Monday, April 25, 2011
A detailed look at the tax valuation of intellectual property
This article focuses on valuation of a taxpayer corporation's intellectual property for purposes of ad valorem property taxation. Basically, the reasons for such a valuation are twofold: (1) when the intellectual property is subject to taxation and the taxpayer has to file, defend, or appeal the property valuation; and (2) when the intellectual property is exempt from taxation but its value is included in the taxing authority's assessment of the taxpayer's overall property value. The second situation occurs most frequently when the taxing authority uses the so-called “unit valuation” principle (or “overall business enterprise valuation” principle) to value taxpayer property. (R.F. Reilly, 21 Journal of Multistate Taxation and Incentives, No. 1, 6 (March/April 2011).)
Tangible Personal Property and Unclaimed Property: What Holders Need to Know
As unclaimed property compliance continues to grow in importance, a “sleeper” that is increasingly making its presence felt is the existence of tangible personal property (TPP). For many years overlooked or forgotten, TPP is increasingly of interest to the states, and should be of interest to many holders. This article will examine the jurisdictional rules pertinent to TPP, discuss a few random state laws, review some of the various types of TPP we have encountered in our practice, and examine the significance of the Internet and how it is fueling interest in this area. To lay the groundwork before focusing on these areas, a few definitions are in order. The term tangible property is defined in Black's Law Dictionary as meaning “Property which may be touched; such as is perceptible to the senses; corporeal property, whether real or personal. The phrase is used in opposition to such species of property as patents, franchises, copyrights, rents, ways and incorporeal property generally.” Thus, TPP should be distinguished both from real property, as well as from intangible property. The latter term is defined in a leading treatise as “...personal property, the physical manifestation of which generally has no intrinsic value, but is merely the representation or evidence of valuable property rights, such as certificates of stock, bonds, etc.”
Pertinent Jurisdictional Rules
The seminal case in this area is Texas v. New Jersey. In that case, the U.S. Supreme Court promulgated jurisdictional or priority rules regarding which state had a right to lay claim to unclaimed intangible personal property. However, the Court also summarized the law pertinent to escheat claims for tangible property, stating as follows: “With respect to tangible property, real or personal, it has always been the unquestioned rule in all jurisdictions that only the State in which the property is located may escheat the property.” Interestingly, Texas sought to argue in that case that mineral proceeds emanating from production in Texas should be escheatable only by the State of Texas. The Supreme Court disagreed, stating as follows: “Texas argues in particular that at least the part of the intangible obligations here which are royalties, rents, and mineral proceeds derived from land located in Texas should be escheatable only by that State. We do not believe that the fact that an intangible is income from real property with a fixed situs is significant enough to justify treating it as an exception to a general rule concerning escheat of intangibles.” Thus, to the extent property is classified as TPP, the Supreme Court ruled that only the state in which the property is located may escheat the property.
Overview of State Law TPP Provisions
As a number of states have enacted variations of one of the versions of the Uniform Unclaimed Property Acts, an analysis of state law provisions pertinent to the treatment of TPP starts with a review of the Uniform Act. Thus, the pertinent provision of the 1995 Act states as follows: “Tangible property held in a safe deposit box or other safekeeping depository in this State in the ordinary course of the holder's business and proceeds resulting from the sale of the property permitted by other law, are presumed abandoned if the property remains unclaimed by the owner for more than five years after expiration of the lease or rental period on the box or other repository.” The Commentary to such section states in pertinent part as follows: “Section 3 parallels Section 2(d) of the 1966 Act and Section 16 of the 1981 Act. This section is not intended to cover property left in places other than safekeeping repositories, for example, airport lockers or field warehouses. Its coverage is limited to tangible property held in safe deposit boxes and financial institutions.” With that background in mind, we will review a few representative state unclaimed property laws. A number of states explicitly provide in such laws that they claim tangible personal property. For example, Delaware law states in pertinent part: “Property” means personal property...of every kind or description, tangible or intangible, in the possession or under the control of a holder...” California law states in relevant part “All tangible personal property located in this state...that is held or owing in the ordinary course of the holder's business and has remained unclaimed by the owner for more than three years after it became payable or distributable escheats to this state.”
Florida provides in its law that “All tangible and intangible property held in a safe deposit box or any other safekeeping repository in this state in the ordinary course of the holder's business, and proceeds from the property permitted by law, that remain unclaimed by the owner for more than 3 years after the lease or rental period on the box or other repository has expired are presumed abandoned.” Florida Reporting Instructions state: “The only tangible personal property subject to the Unclaimed Property Law are items from safe deposit boxes in financial institutions as provided in Section 717.116, Florida Statutes.” Minnesota Department of Commerce Reporting Instructions state that “... the only tangible property that is reported is the contents of safe deposit boxes. Real estate and other tangible property are NOT reported.” Texas Reporting Instructions offer the following commentary on tangible property: “Safe deposit box contents held by depositories that have remained unclaimed by the owners for five years should be reported to the Comptroller's office on Nov. 1 of each year. Safekeeping properties, loan collateral and any other tangible properties not held in safe deposit boxes should be reported after remaining unclaimed for three years.” While these provisions may not be actively enforced, it is important that holders take note of the states' authority to escheat this property as it could become a significant issue under audit.
Discussion of Various Types of Tangible Personal Property
Based on our firm's collective consulting experience, we have encountered a number of diverse TPP types. Although by no means an exhaustive list, this discussion illustrates the myriad of diverse property types that arise in this area. Some of these types include the following:
* Banking/Financial Institutions - In addition to the safe deposit box contents already mentioned above, it is not unusual for loan departments to have tangible property held as collateral for a loan.
* Delivery Services - These companies routinely have TPP that is misplaced or otherwise not claimed. Although federal regulations may come into play, holders of TPP in this industry may desire to involve legal counsel to review the extent to which unclaimed property laws apply.
* Hospitals - It is not uncommon for these organizations to hold patient valuables which cannot be reunited with the owner. It is likely that TPP held in such capacity qualifies as property held in a safekeeping repository.
* Hotels/Motels - Many hotels/motels provide safes for valuables of their customers. This type of TPP also could be claimed by states whose laws either cover tangible property generally, or whose laws otherwise specify property held in a safekeeping repository format.
* Auction Houses - What if tangible property that has not been sold is not claimed by the original owner after several years? Do the unclaimed property laws apply? What about the effect of “liquidated damage” or other similar provisions in the contract that might allow the auction house to retain the property to cover its costs, assuming the owner cannot be found?
* Museums - What about tangible property loaned to a museum that is not claimed upon expiration of the loan agreement? See for example, Georgia S.B. 195 (2006), amending Ga. Stat. Ann., Sec. 44-12-193.
* Airlines - What about luggage that is not claimed, and the contents thereof? Do federal regulations preempt state law? Holders of TPP in this industry may desire to involve legal counsel to review the extent to which unclaimed property laws apply.
* Automobile Dealerships – Whether customers order specialty items or are waiting for standard accoutrements not available at the time of delivery, many fail to return to pick up floor mats, license plate holders, car covers, etc. Are states interested in this TPP? Are there any requirements to at least report an inventory of these items? This certainly warrants discussion with counsel to examine the unclaimed property implications and consider whether language can be incorporated into agreements to establish customer rights, dealer obligations and address the value of items that are not timely claimed.
Significance of the Internet Upon Tangible Personal Property Transactions
A random review of state unclaimed property websites indicated that states generally handle the disposition of unclaimed TPP in one of two alternative ways. First, some states utilize the Internet, and particularly eBay-for continual sales of TPP that is in their possession. Alternatively, some states utilize a traditional auction to dispose of TPP that is in their possession.
