Peter Scott Worldwide ERC Tax Counsel

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Topics: • Federal Tax Changes • New Medicare Taxes for 2013 • IRS Audits of Homesale Programs • Relocation Short Sales • Tax Primer: One year rule

Federal Tax Changes • “American tax laws are constantly changing as our elected representatives seek new ways to ensure that whatever tax advice we receive is incorrect.” Dave Barry

Federal Tax Changes • Most Americans dodged a bullet on January 1 • Tax cuts from 2001 and 2003 were set to expire • A number of other provisions of value to mobility industry would also have expired • “American Taxpayer Relief Act”

Federal Tax Changes • New law Jan 1: • Reduced tax rates made permanent, except for taxpayers with taxable income of $400,000 ($450,000 married filing jointly) • 10%, 15%, 25%, 28%, 33%, 35% • Brackets are adjusted for inflation after 2013

Federal Tax Changes • Top rate returns to 39.6% for taxable income above “high income” thresholds • $400,000/$450,000 also indexed for inflation • Note these taxpayers only paying top rate on income above the thresholds

Federal Tax Changes • Capital Gains • Had Congress not acted, reduced capital gain tax rate would have disappeared • Capital gains will still be taxed at 15%, except 20% rate returns for those in high income brackets above • Dividends • Would have returned to tax at regular income tax rates • 15% rate made permanent • 20% for high income

Federal Tax Changes • Personal exemptions, itemized deductions • Old law phaseouts would have returned had Congress not acted • New law limits phaseouts, but makes permanent • Phaseouts now begin at $250K of adjusted gross income ($300K married filing jointly) • Old phaseouts started at $178K • However, still will raise taxes for fair number of taxpayers (note AGI is larger than taxable income) • This is where Dave Barry comes in!

Federal Tax Changes • Effects on Mobility • Gross-up calculations largely unaffected; would have changed considerably if all rates rose • Saves companies lots of money • Supplemental withholding rate also stays at 25% • Withholding tables provided by IRS, to be used ASAP but no later than February 15 • Reinstatement of personal exemption and itemized deduction phaseouts may prompt a few more gross-up challenges • No more uncertainty about rates

Federal Tax Changes • A casualty: No more reduced FICA tax • Employee portion returns to 6.2% from 4.2% • Employers told to implement increased withholding by February 15, adjust for under-witholding by March 31 • Wage Base $113,500 for 2013

Federal Tax Changes • Alternative Minimum Tax (AMT) • Taxpayer must pay the higher of standard tax or alternative minimum tax • Alternative minimum tax is intended to ensure that taxpayers pay at least minimum tax, but not adjusted for inflation • Original exemption amounts, if allowed to come into play today, would result in some 30-40 million middle class taxpayers paying AMT. Big gross-up problem • AMT doesn’t allow personal exemptions, standard deductions, deductions for state income taxes or for interest on second homes or home equity lines • AMT higher exemption amounts expired on December 31, 2011, but the problem has now been permanently fixed

Federal Tax Changes • Big Deal: AMT permanently fixed • Exemption levels rise, are indexed for inflation • No more annual fixes • Saves some 30 million taxpayers from owing several thousand more • Reduces gross-ups

Federal Tax Changes • Other good news • Exclusion for up to $2 million forgiven mortgage debt on principal residence extended through 2013 • Private mortgage insurance deduction reinstated for 2012 and 2013 • Same for deduction for state and local sales taxes

Federal Tax Changes • Many other credits/breaks extended • Child tax credit • Student loan interest deduction • Child and dependent care credit • Adoption credit • These may be welcome to transferees, but can complicate gross-up when taxable relocation puts transferee above levels when credits phase out

Tax Reform • “A tax loophole is something that benefits the other guy. If it benefits you, it is tax reform.” Russell B. Long • “I was working on a flat tax proposal, and I accidentally proved there’s no God.” Homer Simpson • “This idea that you start with a clean slate and end up with a beautiful, logical tax system just isn’t democracy.” John L. Knapp

Tax Reform • Possibly could happen as part of “grand bargain” to address the deficit • Most popular notion is to reduce/eliminate tax breaks that cost money, reduce/flatten rates somewhat • Tax breaks we care a lot about might be included • Mortgage interest deduction • State/local income tax deduction • Foreign income exclusion • Home sale capital gain exclusion • Moving expense deduction • Not likely this year, but Boy Scout motto applies

