Tax Law and Business Organization Strategy

Highlights of Tax Changes Becoming Effective in 2012

Jack Howell — Thu, 05 Jan 2012 11:27:29 -0600

There are many important tax changes taking effect in 2012, as well as some that took effect late last year and thus are “new.” They are the result of tax legislation enacted in prior years, or are triggered by effective dates in regs, rulings and other guidance, or will occur by default in 2012 absent Congressional action. The following is a list derived from Checkpoint of the key non-inflation-indexed tax changes, categorized by those affecting businesses and individuals. In addition, a list of provisions that expired at the end of last year is provided.

Business and retirement plan changes taking effect in 2012 and late 2011. Business changes effective in 2012 (or went into effect in December of 2011 and are thus “new”), include the following:

New guidance on deduction vs. capitalization of tangible property costs. IRS has issued temporary regs, generally effective in tax years beginning after 2011, on the application of Code Sec. 162(a) and Code Sec. 263(a) to amounts paid to acquire, produce, or improve tangible property. Among other things, these new regs clarify and expand the standards in the current regs; provide certain new bright-line tests for applying these standards; provide guidance under Code Sec. 168 regarding the accounting for, and dispositions of, property subject to that section; and amend the general asset account regs.
Basis reporting requirements. The complex stock basis and character reporting rules under Code Sec. 6045(g) apply to shares in a regulated investment company (RIC, i.e., a mutual fund), or stock acquired in connection with a dividend reinvestment plan (DRP), if acquired after 2011.
Estimated taxes for large corporations. For a corporation with assets of at least $1,000,000,000 (determined as of the end of the previous tax year), the amount of any required installment of corporate estimated tax which is otherwise due in July, Aug. or Sept. of 2012 is 100.5% of that amount, and the amount of the next required installment after the installment due in July, Aug. or Sept. of 2012 is appropriately reduced to reflect the amount of the 0.5% increase.
Use of smartcards or other electronic media to provide qualified transportation fringes. Beginning in 2012, after numerous postponements, the rules under which employers can provide their employees with qualified mass transit fringe benefits through the use of employer-provided credit cards, debit cards, smartcards, or other electronic media officially go into effect (although employers could rely on the guidance before 2012).
Lump-sum payouts from defined benefit plans. Some defined benefit plans offer participants the option of receiving a lump-sum distribution (e.g., at age 65) instead of an annuity. For plan years beginning after 2007, the Pension Protection Act of 2006 (PPA, P.L. 109-280) amended Code Sec. 417(e)(3) to require defined benefit plans to compute the minimum lump-sum value of an annuity using blended corporate bond rates instead of 30-year Treasury bond rates, which were the benchmark under prior law. Because corporate bond rates generally are higher than long-term Treasury bond rates, the change had the overall effect of reducing lump-sum distributions. Under Code Sec. 417(e)(3), this new rule was phased in over 2008 through 2011 and will be fully in effect for plan years beginning after 2011.
Hybrid defined benefit plan regs. Regs that set forth the exclusive list of interest crediting rates and combinations of interest crediting rates that satisfy the market rate of return requirement for hybrid plans, apply to plan years that begin on or after Jan. 1, 2012. For plan years that begin before Jan. 1, 2012, statutory hybrid plans could use a rate that is permissible under the final regs, or the 2010 proposed regs.
“Readily tradable” employer securities. For purposes of meeting Code Sec. 401(a)(35)'s diversification requirements for defined benefit contribution plans, generally effective for plan years beginning on or after Jan. 1, 2012, employer securities that are “readily tradable on an established securities market” and “readily tradable on an established market” mean employer securities that are readily tradable on an established securities market under Reg. § 1.401(a)(35)-1(f)(5).
Community health needs assessment mandatory. To qualify as tax-exempt, for tax years after Mar. 23, 2012, under Code Sec. 501(r)(3), charitable hospital organizations will need to (i) conduct a community health needs assessment during the tax year or in either of the two tax years immediately preceding the tax year, and (ii) adopt an implementation strategy to meet the community health needs identified therein.
Work opportunity tax credit (WOTC) not available except for hiring qualified veterans. The WOTC under Code Sec. 51 generally can't be claimed for an individual who begins work for the employer after Dec. 31, 2011. However, the WOTC continues to be available for employers that hire qualified veterans who began work for the employer before Jan. 1, 2013.
Disregarded entities included in rules for conduit financing arrangements. Effective for payments made after Dec. 8, 2011, transactions that a disregarded entity enters into are taken into account in determining whether a financing arrangement exists and should be recharacterized under Code Sec. 7701(l) and Reg. § 1.881-3.
Longer writeoff period for certain property. For specialized realty assets (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) placed in service after 2011, a 39-year (up from 15-year) writeoff period generally applies.
Reduced bonus depreciation allowance for qualified property. For qualified property acquired and placed in service after 2011 and before 2013 (after 2012 and before 2014 for aircraft and certain long-production period property), a 50% (down from 100%) bonus first-year depreciation allowance applies under Code Sec. 168(k).
Reduced expensing. For a tax year beginning in 2012, the Code Sec. 179 expensing election is reduced to $139,000, with a $560,000 investment-based ceiling (down from $500,000/$2 million). For tax years beginning after 2012, it will be further reduced to $25,000 with a $200,000 investment-based ceiling. Additionally for a tax year beginning after 2011, expensing can no longer be claimed for qualified real property.

Individual changes taking effect in 2012. Individual changes that apply in 2012 include the following. Note that Congress may retroactively amend one or more of these rules:

Reduced alternative minimum tax (AMT) exemption amounts. Absent another AMT “patch,” the AMT exemption amounts for tax years beginning after 2011 revert to the significantly lower “permanent” amounts of $33,750 for unmarried taxpayers, $45,000 for joint filers, and $22,500 for marrieds filing separately.
Reduced adoption credit. For 2012, the total expenses that may be taken as a credit for all tax years with respect to the adoption of a child by the taxpayer will be limited to $12,650 (down from $13,360 for 2011), and the credit for the adoption of a special-needs child will also be $12,650 (down from $13,360 for 2011). Furthermore, the adoption credit will no longer be refundable.
No parity for exclusion from income for employer-provided mass transit and parking benefits. For 2012, unless Congress changes the rules, the exclusion for qualified parking rises from $230 to $240 due to an inflation adjustment, but falls from $230 to $125 for employer-provided transit and vanpooling benefits.
Protective claims for estate tax refunds. For estates of decedents dying after 2011, a Code Sec. 2053 protective claim for refund of estate tax must be filed by either: (i) attaching one or more completed Schedules PC to the estate's Form 706 at the time the return is filed; or (ii) filing a Form 843 with the IRS office where the Form 706 for the decedent's estate was previously filed, with the notation “Protective Claim for Refund under Section 2053” entered across the top of page 1 of the Form 843.
Reporting foreign assets. Beginning in 2012, U.S. taxpayers who have an interest in certain specified foreign financial assets with an aggregate value exceeding $50,000 must report those assets to IRS on Form 8938, Statement of Specified Foreign Financial Assets, with their tax return.

Provisions that expired on Dec. 31, 2011. The following business and individual provisions expired at the end of last year. Note that Congress may retroactively reinstate some or all of these rules:

