California Compliance Potpourri

Torakichi Jesús Oba Pérez, EA, CPA, and Kelly Blocker, CPA; CalCPAs

 

Being a born and raised Californian, I have come to accept certain truths about the California taxation system, which I tend to forget does not necessarily apply outside of my state. Here are a few pointers to consider when dealing with former Californians who could still very much have California income tax to consider although they may have successfully (or unsuccessfully) ceased to be California tax residents.

 

1. Estate Planning

Make sure that inbound Californians update their estate plans for Texas laws/considerations. As much as I love California, I don’t think that feeling would extend to someone passing away without a will with assets in California and Texas. In such cases, it is more than likely that two probates would have to be administered, which ranks low on the scale of desired outcomes for beneficiaries.

Additionally, non-resident beneficiaries of California situs assets would also be subject to backup withholding on any income from the assets of the estate, so when completing the updated estate planning, be sure to keep an eye on any California situs assets and understand the eventual implications of inheriting those assets.

 

2. California LLC Considerations

A good resource to understand what the compliance implications are for California LLCs is FTB Publication 3556. It is filled with information that may be particularly eye catching for non-California practitioners:

        a. Single Member LLCs

Keep in mind that a single member LLC is a disregarded entity for federal tax purposes, but still must file a California Form 568 for every year it has conducted business, as well as pay their applicable LLC annual tax and LLC fees.

        b. Doing Business in California

The section of Pub. 3556 gives an overview of what doing business in California is considered to be and gives specific examples for non-California LLCs that run into California filing requirements because they are interpreted to be doing business in California.

I would pay particular attention to the examples that give an overview of non-California LLCs that are considered to be conducting business in California.

 

3. Management of an LLC

If an LLC is located, operated or managed in California, the LLC is considered doing business in California. This remains true even if the LLC is not a California LLC. If the LLC is located or operated in another state with no business activity in California and no management decisions are made by the California resident manager, the LLC is not considered doing business in California. This becomes especially important because management activities, location and source of sales drives income sourcing.

 

4. Income Sourcing on Sale of an LLC Interest

When an LLC member sells their interest, the sourcing rules vary depending on the assets/interest held/sold. For former Californians considering selling their LLC interests, a few key considerations to ask a potential client are – did the LLC hold inventory, have receivables, have other tangible property subject to depreciation recapture? California generally treats the sale of an LLC interest as a sale of intangible personal property, generally sourced to the seller’s current state of residence. However, per FTB Legal Ruling 2022-02, unrealized receivables or appreciated inventory necessitate the treatment of the sale as two separate sales – (1) the sale of the member’s interest in any unrealized receivables and/or appreciated inventory (is likely to have gain sourced to California) and (2) the sale of the remaining LLC interest (treated as an intangible).

 

5. 1031 Exchange - Isley Brothers Edition

I had a great idea once to take a client’s unrealized gains on their California situs real estate investments and 1031 exchange it to non-California situs property thereby getting rid of any future California tax bill. I was, however, foiled by the forward-thinking folks at the Franchise Tax Board, which requires an annual information return, Form FTB 3840, to be filed annually until the gain is realized and tax is paid to the state of California.  

Much like the haunting refrain from the Isley Brothers’ “Voyage to Atlantis,” the Franchise Tax Board will always come back to you to request their share of the tax on the eventual gain recognition, and if you do not file your 3840 in a timely manner, the Franchise Tax Board may issue a Notice of Proposed Assessment to adjust the income for the California sourced deferred gain and assess tax plus any applicable penalties and interest.

 

In summary, a good rule of thumb may be to assume that anything from California comes with certain strings attached, and the work remains to understand and explain those strings to our clients.

IRS Survey on Services to Tax Practitioners and Clients

William Stromsem, CPA, J.D., George Washington University School of Business

 

The IRS is conducting a random survey of tax professionals to help improve services to practitioners and taxpayers. Although we are always wary of phishing scams, this is a legitimate survey that could help you, your clients and the tax system as you respond to questions about e-filing, electronic document submission, data security, due diligence requirements and other areas of service.

