The Debate to Preserve or Eliminate Section 1031

Real Estate Exchange Property 1031 Section Tax Deferred

Real Estate 1031 Exchange

As lawmakers of the federal government struggle to deal with our ever-increasing national debt, Section 1031 of the Internal Revenue Code has come under scrutiny and may face extinction. Now that Republicans control both sides of the Congress (and the White House), Section 1031 could be seriously threatened if GOP lawmakers feel that reducing or eliminating the advantages of 1031 would prove financially beneficial for the nation as a whole. Discussions have surfaced previously about eliminating Section 1031, but current discussions appear to be more serious given the dire financial situation in which the country is encased.

Not all legislators view Section 1031 as a target for elimination; some lawmakers concur with many real estate professionals that 1031 actually contributes mightily to the national economy in a variety of ways. Let’s look at both sides of the debate in greater detail.

Section 1031 as a Tax Loophole

Under Section 1031, taxpayers are able to defer capital gains tax when they exchange their business or investment property for another property of like-kind (which essentially means another business or investment property). In practice, this can mean the deferral of hundreds of thousands ? and even millions ? of dollars in capital gains tax which would otherwise be collected by the federal government.

Though no lawmaker questions the permissibility of like-kind exchanges as they have developed under current regulations, there is doubt as to whether Section 1031’s true purpose was to defer gain in this particular way. The roots of Section 1031 stretch all the way back to 1921; at that time, however, the exchanges typically consisted of neighboring farmers who wished to swap their property in order to clarify property lines. Numerous common law opinions which occurred decades later shaped the current Section 1031 industry. Though it’s clear that like-kind exchanges do confer at least some benefits to the wider economy, it would be hard for even the most fervent 1031 supporter to deny that current like-kind exchanges are conducted with the same underlying purpose as those which occurred many decades ago.

Section 1031 as an Engine of Economic Activity

On the other side, many (if not most) professionals in the real estate industry contend that Section 1031 benefits the national economy in myriad ways. For one, they claim that Section 1031 encourages economic activity beyond the exchange itself in the form of construction services, title insurance services, real estate agent services, and so forth. Curtailing or eliminating Section 1031 would simultaneously reduce this related economic activity as well.

Furthermore, at least one formal study has concluded that the vast majority of like-kind exchanges eventually result in a taxable sale. In addition to supporting claims about the general economic benefit of 1031, a study by Professors David C. Ling (of the University of Florida) and Milena Petrova (of Syracuse University) stated that as high as 88 percent of exchanges ultimately result in taxable sales.

In our financially troubled state, Section 1031 faces arguably its toughest challenges. We shall have to wait and see whether this decades-old provision will either be preserved or meet its demise.

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A Few Thoughts on the New Seattle Soda Tax

Soda Tax Seattle Drink Council City

Seattle Soda Tax

On Monday, June 5, 2017, the Seattle City Council passed a motion which will implement a tax on sugary soft drinks (soda). This new “soda tax” is designed to reduce statewide obesity rates, particularly among children, and to raise additional funds for public projects. Expectedly, the passage of the soda tax has been met with both surprise and opposition as it raises issues regarding personal freedom and the role of government in the marketplace. Let’s look at the basic provisions and purposes of the tax and then discuss some of the arguments both in favor and against it.

Basic Facts

The soda tax was passed by a margin of 7-1; Lisa Herbold was the sole councilmember to vote against the tax. The city will collect 1.75 cents for every ounce of “sugary” soda, such as regular Coca-Cola, Pepsi and so forth. The tax will not be collected on diet sodas and sodas made by smaller distributors.

The tax is set to take effect on January 1, 2018. This date could be pushed forward, however, in the event that a legal challenge or other type of motion takes place in the interim. Prior to the vote on the tax, councilmember Herbold proposed several amendments which she claimed would mitigate some of the potential negative consequences of the tax. All of Herbold’s amendments failed except for her proposal that some of the tax proceeds be used to fund local food banks.

Pros and Cons

The chief architect of the tax, councilmember Tim Burgess, argued that the tax will make a positive impact on state obesity levels. Though the tax may (indirectly) encourage healthier eating habits, many opponents could argue that this tax represents an undesirable incursion by the state on the free market. Regardless of the price, people have a choice to purchase sugary soft drinks, and the tax on soda could easily be interpreted as a financial penalty on personal freedom. The soda tax, therefore, brings up the recurring issue of what role the government should play in preventing certain behaviors in the interest of the wider public good.

