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Thursday, December 13, 2018

TCJA Expanded Preparer Due Diligence Beyond What Congress and IRS Highlight

The Tax Cuts and Jobs Act enacted December 22, 2017, included over 100 tax changes. In the discussion of tax reform, there was a possibility that the head-of-household filing status would be repealed for simplification purposes. But, it was kept. To try to reduce the errors in claiming this status, Congress expanded the Section 6695(g) preparer penalty to include application of the penalty to a paid preparer who does not exercise the appropriate due diligence in preparing a return where the client claims that status. The penalty is $530 per failure.

The Section 6695(g) penalty has gradually expanded since it was first enacted in 1997 to reduce errors in claiming and calculating the Earned Income Tax Credit by paid preparers. In 2015, Congress expanded the penalty to also possibly apply to a preparer who prepares a return where the client claims the Child Tax Credit (CTC) or American Opportunity Tax Credit (AOTC).

Congress and IRS have highlighted that the TCJA expanded the penalty to cover returns where the client claims head-of-household filing status. See for example, this November 7 news release (IR-2018-216). Well, the TCJA actually made this penalty potentially apply even more broadly! The TCJA temporarily repealed the personal and dependency exemptions. The dependency exemption was partly replaced with a $500 per dependent credit. Generally, this credit is available for your children over age 16 and under 19 (under age 24 is a full-time college student). It is also available to a qualifying relative. If a child is under age 17, the parent most likely gets a $2,000 credit for that child instead of $500.

The $500 credit is new and Congress put it in IRC Section 24 where the CTC is located. The Section 6695(g) penalty applies to "the credit allowable by section 24." So, the $500 dependent credit requires paid preparers to do extra due diligence to be sure the client is entitled to any such credit claimed. This basically means asking appropriate questions and documenting the questions and answers and maintaining this information and any documents received for at least three years after filing the return. Form 8867 must also be attached to the return.


What do you think?

Additional resources for Form 8867 and the Section 6695(g) preparer penalty:

  • Section 6695
  • Final regulations released in November 2018 (TD 9842 (11/7/18)
  • Draft instructions for Form 8867
  • Information from the California Franchise Tax Board on head-of-household status (California requires additional information on a return claiming this status due to potential for mistake)
  • Due diligence for the EITC, CTC and AOTC (IRS Pub 4687) (let's see if this gets updated to address all items under Section 6695(g))
  • AOTC - Pub 970 includes some helpful flowchart a preparer might want to have a client use to determine if they might be eligible for the AOTC

Friday, December 7, 2018

Revenues and customers can still be a hobby

For a few years, I have noted in update presentations and elsewhere that some gig drivers who only drive occasionally, do it for cash generation or to pass the time, or have other income sources, might really have an activity not engaged in for profit ("hobby"), rather than a business. The tax consequences of the hobby designation are tremendous in that no deductions are allowed starting in 2018. No self-employment tax is owed either, but loss of tax deductions for a gig driver is costly.  Following is an example of a taxpayer with revenues, customers and a business premises who was found not to be engaged in a business.

