United States: Tax Hot Topics Retail Update

Introduction

Welcome to our latest quarterly issue of Tax Hot Topics Retail Update. To provide relevant, timely and industry-specific tax developments, we have tailored a tax update specifically for retailers. In each edition we cover legislative, regulatory, case law and administrative guidance changes that can affect retailers and their stakeholders. The format of this publication has been enhanced by adding a table of contents and expanding the coverage to include a wider variety of issues that may concern retailers. Links to Grant Thornton SALT Alerts are provided to enable readers to access more detailed discussions of the topics.

Summary

Highlights of this latest edition include a discussion of two South Carolina decisions concerning apportionment issues for Rent-A-Center, the Gillette litigation in California and related MTC apportionment election developments, the new mandatory combined reporting regulations promulgated by the District of Columbia and legislation regarding forced combinations in North Carolina.

Covered areas of state taxation include special attention to nexus, group reporting, apportionment and tax base, issues likely to be highly impactful to retailers.

Also, this edition covers federal developments such as the IRS's ending "tiered" issue management, issuing proposed regulations on deduction limitations for meal and entertainment reimbursement arrangements, and clarifying and updating guidance on FICA withholding on tips.

State and local news

S.C. Administrative Law Court considers apportionment issues for Rent-A-Center

In two separate cases, the South Carolina Administrative Law Court considered apportionment issues involving Rent-A-Center.

Summary of Rent-A-Center West

In Rent-A-Center West, Inc. v. South Carolina Department of Revenue (Docket No. 09-ALJ-17-0204-CC), the South Carolina Administrative Law Court addressed some interesting and recurring retail apportionment issues.

Background

Rent-A-Center West, Inc. (RAC West) owned a number of retail stores in the western United States and also owns the Rent-A-Center trademark. RAC West's only activity in South Carolina was to license the Rent-A-Center trademark to Rent-A-Center East, which operated Rent-A-Center stores in several states including South Carolina.

Use of alternative apportionment formula

The South Carolina Department of Revenue (DOR) asserted that the standard South Carolina apportionment formula (three-factor, double-weighted sales) did not properly determine RAC West's South Carolina income for the period in question. To properly determine RAC West's South Carolina income, the Department of Revenue excluded sales, property and payroll that could be attributed to RAC West's stores, and instead used a single sales factor formula that consisted of a numerator, which was RAC West's royalties received from South Carolina, and a denominator, which was RAC West's royalties received from everywhere.

In determining the sustainability of the DOR's proposed assessment, the court examined issues such as the burden of proof required to obtain alternative apportionment, unitary business concepts in a separate entity context, and apportionment distortion. The case provides an interesting analysis of apportionment issues commonly affecting retailers and emphasizes the importance of a careful reading of state apportionment statutes.

Summary of Rent-A-Center Texas

In Rent-A-Center Texas, L.P. v. South Carolina Department of Revenue (Docket No. 09-ALJ-17-0206-CC), the court considered the sourcing of fees from the centralized management services performed by Rent-A-Center Texas, L.P. (RAC Texas) for Rent-A-Center East (RAC East).

Background

RAC Texas owned and operated retail stores in Texas and provided centralized managed services to all Rent-A-Center companies, including RAC East, pursuant to a managed services agreement.

Management service fees sourced to Texas

The court considered whether the management service fees that RAC East paid to RAC Texas should be sourced to the state where the stores were located (South Carolina) or to the one where the management services were performed (Texas). Under South Carolina law, the court determined that the revenue received by RAC Texas from the management services agreement must be apportioned to Texas. The court supported its decision by explaining that RAC Texas provided its management services to the RAC East stores through skilled professionals located in Texas. Although RAC East employees performed some management-related services, the work they performed was customary for any company contracting for management services assistance. The court noted that RAC Texas did not physically perform any services in South Carolina and had no employees or facilities in the state. Also, the management services agreement did not require that RAC Texas physically perform any work in South Carolina. Therefore, the court held that the fees received by RAC Texas under the management services agreement must be apportioned to Texas. This case clarifies the factors considered by courts when making income sourcing determinations.

