1. Defer Interest Expense Deduction Related to Deferred Income of Foreign Subsidiaries
The proposal would defer the deduction of interest expense. The deferral rule would apply to the extent that interest expense is properly allocated and apportioned to stock of a foreign corporation that exceeds an amount proportionate to the U.S. taxpayer’s pro rata share of income from such subsidiaries that is currently subject to U.S. tax.

2. Determine the Foreign Tax Credit on a Pooling Basis
A U.S. corporation which owns a foreign subsidiary and receives a dividend would be required to determine its deemed paid foreign tax credit on a consolidated basis. The U.S. taxpayer would be required to take into account aggregate foreign taxes and earnings and profits of all of the foreign subsidiaries with respect to which the U.S. taxpayer can claim a deemed paid foreign tax credit.

3. Impose Current Taxation of Excess Returns Associated with Transfers of Intangibles Offshore
A U.S. person that transfers directly or indirectly an intangible asset from the United States to a related controlled foreign corporation (CFC) would be required to treat excess income from transactions related to the intangible as Subpart F income. The requirement would apply if the income attributable to the intangible is subject to a low foreign effective tax rate.

4. Limit Shifting of Income through Intangible Property Transfers
The definition of intangible would include workforce in place, goodwill and going concern value for purposes of I.R.C. Sections 482 and 367(d). Section 482 provides that, in the case of transfers of intangible assets between related companies, the income with respect to the transaction must be commensurate with the income attributable to transferred intangible assets. Section 367(d) imposes taxation on outbound transfers of intangible assets to foreign corporations in nonrecognition transactions.

5. Disallow the Deduction for Non-Taxed Reinsurance Premiums Paid to Affiliates
An insurance company’s deductions would be disallowed for premiums and other amounts paid to affiliated foreign companies with respect to reinsurance of property and casualty risks. The requirement would apply if the foreign re-insurer or its parent company is not subject to U.S. income tax with respect to the premiums received. The proposal would exclude from the insurance company’s income any return premiums, ceding commissions, reinsurance covered or other amounts received with respect to reinsurance policies for which a premium deduction was denied.

6. Limit Earnings Stripping by Expatriated Entities
The proposal would revise I.R.C. Section 163(j) to tighten the limitation on the deductibility of interest paid by an expatriated entity to related persons. The debt-to-equity safe harbor would be eliminated. The 50% adjusted taxable income threshold for the limitation would be reduced to 25%. The carryforward for disallowed interest would be limited to ten years and the carryforward of excess limitation would be eliminated.

7. Modify Tax Rules for Dual Capacity Taxpayers
A dual capacity taxpayer would be allowed to claim the foreign tax credit on the U.S. tax return for the portion of a foreign tax that does not exceed the foreign tax that the taxpayer would pay if the taxpayer were not a dual-capacity taxpayer.

8. Tax Gain from the Sale of a Partnership Interest on Look-through Basis
Gain or loss from the sale or exchange of a partnership interest by a nonresident foreign individual or company generally would be treated as effectively connected with the conduct of a U.S. trade or business.

9. Prevent Use of Leveraged Distributions from Related Foreign Corporations to Avoid Dividend Treatment
The proposal would prevent a U.S. shareholder from treating certain distributions from a foreign corporation as a return of capital instead of an ordinary income dividend under the I.R.C. Section 301 ordering rule. The requirement would apply where a foreign corporation funds a second related foreign corporation with the principal purpose of avoiding dividend treatment on distributions to U.S. shareholders. The U.S. shareholder’s basis in the stock of the distributing corporation would not be taken into account for the purpose of determining the treatment of the distribution under the ordering rule.

10. Extend I.R.C. Section 338(h)(16) to Certain Asset Acquisitions
I.R.C. Section 338(h)(16) generally provides that the deemed asset sale resulting from a Section 338 election is not treated as occurring for purposes of determining the source or character of any item when the foreign tax credit rules are applied to the seller. Section 338(h)(16) prevents a seller from increasing allowable foreign tax credits as a result of a Section 338 election. I.R.C. Section 901(m) disallows a foreign tax credit for foreign taxes paid or accrued after a covered asset acquisition. The proposal would extend the application of I.R.C. Section 338(h)(16) to any covered asset acquisition within the meaning of I.R.C. Section 901(m).

