Wednesday, January 30, 2013

Tax Break for Employees of Communist Fronts

Internal Revenue Code section 3121(b)(17) provides that the Social Security tax does not apply to wages from any:
"service in the employ of any organization which is performed (A) in any year during any part of which such organization is registered, or there is in effect a final order of the Subversive Activities Control Board requiring such organization to register, under the Internal Security Act of 1950, as amended, as a Communist-action organization, a Communist-front organization, or a Communist-infiltrated organization, and (B) after June 30, 1956."

This provision was added in 1956 to the Internal Revenue Code, in order to deny Social Security retirement checks to the much-feared Communists. Naturally, the Communists were not required to pay into Social Security either.

Congress was particularly irked by a 1955 Washington Daily News article entitled "Red Inmate Gets $88.10 Monthly Security From Hand He Tried to Bite," about a 65-year-old Communist serving a three year prison sentence for conspiring to overthrow the US government, who received Social Security checks while in prison and before his deportation to Russia.
(Senator John Williams complained in gender-confusing terms that all convicted felons were still entitled to Social Security, other than a "person who would thus benefit from his own crime, such as a woman who murdered her husband and thus became eligible for social security.")

What was a penalty in the 1950s might be a blessing today.  Younger employees nowadays might prefer to forgo paying the Social Security Tax and give up on the fragile likelihood of receiving Social Security checks in their retirement.  The employers would also save some money on their Social Security contributions. 

Unfortunately, it is currently unclear how to register one's employer as a Communist-front or Communist-infiltrated organization.  The mandatory registration requirements of the Internal Security Act of 1950 were repealed in 1968 after some court cases found them to be unconstitutional.  The Subversive Activities Control Board was abolished in 1972.   Perhaps an employer could voluntarily send in a registration form and see how it goes.

Monday, January 28, 2013

Taxation of Frequent Flyer Miles

In a 1995 non-binding memorandum sent between IRS offices (TAM 9547001), the IRS hinted that frequently flyer miles might be taxable income (the IRS actually said that the employees should give the miles to the employer).  This created one of the largest firestorms in the history of the Internal Revenue Code.  The IRS caved in Announcement 2002-18, in which the IRS said it will not assert that frequent flyer miles are taxable income. 

However, the IRS noted that "[t]his relief does not apply to travel or other promotional benefits that are converted to cash, to compensation that is paid in the form of travel or other promotional benefits, or in other circumstances where these benefits are used for tax avoidance purposes."  A taxpayer who sells his frequent flyer miles, or sells a ticket bought with those miles, would be subject to tax. 

When the miles are provided outside the employer-employee context, however, the miles are most likely taxable income, such as when a bank gives frequent flyer miles for opening a bank account.  The value of the miles should be around 1 cent per mile, since that is the equivalent alternative in cash back that most credit cards offer.

Frequent flyer miles given for opening a credit card is another murky area.  If 50,000 miles are given after achieving a minimum spending of $5000, for example, one reasonable view is that the miles are a partial refund for the $5000 in expenses.  The taxpayer has no taxable income but is treated as actually paying $4500 for the purchased goods and services.

What about an employee who:
1. bills his employer's clients for first-class travel,
2. buys a coach ticket with much less cash,
3. uses his frequent flyer miles to upgrade the ticket to first class, and
4. pockets the difference?

Thursday, January 24, 2013

Tax Break for Public Transportation Users (TransitCheks, eTRAC, WageWorks, etc)

In 2013, Congress extended the ability for employees to buy public transportation with up to $240 a month of pre-tax dollars.  This usually takes the form of specialized credit cards like TransitCheks, eTRAC, WageWorks, FlexDirect, Commuter Check, RideECO, etc., or vouchers that can be used to buy tickets.  The money is taken out of an employee's paycheck before tax, which effectively reduces the employee's taxable income by up to $2,880 a year. 

After 2013, the monthly limit goes back down to around $125 a month, unless Congress increases the limit again. 

To answer the most frequently asked question about TransitCheks and eTRAC cards:
Yes, the money can be used to buy MetroCards or other tickets for someone else.  The employee does not have to personally use all of the public transportation himself (or herself).  

