Final regulations dealing with the 100 percent bonus depreciation allowance for qualified property acquired and placed in service after September 27, 2017, allow property which is constructed under a pre-September 28, 2017 binding contract to qualify for the 100 percent rate. The final regulations adopt proposed regulations ( REG-104397-18) with certain modifications, including a revised constructed property rule. In addition, the IRS has issued a new set of proposed regulations dealing with issues it is not ready to finalize.

Final regulations dealing with the 100 percent bonus depreciation allowance for qualified property acquired and placed in service after September 27, 2017, allow property which is constructed under a pre-September 28, 2017 binding contract to qualify for the 100 percent rate. The final regulations adopt proposed regulations ( REG-104397-18) with certain modifications, including a revised constructed property rule. In addition, the IRS has issued a new set of proposed regulations dealing with issues it is not ready to finalize.

FINAL REGULATIONS: Written Binding Contract Rules
Constructed property. The proposed regulations provided that property manufactured, constructed, or produced for the taxpayer by another person under a written binding contract entered into prior to the manufacture, etc., of the property is acquired pursuant to a written binding contract. Thus, if the contract was entered into before September 28, 2017, the 100 bonus rate did not apply.

That rule was scrapped in response to negative feedback. Instead the final regulations provide that such property is treated as self-constructed property, and the contract is ignored for purposes of determining when the property is deemed acquired. The acquisition date is now the date that the taxpayer begins manufacturing, constructing, or producing the property as determined under rules similar to those that apply to 50 percent bonus property.

Acquisition date. The final regulations provide that the acquisition date of property acquired pursuant to a written binding contract is the later of:

• the date on which the contract is entered into;
• the date on which the contract is enforceable under state law;
• if the contract has one or more cancellation periods, the date on which all cancellation periods end; or
• if the contract has one or more contingency clauses, the date on which all conditions subject to such clauses are satisfied.

Liquidated damage clause. When a contract has multiple damage provisions, the final regulations clarify that only the provision with the highest damages is taken into account in determining whether the contract limits damages.

Qualified Improvement Property
The IRS once again declined to make qualified improvement property placed in service after 2017 eligible for bonus depreciation. A legislative change is required to give this property its intended 15-year recovery period. With a 15-year recovery period, qualified improvement property will qualify for bonus depreciation under the general rule that allows bonus depreciation on property with an MACRS recovery period of 20 years or less.

Used Property
Predecessor defined. Property previously used by the taxpayer or a predecessor of a taxpayer does not qualify for bonus depreciation if the taxpayer or predecessor had a depreciable interest in the property. The final regulations define "predecessor" as:

• a transferor of an asset to a transferee in a transaction to which Code Sec. 381(a) applies;
• a transferor of an asset to a transferee in a transaction in which the transferee’s basis in the asset is determined, in whole or in part, by reference to the basis of the asset in the transferor’s hands;
• a partnership that is considered as continuing under Code Sec. 708(b)(2);
• the decedent in the case of an asset acquired by an estate; or
• a transferor of an asset to a trust.

Depreciable interest look back rule. The final regulations do not define a "depreciable interest" because this is a facts and circumstances issue. However, a five-year look back period is provided for determining whether a taxpayer or predecessor held a depreciable interest in property.

Substantially renovated property. If a taxpayer places substantially renovated property in service and the taxpayer or a predecessor previously had a depreciable interest in the property before it was substantially renovated, the taxpayer’s or predecessor’s prior depreciable interest does not prevent the taxpayer from claiming bonus depreciation. Property is substantially renovated if the cost of the used parts is not more than 20 percent of the total cost of the substantially renovated property, whether acquired or self-constructed.

Syndication transactions. A lessor who reacquires property in a syndication transaction is not treated as having a prior depreciable interest in the property.

Partnerships
The final regulations permit a partnership to claim bonus depreciation on the portion of a Code Sec. 743(b) basis increase that is attributable to built-in gain under Code Sec. 704(c), even if the partnership is using the remedial allocation method. An exception is provided for publicly traded partnerships that need to maintain fungibility for publicly traded partnership units.

If a partnership interest is acquired and disposed of during the same tax year, the bonus deduction is not allowed for any Code Sec. 743(b) adjustment arising from the initial acquisition. However, if a partnership interest is purchased and disposed of in a "step-in-the shoes" Code Sec. 168(i)(7) transaction in the same tax year, bonus on the section 743(b) adjustment is allowed. The section 743(b) adjustment is apportioned between the purchaser/transferor and the transferee.

The final regulations also clarify the treatment of qualified property transferred in a Code Sec. 721(a) transaction to a partnership in the same tax year that the qualified property is acquired by the transferor if the partnership has another partner who previously had a depreciable interest in the qualified property. In this situation, the qualified property is deemed placed in service by the transferor during that tax year, and the bonus deduction is allocated entirely to the transferor and not to the partnership. Thus, the contributing partner has contributed property with a zero basis to the partnership, and the contributed property is Code Sec. 704(c) property in the hands of the partnership.

Film, Television, and Theatrical Productions
The final regulations clarify that a used qualified film, television, or live theatrical production does not qualify for bonus depreciation. Also, the basis of a qualified film, television, or live theatrical production is reduced by the deduction claimed under Code Sec. 181 before computing the bonus deduction.

Using ADS
Using the alternative depreciation system (ADS) to determine the adjusted basis of a taxpayer’s qualified business investment (under Code Sec. 250(b)(2)(B) or Code Sec. 951A(d)(3)) or the adjusted basis of a taxpayer’s tangible assets for allocating business interests expense between excepted and non-excepted trades or businesses (under Code Sec. 163(j)) does not cause a taxpayer’s tangible property to be ineligible for bonus depreciation.

Public Utility Property
An example is added to clarify that the 100 percent bonus rate does not apply to self-constructed property of a regulated public utility if construction begins after September 27, 2017, and the property is placed in service in a tax year beginning after 2017.

Effective Date
The final regulations apply to qualified property placed in service during or after the tax year that includes the date of publication in the Federal Register. However, a taxpayer may choose to apply the final regulations in their entirety to qualified property acquired and placed in service after September 27, 2017, provided the taxpayer consistently applies all rules in the final regulations. Additionally, a taxpayer may rely on the proposed regulations issued on August 8, 2018, to qualified property acquired and placed in service after September 27, 2017, in tax years ending before the date of publication of the final regulations.

PROPOSED REGULATIONS: Acquired and Self-Constructed Components
A taxpayer may elect to treat components of a larger self-constructed property that are acquired or self constructed after September 27, 2017, as eligible for the 100 percent bonus rate, even though manufacture, construction, or production of the larger self-constructed began before September 28, 2017. The larger property must be eligible for bonus depreciation at the 50 percent rate.

