Blended IRS Interest Rate for Interest-free or Low-interest Loans

You can be taxed on “imputed interest” if you make an interest-free loan to a relative, or if you charge interest at less than the applicable federal rate (AFR) set by the IRS.  If you do not charge interest equal to the applicable AFR, the interest that you do not charge is “imputed” to you by the IRS and taxed to you as interest income. Imputed interest rules also apply to low-or-no interest loans to an employee; the imputed amount is treated as interest to the employer and taxable compensation to the employee.

Many family loans are exempt from the imputed interest rules because of the $10,000 and $100,000 gift loan exceptions in the law. If your loans to another individual (total balance of all loans) do not exceed $10,000, and the loans are not used to purchase or carry income-producing securities, there is no imputed interest. Under the $100,000 exception, no interest is imputed if you make loans to an individual of up to $100,000 (total loan balance owed to you), the borrower’s net investment income for the year does not exceed $1,000, and tax avoidance is not a principal purpose of the arrangement. If the borrower’s net investment income exceeds $1,000, there is imputed interest, but it is limited to the borrower’s net investment income.

For loans to employees and shareholders, the imputed interest rules do not apply if the total amount of outstanding loans between the parties is $10,000 or less, provided tax avoidance is not a principal purpose of the loan. Certain job-relocation loans to employees also are exempt.

If the gift loan or employee loan exceptions do not apply, figuring imputed interest can get complicated, as the AFR that must be used to avoid imputed interest depends on whether the loan is payable on demand or a term loan, and for term loans, the length of the term. To simplify the computation, the IRS provides a “blended” rate that can be used for certain loans to relatives or employees that are payable on demand. The blended rate can only be used for a demand loan that has a fixed loan amount outstanding for the entire year. If the loan is not outstanding for the whole year, or the loan balance varies, the blended rate is not available and the regular AFR-based imputed interest computation applies.

For 2017, the blended rate is 1.09% (Revenue Ruling 2017-14).  For example, assume a business makes an interest-free loan of $50,000 to an employee, payable on demand.  If the $50,000 loan is outstanding for all of 2017, the imputed interest to the employer and the imputed amount of compensation to the employee for 2017 using the blended rate is $545 ($50,000 x 1.09%).

Court Rejects TurboTax Defense

An insurance consultant’s clients are currently primarily accountants. Nonetheless, he prepared his own return for tax years before he had these clients. He admitted to the Tax Court that he made a lot of mistakes when he prepared the return. He claimed payments to his former spouse were deductible. He claimed various business expenses, including interest payments, were deductible. Unfortunately, these deductions were disallowed:

  • It was true that he made these payments to his former spouse, but they were made pursuant to the couple’s oral agreement and not to a court decree or written separation agreement. Thus under tax law they were not deductible.
  • It is also true that he made certain payments, such as interest, but the amounts paid to the lender did not match amounts reported on the returns. What’s more, there were no business records for the loan, any loan statements, or any loan repayment schedules. Without such documentation, it was impossible to determine whether the payments were made on the original loan as he claimed. His claimed deduction for “other expenses” was supposed to be a net operating loss carryforward, but it was entered on the wrong line of the tax return. Again, these deductions were disallowed.

Because of these errors, the IRS imposed an accuracy-related penalty for a substantial underpayment of tax. This penalty applies if the understatement of tax exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. To avoid the penalty, the burden is on the taxpayer to prove that there was reasonable cause and that he acted in good faith. In this case, he said that his software—TurboTax—lured him into claiming some of the deductions (the “TurboTax defense”). The Tax Court dismissed this argument as meritless (Barry Leonard Bulakites, TC Memo 2017-79). He took deductions he shouldn’t have and overstated certain losses. He can’t blame the software, because it is only as good as the information inputted into it.

