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Author: Red Spot Design2

5 Recent Supreme Court Decisions that Could Affect Your Business

Posted on by Red Spot Design2

At the end of June, the U.S. Supreme Court adjourned for its summer recess. Here are five recent cases from its 2016 term that may be of interest to business owners and managers.

Will Supreme Court Rewrite Quill?

Recent legislative proposals to impose state and local sales and use taxes on Internet sales across state lines have yet to come to fruition. The latest version of the Marketplace Fairness Act, which has been kicked around for years, appears to have stalled in Congress. Thus, online sellers still have a decisive tax edge over brick-and-mortar stores.

In the landmark Quill case (Quill v. North Dakota, 504 U.S. 298, 1992), the U.S. Supreme Court ruled that states couldn’t impose sales and use tax collection obligations on vendors without an in-state physical presence. It’s possible that the top court may revisit the Quill interpretation next term if Congress doesn’t enact any related legislation before then.

1. Advocate Health Care Network v. Stapleton (S. Ct. No. 16-74, June 5, 2017)

Under the Employee Retirement Income Security Act of 1974 (ERISA), employees are generally protected from unexpected losses in their retirement plans through various safeguards. However, church plans are specifically exempted from ERISA requirements, in order to avoid any entanglement of government and religion.

In this case, a group of employees work for a health care network that operates hospitals and in-patient and out-patient treatment centers in Illinois. The employees are covered under the network’s retirement plan. The network was formed through a merger of two religiously affiliated hospital systems. Although neither system was owned or financially operated by a church, the network remains affiliated with a church.

The employees sued the network. They argued that the retirement plan is subject to ERISA and failing to meet the ERISA requirements is a violation of federal law. The network countered that its plan falls under the exception for church plans. The Seventh Circuit Court affirmed a lower court’s ruling that a church-affiliated organization isn’t a church plan within the meaning of the law.

In a June ruling, the U.S. Supreme Court unanimously agreed that the ERISA exemption for church plans applies to plans maintained by a church-affiliated organization, even if that organization didn’t originally establish the plan.

2. TC Heartland LLC v. Kraft Food Brands Group LLC (S. Ct. No. 16-341, May 22, 2017)

A company organized under Indiana law and headquartered in Indiana sold liquid water-enhancing products that it shipped to Delaware in accordance with two of its contracts. But a major retailer, organized in Delaware with its primary place of business in Illinois, claimed that these products infringed on its patents for similar products.

The company selling the water-enhancing products argued that Delaware lacked jurisdiction over the lawsuit because the retailer isn’t registered to do business in the state, has no business there and doesn’t solicit any business there. A district court ruled that the subsection of the general venue statute allowing a defendant to reside in multiple jurisdictions for purposes of establishing jurisdiction applies to the patent venue statute.

This precedent conflicts with a previous Supreme Court case, Fourco Glass Co. v. Transmirra Products Corp. (353 U.S. 222, 1957). Fourco Glass holds that corporate jurisdiction is limited to the state of incorporation. The Fifth Circuit decided that the Congressional amendments to the general venue statute post-dated Fourco Glass and, therefore, superseded it.

However, in May, the Supreme Court unanimously ruled that the subsection of the general venue statute doesn’t apply to the patent venue statute. Thus, the Fourco Glass case still prevails. In his opinion, Justice Thomas stated that the patent venue statute hasn’t been amended, and it wasn’t meant to dovetail with other venue statutes.

3. Star Athletica, LLC v. Varsity Brands, Inc. (S. Ct. No. 15-866, March 22, 2017)

In the Star Athletica case, the plaintiff is a company that designs and manufactures clothing and accessories used in various athletic activities, including cheerleading. The design concepts for the clothing incorporate several elements — such as colors, shapes and lines — but they don’t consider the functionality of the final clothing. The plaintiff received copyright registration for two-dimensional artwork of designs that were similar to the ones that the defendant company began using.

In its lawsuit, the plaintiff alleged, among other claims, that the defendant had violated the Copyright Act of 1976. The defendant counter-claimed, asserting that the plaintiff had made fraudulent representations to the Copyright Office because the designs at issue couldn’t be copyrighted.

Significantly, the defendant argued that the plaintiff didn’t have valid copyrights because the designs were for “useful articles,” which can’t be copyrighted. Moreover, because the designs can’t be separated from the uniforms, the designs are impossible to copyright. In response, the plaintiff claimed that the designs were separable and non-functional.

The Sixth Circuit ruled that the Copyright Act allows companies to copyright graphic features of a design, even if the design isn’t separable from a “useful article.” Then the matter was brought before the U.S. Supreme Court.

In a 6-2 vote, the Court decided that copyright protection is allowed if a feature incorporated into the design of a useful article:

  • Can be perceived as a two- or three-dimensional work of art separate from the useful article, and
  • Would qualify as a protectable pictorial, graphic or sculptural work — either on its own or fixed in some other tangible medium of expression — if it were imagined separately from the useful article into which it’s incorporated.

Based on this interpretation, the plaintiff prevailed.

4. Czyzewski v. Jevic Holding Corp. (S. Ct. 15-649, March 22, 2017)

In 2008, a trucking company that was headquartered in New Jersey filed for bankruptcy under Chapter 11 of the U. S. Bankruptcy Code. At that point, it owed about $53 million to its first-priority secured creditors and about $20 million to its tax and general unsecured creditors.

Two lawsuits were initiated in U.S. Bankruptcy Court against the trucking company:

  • The truck drivers alleged that the trucking company violated federal and state Worker Adjustment and Retraining Notification (WARN) laws. Those rules require companies to provide workers with at least 60 days notice before layoffs.
  • A fraudulent conveyance action was made on behalf of the unsecured creditors. In 2012, the parties to the fraudulent conveyance action negotiated a settlement that dismissed many of the claims. But the settlement left out the drivers. The drivers objected to the settlement because it distributed property to creditors of lower priority under the Bankruptcy Code.

The Third Circuit affirmed the district court’s decision that the Bankruptcy Court had the discretion to approve a settlement scheme outside the Chapter 11 proceedings, even if it didn’t comply with distribution priority scheme under the Bankruptcy Code.

