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TAX LAW FOCUSHonigman Miller Schwartz and Cohn LLP’s August 2003

2290 First National Building - Detroit, MI 48226 - (313) 465-7000

In This Issue . . . Page

Planning Opportunities Under the Jobs and Growth TaxRelief Reconciliation Act of 2003– A Taxpayer’s Day in the Sun(set) ..................................... 1

Split-Dollar Insurance: New Rules May ImposeYear-end Deadline for Action .............................................. 1

Michigan Tax Legislation Passed in the First Half of 2003 ..... 1

Recent Ammendment to Michigan’s LLC ActProtects Members’ Interests From Creditors ...................... 3

IRS Permits Netting of Partnership Liabilities in DeferredLike-Kind Exchange Straddling Two Tax Years ................... 3

International Tax Aspects of the Jobs and Growth TaxRelief Reconciliation Act of 2003:What’s In and What’s Out .................................................... 3

Election of Mark-to-Market Accounting forSecurities Traders ................................................................ 7

State Tax Amnesty Programs Abound ..................................... 10

(Continued on page 2)


This issue of the Tax Law Focus includes variousarticles on current tax topics which might be of interestto you. Our Tax Department is ready to help you withspecific questions relating to the tax topics discussedbelow or any of your tax law needs.

We are pleased to announce our firm’s decisionto retain our headquarters in the First NationalBuilding in Downtown Detroit. Our Chairman andCEO, Alan S. Schwartz, recently said that “We arepleased to reaffirm our commitment to DowntownDetroit by extending our lease through 2016. We area Detroit law firm. The First National Building hasalways been our home, and, with the significantimprovements being made to it, we want it to remainour primary location in the years ahead.” With 150attorneys and 270 staff in the First National Building,our f irm is one of Downtown Detroit’s largestemployers, with more attorneys practicing law inDetroit than any other law firm.

PLANNING OPPORTUNITIES UNDERTHE JOBS AND GROWTH TAX RELIEF

RECONCILIATION ACT OF 2003 -A TAXPAYER’S DAY IN THE SUN(SET)

by Michael W. Domanski

Now that the dust has settled after the initialcontroversy generated by The Jobs and Growth TaxRelief Reconciliation Act of 2003 (“2003 Act”), the


SPLIT-DOLLAR INSURANCE:NEW RULES MAY IMPOSE YEAR-END

DEADLINE FOR ACTION

by Regis A. Carozza

The Internal Revenue Service (“IRS”) has issuednew proposed regulations which will significantlyaffect the income tax consequences for participants

in split-dollar life insurance plans. Although thesetypes of insurance arrangements may be entered intoin a variety of contexts (including gifts and betweencorporations and their shareholders), the mostcommon split-dollar arrangements are entered into

MICHIGAN TAX LEGISLATIONPASSED IN THE FIRST HALF OF 2003

by June Summers Haas

In early Spring of this year, the MichiganDepartment of Treasury (“Department”) and theGovernor put forth an ambitious plan to enact 15proposals designated as “tax loophole” closings toraise almost $130 million. Business oppositionstopped all but three proposals from being enactedinto law. Only a few additional taxpayer friendlypieces of tax legislation moved in the first half of this

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Honigman Miller Schwartz and Cohn LLP’s

TAX LAW FOCUS August 2003

crucial question on every business person’s mind is,what’s in it for me?

Many of the key tax relief measures are subjectto sunset provisions and thus, it behooves individualsand business owners to navigate through the new rulesand identify the planning opportunities lurking withinbefore their possible expiration. The followingsummary intends to provide a compass.

Tax Bracket Reductions. The pre-2003 Actbrackets of 15, 28, 31, 36, and 39.6 percent have beenreduced to 10, 15, 25, 33, and 35 percent, effectiveJanuary 1, 2003 through 2010. Therefore, newwithholding tables have been released by the IRS thatallow business persons to reduce their withholding onwages and possibly invest the tax savings into an IRAor other savings vehicle that could result in a taxdeduction that did not previously exist.

Dividends. New preferential rates of 15% and5% apply to certain dividends received by U.S.individuals from domestic and foreign corporations.The lower rates may have application to amounts notactually distributed (e.g., accumulated earnings in U.S.corporations and earnings of foreign corporationsliquidated into the U.S.). Further, introducing orincreasing corporate debt or leverage to assist in thedistribution of cash dividends could result in increasedinterest expense deductions at the corporate level andlower tax costs at the shareholder level.

Capital Gains. New reduced rates of 15% and5% apply to gains on the sale of capital assets.Business owners may want to consider whether thesale of built-in gain assets should be accelerated andthe sale of built-in loss assets should be delayed.

Depreciation and Other Expense Deductions.The amount of certain small business propertypurchases that can be immediately deducted hasbeen increased from $25,000 to $100,000 with the

phase out amount being increased from $200,000to $400,000. Further, an additional 50% bonus first-year depreciation (increased from 30%) may alsoapply to certain property. The utilization of theserelief measures may not necessarily be appropriateif the business has net operating losses that arescheduled to expire in the near term.