7-year straight line cost recovery period for motorsports entertainment complexes under Code Sec. 168(i)(15)(D)
Accelerated depreciation for qualified Indian reservation property under Code Sec. 168(j)
Election to expense 50% of the cost of advanced mine safety equipment under Code Sec. 179E(g)
Election to expense production costs of qualified film and television products in the U.S. under Code Sec. 181(f)
Election to expense environmental remediation costs under Code Sec. 198(h)
Research credit under Code Sec. 41(h)(1)(B)
Income tax credits for biodiesel and renewable diesel under Code Sec. 40A
Alternative fuel and fuel mixture tax credits under Code Sec. 6426(d)(5) and Code Sec. 6426(e)(3)
Indian employment credit under Code Sec. 45A(f)
New markets tax credit under Code Sec. 45D
Railroad track maintenance credit under Code Sec. 45G(f)
Credit for construction of new energy efficient homes under Code Sec. 45L
Energy efficient appliance credit under Code Sec. 45M)
Mine rescue team training credit under Code Sec. 45N(e)
Enhanced charitable deduction for contributions of food inventory under Code Sec. 170(e)(3)(C)
Enhanced charitable deduction for contributions of book inventories to public schools under Code Sec. 170(e)(3)(D)
Enhanced deduction for corporate contributions of computer equipment for educational purposes under Code Sec. 170(e)(6)(G)
Empowerment Zone tax breaks under Code Sec. 1391, Code Sec. 1394, Code Sec. 1396, Code Sec. 179, and Code Sec. 1397B
District of Columbia Enterprise Zone (DC Zone) tax breaks under Code Sec. 1400(f), Code Sec. 1400A(b), and Code Sec. 1400B(b)(2)(A)(i)
The inclusion of Puerto Rico as “within the U.S.” for purposes of determining a taxpayer's domestic production gross receipts (DPGR) under Code Sec. 199(d)(8)(C)
The election to defer gain on sales of qualifying electric transmission property under Code Sec. 451(i)
The exclusion from a tax-exempt organization's unrelated business taxable income (UBTI) of interest, rent, royalties, and annuities paid to it from a controlled entity under Code Sec. 512(b)(13)(E)(iv)
The suspension of income limitations on percentage depletion for marginal wells under Code Sec. 613A(c)(6)(H)(ii)
The ability of a RIC to designate all or a portion of a dividend as an “interest-related dividend” under Code Sec. 871(k)(1)(C) and Code Sec. 871(k)(2)(C)
Inclusion of a RIC in the definition of a “qualified investment entity” under Code Sec. 897(h)(4)
Lower shareholder basis adjustments for charitable contributions by S corporations under Code Sec. 1367(a)
Reduced S corporation recognition period for built-in gains tax under Code Sec. 1374(d)(7)
Exception under subpart F for certain income from the active conduct of a banking or similar business under Code Sec. 953(e)(10) and Code Sec. 954(h)(9)
Look-through treatment for payments between related controlled foreign corporations (CFCs) under the foreign personal holding company rules under Code Sec. 954(c)(6)
The increased limit on cover over of rum excise taxes to Puerto Rico and the Virgin Islands under Code Sec. 7652(f)
Election for itemizers to deduct State and local general sales taxes under Code Sec. 164(b)(5) in lieu of a state and local income taxes
Above-the-line deduction for qualified tuition and related expenses under Code Sec. 222
Treatment of mortgage insurance premiums as qualified residence interest under Code Sec. 163(h)(3)(E)
Above-the-line deduction for up to $250 of certain expenses of elementary and secondary school teachers under Code Sec. 62
Nonbusiness energy property credit under Code Sec. 25C
Tax credit for first-time District of Columbia homebuyers under Code Sec. 1400C(i)
Adoption assistance programs under Code Sec. 137
Allowance of personal tax credits against regular tax and AMT under Code Sec. 26(a)(2)
Exclusion of 100% of gain on certain small business stock under Code Sec. 1202(a)(4)
Tax-free distributions (up to $100,000 annually for taxpayers 70- 1/2 and older) from individual retirement plans for charitable purposes under Code Sec. 408(d)(8)
Special rules to encourage contributions of capital gain real property for conservation purposes under Code Sec. 170(b)(1)(E) and Code Sec. 170(b)(2)(B)
Look-through treatment of certain RIC stock in determining nonresidents' gross estates under Code Sec. 2105(d)

How Today's Low Interest Rates Affect Tax and Estate Planning

Jack Howell — Thu, 13 Oct 2011 15:21:34 -0600

Interest rates have dropped significantly in recent months and may remain low given the state of the economy. Sagging rates can have a significant impact on many tax and estate planning strategies. Lower interest rates affect the income, estate, and gift tax values of many types of transfers. In many cases, the drop in rates produces more favorable results for persons engaging in certain types of transactions. In other cases, however, the lower rates result in higher tax costs. This post examines how low interest rates affect key tax and estate planning transactions and strategies.

IRS valuation tables.

The value of annuities (other than commercial annuities), life estates, term interests, remainders, and reversions for estate, gift, and income tax purposes is determined using tables issued by IRS under Code Sec. 7520. The value in a given month under the tables may be higher or lower than the value in an earlier or later month because the interest factor under the tables changes monthly. For charitable transfers, the interest rate for the month of the transfer or for either of the two preceding months may be used. (Code Sec. 7520(a))

The Code Sec. 7520 interest rate for October 2011 is 1.4%. (Rev Rul 2011-22, 2011-41 IRB) The 1.4% interest rate is an all-time low. The all-time high was 11.6%.

How low rates affect various noncharitable planning strategies.

The discussion that follows explains various noncharitable financial and estate planning strategies and shows how they stack up under current falling rates.

Grantor retained annuity trust (GRAT). An individual can save transfer tax by setting up a GRAT. The individual retains an annuity interest for a specified term at the expiration of which the trust property goes to a child or other individual named at the outset. Gift tax is payable but only on the present value of the remainder interest, which is the value of the property transferred to the trust less the value of the retained annuity interest. A lower interest rate increases the value of the annuity retained by the grantor and thus reduces the value of the gift of the remainder in a GRAT.

The post-transfer appreciation in the value of the trust assets will escape transfer tax. However, this is so only if the grantor survives the trust term. If the grantor dies during the trust term, at least a portion of the trust property will be included in his gross estate under Code Sec. 2036(a), which provides that property transferred by an individual during his lifetime is includible in his estate if he retains an interest for any period that does not in fact end before his death. In 2008, IRS issued regs for determining the extent to which the trust property would be included in a situation like this and in 2009, issued proposed regs that would fine-tune the rules in the final regs. In any event, an individual who sets up a GRAT and dies before the end of the term would be no worse off than if he had not entered into the transaction except that he will have incurred the costs of setting up and administering the trust.

Illustration: When the Code Sec. 7520 interest factor is 1.4%, Smith transfers $1 million to a trust, which is to pay him an annual annuity of $80,000 for 10 years. At the end of the 10 years, the trust property is to go to Smith's daughter. The value of Smith's retained annuity is $741,696. This figure is determined by multiplying $80,000 by 9.2712, which is the annuity factor for a 10-year term and an interest rate of 1.4%. The value of the gift of the remainder to Smith's daughter is $258,304.

By way of comparison, if the interest factor were 5.0%, the value of the retained annuity would be $617,736 ($80,000 times 7.7217) and the value of the gift would be $382,264.

Grantor retained income trust (GRIT). A GRIT is like a GRAT, except that the grantor retains an income interest instead of an annuity interest. Code Sec. 2702 generally treats the grantor as making a gift of the full value of the property. However, the value of the gift of the remainder is determined under the valuation tables where the trust is funded with a personal residence of the grantor or the remainder goes to someone falling outside of the definition of a family member, such as a nephew or niece. A lower interest rate results in a lower value for the retained interest and a higher value for the gift of the remainder interest in a residence GRIT or other GRIT excepted from the Code Sec. 2702 rules.

Illustration: When the Code Sec. 7520 interest factor is 1.4%, Bailey establishes a personal residence GRIT, retaining a 10-year term interest. At the end of the 10-year period, the residence is to go to his son. The value of the residence at the time of the initial transfer to the trust is $400,000. The remainder factor is .870203, making the value of the gift $348,081.

By way of comparison, if the interest factor were 5.0%, the value of the gift would be $245,565 ($400,000 times .613913).

A higher rate produces a better result for this strategy. Accordingly, a person may want to wait until interest rates rise before engaging in this type of transaction.

Grantor retained unitrust (GRUT). The interest factor does not affect the value of a gift of a remainder interest in a GRUT because the retained unitrust interest is the right to receive a fixed percentage of the trust's assets, and changes in rates inure uniformly to the benefit of the unitrust holder and the remainderperson.

Private annuity. Historically, private annuities have offered a number of income, gift, and estate tax advantages. They also can save estate administration expenses and offer other nontax advantages as well. In the typical private annuity transaction, a parent transfers property to his child in return for that child's unsecured promise to pay the parent a fixed, periodic income for life. If the fair market value of the property transferred equals the present value of the annuity under the Code Sec. 7520 valuation tables, there is no gift tax due.

Historically, one huge advantage of a private annuity has been the opportunity to transfer highly appreciated property and defer the gain over several years as annuity payments are received. Additionally, there was the possibility of being taxed on less than the entire gain if the annuitant died before the expiration of his tabular life expectancy. However, in 2006, IRS issued proposed regs that would knock out the income tax advantages of selling appreciated property in exchange for a private annuity. It would do this by causing the property seller's gain to be recognized in the year the transaction is effected rather than as payments are received. The regs generally would apply for transactions entered into after Oct. 18, 2006. However, certain transactions effected before Apr. 19, 2007 would continue to be subject to the historical rules.

Entering into a private annuity when interest rates are lower results in a lower annual payment amount that the younger family member will have to make to the older family member to prevent a gift from arising on the transfer.

Illustration: In October 2011, when the Code Sec. 7520 interest factor is 1.4%, Jones, age 70, transfers property worth $1 million to his daughter in exchange for a private annuity. She must make an annual payment of $79,879.22 to prevent a gift from arising on the transfer. This figure is determined by dividing $1 million by 12.5189, which is the annuity factor from Table S for a 70-year old and an interest rate of 1.4%.

By way of comparison, if the interest factor were 5.0%, the annual payment to prevent a gift would be $107,319.16 ($1 million divided by 9.3180).

A private annuity may be a good strategy for an individual with a short life expectancy who is not expected to survive for too many years. However, the mortality component of the valuation tables cannot be used to determine the present value of an annuity if the person with the measuring life is terminally ill when the gift is completed. Under Reg. § 25.7520-3(b)(3), an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50% probability that he will die within one year.

Someone who is considering setting up a private annuity may want to fund it with stock valued near its original purchase price. Such stock may be a good candidate for funding a private annuity because there would be little or no gain to report in the year of the transfer under the proposed regs, if they take effect. Also, if the stock takes off, the transaction could achieve considerable transfer tax savings. That's because the child will end up with a sizeable amount of property with no gift or estate tax cost imposed on the post-transfer appreciation in its value.

How low rates affect various charitable planning strategies.

The discussion that follows explains various charitable planning strategies and shows how they stack up under current declining rates.

Charitable remainder annuity trust (CRAT). With a CRAT, the donor retains an annuity interest for himself or someone else such as a family member and names a charity to receive the remainder at the end of the annuity term. The donor gets a current income tax deduction for the present value of the charity's remainder interest. Now may not be a good time to establish a CRAT. That's because a lower interest rate produces smaller income, gift and estate tax charitable deductions and a higher gift tax value for a gifted annuity interest.