11. Remove Foreign Taxes from an I.R.C. Section 902 Corporation’s Foreign Tax Pool when Earnings Are Eliminated
For purposes of the deemed paid foreign tax credit, foreign taxes paid by a foreign corporation would be reduced when a transaction results in the elimination of a foreign corporation’s earnings and profits other than by a dividend distribution. An example of such transaction is a corporate stock redemption that is treated as a sale or exchange which results in the reduction of the earnings and profits of the redeeming corporation.

Please contact your Aronson LLC tax advisor or Alison Dougherty, International Tax Services at 301.231.6290 for more information.

The failure to apply this foundational sales and use tax concept had a costly result for a Virginia lessee in a recent ruling issued by the Virginia Department of Taxation (Virginia Public Document Ruling No. 13-41, 03/21/2013). The lessee was a hotel operator that leased the furniture, fixtures, and equipment associated with the hotels. The lessor acquired the assets and paid sales tax on the purchase of those assets. Thus, the lessor did not present a resale certificate to the vendor from which the assets were purchased, despite intending to resell (or lease) those assets to a third party. The lessor did not charge the lessee sales tax on the lease payments. The Department assessed the lessee for the unpaid sales tax on the lease payments. The taxpayer contested the assessment by arguing that it did not owe sales tax because the lessor had already paid the sales tax at the time of purchasing the assets.

The Department concluded that the lessor should have purchased the property for resale pursuant to a resale exemption certificate, and should have charged sales tax to the lessee. Unfortunately for the lessee, the Department also found that the lessee’s sales and use tax liability cannot be avoided because of the lessor’s noncompliance with the sales tax collection rules, as the legal incidence of Virginia’s sales tax is on the end purchaser. Finally, the fact that the lessor paid sales tax on the initial purchase had no bearing on the lessee’s lease payments also being subject to tax under the law.

The legal conclusion in this ruling was unfortunately correct, but the lack of an equitable result meant that the Commonwealth earned double the revenue.  Moreover, assuming that the lessor built in to the lease payments its cost of paying sales tax on the purchase, the lessee essentially paid sales tax twice. Granted, the lessor can file a refund and, if the lessee is lucky, receive a refund from the lessor. However, this after-the-fact option will entail making uneasy requests to the lessor that can hamper a future business relationship. Taking the additional time to get it right up front will avoid the pain felt by the taxpayer in this ruling and, more importantly, prevent the state from getting double the taxes.

For more information on your company’s sales and use tax obligations please contact your Aronson advisor or Michael Colavito at 301.231.6200.

On March 19^th, 75 U.S. Senators supported a non-binding vote of approval for the Marketplace Fairness Act of 2013, a heavily-debated bill that is backed by a coalition of brick-and-mortar retailers such as Wal-Mart and Best Buy and vehemently opposed by certain online retailers such as eBay.  Although the vote was only a preliminary approval of a vague summary of the bill that was an amendment to a budget bill, the bipartisan nature of the vote suggests that remote seller legislation could be voted into law this year.

If enacted as is, the bill would allow states to require remote sellers with over $1 million in annual gross receipts to collect sales tax (i.e., “small seller exception”).  Much of the mainstream media coverage on the issue frames the bill as purely an internet sales tax, but it’s important for businesses to realize that the proposed legislation would require a business selling taxable products and services to collect sales tax on its sales regardless of whether the business sells online or otherwise.

Even without the passage of the federal legislation, states have recently been enacting laws that push the bounds of the physical presence standard.  One such state is New York, where the New York State Court of Appeals on March 28^th upheld the constitutionality of the state’s so-called “click-through” or “Amazon” law (Amazon.com LLC v. Department of Taxation and Finance, 601247/2008; Overstock.com v. Department of Taxation and Finance, 107581/2008).  New York’s law allows the state to require an out-of-state company to collect sales tax if the company receives referrals from an in-state resident “affiliate” in exchange for a commission.  Essentially, New York residents that get a commission for having a link on their website to an online retailer’s website were deemed by the court to be the equivalent to having an in-state sales force.  The court distinguished these types of affiliate arrangements with passive advertising efforts that would not create a sales tax collection obligation.

