Partnership Late Filing Penalty – Rev Proc 84-35 and TEFRA

I have written two prior posts on this issue, and there has been a lot of discussion and important contributions from readers, so I wanted to compile all the information in one post.

The Basics:

Partnerships and entities taxed as partnerships (LLC, LLP, etc) are required to file annual returns by 4/15.  A five month extension is available, making the final deadline 9/15.  Strict penalties are assessed by the IRS if you file late.

The penalty is currently $195 “per partner, per month” that the return is late.  This can add up really fast, and average late filing penalties result in several thousand dollars of non-deductible fees that the IRS is making more and more difficult to get removed.

It does not matter if your business taxed as a partnership did not make any money or never really took off – if you registered for an EIN# or have filed previous returns, you need to follow through and returns annually.  The IRS is not going to listen to they type of excuses.

Abatement Option #1 – Rev Proc 84-35

If the partners or LLC/LLP members filed their personal returns timely (4/15 or extended and filed by 10/15), then you may have a get out jail card that has been available for over a decade now and provides automatic penalty abatement.

Here is the complete list of factors:

  • The partnership has to be a domestic partnership,
  • have 10 or fewer partners (husband and wife and their estate are treated as one partner),
  • all partners have to be natural persons (other than a nonresident alien) or an estate of a deceased partner,
  • each partner’s share of each partnership item has to be the same as their share of every other item,
  • all partners need to have timely filed their income tax returns, and
  • all the partners need to have fully reported their share of the income, deductions, and credits of the partnership on their timely filed income tax returns.

If you meet all these requirements, your first response to a partnership late filing penalty letter from the IRS needs to look like this sample letter.

Now, it seems the IRS has grown tired of Rev Proc 84-35 abatement requests, as they have been trying to shift the discussion of penalty abatement to “reasonable cause”.  Do not let them do this!  Rev Proc 84-35 is available if you meet the criteria.  Even if you have claimed it several years, do not let them try to claim that they cannot abate the penalty or get you side-tracked with a reasonable cause argument – stick to citing Rev Proc 84-35 until you get your abatement.

Important!  This does not work for S corporations and LLCs taxed as S corporations.  A similar Rev Proc for automatic abatement was unfortunately never created for them.  For more information, read my post on S corp late filing abatement.

Abatement Option #2 – The TEFRA Complication

A few years ago, the IRS was looking to raise revenue (they have lavish parties in Disneyland to pay for) and employed a new tactic to reduce partnership late filing penalty abatements.  They found that if a partnership had filed a TEFRA election, that they would not be eligible to use Rev Proc 84-35 to request abatement.  Suddenly, many CPAs who submitted standard Rev Proc 84-35 abatement requests were receiving denials with the IRS claiming the client had filed a TEFRA election.

For all the background on this complication, read my penalty update blog post, but the short story is that the IRS would claim the election was filed clear back in 2002 or earlier, and the client had to dig up a copy of the tax return to prove the election was not made or put together a letter – signed by all partners/members – stating that a TEFRA election had never been filed.  Even then, it often took many letters back and forth or messages on the now defunct IRS eServices resolution service.

I have personally dealt with this issue several times and was able to get abatement in each case; however, I have not had to deal with it in over a year.  Fortunately, some PDXCPA blog readers have had some more current experience, and there was really good information shared in the comments section of the prior posts.  Specifically, Melissa F. Hill, CPA provided a sample abatement letter and backup documentation that became a popular request on this blog.  The documents she has been emailing to readers are available below:

I like Melissa’s sample letter, as that is how you should frame you argument – cite Rev Proc 84-35 and then maintain that a TEFRA election was never filed and request they provide their proof of the election.  A letter signed by all partners maintaining that the election has never been filed helps as well.

Sometimes they will respond with a tax year that they claim the TEFRA election was made in, but then they will claim that it will take them awhile to get a copy from archives.  If you are organized and have a copy of the return, send them a copy and continue to maintain your assertion that the election was not filed and that Rev Proc 84-35 should apply.  You may have to be persistent and put up a strong fight for abatement, but keep trying and do not let them bring up reasonable cause.

Good luck!