 

You may have already received an email from the IRS encouraging you to participate if selected. Those selected will then receive follow-up mail or a phone call from ICF Inc., an independent research firm that is conducting the survey for the IRS, with more information. The survey takes only about 20 minutes, can be completed online, and results are anonymous and confidential. It will be conducted from now through Dec. 6. 

 

The survey will not ask for personal information about tax pros or their clients. All responses are anonymous and confidential.

 

Tax Professionals Might Be Contacted About IRS Survey - CPA Practice Advisor

IRS to Stop Automatic Penalties on Late Forms 3520

John M Kelleher, CPA-Fort Worth

 

On Oct. 24, 2024, IRS Commissioner Danny Werfel announced that effective immediately, the IRS will no longer automatically issue penalty notices for late filed Forms 3520 related to foreign gifts, Part IV of the form. The Commissioner, speaking at a conference at UCLA, also indicated that the IRS will begin to review the reasonable cause statements provided with the late filed forms before any penalties are issued. Prior to the policy change, the IRS would automatically issue penalties for the greater of $10,000 or 25% of the gift for late filed forms. Many taxpayers were not even aware of the requirement to file the form.

 

There has been a strong push from the National Taxpayer Advocate, as well as other bodies such as the TXCPA Federal Tax Policy Committee, for the IRS to change its policy in this area.

 

IRS Hears Concerns from TAS and Practitioners, Makes Favorable Changes to Foreign Gifts and Inheritance Filing Penalties - Taxpayer Advocate Service

Annual IRS Inflation Adjustments

William Stromsem, CPA, J.D., George Washington University School of Business

 

The just-released Revenue Procedure 2024-40 provides the inflation adjustments for next year and some of the numbers may be helpful in year-end planning this year. The Rev. Proc. is 27 pages long and this article will only cover some of the most important changes. 

 

Standard Deduction

 

The standard deduction will rise to $30,000 for married filing jointly, $15,000 for singles and married filing separately, and $22,500 for heads of households. The additional standard deduction for old age and blindness will be $1,350. This may be helpful in timing deductions if a taxpayer wants to use the strategy of “bunching” itemized deductions into alternating years to exceed the standard deduction every other year. 

 

The standard deduction for dependents rises to $1,350 (or to earned income plus $450) and this may be helpful in income shifting without running afoul of the “kiddie tax” rules, where the child can have up to $1,350 of unearned income without any tax liability, and an additional $1,350 taxed at the child’s tax rate, with unearned income over $2,700 taxed at the parent’s marginal rate.

 

Marginal Rates

 

Brackets for marginal tax rates will be adjusted for inflation. These will not be used until 2025 returns are filed in 2026. They will be subject to change depending on election results and they will be built into return preparation software, but they may be of interest in current political discussions. The standard deductions listed above are effectively a 0% tax bracket for lower-income individuals, offsetting otherwise taxable income. On the other end of the scale, taxpayers reach the top marginal tax rate of 37% with taxable income greater than $751,600 for married filing jointly and $626,350 for singles. Note the top marginal rate will sunset at the end of 2025, bringing the maximum rate to 39.6%. 

 

Transfer Taxes

 

The annual gift tax exclusion rises to $19,000 and the transfer tax unified credit offset amount rises to $13,990,000 per transferor. This may be helpful for those planning to make gifts before the expiration of the higher unified credit offset amount at the end of 2025 when the credit amount will sunset back to approximately $6,500,000 per transferor. 

 

Alternative Minimum Tax Exemption

 

The AMT exemption amounts will increase to $88,100 for unmarried individuals and $137,000 for married filing jointly. The exemption begins to phase out at $626,350 for singles and $1,252,700 for married filing jointly.

 

Other Adjustments

 

Many other numbers are adjusted slightly for inflation, so see the Rev. Proc. for specifics, including limits on health care flexible spending accounts, medical savings accounts and the foreign earned income exclusion.    

 

IRS releases tax inflation adjustments for tax year 2025 | Internal Revenue Service

IRS Launches Pass-Through Compliance Unit

David Donnelly, CPA-Houston

 

The IRS announced on Oct. 22, 2024, that the new Pass-Through Unit has started operations. The new unit will audit partnerships, trusts and S corporations of all sizes and will be part of the Large Business & International (LB&I) Division.