With states taking varying approaches in their attempts to require remote sellers to collect sales tax and with other state courts striking down similar legislation (e.g., Illinois and Colorado), a federal solution is clearly the better solution to the seemingly inevitable result of remote sellers being required to collect tax.  The passing of federal legislation will have an impact on many small businesses, as the current threshold of $1 million in sales will protect only the smallest of companies.   We will be sure to keep you posted with any further developments.

In the meantime, if you have any questions regarding your sales tax collection obligations please contact your Aronson tax advisor or Michael L. Colavito, Jr. at 301.231.6200.

The primary issue at hand has been determining whether the Board should make standard the single lease accounting model or a dual income statement recognition approach ultimately championed in the approved exposure draft. At the April 10th meeting, most of those who voted in favor of the proposal did so in recognition that single lease accounting model would not accurately reflect the diverse economic realities of lease transactions and that the proposed dual income statement recognition approach, while more complicated, was more reflective of their constituents needs.

While this brings us a step closer to a new lease accounting model, there are still a wide variety of related issues that would require further examination, including:

• the dividing line between deciding which of the two lease accounting methods to apply;
• what to do with variable expenses; and
• determining lease expiration.

For more information about lease accounting standards or other accounting issues related to the real estate industry, please contact the Aronson Real Estate Industry Services Group.

• An overall aggregate limit of approximately $3 million in retirement accounts. This limit is tied to the maximums allowed in a defined benefit plan and would be indexed annually. Once the limit is reached, additional contributions would not be permitted.
• The capping of retirement plan and IRA contributions at the 28% tax bracket, with taxpayers in higher brackets having their tax benefit reduced.

With more and more stories about the dire retirement prospects for many Americans, it is hard to believe that these provisions — or anything similar — will be passed by Congress. These types of provisions often cause business owners to reconsider the merits of offering a plan, ultimately hurting those who need the plan the most. We seem to hear every day about the demise of the pension system and how all Americans will be responsible for accumulating assets for their retirement, but yet the government may enact provisions that inhibit our ability to do so. If you should have any questions regarding these or any other retirement plan provisions in the Obama Budget, please contact Mark Flanagan of Aronson’s Employee Benefit Plan Services Group at 301.231.6257.

The in-state parent company in Gore had established two out-of-state subsidiaries, to which the parent paid intercompany royalty and interest expenses.  The court held that Maryland could constitutionally tax an apportioned amount of the income of the subsidiaries because the subsidiaries had a unitary relationship with the parent.

States can tax an apportioned amount of income of a unitary business conducted by a corporation in more than one state, but typically can only do so with respect to affiliated entities when the state has adopted combined reporting requirements for related entities.  Here, the appellate court allowed the taxation of the out-of-state companies despite Maryland not having adopted combined reporting for corporate income tax purposes.  Prior cases in Maryland reaching similar decisions are somewhat clearer in that the conclusions were largely based on the subsidiaries being disregarded as separate entities because they lacked economic substance.  Certain language in the Gore opinion suggests that its holding was similarly premised on a lack economic substance in the taxpayer’s structure, but this is not made explicit by the court.

The decision in this case is arguably correct in that the taxpayer admitted to its structure being implemented for tax avoidance reasons.  However, the opinion could be interpreted as expanding Maryland’s authority to tax out-of-state affiliates so long as those entities are conducting a unitary business with an in-state affiliate.

Taxpayers considering implementing certain structures involving intercompany transactions should consider the state tax consequences in the jurisdictions where they do business.  Although the legal analysis in Gore may be questionable, Maryland and other states have adopted other methods allowing for the taxation of income earned under similar arrangements.  For example, many states, including Maryland, disallow certain related party expenses, such as interest on loans and royalty payments for the use of licensed intangibles.

