2013 FEDERAL INCOME TAX UPDATE December 4, 2013 Keith A. Wood, Attorney, CPA Carruthers & Roth, P.A. 235 N. Edgeworth Street Post Office Box 540 Greensboro, North Carolina 27402 Phone: (336) 478-1185 Fax: (336) 478-1184 E-mail: kaw@crlaw.com INTRODUCTION Today’s discussion will focus on some of the more interesting or important tax developments that have transpired over the last year or so. The new developments addressed in this presentation will include numerous tax court cases, decisions of various federal circuit courts, as well as IRS pronouncements, revenue rulings and regulatory changes. PART ONE IRS AUDIT STATISTICS I. Audit Statistics; What Are Your Chances of Being Audited? In early 2013, the IRS published its 2012 Internal Revenue Service Data Book (IR-2013- 32), which contained audit statistics for the Fiscal Year ending on September 30, 2012. Here are the audit statistics: Audit Rates for Individual Income Tax Returns . Only 1.0% of filed individual A. income tax returns were audited. Of these audited returns, only 24% of individual tax audits were conducted by Revenue Agents and the rest of the audits (about 76% of the audits) were correspondence audits. Not surprisingly, the audit rates for Schedule C returns were higher than for individual returns. Schedule Cs, showing receipts of $100,000-$200,000, reported a 3.6% audit rate. Schedule C returns, showing income over $200,000, reported a 3.4% audit rate.
Total Individual Returns Audited 1.0% (1) With Schedule C Income: $100,000 to $200,000 3.6% Over $200,000 3.4% (2) Non-Business Income of: $200,000 to $1 Million 2.8% Positive Income Over $1 Million 12.1% B. Audit Rates For Partnerships and S Corporations: For partnerships and S Corporation returns, the audit rate was only .5%. Audit Rates for Corporations. C Corporation returns had an audit rate of 1.5%. C. However, for large corporations with assets over $10 Million, the audit rate was 17.6%. Total C Corporation Returns Audited 1.5% (1) Assets less than $1 Million 1.7% (2) Assets $1,000,000 to $5 Million 2.1% (3) Assets $5 Million to $10 Million 2.6% (4) Assets Over $10 Million 17.8% D. Offers in Compromise. The IRS received 64,000 offers in compromise, but only accepted 24,000 of them. Criminal Case Referrals. According to the IRS statistics, the IRS initiated 5,125 E. criminal investigations for the fiscal year 2012, and of these, 3,701 ultimately resulted in prosecution, and of these, 2,634 resulted in convictions. For convictions, 81.5% were actually incarcerated. 2
PART TWO SECTION 1031 LIKE KIND EXCHANGES I. Tax Court Affirms A Valid 1031 Exchange, Even Though Rental Property Was Soon Converted to a Primary Residence; Reesink v. Commissioner, TC Memo 2012-118 (April 26, 2012). Mr. Reesink owned an apartment building with his brother. The building was sold in 2005, and Mr. Reesink structured his share of the sale as a Section 1031 tax-free exchange. Mr. Reesink used his share of the sales proceeds to purchase a residence on Laurel Hill Lane in a neighboring city using his share of the Section 1031 sales proceeds, as well as funds from a bank loan. On the bank loan application, Mr. Reesink stated that the property was being acquired "for investment purposes." For the next seven months, Mr. Reesink unsuccessfully attempted to rent the property. Although they never advertised in any local newspapers, the Reesinks posted flyers throughout the town that the Laurel Hill Lane property was available for rent. The Reesinks owned another primary residence and a trailer that was close to Mr. Reesink's job. Due to financial difficulties, the Reesinks sold their primary residence and moved into the Laurel Hill Lane property about seven months after the sale of the apartment building. The IRS sought to disallow the Section 1031 exchange on the basis that the Reesink's primary purpose of acquiring the Laurel Hill Lane property was to use it as a primary residence. Ultimately, Mr. Reesink was able to prevail at trial primarily based upon the testimony of his brother, who testified that the Reesinks had stated that they intended to move to the Laurel Hill Lane area once their children were out of his school. But at that time, Mr. Reesink's son was only fifteen years old and a long way from high school graduation. According to the Court, therefore, at the time the Reesinks acquired the replacement property, they intended to hold it for investment purposes. PART THREE DETERMINING TAXABLE INCOME I. Medical Practice Owes Employment Taxes on Advances to New Doctors Which Were Recharacterized as Compensation; Vancouver Clinic, Inc. v. U.S., 111 AFTR 2d 2013- 1571 (April 9, 2013). Vancouver Clinic was a medical practice which offered a loan program to new doctors. Under the loan program, new physician doctors would be provided with an advance at the beginning of their employment. The "loans" would also accrue interest. However, as long as the physician remained employed for five full years, the loans would be forgiven at the end of five years. If a physician quit during that five year period, then the entire loan amount had to be repaid. 3
The IRS took the position that the loan advances were compensation in the first year and that the employer owed substantial employment taxes on the "advanced" amounts. The Court agreed with the IRS that the early advances were not true loans, but were designed as compensation for the new physicians. According to the Court, the advances were "incentive inducements" for the physicians to be employed for the next five years and that the loan repayment obligation was more in the nature of a penalty if the physician left during the first five years. The Court found that the parties never intended for the advances to be loans because both parties (the employer and the employed physicians) fully expected that the physicians would work the full five year employment term. The Court also noted that, when the loan agreements were signed, the borrowers (the physicians) did not have a reasonable prospect of repaying the loan amounts at that time. II. Ordinary Income or Capital Gain on the Sale of Real Property? The case of Long v. Commissioner, TC Memo 2013 – 233 (October 21, 2013), reviewed the age old issue of whether the taxpayer held real property for investment or as inventory in its capacity as a dealer. A. Background . When a taxpayer sells real estate, often the IRS and the taxpayers are at odds as to whether the sale should be treated as the sale of investment property or as the sale of ordinary income "inventory" property. The tax differences can be significant for both the taxpayer and the IRS. If the transaction is treated as a sale of "investment" real property, then any gain on the sale will be taxed at the capital gain tax rates . And the gain recognized by the investor will not be subject to self-employment taxes. In addition to the capital gain tax and self-employment tax benefits available to the real estate investor, such investors also can benefit from: (i) Section 1031 nontaxable exchanges; (ii) Section 1033(g) (relating to condemnation of real property held for productive use in a trade or business or for investment); and (iii) Section 453 installment sale reporting. These are tax benefits that are not available to dealers of real property. On the other hand, investors in rental real estate must be cognizant of (i) the passive activity loss limitations of Section 469 and (ii) the capital loss limitations applicable to investment property (since, if the sale generates a loss, then the taxpayer's loss will be limited by the capital loss limitation rules - that is, the capital loss can only offset other capital gains income and another $3,000 of ordinary income for the year). 4
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