Here are some of the issues that the Tax Help Desk has encountered as well as a few issues that may be of importance to tax practitioners during this time of the year.
Q-1 We have clients or taxpayers come in on occasion that have formed a charitable remainder trust along with the help of their attorney, and then they come to us not knowing what to do next. They ask us, as their tax preparer, what kind of tax deduction do they get and do they have to file any additional tax forms with their Form 1040?
A-1 The charitable remainder trust is a trust that is used to shift wealth from a taxpayer’s control who may have estate tax planning considerations, have charitable goals in mind as well as assisting in the creation of tax deductions. This kind of tax planning also allows for the transfer or gifting of the income from the trust to non-charitable beneficiaries for a period of time.
The charitable remainder trust (CRT) has many different forms and names to fit all of its various purposes. These purposes are based on the taxpayer’s financial, charitable, estate and tax planning goals. But despite its name, it does not file the traditional Form 1041 that the typical or normal trust would.
There is a different form, the Form 5227 – this form is filed for a taxpayer’s charitable remainder trust (CRT) that is governed under IRC Sec 664. So the charitable remainder trust files the Form 5227 and not the traditional Form 1041. The form is filed separate from the Form 1040, rather than as an attachment. It does, however, like the Form 1040, file on a calendar year basis and is due by the 15th day of the fourth month following its calendar year. The form is currently sent to the IRS Service Center in Ogden UT.
As for the charitable deduction, the individual taxpayer who sets-up a CRT will receive a current charitable deduction in the year that the charitable remainder trust is funded, despite the future nature of the charitable contribution. The tax deduction is based on the present value of the future gift. Often times the organization that will benefit from the future contribution, or the sponsor of the “trust”, will assist with or may actually make the tax deduction calculation.
So the CRT is a trust that creates a charitable contribution tax deduction but does not file the traditional Form 1041 for a trust, but instead files the Form 5227.
Q-2 Another very common question that crosses the Tax Help Desk is the ability to deduct a loss on the sale of an inherited personal residence. The typical or common event is when a parent passes away, leaving the personal home to the surviving children. The beneficiaries, or surviving children then fix-up or renovate the home, list it for sale, and sell the prior principal residence of the deceased parent at a loss. Can they as the sellers of the personal residence deduct the loss on the sale?
A-2 The answer to this question is YES. Absolutely, the beneficiaries—the surviving children— can take a capital loss on the sale of their parent’ principal residence; even though had the parents sold their home before their death, this loss would not have been allowed.
The individuals who inherit the principal residence of a decedent–and who themselves do not occupy the residence post-death–are allowed to deduct the loss on its sale, as it has become investment property rather than personal property.
The reason that there is often a loss on the sale of a decedent’s personal residence is the tax concept of stepped-up basis under IRC Sec 1014. This Code Section allows for the basis of the inherited residence to step-up to the property’s fair market value (FMV) on the date of the decedent’s death. This step-up, or change in basis, is typically upward and combined with the post-death improvements to the residence, as well as the closing costs—which also effect the gain/loss on the sale—which will result in the basis of the property (the home) being sold to exceed the sales price of the property.
The taxpayers, the beneficiaries, or sellers of the property, will often receive a Form 1099-S with their share of the sales proceeds. This, combined with their share of the stepped-up basis, will be reported on the Form 8949 /Schedule D of their personal Form 1040. Then, absent any other capital gains, their individual tax return will be limited to a deduction of $3,000 per year – under the rules of deducting capital losses.
There is a bit of a side note to this tax situation if the personal residence remains titled in the decedent’s name and/or estate. If this is the case, the sale of the principal residence of the decedent will be reported on the Schedule D of the Form 1041 of the estate of the deceased taxpayer.
This presentation will still result in a loss—a capital loss—and this loss will ultimately benefit the decedent’s beneficiaries. There is a dissenting opinion with the IRS: an internal memo (SCA 1998-012) that states that it is their opinion (the IRS’s) that a decedent’s personal residence sold within their estate is still a personal residence and that the loss should not be allowed. So the advice that should be made to every individual who is inheriting the personal home of a deceased taxpayer is:
- Do not move into it,
- and make sure the title is changed from the decedent, or the estate of the decedent to the beneficiaries personal names and social security numbers before the closing to the sale of the property.
These steps will ensure the position of a deductible capital loss to the owners and sellers of a decedent’s principal residence
Q-3 The spouse in a divorce who may not work, or did not have a retirement account, will often ask for a share of or half of the other spouse’s 401(k) plan. The question that often arises is how this part of a divorce or property settlement is handled. The bigger issue is how the recipient spouse is taxed or not taxed on this part of the divorce settlement, and is there a 10% penalty on the distribution?
A-3 The process of splitting assets in a divorce will often surround the IRC Sec 1041: the tax-free gifting rules under the tax concept of the property settlement. However, income based assets like the IRA or the employer-based Sec 401(k) plan asset are a different story…they can create tax and penalty if not handled correctly.
There is a procedure or mechanism in which divorcing taxpayers can legally split their employer based retirement assets through what is formally called a “qualified domestic relations order” or a QDRO for short. This provision covers the employer based retirement assets and does not cover the IRA. It effectively allows for the avoidance of the 10% early distribution penalty under IRC Sec 72(t) as well as making sure that the recipient spouse is taxed on the retirement plan distribution and not the actual owner of the Sec 401(k) plan assets.
