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Practical Insights for In-house Tax and Finance Professionals

1/16/2013

Renewable energy and the ATRA of 2012
January 15, 2013
Tax Credit Alert
Author(s): Forrest Milder
 

This Nixon Peabody Alert discusses recent tax law changes resulting from the American Taxpayer Relief Act of 2012 (ATRA) that apply to renewables.

Change in the sunset for many (but not all) renewables. The act made a significant change to the production tax credit (PTC) and the investment tax credit (ITC) that applies to wind, geothermal that generates electricity, biomass, landfill gas, municipal solid waste, hydroelectric production, and marine and hydrokinetic energy.

Before ATRA, each of these technologies was eligible for a PTC or ITC only if the facility was placed in service by the end of 2013 (except wind, which had to be placed in service by the end of 2012, and geothermal, which can also qualify for a 10% credit beyond that date).

With long lead times, extensive requirements for approvals, and often long construction periods, having the credit depend on whether the facility is completed by a certain date made for a very high burden. Both developers and tax credit investors perceived these kinds of projects as much more difficult because of the risk that the credit could be lost by the time the project was completed. 

ATRA addresses this issue head-on by changing the sunset provision to depend on when the facility begins construction, rather than when the facility is placed in service. Now, if one of the facilities described above begins construction by December 31, 2013, it will be eligible for the applicable PTC or the 30% investment tax credit. Obviously, this is a big change that should help developers trying to line up tax equity in the face of an extended approval process.

A few observations: 

  1. There is no legislative history or other guidance explaining what it means to “begin construction.”

  2. Many practitioners have suggested that the IRS adopt the standards set by Treasury for the 1603 grants in lieu of tax credits program, i.e.:

    1. the test of beginning physical work before the end of 2013 (and then continue to work on the project thereafter), and
    2. the test of accruing at least 5% of the cost of the project before the end of 2013.  
  3. Of course, Treasury’s guidance for these renewable technologies had three sunset provisions—an applicant had to begin construction by December 31, 2011; submit a preliminary (or final) application before October 1, 2012; and then place the facility in service by December 31, 2012, for wind, and December 31, 2013, for geothermal that generates electricity[1] biomass, landfill gas, municipal solid waste, hydroelectric production, and marine and hydrokinetic energy. On the other hand, the new ATRA extension for these kinds of renewables only has one sunset: Construction must have begun by December 31, 2013, so it won’t be surprising if the IRS seeks to impose some other limitations on the definition of “begun construction.”
  4. Accordingly, it may be better to wait until we hear something from the IRS. There are many possibilities—the IRS might require more than 5% be incurred in 2013, 5% plus diligently working to finish the project, that a particular project be identified before it is begun or the end of the year, or other variations. Until something is actually published by the IRS, it isn’t possible to determine what the standard might be. We’ll keep monitoring tax legislation and IRS regulations, looking for any rules or modifications to what we’ve seen so far.

Renewables that are still subject to the old rules. The tax credit rules for solar, fuel cells, small wind, microturbines, combined heat and power facilities, geothermal that generates heat, and geothermal that generates electricity, but that begins construction after 2013, continue to have the same placed-in-service tests as before ATRA. For example, solar facilities must still be placed in service by the end of 2016 to qualify for the 30% ITC. Industry groups are continuing to seek a “begun construction” rule here as well for those projects with very long lead times.

Section 1603 grants. No changes were made to the Section 1603 grant program for any renewable technology. In particular, no change was made in the sunsets for grants. As a result, to qualify for a grant, a renewable facility still has to meet the three sunset provisions described above, with the addition of a later placed-in-service date for solar, fuel cells, small wind, microturbines, geothermal that generates heat, and geothermal that generates electricity but begins construction after 2013, and combined heat and power. To qualify for a grant, each of these must be placed in service before 2017. 

Sequestration. The sequestration rules, which OMB said would result in a 7.6% reduction in amounts paid under Section 1603, are still hanging over the industry. ATRA merely delays implementation by two months, from January 2, 2013, to March 1, 2013, leaving us wondering if the proposed percentage reduction in 1603 grant awards will still go into effect later this year. Again, industry groups are seeking an exemption for the Section 1603 grant program.

Technical fix: Facilities must be new. Most people didn’t realize that, when the American Recovery and Reinvestment Act of 2009 (ARRA) permitted PTC-eligible facilities to instead qualify for the ITC, and for any renewable facility to qualify for a 1603 grant, the legislation did not include the requirement that the facility be “new.” The ATRA legislation retroactively adds that requirement, dating back to ARRA. Of course, for this purpose, “new” generally means “80% new.” This means that a $10M wind project that uses $1.5M of used tower parts should still be considered new.

Other credits. Several other credits were also extended. The homeowner’s credit for energy-efficient homes (Section 25C of the Code), the credit for alternative fuel refueling property (Section 30C), the credit for two- or three-wheeled plug-in vehicles (Section 30D), and the business credits for energy-efficient homes (Section 45L) and appliances (Section 45M) all now include facilities placed in service in 2012 or 2013. Finally, in the case of residences, the reference to an efficiency standard has been updated from the International Energy Conservation Code of 2003 to the Code of 2006.

The credits for cellulosic biofuel, biodiesel, and renewable diesel are extended to apply to fuel production before January 1, 2014. Note that these credits and the corresponding extensions are based on the date of the production of the particular fuel, not the date that the facility is placed in service. In addition, cellulosic fuel is now called “second-generation biofuel,” and the definition is modified to include fuel derived from algae, cyanobacteria (a kind of bacteria that uses photosynthesis), and lemna (a kind of aquatic plant). Similar extensions are provided for the comparable alternative fuels excise tax credits in code sections 6426(d)(5) and (e)(3). Finally, there’s a one-year extension of the Indian coal credit, which is limited to certain facilities placed in service before 2006.

Bonus depreciation. ATRA extends “bonus depreciation” another year so the 50% bonus applies to property placed in service before January 1, 2014, and even January 1, 2015, for certain property. Second generation biofuels (described in the “Other credits” paragraph) have a similar 50% extender until the end of 2013. To illustrate, imagine a $1M facility that qualified for a 30% ITC to be claimed by its owner. The basis in that facility will be $850K (after reduction by half the amount of the $300K credit), and first-year depreciation will be the bonus, i.e., 50% of $850K (or $425K) plus regular 5-year accelerated depreciation, equal to 20% of the balance (or $85K), for a total first-year deduction of $510K. Note that the bonus rules automatically apply unless the taxpayer elects for them not to apply. Sometimes, particularly where there is a tax credit investor, having this much depreciation in one year can overwhelm the investor’s capital account and actually cause some deductions to be allocated to other partners or members, so the effect of bonus depreciation should be carefully monitored.

Special rules for certain utilities. Section 451(i) provides favorable tax rules for certain utilities that sell their property to implement FERC or a state restructuring policy. These rules are extended to apply to sales or other dispositions that occur before January 1, 2014.


  1. There’s also a 10% grant for geothermal placed in service by December 31, 2016.

For more information, contact your Nixon Peabody attorney or: Forrest Milder, fmilder@nixonpeabody.com

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Posted at 9:02 AM by makeenan@nixonpeabody.com | Category: Individual Tax | Permalink | Email this Post | Comments (0)
The American Taxpayer Relief Act of 2012
January 15, 2013
Private Clients Alert

The American Taxpayer Relief Act of 2012, passed by both the House and Senate on New Year’s Day and signed into law by President Obama on January 3, 2013, addressed the revenue side of the so-called “Fiscal Cliff.” Still to come will be agreement on the expenditure side of the equation. This alert will summarize the key provisions of the Act that impact individual taxpayers.