In a 6-2 decision, the U.S. Supreme Court sided with the truck drivers. The Court held that bankruptcy courts may not approve structured dismissals that don’t follow the priority order established in the Bankruptcy Code. While courts have flexibility, settlements must be viewed in light of the claims of affected creditors.

5. Kokesh v. Securities and Exchange Commission (S. Ct. No. 16-529, June 5, 2017)

The Securities and Exchange Commission (SEC) sued a New Mexico-based investment advisor for misappropriating funds from four business development companies. The district court found in favor of the SEC and ordered the advisor to pay $34.9 million for “the ill-gotten gains” connected to the violations. But the advisor argued this “disgorgement” remedy is barred by a five-year statute of limitations.

What is disgorgement? Funds received through illegal or unethical business transactions are disgorged, or paid back, with interest to those affected by the action. Companies that violate SEC regulations are typically required to pay both civil money penalties and disgorgement. In general, civil money penalties are considered punitive, while disgorgement is about paying back profits made from those actions that violated the SEC’s regulations.

The Tenth Circuit held that the usual five-year statute of limitations didn’t apply to this case because the ordered payment was remedial rather than punitive in nature. Therefore, a disgorgement payment may be allowed.

However, the Supreme Court has unanimously reversed the Tenth Circuit ruling. The Court decided that SEC disgorgement functions as a penalty, so it is subject to the five-year statute of limitations. This case is being widely viewed by commentators as a further erosion of the enforcement powers of the SEC.

Why Partnership Tax Status May Sometimes Be Unwanted

Posted on by Red Spot Design2

Many business entities are set up as partnerships. Although there are legitimate reasons for some businesses to choose this structure, partnership status may be undesirable for certain activities involving more than one co-owner.

Determining if a Partnership Exists for Tax Purposes

Unsure whether your activity should be classified as a partnership? In 2012, the U.S. Court of Appeals for the Ninth Circuit upheld a 2010 U.S. Tax Court decision that provides guidance on this issue. (William F. Holdner v. Commissioner, 9th Cir., No. 11-71593, October 12, 2012)

In this case, the Tax Court concluded that a profitable farming, ranching and timberland business conducted by a father and son was a 50/50 partnership for tax purposes. In doing so, the court considered the following eight factors:

1. Written or oral agreement of the parties and their conduct in executing its terms.

2. Contributions of money or services by the parties.

3. Control over income and capital and right to take withdrawals.

4. Whether the parties were co-proprietors with mutual obligations to share losses.

5. Whether the venture was conducted in joint names of parties.

6. Whether the parties filed partnership returns or otherwise represented to the IRS or others that they were engaged in a joint venture.

7. Whether separate books were maintained for the venture.

8. Whether the parties exercised mutual control over and assumed mutual responsibilities for the venture.

Keep in mind that this case doesn’t set precedent beyond the 9th Circuit. But other circuits deciding similar cases might look to the 9th Circuit’s reasoning.

Tax-related reasons to avoid partnership status include:

Tax reporting requirements. Partnerships are required to file annual partnership returns on Form 1065 and issue K-1s to the co-owners. If you can avoid partnership status, each co-owner simply reports the tax results from that person’s ownership interest directly on the appropriate form or schedule.

Tax elections. If a partnership exists, certain tax elections must be made at the partnership level (such as the Section 179 election for first-year depreciation). If you can avoid partnership status, co-owners can make tax elections independently at the co-owner level.

Like-kind exchanges. A partnership interest, by definition, is ineligible for tax-deferred like-kind exchange treatment even if the partnership’s only asset is real estate. But, if you can avoid partnership status, co-owners can trade fractional real estate ownership interests in like-kind exchanges.

The Basics

What qualifies as a partnership? For federal income tax purposes, any unincorporated joint venture or other contractual or co-ownership arrangement, in which two or more participants 1) jointly conduct a business or investment activity, and 2) split the income and expenses, will generally be treated as a partnership.

This general rule holds true even when the joint venture or arrangement isn’t recognized as a separate entity under applicable state law. Put another way, a partnership can be deemed to exist for federal income tax purposes even when there’s no partnership under state law.

There are three arrangements that avoid partnership status for federal income tax purposes:

1. Mere co-ownership, rental and maintenance of real property.

2. A mere agreement to share expenses.

3. When, under certain conditions, the IRS allows taxpayers to “elect out” of partnership status that would otherwise be deemed to exist.

Electing out of partnership tax status is available in the following circumstances:

Jointly owned investment property. Here, the parties must 1) own the investment property in question as co-owners, 2) be able to dispose of their shares independently, and 3) not actively conduct a business. In addition, the co-owners must be able to independently calculate their taxable income from the activity without the necessity of calculating partnership taxable income. This provision is often used to elect out of partnership status for real estate co-ownership arrangements.

Real estate co-ownerships under tenancy-in-common and joint tenancy arrangements often involve “mere co-ownership, rental, and maintenance of real property.” This is the first item in the list of arrangements that avoid partnership status (above). Even so, making an affirmative election out of partnership status will remove any doubt about these types of arrangements.

Joint operating agreements. Here, the parties must engage in the joint production, extraction or use of property (such as oil, natural gas, or other minerals). The parties must own the property as co-owners or hold a lease granting exclusive operating rights as co-owners (such as an oil and gas lease).

In addition, the parties must retain the right to separately take in kind their shares of the property produced, extracted or used. They can’t jointly sell the property that is produced or extracted except under an arrangement that doesn’t extend beyond one year. Finally, each party must be able to independently calculate taxable income from the activity without the necessity of calculating partnership taxable income.

Securities dealers. Dealers in securities can also qualify to elect out of partnership status for short periods in conjunction with joint efforts to underwrite, sell or distribute securities offerings.

Limited liability companies (LLCs) generally can’t elect out of partnership status for federal tax purposes. Why? In most states, state law provides that an LLC, not its individual members, owns the LLC’s property. Additionally, most state LLC statutes provide that an LLC member can’t demand a distribution of property.

The Election Process

There are two ways to elect out of partnership status. The first way is for co-owners to make an affirmative election by the due date, including any extension, of the partnership return that would otherwise be required. This generally means the first year of any activities that create tax consequences for the co-owners. The affirmative election is made by filing a blank partnership tax return form that includes only the name or other identification of the organization, its address and a statement containing certain information required by IRS regulations.