Prior to the advent of the Internet, it is believed states were faced with a number of practical problems entwined with the sale of TPP. Thus, pre-Internet, an annual auction of the property could take place, with attendant logistical difficulties. For example, a venue would need to be secured to have the auction, a percentage of the fees obtained from the sale might have been required to be paid to a contract auctioneer, and, once the auction was over, all the TPP that was not sold presumably would need to be moved and housed again in a different location. With the introduction of the Internet, and particularly eBay, all of this changed. State unclaimed property administrators realized they could have a continuous auction of the TPP, and the audience to bid on the property obviously greatly increased, with attendant higher prices for the TPP being obtained. A document found on the Texas State Comptroller's website captioned “About Texas Unclaimed Property”, indicated under a sub-heading “Online Auctions” the following: “Going, going-but not gone...Texas was the first state to sell unclaimed property online-specifically, safe deposit box contents whose owners have been unreachable for more than six years. The auctions began in 1999 on the popular auction web site eBay.com. The Unclaimed Property Division now holds weekly auctions, and the Comptroller's office is a “Top-rated seller” with 99.8 percent positive feedback. But rest assured that, even if your long-forgotten necklace was sold, the proceeds are and always will be yours. Proceeds from the eBay.com auctions are" liquid" unclaimed assets; belong to the owner (not the state); and have no claim deadline. To view our current auctions, go to the “tx.unclaimed.property” eBay seller site and view current listings.” Similarly, a review of the Pennsylvania State Treasurer's website indicated they use eBay to auction a number of items deposited into their vault including coin collections, jewelry and musical instruments.
Other states utilize the traditional auction to dispose of TPP held in their possession. Thus, a 2009 wire story indicated that Florida was hosting an auction of TPP, stating: “The state will auction at least $500,000 worth of jewelry, watches, rare coins, and other property left in safe deposit boxes.” A related wire story stated that “40,000 items will be auctioned off at the annual Unclaimed Property Auction on Saturday, October 24.”
In addition, Washington has indicated on the state's Department of Revenue website that it usually holds an auction of TPP every four years. Materials found on such website stated: “Safe deposit box contents and safe keeping items are turned over to the state of Washington five years after the owner stops paying rent. If the owner does not claim the items, the State must sell the contents at public auction within five years. The Department typically holds an auction every four years. However, we are currently considering holding our next auction in May, 2011...Our last auction was held in December 2008. At that time, we sold more than 4000 lots with net proceeds of over $545,000. These proceeds were placed in accounts for the owners of the property that was sold. Sale items usually include collectable coins & currency, jewelry, pocket watches, stamps, silver bars, sports cards, and other collectables. We do not auction land, vehicles or most other tangible property.”
In summary, although not every state specifically addresses TPP in the context of unclaimed property law, TPP is a category that can be claimed by a number of states and is often auctioned off when items have some monetary value. Given the current economic climate, the review of TPP as a potential source of unclaimed property will likely continue to grow in visibility with the states. Especially in the areas outlined herein, holders who ignore this area do so at their own peril!
Pertinent Jurisdictional Rules
The seminal case in this area is Texas v. New Jersey. In that case, the U.S. Supreme Court promulgated jurisdictional or priority rules regarding which state had a right to lay claim to unclaimed intangible personal property. However, the Court also summarized the law pertinent to escheat claims for tangible property, stating as follows: “With respect to tangible property, real or personal, it has always been the unquestioned rule in all jurisdictions that only the State in which the property is located may escheat the property.” Interestingly, Texas sought to argue in that case that mineral proceeds emanating from production in Texas should be escheatable only by the State of Texas. The Supreme Court disagreed, stating as follows: “Texas argues in particular that at least the part of the intangible obligations here which are royalties, rents, and mineral proceeds derived from land located in Texas should be escheatable only by that State. We do not believe that the fact that an intangible is income from real property with a fixed situs is significant enough to justify treating it as an exception to a general rule concerning escheat of intangibles.” Thus, to the extent property is classified as TPP, the Supreme Court ruled that only the state in which the property is located may escheat the property.
Overview of State Law TPP Provisions
As a number of states have enacted variations of one of the versions of the Uniform Unclaimed Property Acts, an analysis of state law provisions pertinent to the treatment of TPP starts with a review of the Uniform Act. Thus, the pertinent provision of the 1995 Act states as follows: “Tangible property held in a safe deposit box or other safekeeping depository in this State in the ordinary course of the holder's business and proceeds resulting from the sale of the property permitted by other law, are presumed abandoned if the property remains unclaimed by the owner for more than five years after expiration of the lease or rental period on the box or other repository.” The Commentary to such section states in pertinent part as follows: “Section 3 parallels Section 2(d) of the 1966 Act and Section 16 of the 1981 Act. This section is not intended to cover property left in places other than safekeeping repositories, for example, airport lockers or field warehouses. Its coverage is limited to tangible property held in safe deposit boxes and financial institutions.” With that background in mind, we will review a few representative state unclaimed property laws. A number of states explicitly provide in such laws that they claim tangible personal property. For example, Delaware law states in pertinent part: “Property” means personal property...of every kind or description, tangible or intangible, in the possession or under the control of a holder...” California law states in relevant part “All tangible personal property located in this state...that is held or owing in the ordinary course of the holder's business and has remained unclaimed by the owner for more than three years after it became payable or distributable escheats to this state.”
Florida provides in its law that “All tangible and intangible property held in a safe deposit box or any other safekeeping repository in this state in the ordinary course of the holder's business, and proceeds from the property permitted by law, that remain unclaimed by the owner for more than 3 years after the lease or rental period on the box or other repository has expired are presumed abandoned.” Florida Reporting Instructions state: “The only tangible personal property subject to the Unclaimed Property Law are items from safe deposit boxes in financial institutions as provided in Section 717.116, Florida Statutes.” Minnesota Department of Commerce Reporting Instructions state that “... the only tangible property that is reported is the contents of safe deposit boxes. Real estate and other tangible property are NOT reported.” Texas Reporting Instructions offer the following commentary on tangible property: “Safe deposit box contents held by depositories that have remained unclaimed by the owners for five years should be reported to the Comptroller's office on Nov. 1 of each year. Safekeeping properties, loan collateral and any other tangible properties not held in safe deposit boxes should be reported after remaining unclaimed for three years.” While these provisions may not be actively enforced, it is important that holders take note of the states' authority to escheat this property as it could become a significant issue under audit.
Discussion of Various Types of Tangible Personal Property
Based on our firm's collective consulting experience, we have encountered a number of diverse TPP types. Although by no means an exhaustive list, this discussion illustrates the myriad of diverse property types that arise in this area. Some of these types include the following:
* Banking/Financial Institutions - In addition to the safe deposit box contents already mentioned above, it is not unusual for loan departments to have tangible property held as collateral for a loan.
* Delivery Services - These companies routinely have TPP that is misplaced or otherwise not claimed. Although federal regulations may come into play, holders of TPP in this industry may desire to involve legal counsel to review the extent to which unclaimed property laws apply.
* Hospitals - It is not uncommon for these organizations to hold patient valuables which cannot be reunited with the owner. It is likely that TPP held in such capacity qualifies as property held in a safekeeping repository.
* Hotels/Motels - Many hotels/motels provide safes for valuables of their customers. This type of TPP also could be claimed by states whose laws either cover tangible property generally, or whose laws otherwise specify property held in a safekeeping repository format.