Summary:

 The Act made a number of changes impacting individuals:

  • A permanent extension of the current income tax rates for individuals with taxable income under $400,000 ($450,000 for joint filers);
  • An increase in the top tax rate to 39.6% for individuals with taxable income over $400,000 ($450,000 for joint filers) and for taxable trusts with taxable income over $11,950;
  • A continuation of the preferential 15% tax rate for long-term capital gain and qualified dividend income for individuals with taxable income under $400,000 ($450,000 for joint filers);
  • An increase in the long-term capital gain and qualified dividend income tax rate to 20% for individuals with taxable income over $400,000 ($450,000 for joint filers);
  • A reinstatement of the itemized deduction limitation and personal exemption phase-out for individuals with adjusted gross income over $250,000 ($300,000 for joint filers);
  • A permanent increase in the alternative minimum tax (“AMT”) exemption amount (indexed for inflation);
  • A permanent extension of the estate, gift and generation skipping tax (“GST”) exemptions to $5 million per person (indexed for inflation - $5,250,000 for 2013), with an increase in the top tax rate to 40%;
  • An extension of a number of expired tax provisions such as the child tax credit, dependent care tax credit, adoption tax credit, student loan interest deduction, sales tax deduction, exclusion for employer provided education assistance, and the American opportunity tax credit for college tuition, among other items; and
  • An extension for tax-free distributions from IRAs to charities for qualified individuals, including an opportunity to transfer December, 2012, distributions to charities for a limited period.
  • Not extended was the payroll tax holiday which allowed employees a 2% FICA tax reduction for the past few years.
  • The Act also includes a number of business and energy tax provisions, including an extension of the bonus depreciation and expensing rules.
  • Although not part of the 2012 ATRA, 2013 is the first year that the new Medicare tax will apply to individuals with adjusted gross income over $200,000 ($250,000 for joint filers) at rates of 0.9% on net earned income and 3.8% on “net investment income.”

Explanation:

  1. Tax Rates – Ordinary Income – The tax rates and brackets set in place by 2001 and 2003 legislation (the “Bush Tax Cuts”) and scheduled to sunset at the end of 2010 were extended through 2012 by the current administration. There were six tax brackets – 10%, 15%, 25%, 28%, 33% and a top bracket of 35%.

    The 2012 ATRA eliminates the sunset rule, and therefore makes the tax brackets “permanent” in nature. Of course, permanency is a bit of a misnomer, because any aspect of the tax law may be changed any time Congress is in session. However, the elimination of the sunset provisions, which have been part of the tax landscape since 2001, does provide a bit more certainty for planning purposes, and is a welcome relief.

    The Act also adds a new top tax rate of 39.6% that will apply to single taxpayers with taxable income in excess of $400,000 and joint taxpayers with taxable income in excess of $450,000. The threshold for this new top rate is below the $1 million “Plan B” proposed by the House speaker, but $200,000 higher than the level sought by President Obama.

    As discussed in more detail below, the Medicare tax on earned and unearned income will also have a significant impact on marginal tax rates.

    The tax brackets applicable to single and joint individual taxpayers are listed below:

    2013 Individual Tax Rates

    Taxable Income

    Single Taxpayers

    Joint Filers

    Tax Rate

    $0–$8,925

    $0–$17,850

    10%

    $8,926–$36,250

    $17,851–$72,500

    15%

    $36,251–$87,850

    $72,501–$146,400

    25%

    $87,851–$183,250

    $146,401–$223,050

    28%

    $183,251–$398,350

    $223,051–$398,350

    33%

    $398,351–-$400,000

    $398,351–$450,000

    35%

    $400,001 +

    $451,001 +

    39.6%























    For example, assume a married couple filing a joint return reports $475,000 of taxable income. Their income up to $450,000 will be taxed under the 10% to 35% brackets listed above. Their remaining income of $25,000 (the amount exceeding $450,000) will be taxed at the new top tax rate of 39.6%.

    Taxable trusts have incredibly narrow tax brackets, and reach the top tax rate of 39.6% at $11,950 of taxable income. 

    Taking into account the 3.8% Medicare tax on net investment income and the approximately 1% impact of the itemized deduction and personal exemption phase-outs discussed below, the top combined federal marginal rate (not including state income tax) is approximately 44.4% for interest income, passive income, rents, annuities and short-term capital gain.

    For compensation income (salaries, wages and self-employment income), the top combined federal marginal rate, after considering the 0.9% additional Medicare rate and phase-out impact, is approximately 41.5%, not including state income tax.

  2. Tax Rates – Long-Term Capital Gain & Qualified Dividends – The preferential tax rate on long-term capital gain and qualified dividend income remains at 15% for taxpayers below the 39.6% threshold listed above—that is, single taxpayers with taxable income under $400,000 and joint filers with taxable income under $450,000. The 15% rate for long-term capital gain and qualified dividends was put in place by 2003 legislation and was expected to sunset in 2010, but it was extended through the end of 2012 as part of the extension of the Bush Tax Cuts. The 2003 legislation also instituted a 0% tax rate on long-term capital gain and qualified dividend income for taxpayers in the 10% or 15% ordinary income tax brackets. The Act continues this treatment for individuals in the two lowest tax brackets.

    For taxpayers with taxable income above $400,000 ($450,000 for joint filers), long-term capital gain and qualified dividends will be taxed at 20%.  

    A major concern prior to this new legislation was that qualified dividend income would lose its preferential tax rate and therefore be taxed at ordinary tax rates. This would have meant an increase from 15% to 39.6%, plus the 3.8% Medicare tax. Under ATRA, the qualified dividend preferential tax rate remains part of the permanent tax law.

    The new tax rates for long-term capital gain and qualified dividends are based on taxable income levels as follows: 

    Long-Term Capital Gain and Qualified Dividends

    Taxable Income

    Single Taxpayers

    Joint Filers

    Tax Rate

    $0–$36,250

    $0–$72,500

    0%

    $36,251–$400,000

    $72,501–$450,000

    15%

    $400,001 +

    $450,001 +

    20%


    For example, assume a single taxpayer has $420,000 of taxable income, comprised of $360,000 of salary income and $60,000 of qualified dividend income. Single taxpayers are subject to the top 39.6% ordinary tax rate at $400,000 of taxable income. Under the Act, part of the of the qualified dividend income will be subject to a 15% tax rate, and the remainder subject to the new 20% tax rate. The lesser of a) the $60,000 qualified dividend income or b) the taxable income not subject to the 39.6% tax rate ($400,000) less the taxable income reduced by the qualified dividend income ($360,000) or $40,000, is subject to the 15% rate, with the remaining $20,000 subject to the 20% rate.

    The top tax rate for a trust is reached at $11,950 of taxable income. Thus, qualified dividend income and long-term capital gain will, over this threshold, be subject to 20% taxation. 

    The Act also extends the 100% exclusion of gain on qualified small business stock acquired after September 27, 2010, and before January 1, 2014, and held for more than five years.

  3. Itemized Deduction Phase-out (Pease Limitation), Medical Deduction and Personal Exemption Phase-out (“PEP”)

    Itemized Deduction Phase-out    —The Itemized Deduction Limitation (“Pease Limitation”) is reinstated beginning with the 2013 tax year. Under this limitation, taxpayers’ itemized deductions will be reduced by 3% of the excess of their Adjusted Gross Incomes (“AGI”) over the threshold amounts for their specific filing statuses. Medical expenses, investment interest expenses, and casualty losses are not subject to the limitation, and the total reduction may not exceed 80% of allowable itemized deductions. The filing status threshold amounts are: $300,000 for joint filers, $275,000 for heads of households, $250,000 for single filers and $150,000 for married taxpayers filing separately. These thresholds will be adjusted for inflation for tax years after 2013.

