One Year Anniversary of TCJA

On December 22, 2017, President Trump signed an Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, commonly referred to as the Tax Cuts and Jobs Act (Public Law 115-97). While there were over 100 hearings on tax reform starting in 2011, and a "unified framework for tax reform" released in September 2017, the final legislation moved quickly over about five weeks. There were no public hearings to analyze proposals or look at the big picture to be sure it was the type of reform needed.  The law has a long name because it was created via the budget reconciliation process so that the Senate could pass it with 51 votes rather than the usual 60. The TCJA was a partisan process.

On its anniversary, I'll offer just a few observations on the TCJA:

1. It's major goal was to lower the corporate rate and move the corporate system to more of a territorial system. This was accomplished with a flat rate of 21% rather than the prior top rate of 35%.
2. There are several new areas of complexity including an interest expense limitation of Section 163(j), excess business loss limit of Section 461(l), extra calculations for high income individual business owners under Section 199A (it is simpler if the individual has taxable income below $157,500 ($315,000 if MFJ); and most people are below these levels), and a new international regime with many new rules and complexities.
3. Most of the individual changes, including the rate reductions are temporary for 2018 through 2025.
4. With over 100 changes and the need for lots of guidance from the IRS, we continue to find surprises. One that dawned on my a few weeks ago is that while Congress explicitly expanded the preparer due diligence penalty of Section 6695(g) to cover returns where the client claims head-of-household status, it sneakily also causes this penalty to apply when the client claims the $500 dependent credit because Congress put that credit in Section 24 where the Child Tax Credit is which was already subject to the penalty. For more, see my 12/13/18 post.
5. This legislation is not the end-all of tax reform. There were many areas in need of attention that were not included in the bill for various reasons. Missing items include efforts to reduce the annual $400 billion tax gap (taxes owed but not collected), recognize today's economy that involves intangible assets (most of the TCJA favors tangible assets) and a growing gig workforce (no effort to clarify worker classification or provide a simpler/better retirement system for these workers), address the growing deficit-debt-interest expense which will harm future economic growth and be a big burden for our children and grandchildren, improve IRS operations and the tax compliance process, or address problems with Social Security, Medicare and the Highway Trust Fund. In addition, more work is needed to help our tax system meet principles of good tax policy better, such as improved equity and simplification.

btw - here is my post from 12/22/17.

What do you think?

California to follow South Dakota nexus threshold of the Wayfair decision!

California Revenue & Taxation Section 6203(c) put the state in an unusual position after the June 2018 Supreme Court decision in South Dakota v. Wayfair, Inc. The California Department of Tax and Fee Administration (CDTFA) had to decide what the decision meant and administer that finding. Meanwhile, the state legislature had to determine its role and the timing of any action.

R&T Section 6203(c) provides: “Retailer engaged in business in this state” as used in this section and Section 6202 means any retailer that has substantial nexus with this state for purposes of the commerce clause of the United States Constitution and any retailer upon whom federal law permits this state to impose a use tax collection duty." This certainly meant something different on June 21, 2018 than it did prior to that date. With the Court finding that Quill and its physical presence standard for commerce clause nexus was "unsound and incorrect", what is the new standard?

The Court found the 2016 South Dakota law (SB 106) which was before it acceptable as a nexus standard due to these three features:

1. Threshold - Collection obligations only exist if a seller had over $100,000 of sales into the state in the prior or current calendar year, or 200 or more transactions.
2. No retroactive application.
3. South Dakota adopted the Streamlined Sales and Use Tax Agreement (SSUTA) which provides some simplification and requires the state to offer free software to remote sellers and audit protection if they use it.

Well, how do those factors apply in California which is a much larger state than South Dakota and has not adopted the SSUTA and does not provide free software?

