1 Business Issues Chapter 8 pp. 235-2882017 National Income Tax Workbook™

2 Business Issues Electing Out of Subchapter KBusiness Start-Up & Organizational Expenses Expensing Real Estate Improvements Depreciation Issues DPAD Marijuana and Hemp Taxation Learning Objectives – p. 235

3 Issue 1: Electing Out of Sub K Is It a Partnership?Agreement? Acting accordingly? Contributions made by the parties Control/right to make withdrawals Proprietary interest? Conducted in joint names Represent themselves as PS? Separate books for the venture Mutual control/responsibilities

4 Issue 1: Electing Out of Sub K Dividing Profitspp May be PS if divide the profits of venture Ex 8.1 2-3% interests in oil & gas ventures 1099-MISC, no K-1, no right to participate No 1065’s filed Constituted partnership interest (SE tax applied – still a PS for SE tax)

5 Issue 1: Electing Out of Sub K Dividing ProfitsSharing expenses not PS – reg examples > 2 jointly construct ditch to drain properties > co-owners maintain, repair, lease to a farmer for cash rental or share of crops

6 Issue 1: Electing Out of Sub K Providing Tenant ServicesDegree of business activity determines PS Ex (Rev. Rul ) Each owns ½ interest in apartment project Management agreement with property mgr Collection, pays expenses, maintains Mgr provides more, keeps $$ Co-owners not providing services – not PS

7 Issue 1: Electing Out of Sub K Providing Tenant ServicesEx 8.3 Building held as tenants in common Provide trash, snow removal services Providing customary landlord services Not required to report as a PS

8 Issue 1: Electing Out of Sub K Exclusion from PS RulesUnincorporated orgs excluded if: For investment purposes only, no Tor B For joint production, extraction, property use but not selling services or property produced/extracted (operating agreements) Able to determine income w/o PS tax inc.

9 Issue 1: Electing Out of Sub K Exclusions from PS RulesInvestment Partnerships Joint purchase, holding, sale of invest prop Participants: Hold property as co-owners Right to separately take/dispose of share Do not actively conduct business

10 Issue 1: Electing Out of Sub K Exclusions from PS RulesOperating Agreements Participants: Own property as co-owners Right to separately take/dispose share of any property produced/extracted/used Do not jointly sell services or property produced or extracted. Ex 8.4. Co-own, income = share of production

11 Issue 1: Electing Out of Sub K Making the Electionp. 239 File statement with Form 1065 Names, addresses, TIN – entity/owners That entity qualifies for election That entity & all owners elect exclusion Copy of operating agreement or where it can be obtained Figure 8.1 – Sample Election

12 Issue 1: Electing Out of Sub K Making the Electionp. 240 Where? Where 1065 would be filed When? Due date of year to be effective Revocation? Only with approval May break by unqualified activities Member disagreeing may notify IRS & must notify all members Making election not = to admitting to PS

13 Issue 1: Electing Out of Sub K Making the Electionpp Deemed Election Facts & circumstances show intention @ formation exclusion agreement Members report in manner consistent Partial Exclusion Election State PS rules from which excluded IRS must approve

14 Issue 1: Electing Out of Sub K Qualified Joint Venturep. 241 Joint venture conducting T or B Spouses filing joint only members Each spouse materially participates (no attribution – each must qualify) Co-owned by spouses and not held in name of state law entity (e.g. LLC) Both spouses make election

15 Issue 1: Electing Out of Sub K Qualified Joint Venturepp Ex 8.5 H & W business, each work > 500 hrs, not an LLC, equally split Can elect to be excluded from Sub K Community Property States Can treat as disregarded entity

16 Issue 1: Electing Out of Sub K Qualified Joint Venturepp If elect, each files a Schedule C sharing inc./exp. in accordance with interest Rental real estate business (non SE) reported on Sch E, √ QJV box (Fig. 8.2) Electing does not make rental SE inc. If has EEs, either may report & pay Cannot use EIN of prior PS reporting

17 Issue 1: Electing Out of Sub K Qualified Joint Venturep. 243 Elects out by not filing PS return Election revoked only with IRS consent In effect as long as requirements met If terminates, must re-elect when qualifies – PS terminates at the end of the previous year

18 Issue 1: Electing Out of Sub K Advantagesp. 243 No PS level books, no PS return All elections made by member Can use § 1031 to dispose of interest Eliminates basis limit on losses (but at-risk limit could limit losses) No § 751 reporting if interest sold