Charitable remainder unitrust (CRUT). A change in the rate does not affect income tax deductions for CRUTs or gift tax costs in connection with them.

Charitable lead unitrust (CLUT). Estate and gift tax factors are essentially unaffected by changes in the rates.

Charitable lead annuity trust (CLAT). A lower interest rate results in a larger gift or estate tax deduction for the annuity interest going to the charity and a smaller value for any gift of the remainder interest going to a private beneficiary. Thus, it may be a good time to establish a CLAT if the grantor is going to give the remainder interest to a family member.

Charitable transfer of remainder interest in residence or farm. A lower interest rate provides higher income, estate and gift tax deductions for a transfer of a remainder interest in a residence or farm. Conversely, a higher interest rate provides lower income, estate and gift tax deductions for a transfer of a remainder interest in a residence or farm.

Pooled income funds in existence for more than 3 years. Charitable income, gift and estate tax deductions for transfers to pooled income funds that have been in existence for more than three years are not affected by changes in interest rates because values of respective interests are determined with reference to the funds' own rates of return. Any personal gift arising from the transfer also is not affected.

Convert Your Limited Partnership into a Limited LIability Limited Partnership

Jack Howell — Mon, 29 Aug 2011 13:28:59 -0600

The Texas Legislature made several changes to the Texas Business Organizations Code (BOC) that become effective September 1, 2011. Several of these changes deal with limited liability partnerships. I have, until now, not advised my clients to make use of the limited liability partnership provisions in the BOC because of their administrative difficulties and questionable liability protections. Those impediments have been removed. So, I am now advising my limited partnership and general partnership clients to take advantage of the limited liability partnership provisions unless the annual filing fees prove to outweigh the liability protections offered to LLPs and LLLPs.

Details of Law Changes

Before September 1, 2011, the Texas Business Organizations Code (BOC) required limited liability partnerships, as a condition to their registration, to provide evidence of $100,000 of liability insurance or a $100,000 cash deposit, bank letter of credit or insurance company bond. No other states with limited liability partnership statutes have a similar requirement nor are there
similar insurance requirements in the Uniform Partnership Act (1997) or the current limited liability partnership statutes of most jurisdictions. The BOC does not require any other type of business entity or professional entity (i.e., professional corporation, professional association or
professional limited liability company) to satisfy a similar insurance requirement. The insurance requirement under the BOC cause limited liability partnerships in Texas to suffer a disadvantage compared to limited liability partnerships formed in other states and other types of business entities formed in Texas. For the foregoing reasons, the Texas legislature repealed the insurance requirement imposed on LLPs and LLLPs by the BOC.

Before September 1, 2011, the BOC detailed the circumstances when a partner in a limited liability partnership is liable for an error, omission, negligence, incompetence, or malfeasance of another partner or representative of the partnership. Those provisions specified that a partner could be liable if the partner

was supervising or directing the responsible partner or representative or was directly involved in the specific activity in which the error, omission, negligence, incompetence or malfeasance was committed or
had notice or knowledge of such error, omission, negligence, incompetence or malfeasance by the responsible partner or representative and failed to take reasonable action to prevent or cure the error, omission, negligence, incompetence or malfeasance.

As a result, these Code provisions more closely conform to the approach taken in the Uniform Partnership Act (1997) and the trend in other jurisdictions. The legislature determined that the specified provisions are not found in the uniform law or the statutes of most other jurisdictions and are not considered necessary in view of the principle that a partner is usually liable for the partner’s own tortious conduct.

Impact of Law Changes

From a practical standpoint, these changes are significant. Let’s take the example of a “typical” limited partnership. That limited partnership will have a single general partner that is itself some type of limited liability entity, such as a limited liability company or a corporation. The general partner will have a small interest in the limited partnership (maybe even no interest after other recent changes to the BOC regarding “zero percent” general partners). That general partner will also probably have little or no assets other than whatever interest it may own in the limited partnership. But the general partner, by law, has unlimited liability for limited partnership liabilities that exceed the assets of the limited partnership. It is for this very reason that the entity to serve as a general partner was formed in order to protect the management and ownership of the general partner for the liabilities that the limited partnership might generate.

I am, therefore, advising my clients to form limited liability limited partnerships (LLLPs) instead of simply limited partnerships (LPs) in the circumstances that I would have before advised forming an LP. I also think that existing LPs should change into LLLPs. $200 per year in filing fees seems a small price to pay to get the added layer of protection for their general partner and to head off claims asserting the piercing of the liability veil of the general partner.

What to do

If you are interested in changing your LP into an LLLP, contact me and I will explain in more detail the process involved and its cost.

Make Sure Your Compensation Plans Are in Order and Documented

Jack Howell — Mon, 08 Aug 2011 13:52:30 -0600

I recently finished resolving a dispute between a client and the IRS regarding the amount of compensation for the founder and owner of a corporation. While the amount of compensation during one of the years at issues was probably unjustifiably high if viewed by itself, the person's compensation over the years (and including the year in dispute) was readily justifiable when viewed over the entire period that the person worked for the business. We ended up resolving the dispute and the resolution was within $50,000 in compensation from my initial evaluation of the case. But it was an expensive "victory" for the client.

The strongest point for the IRS, and the reason it took as much time and expense to resolve, was the client’s lack of documentation of a consistently applied compensation plan. The client had annual minutes (which many clients do not), but those minutes did not address how the owner’s compensation was determined. The client also did not have a written employment agreement, nor did they have any written (or “understood”) basis for calculating the client’s incentive compensation each year. This lack of a consciously determined pattern to the compensation ended up costing the client several thousand dollars in attorneys fees, and a like amount in additional taxes.

The moral of the story: properly pay and report compensation to employee/owners as such; have a written employment agreement or at least some sort of documentation in your minutes of the oral arrangements for compensation; make sure you have a documented or easily proved method for determining incentive compensation that is reasonable in amount.

IRS Instructs Examiners How to Seek Approval to Apply Economic Substance Doctrine

Jack Howell — Mon, 08 Aug 2011 13:39:56 -0600

In a July 15th directive from IRS's Large Business & International (LB&I) Division, the IRS issued guidance to managers and examiners on when to seek the approval of the Director of Field Operations (DFO) for asserting the economic substance doctrine. The directive lays out a multi-step analysis for examiners to complete before submitting their requests to the DFO.

Background on Economic Substance.

For transactions entered into after Mar. 30, 2010, and for underpayments, understatements, and refunds and credits attributable to transactions entered into after Mar. 30, 2010, a transaction to which the economic substance doctrine is relevant is treated as having economic substance under a conjunctive two-prong test only if—apart from Federal income tax effects—both:

the transaction changes in a meaningful way the taxpayer's economic position (Code Sec. 7701(o)(1)(A)); and
the taxpayer has a substantial purpose for entering into the transaction. (Code Sec. 7701(o)(1)(B)) -- that is, the taxpayer's non-Federal-income-tax purpose for entering into a transaction must be “substantial.”

Background on Penalties.

For underpayments attributable to transactions entered into after Mar. 30, 2010, a 20% strict liability penalty applies to an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (as defined in Code Sec. 7701(o)), or failing to meet the requirements of any similar rule of law. (Code Sec. 6662(b)(6)) The penalty rate is increased to 40% if the taxpayer doesn't adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return. (Code Sec. 6662(i)(1)) Code Sec. 6664 's reasonable cause exception doesn't apply to the Code Sec. 6662(b)(6) penalty. (Code Sec. 6664(c)(2)) Additionally, a maximum 20% strict liability penalty under Code Sec. 6676 also applies to refund claims based on any transaction described in Code Sec. 6662(b)(6).

IRS’ Guidance.

The new LB&I directive provides instructions to examiners and their managers on determining when to seek the approval of the DFO in order to raise the economic substance doctrine. This approval was mandated by a prior LB&I directive designed to ensure consistent application of the associated strict liability penalty.

Once an examiner determines that raising the doctrine might be warranted, the directive sets out a series of four steps that the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

1. The examiner must determine whether the facts and circumstances of a transaction are similar to those listed in the directive that tend to show that application of the economic substance transaction is likely not appropriate. Among the factors indicating that the doctrine is inappropriate are that the transaction is not promoted by a tax department or outside advisors, is not highly structured, is at arm's length with unrelated third parties, and carries a significant risk of loss.

2. The examiner must determine whether the facts and circumstances of a transaction are similar to those listed in the directive that tend to show that application of the economic substance transaction is likely appropriate. These factors include that the transaction includes unnecessary steps, accelerates a loss or duplicates a deduction, has no credible business purpose apart from federal tax benefits, and is outside the taxpayer's ordinary business operations.

3. The examiner must answer each of the following inquiries before seeking the approval of the appropriate DFO to apply the doctrine. If the answer to (i) through (iv) is affirmative, then application of the doctrine should not be pursued without specific approval of the examiner's manager in consultation with local counsel. In answering (v) and (vi), the examiner should seek the advice of his manager in consultation with local counsel.

Is the transaction a statutory or regulatory election?

Is the transaction subject to a detailed statutory or regulatory scheme and, if so, does it comply with this scheme?

