability Dates

The final regulations (other than the reporting requirements for QDPs) apply to tax years ending on or after December 17, 2018. However, taxpayers may apply these final regulations in their entirety for tax years ending before December 17, 2018. Taxpayers may also apply provisions matching Reg. §§1.59A-1 through 1.59A-9 in their entirety for all tax years ending on or before December 6, 2019. Taxpayers choosing to apply the proposed regulations must apply them consistently and cannot selectively choose which particular provisions to apply.

The related Code Sec. 6038A regulations apply to tax years beginning Monday, June 7, 2021. The related consolidated return regulations generally apply to tax years for which the original consolidated return is due (without extensions) after December 6, 2019.

2019 Proposed Regulations

The 2019 proposed regulations provide rules regarding relating to (1) how a taxpayer determines its aggregate group for purposes of determining gross receipts and the base erosion percentage; (2) an election to waive deductions; and (3) application of the BEAT to partnerships.

The 2019 proposed regulations generally apply to tax years beginning on or after the date that the final regulations are filed with the Federal Register. Certain rules, however, have specific applicability dates. In addition, taxpayers may rely on the rules in the proposed regulations in their entirety for tax years beginning after December 31, 2017, and before the final regulations are applicable.

Practitioner’s Observations

Arlene Fitzpatrick, a Principal in the National Tax Department of Ernst & Young LLP, told Wolters Kluwer that "there are changes and new proposed rules in the package of final and proposed regulations that are helpful, though not all changes requested through the comment process were made. For example, the rules in the final regulations to exclude, in certain circumstances, from the definition of a base erosion payment amounts transferred to, or exchanged with, a foreign related party pursuant to a specified nonrecognition transaction are welcome. Furthermore, clarifying that a built-in loss recognized on a sale or transfer of property to a foreign related party is not in itself a deduction that causes the payment to be treated as a base erosion payment is helpful. The final regulations however, retain the internal dealings rule whereby a notional payment for purposes of attribution of profits under certain tax treaties may be taken into account for purposes of determining BEAT. Thus, although deductions from internal dealings would not be allowed under the Code or regulations, and only relevant under certain treaties (the regulations do not specify the treaties), the regulations provide such amounts are relevant for purposes of determining BEAT."

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The IRS has issued highly anticipated final regulations on the significant changes made to the foreign tax credit rules by the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97). The final regulations retain the basic approach and structure of the 2018 proposed regulations ( NPRM REG-105600-18). The final regulations also eliminate deadwood, reflect statutory amendments made prior to TCJA, and update expense allocation rules not updated since 1988.

Also adopted are proposed regulations on overall foreign losses, published on June 25, 2012 ( NPRM REG-134935-11), and a U.S. taxpayer’s obligation to notify the IRS of a foreign tax redetermination, published on November 7, 2007 ( NPRM REG-209020-86).

A separate set of 2019 proposed regulations were also issued ( NPRM REG-105495-19).

Final Regulations

The final regulations make extensive changes to the rules on the determination of the foreign tax credit. Many of these changes were required to implement the TCJA, including the items discussed, below.

The final regulations provide details on how income is assigned and expenses are apportioned to the Code Sec. 951A global intangible low-taxed income (GILTI) and foreign branch foreign tax credit separate limitation categories added by TCJA.

The regulations provide that, for purposes of applying the expense allocation and apportionment rules, the portion of gross income related to foreign derived intangible income (FDII) or a GILTI inclusion that is offset by a Code Sec. 250 deduction is treated as exempt income. This means that fewer expenses will be allocated to the GILTI category, resulting in a higher foreign source taxable income, a higher foreign tax credit limitation, and a larger foreign tax credit offset with respect to GILTI income.

The regulations also address how the balance of foreign tax credit carryovers prior to the TCJA are allocated across new and existing separate categories. Under a default rule, foreign tax credit carryovers remain in the general category going forward. A taxpayer can elect to reconstruct the carryover regarding a foreign branch. The final regulations provide a simplified rule under which taxpayers can assign foreign tax credits to the foreign branch category proportionately, according to the ratio of foreign taxes paid or accrued by the taxpayer’s branches to total foreign taxes paid or accrued by the taxpayer in that year.