Original post 1/5/09 – http://pdxcpa.wordpress.com/2009/01/05/partnership-late-filing-penalty-abatement/

Update post on TEFRA 10/1/12 – http://pdxcpa.wordpress.com/2012/10/01/partnership-late-filing-penalty-update/

S Corporation Shareholder Health Insurance – 2013 Update

I wrote about about the reporting of health insurance for more than 2% shareholders last November and provided an excerpt from my book on the subject, but for 2013, this issue is even more crucial because of several tax changes.  As a more than 2% S Corporation shareholder, your total health and dental insurance premiums for the year need to reimbursed (if not paid directly) by the corporation and included on your W-2.  If this is not done correctly, you are technically not allowed to claim the self-employed health insurance deduction on your individual tax return, and instead you have to claim the deduction on Schedule A.  This treatment has never been desirable because of limitations on Schedule A, but for 2013 the limitations have been increased.  First, the medical expenses floor has increased to 10% (up from 7.5%), which means you only get a deduction for the amount of expenses that exceed 10% of your adjusted gross income.  Secondly, the itemized deduction phase-out (Pease limitation) is back for 2013 for higher income taxpayers, so even if your medical expenses exceed the 10% floor, you could encounter further limitation.  Overall, the difference between a self-employed health insurance deduction and a very limited deduction on Schedule A can translate to thousands of dollars in taxes for a shareholder, and all because of a minor reporting error.

Here is what you need to do before year-end:

  • Calculate total health and dental insurance premiums for the year for each >2% shareholder (including premiums that will be paid before year-end).
  • Make sure the premiums have been paid or reimbursed by the S Corporation.
  • If amounts were deducted from a >2% shareholder’s wages for a portion of their health or dental insurance, contact your CPA or tax preparer, as adjustments will need to be made.  These deductions should not have been made, so immediate modifications will need to be made to your payroll processing.
  • Contact your payroll processor to have the total 2013 health/dental insurance amount added to your W-2 BEFORE the last pay date in the calendar year.  Also, have them coordinate with your CPA or tax preparer to make sure it is reported correctly.
  • If you self-prepare payroll through QuickBooks, I recommend this resource for recording the insurance amount properly.

I strongly recommend putting this at the top of your to-do list for December, as it can be very costly to amend W-2s and federal and state payroll tax filings after their due dates.

If you are in the Portland metro area and need assistance with this issue, you can reach me at brian@pandgcpa.com or 503.244.8844.

The Minority Owner Report, Part 1- LLCs and Partnerships

I am by no means a “precog”, nor can always predict when minority ownership in a small business will result in disaster, but my 14 years of experience with small business clients has taught me a great deal about what not to do when structuring a business and offering ownership to employees.

If you are currently a minority owner (<50% interest) in an LLC taxed as a partnership or a traditional partnership, or you are being offered such ownership, you may want to consider running away from the ownership if certain warning signs are present.  Also, I highly recommend having your tax professional and/or lawyer look everything over before you sign anything.  Business ownership is a lot like marriage, so know what you are getting into.

Minority Ownership Warning Signs in LLCs and Partnerships

The entity does not increase guaranteed payments by 5% to cover self-employment tax

When an employee becomes a partner or LLC member, their tax burden increases substantially because of the self-employment tax.  Generally, an employee pays social security and Medicare tax of 7.65% on gross wages, and the employer pays another 7.65%.  However, an active partner or LLC member is considered self-employed and has to pay both the employee and employer portions of social security and Medicare tax, which total 15.3%.  Fortunately, the IRS allows a deduction for one half of the self-employment taxes paid (just like the deduction available to employers), which results in an approximate net rate of 12%.  This means that a employee who becomes a partner or LLC member will incur a tax increase of approximately 5%.

Most companies do the right thing and give an employee transitioning to ownership enough additional income to cover this 5% tax increase.  The most effective means of doing this is to provide the additional income to the new partner or LLC member in the form of an increase to their regular guaranteed payment.  Employees are accustomed to predictable cash flow and regular tax withholdings, so the transition to making quarterly estimated tax payments at a higher tax rate can be difficult.  Additional income that is guaranteed and paid on a regular basis is going to ease that transition and insure that there is a tangible benefit to ownership.

Unfortunately, a surprising number of partnerships and LLCs do not provide additional income to employees transitioning to minority ownership, and often it can result in ownership that is actually a detriment to them as a result of the additional tax.  Usually, future profits are promised when selling ownership to the employees, and in some businesses, this works very well when consistent profits easily eclipse the 5% tax burden.  However, taxable business profits can be very unpredictable due to current accelerated tax depreciation rules and other complications, and in order to distribute profits during the year when they are helpful to the owners, a business has to keep very accurate accounting records.  Owners have to pay estimated tax payments quarterly, so the unpredictability of having to rely on distributions of profits can create a lot of dissension among owners – especially during periods of low profits or losses.  The sad irony for these businesses who are unwilling to pay the additional 5% in income to partners/LLC members is that they often make ownership offers to employees for the sole purpose of keeping them at the company, and often the tax burden on the new owners does the exact opposite after several years of seeing no benefit to ownership.