* Auction Houses - What if tangible property that has not been sold is not claimed by the original owner after several years? Do the unclaimed property laws apply? What about the effect of “liquidated damage” or other similar provisions in the contract that might allow the auction house to retain the property to cover its costs, assuming the owner cannot be found?
* Museums - What about tangible property loaned to a museum that is not claimed upon expiration of the loan agreement? See for example, Georgia S.B. 195 (2006), amending Ga. Stat. Ann., Sec. 44-12-193.
* Airlines - What about luggage that is not claimed, and the contents thereof? Do federal regulations preempt state law? Holders of TPP in this industry may desire to involve legal counsel to review the extent to which unclaimed property laws apply.
* Automobile Dealerships – Whether customers order specialty items or are waiting for standard accoutrements not available at the time of delivery, many fail to return to pick up floor mats, license plate holders, car covers, etc. Are states interested in this TPP? Are there any requirements to at least report an inventory of these items? This certainly warrants discussion with counsel to examine the unclaimed property implications and consider whether language can be incorporated into agreements to establish customer rights, dealer obligations and address the value of items that are not timely claimed.
Significance of the Internet Upon Tangible Personal Property Transactions
A random review of state unclaimed property websites indicated that states generally handle the disposition of unclaimed TPP in one of two alternative ways. First, some states utilize the Internet, and particularly eBay-for continual sales of TPP that is in their possession. Alternatively, some states utilize a traditional auction to dispose of TPP that is in their possession.
Prior to the advent of the Internet, it is believed states were faced with a number of practical problems entwined with the sale of TPP. Thus, pre-Internet, an annual auction of the property could take place, with attendant logistical difficulties. For example, a venue would need to be secured to have the auction, a percentage of the fees obtained from the sale might have been required to be paid to a contract auctioneer, and, once the auction was over, all the TPP that was not sold presumably would need to be moved and housed again in a different location. With the introduction of the Internet, and particularly eBay, all of this changed. State unclaimed property administrators realized they could have a continuous auction of the TPP, and the audience to bid on the property obviously greatly increased, with attendant higher prices for the TPP being obtained. A document found on the Texas State Comptroller's website captioned “About Texas Unclaimed Property”, indicated under a sub-heading “Online Auctions” the following: “Going, going-but not gone...Texas was the first state to sell unclaimed property online-specifically, safe deposit box contents whose owners have been unreachable for more than six years. The auctions began in 1999 on the popular auction web site eBay.com. The Unclaimed Property Division now holds weekly auctions, and the Comptroller's office is a “Top-rated seller” with 99.8 percent positive feedback. But rest assured that, even if your long-forgotten necklace was sold, the proceeds are and always will be yours. Proceeds from the eBay.com auctions are" liquid" unclaimed assets; belong to the owner (not the state); and have no claim deadline. To view our current auctions, go to the “tx.unclaimed.property” eBay seller site and view current listings.” Similarly, a review of the Pennsylvania State Treasurer's website indicated they use eBay to auction a number of items deposited into their vault including coin collections, jewelry and musical instruments.
Other states utilize the traditional auction to dispose of TPP held in their possession. Thus, a 2009 wire story indicated that Florida was hosting an auction of TPP, stating: “The state will auction at least $500,000 worth of jewelry, watches, rare coins, and other property left in safe deposit boxes.” A related wire story stated that “40,000 items will be auctioned off at the annual Unclaimed Property Auction on Saturday, October 24.”
In addition, Washington has indicated on the state's Department of Revenue website that it usually holds an auction of TPP every four years. Materials found on such website stated: “Safe deposit box contents and safe keeping items are turned over to the state of Washington five years after the owner stops paying rent. If the owner does not claim the items, the State must sell the contents at public auction within five years. The Department typically holds an auction every four years. However, we are currently considering holding our next auction in May, 2011...Our last auction was held in December 2008. At that time, we sold more than 4000 lots with net proceeds of over $545,000. These proceeds were placed in accounts for the owners of the property that was sold. Sale items usually include collectable coins & currency, jewelry, pocket watches, stamps, silver bars, sports cards, and other collectables. We do not auction land, vehicles or most other tangible property.”
In summary, although not every state specifically addresses TPP in the context of unclaimed property law, TPP is a category that can be claimed by a number of states and is often auctioned off when items have some monetary value. Given the current economic climate, the review of TPP as a potential source of unclaimed property will likely continue to grow in visibility with the states. Especially in the areas outlined herein, holders who ignore this area do so at their own peril!
IRS Offers Guidance on Reporting Schedule M-3 Expenses
The Internal Revenue Service April 21 offered guidance on how taxpayers should report their research and experimentation expenses when filling out the Schedule M-3, which the nation's largest taxpayers must use to reconcile their tax and book income.
In general, IRS said that taxpayers who use a current deduction method of accounting for these expenses under tax code Section 174(a) do not need to provide detail on a project-by-project or product-by-product basis in the M-3 supporting schedules.
However, those who account for R&D expenditures under the deferral and amortization method of Section 174(b) must offer detail on that project-by-project basis, IRS said in a frequently asked question and answer (FAQ) posted to its website April 21.
Recordkeeping Required
Whether or not taxpayers are required to break down expenses by project or product, they all must maintain sufficient records to verify the costs are qualified under Section 174, IRS said. The records need to identify the product, the uncertainty related to the product, and the costs related to resolving such uncertainty.
IRS noted that if an entity adopts the current expense treatment under Section 174(a), this treatment applies to all research projects or products as defined under Section 174. Therefore, taxpayers do not need to go project-by-project when detailing their research and development costs for the Schedule M-3.
However, the agency stressed that these taxpayers still must keep records to verify the amount of expenditures deducted as Section 174(a) expenses.
Those who use the deferral and amortization method under Section 174(b) must take the more detailed approach, the agency said. Taxpayers must include the type and amount for each project or product and a description of each specific project or product to which the qualified expenditures relate, IRS noted.
The complete text of this article can be found in the BNA Daily Tax Report, April 22, 2011.
In general, IRS said that taxpayers who use a current deduction method of accounting for these expenses under tax code Section 174(a) do not need to provide detail on a project-by-project or product-by-product basis in the M-3 supporting schedules.
However, those who account for R&D expenditures under the deferral and amortization method of Section 174(b) must offer detail on that project-by-project basis, IRS said in a frequently asked question and answer (FAQ) posted to its website April 21.
Recordkeeping Required
Whether or not taxpayers are required to break down expenses by project or product, they all must maintain sufficient records to verify the costs are qualified under Section 174, IRS said. The records need to identify the product, the uncertainty related to the product, and the costs related to resolving such uncertainty.
IRS noted that if an entity adopts the current expense treatment under Section 174(a), this treatment applies to all research projects or products as defined under Section 174. Therefore, taxpayers do not need to go project-by-project when detailing their research and development costs for the Schedule M-3.
However, the agency stressed that these taxpayers still must keep records to verify the amount of expenditures deducted as Section 174(a) expenses.
Those who use the deferral and amortization method under Section 174(b) must take the more detailed approach, the agency said. Taxpayers must include the type and amount for each project or product and a description of each specific project or product to which the qualified expenditures relate, IRS noted.
The complete text of this article can be found in the BNA Daily Tax Report, April 22, 2011.
Avoiding Taxes on Life and Disability Insurance
By CRISTINA LOUROSA-RICARDO
Having enough life and disability insurance should be a key element of your personal financial game plan.
