Friday, December 31, 2010

IRS 2010 Milestones

by Robert W. Wood
The Tax Lawyer

“It was the best of times, it was the worst of times,” was Dickens’ elegant nod to the truism that every age has highs and lows. In our current epoch, each year-end is replete with schmaltzy media reprises, lists and more lists. Celebrity hookups and breakups, business booms and busts, political gaffes, deaths, milestones and more. You name it, there’s a list.

I must be out of touch, since I sometimes find myself entirely unfamiliar with items on the lists. Take the Wall Street Journal’s list of the year’s fashion highs and lows. Happily, I had never heard of “jeggings,” an odd hybrid of jeans and leggings. My initial impression?

Horrified, though perhaps that was because the Journal depicted Conan O’Brien mockingly modeling the jeggings. But I’ve been watching the tax world for 30 years, and here’s my own not very scientific list of 10 highs and lows we taxpayers saw in 2010, mostly from the IRS, but some from our elected representatives in Congress.

1. Not So Voluntary Disclosure? If you have a foreign bank account with more than $10,000, you have extra forms to file or penalties to face. As the UBS debacle proved, not much is secret these days, even in the land of rich chocolate. While the special Voluntary Disclosure program deadline for the IRS ended October 15, 2009, many disclosures outside the special program trickled into 2010 and more are coming. See IRS Commissioner Doug Shulman’s Statement on UBS / Voluntary Disclosure Program.

In fact, the IRS is considering a new program. On the one hand, the IRS doesn’t want to make you feel bad if you stepped forward early. They said it was really a deadline and anyone thereafter would get the book thrown at them. On the other hand, if you don’t offer people some incentive to step forward, how will you find them all? It’s a tough debate.

But the IRS could take a page from car dealers. None of us really think it’s “the best sale ever” or the “lowest price ever” when we buy a car, do we? After we buy, we know some other guy or gal will get an even better deal. That’s OK. Like car dealers, maybe the IRS should just come up with a new program, advertise it widely (even more widely than last time, please) and move on. Maybe throw in free undercoating too.

For more, see FAQs Regarding Report of Foreign Bank and Financial Accounts (FBAR) – Financial Accounts.

2. Disaster Relief, Madoff Relief and More. It may be sacrilegious to lump these together, but hear me out. The IRS did a great job of rushing out guidance and assistance to people beset by natural disasters. Not so much with people beset by ponzi schemes.

On the whole, though, you have to hand it to the IRS, which has adapted amazingly well to the hubbub of “we want it now” guidance. Sure, there are many places where tax practitioners remain frustrated for years at the lack of guidance. But with a metaphorical oil can, the IRS applies it pretty effectively where needed to squeaky wheels.

3. Estate Tax. This one was not the IRS’s fault, so thank Congress. The estate planning world was thrown into a frenzy when the Bush Era estate tax holiday finally came due at the end of 2009, with no estate tax at all in 2010. All year we wondered, and Jack Kevorkian followers perked up with water cooler chatter. A number of billionaires died in 2010, and their heirs are smiling all the way to the bank.

Finally, though, at the end of 2010 we got a 2 year patch that seems to make sense. With $5 million exemptions, portability between spouses and unified gift, estate and generation skipping features, here’s hoping it lasts beyond 2012.

4. IRS Website. No kidding, the IRS website is unbelievably helpful, and every year it gets better. The IRS has tweeted itself into this decidedly un-Dickensian era. For consumers and tax practitioners, I suggest going there often. I do.

There are news releases and updates, regulations and rulings, new form announcements, tips and traps about filing, even Q&A formatted guidance that you’ll often find will answer your questions. Sign up for the email alerts too. You can even get on lists to get notices of IRS sales and auctions.

Clients sometimes ask if they will be tracked for visiting the IRS site. For example, if you read about IRS rules regarding foreign accounts, will the IRS know this and think you have a foreign account? I don’t think so.

5. Bush-Era Rates. This was quite ridiculous, with no end of teeter-tottering and political fisticuffs that left taxpayers not knowing until mid December 2010 what rates would apply in 2011! Thank Congress, not the IRS. In fact, the IRS was just as frustrated as we were, worrying over return filing messes.

So we all blathered about what to do. I still say the debate would have been over sooner if we’d called the rates by another name. But all’s well that end’s well. Now we have a two year reprieve of (at least this) rate debate, including 15% long term capital gains for all.

Small Companies Look to Cloud for Savings in 2011

By EMILY MALTBY

A growing number of small-business owners are expected to try cloud computing services next year, hoping to trim costs and stay up and running if disaster strikes.

Cloud computing refers to any service that operates over an Internet connection, allowing immediate access from any computer or mobile device with Web access. Business owners can access software or store information—such as customer contacts, accounting data and presentations—and leave the technical maintenance to the cloud provider.

As of April 2010, only about 7% of small-business owners were using cloud services, but that number is expected to grow to more than 10% by mid-2011, according to a survey by technology-research firm IDC. "Moving the trend forward in the smallest companies is the affordability and flexibility," says Raymond Boggs, vice president of small and mid-sized business research at IDC.

Software that is accessed through the cloud is often free or pay-per-use—a more affordable model than paying big, upfront licensing fees. Half of small firms that use "the cloud" say it has improved their bottom line, according to a survey this fall by Microsoft Corp., which provides cloud services.

A number of surveys show that some business owners are hesitant to try cloud computing because they don't want to stray from familiar systems or invest in new ones. Some owners that have made the switch, however, say it has been a boon to their cash-strapped firms.

Garey Willbanks, owner of Boiler Management Ltd. in Houston, says he pays about $600 a month to store information in the cloud. He estimates that is less than a tenth of what he would pay if he hired technology personnel to run an in-house storage server.

Mr. Willbanks made the switch to cloud computing after Hurricane Ike cut power to his area in late 2008. At the time, he had in-house servers to channel and store vital information about the water-heating systems his firm had installed. Without access to the servers, his business was at a standstill. "We had no connectivity in our office for 24 hours," he says. "I said, 'We can't be this vulnerable.'"

Mr. Willbanks hired Rackspace Hosting Inc., a San Antonio cloud provider, which assumed responsibility for the storage of Boiler Management's information—from the heater monitoring to email contacts. Since then, Mr. Willbanks hasn't needed anyone to trouble-shoot server issues, and he is connected all the time, accessing information from his BlackBerry, iPad, or laptop.

Some owners, like Mr. Willbanks, use the cloud simply to back up information. Others use it to access software programs through the Web, known as "software as a service," rather than from a local computer.

Cloud services often make expensive software affordable to small firms, says Rob Enderle, technology consultant and founder of Enderle Group Inc., in San Jose, Calif.

In June, Michael Tracy, a private law practitioner in Irvine, Calif., decided to try Nextpoint, a cloud-based program for attorneys. He had previously spent $10,000 to $12,000 a year licensing software that would organize materials before a trial. The problem was he needed it just a few times a year. By contrast, Mr. Tracy pays for Nextpoint only when he uses it, and he anticipates spending just $4,000 to $6,000 a year on the service.

The actual savings of using the cloud will vary, says Mr. Enderle. Cloud software is inexpensive upfront and can cut costs by streamlining processes. For example, accounting software helps business owners manage finances. But when that software is in the cloud, the business owner's accountant may also access it. By seeing those finances in real time, the accountant can trouble-shoot cash-flow issues before they arise and can more easily file tax returns.

"If you already have tight control over your company, your expenses may drop 10% to 20%," says Mr. Enderle. Companies that use cloud services to improve inefficiencies might see an even greater return, he says.

Despite the savings, there are risks. Security breaches, for instance, can happen if the cloud provider isn't reliable. "If they make money directly from you, then they will want to secure [your information]," Mr. Enderle says. "If they make it through advertising," they may be more likely to sell the information to advertisers, he says.

And while in-house software can often be customized, cloud software often can't. Mr. Tracy says that when he uses Nextpoint, "some of the documents are case-specific," and he can't use a general software program like Nextpoint to organize and search them.

Others fear that they might lose their information, or have to spend a lot of time transferring data, if they want out. Kirby Allison, founder of Hanger Project LLC, a garment-hanger company in Dallas, has been using a cloud-based marketing software, Campaigner, for two years. "We'd lose access to so much information if we stop using Campaigner," says Mr. Allison, referring to historical data, such as reams of marketing analytics, which he says would require "several days' worth of work" to transfer to another system.

"As with any information you gather over time, if you are relying on the provider to store it then it can be very painful to move it over," says Melanie Attia, project marketing manager at Campaigner. "So make sure it's the right provider and that you're ready to be in it for the long haul."