The entity is providing capital interest ownership in exchange for services

Giving ownership to an employee in exchange for services can actually work very well if structured correctly and all parties are properly informed of the tax ramifications.  However, ideal situations like this rarely happen in the real world, and usually such an arrangement results in a surprise tax bill for the employee receiving ownership.  Avoiding such a disaster requires an understanding of the most common types of interests available in small business organized as LLCs.

Capital Interest – this is the default type of LLC interest, as it is a complete ownership that entitles the holder to a share of profits and losses as well as a share of the proceeds from the sale of the LLC’s assets if the LLC liquidates.  A capital interest is most commonly given to employees brought on for succession planning purposes.

Profits Interest – this interest is like the capital interest, except a profit interest holder does not receive liquidating distributions from the LLC.  In other words, it is only an interest in future profits of the LLC and there is no initial capital balance for the member.  A profits interest is often given to key employees much like stock options are given to employees of corporations.  It is often intended as a form of additional compensation and a method to retain key personnel.

If you receive a capital interest in exchange for services, it is treated as current compensation in an amount equal to the fair market value of the capital interest at the grant date.  The problem is that most small businesses owners organized as LLCs are not aware of this, and rarely do they tell their CPA about such transactions in advance, so it often becomes an ugly year-end or tax-time surprise for the recipient, as they have taxable income to recognize and no cash to pay the tax with.  To make matters worse, most small business owners have no idea what the fair market value of their LLC is, so the transaction becomes very complex can create many problems down the road if not done correctly.  As an employee being offered such an interest, I strongly recommend asking the LLC to involve their CPA and/or lawyer so that the compensation is determined ahead of time.  This will allow you plan accordingly and look into options like the 754 election that can minimize the tax impact.

If you are granted a profits interest in an LLC, no taxable income is recognized as long as the interest satisfies the Revenue Procedure 93-27 safe harbor rules.  Most LLCs that offer a profits interest have already had a CPA and/or lawyer setup it up so that the rules are met, so in most cases it is a good deal for the employee receiving the interest.  However, it is important to get some prior financial statements and/or tax returns so that you can know what to expect, as sometimes start-ups give profit interests and then go several years without any recognized profit.

The entity does not have a method of equalizing expenses

Single-owner businesses have it very easy in the area of expenses, as they can spend how they want without having to justify to other owners or worry about trying to keep things equal.  In multi-owner businesses, there is a constant problem with equalization, as business partners are usually wired differently when it comes to spending and often have different tastes.  One LLC member may be tech savvy with smart phones and tablets and another may still prefer a flip phone and a paper legal pad, so it is crucial for a minority owner that an LLC or partnership have an established method of expense equalization in place.

The most flexible method of expense equalization is to have the operating agreement specifically state that the LLC or partnership will not reimburse partners for certain expenses and that they are required to pay for these expenses.  As long as it is properly setup in this way, each partner or member can deduct their unreimbursed partnership expenses on their own 1040 tax return on Schedule E page 2.  This allows each partner or member to be as lavish or frugal as they want without having to worry about the expenses of the other owners.  Often, meals and entertainment, automobile, travel, and office expenses are treated in this fashion.

The second best method is devising a special allocation where certain expenses are allocated 100% to certain owners against their guaranteed payments.  This can be elaborate or just a simple calculation done with the tax return preparation, but either way – LLCs and partnerships are extremely flexible in this area.  Just make sure the allocation is decided on well in advance, as it is much more difficult to agree on after expenses have already been paid.

That’s it for LLCs and partnerships.  In Part 2, I will concentrate on minority ownership issues in S corporations.

The Pocket Small Business Owner’s Guide Series Expands

Last October, my book – The Pocket Small Business Owner’s Guide to Taxes – was published by AllWorth Press and became part of a series of books for business owners.  The Pocket Small Business Owner’s Guide books cover such topics as negotiating, buidling your business, and business plans, and today a new title has been added to the series: The Pocket Small Business Owner’s Guide to Starting Your Business on a Shoestring by Carol Tice.

