Authored by Mark Lobb
The first quarter of the year is over, which means tax deadlines have passed and more are on the horizon. Individual returns are due April 15, partnerships and S corporation extenders are due September 16, and individuals, sole proprietorships, and C corporation extenders are due on October 15.
This issue of The Lobb Report focuses on:
- Business Expense Substantiation,
- Corporate Jet Depreciation and Expense Deductions,
- Buy-Sale Agreement/Estate Tax/Life Insurance,
- The Biden Administration’s Green Book,
- California: PAGA Taxes
- California: Wine and Cotton Tax
- California Employment Law: Travel Time Liabilities
- California Employment Law: Pay Data Reporting Deadline
Federal Taxation
Business Expense Substantiation:
There have been several recent tax court decisions regarding business expense deductions. I picked out the case of Chappell v. Commissioner (summary opinion issued March 11, 2024) as an example of the granular manner the IRS and Tax Court will go in picking apart expense deductions.
In the case, the Taxpayer took expense deductions related to three cell phones, a vehicle, an iPad, and a tablet related to her tax preparation service.
Generally, Internal Revenue Code section 162 allows deductions for ordinary and necessary trade or business expenses paid or incurred during a taxable year. Rules regarding the application of Section 162 have evolved from case law and administrative guidance.
In Chappell the Taxpayer was entitled to deduct a portion of the expenses she incurred for business use of wireless devices and personal vehicles but was liable for an accuracy-related penalty under IRC section 6662.
The Taxpayer incurred service charges for three cell phones, an iPad, and a tablet that she and an independent contractor used extensively for business purposes. Although she did not account for the personal use of her cell phone, the court estimated the amount of deductible expenses and allowed a deduction for 80% of charges during tax season from and 50% of charges for the remainder of the year.
Based on telephone bills provided and the Taxpayer’s testimony, the court allowed a deduction for expenses related to the contractor’s phone, installment payments of the phones’ purchase price, and expenses related to the other devices.
Regarding vehicle expenses, the court found the Taxpayer did not meet the strict requirements to substantiate business use of the vehicles thus preventing any deduction based on her actual expenses. Instead, the court allowed a deduction calculated at the standard mileage rate for trips whose business purpose was self-evident and based on Petitioner’s mileage logs. Finally, the court held the Taxpayer liable for an accuracy-related penalty on underpayment of tax attributable to negligence for carelessly claiming deductions without adequate substantiation.
Corporate Jet Taxation:
Members in the U.S. Senate are urging the Treasury Department and IRS to tighten restrictions on how corporate jet owners deduct certain travel costs. The request corresponds with an IRS push to enhance audits of corporate jet tax deductions and depreciation.
Taxpayers write off depreciation costs upon purchasing a private jet primarily for business purposes, then deduct the cost of travel including operating costs such as fuel and the cost of the crew.
But, the letter said, some corporate executives and wealthy taxpayers have used these deductions for personal travel, leveraging squads of lawyers and accountants to muddy the distinction between business and personal travel with schemes including opening offices next to vacation homes or neglecting to report non-business passengers.
The Senators urging action include Elizabeth Warren and Ed Markey of Massachusetts, Ron Wyden of Oregon, Bernie Sanders of Vermont, Sheldon Whitehouse of Rhode Island, and Chris Van Hollen of Maryland.
As discussed below, the Biden administration’s recent budget proposal includes a proposal for Treasury to tighten depreciation rules and increase the private jet fuel tax rate.
Estate Tax/Buy-Sale Agreements:
At the end of March, the U.S. Supreme Court entertained oral argument on whether the value of stock redeemed by a closely held business must consider life insurance proceeds which would increase the estate’s tax bill. The case is Connelly v. United States.
Brothers Michael and Thomas Connelly entered into a buy-sale agreement to control their stock ownership in a closely held company called Crown C Supply Co. Under the agreement, Crown maintained an insurance policy on the lives of the shareholders. When Michael died, a death benefit of $2.3 million was used to redeem Michael’s stock.
An appellate court upheld a $1 million tax bill assessed on Michael’s estate because the insurance payout Crown used to redeem Michael’s stocks was deemed to be an asset that increased Crown’s value. Michaels redeemed equity interest in Crown was ruled to be worth $5.3 million when including the insurance proceeds, or $2.3 million more than the estate reported because the estate excluded the insurance proceeds from the estate valuation.