19 Issue 2: Start-Up & Org Expenses Start-Up ExpensesElect: Deduct lesser of $5,000 or actual Total > $50,000: $5,000 reduced $ for $ Remaining amount: Amortize -180 mos. Start-up expenses relate to investigating, creating, or conducting an activity to become an active T or B Deductible if incurred > T or B starts

20 Issue 2: Start-Up & Org Expenses Start-Up Expensespp Beginning a T or B Analysis/survey of possibilities Advertising for opening of business Compensation related EE training Costs for securing distributors, suppliers Salaries/fees for executives/consultants NOT: interest, taxes, R&E costs

21 Issue 2: Start-Up & Org Expenses Start-Up ExpensesPurchasing a T or B General investigative expenses Not specific investigative expenses (not after identifying business to buy) Ex 8.6 Locates business to buy 9/3/17 Investigative exp < 9/3/17 = start-up

22 Issue 2: Start-Up & Org Expenses Start-Up ExpensesExpanding a Business Costs generally deductible – not limited Continuation of an existing business Capitalize if create or enhance separate and identifiable assets Ex Ski-shop owner to buy others Feasibility & market studies deductible

23 Issue 2: Start-Up & Org Expenses Start-Up ExpensesElection deemed made Forgo by capitalizing on timely return for the year in which active T or B begins Ex 8.8 – $3,000 incurred since 2010, business began in 2017, deduct in 2017 Election is irrevocable for the T or B

24 Issue 2: Start-Up & Org Expenses Start-Up Expensespp Method change if ≥ 2 yrs & change in item character/change in Tor B start yr Ex Subsequent Character Change $41,000 start-up, began 7/1/15 In 2017: Found $10k as 2016 deduction Ex Change in year of start 2015 & 2016 amortize, in 2017, determined business start was in 2016

25 Issue 2: Start-Up & Org Expenses Start-Up Expensespp Exp and amortize over 180 months or amortize over not less than 180 months Ex Start-up of $41,000 Expense $5,000 + $41,000/180 x 6 mos Remaining: $34,800/174 or $200/month Ex Start-up of $54,000 Expense $1,000 ($5,000 - $4,000) + $53,000/180 x 6 months ($300/month)

26 Issue 2: Start-Up & Org Expenses Start-Up Expensespp Ex Start-up of $450,000 Expense = $450,000/180 x 6 mos Remainder: $435,000/174 = $2,500/mo Claiming Under “Other Expense” on Sch C Amortization starts on Form 4562 Ex Figures 8.4 and 8.5 (p. 249)

27 Issue 2: Start-Up & Org Expenses Start-Up ExpensesWhen does business start? Rental: Acquisition not the start Vineyard: No start, planned but never planted TV station: Start w/license & broadcast Engineering services: Office, supplies, promotion but no clients, bids: No start Dispose of business? Deduct balance

28 Issue 2: Start-Up & Org Expenses Organizational ExpensesIncident to creation of corp or PS Expense/amortize same as start-up Corporation – direct costs: For the creation of the corporation Chargeable to capital account Amortize over life if corp had fixed life Incurred by first yearend in business

29 Issue 2: Start-Up & Org Expenses Organizational ExpensesCorporation Cash method – costs incurred in 1st yr Org costs examples - p. 250 Stock issuance costs not included Reorg costs if direct to creating a corp Begins business when starts operations Beginning business ≠ in existence

30 Issue 2: Start-Up & Org Expenses Organizational ExpensesPartnership – Direct costs For the creation of the partnership Chargeable to capital account Amortize over life if PS had fixed life Incurred by due date of first year in business Type to benefit throughout PS life

31 Issue 2: Start-Up & Org Expenses Organizational Expensespp Partnership – Direct costs Cash method – amortize in year paid Include: PS agreemt, acct’g/filing fees NOT: List page If PS totally terminated, deduct balance If technical term., new still amortizes Begins when operations begin

32 Issue 2: Start-Up & Org Expenses Research & Experimentalpp Expense or elect ratable over ≥ 60 mos Amort begins month of 1st benefit Elect amortization on Form 4562 Experimental/laboratory sense Costs of development/improvement Costs of obtaining a patent NOT: see list page