The second way to elect out of partnership status is to show that, based on facts and circumstances, the co-owners always intended to be excluded from Subchapter K of the Internal Revenue Code starting with the arrangement’s first tax year.

Important note: The facts-and-circumstances method is not the preferred way to elect out of partnership tax status. That method is a relief provision intended for co-owners that fail to affirmatively elect out using the blank Form 1065 method. The IRS may be reluctant to accept elections made under the facts-and-circumstances method.

Failure-to-File Penalties

If you fail to file a partnership return when it’s required, steep penalties may apply. For tax years beginning in 2017, the monthly penalty for failing to file a partnership return or failing to provide required information is $200 per partner. The penalty can be assessed for a maximum of 12 months.

For example, the maximum penalty for failing to file a calendar-year 2017 Form 1065 for an unincorporated two-person business that must be treated as a partnership would be $4,800 (2 x $200 x 12 = $4,800).

The IRS provides a limited exemption from the failure-to-file penalty, however. This exemption is available to domestic partnerships with 10 or fewer partners — but only when all the partners have reported their proportionate shares of income and deductions on timely filed tax returns.

Need Help?

Deciding when a partnership exists for federal income tax purposes can be tricky. Your tax advisor can help you determine whether you have a partnership and can handle any extra tax filings that may be necessary.

FMLA: The Law that Never Sleeps

Posted on by Red Spot Design2

The Family and Medical Leave Act (FMLA) is often tweaked, adjusted or reinterpreted as cases of alleged abuse continue to pop up and courts are asked to weigh in. With so much change, it’s a good idea to check your policies regularly. Is your company in compliance?

Here’s a very streamlined recap of the top 10 FMLA fundamentals to refresh your memory. (Keep in mind that your state and local laws may have stricter requirements.)

1. Allowable purposes for unpaid leave up to 12 weeks: Attending to the birth or adoption of a child, caring for a family member with a serious health condition, or suffering a health condition that prevents one from performing essential  job tasks. (Special rules apply where family members are on active duty in the military.)

2. To be eligible, employees must: Have logged at least 1,250 hours of service during the period before the leave, and have worked for the employer for one year over a period no greater than seven years (that is, employment gaps are permissible).

3. Private sector employers are exempt from the FMLA if: They have fewer than 50 employees overall or at a specific site that’s at least 75 miles away from any of its other employment sites.

4. When taken, the FMLA leave period: Doesn’t have to be a single block of time consisting of consecutive days; intermittent leave may be possible, as well as working on a reduced schedule basis. When leave is intermittent in a nonemergency situation, employees should make a “reasonable effort” to accommodate the operational scheduling needs of the employer.

5. Maintenance of benefits: Employees out on FMLA leave must stay on the employer’s health plan under the same terms (including cost-sharing provisions) as before.

6. Coordination with paid leave benefits: Often it’s possible for employers to require employees taking FMLA leave to use up accrued paid leave time concurrently.

7. When requesting an FMLA-mandated leave, employees must: Give employers a 30-day notice, if the need for the leave was foreseeable, or otherwise as soon as possible. When making an FMLA leave request for the first time, employees don’t need to state that the request is being made under the FMLA. They merely need to provide employers enough information about the purpose of the leave for the employer to independently determine that the leave is sanctioned by the law.

8. Notification requirements: Employers must maintain posted notices about the FMLA; include information about it in their employee handbooks; and, upon request, provide information about employees’ rights and responsibilities under the law.

9. Medical certification: When a leave request is based on a serious medical condition of the employee or the employee’s family member, the employer can request documentation from a health care provider, as well as seek second and third opinions.

10. Job restoration: When employees return from their leave periods, they must be given their original jobs or another position with equivalent pay, benefits, and other employment terms and conditions.

Legal Authority

In an FMLA case, only a U.S. Supreme Court decision can affect the law nationwide. Still, a lower court ruling — even if it occurs in a jurisdiction other than your own — might be influential where you’re located. Below are three noteworthy cases that highlight the need to keep abreast of FMLA legal developments:

Case 1. The court upheld an employer’s decision to terminate an employee while she was on FMLA leave, against the employee’s claim that her termination violated her FMLA rights and was discriminatory. The court accepted the employer’s explanation that it had a sound business rationale to eliminate the employee’s position: The company was shrinking; other employees could assume her duties, and it would have made the same decision if the employee weren’t on leave.

Case 2. The court agreed with an employee’s argument that she was being prevented from gaining the full benefit of her FMLA leave because of her employer’s pattern of making substantial requests of her time while on leave. The court held that it was permissible for the employer to contact employees on leave for certain tasks. Examples include:

  • Passing along relevant institutional knowledge to new staff,
  • Providing computer passwords,
  • Giving closure on complicated assignments, and
  • Identifying other employees who could fill the void created by her absence.

But it was inappropriate for the employer to contact the employee regularly with questions about her work duties and absences, inputting data, and taking time out to receive training before returning to work. The fact that the employee was terminated shortly after her return to work buttressed her argument that her employer was trying to interfere with her rights.

Case 3. The Ninth Circuit Court of Appeals upheld a lower court ruling in favor of an employer that terminated an employee who claimed her FMLA leave benefits were denied. The employee had requested, and received, a period of leave to care for her sick father. But she’d requested that it not be treated as FMLA leave, but instead as ordinary paid leave. The company agreed.

However, the employee didn’t return to work until two weeks after the date she’d promised to come back and was terminated. She argued that the extra two weeks should have been treated as protected FMLA leave, because her reason for remaining away from work was to care for an ailing family member. The courts drew two conclusions: 1) It’s possible for an employee to seek and receive non-FMLA leave for an FMLA-eligible purpose, and 2) Unauthorized leave cannot automatically become protected FMLA leave without the employee explicitly requesting it on that basis.

Regular Tune-Ups Advised

New FMLA cases are decided all the time, creating a demand for attorneys who specialize in this corner of the law. Therefore, given the fluidity of FMLA legal interpretation, it’s prudent to periodically review your compliance with the evolving legal standards.