Revenues Not Enough to Indicate Business – Ford, TC Memo 2018-8 (1/25/18), aff’d No. 18-1524 (6th Cir., 11/5/18, not for publication) – F used to be recording artist and spend most of her life promoting and performing country music. For the years under exam -  2012 through 2014, she owned and operated the Bell Cove Club in Tennessee on her own. Earlier, she and her husband operated this club (starting in 1986) and wanted it to be a place where artists could perform for talent scouts and producers. It closed when her husband died in 1999 but Joy reopened it in 2008. Customers only had to pay $5 for admission and a small amount for food. F paid performers. Losses were generated. F had some plans she pursued to convert the club into a restaurant or televise the performances, but these changes did not materialize. The IRS disallowed the losses finding the club not operated for profit. The court agreed finding the club was operated mostly for personal pleasure rather than profit with the losses offsetting investment income of F.
F appealed to the 6th Circuit which upheld the Tax Court decision as it did not find any error in that court’s analysis. At the start, the 6th Circuit notes:
“’Find a job doing something you love.’ Perhaps that is sound advice.  But deducting business losses from your taxes when you are not trying to profit from the business you love is not a sound strategy.  Here, the Tax Court found that the appellant did just that: ran a business doing something she loved, accumulated substantial losses, and deducted those losses from her income. Because the court below did not commit clear error in making this determination, we AFFIRM.” The court re-examined the factors under Reg. 1.183-2 that help distinguish a business from an activity not engaged in for profit and concluded that the club wasn’t operated in a for-profit manner. For example, the court noted that Ford did nothing to reduce costs, leaving empty refrigerators and stage lights running even when the club wasn’t open for business. Also, she did not adjust the cover charge to help make a profit. In addition, she did not want to serve alcohol, but let patrons bring in their own. Per the court: “The record paints a picture of a business operated without regard to cost or profit. There is nothing indicating Ford operated in a “business-like manner.””
Observations: The Tax Court generally applied Reg. 1.183-2 without going through a detailed analysis of each of the nine factors. In contrast, the 6th Circuit analyzed each of the nine factors. But both courts concluded that the club was an activity not engaged in for profit (a hobby). Often, we think that an activity with customers and revenues is automatically a business. But more is needed under IRC sections 162 and 183 and the regulations and court cases. Today, this issue can arise with some occasional, part-time gig workers. They generate income from, for example, using the Uber or Lyft platform, but do not set prices, have no business plan, do not regularly engage in the activity, do not have separate financial records, may be doing the activity to generate cash for bills and/or pass the time. These individuals may fall into the same situation as Joy Ford. A tax adviser can help these individuals to convert their hobby or activity at risk of being a hobby into a business by following the Reg. 1.183-2 factors to make the activity a business. After the TCJA, a hobby means all of the revenue is reported, but no deductions are allowed.
What do you think?

Tuesday, November 20, 2018

California, the CDTFA and the Wayfair Decision

On October 24, 2018, the California Department of Tax and Fee Administration (CDTFA) held an information session on the Wayfair decision's application in California. California's statute says we interpret the commerce clause as is done at the federal level. So that interpretation changed with the US Supreme Court's decision on June 21, 2018 when they found that the longstanding physical presence nexus rule of Quill (1992) is incorrect and unsound.

I attended the hearing.  It was short and the CDTFA provided some helpful information about the application of Wayfair to district taxes in California, and more. They also took questions and comments. I offered a few. The CDTFA was also taking written comments.  Following is what I suggested to the CDTFA in my written comments. My key concern is that if California follows the South Dakota standard, hundreds of thousands (possibly even over 1 million, and all over the world) of remote vendors are going to meet the 200 or more transactions per year due to the 39 million possible customers in California (SD has a population under 1 million in contrast). Thus, the transaction threshold should be skipped and we aim for a sales and use tax system that balances realistic enforcement activity by the CDTFA and the continued need to have California buyers self-assess and pay use tax (which will apply in fewer transactions due to larger vendors meeting the $100K per calendar year threshold).

What do you think (please read on)?