Calif. click-through and affiliate nexus provisions became operative on Sept. 15

On June 28, 2011, California amended its use tax law by enacting click-through and affiliate nexus provisions that were immediately effective. Later, however, the legislation was temporarily and retroactively repealed. The prospective operation of the nexus provisions depended on whether federal sales tax nexus legislation was enacted and implemented by California. Because federal legislation was not enacted by July 31, 2012, the California click-through and affiliate nexus provisions became operative on Sept. 15, 2012.

The click-through nexus provisions apply if two threshold conditions are met: (i) the retailer's total cumulative sales of tangible personal property to California purchasers that are referred pursuant to all of those agreements with California entities within the preceding 12 months must be more than $10,000; and (ii) the retailer's total cumulative sales of tangible personal property to California purchasers within the preceding 12 months must be more than $500,000. The affiliate nexus legislation provides that a "retailer engaged in business in this state" includes those retailers that have "controlled group" nexus.

Pa. click-through and affiliate nexus standards became effective Sept. 1

In December 2011, the Pennsylvania Department of Revenue issued a bulletin asserting that under current Pennsylvania law, a remote seller without physical presence may have nexus with the state. The bulletin includes examples of activities that create nexus with Pennsylvania, including click-through and affiliate nexus situations. The nexus compliance deadline for remote sellers was originally Feb. 1, 2012, but the department provided a one-time extension to Sept. 1, 2012. Thus, the click-through and affiliate nexus provisions are currently effective in Pennsylvania.

N.C. DOR contacts taxpayers regarding resolution initiative

The North Carolina Department of Revenue (DOR) special compliance section is currently contacting participants in the DOR's 2009 resolution initiative. At this time, it is uncertain whether the same type of project will occur for the participants in the 2006 settlement initiative. Based on the recent legislative change regarding the DOR's method of combining entities or eliminating transactions for tax years beginning Jan. 1, 2012, and thereafter, the DOR has contacted all participants in the resolution initiative at least once to schedule a discussion. The contacts were made only for combination and intercompany transaction cases with agreements in place.

State and local coverage since May

Apportionment

Calif. Court of Appeal issues revised Gillette opinion concerning MTC apportionment election (SALT Alert, 10/5/12)

On Oct. 2, the California Court of Appeal issued a revised opinion in Gillette, ruling in favor of a group of taxpayers electing to use the equally weighted three-factor apportionment formula provided by the Multistate Tax Compact in lieu of an apportionment formula requiring use of a double-weighted sales factor. This opinion is very similar to the previous opinion the court released for this case on July 24 and subsequently vacated on Aug. 9. The new opinion, however, acknowledges legislation, S.B. 1015, that repealed the compact. Because this legislation repealing the compact was enacted after the years involved in the case, this legislation did not change the court's holding.

On June 27, in anticipation of a decision adverse to the state, California enacted legislation, S.B. 1015, repealing the compact. The legislation, which attempted to limit the tax refunds that the state might be required to pay for open tax years, clarifies that since 1993, the use of an equally weighted three-factor formula by a multistate taxpayer has been disallowed.

Calif. Court of Appeal affirms finding of distortion and FTB's use of alternative apportionment formula in General Mills case (SALT Alert, 9/14/12)

The California Court of Appeal affirmed a trial court's determination that a taxpayer's inclusion of gross receipts from commodity futures contracts used to hedge against price fluctuations was distortive, and an alternative apportionment formula used by the California Franchise Tax Board (FTB) was reasonable. In affirming the trial court, the Court of Appeal applied the qualitative and quantitative tests to determine that distortion existed. The court held that the alternative apportionment formula that limited the amount in the sales factor to net gains was reasonable and fairly represented the extent of the manufacturer's business activity in the state.

Ind. Supreme Court reverses Ind. Tax Court ruling on sourcing of carrier pickup sales (SALT Alert, 8/13/12)

Reversing an August 2011 decision of the Indiana Tax Court, the Indiana Supreme Court held that for purposes of the adjusted gross income tax, a taxpayer's sales of products to Indiana customers who picked up the products through third-party common carriers outside the state should be sourced to Indiana. The Indiana Supreme Court determined that the Indiana sourcing statute was unambiguous and that the example included in the regulation and was relied on by the Tax Court did not have the force of law.

