Monthly Archives: August 2011

Should a Not-For-Profit Form an Audit Committee?

by Andrew Lotts, member, CJBS

With the Sarbanes-Oxley Act (SOX) of 2002, there has been limited direct impact on nonprofits, remembering that SOX is law for publicly traded companies only.  However, many forward-thinking not-for-profits are asking themselves what parts of the SOX they should consider enacting as a part of best-practices. In fact, the Attorney Generals of several states have already implemented some Sarbanes-like reforms. Others are still in the study stage.

A recent trend among nonprofits is to adopt an audit committee structure. There are some pros and cons to this: If implemented correctly, an audit committee should provide the Board with a clear, independent voice to address financial matters. It also establishes that the auditors are neither engaged by nor report to management, but rather, the Board, through its audit committee. On the down-side, the committee members will need to devote the time and develop the expertise to effectively monitor increasingly complex financial practices.

Some of the duties of an audit committee are as follows:

  • Engage the auditing firm
  • Review the audit with the auditor
  • Present the audit to the Board
  • Provide an outlet for confidential reporting of any impropriety suspected by an employee with fear of management’s retribution (whistleblowers)
  • Review the appropriateness of major accounting and internal control policies
  • Protection of assets

Some major characteristics of an audit committee:

  • Should have at least one member of the Board (preferably more than one)
  • Should have a least one “expert” in the field on non-profit accounting/auditing (you may consider engaging such an individual if none are available from your volunteer base)
  • Should meet several times a year
  • Staff members normally do not serve on the committee
  • Boards with high turnover may consider longer terms to retain institutional memory

Many nonprofits will find it difficult to populate such a committee with qualified individuals. If you create an audit committee, it has to actually do what it is designed for. Also, members of an audit committee face strong fiduciary responsibilities, though its presence does not diminish those of the Board itself; it’s important to remember that the creation of an audit committee does not absolve the individual directors on the Board from their director responsibilities.

Another alternative to consider is to augment the mission of an already standing finance committee. Such a committee may already possess individuals with the knowledge necessary. If this is the direction you wish to take, the Board would need to pass a resolution empowering the committee to do such work and the committee name should have “audit” in it; for example, “finance and audit committee.” The drawback to this approach is that if the finance committee makes major financial recommendations, the same committee would not be able to independently review these decisions.  However, your existing finance committee is distinct from employee management so there is already a checks and balance system in place to a degree.

The bottom line is that people expect more from audit committees today, and the summary information below provides insight into audit committee leading practices that can help committees meet those expectations.

1. Financial Reporting and Disclosures

Financial reporting disclosure requirements have been steadily increasing for a number of years, in tandem with the complexity of accounting standards. Regulators and financial statement users continue to press companies for more information and to get that information sooner. This environment makes the audit committee’s responsibility to oversee the company’s financial reporting more difficult. The committee must be aware of the financial reporting risks to focus its attention appropriately. And it cannot lose sight of the need to maintain its skepticism.

2. Risk Management and the System of Internal Control

Given how many risks — known and unknown — a company faces, it’s a challenge for a board or audit committee to be assured that the organization is addressing risk appropriately. One of the difficulties facing the audit committee is clearly defining its risk responsibility relative to that of the entire board. While the company’s system of internal control is designed to help mitigate risk, the audit committee focuses particularly on controls relating to financial reporting, fraud, and compliance. Most existing finance committees have a history of handling these matters.

3. Oversight of Management and Internal Audit

The audit committee needs to oversee management while taking care not to step into management’s role. Establishing an effective relationship with management is essential — it allows the committee to effectively monitor the company’s financial reporting practices and evaluate management’s competence. Similarly, the committee relies heavily on internal audit or the external auditors to provide an objective view on how the company is handling a number of key risks, including those relating to financial reporting and compliance. (Traditionally, non publicly traded entities and not-for-profits do not specifically have controls tested as this is typically outside the scope of a financial audit.)

4. Relationship with External Auditors

The audit committee has to select the right external auditors to conduct a quality audit. As part of executing their audit plan, the external auditors provide the audit committee with assurance regarding the company’s financial reporting. Additionally, external auditors are in a unique position to provide unfiltered and unbiased feedback to the committee about management and the company’s processes.

