2007 Federal Tax Update

“More-Likely-Than-Not” We’re in the IRS Now -

Supplement

Important Issues for 2007• Preparer Penalties

• Expiring Provisions Expected Changes

• Kiddie Tax

• Simplified Research Credit

• IRS Aggressively Auditing Passive Losses

• Investor, Trader, Dealer

• IRS Nixes Ordinary Loss on Abandonment

• Payroll Taxes Not Subject to Deferred Compensation Deduction Rules

• Advance Trade Discount Method of Accounting

• Section 118 “Abuse”

• 1031 Exchanges

• Trust Cannot Materially Participate

• Flat Investment Advisory Fee Cannot be Capitalized

• IRS Avoids Statute of Limitations by Labeling “Change in Method”

Important Issues for 2007• Charitable Contributions

• No Relief for Underwater ISOs

• Employee Spouse Health Insurance

• Trust Investment Advisor Fees Subject to 2% Floor

• Co-ownership of Property-Planning Idea?

• New Corporate Estimated Tax Payment Requirements

• S Corp Open Account Debt

• IRS on a Roll with FLP Challenges

• Fractional Discount in Art Collection

• 409A Final Regs Written Plan Deadline Deferred

• Restorative Payments to IRAs

• Crummey Powers Have Not Impact on Grantor Trust Status

• Distribution Committee

• Top 11 for 2007 – Some of the best of what is left of “safe” planning ideas

Preparer Penalty Legislation - §6694(a)-Part II p. 1-5; p. 183-186 p. 193

 

Preparer “Old” Rule

Preparer“New” Rule

Taxpayer Rule

WithoutDisclosure

RealisticPossibility (≥ 33%)

Reasonable Belief-MLTN

(>50%)

SubstantialAuthority (35-50%)

With Disclosure

Not- Frivolous

(5-10%)

Reasonable Basis

(10-20%)

Reasonable Basis

(10-20%)

Penalties $250

Greater of $1,000

or 50% of fees

Various

Expiring Provisions Expected Changes – Part II p. 6-12• 2007 - AMT exemption drops to 1993 levels;

$33,750, $45,000 and $22,500; 10/31/07 letter Baucus, Rangel promise 1 yr fix $44,350, $66,250, $33,125

• 2008 - Research credit, sales tax, IRA to charity

• 2010 - Estate tax “repeal,” reduced rates, reduced phase out, reduced rates capital gains dividends

• Rangel – Repeal AMT, LIFO, LCM 199, ICDISC, report cost basis; repeal 199; codify economic substance

• “Wish List” – Repeal LIFO, deduction punitive damages, interest deduction home equity, nonrecourse liabilities from basis

2007 Act – Part II p. 9

• Preparer penalties

• Extend WOTC

• Increase 179 expensing

• Simplify certain S corporation rules

• Expand Kiddie Tax – increase to 19, 24 in case of full time student unless more than 50% support

• Increase 3rd quarter corporate estimated pmts 3rd qtr of 2012 from 106.25 to 114.25% of amt otherwise due

2006 Act – Part II p. 10

• Extenders-sales tax deduction, teachers deduction, Brownfield expensing, certain charitable contributions, 15 year recovery leaseholders etc.

• New simplified research credit

• Refundable AMT credit

• Rollover from IRA to HSA

Kiddie Tax – Part II p. 12

• Unearned income over $1,700 taxed at parents’ rate

• 2006 from under age 14 to under age 18

• 2008 from under age 18 to under age 19/24

• One time chance to transfer appreciated securities to child 18 or older to sell this year; taxed at 5%; max savings $3,185

Simplified Research Credit Part II, p. 13• 12% of qualifying expenditures in excess of 50% of

average qualifying expenditures prior 3 years

• If no qualifying expenditures in any 1 of prior 3, credit is 6% of current year (100%-not excess of 50%)

• Who Benefits

– Expenditures low, receipts high

– Expenditures increasing

– Reg Credit limited by minimum base amount

– No documentation to support 1984-1988 base yrs

– Those now using AIRC

IRS Aggressively Auditing Passive Losses – P. 1• Beecher, Krukowski, Sidell, Fransen, Carlos,

Connor, Schwalbach all agree “heads the IRS wins, tails the taxpayer loses”

• Rechacterization rule

• Material participation not enough for real estate unless $25,000 allowance AGI under $100,000/$200,000 or qualified real estate professional (QREP)

• Difficult to qualify for QREP; Harmon p. 63 can’t qualify if have other full-time job

• Grouping rule – Glick p. 3

• Net lease property never active p. 6

Investor, Trader, Dealer

• Kirch p. 9, Marandola, p. 9 Cameron, p. 54, Ferguson, p. 56, Tschetschot p. 74

• Investor: Capital gain (loss), itemized deductions, no mark to market; abandonment will be capital (under new proposed regs see following)

• Trader: Capital gain (loss), above the line deductions, mark to market; abandonment ordinary

• Dealer: Ordinary income, above the line deductions, mark to market; abandonment ordinary

IRS Nixes Ordinary Loss on Abandonment – p. 21• Abandonment is deductible as ordinary loss

• Rev. Rul. 93-80 permits ordinary loss on abandonment of partnership interest provided no relief of liabilities (note even $1)

• Rev. Rul. 2004-58 lays out what it takes to abandon

• Citron – abandonment partnership ordinary loss

• Proposed regs treat as capital loss

• Another “heads the IRS wins, tails the taxpayer loses” situation

• Effective after date regs are final

Payroll Taxes Not Subject to Deferred Compensation Deduction Rules - p. 24

• 404(a)(5) - Generally deferred comp deductible only in year included in income by payee

• Amt paid within 2 ½ months of BOY, considered paid as of end of prior

• Thus, can deduct in prior year

• Rev. Rul. 2007-12 says this rule doesn’t apply to accompanying payroll taxes.