    As an example, Taxpayer A is a single filer with an AGI of $450,000 and total itemized deductions of $120,000. He does not claim any medical expenses, investment interest expenses or casualty losses. The amount of his 2013 Pease Limitation is $6,000 ($450,000 AGI minus $250,000 single filer threshold times 3%), and his allowed itemized deductions after the limitation are $114,000 ($120,000 minus $6,000).

    Medical Deduction—Although not part of the 2012 ATRA, beginning in 2013, the threshold for deducting medical expenses as an itemized deduction will increase from 7.5% to 10% of AGI. Taxpayers who are 65 and older, however, are granted an exception, and will still be able to deduct medical expenses that exceed 7.5% of their AGI.  The exception for taxpayers 65 and older will continue through 2016, and all taxpayers will be subject to the 10% threshold in 2017. 

    Personal Exemption Phase-out (“PEP”)—After a long hiatus, the phase-out of personal exemptions is also reinstated beginning with the 2013 tax year. Each personal exemption is set at $3,900 for 2013. Under this PEP calculation, a taxpayer’s personal exemptions will be reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer’s AGI exceeds specific thresholds for his or her filing status. The threshold amounts are: $300,000 for joint filers, $275,000 for heads of households, $250,000 for single filers and $150,000 for married taxpayers filing separately. These thresholds will be adjusted for inflation for tax years after 2013.

    For example, Taxpayer B is entitled to the head of household filing status and claims personal exemptions for herself and her three children (4 times $3,900 or $15,600). Her AGI is $350,000, which exceeds her $275,000 filing status threshold by $75,000. When the phase-out calculation is applied ($75,000 divided by $2,500 times 2% equals 60%), she will lose 60% of her personal exemptions ($9,360), and will only be allowed to claim $6,240 of personal exemptions.

  4. Alternative Minimum Tax Exemption (“Patch”)—Previous temporary measures to deal with the contagion of the Alternative Minimum Tax (“AMT”) expired at the end of 2011, meaning that millions of additional taxpayers faced the prospect of paying the AMT on their 2012 returns. To prevent the unintended consequence of millions of middle-income taxpayers falling victim to the AMT, Congress once again applied a “patch” to the problem. The “patch” extends a provision allowing for an increased AMT exemption amount, but this time the patch is intended as a permanent fix.  Under the new law, for tax years beginning in 2012, the AMT exemption amounts have increased to: (1) $78,750 from $74,450 in the case of married individuals filing a joint return and surviving spouses; (2) $50,600 from $48,450 in the case of unmarried individuals other than surviving spouses; and (3) $39,375 from $37,225 in the case of married individuals filing a separate return. More importantly, these amounts will be indexed for inflation after 2012, meaning that annual “patches” will no longer be needed.  For 2013, the AMT exemption amounts are $80,800 for joint filers, $58,900 for single individuals and $40,400 for married individuals who file separate returns. 

    In addition to indexing the AMT exemption amount for inflation, the 2012 ATRA has also indexed the breakpoint for the 26% and 28% tax brackets, as well as the Alternative Minimum Taxable Income (“AMTI”) level at which point the exemption amount is phased out.  For 2012, the tax-rate breakpoint is set at $175,000 and the exemption phase-out begins once an individual’s AMTI exceeds $150,000. For 2013, the AMT tax rate breakpoint and the AMT exemption phase-out floor increase to $179,500 ($89,750 for married filing separately) and $153,900, respectively.

    By finally indexing the AMT exemption, the tax-rate breakpoint and the AMTI floor to inflation, the 2012 ATRA should slow the spread of the AMT burden that has been impacting millions of middle-income taxpayers over the past few years.

    Another provision in the Act provides AMT relief for taxpayers claiming personal tax credits. The tax liability limitation rules generally provide that certain nonrefundable personal credits (including the dependent care credit and the elderly and disabled credit) are allowed only to the extent that a taxpayer has regular income tax liability in excess of the tentative minimum tax, which has the effect of disallowing these credits against the AMT. Temporary provisions had been enacted that permitted these credits to offset the entire regular and AMT liability through the end of 2011. The new law extends this relief permanently.

  5. Estate, Gift, and Generation Skipping Tax Exemption and Rate—Under 2001 legislation, the estate, gift and generation skipping tax (“GST”) was phased out and fully repealed in 2010, putting in its place a modified carryover basis regime.  However, 2010 legislation reinstated the estate and GST tax, setting an exemption of $5 million per person and a top tax rate of 35% through 2012. The exemption amount was indexed for inflation, and the exemption for 2012 was $5.12 million per person. The 2010 legislation also introduced the concept of portability for deaths after 2010.  Portability allows a surviving spouse to use any unused exemption of the deceased spouse in the surviving spouse’s estate.

    The 2012 ATRA eliminates the sunset provision and makes the $5 million exemption permanent (indexed for inflation). The 2013 indexed exemption is $5,250,000.  Moreover, the concept of portability was made part of the permanent tax law.

    The Act did, however, increase the top tax rate from 35% to 40%. Under the existing sunset provisions, the top tax rate would have increased to 55%, and the exemption would have dropped to $1 million.  

    Regarding the gift tax, the $5 million lifetime gift tax exemption (indexed for inflation) was also scheduled to revert to $1 million after 2012. The 2012 ATRA makes the $5 million lifetime exemption permanent (indexed for inflation), again unifying the estate and gift tax regimes on a permanent basis. Prior to 2001, the two regimes were unified, and were decoupled for the 2001–2010 period.  

    Previously, certain commentators raised a potential risk of a “clawback” of prior taxable gifts if the exemption were to revert to $1 million. That concern is negated by the “permanent” indexed exemption provision.

    A summary of the exemption amount and the top tax rate follows:

    Estate, Gift & GST Regimes

    Year

    Exemption

    Top Tax Rate

    2011

    $5,000,000

    35%

    2012

    $5,120,000

    35%

    2013

    $5,250,000*

    40%

    2014 & Future

    Indexed for Inflation

    40%

    *The 2013 exemption amount of $5,250,000 equates to a unified credit equivalent of $2,045,800.

    Notwithstanding the unification of the estate and gift tax system, the basic math almost always favors a lifetime gift as opposed to holding the property until death (income tax basis rules ignored). For a rough example, assume a marginal $1 million investment portfolio. If $714,000 is transferred as a gift during lifetime (and assuming the lifetime gift exemption has already been used), the taxpayer will pay about $286,000 of gift tax, thus reducing the portfolio in the hands of the taxpayer to $0. On the other hand, if the $1 million portfolio is held until death, the estate tax would be $400,000, with $600,000 left for the family, an amount that is clearly lower than the $714,000 the family would receive through a lifetime gift. The reason: the gift tax is exclusive (it does not calculate the tax including the gift tax due), while the estate tax is inclusive (it does calculate the tax including the estate tax due). 

    Interestingly, the Act does not include any provisions related to the current administration’s proposals to restrict the use of grantor retained annuity trusts (“GRATs”), to eliminate sales to intentionally defective trusts by making grantor trusts includable in one's taxable estate, to restrict the use of valuation discounts or to eliminate the use of dynasty trusts by restricting the GST exemption period to 90 years. Thus, these techniques continue to be viable alternatives for planning one’s estate.