Summary. Because the various choices of entity(corporations, LLCs, partnerships) have there ownunique tax treatment in which they are taxed either asa separate entity or at the shareholder level only, theinterrelationship of the new tax rules should bereviewed on a broader scale to determine whether morestructural changes could result in increased taxbenefits. Further, optional methods of moving cash(e.g., through loans, fees or dividends) should also berevisited. Therefore, in addition to plucking the low-hanging fruit provided by the 2003 Act, businessowners may want to consider shaking the tree a littleas well.

between employers and employees. Split-dollararrangements generally involve the payment ofpremiums by a sponsor (in the employment context,the sponsor typically is the employer) on life insurancewhich insures the life of a “benefited person” (in theemployment context, the benefited person typicallyis the employee), with the sponsor being entitled tothe return of the premiums paid at the benefitedperson’s death or upon the termination of the insurancepolicy.

Under the new regime, the IRS will take theposition that accumulated policy cash value, which isowned by a benefited person and which is in excessof the sponsor’s contributions, is subject to incometax when the split dollar arrangement is terminated.However, the IRS has advised that the equity in somesplit-dollar policies will be exempt from taxation ifcertain elections are made prior to December 31, 2003.Specifically, with respect to split-dollar arrangements

Split-Dollar Insurance: New Rules May ImposeYear-end Deadline for Action

(Continued from page 1)


Planning Opportunities Under the Jobs andGrowth Tax Relief Reconciliation Act of 2003

- A Taxpayer’s Day in the Sun(Set)



TAX LAW FOCUS

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August 2003

RECENT AMENDMENT TO MICHIGAN’SLLC ACT PROTECTS MEMBERS’INTERESTS FROM CREDITORS

by Aaron M. Silver

The Michigan Legislature recently passed PublicAct 686 of 2002 (“PA 686”), making severalamendments to the Michigan Limited LiabilityCompany Act (the “Act”). The amendments becameeffective December 30, 2002. Of particularsignif icance, the amended Act clarif ies that amembership interest in a limited liability company(“LLC”) may be held by husband and wife as tenantsin the entirety. This amendment permits a husbandand wife to protect and immunize an investment in aLLC from the claims of certain creditors, and may bea prudent asset protection planning technique forindividuals practicing in a profession with significantexposure to litigation.

In Michigan, it is well settled that real estate canbe held by husband and wife as tenants in the entirety.A traditional and legitimate asset protection planningtechnique has been for husband and wife to protectthe family home and other real estate from the claimsof creditors by holding real property jointly as tenants


IRS PERMITS NETTING OF PARTNERSHIPLIABILITIES IN DEFERRED LIKE-KIND

EXCHANGE STRADDLING TWO TAX YEARS

by Alexander G. Domenicucci

In Revenue Ruling 2003-56 (“Ruling”), the IRSruled that if a partnership enters into a qualifyingdeferred like-kind exchange in which propertyencumbered by debt (“relinquished property”) istransferred in one tax year and other property alsoencumbered by debt (“replacement property”) isreceived in the following tax year, the liabilities maybe netted for purposes of determining any increase ordecrease in the partners’ share of partnership liabilities.Any net decrease in a partner’s share of partnershipliabilities resulting from the exchange is taken intoaccount in the partnership’s tax year in which the

relinquished property is transferred. Conversely, anynet increase in a partner’s share of partnershipliabilities is taken into account in the partnership’s taxyear in which the replacement property is received.

The Ruling addressed two scenarios. In the firstscenario, a general partnership with two equal partnersowned property with a fair market value of $300x,with a basis of $80x and subject to a liability of $100x.The partnership entered into a qualifying deferred like-kind exchange under Code Section 1031 in which thepartnership transferred the property subject to the$100x liability on October 16 of year 1. On January17 of year 2, the partnership received replacement


INTERNATIONAL TAX ASPECTS OFTHE JOBS AND GROWTH TAX RELIEF

RECONCILIATION ACT OF 2003:WHAT’S IN AND WHAT’S OUT

by Michael W. Domanski

Since much of the significance of The Jobs andGrowth Tax Relief Reconciliation Act of 2003 (“2003Act”) from an international tax perspective relates tothe revenue-raising provisions that were left on thecutting room floor, this article will discuss, in theinternational tax context, not only the impact of thetax rules that were revised by the 2003 Act but alsohighlight the key omissions from the new legislation.

What’s In

Benefits. Included in the 2003 Act arepreferential rates on certain corporate dividends paidto U.S. individuals. Under the prior law, U.S.individuals were taxed on these dividends based ontheir particular income tax bracket (the pre-2003 Actbrackets of 15, 28, 31, 36 and 39.6 percent have alsobeen reduced to 10, 15, 25, 33, and 35 percent).However, the 2003 Act provides for certain corporatedividends to be taxed at the U.S. individual shareholderlevel at rates of 15 and 5 percent.