Does judicial or administrative precedent exist that either rejects the application of the economic substance doctrine to the type of transaction or a substantially similar transaction, or upholds the transaction without reference to the doctrine?

Does the transaction involve tax credits (e.g., for low-income housing or alternative energy) that are designed by Congress to encourage certain transactions that would not be undertaken but for the credits?

Does another judicial doctrine more appropriately address the noncompliance that is being examined?

Does recharacterizing a transaction more appropriately address the noncompliance that is being examined?

In considering all the arguments available to challenge a claimed tax result, is the application of the doctrine among the strongest arguments available? If not, it shouldn't be pursued without specific approval of the examiner's manager in consultation with local counsel.

4. If an examiner completes the above inquiries and concludes that it is appropriate to seek approval to apply the doctrine, the examiner, in consultation with his manager and territory manager, should describe for the appropriate DFO in writing how the analysis was completed. The DFO should then review the written material provided and consult with counsel. If the DFO believes it is appropriate to approve the request, the DFO should provide the taxpayer an opportunity to explain their position. The DFO should convey the final decision to the examiner in writing.

Individual Steps of Multi-step Transactions.

The directive provides that when a transaction involves a series of interconnected steps with a common objective, the steps are generally viewed together in applying the above guidance. However, in certain circumstances, it may be appropriate to apply this guidance separately to one or more steps that are included within a series of arguably interconnected steps, such as when an integrated transaction includes one or more tax-motivated steps that bear only a minor or incidental relationship to a single common business or financial transaction. If an examiner wants to apply this guidance separately to one or more steps with a common objective, the examiner must first seek guidance from their manager and consult with their local counsel.

Taxpayer Notification.

An examiner should notify a taxpayer that he is considering whether to apply the economic substance doctrine to a particular transaction as soon as possible, but not later than when the examiner begins the four-step analysis.

Penalties Limited to Economic substance Doctrine.

The directive also clarifies that, until further guidance is provided, the penalties under Code Sec. 6662(b)(6) and Code Sec. 6676 are limited solely to the application of the economic substance doctrine. They may not be imposed due to the application of any other similar “rule of law” or judicial doctrine, like the step transaction doctrine or substance over form.

The text of LB&I-4-0711-015 “Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties” can be viewed on the IRS website at http://www.irs.gov/businesses/article/0,,id=242253,00.html.

Form 990: Could yours be front page news?

Mindi Bozeman Zanowiak — Fri, 05 Aug 2011 14:18:09 -0600

One major difference between Form 990 and the tax forms filed by individuals and businesses has to do with privacy and confidentiality. On Form 990, almost nothing (except the list of donors' names) is private or confidential. The financial data of exempt organizations is out there for the world to see—and now that many Web sites carry copies of Forms 990, "the world" is probably not an exaggeration.

Form 990 is prepared for review by the IRS as well as state attorneys general, to whom copies are sent. Others can also be expected to read an organization's Form 990, including:

(1.) Congress, if it is studying an issue to which the organization's Form 990 relates.

(2.) State officials and agencies that perform charitable or regulatory oversight, or enforce state income tax filing requirements.

(3.) Prospective donors and their legal and financial advisors. The $50 donor might not seek out a Form 990, but there is a high probability that the largest donors will.

(4.) Members of the general public who are interested in the programs and accomplishments of an organization, and the efficiency with which it operates.

(5.) News media and researchers seeking information about an organization.

(6.) Self-appointed "watchdog" organizations and others who may be checking up on an organization. These may include competing charities, organizations with opposing policy views, or taxable organizations checking to see whether a tax-exempt organization is providing unfair competition.

(7.) Employees and former employees of the organization.

When completing Form 990, the answers should be prepared as if they may appear on the front page of the local newspaper…they just might!

"Gang of Six" tax proposals

Jack Howell — Wed, 20 Jul 2011 09:18:45 -0600

I don't know about any of you, but I didn't see any specifics mentioned in the news reports yesterday about the tax proposals that are part of the newest compromise proposal to fix the debt ceiling. But I am happy to report that RIA included them this morning in their daily update. Here they are:

A single corporate tax rate between 23% and 29% and shift to a competitive territorial tax system.
Tax simplification that involves reducing the number of tax expenditures (i.e., tax breaks) and reducing individual tax rates. There would be three tax brackets with rates in the range of 8%–12%, 14–22%, and 23%–29%. To the extent future Congresses find that the dynamic effects of tax reform result in additional revenue beyond initial targets, this revenue would go to additional rate reductions and deficit reduction, not to new spending.
Permanent repeal of the alternative minimum tax (AMT).
Reform, rather than elimination, of tax breaks for health, charitable giving, homeownership, and retirement.
Retention of the earned income tax credit and child tax credit, or creation of an alternative that would provide at least the same level of support for qualified beneficiaries.

The bipartisan plan calls for the Senate Finance Committee within six months to report a comprehensive tax reform package using the listed items to deliver “real deficit savings by broadening the tax base, lowering tax rates, and generating economic growth.”

Choosing a Fiduciary-Part II of II

Mindi Bozeman Zanowiak — Fri, 17 Jun 2011 14:10:00 -0600

As you are choosing a fiduciary, it is also important to name successor fiduciaries. What if the executor or trustee you choose is unable or unwilling to serve when the time comes? What if that person is sick, deceased or incapacitated when it comes time for them to serve? What if they move far away, making it difficult to perform important duties?

Because of the issues identified above, it can make sense to consider an institutional fiduciary, like a bank or trust company. Theoretically, a bank or trust company will be around when you need it. Additionally, the bank or trust company should have the resources to redress any errors they make. Most importantly, however, is that they have the infrastructure and processes already in place to perform their duties. Yes, they charge a fee for serving as a fiduciary, but it is often worth the price.

There are no “rules” to follow in making fiduciary appointments. The important thing is to think long and hard about these issues and then make the best decision you can based on the information you have.

Choosing a Fiduciary-Part I of II

Mindi Bozeman Zanowiak — Fri, 10 Jun 2011 08:00:00 -0600

Good estate planning requires serious thought when making "fiduciary" (e.g., power of attorney, executor, and trustee) appointments. Black's Law Dictionary describes a fiduciary relationship as "one founded on trust or confidence reposed by one person in the integrity and fidelity of another." These appointments will dictate who controls, manages and distributes your assets when you are incapacitated or have passed away.

At first glance, it may seem that choosing a fiduciary is a simple decision. Married couples often name each other to serve as agents under powers of attorney, as executor and as trustee. It is also common to appoint the eldest child, a family member, or a close friend to the position. Contrary to what many people think, however, it's not just an "honor" to serve as someone's fiduciary- it's actually a lot of hard work. Additionally, executors and trustees have "fiduciary duties" (the highest duties imposed by law) and can be held legally liable for failing to properly carry them out. Accordingly, it is important that you choose these fiduciaries wisely because they usually have very broad powers which can be easily abused.

Before appointing a fiduciary, consider the following:

Do you trust them completely?
Can they be objective?
Are they financially competent, well organized, and detail-oriented?
Do they have the time?
If you own a business or farm and ranching operation, do they have the time and talent to oversee and operate it?
Are they willing to serve?
Will they mind having their actions scrutinized by the beneficiaries?
Do they have the financial resources to pay for any damages they cause?

The IRS is on the hunt. Are you a target?

Mindi Bozeman Zanowiak — Fri, 03 Jun 2011 08:00:00 -0600

If one thinks the IRS has nothing to do at the estate and gift tax division (because of the increased estate and gift tax exemptions to $5.0 million), think again.

The IRS has begun a hunt for recorded transactions that indicate a gift or gifts by a taxpayer that exceed the annual $13,000 gift tax exclusion. Arden Dale in the Wall Street Journal reported on the IRS’s efforts. A court filing in California described efforts by the IRS estate and gift tax division to find people who have not filed gift and generation-skipping tax returns and reported the taxable transfers. Obvious targets include transfers that may have exceeded the $1.0 million gift tax exemption in calendar year 2010 and prior. States are cooperating with the information requests, including TEXAS, Connecticut, Florida, Hawaii, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Virginia, Washington and Wisconsin. The court filing notes that Josephine Bonaffini, the coordinator of an IRS state and federal gift-and-estate tax program, examined a sampling of data from these states and it showed an extremely high failure-to-report rate.

New tax rules have made big gifts to family members popular this year, as Congress raised the limit on how much a person can give in a lifetime to $5 million without having to pay gift tax. Still, any time a gift to one person exceeds $13,000, the giver is supposed to let the IRS know by reporting such gifts on Form 709.

Turning Startup Profits into 100% Tax-free Gains under the Qualified Small Business Stock Rules

Jack Howell — Mon, 23 May 2011 12:34:37 -0600

Venture capitalists and private equity groups are reportedly taking an interest in structuring startups to qualify under the qualified small business stock (QSBS) provisions of Code Sec. 1202. It's not hard to see why — this often-overlooked Code provision can turn much or all of the profit on a successful investment in a startup into tax-free gain. But time may be of the essence: Under current law, the 100% exclusion won't apply for QSBS acquired after 2011.

Noncorporate taxpayers may exclude from gross income 100% of any gain realized on the sale or exchange of QSBS held for more than five years if the QSBS is acquired after Sept. 27, 2010 and before Jan. 1, 2012. The exclusion is 75% of gain realized on the sale or exchange of QSBS acquired after Feb. 17, 2009 and before Sept. 28, 2010, and 50% of gain realized on the sale or exchange of QSBS acquired either before Feb. 18, 2009, or after Dec. 31, 2011 (but 60% instead of 50% for certain gain attributable to QSBS in a qualified business entity). Excluded gain is subject to a cumulative and annual dollar limitation.