Businesses With Floor Plan Financing
Property used in a trade or business that has had floor plan financing indebtedness does not qualify for bonus depreciation if the floor plan financing interest related to the indebtedness is taken into account under Code Sec. 163(j)(1)(C) in determining the allowable business interest deduction.

The proposals provide rules for determining whether interest in floor plan financing indebtedness has been taken into account during a tax year. In general, floor plan interest is not considered taken into account for a tax year if the sum of interest business income for the tax year and 30 percent of the adjusted taxable income for the tax year equals or exceeds business interest as defined in Code Sec. 163(j)(5). The proposals clarify that the determination of whether a trade or business that has had floor plan financing indebtedness has taken floor plan financing interest into account is made annually.

Leased Property
The proposals clarify that taxpayers leasing property to a trade or business with floor plan financing indebtedness or a rate-regulated utility may claim bonus depreciation. The taxpayer, however, may not be a trade or business with floor plan financing indebtedness that prevents it from claiming bonus depreciation or a rate-regulated utility.

Used Property
Five-year lookback. A safe harbor provides that a taxpayer who disposes of property within 90 days after placing it in service did not hold a prior depreciable interest in the property. Consequently, the property is eligible for bonus depreciation if subsequently reacquired.

Partnerships. A taxpayer has a prior depreciable interest in a portion of property if the taxpayer was a partner in a partnership at any time the partnership owned the property. The amount of the prior depreciable interest is based on the partner’s total share of depreciation deductions with respect to the property.

Series of related transactions. Special rules in the original proposed regulations governing the treatment of a series of related transactions for purposes of the used property acquisition requirements are modified and expanded.

Consolidated groups. Significant clarifications to the rules governing the used property acquisition requirements for consolidated groups are also made.

Written Binding Contract Rules
Property not acquired pursuant to a contract. The acquisition date of property that is not acquired pursuant to a written binding contract is the date on which the taxpayer paid or incurred more than 10 percent of the total cost of the property. The cost of land and preliminary activities are excluded from cost for this purpose.

Purchase of entities. Binding contract rules that apply to the purchase of an entity are proposed. The current binding contract rules only deal with purchases of assets.

A contract to acquire all or substantially all of the assets of a trade or business, or to acquire an entity such as a corporation, a partnership, or a limited liability company, is binding if it is enforceable under state law against the parties to the contract. The presence of a condition outside the parties’ control (including, for example, regulatory agency approval) will not prevent the contract from being a binding contract. Further, the fact that insubstantial terms remain to be negotiated by the parties to the contract, or that customary conditions remain to be satisfied, does not prevent the contract from being a binding contract. This proposed rule also applies to a contract for the sale of the stock of a corporation that is treated as an asset sale as a result of a deemed asset acquisition election under Code Sec. 338.

Long Production Property
The proposals provide rules for determining qualifying basis attributable to the manufacture, construction, or production of long production property and certain aircraft eligible for an extended placed in service deadline.

Mid-Quarter Convention
The mid-quarter convention applies to property placed in service during the tax year if 40 percent or more of the basis of the property was placed in service in the last three months of the tax year. The proposals clarify that the basis of property is not reduced by the 100 percent bonus allowance. This rule has always applied to 50 percent bonus property.

Effective Date of Proposals
In general, the proposed regulations apply to qualified property placed in service during or after the tax year that includes the date the proposals are finalized. A taxpayer may rely on the proposals in their entirety to qualified property acquired and placed in service after September 27, 2017.

Proposed regulations would provide guidance on the inclusion of income and deduction items in the calculation of built-in gains and losses under Code Sec. 382(h). The proposed regulations would:

• simplify the application of Code Sec. 382;
• provide more certainty to taxpayers in determining built-in gains and losses for Code Sec. 382(h) purposes; and
• ensure that the application of certain law changes made by the Tax Cuts and Jobs Act ( P.L. 115-97) (TCJA) does not further complicate the application of Code Sec. 382(h).

Taxpayers may rely on these proposed regulations until final regulations are issued. When these proposed regulations are adopted as final regulations, it is expected that Notice 87-79, 1987-2 CB 387, Notice 90-27, 1990-1 CB 336, Notice 2003-65, 2003-2 CB 747, and Notice 2018-30, 2018-21 I.R.B. 610, will be withdrawn and declared obsolete.

Built-in Gains and Losses
Generally, Code Sec. 382 imposes a value-based limitation (section 382 limitation) on the ability of a loss corporation to offset its taxable income in periods subsequent to an ownership change with losses attributable to periods prior to that ownership change.

Code Sec. 382(h) provides rules relating to the determination of a loss corporation’s built-in gains and losses as of the date of the ownership change (change date). In general, built-in gains recognized during the five-year period beginning on the change date (recognition period) allow a loss corporation to increase its section 382 limitation. Built-in losses recognized during the recognition period are subject to the loss corporation’s section 382 limitation.

Specifically, if a loss corporation has a net unrealized built-in gain (NUBIG), the section 382 limitation for any tax year ending during the recognition period is increased by the recognized built-in gain (RBIG) for the year, with cumulative increases limited to the amount of the NUBIG. If a loss corporation has a net unrealized built-in loss (NUBIL), the use of any recognized built-in loss (RBIL) during the recognition period is subject to the section 382 limitation.

IRS Guidance and TCJA
Notice 2003-65 provides interim guidance on the identification of built-in gains and losses under Code Sec. 382(h). This notice permits taxpayers to rely on safe harbor approaches for applying Code Sec. 382(h) to an ownership change prior to the effective date of temporary or final regulations issued under that provision.

Notice 2003-65 provides (i) a single safe harbor for computing the NUBIG or NUBIL of a loss corporation, based on principles underlying the calculation of net recognized built-in gain under Code Sec. 1374, and (ii) two safe harbors for the computation of a loss corporation’s RBIG or RBIL: the 1374 approach and the 338 approach.

The 1374 approach identifies RBIG and RBIL at the time of the disposition of a loss corporation’s assets during the recognition period. Generally, this approach relies on accrual method of accounting principles to identify built-in income and deduction items at the time of the ownership change, with certain exceptions.

In contrast, the 338 approach identifies items of RBIG and RBIL generally by comparing the loss corporation’s actual items of income, gain, deduction, and loss recognized during the recognition period with those that would have been recognized had an election under Code Sec. 338 (section 338 election) been made with respect to a hypothetical purchase of all of the outstanding stock of the loss corporation on the change date.

Taxpayers may rely on either the 338 approach or the 1374 approach until the IRS issues temporary or final regulations under Code Sec. 382(h). Compared to the 338 approach, the accrual-based 1374 approach is simpler to apply and administer and provides greater certainty for taxpayers.

Prior to the issuance of Notice 2003-65, the IRS had issued Notice 87-79 and Notice 90-27, which provided much more limited guidance regarding the determination of built-in gains and losses. After the TCJA, the IRS issued Notice 2018-30, which makes the 338 approach unavailable when computing items arising from bonus depreciation under Code Sec. 168(k).

