The IRS has a complicated set of guidelines for determining whether a worker should be treated as an employee or independent contractor for payroll tax purposes. It may be tempting for business owners to just classify people as independent contractors and save payroll taxes, but it’s not worth the risk, says Jim Forbes, CPA, a principal with Skoda Minotti.
“The IRS is conducting more payroll tax audits of small businesses, but the risk is always there with any audit. No matter what triggers the audit, the IRS will ask for all of your W-2s and 1099s and will be suspicious if a contractor is being paid like an employee,” Forbes said.
Smart Business spoke with Forbes about the process of determining whether a person is an employer or an independent contractor and why it poses such problems for businesses.
How do you determine if a worker is an employee or independent contractor?
The IRS uses 13 factors; some employers will look at a couple and think a person is clearly an employee or a contractor, but you have to look at all 13. Even then, there’s no set number you have to pass, it’s all a matter of facts and circumstances. That’s why it’s tricky for companies to figure out how to classify workers.
The 13 factors are:
• Type of instructions given. An employee is generally subject to follow instructions about when, where and how to work.
• Degree of instruction. The key consideration is whether the business retains rights to control details of a worker’s performance.
• Evaluation system. If the system measures details of how work is performed, that points to the person being an employee.
• Training. On the job training indicates a particular way of performing the job is desired and is strong evidence the worker is an employee.
• Significant investment. Independent contractors often have invested in the equipment used for work. However, that is not required for independent contractor status.
• Unreimbursed expenses. Independent contractors are more likely to have unreimbursed expenses.
• Opportunity for profit or loss. Having the potential of incurring a loss indicates a worker is an independent contractor.
• Services available to market. An independent contractor is generally free to seek out business opportunities.
• Method of payment. An employee is generally guaranteed a wage for hourly, weekly or other period of time. Independent contractors are usually paid a flat fee for jobs.
• Written contracts. The IRS is not required to follow a contract stating that a worker is an independent contractor; how the parties work together determines how the worker is classified.
• Employee benefits. Insurance, pension plans and other benefits are generally not given to independent contractors. However, absence of benefits does not necessarily means the worker is an independent contractor.
• Permanency of the relationship. If a worker is hired for an indefinite time, that is generally considered evidence of an employee/employer relationship.
• Services provided as a key activity of the business. Companies are more likely to have the right to control activities when the services are a key aspect of the business.
Why would companies attempt to classify employees as independent contractors?
With smaller companies, there is a greater impact from the additional payroll taxes. If the person is an employee, you have to pay 7.65 percent payroll taxes for Social Security and Medicare. There are other taxes, including unemployment, but that is the primary motivation.
There could be more incentive in 2014 with the employer mandate under health care reform. A business with 49 employees that needs to add two more people might want to bring them on as independent contractors to avoid the rules that kick in when you reach 50 full-time equivalents.
Still, most companies will try to do the right thing; it’s just difficult sometimes to figure out what that is. You can meet 10 of the 13 tests, but there’s no guarantee that means the person is an independent contractor. Ultimately, that answer rests with the IRS.
Jim Forbes, CPA, is a principal at Skoda Minotti. Reach him at (440) 449-6800 or email@example.com.
Follow up: If you’d like to schedule a confidential consultation regarding employee classification concerns, call Jim at (440) 449-6800.
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Businesses have been given more time to prepare for changes in the way they account for expenses related to tangible property, but it might be advantageous to get an early start.
The U.S. Department of the Treasury issued temporary regulations that were to be effective in 2012, but the Treasury and IRS revised the effective date to Jan. 1, 2014. Final regulations that include the new effective date are expected in 2013.
“The regulations focus primarily on whether an expenditure is for immediately deductible repairs and maintenance or for capital improvements that must be depreciated over time. An expenditure on tangible property can be a current deduction if it’s considered incidental in nature and doesn’t add to the value of the property or prolong its useful life,” says Tom Tyler, partner at Crowe Horwath LLP.
“The temporary regulations are of particular interest to businesses with significant amounts of brick-and-mortar properties or to machinery-intensive businesses,” he says.
Smart Business spoke with Tyler about the regulations and what businesses should do to prepare for the change.
Should businesses act now or wait for final regulations?
The IRS announced the change to the effective date on Nov. 20, 2012. The revised date covers tax years beginning on or after Jan. 1, 2014. However, taxpayers can early-adopt the regulations for their 2012 and/or 2013 tax years. The early adoption allowance is an acknowledgement on the Treasury’s part that taxpayers might have already expended resources in order to adopt the temporary regulations. Taxpayers still can apply the temporary regulations as long as they file an accounting method change if the final regulations turn out to be different.
