Wednesday, March 27, 2013

What Are Your Chances of Being Audited?

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The IRS has issued statistical data on its 2012 fiscal year activities.  This data provides valuable information about how many tax returns the IRS is likely to audit in future years, and what categories of returns the IRS will be focusing.  This data also provides insight into other IRS enforcement activities such as collections.  Overall there seems to be a slight downward trend in the percentage of returns being audited.

Percentage of Returns Audited.   Of the 144 million individual tax returns filed in 2011, less than 1.5 million, or about 1%, were audited in 2012. This is down from the prior year when 1.1% of the filed returns were audited in this period.   Of the total number of 2011 individual income tax returns that were audited in 2012, 487,408 (32.9%) were for returns claiming an earned income tax credit (EITC).  This was a small increase over the 483,574 (30.9%) of 2010 returns that were audited in 2011 for this reason.

Field Audits v. Correspondence Audits.  About 24.3% of the individual audits conducted in 2012 were field audits conducted by revenue agents, tax compliance officers, tax examiners and revenue officer examiners. That is a slight decrease from the prior year when 25% of the audits were field audits.  The 75.7% balance of the audits conducted in 2012 were correspondence audits.

Audit Risk Higher if Return includes Business Income.  For individual returns with business income other than farm income showing total gross receipts of $100,000 to $200,000, 3.6% of returns were audited in 2012, compared to 4.3% in 2011.  For returns with business income other than farm income showing total gross receipts of $200,000 or more, 3.4% of returns were audited in 2012, compared to 3.8% in 2011.  For returns showing farm income, 0.5% were audited in 2012 compared to 0.6% in 2011.

 Audit Risk Lower if No Business Activity.  For individual returns showing total income of $200,000 to $1 million, 2.8% of returns NOT showing any business activity were audited in 2012, while 3.7% of returns showing some business activity were audited in 2012.  In 2011, the rate of audit for such returns not showing any business activity was 3.2% compared to 3.6% for returns showing business activity.  In 2012, the audit rate for all returns with total income of $1 million or more was 12.1%, compared to 12.5% for 2011.  Business activity shown on a return includes any Schedule C business as well as claiming home office and similar deductions.

Audit Risk Increases as Income Increases.  The data clearly shows that the audit rate in 2012 increased for higher income earners. The audit rate in 2012 was 0.85% for returns with adjusted gross income (AGI) between $100,000 and $200,000 (down from 1% for 2011), and 1.96% for those with AGI of $200,000 to $500,000 (down from 2.66% for 2011). The audit rate increased to 8.9% for those with AGI of $1 million to $5 million (down from 11.8% for 2011). The audit rate for 2012 as compared to 2011 also increased for taxpayers with AGI of $5 million to $10 million, as well as for those with AGI of $10 million or more.

C Corporation Audit Rate.   For all corporate returns other than Form 1120S, the audit rate in 2012 was 1.5%, same as in 2011.  For C corporations with total assets of $250,000 to $1 million, the audit rate in 2012 was 1.7% vs. 1.6% in 2011.  For C corporations with total assets of $1–$5 million, the audit rate was 2.1% vs. 1.9% in 2011.  For C corporations with net assets of $5–10 million, the audit rate was 2.6% vs. 2.6% in 2011.  For C corporations with returns showing total assets of $10 million or more, the overall audit rate in 2012 was 17.8%, up slightly from 17.6% for 2011.  For larger C Corporations, the audit rate increased with the size of the entity.

Partnership and S Corporation Audit Risk.  The 2012 audit rate for partnership and S corporation returns was 0.5%, as compared to 0.4% for 2011.  The 2012 audit rate for partnerships and S corporations was well less than the rate for C corporations.

Summary.  The good news is that the risk of audit in almost all categories has at least temporarily decreased slightly.  Individuals claiming an earned income credit, however, significantly increase their risk of audit.  Individual returns that include business activity also increase the risk of audit.  The higher the reported income, the higher the audit risk as well.  The point of studying and reporting these statistics is not to scare you or convince you not to take an aggressive position on an item of income or expense on your return.  Rather, the point is to make you aware that audits do occur, that they occur more often in certain situations, and that you want to be in a position to defend yourself if you happen to be audited.  Contact me at 937-223-1130 or if you get audited or need some assistance dealing with a tax matter.