The law changes made by the TCJA created additional uncertainty regarding the application of Code Sec. 382 in general, and Notice 2003-65 in particular. Specifically, certain important changes under the TCJA could potentially compromise the mechanics of the 338 approach and further complicate its application.

1374 Approach
For purposes of computing NUBIG and NUBIL, the proposed regulations would adopt as mandatory the NUBIG/NUBIL safe harbor and the 1374 approach described in Notice 2003-65, with certain modifications. These modifications would include technical fixes to calculations involving cancellation of indebtedness (COD) income, deductions for contingent liabilities, and cost recovery deductions. Additionally, the proposed regulations would clarify that carryovers of Code Sec. 163(j) disallowed business interest are counted only once for purposes of Code Sec. 382.

The modifications to the existing NUBIG/NUBIL safe harbor and the 1374 approach would ensure greater consistency between:

• amounts that are included in the NUBIG/NUBIL computation; and
• items that could become RBIG or RBIL during the recognition period.

Comment 
According to the IRS, the proposed regulations would modestly restrict net operating loss usage by reducing the amount that would qualify as RBIG, reducing the incentive to engage in inefficient, tax-motivated mergers and acquisitions.

NUBIG or NUBIL Computation
The proposed rules for the computation of NUBIG/NUBIL would capture a range of items that closely tracks the NUBIG/NUBIL safe harbor computation in Notice 2003-65. However, the component steps of the proposed NUBIG/NUBIL computation would be more explicit, as follows:

• The proposed NUBIG/NUBIL computation would first take into account the aggregate amount that would be realized in a hypothetical disposition of all of the loss corporation’s assets in two steps treated as taking place immediately before the ownership change:
  • —Step 1: the loss corporation would be treated as satisfying any inadequately secured nonrecourse liability by surrendering to each creditor the assets securing such debt.
  • —Step 2 : the loss corporation would be treated as selling all remaining assets pertinent to the NUBIG/NUBIL computation in a sale to an unrelated third party, with the hypothetical buyer assuming no amount of the seller’s liabilities.
  • That total hypothetical amount realized by the loss corporation pursuant to Steps 1 and 2, above, would be then decreased by (i) the sum of the loss corporation’s deductible liabilities (both fixed and contingent), and (ii) the loss corporation’s basis in its assets.
  • Finally, the decreased hypothetical total would be then increased or decreased, as applicable, by the following:
  • —(i) the net amount of the total RBIG and RBIL income and deduction items that could be recognized during the recognition period (excluding COD income); and
  • —(ii) the net amount of positive and negative section 481 adjustments that would be required to be included on the previously-described hypothetical disposal of all of the loss corporation’s assets.

The proposed regulations generally would not allow COD income to be included in the calculation of NUBIG/NUBIL, but would provide certain exceptions.

RBIG and RBIL Items
As mentioned above, the proposed regulations would apply a methodology for identifying RBIG or RBIL that closely tracks the accrual based 1374 approach described in Notice 2003-65. However, the proposed regulations would significantly modify the 1374 approach to include as RBIL the amount of any deductible contingent liabilities paid or accrued during the recognition period, to the extent of the estimated value of those liabilities on the change date.

The proposed regulations also would add a rule clarifying that certain items do not constitute RBIG (such as dividends paid during the recognition period). In addition, limitations would be provided on the extent to which excluded COD income is treated as RBIG. Further, the proposed regulations would provide two different RBIG ceilings with regard to COD on recourse debt, and would provide special rules for COD income on nonrecourse debt.

Finally, rules would be provided for the interaction between Code Sec. 163(j) and Code Sec. 382. To eliminate the possibility of duplication of RBIL items, the proposed regulations would provide that Code Sec. 382 disallowed business interest carryforwards would not be treated as RBIL if such amounts were allowable as a deduction during the recognition period. The proposed regulations also would clarify the treatment of certain items allocated from a partnership.

Applicability Date
The regulations are proposed to be effective for ownership changes occurring after the date the proposed regulations are published as final regulations in the Federal Register. However, taxpayers and their related parties may apply these proposed regulations to any ownership change occurring during a tax year with respect to which the period described in Code Sec. 6511(a) has not expired, so long as the taxpayers and all of their related parties consistently apply the rules of these proposed regulations to such ownership change and all subsequent ownership changes that occur before the applicability date of the final regulations.

Comments and Requests for Hearing
Written or electronic comments must be received by November 9, 2019. Written or electronic requests for a public hearing and outlines of topics to be discussed at the public hearing must be received by November 9, 2019. Electronic submissions must be sent via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-125710-18) by following the online instructions for submitting comments. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The Treasury and the IRS will publish for public availability any comment received to its public docket, whether submitted electronically or in hard copy.

Hard copy submissions must be sent to: Internal Revenue Service, CC:PA:LPD:PR (REG-125710-18), Room 5203, Post Office Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8:00 a.m. and 4:00 p.m. to CC:PA:LPD:PR (indicate REG-125710-18), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC 20224.

The IRS has issued final regulations that amend the rules relating to hardship distributions from Code Sec. 401(k) plans. The final regulations are substantially similar to the proposed regulations. Further, plans that complied with the proposed regulations satisfy the final regulations as well. The regulations are effective on September 23, 2019.

The IRS has issued final regulations that amend the rules relating to hardship distributions from Code Sec. 401(k) plans. The final regulations are substantially similar to the proposed regulations. Further, plans that complied with the proposed regulations satisfy the final regulations as well. The regulations are effective on September 23, 2019.

The final regulations:

• reflect statutory changes affecting Code Sec. 401(k) plans, including changes made by the Bipartisan Budget Act of 2018 ( P.L. 115-123); and
• affect participants in, beneficiaries of, employers maintaining, and administrators of plans that include cash or deferred arrangements or provide for employee or matching contributions.

Deemed Immediate and Heavy Financial Need
The final regulations modify the safe harbor list of expenses for which distributions are deemed to be made on account of an immediate and heavy financial need. The final regulations:

• add "primary beneficiary under the plan" as an individual for whom qualifying medical, educational, and funeral expenses may be incurred;
• modify the expense listed in existing Reg. §1.401(k)-1(d)(3)(iii)(B)(6) to provide that the limitations in Code Sec. 165(h)(5) do not apply for this purpose; and
• add to the list a new type of expense, relating to expenses incurred as a result of certain disasters.

Distribution Necessary to Satisfy Financial Need
The final regulations modify the rules for determining whether a distribution is necessary to satisfy an immediate and heavy financial need, by:

• eliminating any requirement that an employee be prohibited from making elective contributions and employee contributions after receipt of a hardship distribution; and
• eliminating any requirement to take plan loans prior to obtaining a hardship distribution.