“Retailer engaged in business in this state” as meaning “any retailer that has substantial nexus with this state for purposes of the commerce clause of the United States Constitution” (R&T §6203(c)) must now be interpreted in light of the U.S. Supreme Court’s new commerce clause interpretation as spelled out in South Dakota v. Wayfair, 138 S.Ct. 2080 (6/21/18). This is not an easy task, but a necessary one as the statute needs to be followed.
Key elements of the Wayfair decision:
  • The “physical presence rule of Quill [Corp. v. North Dakota, 502 U.S. 808 (1992)] is unsound and incorrect.”
  • The physical presence standard should not be the standard for the “substantial nexus,” first part of the four-part test of Complete Auto Transit (430 U.S. 274, 279 (1977)).
  • Physical presence is an “arbitrary, formalistic” measure.
  • South Dakota’s sales tax collection requirement protects interstate commerce by ensuring “sufficient nexus” based on both “economic and virtual contacts” sellers have with the state. Three features of South Dakota law (S. 106 (2016)) support this:
a.     Safe harbor for limited business activity: South Dakota law only requires remote sellers who annually have over $100,000 of sales of goods or services into the state or 200 or more transactions.
b.     No retroactive application: There is no obligation to remit sales tax for years preceding the effective date of the state’s remote sales law.
c.      A system to reduce administrative and compliance costs: South Dakota follows the Streamlined Sales and Use Tax Agreement (“SSUTA”). The SSUTA requires uniform definitions, state level tax administration, and the provision of compliance software to sellers with audit protection to those who use it.
d. The Court did not find that all remote sellers can be subject to a state’s taxes.
The first two of the three features of South Dakota law are relatively easy to implement. However, the third feature is not so simple and it is not clear how important each feature of the SSUTA is. For example, is it the availability of free, audit protected software to remote sellers? Or are other compliance features possible substitutes?
Another factor to consider is that California with a population of 39.5 million, relative to South Dakota’s population of 870,000, presents an entirely different administrative challenge for the CDTFA. That is, far more remote vendors will meet the 200 or more transactions in a year in California than in South Dakota. These sellers are not only located in the U.S. but outside of California, but also outside of the United States. For example, Amazon’s Fulfillment by Amazon (FBA) program, Shopify and eBay serve sellers from outside of the U.S. It would be very easy for a vendor selling socks, books, holiday decorations, or other tangible items to have 200 customers in a year in California. In addition, other sales sites including crowdfunding sites where emerging businesses provide tangible goods to funders, can easily become “retailers engaged in business” in California under the limited business activity thresholds of South Dakota law that were reviewed by the Court.
The significant number of vendors that would be subject to sales tax collection in California under the South Dakota thresholds raises at least two challenges:
1)     Possible litigation under the commerce clause that the burden of compliance with California and other state tax laws is an undue burden on interstate commerce. While the Court did uphold the South Dakota law, the retailers involved in the litigation all had annual revenues exceeding $1 billion. The Court did not consider that the 200-transaction threshold could apply to vendors with far less than $100,000 annual sales in a state. In its amicus brief, Etsy states that in 2017, 1.9 million businesses using its site generated $3.25 billion of gross sales. This averages $1,711 per seller. Many of these sellers though, could easily have 200 or more transactions in states with large populations such as California. This litigation possibility is not unique to California but could arise in any state.
Application of the 200-transaction threshold without the SSUTA features or SSUTA-type features might also lead to litigation on the basis that the state’s broadened nexus reach violates the commerce clause and is not in line with the Supreme Court’s new nexus interpretation.
2)     Can the CDTFA effectively administer sales tax administration for hundreds of thousands of remote vendors that would meet the 200-or-more-transaction threshold and treat such “retailers engaged in business in this state” similar to retailers physically present in the state? Also, is this significant task an appropriate use of resources considering the ability to continue to collect use tax from in-state buyers who are not charged sales tax by a seller? The Wayfair decision does not eliminate the need to continue to enforce use tax laws against in-state buyers as not all sellers will meet sales tax collection requirements under the South Dakota thresholds.
New sales tax collection obligations for vendors requires vendors to make possibly significant changes to be ready to calculate, collect and remit the sales tax. Software is likely needed that needs to be integrated into existing recordkeeping and sales software. Vendors may need to seek assistance from tax advisers which requires time in finding an adviser and ensuring everything is properly in place so that collection and remittance can be performed correctly and efficiently. Thus, when the CDTFA announces a date for when its interpretation of Revenue and Taxation §6203(c) in light of the Wayfair decision is effective, there should be sufficient lead time (likely 90 days minimum) before any vendor is required to start collecting and remitting. Vendors need time to review sales of the past calendar year and current calendar year to see if they even meet the specified thresholds.
Similarly, going forward once a vendor crosses the collection thresholds, they should be given 60 to 90 days before they must start collecting, for the reasons noted earlier.
Also, changes in the responsibility of in-state vendors to start collecting district taxes in districts where the vendor meets the CDTFA threshold requires lead time to review past records and get a recordkeeping system in place to track where and when a vendor has new district tax obligations.
Finally, consumers may think that the Wayfair decision and the announcement of how the CDTFA will modify the interpretation of R&T §6203(c) in light of that decision, means that use tax is no longer required. Thus, it will be important to clarify this for both individual and business buyers so they know they still have use tax reporting and payment obligations when they are not charged sales tax on taxable items.

Additional Information:

Thursday, November 1, 2018

Digital Services Tax (DST) Plans Outside the US

New ways of doing business often challenge tax rules written for a different model. That is a concern expressed for many years by several countries. The concern is that it looks like companies that make money by other than selling tangible goods are profiting by activity in the country, but have no permanent establishment in the country, so owe no income tax. For example, a search engine company makes money when someone uses its search engine because it provides data to the company. And if the user clicks on an ad, the search engine company makes money. But no tax revenues go to the user's country.