Potential corporate tax reform also could affect decisions regarding tangible property. Because of that, it’s advisable to evaluate the effects of the final regulations now, regardless of whether you’re going to adopt them in advance of the required date.
Is the final version expected to vary much from the temporary regulations?
There were sections of the temporary regulations that generated a lot of feedback from taxpayers and practitioners, and the Treasury likely will incorporate that feedback into the final regulations. For example, there is a new de minimis rule that exempts certain acquisitions from capitalization. If it’s under a certain threshold dollar amount, a taxpayer can deduct the purchase price of the property for tax purposes as long as it follows a written expense policy and has an applicable financial statement. Under the rule, the amount paid and expensed must be less than or equal to the greater of 0.1 percent of gross receipts for income tax purposes or 2 percent of the total depreciation and amortization expense for the tax year.
Treasury officials have suggested the de minimis rule might be expanded to taxpayers without audited financial statements, and they may revise the way the ceiling limitation is computed. Temporary regulations regarding dispositions and safe harbor for routine maintenance also are likely to be revised.
What steps should businesses take now?
Don’t hold off on implementation plans; instead, proceed while bearing in mind the effect of potential revisions. If the de minimis rule is expanded but retains the written policy requirement, businesses should establish a written capitalization policy for financial reporting purposes by the first day of the tax year they want to apply those rules.
Additionally, taxpayers might need to file an accounting method change if the final regulations differ from the temporary ones, even if no changes are made to the deductions claimed under the temporary regulations.
Taxpayers should weigh the pros and cons of the options outlined by the Treasury and IRS to determine the most advantageous approach. Those options are:
- Adopt the final regulations in 2014 with their 2014 tax return.
- Early adopt the final regulations with their 2012 or 2013 tax return.
- Adopt temporary regulations with their 2012 or 2013 tax return with the possibility of filing a second method change to adopt the final regulations for the 2014 tax year.
Tom Tyler is a partner at Crowe Horwath LLP. Reach him at (214) 777-5250 or firstname.lastname@example.org.
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Cost segregation studies are an effective component of any cash management strategy for a business that owns buildings or other depreciable real property for business use. The strategy involves the deferral of income tax liabilities to later years through the identification of property having a shorter cost recovery period for federal income taxes, which even the IRS acknowledges as an appropriate deferral method.
Smart Business spoke with Walter McGrail, senior manager at Cendrowski Corporate Advisors LLC about using cost segregation.
Why are cost segregation studies effective?
The benefit is the ‘present value savings’ attributable to the deferral of federal and state income taxes. The actual savings is the reduction in current tax payments now, with resulting increases in taxes payable in subsequent periods, i.e., the ‘time value of money’ attributable to tax deferral. As with any treasury cash management program, a property owner’s cost of capital is typically the appropriate discount rate to measure the ‘present value savings’ of deferring cash charges for income taxes.
How does it work?
First, cost segregation studies identify categories of costs that have a shorter cost recovery period for income tax purposes. Buildings typically have a depreciable life of either 27 or 39 years, while the depreciable lives of furniture and fixtures ranges from five to seven years. Though the total amount of cost recovered is the same regardless of the recovery period, the shorter it is, the sooner the resulting tax savings occurs.
Second, shorter life property generally qualifies for accelerated depreciation methods. Buildings are depreciated under the straight line method, which results in the same depreciation expense during each year the building is owned. Shorter recovery life property identified in a cost segregation study may be depreciated under accelerated cost recovery methods. For example, depreciating property with a five year life using accelerated depreciation on the same five year property results in more than 70 percent of the cost being depreciated during the first three-year period. There are also new Treasury regulations that permit immediate deduction of qualified repair costs. The professional conducting the cost segregation study will be able to apply the new expensing regulations, as well. The tax savings occurs for both federal and state income taxes. Current federal corporate income tax rates are 35 percent and states’ are typically are around 5 percent.
How is a cost segregation study conducted?
Studies must be properly conducted to withstand IRS scrutiny, which requires not only professionals trained in the proper classification of assets for federal depreciation purposes but also personnel with engineering and construction experience to properly classify the components of a structure. Key to a successful audit defense are documentation of findings and expert personnel.
What businesses might benefit from this?
Cost segregation studies can be conducted on new construction, rehabs, recently purchased properties, or even properties held for a period of years. For newly constructed property, and to some extent rehabilitated properties, shorter life depreciable property may qualify for bonus depreciation. Bonus depreciation rules permit a first year depreciation deduction equal to 50 percent of the cost of identified qualifying property. Bonus depreciation and more favorable capital expenditure expensing elections will expire after 2012.