When viewed in this fashion, the soda tax acquires a rather lengthy pedigree. Sin taxes, such as those imposed on tobacco and liquor, have been relatively common throughout American history. In the 1920s (and early 1930s), we used Prohibition to guard against the supposedly toxic influence of alcoholic beverages; today, historians almost all concur that Prohibition was a failed experiment, but the issue of what level of responsibility the state has for promoting public health remains hotly contested. Here at HTC, we think it prudent to avoid a definitive stance on the issue; after all, we are not dealing with a ban or severe financial burden, only a small incentive to avoid sugary drinks. HTC is certainly very curious about the impact of the tax and we look forward to seeing hard numbers on whether the tax lives up to its expectations.

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HTW Post-Season News & Upcoming Small Business Webcasts

News Update Huddleston Tax CPAs Webcast

Huddleston Tax Weekly News

Now that we’re past our busiest part of the year, HTW is happy to announce that we’ll be continuing our previous trend of bringing topical, high-quality material to our readers on a regular basis. HTW would like to continue examining the contours of the sixteenth amendment for a bit longer; the reason for this is because we believe firmly that an understanding of this exceedingly important political act is vital to gaining a full picture of our whole tax edifice. But after we explore the amendment in a bit more detail, we’re excited to say that we’ll be moving on to other issues which should be equally interesting to our audience. We will explore more real estate cases, current tax cases, international issues, and plenty of other exciting things.

Small Business Webcast

We’d also like to draw our readers’ attention to two upcoming webcasts which will be hosted from our site, smallbusinesswebcast.com. The first webcast — The Tax Benefits of Real Estate Ownership — will be given by our CPA, Jessica Chisholm. Jessica has given this presentation previously and is well familiar with this specialized area. The second webcast — Tax Reduction Strategies for Small Law Firms — will be presented by our CPA, Steven Lok. Assisting small law firms is one of Steven’s specializations.

As always, these presentations are entirely free to attend. We hope you enjoy these webcasts and the many more entertaining articles HTW has in store!

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The Basics of Inslee’s New Tax Plan

State Tax Plan Governor Education Funding

Olympia, WA

In the first half of this last December, Governor Jay Inslee proposed a new tax plan designed to generate funding for basic education. The plan is responsive to a recent state court opinion which held that funding for K-12 education in Washington must come from the state rather than local districts. Prior to this opinion – the McCleary opinion – local districts contributed a substantial part of the cost for education through local property taxes; now, the state must foot the entire bill, and Mr. Inslee’s new plan addresses the deficit created by the removal of this familiar source of funds.

Mr. Inslee’s plan would draw tax revenue from several sources. Let’s review these sources and then take a look at the political reaction to his proposal.

Revenue Sources

The tax plan of Mr. Inslee would draw revenue from four sources. The plan would implement a capital gains tax of 7.9 percent on the sale of a number of assets, including stocks, bonds and others. The capital gains tax of Inslee’s plan would not apply to retirement accounts, homes, farms and forestry. The tax would apply to earnings above $25,000 for single filers and $50,000 for joint filers. Approximately $821 million would be raised from this tax for the fiscal year of 2019.

The plan would also impose a carbon emissions tax of $25 per metric ton. This tax would raise approximately $2 billion (per year).

Also included in Inslee’s plan would be an increase to the business-and-occupation (B&O) tax for attorneys, real estate agents and other professionals. The rate would be increased from its current level of 1.5 percent to 2.5 percent. This would generate roughly $2.3 billion.

Inslee’s proposal would also eliminate multiple tax exemptions, such as the exemption on bottled water and the exemption which benefits oil refineries.

Political Reaction

Unsurprisingly, given the severity of its probable impact, Inslee’s proposal has sparked substantial criticism from lawmakers on the other side of the political spectrum. Senate Majority Leader Mark Schoesler, for instance, was quoted as saying (disapprovingly) that the proposal by Mr. Inslee would constitute the single largest state tax increase in Washington’s history. Another senator, Ann Rivers, also of the Republican Party, said she felt that Mr. Inslee’s plan appeared to be an overly aggressive solution to the issue of funding state education.

Democratic lawmakers have been more sympathetic, and it seems that Mr. Inslee will likely have full support from members of his party. Importantly, newly elected Superintendent of Public Instruction Chris Reykdal has voiced his support for the proposal and even appeared alongside Inslee during the unveiling of the plan at Lincoln High School in Tacoma.