In particular, the final regulations, like the proposed regulations, eliminate the safe harbor in existing Reg. §1.401(k)-1(d)(3)(iv)(E), under which a distribution is deemed necessary to satisfy the financial need only if elective contributions and employee contributions are suspended for at least six months after a hardship distribution is made and, if available, nontaxable plan loans are taken before the hardship distribution is made.

Expanded Sources for Hardship Distributions
The final regulations modify existing Reg. §1.401(k)-1(d)(3) to permit hardship distributions from Code Sec. 401(k) plans of elective contributions, qualified nonelective contributions (QNECs), qualified matching contributions (QMACs), and earnings on these amounts, regardless of when contributed or earned.

Section 403(b) Plans
A hardship distribution of Code Sec. 403(b) elective deferrals is subject to the rules and restrictions set forth in Reg. §1.401(k)-1(d)(3). Accordingly, the preamble to the proposed regulations had stated that the new rules relating to a hardship distribution of elective contributions from a Code Sec. 401(k) plan generally apply to Code Sec. 403(b) plans. Because this requirement is retained in the final regulations, at Reg. §1.401(k)-1(d)(3)(iii)(B), it applies to Code Sec. 403(b) plans.

Applicability Dates
The changes to the hardship distribution rules made by the Bipartisan Budget Act of 2018 are effective for plan years beginning after December 31, 2018.

Plan Amendments
The Treasury Department and IRS expect that plan sponsors will need to amend their plans’ hardship distribution provisions to reflect the final regulations, and any such amendment must be effective for distributions beginning no later than January 1, 2020. The deadline for amending a disqualifying provision is set forth in Rev. Proc. 2016-37, I.R.B. 2016-29,136.

For a taxpayer using an accrual method of accounting, the all events test is not met for item of gross income any later than when is included in revenue on an applicable financial statement (AFS) or other financial statement specified by the Treasury Secretary. How the AFS income inclusion rule applies to accrual method taxpayers with an AFS is described and clarified by Proposed Reg. §1.451-3.

For a taxpayer using an accrual method of accounting, the all events test is not met for item of gross income any later than when is included in revenue on an applicable financial statement (AFS) or other financial statement specified by the Treasury Secretary. How the AFS income inclusion rule applies to accrual method taxpayers with an AFS is described and clarified by Proposed Reg. §1.451-3.

Year-by-Year Application
The proposed regulations provide that the AFS income inclusion rule generally applies to accrual method taxpayers with an AFS when the timing of income inclusion for one or more items of income is determined using the all events test. They further clarify that the AFS income inclusion rule applies only to taxpayers that have one or more AFS covering the entire tax year.

The AFS income inclusion rule applies on a year-by-year basis and, therefore, an accrual taxpayer with an AFS in one tax year that does not have an AFS in another tax year must apply the AFS income inclusion rule in the tax year that it has an AFS, and does not apply the rule in the tax year in which it does not have an AFS.

No Change to Income Tax Treatment
The proposed regulations also clarify that AFS income inclusion rule does not change the treatment of a transaction for federal income tax purposes:

• The treatment of a transaction or event in a tax year may be different for federal income tax and AFS purposes.
• The applicability of any exclusion provision, or the treatment of nonrecognition transactions, in the Code, the Income Tax Regulations, or other guidance does not change.

Partial Payment
The proposed regulations provide that an amount included in the transaction price for AFS purposes may not be treated as contingent on the occurrence or nonoccurrence of a future event if the taxpayer has been paid or has an equitable, contractual, or other right to partial payment for performance completed to date. Additionally, that transaction price may not be reduced for amounts subject to Code Sec. 461, including reward amounts in credit card transactions.

Special Methods and Multi-Year Contracts
The proposed regulations clarify that when a taxpayer uses a special method of accounting, the special method of accounting determines the timing of the income inclusion.

Proposed regulations also provide guidance for taxpayers with a financial reporting period that is different than the taxpayer’s tax year. The taxpayer must use one of three permissible methods in order to determine whether an item of income has been included in revenue on an AFS.

For a contract with multiple performance obligations, the allocation of the transaction price to each performance obligation equals the amount allocated to each performance obligation for purposes of including the item in revenue in the taxpayer's AFS. The proposed regulations clarify that a transaction price does not include amounts collected on behalf of third parties, or amounts that are contingent on the occurrence or nonoccurrence of a future event.

A taxpayer with a multi-year contract applies the all events test by applying a cumulative approach reflecting amounts previously included under Code Sec. 451 rather than an annualized approach.

Fees
Under the proposed regulations if the taxpayer does not treat a fee as discount or as an adjustment to the yield of a debt instrument over the life of the instrument (such as points) in its AFS, and the fee otherwise would be treated as creating or increasing original issue discount (OID) for federal income tax purposes (specified fee), then the rules in the proposed regulations under Code Sec. 451(b) apply before the rules in Code Secs. 1271 through Code Sec. 1275. Removing specified fees and specified credit card fees from the calculation of OID will permit taxpayers to apply only the rules of Code Sec. 451(b) to these fees, without also having to apply the rules relevant to OID.

The proposed section regulations would not apply to determine the time at which OID generally is includible in income.

Effective Date
The regulations are proposed generally to apply to tax years beginning on or after the date the final regulations are published in the Federal Register. However, in the case of a specified fee, Proposed Reg. §1.451-3(i)(2) is proposed to apply for a taxpayer’s first tax year beginning one year after the date the Treasury Decision adopting these regulations as final is published in the Federal Register.

A taxpayer may rely on the proposed regulations (other than the proposed regulations relating to specified fees) for tax years beginning after December 31, 2017 (after December 31, 2018, for specified credit card fees), as long as the taxpayer: (1) applies all the applicable rules contained in the proposed regulations for specified credit card fees; and (2) consistently applies the proposed regulations to all items of income during the tax year (other than specified fees).

Proposed regulations provide rules for accrual method taxpayers who receive advance payments. The proposed regulations include provisions affecting both taxpayers both with and without applicable financial statements (AFS), and describe and clarify the statutory requirements of Code Sec. 451(c).

Similar to Rev. Proc. 2004-34
The proposed regulations include many provisions similar to those of Rev. Proc. 2004-34, I.R.B. 2004-22, 991. For example the proposed regulations:

• provide a similar deferral method for non-AFS taxpayers;
• provide a list of items excluded from the definition of advance payment;
• provide rules consistent with Rev. Proc. 2004-34 to ensure the acceleration of an advance payment when a taxpayer dies or ceases to exist, or when a taxpayer’s obligation is satisfied or otherwise ends; and
• use the short tax year rules of Rev. Proc. 2004-34 for the AFS and non-AFS deferral methods
  The proposed regulations also provide additional definitions and clarifications.

Change in Accounting Method
The IRS intends to provide the procedures by which a taxpayer may change its method of accounting to use one of the deferral methods described in these proposed regulations. Until further guidance is issued, a taxpayer may continue to rely on Rev. Proc. 2004-34, as described in Notice 2018-35, I.R.B. 2018-18, 520.