Treasury Regulation section 1.132-9(b) Question and Answer 18 provides: What are the substantiation requirements if an employer distributes transit passes?  "There are no substantiation requirements if the employer distributes transit passes. Thus, an employer may distribute a transit pass for each month with a value not more than the statutory monthly limit without requiring any certification from the employee regarding the use of the transit pass."

On a related note, the money does not have to be used solely for transportation between home and work.  Obviously someone who buys a monthly MetroCard can ride the subway on the weekend.  Less obviously, the money can be spent on Amtrak tickets or on public transportation in another city while on vacation.

Technically, Internal Revenue Code section 132(f) provides that an employee is not taxed on "any transit pass" received by the employee from the employer.  The term “transit pass” means "any pass, token, farecard, voucher, or similar item entitling a person to transportation (or transportation at a reduced price) if such transportation is (i) on mass transit facilities (whether or not publicly owned)," or (ii) in a bus or van that seats at least six people and carries mostly people who work at the same place.

The above statute answers the second most frequently asked question, one that is also raised by the beginning scene in the movie The Devil Wears Prada:
No, the money cannot be used to pay for a cab to work. 

Tuesday, January 22, 2013

Tax Break for Employee Achievement Awards

The Internal Revenue Code contains the answer to everyone's question of whether employee achievement awards should be considered taxable income.  The answer is way more complicated than it should be.

If the award is an item awarded for "length of service" or "safety achievement," the award can generally cost up to $1,600 and not be considered taxable income to the employee.  Nearly all other awards result in taxable income, unless the value of the item is minimal.

A taxable award.
Employee achievement awards were apparently a hotbed of tax evasion in earlier years, because the Internal Revenue Code requires for tax-free awards that:
1. The length-of-service or safety-achievement awards must be "awarded as part of a meaningful presentation,"
2. A length-of-service award cannot be given to someone who has worked for less than five years,
3. An employee cannot receive a length-of-service award more than once every five years,
4. The award is not in the form of cash, vacations, meals, lodging, tickets to theater and sporting events, or stocks, bonds, and other securities.
5. The $1,600 cap applies to all awards received by a single employee during the year,
6. Tax-free safety achievement awards cannot be given to a manager, administrator, clerical worker, or other professional employee,
7. Safety achievement awards cannot be given to more than 10% of all the company's employees in a single year,
8. Safety achievement awards must be given to full-time employees who have worked for at least one year.
9. The award's circumstances cannot create a significant likelihood that it is being used as disguised compensation, such as giving the "award" around the time of annual bonuses,
10. If the award discriminates in favor of highly compensated employees who make more than $115,000 a year, the $1,600 cap is reduced to $400 per employee, and
11. There are maximum limitations on the average cost of all employee achievement awards.

From 1981 to 1986, employee achievement awards could also be given for "productivity," but Congress eliminated that category for an unknown reason.

Friday, January 18, 2013

Tax Break for Startup Founders (But Not So Much for Californian Founders)

The tax code contains several tax breaks for the stock of certain qualifying small businesses:

1. If the stock is acquired between late-2010 and December 31, 2013, the federal tax rate is 0% for any gain on stock held for more than five years (Internal Revenue Code section 1202),
2. The federal capital gains rate is reduced by 50% to 75% for stock acquired at other times, and
3. Even if there is taxable gain, the gain is deferred if the taxpayer invests in another qualified small business (section 1045).

The Californian tax code did not follow the same rules, but it contained similar tax breaks that applied only to Californian small businesses, which must have at least 80% of its payroll and assets be in California.  California taxed the gain at a rate of up to 6.65% (half the normal California top tax rate of 13.3%), and gain was deferred if the taxpayer invested in another Californian small business.  Both the federal and California rules were originally enacted in 1993.

California could use a time machine
(invented by a small business).
But on December 21, 2012, the California Franchise Tax Board revoked all of the above tax breaks retroactively to 2008 (pdf).  Any taxpayer who saved Californian taxes when selling Californian small business stock in 2008 and later must pay back the tax savings plus any interest and penalties.  The only reason California did not cancel the statute all the way back to 1993 was due to the the four-year-statute of limitations.

The reason for the drastic tax change in California was the Franchise Tax Board's loss in Cutler v. Franchise Tax Board (2012), which declared that the requirement that 80% of payroll and assets be in California to be unconstitutionally discriminatory against other states.  The taxpayer Cutler was a California resident who in 1998 sold stock in an Internet start-up that operated in other states and who deferred the gain by investing in three other small businesses. 