33 Issue 3: Expensing RE Improvements DeMinimis Safe Harborpp Expense in year paid or incurred Acquisition / production of units Economic useful life not > 12 months Cost (invoice) ≤ specified amount - $5,000 with AFS, $2,500 w/o AFS Accounting policy at beg’g of year to write off for book (written if has AFS) Sets minimum for deduction

34 Issue 3: Expensing RE Improvements DeMinimis Safe HarborAll that qualify must be expensed Subsequent gains on sale = ordinary N/A to land or inventory items Ex Improvemt < applicable $ amt. Figure 8.7 w/AFS: $10,089, w/o $5,089 But see PNote – Per Item or Per Unit

35 Issue 3: Expensing RE Improvements DeMinimis Safe HarborAntiabuse Rule Deemed to manipulate w/intent to avoid Invoices show components & If single unit would > safe harbor limit Ex Truck Purchase Cab, engine, trailer, tires separate invoice – all under $2,500, total $3,500

36 Issue 3: Expensing RE Improvements DeMinimis Safe HarborN/A if items are direct or allocable indirect costs subject to § 263A Ex 8.17 Other costs on invoice included in item cost

37 Issue 3: Expensing RE Improvements Unit of Propertypp Affects: If = repair or if ≤ Safe Harbor $ Functional interdependence standard Placing one in service dependent on placing others in service Larger the unit, better repair chance Smaller the unit, more likely improvemt

38 Issue 3: Expensing RE Improvements Unit of Property - Buildingpp Building = single unit but has 9 specific systems each treated as separate unit Building structure = building with all but specific systems (see list p. 257) Ex Evaluate as part of HVAC only Ex Evaluate as elevator part only Leased? Unit = property of each lease

39 Issue 3: Expensing RE Improvements Qualified Improvement Prop.pp Can expense: qualified leasehold improvements, qualified restaurant property, qualified retail property, & > 12/31/15, HVAC units Figure 8.8 – Tax Benefits Qual. Imp. Figure 8.9 – Example $1,000,000 imp. In service 1/1/16, 50% bonus, max § 179

40 Issue 3: Expensing RE Improvements Qualified Improvement PropertyDefinition: Interior improvement to commercial real placed in service after building 1st placed in service 1st placed in service = placed in service by any person for any type of use Excludes: enlargements, improvements to internal building structure

41 Issue 3: Expensing RE Improvements Qualified Improvement Prop.pp Can claim bonus dep – Figure 8.10 § 179 eligible: Qualified leasehold or retail improvement, restaurant property Ex 8.20 2010 – Laura placed bldg in service 2017 – Sold to Brent – interior improved = Qualified improvement property

42 Issue 3: Expensing RE Improvements Qualified Improvement Property2015 – Building construction w/no private restroom for owner New Contract for restroom 5/27/16 Building placed in service 5/28/16 Restroom placed in service §1250 in restroom = Qualified Imp Prop

43 Issue 3: Expensing RE Improvements Qualified Improvement PropertyEx Commercial Rental 3/2015: Contract to build – exterior and minimal finish to interior 12/2015 lease, tenant to finish (build-out) 2/8/16 Lessor placed bldg in service 6/4/16 Tenant placed build-out in service §1250 in build-out = Qualified Imp Prop

44 Issue 3: Expensing RE Improvements HVAC UnitsA/C and heating units = §179 property if: § 1245 property, Depreciated under §168, Acquired by purchase, active Tor B use, & Placed in service tax year beg’g > 2015 N/A if component of central air/heating

45 Issue 4: Depreciation Issues MACRSMust if tangible property > 1986 except: Placed in service before 1987 Owned/used in 1986 by TP or related Intangible property Films, videotapes, recordings Some corp/PS prop – nontax. transfer TP elects to exclude from MACRS

46 Issue 4: Depreciation Issues MACRSSystems: GDS (DB or SL) or ADS (SL) Use GDS unless ADS required/elected When ADS required? See list p. 262 Ex 8.23 Truck use 100% to 40%: recapture excess depreciation & change to ADS Ex Tax-exempt owned frat house – must use ADS for all property

47 Issue 4: Depreciation Issues MACRSpp Electing ADS (irrevocable) Personal property – all property in same class placed in service during yr Residential rental/nonresidential real can elect property by property Form 4562, line 20, Part III 9 GDS property classes (p ) Dwelling unit = not used on transient basis