Nexus

Ga. enacts tax reform package that includes sales tax nexus provisions (SALT Alert, 5/4/12)

Georgia enacted extensive tax reform legislation that, effective Dec. 31, 2012, adds a click-through nexus provision by expanding the definition of a "dealer" required to collect and remit sales and use tax. Under the expanded definition, "dealer" includes out-of-state Internet vendors that pay in-state entities in exchange for referrals that result in a certain amount of Georgia sales. Also, effective Oct. 1, 2012, the definition of a dealer was further expanded to include certain out-of-state vendors with in-state affiliates.

Hawaii Department of Taxation finds Internet retailer has general excise tax nexus (SALT Alert, 8/6/12)

On July 10, the Hawaii Department of Taxation issued a letter ruling determining that an out-of-state Internet retailer was subject to the Hawaii General Excise Tax (GET) and the Honolulu County GET surcharge by virtue of its relationship with an affiliate that had a number of store locations in Hawaii and at least one store location in Honolulu County. In particular, since the affiliate accepted returns on behalf of the Internet retailer at its stores and also participated in a loyalty points program that allowed customers to accrue and redeem points interchangeably at either its stores or the Internet retailer's website, the affiliate was acting as an "agent" of the Internet retailer and established nexus for the Internet retailer.

Ill. circuit court holds click-through nexus statute is unconstitutional and violates ITFA (SALT Alert, 5/15/12)

On April 25, an Illinois circuit court ruled that Illinois' recently enacted click-through nexus law violates the commerce clause of the U.S. Constitution and is pre-empted under the supremacy clause of the U.S. Constitution because of the federal moratorium against discriminatory state taxes on electronic commerce contained in the Internet Tax Freedom Act.

Minn. holds merchandisers create corporate income tax nexus (SALT Alert, 5/31/12)

The Minnesota Tax Court held that the in-state activities of merchandisers employed by an out-of-state distributor created corporate income tax nexus for the distributor. Specifically, the merchandisers' activities exceeded the mere "solicitation of orders," which would be afforded immunity from a state's income tax under Public Law 86-272. The merchandisers' training sessions provided to retail store employees and their preparation of store reports, photos and floor maps were not ancillary to the "solicitation" of orders or the "requesting" of orders. Instead, the training sessions and the prepared materials served independent business purposes. In addition, when taken together, the merchandisers' nonimmune activities were not de minimis, and as a result, the out-of-state distributor was subject to Minnesota's corporate income tax.

N.M. court holds online retailer sharing trademark with in-state retailer has nexus (SALT Alert, 5/7/12)

On April 18, the New Mexico Court of Appeals held that an out-of-state online bookseller, Barnesandnoble.com LLC (B&N), had substantial nexus for purposes of the New Mexico gross receipts tax based on its shared trademarks with an in-state related party's activities. In reversing the hearing officer, the court found that the in-state related party created goodwill for the shared trademarks and, as a result, helped B&N to create and maintain a market within the state.

Okla. Supreme Court holds out-of-state IHC did not have income tax nexus (SALT Alert, 5/16/12)

The Oklahoma Supreme Court held that an out-of-state company's licensing agreement with another out-of-state company did not create Oklahoma corporation income tax nexus. The taxpayer was a Vermont corporation that allowed its out-of-state licensee to sublicense its intellectual property rights to Oklahoma restaurants. The restaurants paid the out-of-state licensee a percentage of their gross sales for the use of the intellectual property, and the out-of-state licensee, in turn, paid a smaller percentage of the restaurants' gross sales to the taxpayer under the original license agreement. The court determined that the out-of-state licensee was solely responsible for the sublicenses and that the connection between the taxpayer and Oklahoma was insufficient to support a finding of nexus.

Wash. BTA holds delivery of goods by leased railcars did not establish B&O tax nexus (SALT Alert, 10/4/12)

The Washington Board of Tax Appeals (BTA) held that a seller of raw materials used in food manufacturing that delivered its goods in leased railcars did not have nexus for purposes of the business and occupation tax and litter tax. The railcars were physically present in Washington on a regular basis to deliver the goods, but the seller's use of the leased railcars was not significantly associated with its ability to establish and maintain a market in the state.

W.V. Supreme Court of Appeals holds out-of-state IHC does not have income or franchise tax nexus (SALT Alert, 6/7/12)

The West Virginia Supreme Court of Appeals held that an out-of-state company licensing intellectual property to out-of-state licensees did not have corporation net income tax or business franchise tax nexus. The court based its determination on the following facts of the case: (i) the licensor lacked a physical presence in the state and did not sell products or services within the state; (ii) the licensees manufactured the products bearing the trademarks and trade names outside the state; (iii) the licensor did not direct or dictate how the licensees distributed the products; and (iv) the licensees did not operate any stores in the state and sold the products only to wholesalers and retailers in the state.