Also known as the Shoestring Startup Guide, the book definitely looks like a great resource for anyone considering starting a new small business.  I meet with new business owners all the time, and unfortunately I see a lot of new businesses run into early cash flow problems or even fail, so there is a definite need for practical money-saving advice for small business owners.

If you buy the book in July, you get a free Shoestring Startup Guide workbook that provides checklists that can be used to brainstorm money-saving opportunities for your business.  Also, you can enter to win a copy of the book on Goodreads.

Manual Review: Oregon Department of Revenue’s Refund Delay Tactic?

If you have an overpayment of over $5,000 on your Oregon tax return, be forewarned – the Oregon Department of Revenue may sit on your refund for up to six months while they “manually review” your return.

In the last year, we have witnessed a sharp increase in the number of clients who had their refund delayed by ODR.  The only common factor we can find is that they all had large overpayments.  In each case, the return was selected for “manual review”, and after weeks and sometimes months of waiting, ODR asks for something as simple as copies of the W-2s (which they should already have since employers are now required to efile W-2s to Oregon).  Even after you supply them with copies of the W-2s, the manual review and refund can often take weeks to process.  Even worse, when you call them, they offer very little information into why the manual review was triggered in the first place and cite their “policies” without letting you speak to a manager.

If I had to venture a guess as to the reason for these delays, I would point to the embarrassing $2.1 million dollar refund error that ODR made last year.  In fact, soon after that error is when our clients started encountering these manual review delays.  Could overreaction be the cause of these delays, or are they simply a fumbling bureaucracy that cannot process refunds in a reasonable period of time?

You can draw your own conclusion, but what I do know is that I am changing my tactics when I have a client with a large Oregon overpayment.  From now on, I am applying the entire overpayment to the next year and then the client can just pay less in estimates during the year.  That way, ODR can take an entire year manually reviewing the return to their hearts content and it will not delay refunds for my clients.

If your 2012 return has been selected for manual review, I would love to hear from you.  There is little advice I can give you other than calling ODR every other day, but the more taxpayers voicing concern about this, the better.  This needs to be given proper attention, as ODR is wasting the time and money of honest Oregon taxpayers and small business owners.

Business Provisions of the American Taxpayer Relief Act

While a good majority of the tax changes in the 11th hour Fiscal Cliff bill (American Taxpayer Relief Act of 2012) concern individual taxes, there are a few changes for small business owners, which are mostly centered around the extension of and retroactive change to depreciation limits and rules.

Section 179 Depreciation Limit

In 2011, we had a $500k limit on the amount that could be taken as Section 179 depreciation expense (provided the business purchased less than $2 million in qualifying property in the year).  This limit was very generous and few small businesses had to worry about getting close to this limit.  However, in 2012 the limit was scheduled to be reduced to $139k (after inflation adjustments), and then even further reduction to $25k in 2013.  For small businesses that acquire a lot of equipment each year, such large limit reductions would have a big impact.

All of 2012, we were unsure if Congress would increase the Section 179 limit, and finally after the ball dropped in Times Square and many of us had resigned ourselves to the 139k limit, our bickering government representatives finally get it together and decided to make a retroactive change to the 2012 limit.  Now, it is as if the the treat of the $139k limit never existed, and we now have a $500k limit for 2012 and 2013.

Now, correct me if I am wrong, but I thought the purpose the Section 179 depreciation benefit was to encourage business owners to buy more business equipment and help spur economic growth?  How are we suppose buy equipment when our government does not decide on the depreciation limit until after the year is over?  I had several clients that typically buy more than $139k in equipment that were trying to make purchase decisions at year-end, and the delay caused by partisan politics in Washington on this limit was extremely frustrating.

Bonus Depreciation Kept Alive

Is bonus depreciation ever going to truly go away?  It seems it is always brought back by 11th hour legislation.  Unfortunately, this time around we only have 50% bonus depreciation that is extended through 2013.  While businesses with net taxable income will use Section 179 depreciation, bonus could be useful for those with losses.

In 2011, we were spoiled with 100% bonus depreciation, and we pretty much wrote off everything in the first year that qualified.  Now we are going to be a little more limited, but it is still a good benefit if you remember back to years before bonus was available.  At best, it provides a great first year deduction for those of you who purchased new vehicles weighing less than 6,000 GVW.  Even with 50% bonus depreciation, you are still going to get $11,160 in depreciation in the first year ($11,360 if a light van or truck) given that most new vehicles are well over $22,320 these days.  Remember, it has to be a brand new.  Certified new does not qualify.