Whether Governor Inslee’s tax plan will be enacted in its current form remains to be seen. What is certain is that the state must develop a workable plan in double quick time. The court of Washington has already held the state in contempt because of the state’s failure to supply sufficient educational funding and has ordered the state to pay hefty fines. If it wishes to avoid further consequence, the state must develop a full funding plan by September 1, 2018.

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The Cost of Starbucks’ Dutch Connection

Starbucks Dutch Tax Haven

Starbucks

Back in October of 2015, the European Commission ordered the Dutch government to recover approximately €30 million (or about $34 million) from Starbucks. The EC determined that the arrangement made between the two entities was illegal and had given Starbucks an unfair advantage in the marketplace. The Netherlands and Starbucks are expected to appeal the decision.

The EC ruling is significant for a number of reasons. For one, it brings attention to the complex maneuvers multinational corporations employ in order to receive the best tax treatment. And it also highlights how serious the European Union has become in its efforts to crackdown on tax avoidance. While the sum that the Dutch government is required to recover in back taxes is not outrageously large, the decision may prove to be extremely important as a portent of future events.

The Decision

The European Commission found that the tax deal made between the Netherlands and Starbucks enabled the multinational coffee company to shift profits and dramatically lower its tax burden. Through its ruling, the EC intends to shut down the tax avoidance strategies utilized by large companies. Such strategies are usually highly sophisticated and unavailable to start-up companies and small to medium sized businesses. Hence, even though Starbucks maintains it didn’t violate any established rules, the arrangement compounds the preexisting economic advantage Starbucks already possesses.

Although it may be tempting to immediately side with the EC, it should be kept in mind that EU states face an increasingly competitive world and tax deals are just one means to attract foreign investment. And if Starbucks is able to employ complex tax strategies which give it an advantage, perhaps this is just a natural consequence of how the market works? And besides, even if this ruling curtails tax avoidance strategies in the short-term, what guarantee exists that companies will not respond with even more creative strategies in the future?

Starbucks may be stuck with a sizable tax bill, but the days of sophisticated tax structuring are far from over.

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The New Connecticut State Budget

Connecticut State Budget

The State of Connecticut

Back in May, the state government of Connecticut approved a new budget with the goal of fixing a deficit of approximately $960 million. The budget – which was proposed by the Democrats – did not raise taxes but instead addressed the deficit through various spending cuts and layoffs. General fund spending was cut by $821 million, hospital funding was cut by $43 million and state grants to non-profit industries which provide addiction and mental health services were cut by roughly $8.7 million.

The budget took effect on July 1. Opponents stress the cuts to the medical and non-profit industries and highlight the impact of such cuts on Connecticut families. Supporters emphasize the absence of tax increases and point to the fact that difficult decisions were inevitable in order to balance the budget. Though certain negative effects will undoubtedly ensue, the Democratically-sponsored budget was in fact the lone option as the Republicans failed to put forth an alternative proposition.

When the budget passed, Connecticut governor Dannel P. Malloy foresaw as many as 2,500 state jobs being eliminated. Some of these eliminations would result from retirements and other forms of voluntary resignation. The layoffs were projected to occur across a broad range of employment sectors including education, law, medicine and others as well. The layoffs have sparked protests and heated opposition from union leaders. Lori Pelletier, president of the Connecticut AFL-CIO, went so far as to say the following: “A vote for this budget is a vote for laying off rape crisis counselors, corrections officers, nurses, mental health workers, and teachers.”

Though it is certainly not without its unattractive elements, the new state budget of Connecticut appears to be on path with projections and should lead to a balanced fiscal situation in 2017. Connecticut state revenue derives from various sources, several of which are rather volatile, and so only time will reveal whether these projections turn out to be correct. When budgets are greatly off-kilter – as was clearly the case with Connecticut’s budget prior to the passing of this new plan – easy solutions are often impossible to come by. Hopefully economic growth can help relay former state employees into well paying new jobs.

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Apple’s New Tax Bill

Apple Company Tax Bill

Apple Logo

The European Commission has recently ordered multinational tech giant Apple, Inc. to pay €13 billion to Ireland to settle back tax debt. The EC concluded that the deal made between Apple and Ireland was illegal and aided Apple in avoiding its proper tax liability. Though it is not the largest corporate back tax bill by a long shot, this tax bill will certainly spell substantial changes in the way Apple conducts its tax affairs.