    The following is a summary of the new estate, gift and GST tax rates:

    2013 Estate, Gift, and GST Tax Rates

    $0–$100,000

    Varies From

    18%–28%

    $100,001–$150,000

    30%

    $150,001–$250,000

    32%

    $251,001–$500,000

    34%

    $500,001–$750,000

    37%

    $750,001–$1,000,000

    39%

    $1,000,001 +

    40%

  6. Extension of Miscellaneous Tax Provisions—The Act extended, with certain modifications and for various durations, a number of tax provisions that will impact individual taxpayers. Some of these provisions expired at the end of 2012, while others expired at the end of 2011 and are being extended retroactively to the beginning of 2012.

    Credits and other provisions that have been extended permanently include:

    • Earned Income Tax Credit
    • Child Tax Credit
    • Dependent Care Tax Credit
    • Adoption Tax Credit and employer-provided adoption assistance program exclusion
    • Employer-Provided Childcare Tax Credit
    • Nonbusiness Energy Property Credit for qualified energy-efficient improvements and residential energy property expenditures.
    • Coverdell Education Savings Accounts
    • Qualified tuition deduction
    • Student loan interest deduction
    • Exclusion from income for employer-provided education assistance
    • Exclusion from income for certain scholarships

    The American Opportunity Tax Credit for college tuition and related education expenses, which may result in a credit of up to $2,500 for each of the first four years of post-secondary education, has been extended for five years, through 2017.

    Other credits and provisions that have been extended only through 2013, when they will once again expire, include:

    • Deduction for mortgage insurance premiums (PMI)
    • Option to deduct state and local general sales taxes
    • Above-the-line deduction for qualified tuition and related expenses
    • Deduction for certain expenses of elementary and secondary school teachers
    • Exclusion for discharge of qualified principal residence indebtedness

    • Special rule for charitable contributions of real estate conservation easementsprincipal residence indebtedness

  7. Tax-Free Distributions from IRAs—The 2012 ATRA temporarily extends existing tax law, which had expired at the end of 2011, so taxpayers age 70 ½ or older may continue to make tax-free distributions from their individual retirement accounts (“IRAs”) directly to qualifying charities. The extension is through the 2012 and 2013 tax years. This means that taxpayers who (in anticipation of retroactive extensions of the law) made direct transfers from their IRAs to qualifying charities during 2012 may qualify those transfers for favorable tax treatment. Furthermore, because 2012 has already passed, the 2012 ATRA provides two special provisions in the area of qualified charitable distributions. First, an eligible taxpayer who received a distribution after November 30, 2012, but before January 1, 2013, may treat any portion of the distribution as a qualified charitable distribution provided, (i) such portion is transferred in cash, after the distribution, to a qualified charitable organization before February 1, 2013, and (ii) such portion is not more than the $100,000 annual distribution limitation. Second, another special rule deems distributions made after December 31, 2012, and before February 1, 2013, as being made on December 31, 2012. Therefore, those taxpayers who waited patiently, hoping that the qualified charitable distribution provision would be extended for 2012, only to be disappointed when December 31, 2012, passed without passage of an extenders package, now have a short window during the month of January, 2013, in which to make a charitable gift from their IRAs that will be treated as a 2012 distribution.

  8. New Medicare Tax on Earned and Unearned Income—Although not part of the 2012 ATRA, taxpayers will be subject to an additional tax burden beginning in 2013 in the form of a Medicare tax, legislated under the Patient Protection and Affordable Care Act (“PPACA”). Although the PPACA was signed into law over two years ago, it contains several revenue provisions that will affect individual taxpayers beginning in 2013.

    Beginning in 2013, the Medicare payroll tax will increase by 0.9% on the earned income (wages and self-employment income) of single and married filing jointly taxpayers in excess of $200,000 and $250,000, respectively. The increased Medicare tax applies to employees only, not to employers. Accordingly, the increased Medicare tax rate on wages over the $200,000/$250,000 thresholds will be 2.35% (increased from 1.45%) and the increased Medicare tax rate on self-employment income over the $200,000/$250,000 thresholds will be 3.8% (increased from 2.9%). The $200,000 threshold for single taxpayers and the $250,000 threshold for married taxpayers filing jointly are not indexed for inflation, so it is possible that a greater number of taxpayers will be subject to this tax increase in subsequent years.

    Employers will apply the increased 0.9% Medicare tax when wages exceed $200,000, regardless of the employee’s filing status or wages paid by another employer. Married taxpayers who individually earn less than $200,000 but jointly earn more than the threshold amount (i.e., more than $250,000 together) will pay additional Medicare taxes through increased withholding adjustments, estimated tax payments or when they file their 2013 Forms 1040.

    Effective in 2013, the PPACA imposes a 3.8% Medicare surtax on the unearned income of single taxpayers with Modified Adjusted Gross Income (“MAGI”) in excess of $200,000 and joint taxpayers with MAGI in excess of $250,000. For the purpose of this tax, MAGI is comprised of AGI plus foreign earned income. This new tax is noteworthy, as this is the first time, since its implementation in 1966, that Medicare taxes have ever been applied to anything other than wages and self-employment income.

    The Medicare surtax will be imposed on the lesser of a taxpayer’s unearned income or the excess of the taxpayer’s MAGI over the specific MAGI filing status threshold. For example, a single taxpayer with a MAGI of $230,000 ($30,000 over the threshold) and $50,000 of unearned income will pay the 3.8% tax on $30,000. Similarly, joint taxpayers with a MAGI of $400,000 ($150,000 over the threshold) and $40,000 of unearned income will pay the 3.8% tax on $40,000.

    Sources of unearned income subject to this Medicare tax include interest, dividends, capital gains, annuities, royalties and passive rental income. Tax-exempt interest and distributions from retirement plans—(401(k) Plans, IRAs, Roth IRAs, Profit Sharing Plans and Defined Benefit Plans)—are not subject to the 3.8% Medicare surtax. 

     The Medicare tax rates at applicable AGI levels are as follows:  

    2013 Medicare Tax Rates

    Modified Adjusted Gross Income (MAGI)

    Single Taxpayers

    Joint Filers

    Earned

    Income*

    Net Investment

    Income

    $0–$200,000

    $0–$250,000

    1.45%

    0%

    $200,001+

    $250,001+

    2.35%

    3.8%

    *For self-employed individuals, the rate up to $250,000/$250,000 is 2.9% and 3.8% for amounts in excess of these thresholds.

  9. Other Provisions—The 2012 ATRA did not extend the payroll tax holiday that applied to the 2011 and 2012 tax years. For the past two years, employees paid a 4.2% FICA tax on their wages up to the Social Security limit ($110,100 for 2012), a 2% reduction from the normal 6.2%. Many commentators feel that this will be the one provision in the Act that will have the most impact on taxpayers.

     ATRA includes a number of business tax breaks. The Act extends the additional first-year depreciation deduction known as bonus depreciation for one year. In general, 50% of the adjusted basis of qualified property acquired in 2013 may be claimed as bonus depreciation. Moreover, the first-year depreciation for autos and trucks acquired in 2013 is also enhanced by an additional $8,000 depreciation deduction, extending the rule that was to sunset at the end of 2012.

    The Act also retroactively increases the maximum Section. 179 expensing amount (in lieu of depreciation) to $500,000 for tax years 2012 and 2013, with a phase-out if total investment in depreciable assets exceeds $2 million.