The regulations modify the proposed rule for determining foreign branch income based on the U.S. tax-adjusted books and records of the foreign branch. The proposed regulations disregarded transfers of intellectual property (IP) between a foreign branch and its owner if the transfer would result in a deemed payment that reallocates income between the foreign branch category and the general branch category. The final regulations limit the rule to transactions that occurred after the date of the proposed regulations and include an exception for transitory ownership.

The regulations provide rules for the treatment of GILTI for purposes of the interest allocation rules. In general, a controlled foreign corporation (CFC) must allocate and apportion its interest expense among groups of income for purposes of determining tested income, subpart F income and other types of net foreign source income. A U.S. taxpayer must characterize the value of its CFC for allocating and apportioning its own interest expense. A CFC allocates and apportions its interest expense using either the modified gross income (MGI) method or the asset method. The U.S. taxpayer uses the same method to characterize the stock of its CFC. The regulations take into account gross tested income from a lower-tier CFC with respect to an upper-tier CFC for allocating the upper-tier CFC’s interest expense when applying the MGI method.

Dividends, interest, rents and royalties (look-through payments) paid to a U.S. shareholder by a CFC were generally allocated to general category income to the extent that they were not treated as passive category income. Because this type of payment made directly by a U.S. shareholder is not included in the GILTI category, the regulations provide that the look-through payments are assigned either to the general category or the foreign branch category. The payments cannot be assigned to the GILTI category.

The final regulations also address certain potentially abusive borrowing arrangements involving loans by U.S. persons to foreign partnerships that artificially increase foreign source income and the foreign tax credit limitation without affecting U.S. taxable income. Under the regulations, the interest income attributable to borrowing through a partnership is allocated across the foreign tax credit separate limitation categories in the same manner as the associated interest expense.

Applicability of Final Regs

The final regulations related to statutory amendments made by the TCJA apply to tax years beginning after December 31, 2017. Regulations that contain both rules that relate to the TCJA and rules that do not relate to the TCJA generally apply to tax years that both (1) begin after December 31, 2017, and (2) end on or after December 4, 2018.

The regulations on the deemed paid credit under Code Sec. 960 apply to tax years that both begin after December 31, 2017, and end on or after December 4, 2018. The final OFL regulations apply to tax years on or after the date the regulations are filed in the Federal Register. The final foreign tax redetermination regulations apply to foreign tax redeterminations occurring in tax years ending on or after the date the regulations are filed in the Federal Register.

Proposed Regulations

Proposed foreign tax credit regulations address changes made by the TCJA, and also respond to issues raised in the 2018 proposed regulations on the foreign tax credit ( NPRM REG-105600-18). The proposed regulations address:

the allocation and apportionment of deductions under Code Sec. 861 through Code Sec. 865;
the definition of "financial services income" under Code Sec. 904(d)(2)(D);
the allocation and apportionment of creditable foreign taxes;
the interaction of branch loss and dual consolidated loss recapture rules under Code Sec. 904(f) and Code Sec. 904(g);
the effect of Code Sec. 905(c) foreign tax redeterminations of foreign corporations on the high-tax exception in Code Sec. 954(b)(4) and the required notification and penalty provisions;
the definition of "personal holding company income" under Code Sec. 954; and
the application of the foreign tax credit limitation rule to consolidated groups.

Allocation and Apportionment

Under the general rule, a taxpayer may allocate research and experimentation (R&E) expenses to the foreign tax credit separate limitation categories under the sales method or the gross income method. The proposed regulations revise the sales method to provide that R&E expenses are only allocated to income that represents return on intellectual property. When applying these rules, gross intangible income does not include dividends or amounts included under subpart F, GILTI or Code Sec. 1293. As a result, none of a U.S. taxpayer’s R&E expenses are allocated to the GILTI category. The proposed regulations eliminate the gross income method for purposes of allocating R&E expenses.

Stewardship expenses are related and allocable to dividends received or to be received from related corporations. The proposed regulations provide that stewardship expenses are allocated to subpart F and GILTI inclusions, to Code Sec. 78 dividends and all amounts included under the passive foreign investment company (PFIC) provisions.