New Medicare Taxes • Two new taxes on high income individuals begin January 1, 2013 • .9% increase, to 2.35%, in employee share of Medicare • Applies to those whose wages exceed $200,000 ($250,000 married filing jointly) • Employer not required to withhold unless the wages of the spouse working for the employer exceed $200k, even if joint wages exceed $250k • Will require adjustment of withholding for high income employees, and consideration of gross-up if taxable relocation puts employee over $200k and if company grosses up for Medicare

New Medicare Taxes • Second new tax is a 3.8% tax on unearned income (for example, interest, dividends, annuities, rents, capital gains) • Applies to those whose Adjusted Gross Income exceeds $200,000 ($250,000 married filing jointly). Note different standard for threshold • Applies to the lesser of unearned income or the amount AGI exceeds the threshold • Example: UI is $15,000, AGI is $210,000. Tax applies to $10,000. • No withholding required, but companies will have to consider gross up if taxable relocation puts employee over the AGI threshold. This is not a Medicare tax, but an additional INCOME tax to help fund Medicare

New Medicare Taxes • UI tax could apply to gain from home sale • However, applies after the home sale capital gain exclusion ($250,000, or $500,000 married filing jointly), and after basis is subtracted. That is, applies to net capital gain after the exclusion • Example: Sale price $800,000, basis $600,000, capital gain exclusion $250,000, amount subject to 3.8% tax is zero • Very few relocating employees have reportable capital gain beyond the home sale exclusion • Reports circulating on internet that this is a tax on real estate sales are erroneous • However, would apply to gain from sales of second homes if seller income is high enough

New Medicare Taxes • May cause estimated tax issues for those affected • Some may owe both the 0.9% Medicare tax and the 3.8% UI tax, although applied to different parts of the income base • Gross-up issues will require reference to actual tax returns

IRS Audits of Homesale Programs • “The Opera reminds me of my tax audit. It was in a language I didn’t understand, and it ended in tragedy.” Jeff McNelly’s “Shoe”

IRS Audits-Homesale Program • IRS agents still sometimes contend BVO with no appraisal, guaranteed buyout, not within Rev. Rul. 2005-74 • Good case they are wrong, but ERC continues to recommend addition of delayed AV process • Position of IRS lawyers who wrote Rev. Rul. 2005-74 unclear • Have expressed some skepticism that BVO works, but no definite position • No indication yet that issue has resurfaced as part of the IRS’s ongoing special employment tax audits, but caution advised

IRS Audits-Homesale Programs • Delayed AV Process-Example • Employee markets with BVO for 90 days • If no offer, company does appraisals or BMA’s, determines an appraised value • Offers employee appraised value, or some realistic percentage of it (e.g., 90%), but • Employee must continue to market for 60 days before accepting • Must market at no more than realistic percentage of appraised value (e.g., 102%) • IRS invariably accepts this process as a qualifying AV

IRS Audits-Homesale Programs • Generally, audits less frequent than in past, but still a number every year • Audits focus not only on basic BVO, but procedures used (also in AV) • Poor audit results are almost always the result of questionable risk reduction procedures used by company

Procedure Problems • In both AV and BVO, companies often have waited to enter contract with transferee until inspections are complete, all contingencies are removed from outside contract • Transferee is usually involved in negotiating inspection results • Sometimes, company intentionally waits to sign contract with transferee until very shortly before outside closing, resulting in a “holding period” of no more than 1-3 days

Procedure Problems • IRS consistently maintains that this practice falls within “situation 3” of Rev. Rul. 2005-74 and that the program fails. Company has simply not assumed significant ownership risk for any significant period of time • Recent audit: IRS disqualified all transactions in which contract with outside buyer signed first • Cost company millions, will also cost more millions for the next few years until company can clean up its practice

Procedure Problems Companies should NOT engage in practices that artificially create short holding periods. They should also NOTwait for inspections to be completed before contracting with employee. Better practice is to do own inspections up front, do not rely on buyer inspections to set price for purchase from employee

Audit Results • “We try to cooperate fully with the IRS, because, as citizens, we feel a strong patriotic duty not to go to jail.” Dave Barry • Tax Lawyer’s Golden Rule: If somebody has to go to jail, make sure it’s the client