5. What to Do When Things Go Wrong — Financial Statement Errors and Fraud Investigations

At times, breakdowns in financial reporting processes lead to potential errors in previously issued financial statements. Management and the audit committee have to assess whether an error is material and, if it is, take steps to resolve the situation. The situation can become more complex if the error results from fraud.

6. Committee Composition

Composition and leadership are critical in supporting the audit committee’s ability to carry out its responsibilities effectively. The committee needs the right combination of skills and experience. It also needs a chair with the knowledge and commitment to drive the committee’s work.

7. Meetings

To ensure committee meetings run well, the committee needs to have the right agenda and receive the right materials beforehand. The attendees, and how they interact with committee members, also influence the success of meetings. Given how many responsibilities the committee has, it needs to ensure it is meeting often enough and at the right points during the year.

8. Supporting Committee Effectiveness — Charter, Evaluations, Resources, and Training

The audit committee’s charter helps distinguish the committee’s responsibilities from those of the full board of directors. An audit committee that periodically evaluates its performance will be able to identify ways to improve its effectiveness. Orientation training for new members and ongoing development for all members are essential, particularly given the velocity of changes to financial reporting and governance standards.

We have found that maintaining a sub-committee for dealing specifically with auditor level matters and other potentially sensitive areas has been an effective tool for many of our not-for-profit clients.  The rigid audit committee structure, separate charter and additional layer of communication are often just too much to maintain effectively for many of our clients.  The key still gets back to effective communication and efficient dissemination of important information, responsive management and implementation of controls within the organization to ensure successful outcomes.

In general, we find that larger not-for-profits, typically greater than $25 million in gross receipts, with complex programs, multiple sites, and relatively large volumes of transactions have audit committees.  We believe that the relative complexities found at the larger organizations necessitate the use of an audit committee because it enhances communication and strengthens the organizations that have these characteristics.

Once again, having an audit committee is not a requirement for nonprofits, but in today’s marketplace, with its heightened scrutiny, everyone should explore all alternatives to best safeguard the resources they have been entrusted with. This is only a snapshot of some of the considerations involved. To discuss any of these issues or for more information, please feel free to contact me.

Best regards,

Andrew Lotts, CPA
Phone:  (847) 580-5422
E-mail:  mailto:arl@cjbs.com

State Nexus Issues

by Robin Mandell, CPA

Many states are becoming aggressive in taxing corporations based on the privilege of conducting business or deriving income within a state.   Florida has just ruled on a case subjecting a corporation to income tax even though it has no physical presence in Florida.

A corporate taxpayer had nexus with Florida and was subject to the state corporate income tax because some of its products were shipped or delivered inside the state. The taxpayer’s business activity in Florida consisted of the solicitation of sales of gifts and products the taxpayer’s customers use to reward their employees. Some of the products were shipped from the taxpayer’s warehouse outside the state while others were shipped directly to the customers from unrelated vendors’ warehouses, some of which are in Florida. To be protected from nexus, shipment or delivery must be from a point outside the state. Despite the fact that the taxpayer had no other business activity in Florida, because some of the shipments were made from within Florida, the taxpayer was not protected and was subject to Florida corporate income tax.

For sales tax purposes, states watch for is internet activity as many states have implemented “click through” nexus standards as well.  From a recent seminar I attended, the following states have enacted “click through” nexus standards for sales tax –

  • North Carolina  – 8/1/09
  • Rhode Island – 7/1/09 ($5,000 threshold)
  • Illinois – 7/1/11 ($10,000 threshold)
  • Arkansas  – 7/1/11 ($10,000 threshold)
  • Connecticut – 7/1/11($2,000 threshold)
  • Texas – letter ruling 3/24/11.

We expect many other states will be following suit.