Group reporting

D.C. promulgates corporate income tax regulations to clarify mandatory combined reporting (SALT Alert, 9/24/12)

On Sept. 14, the District of Columbia Office of Tax and Revenue (OTR) promulgated combined reporting regulations that are effective for tax years beginning after Dec. 31, 2010. These new regulations address several combined reporting issues including the composition of the combined group, worldwide reporting election, determination of taxable income or loss, computation of net operating losses, adoption of the Joyce rule for apportionment, treatment of partnerships, FAS 109 deduction and the automatic filing extension for the first combined return. Also, the OTR has developed a combined reporting website that provides additional information.

D.C. OAH holds transfer pricing study unreliable for determining reallocation of income (SALT Alert, 5/30/12)

The District of Columbia Office of Administrative Hearings (OAH) has issued an order reversing an assessment that was issued against a software company on the basis of a transfer pricing analysis. The OAH determined that the transfer pricing study was "arbitrary, capricious and unreasonable" because it did not comport with appropriate transfer pricing methodology as allowed by the federal Treasury regulations interpreting Internal Revenue Code Section 482.

Minn. Tax Court finds lack of unitary relationship; no apportionment required for Section 382 limitation on NOLs (SALT Alert, 9/20/12)

On Aug. 20, the Minnesota Tax Court held that an out-of-state provider of pharmacy benefit management and mail-order pharmacy services did not have a unitary business relationship with its one-third-owned Minnesota joint venture partnership that created an electronic prescription and information routing service. The court determined there was no flow of value or sufficient control to establish a unitary relationship between the taxpayer and the joint venture partnership. Therefore, the taxpayer's income was not required to be combined with the joint venture partnership's income for combined reporting purposes. Separately, the court held that a subsidiary of the taxpayer was not required to apportion its Internal Revenue Code Section 382 limitation on net operating losses.

N.C. may not redetermine income or force combination until rule adopted (SALT Alert, 7/16/12)

On June 20, North Carolina enacted legislation providing that, except for a voluntary redetermination, the secretary of the North Carolina Department of Revenue may not redetermine a corporation's state net income that can properly be attributed to its business carried on in the state until an administrative rule is adopted and becomes effective. The legislation provides an expedited procedure for adopting the rules needed to administer the statute that allows the secretary to redetermine income and force combination. The secretary is no longer allowed to interpret the statute in the form of a directive or bulletin.

Oregon Tax Court holds retailer required to include foreign insurance company's income in consolidated return (SALT Alert, 9/10/12)

The Oregon Tax Court held that the income of an out-of-state retailer's foreign insurance company subsidiary was required to be included in the retailer's consolidated Oregon corporation excise tax returns. The court based its determination on the facts that the insurance company was not independently subject to Oregon corporation excise tax and that the insurance company, which was a member of the retailer's federal affiliated group, was also a member of a unitary group with more than one corporation that Oregon had the jurisdiction to tax.

S.C. DOR rules subsidiaries of foreign corporation can file single consolidated return (SALT Alert, 9/18/12)

On Aug. 27, the South Carolina Department of Revenue issued a private letter ruling that permits a group of subsidiary corporations of a foreign corporation to file a single South Carolina consolidated return even though the subsidiaries were required to file two different consolidated returns for federal income tax purposes. The department adopted the position that as long as the subsidiaries had income tax nexus with the state and met the "substantial control" test, the subsidiaries could be included on the same consolidated return regardless of whether the common parent corporation was included on the return.

Tax base

Tenn. enacts legislation affecting add-back rules and net worth group membership (SALT Alert, 6/1/12)

Applicable to tax years ending on or after July 1, 2012, Tennessee enacted legislation that amends the related-party add-back rules currently governing intangible expenses for purposes of the corporation excise (income) tax. Pursuant to the legislation, the definition of "intangible expenses" is expanded to include certain interest expenses. Also, the procedure for deducting intangible expenses from related-party transactions is changed substantially and, in certain cases, may require the taxpayer to submit an application to the Tennessee Commissioner of Revenue prior to approval. The legislation also allows Tennessee net worth taxpayers to request from the commissioner the exclusion of one or more members from its affiliated group.