Hopefully, with some advance planning, you can collect life and disability insurance proceeds free of taxes. Here's how.
Life Insurance: The main reason most people have life insurance is to replace income that would be lost if they die prematurely. Life-insurance death benefit payments can generally be received by beneficiaries free of any federal income tax (and usually free of state income tax, too).
But the benefit payments still may be subject to the federal estate tax. If the tax rules treat you as the owner of a policy on your own life, the death benefit is included in your taxable estate -- unless the money goes to your surviving spouse, and he or she is a U.S. citizen. When death benefits go directly to a nonspouse policy beneficiary, such as a child or sibling (even without passing through your estate), the money is included in your taxable estate.
The solution is to set up an irrevocable life-insurance trust to own the policy. The trust then pays the premiums, and the death benefits go to whomever you name as the trust's beneficiaries. Your estate is out of the picture.
There are a few complexities with this strategy, however, so hire an experienced estate-planning professional to get the job done right.
Disability Insurance: Long-term disability coverage protects you against lost earnings during any lengthy period out of work because of a disability. The catch? Most long-term disability, or LTD, policies limit benefits to 60% or 70% of earnings before income taxes.
That's generally OK as long as you don't have to pay income taxes. But if you do, you're probably going to lose 30% to 40% (or more) to federal and state taxes.
LTD benefits are generally income-tax-free when you, rather than your employer, pay the premiums. But if your employer pays the premiums as a tax-free fringe, LTD benefits will be fully taxable to you. The same is true if you set aside part of your salary pretax to pay the premiums.
If LTD benefits would be taxable because your employer is paying the premiums, the preferred solution is to arrange for the premiums to be paid with aftertax dollars through withholdings from your checks.
The other alternative is to buy a supplemental LTD policy. The idea is to buy enough extra coverage to cover the income-tax hit on the benefits that you would receive under the company-provided coverage.
Having enough life and disability insurance should be a key element of your personal financial game plan.
Hopefully, with some advance planning, you can collect life and disability insurance proceeds free of taxes. Here's how.
Life Insurance: The main reason most people have life insurance is to replace income that would be lost if they die prematurely. Life-insurance death benefit payments can generally be received by beneficiaries free of any federal income tax (and usually free of state income tax, too).
But the benefit payments still may be subject to the federal estate tax. If the tax rules treat you as the owner of a policy on your own life, the death benefit is included in your taxable estate -- unless the money goes to your surviving spouse, and he or she is a U.S. citizen. When death benefits go directly to a nonspouse policy beneficiary, such as a child or sibling (even without passing through your estate), the money is included in your taxable estate.
The solution is to set up an irrevocable life-insurance trust to own the policy. The trust then pays the premiums, and the death benefits go to whomever you name as the trust's beneficiaries. Your estate is out of the picture.
There are a few complexities with this strategy, however, so hire an experienced estate-planning professional to get the job done right.
Disability Insurance: Long-term disability coverage protects you against lost earnings during any lengthy period out of work because of a disability. The catch? Most long-term disability, or LTD, policies limit benefits to 60% or 70% of earnings before income taxes.
That's generally OK as long as you don't have to pay income taxes. But if you do, you're probably going to lose 30% to 40% (or more) to federal and state taxes.
LTD benefits are generally income-tax-free when you, rather than your employer, pay the premiums. But if your employer pays the premiums as a tax-free fringe, LTD benefits will be fully taxable to you. The same is true if you set aside part of your salary pretax to pay the premiums.
If LTD benefits would be taxable because your employer is paying the premiums, the preferred solution is to arrange for the premiums to be paid with aftertax dollars through withholdings from your checks.
The other alternative is to buy a supplemental LTD policy. The idea is to buy enough extra coverage to cover the income-tax hit on the benefits that you would receive under the company-provided coverage.
Tax Relief for Homeowners With Corrosive Drywall
IRS safe harbor offers clear method to claim deduction.
By KARL L. FAVA, CPA, ELLEN WEISS, ESQ. and ROBERT E. HUBER, CPA
Some homeowners who have built or purchased new homes in recent years are experiencing the destructive effects of sulfur emissions from so-called corrosive gypsum plasterboard, or drywall. This drywall was manufactured in China in response to the mini-construction boom after the destruction from Gulf Coast hurricanes in the mid-2000s. Most of it was installed between 2005 and 2006. U.S. suppliers could not keep up with the increased demand, and imports of Chinese drywall increased 17 times. However, corrosive drywall had been installed as early as 2001. It has been found across the country, but mainly in Florida and Louisiana.
As of late January this year, the U.S. Consumer Product Safety Commission (CPSC) had received nearly 3,800 reports of corrosive drywall in buildings in more than 40 states, the District of Columbia, American Samoa and Puerto Rico (see tinyurl.com/5rvq4xj). The corrosive drywall emits hydrogen sulfide gas (which is what gives rotten eggs their distinctive odor) and, in buildings where it has been installed, causes blackening and corrosion of copper wiring, copper components of household appliances and copper air conditioning evaporator coils. Residents of homes where it is present say it also causes health problems that include headaches; itchy eyes; scratchy, burning throat; and skin irritations.
Homeowners in Florida, Mississippi, Alabama and Louisiana account for more than 87% of the CPSC’s reports, with a significant number (165) also reported in Virginia. The numbers increased during 2010, and more cases are likely to continue to come to light. The CPSC reports that in 2006 alone, more than 5.5 million sheets of drywall were imported from China, although only some brands were found to give off hydrogen sulfide gas (see tinyurl.com/29m3vgl).
This article is intended to help CPAs guide their clients who have or think they may have a problem with corrosive drywall to take advantage of guidance and a safe harbor method of deducting a casualty loss outlined in Revenue Procedure 2010-36 (tinyurl.com/37um6y4), which the IRS issued in September 2010 after numerous inquiries from taxpayers and their congressional representatives. Acknowledging the “unique circumstances” involved, the IRS provided the safe harbor and a formula for determining its amount. The revenue procedure is available to individuals who pay to repair damage to their personal residence or household appliances from the effects of corrosive drywall.
CONFIRMING THE PRESENCE OF CORROSIVE DRYWALL
Section 4.01 of Revenue Procedure 2010- 36 states its special tax treatment is available for “problem drywall” as identified in two steps outlined by the CPSC and the Department of Housing and Urban Development in interim guidance from those agencies issued Jan. 28, 2010 (tinyurl.com/69dsq6g). On Aug. 27, 2010, the agencies revised this guidance (see tinyurl.com/4h6oj55).
Step 1. An initial inspection finds blackening of copper electrical wiring or air conditioning evaporator coils and evidence the drywall was installed between 2001 and 2008.
Step 2. A further inspection finds corroborating evidence or characteristics, such as results of testing a sample of the drywall for sulfur content, metal corrosiveness and/or sulfide gas emission. Other possible corroborating evidence can be labeling or other marks indicating the drywall is of Chinese origin.