Without the use of the QDRO, the ex-spouse that is giving up their part or half of their Sec 401(k) would be taxed and penalized; their subsequent transfer would be a part of the “property settlement” and would be tax-free to the recipient spouse. So depending on which side of the divorce that you—as the tax practitioner—are on and when in the divorce proceedings your advice is sought, the QDRO can be a key component to the divorce negotiations relating to the employer based retirement assets.
Just remember that the provisions of the qualified domestic relations order, or QDRO, does not eliminate the income tax on the retirement plan distribution… it can just shift the responsibility for the tax to the recipient spouse and can also allow for the waiver of the IRC Sec 72(t) 10% early distribution penalty. This is a big part of the whole divorce tax situation and often a rather big part of the whole divorce’s financial assets settlement.
Q-4 We often receive tax questions or issues, here at the Tax Help Desk, that relate to how to handle the cost of computer software. This is an expense of almost every business these days, whether they are buying off-the-shelf tax software, or maybe it is just a part of the equipment, the computer they buy—whether they are spending thousands of dollars on specially designed software applications for their business—or the company website… The questions always arise as to how to handle the costs, the expense of this often intangible asset.
So how does one write-off, or deduction for tax purposes, the cost of a special computer software application that they are spending $20,000 or $50,000 on?
A-4 Believe it or not, but with all of the activity in the computer software and website design industry, the IRS uses a Revenue Procedure issue over 15 years ago as its guide. Rev Proc. 2000-50 is the rule or the guide as to how to handle computer software and the tax treatments vary for a current expense to a capitalized cost as part of the equipment or as a separate intangible asset.
The computer software may even be a cost that is eligible for the research and development (R&D) credit under IRC Sec 41.
But the bottom line to the software development costs that are incurred by a taxpayer is that they can be currently expensed under a tax concept contained in IRC Sec 174, or they can be capitalized and amortized over a period of either 36 months or 60 months. The details to Rev Proc. 2000-50 should be reviewed for any or every tax situation to see how they may affect your taxpayer’s situation. Also, what needs to be considered is that their prior tax treatment of similar costs as this treatment in the past, could bind you and them to a “current expense” method or one of capitalization. Because once a taxpayer adopts a method of handling or treating computer software costs they are bound by that method, and actual IRS permission is required should something different be used by a taxpayer on a year-by-year basis. This is a point often missed by tax practitioners in dealing with software costs.
We have attached a copy of the Revenue Procedure for reference and review should this particular tax situation be one you are currently dealing with. This is often a year-end expense or cost that our taxpayers are contemplating and could be a good source of year-end tax planning fees for us as their tax consultants, and a good reason to sit down for that year-end tax planning meeting.
Q-5 Speaking of year-end tax planning… How about a couple of year-end tax planning tips, ideas, or even potential necessary steps that need to be taken before December 31st rolls around?
A-5 One of the first things that comes to mind, as year-end approaches, is the year-end salary check for the corporate shareholder or owner…that year-end reconciliation check for the S-Corporation owner whom has taken a draw against their earnings, their AAA, all year long—that we now have to turn into a reasonable and defendable salary check to match a decent Form W-2, based on the profits of the S-Corp.
This is also the time to decide and pay year-end bonuses to owners and shareholders – in which the actual check and payment need to be made before year-end. Unlike the non-owner employee bonuses which can be made for up to 2 ½ months after year-end, and still be deducted on the prior years’ tax return, the owner/ shareholders bonus does not have that same cushion or window: it must be paid by year end to be deductible.
Next you might check for any expiring carryovers, a NOL or a charitable deduction carryover. Check for any expiring tax laws or provisions that may not be in place next year. Or if a capital loss carryover can be used to absorb the gain on the sale of a capital asset that might be needed for cash flow or to fund a year-end payment.
And speaking of year-end payments, the status of the taxpayer’s estimated tax payments should be reviewed: has enough been paid in; should the last payment or installment in January be modified or maybe there should be some final paycheck Federal tax withholding to help cover an early in the year tax liability—because remember, Federal withholding is spread ratable over the year—where an estimated tax payment is just applied to tax liability at its date of payment.
The end of the year is also a good time to analyze whether or not to defer income, a bonus or paycheck, to accelerate a tax deduction, or buy some equipment or a piece of business property and take advantage of “bonus” depreciation or IRC Sec 179 and the expensing election.
Then there are the retirement plan issues if your taxpayer is older and receiving their required minimum distributions. Has it been distributed, did they receive their MRD or RMD? Did they turn age 70 during 2016, and is their birthday before July? They could have a required IRA distribution to make before December 31st. They may want to avoid this IRA distribution from being taxable by rolling it over to a charity. This is one of those tax planning tactics that needs to take place before the end of the year.
There is also the forming of some more formal retirement plans like a Sec 401(k) plans or profit sharing plan that can be funded after year-end, but actually need to be “formed”, opened before the end of the physical calendar year. Where the traditional IRA and the SEP (simplified employee pensions) can be formed and funded after year-end, other plans need some attention before the end of the year.
Prepaying some bills such as the property tax bill or a state estimated tax payment can save some taxes, prepaying a business expense, an insurance premium, or some liability due next January or February. There is also the possibility that deferring an expense into next year, or accelerating some income into the current year, can help save taxes in 2017. The key here is, with all of this, you just do not know unless you sit down and talk to your clients. Extend that offer to meet, to have that year-end talk about where they are at “tax-wise” or even financially – because some things do need to be done in 2016, before they bring in their tax organizer in February or March. By then it might be too late.
Your membership in the NSA give you access to tax organizers like this one to help your clients better prepare for that pre-tax season meeting.