Commissioner Margrethe Vestager determined that the Irish deal enabled Apple to pay an effective tax rate of just 1 percent on its European profits in 2003, and that this sunk to just 0.005 percent in 2014. The European authorities have put Ireland in charge of recovering the €13 billion (approximately $14.6 billion) from Apple.

This new tax bill can accurately be perceived as an inevitable consequence of Apple’s practice of using creative accounting strategies to avoid tax obligations.

Context

Apple has used three primary methods to minimize its tax burden: deferral, transfer pricing and check-the-box. Deferral simply allows U.S. firms to avoid paying U.S. tax on income earned abroad until it is physically returned to the states. In reality, companies often keep international earnings offshore indefinitely and thus avoid paying tax altogether. Transfer pricing is a bookkeeping method used by companies to distribute expenses among their affiliates. Apple is able to utilize transfer pricing to its benefit by charging small fees to foreign subsidiaries for use of its intellectual property; in this way, Apple maximizes the profits of its affiliates and minimizes its intellectual property income in the U.S. Check-the-box allows firms to classify their affiliates as “disregarded entities” which are not subject to U.S. income tax.

The deal struck with Ireland further enhanced the effectiveness of these strategies. Apple set up two entities in Ireland through which it was able to channel two-thirds of its pre-tax global income. The income which passed through these Irish entities did not return back to Apple but was instead routed to the U.S.-based bank accounts of these entities. This allowed the income to avoid U.S. tax.

Final Thoughts

The European Union is trying diligently to crack down on faulty agreements between multinational firms and EU member states. European authorities have already ordered the Dutch government to recover €30 million from Starbucks and demanded that Luxembourg recover roughly the same amount from Fiat Chrysler. Both Amazon and McDonald’s are also likely to face similar treatment in the near future as a result of their dealings with Luxembourg. Though creative accounting will almost certainly continue well into the future, it appears that European authorities will take an increasingly aggressive approach to enforcing EU tax laws.

Apple certainly has the cash to settle its tax bill. And its relationship with Ireland is likely to suffer little as Ireland still has a relatively low corporate tax rate of 12.5 percent. However, it seems clear that Apple will have to employ cleverer strategies in the future in order to dodge the European taxman.

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The Basics of the Google Tax Quandary in the U.K.

Google Tax UK

Google Logo

With total earnings of approximately $74.5 billion for 2015, Google is truly a multinational corporate juggernaut. International sales constitute a substantial portion of Google’s overall revenue source. Presently, sales in the United Kingdom make up about a tenth of Google’s entire income. In recent years, a controversy has developed over Google’s supposed attempts to divert profits in an effort to avoid paying the typical corporate tax rate for U.K. sales. The standard corporate tax rate in the United Kingdom is 20 percent. By way of a host of creative strategies, Google has historically paid nothing close to this rate. Two recent developments — a settlement regarding Google’s back tax debt and a law passed by the British parliament — have helped create a measure of progress, but the matter remains far from fully resolved.

In the last three years, Google has managed to keep its effective tax rate on foreign (i.e. non-U.S.) profits at 6.6 percent. There appears to be some uncertainty over the exact rate paid by Google in the United Kingdom: some allege the rate is as low as 2.5 percent, although Matt Brittin, Google’s president in Europe, states that the rate is much higher.

Back Tax Deal

In January of 2015, a settlement was reached regarding Google’s past tax liability stretching back to 2005. Google agreed to a sum of $130 million (approximately £190 million). While many cite the deal as a clear triumph for the British government, many others see it as overly gentle on Google. Though the issue of profit shifting still lingers, this settlement brought at least some degree of satisfaction for the U.K.

Diverted Profits Tax

In its Finance Act of 2015, the British government included a provision called the Diverted Profits Tax — informally referred to as the Google Tax — which attempts to shut down the improper shifting of profits to offshore tax havens. In the past, Google has avoided paying the standard corporate tax rate on most of its U.K. profits due to its practice of shifting these profits to other venues, primarily Bermuda. The Diverted Profits Tax will attempt to halt this practice and implement a 25 percent tax rate on funds being shifted in this fashion.

There is uncertainty whether Google will comply with the law as Google contends that it already pays its fair share of taxes in the U.K. Only time will reveal precisely how the matter will be settled.

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The Dire Condition of Kansas’ State Budget

Kansas State Budget

State of Kansas

In 2012, Kansas governor Sam Brownback and the state legislature passed a measure to reduce state income tax rates for all Kansans and eliminate income tax for some 300,000 LLCs. Brownback and his fellow statesmen reasoned that such a measure would re-energize the state economy and promote job creation; neither Brownback nor any of the legislators believed that such a reduction would have a net negative impact of the state pocketbook. As it turns out, the cuts — which only took effect in 2014 — have led to a massive downfall in tax revenue and prompted a variety of new measures in order to cover the shortage.

