For this week’s in review, we are covering updates and news releases on the IRS unit guidelines on how to calculate the Foreign Tax Credit, the IRS recent release of proposed forms to report a partner’s foreign tax attributes on for future years, a recent court case denying ordinary loss treatment on the sale of a Newport mansion, and the IRS unveiling of its “dirty dozen” list of top tax scams in 2020.
Specifically, we will be covering the following this week—
- IRS LB&I Unit Releases Guidance on Calculating the Foreign Tax Credit;
- IRS Release of Proposed Forms for Partners Reporting Items of international Tax Relevance
- Discussion on a Recent Court Case Court Case Denying Ordinary Loss Treatment on the Sale of an Newport Historical Mansion; and
- The IRS Unveiling its “Dirty Dozen” List of Tax Scams for 2020.
The IRS’ Large Business and International Concept Unit (LB&I) Released is Explanation on the Computation of the FTC
July 16, 2020. The IRS’s Large Business and International Concepts Unit (LB&I) released its outlined as to how the limit on a taxpayer’s “foreign tax credit” (FTC) is generally calculated.
The FTC limitation is to prevent foreign taxes from offsetting the U.S. tax on U.S. source taxable income (USTI), the IRS stated. The amount of a taxpayer’s FTC is the lesser of the creditable foreign income taxes actually paid or accrued, or the FTC limitation.
The FTC is computed using the following formula
(Foreign Source Taxable Income / Worldwide Taxable Income) X US Income Tax Liability Before the Credit
The LB&I unit outlined the calculation of the FTC limit in the following 4 steps
- Step 1: Determine Worldwide Taxable Income
- Step 2: Determine Foreign Source Taxable Income
- Step 3: Determine US Tax Liability Before Any Credits
- Step 4: Computer FTC Limitation
Step 1: Determine Worldwide Taxable income
Worldwide taxable income is the total domestic and foreign sourced taxable income earned by a taxpayer in a given year. For years prior to 2018, that number is taxable income for the deduction for personal exemptions. For years after 2017, there are no longer deductions for personal exemptions and thus are not considered.
Step 2: Determine Foreign Source Taxable Income
Foreign source income is income identified as being foreign under the sourcing rules of the Internal Revenue Code.
Next the taxpayer identifies, allocates and apportions expenses and deductions to that gross FSI in accordance with specific rules under the Internal Revenue Code.
Audit Considerations: The IRS recommends that a schedule be requested in which the taxpayer identifies the source of all items of gross income and the allocation and apportionment of all expenses and deductions to either Foreign source income or gross US source income
Step 3: Determine US Tax Liability Before Any Credits
Step 3 is to determine the individual’s U.S. income tax liability before FTCs.
What is important to note is that the US income tax liability before FTCs does not include the AMT tax
Once determine, the number is multiples by the ratio of foreign source taxable income to worldwide taxable income
Step 4: Compute the FTC Limit
The final step is to compute the actual limitation.
As noted above, this is defined by the following equation (Foreign Source Taxable Income / Worldwide Taxable Income) X US Income Tax Liability Before the Credit
If the creditable foreign taxes are less than the limitation, the taxpayer’s FTC is limited to the creditable foreign taxes. They are thereafter reported on Form 1040 to reduce the US income tax liability for the year.
Foreign taxes in excess of the FTC limitation may be credited in the prior tax year to the extent there is excess FTC limitation in that year. Any excess foreign taxes not credited in the prior tax year may be carried forward and credited to the extent of excess FTC limitation in each of the subsequent ten years.
You can view the IRS’s full guidance on this topic via the following link.
IRS News Release – Proposed Forms for Partners Reporting Items of international Tax Relevance
July 13, 2020. Proposed redesigned partnership form(s) for tax year 2021 designed to provide greater clarity for partners on how to compute their U.S. income tax liability with respect to items of international tax relevance, including claiming deductions and credits, the IRS announced.
The redesigned form and instructions provide a standardized format, the IRS stated.
The proposed form will apply to a partnership required to file Form 1065 only if the partnership has items of international tax relevance (generally foreign activities or foreign partners).
The proposed changes would not affect domestic partnerships with no international tax items to report, the IRS advised.
The new forms are Schedule K-2 and Schedule K-3. Comments from affected stakeholders are being accepted through September 14, 2020.
You can find the IRS’s full discussion on this topic via the following link.
Court Case Update: Newport Mansion Never Rented Considered a Capital Asset
July 17, 2020. The 2nd Circuit Released its decision in Keefe v. Commissioner, No. 18-2357-ag (2d Cir. July 17, 2020), which held denied the Taxpayers ordinary loss treatment on the sale of a historic mansion purchased in Newport, Rhode Island.
Taxpayers purchased the historic mansion with the intention of renting the premises out once they had completed renovations to it.
The rehabilitation of the property took six years and at the end Taxpayers sold the property at a loss.
The Taxpayers never rented the property but did engage a listing agent during the latter part of construction.
Taxpayers originally claimed a capital loss on their return but filed an amended return claiming an ordinary loss that created a net operating loss they carried back to eliminate most of their tax liability.
The IRS denied the ordinary loss, a decision of which the Taxpayers appealed.
Taxpayers contended that they used the house in a rental trade or business despite never having rented it, and that they therefore incurred an ordinary loss, rather than a capital loss, on its sale.
Upon review, the court found that Taxpayers did not perform regular and continuous rental activities. Instead, the court found that the Taxpayers engaged in more time trying to sell the property than rent it.
Thus, the failure to engage in “regular and continuous” rental activities on historic mansion negates taxpayers claim they were operating a trade or business eligible for ordinary loss treatment, the Second Circuit Court of Appeals held.
However, it is important to note that a property never rented can still be considered part of a trade or business if the taxpayer was already engaged in a trade or business, the court determined in distinguishing cases put forth by Taxpayers.
You can read the full court case here.
IRS News Release – IRS Unveils “Dirty Dozen” List of Tax Scams for 2020
July 16, 2020. The IRS released the annual “Dirty Dozen” tax scams with special emphasis on aggressive and evolving schemes related to coronavirus tax relief, including Economic Impact Payments.
Specifically, the IRS listed 13 scams:
- Phishing on potential fake emails or websites,
- Fake charities,
- Threatening impersonator phone calls,
- Social media scams,
- EIP or refund theft,
- Senior fraud,
- Scams targeting non-English speakers,
- Unscrupulous return preparers,
- Offer in compromise mills,
- Fake payments with repayment demands,
- Payroll and HR scams, and
Further details and methods to avoid falling victim to these scams can be found be found on the IRS’s news release.
The IRS plans to unveil a similar list of enforcement and compliance priorities this year, the IRS announced.