Under the Code Sec. 818(f) allocation rules that apply to life insurance companies, expenses are generally apportioned ratably across all gross income. Under a new rule, the proposed regulations allocate expenses in a life-nonlife consolidated group solely among items of the insurance company that has reserves (separate entity method).

The final foreign tax credit limitations provide a matching rule for a U.S. partner that makes loans to a foreign partnership. Under the rule, the partner’s gross interest income is apportioned between U.S. and foreign sources in each separate foreign tax credit limitation category based on the partner’s interest expense apportionment ratios. The proposed regulations provide the same rule for loans from partnerships to U.S. partners (upstream partnership loans).

Redeterminations

Portions of the 2007 temporary regulations on foreign tax redeterminations ( T.D. 9362) are reproposed so that taxpayers can provide comments on the rules in light of the changes made by the TCJA. The proposed regulations address foreign tax redeterminations that affect the deemed paid credit under Code Sec. 960; procedural notification rules; and penalties for failure to notify the IRS of a foreign tax redetermination.

The proposed regulations require taxpayers to account for foreign tax redeterminations of foreign subsidiaries on an amended return that reflects the revised foreign taxes deemed paid under Code Sec. 960 and any changes to the taxpayer’s U.S. tax liability. This reflects the repeal of the pooling mechanism to account for redeterminations of foreign taxes.

A transition rule provides that post-2017 redeterminations of pre-2018 foreign income taxes must be made by adjusting the foreign corporation’s taxable income and earnings and profits and post-1986 undistributed earnings and income taxes in the pre-2018 year to which the redetermined foreign taxes relate. The proposed regulations also provide that the foreign tax redetermination rules cover situations in which the foreign tax redetermination affects whether or not the CFC qualifies for the high-tax exceptions under GILTI and subpart F.

Additional Rules

Additional provisions in the proposed regulations:

modify the definition of a "financial services entity" by adopting a definition of "predominately engaged in the active conduct of a banking, insurance, finance, or similar business" and "income derived in the active conduct of a banking, insurance, finance, or similar business" that is generally consistent with Code Secs. 954(h), 1297(b)(2)(B), and 953(e);
provide more detailed guidance on the allocation and apportionment of foreign income taxes, and generalize the rules to apply to statutory and residual groupings;
provide a new ordering rule for overall foreign loss recapture that addresses additional income recognition under the branch loss recapture and dual consolidated loss recapture rules: the amounts are not taken into account for purposes of the ordering rules until Code Sec. 904(f)(3) amounts are determined;
clarify the rules that apply to jurisdictions that do not impose corporate income tax on CFCs until earnings are distributed. or where foreign tax is contingent on a future distributions, for purposes of the high-tax exception in Code Sec. 954(b)(4);
apply the principles for allocating and apportioning foreign income taxes for purposes of Code Sec. 965(g); and
update the Code Sec. 1502 regulations relating to the computation of the consolidated foreign tax credit to reflect changes in the law, and add new rules for the determining the source and separate category of the a consolidated NOL, as well as the portion of a consolidated net operating loss (CNOL) that is apportioned to a separate return year of a member.

Applicability of Proposed Regs

The proposed regulations are generally proposed to apply to tax years that end on or after the date the proposed regulations are filed in the Federal Register, with exceptions. For example, the rules for R&E expenses are proposed to apply to tax years beginning after December 31, 2019. However taxpayers on the sales method for tax years beginning after December 31, 2017, and before January 1, 2020, may rely on the proposed regulations if the rules are applied consistently. Thus, a taxpayer on the sales method for its tax year beginning in 2018 may rely on the proposed regulation, but must also apply the sales method (relying on the proposed regulation) for its tax year beginning in 2019.

Practitioner’s Observations

WK: Were you surprised by anything in the final regs?

Martin Milner: The final regulations are generally consistent with the proposed regulations and do not include any major surprises. The changes and clarifications that are in the final regulations are largely helpful. As would be expected, most of the new provisions are in the proposed portion of the package.

WK: With the proposed regs are there areas that you can see may result in pushback? If so why?