The following states have enacted economic nexus standards in addition to Florida –

  • California – effective for taxable years beginning after 1/1/11
  • Iowa – case that went to Iowa Supreme Court, 4/28/11
  • New Jersey – issued 1/10/11, applies retroactively to tax years beginning in 2002

Minimizing Nexus

An important facet of tax planning is the minimization of corporate income tax nexus with unfavorable taxing jurisdictions. This can be accomplished by segregating activities from income producing operations. The first method of segregation is to separately incorporate certain portions of the business. Examples include creation of sales and distribution companies, contract manufacturers, service companies, or research and development companies. A second method of segregation is to create a pass-through entity, such as a limited liability company. A third method is the creation of an intangible holding company to license out the intellectual property of the corporation. Each of these methods of segregation has benefits and attendant risks, varying from state to state, but consideration of one or more of these tools can lead to successful tax planning through isolation of income producing activities from less favorable taxing jurisdictions.

IRS Issues Guidance on Carryover Basis Rules for 2010 Decedents’ Estates

by Matthew Bergman, CPA 

On August 7, 2011, the IRS issued guidance on the time and manner for making the election not to have estate tax apply to estates of decedents who died in 2010. The election must be made by November 15, 2011. The notice also discusses how donors can elect out of automatic allocation of the generation-skipping transfer (GST) tax exemption for direct skips in 2010 and clarifies when 2010 GST tax returns are due.

IRS also provided details on how executors who elect not to have estate tax apply can allocate increase in basis to decedents’ assets.

The Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010 reinstated the estate tax for 2010 after it had been repealed under the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001. However, the Tax Relief Act allows executors of the estates of decedents who died in 2010 to elect to apply the Code as if the estate tax had not been reinstated. Under this election, no estate tax would be due, but assets in the estate do not receive a step-up in basis to fair market value (FMV) at the date of death (or alternate valuation date). Instead, heirs’ basis in assets they inherit is determined under the modified carryover basis rules, with their basis being the decedent’s adjusted basis at date of death; however, the executor can elect to allocate up to $1.3 million to increase certain assets’ basis to their FMV at death (basis increase).

Executors can elect to have the provisions of Section 1022 apply by filing Form 8939, Allocation of Increase in Basis for Property Acquired from a Decedent, on or before November 15, 2011. The IRS will not grant extensions of time to file Form 8939 and will not accept late-filed forms, except in certain narrowly defined circumstances. However, the IRS had not yet released a final version of Form 8939.

The notice explains that executors must allocate the basis increase on Form 8939. The executor must report on Form 8939 all property acquired from the decedent (except cash and rights to receive income in respect of a decedent). The executor must also provide a statement to each recipient of property reported on Form 8939, within 30 days of filing Form 8939, setting forth information required under Section 6018(e).

Revenue Procedure 2011-41 explains in detail how the allocation of the basis increase works and what assets it applies to. It also discusses how to determine fair market value, gives special rules for community property states, and explains the interaction of section 1022 with other tax provisions.

If the executor of the estate of a decedent who died in 2010 makes the Section 1022 election, the executor will allocate the decedent’s available GST exemption by filing Schedule R with Form 8939. The notice provides two ways for the executor to elect out of the automatic allocation of the GST exemption.

The due date for filing a return reporting a direct skip, taxable distribution, or taxable termination that occurred during 2010 (before December 17, 2010) is September 19, 2011, except in the case of Form 8939, Schedule R, which is due November 15, 2011.

S Corporation Stockholder-Employee Compensation

by Michael W. Blitstein, CPA 

S corporation stockholder-employees and their tax advisers often find themselves with conflicting goals when setting the stockholder-employee’s compensation. Typically, the stockholder-employee prefers to minimize compensation in favor of distributions to reduce payroll taxes. Tax advisers, however, are faced with a body of governing authority providing that the stockholder-employee cannot avoid the imposition of payroll taxes by forgoing reasonable compensation. Unfortunately, until recently this governing authority had offered little in terms of how to actually compute reasonable compensation, leaving tax advisers with sparse guidance upon which to rely when recommending salary amounts to their clients.

In late 2010, an Iowa district court decided Watson, a reasonable compensation case that, together with the North Dakota District Court’s 2006 decision in JD & Associates, provides the direction tax advisers have been seeking. These two cases shed much needed light on the methodology the IRS and the courts use to determine reasonable compensation in the S corporation arena.