Effective Date
The proposed regulations are to apply to tax years beginning on or after the date the final regulations are published in the Federal Register. Until the date the Treasury Decision adopting these regulations as final regulations is published in the Federal Register, a taxpayer may rely on these proposed regulations for tax years beginning after December 31, 2017, as long as the taxpayer: (1) applies all the applicable rules contained in these proposed regulations, and (2) consistently applies these proposed regulations to all advance payments.

Taxpayers may use the automatic consent procedures to change accounting methods to comply with the recent proposed regulations described above. Rev. Proc. 2018-31, I.R.B. 2018-22, 637, is modified.

Taxpayers may use the automatic consent procedures to change accounting methods to comply with the recent proposed regulations described above. Rev. Proc. 2018-31, I.R.B. 2018-22, 637, is modified.

The proposed regulations provide rules for:

• inclusion in gross income under the all events test for taxpayers with an applicable financial statement (AFS) ( NPRM REG-104870-18); and
• use of the deferral method for advance payments for taxpayers with or without an AFS ( NPRM REG-104554-18).

Certain qualifying taxpayers may apply for a change to comply with the proposed regulations without filing a Form 3115, Application for Change in Accounting Method.

Taxpayers Affected
The accounting change procedures for inclusion in gross income for taxpayers with an AFS generally apply to taxpayers with an AFS that want to:

• change to a method of accounting that treats an item of gross income as meeting the all events test no later than when the item is taken into account as revenue in its AFS under Code Sec. 451(b)(1)(A);
• in certain cases, allocate the transaction price to performance obligations under Code Sec. 451(b)(4);
• change to a method of accounting that complies with Proposed Reg. §1.451-3; or
• change to a method of accounting that complies with Proposed Reg. §1.451-8(c).

The procedures also apply to taxpayers that do not have an AFS and that want to change to a method of accounting that complies with Proposed Reg. §1.451-8(d).

In addition, the procedures apply to a change in AFS in order to apply certain revenue recognition methods of accounting.

Pending Nonautomatic Applications
The IRS will return any Form 3115 requesting a change in method of accounting available under this revenue procedure that:

• was filed on or before September 9, 2019, under the non-automatic procedures for a tax year beginning after December 31, 2017; and
• is pending with the National Office on September 9, 2019.

The National Office will send a letter to the taxpayer acknowledging the return of the Form 3115, and will return the user fee submitted with the form. A timely resubmitted Form 3115 will be considered filed as of the date the taxpayer originally filed the Form 3115 under the nonautomatic change procedures.

Effective Date
This revenue procedure is generally effective for tax years beginning after December 31, 2017. For specified credit card fees, it is effective for tax years beginning after December 31, 2018.

Amendments to have been proposed to update the information reporting regulations under Code Sec. 6033, which generally apply to organizations exempt from tax under Code Sec. 501(a). The proposed regulations reflect statutory amendments and certain grants of reporting relief announced through guidance that has been made since the current regulations were adopted. The amendments and grants of relief apply particularly with respect to tax-exempt organizations required to file an annual Form 990, Return of Organization Exempt from Income Tax, or a Form 990-EZ information return.

Amendments to have been proposed to update the information reporting regulations under Code Sec. 6033, which generally apply to organizations exempt from tax under Code Sec. 501(a). The proposed regulations reflect statutory amendments and certain grants of reporting relief announced through guidance that has been made since the current regulations were adopted. The amendments and grants of relief apply particularly with respect to tax-exempt organizations required to file an annual Form 990, Return of Organization Exempt from Income Tax, or a Form 990-EZ information return.

Annual Return and Reporting Requirements
Code Sec. 6033 outlines various requirements for an annual information return to be filed by organizations that are exempt from tax under Code Sec. 501(a) or are described in Code Sec. 527, including exceptions to the filing requirement. The reporting requirements under Code Sec. 6033(h) mandate controlling organizations to include on their returns:

• interest, annuities, royalties, or rents received from each controlled entity under Code Sec. 512(b)(13);
• any loans made to each such controlled entity; and
• any transfers of funds between such controlling organization and each such controlled entity.

Penalty Relief
Under Code Sec. 6104(b), the IRS must make the filed annual returns available to the public. Under Rev. Proc. 2018-38, I.R.B. 2018-31, 280, tax-exempt organizations (other than charities exempt under Code Sec. 501(c)(3) and Code Sec. 527 political organizations) were no longer required to report the names and addresses of contributors on Schedule B when filing their information returns. This change applied to information reporting for tax years ending on or after December 31, 2018, for donations above certain applicable thresholds.

However, Rev. Proc. 2018-38 has been overturned by a federal district court ( S.C. Bullock, DC Mont., 2019-2 ustc ¶50,245), which held that the IRS failed to follow the notice and comment procedures required by the Administrative Procedure Act (APA).

Code Sec. 6652(c)(1)(A) imposes penalties for a failure to file a return required under Code Sec. 6033, failure to include any required information, or failure to provide correct information. Under Code Sec. 6652(c)(5), the penalty is not imposed if it is shown that the failure was due to reasonable cause. Notice 2019-47 provides that the IRS will consider there to be a reasonable cause based on reliance on Rev. Proc. 2018-38 for any organizations that file Form 990 or 990-EZ and did not include on their 2018 information return such donor information as Rev. Proc. 2018-38 indicated was not required.

Proposed Amendments
The proposed amendments to the regulations would restore relief from the requirement to report contributor names and addresses on the annual returns filed by certain tax-exempt organizations that was previously provided in Rev. Proc. 2018-38 before the federal district court overturned that rule. Therefore, only organizations exempt under Code Secs. 501(c)(3) and 527 would need to continue reporting their donor information on their Forms 990, 990-EZ, or 990-PF.

In addition, the proposed amendments would incorporate into the regulations the existing exception from having to file an annual return for certain organizations that normally have gross receipts of $50,000 or less, found in Rev. Proc. 2011-15, I.R.B. 2011-3, 322.

Telecommuting not only offers employees flexibility, but accommodates lives that can often be hectic. While employees love the lifestyle and family/home advantages of telecommuting, the potential improvement to the bottom line is what appeals to employers.

Telecommuting not only offers employees flexibility, but accommodates lives that can often be hectic. While employees love the lifestyle and family/home advantages of telecommuting, the potential improvement to the bottom line is what appeals to employers. For example, turnover may decrease as satisfied employees are less likely to jump ship; absences may decrease since inclement weather and sick children do not prevent a home-bound employee from working; and overhead is reduced as less office space and support staff are required. Employees also enjoy financial benefits as they find their expenses for clothing, lunch and commuting are drastically reduced.