Can Your Research Credits Offset Your Payroll Tax Bill?

Posted on by Red Spot Design2

Does your small business engage in qualified research activities? If so, you may be eligible for a research tax credit that can now be used to offset your federal payroll tax bill.

Which Research Activities Qualify?

To be eligible for the research credit, a business must have engaged in “qualified” research activities. To be considered “qualified,” activities must meet the following four-factor test:

  1. The purpose must be to create new (or improve existing) functionality, performance, reliability or quality of a product, process, technique, invention, formula or computer software that will be sold or used in your trade or business.
  2. There must be an intention to eliminate uncertainty.
  3. There must be a process of experimentation. In other words, there must be a trial-and-error process.
  4. The process of experimentation must fundamentally rely on principles of physical or biological science, engineering or computer science.

Expenses that qualify for the credit include wages for time spent engaging in supporting, supervising or performing qualified research, supplies consumed in the process of experimentation, and 65% of any contracted outside research expenses.

This relatively new privilege allows research credits to benefit small businesses that may not generate enough taxable income to use the credits to offset their federal income tax bills. The IRS recently issued guidance that explains how to take advantage of this election. Here are the details.

Eligibility

Under the Protecting Americans from Tax Hikes Act of 2015, a qualified small business (QSB) can elect to use up to $250,000 of its research credits to reduce the Social Security tax portion of its federal payroll tax bills. Under the old rules, QSBs could use the credit to offset only their federal income tax bills. However, many small businesses owe little or no federal income tax, especially small start-ups that tend to incur significant research expenses.

A QSB is generally defined as a business with:

  • Gross receipts of less than $5 million for the current tax year, and
  • No gross receipts for at least one tax year in the five-year period preceding the current tax year.

So the payroll tax reduction election is available to only newer small businesses that may still be in the unprofitable start-up phase.

Timing Issues

The payroll tax reduction election must be made on or before the due date (including extensions) of the QSB’s federal income tax return for the tax year for which the election is to apply. The research credit for that tax year can then be used to reduce the QSB’s federal payroll tax bills, starting with the bill for the first calendar quarter that begins after the date that the QSB files its federal income tax return for the tax year for which the election is to apply.

To illustrate, suppose your business is a calendar-year C corporation that filed its 2016 federal income tax return on April 18, 2017. The company can use its 2016 research credit to reduce its federal payroll tax bills, starting with the third quarter of 2017.

The allowable payroll tax reduction credit can’t exceed the employer’s portion of the Social Security tax liability imposed for any calendar quarter. Any excess credit can be carried forward to the next calendar quarter, subject to the Social Security tax limitation for that quarter.

For QSBs that file only an annual federal payroll tax return (for example, certain agricultural employers), IRS guidance specifies that the payroll tax reduction credit is claimed on the annual payroll tax return that includes the first quarter beginning after the date on which the business files its federal income tax return with which the payroll tax reduction credit election is made.

Tax Return Filing Requirements

QSBs must file specific forms to elect the payroll tax reduction credit for a tax year for which the election is to apply. There are separate forms to attach to your federal income tax return and payroll tax return. In addition, members of a controlled group of corporations must attach a statement showing how each member’s share of the research credit was determined and providing the names and employer ID numbers (EINs) of the other group members.

Many QSBs have already filed their 2016 federal income tax returns without making the payroll tax reduction election. If you need to file an amended return for 2016, IRS guidance suggests that you file it by no later than December 31, 2017.

Need Help?

The new payroll tax reduction credit deal is a welcome change for eligible small businesses that generate research credits. Your tax advisor can help you make the election for your business (or amend your business’s 2016 federal income tax return, if necessary) and help you file payroll tax returns that take advantage of the new privilege. Your advisor can also answer any additional questions you may have about claiming the research credit.

Types of Oil & Gas Investments

Posted on by Red Spot Design2
Business diagram shows change of the prices for oil
Business diagram shows change of the prices for oil

Oil and gas investments have unique aspects of finance and taxes that are not seen in any other industry. High oil inventories have driven commodity prices and oil investment prices down, and it may be time to consider adding oil investments to a portfolio. Different entity structures and the accounting methods used make it difficult for investors to get a side-by-side comparison of O&G developers. Investors need to understand the pros and cons of each investment type under consideration, including the impact of accounting methods used, the developer’s strategy with regard to reserves, and finally the potential tax benefits or impacts.

‘Rise early, work late, strike oil.”

This quote was attributed to J. Paul Getty, one of the first U.S. oil tycoons who was once listed as the world’s richest private citizen at $1.2 billion. That was in 1966.

Anyone with dreams of striking it rich through oil and gas investments needs to rise early and work late to choose the right investment option. Investor responsibilities and tax compliance are complex. If it seems like a good way to diversify an already well-rounded portfolio, however, the landscape for investment is certainly looking up.

Over the last decade the U.S. oil and gas industry has undergone somewhat of a renaissance due to technological improvements in hydraulic fracturing, horizontal drilling, drilling fluids, and other techniques, which has allowed U.S. producers to begin to economically unlock the shale oil reserves. The result has been increasing U.S. oil production for the first time since 1970 when U.S. oil production peaked at nearly 9.7 million barrels of oil per day. By 2008, U.S. oil production had fallen to approximately 5 million barrels of oil per day.  Currently, U.S. production is on pace to exceed 9.9 million barrels of oil per day by 2018, an increase of nearly 100% in 10 years.

With the resurgence of the U.S. oil and gas industry, investment opportunities abound. I am a tax compliance expert, so this information should not be interpreted as investment advice. This article will briefly touch on the various types of oil and gas investments available today and will discuss the unique accounting and tax attributes related to these types of investments.

Types of Oil & Gas Investment

The following is a brief summary of different types of oil and gas investments. The bullet points outline the pros and cons for investors.