IRS Announces Health Savings Account Changes for 2018

The IRS has released the 2018 contribution limits for health savings accounts (HSAs), as well as the requirements for high-deductible health plans (HDHPs), since you can only contribute to an HSA if you have health coverage through an HDHP (Revenue Procedure 2017-37, 2017-21 IRB 1252). An HDHP must have a minimum annual deductible and a limit on out-of-pocket expenses other than premiums. The 2018 amounts are slightly higher than for 2017. The table below shows the year-to-year comparison.

An HSA is an IRA-type of account for medical expenses that can offer multiple tax benefits:

Contributions to the HSA are tax deductible. You don’t have to itemize deductions to take this write-off. You can make contributions up until the due date for filing that year’s return. For 2017 returns, the deadline is April 17, 2018, and for 2018 returns, the deadline is April 15, 2019.

Earnings in the account grow on a tax-deferred basis.

Withdrawals to pay qualified medical expenses for yourself, your spouse, or your dependents are tax free. Withdrawals for any other purpose are permissible, but taxed as ordinary income. If you’re under age 65, the non-qualified withdrawals are also subject to a 20% penalty; there’s no penalty once you reach age 65 regardless of how you use the withdrawals.

Health care reform could expand HSA benefits. The American Health Care Act (AHCA), passed by the House on May 4, would nearly double the deductible HSA contribution limit by making it equal to the HDHP cap on out-of-pocket expenses. The AHCA would also broaden the category of qualified medical expenses that could be paid tax free from an HSA, and reduce the penalty for non-qualifying withdrawals to 10% (from 20%). However, the fate of the AHCA in the Senate is uncertain. Stay tuned for future developments from Congress.

 

HSA and HDHP RULES for 2017 and 2018

IRS AMOUNT

SELF-ONLY COVERAGE

FAMILY COVERAGE

2017

2018

 2017

2018

Maximum deductible contribution*

$ 3,400

$3,450

$6,750

$6,900

Minimum HDHP deductible

1,300

1,350

 2,600

2,700

Cap on out-of-pocket costs (such as deductibles and co-pays but not premiums)

6,550

6,650

13,100

13,300

* An additional “catch-up” contribution of $1,000 is allowed if you are age 55 by the end of the year, provided you are not enrolled in Medicare. The $1,000 catch-up amount is set by statute with no annual inflation adjustments. No further HSA contributions (regular or catch-up) can be made starting with the month you enroll in any type of Medicare.

Average Itemized Deductions for 2015

The IRS provides a wealth of preliminary tax data for tax year 2015 in the Spring 2017 Statistics of Income Bulletin (SOIB). The data is based on a sample of 257,083 individual income tax returns for 2015, processed between January and late September of 2016, out of a total of 150.6 million returns. The preliminary data can be found at https://www.irs.gov/pub/irs-soi/soi-a-inpd-id1703.pdf.

Included in the SOIB is data on itemized deductions. Based on the IRS sample, the standard deduction was claimed on 69.2% of 2015 returns and itemized deductions were claimed on only 29.5%(neither the standard deduction nor itemized deductions were needed on the remaining 1.3% of returns that had no AGI).  The amount of total itemized deductions claimed increased 4.2% compared to 2014, up to $1.2 trillion.  The average claim for itemized deductions was $27,053.

The most claimed itemized deduction by far is the deduction for taxes paid, which includes state and local income taxes and general sales taxes as well as real estate taxes. For 2015, $539.8 billion in taxes was deducted, 6.2% more than for 2014. The next largest deduction, for interest paid, was down 1%, to $294.5 billion, of which 94.6%, or $278.5 billion, was for mortgage interest. Charitable contribution deductions totaled $201.3 billion, a 6% increase. Medical and dental expenses were up 3.5% to $84.2 billion.

Based on the IRS data, we have prepared the table below, which shows the average 2015 itemized deductions claimed for medical (including dental) expenses, taxes, interest, and charitable contributions by taxpayers in the seven AGI categories provided by the IRS.  Note that the highest income group is for those with AGI of $250,000 or more. The averages shown for these taxpayers may be misleadingly high, because the amounts claimed by the very highest earners could dwarf those claimed by those with AGI closer to $250,000, but the IRS does not provide a further break-down.