    There are a number of other business tax provisions in the 2012 ATRA that are beyond the scope of this alert. 

Conclusion:

The Act provides some clarity for planning purposes.  On the horizon is the next battle, which would be an agreement on the expenditure side of the equation.  Please stay tuned!

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Posted at 9:00 AM by makeenan@nixonpeabody.com | Category: Individual Tax | Permalink | Email this Post | Comments (0)

1/14/2013

The American Taxpayer Relief Act of 2012 and charitable giving
January 7, 2013
Nonprofit Organizations Alert
Author(s): Michael J. Cooney
 

An admittedly unscientific survey reveals that 2012 finished with a flurry of charitable giving, particularly to donor advised funds, out of concern of what Congress would or would not do. There is something to like for everyone in promoting charitable giving—wealth redistribution to those most in need through a wide base of programs for liberals, and the ability of individual donors to self-direct charitable support without the interference of the government for conservatives. Yet the effect of these multiple, seemingly unrelated changes in the tax law will have an as yet unknown effect on this well-functioning social support system.  

Rate impact

The saying goes that tax policy does not initiate charitable giving; tax incentives never fully make up for the cost of the donor parting with contributed assets. Every development officer knows that some level of innate generosity (preferably of the “detached and disinterested” type) prompts gifting. Yet an increase in tax rates on certain donors may affect the amount of a contribution based on myriad personal factors. A simple conclusion that higher income tax and capital gains rates will lead to more charitable giving proves too much, especially when Congress has left any number of traps for the unwary.

ATRA continued the Bush-era income tax rates, but imposed a new, higher 39.6% rate for those taxpayers with taxable income above $400,000 ($425,000 for heads of households, $450,000 for married filing jointly). The same taxable income threshold applies to the increased capital gains rate, moving from 15% to 20%. Remember, too, the 3.8% additional tax on net investment income for those with income above $200,000 ($125,000 for married filing separately, $250,000 for married filing jointly) under the Patient Protection and Affordable Care Act in 2013. 

The reaction of donors to these increases is difficult to judge. Often the response is relative to the current state of affairs; tax rates on many major donors just went up. And the impact is not the same for everyone. For single taxpayers, the 35% tax rate has almost entirely been replaced by the higher rate. Yet, the new 39.6% rate is the same percentage that applied during the Clinton era, which certainly had its share of charitable giving. There is a good deal more capital invested today in limited liabilities companies taxed as pass-through entities, so the higher individual rate relative to the corporate tax rate of 35% may have some effect. In summary, development officers need to be aware of the higher rates and how they work, but there is no clear path to stimulate charitable giving here.

The Pease limitation

We are familiar with the percentage limitations which prevent a donor from taking a full deduction for gifts made in a particular year based on the donor’s adjusted gross income (or AGI), the nature of the gifted assets, and the form of recipient charity. We are familiar with the charitable reduction from fair market value for certain gifts of ordinary income property. But the effect of a dormant cap on itemized deductions generally could have the most deleterious effect on the value of current charitable gifts.

In order to recognize the benefit of a large income tax deduction, a taxpayer will itemize deductions on his or her tax return. The so-called Pease limitation reduced the amount of itemized deductions claimed depending on the taxpayer’s AGI. The underlying basis for the concept, apparently shared by the President, is that high net worth individuals can radically diminish their tax bill by the aggressive use of legitimate deductions. In the case of charitable giving, that means avoiding tax on income by giving it away for the benefit of others without an expectation of any return . . . hardly an inventive tax-avoidance scheme. That limitation was repealed from 2010 through 2012, but now is back. 

ATRA shields income from the Pease limitation at or below $250,000 (individual filers), $275,000 (heads of households) and $300,000 (married filing jointly) for taxable years beginning after December 31, 2012. Itemized deductions in excess of these amounts will be reduced by 3%. The higher the AGI, the greater the effect of the limitation growing to a possible reduction of the value of deductions by up to 80%.

The net effect? Charitable solicitors are rarely invited into the details of how a charitable gift will be reflected on a tax return beyond the terms of the gift itself. There is a value in being unobtrusive. Donors will now need to look more deeply at their personal tax situation to assure that the expected level of tax benefit is available and is not the victim of the Pease limitation.  

Estate taxes

The federal estate tax (together with the gift tax) has been the subject of much debate. Labeled the “death” tax by those perceptive enough to recognize that the levy is indeed made only after someone dies, the tax now is imposed at a rate of 40%, with an inflation-adjusted $5 million exclusion for the estates of those who die after December 31, 2012. ATRA continues the portability feature allowing the estate of a spouse to transfer the unused exclusion to the surviving spouse. Once again, the estate tax is unified with the gift tax.

Predicting the effect of this change in the estate tax is even more daunting than for the income tax. Given that those contemplating a bequest are less concerned with timing advantages and were probably only confused by the dizzying array of changes over the past few years, some certainty in this area will be a welcome change for estate planners and their clients. Charities will continue to promote their wills programs as in the past with some assurance that tax policy will not evince the gyrations of years past.

Alternative Minimum Tax

The AMT is the phantom tax system intended to make up for apparent unintended disparities of the regular tax system in favor of the highly compensated. Should that second tax regime compromise the effectiveness of any charitable giving program, it poses a threat to giving. The oft-asked question was whether the charitable deduction would be a “preference” ignored under the AMT.

The Act fashions a permanent “patch” for the AMT, retroactive for 2012, indexing the AMT exclusion for inflation. That is not to say that the system goes away, but only that it is more predictable. Importantly, charitable giving was not disadvantaged by the patch.

Extenders

Congress sees fit to extend certain charitable deductions instead of incorporating them “permanently” into the law. Of course, not even “permanent” provisions are really permanent anymore, with the effect being that members of Congress regularly put these extended deductible contributions into play, subject to frenetic lobbying when they are about to expire. (For example, the enhanced deductions for corporate gifts of book and computer inventory was allowed to sunset.)

ACTA’s extenders include those: preserving the 50% contribution limit for contributions of capital gain realty for conservation purposes; allowing businesses to claim an enhanced deduction for the contribution of food inventory; allowing S corporation shareholders to take into account their pro rata share of charitable deductions, even where such deductions exceed the shareholder’s adjusted basis (available from December 31, 2011 to January 1, 2014); and continuing the popular Tax-Free Charitable Distribution from Individual Retirement Plans after it expired at the end of 2011.  As in the past, the Charitable IRA Distribution includes transition rules: a taxpayer can make a distribution during January, 2013 and have it count for the prior year; while those who took a distribution in December of 2012 will be able to contribute that amount to a charity before February 1 and count it as an eligible charitable distribution. 

Research tax credit

While not a charitable giving device as such, the reinstatement of the research tax credit will benefit payments to universities and exempt research institutes. The credit applies to increased qualified research expenditures averaged over the preceding four years.

Conclusion

The effect of ACTA on charitable giving is as yet unclear. The messaging from charities to donors will offer no new tax incentives or giving methods, though the relative certainty of the estate tax regime and the availability of the IRA rollover for a very limited time will require some communication. What is especially clear is that our lawmakers lack a basic appreciation of tax policy, especially as it comes to charitable giving. For example, what distinguishes charitable giving from the other deductions affected by the Pease limitation? Well, paying state and local taxes, mortgage interest, and other deductible expenses are certainly less discretionary than charitable giving. And isn’t one of the core purposes of tax policy (versus unbridled tax collection) the provision of incentives to individual taxpayers to engage in behaviors we all wish to promote . . . behaviors which benefit all of us with little if any benefit to the taxpayer, all while relieving the increasingly heavy burdens of government? Despite the urgings of the sector, lawmakers continue to ignore the benefits of a uniquely American concept forged in the tax law from its inception. Let’s hope for better in 2013.