PROBLEM ISSUES CLARIFIED
The revenue procedure clarified a number of problematic areas for homeowners seeking to claim a casualty loss deduction for damage caused by corrosive drywall and the cost to remove and replace it and repair or replace affected metal components or household appliances. One was the nature of the damage. For loss deduction purposes, a casualty is generally defined as partial or complete destruction of property resulting from an event “of a sudden, unexpected, and unusual nature” (Revenue Ruling 72-592). The effects of corrosive drywall could easily be described as unexpected and unusual, but they might be difficult or impossible to characterize as a sudden event. The damage from the drywall typically occurs over time; copper tubing does not corrode overnight. Yet Revenue Ruling 72-592 underscores the suddenness of a casualty as an event “that is swift and precipitous and not gradual or progressive.” The revenue procedure also cites Matheson v. Commissioner (54 F.2d 537 (2nd Cir. 1931)), in which the taxpayer was denied a casualty loss deduction related to a flawed design that allowed a home’s steel foundation reinforcement bars to corrode. Because a personal property casualty loss is defined as arising “from fire, storm, shipwreck, or other casualty” (section 165(c)(3)), courts have reasoned that by “other casualty,” Congress meant events as sudden as fire, storm and shipwreck. Courts have similarly ruled against taxpayers with respect to wood “dry rot” (Hoppe v. Commissioner, 42 TC 820, (aff’d, 9th Cir. 1965)) and termite damage (Fay v. Helvering, 120 F.2d 253 (2nd Cir. 1941)).
A second problem was also time-related. Section 165(a) provides that the loss is properly claimed in the tax year in which it is sustained. With respect to corrosive drywall damage, when exactly was the loss sustained? Was it the year the drywall was installed, or later, when the effects were discovered?
Third, how was the amount of loss to be determined? Under the existing regulations, the amount of a casualty loss generally is the decrease in the fair market value of the property as a result of the casualty, limited to the taxpayer’s adjusted basis in the property (Treas. Reg. § 1.165-7(b)). However, determining the fair market value before the loss, especially in the economic conditions existing at the time, could be problematic. To simplify the calculation of the loss, regulations also permit taxpayers to use the cost to repair damaged property as evidence of the decrease in the value of the property. Such repairs must be only those needed to restore the property to its condition immediately before the casualty, and their cost must not be excessive. They must not increase the property’s value beyond its value immediately before the casualty (Treas. Reg. § 1.165-7(a)(2)(ii)). The revenue procedure applies these requirements, stating that only amounts paid to restore the taxpayer’s personal residence to the condition existing immediately prior to damage qualify for loss treatment (section 4.03). Where a household appliance is replaced rather than repaired, the amount of the loss attributable to the appliance under the revenue procedure is the lesser of the current cost to replace the original appliance or the basis of the original appliance (generally its cost) (section 4.04).
Fourth, taxpayers generally must wait to claim a casualty loss until they are reasonably certain whether they will receive any insurance reimbursement or other recovery for any portion of it covered by a claim for reimbursement with respect to which there is a reasonable prospect of recovery (Treas. Reg. § 1.165-1(d)(2)).
CLEARING THE HURDLES
The revenue procedure addresses the first three hurdles by stating that the Service will not challenge a casualty loss claim by an individual to repair damage to the individual’s personal residence or household appliances resulting from corrosive drywall (as defined in the revenue procedure) if the individual treats the amount paid to repair the damage as a casualty loss in the year of payment.
The fourth problem, reimbursement for the loss, is addressed in section 4.02 of the revenue procedure for taxpayers in each of the following circumstances:
No claim for reimbursement. A taxpayer who does not have a pending claim for reimbursement (and does not intend to pursue reimbursement) may claim as a loss all unreimbursed amounts paid during the taxable year to repair damage to the taxpayer’s personal residence and household appliances that results from corrosive drywall.
Pending claim for reimbursement. A taxpayer who has a pending claim for reimbursement (or intends to pursue reimbursement) may take advantage of the safe harbor method and claim a loss for 75% of the unreimbursed amounts paid during the tax year to repair damage to the taxpayer’s personal residence and household appliances that resulted from corrosive drywall. The taxpayer may have to include in gross income the amount of recovery previously deducted or have an additional deduction in subsequent tax years, depending on the actual amount of the reimbursement received (section 4.02 of the revenue procedure).
Reimbursement already received. A taxpayer who has been fully reimbursed before filing a return for the year the loss was sustained may not claim a loss.
The general floor for losses of personal-use property as an itemized deduction applies: $100 ($500 for 2009), plus 10% of the taxpayer’s adjusted gross income (AGI).
COMPARISON OF THE SAFE HARBOR AND SECTION 165
The main advantage of the revenue procedure is that a taxpayer does not need to substantiate that the loss was a casualty as defined under section 165. The main disadvantage is that, to fall under the safe harbor and avoid any possible IRS challenge, the taxpayer must pay for the required repairs. Thus, only those taxpayers able to pay for the cost of repairs will be allowed to claim the casualty loss under the safe harbor.
For casualty losses generally, Treas. Reg. § 1.165-7(b) allows the amount of loss to be based on the decrease in the property’s fair market value, but this would be open to challenge by the IRS, as it does not fall under the safe harbor method contained in the revenue procedure. In addition, the amount of loss may be difficult to prove if the difference in fair market value is used as the measurement of the amount of loss, especially considering the overall economic condition of the real estate market. As noted in Brandom v. U.S. (docket no. 76CV779-W-3 (W.D. Mo. 1978)), the casualty loss must recognize effects of any general market decline affecting undamaged property and exclude that decline in value. If there is not an accurate appraisal of the property prior to any damage from drywall, it could be difficult to determine just how much of the loss is attributable to corrosive drywall versus an overall decline in residential housing prices.
Under the safe harbor in the revenue procedure, a taxpayer may be able to take a deduction in the year that he or she pays for repairs, regardless of the prospects for a recovery or reimbursement for the damage; under Treas. Reg. § 1.165-1(d)(2)(i), a taxpayer attempting to take a loss outside the revenue procedure would be able to take a loss only in the year that no prospect for reimbursement exists. With many builders being insolvent and the supplier of the drywall difficult or impossible to determine (and possibly also insolvent), a reasonable prospect of recovery may not be likely. A taxpayer may be able to substantiate that recovery is unlikely if the taxpayer can track down these parties and execute a release (see Treas. Reg. § 1.165-1(d)(2)(i)). Absent such definitive proof, and since this is a question of fact (as stated in the regulations), opinions could vary on exactly when the likelihood of recovery is no longer reasonable.
CLAIMING THE LOSS
A casualty loss is claimed as an itemized deduction on Schedule A of Form 1040 and Form 4684, Casualties and Thefts. The safe harbor provision of the revenue procedure requires the taxpayer to include the heading “Revenue Procedure 2010-36” at the top of Form 4684.
For corrosive drywall losses incurred in prior years, taxpayers may file an amended return.
For tax years before 2010, a taxpayer’s itemized deductions may be limited by the phaseout based on AGI. The casualty loss deduction should not increase the likelihood that the taxpayer will be subject to the alternative minimum tax. The casualty loss described in this article relates to personal property and is not a tax preference item. Taxpayers must reduce their basis in the home by the amount of the casualty loss deduction and any reimbursement from insurance or otherwise.
Example 1: Safe harbor without reimbursement claim. During the 2010 tax year, Taxpayer A incurred $12,500 to replace corrosive drywall and repair damaged appliances. Taxpayer A cannot seek reimbursement from any parties that contributed to the damages. Taxpayer A’s AGI in 2010 was $45,000.
Step 1. Since Taxpayer A does not have a pending claim for reimbursement and does not plan to seek reimbursement, his gross casualty loss is equal to the full amount of costs incurred in 2010, $12,500.
Step 2. Reduce casualty loss by $100 due to section 165(h)(1).
Step 3. Casualty loss is reduced by an additional 10% of Taxpayer A’s AGI ($45,000 x 10% = $4,500). Taxpayer A’s allowable casualty loss claim is $7,900 ($12,500 –100 – 4,500 = $7,900).
