Spouse May Roll Over Decedent's IRA Made Payable to Trust for Spouse's Exclusive Benefit with Spouse as Trustee

In PLR 201923002 (June 7, 2019), the IRS stated that a surviving spouse could roll over to an IRA in her own name a distribution from her late husband's IRA, even though the beneficiary was a trust for the benefit of the spouse, rather than the spouse. The IRS stated that, because the spouse was entitled to the IRA proceeds as the sole beneficiary of the trust during her life, she was effectively the individual for whose benefit the account is maintained for purposes of the roll-over rules.

Moreover the Decedent's IRAs will not be treated as inherited IRAs under IRC §408(d) as to taxpayer/surviving spouse. Also, taxpayer/surviving spouse was entitled to rollover distributions from stated IRAs into one or more IRAs set up and maintained in her own name, as long as rollover occurred within 60 days from date distribution was received from stated IRAs.

The Facts

The Decedent was married to Taxpayer (hereinafter “Spouse”) until his death, at which time both the Decedent and his Spouse were over 70 ½ years old.

At the time of his death, the Decedent owned an individual retirement account- the “Decedent's IRA.” The beneficiary of Decedent's IRA was a Trust for the benefit of the spouse. The spouse was the sole trustee and beneficiary of Trust which provided that the spouse could withdraw its net income and/or its principal. Additionally the spouse has the right to modify, amend, or revoke the Trust at any time and has the sole authority and discretion to distribute the Decedent's IRA proceeds to herself at any time. The spouse decided to roll the amounts paid to her from Decedent's IRA to an IRA in her own name rather than the Trust.

The critical question was the application of IRC §1.408-8, Q&A-5, which provides that a surviving spouse of an individual may elect to treat the spouse's entire interest as a beneficiary in the individual's IRA as the spouse's own IRA. In order to make this election, the spouse must be the sole beneficiary of the IRA and have an unlimited right to withdraw amounts from the IRA. If a trust is named the beneficiary of the IRA, this requirement is not satisfied even if the spouse is the sole beneficiary of the trust.

As the Trust was the named beneficiary the interpretation and application of this provision was critical.

Since the US Supreme Court Decision in Clark v. Rameker, 134 S. Ct. 2242, (2014) the trusteed Individual Retirement Account has become a way of shielding retirement account from creditors[1]. Accordingly it’s not uncommon to have a trusteed IRA rather than a custodial IRA. Indeed several institutional investment companies have picked up on this issued and have formulated their own trusteed IRA trusts.

The dilemma therefore is how to draft a trusteed IRA trust to avoid the application of IRC §1.408-8, Q&A-5. Most trusteed IRA trust have minimum distribution requirements and limited withdrawal powers. If the beneficiary is a spouse of a second marriage it is unlikely that the Settlor will give his or her spouse unlimited withdrawal powers. If the spouse is the spouse of a long standing marriage it is more likely that the spouse will have an unlimited withdrawal power.

In PLR 201923002 the spouse had an unlimited withdrawal power. The IRS reasoned that notwithstanding IRC §1.408-8, Q&A-5, which prohibits a rollover of an IRA to a spouse who is a beneficiary of a trust, because the spouse was entitled to the proceeds of Decedent's IRA as the sole beneficiary of Spouse’s Trust during her life, for purposes of applying IRC §408(d)(3)(A) to Decedent's IRA, the Spouse is effectively the individual for whose benefit the account is maintained. Accordingly, the IRS ruled that if the Spouse receives a distribution of the proceeds of Decedent's IRA, subject to the limitation of IRC §408(d)(3)(B), she may roll over the distribution (other than amounts required to have been distributed or to be distributed in accordance with section 401(a)(9)) into one or more IRAs established and maintained in her name.

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[1] Brunetti, the Trusteed Individual Retirement Account, New Jersey Law Journal, (December 29, 2014).

Remote Material Participation Approved by US Tax Court

In a recent Memorandum Opinion, the Tax Court held that a taxpayer satisfied the requirements for materially participating in his Chicago based business despite living in Florida approximately 60 percent of the year. Satisfying the test for material participation is important because it allows you to use your business losses to offset other sources of business income. Meanwhile, deductions and losses generated by a “passive activity” are limited to income from passive activities.