As to the valuation, the estate takes the position that the “asset” consisting of the insurance proceeds was offset under the terms of the buy-sale agreement, since it required Crown to use the money to redeem Michael’s stocks.
The United States argues such an offset creates a discrepancy in the value of Thomas’ and Michael’s shares. The U.S. argues that excluding the insurance payout quadruples the value of Thomas’ shares “solely because of the stock redemption,” giving him a windfall contrary to the redemptions purported dollar-by-dollar offset.
Biden Administration Budget Proposal:
In early March the Biden Administration released the 2025 budget proposal which is also referred to as the Green Book. The Green Book has the following host of goodies!
Capital Gains
The budget proposes to increase the capital-gains tax rate to equalize the taxation of investment and wage income. That means capital gains for those earning at least $1 million would be taxed at a base rate of 39.6%, up from 20%.
The Biden Administration is also proposing to increase the 3.8% Medicare tax to 5% for those earning at least $400,000. This means taxpayers in the higher bracket will pay a 44.6% federal rate on investment income and other earnings.
Billionaires Tax
The Biden Administration proposes a 25% minimum tax rate on households worth at least $100 million which is up from an estimated 8% currently.
Income Taxes
The Biden Administration proposes to raise the top personal-income tax rate to 39.6%, from 37%, for those making more than $400,000.
Real Estate
The budget proposal would eliminate a tax break known as “like-kind exchanges” that allows wealthy investors to avoid paying taxes on the proceeds of a property sale if they reinvest those profits into real estate.
Corporate Taxes
The corporate tax rate will go from 21% to 28%. Taxes on foreign corporate earnings will increase from 10.5% to 21%.
The administration also seeks to raise the corporate minimum tax on domestic corporations from 15% to 21%.
Carried Interest
The carried-interest tax rate of 20% paid by private equity fund managers is proposed to be eliminated. Such income will be paid at the ordinary income tax rates.
Executive Compensation
The proposal would deny corporations from taking an expense deduction for compensation paid to any employee exceeding $1 million.
Private Planes
The proposal would lengthen the period over which “general aviation passenger aircraft” must be depreciated from 5 to 7 years, or, if using the alternative depreciation system, 12 years. Additionally, the proposal would reform excise taxes on business aviation by raising the taxes on kerosene used for private jet travel. The current rate is 21.8 cents per gallon, and the proposal would increase that rate to $1.05 per gallon. This increase would be phased in over a 5-year period.
Estate and Gift Taxes
The proposals regarding gift and estate taxes cause capital gain recognition at the time of transfer by gift or upon death. This proposal affects transfers occurring after December 31, 2024.
Transfers to a U.S. spouse or to a charity will not be treated as a realization event but will be subject to carryover basis rules. The gift tax exclusion will be reduced to $5 million per person for gifts and transfers during life. The unused exclusion can be used at death.
When gains are triggered under the deemed realization rule, recipients obtain a basis in inherited and gifted property equal to the fair market value on the transfer date. The deemed realization of gains on transfer will trigger an income realization event.
Tax Rules for Certain Grantor Trusts
For transactions occurring on or after the date of enactment, the proposal will do the following: (1) treat sales of property between a grantor and an irrevocable trust as taxable transactions for income tax purposes, (2) treat the payment of income tax by a grantor on the income of a grantor trust as a gift, (3) require that the remainder interest in a Grantor Retained Annuity Trust (GRAT) at the time the interest is created must have a minimum value equal to the greater of 25% of the GRAT assets or $500,000, and the GRAT term must be between ten years and the annuitant’s life expectancy plus ten years, (4) for valuations as of a valuation date the proposal limits valuation discounts involving liquidation restrictions for intrafamily transfers of partial interests in non-publicly traded property, if the family collectively holds at least 25% of the property.
Finally, there will be a new annual total gifting limit of $50,000 per donor which will cap the $18,000 gifting limit per donee. Currently, a donor can give gifts of $18,000 each to an unlimited number of donees.
The takeaway is to be diligent in gifting this year and plan as though the Democrats will control Congress and the Executive office after the election in November. As it stands, the lifetime exclusion amount will be cut in half at the end of 2025 so maximizing estate tax planning structures now will take away the risk of losing the current beneficial laws and stress next year.