Audit Results • In audits, IRS invariably asks for complete list of purchase and sale dates • IRS invariably concludes that all purchases/sales within a few days of each other fail • Some success for taxpayer when it can be shown that nothing other than transferee vacate date causes some to be close together • However, if procedures force short periods, IRS always sticks to disallowance • Settlements usually involve company conceding all transactions where purchase/sale within some agreed number of days of one another

Audit Results • Other issues: • Reverse contracts • Can be explained if occasional delays on one side or the other the cause • IRS always questions if delay intentional • Regular delays in payments of equity until outside sale closes • Repayment agreement including home sale expenses

Audit Results • IRS sometimes notes company is not treating houses as capital assets for income tax deduction purposes, takes that to mean it is contending it doesn’t actually own them • But company does agree it owns houses • They are not capital assets because section 1221 excludes from that category property held for sale in the ordinary course of a trade or business • Interestingly, incidence of income tax audits raising capital loss issue has greatly declined

Relocation Short Sales • Old Country Song: “How can I miss you if you won’t go away”? • Another: “I’m so miserable without you, its just like you’re still here” • Short sales can involve both of these principles

Relocation Short Sales • It is possible to take these homes into a relocation home sale program (some companies will do so, others won’t), but some issues must be addressed

Relocation Short Sales • In a relocation short sale, still must have two separate, independent sales for tax purposes • In a homesale program, companies must be extremely careful that the amount of negotiation and finalization of the outside sale between transferee and buyer does not violate the “two transaction” requirement for favorable tax treatment • Lender ordinarily willing to base acceptance of short sale on offer from employer, provided it can be satisfied amount is FMV • In an AV or GBO, there will be appraisals • In a BVO, need contract with outside buyer to establish value.

Relocation Short Sales • But company must protect itself in event lender approval to reduce debt is not obtained • If company buys house without reduced debt, will become liable for entire debt • Excess debt over FMV of house will be wage income to employee, subject to withholding, FICA • Same result as if employer had paid negative equity on employee’s behalf

Relocation Short Sales • How to protect company: • DO NOT include clause in sale contract with outside buyer making that contract contingent on employee obtaining debt reduction • DO include clause in purchase contract with employee making that transaction dependent upon employee obtaining debt reduction • This is no different than standard clause in such contracts requiring that employee pay negative equity • DO include clause in Addendum with buyer making entire contract contingent upon company ability to obtain ownership of the home • This is a standard clause in all relocation sales

Relocation Short Sales • Other factors: • Lenders should actually prefer relocation short sales over not only foreclosures, but over other short sales • Unlike other short sales, company is paying sale costs, they don’t come out of proceeds and reduce lender share • Sometimes lenders don’t understand this, have to be reminded • Some lenders continue to have issues with corporate purchasers, or with fact there will be a “flip” within a short period • Lenders sometimes include various representations in affidavits that purchaser must sign that are problematic because company doesn’t know all the facts relating to outside buyer

Tax Primer: One-year rule • Moving expense regs say move has to be “proximate in time” with beginning of work at new location • One year is presumed to be proximate • But if taxpayer can show that “circumstances existed which prevented” the move within one year, moving expenses still deductible • Example: children finishing school (IRS has allowed 30 months)

Tax Primer: One-year rule • What else might “prevent” the move? • Spouse employment • Parent or dependent care • How about inability to sell the old home? • No authority, but good case • If transferee has made good faith and unsuccessful efforts to sell, or • Cannot afford to sell because “underwater” on debt • Won’t work if transferee just wants to wait for market to improve

Tax Primer: One-year rule • Important principle: • One-year rule has NOTHING TO DO with the tax treatment of home sale programs • Employee goes to new job in 2009, doesn’t want to sell old home yet • Employer puts home through qualifying Amended Value program in 2012 • Home sale costs are not taxable to employee • However, costs of moving HHG in 2012 will be taxable unless transferee can show that “circumstances existed which prevented” a move within one year

The End (whew!) • Old saying: “Knowledge is knowing the tomato is a fruit. Wisdom is not putting it in a fruit salad.” However, • Murphy’s First Minor Law: • Anything you try to make absolutely clear will confuse everybody • Therefore:

QUESTIONS!!! (And Answers) • Rules: • Has to be one I can answer (but not necessarily on the subjects we covered) • Questioner cannot be on permanent “banned” list (you know who you are) • No “stump the tax nerd” • No questions such as “how much do you weigh” • Contact information: • pkslawoffice@gmail.com • 910-579-5332

Peter Scott Worldwide ERC Tax Counsel