Mr. Allison plans to continue using Campaigner, as he estimates that the $25 a month he pays to send email promotions to thousands of customers is a fraction of what he'd pay a marketing firm. "It really isn't much money at all," he says. "And it works great."

Thursday, December 30, 2010

New Estate Tax Law Could Hurt Charity

by Deborah L. Jacobs

Billionaires Gates, Buffett and Zuckerberg will still give big. But what about ordinary donors?

For donors, a crucial question has always been how much to give to charity while alive and what to leave as charitable bequests in their wills or trusts. The economic crisis has caused many people to cut back on current charitable giving, perhaps figuring they could always make up for it with bequests. But changes in the federal estate tax system signed into law by President Obama on Dec. 17 may well lead some of those who had postponed charitable giving to cut back on future bequests too.

The new tax law raises the exemption from federal estate tax to $5 million a person ($10 million per couple) for deaths in 2011 and 2012. As a result, fewer families will even come close to paying the tax. That means that, except for the super wealthy, the tax benefits of giving through an estate plan have been wiped out.

Previously, charities could point to the estate planning benefits of both lifetime gifts and charitable bequests. There’s an income tax deduction associated with gifts during life--adjusted gross income can be reduced up to 50% for cash gifts to public charities and by up to 30% for donations of appreciated assets, such as stock held longer than 12 months. But charities could also make another argument: If you’re not comfortable making a large gift now, remember your favorite cause or alma mater money in your will and you will be leaving less for Uncle Sam.

Of course that’s still a huge estate tax benefit for the nearly 60 U.S. billionaires who have now pledged to give away at least half their fortunes during life or at death. Facebook co-founders Mark Zuckerberg and Dustin Moskovitz are among those to have recently joined the philanthropic campaign led by Berkshire Hathaway ( BRK - news - people )'s Warren Buffett and Microsoft ( MSFT - news - people ) co-founder Bill Gates.

And certainly there are many others of lesser means committed to supporting charity regardless of the tax benefits. But without being too cynical or ignoring the power of altruism, studies do suggest that tax incentives are a positive influence on giving, and tough economic times are a negative one.

Had the Bush tax cuts been allowed to expire at the end of this year, the estate tax exemption amount would have returned to just $1 million, giving many affluent folks a tax reason to make both lifetime charitable gifts and charitable bequests. Now, with married couples able to pass up to $10 million tax-free, most people do not need to be concerned about pruning their net worth through lifetime gifts, whether to charity or to family.

Even for billionaires, who still have a tax incentive to make charitable bequests, the new law diminishes the tax savings. To compute what’s saved you multiply the amount donated by the estate tax levy--at the new rate, that’s 35 cents on every dollar donated; it would have been 55 cents if the tax rate had gone to 55% for most estates in 2011, as it was scheduled to do under the previous law.

At the same time, a special tax break that allows older folks to donate assets directly to charity directly from an IRA suddenly has less allure too. As a part of the just passed tax package, Congress extended retroactively the "charitable IRA rollover" that had expired on Dec. 31, 2009. This on-again, off-again provision, first introduced in 2006, allows people 70 1/2 and older to transfer as much as $100,000 per year directly from their traditional IRAs to charity. The donation can count against the "required minimum distributions" they would otherwise be required to take.

Note that there’s no income tax deduction for these contributions, but the sum going to charity is not included in the donor’s adjusted gross income. (The advantage of this is that the older donor isn’t subject to percentage limitations on charitable deductions and may be able to avoid certain penalties that come with a higher AGI, such as higher Medicare premiums.) The provision was only extended until the end of 2011, although donors can make 2010 contributions retroactively through January.

Certain limitations continue to apply: the IRA rollover money cannot be contributed to donor-advised funds, supporting organizations or private non-operating foundations. Whether or not you’re eligible to do a rollover, you can still donate IRA assets through an estate plan. And in doing so there’s more latitude about which charitable entity can receive the gift. To make these gifts, you must name the charity on the beneficiary designation form--for example, by making the charity a 100% beneficiary of the account or indicating that the charity is a beneficiary of a specific percentage of the funds and having the rest go to other beneficiaries.

Still, from a tax perspective, why would you want to donate IRA assets? Until recently, charities could make the case that these gifts, whether made during life or through an estate plan, were preferable to leaving retirement assets to heirs. In both cases the strategy avoided the possibility that together estate tax and income tax would eat into the inheritance. (Since charity is tax-exempt, it can draw the funds without paying income tax.)

But how the world has changed during the past year. With a higher exemption amount, the federal estate tax concerns fewer donors who might have otherwise donated IRA assets. And meanwhile, the possibility of converting a traditional IRA to a Roth IRA -- an option that became available in 2010 to all taxpayers, regardless of their income or filing status -- has given the charities some stiff competition for IRA nest eggs that account owners don’t expect to need.

Although you have to pay income tax on the amount converted from a traditional account, doing that eliminates the requirement for you or your heirs to pay tax on future distributions. And because you avoid the requirement to take yearly minimum distributions starting at age 70 1/2, that can leave more for beneficiaries if you don’t use the money yourself. The potential for growth inside this tax-free wrapper is substantial. So assuming you can afford to pay the tax with nonretirement assets--and can stomach the idea--you might now find this strategy preferable to giving an IRA to charity.

For all these reasons, it’s small wonder that charities mostly stood on the sidelines during the 2010 debate over reinstating the estate tax. The charities would have fared much better if, as scheduled, the tax-free amount reverted to $1 million in 2011 with the tax on the balance rising to 55% in most cases. But had they openly lobbied for this, they would have angered potential donors.

As always, gifts made during life, if you can afford them, have a lot more psychic appeal since you have the satisfaction of seeing for yourself how your money is put to use. Plus (with the exception of money donated through an IRA rollover) you get a current income tax deduction. Yet until the economy rebounds, questions like "Will I have enough to retire comfortably?" and "Do my spouse and children need a larger inheritance than I previously assumed?" are likely to keep distracting donors from philanthropy.

In an ideal world, wealthy families that stand to benefit from the estate tax cut will make provisions to give at least some of those tax savings back to charity--either during life or through an estate plan. Whether this will happen, remains to be seen.

Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide (DJWorking Unlimited, 2009).

Gift Tax Under The 2010 Tax Relief Act (P.L. 111-312): Different Rules For 2010, 2011 & 2012

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312 (2010 Tax Relief Act), which President Obama signed into law on December 17, 2010, makes significant changes to the gift tax.

Different Years, Different Rules

2010

The 2010 Tax Relief Act keeps the gift tax rate and exemption the same as it was under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA): 35% tax rate and $1 million exemption for individuals.

2011 and 2012

The 2010 Tax Relief Act keeps the gift tax rate at 35% for 2011 and 2012, but the gift tax will be significantly different in 2011 and 2012.

(1) Higher exemption. The gift tax exemption for 2011 and 2012 is increased from $1 million to $5 million for individuals. So, individuals who used their entire $1 million gift tax exemption prior to 2011 will be able to gift an additional $4 million in 2011 and 2012 without incurring a gift tax.

(2) Unified exemption. The gift tax exemption will be reunified with the estate tax exemption, starting 2011.

(3) Indexed for inflation. Starting 2012, the gift tax exemption will be indexed for inflation.

(4) Portable. In 2011 and 2012, the gift tax exemption will be portable. Portability allows a surviving spouse to use the amount of estate and gift tax exemption not used by the decedent spouse. For an explanation, see Deborah L. Jacobs, Married Couple’s Guide To The New Estate Tax Law, Forbes, Dec. 23, 2010.

Gift Tax Strategies

The changes that the 2010 Tax Relief Act has a number of implications for estate planning.

(1) Changes year-end planning.

Many older, wealthy people were waiting until the end of the year to make large taxable gifts. Under EGTRRA, there was no estate tax in 2010, but it was scheduled to return in 2011 with an exemption of $1 million and a tax rate of 55% (60% in some cases). Also, under EGTRRA, the gift tax rate was scheduled to jump from 35% in 2010 to 55% in 2011 (with an exemption of $1 million). The idea was to make large taxable gifts and pay a gift tax of 35%. A transfer in 2010 under EGTRRA would have saved at least 20% compared to a transfer (either during life or upon death) under the rules that were scheduled for 2011. A 20% tax savings is significant.

The 2010 Tax Relief Act changes this year-end planning. Taxable gifts for clients in the $5 to $10 million dollar range probably should not be made in 2010. The reason for this is that the exemption under the 2010 Tax Relief Act jumps from $1 million in 2010 to $5 million in 2011. So, by waiting just a few days, money can be transferred by gift without incurring a gift tax.