The Tax Court’s ruling in Barbara v. Commissioner, TC Memo 2019-50, is good news for business owners because it confirms that working remotely will not be treated any differently than working in a physical office with respect to calculating the time spent towards an activity for purposes of material participation. Accordingly, you may live in one state and operate a business in another while still satisfying the material participation requirements.

Material Participation Tests

Red state, blue state, high tax state, low tax state; with the passage of the TCJA, these issues have become more significant.  The income tax rates for several states are as follow:

                        New Jersey                 8.97%

                        New York                   8.82%

                        Vermont                      8.95%

                        Illinois                        4.95%

                        New York City (in addition to the New York

                        State Tax Rate)           3.876%

           

On the other hand, seven states do not have income taxes.  They are:

                        Florida

                        Nevada

                        South Dakota

                        Texas

                        Washington

                        Alaska

                        Wyoming

If you were to select a place to live and your focus was the least amount of state and local income taxes, the choices are obvious.  The issue is, however, if you are conducting a business in a high tax state, can you have your domicile in a low tax state. Perhaps under the right circumstances, you may utilize Puerto Rico’s incentive provisions. Act 20 and Act 22, to substantially reduce your combined federal and state income tax burden.  These acts were designed to bring service businesses and wealthy individuals to Puerto Rico.  Act 20 and Act 22 are attractive to service providers who do not need to be physically present in one of the fifty states.

Aside from the obvious geographical challenges and perhaps time zones, there is also an IRS tax section that might prevent you from utilizing a loss in a tax year to offset gains in current or subsequent years.  Normally if a taxpayer, who is in a trade or business and suffers a net operating loss, under the TCJA 80% of the loss can be carried forward to offset income in a future year.  The key element is the loss occurs in a trade or business in which the taxpayer is active.  Being an active participant allows losses in the activity to offset other current ordinary income or future income.  See Section 162(a) and Section 212(1).

On the other hand, if the taxpayer is not active in the business, the losses cannot be used because the losses are passive losses passive losses can only be used against passive income.  Section 469 limits those deductions when they arise from “passive activities.”  A passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not materially participate.  Section 469(c)(1).  A taxpayer materially participates in an activity if such participation is regular, continuous and substantial.  Section 469(h)(1).  Regulations provide seven alternative tests to determine whether a taxpayer has materially participated in an activity for the taxable year.

These are:

Tests Based on Current Participation

1.         The individual participates in the activity for more than 500 hours during the year.

2.         The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in the activity of all individuals (including nonowner employees) for the year.

3.         The individual participates in the activity for more than 100 hours during the year, and this participation is not less than that participation of any other individual (including nonowner employees) for the year.

4.         The activity is a significant participation activity (where the person’s participation exceeds 100 hours during the year), and the hours for all significant participation activities during the year is more than 500 hours.

Tests Based on Prior Participation

1.         The individual materially participated in the activity for any 5 taxable years during the 10 taxable years that immediately precede the current taxable year.

2.         The activity is a personal service activity, and the individual materially participated in the activity for any 3 preceding taxable years.

Tests Based on Facts and Circumstances

1.         Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

The IRS regulations contained substantial detail on how to meet one of the seven tests.  Mr. Fred Barbara managed to be a Florida domiciliary and operated a business in Chicago and yet satisfy the material participation test of the passive activity rules.

Barbara v. Commissioner, TC Memo 2019-50

The Barbaras reside in Florida when they filed their petition.  Presumably, they were domiciled in Florida.

For many years, Fred Barbara owned and managed Barbara Trucking, a Chicago-area garbage collection and waste management business.

In 1997, Mr. Barbara sold Barbara Trucking for tens of millions of dollars.

Mr. Barbara used the proceeds from the sale of Barbara Trucking to start a money lending business.  This business capitalized on the network of contacts in the Chicago construction industry that he had developed while running Barbara Trucking.

In conducting the lending business, he usually lent the money in his personal capacity.  But on a few occasions, he lent the money through a family trust or a closely held limited liability company, Barbara Capital II, LLC.  This LLC is treated as a partnership for federal tax purposes.