Qualified Leasehold Improvement Retroactive Change

Even though this one will greatly benefit my calendar year filing businesses, it frustrates me to no end that Congress would make this change retroactive to 2012.  Not only did it make one paragraph from my book obsolete, but we are going to have to file several amendments for our fiscal year corporations that have already filed tax returns with qualified leasehold improvements put into use after 1/1/12.

To fully understand my frustration, you need the background history on this tax deduction:

  • In 2011 (and several years prior) you could depreciate qualifying leasehold improvements over 15 years and then use Section 179 or bonus depreciation on the improvements.
  • Before this rule, we had to depreciate them over 39 years, so this was a BIG benefit.
  • Due to the patchwork of tax code in the last few years, the special treatment expired as of 1/1/12, and qualified leasehold improvements could no longer be depreciated over 15 years.
  • Even worse, if you had any 179 carryover originating from qualified leasehold improvements at that point, you had to reclassify the amount (according to steps in Sec 179(f)(4)) and depreciate it under the 2012 rules over 39 years.  Reporting this adjustment was a bit complicated since the IRS did really anticipate the expiration of the tax rules, so not only was it a lost benefit, but it cost fiscal year small businesses more in tax prep fees.
  • Fortunately, there was some saving grace in that the qualifying improvements still qualified for bonus depreciation (since the availability of bonus treatment was not based on the 15 year life), so we were able to take 50% bonus depreciation, but the rest went over 39 years.

Now, fast forward a few months after these fiscal year returns have been filed to when we are all enjoying New Years and watching football (or soccer in my case).  Our government officials, in all their wisdom, decide to retroactively change the 2012 rules and make the 15 year special treatment available again.  In addition, they extend it to 2013 as well, so it is as if the rules we used during 2012 for fiscal year filers never existed.

Again, if you are a calender year filer and you made or are looking to make some leasehold improvements that qualify for the 15 year treatment, this is very welcome news.  However, if you are a fiscal year filing corporation, your CPA may need to file amendments for you once the tax preparation software companies update their software for all the Fiscal Cliff bill changes.

By the way, if you bought my book and would like more information on this change, please feel free to email me at pdxcpa@gmx.com.  Again, it only changes one paragraph in the Fixed Assets chapter, but I would be happy to provide additional details on this change for my readers.

Other Extenders

In addition to the depreciation changes and the retroactive change that has me all riled up (much like the Cascadian supporter groups are at Don Garber), there were also some minor extensions that will benefit a select group of small businesses.  The Research and Work Opportunity Tax Credits were both extended through 2013.  The enhanced charitable deduction for contributions of food inventory is also extend through 2013, as is the special treatment of qualified small business stock.

All in all, there was not much change for businesses; however, we will likely see more substantial changes later in the year.  You may say I am a dreamer, but I am thinking we may actually see some comprehensive tax reform this year.

Avoid Fiscal Cliff Panic

As you can imagine, I have heard a lot of panic from clients since the election results came in last month.  Some panic is warranted, as most acknowledge that the 2% payroll tax reduction will not be extended, capital gains will likely be increased to 20% or 25% at most, and that tax rates will likely be increased for married couples with AGI over $250k.  However, when it comes to capital gains, panic can actually be very detrimental and cost you much more in taxes than you would think.

Naturally, you would assume accelerating a large capital gains to take advantage of the 15% rate would result in large tax savings, but unfortunately the alternative minimum tax erodes the tax savings if you are a high-income taxpayer.  In fact, most of the time it results in an overall tax rate between 20% and 25%.  Why this happens is very complex and even CPAs get frustrated in fully understanding the alternative minimum tax, but here is the best explanation I could find.  Basically, if a large amount of your income is long-term capital gain income and you are a high-income taxpayer, the AMT tax can kick in and erase the benefit of the 15% rate.  We witnessed this quite a bit back in 2010 when financial advisers worried about the expiration of the 15% rate and advised their clients to sell off their low basis stock.  It sounded like a great idea at the time, but when preparing the tax returns in 2011, many were surprised at how AMT tax erased much of the benefit.  Well, the same thing can happen for tax year 2012 if you give in to panic.

Before you make any big moves on capital gains before year-end, talk to your CPA and and have them run a projection to see what the true impact would be.  It may just be that there is no need to panic.