Va. circuit court holds add-back exception applies if licensing royalties are indirectly paid to related member (SALT Alert, 5/31/12)

A Virginia circuit court held that a taxpayer was entitled to an exception to the general rule requiring the add-back of federal intangible expense deductions and costs to taxable income. Virginia law provides an exception for certain taxpayers that license intangible property to unrelated parties. The taxpayer was a franchisor that sublicensed the intangible property to franchises that were not related to the original licensor. The court determined that the original licensor met the "licensing to unrelated parties" requirement based on the sublicense agreements and, as a result, the franchisor taxpayer was entitled to a refund based on the exception to the add-back rule.

Miscellaneous

Ill. Appellate Court holds taxpayer subject to double interest penalty for failure to participate in 2003 amnesty program (SALT Alert, 9/5/12)

On Aug. 22, the Illinois Appellate Court held that a taxpayer's additional income tax liability for tax years 2000 and 2001, resulting from a federal audit conducted after the conclusion of the state's 2003 amnesty program, was subject to a double interest penalty because of the taxpayer's failure to participate in the program. The justices concluded that even though the taxpayer had no knowledge of the additional liability during the amnesty period, the liability was "due" and required to be paid during the program and, thus, was subject to the double interest penalty. Further, the Appellate Court expressly rejected the reasoning in its recent decision in Metropolitan Life Insurance Co. v. Hamer that reached the opposite result.

Ill. legislation increases cigarette taxes (SALT Alert, 6/20/12)

On June 14, Illinois enacted a package of significant Medicaid reform legislation, cutting $1.6 billion from the program and raising the tax on hospital providers and cigarettes to compensate for the cut. The legislation created the Cigarette Machine Operators' Occupation Tax Act, which, beginning on Aug. 1, 2012, imposes a tax on all people engaged in the business at a rate of 99 mills per cigarette. Beginning July 1, 2012, the term "cigarette" was amended to permit the cigarette tax to reach an expanded group of products. Also, beginning June 24, 2012, retailers and consumers of cigarettes became subject to an additional tax on cigarettes at a rate of 50 mills per cigarette sold. Further, beginning July 1, 2012, the tax rate on "tobacco products" increased.

La. DOR changes resale exemption certificate renewal process and issues guidelines (SALT Alert, 6/1/12)

On May 24, the Louisiana Department of Revenue released a revenue information bulletin and a revenue ruling addressing sales and use tax issues. The bulletin changes the renewal procedures for resale exemption certificates issued by the department. The revenue ruling explains that coating, wrapping and galvanizing previously untreated tangible personal property are considered "fabrications" that are subject to sales and use tax.

N.J. Division of Taxation offers limited voluntary disclosure initiative for intangible holding companies (SALT Alert, 10/8/12)

On Sept. 18, the New Jersey Division of Taxation announced it was offering a limited voluntary disclosure agreement (VDA) initiative for companies that have not filed corporation business tax (CBT) returns but have nexus with New Jersey as a result of deriving income from the use of intangible assets in the state. The division's announcement outlines the parameters of a new, time-sensitive VDA program for intangible holding companies (IHCs), describing the program's duration, look-back period, penalty provisions, treatment of throw-out receipts and the prospect of amending CBT returns filed by operating affiliates. While this initiative offers IHCs more favorable terms than in the past, this VDA still does not offer terms as favorable as those offered under VDAs by most other states including New Jersey (for non-IHCs). Accordingly, companies considering the new program should carefully consider the consequences of their participation. The new program began on Sept. 15 and runs through Jan. 15, 2013.

N.J. addresses sourcing of income from gift cards, amends treatment of stored value cards (SALT Alerts, 7/26/12 and 8/23/12)

On June 29, New Jersey amended its unclaimed property statutes related to stored value cards. This amendment is the latest in a series of changes in the state's treatment of stored value cards over the past two years. The new version of the stored value card law includes several important components that will affect both holders and owners of unclaimed property, and possibly taxpayers subject to the New Jersey Corporation Business Tax (CBT).