The office of the lending business was in Chicago. The office was staffed by two full-time employees: an accountant and a secretary.

Mr. Barbara performed all executive functions for the lending business. He decided when to make loans. He decided how to handle defaulted loans. He managed over 40 outstanding loans during the years at issue. He had no other significant work-related demands on his time besides the lending business.

During the years 2009-2012, Mr. Barbara split his time between Chicago and Florida. For each year he was in Chicago, 40% of his time and in Florida 60% of his time. He worked at least 200 days in a year, proportioned between Chicago and Florida on a 40/60 basis.

When in Chicago, Mr. Barbara lived in residences he owned. He was in the Chicago office for about 5-3/4 hours each work day. When there he was working on the lending business. He kept a regular schedule. Therefore, he was in the Chicago office at least 460 hours per year working on the lending business, computed as follows:

200 days x 40% × 5.75 hours = 460 hours per year

When in Florida, Mr. Barbara lived in a house that he had purchased in 1995. He called the Chicago office every day when it opened at 9:00 a.m. He also communicated with the office at other times, through telephone, fax, and e-mail. He averaged at least two hours of work per day on the lending business while in Florida. This means that he worked at least 240 hours per year on the lending business while he lived in Florida, computed as follows:

200 days × 60% × 2 hours = 240 hours per year

One of the issues determined by the US Tax Court was whether Mr. Barbara materially participated in his money lending business.  The significance was that if he did not materially participate the income and losses would be passive.

The court agreed that the activity at issue is all of Mr. Barbara’s lending, whether loans were made individual or through an entity, was active and that he materially participated in the lending business.

For each year, Mr. Barbara’s total hours participating in the lending business were (1) 460 hours or more while in Chicago and (2) 240 hours or more while in Florida.  Thus, his total hours participating in the lending business each year were 700 or more.  This exceeds the 100-hour threshold that is part of the material participation test.

Both while he was in Chicago and in Florida, Mr. Barbara’s participation in the lending business was regular, continuous and substantial.  Accordingly, losses were deductible under IRS Section 162. Moreover, the losses suffered in the prior year could be used to offset income in another year.

The case is significant for two reasons:  First, the material participation test has no geographic limitations; second, the material participation test rest on quantitative i.e. number of hours spent, and qualitative, i.e. the significance of the individuals’ participation, good record keeping is essential.  What kind of record keeping would be needed?  A journal or daily diary detailing the nature of the activity, i.e. telephone calls, examination of records, agreements, etc. and the maintenance of regular business financial records as well as time spent on each activity and so forth.

Meeting the material participation requirements among other requirements might allow a taxpayer to live in a low tax state and yet manage a business in a high tax state. Consider an additional possibility, one that may allow one to avoid these rules.

Puerto Rico enacted a corporate incentive scheme Act 20, that provides a 4% corporate tax on income and zero percent on dividends and capital gains.  A software company could easily avail itself of this opportunity.  There are requirements, such as the hiring of local employees and a business presence, which require more than a nameplate on a wall in a foreign jurisdiction.  Individuals, under Act 22, who are present in Puerto Rico for six months in the prior year, receive government approval and draw a reasonable salary form the relocated business may benefit from this regime.  There is a 100% exemption from Puerto Rican taxes on dividends, interest and capital gains accrued after residency. Act 20 and Act 22 offer an alternative to expatriation and may prove valuable in the right situation. 

While there are obvious geographical and other challenges, the Tax Court has provided a path for the operation of a remote business from a tax friendly jurisdiction.

Does Your Retirement Plan Protect Your Home from Medicaid Recovery?

A recent U.S. News and World Report listed five major risks for retirement. One of these risks is health problems. If you don’t plan accordingly, the financial costs of healthcare can lead to everyone’s greatest fears — running out of money.

Healthcare Costs Can Erase Retirement Assets

Healthcare costs skyrocket as we age. Even if your insurance company or Medicare covers some of the costs, a couple retiring at age 65 with Medicare will need about $240,000 for uninsured medical expenses, which does not include long-term care expenses. Long-term care expenses can add dramatically to the cost of retirement. A nursing home costs on average $79,935 per year, an assisted living facility costs on average $37,572 per year, and in-home are costs about $19 per hour. These costs result in another retirement risk, running out of money.