Additionally, the alternative minimum tax (AMT) preference for a portion of gain from the sale or exchange of QSBS that is excluded from gross income for regular tax purposes under Code Sec. 1202 doesn't apply to QSBS acquired after Sept. 27, 2010 and before Jan. 1, 2012.

A noncorporate taxpayer's net capital gain that is adjusted net capital gain is taxed at a maximum rate of 15%. If the adjusted net capital gain would otherwise be taxed at a rate below 25% if it were ordinary income, it is taxed at a zero percent rate. Under current law, these rates are in effect through 2012. Net capital gain attributable to section 1202 gain (as well as collectibles gain) is taxed at a maximum rate of 28%. Section 1202 gain is the excess of (1) the gain that would be excluded from gross income on the sale of certain QSBS under Code Sec. 1202, if the percentage limitations of Code Sec. 1202(a) didn't apply, over (2) the gain actually excluded under Code Sec. 1202.

Qualifying as QSBS. Stock qualifies as QSBS only if it meets all of the following tests.

It must be stock in a C corporation (that is, not S corporation stock) originally issued after Aug. 10, '93.
As of the date the stock was issued, the corporation was a domestic C corporation with total gross assets of $50 million or less (a) at all times after Aug. 9, '93, and before the stock was issued, and (b) immediately after the stock was issued. Gross assets include those of any predecessor of the corporation, and all corporations that are members of the same parent-subsidiary controlled group are treated as one corporation.
In general, the taxpayer must have acquired the stock at its original issue (either directly or through an underwriter), either in exchange for money or other property or as pay for services (other than as an underwriter) to the corporation.
During substantially all the time the taxpayer held the stock:

The corporation was a C corporation;
At least 80% of the value of the corporation's assets were used in the active conduct of one or more qualified businesses; and
The corporation was not a foreign corporation, domestic international sales corporation (DISC), former DISC, regulated investment company (RIC), real estate investment trust (REIT), real estate mortgage investment conduit (REMIC), financial asset securitization investment trust (FASIT), cooperative, or a corporation that has made (or that has a subsidiary that has made) a Code Sec. 936 election.

Active conduct of a qualified business. For purposes of the rule requiring 80% of the value of assets to be used in the conduct of a qualified business, all of the following are treated as used in the active conduct of a qualified business:

Assets used in certain activities with respect to future qualified businesses, without regard to whether the corporation has any gross income from these activities at the time this rule is applied. Those activities are (a) Code Sec. 195(c)(1)(A) startup activities, (b) activities that result in the payment or incurrence of qualifying research and experimental expenditures under Code Sec. 174, and (c) activities with respect to in-house research expenses.
Assets held to meet the reasonably required working capital needs of a qualifying business, and assets held for investment that are reasonably expected to be used within two years to finance research and experimentation in a qualified business or to finance increases in working capital needs of such a business. But, after the corporation has been in existence for at least two years, no more than 50% of its assets may qualify as being used in the active conduct of a qualified business by reason of these rules.
The rights to computer software which produces active business computer software royalties as defined in Code Sec. 543(d)(1)

A corporation will be treated as failing to meet the active business requirement for any period during which: (1) more than 10% of the value of its assets in excess of its liabilities consists of stock or securities in other corporations which are not subsidiaries of the corporation, other than working capital assets; or (2) more than 10% of the total value of its assets consists of real property which is not used in the active conduct of a qualified business (for this purpose, owning, dealing in, or renting real property is not considered to be the active conduct of a qualified business).

Note that a corporation will be treated as meeting the active business requirement for any period during which it is a specialized small business investment company (SSBIC).

Qualified business. For QSBS purposes, a qualified business is one that isn't:

A business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
A banking, insurance, financing, leasing, investing, or similar business.
A farming business (including the raising or harvesting of trees).
A business involving the production of products for which percentage depletion can be claimed.
A business of operating a hotel, motel, restaurant, or similar business.

Dollar limit on eligible gain. For each tax year, for each corporation in which the taxpayer sells or exchanges QSBS, the amount of gain eligible for the exclusion can't exceed the greater of:

$10 million ($5 million for married persons filing separately), less the total amount of eligible gain (i.e., gain on the sale or exchange of QSBS held for more than five years) taken into account under the Code Sec. 1202(a) rules by the taxpayer with respect to dispositions of stock issued by the corporation in all earlier tax years, or
ten times the taxpayer's total adjusted basis in QSBS of the corporation disposed of by the taxpayer in the tax year.

IRS tool makes it easier for employers to keep track of important tax deadlines

Jack Howell — Wed, 16 Mar 2011 08:53:37 -0600

The IRS has a new online tool to make it easier to remember important tax return and deposit deadlines. It's called the “IRS Calendar Connector” and it doesn't cost anything to download it to a computer desktop. The calendar includes deadlines for all types of taxes, including income, employment, and excise taxes. However, employers may customize the calendar to only include deadlines for certain types of taxes. For example, a calendar that was customized to only show employment tax deadlines would display semiweekly and monthly payroll tax deposit due dates and the deadlines for filing employment tax returns. Employers may choose whether they want to see a list of deadlines by day, week, or month. The “settings” option allows users to check for updates, which will refresh in real time. The settings may also be adjusted to have the calendar start up at the time a user logs onto his or her computer.

The “Calendar Connector” may be downloaded at http://www.tax.gov/irscalendarconnector/. In addition, the IRS also has a monthly online calendar on its website at http://www.tax.gov/calendar/, and Publication 509 (http://www.irs.gov/pub/irs-pdf/p509.pdf) that provides tax calendars and deadline dates for 2011.

Obama Wants to Change How All Businesses Are Taxed?

Jack Howell — Mon, 28 Feb 2011 14:22:40 -0600

According to Bloomberg News, Geithner Says Tax Overhaul Must Address Businesses Filing as Individuals. It is not clear from the article exactly what this means. It could mean that the administration wants to impose the same type of taxes on all businesses, whether they are incorporated or not. Or it could be something less sinister. But, in either event, it does look like tax changes will be proposed by the administration to all business taxes, whether they are earned by C corporations or pass-through entities. We'll continue to monitor the situation to find out exactly what the administration has in mind.

Highlights of New Items on 2010 Form 1040

Jack Howell — Wed, 09 Feb 2011 14:18:23 -0600

Politicians say they want to simplify the tax laws; yet they continue to make the law more complicated. This year is no different. The 2010 Form 1040 reflects a number of new tax breaks. Some are straightforward. Others are complex. Some present choices. But they all provide an opportunity to save money.

Here is a list of the key changes for this filing season:

• Roth IRA rollovers no longer restricted. You can now make a qualified rollover contribution to a Roth IRA, regardless of the amount of your modified adjusted gross income.

• Income from Roth rollover can be spread out. Half of any income that results from a rollover or conversion to a Roth IRA from another retirement plan in 2010 is included in income in 2011, and the other half in 2012, unless you elect to include all of it in 2010.

• Self-employed health insurance deduction. Effective March 30, 2010, a self-employed person who paid for health insurance may be able to include in his self-employed health insurance deduction any premiums he paid to cover his child who was under age 27 at the end of 2010, even if the child was not his dependent. Also, health insurance costs for a taxpayer and his family are deductible in computing 2010 self-employment tax.

• Small business health insurance credit. There's a new tax credit for an eligible small employer who makes qualifying contributions to buy health insurance for his employees. This credit is very complex but it can yield substantial tax savings. In general, the credit is 35% of premiums paid and can be taken against regular and alternative minimum tax.

• Limits on personal exemptions and itemized deductions ended. You no longer lose part of your deduction for personal exemptions and itemized deductions, regardless of the amount of your adjusted gross income.

• Personal casualty and theft loss limit reduced. Each personal casualty or theft loss is limited to the excess of the loss over $100 (instead of the $500 limit that applied for 2009). This yields larger deductions and thus greater tax savings for affected individuals.

• Corrosive drywall damage. A taxpayer who paid for repairs to his personal residence or household appliances because of corrosive drywall that was installed between 2001 and 2008 may be able to deduct those amounts as casualty losses under a special safe harbor crafted by the IRS.

• Homebuyer credit. An eligible first-time homebuyer (and a long-term resident treated as a first-time homebuyer) may be able to claim a first-time homebuyer credit for a home that was purchased in 2010. To qualify, the home must have cost $800,000 or less. You generally cannot claim the credit for a home you bought after April 30, 2010. However, you may be able to claim the credit if you entered into a written binding contract before May 1, 2010, to buy the home before July 1, 2010, and actually bought the home before October 1, 2010.

• Adoption credit. The maximum adoption credit is $13,170 per eligible child for both non-special needs adoptions and special needs adoptions. In addition, the adoption credit is refundable, i.e., you get the credit even if it exceeds your taxes.

• Gifts to charity. The provision that excludes up to $100,000 of qualified charitable distributions (distributions to a charity from an Individual Retirement Account) has been extended. If you elect, a qualified charitable distribution made in January of 2011, will be treated as made in 2010.