48 Issue 4: Depreciation Issues MACRSpp GDS: Figure 8.11, ADS: Figure 8.12 Conventions Mid-month: real property, railroad grading/tunnel bore Midquarter: basis placed in service last 3 mos of year > 40% total for year Half-year: all others

49 Issue 4: Depreciation Issues MACRSpp Methods 200% DB, 150% DB or SL over GDS SL over ADS recovery period DB switches to SL when beneficial Slower method if need later deductions Ex Deferring for higher tax % yr

50 Issue 4: Depreciation Issues MACRSElecting alternative method (on Form 4562) Apply to all new in same property class (except residential rental/commercial real) Due date + 6 mos (extension/§ ) 150% rather than 200% (No AMT adjmt) SL rather than 150% or 200% ADS for any GDS property

51 Issue 4: Depreciation Issues MACRSOptional tables for computations Apply rates to original cost No special election required for use Once used must always use for asset Discontinue if basis adjusted for other than depreciation (Casualty Ex. 8.26) Cannot be used for short tax year

52 Issue 4: Depreciation Issues Section 179$500,000 limit > 2015 (2017: $510,000) Reduced if > $2M qual. ($2,030,000) Limited to active TorB net income Tangible purchased from unrelated New or used Listed property must be > 50% business

53 Issue 4: Depreciation Issues Section 179Max for SUV after 10/22/2004: $25,000 4 wheeled to carry passengers Not subject to §280F Rated > 6,000 but not > 14,000 GVW Excludes busses, pickups, cargo vans Related party § 267(b) (brother/sister o.k.) Ex 8.27

54 Issue 4: Depreciation Issues Bonus Depreciationpp Applies after §179 – in first year only 2017: 50%, phaseout > (Fig. 8.10) Tangible with MACRS life ≤ 20 years Original use must be with taxpayer Elect out of bonus for property class Ex Cost less bonus = basis for dep.

55 Issue 4: Depreciation Issues Depreciation Recapture§ 1245 Property – ordinary income = depreciation allowed/allowable Personal property depreciated Certain real (e.g. single-purpose agric.) Used as integral part of manufacturing, production, extraction ACRS nonresidential real w/accelerated

56 Issue 4: Depreciation Issues Depreciation Recapturepp Recomputed Basis – Gain due to sale price > recomputed basis = capital gain Recomputed basis = adjusted basis + all adjustments (see list) = original cost Ex 8.29 No bonus, §179 = $10K, Dep = $58,520 Figure 8.13, Figure 8.14 (Form 4797)

57 Issue 4: Depreciation Issues Depreciation Recapturepp Ex 8.30 Bonus $52,500, no §179, Dep. $32,340 Figure Gain = $44,840 (ordinary) Dep. component in standard mileage rate Figure components Ex 8.31 – Figure 8.17 Ordinary gain

58 Issue 5: Domestic Production Activities Deduction (DPAD)QPAI: Qualified production activity income DPGR: Domestic production gross receipts QPAI = DPGR less allocable expenses DPAD = smallest of: 9% x taxable income from QPAI 9% x taxable income for yr w/o DPAD 50% x W-2 wages attributable to DPAD

59 Issue 5: DPAD Domestic Production Gross ReceiptsDPGR: gross receipts from lease, rental, license, sale, exchange, disposition of Qualifying production property (QPP) manufactured, grown or extracted (MPGE) by TP, in whole or significant part, in U.S. Film production in certain circumstances Electricity, natural gas, or potable water produced by the TP in the U.S.

60 ISSUE 5: DPAD Domestic Production Gross Receiptspp Includes receipts from: If construction T or B: Construction or substantial renovation of real property in U.S. If engineering or architectural T or B: services performed in U.S. relating to construction of real property Self-constructed property used by taxpayer Business interruption insurance proceeds & payments not to produce (if DPGR substitute)

61 ISSUE 5: DPAD Domestic Production Gross ReceiptsEmbedded Services Generally, services do not qualify as DPGR If embedded services < 5% of gross receipts, can include in DPGR N/A if service amount separately stated

62 ISSUE 5: DPAD Qualified Production Property - QPPTangible personal property (TPP) Other than land, buildings, computer software, sound recordings, qualified films, electricity, natural gas, or potable Computer software Sound recordings

63 ISSUE 5: DPAD Manufactured, Produced, Grown, ExtractedManufacturing, producing, growing, extracting, installing, developing, improving, creating QPP Making QPP from scrap or new materials or by combining 2 or more articles Cultivating soil, raising livestock, fishing, mining Installing QPP is in another activity with the QPP Storage, handling or other processing activities connected with certain agricultural products

64 DPGR Activities – Figure 8.18 (p.274)ISSUE 5: DPAD DPGR - MPGE pp MPGE does not include Transportation Packaging, repackaging, labeling, or minor assembly of QPP QPP installation if no other MPGE for QPP DPGR Activities – Figure 8.18 (p.274) Assumes all QPP is MPGE in U.S.