Protecting Your Home from Medicaid Recovery

For many retirees, Medicaid planning is necessary to ensure the payment of necessary long-term care services without running out of money. This is particularly true if you have been diagnosed with an illness, and, therefore, the option of long-term care insurance is no longer available.

As states begin to crack down more and more on traditional Medicaid planning, it is important to be more creative in designing strategies, particularly with regard to your home. In many states, including New Jersey, Medicaid considers the home a countable asset unless it is occupied by the community spouse, a child under age 21, a child of any age who is blind or disabled, a child who qualifies as a caregiver, or a sibling who has resided in the home for at least one year and has had an equitable interest in the home for at least one year (the protected class).

However, on the death of the Medicaid recipient, if the home is an Estate asset, the state will assert estate recovery, which means that is any funds expended for the Medicaid recipient will be collected against the estate. If the home is occupied by a member of the protected class, Medicaid will assert estate recovery but will permit the member of the protected class to remain in the property. When the property is sold or on the subsequent death of the protected class member, the estate recovery lien must be satisfied. If the home is owned as tenants by the entirety or jointly with right of survivorship, estate recovery will be asserted in those states that have adopted the broad definition of “estate,” which includes New Jersey.

Transferring the Home Outright

In order to protect the home, parents often transfer it outright to their children. Clients must be aware of the carryover basis by which the parents' cost basis in the home will carry over to the child. If the child lives in the home for a period of two years after obtaining ownership, then the child may satisfy the requirements pertaining to the sale of a principal residence.  Unless the child meets the principal residence exclusion, there will be significant capital gains tax on the sale of the parent's home by the child.

From a Medicaid standpoint, the transfer of the home to a child who is not a member of the protected class is subject to the five-year lookback. The transfer is subject to the Medicaid transfer penalties. If there is a Medicaid transfer penalty, it is calculated by dividing the uncompensated value of the transfer by the statewide monthly average of the lowest semiprivate room rate in Medicaid-certified nursing facilities. In New Jersey, this is currently $10,459.

When property is transferred from parent to child, the casualty insurance policy should also be changed. Insurance companies usually permit the homeowner's policy to remain in effect if the parent reserves a life estate but usually do not permit the homeowner's policy to remain in effect if a life estate is not reserved.

Retaining a Life Estate

A variation of the strategy of transferring a home to a child outright is transferring the home to the child and retaining a life estate or a use and occupancy agreement for the parent. The retention of a life estate usually makes the parent more comfortable in making the transfer. One of the benefits of transferring the home and retaining the life estate is that the Medicaid period of ineligibility is reduced. The transfer is only for the value of the remainder interest.

For example, if an 80-year-old New Jersey person transfers a home worth $500,000 to a child and the divisor is $10,459 per month, the penalty is 34 months. However, if the same parent transfers the home to the child and retains a life estate, the penalty is significantly reduced. The calculation looks like this:

  $500,000               (value of home)

  × 0.5634                  (remainder factor)

  ---------------

$281,705                  (uncompensated value of transfer)

÷ $10,439                 (average cost of nursing home)

 ---------------

      26.9                       Months - Period of Ineligibility

Round up to 27 months.

An additional benefit is that if the home is not sold during the lifetime of the parent, the child will receive a “step up” in basis on the death of the parent.  

Advantages

·       Protects the home after five years

·       Preserves step-up in basis on death.

·       Parent feels as if he has more control.

·       No gift tax return needs to be filed, because it is an incomplete gift for gift tax purposes.

·       Section 121 exclusion can be preserved.

·       State real estate taxes may be able to be preserved.

·       Parent not entitled to any portion of proceeds, if home is sold.

·       Parent not entitled to any rental income, if property is leased.

Disadvantages

·       Loss of control.

·       If state penalizes transfers out of the trust, if income-only trust is used and house is sold during parents’ lifetime, proceeds are effectively “locked up” during parents’ lifetime.