Martin Milner: The business community is likely to comment on the proposal to apportion stewardship expenses to dividends, subpart F income and GILTI (including IRC Section 78 gross-ups) because many had hoped that stewardship expenses would not be apportioned to GILTI.

WK: How did you feel about the R&E Expense Apportionment changes?

Martin Milner: The mandatory sales-based apportionment of R&E expenses to all gross intangible income related to the relevant product SIC code will be complicated in practice. However, it is helpful that the proposed rules specifically exclude dividends, subpart F income and GILTI.

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The IRS has released guidance that provides that the requirement to report partners’ shares of partnership capital on the tax basis method will not be effective for 2019 partnership tax years, but will first apply to 2020 partnership tax years.

2019 Reporting

For 2019, partnerships and other persons must report partner capital accounts consistent with the reporting requirements in the 2018 forms and instructions, including the requirement to report negative tax basis capital accounts on a partner-by-partner basis.

Section 704(c) Gain or Loss

As a clarification, the notice also defines the term "partner’s share of net unrecognized Code Sec. 704(c) gain or loss," which must be reported by partnerships and other persons in 2019. Further, the notice exempts publicly traded partnerships from the requirement to report their partners’ shares of net unrecognized Code Sec. 704(c) gain or loss until further notice. Solely for purposes of completing the 2019 Forms 1065, Schedule K-1, Item N, and 8865, Schedule K-1, Item G, the notice defines a partner’s share of "net unrecognized Code Sec. 704(c) gain or loss" as the partner’s share of the net (meaning aggregate or sum) of all unrecognized gains or losses under Code Sec. 704(c) in partnership property, including Code Sec. 704(c) gains and losses arising from revaluations of partnership property.

Section 465 At-Risk Activities

The notice provides that the requirement added by the draft instructions for 2019 for partnerships to report to partners information about separate Code Sec. 465 at-risk activities will not be effective until 2020. The draft of the instructions for the 2019 Form 1065, Schedule K-1, released October 29, 2019, included a new paragraph at page 12, At-Risk Limitations, At-Risk Activity Reporting Requirements, that would expressly require partnerships or other persons that have items of income, loss, or deduction reported on the Schedule K-1 from more than one activity that may be subject to limitation under Code Sec. 465 at the partner level to report certain additional information separately for each activity on an attachment to a partner’s Schedule K-1. The new paragraph would require the partnership to identify the at-risk activity, the items of income, loss, or deduction for the activity, other items of income, loss, or deduction, partnership liabilities, and any other information that relates to the activity, such as distributions and partner loans. This requirement in the draft instructions for the 2019 Form 1065 is in addition to long-standing at-risk reporting requirements included in the instructions to the Form 1065.

Penalty Relief

Taxpayers who follow the provisions of the notice will not be subject to any penalty, including a penalty under Code Sec. 6722 for failure to furnish correct payee statements, under Code Sec. 6698 for failure to file a partnership return that shows required information, and under Code Sec. 6038 for failure to furnish information required on a Schedule K-1 (Form 8865).

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The IRS has released final regulations that present guidance on how certain organizations that provide employee benefits must calculate unrelated business taxable income (UBTI) under Code Sec. 512(a).

Background

Organizations that are otherwise exempt from tax under Code Sec. 501(a) are subject to tax on their unrelated business taxable income (UBTI) under Code Sec. 511(a). Code Sec. 512(a) defines UBTI of exempt organizations and provides special rules for calculating UBTI for organizations described in Code Sec. 501(c)(7) (social and recreational clubs), voluntary employees’ beneficiary associations (VEBAs) described in Code Sec. 501(c)(9) and supplemental unemployment benefit trusts (SUBs) described in Code Sec. 501(c)(17).

Covered Entity

"Covered entity" describes VEBAs and SUBs subject to the UBTI computation rules under Code Sec. 512(a)(3). A corporation is treated as having exempt function income for a taxable year only if it files a consolidated return with the organization described in Code Sec. 501(c)(7), (9), or (17). These final regulations add a clause to clarify that the term "covered entity" includes a corporation described in Code Sec. 501(c)(2) to the extent provided in Code Sec. 512(a)(3)(C).