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Posted at 1:32 PM by makeenan@nixonpeabody.com | Category: Gift Tax | Permalink | Email this Post | Comments (0)
American Taxpayer Relief Act of 2012 extends the New Markets Tax Credit two years and with $7 billion
January 4, 2013
Tax Credit & Syndication Alert
Author(s): Michael J. Goldman

The American Taxpayer Relief Act of 2012 extends the New Markets Tax Credit program for two years and $7 billion, with the first $3.5 billion scheduled to be awarded in April.

On January 2, President Obama signed into law the American Taxpayer Relief Act of 2012 (ATRA). Section 305 of ATRA extends the New Markets Tax Credit (NMTC) under Section 45D of the Internal Revenue Code by providing for $3.5 billion of NMTC allocation authority to be available for the Treasury to award for calendar years 2012 and 2013. In addition, Section 305 of ATRA extends the deadline by which the Treasury must re-allocate any unused awards by two years to the end of 2018.

The NMTC industry was optimistic there would be an extension of the program, though the hope was for Congress to authorize $5 billion of the NMTC allocation authority for each year of the extension (consistent with the amounts authorized in 2008 and 2009). Similar to the most recent 2-year extension of the program in 2010, the Community Development Financial Institutions Fund (CDFI Fund), the division of the Treasury delegated the authority to administer the NMTC program, conducted an application round assuming there would be an extension of the program. In fact, the 2012 applications were due in September, and there were 282 applications submitted, seeking an aggregate total in excess of $21.9 billion in NMTC allocation authority (i.e., greater than 625% of the amount made available under ATRA).

On January 3, the CDFI Fund posted on its website that it is currently reviewing these 2012 applications, and it plans to announce the awards in April.

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Posted at 1:29 PM by makeenan@nixonpeabody.com | Category: Tax Credits | Permalink | Email this Post | Comments (0)
American Taxpayer Relief Act of 2012 extends key tax credit and deduction provisions

January 3, 2013
Tax Credit & Syndication Alert
Author(s): Susan P. Reaman

Congress averted the expiration of many key tax credit and deduction provisions affecting the housing, new markets, and energy credit industries by passing the American Taxpayer Relief Act of 2012 on January 1, 2013, and President Obama has since signed the legislation into law. This alert summarizes select provisions relevant to these industries.

Low-Income Housing Tax Credit

The Act includes a 9% housing credit floor provision that allows any project receiving an allocation of Low-Income Housing Tax Credits before January 1, 2014, to qualify for the 9% credit floor. Effectively, because of the regular two-year placed-in-service deadline for carryover allocations, this amounts to a two-year extension for projects receiving 2013 allocations and a one-year extension for projects receiving 2012 allocations. Please note that this rule applies only to 2013 or earlier housing allocation authority. Thus, the 9% credit does not apply to binding commitments to allocate housing credit authority from a housing agency’s allocation authority in years after 2013, even if such a commitment is entered into in 2013. The 4% credit was not changed by this legislation, and continues to float.

Military housing allowance

The Act retroactively extends the provision that the basic housing allowance of a member of the military is not considered income for purposes of calculating whether that person qualifies as a low-income tenant from December 31, 2011, through December 31, 2013.

New Markets Tax Credit

The Act retroactively extends the new markets tax credit for 2012 and also for 2013, providing for annual allocations of qualified equity investments of $3.5 billion, and it extends the period for re-allocating unused allocations to 2018.

Bonus depreciation

Current law allows a 100% bonus depreciation for investments placed in service after September 8, 2010, and before January 1, 2012, and a 50% bonus depreciation for investments placed in service during 2012 (with the possibility of 100% for certain longer-lived and transportation assets). The Act extends the current 50% expensing provision for qualifying property purchased and placed in service before January 1, 2014 (before January 1, 2015, for certain longer-lived and transportation assets), and also allows taxpayers to elect to accelerate some alternative minimum tax (AMT) credits in lieu of bonus depreciation, thereby helping to avoid the AMT.

Energy PTCs and ITCs

The Act makes a significant change to the production tax credit (PTC) and the investment tax credit (ITC) that applies to otherwise PTC-eligible facilities (e.g., those that generate electricity using wind, geothermal, biomass, landfill gas, municipal solid waste, hydroelectric production, and marine and hydrokinetic energy). All of these are now eligible for the PTC or the 30% ITC, provided the facility begins construction not later than December 31, 2013. Formerly, the test had been whether the facility was placed in service by that date (or even earlier, in the case of wind). As yet, there is no guidance on what it means to “begin construction.” Treasury may adopt rules similar to those used by Treasury in administering the 1603 grant in lieu of tax credits program under the American Recovery and Reinvestment Act of 2009—i.e., either (A) continuous physical work of a significant nature commencing before 2014, or (B) incurring 5% of the cost of the facility before 2014—but remember that Treasury’s rules for grants are not binding on the IRS in administering this new energy credit extension. The rules for solar, fuel cells, and geothermal that generates heat continue to have the same placed-in-service tests as before the extension (e.g., solar facilities must be placed in service by the end of 2016 to qualify for the 30% ITC).

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Posted at 1:26 PM by makeenan@nixonpeabody.com | Category: Tax Credits | Permalink | Email this Post | Comments (0)

8/8/2012

Another win for a District of Columbia taxpayer—and a reminder that a state cannot tax a taxpayer without first satisfying state standards

August 8, 2012

In a recent decision by the District of Columbia’s Office of Administrative Hearings, a food distributor defeated an attempt by the District of Columbia’s Office of Tax and Revenue to impose corporate franchise tax and ball park fees for tax years 2000 to 2009. The distributor argued that it did not conduct business in the District within the meaning of the District’s tax laws and therefore the District lacked authority to tax it. This case serves as a reminder that before a state (or the District) can impose its income tax on a business, the state’s (or the District’s) applicable tax law must first authorize it. This is the third major taxpayer win in the last two years before the new Office of Administrative Hearings.

Click here to read the full article on nixonpeabody.com.

For more information regarding state and federal business income tax, please contact your regular Nixon Peabody attorney or:

Posted at 5:49 PM by tking@nixonpeabody.com | Category: Corporate Tax; State and Local Tax; Tax Controversy | Permalink | Email this Post | Comments (0)

8/3/2012

Charitable contributions to single-member LLCs: The questions left unanswered

August 3, 2012

The IRS finally agreed in Notice 2012-52 (to be published in the Federal Register later this month) that a contribution to a single-member LLC is akin to a contribution to its owner. Importantly, the Notice is retroactive to taxable years for which the statute of limitations has not expired. While this is good news, the use of wholly-owned LLCs by charities is not without its complications. In order to make LLC gifting a viable tool, several considerations should be undertaken ahead of time. Continue reading for a list of points to consider.

Click here to read the full article on nixonpeabody.com.

For further information, contact your Nixon Peabody attorney or:

Posted at 1:36 PM by tking@nixonpeabody.com | Category: Corporate Tax | Permalink | Email this Post | Comments (0)

6/14/2012

IRS issues cloudy clarification of vesting rules

6/7/2012

Open PDF: IRS issues cloudy clarification of vesting rules

The IRS recently issued regulations clarifying the answers to some long-standing questions regarding the taxation of restricted stock. However, these clarifications do not answer and indeed may raise new questions concerning the IRS positions on certain cash-based deferred compensation vesting issues.