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entered into before January 28, 2002, where thesponsor is entitled to recover its payments, thebenefited person will not incur income tax on theaccumulated cash value in excess of those paymentsupon the termination of the plan if: (1) the arrangementis terminated before January 1, 2004; or (2) for allperiods after January 1, 2004, all payments by thesponsor from the inception of the arrangement (lessany repayments) are treated as loans for federal taxpurposes, and the parties report the tax treatmentaccordingly.

It is critical that planning with respect to split-dollar life insurance arrangements be done promptly,and that decisions with respect to these plans be madeprior to December 31, 2003. Although the IRS hasnot explicitly stated what the consequences of a failureto select one of the options will be, the IRS mightvery well take the position that the benefited personwill be taxed on the excess equity when thearrangement is terminated or the cash value isaccessed. If you participate in a split-dollar lifeinsurance program, we encourage you to contact amember of our Tax Department so that we can assistyou in determining how the new regulations and theDecember 31st deadline affect you.

Split-Dollar Insurance: New Rules May ImposeYear-end Deadline for Action


Michigan Tax Legislation Passed in theFirst Half of 2003


year. The following is a summary of the enactedlegislation.

Flow-Through Entities. Public Act (“PA”) 22,and PAs 45-52 all affect flow-through entities such asS corporations, partnerships, limited partnerships,limited liability partnerships, and limited liabilitycompanies. Under these new laws, flow-throughentities must withhold and remit Michigan individualincome taxes on the distributive shares of non-resident

individual owners. Flow-through entities are nowallowed to file composite Michigan income tax returnswith their non-resident individual owners. The newprovisions are effective October 1, 2003. PA 23expands corporate officer liability to include members,managers, and partners of limited liability companiesand partnerships effective June 24, 2003. PA 24 andPA 25 removed corporate officer liability provisionsfrom the sales and use tax acts so that all corporateofficer, member, partner liability provisions are nowgoverned by the Revenue Act.

Nonresident Taxation. PA 21 and PA 47 providethat nonresidents’ casino winnings are now subject toMichigan income tax and casinos and racetracklicensees must withhold on nonresident individuals’gaming winnings effective October 1, 2003. PA 52provides that nonresident individuals’ business incomeis taxed to the fullest extent of the constitution, therebyeliminating casual transaction or nonbusinessexemption claims effective July 14, 2003.

New Use Tax Exemption. PA 27 provides thattangible personal property (other than aircraft) usedsolely for personal nonbusiness purposes that isbrought into Michigan more than 90 days afterpurchase by a nonresident or more than 360 days afterpurchase by a resident is exempt from use tax.

Mandatory Letter Ruling Publication. PA 92requires all letter rulings issued by the Departmenton or after August 18, 2000 be published bothelectronically and by paper. Many members of thebusiness community have been eagerly awaiting thislegislation hoping for a flurry of new tax guidance tobe published. It remains to be seen whether thislegislation will result in more letter rulings beingpublished or fewer letter rulings being issued by theDepartment.

Tax Expenditure Report Renamed. In a mostlysymbolic move, PA 92 renames the Tax ExpenditureReport required to be included with the Governor’sannual budget message to the Tax Credit, Deductionsand Exemptions Report.

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TAX LAW FOCUSAugust 2003

Recent Amendment to Michigan’s LLC ActProtects Members’ Interests from Creditors

(Continued from page 3)in the entirety. Prior to PA 686, however, it wasuncertain whether a membership interest in a LLCcould be held by husband and wife as tenants in theentirety. PA 686 clarifies that this asset protectionplanning technique is now available for membershipinterests in LLCs.

Tenants by the entirety is a unique form ofholding property available only to a husband and wife.A tenancy by the entirety automatically terminatesupon the death of one spouse, or upon the divorce ofthe husband and wife. The concept of tenants in theentireties is a dated legal fiction by which husbandand wife are regarded as a single person. Consistentwith this single person theory, property held by tenantsin the entireties is treated as property owned by bothhusband and wife as to the whole. During themarriage, any sale of the property must be consentedto by both spouses. In addition, neither spouse canunilaterally encumber the property, and judgmentcreditors of either spouse cannot execute the judgmentagainst the property. In short, when husband and wifehold property as tenants in the entirety, creditors ofhusband or creditors of wife cannot maintain a claimagainst that property. Only with respect to debts forwhich both spouses are jointly liable (such as amortgage signed by both spouses) can a creditorenforce the claim against the property.

PA 686 clarifies that a husband and wife canprotect LLC membership interests from the claim ofone spouse’s creditor by holding the interest as tenantsin the entirety. The decision to re-title a membershipinterest to create a tenancy in the entirety should bemade prior to the occurrence of an event giving riseto a claim. Furthermore, the decision should becarefully integrated with a comprehensive estate plancrafted to satisfy the specific needs of the individualand family. If you would like to know more about PA686, or about asset protection planning in general,please contact a member of the Estate Planning Groupof our Tax Department.

property with a fair market value of $260x and subjectto a liability of $60x. Therefore, the partnership hada net decrease in liabilities of $40x. The secondscenario only differed from the first scenario in thatthe replacement property had a fair market value of$340x and was subject to a liability of $140x. Thus,under the second scenario, the partnership had a netincrease in liabilities of $40x.