• Enhanced small business expensing (Section 179 expensing). To help small businesses quickly recover the cost of capital outlays, small business taxpayers can elect to write off these expenditures in the year they are made instead of recovering them through depreciation. For 2010, you generally may expense up to $500,000 of qualifying property placed in service during the tax year. This annual limit is reduced by the amount by which the cost of property placed in service exceeds $2,000,000. \

• Special depreciation allowance. Businesses that acquire and place qualified property into service after September 8, 2010 can now claim a depreciation allowance in the placed-in-service year equal to 100% of the cost of the property. Businesses that acquired qualified property from January 1, 2010 through September 8, 2010 can claim a bonus first-year depreciation allowance of 50% of the cost of the property.

• Cellular telephones. Cellular telephones (cell phones) and other similar telecommunications equipment have been removed from the categories of “listed property.” This means that cell phones can be deducted or depreciated like other business property, without onerous record keeping requirements.

• Carryback of general business credits. Generally, a business's unused general business credits can be carried back to offset taxes paid in the previous year, and the remaining amount can be carried forward for 20 years to offset future tax liabilities. However, for 2010, eligible small businesses can carry back unused general business credits for five years instead of just one.

• Luxury auto limits. First-year luxury auto limits for vehicles first placed in service in 2010 are $11,060 for autos and $11,160 for light trucks or vans (for vehicles ineligible for bonus depreciation, or if the taxpayer elects out, $3,060 and $3,160, respectively).

Brief Summary of Recent Income Tax Changes

Jack Howell — Mon, 24 Jan 2011 09:48:55 -0600

The tax laws enacted in the last couple of years contain important income tax and information reporting provisions that are effective for the first time in 2011. Here's a summary of the key tax changes for 2011, broken down into three categories: Personal Income Taxes, Retirement Plan Changes, and Tax Changes for Businesses and Investors.

Personal Income Taxes

Payroll tax holiday in place. Employees will pay only 4.2% (instead of the usual 6.2%) OASDI (Social Security) tax on compensation received during 2011 up to $106,800 (the wage base for 2011). Similarly, for tax years beginning in 2011, self-employed persons will pay only 10.4% Social Security self-employment taxes on self-employment income up to $106,800. In either case, the maximum savings for 2011 will be $2,136 (2% of $106,800) per taxpayer. If both spouses earn at least as much as the wage base, the maximum savings will be $4,272.

Stricter rules apply to energy saving home improvements. You can claim a tax credit for energy saving home improvements you make this year, but stricter rules apply for 2011 than for 2010. You can only claim a 10% credit for qualified energy property placed in service in 2011 up to a $500 lifetime limit (with no more than $200 from windows and skylights). What's more, the credit you claim for any year can't exceed $500 less the total of the credits you claimed for all earlier tax years ending after Dec. 31, 2005. The amount you claim for windows and skylights in a year can't exceed $200 less the total of the credits you claimed for these items in all earlier tax years ending after Dec. 31, 2005. The credit is equal to the sum of: (1) 10% of the amount you pay or incur for qualified energy efficient improvements (such as insulation, exterior windows or doors that meet certain energy efficient standards) installed during the year, and (2) the amount of the residential energy property expenses you paid or incurred during the year.

The credit for residential energy property expenses can't exceed: (A) $50 for an advanced main circulating fan; (B) $150 for any qualified natural gas, propane, or hot water boiler; and (C) $300 for any item of energy efficient property (advanced types of energy saving equipment, such as electric heat pumps, meeting specific energy efficient standards).

Partial annuitization of annuity contracts. When you receive non-retirement-plan annuity payments from an annuity contract, part of each payment is a tax-free recovery of your basis (cost of the annuity contract for tax purposes), and part is a taxable distribution of earnings. For amounts received in tax years beginning after Dec. 31, 2010, taxpayers may partially annuitize such an annuity (or endowment, or life insurance) contract. If you receive an annuity for a period of 10 years or more, or over one or more lives, under any portion of an annuity, endowment, or life insurance contract, then that portion is treated as a separate contract for annuity taxation purposes. The net effect is that the annuitized portion is treated as a separate contract, and each annuity payment from that portion is partially a tax-free recovery of basis and partially a taxable distribution of earnings. Absent this rule, the payments might have been treated as coming out of income before recovery of any basis. The portion of the contract that is not annuitized is also treated as a separate contract and will continue to earn income on a tax-deferred basis.

Restricted definition of medicine for health plan reimbursements. Beginning this year, the cost of over-the-counter medicines can't be reimbursed with excludible income through a health flexible spending arrangement (FSA), health reimbursement account (HRA), health savings account (HSA), or Archer MSA (medical savings account), unless the medicine is prescribed by a doctor or is insulin. This new rule applies to amounts paid after 2010. However, it does not apply to amounts paid in 2011 for medicines or drugs bought before Jan. 1, 2011. Also, for distributions after 2010, the additional tax on distributions from an HSA that are not used for qualified medical expenses increases from 10% to 20% of the disbursed amount, and the additional tax on distributions from an Archer MSA that are not used for qualified medical expenses increases from 15% to 20% of the disbursed amount.

Retirement Plan Changes

Small employers may establish “simple cafeteria plans.” For years beginning after Dec. 31, 2010, small employers (those having an average of 100 or fewer employees on business days during either of the two preceding years) may provide employees with a “simple cafeteria plan.” An employer that uses this type of plan gets a safe harbor from the nondiscrimination requirements for cafeteria plans as well as from the nondiscrimination requirements for certain types of qualified benefits offered under a cafeteria plan, including group term life insurance, benefits under a self-insured medical expense reimbursement plan, and benefits under a dependent care assistance program.

Election to treat January 2011 charitable distributions as made in 2010. If you are age 70 1/2 or older, you can make tax-free distributions to a charity from an Individual Retirement Account (IRA) of up to $100,000. This applies for charitable IRA transfers made in tax years beginning before Jan. 1, 2012. In addition, if you make such a distribution in January of 2011, you can treat it for income tax purposes as if it were made on Dec. 31, 2010. Thus, a qualified charitable distribution made in January of 2011 may be treated as made in your 2010 tax year and count against the $100,000 exclusion for 2010. It is also may be used to satisfy your IRA required minimum distribution for 2010.

Tax Changes for Businesses and Investors

Electronic filing rules now in place. Beginning Jan. 1, 2011, employers must use electronic funds transfer (EFT) to make all federal tax deposits (such as deposits of employment tax, excise tax, and corporate income tax). Forms 8109 and 8109-B, Federal Tax Deposit Coupon, cannot be used after Dec. 31, 2010.

Up-to-$1,000 credit for “retained workers” in 2011. Employers may claim a “retention credit” for retaining qualifying new employees (certain formerly unemployed workers meeting specific requirements). The amount of the credit is the lesser of $1,000 or 6.2% of wages you pay to the retained qualified employee during a 52 consecutive week period. The qualified employee's wages for such employment during the last 26 weeks must equal at least 80% of wages for the first 26 weeks. The credit may be claimed for a retained worker for the first tax year ending after Mar. 18, 2010, for which the retained worker satisfies the 52 consecutive week requirement. However, the credit applies only for qualifying employees hired after Feb. 3, 2010, and before Jan. 1, 2011.

New basis and character reporting rules. Generally effective on Jan. 1, 2011, every broker required to file an information return reporting the gross proceeds of a “covered security” such as corporate stock must include in the return the customer's adjusted basis in the security and whether any gain or loss with respect to the security is short-term or long-term. The reporting is generally done on Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions.” A covered security includes all stock acquired beginning in 2011, except stock in certain regulated investment companies (i.e, mutual funds) and stock acquired in connection with a dividend reinvestment plan (both of which are covered securities if acquired beginning in 2012).

Corporate actions that affect stock basis must be reported. Effective Jan. 1, 2011, issuers of “specified securities” must file a return describing any organizational action (e.g., stock split, merger, or acquisition) that affects the basis of the specified security, the quantitative effect on the basis of that specified security, and any other information required by IRS. The issuer's return (and information to nominees or certificate holders) must be filed within 45 days after the date of the organizational action or, if earlier, by January 15th of the year following the calendar year during which the action occurred. Nominees or certificate holders must (unless the IRS waives this requirement) be given a written statement showing (1) the name, address, and telephone number of the information contact of the person required to file the return, (2) the information required to be included on the return for the security, and (3) any other information required by the IRS. In general, a specified security is any share of stock in an entity organized as, or treated for federal tax purposes as, a foreign or domestic corporation.

Reporting requirement for payment card and third-party payment transactions. After 2010, banks generally must file an information return with the IRS reporting the gross amount of credit and debit card payments a merchant receives during the year, along with the merchant's name, address, and TIN. Similar reporting is also required for third party network transactions (e.g., those facilitating online sales).

Information reporting for real estate. For payments made after Dec. 31, 2010, for information reporting purposes, a person receiving rental income from real estate is treated as engaged in the trade or business of renting property. As a result, recipients of rental income from real estate generally are subject to the same information reporting requirements as taxpayers engaged in a trade or business. In particular, rental income recipients making payments of $600 or more during the tax year to a service provider (such as a plumber, painter, or accountant) in the course of earning rental income must provide an information return (typically Form 1099-MISC) to the IRS and to the service provider.