 

Commissioner Danny Werfel said, “…we will be able to reverse our historically low audit rates for complex arrangements employed by certain high-wealth individuals and large entities, while at the same time improving the taxpayer experience through a more tailored exam approach.”

 

The announcement also included the disclosure that the IRS has “…launched examinations of 76 of the largest partnerships with average assets over $10 billion that includes hedge funds, real estate investment partnerships, publicly traded partnerships, large law firms and many other industries.”

 

IRS Announces Launch of Pass-Through Compliance Unit in LB&I

Draft Form 7217 for Reporting Property Distributed by a Partnership

Chris Keegan, CPA-Austin

 

The IRS has recently released a draft of the new Form 7217, Partner’s Report of Property Distributed by a Partnership, and is currently requesting comments.

 

Form 7217 is designed to facilitate reporting of property distributions to partners. This form is part of a broader effort in recent years by the IRS to gather more information related to partnerships and their partners.

 

Partnerships have traditionally provided information to partners to assist them in determining their basis in distributed assets. Until now, there has not been a requirement for the partner to report their basis calculation for assets received. Form 7217 will include information on the distributed assets including the partnership’s basis in the assets, fair market value of the assets, and basis adjustments as required under various provisions of the Internal Revenue Code including Sections 732, 734 and 743.

 

If finalized by the IRS, Form 7217 will be required beginning with 2024 tax filings.

 

Draft Form 7217

Draft Form 7217 Instructions

Section 721: The “Other” Tax Deferred Exchange

By Janet C. Hagy, CPA-Austin

 

Often overlooked as an option for wealth planning, IRC Section 721 – Nonrecognition of gain or loss on contribution to a partnership is creating a growing business for real estate managers. But for the real estate owners, these transfers are not without risks. In the right circumstances and working with a reputable manager, Section 721 transfers can solve income recognition and estate planning challenges.

 

Under Section 721, the real estate owner irrevocably transfers their property to an operating partnership, where they become a unitholder. The transfer is a tax deferred transaction. This partnership has a large pool of other properties. The operating partnership is a subsidiary of an Umbrella Partnership Real Estate Investment Trust (UPREIT). The operating partnership typically contracts with the UPREIT to manage the properties.  The owner loses all control over the property but can receive an income stream from the property while the property is in the partnership. The unitholders do not participate in future appreciation of the real estate.

 

If encumbered property is contributed to the operating partnership, the debt will be refinanced and a portion of the overall debt will be allocated to the unitholder.

 

During the life of the operating partnership, the limited partner can sell their units or transfer them to the REIT over time. The sale or transfer of units is a taxable event. But this allows the unitholder flexibility to generate cash flow from the sale of their units and to control the timing of recognition of the deferred gain as they dispose of the units. Heirs will receive a stepped-up basis in the units upon death of the unitholder.

 

The ideal owner who could benefit from a Section 721 transfer is someone who:

1. Is ready to sell their property but wants to postpone recognition of the gain.
2. Does not want to acquire other traditional like-kind real estate.
3. Wants more liquidity from their investments.
4. Wants to simplify transfers to heirs with a more liquid asset.

 

However, besides loss of control and losing access to future appreciation of the contributed property, some of the other risks include:

1. Managers can unilaterally decide to sell the partnership properties or transfer them to the REIT at any time. This creates a taxable event for the unitholder, possibly unexpected.
2. Under-performing properties in the pool can affect unit values and cash distributions to the owner.
3. Managers can incur additional debt.
4. The management agreement may have liquidation restrictions.

 

Another type of Section 721 transfer, called a DOWNREIT, may offer the real estate owner a share of the appreciation and have other benefits, but it is also harder to meet all the requirements for gain deferral.

 

There are many real estate managers offering UPREIT and DOWNREIT products. Careful review of the rules and restrictions under the operating and REIT management agreements is imperative. Historical performance statistics, a list of the real estate portfolio and outstanding debts are also items for review. A private letter ruling on the tax effect of the transaction, especially on the DOWNREIT option, may be desirable if the transaction is sizeable.