A taxpayer that enters into a like-kind exchange(such as the partnership in the Ruling) is treated asreceiving cash to the extent that the debt secured bythe relinquished property exceeds the debt secured bythe replacement property. On the other hand, ataxpayer is treated as having paid cash if the debtsecured by the replacement property exceeds the debtsecured by the relinquished property. In addition, anydecrease in a partner’s share of partnership liabilitiesis treated as a distribution of cash to the partner by thepartnership (resulting in income to the partner to theextent the deemed distribution exceeds the partner’sadjusted basis in his partnership interest). Anyincrease in a partner’s share of partnership liabilitiesis treated as a contribution of cash by the partner tothe partnership.

Before issuance of the Ruling, there was somequestion as to whether the partners of the partnershipin the first and second scenarios would be treated asreceiving a distribution in year 1 equal to the debtsecured by the relinquished property ($100x),notwithstanding the partnership receiving in year 2replacement property also encumbered by debt ($60xin the first scenario and $140x in the second scenario).The Ruling removes this uncertainty as to the taxtreatment of the exchange. With regard to the firstscenario, the IRS held that the partnership is treatedas receiving $40x of cash (and recognizing $40x ofgain) in year 1 ($100x of debt secured by therelinquished property minus $60x of debt secured bythe replacement property). The $40x of gain isallocated equally to each partner with each partner

IRS Permits Netting of Partnership Liabilitiesin Deferred Like-Kind Exchange

Straddling Two Tax Years


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Limitations. Not only are the new preferentialrates inapplicable to corporate shareholders, but theyare also not available to non-resident aliens of theUnited States. Therefore, the current withholding taxrate of 30 percent on gross amounts of U.S. dividendincome remains applicable to individuals that are non-residents for U.S. income tax purposes. This statutoryrate may be reduced according to a relevant U.S.income tax treaty.

The new dividend tax regime applies todistributions from eligible foreign corporations aswell. Such corporations must meet the definition of a“qualified foreign corporation” which, in general,includes: (1) companies incorporated in a U.S.possession, (2) foreign corporations eligible forbenefits from certain U.S. income tax treaties, and (3)foreign corporations whose shares are “readilytradeable on an established securities market” in theU.S.

However, it is important to note that,notwithstanding the above, the preferential rates arenot available to specific foreign corporations. Ingeneral, these excluded foreign corporations includeforeign personal holding companies, foreigninvestment companies, and passive foreign investment

companies, as they are defined by the Internal RevenueCode (“Code”).

Issues. While the 2003 Act clearly identifies theclass of foreign corporations that are potentiallysubject to the new dividend tax regime, it is less thanclear with respect to the class of taxable distributions(aside from actual declared dividends) that are eligiblefor the preferential rates. For example, the Codeintegrates various anti-deferral provisions that operateto include as income at the shareholder level earningsfrom certain foreign corporations. However, these“deemed dividends” are not uniformly defined as“dividends” according to the relevant U.S. taxauthorities. Therefore, to the extent that taxpayers areinvolved in structures that result in “deemed”dividends or “inclusions,” this issue should beexamined closely.

What’s Out

U.S. Individuals Working Abroad. The proposalto eliminate the current exclusion from U.S. incometaxation on income (up to predetermined limits thatare indexed for inflation or $80,000 for 2002) earnedby certain U.S. individuals while working abroad didnot survive. However, published comments from theSenate Finance Committee suggest that this provisionmay resurface at another time in a new bill.

Under the proposal, rather than being subject totax on this income only in the foreign jurisdiction,taxpayers impacted by the reform could have also beensubjected to U.S. income tax as well. However, dueto the foreign tax credit mechanism inherent in theCode, the U.S. income tax liability of the taxpayerwith respect to this non-U.S. income (as preliminarilydetermined after applying any relevant income taxtreaties and the standard U.S. income tax rules andbrackets) would have been reduced by any amountsof tax paid in the foreign country. Consequently, thenet effect of the proposal to the taxpayer would havebeen an additional overall tax cost representing thedifference between the income tax rates in the U.S.and the foreign jurisdiction.

Expatriation of Individuals. Another proposalthat was omitted from the 2003 Act included

treated as receiving a $20x distribution. With regardto the second scenario, the IRS held that thepartnership is not treated as receiving cash (and thusrecognizes no gain). Moreover, each of the partnersis treated as contributing $20x to the partnership inyear 2 ($140x of debt secured by the replacementproperty minus $100x of debt secured by therelinquished property, divided by the number of equalpartners (2)).

Please contact any member of our Tax Departmentif you have any questions regarding the application ofRevenue Ruling 2003-56 or need assistance in planninga Code Section 1031 like-kind exchange.