The rental property expense payment reporting requirement doesn't apply to: (1) an individual who receives rental income of not more than a minimal amount (to be determined by the IRS); (2) any individual (including one who is an active member of the uniformed services or an employee of the intelligence community) if substantially all of his or her rental income is derived from renting the individual's principal residence (main home) on a temporary basis; or (3) any other individual for whom the information reporting requirement would cause hardship (to be defined by the IRS).

IRS Successfully Recharacterizes S Corporation Dividends as Salary

Jack Howell — Fri, 14 Jan 2011 10:45:04 -0600

Many tax advisors have recommended that their clients use the S election to reduce their social security and medicare tax liability. This type of planning has been on the IRS’ radar screen for a while. Now we have a case where the S corporation did pay some wages to its owner, and a District court found that the portion of the dividend distributions that the IRS claimed to be salary substitutes were in fact salary, making them subject to social security and medicare taxes. The moral of the story: you better have good factual support for what a service corporation is paying the professionals working for the service business.

In Watson, P.C. v. U.S., (DC IA 12/23/10) 107 AFTR 2d ¶2011-305, a district court has concluded that an S corporation shareholder-employee's $24,000 salary in 2002 and 2003 was unreasonably low, and allowed IRS to reclassify as salary over $67,000 in dividend payments to the officer during each of those years. The corporation will also owe employment taxes on the reclassified dividend payments.

Facts. David E. Watson had a bachelor's degree in business administration and a specialization in accounting. He owned a professional corporation (PC) called DEWPC that, since its inception, had elected to be taxed as an S corporation. Watson was its sole shareholder, employee, director, and officer, and was the only person to whom DEWPC distributed money during the years at issue. His $24,000 annual salary was documented in the corporate minutes. In selecting his salary, he did not look at what comparable businesses paid for similar services. For both years at issue, Watson received dividend distributions from DEWPC that totaled over $175,000 annually.

On Feb. 5, 2007, IRS assessed $48,519 in taxes, penalties, and interest against DEWPC for the eight calendar quarters of 2002 and 2003. It made these assessments after it determined that portions of the dividend distributions from DEWPC to Watson should have been characterized as wages paid to Watson that were subject to employment taxes. DEWPC later paid $4,063.93 toward these assessments and then filed a claim for refund of the payments. IRS denied the claim and DEWPC sued in district court.

Background. Employers are liable for FICA (Social Security) taxes on wages paid to their employees. Fact Sheet 2008-25, August 2008 warns S corporations not to attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages. Fact Sheet 2008-25, August 2008 lists these factors that courts have considered in determining reasonable compensation:

training and experience;
duties and responsibilities;
time and effort devoted to the business;
dividend history;
payments to non-shareholder employees;
timing and manner of paying bonuses to key people;
what comparable businesses pay for similar services;
compensation agreements; and
use of a formula to determine compensation.

DEWPC argued that IRS did not have the authority to recharacterize any of the dividend payments as compensation. DEWPC cited three federal court cases to support its argument.

Court’s ruling. The district court found that DEWPC's position was undermined by IRS revenue rulings and case law. For example, in Rev Rul 74-44, 1974-1 CB 287, IRS concluded that dividends received by an S corporation's two sole shareholders were wages for which the corporation was liable for FICA, FUTA and income tax withholding. In Joseph Radtke v. U.S., (DC WI 4/11/89) 63 AFTR 2d 89-1469, aff'd, (CA 7 2/23/90) 65 AFTR 2d 90-1155, a district court determined that certain funds designated as dividends were actually compensation for which an S corporation owed employment taxes. The district court was not persuaded by the rulings that DEWPC cited because in those rulings, the taxpayer was attempting to recharacterize funds, whereas in DEPW's case, it was the government that was attempting to recharacterize the funds.

The district court said that the proper tax treatment of funds disbursed by an S corporation to its employees or shareholders turns on an analysis of whether the payments were remuneration for services performed. After reviewing the facts, the court concluded that DEWPC structured Watson's salary and dividend payments in an effort to avoid federal employment taxes, with full knowledge that the dividends paid to Watson were actually “remuneration for services performed.” The court believed that a reasonable person in Watson's role as DEWPC's sole shareholder, officer, and employee would be expected to earn far more than a $24,000 salary for his services. The court pointed out that Watson was an exceedingly qualified accountant, with both bachelor's and advanced degrees, working as one of the primary earners in a reputable firm that had over $2 million in gross revenues in 2002 and nearly $3 million in 2003.

As a result of the ruling, DEWPC will owe employment taxes, penalties, and interest on the 2002 and 2003 dividend distributions to Watson that were reclassified as salary.

Rebuttal of Op-Ed Article on Tax Policy

Jack Howell — Mon, 10 Jan 2011 15:13:40 -0600

I don’t know if any of you read the Amarillo Globe-News. This last Sunday, the following appeared in the paper on the opinion page: Tax policy falls short of Founders' goal. I found it to contain inaccuracies of fact and of reasoning. Since taxes and tax policy are of interest to me as a tax attorney, I felt it appropriate to comment on those errors.

The premise that a business owner somehow chooses how much tax to pay is patently incorrect. First of all, Early’s statement itself contains a significant factual error. Only a limited amount of equipment purchases can be immediately written off against the income of a business. The generous write-offs businesses currently enjoy are recent additions to the tax code. Investments in equipment in excess of those limits must be depreciated, amortized, or otherwise deducted from income over a series of years, not in the year of purchase. So, a business owner cannot invest profits from the business into equipment, buildings, land, and other capital improvements in order to immediately avoid income tax on the profits reinvested in that capital.

Second, what if we are talking about an entirely new business? Where does the money to start up the business come from? It cannot come from the profits of that business since there are none yet. The start-up capital has to come from profits of some other business that are not reinvested in that business. That is, they come from the very amounts that Early postulates as the amounts that business owners purposefully pay taxes on and then remove from their business. Early implies that these amounts are taken out of the economy (or consumed by the business owners). This fairly simple example shows, to the contrary, even the profits taken out of a business can be used to create economic activity and jobs. In my almost 30 years of experience in advising business owners, the extraction of money from an existing business is either consumed or reinvested in another business. So the idea that removing money from a business somehow inherently damages our economy is hogwash.

Third, it is incorrect to surmise that a business owner is more susceptible to marginal tax rates in making business decisions than she is to market forces. Does Early think it wise to continue to reinvest a business’s profits when the goods or services that business sells are falling in demand and profitability? Wouldn’t the wise business owner take the profits out of that business and invest them in some other endeavor that she thinks will be more successful (and generate more profits) in the future. Getting capital moved to the places in the economy with the most demand and the most profit potential is the essence of capitalism and the market economy. Low taxes on this movement of capital makes it easier for the economy to stay agile and meet constantly changing demands. Thus, low taxes on capital movement will not keep the economy strong 100% of the time, but it will shorten the length of time necessary to put a weak economy back on its feet.

So, Early’s initial premise that the income tax applies only on income not spent on growing a business falls flat on its face. And taxing the movement of capital from one business activity to another clearly impedes economic activity that can generate jobs. Based on this reasoning, Early’s claimed “subtle lie” appears to be a truism after all and not a “lie” at all.

Jobs are a function of matching labor, skills, and intellect with demand for goods and services. Like the owner of capital must be ready to extract her investment from unprofitable endeavors and move it to profitable ones, individuals must be ready to take their labor, skills, and intellect and move it to where the demand is. The cost of doing this for the capital owner is taxes and other transaction costs. The cost to do this for “labor” is the cost of education and of picking up and moving to where the demand is. High tax rates on capital formation and transfer of capital from one business to another decrease the economy’s ability to move its capital to the businesses that will generate the most economic activity. High costs of education (or the inability or unwillingness of labor to learn the skills necessary for the new jobs) and mobility costs decrease the economy’s ability to get the labor it needs at the time and places it needs it. This means we not only need our tax policy to encourage capital movement, but we also need our education policy to encourage education and constant re-education, to keep up with the constantly changing economic environment.

Early goes on to cite other facts and figures and attempts to use them as support for his argument on what the “ideal” top marginal tax rates are. For example, Early assumes, without adequate evidence, that the decrease in the amount of GDP attributable to wages and capital must have gone into the pockets of the “wealthy.” It seems more likely to me that it has gone into the government coffers. If it had gone into private hands, it should have shown up as investment capital somewhere or have been consumed. Either or both would have generated economic activity. It’s only if the money was actually pulled out of the economy (in effect stuck in the mattress) that it would not generate economic activity. If it’s being stuck in the mattress, no change in tax policy will bring it back out. Only increased chances for investing it profitably will bring it out. Tax policy cannot cause that to happen. Decreased taxes might be able to increase the chances of the “mattress” money coming out by decreasing the cost of putting the money back to work in the economy. But it can’t make it happen when there are no places to put the money where it will make a profit instead being lost.

Early’s attempt to correlate tax rates to good economic times is strained, and only a correlation. Early offers no proof, and little real reasoning, regarding why it is reasonable to conclude that these correlations actually represent some sort of cause and effect. His “two year” theory is belied by the fact that the tax rate dropped to 25% in 1925 –four years before the depression, not two. This is the first, but not the only, inconsistency in his attempts to find a pattern in tax rates and the state of the economy. I’m not going to take the time and space to enumerate all of them. For those interested, you can see for yourself what historic rates on income (not capital gains) looks like here: U.S. Federal Individual Income Tax Rates History, 1913-2011.