In states where estate recovery is asserted against the probate estate (like New Jersey), the value of the life estate would not be included in estate recovery. Some of the states using the broad definition of an “estate,” including life estates, have taken the position that the value of a life estate at death is zero; other states using the broad definition have claimed that the life estate is valued at the moment before death. At the present time in most instances, New Jersey does not seek a recovery against the life estate.

The disadvantage to transferring the home and retaining a life estate is that if the home is sold during the lifetime of the parent, the parent would be entitled to a portion of the proceeds of sale represented by the value of the parent's life estate (refer to the above example). Receipt of these proceeds of sale would disqualify the parent from Medicaid, because the parent would be over resourced.

Right to Use and Occupy

A variation on the retention of a life estate is to retain a right to use and occupy. Under a right to use and occupy, the parent does not reserve the right to receive rent or any portion of the proceeds of sale. The disadvantage to the right to use and occupy is that there is a complete loss of the Section 121 Exclusion on the Sale of the Principal Residence because all of the proceeds would go to the children who, presumably, would not qualify.  In which case, the entire amount would be subject to capital gains tax.

Power of Appointment

Another alternative to the reservation of a life estate, grantors may reserve a special power of appointment. For Medicaid purposes, the transfer of property when grantors cannot recover the property for their own benefit is a completed transfer.  The special power of appointment is a “personal privilege” and not an interest in property. Therefore, it should not be subject to Medicaid estate recovery. For gift tax purposes, however, the gift will not be complete. In addition, the grantors' reservation of the special power gives them continuing influence over their issue and flexibility to deal with their children's deaths, divorces, or bankruptcies.

This power of appointment may be reserved in trust into which property (such as the residence) and may be transferred.  The funding of the trust triggers the Medicaid lookback period. If the trust is drafted as a “Grantor Trust,” even using a use and occupancy, should the residence be sold during your lifetime the gain would be protected from taxation up to $500,000 under IRC 121.

As highlighted above, there is a great deal to consider when planning for retirement. In order to protect your home and other assets from Medicaid recovery, it is particularly important to be proactive. 

IRS Issues New Forms Related to Modification of Imputed Partnership Underpayments

As we get ready to file 2018 partnership tax returns new rules audit have been implemented which require close examination of the partnership and its partners. This is because the Centralized Partnership Audit Regime (CPAR) is now the methodology used by the IRS to audit partnership tax returns for 2018 going forward. If the partnership can elect out of the CPAR an would be under the pre-TEFRA rules. In order to implement the requirements of the CPAR the IRS has issued new forms.

Under the CPAR, adjustments to partnership-related items are determined at the partnership level. The tax attributable to those adjustments is also assessed and collected at the partnership level in the form of an imputed underpayment determined pursuant to Code Sec. 6225. The imputed underpayment is determined by netting, in the manner described in Code Sec. 6225(b), all partnership adjustments with respect to the reviewed year and applying the highest rate of tax in effect for that year under Code Sec. 1 or Code Sec. 11. 

The Code requires IRS to establish procedures under which adjustments may be modified to reflect a lower level of tax due because of (i) payment of the tax by the partners either through amended returns or by the use of an alternative procedure in which the partners otherwise take the adjustment into account, (ii) the fact that the partnership has one or more tax-exempt partners, (iii) lower rates applying to the partners, (iv) special rules relating to specified passive losses of publicly traded partnerships (as defined in  Code Sec. 469(k)(2) ), or (v) as otherwise specified by IRS regs. or other guidance. ( Code Sec. 6225(c) )

 Code Sec. 6227 provides a mechanism for a partnership to file an administrative adjustment request (AAR) to correct errors on a partnership return for a prior year. A partnership may file a request for administrative adjustment in the amount of one or more items of income, gain, loss, deduction, or credit of the partnership for any partnership tax year. ( Code Sec. 6227(a) )

Under Prop Reg § 301.6227-2(a)(2), in the case of an AAR, a partnership would be able to reduce the imputed underpayment as a result of certain modifications allowed under Prop Reg §301.6225-2 that relate to tax-exempt partners, rate modification, modification related to certain passive losses of publicly traded partnerships, modification applicable to qualified investment entities described in Code Sec. 860, and other modifications to the extent allowed under future IRS guidance. Other types of modification-such as modifications with respect to amended returns and closing agreements-would not be available in the case of an AAR.