What is the time frame to conduct a study?
In order to make a claim for the 2012 calendar year, the study must be conducted before the extended due date of the 2012 returns, typically Sept. 15, 2013. Sufficient time should also be permitted to coordinate the findings of the study with the business’s preparation of its 2012 income tax returns. For properties owned prior to 2012, the IRS has provided a relatively straightforward means to claim the resulting difference in depreciation expense before and after the study is conducted.
Walter McGrail is a senior manager at Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or email@example.com
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As the Patient Protection and Affordable Care Act (PPACA) implementation unfolds, health lawyers continue to answer employers’ questions about its impact.
“The act has multiple potential penalties for failure to comply with its various requirements. The risk of not complying is a financial risk,” says Jules S. Henshell, of counsel at Semanoff Ormsby Greenberg & Torchia, LLC.
Smart Business spoke with Henshell about what employers need to be aware of as they take their next steps under the PPACA.
What do employers most frequently ask?
The most frequent questions relate to the ‘pay or play’ penalties in the law. The majority of employers are currently providing health care coverage through group insurance plans. However, it’s too early to determine whether to provide coverage at levels required by the act or pay the penalties because future premium costs and the affordability of employer offerings through health exchanges are uncertain.
Employers also are concerned about reporting health care benefits on W-2 forms, whether they qualify for transitional relief, and the provisions against discrimination in favor of highly compensated individuals.
What’s important to know about W-2 reporting and IRS transitional relief?
In 2012, employers are required to report health care costs to the employer and employee on employee W-2 forms or face a $200 per-form penalty.
The IRS has provided transitional relief from reporting for employers that file fewer than 250 W-2 forms. Some employers question if they are entitled to relief from reporting when their company files fewer than 250 W-2 forms but is one of a number of related companies. The IRS’s informational Q&A suggests that it will not aggregate among related companies to calculate the threshold for reporting.
Whether the W-2 reporting currently applies or not, it’s a good idea to formalize the practice of tracking these health insurance costs to better enable retrieval of information in the future.
How do provisions about non-discrimination impact employers?
The PPACA prohibits discriminatory practices in favor of highly compensated individuals. Prohibited practices include providing benefits to highly compensated individuals that are not provided to other employees as well as affording greater choice, higher amounts, lower premiums, a higher employer subsidy or more favorable benefits. Many companies have used such practices to create competitive compensation packages for executives and management. Penalties include an excise tax or civil monetary penalty or civil action to compel provision of nondiscriminatory benefits.
The IRS, U.S. Department of Labor and U.S. Department of Health and Human Services (HHS) have stated that non-discrimination requirements will not be enforced until the first plan year after regulations are issued. And so far, they have not issued regulations.
Employer health plans with grandfather status are not impacted, but should be conscious of how their status could be jeopardized. Raising co-insurance, significantly raising co-pays and deductibles, lowering employer contributions, and adding or tightening annual limits on what the insurer pays will result in loss of grandfather status. Those without grandfather status need to review their compensation packages and practices in anticipation of future regulation and enforcement.
Do any significant PPACA cases remain?
The most active litigation challenging the PPACA in multiple jurisdictions target the requirement that new, non-grandfathered group insurance plans provide contraceptive coverage. The lawsuits focus on alleged violations of either the First Amendment right to free exercise of religion or the Religious Freedom Restoration Act.
Regulations have granted exceptions for certain religious employers and provided a one-year safe harbor for religiously affiliated institutions that wouldn’t otherwise qualify for exemption. HHS has stated it will provide further accommodations before the end of the safe harbor period.
Jules S. Henshell, of counsel, Semanoff Ormsby Greenberg & Torchia, LLC. Reach him at (215) 887-3754 or firstname.lastname@example.org.
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This past tax season, you could have filed your tax return, but then found out your return had been flagged and someone already collected a refund under your name.
“A lot of CPAs at the end of the filing season found out that a number of their clients fell victim to tax identity fraud, which significantly lengthens the time it takes for them to get legitimate refunds or fix the error,” says Michelle Mahle, CPA, director of tax at SS&G.
Smart Business spoke with Mahle about this growing fraud problem and how taxpayers can try to protect themselves.
What is happening with this type of identity fraud?
Thieves steal someone’s name and Social Security number and use it to e-file a false tax return with a refund, taking money from the IRS. The thieves use e-file because of the quick refund turnaround and often have the refund deposited to a debit card. Then, when the taxpayer e-files a legitimate tax return, there’s immediate notification that a tax return has already been filed for this Social Security number.