65 ISSUE 5: DPAD Construction ActivityEngaged on a regular/ongoing basis Gross receipts from unrelated by selling constructed real by completion + 60 mos New? Reasonably expects to be engaged on regular/ongoing basis Construct = erect or substantially renovate (increase value, prolong life, adapt to new use) Can qualify without ownership of property

66 ISSUE 5: DPAD Construction Activity - Ex 8.32General contractor – new homes – SMLLC Figure Revenue & Expenses Allocate for nonqualified land sales - $85K DPGR/Total = (1,319,000/1,404,000) Gen & Admin expenses x = $291,245 QPAI = 1,319,000 – 291,245 − 870,000 QPAI is construction revenue minus construction costs, minus the allocable share of administrative expenses. Example 8.32 erroneously omits the construction costs from the calculation of QPAI.

67 ISSUE 5: DPAD Construction Activity – Ex 8.32pp DPAD = lesser of: 9% x $157,755 (QPAI) = $14,198 9% x $213,114 (AGI w/o DPAD) = $19,180 50% x $325,000 (wages) = $162,500 DPAD = $14,198 Figure Form (p. 279)

68 ISSUE 6: Marijuana/Hemp Taxationpp Hemp & marijuana from cannabis plant Industrial hemp in wide range of products Figure Marijuana laws by state No distinction marijuana vs hemp for purposes of federal law except for industrial hemp produced in authorized agricultural pilot program State laws on industrial hemp – p. 282

69 ISSUE 6: Marijuana/Hemp Taxation Federal LawFederal laws take precedence over conflicting state laws Marijuana & hemp both controlled substances Farm Bill (2014) allows hemp research activity by universities & states

70 ISSUE 6: Marijuana/Hemp Taxation Federal Lawpp Financial institutions risk violating law if offer services to cannabis business 2/4/2014 guidance – must know their customers/report illegal activity Customer due diligence – list p. 283 Currency transactions reporting must be followed – Form $10,000 cash

71 ISSUE 6: Marijuana/Hemp Taxationpp §61: Gross income = net gains from dealing in property – includes controlled substances §280E: Denies deductions under §162 for illegal businesses (e.g. cannabis business) CGS: CCA §263A N/A as it was enacted after §280E §471 regs apply as in effect before §280E

72 ISSUE 6: Marijuana/Hemp Taxation §471 regulations - 1982pp Direct Costs Reseller: Transportation + other acquisition costs, trade discounts, Producer: Direct material & labor costs Indirect Costs for Producer In general: See list If GAAP financial statements: include if also in inventory for GAAP (see list)

73 ISSUE 6: Marijuana/Hemp Taxation Inventory MethodCCA IRS can require inventory method to clearly reflect income Would benefit cash method producer or seller – moving nondeductible expenses to inventory (thus becoming deductible)

74 ISSUE 6: Marijuana/Hemp Taxationpp Dual-purpose business Can break business into two parts – subject or not subject to § 280E Entire business not tainted by activity with limitation on deductions

75 ISSUE 6: Marijuana/Hemp Taxation Risks – Tax ProfessionalsIs facilitating a cannabis in violation of the Controlled Substance Act? Is assisting a violation of Circular 230? AICPA – “Issue Brief on State Marijuana Laws and the CPA Profession” What is state board of accountancy position? What is legal risk of services in the state?

76 ISSUE 6: Marijuana/Hemp Taxation Risks – Tax ProfessionalsIs there risk of prosecution? Likelihood DEA to prosecute the business? How are others offering services to state-recognized dispensaries? Affect insurance (malpractice/prof. liab.)? Likelihood of discipline, sanctions, etc? What procedures/policies to assess client’s knowledge of law and compliance with it?

77 Questions?