AVERAGE ITEMIZED DEDUCTIONS FOR 2015

AGI (thousands) Medical Taxes Interest Charitable
Under $15 $ 9,210     3,667     6,397    1,533
15- <30    8,646     5,497     6,572    2,483
30- <50    8,761    4,027     6,357    2,812
50- <100    9,426    6,323     7,382    3,244
100- <200   11,305 11,052     8,905    4,155
200- <250   17,625 17,711   11,370    5,779
250 and more   37,032 51,906   16,580  21,769

Portability Election Relief

Under estate tax rules, if a spouse dies and does not use up his/her entire exemption amount ($5.49 million if death is in 2017), the surviving spouse’s estate can use the balance. This is called the deceased spousal unused exclusion amount (DSUE amount) or “portability.” It became effective with respect to decedents dying after 2010. In order to make this possible, the estate of the first spouse to die must make a timely election.

How to make the election. The election must be made within nine months of the death of the first spouse on a federal estate tax return. This is so whether or not the estate is large enough to be required to file an estate tax return (e.g., valued at more than $5.49 million for a spouse dying in 2017). No extension of time to make the election will be granted to an estate required to file an estates tax return, but the IRS may grant one to a smaller estate. The problem: To request an extension means submitting a private letter ruling request, and this can only be done if there is reasonable cause for the failure to timely elect portability. Moreover, there are substantial professional fees and IRS user fees for making the request. There had been a simplified request method, but it only applied through December 31, 2014.

Special relief. Because many small estates were unaware of the requirement to make an affirmative election, the IRS has provided relief to estates of decedents dying after 2011 and before January 2, 2016 (Rev. Proc. 2017-34, 2017-26 IRB 1282). These estates are given two years to submit an election; the deadline is January 2, 2018. State at the top of the return “FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER § 2010(c)(5)(A).”

If the surviving spouse has died and the estate paid estate tax that would not have been due if a portability election had been made, it can file Form 843, Claim for Refund and Request for Abatement, as a protective claim or refund of tax if the estate of the first spouse has now made or will make a portability election.

Pending legislation. The question of portability may become moot if Congress repeals the federal estate tax, a proposal that is currently under consideration. However, the rules for making an election should be following nonetheless should the estate tax be reinstated in the future.

Back Pay Recovery Can Include Tax Burden

A person who suffers job-related discrimination may be awarded back pay. Recently, a district court said that the award could be increased to account for the person’s tax bill on the recovery (Greg Allen, et al., District Court, Indiana, 4-18-17, No. 1:02-cv-00902).

The case involved an electrician who was denied a job because of race. He was awarded $363,000 for back pay. Such an award is includible in gross income; only amounts for personal physical injury are excludable. The district court permitted the award to be increased to reflect the tax liability on that award. The case was brought within the Seventh Circuit, and in 2015 the Seventh Circuit joined the Third and Tenth Circuits in holding that it is appropriate to provide an additional award to account for the tax burden in cases involving racial discrimination (Title VII of the 1964 Civil Rights Act).

These three appellate courts (the Third, Seventh, and Tenth Circuits) have recognized that if the pay had been received in the regular manner, the taxes would have been much lower than they are when received in a lump sum. In order to make the injured party whole, taxes should be factored in.

Fast Track Settlement Procedures for the Self-Employed

The IRS has long had a fast track settlement program for large and mid-sized businesses to resolve outstanding legal and factual issues in contention through mediation. The IRS had started a similar program for small businesses and self-employed individuals and, over the years, extended and expanded it. Now this program—Fast Track Settlement (FTS)—is permanent.

This mediation option is commenced when an eligible taxpayer files Form 14017, Application for Fast Track Settlement, and submits the Application Package. Once accepted, the process is handed by an Appeals Officer trained in mediation, who serves as a neutral party. The IRS says that a settlement can be reached within 60 days of acceptance of the application. The resolution is not binding on the parties. However, once a taxpayer opts for FTS, post-appeals mediation is not available for any issues that had been considered. Of course, if a taxpayer continues to dispute the IRS position, litigation is always an option.