Example 2: Safe harbor with reimbursement claim. The facts are the same as Example 1, except that Taxpayer B has a claim pending for reimbursement by the builder.
Step 1. Since Taxpayer B has a pending claim for reimbursement, his gross casualty loss is equal to 75% of the amount of costs incurred in 2010, or $9,375 ($12,500 x 75%).
Step 2. Reduce casualty loss by $100 due to section 165(h)(1).
Step 3. Casualty loss is reduced by an additional 10% of Taxpayer B’s AGI ($45,000 x 10% = $4,500). Taxpayer B’s allowable casualty loss claim is $4,775 ($9,375 – 100 – 4,500 = $4,775).
CLARITY AND GREATER CERTAINTY
Prior to Revenue Procedure 2010-36 there was much uncertainty about whether the damages caused by corrosive drywall qualified as a casualty loss. The revenue procedure provides taxpayers with a clear method to claim a deduction for the cost of repairs due to corrosive drywall. However, because it generally requires basing the amount of loss on amounts paid to repair damage, it may prevent taxpayers who are unable to pay for repairs from claiming a loss.
EXECUTIVE SUMMARY
Taxpayers may seek relief under IRS Revenue Procedure 2010-36, which addresses tax implications of corrosive drywall and the resulting economic loss. The procedure addresses what constitutes a deductible casualty loss, the tax year in which the loss is deductible, and how to compute the amount of the loss. It provides a safe harbor method for determining the amount of the loss.
Under the safe harbor, a taxpayer who does not have a pending claim for reimbursement of damages and does not intend to pursue reimbursement may claim a loss of all unreimbursed amounts paid during the tax year to repair damage from corrosive drywall to the taxpayer’s personal residence and household appliances. If there is a pending claim for reimbursement or an intention to pursue reimbursement, a taxpayer may claim only 75% of the unreimbursed amounts paid to repair the damages. Income or an additional deduction may arise in a subsequent tax year, depending on the amount of any reimbursement actually received.
The revenue procedure carries a drawback of basing the amount of the deduction on payment for repairs rather than a calculation of decrease in fair market value as a result of the casualty (limited to the taxpayer’s basis in the property), that is otherwise allowed as a method under Treas. Reg. § 1.165-7(b).
However, the revenue procedure gives taxpayers certainty that the IRS will not challenge treatment of the repairs as a casualty loss under the requirement that a casualty is the result of an “identifiable event” that is “sudden, unexpected, and unusual” rather than the result of “progressive deterioration.”
Karl L. Fava (kfava@bfcinc.com) is a principal with Business Financial Consultants Inc. in Dearborn, Mich. Ellen Weiss (ellenlweiss@yahoo.com) is a tax consultant in Canton, Mich. Robert E. Huber (robert@hubercpapc.com) is a principal with Huber CPA PC, and a Ph.D. candidate at the University of Arizona, both in Tucson, Ariz.
By KARL L. FAVA, CPA, ELLEN WEISS, ESQ. and ROBERT E. HUBER, CPA
Some homeowners who have built or purchased new homes in recent years are experiencing the destructive effects of sulfur emissions from so-called corrosive gypsum plasterboard, or drywall. This drywall was manufactured in China in response to the mini-construction boom after the destruction from Gulf Coast hurricanes in the mid-2000s. Most of it was installed between 2005 and 2006. U.S. suppliers could not keep up with the increased demand, and imports of Chinese drywall increased 17 times. However, corrosive drywall had been installed as early as 2001. It has been found across the country, but mainly in Florida and Louisiana.
As of late January this year, the U.S. Consumer Product Safety Commission (CPSC) had received nearly 3,800 reports of corrosive drywall in buildings in more than 40 states, the District of Columbia, American Samoa and Puerto Rico (see tinyurl.com/5rvq4xj). The corrosive drywall emits hydrogen sulfide gas (which is what gives rotten eggs their distinctive odor) and, in buildings where it has been installed, causes blackening and corrosion of copper wiring, copper components of household appliances and copper air conditioning evaporator coils. Residents of homes where it is present say it also causes health problems that include headaches; itchy eyes; scratchy, burning throat; and skin irritations.
Homeowners in Florida, Mississippi, Alabama and Louisiana account for more than 87% of the CPSC’s reports, with a significant number (165) also reported in Virginia. The numbers increased during 2010, and more cases are likely to continue to come to light. The CPSC reports that in 2006 alone, more than 5.5 million sheets of drywall were imported from China, although only some brands were found to give off hydrogen sulfide gas (see tinyurl.com/29m3vgl).
This article is intended to help CPAs guide their clients who have or think they may have a problem with corrosive drywall to take advantage of guidance and a safe harbor method of deducting a casualty loss outlined in Revenue Procedure 2010-36 (tinyurl.com/37um6y4), which the IRS issued in September 2010 after numerous inquiries from taxpayers and their congressional representatives. Acknowledging the “unique circumstances” involved, the IRS provided the safe harbor and a formula for determining its amount. The revenue procedure is available to individuals who pay to repair damage to their personal residence or household appliances from the effects of corrosive drywall.
CONFIRMING THE PRESENCE OF CORROSIVE DRYWALL
Section 4.01 of Revenue Procedure 2010- 36 states its special tax treatment is available for “problem drywall” as identified in two steps outlined by the CPSC and the Department of Housing and Urban Development in interim guidance from those agencies issued Jan. 28, 2010 (tinyurl.com/69dsq6g). On Aug. 27, 2010, the agencies revised this guidance (see tinyurl.com/4h6oj55).
Step 1. An initial inspection finds blackening of copper electrical wiring or air conditioning evaporator coils and evidence the drywall was installed between 2001 and 2008.
Step 2. A further inspection finds corroborating evidence or characteristics, such as results of testing a sample of the drywall for sulfur content, metal corrosiveness and/or sulfide gas emission. Other possible corroborating evidence can be labeling or other marks indicating the drywall is of Chinese origin.
PROBLEM ISSUES CLARIFIED
The revenue procedure clarified a number of problematic areas for homeowners seeking to claim a casualty loss deduction for damage caused by corrosive drywall and the cost to remove and replace it and repair or replace affected metal components or household appliances. One was the nature of the damage. For loss deduction purposes, a casualty is generally defined as partial or complete destruction of property resulting from an event “of a sudden, unexpected, and unusual nature” (Revenue Ruling 72-592). The effects of corrosive drywall could easily be described as unexpected and unusual, but they might be difficult or impossible to characterize as a sudden event. The damage from the drywall typically occurs over time; copper tubing does not corrode overnight. Yet Revenue Ruling 72-592 underscores the suddenness of a casualty as an event “that is swift and precipitous and not gradual or progressive.” The revenue procedure also cites Matheson v. Commissioner (54 F.2d 537 (2nd Cir. 1931)), in which the taxpayer was denied a casualty loss deduction related to a flawed design that allowed a home’s steel foundation reinforcement bars to corrode. Because a personal property casualty loss is defined as arising “from fire, storm, shipwreck, or other casualty” (section 165(c)(3)), courts have reasoned that by “other casualty,” Congress meant events as sudden as fire, storm and shipwreck. Courts have similarly ruled against taxpayers with respect to wood “dry rot” (Hoppe v. Commissioner, 42 TC 820, (aff’d, 9th Cir. 1965)) and termite damage (Fay v. Helvering, 120 F.2d 253 (2nd Cir. 1941)).