An employer has to issue W-2s to employees by Jan. 30, but those forms are not due to the IRS until the end of February. Most fraudulent tax returns requesting refunds are filed in January or February as soon as the e-filing season opens. At that time, the government doesn’t have the information on file to verify what the taxpayer reports. Yet the IRS continues to fall under extreme scrutiny to turn around refunds as quickly as possible.
How does tax identity fraud affect individual taxpayers?
It causes unnecessary delays to refunds, but you won’t know until you file your return and it’s rejected. If there’s a problem with your electronically filed tax return, you’ll get an immediate notification. Then the CPA or tax adviser you are working with would likely step in and deal with the IRS on your behalf. A paper return works the same way; it just takes longer for it to be processed and for the notification letter to get back to you.
It can take four to six months — probably closer to the six-month range — to resolve the issue and get a refund issued to the legitimate taxpayer. The burden of proof falls on the legitimate taxpayers to go through the trouble of proving who they are and why they are entitled to the refund. For example, one taxpayer filed in June and the IRS flagged the return as suspicious. The return consisted primarily of a large salary with a lot of withholdings, resulting in a significant tax refund. The taxpayer didn’t get the refund until around Sept. 15. Normally, with e-file, the refund cycle can be as short as 11 days.
How is tax identity fraud growing?
It’s becoming more prevalent, and the statistics every year are astounding. The IRS has issued billions of dollars in fraudulent refunds. Like credit fraud, the money is usually already spent by the time the government finds and convicts someone of the crime. Many taxpayers are caught off guard and immediately want to know their risk or exposure. CPAs and tax advisers should be warning their clients that this could happen to them.
What can taxpayers do to protect their identity from being used for tax fraud?
Even the most cautious, careful person can fall victim to this type of fraud, based on the way records are kept and maintained. Taxpayers may be doing well with protecting their credit card information, but they also have to be aware of tax identity theft and protect their Social Security number. It really is a matter of matching a name and a Social Security number, and that’s it — the address seems to be irrelevant for purposes of claiming that refund. In one instance, multiple fraudulent returns were filed with the same mailing address.
The government does require that Social Security numbers not appear on documents being sent through the mail, but that may or may not be happening. In many cases, thieves actually steal mail from mailboxes. It’s been so severe that postal workers have been mugged for information around retirement villages or communities, which is particularly prevalent in Tampa Bay and Miami, Fla. If you’re living in a retirement community, it may make sense to use a post office box. Also be conscientious of paper documentation at stores requesting credit applications or completing forms at medical facilities and how they file, share or dispose of your Social Security number. If someone needs your Social Security number for a specific purpose, perhaps write it down in a manner that can be immediately discarded.
If you can legitimately speed up the timing of your filing, you also should do so, as the fraudulent returns are generally filed early on. However, that’s not an option for a lot of taxpayers.
How is the IRS reacting?
There’s been nothing specific announced yet for this upcoming tax season, although the IRS is definitely aware of the increasing fraud and working to control it. If they come out with any provisions or changes, it will be on its website, www.irs.gov.
One way it could possibly crack down is to only allow one refund per account. The IRS also will be looking more closely at mailing addresses in the upcoming filing season and appears to have implemented an internal grading system that makes a return ‘suspicious.’ The IRS can implement things that would restrict a lot of the occurrences, but in the end, it also restricts the flexibility we have as taxpayers. So, do we want to be inconvenienced and have our affairs secure, or have the convenience of a quick, timely refund at the cost of having our affairs exposed to tax identity fraud?
Michelle Mahle, CPA, is a director of tax at SS&G’s Cleveland office. Reach her at (440) 248-8787 or MMahle@SSandG.com.
Business owners have long understood the importance of income tax compliance. Companies that understand the tax law and apply it correctly can save money and reduce the risk of surprises in the event of an audit. But recent focus on employment taxes by the IRS has caught even savvy business owners off guard, and in some cases, out of compliance.
Smart Business spoke with Claudia Necke-Lazzarato, a tax manager at Sensiba San Filippo LLP, about changes in employment tax rules, increased IRS scrutiny, and what businesses should be doing to ensure compliance and limit their risk.
Why is employment tax compliance becoming more important?
Compliance has always been important. However, recently the IRS has shown an increased focus on employment taxes. With the economic slowdown, income tax revenue growth has slowed as well, and the IRS has increased its focus on employment taxes. These types of tax audits are definitely on the rise. This increase in IRS audits means an increase in risk for taxpayers. It is essential that business owners understand the importance of employment tax compliance. If it’s important to the IRS, it should be important to every business owner.