Not all cases can be addressed in FTS. For example, it cannot be used for a correspondence audit. The list of cases for which FTS can and cannot be used are listed in Rev. Proc. 2017-25 (2017-14 IRB 1039).

LLC Member-Managers Subject to Self-Employment Tax

General partners are subject to self-employment tax on their distributive share of partnership interest (Code Sec. 1402(b)). In contrast, limited partners are not subject to self-employment tax on their distributive share (Code Sec. 1402(a)(13); they only pay self-employment tax on guaranteed payments. Should members of limited liability companies be treated as general partners or limited partners for purposes of self-employment tax?

This is a question that’s been unsettled for 20 years. The IRS had proposed legislation that was subject to a moratorium until July 1, 1998. Even though that date has passed, there has been no additional IRS guidance on the question. It remains on the 2016-2017 Priority Guidance List.

The Tax Court recently shed some light on the issue (Vincent J. Castigliola, TC Memo 2017-62). The case involved three attorneys of a professional limited liability company (PLLC). Each attorney was a member-manager, which meant each one had management power over the business. There was no written operating agreement that limited this power in any way. All of the members participated in relevant decision-making, including decisions about distributive shares, borrowing money, hiring and firing, and the rate of pay for employees. They all supervised associate attorneys and each signed checks.

The court determined because they were managers, they were not “functionally equivalent” to limited partners and could not rely on the exemption from self-employment tax that applies only to the distributive share paid to limited partners. The court noted that the Uniform Limited Partnership Act says that a limited partner can lose personal liability protection if he or she takes part in the control of the business. In contrast, a member-manager does not lose personal liability protection when he or she exercises control. Thus, a member-manager more closely resembles a general partner. As such, their distributive shares were subject to self-employment tax.

Depreciation Limits for Vehicles Placed in Business Service in 2017

If you use a car, light truck or van for business, you can claim depreciation in addition to your vehicle operating costs (gasoline, oil, repairs, insurance, parking and tolls allocated to business use) if that is more than the IRS’ standard mileage allowance, which for 2017 is 53.5 cents per mile. However, the depreciation deduction is subject to an annual ceiling. If the amount allowed under the regular MACRS depreciation rules is more than the annual ceiling, you can only deduct the ceiling. The annual ceiling does not apply to (1) certain delivery trucks, modified trucks and moving vans that the IRS considers to be not conducive to personal use, and (2) trucks, vans and SUV’s weight-rated by the manufacturer at over 6,000 pounds gross vehicle weight.

The tables below show the year-by-year depreciation ceilings for vehicles placed in service in 2017 (Rev. Proc. 2017-29, 2017-14 IRB 1065). Note that the first -year limit depends on whether “bonus depreciation” applies. For a vehicle that is purchased new and used over 50% for business in 2017, bonus depreciation allows an extra $8,000 increase to the first-year depreciation limit, assuming you do not “elect out” from the bonus rule. Bonus depreciation only affects the limit for the first year.

Depreciation Limits for Passenger Cars Placed in Service in 2017

Tax year Ceiling
1st year $11,160 ($3,160 if no bonus depreciation)
2nd year $5,100
3rd year $3,050
Succeeding years $1,875

 

Depreciation  Limits for Light Trucks and Vans Placed in Service in 2017

Tax year Ceiling
1st year $11,560 ($3,560 if no bonus depreciation)
2nd year $5,700
3rd year $3,450
Succeeding years $2,075

 

Personal use reduces annual limit. The amounts shown in the tables above assume 100% business use of the vehicle, and must be reduced if there is any personal use. For example, if in 2017 you buy and place in service a new passenger car that you use 75% for business, the dollar limit on depreciation, taking into account the extra allowance for bonus depreciation, is $8,370 ($11,160 x 75%).