(2) Limits the 2010 GST tax opportunity.

As I wrote in an earlier post, Congress provided the wealthy a tremendous generation-skipping transfer tax opportunity just for 2010. The 2010 Tax Relief Act reinstated the GST tax in 2010. But Congress is providing a GST tax “holiday” because the GST tax rate in 2010 is 0%.

The $1 million gift tax exemption in 2010 acts as a limit or cap to the 2010 GST tax opportunity. At a minimum, it makes decisions regarding whether to take advantage or pass on Congress’ 2010 GST tax gift more complicated.

Still, distributions in 2010 from non-exempt GST tax trusts can generally be made without incurring a gift tax. (If you have further questions about the GST tax opportunity in 2010 and whether it is right for you, you should consult your estate planning advisor immediately. Time is of the essence as this opportunity is only around for a few more days.)

(3) Creates gifting opportunities in 2011 and 2012.

The gift tax in 2011 and 2012 will be levied at a rate of 35% and with an exemption of $5 million that is portable.

(a) People who were once limited by the $1 million gift tax exemption will be able to gift up to the new limit.

(b) The $5 million exemption can be stretched with proper estate planning. Congress did not change the rules for grantor retained annuity trusts or for valuation discounts. It had been threatening to significantly restrict these estate planning tools. So, they can be used in 2011 and 2012 (so far). (Further, planners who make seed gifts before selling to intentionally defective grantor trusts will use the higher exemption to transfer tremendous amounts of wealth. I am planning to discuss this strategy in a separate post.)

Resources

•Deborah L. Jacobs, How the New Tax Law Affects Your Estate Plan, Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide (Update 2) (a summary that everyone can understand).

•Joint Committee on Taxation, Technical Explanation Of The Revenue Provisions Contained In The “Tax Relief, Unemployment Insurance Reauthorization, And Job Creation Act Of 2010″ Scheduled For Consideration By The United States Senate (JCX-55-10) (summarizing H.R. 4853; providing a plain English explanation of the law before EGTRRA, under EGTRRA, and as reformed by H.R. 4853).

•Steve R. Akers, Estate, Gift and Generation-Skipping Transfer Tax Provisions of “Tax Relief… Act of 2010,” Enacted December 17, 2010, ACTEC, Dec. 21, 2010 (a technical discussion of the changes; cites to the 2010 Tax Relief Act).

•Hani Sarji, Gift Tax: Changes Made by the 2010 Tax Relief Act (visually presenting the changes that the 2010 Tax Relief Act makes to the gift tax, IRC § 2505).

Handling Sales And Use Tax Audits: Best Practices That Every Tax Department Needs To Know

The current recession has had a devastating effect on U.S. state budgets; in some states, sales and use tax revenues have fallen by as much as 14% since 2008. To increase audit-generated revenues, many states are expanding their efforts to identify companies likely to have issues with sales and use tax compliance, and taxing authorities are pursing audit leads from various sources. To help you prepare for and manage audits that achieve the best outcome for your business, this article captures audit best practices and offers tips on how to jump-start development of an internal audit manual for your business. An audit manual documents how your organization manages audits and helps ensure that future audits are handled in a consistent and efficient manner. (P. L. Pelino, C. S. Iafrate, and S. Steinbring, 20 Journal of Multistate Taxation and Incentives, No. 9, 18 (January 2011).)

IRS Issues Long-Awaited Guidance On Series LLCs; Will The States Soon Follow?

In September 2010, the IRS issued proposed regulations that generally treat each series of a limited liability company (LLC) as a separate entity and wisely apply the entity classification provisions of the “check-the-box” regulations to each series. This article first examines the “helpful and well-written guidance” provided by Treasury in the proposed regulations, and then analyzes the impact that the proposed regulations may have on state tax issues regarding series LLCs. With the issuance of this long-awaited guidance, there will likely be an increased use of series LLCs as well as the issuance of additional guidance by the states regarding whether they will adhere to the federal tax treatment. (M.W. McLoughlin and B.P. Ely, 20 Journal of Multistate Taxation and Incentives, No. 9, 8 (January 2011).)

H&R Block Announced It Will Be Unable To Offer Customers Refund Anticipation Loans

H&R Block Inc., the giant tax preparation provider, announced on Dec. 24 that, at present, it will be unable to offer customers refund anticipation loans (RALs) due to a federal regulatory decision. (Dec. 24 Press Release - HSBC Terminates Agreement to Provide RALs at Direction of OCC) HSBC, the company's banking partner, which has had a long-term contract with H&R Block to provide all of its RALs, was ordered by the Office of the Comptroller of the Currency to stop making any form of the loans, H&R Block said. According to news reports, H&R Block and HSBC have been engaged in a legal dispute over attempts by the bank since August to disengage from its agreement to make such loans. The bank's motivation was reportedly linked to an IRS decision announced on August 5 that starting with the 2011 tax filing season the agency will no longer provide tax preparers and associated financial institutions with the “debt indicator,” which is used to facilitate RALs. HSBC no longer has the exclusive right to provide RALs to H&R Block customers and the tax preparer will now be able to enter into other partnerships for financial products, the firm said. “As a result of the OCC's decision, millions of taxpayers will be deprived of credit, or they will be forced to use higher-priced alternatives, without the slightest benefit to the solvency of HSBC or the banking system in general,” said Alan Bennett, H&R Block's president and CEO. “While we are very disappointed by this decision, we have been preparing for the loss of RALs, so we have several other financial products available and under development for this tax season.”

Congress-Passed Omnibus Trade Act Of 2010 Includes Health Care Tax Credit And Large Corporate Estimated Tax Changes

On December 22, the House and Senate by unanimous consent approved H.R. 6517, the Omnibus Trade Act of 2010 (Trade Act), clearing the bill for the President's signature. The bill amends the Trade and Globalization Adjustment Assistance Act of 2009, and also makes changes to the refundable health coverage tax credit (HCTC) under Code Sec. 35 and to estimated taxes of large corporations in 2015.

HCTC changes. Under pre-Trade Act law, an “eligible individual” (e.g., an eligible trade adjustment allowance (TAA) recipient) could claim a refundable HCTC equal to 80% (65% for “coverage months” beginning after 2010) of the amount paid by the taxpayer for coverage of the taxpayer and qualifying family members (spouse and dependents) under qualified health insurance for eligible coverage months beginning in the tax year. For eligible coverage months beginning before Jan. 1, 2011, qualifying family members could continue claiming the HCTC for up to 24 months after the eligible individual enrolls in Medicare, divorces, or dies.

New law. The Trade Act keeps the HCTC percentage at 80% for eligible coverage months beginning before Feb. 13, 2011. (Code Sec. 35(a), as amended by Trade Act Sec. 111(a)) The Trade Act also provides that for eligible coverage months beginning before Feb. 13, 2011, qualifying family members may continue claiming the HCTC for up to 24 months after the eligible individual enrolls in Medicare, divorces, or dies. (Code Sec. 35(g)(9), as amended by Trade Act Sec. 115(a)) A number of conforming extensions are made, e.g., to Code Sec. 35(c)(2)(B), Code Sec. 35(e)(1)(K), Code Sec. 7527(e), and Code Sec. 9801(c)(2)(D).

Estimated tax change. For large corporations (those with assets of at least $1 billion determined as of the end of the previous tax year), Sec. 561(2) of the Hiring Incentives to Restore Employment Act (HIRE Act, P.L. 111-147) increases the percentage of any required installment of corporate estimated tax which is otherwise due in July, Aug., or Sept. of 2015. The Trade Act increases the percentage under Sec. 561(2) of the HIRE Act in effect on the enactment date by 4.5 percentage points. (Trade Act Sec. 302)

Automatic Consent Procedures For Failure To Meet New Code Sec. 833(C)(5) Medical Loss Ratio Limit — Notice 2011-4, 2011-2 IRB

A new Notice provides procedures for a taxpayer to obtain automatic consent to change its method of accounting for unearned premiums because of Code Sec. 833(c)(5). This provision, which was added by the Patient Protection and Affordable Care Act (Affordable Care Act, P.L. 111-148), limits the application of Code Sec. 833 to otherwise-qualifying taxpayers with a medical loss ratio that is not less than 85%.

Background. Code Sec. 833 provides special rules for existing Blue Cross and Blue Shield organizations within the meaning of Code Sec. 833(c)(2) and certain other organizations that are described in Code Sec. 833(c)(3) (generally, other organizations that meet certain community-service-related requirements and substantially all of whose activities involve providing health insurance).

Under Code Sec. 833(c)(5), as amended by the Affordable Care Act, for tax years beginning after Dec. 31, 2009, health organizations whose medical loss ratio is below 85% cannot take advantage of the favorable tax provisions of Code Sec. 833.