A second problem was also time-related. Section 165(a) provides that the loss is properly claimed in the tax year in which it is sustained. With respect to corrosive drywall damage, when exactly was the loss sustained? Was it the year the drywall was installed, or later, when the effects were discovered?
Third, how was the amount of loss to be determined? Under the existing regulations, the amount of a casualty loss generally is the decrease in the fair market value of the property as a result of the casualty, limited to the taxpayer’s adjusted basis in the property (Treas. Reg. § 1.165-7(b)). However, determining the fair market value before the loss, especially in the economic conditions existing at the time, could be problematic. To simplify the calculation of the loss, regulations also permit taxpayers to use the cost to repair damaged property as evidence of the decrease in the value of the property. Such repairs must be only those needed to restore the property to its condition immediately before the casualty, and their cost must not be excessive. They must not increase the property’s value beyond its value immediately before the casualty (Treas. Reg. § 1.165-7(a)(2)(ii)). The revenue procedure applies these requirements, stating that only amounts paid to restore the taxpayer’s personal residence to the condition existing immediately prior to damage qualify for loss treatment (section 4.03). Where a household appliance is replaced rather than repaired, the amount of the loss attributable to the appliance under the revenue procedure is the lesser of the current cost to replace the original appliance or the basis of the original appliance (generally its cost) (section 4.04).
Fourth, taxpayers generally must wait to claim a casualty loss until they are reasonably certain whether they will receive any insurance reimbursement or other recovery for any portion of it covered by a claim for reimbursement with respect to which there is a reasonable prospect of recovery (Treas. Reg. § 1.165-1(d)(2)).
CLEARING THE HURDLES
The revenue procedure addresses the first three hurdles by stating that the Service will not challenge a casualty loss claim by an individual to repair damage to the individual’s personal residence or household appliances resulting from corrosive drywall (as defined in the revenue procedure) if the individual treats the amount paid to repair the damage as a casualty loss in the year of payment.
The fourth problem, reimbursement for the loss, is addressed in section 4.02 of the revenue procedure for taxpayers in each of the following circumstances:
No claim for reimbursement. A taxpayer who does not have a pending claim for reimbursement (and does not intend to pursue reimbursement) may claim as a loss all unreimbursed amounts paid during the taxable year to repair damage to the taxpayer’s personal residence and household appliances that results from corrosive drywall.
Pending claim for reimbursement. A taxpayer who has a pending claim for reimbursement (or intends to pursue reimbursement) may take advantage of the safe harbor method and claim a loss for 75% of the unreimbursed amounts paid during the tax year to repair damage to the taxpayer’s personal residence and household appliances that resulted from corrosive drywall. The taxpayer may have to include in gross income the amount of recovery previously deducted or have an additional deduction in subsequent tax years, depending on the actual amount of the reimbursement received (section 4.02 of the revenue procedure).
Reimbursement already received. A taxpayer who has been fully reimbursed before filing a return for the year the loss was sustained may not claim a loss.
The general floor for losses of personal-use property as an itemized deduction applies: $100 ($500 for 2009), plus 10% of the taxpayer’s adjusted gross income (AGI).
COMPARISON OF THE SAFE HARBOR AND SECTION 165
The main advantage of the revenue procedure is that a taxpayer does not need to substantiate that the loss was a casualty as defined under section 165. The main disadvantage is that, to fall under the safe harbor and avoid any possible IRS challenge, the taxpayer must pay for the required repairs. Thus, only those taxpayers able to pay for the cost of repairs will be allowed to claim the casualty loss under the safe harbor.
For casualty losses generally, Treas. Reg. § 1.165-7(b) allows the amount of loss to be based on the decrease in the property’s fair market value, but this would be open to challenge by the IRS, as it does not fall under the safe harbor method contained in the revenue procedure. In addition, the amount of loss may be difficult to prove if the difference in fair market value is used as the measurement of the amount of loss, especially considering the overall economic condition of the real estate market. As noted in Brandom v. U.S. (docket no. 76CV779-W-3 (W.D. Mo. 1978)), the casualty loss must recognize effects of any general market decline affecting undamaged property and exclude that decline in value. If there is not an accurate appraisal of the property prior to any damage from drywall, it could be difficult to determine just how much of the loss is attributable to corrosive drywall versus an overall decline in residential housing prices.
Under the safe harbor in the revenue procedure, a taxpayer may be able to take a deduction in the year that he or she pays for repairs, regardless of the prospects for a recovery or reimbursement for the damage; under Treas. Reg. § 1.165-1(d)(2)(i), a taxpayer attempting to take a loss outside the revenue procedure would be able to take a loss only in the year that no prospect for reimbursement exists. With many builders being insolvent and the supplier of the drywall difficult or impossible to determine (and possibly also insolvent), a reasonable prospect of recovery may not be likely. A taxpayer may be able to substantiate that recovery is unlikely if the taxpayer can track down these parties and execute a release (see Treas. Reg. § 1.165-1(d)(2)(i)). Absent such definitive proof, and since this is a question of fact (as stated in the regulations), opinions could vary on exactly when the likelihood of recovery is no longer reasonable.
CLAIMING THE LOSS
A casualty loss is claimed as an itemized deduction on Schedule A of Form 1040 and Form 4684, Casualties and Thefts. The safe harbor provision of the revenue procedure requires the taxpayer to include the heading “Revenue Procedure 2010-36” at the top of Form 4684.
For corrosive drywall losses incurred in prior years, taxpayers may file an amended return.
For tax years before 2010, a taxpayer’s itemized deductions may be limited by the phaseout based on AGI. The casualty loss deduction should not increase the likelihood that the taxpayer will be subject to the alternative minimum tax. The casualty loss described in this article relates to personal property and is not a tax preference item. Taxpayers must reduce their basis in the home by the amount of the casualty loss deduction and any reimbursement from insurance or otherwise.
Example 1: Safe harbor without reimbursement claim. During the 2010 tax year, Taxpayer A incurred $12,500 to replace corrosive drywall and repair damaged appliances. Taxpayer A cannot seek reimbursement from any parties that contributed to the damages. Taxpayer A’s AGI in 2010 was $45,000.
Step 1. Since Taxpayer A does not have a pending claim for reimbursement and does not plan to seek reimbursement, his gross casualty loss is equal to the full amount of costs incurred in 2010, $12,500.
Step 2. Reduce casualty loss by $100 due to section 165(h)(1).
Step 3. Casualty loss is reduced by an additional 10% of Taxpayer A’s AGI ($45,000 x 10% = $4,500). Taxpayer A’s allowable casualty loss claim is $7,900 ($12,500 –100 – 4,500 = $7,900).
Example 2: Safe harbor with reimbursement claim. The facts are the same as Example 1, except that Taxpayer B has a claim pending for reimbursement by the builder.
Step 1. Since Taxpayer B has a pending claim for reimbursement, his gross casualty loss is equal to 75% of the amount of costs incurred in 2010, or $9,375 ($12,500 x 75%).
Step 2. Reduce casualty loss by $100 due to section 165(h)(1).
Step 3. Casualty loss is reduced by an additional 10% of Taxpayer B’s AGI ($45,000 x 10% = $4,500). Taxpayer B’s allowable casualty loss claim is $4,775 ($9,375 – 100 – 4,500 = $4,775).
CLARITY AND GREATER CERTAINTY
Prior to Revenue Procedure 2010-36 there was much uncertainty about whether the damages caused by corrosive drywall qualified as a casualty loss. The revenue procedure provides taxpayers with a clear method to claim a deduction for the cost of repairs due to corrosive drywall. However, because it generally requires basing the amount of loss on amounts paid to repair damage, it may prevent taxpayers who are unable to pay for repairs from claiming a loss.