New Tax Forms  

Form 8980, Partnership Request for Modification of Imputed Underpayments Under IRC Section 6225(c).

Form 8980 is a 12-page form that should be submitted by a partnership to request the modification of an imputed underpayment under Code Sec. 6225(c). An imputed underpayment is reported to a partnership in a notice of proposed partnership adjustment (NOPPA).  

Form 8980 is also used by a partnership which is applying certain permitted modifications to an imputed underpayment included in the filing of an AAR. In the case of an AAR which includes modifications to an imputed underpayment, the partnership should complete and attach Form 8980 (including all required Form 8980 supporting forms and attachments, and any supporting documents) to the AAR when filed.

Form 8982, Affidavit for Partner Modification Amended Return Under IRC §6225(c)(2)(A) or Partner Alternative Procedure under IRC §6225(c)(2)(B).  

Form 8982 is a supporting form that the partnership representative attaches to Form 8980. It is used to affirm that a relevant partner has either: a) filed modification amended return(s) that meet the requirements under Code Sec. 6225(c)(2)(A) (Use Form 8982, Section A); or b) in lieu of filing modification amended return(s), has met the requirements under the alternative procedure in Code Sec. 6225(c)(2)(B) (Use Form 8982, Section B). 

Form 8982 must be completed and signed by a relevant partner after the partner files the appropriate modification amended returns or meets the requirements under the alternative procedure. The relevant partner must then provide Form 8982 to the partnership representative.

Form 8983, Certification of Partner Tax-Exempt Status for Modification under IRC §6225(c)(3). 

Form 8983 is used to certify: a) that a relevant partner in a partnership requesting modification of an imputed underpayment under  Code Sec. 6225(c)(3) is, in the reviewed year, a domestic partner that is either a tax-exempt entity within the meaning of Code Sec. 168(h)(2)(A), or a foreign partner that is a exempt from tax under Code Sec. 501(a); and (b) that, for the reviewed year, all or a portion of the relevant partner's distributive share of the partnership's adjustment is not subject to tax under any section of the Code.

The partner should complete and sign Form 8983 and provide it to the partnership representative. The partnership representative will submit Form 8983 along with the partnership's Form 8980.

Form 15028, Certification of Publicly Traded Partnership to Notify Specified Partners and Qualified Relevant Partners for Approved Modifications Under IRC §6225(c)(5). 

Form 15028 is used by a partnership that is a publicly traded partnership (PTP) that is requesting modification under Code Sec. 6225(c)(5) , in order to certify to IRS that the partnership will report to each specified partner or qualified relevant partners their respective amount of reduction to their suspended passive activity loss carryover based on the partnership's approved modification under Code Sec. 6225(c)(5) . Form 15028 is a required attachment to Form 8980 for any modification requests under Code Sec. 6225(c)(5). 

Form 15028 should be completed by the partnership under the assumption that the partnership's requested modification under Code Sec. 6225(c)(5) will be approved by IRS. If IRS approves the modification under Code Sec. 6225(c)(5) and approves the amounts reported on Form 15028, IRS will send the PTP an approved copy of Form 15028. If the modification request is disallowed in whole or in part, a corrected Form 15028 will need to be submitted by the PTP and approved by IRS. IRS will contact the PTP if a revised Form 15028 is required.

Important Changes in the New Jersey Corporation Business Tax Act as Tax Season Approaches

P.L. 2018, c. 48, signed into law on July 1, 2018, and P.L. 2018, c. 131, signed into law on October 4, 2018, significantly changed the New Jersey Corporation Business Tax Act.

TB-84 summarizes the major changes listed by the effective dates.

Effective for tax years beginning on and after January 1, 2017:

Repatriation of Accumulated Foreign Earnings. A taxpayer is not allowed to use any deduction, exemption, or credit taken for federal purposes when reporting repatriation income (IRC §965(a) deemed dividends) on its New Jersey Corporation Business Tax return.

Dividend Exclusion Changes. Taxpayers who own 80% or more of the stock of a subsidiary will only be able to exclude 95% of the dividends received from those subsidiaries for tax years beginning after December 31, 2016.