 AND ONE MORE THING.  Don’t forget, the American Tax Relief Act made several changes to the tax code that are short lived.  You need to act fast to take advantage of them. For example, the asset holding period for built-in-gains tax purposes is reduced from 10 years to 5 years for assets sold in 2012 or 2013.  Likewise, the small business stock gain exclusion is increased to 100% from 75% for stock acquired in 2012 or 2013.  If you would like to know more about the provisions of the American Tax Relief Act, contact me at 937-223-1130 or

Thursday, March 21, 2013

Avoiding Problems When Making S Election for LLC

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As you may know, an LLC with more than one member is treated as a partnership unless it elects to be treated as a corporation or S corporation.  When deciding whether to make an election for an LLC to be taxed as an S corporation, there are various tax issues to consider and pitfalls to avoid.

Why Elect S Status?  One of the most common reasons for electing S corporation status is to reduce the amount of social security and medicare tax that owner-employees of the LLC pay.  This reason to elect S corporation status was given a boost with the enactment of the additional 0.9% medicare tax imposed on the compensation of employees with income in excess of $250,000 (married filing jointly) or $200,000 (individual).

How to Elect S Status.  S corporation status is obtained by filing IRS Form 2553 indicating that the LLC elects to be treated as an S corporation for federal income tax purposes.  But filing the Form 2553 is not effective unless the LLC otherwise qualifies to be treated as an S corporation as of the election date.

S Corporation Requirements.  An S corporation is not permitted to have owners who are corporations or non-resident aliens.  An S corporation is not permitted to have more than 100 owners.  An S corporation may have only one type of ownership interest (cannot have both common and preferred stock).  If your LLC violates any of these requirements, the LLC cannot be treated as an S corporation for federal income tax purposes.

Governing Documents.   The main governing document for an LLC is its operating agreement.  Since  LLCs are by default treated as partnerships for federal income tax purposes, most off-the-shelf, boilerplate operating agreements are set up in the form of modified partnership agreements.  As such, the standard operating agreement contains many provisions whose only purpose is addressing federal partnership income tax issues.  Many of the partnership tax provisions are not required, or even permitted, if the LLC is intended to be treated as an S corporation for federal income tax . Many of these typical LLC operating agreement provisions are not permitted if the entity is to be taxed as an S corporation.

One Class of Stock.  S corporations may have only one class of stock (although voting differences are ignored).  Partnerships may have any number of different preferred classes of ownership interests.  S corporations are not permitted to have classes of ownership which have different rights to share in distributions of cash or assets, or in allocations of profit and loss.   Since LLC operating agreements are generally set up as modified partnership agreements, they often contain partnership tax language including , qualified income offsets, minimum gain chargebacks and other provisions that may override allocations and distributions that would otherwise be done on a pure ownership percentage basis.

State Law Defaults.  Under most state LLC laws, provisions that are not otherwise covered in the LLC operating agreement are governed by state law.  It is possible that the LLC default rules could result in the LLC failing to qualify for S corporation treatment.  For example, if there is no provision describing how cash is to be distributed or income allocated among the members, the Ohio default is that allocations and distributions by an LLC are to be made based on the relative capital contributions made by the members.  To the extent one member has contributed more or less to the LLC on a relative pro rata basis than his ownership percentage would otherwise dictate, such LLC could be found to have violated the “one class of stock” rule.

Fixing Operating Agreements.  Care needs to be taken to remove any language giving a member’s ownership interest priority over another member’s ownership interest.   References to IRC section 704 and other partnership tax provisions should be eliminated.  Any references to doing allocations or distributions in relation to capital account also need to be carefully analyzed and probably deleted.  Many LLC operating agreements provide for capital calls.  Capital call provisions are permissible for an S corporation, but the remedy for failure to meet the capital call must result in a change in the ownership percentage and not affect right to, or priority of, distributions or allocations.

Failure to Meet S Corporation Requirements.  If an LLC that has elected to be taxed as an S corporation fails to meet the S corporation requirements (and the LLC does not apply for and obtain late election or inadvertent invalid election relief) the LLC will be treated as a partnership (not a C corporation) under the entity status default classification rules.