Section 83 of the Internal Revenue Code governs the taxation of a transfer or grant of restricted property, typically stock, as compensation. (Separate tax rules, including Sections 409A, 457, and 457A, apply to cash-based deferred compensation.) 

In general, the transfer of stock or other property is only taxable when the property is no longer subject to a “substantial risk of forfeiture.” A typical vesting restriction is service-based, e.g., the granted stock is forfeited if the recipient terminates service before a specified number of years have elapsed. Whether other non-service types of restrictions are effective to defer taxation has always been determined based on the facts and circumstances. The IRS has now clarified under what circumstances non-service restrictions would be considered a substantial risk of forfeiture.

First, the IRS has clarified that any non-service based vesting condition must be “related to the purpose of the transfer.” For example, a vesting condition based upon the company achieving a specified level of earnings would be a condition related to transfer or grant of the company stock.

Second, the likelihood of the forfeiture occurring and the likelihood that the forfeiture will be enforced must be considered. For example, if stock is granted subject to a condition that the stock is forfeited if the gross receipts of the employer fall by 90% over three years, the likelihood of such a percentage fall must be considered. If the employer were a long-standing seller of a product and there was no indication that there would either be a fall in demand or an inability of the employer to sell the product, the IRS would take the position that the transfer was taxable when granted, rather than after the three-year period had elapsed.

Third, a mere restriction on transferring the stock does not create a substantial risk of forfeiture, even if the stock would be forfeited if the employee attempted to transfer it. For example, if an employee is awarded stock subject only to the condition that the employee not sell or otherwise transfer the stock for five years, the stock is taxable at the time of transfer, even if the recipient were to forfeit the stock if he or she did attempt such a transfer.

Also, the regulations now clarify that the only provision of the securities law that delays taxation under Section 83 is Section 16(b) of the Securities Exchange Act. Section 16(b) restricts “certain” insiders from selling their company stock within six months of a covered purchase of company stock. Other types of transfer restrictions in connection with securities transactions, such as restrictions imposed by lock-up agreements or restrictions related to fraudulent or deceptive insider trading under Rule 10b-5 of the Exchange Act, will not cause the stock to be substantially unvested.

These clarifications under Section 83 are not particularly new, and were foreshadowed in prior IRS rulings. However, other tax deferral techniques are also dependent on whether there is a vesting condition that is a “substantial risk of forfeiture.” In particular, Sections 409A and 457A use the same phrase to determine the taxation of deferred compensation. Moreover, for executives of tax-exempt organizations, Section 457(f) determines whether a potential deferred compensation arrangement is taxable based on when it is subject to a “substantial risk of forfeiture.”

Even though the phrase “substantial risk of forfeiture” is in each of these statutes, the IRS has so far not chosen to interpret the phrase identically. For example, the IRS has said that a covenant not to compete never results in a substantial risk of forfeiture under Section 409A, but may in limited circumstances qualify as a substantial risk of forfeiture under Section 83. The IRS has also previously announced an intention to issue final regulations on Section 457(f) that would interpret this phrase, but not necessarily in a manner identical to other tax code sections. As a result, when designing non-service-based vesting restrictions for deferred compensation arrangements, employers need to be careful in comparing and contrasting the alternative meanings of the phrase “a substantial risk of forfeiture.”

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

Posted at 5:23 PM by makeenan@nixonpeabody.com | Category: Individual Tax | Permalink | Email this Post | Comments (0)

5/31/2012

Foreign Account Tax Compliance Act: U.S. payors need to act now to avoid taxation later

Open PDF: Foreign Account Tax Compliance Act: U.S. payors need to act now to avoid taxation later

U.S. taxpayers making “withholdable payments” abroad to foreign entities, absent taking preparatory steps, could soon see their U.S. tax liability dramatically increase. In March of 2010, in an effort to reduce the ability of U.S. taxpayers to hide income overseas, Congress passed the Foreign Account Tax Compliance Act (FATCA). FATCA establishes a comprehensive information reporting and withholding regime that empowers the Internal Revenue Service (the Service) to monitor and collect tax on U.S. source payments made to foreign entities that have U.S. account holders. For the last two years, the lack of cohesive guidance from the Treasury Department gave hope to financial institutions and multinational corporations in both the U.S. and abroad that the arduous reporting obligations imposed by FATCA would be repealed. Proposed regulations released earlier in 2012 make certain that FATCA is entrenched in the U.S. tax code. Unfortunately, the burden of tax collection under the act is placed on withholding agents, which are most frequently the U.S. payors. 

Nuts and bolts

Pursuant to FATCA, “withholding agents” must withhold 30 percent of any withholdable payments made to foreign financial institutions (FFIs) that do not agree to share information with the Service regarding their U.S. account holders (nonparticipating FFIs). Furthermore, withholding agents must withhold on withholdable payments to non-financial foreign entities (NFFE) that fail to certify that they do not have any substantial U.S. owners or, alternatively, do not provide information regarding their substantial U.S. owners (noncompliant NFFE).

The definition of withholding agent is quite broad and includes U.S. financial institutions, U.S. multinational institutions, U.S. investment funds, and any other U.S. taxpayer that controls or makes any withholdable payment abroad (collectively “U.S. withholding agents”).[1]  Failure to withhold will subject withholding agents to tax liability both for the under withheld tax as well as related penalties and interest that may be assessed as a result of the failure. The breadth of FATCA and the subsequent proposed regulations leave certain that to varying degrees, U.S. withholding agents will have to adjust their current practices to avoid tax liability for failure to withhold and remit taxes to the Service.

The definition of withholdable payments is also broad and includes any payments of U.S. source fixed or determinable, annual or periodical income (known as FDAP under existing law), as well as U.S. source gross proceeds from the sale of stock, securities, and other debt instruments. Among other things, FDAP includes interest (without an exclusion for portfolio interest or bank deposit interest), original issue discount (OID), dividends, rents, royalties, compensation for services, prizes or awards, scholarships, pensions and annuities, and commissions and fees. For example, if a U.S. company pays royalties to a non-U.S. entity for technology or other property licensed for use in the U.S., or pays fees to a non-U.S. entity for individuals performing services in the U.S., such payments could be withholdable payments, if the non-U.S. entity (an NFFE) is not treated as in an active business under IRS guidance.

The effective dates of FATCA will be phased in over the next few years. A withholding agent may be subject to a 30% U.S. withholding tax imposed on its share of payments of (1) U.S.-sourced dividends, interest, royalties, and other types of FDAP on and after January 1, 2014, and (2) gross proceeds from the sale or other disposition of U.S. stocks, securities, and other debt instruments on and after January 1, 2015.

The sting of FATCA is mitigated to the extent that U.S. withholding agents adequately monitor their activities and ensure that payments subject to FATCA are being withheld upon unless the foreign recipient provides the requisite documentation to the withholding agent. Once fully implemented, U.S. withholding agents must have processes in place that do the following:

  • Identify payments made to foreign entities
  • Characterize these payments to determine if they are withholdable payments subject to FATCA
  • Characterize the foreign entity as an FFI or an NFFE
  • Determine whether the foreign entity is a nonparticipating FFI or a noncompliant NFFE
  • Determine whether the recipient of the payment, the foreign entity, is also the beneficial owner of the payment
  • Determine if an exception exists to avoid withholding under the statute or IRS guidance
  • Withhold on payments to nonparticipating FFIs, non-withholding participating FFIs, and noncompliant NFFEs beginning January 1, 2014 (or January 1, 2015 for applicable gross payments)
  • Obtain adequate documentation from participating FFIs and compliant NFFEs to justify the decision not to withhold on the payment

Going forward

U.S. payors familiar with the domestic backup withholding provisions are often surprised by the inflexible approach taken by the Service with respect to payments directed abroad. The Service has less control over payments to non-U.S. recipients and to offset its lack of control, it has constructed an inflexible withholding regime that imposes significant compliance hurdles on U.S. payors. Fortunately, similar to other information reporting provisions in the Internal Revenue Code, FATCA is largely an exercise in administrative diligence.