Publicly traded stocks (such as the major integrated oil companies and large independent oil companies) and ETF’s:

  • Highly liquid since there is an active trading market
  • Income and expenses are not passed through to investors.
  • Company retains any beneficial tax attributes
  • Cash returned to investors via dividends or stock buy backs
  • Arguably, the primary goal is increasing value through increasing reserves and production

Master Limited Partnerships (also publicly traded)

  • Highly liquid since there is an active trading market
  • Income and expenses are passed through to investors, thus investors are taxed on the operating income of the company
  • Beneficial tax attributes such as depletion and drilling costs are minimized because of publicly traded partnership/passive activity tax rules
  • Cash flow is normally distributed to partners on a regular basis

Publicly traded royalty trusts

  • Highly liquid since there is an active trading market
  • No exploration risk
  • Net income passed through to investors
  • Minimal tax benefits available
  • Cash flow is normally distributed on a monthly basis

Drilling partnerships (may be issued through a private placement offering, but generally are not publicly traded)

  • Illiquid – no active trading market
  • High exploration risk
  • Income and expenses passed to investors
  • Beneficial tax attributes such as intangible drilling costs and depletion pass through to investors
  • Cash flow is normally distributed on a monthly basis

Direct investments in working interests

  • Illiquid – no active trading market
  • Exceptionally high exploration risk
  • All income paid directly to investor and expenses paid directly by investor
  • Beneficial tax attributes such as drilling costs and depletion
  • By definition working interests are non-passive (unless owned in an entity that limits liability)

Direct investments in royalties

  • Illiquid – no active trading market
  • No exploration risk
  • Income (net of severance tax and certain marketing/transportation cost) paid directly to investor
  • Investor is not responsible for exploration, development or production expenses
  • Beneficial tax attributes limited to depletion

Next, we’ll look at how accounting methods used for publicly traded oil stocks and Master Limited Partnerships (MLPs) can impact how the balance sheet, net income and cash flows are presented on financial statements. In other words, the accounting method can influence how well an investment vehicle appears to be performing.

Continue Reading: A Look at Accounting Methods of Developers

Scott Allen, CPA, joined Cornwell Jackson as a Tax Partner in 2016, bringing his expertise in the Construction and Oil and Gas industries and 25 years of experience in the accounting field. As the Partner in Charge of the Tax practice at Cornwell Jackson, Scott provides proactive tax planning and tax compliance to all Cornwell Jackson tax clients.

Contact him at Scott.Allen@cornwelljackson.com or 972-202-8032.

6 Strategic Steps to Help Spur Manufacturing Growth in 2017

Posted on by Red Spot Design2

Former New York City Mayor Ed Koch was famous for asking his constituents, “How am I doing?”

Similarly, leaders in the manufacturing industry like to take the pulse of the sector from time to time, especially after the economic struggles of the last decade and a lull stretching over the past two years.

Although the Institute for Supply Management said its index of national factory activity rose to 57.8 in June, from 54.9 in May, manufacturing is still expected to weaken somewhat after the “Trump Bump” wears off and the Bull market slows.

Are You Proactive or Reactive?

Uncertainty regarding political, social and economic events is a major concern for manufacturers. It’s difficult to project what the remainder of 2017 will bring, but proactive firms aren’t waiting to see what happens next. Here are six strategies that industry leaders are implementing today to help spur growth tomorrow.

1. Incorporate technology. The old way of doing things might not be the best way. For instance, if your firm relies more heavily on new technology, it may be able to replace the outdated models that required firms to sell an entire machine and a service agreement for maintenance and repairs.

Instead, new technology can allow you to offer a combination of services, including real-time monitoring of equipment to determine its maintenance needs, daily collaboration with customers to customize and modify equipment, and predictive performance management for large and small projects.

Bundling these services can lead to a more robust operation. With this approach, manufacturers may solidify customer retention and gain access into more lucrative activities.

2. Adjust pricing models. Successful manufacturers don’t use guesswork to set prices. Traditional pricing models may need to be altered based on changes in the marketplace. One example is the movement from paying for products to paying for performance.

For instance, if performance-based maintenance based on technology becomes common, fewer repair visits will be needed. Although customers may expect more favorable terms, they may also be willing to share some of the risks. Rather than basing pricing on products and fixed maintenance or warranty costs, fee structures may be tied to results.

For example, a manufacturer may be paid more if downtime is effectively reduced or productivity is improved. Some manufacturers prefer a “blended” fee structure that combines traditional fixed pricing and performance-based pricing.

3. Find a partner. If technology isn’t your firm’s strong suit, consider partnering with a third-party provider that can help improve equipment connectivity and data analysis. If you find a good match, it could be beneficial for both parties and lead to additional engagements.

Strategic alliances aren’t risk free, however. So, you need to balance the benefits of collaborating with a partner with your ability to maintain market share. Consider, too, whether your partner will keep up with the rapid advances in technology. There’s also a chance that your firm could eventually compete with your partner, endangering the entire relationship and perhaps defeating its purpose.

4. Mine customer data. If connectivity becomes the backbone of manufacturing in the future, as many have predicted, there will be an influx of data from a multitude of sources, including sensors, integrated equipment and platforms. What’s more, information systems will be able to process the data faster than before.

In light of this technological evolution, manufacturers may be able to achieve a competitive advantage if they hire people who can use this information to help customers improve equipment performance and increase overall productivity. By proactively mining customer data, manufacturers can boost overall revenue.

5. Overhaul IT systems. It can be difficult to manage technology integration and big data analytics if internal IT systems become unwieldy. As company operations expand into new product lines and global markets, IT systems often become tangled and twisted.

To avoid problems, update your IT systems and create a new streamlined infrastructure. As manufacturing technology evolves, it’s critical for IT to communicate throughout the organization with standardized procedures. This can help your firm manage data from thousands of equipment pieces in the field, support supply chains and deliver timely customized reports.

6. Recruit top talent. Unless your firm is located in Silicon Valley or another technology hub, it may not be easy to find IT experts. In many markets, job openings are expected to outpace viable candidates for the foreseeable future. However, a formal technology plan can help you attract high quality talent.

Map out a robust technology strategy with specific benchmarks and goals for, say, the next two or three years. Then share this story with job candidates.

During the recruiting process, don’t just advertise for someone who can read data without emphasizing the manufacturing basics. Balanced capabilities are important, allowing the equipment manufacturers to use smart operational data and sensor analysis in a real-time context. This will drive innovation for improving equipment functionality and performance.