Nonrecognition of Gain

If a property used directly in the performance of the exempt function of a covered entity is sold by that covered entity, and other property is subsequently purchased and used by the covered entity directly in the performance of its exempt function—at any point within a four-year period beginning one year before the date of the sale and ending three years after the date of sale—gain, if any, from the sale is recognized only to the extent that the sales price of the old property exceeds the covered entity’s cost of purchasing the other property.

Limitation on Amounts Set Aside for Exempt Purposes

The total amount of investment income earned during the year should be considered when calculating whether an excess exists at the end of the year. Any investment income a covered entity earns during the taxable year is subject to unrelated business income tax (UBIT) to the extent the covered entity’s year-end assets exceed the account limit.

Effective Date

The final regulations apply to tax years beginning on or after December 10, 2019.

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The IRS has issued Reg. §20.2010-1(c) to address the effect of the temporary increase in the basic exclusion amount (BEA) used in computing estate and gift taxes. In addition, Reg. §20.2010-1(e)(3) is amended to reflect the increased BEA for years 2018-2025 ($10 million, as adjusted for inflation). Further, the IRS has confirmed that taxpayers taking advantage of the increased BEA in effect from 2018 to 2025 will not be adversely affected after 2025 when the exclusion amount is set to decrease to pre-2018 levels.

The regulations apply to estates of decedents dying on and after November 26, 2019.

Special Rule for Post-2025 Decedents

Reg. §20.2010-1(c) provides a special rule in cases where the portion of the credit against the estate tax that is based on the BEA is less than the sum of the credit amounts attributable to the BEA allowable in computing gift tax payable within the meaning of Code Sec. 2001(b)(2). In that situation, the portion of the credit against the net tentative estate tax that is attributable to the BEA is based upon the greater of those two credit amounts.

Inflation-Adjusted Amounts and DSUE Amount

Because the term "BEA" includes the exclusion amount, as adjusted for inflation, the examples in the regulations reflect hypothetical inflated adjusted BEAs. Reg. §20.2010-1(c)(2)(ii), Example 2, illustrates the application of the special rule based on gifts actually made, and would be inapplicable to a decedent who did not make gifts in excess of the date of death BEA, as adjusted for inflation.

Reg. §20.2010-1(c)(2)(iii) and (iv), Examples 3 and 4, illustrate that if a spouse dies during the increased BEA period, and the deceased spouse’s executor makes the portability election, the surviving spouse’s applicable exclusion amount includes the full amount of the deceased spousal unused exclusion (DSUE) amount based on the deceased spouse’s increased BEA. The DSUE amount is available to reduce the surviving spouse’s transfer tax liability regardless of when transfers are made.

BEA Calculations

The final rules explain how to determine the extent to which a credit allowable in computing gift tax payable is based solely on the BEA. Reg. §20.2010-1(c)(2)(iv), Example 4, addresses the application of the DSUE ordering rule, as well as the computation of the credit based solely on the BEA in a calendar period in which the transfer exhausts the remaining DSUE amount with the result that the BEA is also allowable.

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The Treasury Inspector General for Tax Administration (TIGTA) has released a report on suitability checks for participation in IRS programs. TIGTA initiated this audit to assess the effectiveness of IRS processes to ensure the suitability of applicants seeking to participate in IRS programs and to follow up on IRS planned corrective actions to address prior TIGTA recommendations.

TIGTA Final Audit Report

The Treasury Inspector General for Tax Administration (TIGTA) has released a report on suitability checks for participation in IRS programs. TIGTA initiated this audit to assess the effectiveness of IRS processes to ensure the suitability of applicants seeking to participate in IRS programs and to follow up on IRS planned corrective actions to address prior TIGTA recommendations.

Suitability Checks

The IRS’s suitability checks for applicants to the Acceptance Agent, Enrolled Agent, and e-File Provider Programs generally ensured that only reputable individuals were accepted in the programs during fiscal year 2018. Further, the IRS’s continuous suitability checks also ensured that individuals accepted in the programs prior to the initial suitability checks had not engaged in criminal activity warranting removal from the program. TIGTA also identified that when the Federal Bureau of Investigation reported a criminal history for an applicant, the adjudication process was inconsistent depending on the program to which the individual was applying. Finally, the IRS did not take sufficient actions to address the fraudulent submission of fingerprint cards by some applicants to pass their background investigations.

