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By Brandi Fruik, CPA MST | Clark Nuber PS

Our high net worth clients often want to get their children interested in finance and investing at a young age. Along with this desire comes setting up brokerage accounts, which may produce taxable income to the child. There are two different ways to report your child’s unearned taxable income: the parents can report it on their tax return by attaching Form 8814 to their Form 1040, or the child can report in on their tax return by attaching Form 8615 to their Form 1040.

There are certain requirements that need to be met for the parents to report their child’s unearned income on Form 8814 on their personal Form 1040, rather than having the child file a separate 1040:

  • The child must qualify as a dependent;
  • The child must only have income from interest, dividends, or capital gain distributions in the total amount of less than $10,500;
  • The child must not otherwise be required to file a separate tax return; and
  • The child must not have made any estimated tax payments, had a prior year overpayment applied to estimated taxes or had any backup withholding on the income.

If you choose to report the income on Form 8814, this form will calculate the tax due on the first $2,100 of the child’s unearned income. Any amounts over $2,100 will be added to the income reported on the parents’ Form 1040 and taxed there accordingly.

Reporting a child’s income on the parent’s personal Form 1040 has both advantages and disadvantages. One advantage is a decreased  number of family tax filings. Some of the disadvantages include losing the child’s deductions, which may offset this income, or having to pay tax on this income at a higher rate.

Another option is for the child to file their own Form 1040 to report the unearned income. In this scenario, Form 8615 needs to be included in the following situations:

  • The child’s unearned income is more than $2,100,
  • The child is required to file a tax return,
  • The child is in the age-range to be classified as a dependent,
  • The child’s unearned income is more than half of what they paid to support themselves,
  • The child has at least one parent who is alive, and
  • The child is not filing a joint tax return.

In this situation, unearned income includes interest, dividends, capital gains, taxable social security and pension payments, certain distributions from trusts and unemployment compensation.

Once the amount of unearned income is determined, the amount is taxed at the parents’ tax rate. An advantage of having the child file their own tax return is the ability to use deductions to offset unearned income or potential lower tax rates. A disadvantage is having to perform additional tax filings. Please contact us if you would like to discuss methods of reporting your child’s unearned income.

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Brandi Fruik is a manager in Clark Nuber’s tax practice. She serves closely held entities and high net worth individuals.

© Clark Nuber PS and Developing News, 2017. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to Clark Nuber PS and Developing News with appropriate and specific direction to the original content.

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Articles and Publications

Drop Shippers Beware: Should you be Collecting Sales Tax?

Generally, sales for resale are not subject to state and local sales taxes - provided that a purchaser supplies proper exemption documentation. As a result, wholesalers who deliver taxable products directly to their customer’s customer do not typically worry about collecting sales or use taxes. This is because they assume their customer can give a valid resale certificate. But, as explained below, that is not always the case. Figuring out when a purchaser can give a resale certificate can be challenging. No more so than in the case of a drop shipment. States’ sales tax rules on drop shipments can be complex, depending on the locations and circumstances of the parties involved. Failure to comply with these rules can lead to an expensive surprise on audit. A typical drop shipment transaction involves at least two sales. First, a consumer purchases a product from a retailer who does not have the product on hand. In order to fulfil the sale to the consumer, the retailer places an order for the product with a supplier, along with instructions to ship the product directly to the consumer. Drop shipment transactions may involve multiple intermediate sales, where someone in the supply chain ships the product directly to someone other than their customer. If the supplier has a taxable presence, or “nexus,” in the destination state and the product is taxable there, the supplier will want to collect a resale certificate (or similar exemption documentation) from its customer. The question then arises as to whether the customer can give a valid resale certificate to the supplier. If the supplier’s customer is registered in the destination state, the supplier should have no difficulty obtaining a valid certificate. However, what happens if the customer is not registered in the destination state? Can the customer give valid resale documentation? This is where the rules can get tricky. States have lost significant revenue from being unable to require that out-of-state retailers collect and remit sales tax. Consequently, some states have reacted by shifting collection obligations to suppliers that make drop shipments when they are registered, or do business, in those states. The complexities involved in determining the taxability of drop shipments are due to state nexus considerations. Generally, nexus with a state exists when a business has a physical presence in the state.  The state may then legally impose sales tax reporting and/or collection obligations on the business. Typically, an out-of-state supplier will have sales tax nexus in a state if they have a business location or an employee in the state. However, merely sending independent salespersons into the state, or engaging in other types of promotional activities, is enough. The following is a common example of how the rules apply to multi-state suppliers. Suppose a consumer in Connecticut purchases a product from a retailer located in Georgia. Suppose that retailer purchases the product at wholesale from a supplier located in Washington, who drop ships the product directly to Connecticut. The Washington supplier is registered for sales tax purposes in both Connecticut and Georgia.