California Taxation
PAGA Taxes:
In previous editions, this Report has discussed concerns related to the Private Attorneys General Act (PAGA). Rankings which are published regarding the best to worst states when it comes to overall taxation leave some items out of the equation. One such item is related to payments made by companies in California to resolve cases brought under the PAGA statute. The “cost” associated with these cases is a tax to businesses and individuals in California.
Although the Labor and Workforce Development Agency (the “Agency”) does not actively participate in PAGA litigation, the financial benefits of such claims end up with the Agency. Under the current law, 75% of civil penalties recovered under PAGA are awarded to the Agency, with only 25% awarded to employees. From 2019 through 2022, the Agency received $109,800,000, $111,500,000, and $157,000,000, respectively, from PAGA settlements or judgments.
Proposed Tax on Wine, Products Made of Cotton, etc.:
There is a new bill in the Assembly (A.B. 3152) seeking reparations for African Americans in California, especially those who are descendants of enslaved people. Under the Bill, California would levy a new excise tax on gold, cotton, wine, olives, cane, granulated sugar, rice, and coffee beans.
Revenue from the tax would be placed in a reparations fund. African Americans could apply for loans to buy, build, or repair their homes, pay delinquent debt or taxes on their homes, finance farming operations, and receive tuition payments for educational or vocational schools and career support services.
If lawmakers enact the bill, voters will need to approve a state constitutional amendment making an exception to a state law prohibiting discriminating against or granting preferential treatment to specific groups.
Although the reparations committee acknowledges California was not a slave state, there are other pending bills which would require the state to issue a formal state apology for human rights violations and crimes against humanity to descendants of African enslaved people.
California Employment Law
Compensability of Employee Travel Time:
On March 25, 2024, the California Supreme Court issued a decision on the compensability of travel time to and from a construction project and unpaid meal periods under California law. In Huerta v. CSI Electrical Contractors, the Court made the following findings:
- Employee time spent on an employer’s premises in a personal vehicle waiting to scan an identification badge, having security guards peer into the vehicle, and then exiting a security gate is compensable as “hours worked.”
- Employee time spent on an employer’s premises in a personal vehicle, driving between the security gate and the employee parking lots can be compensable as “hours worked” or as “employer-mandated travel.”
- Unpaid meal periods are compensable if the employer “prohibits the employee from leaving the employer’s premises or a designated area during the meal period and this prohibition prevents the employee from engaging in otherwise feasible personal activities.”
The case involved employee travel on a designated road which provided access between a guard shack located at the site’s perimeter and the employee parking lots. A security gate was located on the road. It would take employees10 to 15 minutes to reach the parking lots in their personal vehicles. Employees underwent security checks at the security gate and were told by management that the gate was the first place they had to be at the start of the workday.
Employees were not paid for the time spent at the security gate and while driving between the security gate and the employee parking lots and were not allowed to leave the work site during their meal periods. The Court noted that an employee does not have to be working when subject to an employer’s control, and an employee who is “suffered or permitted to work” does not have to be under an employer’s control “provided the employer has or should have knowledge of the employee’s work.”
California Pay Data Reporting Deadline:
For employers with at least 100 employees (with at least one employee in California), the reporting deadline for the 2023 California Pay Data Report is on May 8, 2024. The report must be filed with the California Civil Rights Department (“CRD”). Unlike the 2022 reporting requirements, the CRD now requires information on remote workers and labor contractor demographic data.
Both payroll and labor contractor employee reports must include information regarding the number of employees per employee group who worked remotely including (1) the number of employees that do not work remotely, (2) the number of remote employees located within California, and (3) the number of remote employees located outside of California.
A “remote worker” is defined as “a payroll or labor contractor employee who is entirely remote, teleworking, or home-based, and has no expectation to regularly report in person to a physical establishment to perform work duties.”
There are a number of enforcement mechanisms for employers who fail to comply with the pay data reporting requirements which include civil penalties of $100 per employee which increases to $200 per employee for a subsequent failure to file, an order to file, and the CRD may recover its costs in any enforcement action.
Meet the Author:
Mark Lobb is a founder of the firm and the Managing Partner of Lobb & Plewe. He focuses on matters concerning middle-market companies which are closely held and the owners of such companies.