Guaranteed Success?

Will taking these steps at the end of 2017 guarantee success for 2018 and beyond? Of course not. But they’ll likely improve your operation and better position your firm for the challenges that lie ahead.

The Future Is Here

The Industrial Internet of Things (IIoT) has taken over.

Almost every new piece of equipment or technology is equipped with data capture and processing capabilities. Machines can essentially “talk” to one another. For example, the printer on your desk can alert your smartphone if ink runs low.

A recent report by Synchrono, a Minnesota-based software company, identifies how every new upgrade leads to greater use of the IIoT in manufacturing. It indicates that manufacturers that haven’t upgraded systems recently will be faced with added challenges in implementing digital processes. Changing today is critical to meeting tomorrow’s demands.

 

Unlock the Biggest Possible Deduction for a Home Office

Posted on by Red Spot Design2

The IRS recently issued a reminder about claiming the home office deduction. In particular, it explained a simplified method that offers a time-saving option. But many taxpayers who maintain a home office fare better tax-wise by deducting expenses under the regular method. Others may not be eligible to deduct any home office expenses. Here’s why.

Tax Wisdom of Soliman

Historically, self-employed taxpayers have fought the IRS over the determination of a principal place of business when their work was conducted at multiple job locations. The matter was finally resolved by the U.S. Supreme Court in a landmark, taxpayer-friendly ruling. (Commissioner v. Soliman, 506 U.S. 168, January 12, 1993.)

Background

Dr. Soliman, an anesthesiologist, performed services in three hospitals for about 30 to 35 hours a week. He didn’t have an office in any of the hospitals. His only office was a room in his condominium where he worked two to three hours a day. During that time period, he would work on administrative matters, such as:

  • Contacting patients, surgeons and hospitals by telephone,
  • Maintaining billing records and patient logs, and
  • Preparing treatments and presentations.

However, Dr. Soliman never saw any patients at his home office.

Under the view of the Supreme Court in this case, later codified by a 1997 tax law, home office deductions should be allowed where:

  1. The individual taxpayer uses a home office to conduct administrative or management activities of his or her business, and
  2. The business has no other fixed location where the individual conducts substantial administrative or management activities.

Thus, Dr. Solimon was allowed to deduct his home office expenses. This ruling opened the door to home office deductions for taxpayers in other walks of life — such as landscapers and plumbers — who do administrative work at home and perform actual services at multiple locations. Regular and Exclusive Use

Most home-related expenses, such as utilities, insurance and repairs, aren’t deductible. But if you use part of your home for business purposes, you may be entitled to deduct a portion of these everyday expenses, within certain limits.

In general, you’ll qualify for a home office deduction if part of your home is used “regularly and exclusively” as your principal place of business. Here’s an overview of these two tests:

1. Regular use. You must use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use. The IRS considers all the facts and circumstances for this determination.

2. Exclusive use. You must use a specific area of your home only for business. This area can be a room or other separately identifiable space. It’s not necessary for the space to be physically partitioned off from the rest of the room. However, you don’t meet the requirements for the exclusive use test if the area is used both for business and personal purposes.

Rules for Employees

If you’re an employee, the home office must be used for the employer’s convenience. In essence, this requirement should be spelled out in an employment contract with the company. For this reason, home office deductions are more likely to be claimed by self-employed taxpayers than employees who work for an unrelated business.

Typically, you won’t qualify for deductions if you bring work home at night from your daytime office, either. Consider the relative importance of the activities performed at each place where you conduct business and the amount of time spent at each business location.

Principal Place of Business Tests

Your home office will qualify as your principal place of business if you 1) use the  space exclusively and regularly for administrative or management activities of your business, and 2) don’t have another fixed location where you conduct substantial administrative or management activities. (See “Tax Wisdom of Soliman” at right.)

Examples of activities that are administrative or managerial in nature include:

  • Billing customers, clients or patients,
  • Keeping books and records,
  • Ordering supplies,
  • Setting up appointments, and
  • Forwarding orders or writing reports.

Other Ways to Qualify

If your home isn’t your principal place of business, you may deduct home office expenses if you physically meet with patients, clients or customers on your premises. To qualify, the use of your home must be substantial and integral to the business conducted.

Alternatively, you can claim the home office deduction if you use a storage area in your home — or if you have a separate free-standing structure (such as a studio, workshop, garage or barn) that’s used exclusively and regularly for your business. The structure doesn’t have to be your principal place of business or a place where you meet patients, clients or customers.

Two Methods: Actual Expenses vs. Simplified

Traditionally, taxpayers deduct actual expenses when they claim a home office deduction. Deductible home office expenses may include:

  • Direct expenses, such as the cost of painting and carpeting a room used exclusively for business,
  • A proportionate share of indirect expenses, such as mortgage interest, property taxes, utilities, repairs and insurance, and
  • A depreciation allowance.

Keeping track of actual expenses can be time consuming. Fortunately, there’s a streamlined method that’s allowed under a tax law change that went into effect in 2013: You can simply deduct $5 for each square foot of home office space, up to a maximum total of $1,500.

For example, if you’ve converted a 300-square-foot bedroom to an office you use exclusively and regularly for business, you can write off $1,500 under the simplified method (300 square feet x $5). However, if your business is located in a 600-square-foot finished basement, the deduction under the simplified method will still be only $1,500 because of the cap on the deduction under this method.

As you can see, the cap can make the simplified method less beneficial for larger home office spaces. But even for spaces of 300 square feet or less, taxpayers often qualify for a bigger deduction using the actual expense method. So, it can be worth the extra hassle.

Hypothetical Example

To illustrate how this might work, let’s assume that your 3,000-square-foot home is your principal place of business. You use a 300-square-foot bedroom as your home office. For 2017, you expect to have $1,500 of direct expenses for your home office plus $10,000 of indirect expenses for the entire home, including utilities, insurance and repairs. (For simplicity, we’ll disregard mortgage interest and property taxes that would be deductible on Schedule A, “Itemized Deductions.”) Based on IRS tables, you’re also entitled to a $500 depreciation allowance.