An organization's medical loss ratio is equal to the amount expended on reimbursement for clinical services provided to enrollees under its policies during the tax year (as reported under Sec. 2718 of the Public Health Service Act) (the Section 833 MLR Numerator) divided by the organization's total premium revenue (Section 833 MLR Denominator).

In Notice 2010-79, 2010-49 IRB, IRS provided interim guidance on the new Affordable Care Act rule. Among other items, the interim guidance provided that if an affected organization's percentage of total premium revenue expended on reimbursement for clinical services provided to enrollees is less than 85%, then:

1. The organization is not taxable as a stock insurance company by reason of Code Sec. 833(a)(1) (but may be taxable as an insurance company if it otherwise meets the requirements of Code Sec. 831(c));

2. The organization is not allowed the special deduction set forth in Code Sec. 833(b); and

3. The organization takes into account 80%, rather than 100%, of its unearned premiums for purposes of computing premiums earned on insurance contracts during the tax year under Code Sec. 832(b)(4).

Notice 2010-79 provided interim relief for the first tax year beginning after Dec. 31, 2009 (IRS will not treat a taxpayer as losing its status as a stock insurance company by reason of Code Sec. 833(c)(5) if specified conditions are met), and noted that the application of Code Sec. 833 in one tax year followed by nonapplication of that provision in the subsequent tax year (or vice versa) may result in one or more changes in accounting method. For example, accounting for 100% of unearned premiums under Code Sec. 833(a)(3) (dealing with unearned premium reserve) in one year, but only 80% of unearned premiums under Code Sec. 832(b)(4) in the next year, is a change in method of accounting. Likewise, the loss (or recovery) of insurance company status may implicate a number of changes in methods of accounting because some methods of accounting are available only to insurance companies under Subchapter L. The special deduction allowed under Code Sec. 833(a)(3) and Code Sec. 833(b) is not, however, a method of accounting.

How to change accounting method because of Code Sec. 833(c)(5). Notice 2011-4, explains how a change in accounting method is made by an existing Blue Cross or Blue Shield organization within the meaning of Code Sec. 833(c)(2) or an organization described in Code Sec. 833(c)(3), that is required to change its method of accounting for unearned premiums because it fails to meet the MLR requirements of Code Sec. 833(c)(5), or because it meets the MLR requirements after failing to meet those requirements in a prior year.

Affected organizations are told to use the automatic method change procedures in Rev Proc 2008-52, 2008-2 CB 587, as amplified and modified by subsequent procedures, and as modified by Notice 2011-4. In particular, the Code Sec. 481 adjustment period will be accelerated if a taxpayer with a remaining balance of a Code Sec. 481 adjustment that arose because of a change in method of accounting triggered by Code Sec. 833(c)(5) is required to effect another change in method of accounting related to Code Sec. 833(c)(5). Thus, for example, a taxpayer that fails to satisfy the requirements of Code Sec. 833(c)(5) and as a result has a positive Code Sec. 481 adjustment must accelerate the remaining balance, if any, of that adjustment in a subsequent tax year in which the taxpayer meets the Code Sec. 833(c)(5) requirements.

References: For automatic consent accounting method changes, see FTC 2d/FIN ¶G-2203; United States Tax Reporter ¶4464.225; TaxDesk ¶442,606; TG ¶6307.

Right To Pool Assets In Group Trust Is Extended To Custodial & Retirement Income Accounts, And Governmental Plans — Rev Rul 2011-1, 2011-02 IRB

IRS has extended to certain custodial accounts, retirement income accounts, and governmental plans the right to pool assets in a group trust. IRS also has provided model amendments for group trusts that intend to permit such custodial accounts, retirement income accounts, or governmental retirement plans to participate in the group trust.

Background. Various Code provisions require that retirement plan and IRA assets be held in trust for the exclusive benefit of plan participants and beneficiaries, and there are Code prohibitions against commingling of trust fund assets.

Notwithstanding these rules, IRS provided in Rev Rul 81-100, 1981-1 CB 326, that if certain requirements are met, a group trust is exempt from tax under: (a) Code Sec. 501(a) with respect to funds that equitably belong to participating Code Sec. 401(a) trusts; and (b) Code Sec. 408(e), with respect to funds that equitably belong to IRAs that meet the requirements of Code Sec. 408. The status of the individual trusts as qualified under Code Sec. 401(a), or as meeting Code Sec. 408, and as being tax-exempt, is not affected by the pooling of their funds in a group trust. In Rev Rul 2004-67, 2004-2 CB 28, IRS extended these rules for group trusts to governmental Code Sec. 457 plans, Roth IRAs, and deemed IRAs.

Group trust rules extended further. Effective Jan. 10, 2011, Rev Rul 2011-1 provides that the assets of qualified plans, IRAs, and Code Sec. 457(g) governmental plans may be pooled in a group trust with the assets of Code Sec. 403(b)(7) custodial accounts, Code Sec. 403(b)(9) retirement income accounts, and Code Sec. 401(a)(24) governmental plans (collectively referred to as “group trust retiree benefit plans”) without affecting the tax status of the group trust or the tax status of each of the separate group trust retiree benefit plans participating in the group trust, if the eight requirements listed below are met:

1. The group trust must be adopted as a part of each adopting group trust retiree benefit plan.

2. The group trust instrument must expressly limit participation to: (a) qualified pension, profit-sharing, and stock bonus trusts or custodial accounts; (b) IRAs that are exempt under Code Sec. 408(e); (c) eligible governmental plans that are exempt under Code Sec. 457(g); (d) custodial accounts under Code Sec. 403(b)(7); (e) retirement income accounts under Code Sec. 403(b)(9); and (f) Code Sec. 401(a)(24) governmental plans (group trust retiree benefit plans).

3. The group trust instrument must prohibit any part of its corpus or income that equitably belongs to any group trust retiree benefit plan from being used for, or diverted to, any purpose other than for the exclusive benefit of the participants and beneficiaries of the group trust retiree benefit plan.

4. Each group trust retiree benefit plan must itself be a trust, a custodial account, or a similar entity that is tax-exempt under either Code Sec. 408(e) or Code Sec. 501(a). An adopting Code Sec. 401(a)(24) governmental plan is treated as meeting this requirement if it is not subject to federal income taxation.

5. Each group trust retiree benefit plan must expressly and irrevocably provide in its governing document that it is impossible for any part of the corpus or income of the group trust retiree benefit plan to be used for, or diverted to, purposes other than for the exclusive benefit of the plan participants and their beneficiaries. Certain plans satisfy this requirement if they satisfy one of the following regs: Reg. § 1.401(a)-2 (for qualified plans); Reg. § 1.403(b)-8(d)(2)(iii) (for Code Sec. 403(b)(7) custodial accounts); Reg. § 1.403(b)-9(a)(2)(i)(C) (for Code Sec. 403(b)(9) retirement income accounts); Reg. § 1.408-2(b) (for IRAs); and Reg. § 1.457-8(a)(2)(i) (for eligible governmental plans described in Code Sec. 457(g)).

6. The group trust instrument must expressly limit the assets that may be held by the group trust to assets that are contributed by, or transferred from, an adopting entity to the group trust. Also, the group trust instrument must expressly provide for separate accounts (and appropriate records) to be maintained to reflect the interest which each group trust retiree benefit plan has in the group trust, including separate accounting for contributions to the group trust from the adopting plan, disbursements made from the adopting plan's account in the group trust, and investment experience of the group trust allocable to that account.

7. The group trust instrument must prohibit assignment by an adopting entity of any part of its equity or interest in the group trust.

8. The group trust must be created or organized in the U.S. and maintained at all times as a domestic trust in the U.S.

A group trust will not be treated as failing to satisfy these requirements merely because PBGC, rather than a qualified plan, holds the interest in the group trust, or merely because the group trust holds assets attributable to PBGC's commingled trust funds.

Other provisions. Rev Rul 2011-1 includes two model amendments that reflect the extension of the group trust rules, and carries special rules for certain Puerto Rican trusts.

References: For the pooling of pension plans, section 457 plans, and IRA funds in group trusts, see FTC 2d/FIN ¶H-8062.

FedEx Drivers In Multidistrict Litigation Largely Held To Be Independent Contractors — In re FedEx Ground Package System, Inc., (DC IN 12/13/2010)

In a multidistrict litigation (MDL) in which delivery drivers from 26 states sought determinations that they were employees of FedEx for purposes including reimbursement of business expenses and entitlement to overtime pay, a district court has held that the majority of the drivers were independent contractors. The court engaged in a state-by-state analysis and concluded, that in most instances, the drivers weren't employees because FedEx didn't retain on a nationwide basis the right to either control the means by which the drivers perform their work or terminate the drivers at will.