International Tax Aspects of the Jobs andGrowth Tax Relief Reconciliation Act of 2003:

What’s In and What’s Out


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provisions relating to U.S. individuals that eitherrevoke their U.S. citizenship or change their countryof permanent residence from the U.S. The proposalwould have subjected certain taxpayers to income taxon any built-in gain in their current assets to the extentthat these gains exceeded specific amounts.

This deemed sale of assets approach is in contrastto the current rules that integrate: (1) a threshold taxavoidance purpose test (which is not integrated in theproposed regime) to determine whether the taxpayer’sexpatriation was tax motivated or abusive, and (2) if thisthreshold test is met, an alternative taxing regime (for aten-year period) in which the expatriate taxpayer couldbe subject to more U.S. income tax on specific items ofincome than would be the case for a comparable non-resident alien taxpayer that was not an expatriate.

Therefore, in this context, the current andrelatively more taxpayer-friendly rules continue toconsider the taxpayer’s motive for the expatriation andanalyze the taxpayer’s activities for a protracted periodto determine whether additional taxes should be levied.

Expatriation of Corporations. Finally, from acorporate income tax perspective, attempts to attackU.S. multinational corporations seeking to transfer amajority of their shares and/or assets offshore,including the conversion of its organizational structurefrom U.S.-based to foreign-based, were unsuccessful.

Because U.S.-based companies are generallysubject to U.S. income tax on their worldwide incomeand foreign-based companies are generally onlysubject to U.S. income tax on income related to theirU.S. activities, U.S. companies sometimes seek to“invert” their organizational structure to takeadvantage of this dichotomy.

Pursuant to the proposal, U.S. companiesattempting to effect such an inversion could have been,inter alia, faced with the following: (1) theirtransaction could have been disregarded for U.S.income tax purposes (and thus, been treated as if theirstructure had not changed); (2) the taxpayer could havebeen prohibited from utilizing favorable tax attributes(e.g., net operating losses or foreign tax credits) inthe transaction; and/or (3) the Internal RevenueService could have been given expanded authority to

ELECTION OF MARK-TO-MARKETACCOUNTING FOR SECURITIES TRADERS

by James H. Combs

Certain taxpayers who buy and sell securities asa trade or business are classified for federal incometax purposes as “traders” and are eligible to make anelection under Section 475 of the Internal RevenueCode (“Code”) to account for gains and losses onsecurities using a “mark-to-market” method ofaccounting. Mark-to-market accounting isfundamentally different from the federal income taxlaw’s generally applied “realization” accounting underwhich gains and losses are not subject to tax until thereis a realization event such as the sale or exchange ofproperty. The election results in the acceleration ofthe recognition of unrealized gains and losses fromsecurities, but it also avoids tax law restrictionsotherwise applicable to securities traders and mayreduce compliance burdens and lower a taxpayer’soverall federal income tax liability.

Background

Section 475, as originally enacted, requireddealers in securities (i.e., those persons who regularlyacquire securities from, and sell securities to,customers) to “mark to market” their positions insecurities. This mandatory mark-to-market accountingpreempted the use of previously allowed inventoryaccounting methods. The legislative intent of theSection 475 mark-to-market rule was to provide a more

monitor related party transactions (includingintercompany debt arrangements) in order to attackpotentially tax abusive strategies. The proposal, if ithad survived, would have made it much more difficultfor U.S. multinational corporations to reduce their U.S.income taxes through worldwide restructuring.

Although none of these proposals were integratedin the 2003 Act, taxpayers and tax practitioners alikeshould be mindful of the objectives and ramificationsof these provisions, since some or all of them mayrise again in the future, possibly in different guises,but potentially with no less of an adverse impact onindividuals and multinational corporations.

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The IRS has challenged these assertions and the courtshave developed a facts and circumstances analysis toclassify taxpayers as traders or investors.

There are three primary factors for traderclassification: (i) intent to carry on a trade or business,(ii) the buying and selling of securities as a frequentand continuous activity, and (iii) the seeking of profitsfrom short-term price swings rather than from interest,dividends and capital appreciation. Thus, a taxpayerwho does not intend to purchase and sell securitiesfor investment purposes and has a large volume oftrades and predominantly short-term capital gains maybe able to sustain trader status and would then beeligible to make the Section 475 election.

For some investors, the buying and selling ofsecurities, even though not their main occupation,rises to the level of a trade or business. Irrespectiveof the Section 475 election, it may be advantageousfor a person who may qualify as a trader, but who hashistorically filed tax returns as an investor, to considerreporting securities trades as a trade or businessactivity. Based on the heavily factual nature of thisinquiry, consultation with an attorney to evaluatewhether you potentially qualify as a securities traderrather than an investor is urged. Any of the attorneysin our Tax Department are able to assist you with thisdetermination.