Drop shipment graphic

  Under all states’ sales tax laws, an interstate sale of goods is deemed to occur at the shipment destination. Therefore, both the retail and wholesale sales in our example are considered Connecticut sales. Here are the questions to consider:
  • Since the product never ships to the Georgia retailer, should the supplier obtain resale documentation from the retailer pursuant to Connecticut’s rules, or Georgia’s rules?

Resale documentation usually includes a resale certificate, or permit number, issued by a state. During an audit, the supplier takes on the burden of showing that they collected “proper” resale documentation. What is considered “proper” varies by state.

Often, a retailer will do business in a number of states. This mean that the supplier should obtain the appropriate documentation for the state in which the sale occurs. In our example, that state would be Connecticut. While some states allow suppliers to accept retailers’ home-state resale certificates (Georgia in our example), some do not.

Further, more than twenty states that are members of the Streamlined Sales and Use Tax Agreement accept a “SST Exemption Certificate” to document resales. Washington allows suppliers to accept a valid reseller permit issued by the state, an SST Exemption Certificate, and certain other documents under appropriate circumstances.

  • Suppose the retailer does not have nexus in Connecticut and does not collect sales tax from the consumer. Since the supplier is registered in Connecticut, do they have an obligation to collect sales tax and remit it to Connecticut?

The answer is yes; the supplier must collect sales tax from the retailer. This is because, under Connecticut law, the supplier may only take a valid resale certificate from a retailer registered in Connecticut. In this way, Connecticut insures the sales tax will be collected and remitted to the state. This is the case in a number of other states as well.

  • If the supplier has an obligation to collect sales tax, is it collected from the retailer or the purchaser? Further, should sales tax be calculated based on the price of the wholesale sale, or the retail sale?

The majority of states, including Connecticut, require suppliers to collect sales tax from retailers based on retail prices, if known, or based on wholesale prices if retail prices are unavailable.

In the case of California drop shipments, the drop shipper is liable for sales tax based on the retail selling price. If the drop shipper does not know the retail price, California tax regulations provide a safe harbor that allows suppliers to calculate the amount of the tax due, based on a 10% markup of the wholesale price.

In summary, while the structure of a multi-state drop shipment may be simple, the sales tax consequences are complex.

In addition to dealing with resale documentation issues, suppliers making drop shipments must also be aware of, and comply with, the various tax collection requirements in each state.

Given the complexities involved, we encourage suppliers to contact their tax advisor or Clark Nuber for assistance in complying with each state’s drop shipment rules.

© 2017 Clark Nuber PS All Rights Reserved

Appeals Decision Creates Refund Opportunity for Investors in California Limited Liability Companies

In January 2017, the California Court of Appeals held in Swart Enterprises, Inc. v. Franchise Tax Board that an out-of-state C corporation could not be required to file a California franchise tax return and pay the $800 minimum tax merely because it held a 0.2% interest in a manager-managed LLC that operated in the state. In its decision, the appellate court compared this passive investment to a limited partner interest in a California partnership, which California courts have previously held does not create a taxable presence for the limited partner. On February 28, 2017, the California Franchise Tax Board announced it would not appeal the Swart decision and would issue refunds for prior years, where appropriate.  We expect a substantial number of refund claims to be filed because California has historically been aggressive in enforcing the filing requirement on out-of-state companies with ownership interests in California LLCs. Although the taxpayer in Swart is a C corporation, it appears the court’s logic could apply equally to California’s $800 LLC tax.  Where a parent or intermediate-tier LLC is not doing business in California in its own right and merely holds a non-manager interest in a lower-tier LLC doing business in the state, we question whether the LLC tax can still be imposed. Questions Remain Although it is a good outcome and a well-reasoned decision, there are several questions left unanswered by the court:

1. Does the ownership percentage matter? The Swart taxpayer owned only a 0.2% interest, but once we accept the Court’s logic that a company is not “doing business” in California simply by holding a passive investment in a California LLC, shouldn’t the same conclusion result even if the out-of-state member owns a 99% interest?