Observation: As a result, FedEx won't have to withhold income taxes, withhold and pay Social Security and Medicare taxes, or pay unemployment tax on payments to the drivers. On the other hand, the drivers will be able to deduct expenses incurred in the performance of services on Schedule C without the limitations applicable to employees but will have to pay self-employment tax. Note that under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the OASDI tax rate under the SECA tax for 2011 is reduced two percentage points to 10.4% percent for self-employed individuals on self-employment income up to $106,800. (See ¶4)

Procedure and case history. The district court noted as a preliminary matter the “procedural uniqueness” of this case, largely stemming from the fact that it was a MDL consisting of class actions with plaintiffs from 26 different states. The posture of the case also limited the scope of evidence available to the court in determining the drivers' generalized employment status, and the court's analysis was based mainly on the operating agreement and FedEx's policies and procedures. The court also stated that, given the nature of the case, it would have limited preclusive effect in subsequent proceedings involving personal injury or workers' compensation.

The district court had previously granted summary judgment in favor of FedEx in an earlier decision involving drivers from Kansas (the “Kansas decision”). Following the Kansas decision, the parties were ordered to file supplementary briefs for each of the outstanding class cases addressing why the outcome in each such case should be the same as, or different from, the Kansas decision.

The Kansas decision held that there was no “reasonable inference” that FedEx retained, on a class-wide basis, the right to control the means and methods of the drivers' work or terminate the drivers at will. In so holding, the court distinguished between retained control with respect to the results of the drivers' work and retained control as to how such work is performed. The court also found that FedEx afforded its drivers with certain entrepreneurial opportunities that were indicative of independent contractor status.

Judgment independent of the motion. In cases involving 11 of the states with pending summary judgment motions filed by the drivers, FedEx didn't file its own motions for summary judgment, arguing instead that a trial was required on the employment classification issue. However, in light of the Kansas decision, FedEx now requested that the district court enter judgment in its favor.

The district court found, under the new F.R.Civ.P. 56(f)(1) provision (effective Dec. 1, 2010) for “judgment independent of the motion,” that granting judgment in favor of FedEx: (i) was permissible so long as the drivers had notice that FedEx would seek such judgments and a reasonable opportunity to respond; and (ii) would best serve judicial economy.

Background. Under the common law rules, whether a worker is an independent contractor or employee generally is determined primarily by whether the enterprise he works for has the right to control and direct him regarding the job he is to do and how he is to do it. In certain instances, workers seek declarations that they are employees instead of independent contracts in order to vindicate statutorily created rights (such as overtime pay) or shift certain duties to the putative employer.

The tests used to evaluate whether a worker is an independent contractor or employee vary somewhat from state to state, but are generally comprised of a number of the following factors:

1. The degree of control retained by the principal;

2. whether the principal can discharge the individual;

3. the opportunity of the individual for profit or loss;

4. which party invests in work facilities used by the individual;

5. whether the work is part of the principal's regular business;

6. the permanency of the relationship;

7. the relationship the parties believed they were creating;

8. the provision of employee benefits;

9. where the work is performed; and

10. the method and regularity of payments.

In addition, certain states have other tests for determining employee status for purposes of, for example, a state law wage or worker's compensation statute. These statutes generally construe employee status more broadly than common law.

Facts. The drivers in the multistate action had entered into independent contractor agreements with FedEx to provide package delivery services, and FedEx was contractually bound to provide them with work. The drivers were responsible for acquiring their own delivery trucks and equipment, and they were permitted to hire assistants with FedEx's consent.

Generally, the drivers sought determinations that they were employees under various state laws and were accordingly entitled to reimbursement of business expenses, backpay for overtime, and other wages. Certain individual drivers and classes also alleged, among other things: fraud; breach of contract; employment discrimination; violations of a number of state laws; ERISA claims; and violations of several federal statutes, including the Fair Labor Standards Act (FLSA) and the Family Medical Leave Act (FMLA).

The drivers' argued primarily that, despite the contrary language in their agreements, FedEx exercised sufficient control over their work so as to support an employer-employee relationship. Specifically, they claimed that FedEx supervised their work, assigned them an amount of work to be completed within a certain timeframe, and could decline to renew or cancel for cause a driver's contract.

Conclusion. The district court analyzed the law of each state and the claims asserted by each class of drivers (and some individuals) and largely granted summary judgment or judgment independent of the motion, in whole or in part, in favor of FedEx that the drivers were independent contractors.

In many cases, the court found that all or many of the claims turned on the employment classification issue (or the drivers didn't assert otherwise), examined the operative employment classification test of the state, and concluded that the test was sufficiently similar to that in the Kansas decision so as to resolve those claims against the drivers.

The following distinctions were highlighted throughout the court's decision on the workers' employment classification:

... The court based its decision on controls that were institutionally retained by FedEx, and not those which were exercised in various instances.

... In evaluating the control retained by FedEx, the court focused on control over the manner in which the drivers performed their work. In contrast, the court said that the right to control what is ultimately to be accomplished (“results-based control”) doesn't necessarily indicate employee status.

... The court emphasized the difference between employment classification for personal injury-type cases and others, such as this case. In personal injury cases, the term “employee” is often construed in a broader manner so as to justify holding the employer liable for the worker's injuries.

However, drivers from several states were granted partial summary judgment as to their employee status under state statutes, and their claims based on those statutes were accordingly entitled to proceed.

The court also remanded a number of the claims of individuals or certain classes that were not resolved by the employee classification issue. Remanded issues included FLSA and FMLA claims, various state law statutory claims, and employment discrimination based on age and disability. In addition, the employee status of one driver wasn't resolved because it wasn't clear whether he was a member of and thus bound by an adverse decision in respect to a separate class.

References: For determining who is an employee, see FTC 2d/FIN ¶H-4250; United States Tax Reporter ¶34,014.37; TaxDesk ¶535,001; TG ¶9160.

IRS Issues Guidance On Compensation Deduction Limit For Health Insurance Providers — Notice 2011-2, 2011-2 IRB

In a Notice, IRS has provided guidance on the application of Code Sec. 162(m)(6) (added by Sec. 9014 of the Patient Protection and Affordable Care Act, P.L. 111-148), which limits to $500,000 the deduction allowed for remuneration paid to an individual by certain health insurers for tax years beginning after 2012. The provision is generally effective for tax years beginning after 2012. However, it also applies to deferred deduction remuneration for services performed in a tax year beginning after Dec. 31, 2009, and before Jan. 1, 2013, if certain conditions are met.

Background. Code Sec. 162(m)(6) disallows any deduction for “applicable individual remuneration” in excess of $500,000 paid to a “qualified individual” by certain health insurers for any “disqualified tax year” beginning after Dec. 31, 2012. This limit will apply whether the remuneration is paid during the tax year in which the services are performed or a later tax year.

“Applicable individual remuneration” means the aggregate amount allowable as an income tax deduction for a disqualified tax year for remuneration for services performed by an applicable individual, whether or not during the tax year. A “qualified individual” is one who: (i) is an officer, director, or employee of a covered health insurance provider in a disqualified tax year; or (ii) provides services for or on behalf of a covered health insurance provider during such tax year. The term “disqualified tax year” means, for any employer, any tax year for which that employer is a “covered health insurance provider” for any portion of the tax year.

For years beginning after Dec. 31, 2009, and before Jan. 1, 2013, “covered health insurance provider” means a health insurance issuer that receives premiums from providing health insurance coverage (“pre-2013 covered health insurance provider”); and for tax years beginning after Dec. 31, 2012, the term means a health insurance issuer with 25% or more of its premiums attributable to providing minimum essential coverage (“post-2012 covered health insurance provider”). For purposes of determining whether a health insurance issuer is a covered health insurance provider, premiums received under an indemnity reinsurance contract are not treated as premiums from providing health insurance coverage.

Code Sec. 162(m)(6) also applies to deferred deduction remuneration that is attributable to services performed in a disqualified tax year beginning after Dec. 31, 2009, and that is otherwise deductible in a tax year beginning after Dec. 31, 2012. When deferred deduction remuneration is attributable to services performed in a disqualified tax year, any unused portion of the $500,000 limit for the year in which the services were performed can be carried forward to the year(s) in which that compensation is otherwise deductible.