Operation of IRC § 475

Taxpayers generally account for gains and lossesat the time of a realization event and this rule appliesequally to non-electing securities traders and investors.However, an electing trader opts out of realizationaccounting with respect to securities held inconnection with his trade or business of buying andselling securities. Instead, an electing trader marksthe securities to market by determining the fair marketvalue (“FMV”) of the securities on the last day of histaxable year and treating the securities as sold andthen immediately repurchased at that price. Theelecting trader’s gains and losses equal the differencebetween his adjusted basis in the securities and theirFMV. The items of gain and loss are netted in thecalculation of taxable income from the securitiestrading activity. This income or loss, and any income

accurate reflection of a dealer’s taxable income.

In 1997, Congress expanded Section 475 topermit, among others, securities traders to elect mark-to-market accounting for securities held in connectionwith their trade or business of buying and sellingsecurities. Under Section 475(f), a securities traderwho makes the election (an “electing trader”) willrecognize gains and losses on his securities positionseach year despite the lack of a realization event.Although mark-to-market accounting eliminates taxdeferral opportunities for electing traders (becauseunder realization accounting taxpayers can defer gainsby continuing to hold an appreciated position and cantime losses to match recognized gains), the electioncan provide other significant tax advantages. Thisarticle provides a brief overview of (i) who is eligibleto make the Section 475(f) election, (ii) the operationof Section 475, (iii) the potential tax benefits anddetriments of making the election, and (iv) theprocedures for making the election.

Eligible Persons

Taxpayers are generally classified in one of threecategories with respect to the buying and selling ofsecurities: as a dealer, trader or investor. Mosttaxpayers who buy and sell securities are not dealersand their status as a trader depends upon establishingthat they are engaged in a trade or business and arenot merely investors (who are not eligible to make theSection 475 election). Section 475 does not provide adefinition of “trader” nor do other Code provisions orregulations. Whether a taxpayer is a trader isdetermined based on case law developed in othercontexts.

The distinction between an investor and a traderhas implications under various Code sections. Forexample, a trader can deduct certain costs associatedwith buying and selling securities as business expensesunder Section 162; an investor can only deductinvestment expenses under Section 212, subject to a2% adjusted gross income limit. This has resulted inlitigation where taxpayers who manage their ownportfolios have asserted that their activity of buyingand selling securities exceeded mere investmentactivity and rose to the level of a trade or business.

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or loss from securities subject to mark-to-marketaccounting that are sold before the end of the taxableyear, is ordinary in character rather than capital (aswould be the case for an investor or a non-electingtrader). The mark-to-market price at which theelecting trader is deemed to repurchase the securitiesbecomes their new tax basis.

Electing traders are not precluded from holdingsecurities for investment (i.e., as capital assets thatmay be taxed at favorable long-term, capital gainsrates). The electing trader does not mark to marketsecurities held as investments if he identifies thesecurities by the close of the business day on whichthe securities are acquired (or such other time asprescribed in regulations, when issued). The burdenof proof is on the electing trader to demonstrate thatthe identified securities have “no connection” to histrade or business activity. It is possible for a securitythat qualifies for this exception to mark-to-marketaccounting to become subject to mark-to-marketaccounting if a connection to the electing trader’s tradeor business develops.

Consequences of a Section 475(f) Election

The Section 475 election has signif icantconsequences because the electing trader has foregonethe ability to indefinitely defer unrealized appreciationfor securities not identified as investment assets.However, the nature of securities trading (which formsthe basis for classification as a trader) is such thatsecurities are generally held short-term. Therefore,long term capital gains rates would usually not beavailable in any event and the timing difference mayrealistically be the loss of no more than one year’s taxdeferral. This detriment is also offset by the electingtrader’s ability to avoid tax law restrictions (describedbelow) that apply to investors and non-electing traders.The required recognition of both gain and loss rendersthe restrictions unnecessary. Some of the primarybenefits of making the Section 475 election are:

• The wash sale rules of Section 1091 do not applyto an electing trader’s securities that are marked tomarket. These rules generally defer a taxpayer’sloss if the taxpayer sells securities at a loss and has

bought substantially identical securities within theprevious 30 days or repurchases substantiallyidentical securities within the subsequent 30 days.Electing traders can buy and sell substantiallyidentical securities without deferral of the loss.

• Restrictions on the use of capital losses underSection 1211 do not apply to electing tradersbecause all securities trading gains and losses areordinary. Therefore, the electing trader is notlimited to deducting securities losses to the extentof capital gains and $3,000 in ordinary income. Inaddition, the electing trader can carry net operatinglosses back 2 years and forward 20 years underSection 172 to offset both ordinary income andcapital gain (rather than just being able to carry thelosses forward under Section 1212 and offsettingincome as provided in Section 1211).

• The election does not cause the electing trader tobecome subject to self-employment tax.

• Securities that are marked to market will not causea constructive sale under Section 1259 of a positionin securities that are not marked to market.

• The straddle rules of Section 1092 do apply toelecting traders. A straddle involves a taxpayerentering into economically offsetting positions; asone position appreciates, the other correspondinglydepreciates. The straddle rules require the taxpayerto defer any losses on the disposition of theunprofitable leg, except to the extent that the lossesdo not exceed unrealized appreciation on theprofitable leg. This eliminates the ability to generatetax losses without economic exposure. However,the straddle rules will not affect an electing traderif both the profitable and unprofitable legs aremarked to market.