The figures for the most recent fiscal years show the extent of the problem with unmistakable clarity. In 2013, the state of Kansas brought in $2.931 billion; this was a modest increase from the $2.908 billion which was collected in 2012. In 2016, Kansas collected a startlingly low $2.249 billion. To put it differently, as a result of the cuts, in 2016 Kansas collected roughly $650 million less in individual income tax dollars than in every year prior to the passing of the cuts. Though all positive intent may be imparted to him, the governor’s actions have created a distressful predicament for the state’s budget.

Kansas has actually lost 700 jobs over the course of the past year and currently ranks sixth worst in the nation in terms of rate of job growth. In response to the revenue downfall, the state has been compelled to divert more than $1 billion away from road improvements, implement a sizable sales tax increase, slash tens of millions of dollars from higher education and exhaust all of its cash reserves. Though they were intended to promote economic growth, given the consequences which have followed it is impossible to call the tax cuts of 2012 anything but a failure.

The governor has attempted to downplay the role of the tax cuts in creating the financial quandary: he’s alleged that recent financial projections have been overly optimistic, he’s highlighted the poor performance of the farm and oil industries, and he’s also reminded everyone that Kansas brought in more money in 2016 than in 2015. But these attempts ultimately fail to excuse the fact that, so far, the 2012 tax cuts have failed to deliver the benefits he promised and have led to the awful financial situation we see today.

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Alaska’s Current Tax Debate

Alaska Tax Debate

State of Alaska

The decline in oil tax revenue has sparked an important debate among Alaskan policymakers. Historically, Alaska’s oil supply has resulted in surpluses for its state government; now, with oil production on the decrease, state legislators are seeking measures in order to confront the newly created deficit. At this point, the debate has narrowed down to whether Alaska should adopt a state personal income tax or a sales tax. Alaska has been without a state personal income tax for 35 years and it has never collected sales taxes in its entire history.

The Institute for Taxation and Economic Policy (ITEP) released a report back in mid-July which addressed the issue of Alaska’s revenue woes. The report – which was entitled “Income Tax Offers Alaska a Brighter Fiscal Future” – makes the case that implementing personal income taxes for Alaskan residents is the better option. Essentially, the report propounds that adopting a personal income tax is more equitable, more sustainable in the long-term and also more financially beneficial to the bulk of Alaskans.

Though the debate is alive and well, several actions have already been taken. Governor Bill Walker has already made cuts to state spending and substantially curtailed tax breaks available to the oil industry. What’s more, Walker also reduced the maximum amount Alaskans may receive through the Permanent Fund; each person may now receive a maximum of $1,000 rather than the previous maximum of $2,072. The Permanent Fund is a statewide fund established to help ensure that a greater share of the Alaskan population benefits from the state’s oil stock.

Bringing balance to Alaska’s fiscal quandary will be no easy matter. Whatever option is selected, there will be a sizeable bite taken out of Alaskan pocketbooks. The hope is that the settling of Alaska’s revenue problems won’t disproportionately affect lower to middle level income families. So far, with all available evidence taken into consideration, it appears that reinstituting a personal income tax in conjunction with a few other measures is the surest means to provide both an equitable and sustainable financial future. Only time will tell if this is indeed the means which will be adopted.

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Huddleston Tax CPAs of Seattle & Bellevue
Certified Public Accountants Focused on Small Business

(800) 376-1785
40 Lake Bellevue Suite 100, Bellevue, WA 98005

Huddleston Tax CPAs & accountants provide tax preparation, tax planning, business coaching, Quickbooks consulting, bookkeeping, payroll and business valuation services for small business. We serve Seattle, Bellevue, Redmond, Tacoma, Everett, Kent, Kirkland, Bothell, Lynnwood, Mill Creek, Shoreline, Kenmore, Lake Forest Park, Mountlake Terrace, Renton, Tukwila, Federal Way, Burien, Seatac, Mercer Island, West Seattle, Auburn, Snohomish and Mukilteo. We have a few meeting locations. Call to meet John Huddleston, J.D., LL.M., CPA, Tawni Berg, CPA, Jennifer Zhou, CPA, Jessica Chisholm, CPA or Chuck McClure, CPA. Member WSCPA.