What are some common employment tax reporting mistakes?
Underreporting W-2 wages is the easiest way for businesses to fall out of compliance. Whether it’s wages that are improperly characterized as reimbursable expenses, or employees who are incorrectly designated as subcontractors, it is very common for a misunderstanding of tax law to lead to the underpayment of taxes.
Just this year, the IRS released a clarification on what qualifies as a reimbursable expense. This clarification created a requirement that employers have ‘accountable plans’ for reimbursement. The IRS also defined these ‘accountable plans’ for employee reimbursements, and according to the new ruling, they must meet the following three requirements:
• The reimbursed expense must be allowable as a deduction and must be paid or incurred in connection with performing services as an employee of the employer.
• Each reimbursed expense must be adequately accounted for to the employer with receipts or other proof of expense.
• Any amounts paid to employees in excess of expense must be returned within a reasonable period of time.
If all of these requirements are not met, reimbursements will not be treated as reimbursable expenses. Instead, these payments would be considered wages, and would be subject to withholding and employment taxes.
This means that flat value ‘expense allowances,’ which allow a set amount of funds to offset the costs of tools, automobiles and other business-related expenses, may now be reportable as W-2 income. To simplify internal reporting, many companies have historically provided fixed-value allowances for common expenses. Typically, these allowances would not meet the new requirements for ‘accountable plans.’
How do you determine if someone should be designated as an employee or a subcontractor?
Another very common mistake is mischaracterizing employees as subcontractors. If an employer incorrectly designates a worker as a subcontractor, it will fail to withhold tax for the employee and fail to pay the employer’s share of employment taxes. This can put both the employee and employer at significant financial risk.
To feel confident that they have correctly determined employment status, employers should know what questions to ask and who to speak with for clarification. Evaluate each contractor’s relationship with a few simple questions, then ask a CPA who is well versed in employment tax law if there is any ambiguity remaining. Look closely at who has behavioral and financial control in the relationship and answer the following questions:
• Is the work performed as part of a defined project?
• Who is supervising the work?
• Who provides the tools and supplies needed to complete the work?
• Who sets the schedule for the work?
If you still aren’t sure of the answer, find a CPA and ask for help. The IRS defaults to assuming an employee/employer relationship, so be certain you’re getting it right.
What are the consequences of underreporting employment tax?
Employment tax compliance isn’t just about having the right answer. There are real consequences for underpayment of taxes. The IRS has sharpened its focus on the reimbursement arrangement taxpayers have in place. In several instances, companies have a reimbursement arrangement that does not pass the requirements of accountability, from the IRS’s point of view. The IRS penalties can be very costly and time consuming to resolve, with companies having to pay all underpayments with interest, and in addition, pay an automatically assessed 20 percent penalty. Working with a CPA firm with IRS audit experience can help clients receive a negotiated reduced penalty and put a qualifying accountable plan in place.
How can business owners ensure compliance?
Understanding the importance of getting employment taxes correct is the first step. Rules and enforcement change frequently, so partnering with an experienced tax professional is a good idea.
A best practice to help remain compliant is to talk about the issue as much as possible and in a proactive manner, rather than taking the rearview mirror approach after an audit notice is received. When ongoing success is your primary objective, you need a tax professional who actively helps you to find opportunities and avoid potential problems.
Claudia Necke-Lazzarato is a tax manager at Sensiba San Filippo LLP, a regional CPA firm based in the San Francisco Bay area. Reach her at (925) 271-8700 or email@example.com.
It’s a common misconception that if you have income or assets offshore and it never touches U.S. soil, then you don’t have to report it. That belief is proved wrong with a new tax form, Form 8938, which seeks information on individuals’ foreign financial assets, with substantial penalties for failure to report. In future years, entities also will be required to fill out the form.
“This area is just ripe for people to misstep, and the penalties for noncompliance in this area are incredibly steep, starting at $10,000,” says Henry J. Grzes, CPA, director, international tax, at SS&G, Inc. “Many tax practitioners, as well as taxpayers, are unaware of these new rules.”
Smart Business spoke with Grzes about Form 8938, why it was created and some the challenges taxpayers may face in staying on the right side of the law.
What is tax Form 8938, Statement of Specified Foreign Financial Assets?
Form 8938 requires individuals — if they meet certain filing thresholds — to disclose the existence of foreign financial assets they have an ownership interest in, which can be individually or jointly owned. The form was first required to be filed with 2011 tax returns. The law that requires disclosure of assets is complex, so the IRS initially decided only individuals would be required to file, but once it finalizes regulations and provides additional guidance, corporations, trusts and partnerships will also have to comply.