Using the simplified method, you’re eligible to deduct $1,500, as described above. But, if you keep the required records to deduct your actual expenses, you could deduct $3,000 for your home office — $1,500 in direct expenses, $1,000 in indirect expenses (10% of $10,000) and $500 in depreciation. That’s double the maximum amount you could deduct with the simplified method. The deduction would be even greater if the home office space were larger.

Flexibility in Filing

When claiming the home office deduction, you’re not locked into a particular method. For instance, you might choose the actual expense method in 2017, use the simplified method in 2018 and then switch back to the actual expense method thereafter. The choice is yours.

This is a valuable tax-saving opportunity for many taxpayers, especially those who are self-employed and work from home. Consult with your professional tax advisor regarding what’s right for your personal situation.

Know the Rules for Amending a Federal Income Tax Return

Posted on by Red Spot Design2

What should you do if you discover an error on a previously filed individual tax return? For example, you might have missed some tax-saving deductions and credits on your 2016 personal federal income tax return that you filed in February. Or you might have recently discovered that you failed to claim some legitimate tax breaks on your 2015 return that you filed last year. Here are the rules for filing an amended return.

The Basics

The first thing to know is that you should not attempt to correct the situation by filing another original return using Form 1040. That will just create confusion at the IRS and cause headaches for you. Instead, file Form 1040X, “Amended U.S. Individual Income Tax Return.”

How long do you have to file an amended return? The answer depends on whether you’re asking for a refund or you owe additional taxes.

When claiming a refund. The sooner you file an amended return, the sooner you’ll receive any refunds due. So it doesn’t pay to wait. If amending your return will produce a tax refund, the deadline for filing Form 1040X is generally the later of:

  1. Three years after the original return for the year in question was filed, or
  2. Two years after the tax for that year was paid.

Most taxpayers focus on the three-year rule. If you filed your original Form 1040 before the April 15 due date — adjusted for weekends and holidays — you’re considered to have filed the return on April 15 for purposes of the three-year rule. However, if you extended the return to October 15 — adjusted for weekends — you’re considered to have filed on the earlier of the actual due date or the October 15 extended deadline.

To illustrate, suppose you filed your 2016 tax return on March 1, 2017, and paid the tax due on that date. You now realize you should have itemized deductions instead of taking the standard deduction. Based on the three-year rule, you have until April 15, 2020, to file an amended 2016 return and claim your refund. On the other hand, if you extended your 2016 return to October 16, 2017, and then file before the extended deadline on September 1, 2017, the three-year period for filing an amended 2016 return starts running on September 1, 2017.

When additional taxes are due. This is a trickier scenario. If you discover that you understated your tax liability on the original tax return, you’re expected to file an amended return and pay the additional tax. If you don’t and the IRS discovers the error, the government will bill you for:

  1. The unpaid tax amount plus interest, which is currently at a 4% annual rate, compounded daily, and
  2. The additional failure-to-pay interest charge penalty at a 6% annual rate.

The sooner you file an amended return and pay the tax due, the sooner you’ll stop racking up interest and the failure-to-pay penalty.

You may also be assessed other penalties, depending on the nature of your underpayment — but the IRS can waive all penalties if you show you had a reasonable cause for the underpayment. For example, you might have reasonable cause if you received incorrect information from a third party, such as an inaccurate Schedule K-1 from a partnership or S corporation investment.

Although IRS audits are relatively rare these days, there is a strong chance of getting caught for omitting income that’s automatically reported to the IRS on an information return, such as Form W-2 or Form 1099.

Also, beware of the three-year statute of limitations rule: The IRS generally has three years after the date the original return was filed to discover errors and omissions and assess additional tax, interest and penalties. But a longer six-year statute of limitations rule applies if the original return understated gross income by over 25%. In addition, there’s no statute of limitations on a fraudulent return.

Bottom Line

Filing an amended return is relatively straightforward if you expect a refund — as long as you’re within the requisite two- or three-year window of opportunity. But when you’ve underpaid your taxes, filing an amended return can be a dicey situation. Always consult a tax professional first to discuss the full consequences of amending your return.

Generally, if the original return understated your tax bill by only a small amount, your tax advisor will recommend that you amend your return and pay the additional taxes, interest and penalties as soon as possible.

For larger understatements, let your tax advisor take the reins. He or she has experience in dealing with past-due taxes and may be able to get you off the hook with minimal or no penalties. But be prepared to pay at least the past-due tax plus interest. He or she can also help you file amended business returns, if needed.

Should Your Company Offer Paid Parental Leave?

Posted on by Red Spot Design2

Organizations that advocate for paid parental leave recognize that for most employers, the decision of whether to offer that benefit will be rooted in economics. In a competitive environment, it’s a rare employer that can afford to add to personnel costs without a bottom line-based rationale.

The motivation of employers in California, New Jersey, Rhode Island, New York and the District of Colombia, includes obeying state law. However, in some of those states, the compensation employees receive while on leave may be less than the full amount of their earnings, and is funded by a state-run insurance system that employees fund via mandatory payroll-deducted premiums.

What’s the outlook for paid parental leave? Based on a recent survey by the Society for Human Resource Management (SHRM), dealing with employer-paid family leave practices, growth appears to be on the horizon. SHRM’s analysis includes this prediction: “A competitive labor market may prompt more organizations to adopt robust, paid parental-leave policies in order to attract needed workers.”

Industry Variation

SHRM’s research shows that 18% of U.S. employers offer paid maternity leave, and 12% also offer paid paternity leave. Paid parental leave is most common in the technology sector, where competition for talent is intense. 

Research by WorldatWork, another professional membership group, delved into the same topic in 2016. Assessing the prevalence of paid parental leave policies is tricky because companies often don’t distinguish between paid family leave benefits, and paid leave earmarked specifically for new parents. Below are some of the findings.

Among companies that do offer paid leave to new parents as a separate benefit from their overall paid family leave policy:

  • More than half limit the time period to six weeks or less,
  • More than one-third make employees eligible to receive it immediately upon being hired,
  • Less than half have a one-year waiting period, and
  • The largest segment, about one half, requires new parents to use the benefit within the first year of parenthood, while just over one-third have a six-month deadline.

Potential Benefits

According to a report compiled by the National Partnership for Women and Families, employers that offer paid leave plans may enjoy many benefits as a result, some of which are listed below.