Planning.   When setting up or converting an LLC to be taxed as an S corporation, you need to prepare and file the appropriate IRS election form.   But you must also carefully review and consider the various provisions of the LLC operating agreement and the state law LLC default provisions.  If you are setting up or converting an LLC to be taxed as an S corporation give Jeff Senney a call or email at 937-223-1130 or

AND ONE MORE THING.  The IRS has recognized that the delayed issuance and processing of income tax forms resulting from the income tax code changes contained in the 2012 Taxpayer Relief Act has impacted the ability of taxpayers to timely estimate and pay their 2012 tax liability.  The IRS has provided relief to taxpayers who request an extension of time to file a 2012 income tax return that includes one of the affected tax forms.  Taxpayers will be deemed to have demonstrated reasonable cause and lack of willful neglect, provided that the following requirements are met (1) a good faith effort is made to properly estimate the tax liability on the extension application; (2) the estimated amount is paid by the original due date of the return; and (3) any tax owed on the return is fully paid no later than the extended due date of the return.  When responding to an assessment notice, a taxpayer should submit a letter describing eligibility for this relief, identifying which of the affected form(s) below was included with the taxpayer's return as filed, and make reference to Notice 2013-24.  Call or email Jeff Senney at 937-223-1130 or if you would like to see a list of the affected forms or want help with seeking penalty abatement.

Friday, March 15, 2013

Affordable Care Act Update - How to Make Determinations Regarding Employer Mandate and Part-time Employees

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Matt Stokely of our firm has written a timely article on how to make determinations regarding the Employer Mandate and Part-time employees.  Check out Matt's article below.

One of the biggest decisions for many companies this year will be what to do about their health benefits.  Major provisions of the Affordable Care Act (“ACA”) take effect on January 1, 2014, and certain employers could see health-related costs go up as a result of the law’s requirements.  Employers will have to determine if they are subject to the Employer Mandate, and if so, to whom they will be responsible for offering health insurance or paying penalties.  Specifically, the ACA requires Applicable Large Employers – those with 50 or more full-time-equivalent employees – to ether provide “qualified” health coverage for all of their employees, or pay an annual penalty of $2,000 per full-time employee (after the first 30) if they don’t provide such coverage.  If they do provide coverage but it’s not “affordable,” the penalty is $3,000 per employee who finds it “unaffordable” (with a cap at the penalty they’d pay for not offering coverage at all).  “Full-time” is defined as 30 hours or more per week, or 120 hours or more per month.  (“Affordable” is defined as less than 9.5% of the employee’s family income).  This article describes how employers are required to make these calculations.

Applicable Large Employers Subject to Employer Mandate

An employer is subject to the Affordable Care Act Employer Mandate as an Applicable Large Employer if it employed an average of at least 50 full-time employees (including full-time equivalent employees (FTEs)) on business days during the preceding calendar year.  This involves the calculation of Full-Time Employees that work on the average of 30 or more hours per week and “FTEs”.  In determining whether an employer is an Applicable Large Employer for the current calendar year, the employer is required to calculate the number of FTEs it employed during the preceding calendar year.  All employees (including seasonal employees) who were not full-time employees for any month in the preceding calendar year are included in calculating the employer’s FTEs for that month.  The number of FTEs for each calendar month in the preceding calendar year are determined using the following steps:

1)      Calculate the aggregate number of hours of service (but not more than 120 hours of service for any employee) for all employees who were not full-time employees for that month.
2)      Divide the total hours of service in step (1) by 120.  This is the number of FTEs for the calendar month.

In determining the number of FTEs for each calendar month, fractions would be taken into account.  For example, if in a calendar month employees who are not full-time employees work 1,260 hours, there would be 10.5 FTEs for that month.  Using this calculation, if the employer employs 50 or more FTEs in the prior calendar year, it is subject to the Employer Mandate, and must offer affordable health insurance to its full-time employees or pay penalties.

Determination of Part-Time Employee Status

The IRS has issued Notice 2012-58 to modify and expand on the safe harbor guidance previously provided concerning how to make determinations about full or part-time employees status.  If an employee is a part-time employee who works an average of less than 30 hours per week, the Applicable Large Employer will not have to offer health insurance or pay penalties on those part-time employees.

Notice 2012-58 defines three time periods- measurement periods, stability periods, and administrative periods.  New employees who are not expected to work full-time (variable hour or seasonal employees) can be employed without health insurance for an “initial measurement period” of between 3 and 12 months, as determined by the employer, during which the employees hours are tracked.  If at the end of that period it becomes clear that the employee has been working an average of 30 hours a week or more, the employer must offer health insurance to the employee for a “stability period” of at least 6 months or for the length of the initial measurement period, whichever is longer.

Alternatively, if the employee worked on average less than 30 hours a week, the employer can treat the employee as a part-time employee for a subsequent stability period and not offer insurance.  The employer can take up to 90 days for an “administrative period” before the stability period begins during which the employer can determine eligibility and add the employee to its health insurance program.  In no event, however, can the combined measurement period and administrative period extend beyond the last day of the first calendar month beginning on or after the one-year anniversary of the employee’s start date.