We recommend that our clients take a measured approach to FATCA, but not to delay consideration of it. Today, it is important to analyze your payment streams and determine the extent to which you will be impacted by FATCA. Once you have properly characterized the impact, it is necessary to determine the degree to which your operations must be adjusted to facilitate future compliance. For the majority of our clients, the “shock and awe” approach suggested by some other law firms and large accounting firms may not be necessary—slight modifications to existing foreign withholding procedures will be sufficient. For others, a more comprehensive approach is inevitable.

  1. Although usually the case, the withholding agent is not necessarily a U.S. payor. For example, unless it elects otherwise, an FFI that has agreed to share information with the Service is the withholding agent when it receives a “passthru payment” on behalf of a recalcitrant account holder or another FFI or NFFE that has not entered into the requisite agreements with the Service.
    [Back to reference]

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

Posted at 2:11 PM by makeenan@nixonpeabody.com | Category: Foreign Account Tax | Permalink | Email this Post | Comments (0)

5/23/2012

Will your products be subject to the new 2.3% Federal Excise Tax on “taxable medical devices” next year?

A new medical device manufacturers’ excise tax, effective for sales made after December 31, 2012, employs the same procedures that for many years have governed other manufacturers’ excise taxes, so many expected it to be a relatively “routine” way to increase the federal government’s revenue and to offset certain tax expenditures. But that simple plan was foiled with the addition of a very complex inclusion—a so-called “retail exemption.” Although lobbying is still underway to encourage a repeal of the new tax, observers generally believe it will become effective as enacted. What can manufacturers of medical devices do in the meantime?

5/23/2012

Open PDF: Will your products be subject to the new 2.3% Federal Excise Tax on “taxable medical devices” next year?

You have six months to determine what’s taxable and gear up for payment

In March 2010 Congress passed Internal Revenue Code Sec. 4191, effective for sales made after December 31, 2012. The new medical device manufacturers’ excise tax employs the same procedures that for many years have governed other manufacturers’ excise taxes, so it was expected to be a relatively “routine” way to increase the federal government’s revenue and to offset certain tax expenditures.

Congress had a relatively simple plan, but unfortunately made the new tax very complex by including a so-called “retail exemption.” Under the new tax law, all medical devices are subject to the tax except for:

  1. Eyeglasses,
  2. Contact lenses,
  3. Hearing aids, and
  4. “. . . any other medical device determined by the Secretary (of Treasury) to be of the type which is generally purchased by the general public at retail for individual use.”

On February 7, 2012, the Treasury Department issued proposed regulations to implement the new tax regime. At a hearing last week, numerous industry representatives criticized the proposed regulations and identified numerous uncertainties regarding exactly what is subject to the tax. Most of the uncertainties involved the retail exemption.

Although lobbying is still underway to encourage a repeal of the new tax, observers generally believe it will become effective as enacted.

What is a medical device?

The definition of medical device is identical to that used in Sec. 201(h) of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 301 et seq.). FFDCA defines a “device” as any instrument, apparatus, implement, machine, contrivance, implant, as well as in vitro, or any other similar or related article, including any component, part, or accessory that is intended for human or animal use in the diagnosis, cure, mitigation, treatment, or prevention of disease or other conditions, or intended to affect the structure or function of the body, and which requires no chemical action or metabolization in order to be effective. Because of the astounding breadth of this definition, the medical device tax may be levied on manufacturers of the components or parts of a medical device as well as manufacturers of a finished medical device. 

The FDA regulations at 21 C.F.R. Part 862-892 classify over 1700 types of medical devices into Class I, II, and III, based on the degree of risk they pose. The three classes are irrelevant for tax purposes, but the list of devices is incorporated by reference directly into the tax law. Treasury believes that anyone manufacturing a covered medical device will have already been subjected to the FDA device regulation process before being allowed to market his or her product. Therefore, the drafters of the tax regulations do not expect any significant degree of uncertainty regarding the definition of a medical device.

The retail exemption

The proposed regulations employ a “facts and circumstances” test to determine what qualifies for the exemption, based on a nonexclusive list of factors. The regulations also contain safe harbor exemption categories for specific devices, such as home use lab tests, certain durable medical equipment, and enteral nutrients.

The comments made to Treasury regarding the proposed regulations highlight several areas of concern.

  • Bonus goods and rebates are common in the medical device industry. How do these figure into the taxable sales price?
  • “Convenience kits” present several tax issues.
    • These kits often contain both exempt and taxable items, and since the entire kit will be taxable, the exempt items effectively lose the benefit of their exemption.
    • Some kit packagers will pay the excise tax on component items. When the items are assembled into a kit, which itself is a taxable item, some of the contents will be subject to double taxation.
  • There are numerous non-economic uses of medical devices, such as samples, demonstration products, charitable contributions, and surgical instruments loaned by manufacturers to health care providers for implanting their devices. Will these be subject to the tax?
  • Sales of devices to purchasers for further manufacture and for export are exempt. How will this category be defined?
  • Treasury has reserved the authority to impose the tax on a “constructive sale price” if it determines that the actual sale was not made at arm’s length. How will this be determined?

General rules and procedures applicable to all excise taxes

Most manufacturers of medical devices are unfamiliar with the existing rules for payment of the excise tax. The general rules are published in Chapter 5 of IRS Publication 510. These include:

  • The taxable sales price of a device will include charges for packaging but not for delivery.
  • Both leases and installment sales of taxable medical devices are subject to the tax.
  • A manufacturer whose sales are exempt because the customers will conduct further manufacturing, or because they are export sales, must register in advance using IRS Form 637, to be entitled to claim exempt sales.
  • Sales to state and local governments are exempt, but they require the manufacturer to obtain a copy of the customer’s exemption certificate at or before the time of sale.

What should manufacturers do now?

Six months is not enough time to expect Treasury to clarify all these areas of uncertainty. Manufacturers of medical devices must design a plan of action so that they are prepared to pay the tax on sales beginning January 1, 2013.

It may be wise to resolve all doubts in favor of presuming that a device is taxable. This will enable manufacturers to determine a new pricing strategy and evaluate the competitive market. If the manufacturer initially pays tax on some sales that are later determined to be exempt, there is a procedure for claiming refunds or credits against future tax payments.

Nixon Peabody will continue to publish clarifications of these rules as they become available. We will also advise clients when it becomes possible to obtain IRS private letter rulings regarding the taxability of specific products.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

Posted at 5:31 PM by makeenan@nixonpeabody.com | Category: Excise Tax | Permalink | Email this Post | Comments (0)
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Postings on this site are intended as a general source of information for clients and friends of Nixon Peabody LLP. The content should not be construed as legal advice, and readers should not act upon anything posted here without professional counsel. This material may be considered advertising under the rules of professional conduct of certain states or countries. To ensure compliance with IRS requirements, we inform you that any discussion of U.S. federal taxation provided here (including any attachment or link) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter. Copyright © 2013 Nixon Peabody LLP. All rights reserved.   Terms of Use