Why did the IRS create Form 8938?
It was created to make sure taxpayers are properly reporting the existence of and any income from a bank account, ownership in a foreign corporation, whether public or private, and other offshore assets. The IRS has been focusing on taxpayers with offshore activities, especially if those activities aren’t being properly reported on their tax returns.
The recent U.S. pursuit of UBS, a global financial institution, brought the issue to the forefront. UBS employees allegedly attended high-profile events such as the Super Bowl and solicited people to invest money with them by saying they wouldn’t disclose the existence of the investment to other parties..
What are the penalties for failing to properly file Form 8938?
There’s an initial penalty of $10,000 for failure to file, which applies to both spouses if you file jointly, even if only one spouse has foreign financial assets. Failure to file or failure to disclose an asset will also extend the statute of limitations for a return. For example, if you don’t file Form 8938 for the 2011 return until tax year 2013, the statute may remain open for all or part of your income tax return until three years after the date in which the 2011 Form 8938 is filed. If there is unreported income from the assets included on the 2011 filing, the statute of limitations is extended even further.
What advice would you give individuals who aren’t sure if they qualify for Form 8938?
Seek qualified help and inquire whether your tax preparer has experience in international reporting. Some tax practitioners might not want to take on such a filing burden because they aren’t familiar with the area and could be liable for potential preparer penalties.
The form can be confusing because whether you have to file depends on whether you file separately or jointly and whether you live in the United States or abroad. In each circumstance, there is a different filing threshold. In addition, a specified foreign financial asset may not be what you think. For example, holding precious metals directly doesn’t need to be reported on Form 8938, but if you hold precious metals in an account in a foreign financial institution, the account must be reported. When in doubt, report it.
It’s also hard to determine the fair market value of some assets, such as ownership in a closely held business. The IRS requests that you use readily accessible information to determine the maximum value of the foreign asset. If you can’t determine the value, put it down on the form as a value of zero. This is often the case where a taxpayer is a beneficiary to a foreign estate and no distributions were received by the taxpayer in the reporting year.
If individuals have to file the Foreign Bank Account Report (FBAR), why do they need to fill out Form 8938?
The rules for filing the FBAR and Form 8938 are promulgated under different titles of the U.S. code. Form 8938 is part of the Income Tax Act, so only certain individuals can access the information without a subpoena or legal reason. FBAR is part of the Bank Secrecy Act and is a law enforcement tool used to detect money laundering or terrorism.
Filing and reporting requirements for the FBAR and Form 8938 requirements are different; if you file either Form 8938 or FBAR, it doesn’t mean you have to file the other, but you may have to file both.
What happens if someone failed to file the form for the 2011 tax year?
The IRS is playing hardball. There is a reasonable cause provision that allows a taxpayer to avoid any late filing penalties if the failure to file or to disclose an asset is due to reasonable cause and not due to willful neglect. If you have a reasonable argument to put forth, it’s still going to involve time and money. You may not end up having to pay any penalties that might be assessed, but to get to that point, you will have to affirmatively show to the IRS that the facts support a reasonable cause claim.
For taxpayers who determine they need to file this form and did not include it with their 2011 returns, it would be wise to address this failure as soon as possible. Such a voluntary admission of noncompliance and taking corrective action to immediately cure this filing deficiency will generally be to an individual’s benefit when attempting to negotiate any penalty abatements with the IRS as a way to demonstrate a good faith effort to be in compliance with these new filing obligations.
Henry J. Grzes, CPA, is a director, international tax, at SS&G, Inc. Reach him at (919) 651-1616 or HGrzes@SSandG.com.
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Bolstered by new legislation that will provide it with valuable information about foreign asset ownership, the IRS has launched a crackdown on international tax evasion that will impact most U.S. taxpayers with foreign financial assets. U.S. tax evaders hiding foreign assets have a much greater risk of detection, but the draconian penalites can also be imposed upon law-abiding U.S. individuals and business that have reported all of their income to the IRS, but failed to file one of the reports disclosing ownership of foreign assets.
“The back tax and interest on unreported income from offshore accounts is often small potatoes compared to the penalties for failing to disclose the foreign account to the government,” says Dr. Gary McBride, professor of Accounting and Finance at California State University, East Bay. “Businesses and individuals can be fined up to $100,000 for willfully failing to meet the filing requirements, if the value of foreign financial accounts exceed $10,000 at any time during the year.”
Smart Business spoke with McBride about the IRS crackdown on offshore tax evasion.