Ongoing employees with variable hours can also be made subject to measurement periods and stability periods, with the measurement periods lasting 3 to 12 months and the stability periods lasting for the same period of time but in no event less than 6 months.  If an ongoing employee is determined to be part-time during any measurement period, the employer can deny coverage to that employee without risking a penalty for the next stability period.  If the employee is determined to be full-time during the measurement period, the employer must insure the employee for the following stability period or risk paying a tax penalty.

Employers needing assistance in making these determinations or who wish to consider other issues under the ACA, can call Matt Stokely at Pickrel, Schaeffer & Ebeling at 937-223-1130 or

AND ONE MORE THING.  The 2012 Taxpayer Relief Act will prevent many of the tax hikes that were scheduled to go into effect this year and retain many favorable tax breaks that were scheduled to expire, but will also increase income taxes for some high-income individuals and slightly increase transfer tax rates from 2012 levels. Further, the Act extends a host of expired and expiring tax breaks for businesses and individuals, and also adds a number of new provisions to the Code.  More about this will be coming out in a future blog.  Call me at or 937-223-1130 if you have questions and can’t wait.

Tuesday, March 5, 2013

In Plan Roth Rollover - Does Your Plan Permit it?

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In the “Blue Book” for the recently enacted American Taxpayer Relief Act of 2012 , the Joint Committee on Taxation provided a detailed explanation of the Internal Revenue Code provision regarding how to accomplish a qualified “in-plan Roth rollover” starting January 1, 2013.   This Blue Book explanation is helpful since no formal committee report or other explanation has been provided yet.

Taxpayers generally may transfer or convert amounts in a traditional IRA to a Roth IRA if such amounts are eligible for rollover by either doing a 60-day rollover, a trustee-to-trustee transfer, or an account re-designation.  The amount so transferred or converted is includible in income as if a withdrawal had been made, except that the 10% early withdrawal tax won’t apply.

The Blue Book notes that amounts under a qualified plan are distributable only as permitted under the terms of the plan and law.  One law that applies to plans generally is a requirement that amounts contributed to a 401(k) or profit sharing plan may not be distributed in-service for at least two years.   So even if no other statutory distribution restriction applies to an amount, the plan must generally contain language that permits in-service distributions after a fixed number of years, and such fixed number of years must be no less than two.

But if a qualified plan has a qualified Roth contribution program, any amount eligible under the plan for distribution and rollover to another eligible plan may be rolled over into a designated Roth account in the plan for the individual.   If this is done, the amount rolled-over is includible in gross income (except to the extent it represents after-tax contributions), but the 10% early distribution tax won’t apply.

The 2012 Taxpayer Relief Act provides that an applicable retirement plan that includes a qualified Roth contribution program may allow an individual to elect to have the plan transfer amounts not otherwise distributable under the plan to a designated Roth account in the plan maintained for the individual's benefit.  Under the 2012 Taxpayer Relief Act, the plan will not be treated as violating the restrictions on distributions applicable to such plan solely because of the transfer.

The Blue Book explains that the new law doesn't change the basic character of the amounts being rolled-over.  So if otherwise non-distributable amounts are rolled-over into the Roth account, such amount remain non-distributable.   For example, an amount in a 401(k) or profit-sharing plan which is not distributable because the required number of years has not passed remains non-distributable for the balance of the required number of years.

Making a rollover contribution to a Roth account is not without cost.  In exchange for getting tax-free distributions out of the Roth account down the road, you are required to recognize and pay tax now on the amount rolled over.  In evaluating whether you should make a Roth rollover, you need to consider how much tax you would pay now versus how much tax you expect to save later, and also consider how long you have before retirement and how you expect your plan investments to perform.   This can be a bit of a guessing game.   The income and capital gains rates have changed recently and it is not unlikely they will change again in the future.  And while the stock market has been ticking upwards, will that continue?

Please call or contact me at 937-223-1130 or if you would like to discuss the new in-plan Roth rollover provision further.

AND ONE MORE THING.   For some time, the IRS and the courts have held that the annual gift exclusion is unavailable for certain transfers involving minority interests in closely held business entities.  The IRS has taken the position that gifts of minority interests in closely held entities do not qualify as gifts of present interests, and are therefore ineligible for the annual exclusion, where the distribution of profits in those entities is discretionary and such minority interest are subject to transfer restrictions.  A recent Tax Court case, however, has drawn a distinction where entity income was somewhat predictable and where some income was paid to owners annually.  If you would like to know more about the annual gift exclusion, business valuation discounts, or succession planning please call or contact me at 937-223-1130 or