• Electing traders can still identify securities held forinvestment, which permits the electing trader todefer unrealized gains and qualify for favorablelong-term capital gains rates with respect toinvestments.

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Procedure for Electing Under Section 475(f)

The IRS has published rules for making a Section475 election. These rules are very specific and, inprivate letter rulings, the IRS has not granted relief totaxpayers requesting permission to file a late election.In order to comply with the IRS’ rules, a taxpayer mustfile a statement by the due date of his tax return (withoutregard to extensions) for the taxable year immediatelypreceding the taxable year for which the election isbeing made. Therefore, a calendar year taxpayer whose2002 return is due April 15, 2003 must file the statementwith that return on or before April 15, 2003 in order tomake the election effective for 2003. For taxpayersrequesting an automatic extension for the filing of theirreturn, the statement must be filed with the request onor before the due date for filing the request (e.g., April15 for a calendar year individual). A different ruleapplies to a “new” taxpayer, i.e., a taxpayer that did notfile a return in the previous year. New taxpayers mustmake a statement in their books and records no laterthan the 15th day of the third month after the beginningof the election year and file a copy of the statementwith their tax return for the election year. The statementmust provide information on the election being made(e.g., “Election Under Section 475(f)”), must identifythe first taxable year for which the election is effectiveand must identify the trade or business for which theelection is made.

The change to mark-to-market reporting is achange in method of accounting. Although the IRSmay require consent before a taxpayer can change amethod of accounting, this consent is automaticallygranted where the taxpayer satisfies the rules for makingthe election. (In contrast, the election can only berevoked with the consent of the IRS.) The taxpayermust file a Form 3115 both with its timely filed return(including extensions) and with the National Office ofthe IRS. As a result of the change in method of accounting,the taxpayer may have to make a “Section 481 adjustment”if the taxpayer has filed returns as a trader in prior yearsand holds appreciated or depreciated securities in its tradeor business at the time of the election. The built-in gain orloss on these securities is generally taken into account asan adjustment in the four years beginning the year of thechange by including in (or deducting from) income one-fourth of the amount of gain (loss) each year.

Conclusion

The Section 475 election presents opportunitiesfor securities traders. These taxpayers may benefit frombetter matching of income and losses in their securitiespositions without the application of various tax lawrestrictions. However, these taxpayers may also sufferthe detriment of the loss of deferral of gains in thesecurities marked to market. For this reason, eligibletaxpayers should carefully review their individualsituation to determine whether to make the Section 475election.

STATE TAX AMNESTY PROGRAMS ABOUND

by June Summers Haas

Multi-state taxpayers with outstanding tax bills,tax warrants, audit assessments, or potential filingresponsibilities have the unique opportunity to clear upthese liabilities at a reduced cost. Six states and NewYork City are running state tax amnesty programs forthe periods listed below:

• Florida amnesty - July 1, 2003 - October 31, 2003• Missouri amnesty - August 1, 2003 - October 31, 2003• Arizona amnesty - September 1, 2003 - October 31, 2003• Maine amnesty - September 1, 2003 - October 31, 2003• Virginia amnesty - September 2, 2003 - November 3, 2003• Illinois amnesty - October 1, 2003 - November 15, 2003• New York City amnesty - October 20, 2003 - January 23, 2004

A brief summary of each tax amnesty program isset forth below.

Florida Tax Amnesty. The Florida tax amnestyapplies to all bills, delinquencies, tax warrants, auditassessments, and unreported taxes due on or before July30, 2003. Under the tax amnesty, taxpayers whovoluntarily pay all back-taxes will be assessed nopenalty and reduced interest rates. Interest will bereduced by 50% for all taxpayers reporting anunassessed liability or who are filing a late return.Interest will be reduced by 25% for all taxpayers payingassessments, bills, or warrants. All taxes administeredby the Florida Department of Revenue are included inthe amnesty, except unemployment tax and Miami-

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Dade County Lake Belt mitigation fees. Certaintaxpayers under criminal investigation or those whohave entered into a settlement or payment agreementprior to July 1, 2003 are not eligible for tax amnesty.

Missouri Tax Amnesty. The Missouri tax amnestyis available to all taxpayers with unpaid state taxes thatwere due on or before September 31, 2002. Lien feesand bad check charges are not eligible for tax amnesty.Taxpayers paying all unpaid taxes will receive a waiverof all penalties and interest otherwise due. Toparticipate in the state amnesty program, a taxpayermust sign and return a Tax Amnesty Eligibility Noticeor a Tax Amnesty Application and send full payment tothe Department between August 1 and October 31,2003. To qualify for tax amnesty, taxpayers must be incompliance with all taxes administered by theDepartment.