How will the legislation impact U.S. taxpayers?
The foreign asset reporting requirements impact every law-abiding business — partnerships, corporations and individuals — with an overseas bank, securities or other financial account, as well as those with substantial ownership interest in a foreign entity. The crackdown was buoyed by new legislation in 2010 called the Foreign Accounts Tax Compliance Act (FATCA), which forces foreign financial institutions to disclose the names of U.S. account holders to the IRS beginning Jan. 1, 2014. If a foreign bank doesn’t comply, then corporations and other U.S. payors that make payments such as dividends, interest, rents or royalties to a foreign financial institution are required to withhold a 30 percent tax. If the tax is not withheld, the IRS will pursue the U.S. payor for the deficiency. The legislation also represents a unique exercise of extra-territorial jurisdiction by the U.S. government.
What are the most notable changes to the tax forms and filing requirements?
U.S. Corporations, partnerships, individuals, estates and trusts must file a Foreign Bank and Financial Accounts Form (FBAR) if they have a financial interest or even signature authority over accounts totaling over $10,000 in a foreign country. That requirement has been in the law for decades, but compliance and IRS enforcement have been lax until recently. Taxpayers must be far more attentive to the question on the income tax return about foreign financial accounts over $10,000. Beginning in 2011, U.S. individuals must also attach to their Form 1040 individual income tax return new IRS Form 8938, if they have foreign financial assets that exceed a specific threshold. The threshold varies depending upon filing status, but the IRS has the authority to set the threshold as low as $50,000. For a U.S. individual who is required, but fails, to file both an FBAR and a new Form 8938, the harsh penalties can be imposed for both omissions, and that is in addition to the income tax and penalties on any unreported income generated by the foreign financial asset.
Why is the risk of getting caught much higher?
The clear IRS commitment to enforce the foreign assets reporting laws and impose the penalties for noncompliance causes the greatest risk. Not all foreign financial institutions will cooperate with the upcoming requirement to disclose the names of U.S. account holders. In many instances, disclosure by a foreign financial institution may be prohibited by the domestic privacy laws. Regardless, the IRS Commissioner made the following statement in testimony before the U.S. Senate Appropriations Committee: ‘We are well on our way to deterring the next generation of taxpayers from using hidden bank accounts to avoid paying taxes.’
The IRS will eventually be able to cross-reference disclosed foreign accounts held by U.S. account holders against the database of returns to identify taxpayers who haven’t filed the proper forms or paid the requisite taxes.
What are the penalties for failing to comply?
Business entities (and even trusts and estates) face a penalty of the greater of 50 percent of the value of the foreign account or $100,000 for willfully failing to file an FBAR. Do the math: willful failure to file an FBAR for an $11,000 account is $100,000. If the account balance were $1 million the penalty would be $500,000, and, if the FBAR is not filed for three years, the penalty is $1.5 million. The nonwillful penalty for failure to file an FBAR is $10,000. For the new Form 8938, the minimum failure to file penalty is $10,000 plus a penalty of up to $50,000 for continued failures after IRS notification. Furthermore, underpayments of income tax attributable to non-disclosed foreign financial assets will be subject to an additional accuracy–related income tax penalty of 40 percent (up from 20 percent for most understatements).
How can taxpayers prepare and take steps to avoid hefty penalties?
First, make sure that all foreign financial accounts are reported on the FBAR as well as the new Form 8938 for individuals. Then, make the proper disclosure on the income tax return acknowledging the existence of any and all foreign financial accounts over $10,000. U.S. taxpayers may be required to report foreign trusts on Forms 3520 and 3520-A, foreign corporations on Form 5471, foreign partnerships on form 8865 and foreign disregarded entities on Form 8858. Failure to file any of these forms results in a $10,000 penalty.
If you don’t have substantial foreign holdings, consider moving them to a domestic bank or a U.S. bank that has a branch in that foreign country, but, even if you choose the second option, you’ll still have to file an FBAR. Remember, the U.S. Treasury has promised proposed regulations on FATCA by the end of December and final regulations by the summer of 2012, so keep your eyes and ears open, because the revisions may usher in new requirements for U.S. taxpayers.
Dr. Gary McBride is a professor of Accounting and Finance at California State University, East Bay. Reach him at (510) 885-2922 or firstname.lastname@example.org.
With the passage of several tax acts over the last few years — and the enhancement of existing acts — small, medium, and large businesses are in a strong position to claim tax credits, at both the federal and state levels.
The credits are designed to foster economic growth and job creation, and business owners should be aware of them so they can take advantage of a political environment that is making it easier to obtain these tax credits, says Bill McDevitt, tax manager at Nichols Cauley & Associates LLC.