Following the defeat, California could have followed 40+ other states and allowed the tax breaks for all qualifying small businesses that operated in any state.  Instead, it took its ball and went home by cancelling the tax break for everyone for the past four years.

An affected Californian entrepreneur might consider challenging the constitutionality of the retroactive order, since the California Franchise Tax Board seems to have a poor track record in that front.

The complex definition of a "qualifying small business" and why it cannot be a motel or restaurant will be the topic of a later post.

Thursday, January 17, 2013

Tax Break for Babysitters

Everyone who has received a paycheck has noticed a sizable chunk of money taken out for Social Security and Medicare.  The Federal Insurance Contributions Act (FICA) tax pays for Social Security and Medicare by generally sending 7.65% of every paycheck to the government.  The employer chips in an additional 7.65% of the paycheck to the government, for a total tax of 15.3%.

Every employee is subject to the FICA tax unless there is a specific exception.  Internal Revenue Code section 3121(b)(21) provides that the FICA tax does not apply to domestic service performed in the private home of the employer by an employee under the age of 18, as long as the domestic service is not the principal occupation of the employee.  

Being a student counts as a principal occupation.  In other words, 17-year-old student babysitters and housekeepers do not have to pay into Social Security.  However, a 17-year-old single mother who drops out of school would have to pay into Social Security for her work as a domestic (Congress came up with this example).

This exception was added to the Internal Revenue Code in 1994 by the Social Security Domestic Employment Act of 1994.  Before the change, the FICA tax applied to anyone who earned more than $200 a year in domestic service, which greatly curtailed the pre-1994 babysitting industry.  The employer might have paid in cash off the books, but obviously nobody ever did that because that would be illegal.

The Code says that the domestic service employee only has to be "under the age of 18 during any portion" of the year.  Since most people age chronologically, this basically means the employee should be 17 or younger on January 1 of the year.

Most other child labor is subject to the 15.3% FICA tax in full.  Older domestic service employees are subject to the FICA tax if they make more than $1,800 a year from such domestic service.

Tuesday, January 15, 2013

Tax Break for Mother-in-Laws

Internal Revenue Code sections 4941 and 4946 prohibit various transactions between private foundations and certain "disqualified persons."  For instance, disqualified persons are not allowed to sell or rent property to the private foundation, even for fair market value.

Disqualified persons include:
1. A substantial contributor to the private foundation (generally gave more than $5,000 in total),
2. A foundation manager, and
3. Members of their family.

Section 4946(d) explains that for this purpose, family members include only the spouse, ancestors, children, grandchildren, great grandchildren, and the spouses of children, grandchildren, and great grandchildren.  As a result, Bill Gates can't sell property to his mother-in-law's private foundation, but his mother-in-law can sell property to Bill Gates's private foundation

Under a separate rule in Internal Revenue Code section 108(e)(4), a mother-in-law can buy the debts owed by her son-in-law without triggering adverse tax consequences, while the son-in-law who buys debts owed by the mother-in-law would cause the mother-in-law to pay more taxes.  The policy rationale of this rule is left as an exercise to the reader. 

More after the jump...

Monday, January 14, 2013

Tax Break for Supporting Poor Mexican or Canadian Relatives

Everyone who has filed a tax return has noticed the section devoted to claiming "dependents," each one of which reduces the taxpayer's taxable income by around $4,000.

Pets do not count as dependents.  Normally, only US citizens and US residents can be claimed as dependents, but Internal Revenue Code section 152(b)(3)(A) provides that a dependent can be a resident of Canada or Mexico, without having to be a citizen or resident of the United States.

Technically, the rule applies to residents of any country "contiguous" to the United States.
In contrast, foreigners who are residents of other countries cannot be claimed as dependents for tax purposes, no matter how dependent they are on the taxpayer for real life purposes.  In a 1970 case called Hoyle, for example, the taxpayer was not allowed to claim as dependents his three children who lived in the UK (and who were not US citizens). 