S Corporations and Employment Taxes

As passthrough entities, S corporations generally do not pay entity level tax on their taxable income. Instead, taxable income and other attributes are allocated among the stockholders, who report the items and pay the corresponding tax on their personal income tax returns.

This S corporation flowthrough income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships, and LLCs. The advantage finds its genesis in that a stockholder’s undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, a general partner, or many LLC members are subject to self-employment taxes.

As the need to fund Social Security and Medicare payments has risen, the employment tax burden on employers, employees, and the self-employed has increased dramatically. In 2011, employers will pay 6.2% of the first $106,800 of an employee’s wages toward the Social Security tax, with employees paying an additional 4.2% through wage withholding. Employers and employees will split the 2.9% Medicare tax on all wages, without limitation.

Self-employed individuals will be responsible for the entire 10.4% Social Security tax—again limited to the first $106,800 of self-employment income—and the 2.9% Medicare tax on all self-employment income.

As these employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for stockholder-employees to minimize their salary in favor of distributions, which are not subject to payroll or self-employment tax. Consider the following examples.

Example 1: John owns 100% of the stock of S Corporation, an S corporation. John is also S’s president and only employee. S generates $100,000 of taxable income in 2011, before considering John’s compensation. If John draws a $100,000 salary, S’s taxable income will be reduced to zero. John reports $100,000 of wage income on his individual income tax return, and S and John are liable for the necessary payroll taxes. S is required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S withholds $5,650 (5.65% of $100,000) from John’s salary toward John’s payroll obligation, resulting in a total payroll tax bill of $13,300.

Example 2: Alternatively, John withdraws $100,000 from S as a distribution rather than a salary. S’s taxable income will remain at $100,000 and will be passed through to John and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to John, as it represents a return of basis. By choosing to take a $100,000 distribution rather than a $100,000 salary, S and John have saved a combined $13,300 in payroll taxes.

Reasonable Compensation History: No Salary Taken

In light of these potential employment tax savings, the IRS has long challenged attempts by stockholder-employees to minimize compensation in favor of distributions. IRS opened its attack on these perceived abuses in Revenue Ruling 74-44. In the ruling, the IRS imputed the payment of reasonable salaries to an S corporation that paid distributions but no compensation to two stockholders who provided services to the corporation.

Fifteen years later, an oft-cited decision further clarified the IRS’s position on reasonable compensation. In Radtke, the taxpayer was the sole stockholder and director of a law firm established as an S corporation. Although the taxpayer devoted all his working time to the law firm, he took no compensation for the year at issue, opting instead to withdraw $18,225 in distributions.  The IRS argued, and the district court agreed, that the distributions represented wages subject to payroll taxes, with the court adding, “where the corporation’s only director had the corporation pay himself, the only significant employee, no salary for substantial services . . . [h]is ‘distributions’ functioned as remuneration for employment.”

Soon after, the Ninth Circuit Court of Appeals expanded on this line of reasoning with its decision in Spicer.  In that case, the taxpayer was Spicer Accounting Inc. (SAI), an accounting firm established as an S corporation. SAI was owned by Spicer, who was a CPA, and his spouse. Spicer also served as president, director, and treasurer. As SAI’s lone accountant, Spicer performed substantial services, working approximately 36 hours per week.

Spicer had an arrangement with his corporation whereby he donated his services to the corporation in exchange for no compensation, and as a stockholder he withdrew his earnings as distributions. Accordingly, Spicer did not pay payroll taxes on the amounts he received.

The Ninth Circuit, in analyzing the nature of the payments made to Spicer, stated that “salary arrangements between closely held corporations and [their] stockholders warrant close scrutiny.”  In an effort to determine if the distributions truly represented remuneration for services, the Ninth Circuit established a line of analysis that would be followed repeatedly in the years to follow.

The Ninth Circuit first looked to Sec. 3121(d), which defines an employee for payroll tax purposes in part as “any officer of a corporation.”  Because Spicer was the president of SAI, this requirement was easily met. The Ninth Circuit then turned its attention to Regulations Section 31.3121(d)-1(b), which provides an exception to employee status for some officers, but only to an officer who “does not perform any services or performs only minor services.”