On the same day, the New Jersey Division of Taxation issued a letter ruling addressing the application of the CBT to the sourcing of income from a taxpayer's sales of stored value cards, gift cards and gift certificates to retailers. The redemption fees that can be attributed to a consumer's redemption of gift cards in stores located in New Jersey, and the income recognized from dormant gift cards and deferred unredeemed gift cards that were activated in New Jersey, were sourced to the numerator of the CBT sales factor. The taxpayer's investment income was sourced to its commercial domicile in New Jersey, since the cash on hand for the investment was managed from the taxpayer's New Jersey office.

N.Y. trial court holds Metropolitan Transportation Authority's payroll tax is unconstitutional (SALT Alert, 8/31/12)

On Aug. 22, the Supreme Court for Nassau County, N.Y., held that the metropolitan commuter transportation mobility tax (MCTMT) is unconstitutional because the New York State Legislature did not follow proper procedures in enacting the law. The New York State Department of Taxation and Finance has announced, however, that taxpayers that have been paying the MCTMT should continue to pay and file returns.

Streamlined Sales Tax Board meets, fails to take position on deal-of-the-day vouchers (SALT Alert, 6/13/12)

The governing board of the Streamlined Sales Tax states and the Streamlined Sales Tax State and Local Advisory Council held their meetings in Milwaukee on May 22-24. While businesses urged the governing board to adopt a uniform position on the treatment of deal-of-the-day vouchers, a position was not adopted because too few states voted in favor of a uniform position. The governing board did, however amend the agreement to enable Ohio and Utah to petition to become full member states. Also, during the State and Local Advisory Council meeting, there were significant discussions about the sourcing of the sale of digital products and when states must provide a credit for prior taxes that were paid.

Federal coverage since May

IRS ends "tiered" issue management (Tax Hot Topics, Aug. 27, 2012)

The IRS Large Business and International Division (LB&I) has announced (LB&I-04-0812-010) that it will no longer use its "tiered issue process" to manage audit issues. Instead, LB&I is creating a knowledge management network with issue practice groups (IPGs) for domestic issues and international practice networks (IPNs) for international issues.

The tiered issue process was established in 2006 to promote greater consistency and accountability in the resolution of "high risk" compliance issues. Under the process, many issues were assigned to one of three tiers and managed by issue management teams. These teams were responsible for developing resolution strategies and tools, and each tier carried specific requirements for coordinating audit issues. Examiners were required to address any Tier I issues on a return, though having a Tier I issue did not mean a taxpayer's return would automatically be selected for audit.

Effective with LB&I's announcement, all Tier I, II and III issues are no longer tiered and should be risk-assessed and examined in the same manner as any other issue in an audit. All prior industry director directives issued under the tiered issue process are withdrawn.

LB&I said the new IPGs and IPNs are designed to be a resource for examiners to use in audits and to manage compliance priorities. According to the IRS, the goals are to:

• provide LB&I examiners with clear and timely guidance on how to address issues,
• promote collaboration among LB&I employees,
• increase accountability and transparency in the resolution of issues, and
• enable robust lines of communication with taxpayers.

The end of the tiered issue process should give audit teams more flexibility to settle issues, but LB&I is instructing front-line managers, territory managers and directors of field operations to consult IPGs and IPNs when reviewing cases and considering the proper treatment of issues under their supervision.

IRS issues proposed regulations on deduction limitations for meal and entertainment reimbursement arrangements (Tax Hot Topics, Aug. 13, 2012)

The IRS recently proposed regulations (REG-101812-07) addressing deduction limitations under sections 274(a) and (n) for reimbursement or other expense-allowance arrangements for meals and entertainment. In general, Section 274(a) does not allow a tax deduction for entertainment expenses that are not related to business, and Section 274(n) limits the tax deduction for meals to 50 percent of the expense. These proposed regulations provide guidance on who is subject to these deduction limitations when employees and independent contractors are reimbursed for meals and entertainment expenses by an employer or other service recipient, and for multiparty reimbursement arrangements.

The proposed regulations provide that only one party is subject to the deduction limitations under Section 274. When an employee is reimbursed for meals and entertainment expenses by the employer, the employer is the party subject to the Section 274 deduction limitations if the employer does not treat the reimbursement as compensation to the employee. Conversely, if the employer does treat the reimbursement as compensation to the employee, the compensation expense is fully deductible by the employer, and the employee is the party subject to the deduction limitations under Section 274 (if the employee deducts the expenses as a business expense on his or her return).