When tax rates are low, yes, the people with high incomes will have more money left over from their economic endeavors after paying their taxes. And, yes, that means that they can spend more money on things that you and I would consider silly luxuries. But there is a limit on how much they can consume. (Ever seen “Brewster’s Millions”?) The amount in excess of their consumption must go somewhere, even if it is simply a checking account or “the mattress.” (Maybe the excess is being handled by some that are not competent to do so. But I would still rather it be “lost” back into the economy by those incompetents than seized by the government so that politicians can spend it and increase their power. And even then, it is generating economic activity.) Even if it goes into a checking account or savings account, it goes back into the economy to be invested somewhere. The capital it represents does not disappear. And even if it was all consumed, that means it was spent on goods and services that have no inherent value. Doesn’t that mean it was spent on creating jobs or some sort of economic activity? So, even though Early claims that his argument is not about jealousy or class warfare, ultimately it does come down to where does the money in excess of necessary taxes end up. Is it better to have it end up in the hands of people who will invest it in businesses in which they hope to generate a profit (and that may also entail increases in jobs) or in the hands of the government? That is for each of us to decide. But I don’t find Early’s arguments very enlightening in making that decision.

Tax policy is about raising enough money to run the government. Good tax policy will do that in a fashion that has as little real effect on economic activity as possible. Good (or bad) tax policy is not some balancing act between high and low marginal tax rates that, by itself, can cause a “good” economy or a “bad” economy. The market will drive the economy, and we can only hope that tax policy will not cause good economic times to go bad or bad economic times to be worse.

It is poor tax policy to try to encourage certain actions through the tax law. That is how tax loopholes are born. Personally, I think that a consumption tax accomplishes the policy goal of raising revenue without attempting to distort the markets and also makes our economy more competitive internationally. But even if you don’t agree with my personal opinion, Early’s arguments do not have a valid factual or logical basis.

Joint Committee on Taxation Publishes Analysis of Tax Expenditure Estimates

Jack Howell — Tue, 04 Jan 2011 14:51:27 -0600

The Joint Committee on Taxation (JCT) periodically publishes an analysis of tax expenditures. The JCT has recently published another of its periodic tax expenditure analyses. The analyses are designed to aid policymakers and the public in understanding “the actual size of government, the uses to which government resources are put, and the tax and economic policy consequences that follow from the implicit or explicit choices made in fashioning legislation.” Tax expenditures are defined as “revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” As described by the JCT, tax expenditures include any reductions in income tax liabilities that result from special tax provisions or regulations that provide tax benefits to particular taxpayers. The estimates in the report are based on the provisions in federal tax law as enacted through Dec. 15, 2010. The report discusses the concept and measurement and tax expenditures, and also provides estimates of tax expenditures for the tax period covered as well as tables showing the distributions of tax returns and selected individual tax expenditures by income class. The document “Estimates of Federal Tax Expenditures for Fiscal Years 2010-2014” can be downloaded at http://www.jct.gov/publications.html.

What I don’t understand is why the progressive rate structure (which is probably the single largest tax expenditure in the entire Internal Revenue Code) is not included in the list of tax expenditures. Actually, I do understand. But that is just another example of how the government mischaracterizes its actions and the information it provides us. The progressive rate structure meets the definition of a tax expenditure; yet it is not included. You can draw your own conclusion from that fact.

IRS Still Says That Trust's Material Participation Depends on Trustees' Activities

Jack Howell — Wed, 28 Jul 2010 12:50:09 -0600

In a new private letter ruling, IRS continues to take the position that trusts materially participate in an activity for purposes of the Code Sec. 469 passive activity loss (PAL) rules only when their trustees participate in the operations of the activity on a regular, continuous, and substantial basis.

Query: Does this mean that you look at the participation of all of a corporate trustee's employees, but not the agent's of an individual trustee?

Background. In general, losses from a trade or business are suspended (i.e., may not be currently deducted) under the PAL rules if the taxpayer does not materially participate in it. Participation is material under Code Sec. 469(h)(1) only if the taxpayer is involved in the activity on a regular, continuous, and substantial basis. While Reg. § 1.469-5T(a) provides quantitative tests on how individuals can meet the Code Sec. 469(h)(1) test, there aren't any regs on the material participation requirement for trusts and estates. The legislative history to Code Sec. 469 provides, however, that an estate or trust materially participates in an activity if an executor or fiduciary, in his capacity as such, so participates. (S Rept No. 99-313 (PL 99-514) p. 735)

In Mattie K. Carter Trust v. U.S. (ND Tex., 4/11/03) 91 AFTR 2d 2003-1946, a district court held that in determining material participation for trusts, the activities of its employees should be included in determining whether a trust's participation is regular, continuous, and substantial (see Federal Taxes Weekly Alert 04/24/2003).

In a Technical Advice Memorandum (TAM) issued as PLR 200733023, IRS said that notwithstanding the decision in Mattie K. Carter, in the absence of regs, material participation by a fiduciary requires the fiduciary's “regular, continuous, and substantial” participation required by Code Sec. 469(h)(1). Moreover, this “regular, continuous, and substantial” participation must be in the estate's or trust's business activities.

Facts. Taxpayer A is the beneficiary and a trustee of a complex trust. The trust holds various assets including a partnership interest in B, which in turn owns C, which in turn wholly owns D. The trust asked IRS to rule as to whether the trust can materially participate in the activities of D.

IRS sticks to its position. Without mentioning the Mattie K. Carter Trust decision (or the 2007 TAM), IRS ruled that the trust may materially participate in D's activities if the trustee, in this case A, is involved in the operations of D's activities on a regular, continuous, and substantial basis. IRS didn't rule on whether A in fact materially participated in D's activities or whether D's activities constitute an appropriate economic unit under Reg. § 1.469-4(c).

The PLR said that determining the proper focus in Code Sec. 469 for the trust's activities is a question of federal tax law and must include an examination of the treatment of trusts under Subchapter J. The taxation of trusts under Subchapter J is a hybrid regime involving an entity-level tax as well as the pass-through of income to the beneficiaries. While a trust is sometimes required to pay tax on its own income under Code Sec. 641 , it may also generally deduct under Code Sec. 661 income that is passed through to its beneficiaries under Code Sec. 662. Although the beneficiaries of a trust do not generally participate in the activities of the trust, the designated trustee acts on behalf of, and in the interests of, the beneficiaries.

IRS said that focusing on a trustee's activities for PAL purposes accords with the general policy rationale underlying the PAL rules. Generally, the owner of a business can't look to the activities of the owner's employees to satisfy the material participation requirement. Indeed, because an owner's trade or business will generally involve employees or agents, a contrary approach would result in an owner invariably being treated as materially participating in the trade or business activity. A trustee performs its duties on behalf of the beneficial owners. Consistent with the treatment of other business owners, therefore, IRS said it is appropriate in the trust context to look only to the activities of the trustee. Thus, the sole means for a trust to establish material participation is if its fiduciary is involved in the operations of the activity on a regular, continuous, and substantial basis.

Costs of Forming and Maintaining Entities

Jack Howell — Wed, 18 Nov 2009 15:25:54 -0600

I form and maintain many entities each year for my clients. Since I am located in Texas, I form mostly Texas entities. But I am frequently asked to form entities elsewhere -- mainly Nevada and Delaware. I always assumed that the filing fees and simlar charges made by Nevada and Delaware were less than those in Texas (not counting the cost of maintaining a registered office if you weren't actually located there). But the other day, I was informed that Nevada was going to start strictly enforcing its charges for a Business License. So, I asked one of my paralegals to investigate the various charges of each of these states. You may find the results as interesting as I did. Read on . . .

Texas

Texas only charges an initial filing fee for its entities. While that charge is high ($750 for limited partnerships and $300 for all other business entities), That is the only charge that it imposes.

Texas does have a franchise tax for all of its entities. But that tax is imposed based on Texas activitity. That is, you pay it if you have Texas activitity even if you are organized in Nevada or Delaware. And you don't pay it if you don't have Texas income or presence, even if you are organized in Texas.

Nevada

Nevada charges filing fees for the various types of entities. The basic filing fee charge is $75. However, you can add to that another fee of $125 for your list of officers, managers, members, or partners, depending on what type of entity you have.

Nevada also has a $200 charge for a Business License. Even if you don't do any business in Nevada, you have to obtain and pay for this license.

So, your real cost to organize a Nevada entity is at least $400. And this doesn't count the annual charges. the list of officers, etc., has to be filed annually. Similarly, the cost for the Business License is an annual cost. So, not only does it cost $400 to form a Nevada entity, it costs $325 per year to maintain the entity.

Delaware

Delaware is a little more complicated since the costs for corporations differs significantly from the cost of other entities. Like Nevada, their initial costs seem to be quite reasonable. The filing fees for a corporation are based on the amount of stock authorized, and begin at $89. Limited partnerships are $200; and limited liabitlity companies are $90.

But Delaware has annual costs that apply even if you don't do anything in Delaware. Corporations must file and annual report and pay $50. In addition, corporations must pay a franchise tax (even if the corporation has no Delaware activities) that ranges from $75 to $180,000. Limited partnerships and LLCs have to pay an annual tax of $250 per year to maintain their existence in Delaware.

Conclusion

Unless your entity is going to have a short life, the lack of annual expenses in Texas makes Texas entities more economical than Nevada or Delaware. This would be true even if your entity is not going to be doing business in Texas.