In arriving at its decision, the Ninth Circuit held that Spicer’s services were substantial. As the firm’s lone CPA, Spicer was the only person capable of signing tax returns, performing audits, and preparing opinion letters. The Ninth Circuit concluded that distributions paid to Spicer were classified properly as compensation subject to payroll taxes because “a corporation’s sole full-time worker must be treated as an employee.”

A line of nearly identical rulings followed, with one Pennsylvania CPA at the heart of many of the decisions. In Grey, the sole stockholder of an accounting firm took no salary despite rendering significant services, opting instead to withdraw amounts as independent contractor fees. The Tax Court, using the line of reasoning established in Spicer, held that the stockholder was an employee and the accounting firm was liable for payroll taxes on the independent contractor fees.

After its victory in Grey, the IRS zeroed in on the accounting firm’s client list. In all, six of those clients found themselves in front of the Tax Court, defending the reasonableness of their compensation.  In each case, stockholder-employees who provided significant services to their S corporation withdrew the entire taxable income of their corporation as distributions, neglecting to take any salary. The Tax Court held that the stockholders were employees and recharacterized the distributions as compensation.

The abuses evidenced in these decisions did not go unnoticed. In 2005, the Treasury Inspector General for Tax Administration (TIGTA) issued a report examining the payroll tax advantage that S corporations enjoyed over sole proprietorships. The report, which analyzed S corporation tax returns filed in 2000, revealed the following:

  • Approximately 80% of all S corporations were more than 50% owned by one stockholder, giving that stockholder control in setting his or her compensation.
  • Owners of single-stockholder S corporations paid themselves salaries equaling only 41.5% of the corporation’s profits, down from 47.1% in 1994.
  • There were 36,000 situations in which the sole owners of S corporations generating over $100,000 of income took no salaries. These corporations passed through $13.2 billion to their owners free from payroll tax.
  • In total, the payroll taxes paid by single-stockholder S corporations were $5.7 billion less than the self-employment taxes that would have been imposed if the taxpayers were sole proprietors.

In 2009, a U.S. Government Accountability Office (GAO) report to the Senate Committee on Finance echoed the concerns expressed in the TIGTA findings. The GAO report noted that in 2003 and 2004 combined, S corporations had underreported their stockholder compensation by $24.6 billion, with corporations with fewer than three stockholders responsible for nearly all the underreporting.

A Rare Defeat for the IRS

Although a stockholder faces a heavy burden in proving that services provided to a corporation are not substantial, it can be accomplished. For example, in Davis, a district court held that the stockholder had proved this point and rejected the IRS’s attempt to recharacterize distributions made to a stockholder of an S corporation as “arbitrary and capricious.”

Davis was the president of the corporation but did not actively participate in its activities. The court, citing Spicer, found that based on the uncontroverted evidence of the stockholder, she did not provide substantial services to the corporation and met the exception from employee treatment provided for in the Section 3121 regulations. While this decision remains an anomaly in the relevant case history, it confirms that stockholders need not draw a salary provided they render only minimal services to the corporation.

Changes to Innocent Spouse Relief

by Larry Goldsmith, C.P.A., J.D., C.F.F.A.

The Internal Revenue Service recently announced that it will extend help to more innocent spouses by eliminating the two-year time limit that now applies to certain relief requests.

“In recent months, it became clear to me that we need to make significant changes involving innocent spouse relief,” said IRS Commissioner Doug Shulman. “This change is a dramatic step to improve our process to make it fairer for an important group of taxpayers. We know these are difficult situations for people to face, and today’s change will help innocent spouses victimized in the past, present and the future.”

The IRS launched a thorough review of the equitable relief provisions of the innocent spouse program earlier this year. Policy and program changes with respect to that review will become fully operational in the fall and additional guidance will be forthcoming. However, with respect to expanding the availability of equitable relief:

  • The IRS will no longer apply the two-year limit to new equitable relief requests or requests currently being considered by the agency.
  • A taxpayer whose equitable relief request was previously denied solely due to the two-year limit may reapply using IRS Form 8857, Request for Innocent Spouse Relief, if the collection statute of limitations for the tax years involved has not expired. Taxpayers with cases currently in suspense will be automatically afforded the new rule and should not reapply.
  • The IRS will not apply the two-year limit in any pending litigation involving equitable relief, and where litigation is final, the agency will suspend collection action under certain circumstances.