Guidance. Notice 2011-2 provides that Code Sec. 162(m)(6)’s deduction limitation applies to deferred deduction remuneration attributable to services performed in a tax year beginning after Dec. 31, 2009, and before Jan. 1, 2013, if: (i) the employer was a pre-2013 covered health insurance provider for the tax year in which the services were performed to which the deferred deduction remuneration is attributable; and (ii) the employer is a post-2012 covered health insurance provider for the tax year in which such deferred deduction remuneration is otherwise deductible.

Notice 2011-2 carries several illustrations of these rules, including the following:

... Corporation A is a pre-2013 covered health insurance provider for 2010–2012 and a post-2012 covered health insurance provider for all tax years thereafter. Any deferred deduction remuneration attributable to services performed in 2010–2012 is subject to Code Sec. 162(m)(6)’s deduction limitation in years after 2012 when such amounts are otherwise deductible.

... Corporation B is a pre-2013 covered health insurance provider for 2010–2012. It does not qualify as a post-2012 covered health insurance provider for 2013–2015, but it does qualify for 2016 and thereafter because less than 25% of its gross premiums from health insurance coverage during those years are from minimum essential coverage. Any deferred deduction remuneration attributable to services performed in 2010–2012 that is otherwise deductible in 2016 and subsequent years is subject to Code Sec. 162(m)(6)’s deduction limitation in the tax year in which such amounts are otherwise deductible. However, any deferred deduction remuneration attributable to services performed in 2010–2012 that is otherwise deductible in 2013–2015, or any deferred compensation attributable to services performed in 2013–2015, is not subject to Code Sec. 162(m)(6)’s limitation.

De minimis rule. An employer will not be treated as a covered health insurance provider for a tax year beginning after Dec. 31, 2009, and before Jan. 1, 2013, if the premiums received for providing health insurance coverage are less than 2% of its gross revenues for that tax year. For post-2012 years, an employer will not be treated as a covered health insurance provider if the premiums received for providing health insurance coverage that are from providing minimum essential coverage are less than 2% of the employer's gross revenues for that tax year.

IRS requests public comments on various aspects of this guidance. (Notice 2011-2, Sec. 5)

Effective date. This guidance is effective for tax years beginning on or after Jan. 1, 2010.

References: For the health insurer compensation deduction limit, see FTC 2d/FIN ¶H-3824.3 et seq.; United States Tax Reporter ¶1624.009; TaxDesk ¶276.001.11A et seq.; TG ¶7531.

IRS Modifies Earlier Guidance On FSA And HRA Debit Cards For Over-The-Counter Drugs — Notice 2011-5, 2011-3 IRB; IR 2010-128

In a Notice, IRS has modified earlier guidance and approved the use of health flexible spending arrangement (FSA) and health reimbursement arrangement (HRA) debit cards, if certain conditions are met, for purposes of substantiating prescribed over-the-counter medicines or drugs under Code Sec. 106(f), added by Sec. 9003 of the Patient Protection and Affordable Care Act (Affordable Care Act, P.L. 111-148, 3/23/2010).

Background. Under Code Sec. 213, expenses for medical care, not compensated for by insurance or otherwise, may be claimed as an itemized deduction to the extent they exceed 7.5% of adjusted gross income (AGI). (For tax years beginning after Dec. 31, 2012, medical expenses will be deductible to the extent they exceed 10% of AGI.) Medical care generally is defined broadly as amounts paid for diagnoses, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure of the body. However, any amount paid during a tax year for medicine or drugs is explicitly deductible as a medical expense only if it is a prescribed drug or is insulin. Thus, any amount paid for non-prescription medicine is not deductible as a medical expense, including any medicine recommended by a physician.

The general definition of medical care without the explicit limitation on medicine applies for the exclusion for employer-provided health coverage and medical care. Thus, under a health FSA or HRA, amounts paid for prescription and over-the-counter medicine are treated as medical expenses, and reimbursements for these amounts are excludible from gross income.

The Affordable Care Act conforms the definition of “medical expense” for purposes of employer-provided health coverage, including FSAs and HRAs, to the definition for purposes of the itemized deduction for medical expenses, except that a prescribed drug is determined without regard to whether it is available without a prescription. The changed definition for health FSAs and HRAs applies for expenses incurred with respect to tax years beginning after Dec. 31, 2010. (Code Sec. 106(f), Code Sec. 220(d)(2)(A), and Code Sec. 223(d)(2)(A), as amended by Affordable Care Act Sec. 9003) Thus, the cost of over-the-counter medicines can't be reimbursed with excludible income through a health FSA or HRA unless the medicine is insulin or prescribed by a doctor.

Notice 2010-59, 2010-39 IRB 396, stated that current health FSA or HRA debit card systems weren't capable of meeting Code Sec. 106(f)’s substantiation requirements for over-the-counter medicines or drugs and generally couldn't be used to purchase over-the-counter medicines or drugs on and after Jan. 15, 2011.

Updated guidance. In Notice 2011-5, IRS says that health FSA and HRA debit cards may continue to be used after Jan. 15, 2011 to purchase and substantiate over-the-counter medicines or drugs at drug stores and pharmacies, at non-health care merchants that have pharmacies, and at mail order and web-based vendors that sell prescription drugs, if:

(1) prior to purchase, (i) the prescription for the over-the-counter medicine or drug is presented (in any format) to the pharmacist; (ii) the over-the-counter medicine or drug is dispensed by the pharmacist in accordance with applicable law and regs; and (iii) an Rx number is assigned;

(2) the pharmacy or other vendor retains, in a manner that meets IRS's recordkeeping requirements: (i) the Rx number; (ii) the name of the purchaser or person for whom the prescription applies; and (iii) the date and amount of the purchase;

(3) all of these records are available to the taxpayer's employer or its agent upon request;

(4) the debit card system won't accept a charge for an over-the-counter medicine or drug unless an Rx number has been assigned; and

(5) additional requirements regarding the use of health FSA or HRA debit cards set forth in Prop Reg § 1.125-6; Rev Rul 2003-43, 2003-1 CB 935; Notice 2006-69, 2006-2 CB 107; Notice 2007-2, 2007-1 CB 254; and Notice 2008-104, 2008-2 CB 1298 are met.

After Jan. 15, 2011, health FSA and HRA debit cards may also continue to be used to purchase over-the-counter medicines or drugs from vendors other than those described above that have health care-related “Merchant Codes” as described in Rev Rul 2003-43, 2003-1 CB 935, including physicians, pharmacies, dentists, vision care offices, hospitals, and other medical care providers. If all other requirements in the preceding paragraph are satisfied, then these debit card transactions will be considered fully substantiated at the time and point-of-sale.

Health FSA and HRA debit cards may also continue to be used to purchase over-the-counter medicines and drugs at “90% pharmacies” with at least 90% of the store's gross receipts during the prior tax year consisting of qualified medical care expenses under Code Sec. 213(d).

Effective date. Notice 2011-5 is effective for health FSA and HRA debit card purchases of over-the-counter medicines or drugs made after Jan. 15, 2011.

Effect on other documents. Notice 2011-5 modifies Notice 2010-59 as it applies to the use of health FSA and HRA debit cards to reimburse expenses for over-the-counter medicines or drugs. IRS and Treasury intend to amend Prop Reg § 1.125-6 to reflect these provisions of this notice. Taxpayers may rely on Notice 2011-5 until the amended regs are issued.

References: For expenditures that qualify as medical care expenses, see FTC 2d/FIN ¶K-2100; United States Tax Reporter ¶2134.04; TaxDesk ¶346,003; TG ¶18800.

Official IRS Inflation-Adjusted Tax Figures For 2011 Reflect 2010 Tax Relief Act Changes — Rev Proc 2011-12, 2011-2 IRB; IR 2010-127

A new revenue procedure carries IRS's official 2011 inflation-adjusted figures for tax provisions that were in limbo until passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Relief Act, P.L. 111-312). These include the tax rate brackets, the standard deduction amounts and the phaseout ranges for education credits.

Background. In late October, IRS issued a revenue procedure carrying a listing of official inflation-adjusted tax figures for 2011, but the listing was only partial because of uncertainty, at that point, over whether legislation would be passed extending the Bush-era tax cuts and various other tax breaks (Rev Proc 2010-40, 2010-46 IRB 663). Reacting quickly to passage of the 2010 Tax Relief Act, IRS has now issued a follow-up revenue procedure carrying the 2011 figures for the inflation-adjusted tax figures not covered in Rev Proc 2010-40.

Tax rate tables. Under Sec. 101 of the 2010 Tax Relief Act, the tax rate schedules for individuals will remain at 10%, 15%, 25%, 28%, 33% and 35% for two additional years, through 2012. In addition, the size of the 15% tax bracket for joint filers and qualified surviving spouses will remain at 200% of the 15% tax bracket for individual filers through 2012. Rev Proc 2011-12, carries the official tax rate tables for 2011 for individuals as well as for estates and trusts, and reflects these 2010 Tax Relief Act changes.