Factor Relief. A special allocation was created to provide factor relief. Taxpayers can use a special allocation formula that is the lesser of the three-year average 2014 through 2016 allocation factor or 3.5% for calculating the tax on dividends received (or deemed received) by a taxpayer from a subsidiary for tax years beginning on and after January 1, 2017, and beginning before January 1, 2019.

Tiered Dividend Exclusion. The law provides an allocated tiered subsidiary dividend exclusion for dividends paid to a taxpayer by certain subsidiaries. The exclusion is intended to avoid multiple layers of tax on dividends that are included in entire net income.

Penalties and Interest. The law provides that penalties and interest are not imposed on the underpayment of tax resulting from the retroactive changes for the 2017 tax year. This provision only applies if the payments are made by the second estimated payment due date subsequent to the enactment of the law (e.g., for a calendar year taxpayer, by December 31, 2018, for tax years beginning on or after January 1, 2017)

Effective for tax years beginning on and after January 1, 2018:

Surtax. For tax years beginning on or after January 1, 2018, through December 31, 2021, there is a surtax imposed on every business entity that is subject to the Corporation Business Tax based on the taxpayer’s allocated taxable net income to New Jersey. The surtax is not imposed on New Jersey S corporation or partnership tax returns. The surtax is imposed only if the taxpayer’s allocated taxable net income is in excess of $1,000,000. The rate varies depending on the tax year (2.5% for tax years beginning on or after January 1, 2018, through December 31, 2019, and 1.5% for tax years beginning on or after January 1, 2020, through December 31, 2021). Allocated taxable net income is defined as being either the allocated net income for tax years ending before July 31, 2019, or taxable net income for tax years ending on and after July 31, 2019. The definition of allocated taxable net income was included to account for the change in net operating loss subtraction methods from a pre-allocation method to a post-allocation method. The surtax does not apply to New Jersey S corporations and partnerships. A corporate partner’s share of partnership income is subject to the surtax if the corporate partner’s allocated taxable net income meets the threshold for the surtax. However, if a New Jersey S corporation is included in a unitary combined return, then its portion of income is subject to the surtax.

GILTI and FDII. The law permits the taxpayer to use the amount of its federal IRC §250(a) deduction against its Global Intangible Low Taxed Income (GILTI) and Foreign Derived Intangible Income (FDII) if the income was included in the taxpayer’s entire net income for New Jersey Corporation Business Tax purposes. Additionally, GILTI and FDII income is treated the same as for federal purposes. For federal income tax purposes, GILTI and FDII are their own types of business income and are not dividends. Therefore, for New Jersey Corporation Business Tax purposes, GILTI and FDII are not dividends or deemed dividends. Additional information will be posted to the Division’s website as soon as it becomes available.

Treaty Exceptions. The treaty exceptions for the related party addbacks of interest and intangible expenses (set forth in N.J.S.A. 54:10A-4(k)(2)(I) and N.J.S.A. 54:10A-4.4) have been amended to add additional requirements. Previously, a taxpayer only needed to establish that the amounts were paid, accrued or incurred by or to related members domiciled in nations with a comprehensive tax treaty with the United States. The taxpayer must also now establish that: 1) the related member was subject to tax in the treaty nation on a tax base that included the amount paid, accrued or incurred, and 2) the related member’s income received from the transaction was taxed at an effective tax rate equal to or greater than 6 percent.

Qualified Business Income Deduction. No deduction under IRC §199A is allowed for either Corporation Business Tax or Gross Income Tax purposes for tax years beginning after December 31, 2017.

IRC §163(j) Limitation Method. For Corporation Business Tax purposes, the 30% business interest expense deduction limitation set forth under IRC §163(j), applies on a “pro-rata” basis as between the total categories of related party and unrelated party interest. Additional information will be posted to the Division’s website as soon as it becomes available.

Research and Development Credit. The New Jersey Research and Development Credit (R&D Credit) is recoupled to the current IRC §41. Previously, the New Jersey R&D Credit was coupled to IRC §41 in effect on June 30, 1992 and was not refundable. In recoupling to the current IRC §41, it was expressly made clear that the New Jersey R&D Credit continued to be non-refundable. In addition, to prevent any unintended consequences by acts of Congress, the law states that no act of Congress terminating the federal credit would terminate the New Jersey R&D Credit. Both of the methods used for calculating the federal corporate income tax credit are now allowable for purposes of calculating the New Jersey R&D Credit.