“Politically, both sides of the aisle have more recently been working together to create a positive climate for business owners. As a result, the number of tax credits available to businesses right now is abundant and the barriers to claiming them are fewer,” he says.
Smart Business spoke with McDevitt about how businesses should now be taking advantage of the tax credits available to them.
Are tax credits more valuable to business owners than tax deductions?
Often, they are. Credits are dollar-for-dollar reductions in the amount of taxes owed. For example, if your business qualifies for a $12,000 tax credit for expenses incurred to develop a new or improved product or process, the IRS may give your business a credit for having already paid $12,000 in taxes, and that amount is subtracted from the amount of tax owed on your company’s federal tax return.
Tax deductions, on the other hand, are expenses subtracted from your company’s income during the year that lower your company’s taxable income. An example of a deduction would include the cost of a new network server that the IRS may allow you to expense rather than capitalize in the year it is placed in service. Deductions are subtracted from income to arrive at taxable income, which is then used to determine the amount of tax you owe.
As a simplified illustration, assume your business is eligible for either a $12,000 tax deduction or a $12,000 tax credit. Which would you choose? If your company’s tax rate is 20 percent, the tax deduction may be worth about $2,400 after subtracting it from income to arrive at taxable income, and may only decrease the tax your business owes by $2,400. The tax credit, on the other hand, is subtracted dollar-for-dollar directly from the tax owed. So if the business made $100,000, subtracting $12,000 in deductions gets you a taxable income of $88,000, which, when taxed at 20 percent, means the company may owe $17,600 in tax. If, however, you chose a $12,000 credit rather than a deduction, the company may owe $20,000 in tax before the credit, but only $8,000 after $12,000 of the tax was paid with the credit. Choosing the tax credit rather than the deduction saved $9,600 in tax owed.
Are some tax credits only available to businesses of certain sizes?
While some credits are scalable to a wide range of businesses, others are limited to small businesses. For example, the Hiring Incentives to Restore Employment (HIRE) credit, which rewards employers for hiring and retaining employees, is allowed for large or small businesses. Also applying to businesses large and small: (1) the Work Opportunity Credit, a generous federal credit that encourages businesses to hire people from certain target groups — such as unemployed veterans, those with disabilities and convicted felons; (2) the Alternative Fuel Tax Credit, which may provide an incentive of 50 cents per gallon of alternative fuel sold by a retail dealer; and (3) the Georgia Retraining Credit, which allows employers to claim a tax credit for employee training.
In addition, the well-known Research and Development Credit has historically been pursued by larger companies, but new laws have made the credit cheaper and easier to obtain by mid-sized and smaller businesses.
Other credits, such as the Small Business Health Insurance Credit, only offer the maximum credit to employers with 10 or fewer employees who average $25,000 or less per year in wages. And the Small Employer Pension Plan Startup Cost Credit applies only to employers with 100 or fewer employees who received at least $5,000 in compensation in the preceding year.
Can tax credits offset Alternative Minimum Tax?
The HIRE credit cannot. However, the Work Opportunity Credit, Alternative Fuel Tax Credit, Small Employer Pension Plan Startup Cost Credit and the Research and Development Credit can. And in certain instances, the Small Business Health Care Tax Credit can also help offset Alternative Minimum Tax.
How can a business file for tax credits?
For the HIRE credit, employees simply complete an IRS Form W-11, ‘Hiring Incentives to Restore Employment Act Affidavit,’ which is kept on file with the employer and does not need to be sent to the IRS to certify the employee. Once the employee has been certified, the employer will file the easy-to-complete IRS Form 5884-B to claim the amount of the credit. This form is filed with the company’s federal income tax return.
For the Small Business Health Insurance Credit, an employer completes Form 8941 to calculate the credit and includes it with the company’s income tax return.
To claim the Work Opportunity Tax Credit, the employer should have the new hire complete IRS Form 8850 and U.S. Department of Labor Form ETA Form 9061 to obtain certification from its state work force agency that the new hire qualifies for the credit. These forms must be mailed to the state’s Work Opportunity Tax Credit coordinator no later than 28 days after the new hire begins work. The credit is claimed on IRS General Business Credit Form 3800 that is filed along with your company’s income tax return.
Filing these forms may seem like a complicated process, but is not. Given the favorable political environment to create jobs, this is low-hanging fruit that qualified business should take advantage of.
Bill McDevitt is a tax manager at Nichols Cauley and Associates LLC. Reach him at (404) 425-5338 or email@example.com.