Questions and Answers from the Tax Help Desk

In this issue, we feature four commonly asked questions and topic areas posed to the NSA Tax Help Desk.  All Active and Life NSA members can have five federal tax questions answered for free each year. For more information on the NSA Tax Help Desk and how to submit a question, visit http://www.nsacct.org/taxhelpdesk.

Q:   What happens upon the death of a taxpayer, when that taxpayer owns investment assets such as an annuity or an installment sales contract? Do these assets get a stepped-up basis under IRC Sec 1014 – like other investments such as real estate or a stock?

A:    Unfortunately, no.  There are certain assets that the beneficiaries of a decedents’ estate will “step into the shoes” of the decedent and to recognize the income from the investment asset as the decedent would have had they not passed.

This tax concept is known as “income in respect of a decedent” and is governed under IRC Sec 691. This income or IRD income is taxed to the estate or the decedents’ beneficiaries without any benefit of the stepped-up basis rules of IRC Sec 1014.

The items of IRD under Section 691 cover assets including retirement plan distributions and IRA accounts, as well as the annuity contracts, installment sales contracts, trade or business income or farming income from decedents’ activities prior to death, or that check from the decedents’ employer for accrued vacation pay or sick time.

The income from this kind of inheritance will maintain the character of what it was to the decedent, had they not passed-away; so the annuity or retirement plan would generate ordinary income and the installment sales contract, maybe some capital gain.

There has been a lot of confusion and concern stemming from the changes in health care benefits for S-Corporation shareholders’ and the use of health reimbursement arrangements or HRAs.

Q:    Can an S-Corporation shareholder still pay for health insurance outside the corporate entity and be reimbursed by the same S-Corporation without violating the compliance provisions under the Affordable Care Act (ACA)?

A:   This particular tax question and its answer goes back to 2013 and IRS Notice 2013-54. This particular IRS Notice, amongst other items, eliminated the tax benefits of the health reimbursement arrangement for S-Corporations with basically more than one (1) employee, in most cases - the owner/employee. There have been some delays – notably the IRS Notice 2015-17, which basically postponed any penalties and violations of this particular provision through calendar year 2015. That allowed S-Corporations to continue to use the provision of IRS Notice 2008-1 and reimburse for health insurance costs paid for outside the corporate entity by S-Corporation owners and employees. The ability to exclude this reimbursement from the income of the employee and to use this same reimbursement for the S-Corporation owner/ employee (the 2% shareholder rule) as self-employed health insurance under IRC Sec 162(l).

The provisions of IRS Notice 2013-54, which are now in effect have pretty much eliminated the use of HRA for S-Corporation with more than one (1) employee. The S-Corporation could still have a medical reimbursement plan for items like dental and vision expenses – but not for traditional health insurance.

The S-Corporation could still reimburse for the S-Corporation (100%) shareholder covering themselves and any family employees such as a spouse or their children, without violating the “less than two (2) employee” rule of IRS Notice 2013-54. But that is it, if the S-Corporation even has one other unrelated employee, the entity could not provide health insurance through a HRA type plan. The company’s options would be a full blown ACA compliant health insurance premium plan or the employer could offer to pay some additional compensation to help employees with their own health insurance expenses. But the additional compensation or salary can have no ties or conditions to health insurance or the employer would be right back into some trouble or problems with the penalties under ACA and health care reform.

A common question that crosses the Tax Help Desk involves the filing of the Form 1041 for a trust or a decedents’ estate and the tax treatment of capital gains.

Q:   Does capital gain not pass-thru to the estate or trust beneficiary? Why can’t the capital gain from the sale of property or stock within the trust or estate be passed-thru on the Schedule K-1 to the beneficiaries?

A:   The basic definition of “distributable net income” or DNI does not include capital gain income – so by strict definition it is not distributable, absent the final year of the estate or trust. The final year exception is the most common exception to this no distribution rule for capital gain income, but there are a few others.

When you look to the actual form, the Form 1041, Page 2, Schedule B, Line 6 – the capital gain or loss within the trust or estate tax return is backed-out or adjusted from the calculation of DNI and is therefore left within the trust or estate tax return to be taxed at the Form 1041 level. This whole tax concept is covered by IRC Sec 643(a)(3). So absent a few exceptions and the final tax return – a trust or estate’s capital gains cannot be distributed and your tax software, will follow this rules unless you override the distributable net income figure and change the results of the natural calculations in Schedule B of the Form 1041.

The only other exceptions to this rule that capital gains are not includable in DNI is if the terms of the trust instrument, the trust document defines capital gains as income, rather than as principal, for purposes of DNI. There are also some provisions under state law where this difference or distinction can be made with how capital gains are defined.

Q:   In various formats and situations the issue of who is entitled to mortgage interest deductions and/or property tax deductions on various types of real estate and ownership combinations comes up. The underlying question as to who is entitled to the deduction shows up in so many questions that cross the Tax Help Desk we thought we would address a few points.

A:   The general rule of taxation when it comes to deductions like this tied to real estate is that first, you have to make the payment. You have to be the individual cutting the check and making the payment on the liability. The second part of the equation that makes up the tax deduction is that generally you have to be the one liable for the payment. This typically means that in dealing with real estate and property taxes, you generally need to be on title. And then with the mortgage interest side of the typical deductions associated with buildings you need to be on the mortgage on the note that secured the property’s purchase. It is generally these two (2) components that need to be satisfied in order to support a tax deduction.

However, as with so many tax provisions and tax deductions, there are exceptions to the general rules. And there are a series of tax cases and rulings that have proven beneficial to taxpayers’ arguing for write-offs when they have satisfied the payment side of the equation, but not the ownership, title or liability side of the two (2) components.

What the courts have sided with the taxpayers on is a concept known as equitable ownership.

This is a test or a tax position where the taxpayer has proven that they possess the “burdens and benefits” of ownership. This test or position in the courts have then allowed the taxpayer—without physical title to the property or being physically named on the mortgage—to claim the benefits of the tax deductions for the payment of property taxes and mortgage interest. This argument or tax position have allowed taxpayers’ to claim these deductions without all of the traditional requirements. They have won in the courts with the equitable ownership argument.

This is an interesting tax situation and the scenarios that can be applied to these rules are numerous and apply to many tax situations that are posed to the Tax Help Desk.