Standard deduction. Under Sec. 101 of the 2010 Tax Relief Act, the standard deduction for married taxpayers filing jointly (and qualified surviving spouses) remains at 200% of the standard deduction for single taxpayers for two additional years, through 2012. Rev Proc 2011-12, carries the standard deduction for marrieds for 2011 ($11,600 for joint filers, $5,800 for marrieds filing separately), as well as all of the other standard deduction figures.

Personal exemption amount. Under Rev Proc 2011-12, the personal exemption amount for 2011 will be $3,700.

Observation: Thanks to the 2010 Tax Relief Act, personal exemptions of higher income taxpayers won't be phased out for 2011 or 2012.

Education credit phaseouts. The Code Sec. 25A American opportunity tax credit (AOTC)/Hope scholarship credit was kept in place for 2011 and 2012 by the 2010 Tax Relief Act. The AOTC/Hope credit is equal to 100% of up to $2,000 of qualified higher-education tuition and related expenses (including course materials), plus 25% of the next $2,000 of expenses paid for education furnished to an eligible student in an academic period—i.e., a maximum credit of $2,500 a year for each eligible student. The AOTC/Hope credit phases out ratably if modified adjusted gross income (MAGI) exceeds an inflation-adjusted level. For 2011, under Rev Proc 2011-12, the AOTC/Hope credit phases out ratably for taxpayers with MAGI of $80,000 to $90,000 ($160,000 to $180,000 for joint filers). These phaseout ranges are unchanged from 2010.

Under Code Sec. 25A(a)(2), taxpayers may elect a Lifetime Learning credit equal to 20% of up to $10,000 of qualified tuition and related expenses paid during the tax year. The maximum credit is $2,000. Unlike the American opportunity tax credit (AOTC)/Hope credit, which is available for the qualifying expenses of each qualifying student, the Lifetime Learning credit is available only per taxpayer.

Under Rev Proc 2011-12, for 2011, the Lifetime Learning credit phases out ratably for taxpayers with MAGI of $51,000 to $61,000 ($102,000 to $122,000 for joint filers). For 2010, the Lifetime Learning credit phased out ratably for taxpayers with modified AGI of $50,000 to $60,000 ($100,000 to $120,000 for joint filers).

Observation: The Lifetime Learning credit was not affected by the 2010 Tax Relief Act.

Earned income tax credit (EITC). Rev Proc 2011-12, reflects the 2010 Tax Relief Act's extension for 2011 and 2012 of various liberalized EITC rules. For example, for 2011, the maximum EITC for low- and moderate- income workers and working families rises to $5,751, up from $5,666 in 2010. The maximum income limit for the EITC rises to $49,078, up from $48,362 in 2010. The credit varies by family size, filing status and other factors, with the maximum credit going to joint filers with three or more qualifying children.

Other figures stay the same. Thanks to the 2010 Tax Relief Act:

• The monthly limit on the value of qualified transportation benefits (parking, transit passes, etc.) provided by an employer to its employees will remain at $230 for 2011.

• The up-to-$2,500 above-the-line deduction for interest paid on qualified education loans under Code Sec. 221 will continue to be available for 2011 (and 2012). For 2011, the maximum deduction for interest paid on qualified education loans begins to phase out for taxpayers with MAGI in excess of $60,000 ($120,000 for joint returns), and is completely phased out for taxpayers with modified adjusted gross income of $75,000 or more ($150,000 or more for joint returns), unchanged from the 2010 phaseout figures. (Rev Proc 2011-12)

IRS Updates Disclosure Rules To Lessen Understatement And Preparer Penalties — Rev Proc 2011-13, 2011-3 IRB

A revised revenue procedure identifies when disclosure on a taxpayer's return for an item or a position is adequate to reduce a Code Sec. 6662(d) understatement of income tax under the accuracy-related penalty, and to avoid the Code Sec. 6694(a) preparer penalty for understatements due to unreasonable positions. It applies to any income tax return filed on 2010 tax forms for tax years beginning in 2010, and to any income tax return filed on 2010 tax forms in 2011 for short tax years beginning in 2011.

Background. Under Code Sec. 6662, a 20% penalty applies to the portion of a tax underpayment that is attributable to a substantial understatement of income tax. The penalty rate is 40% in the case of gross valuation misstatements under Code Sec. 6662(h), nondisclosed noneconomic substance transactions under Code Sec. 6662(i), or undisclosed foreign financial asset understatements under section Code Sec. 6662(j). An understatement is “substantial” if it exceeds the greater of 10% of the amount of tax required to be shown on the return for the tax year or $5,000. However, a corporation (other than an S corporation or personal holding company) has a substantial tax understatement if the understatement exceeds the lesser of (1) 10% of the tax required to be shown on the return for a tax year (or, if greater, $10,000), or (2) $10 million. (Code Sec. 6662(d))

For a non-tax shelter item, the understatement is reduced to the extent the relevant facts affecting the item's tax treatment are adequately disclosed in the return or in a statement attached to the return, and there is a reasonable basis for the taxpayer's tax treatment. (Code Sec. 6662(d)(2)(B)(ii))

Under Code Sec. 6694(a), a penalty is imposed on a tax return preparer who prepares a return or refund claim reflecting an understatement of liability due to an “unreasonable position” if he knew (or reasonably should have known) of the position. A position (other than for a tax shelter or a reportable transaction) is generally treated as unreasonable unless (1) there is or was substantial authority for the position; or (2) the position was properly disclosed under Code Sec. 6662(d)(2)(B)(ii)(I) and had a reasonable basis. If the position is with respect to a tax shelter or a reportable transaction, the position is treated as unreasonable unless it is reasonable to believe that the position would more likely than not be sustained on the merits. (Notice 2009-5, 2009-1 CB 309)

Revised procedure. In Rev Proc 2011-13, IRS sets out the circumstances under which disclosure of information on a return is considered to be adequate to avoid the substantial understatement penalty under Code Sec. 6662(d) and the preparer penalty under Code Sec. 6694(a) for understatements due to unreasonable positions. A corporation making a complete and accurate disclosure of a tax position on the appropriate year's Schedule UTP (Uncertain Tax Position Statement), will be treated as if it had filed a Form 8275 (Disclosure Statement) or Form 8275-R (Regulation Disclosure Statement) regarding the tax position. However, the filing of a Form 8275 or Form 8275-R, will not be treated as if the corporation filed a Schedule UTP.

Additional disclosure of relevant facts or positions taken with respect to issues involving any of the items listed in Rev Proc 2011-13 is unnecessary for purposes of reducing any understatement of income tax under Code Sec. 6662(d) (except as otherwise provided in Rev Proc 2011-13, Sec. 4.02(3), concerning Schedules M-1 and M-3), if forms and attachments are completed in a clear manner and in accordance with instructions.

Although a taxpayer may literally meet Rev Proc 2011-13’s disclosure requirements, the disclosure won't have an effect for purposes of the Code Sec. 6662 accuracy-related penalty if the item or position on the return: (1) doesn't have a reasonable basis as defined in Reg. § 1.6662-3(b)(3); (2) is attributable to a tax shelter item as defined in Code Sec. 6662(d)(2); or (3) isn't properly substantiated or the taxpayer failed to keep adequate books and records with respect to the item or position. Disclosure will have no effect for purposes of the Code Sec. 6694(a) penalty as applicable to tax return preparers if the position is with respect to a tax shelter (as defined in Code Sec. 6662(d)(2)(C)(ii)) or a reportable transaction to which Code Sec. 6662A applies.

Rev Proc 2011-13, Sec. 4.01(2), provides that money amounts entered on forms must be verifiable, and the information on the return must be disclosed in the manner described in Rev Proc 2011-13, Sec. 4.02(3). A number is verifiable if, on audit, the taxpayer can prove the origin of the amount (even if that number is not ultimately accepted by IRS) and can show good faith in entering that number on the applicable form. Further, the disclosure of an amount as provided in Rev Proc 2011-13, Sec. 4.02, isn't adequate when the understatement arises from a transaction between related parties. If an entry may present a legal issue or controversy because of a related-party transaction, then that transaction and the relationship must be disclosed on Form 8275 or Form 8275-R.