The OECD, European Commission and others have been studying this for many years. The AICPA recently released a policy paper that explains the topic, issues and lists what some countries are doing or proposing. See AICPA Policy Report – Taxation of the digitized economy: A policy paper designed to educate, enlighten and stimulate discussion (October 2018).

The UK has also studied this issue and solicited comments on its suggestions. It now proposes to start a Digital Services Tax (DST) in 2020. In November 2017, the UK government released a discussion paperCorporate tax and the digital economy: position paper; later updated in 2018. The position is that “a multinational group’s profits should be taxed in the countries in which it generates value.”  Also see the UK policy paper – Digital Services Tax: Budget 2018 brief. It states:

 “The DST applies a 2% tax on the revenues of specific digital business models where their revenues are linked the participation of UK users. The tax will apply to: search engines; social media platforms; and online marketplaces. That is because the government  considers  these business models derive significant value from the participation of their users.”

The UK DST will only apply to businesses with at least £500 of global revenues ($650 million USD).

Congressman Brady, Chair of the House Ways and Means Committee, stated his opposition to the UK DST – On 10/31/18, he released the following statement:

“The United Kingdom’s introduction of a new tax targeting cross-border digital services – which mirrors a similar proposal under consideration in the European Union – is troubling.  Singling out a key global industry dominated by American companies for taxation that is inconsistent with international norms is a blatant revenue grab. 

“The ongoing global dialogue on the digital economy through the OECD framework should not be pre-empted by unilateral actions that will result in double taxation. If the United Kingdom or other countries proceed, that will prompt a review of our U.S. tax and regulatory approach to determine what actions are appropriate to ensure a level playing field in global markets.”

Spain has also proposed a DST of 3%.  See DLA Piper Global Tax Alert 11/1/18.

Is a new tax the answer? Can existing income taxes be modified to address where income is generated? How easy it is to know where income is generated? I think technology makes it possible to know the location of the person clicking on a social media ad. The harder question might be where is that income generated for tax policy purposes. That has been a longstanding multistate question - where the costs of performance occur or at the destination, or perhaps some combination?

What do you think?

Sunday, October 14, 2018

More on Wayfair

There have been many articles on the June 2018 US Supreme Court's decision in South Dakota v Wayfair. But, that's not surprising given the decision overrode 51 years of state tax precedence!  I've written two article (so far) and a few blog posts.

One post was on where I asked the question - what if the parties were not billion dollar vendors? I think it is too bad the vendors in the case were so large. After the case, Wayfair issued a press release noting that it was already collecting tax on 80% of sales with that figure growing as its logistics footprint grows (that is, it was setting up distribution or other operations in more states).

Wayfair's 2017 10-K also indicates it has over 1,300 engineers and data scientists! Well, that makes it a lot easier to create a logistics system to collect sales tax from all customers and remit it to the state. What about a vendor who sold 200 $1 items to customers in the state?

Additional examples of small vendors I came across recently in doing research on taxes and crowdfunding are small vendors raising money on crowdfunding sites such as Kickstarter. In fact, I gave $30 to a party trying to raise funds to create and distribute calendars. And they are not alone. There are similar sites where someone is trying to raise funds to create a comic book, artwork and more calendars. If the party I gave the money to hits his target (and he did), I'll be sent a printed calendar. The party says they will ship to anywhere in the world. Well, 200 or more of these sales in a state will create sales tax collection costs too in a growing number of states, despite being what appears to be a small vendor. Hitting that figure is more likely in high population states such as California.

I see that some of the sellers of calendars and comic books are providing a pdf of the item. While that is not taxable in all states, the seller needs to check the law in each state to be sure and for states that find sales tax nexus with 200 or more transactions in the state, whether that figure includes taxable and non-taxable transactions in that count.

Some states and likely more will enact legislation making the "marketplace facilitator" such as Etsy and eBay collect tax.  I think Kickstarter and other crowdfunding sites will likely fall under this definition, but states should be sure (see Pennsylvania's definition here). Unlike eBay and Etsy, Kickstarter does more than help people sell products. Also, the funders might be providing more than needed to receive the product. That raises more issues on the sales tax collection side. Also, when must the sales tax be remitted because on many sites, the party doesn't get the funds if their target is not met, or they might get the funds, but never deliver the product.

What do you think?