TIGTA Recommendations

TIGTA recommended that the IRS:

assess the risk to tax administration of performing inconsistent initial and continuous suitability checks on individuals seeking to participate or enrolled in the e-File Provider, Acceptance Agent, and Enrolled Agent Programs;
assess the risk of the e-File Provider Program’s use of decision matrices to adjudicate an applicant’s criminal history that are inconsistent with the matrices used by the Acceptance Agent and Enrolled Agent Programs; and
work with the Federal Bureau of Investigation to identify additional individuals who may have submitted fingerprint cards that match the fingerprints of another individual.

The IRS agreed with all the recommendations.

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Some individuals must pay estimated taxes or face a penalty in the form of interest on the amount underpaid. Self-employed persons, retirees, and nonworking individuals most often must pay estimated taxes to avoid the penalty. But an employee may need to pay them if the amount of tax withheld from wages is insufficient to cover the tax owed on other income. The potential tax owed on investment income also may increase the need for paying estimated tax, even among wage earners.

The trick with estimated taxes is to pay a sufficient amount of estimated tax to avoid a penalty but not to overpay. The IRS will refund the overpayment when you file your return, but it will not pay interest on it. In other words, by overpaying tax to the IRS, you are in essence choosing to give the government an interest-free loan rather than invest your money somewhere else and make a profit.

When do I make estimated tax payments?

Individual estimated tax payments are generally made in four installments accompanying a completed Form 1040-ES, Estimated Tax for Individuals. For the typical individual who uses a calendar tax year, payments generally are due on April 15, June 15, and September 15 of the tax year, and January 15 of the following year (or the following business day when it falls on a weekend or other holiday).

Am I required to make estimated tax payments?

Generally, you must pay estimated taxes in 2012 if (1) you expect to owe at least $1,000 in tax after subtracting tax withholding (if you have any) and (2) you expect your withholding and credits to be less than the smaller of 90 percent of your 2012 taxes or 100 percent of the tax on your 2011 return. There are special rules for higher income individuals.

Usually, there is no penalty if your estimated tax payments plus other tax payments, such as wage withholding, equal either 100 percent of your prior year's tax liability or 90 percent of your current year's tax liability. However, if your adjusted gross income for your prior year exceeded $150,000, you must pay either 110 percent of the prior year tax or 90 percent of the current year tax to avoid the estimated tax penalty. For married filing separately, the higher payments apply at $75,000.

Estimated tax is not limited to income tax. In figuring your installments, you must also take into account other taxes such as the alternative minimum tax, penalties for early withdrawals from an IRA or other retirement plan, and self-employment tax, which is the equivalent of Social Security taxes for the self-employed.

Suppose I owe only a relatively small amount of tax?

There is no penalty if the tax underpayment for the year is less than $1,000. However, once an underpayment exceeds $1,000, the penalty applies to the full amount of the underpayment.

What if I realize I have miscalculated my tax before the year ends?

An employee may be able to avoid the penalty by getting the employer to increase withholding in an amount needed to cover the shortfall. The IRS will treat the withheld tax as being paid proportionately over the course of the year, even though a greater amount was withheld at year-end. The proportionate treatment could prevent penalties on installments paid earlier in the year.

What else can I do?

If you receive income unevenly over the course of the year, you may benefit from using the annualized income installment method of paying estimated tax. Under this method, your adjusted gross income, self-employment income and alternative minimum taxable income at the end of each quarterly tax payment period are projected forward for the entire year. Estimated tax is paid based on these annualized amounts if the payment is lower than the regular estimated payment. Any decrease in the amount of an estimated tax payment caused by using the annualized installment method must be added back to the next regular estimated tax payment.

Determining estimated taxes can be complicated, but the penalty can be avoided with proper attention. This office stands ready to assist you with this determination. Please contact us if we can help you determine whether you owe estimated taxes.