Tax implications of telecommuting

Although it may not be a top consideration as you and your employees contemplate the desirability of telecommuting, the question should nevertheless be addressed: what is the tax effect of such an arrangement?

Employer

If your employees telecommute, you probably won't feel a thing. The employee is paid just as he would be if he were on-site; the collection and payment of employment taxes will still be your responsibility as the employer; supplies and computer that you provide will still be deductible as an ordinary and necessary business expense.

Employee

But what about a telecommuting employee? Can telecommuting lead to an increase or decrease in net income? A change in deductions? An increase in the amount and types of required recordkeeping? The answer is yes... to all of the above.

Home office deduction. A discussion of telecommuting deductions should begin with the telecommuter's home office. A home office offers not only the possibility of a tax deduction in and of itself; it also affects the employee's ability to deduct other items that he may provide in order to do his job, such as computers and peripherals.

Strict requirements are applied by the IRS to home offices: expenses of the office are deductible only if certain conditions are met. The area used for business must be used (1) for the convenience of his employer and (2) regularly and exclusively as a principal place of business (or as a place to meet with clients or customers, but that will not usually be the case for a telecommuting employee).

• Convenience of the employer. When is an employee's home office used for the "convenience of the employer"? Courts, taxpayers and the IRS have struggled with this issue. The U.S. Supreme Court has said that it is a response to a business necessity. This test is satisfied if it is the employer who wants the arrangement. It is possible, however, that if it is the employee who asks for telecommuting, the IRS will conclude that the arrangement is not for the convenience of the employer. If your employee plans to take a home office deduction, it will be easier for him to meet the test if your records document that you requested the arrangement or that you mutually decided that telecommuting was preferred.

• Principal place of business. If the convenience of the employer test is met, the employee still has to show that his home office is his principal place of business. If he strictly telecommutes, this should not be a problem. If he alternates between his home office and your office location, he will meet this test if (1) he uses his home office for administrative and management activities related to the business and (2) there is no other place where he conducts substantial activities of this type. If this test doesn't produce a clear answer, the determination will have to be made based on (1) which location he spends more time at and (2) the relative importance of the business activities he conducts at both.

If the home office qualifies for deduction, all of the expenses relating to the office and its use may be deductible. These expenses include direct expenses, such as repairs to the room, installation of carpeting, etc. and indirect expenses, which relate to the office as part of the entire house, such as utilities, rent or mortgage interest, real estate taxes, etc. If the employee's income from the business use of his home equals or exceeds total business expenses, all of the expenses can be deducted.

Deducting computers and peripherals. How a telecommuting employee treats computers and related equipment depends on whether these items are the property of the employer or the employee.

• Supplied by employer. If the employer supplies them, he is entitled to deduct the cost. The tax result to the employee is less clear. It is possible, and in fact most likely, that the items will simply be treated as any other untaxed supplies and equipment provided to on-site employees to do their job, like paper and pens and a desk.

Alternatively, although it is difficult to support an argument that an employee's use of a computer in doing business for his employer should be treated as a fringe benefit, this is relatively new territory for the IRS and it has not officially tackled the issue. If employee non-office business use of employer-provided equipment is determined to be covered by the Internal Revenue Code, it seems likely that it would be treated as an excludable working condition fringe benefit. If so, employees will have to substantiate their business use in order to qualify for the exclusion. And what about an employee's personal use of the employer's computer? If the employee who uses an employer-provided computer can substantiate his business use of the computer and if his personal use is minimal, that benefit may be a de minimis fringe benefit he can exclude from taxation.

• Supplied by employee. If the computer is supplied by the employee, he can expense or depreciate the computer if it is both (1) required as a condition of employment and (2) used for the convenience of the employer. Qualifying for the home office deduction operates somewhat as a safe harbor for computer-related deductions. If the employee couldn't satisfy the requirements for a deductible home office, he will have to substantiate his business use in order to depreciate the computer and/or deduct related expenses. Substantiation requires the employee to keep adequate records documenting the time and amount of the business use, the date of expenditure or of use of the computer, the business purpose of the use of the computer, and the amount of each expenditure respecting the computer, such as the acquisition cost. If he met the requirements for taking a home office deduction, however, he does not have to substantiate the business use of the computer. Regardless, if the computer is not acquired or used by the employee as a condition of his employment and for the convenience of his employer, he can't depreciate or expense it. In addition to these requirements, computer expenses, just like all other business expenses, must be ordinary and necessary.

If the employee does use the computer for the employer's convenience and as a condition of his employment but can't meet the requirements for a home office deduction and must substantiate his business use in order to depreciate or deduct his computer, the amount deductible will be that proportion of expenses that correlates to the business use of the computer. The depreciation method available to the telecommuting employee will depend on whether the computer or other related equipment is used more or less than 50% for business. If more than 50%, he can use MACRS 200% declining balance depreciation for the business-use portion of the property plus that portion of the computer he personally used in the production of investment, royalty or rental income. If business use was less than 50%, the employee is limited to the straight-line method of depreciation. If the employee wants to expense the computer, he can only do so if its business use was more than 50%, and then he can expense only that portion of the property that was allocated to business use.

Dealing with reimbursed expenses. What about employer-reimbursed expenses? A telecommuting employee may be reimbursed for utilities, phone expenses or similar charges related to his home office and may be supplied with office materials or other supplies. All of these amounts will be considered either (1) employer owned items used in performing the employer's work and not income to the employee or (2) working condition fringe benefits and tax-free to your employee if he could deduct them as ordinary and necessary business expenses if he had paid them himself. In order to categorize these amounts as working condition fringes, the employee must be able to establish his home office as his principal place of business.

Telecommuting is increasing in acceptance and favor as a work option providing significant benefits to employee and employer alike. As its use expands, employers and employees should be aware that there is more to telecommuting than reduced costs and a more relaxed lifestyle. Careful and creative tax planning will help avoid any surprises or pitfalls.

Q. I am reviewing my portfolio and considering selling some of my stock. How do I determine what tax basis I have in the publicly-traded shares that I own for purposes of determining my gain or loss if I buy and sell multiple shares at different times? Does keeping track of basis really matter?

Q. I am reviewing my portfolio and considering selling some of my stock. How do I determine what tax basis I have in the publicly-traded shares that I own for purposes of determining my gain or loss if I buy and sell multiple shares at different times? Does keeping track of basis really matter?

A. In order to accurately calculate the gain or loss realized on assets you sell, it is important that you keep track of the bases of all of your assets, including stock. However, when it comes to stock--especially lots of stock bought and sold at different times-- it may seem a bit tricky. Fortunately, the rules related to determining the basis of stock sold make the task more manageable.

In general, the basis of stock sold will be determined under one of the following methods: first-in, first-out (FIFO) or specific identification. However, securities held in mutual funds and received as a result as a corporate reorganization may be handled differently.