If there are any questions please contact your Aronson tax advisor, Michael L. Colavito, or Henry Chiwaya at 301.231.6200.

IRC 162(a)(1) specifies two tests that must be met for compensation to be deductible – the compensation must be reasonable, and it must be paid purely for personal services actually rendered.  It is the first prong of this test that the IRS and courts focus most on.  Looking back to various cases, the Court identified six factors in determining the reasonableness of compensation:

The employee’s role in the business

• What is the employee’s position, hours worked, and duties performed?
• What is the significance of the employee to the business?
• How does the employee contribute to the success of the company?

Comparison of the employee’s salary with what similar companies pay for similar services

• What is the total compensation package given to the employee?
• How does this compare to what employees in similar-sized companies in a similar line of business pay for similar services?

The character and condition of the company

• What is the company’s size, profitability, and general economic health?
• Does paying the compensation amount compromise the company’s health beyond what an independent investor would allow?
• Is there an element of catch-up compensation paid, to account for years in which lower than customary compensation was paid to the employee?

Any potential conflicts of interest

• What is the relationship between the employee and the company?
• Could any of the compensation be, in fact, disguised dividends?

Internal consistency

• Is compensation set in a consistent manner year to year?
• Were bonuses awarded under a structured and formal program consistently applied?

Whether an independent investor would be willing to compensate the employee for that amount

• Does the compensation amount effectively deny a theoretical independent investor’s return on equity?
• Does the compensation amount compromise the ability of the company to grow or deplete the company assets?
• Is the compensation arrived at to basically siphon the profits out of the company?

It is often tempting for the owners of closely-held businesses to use compensation as the be-all and end-all in reducing profits in conjunction with year-end tax planning.  However, this must be done with care and deliberation, to ensure that the compensation paid adequately addresses the six criteria described above, in order to meet the reasonableness test.  Otherwise, what the IRS deems to be excess compensation is not deductible and may be taxed as a dividend to the recipient.

We are here to assist you to evaluate and document the reasonableness of compensation.  For further information, please contact your Aronson tax professional or Laurence Rubin, Aronson’s tax controversy lead partner, at 301.222.8212.

Closely held businesses are in particular in danger of being seen as the alter ego of its owners. Common elements the IRS can use to find an alter ego relationship exists include:

• Using business funds to pay personal expenses (this should never, ever be done)
• Using personal funds to pay business expenses on more than an incidental basis
• Personal enjoyment of business property
• Transactions between the business and its owner for which inadequate consideration is paid
• Whether assets used in the business are titled in the owner’s name

This is by no means an exhaustive list, but conveys the general idea that for the owner to take advantage of the insulation provided by a corporate or LLC structure, there must be an arm’s length relationship between the parties, no different than what would exist between an employee and employer.

For further information, please contact your Aronson tax professional or Laurence Rubin, Aronson’s tax controversy lead partner, at 301.222.8212.

If the safe harbor is used:

• The safe harbor is the total deduction. No depreciation or any other costs can be taken in addition to the safe harbor amount.
• The taxpayer can take 100% of the mortgage interest and property taxes as an itemized deduction on schedule A. No reduction of these expenses are required.
• Disallowed home office expenses that were carried over from prior years cannot be used in the year the safe harbor is taken. These amounts continue to be carried over and are usable in a year in which actual (substantiated) expenses are claimed.
• The taxpayer can elect safe harbor or substantiated expenses year-by-year.

The most recent case, Cherry vs. Commissioner (TC Memo 2013-3), the taxpayer offered oral testimony as to the nature of various bank deposits. The court rejected this, citing Nicholas vs. Commissioner (70 TC 1057), a 1978 case in which the court ruled that absent documentary evidence that various deposits were from nontaxable sources, the deposits were income.

The lesson is that taxpayers need to keep books and records under the assumption that the IRS will audit their return. Whether the taxpayer is an individual, business, trust, or nonprofit, the rules are the same. Proper documentation is key in avoiding paying tax on what should be nontaxable income.

For further information, please contact your Aronson tax professional or Laurence Rubin, Aronson’s tax controversy lead partner, at 301.222.8212.