Miscellaneous Major Changes.

· Taxpayers must addback all income that is exempt under any law of the United States to their entire net income.

· The law adjusts the depreciable basis of assets for certain utility companies.

Penalties and Interest. The law provides that penalties and interest are not imposed on the underpayment of tax resulting from the retroactive changes applying to returns filed for tax year 2018. This provision only applies if the payments are made by the first estimated payment due after January 1, 2019.

Effective for tax years ending on and after July 31, 2019 (beginning on or after August 1, 2018 for full 12-month fiscal tax years)

Market Based Sourcing. Under the new market-based sourcing provisions, sourcing for services is based on where the benefit of the service is received, rather than where the service is performed (aka “cost of performance” method).

Alternative Minimum Assessment. The Alternative Minimum Assessment is repealed and a transition conversion credit for unused Alternative Minimum Assessment credits of taxpayers that are members of a combined group provides relief to combined return filers.

Mandatory Combined Reporting. The law mandates combined returns for unitary businesses.  

· The law provides a net deferred tax liability deduction for publicly

· The law provides a net deferred tax liability deduction for publicly traded corporations that are impacted by the switch to combined reporting, beginning five years after a combined group’s first combined return.

· The law designates the default managerial member, provides options for selecting an alternate manager, and details the various responsibilities of the managerial member.

· The law provides combined return exceptions to the related party addbacks.

· The law provides a method for calculating the entire net income of members of a combined group, and methods for using tax credits and net operating losses.

· New Jersey S corporations that do not elect to be included in a combined group are not considered “taxable members” included on the combined return.

· The minimum tax for each member of a combined group is $2,000. Taxpayers filing a separate return must continue to calculate the minimum tax as per the statutes and regulations. Minimum tax is never prorated.

Water’s-Edge Default Combined Return. The default combined return filing method is the water’s-edge method. Taxpayers in a unitary business must file a mandatory unitary tax return on a water’s-edge basis. The members included in the water’s-edge group are: 1) 80/20 property and payroll domestic corporations; 2) 80/20 property and payroll foreign corporations; 3) members that earn more than 20% of their income, directly or indirectly, from intangible property or related service activities that are deductible against the income of other members of the combined group; and 4) all members that have nexus with New Jersey pursuant to N.J.S.A. 54:10A-2.

Worldwide or Affiliated Group Combined Return Basis. The law allows taxpayers to elect to file either on a worldwide combined return basis or an affiliated group combined return basis, but not both at the same time.

Businesses Excluded from a Combined Group. Insurance companies that are not combinable captive insurance companies and certain regulated public utilities are excluded from the combined group. This includes gas, electric, water, waste water treatment, and other statutorily defined utilities.

Combinable Captive Insurance Companies. Combinable captive insurance companies are no longer exempt from the Corporation Business Tax, but are exempt from the Insurance Premiums Tax. Captive insurance companies that do not meet the definition of a combinable captive insurance company are still subject to Insurance Premiums Tax and the cap imposed under N.J.S.A. 17:47B-12. Combinable captive insurance companies are included in the combined group on a combined return.

Penalties, Interest, and Estimated Payments. In the first tax year that a mandatory combined return is due, penalties or interest will not be imposed on an underpayment that results from the change from separate return reporting to mandatory combined return reporting. Any overpayment by a member of the combined group from the prior tax year is credited as an overpayment of the tax owed by the combined group or credited toward future estimated payments by the combined group.

Net Operating Loss Changes. The law also transitions New Jersey net operating losses to a post-allocation method. Prior to the enactment of P.L. 2018, c. 48, New Jersey net operating losses were calculated on a pre-allocation method. The law includes a method for converting outstanding pre-allocation net operating loss carryovers to post-allocation net operating loss carryovers. Net Operating Losses and Changes in Ownership. The law clarifies that N.J.S.A. 54:10A4.5 does not apply to members of a combined group filing a New Jersey combined return. More Information. This document provides a general summary of the major changes.