EXECUTIVE SUMMARY
Taxpayers may seek relief under IRS Revenue Procedure 2010-36, which addresses tax implications of corrosive drywall and the resulting economic loss. The procedure addresses what constitutes a deductible casualty loss, the tax year in which the loss is deductible, and how to compute the amount of the loss. It provides a safe harbor method for determining the amount of the loss.
Under the safe harbor, a taxpayer who does not have a pending claim for reimbursement of damages and does not intend to pursue reimbursement may claim a loss of all unreimbursed amounts paid during the tax year to repair damage from corrosive drywall to the taxpayer’s personal residence and household appliances. If there is a pending claim for reimbursement or an intention to pursue reimbursement, a taxpayer may claim only 75% of the unreimbursed amounts paid to repair the damages. Income or an additional deduction may arise in a subsequent tax year, depending on the amount of any reimbursement actually received.
The revenue procedure carries a drawback of basing the amount of the deduction on payment for repairs rather than a calculation of decrease in fair market value as a result of the casualty (limited to the taxpayer’s basis in the property), that is otherwise allowed as a method under Treas. Reg. § 1.165-7(b).
However, the revenue procedure gives taxpayers certainty that the IRS will not challenge treatment of the repairs as a casualty loss under the requirement that a casualty is the result of an “identifiable event” that is “sudden, unexpected, and unusual” rather than the result of “progressive deterioration.”
Karl L. Fava (kfava@bfcinc.com) is a principal with Business Financial Consultants Inc. in Dearborn, Mich. Ellen Weiss (ellenlweiss@yahoo.com) is a tax consultant in Canton, Mich. Robert E. Huber (robert@hubercpapc.com) is a principal with Huber CPA PC, and a Ph.D. candidate at the University of Arizona, both in Tucson, Ariz.
Thursday, April 21, 2011
Late 2010 Legislation Resulted In IRS Having Electronic Return Originators Hold 6.5 Million E-Filed Tax Returns
The enactment of legislation in late 2010 resulted in IRS having Electronic Return Originators hold 6.5 million e-filed tax returns for transmission on Feb. 14, the Treasury Inspector General for Tax Administration (TIGTA) said in an audit released on April 18. (Audit Report No. 2011-40-032) In addition, the agency held some 100,000 paper tax returns received prior to that date. The audit provided interim results for the 2011 filing season through March 5. Auditors found programming errors that led to the issuance of erroneous First-Time Homebuyer Credits and Non-Business Energy Property Credits. According to the audit, IRS had received returns from 9,859 individuals claiming over $124 million in Adoption Credits, with 6,974 (or 71%) of the claims “either having invalid, insufficient, or missing documentation to support the legitimacy of the claims.” IRS also identified 335,341 tax returns with $1.9 billion claimed in fraudulent refunds and prevented the issuance of $1.8 billion (or 97%) of those fraudulent refunds. The agency also selected 63,501 tax returns filed by prisoners for fraud screening, representing an 88% increase compared to last filing season. In addition, auditors visited 26 Taxpayer Assistance Centers and “assistors answered all 35 tax law questions accurately.” On the downside, auditors encountered an average waiting time of 62 minutes before they received assistance. “Our interim report on the IRS filing season provides a valuable opportunity for review, which is mixed again this year,” said J. Russell George, the inspector general. “On the one hand, the IRS is to be commended for its sharpened focus on fraud interception and prevention,” George said, adding that “on the other, its efforts to prevent improper credits still leave much to be desired, and customer service problems continue.” He urged IRS officials to solve the problems that were identified “without delay.” The audit is available at http://www.treasury.gov/tigta/auditreports/2011reports/201140032fr.pdf.
IRS And Foreign Tax Administrators Encounter Similar Issues Even Though Tax Law Provisions May Differ
IRS and foreign tax administrators encounter similar issues even though their tax law provisions may differ, the Government Accountability Office (GAO) recently told the Senate Finance Committee. (GAO-11-540T) GAO cited examples such as assisting taxpayers with the preparation and filing of returns, and ensuring tax compliance. GAO's testimony described the way foreign tax administrators deal with issues similar to those encountered in the U.S. It also addressed IRS's approach to the possibility of adopting tax administration practices used in other countries. As the basis for its testimony, GAO looked at tax administration practices in Australia, the European Union, Finland, Hong Kong, New Zealand, and the United Kingdom. As described by GAO, foreign and U.S. tax administrators use common practices, including information reporting, tax withholding, and seeking new approaches for tax compliance. “These practices, although common to each system, have important differences,” GAO said. “Although differences in laws, culture, or other factors likely would affect the transferability of foreign tax practices to the U.S., these practices may provide useful insights for policymakers and the IRS,” GAO added. IRS officials learn about various practices through interactions with other tax administrators and participation in international organizations, such as the Organization for Economic Co-operation and Development. The GAO testimony can be found at http://www.gao.gov/new.items/d11540t.pdf.
IRS Announced Late Surge Of E-Filed Returns Pushed Total Number Above 100 Million
Hours before the April 18 filing deadline, IRS announced that a late surge of e-filed returns pushed the total number of such returns above 100 million. (IR 2011-46) This marks a record for the most e-filed returns during a filing season. The total of e-filed returns was nearly 101 million, which represents an 8.8% increase over the figure for 2010. For all of calendar year 2010, IRS received 98.7 million e-filed returns. The agency also reminded taxpayers that e-file and Free File remain available for those filing with a six-month extension.
Earned Income Tax Credit Program Source Of $16.9 Billion In Improper Payments
The Earned Income Tax Credit (EITC) program was the source of $16.9 billion in improper payments in fiscal year 2010, according to the Government Accountability Office (GAO). (GAO-11-443R) The error rate regarding the improper payments was 26.3%. This information was contained in a March 25 letter to several members of the Senate Banking Committee that was released on April 15. In fiscal year 2009, the EITC program paid out $12.3 billion in improper payments with an error rate of 25.5%. The EITC program was ranked fourth on the list of the top 10 sources of improper payments by the federal government. Medicare fee-for-service, Medicaid, and the Unemployment Insurance program held the first three places on the list. Overall, federal agencies reported a total of $125.4 billion in improper payments in FY 2010, an amount that was $16.2 billion higher than the estimates for FY 2009. “In light of today's fiscal environment, the need to ensure that federal dollars are spent as intended is critical,” the GAO letter said. “Establishing effective accountability measures to prevent and reduce improper payments, and to recover overpayments, becomes an extremely high priority,” the letter added. It is available at http://www.gao.gov/new.items/d11443r.pdf.
IRS Remind To Review Individual Tax Returns For Common Errors That Could Delay Refunds
On April 14, IRS issued a reminder to taxpayers stressing the importance of reviewing their federal individual income tax returns for common errors that could delay refunds. (IR 2011-45) The agency listed a number of ways to avoid such errors, including the following: file electronically; remember the Making Work Pay credit; mail a paper return to the correct address; check only one filing status; double-check all figures; provide the right routing and account numbers when requesting a direct deposit of a refund; sign and date the return or, if e-filing, use a self-selected personal identification number; if filing a paper return, attach forms to the front of the return; and if you owe money, look at the e-payment options or send a check or money order payable to the “United States Treasury.” Additional information can be found at http://www.irs.gov/newsroom/article/0,,id=238479,00.html.
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