The change to the two-year limit is effective immediately.

Existing regulations, adopted in 2002, require that innocent spouse requests seeking equitable relief be filed within two years after the IRS first takes collection action against the requesting spouse. The time limit, adopted after a public hearing and public comment, was designed to encourage prompt resolution while evidence remained available. The IRS plans to issue regulations formally removing this time limit.

By law, the two-year election period for seeking innocent spouse relief under the other provisions of section 6015 of the Internal Revenue Code, continues to apply. The normal refund statute of limitations also continues to apply to tax years covered by any innocent spouse request.

Available only to someone who files a joint return, innocent spouse relief is designed to help a taxpayer who did not know and did not have reason to know that his or her spouse understated or underpaid an income tax liability.

Real Estate Professionals Allowed Late Election to Aggregate Rental Real Estate Interests

by Michael W. Blitstein, CPA 

Revenue Procedure 2011-34

In a Revenue Procedure, IRS has provided guidance that allows certain real estate professionals to make a late election under Regulation § 1.469-9(g) to treat all interests in rental real estate as a single rental real estate activity for purposes of the passive activity loss (PAL) rules.

Background

Under Code Section 469(c)(1), the PAL disallowance rules apply to any trade or business in which the taxpayer does not materially participate. A taxpayer is treated as materially participating in an activity if he meets at least one of the seven tests in Regulation § 1.469-5T. In general, any rental activity is per se a passive activity regardless of the taxpayer’s participation in the activity. However, there are exceptions to the general per se rule.

The Code’s per se rule for rental activities doesn’t apply to a qualifying real estate professional. A taxpayer qualifies as such for a particular tax year if: (1) more than half of the personal services that he performs during that year are performed in real property trades or businesses in which he materially participates; and (2) he performs more than 750 hours of services during that tax year in real property trades or businesses in which he materially participates.

If a taxpayer is a qualifying real estate professional, the PAL rules generally are applied as if each interest of the taxpayer in real estate were a separate activity. But a qualifying taxpayer may elect to treat all his interests in rental real estate as one activity.

The election is made by filing a statement with the taxpayer’s original income tax return for the tax year. This statement must contain a declaration that the taxpayer is a qualifying taxpayer for the tax year and is making the election under Code Sec. 469(c)(7)(a).

Late filing relief

A taxpayer receiving relief under Revenue Procedure 2011-34 is treated as having made a timely election to treat all interests in rental real estate as a single rental real estate activity as of the tax year for which the late election was requested. A taxpayer is eligible for an extension of time to file an election under Revenue Procedure 2011-34 if he represents in a statement (under penalties of perjury) that he:

… failed to make the election solely because he failed to timely meet the requirements in Regulation § 1.469-9(g);

… filed consistently with having made an election under Regulation § 1.469-9(g) on any return that would have been affected if he had timely made the election. He must have filed all required federal income tax returns consistent with the requested aggregation for all of the years, including and following the year he intends the requested aggregation to be effective, and no tax returns containing positions inconsistent with the requested aggregation may have been filed by or with respect to him during any of the tax years;

… timely filed each return that would have been affected by the election if it had been timely made. He will be treated as having timely filed a required tax or information return if the return is filed within six months after its due date, excluding extensions; and

… has reasonable cause for failing to meet the requirements in Regulation § 1.469-9(g)

A taxpayer must attach the statement required to an amended return for the most recent tax year and mail it to the IRS service center where the taxpayer will file its current year tax return. The statement must contain the declaration required by Regulation § 1.469-9(g), explain the reason for the failure to file a timely election, and include the above representations. The statement must identify the tax year for which it seeks to make the late election and must state at the top “FILED PURSUANT TO REVENUE PROCEDURE 2011-34.”