Safeguard Your Records in Case of a Disaster

William Stromsem, CPA, J.D., George Washington University School of Business

 

With better weather forecasting, individuals and businesses may have more advance notice to prepare for approaching hurricanes. Here are some suggestions: 

 

• Safeguard important business and tax records by storing originals in waterproof bags in a safe place and keeping copies in a different location. These should be secured from the elements and also from unauthorized access. 
• Consider scanning or photographing important documents and saving them on a flash drive that can be easily stored in a safety deposit box. 
• Back up business records in the cloud, if available. 
• For personal property, inventory valuable items and take photographs. It might be advisable to video the contents of the entire premises on your smartphone—this will help you recall items that might otherwise not be noticed, particularly if the building is gone after the disaster as happened all too frequently with Hurricane Helene. 

 

IRS Publications 584 and 584-B have additional information on preparing for a disaster and making claims for losses. Also, even if a hurricane or other disaster isn't imminent, check that your emergency plans are updated so that you can implement them when needed.  

 

Publication 584 (Rev. February 2019) (irs.gov), Casualty, Disaster and Theft Loss Workbook

Publication 584-B (Rev. October 2017) (irs.gov) Business Casualty, Disaster and Theft Loss Workbook

cri-before-disaster-strikes-resource-2024-2.pdf (cricpa.com)

Safeguard Tax Documents in Case Disaster Strikes, IRS Says | Tax Notes

An Evergreen Reminder of Requirements Regarding Securing Client Data

William Stromsem, CPA, J.D., George Washington University School of Business

 

Cyberthieves are trying to get your information year-round. Now that October 15 is behind us and year-end tax planning is not here yet, this might be a good time to review requirements for securing client information. If you have a data breach, this can ruin client relationships and even end your practice.

 

The IRS requires a Written Information Security Plan (WISP) to protect your firm and clients from cyberattacks. Ensure that your plan is valid, up to date and in compliance with the IRS requirements. IRS Publication 5708 is a brief document that details what is required and how to customize your plan for your practice. AICPA Tax Section members can download a copy of AICPA's WISP template.

 

Also, the Federal Trade Commission requires practices to use multifactor authentication in accessing client information that is stored on computers or on networks (including cloud storage). This would include return preparation records when vendor software is used. Multifactor identification involves using two or more items that only the user would know, like username and password, or if available, facial recognition, fingerprints or other means of verifying that the person accessing the information is authorized to do so. 

 

Hopefully, your firm has this fully implemented.

 

Publication 5708 (Rev. 8-2024) (irs.gov) Creating a WISP for your tax and accounting practice

How To Comply with the Privacy of Consumer Financial Information Rule of the Gramm-Leach-Bliley Act | Federal Trade Commission (ftc.gov)

FTC Safeguards Rule: What Your Business Needs to Know | Federal Trade Commission

Gramm-Leach-Bliley Act (GLBA) and the FTC Safeguards Rule | Resources | AICPA & CIMA (aicpa-cima.com)

1099-Ks Will Reappear in This Filing Season

William Stromsem, CPA, J.D., George Washington University School of Business

 

Remember the problem with taxpayers bringing in Forms 1099-K to report income from third-party settlement networks like PayPal and the client having no business records of expenses to offset the reported revenue? Note that after suspending 1099-K reporting for 2022 and 2023, the IRS has set the dollar amount for 1099-Ks for 2024 (to be reported early in 2025) at $5,000. This is higher than the 2021 law, which required reporting of receipts of over $600, but the IRS is apparently prepared to implement the $5,000 requirement for 2024. 

 

This might be a good time to advise clients to be sure that expenses related to any reported revenue are supported so that they can take business deductions. The IRS has clarified that money taxpayers received from friends and family as a gift or repayment for a personal expense should not be reported on a Form 1099-K, as these payments are not taxable income.

 

Hopefully, you and your clients will be prepared for this upcoming filing season.   

 

About Form 1099-K, Payment Card and Third Party Network Transactions | Internal Revenue Service (irs.gov)

Understanding your Form 1099-K | Internal Revenue Service (irs.gov)