2. How important is it that the LLC’s operating agreement in Swart delegated “full, exclusive and complete authority in the management and control of the business” to the third-party manager? If the investor had participated in making major decisions for the LLC (but ceded authority to the manager on day-to-day operational issues), would the investor have been “doing business” in California?

3. Could the court’s ruling be extended to nonresident, non-managing LLC members whose California tax would exceed the $800 minimum? If so, the potential refunds (and the number of affected taxpayers) would increase substantially.

While we don’t yet have answers to all the questions, it is clear that, for investors matching the Swart fact pattern, California’s reviled $800 annual tax should thankfully become a thing of the past. Please contact Clark Nuber or your state tax professional if you would like more information about this decision or to discuss if it could affect your specific situation. © 2017 Clark Nuber PS All Rights Reserved

Proposed Changes to Employee Benefit Plan Annual Reporting

Filing a Form 5500, along with any required schedules and attachments, typically satisfies the annual reporting requirement. The Form 5500 is the primary source of information about a plan’s financial condition and operations. Federal agencies use this important tool to determine compliance and enforcement initiatives. Last July, the Department of Labor (DOL), IRS, and the Pension Benefit Guaranty Corporation (PBGC) proposed changes to employee benefit plan annual reporting. These new regulations would update and expand Form 5500 reporting requirements. The proposed changes would increase the amount of information reported, as well as the time needed to request, collect, and accurately present this information on the Form 5500. Why the proposed revisions? According to the DOL, the proposed revisions are intended to:
  • Update/modernize employee benefit plan financial statements and investment information;
  • Update reporting requirements for service provider fee and expense information. Specifically, these regulations would represent an attempt to synchronize annual reporting requirements on Schedule C of Form 5500 with the DOL’s service provider fee disclosures under Section 408(b)(2);
  • Enhance the government’s ability to access and use data included in Form 5500 for research, policy analysis, and enforcement purposes;
  • Require reporting by all group health plans covered by Title I of ERISA; and
  • Improve compliance under ERISA and the IRC, through new questions about plan operations, service provider relationships, and financial management of the plan.
The proposed regulations would enable group health plans to use Form 5500 to meet specified reporting requirements in the Affordable Care Act (ACA). According to the DOL, proposed changes to the regulations are necessary for implementing the form revisions. The proposed revisions would also affect small plans that are filing a Form 5500-SF, Short Form Annual Return/Report of Small Employee Benefit Plan. For example, they would be required to disclose detailed information regarding the types of investments held. Under the proposal, form revisions would apply to plan years beginning on or after January 1, 2019. These revisions would affect employee pension and welfare benefit plans, as well as plan sponsors, administrators, and service providers. In the DOL release, Phyllis C. Borzi, Assistant Secretary for the Employee Benefits Security Administration, said, The proposed form changes and related regulatory amendments are important steps toward improving this critical enforcement, research, and public disclosure tool. The 5500 is in serious need of updates to continue to keep pace with changing conditions in the employee benefit plan and financial market sectors. We must also remedy the form’s current gaps in collecting data from ERISA group health plans.

Concluding Thoughts

Although the proposed revisions will likely be subject to changes based on feedback from various stakeholders, the new Form 5500 will require more time and resources to complete. Plan sponsors and their service providers should consider whether they have the systems in place to capture the information needed. Expanded data collection will assist federal agencies in research and policymaking objectives, and may also help plan sponsors and fiduciaries better understand their plans and plan investments. If you need additional information about employee benefit plan reporting, please contact us at info@clarknuber.com. © 2017 Clark Nuber PS All Rights Reserved

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