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The dependency exemption is a valuable deduction that may be lost in many situations simply because some basic rules for qualification are not followed. Classifying someone as a dependent can also entitle you to other significant deductions or credits. Here is a rundown of some of the rules and their implications.

Exemptions reduce your adjusted gross income. There are two types of exemptions: personal exemptions and exemptions for dependents. For each exemption you can deduct $3,800 on your 2012 tax return. In computing the amount to be withheld from an employee's wages, the employee is entitled to an allowance equal to the exemption amount used to calculate the personal exemption deduction. On a joint return, you may claim one personal exemption for yourself and one for your spouse. If you're filing a separate return, you may claim the exemption for your spouse only if he or she had no gross income, is not filing a joint return, and was not the dependent of another taxpayer.

Exemptions for dependents. You generally can take an exemption for each of your dependents. A dependent is your qualifying child or qualifying relative. In some circumstances, even an aged parent who lives with you may qualify. No personal exemption is allowed for a dependent or any other individual unless the taxpayer identification number (TIN) of that individual is included on the return claiming the exemption. The TIN generally must be a social security number (SSN).

Support test. A qualifying child must not have provided more than one-half of his or her own support during the calendar year in which the taxpayer's tax year begins. In contrast, the taxpayer must provide at least one-half of a qualifying relative's support in order to claim the relative as a dependent.

As of the close of the calendar year in which the taxpayer's tax year begins, a qualifying child must not have attained the age of 19, or must be a student who has not attained the age of 24. This age test does not apply to a child who is permanently and totally disabled at any time during the calendar year in which the taxpayer's tax year begins. A student for this purpose is an individual who, during each of five calendar months of the calendar year in which the taxpayer's tax year begins, is a full-time student at an educational organization, or is pursuing a full-time course of instructional on-farm training. This five-month rules generally enables most parent of college students graduating in May to take their child as an exemption "one last time."

An adoptive parent in the process of a domestic adoption who has custody of the child pending the final adoption and who provides enough financial support during the year is entitled to claim a dependency exemption for the child.

Possible downsides of being a dependent. If someone else - such as your parent - claims you as a dependent, you may not claim your personal exemption on your own tax return. Further, some people cannot be claimed as your dependent. Generally, you may not claim a married person as a dependent if they file a joint return with their spouse. Also, to claim someone as a dependent, that person must be a U.S. citizen, U.S. resident alien, U.S. national or resident of Canada or Mexico for some part of the year. There is an exception to this rule for certain adopted children.

An individual who qualifies as another taxpayer's dependent cannot claim any amount for a personal exemption, even if the individual files a return and the other taxpayer does not actually claim the individual as a dependent. For instance, in a court case in which a college student filed his own return, he was not entitled to any deduction for his personal exemption because he also qualified as his parent's dependent, even though they did not actually claim his exemption.

Ancillary benefits. As discussed, a dependent cannot file joint returns or claim dependency exemptions. In addition, a dependent who is a qualifying relative cannot have income in excess of the annual exemption amount. However, these restrictions do not apply to a person's classified as dependents for several other tax items. If a person would qualify as a dependent but for filing a joint return, claiming dependency exemptions, or having gross income in excess of the exemption amount, the person is nonetheless treated as a dependent for the following purposes (not a complete list):

the taxpayer's head-of-household filing status;
the exception from the early distribution penalty for qualified retirement plan distributions used to pay health insurance premiums for an unemployed taxpayer's dependents;
the exclusion from income of amounts received under accident and health insurance plans;
the definition of a highly compensated participant for purposes of cafeteria plans;
the exception from the rules that allow certain amounts paid to maintain a student in the taxpayer's home to qualify as deductible charitable contributions;
the deduction for medical expenses incurred by the taxpayer's dependent;
the exclusion for distributions from an Archer medical savings account (MSA) that are used to pay a dependent's medical expenses;
the rules governing the deduction for qualified student loan interest; and the treatment of educational and medical indebtedness in calculating the value of a decedent's qualified family-owned business interests for purposes of the estate tax.

As you may gather, the rules associated with the dependency exemption can get complex rather quickly. If you need any assistance in sorting out any dependency exemption or related benefits, please you do hesitate to contact this office.

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