In addition, the proposed regulations address the situation in which a service recipient reimburses an independent contractor for meals and entertainment expenses. In that case, the service recipient and the independent contractor may express in writing who is subject to the limitations. If they do not do so, the deduction limitations apply to the service recipient if the independent contractor provides the service recipient with substantiation of the expenses that meets the requirements of Section 274(d). If the independent contractor does not provide substantiation, the deduction limitations apply to the independent contractor.

Section 274(d) requires substantiation of:

• the amount of the expense;
• the time and place of the travel, entertainment, amusement, recreation or use of the facility or property;
• the business purpose of the expense; and
• the business relationship to the taxpayer of the people entertained or using the facility or property.

The proposed regulations also address situations involving a multiparty reimbursement arrangement. An example is an arrangement in which: (1) an employee pays or incurs an expense subject to a Section 274 limitation, (2) the employee is reimbursed for that expense by his or her employer and (3) the client of the employer reimburses the employer. Only one party is subject to the deduction limitation. Generally, the client is subject to the deduction limitation as long as the agreement between the employer and client provides for the reimbursement, and the employer provides the client with substantiation of the expense. The client and employer may agree in writing, however, that the employer will be the party subject to the deduction limitation.

These regulations are proposed to apply to expenses paid or incurred in the taxable year beginning on or after the regulations become final, but taxpayers may rely on the regulations before they are final.

IRS says taxpayer cannot capitalize lessor-owned leasehold improvements under Section 263A (Tax Hot Topics, May 29, 2012)

The IRS has determined in a recent legal memorandum (ILM 2012-20-028) that a taxpayer's allocation of indirect costs between leasehold improvements it owned and those owned by its lessor was not reasonable, because all of the indirect costs were allocated to the taxpayer-owned property even though some costs were related to property owned by the lessor.

The taxpayer referenced in the memorandum leased real property. Pursuant to the lease agreement, the taxpayer entered into an agreement with the lessor to construct improvements on the property. The lessor provided an allowance to cover a portion of the construction, and the taxpayer used its own funds for the remaining portion. The agreement provided that the lessor would own all of the real property and some of the real property improvements, while the taxpayer would own all of the personal property and some of the real property improvements. The agreement also required the taxpayer to incur certain indirect costs related to the real property and improvements owned by the lessor, but did not state that these costs were a substitute for rent.

The taxpayer took the position that indirect costs incurred under the agreement associated with the construction of the leased property owned by the lessor could be capitalized under Section 263A to the basis of the property produced and owned by the taxpayer. The IRS Large Business and International Division (LB&I) disagreed with this treatment, contending that the indirect costs related to property not owned by the taxpayer could not be capitalized under Section 263A to the basis of the property owned by the taxpayer.

The IRS National Office concluded in the legal memorandum that the indirect costs incurred that were related to property that was not owned by the taxpayer could not be capitalized to the property that the taxpayer did own under Section 263A. Rather, the indirect costs that were related to the property owned by the lessor and that were not additional rent could be capitalized under Section 263(a) as an intangible cost to improve property.

The effect of this treatment is that the indirect costs related to property owned by the lessor would be treated as intangible costs and amortized over their useful life or the safe harbor 15-year amortization period rather than capitalized to the leasehold improvement property owned by the taxpayer and recovered through modified accelerated cost recovery system (MACRS) depreciation.

IRS clarifies and updates guidelines on FICA withholding on tips (Tax Hot Topics, July 2, 2012)

The IRS has clarified and updated guidelines (Rev. Rul. 2012-18) first presented in 1995 (Rev. Rul. 95-7) concerning FICA taxes imposed on tips and the notice and demand rules under Section 3121(q).

In general, tips received by an employee are subject to payroll taxes under the Federal Insurance Contributions Act (FICA) and are deemed to be paid to the employee on the date the employee reports the tips to the employer. Employees who receive more than $20 in tips per calendar month are required to report the tips to the employer.

The revenue ruling points out that the employee is responsible for FICA taxes on unreported tips and the employee may be subject to a penalty equal to 50 percent of the employee's share of FICA taxes on the unreported tips. The employer is not liable for the employer's share of FICA taxes on unreported tips until notice and demand for the taxes are made to the employer by the IRS. Rev. Rul. 2012-18 also addresses many other issues concerning FICA tax on reported and unreported tips.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.