Arizona Tax Amnesty. Arizona is offering taxamnesty on individual, corporate, and fiduciary incometax, withholding tax, luxury tax, transaction privilege,and use taxes that are due for any tax year beginningon or after January 1, 1983, but ending before January1, 2002. Eligible taxpayers are those who haveunreported tax liabilities, underreported tax liabilities,or assessments from the Department that have not yetbecome final. To take advantage of the tax amnesty,taxpayers must fill out the appropriate tax amnestyapplication and pay at least one-third of the amountdue for all amnesty periods by October 30, 2003.Taxpayers have until May 1, 2004 to pay the remainingbalance in equal monthly installments. In certaincircumstances, other payment arrangements may beconsidered.

Maine Tax Amnesty. Maine is offering tax amnestyfor all taxes administered by the Maine RevenueServices, including corporate and individual incometax, withholding tax, sales and use tax, motor fuel tax,and estate tax. Taxpayers with any outstanding taxliability, or unreported or underreported tax liabilitiesdue on or before August 31, 2003 are eligible. Eligibletaxpayers must fill out an amnesty application and enclosefull payment of the full amount of tax and 50% of theinterest due. The remaining interest and all of the penaltieswill be waived. Payment may be made by credit card.

Virginia Tax Amnesty. Virginia is offering taxamnesty for all outstanding tax bills, delinquent returns,and unfiled taxes. The Virginia Department of Taxationwill waive all penalties and 50% of the outstandinginterest. The Department is still developing programguidelines and eligibility requirements that are expectedto be issued on September 2, 2003.

Illinois Tax Amnesty. Illinois is offering taxamnesty for all taxes collected by the IllinoisDepartment of Revenue for taxes due after June 30,1983 and before July 1, 2002, except motor fuel usetax. All taxpayers are eligible except those involved incriminal or civil litigation relating to any Illinois tax.All penalties and interest will be waived for eligibletaxpayers. The Department is drafting rules toimplement this program.

New York City Tax Amnesty. The New York CityDepartment of Finance is offering tax amnesty for itsgeneral corporation tax, unincorporated business tax,commercial rent tax, and several other taxes. Theamnesty does not include real estate, personal income,or sales and use taxes. Under the amnesty program,the Finance Department will waive penalties and reduceinterest for qualifying taxpayers. Amnesty is availableonly for tax years or periods ending on or beforeDecember 31, 2001. Under the amnesty program, allunpaid penalties are waived and the taxpayer isresponsible only for interest accrued since October 20,2000. All interest accrued in prior periods will bewaived. Taxpayers who have unf iled returns,underreported income, outstanding interest or penalties,outstanding tax bills or warrants, and tax assessmentsthat are under appeal are eligible. Taxpayers that haveentered into settlement or payment agreements are noteligible for tax amnesty. The Finance Department isstill developing more detailed information, includingapplications, instructions, and eligibility requirements.

It is unprecedented for six states and New YorkCity to offer tax amnesties almost simultaneously.Multi-state taxpayers should carefully review theiroutstanding tax debts and potential tax filing obligationsto see if they can take advantage of any of theseopportunities. Contact your tax professional to ensureyou meet all eligibility requirements.

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Honigman Miller Schwartz and Cohn LLP is a general practice law firm with over 190 attorneys at its three officesin Michigan. Our Tax Department includes the attorneys listed below. Except as indicated below, the attorneys arelicensed to practice law in the state of Michigan only.

Regis A. Carozza [email protected] (313) 465-7342James H. Combs (a) [email protected] (313) 465-7588Roger Cook [email protected] (313) 465-7358Michael W. Domanski [email protected] (313) 465-7352Alexander G. Domenicucci [email protected] (313) 465-7672Gerald M. Griffith [email protected] (313) 465-7402June Summers Haas (b) [email protected] (517) 377-0734Jeffrey A. Hyman [email protected] (313) 465-7422Marguerite Munson Lentz (c) [email protected] (313) 465-7462Charles Nida [email protected] (313) 465-7496Aaron M. Silver [email protected] (313) 465-7560Richard S. Soble [email protected] (248) 566-8488Daniel L. Stanley [email protected] (517) 377-0714Alan M. Valade (c) [email protected] (313) 465-7636Patrick R. Van Tiflin [email protected] (517) 377-0702Richard E. Zuckerman (d) [email protected] (313) 465-7618

(a) Licensed to practice law in Michigan and Texas.(b) Licensed to practice law in Michigan and California.(c) Licensed to practice law in Michigan and Florida.(d) Licensed to practice law in Michigan, California and Nevada.

Honigman Miller Schwartz and Cohn LLP’s Tax Law Focus is intended to provide information but not legal adviceregarding any particular situation. Any reader requiring legal advice regarding a specific situation should contactan attorney.

Honigman Miller Schwartz and Cohn LLP also publishes newsletters concerning antitrust, corporate, employment,environmental, health care and immigration matters. If you would like further information regarding thesepublications, please contact Mary Sanders at (313) 465-7938. Articles and additional information about our firmand its attorneys are included in our Internet Web site (www.honigman.com).

(c) Copyright 2003 Honigman Miller Schwartz and Cohn LLP. Photocopying or reproducing is a violation offederal copyright law and is strictly prohibited without our consent.

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