South Dakota has just under 1 million people which California has over 39 million. So, with far more buyer in California as well as far more business buyers, considering the worldwide market, the South Dakota threshold would cause hundreds of thousands of small businesses to become collectors of California sales tax In Etsy's amicus brief filed in the Wayfair case, it noted that in 2017, its 1.9 million sellers generated $3.25 billion of gross sales (page 8). That means average sales for an Etsy business of $1,710, well below the $100,000 threshold. But, it would be very easy for many of these businesses to have 200 or more transactions in California in a year. Think of all of the sellers using Fulfillment by Amazon (FBA), eBay, Etsy, crowdfunding sites, and others to sell low value items. With over 39 million possible buyers in California, the CDTFA should be seeing an incredible increase in registered sellers.

Can a state that does not follow the SSUTA or provide free software to remote vendors meet the Court's new nexus standard? We don't know.

Well, on December 11, the CDTFA announced that it would follow the South Dakota thresholds starting April 1, 2019 (NR-18-59). This allows some lead time for the thousands of remote vendors who crossed one of the thresholds in 2018 (the calendar year prior to 4/1/19). It also gives some time for all remote vendors to start tracking sales into California. However, the new procedure does not provide any lead time once you cross the threshold. For example, let's say a vendor selling $10 socks online makes its 200th transaction to a California customer on July 1, 2019, based on 2019 sales. It needs to register and start collecting immediately(similar in most other states as well). There is no lead time once the threshold is crossed to allow for updating or obtaining software and being prepared for the new compliance obligations. For more, see CDTFA Special Notice L-565 (Dec. 2018). Note: The CDTFA held a stakeholder meeting to explain its role per R&T 6203(c) and obtain income (see information and links here).

Another change announced December 11 affects both remote and in-state sellers. Many cities, counties and special districts in California have various sales taxes such as to help fund transportation. These are known as district taxes. Prior to Wayfair, an in-state vendor only had to collect them on sales delivered to districts where they had a physical presence. Now, they must be collected in districts where they meet the over $100,000 sales or 200 or more transactions threshold. See CDTFA Special Notice L-591 (Dec. 2018). So, even in-state sellers already collecting California sales tax must implement new recordkeeping requirements. The CDTFA notes that sellers might just want to "courtesy collect" the district tax for all California sales. That likely is easier than having to track sales into all counties unless the seller knows it won't meet the threshold anywhere so only has to collect where it has a physical presence.

The CDTFA provides a good deal of information on collection obligations at http://cdtfa.ca.gov/industry/wayfair.htm.

On December 10, the chairs of the state's tax committees announced that they would continue to look at whether changes are needed, noting that the decision might not work in a state with almost 40 million residents.

Certainly one area that lawmakers have to address is additional funding for the CDTFA to deal with the hundreds of thousands of new sales tax collectors that should be registering and perhaps seeking assistance of the CDTFA. These vendors are located throughout the world. Also, the CDTFA needs to get and regularly update data on the number of vendors outside of California that meet the threshold. If the number of registrants doesn't match this data, to be fair to instate tax collectors, the CDTFA needs to go out and find these vendors even though they are located throughout the world.

With such a low threshold of 200 or more transactions, the enforcement effort will be a poor use of resources. There needs to be a balance of what is realistic for the CDTFA to enforce among sellers versus continuing to collect use tax from California buyers.

Also, the risk of litigation in California or another state by small vendors challenging the 200 or more transactions threshold seems great. That threshold seems to impede interstate commerce, particularly where the transaction value is low. After all, someone selling $1 items would have to start collecting even though sales into one of several states now using the South Dakota standards is only $200!

We'll see what happens. The April 1, 2019 start date gives lawmakers time to act, such as by removing the transaction threshold and just using the $100,000 gross receipts threshold. They should also see about offering free software to remote vendors as that should help the CDTFA as well. And more funds should be allocated to the CDTFA to help with their expanded tax administration duties. The lawmakers' press release also includes a statement from former BOE member and now State Treasurer-elect Fiona Ma that suggests California should follow the lead of a few others states and have marketplace facilitators, such as Amazon collect.

We'll see.

Originally posed on SalesTaxSupport on 12/17/18.

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.

Surprise!

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

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 (6^th 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 6^th Circuit which upheld the Tax Court decision as it did not find any error in that court’s analysis. At the start, the 6^th 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 6^th 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?