Advance Trade Discount Method of Accounting – p. 36• Westpac Pacific Food – Advanced trade discounts

not income; treated as trade discounts in manner handled for financial statement purposes

• Rev. Proc. 2007-53 permits automatic change to this method

• Generally, 5 year or less term

• See Karn’s Prime & Fancy on p. 7

• See CCA 200727014 p. 37 for another example of the IRS not following the statute and its own regulations

• See Affiliated Foods p. 93 “show money” paid as a cash discount by vendors to members of a grocery purchasing cooperating is not gross income.

Section 118 “Abuse” – p. 40• Section 118 excluded capital contributions from

income

• Edwards v. Cuba Railroad (1925)

• IRS argues its an “abuse” to permit for partnerships and LLCs

• IRS Industry Field Directive #3 labels this Tier 1 audit issue an “abuse”

• IRS claims position changed in 1982

1031 Like-kind Exchanges • To qualify, property must be held for use in a trade

or business or for investment

• Concerns about what is “held for investment,” held, related party dispositions

• If done carefully, permissible to “drop and swap” and “swap and drop”

• PLR 200651030 – p. 41 - Transferring to LLC from trust does not violate “held”

• PLR 200706001 – p. 42 – Exchange of undivided 25% interest for 100% interest timberland qualifies

• PLR 200712013 – p. 43 – Controversial ruling that seems to permit disposition by related party

• Moore – p. 10 – Vacation home doesn’t qualify

• T.D. 9314 – p. 16 - New Regs on depreciating property received in 1031; special election out possible

Trust Cannot Materially Participate – p. 47• TAM 200733023 – IRS maintains fiduciaries must

participate in activities on a regular, continuous, and substantial basis.

• Runs counter to Mattie K. Carter

• 21 years after enactment, IRS still hasn’t issued regs on how passive losses apply to trusts

Flat Investment Advisory Fee Cannot Be Capitalized – p. 48• Because of wide-spread application of AMT, some

taxpayers with investment advisory fees have been electing to capitalize those fees into basis pursuant to Treasury Reg. Sec. 1.266-1(b).

• CCM 200721015 – IRS held that a flat fee paid to a brokerage firm to act as a discretionary investment advisory may not be capitalized and is deductible only as an itemized deduction on schedule A.

• Another IRS rule going against a long-standing policy and its own regulation

IRS Avoids Statute of Limitations by Labeling “Change in Method”- p. 48• CCM 200728001 – IRS holds that how income from

the sale of an individual’s partnership interest is reported constitutes a change in accounting method and therefore changeable outside of the statute of limitations

• A change in method of accounting includes a change in the overall plan of accounting for income or deductions, or a change in the treatment of any material item used in such overall plan.

• A material item includes any item that involves the proper time for the inclusion of the item of income.

Charitable Contributions• IRS aggressively challenging noncash contributions

• Do not recommend charitable easements

• Do not recommend claiming charitable deduction for burning down or destroying home

• Do not recommend contributing car or boat to charity

• Better to give charity money and have them purchase the property

• Notice 2006-96 – p. 49 - Guidance on “qualified appraisal” and “qualified appraiser” and penalties associated with substantial or gross misstatements

• Notice 2007-50 – p. 51 – Guidance on new % limits for qualified conservation contributions

• Notice 2007-50 – p. 196 – Forms 1098-C contributions of cars, boats, airplanes

Charitable Contributions (cont.)• Glass – p. 60 – IRS challenges conservation

easement for Lake Michigan property and loses

• CCA 200738013 – p. 87 – Cannot value façade easement based on percentage of underlying property before granting the easement

• Notice 2006-110 – p. 87 – new guidelines on substantiating deductions; strict documentation requirements

• Our client was denied any charitable deduction whatsoever on a contribution of property with multiple appraisals in excess of $50 million. Watch for our Tax Court case coming soon!

No Relief Underwater ISO

• Without exception, cases denying relief for those who exercised ISOs only to see FMV fall to significantly below that required to pay the tax.