First-in, first-out (FIFO)

In general, if you buy identical shares of stock at different prices or on different dates and then you sell only part of the stock, your basis and holding period of the shares sold are determined on a first-in first-out (FIFO) basis, based upon the acquisition date of the securities. However, if specific shares sold are adequately identified by the delivery of certificates, by a broker having custody of them, or by a trustee or executor, the basis will be determined by the specific identification method (see below).

The acquisition date for purpose of applying the FIFO method follows the rules for holding period. For example, the acquisition date of securities received by gift takes into account the donor's holding period, and securities received in an estate distribution includes the holding period of the executor or trustee.

Margin accounts. If your shares are held in a margin account, they are considered sold in the order in which they were purchased, rather than the order in which they were placed in the account.

Stock splits or dividends. If you receive shares as a result of a stock split or tax-free stock dividend, they must be allocated among the original lots to which they relate, with the basis of the original shares allocated between the new shares and the old shares based on their fair market values.

Stock rights. If you acquire additional shares by exercising stock rights, your new shares are treated as a separate lot and your basis in them is equal to the amount paid plus the basis of the stock rights.

Multiple contracts. Shares acquired on the same day under several contracts entered into at different times to purchase stock when issued are deemed acquired for the FIFO rule in the same order as the contracts were entered into.

Specific identification

When you are able to identify the securities to be sold, and do so, FIFO will not apply to your basis allocation. The identity of securities sold or otherwise transferred generally is determined by the certificates actually delivered to the transferee (usually by CUSP number). Thus, if you have records showing the cost and holding period of securities represented by separate certificates, you can often better control the amount of gain or loss realized by selecting the certificates to be transferred. But be careful: delivery of the wrong certificates is binding, despite your intention to transfer securities from a different lot.

Example: You hold 1000 shares of IBM. You purchased 400 shares (actually 100 shares that split twice) in 2000 for $8,000 (net brokerage commissions). You bought 400 more shares in 2005 at $18,000; and 200 more in early 2007 for $16,000. You want to sell 300 shares now when its value is down to $50 per share. If you do not specify to your broker before the trade to sell the 200 shares purchased in 2007 and 100 shares from the 2005 lot, you will realize $9,000 in long term capital gains instead of $500 in long-term capital gain and a $6,000 short-term capital loss.

Mutual funds

If you own shares in a mutual fund, you may elect to determine the basis of stock sold or transferred from your accounts by using one of two average cost methods: either the double-category method or the single-category method. An election to use one of the average basis methods for mutual fund shares must be made on either a timely filed income tax return or the first late return for the first tax year to which the election is to apply. Different methods may be used for accounts in different regulated investment companies.

Securities received in reorganization

An exception to the FIFO rule applies to securities received in reorganization (such as a merger) and not adequately identified. These securities are given an average basis, computed by dividing the aggregate basis of the securities surrendered in the exchange by the number of shares received in the exchange. If securities in the same corporation are received in the exchange, however, they are divided into lots corresponding with those of the securities surrendered and the FIFO principle is applied, in the absence of adequate identification on a later disposition.

As illustrated in an example above, there can be negative tax effects from the misidentification of stock sold. If you are uncertain how to properly identify stock sold, please contact the office for further guidance.

An attractive benefit package is crucial to attract and retain talented workers. However, the expense of such packages can be cost-prohibitive to a small business. Establishing a tax-advantaged cafeteria plan can be an innovative way to provide employees with additional benefits without significantly adding to the cost of your overall benefit program.

An attractive benefit package is crucial to attract and retain talented workers. However, the expense of such packages can be cost-prohibitive to a small business. Establishing a tax-advantaged cafeteria plan can be an innovative way to provide employees with additional benefits without significantly adding to the cost of your overall benefit program.

Rising healthcare costs affect small businesses

If you are like most employers today, you have been dealing with the sting of rising prices for health benefits for some time. As a matter of economic survival, many small businesses have had to pass on at least some of the cost of providing health, dental and prescription benefits to their employees. As the prices continue to rise to fund these benefits, employees have been required to pay an increasing share of these costs. Establishing a cafeteria plan can be a way to make this problem more palatable for your employees at relatively little cost to your business.

Cafeteria plans defined

Technically, a cafeteria plan is a program through which you can offer your employees a choice between two or more "qualified benefits" and cash. The plan must be set forth in a written document and it can only be offered to employees. Depending on what you want to accomplish through a cafeteria plan, the plan can vary from being extremely simple (e.g., premium conversion plans) to being somewhat more complex as more features are added (e.g. flexible spending accounts).

Premium conversion plans: Popular and simple

A very simple type of cafeteria plan that is very popular among small to mid-size employers is sometimes referred to as a "premium conversion" plan. Establishment of a premium conversion plan would not require you to provide any significant additional funding for benefits other than what you are currently spending.

Here's how it works: through the structure of a cafeteria plan, you can offer your employees the ability to use pre-tax dollars to pay the portion of premiums you require them to contribute for their health, dental, and prescription benefits (including the cost of dependent benefits). Using pre-tax dollars to pay for their portion of health care premiums saves your employees money and will result in more net dollars in their paychecks. It may seem surprising, but your employees will appreciate even this small dollar-saving benefit.

With a premium conversion plan, the only costs to you as an employer is the expense of hiring an attorney or other benefits professional to draft a cafeteria plan document for you and the expense of making the small adjustment to your system of payroll deductions so that the employees' portion of the health benefit premiums is deducted from their gross pay rather than their after-tax pay.

Flexible spending accounts

Another benefit that can be made available under a cafeteria plan is a flexible spending account option. These accounts permit employees to have a specific amount withheld from each paycheck and set aside to be used for reimbursement of medical expenses not covered by the group health insurance plan or to be used to cover dependent care expenses. Keep in mind, however, that if you want to establish flexible spending accounts through a cafeteria plan, it will involve more ongoing administrative expense on your part than a simple premium conversion cafeteria plan.

Additional options

You also may want to offer your employees a cafeteria plan which provides them a set dollar value that each employee can take either as additional salary or choose to spend on a variety of benefits, e.g., health insurance, dental coverage, dependent care, or retirement plan contributions. With this type of plan, all benefits other than additional salary are not taxable to the employee. This type of plan can provide desirable flexibility to your employees, but will also cost more to establish and administer.

As you make the determination regarding what type of benefit program you would like to offer your employees, there are many other options that should be taken into consideration. If you require additional guidance, please contact the office for a consultation.

An employee stock ownership plan (ESOP) is a retirement plan option that offers even greater tax advantages than many other retirement plans. However, for the small business owner, ESOPs have another significant advantage: in the right situation, an ESOP can be an extraordinarily useful estate and business succession planning tool.

An employee stock ownership plan (ESOP) is a retirement plan option that offers even greater tax advantages than many other retirement plans. However, for the small business owner, ESOPs have another significant advantage: in the right situation, an ESOP can be an extraordinarily useful estate and business succession planning tool.