Paid leave:

  • Improves worker retention, reducing turnover costs. First-time mothers who take paid leave are more likely to return to the same employer than to an employer who doesn’t offer paid leave,
  •  Increases worker productivity, according to survey data from California employers, where paid family leave is mandatory,
  •  Boosts employee loyalty and morale,
  •  Helps put smaller employers in a position to compete with larger employers, and
  •  Heightens competitiveness in the global economy for American businesses. (Most industrialized countries mandate paid family leave.)

These claims are general, so assessing the potential benefits of having a paid leave plan in your workplace will require some analysis on your own part. Here are some questions suggested by SHRM to help with such an evaluation.

1. Which job categories or demographic segments of your workforce are most vital to your success? For example, you may find that the group you most rely on is composed of younger employees who are more likely to need paid parental leave.

2. What motivates the workers who are most vital to your success? It’s possible that the employees who are most likely to take advantage of paid parental leave would place a higher value on some other form of compensation, such as more generous paid vacations.

3. What’s the competitive landscape in your labor market? If you’re not having a turnover problem or if your competitors aren’t offering paid family leave, you may not feel compelled to consider it.

4. What’s your overall employment strategy and workplace culture? If your primary employment value proposition is, for example, schedule and career flexibility and a “family friendly” culture, paid family leave would be a natural fit.

5. Crunch the numbers. While it’s impossible to project with precision the cost in “extra” wages and financial payoff that’s involved in reduced employee turnover and higher productivity levels, you’ll need to give it a shot. If you move forward with a paid family leave policy, after you have accumulated some history, you will be able to verify or correct the preliminary conclusions you have drawn.

Going Forward

Will paid maternity and related family leave benefits become more commonplace, as often predicted? The answer will depend on the conclusions employers draw as they consider these and other questions and factors beyond their control, including the future strength of the economy and birth rate trends.

Appeals Court: Commissions Can Be Apportioned Back Over Time

Posted on by Red Spot Design2

Sometimes it’s clear when an employee is entitled to overtime pay, and how much, and other times it isn’t.The issue can become especially tricky when employees are paid at least partially in commissions. In a recent case, a federal appellate court remanded back to a lower district court its ruling on the allocation of commissions in determining overtime pay. The appeals court said the lower court didn’t properly interpret federal overtime law. (Freixa v. Prestige Cruise Services, LLC, CA-11, No. 16-13745, 4/14/17).

Key Facts of the Case

The District Court for the Southern District of Florida had ruled that a cruise ship employee who received commissions was ineligible for overtime pay. As a sales representative, the employee sold cruise trips to customers. He received a fixed salary of $500 a week plus commissions. During the one year he was with the company, he earned over $70,000 in compensation. Of this amount, 63% was paid in commissions.

The commissions were calculated monthly and paid the following month. Both parties agreed in court that the sales rep worked an average of 60 hours a week during his employment, but they disagreed about the number of hours he worked in any individual week.

Subsequently, the employee sued the cruise ship line for overtime pay. He argued that the compensation he received in certain weeks fell below the required threshold for the exemption from overtime that applies to retail workers who are paid commissions.

Lower Court’s Rationale

The district court acknowledged that the law generally requires a calculation of the regular rate of pay on a week-to-week basis. But the court found it difficult to determine the exact weeks during which the sales representative earned commissions.

As a result, it decided to divide his entire remuneration for the year across every hour in every week he worked — assuming 60 hours of work a week — to arrive at an average hourly rate of $23.45. Because that rate exceeded the exemption threshold of $10.88 per hour, the district court awarded summary judgment in favor of the cruise ship company.

In reaching this decision, the district court said it believed its calculation conformed with federal regulations that allow for a different “reasonable and equitable method” to calculate the regular rate of pay “if it is not possible or practicable to allocate the commission among the workweeks of the period in proportion to the amount of commission actually earned or reasonably presumed to be earned each week” (29 CFR 778.120).

Appeals Court’s Rationale

But that wasn’t the end of the story. After the sales representative appealed, the Eleventh Circuit Court overturned the lower court’s ruling, saying that the district court had misinterpreted the federal regulations.

The appeals court ruled that when commissions are computed monthly, those earned in one month might not be allocated across weeks worked in other months. Instead, federal regulations limit the district court to allocating commissions across weeks within the time period in which they were earned. The appeals court cited a related regulation that required as a general rule, “that the commission be apportioned back over the workweeks of the period during which it was earned” (29 CFR 778.119).

Based on the context of this and other regulations, the appeals court said it’s clear that the term “period” means “computation period.” For the sales representative in this case, it refers to each month of his employment, not the entire year that he worked. For example, the court said it believed that the district court could allocate commissions earned in January across weeks worked in January, but not across weeks worked from February through December.

We haven’t heard the last word on this matter. The case was remanded back to the district court for further proceedings.

What the Upper Court Cited

The regulation cited by the appeals court says that if calculation and payment can’t be completed until after the regular pay day, the employer may disregard the commission in computing the regular hourly rate until the amount of commission can be determined. Until then, the employer may pay overtime at a rate not less than one and one-half times the hourly rate paid the employee, excluding the commission.

Then, when the commission can be determined, the employer must pay any additional overtime compensation due once the commission is included. To compute the additional overtime, “it is necessary, as a general rule, that the commission be apportioned back over the workweeks of the period during which it was earned.”

The additional compensation must be not less than one-half of the increase in the hourly rate of pay attributable to the commission for that week in question multiplied by the number of overtime hours worked.

Key point: In accordance with the the Fair Labor Standards Act of 1938, an exemption to the usual overtime pay requirements exists for employees who work for a retail or service establishment if two requirements are met:

  1. The regular rate of pay exceeds one and one-half times the minimum hourly rate (that is, $10.88 an hour), and
  2. More than half of the compensation for a reasonable period (but not less than one month) represents commissions paid on goods and services. This calculation of overtime pay under this exemption was at the core of the above case.

Avoid Rapid Decisions

The rules in this area are complex and may be open to interpretation. Don’t make any quick assumptions about your company’s responsibilities without consulting with your professional payroll advisors.

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