• Courts reject argument margin debt creates new option that further postpones income recognition: Cidale p. 55, Palahnuk p. 55, Tuff p. 75, Moore p. 68, Racine p. 69

• Courts reject argument capital loss can be carried back for AMT purposes: Guzak p. 63, Kadillak p. 64, Pierce p. 63, Marcus p. 67, Merlo p. 67

Gambling – Trade or Business?• Yes – Myers, TC Summary Opinion 2007-194 (11/29/07)

woman who ran trucking business found to be in trade or business of gambling

• No - Ferguson p. 56

• No – Tschetschot p. 74

• No – Mohammadpour, TC Summary Opinion 2007-163

• No – Calvao TC Memo 2007-57

• But see Rozzano p. 70, where a loss-generating horse boarding activity was upheld; excellent roadmap to what you must prove; also see Topping p. 73

• CCA 200725036 taxpayer may combine his share of partnership’s gambling gains and losses with his personal ambling gains and losses in calculating deductible gambling losses.

Spousal Health Insurance Strategy• Self-employed individual employs spouse and provides

health insurance coverage; nonemployed spouse then covers spouse (i.e., self-employed individual).

• 100% above the line deduction; reduces SE income

• Sanctioned by IRS Industry Specialization Program Settlement Guideline (UIL 162.35-02, dated 1/25/01) and Rev. Rul. 71-588

• 100% deduction now allowed for regular but not SE tax

• Francis – p. 58 – Unreasonable compensation

• Poyda – p. 58 – No bona fide employment relationship

• Speltz (2006) – TC finds for taxpayers

• Snorek – p. 71 – Lack of documentation unclear who paid

• Ralph Frahm, TC Memo 2007-351 – TC finds for taxpayers.

Trust Investment Advisory Fees Subject to 2% Floor• Supreme Court has decided to review Second

Circuit decision in Rudkin.

• O’Neill - Tax Court held subject to 2% floor

• O’Neill – 6th CA reverses

• IRS “jumps the gun” and issues proposed regs. 1.67-4 listing expenses subject to the 2% floor; p. 79

• In the regs, IRS attacks the current “bundling” strategy that is routinely taking place where investment advisory and trustees fees are combined

Co-ownership of Property – Planning Idea? P. 98• Reeves v. Commissioner

• You be the judge!

New Corporate Estimated Tax Payment Requirements p. 104• Final regulations that apply to tax years

beginning after September 5, 2007 radically change how corporate income is determined on an annualized basis for purposes of calculating estimated taxes

• Reasonable estimates can be made only for certain items if the amounts cannot be determined with reasonable accuracy by the installment date

• Extraordinarily complex

• Economic performance rules apply

• Expensive to comply with

S Corp Open Account Debt p. 112• Brooks – Tax Court treats shareholder advances

as open account debt ; repayments netted against advances

• Prop. Reg. 1.1367-2 and -3 narrow definition of open account debt and generally change the basis rules to eliminate ability to net as was done in Brooks

• Bottom line is IRS is trying to generate gain even though at the end of the year, taxpayer has not taken excess basis out of the S corporation.

IRS on a Roll Challenging FLPs• Bigelow p. 129 – includible under 2036(a); found

implied agreement

• Erickson p. 132 – includible under 2036(a); found implied agreement

• Gore p. 136 – assets “withdrawn” from marital fund and transferred to FLP includible in estate because did not relinquish “dominion and control”

• Korby p. 142 – includible under 2036 because retained the right to the income and transfers were not for bona fide consideration

• See IRS Appeals Settlement Guidelines for FLPs

Fractional Discount in Art Collection p. 143• Stone – a fractional discount is appropriate in

determing the value for estate tax purposes of an undivided 50% interest in an art collection.

• IRS long resisted fractional discounts in cases involving real estate and personal property

• After losing those cases, IRS has relented; now the focus turns to Art collections.

• See also Janis p. 140 where FMV of art negotiated for estate tax purposes by the IRS must be used for its cost basis; seems rudimentary, but IRS has been known to challenge basis even though taken from Form 706.

409A Final Regs Written Plan Deadline Deferred p. 145 p. 166• IRS issued final regulations regarding application

of 409A to deferred compensation plans

• Apply to amounts deferred in tax years beginning after 12/31/04.

• Also issued Notice 2007-34 providing guidance on application of 409A to split-dollar insurance ; p. 164

• Notice 2007-78 - Written plan deadline deferred one more year.

Restorative Payments to IRAs• 200714030 p 157

Crummey Powers Have No Impact on Grantor Trust Status• 200729005-200729016 p. 159

• Appears to conflict with Rev. Rul. 81-6

IRS Reconsidering the Treatment of Trusts Involving Distribution Committees - p. 168• IRS reconsidering a series addressing the gift tax

consequences of trust that use a distribution committee consisting of trust beneficiaries who direct distributions of trust income and principal

• IRS concerned the rulings may be at odds with previous holdings in Rev. Rul. 76-503 and Rev. Rul. 77-158

• See PLR 200647001 p. 156

Top 11 for 2007

• Gain Shifting Strategy 18-24 Year Olds

• Nondeductible IRAs

• $100,000 Distribution to Charity

• $125,000 expense election

• Deduction for Sales Taxes

• Defer Expenses to Increase Itemized

• Single Person 401(k) for Directors Fees

• Catch Up Adjustments for Age 50 and Older

• Employ Children Establish Roth

• Real Magic Avoiding AMT

• 529 Plans