Tuesday, January 20, 2015

Due-diligence considerations for 2014 individual income tax returns

FROM http://www.cpa2biz.com/

Laws and guidance on some new issues in the “virtual” and “sharing” economy, in the new health care law, and changes to foreign reporting rules are interesting on many fronts, including whether practitioners should modify the questions they ask clients to ensure proper compliance. This article suggests which questions to ask to ensure due diligence.

1. Do you own or use any virtual currency?

Virtual or digital currency, such as bitcoin, has been around for a few years. What is new is Notice 2014-21, where the IRS states that this convertible currency should be treated as property for tax purposes (rather than as a currency). The notice also provides that “mining” a virtual currency (which is the process for obtaining the virtual currency by solving mathematical problems) produces income upon receipt using the fair market value (FMV) at that time. Treatment of virtual currency as property means that when it is used, such as to buy goods, its basis and FMV must be determined to measure the resulting gain or loss. The holding period of the asset and character of the income (ordinary or capital) must also be determined. Practitioners will need to find out whether and how clients are using virtual currency, if the clients’ records are sufficient, and the tax effects of these transactions.

2. Do you rent out property, such as through an online exchange?

Web-based accommodation businesses, such as Airbnb, make it relatively easy (and enticing) for property owners to become landlords. These new landlords may not understand the tax consequences of short-term rentals. Thus, a conversation about rental rules (Sec. 280A and Sec. 469, both of which may limit deducting losses) is warranted. Beyond federal and state income tax considerations, clients may need guidance regarding possible obligations for local taxes, such as business license and transient occupancy taxes.

3. Did you receive a Form 1095-A?

Form 1095-A, Health Insurance Marketplace Statement, is a new form for 2014, and is related to the new health care law. Clients who receive this form for the first time might not know to provide it to their tax preparer. Individuals who enrolled in a federal or state exchange to obtain health insurance will receive this form, which provides information for determining the Sec. 36B premium tax credit for the individual and his or her family. Individuals eligible to claim the premium tax credit on their returns or who received it in advance (through reduced monthly premiums) will need to complete new Form 8962, Premium Tax Credit (PTC), and attach it to their Form 1040, U.S. Individual Income Tax Return, or 1040A, U.S. Individual Income Tax Return. (The credit cannot be claimed on Form 1040-EZ, Income Tax Return for Single and Joint Filers With No Dependents.) Clients who received Form 1095-A are likely to want an explanation of the credit and its effect on their federal tax liability, as these health care rules are new for 2014.

4. Did you and everyone in your family have health care coverage for every month of 2014?

Another new health care rule that first applies for 2014 is the individual shared-responsibility payment (Sec. 5000A). This provision, which affects all individuals, requires individuals to have “minimum essential coverage.” To implement this rule, there is a new line on the 2014 tax form (line 61 on Form 1040; line 38 on Form 1040A; and line 11 on Form 1040EZ), which will require the preparer to find out who is in a client’s “shared responsibility family” (Regs. Sec. 1.5000A-1) and whether they had minimum essential coverage for each month of the year.

If anyone did not have coverage for any month, the next question is whether an exemption applies. If an exemption does not apply to all or some of the noncoverage months, the shared-responsibility payment must be computed. Exemptions are claimed on Form 8965, Health Coverage Exemptions. Worksheets in the Form 8965 instructions assist with calculating the payment, which is reported on line 61 of Form 1040 (or equivalent line on the other 1040 forms).

Preparers will need to determine what questions to ask clients and when they will want to obtain additional documentation or have a conversation with the client. The number of questions needed may vary depending on the client.

Example 1: Gail is single, age 75. It is likely that Gail is on Medicare Part A, which is considered minimum essential coverage. The preparer asks all clients what type of health coverage they had for each month of 2014. Gail responds that she had Medicare Part A. Given that this is a reasonable answer, the preparer should not have to ask other questions.

Example 2: Tom and Jane have two dependent children under age 18. Both Tom and Jane work full time for large employers and have each been at the same place of employment for several years. Their Forms W-2, Wage and Tax Statement, for 2014 have figures in Box 12 with code “DD” indicating that the employers provide health coverage. The preparer asks all clients what type of health coverage they had for everyone in their family for each month of 2014. Tom and Jane indicate that Tom was covered by his employer’s insurance, and Jane and the children were covered by insurance from Jane’s employer. Given that this is a reasonable answer, further supported by information on the W-2s, the preparer should not have to ask other questions.

Example 3: Jerry is single, age 32. He changed jobs during 2014 and had a period of unemployment. The preparer asks all clients what type of health coverage they had for each month of 2014. Jerry answers that he is not sure. The preparer will need to follow up with Jerry to discuss what minimum essential coverage means (perhaps using the IRS chart). For any months for which Jerry did not have coverage, questions must be asked about exemptions. Using the IRS chart should be a good starting point. The preparer might also want to use IRS Publication 5156, Facts About the Individual Shared Responsibility Provision, to help the client in answering the coverage and exemption questions.

Preparers should consider how they want to ask the questions necessary to complete line 61. They may want to create a worksheet (see the sample worksheet below) as a starting point. To best ensure that the answers are reliable, clients likely need to be educated about the shared-responsibility payment to understand its purpose and when it does and does not apply. Some IRS resources may be useful to include in this background explanation:

IRS Individual Shared Responsibility Provision webpage with additional links; and
IRS Publication 5187, Health Care Law: What’s New for Individuals & Families, on the premium tax credit and the individual shared-responsibility payment.
The IRS also has health reform resources for tax professionals, including best practice guides for the credit and payment.

Preparers will also want to determine when they want to obtain documentation, such as a health insurance card, beyond what they may already have (such as Form 1095-A or W-2). For the 2015 tax year, clients are likely to have more documentation about their coverage, such as Form 1095-B, Health Coverage, and/or Form 1095-C, Employer-Provided Health Insurance Offer and Coverage, than they do for 2014.

5. Do you have foreign assets?

For many years, a standard question for clients has been whether they have a foreign bank account. Today, that question is too narrow. The Foreign Account Tax Compliance Act (FATCA), P.L. 111-147, added a new reporting requirement under Sec. 6038D using Form 8938, Statement of Specified Foreign Financial Assets. In addition, reporting for FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), has expanded to require more than information on a directly owned account at a foreign bank. Preparers should review the instructions for these forms to be sure the questions clients are asked are sufficiently comprehensive to fully address these reporting obligations.

Also, a 2014 court case held that an individual’s online gambling accounts held by a foreign casino were required to be reported on the FBAR (Hom, No. C 13-03721 WHA (N.D. Cal. 6/4/14)). The rationale was that the accounts functioned as banks. A similar rationale might hold for other types of accounts. For example, virtual currency an individual holds through an account or “wallet” set up by a foreign entity might be reportable on the FBAR.

Standard questions

The five questions above concern issues that are new or different for 2014. This 2014 tax update should also remind practitioners of the importance of long-standing due-diligence areas, such as for charitable contributions and mortgage interest. Court cases continue to hold that charitable contribution deductions are denied if the required documentation is lacking or incomplete or the valuations are incorrect (see, e.g., Chandler, 142 T.C. No. 16 (2014), and Smith, T.C. Memo. 2014-203). Thus, questions need to be asked to determine that documentation and valuations are valid.

Mortgage interest due-diligence questions include whether the Sec. 163(h) dollar limits were exceeded and whether debt is properly secured by the house. A 2014 case found that a note from a relative to purchase a home did not produce qualified residence interest because the note was not recorded and, thus, was not secured (Dong, T.C. Summ. 2014-4).