The Canadian or Mexican can qualify as a dependent in several ways.  For someone who doesn't live with the taxpayer, the easiest way to qualify is under the"qualifying relative" test:
1. The dependent has less than ~$3,800 of gross income during the year,
2. The taxpayer provides over half of the dependent's financial support during the year,
3. The dependent generally is not a dependent for US tax purposes of another US taxpayer,
4. The dependent is related to the taxpayer as a child, stepchild, other descendant, sibling (including step- and half-sibling), parent, step-parent, other ancestor, nephew/niece, aunt/uncle, or son/daughter/father/mother/brother/sister-in-law of the taxpayer, and
5. The dependent can be of any age.

A US taxpayer who supports a large family of low-income Canadians can save quite a bundle. 

(There are other exceptions for young adopted children and for certain nonresident aliens filing US tax returns, which future posts may cover.)

Saturday, January 12, 2013

Tax Break for Christmas Tree Farmers

The Internal Revenue Code has different tax rates for ordinary income and capital gains.  Capital gains, which are generally taxed at a lower rate, tend to be gains from investment assets held for a relatively long period of time.  Capital assets do not include inventory sold to customers in the ordinary course of business.  A farmer who sells cows and oranges, for example, would pay taxes on ordinary income. 

Internal Revenue Code section 631 effectively allows timber to be sold at capital gain rates.  This loophole, which has been around for a while, has greatly benefited the Oregonian timber lords.

Timber would normally be wood products like oak and cedar.  But section 631 helpfully clarified that the term “timber” includes evergreen trees which are more than 6 years old at the time severed from the roots and are sold for ornamental purposes.  Most Christmas trees qualify under this provision, since they take six to twelve years to be fully grown.

But the Big Christmas Tree industry is not satisfied with just one tax break (that reduces its tax rate from 35% to 15%). 

Internal Revenue Code section 263A contains rules on whether farmers can deduct their expenses in growing crops, or whether they have to capitalize the costs (and amortize it over time or benefit from the deduction only when they finally sell their crops).  Christmas tree farmers can deduct all of their expenses immediately, while other tree farmers (and general crop farmers) must wait several years until they sell the trees before they can benefit from the deduction. 

The above rules also apply to Christmas trees grown abroad by multinational Christmas Tree corporations.

Friday, January 11, 2013

Tax Break for Attending Conventions in Bermuda and Other Caribbean Countries

In 1976, Congress finally got tired of taxpayers claiming deductions for boondoggle business conventions in exotic foreign locations, and it imposed strict deduction limits for conventions located outside the "North American area."  The North American area consisted of the United States and its territories, Canada, and Mexico.

But a mere seven years of lobbying later, in the aptly-named Interest and Dividend Compliance Act of 1983, Congress expanded the definition of "North American area" to include select Caribbean countries as specified in the Caribbean Basin Economic Recovery Act.  Oh and it also included Bermuda, which is not very close to the Caribbean.

The end result is that a taxpayer attending a business convention in France or Peru must prove to the IRS that it is as reasonable for the convention to be held there as it is for the convention to be held within the North American area.  But the same rule does not apply to a doctor's tax deductions for attending a medical convention at a Dominican beach resort.

The list of select qualified "Caribbean" countries are:
Antigua and Barbuda
Costa Rica
Dominican Republic
Netherland Antilles
Trinidad and Tobago

I hear the business convention facilities are fabulous in these countries.

Thursday, January 10, 2013

Tax Loophole for Chrysler

In 2008, Congress enacted a special tax provision that applied only to:

1) a domestic partnership entity,
2) that was formed effective on August 3, 2007, and
3) produced over 675,000 cars during the period from January 1, 2008 to June 30, 2008.

Coincidentally, the only taxpayer that qualified for this special tax provision was Chrysler LLC.
(Ford and General Motors made a lot of cars too, but they were organized as corporations instead of partnerships)

Every eligible partnership that met the above requirements could receive from the IRS a payment of up to $30 million in cash, in exchange for giving up on certain special depreciation deductions and research credits (which the partnership may or may not have been able to use). 

The Internal Revenue Service is required to send the $30 million of cash to the partnership even if the partnership failed to pay its taxes and still owed the IRS money.

The IRS issued at least two Revenue Procedures to guide everyone on how to use this provision, in order to reduce the barrage of questions it was getting from all the eligible taxpayers (Revenue Procedure 2009-16 and Revenue Procedure 2009-33).