The Internal Revenue Code offers great benefits for tax-qualified retirement plans such as ESOPs. Employers can get a tax deduction for contributions made on employee's behalf to the plan, while employees do not have to pay immediate income tax on these contributions. An employee stock ownership plan (ESOP) is a very specialized type of qualified retirement plan that offers even greater tax advantages than many other retirement plans. However, for the small business owner, ESOPs have another significant advantage: in the right situation, an ESOP can be an extraordinarily useful estate and business succession planning tool.

Unfortunately, it is all too common for owners of closely held businesses to approach retirement age without having an adequate business succession plan in place that will allow them to comfortably retire and enjoy the fruits of their labor. In many cases, these businesses may be very successful but not readily marketable due to heavy dependence on the input from the business owners on an ongoing basis. In these situations, the owner may find it very difficult to sell the business for its full value and due to inadequate planning, may have to sell the business for a fraction of its worth at retirement.

If you are a business owner considering selling your business at retirement and are concerned about getting the full fair market value for your business, the answer may be right in front of you. In many cases, the most logical buyers for your business may be your key employees. These key employees are familiar with your business including customers, vendors, and processes as well as your long-term vision for the business. They have an excellent chance to continue fostering the success of your business after your departure.

However, in many circumstances, your employees will not have the cash to buy your business outright and therefore, the business must, in one way or another, provide them with the means to pay the purchase price. This is a situation when an ESOP can be used as an effective planning tool to "save the day" by providing a financially effective way to help fund the sale of your business to your key employees at full market value.

There are numerous tax benefits that are available to you as an owner to sell your business to your employees through the use of an ESOP. These benefits allow you t

• Sell your shares of stock tax-free to the ESOP;

• Utilize an ESOP loan (for which the bank and your company get special tax treatment); and

• Have your employees pay for the stock while the business pays back the ESOP loan using (a) deductible and enhanced contributions to the ESOP, and (b) tax deductible dividends.

These benefits mean that by using an ESOP, you can sell your business tax-free and at full value (as determined by an appraiser) to your employees who are more able to pay because they can deduct the purchase price. These tax benefits provide a mechanism for you to receive maximum value for your business in cases where there may not be any other way to accomplish this.

Providing business succession to key employees through an ESOP may not only give you adequate funds on which to retire, but also can leave your family with a portfolio of liquid investments in the form of the proceeds from the tax-free stock sale of your stock back to the ESOP, instead of a business that your family may have not know-how to run nor have any desire to run. Further, an ESOP can also help if you have one or more children that want to remain active in the business, while others want to receive an equal share of the your estate and do not want to be required to remain involved in the operation of the business.

Subchapter S corporations have been permitted to establish an ESOP for the last couple of years. If you are operating as an S corporation and are interested in establishing an ESOP, it is important to be aware of the differences between ESOPs that can be established for standard corporations and S corporations.

An ESOP is an extremely specialized type of profit sharing or stock bonus plan and must comply with all of the requirements for any other tax-qualified retirement plan that are imposed under the Internal Revenue Code and the supporting Treasury regulations. However, an ESOP is only slightly more complicated to establish than a profit sharing or 401(k) plan. For more information about how an ESOP can be used in your business succession plans, please contact the office to schedule a consultation.

Incentive stock options (ISOs) give employees a "piece of the action" while allowing employers to attract workers at relatively inexpensive costs. However, before you accept that job offer, there are some intricate rules regarding the taxation of ISOs that you should understand.

ISOs give employees a "piece of the action" while allowing employers to attract workers at relatively inexpensive costs. However, before you accept that job offer, there are some intricate rules regarding the taxation of ISOs that you should understand.

How are ISOs taxed?

An incentive stock option is an option granted to you as an employee which gives you the right to purchase the stock of your employer without realizing income either when the option is granted or when it is exercised. You are first taxed when you sell or otherwise dispose of the option stock. You then have capital gain equal to the sale proceeds minus the option price, provided that the holding period requirement is met.

Note. The IRS has temporarily suspended collection of ISO alternative minimum tax (AMT) liabilities through September 30, 2008.

How long do I need to hold ISOs to get capital gain treatment?

To obtain favorable tax treatment, the stock acquired under an incentive stock option qualifies for favorable long-term capital gain tax treatment only if it is not disposed of before the later of two years from the date of the grant of the option, or one year from the date of the exercise of the option. If this holding period is not satisfied, the portion of the gain equal to the difference between the fair market value (FMV) of the stock at the time of exercise and the option price is taxed as compensation income rather than capital gain. In this case, you may be subject to the higher rate of income imposed on ordinary income.

For example, your employer granted you an incentive stock option on April 1, 2006, and you exercised the option on October 1, 2006, you must not sell the stock until April 1, 2008, to obtain favorable tax treatment (the later of two years from the date of the grant or one year from the date of exercise).

What key dates should I remember?

Because of the importance of receiving capital gain treatment, it is important that you keep in mind key dates such as the date of grant of the ISO and its date of exercise. These periods are measured from the date on which all acts necessary to grant the option or exercise the option have been completed. Therefore, the date of grant is treated as the date on which the board of directors or the stock option committee completes the corporate action which constitutes an offer of stock, rather than the date on which the option agreement is prepared. The date of exercise is the date on which the corporation receives notice of the exercise of the option and payment for the stock, rather than the date the shares of stock are actually transferred.

Will I be subject to alternative minimum tax?

The effect of the alternative minimum tax (AMT) on ISOs can amount to a potential trap for the unwary. This is because under the regular tax there is no tax until the stock is sold or otherwise disposed of. Under the AMT, however, the trap takes place when the ISO is exercised, since alternative minimum taxable income includes the difference between the FMV of the stock on the date the ISO is exercised and the price paid for the stock (the "ISO spread").

If you pay AMT, you are given a credit against regular income tax for the portion of the AMT attributable to ISOs and other tax preference items that result in deferral of income tax. The credit is taken in later years when no AMT is due, and may be taken to the extent that regular tax liability exceeds tentative minimum tax liability. The effect of this is that the AMT is a prepayment of tax, rather than an additional tax.

Since the AMT only applies if it is higher than your regular income tax, one strategy is to time the exercise of ISOs each year to come under the AMT exemption levels. Purely from a tax standpoint, the ideal situation is to exercise ISOs each year that would result in AMT equal to your regular tax. Of course, other factors, such as market conditions, financial needs, etc. may play a greater role in deciding when to exercise an option. If you pay high property tax or state income tax, you may find it more challenging to calculate the optimum exercise of ISOs in relation to the AMT, since both of these deductions are counted against their annual AMT exemption.

ISOs can be a nice additional employee benefit when considering a job offer. However, because the tax implications surrounding certain key trigger events related to ISOs can have a significant impact on your tax liability, we suggest that you contact the office for additional guidance.