When the amount of an item is shown on a line that doesn't have a preprinted description identifying that item, the taxpayer must clearly identify the item by including the description on that line. For example, to disclose a sole proprietorship's bad debt, the words “bad debt” must be written or typed on the line of Schedule C that shows the amount of the bad debt. Also, for Schedule M-3 (Form 1120), Part II, line 25, Other income (loss) items with differences, or Part III, line 35, Other expense/deduction items with differences, the entry must provide descriptive language (e.g., “Cost of non-compete agreement deductible not capitalizable”). If space limitations on a form do not allow for an adequate description, the description must be continued on an attachment.

References: For the substantial understatement penalty, see FTC 2d/FIN ¶V-2151; United States Tax Reporter ¶66,624.03; TaxDesk ¶863,014; TG ¶71638. For the preparer penalty, see FTC 2d/FIN ¶V-2631; United States Tax Reporter ¶66,944; TaxDesk ¶867,019; TG ¶71769.

IRS Defers Application Of Nondiscrimination Rule To Insured Group Health Plans — Notice 2011-1, 2011-2 IRB

In a new Notice, IRS says that compliance with a rule prohibiting insured group health plans from discriminating in favor of highly compensated individuals should not be required (and thus, any sanctions for failure to comply will not apply) until after regs or other administrative guidance of general applicability have been issued. The rule was enacted by Sec. 10101(d) of the Health Care and Education Reconciliation Act (the Reconciliation Act, P.L. 111-152).

Background. Under Code Sec. 105(b), there's an exclusion from gross income for amounts paid through employer-sponsored health care coverage. However, the exclusion does not apply to amounts paid to a highly compensated individual under a self-insured medical reimbursement plan that does not satisfy the requirements of Code Sec. 105(h)(2) for a plan year, to the extent the amounts constitute an excess reimbursement of the highly compensated individual. (Code Sec. 105(h)(1)) Code Sec. 105(h)(2) provides that a self-insured medical reimbursement plan must not discriminate in favor of highly compensated individuals as to eligibility to participate or regarding benefits provided under the plan. If a self-insured medical reimbursement plan is discriminatory because it fails to satisfy either the nondiscriminatory eligibility rules or the nondiscriminatory benefit rules, then an employee who is considered a highly compensated individual must include amounts which represent “excess reimbursements” in gross income. (Code Sec. 105(h)(1))

Sec. 10101(d) of the Reconciliation Act provides: that a group health plan (other than a self-insured plan) must satisfy the Code Sec. 105(h)(2) requirements; that rules “similar to” the rules of Code Sec. 105(h)(3) (nondiscriminatory eligibility classification), Code Sec. 105(h)(4) (nondiscriminatory benefits), and Code Sec. 105(h)(8) (certain controlled groups) apply; and that the term “highly compensated individual” has the meaning given by Code Sec. 105(h)(5). These requirements for insured group health plans are effective for plan years beginning on or after Sept. 23, 2010.

Code Sec. 9815 incorporates by reference the requirements of Sec. 2716 of the Public Health Service (PHS) Act into chapter 100 of the Code. Code Sec. 4980D provides that group health plans failing to satisfy the requirements of chapter 100 are subject to an excise tax.

How the Code Sec. 105(h)(2) nondiscrimination rule applies to insured group health plans. Sec. 2716 of the PHS Act (PHSA) incorporates the substantive nondiscrimination requirements of Code Sec. 105(h) (but not the taxes on highly compensated individuals in Code Sec. 105(h)(1)) and applies them to insured group health plans. An insured plan failing to comply with Code Sec. 105(h) may be subject to a civil action to compel it to provide nondiscriminatory benefits (under part 7 of ERISA), and may be subject to an excise tax of $100 per day per individual discriminated against for each day the plan does not comply with the requirement (under Code Chapter 100) or a civil money penalty of $100 per day per individual discriminated against (under title XXVII of the PHSA).

If a self-insured plan fails to comply with Code Sec. 105(h), highly compensated individuals lose a tax benefit; if an insured group health plan fails to comply with Code Sec. 105(h), it is subject to a civil action to compel it to provide nondiscriminatory benefits and the plan or plan sponsor is subject to an excise tax or civil money penalty of $100 per day per individual discriminated against.

The rules prohibiting discrimination in favor of highly compensated individuals by insured group health plans do not apply to “grandfathered health plans”. But the Code Sec. 105(h) rules continue to apply to any self-insured medical reimbursement plan regardless of whether the plan is a “grandfathered health plan.”

In Notice 2010-63, 2010-41 IRB, IRS said it was thinking of issuing guidance on the extension, through Sec. 2716 of the PHSA and Code Sec. 9815, of the Code Sec. 105(h) requirements to insured group health plans, and requested comments on how this guidance should be formulated.

Deferral of new nondiscrimination rule. Because regulatory guidance is essential to the operation of the new statutory provisions, Treasury, IRS, and the Departments of Labor and Health and Human Services (the Departments) have determined that compliance with PHSA Sec. 2716 should not be required (and thus, any sanctions for failure to comply do not apply) until after regs or other administrative guidance of general applicability have been issued under PHSA Sec. 2716. To provide insured group health plan sponsors time to implement any changes required as a result of the regs or other guidance, the Departments anticipate that the guidance will not apply until plan years beginning a specified period after issuance. Before the beginning of those plan years, insured group health plan sponsors will not be required to file IRS Form 8928 (Return of Certain Excise Taxes Under Chapter 43 of the Internal Revenue Code) with respect to excise taxes resulting from the incorporation of PHSA Sec. 2716 into Code Sec. 9815. (Notice 2011-1, 2011-2 IRB, Sec. III)

The Departments also solicit additional public comments on various aspects of the application of the new nondiscrimination rule to insured group health plans. (Notice 2011-1, 2011-2 IRB, Sec. 4, Sec. III)

Congress-Passed James Zadroga 9/11 Act Includes New Excise Tax On Foreign Procurement Payments

On December 22, Congress passed H.R. 847, the “James Zadroga 9/11 Health and Compensation Act of 2010” (the Zadroga Act). This legislation, which provides relief to 9/11 first responders and recovery and cleanup workers who got ill after working at the World Trade Center site, carries an offset provision that imposes a new excise tax on certain foreign persons providing goods and services to the federal government.

Effective for payments received under contracts entered into on and after the enactment date, the 2010 Zadroga Act imposes on any foreign person that receives a specified Federal procurement payment a tax equal to 2% of the amount of the specified Federal procurement payment. (Code Sec. 5000C, as added by Zadroga Act Sec. 301)

A “specified Federal procurement payment” is any payment made under a contract with the U.S. for:

1.the provision of goods, if the goods are manufactured or produced in any country which is not a party to an international procurement agreement with the U.S., or
2.the provision of services, if the services are provided in any country which is not a party to an international procurement agreement with the U.S. (Code Sec. 5000C(b))
A foreign person is any person other than a U.S. person. (Code Sec. 5000C(c))

The amount deducted and withheld under chapter 3 of the Code (Withholding of Tax on Foreign Persons, Code Sec. 1441 through Code Sec. 1446) will be increased by the amount of tax imposed on a specified Federal procurement payment. (Code Sec. 5000C(d)(1)) For purposes of subtitle F of the Code (Procedure and Administration, Code Sec. 6001 through Code Sec. 7874), any tax imposed by the new excise tax provision will be treated as a tax imposed by subtitle A of the Code (Income Taxes, Code Sec. 1 through Code Sec. 1564). (Code Sec. 5000C(d)(2))

The head of each executive agency is directed to take any and all measures necessary to ensure that no funds are disbursed to any foreign contractor in order to reimburse the tax imposed under Code Sec. 5000C. (Zadroga Act Sec. 301(b)(1))

The Administrator for Federal Procurement Policy is directed to annually review the contracting activities of each executive agency to monitor compliance with the above requirements. (Zadroga Act Sec. 301(b)(2))

The above rules are to be applied in a manner consistent with U.S. obligations under international agreements. (Act Sec. 301(b)(4))

Wednesday, December 29, 2010

Estate and Gift Tax Relief in the 2010 Tax Relief Act

Source: david.franco@thomsonreuters.com

Overview of relief. Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), there was no estate tax for decedents dying in 2010, but estate and other transfer taxes were scheduled to rise substantially for post-2010 transfers. The 2010 Tax Relief Act provides temporary relief. It reduces estate, gift and generation-skipping transfer taxes for 2011 and 2012 and continues a host of other estate and gift tax relief provisions that were set to expire after this year. It preserves estate tax repeal for 2010, but in a roundabout way. Estates wanting zero estate tax for 2010 must elect that option, along with the modified carryover basis rules that were set to apply for this year. Otherwise, by default, the estate tax is revived for 2010, with a $5 million exemption and a step-up in basis. In a totally new provision, the Act allows a deceased spouse's unused exemption to be shifted to the surviving spouse. However, these generous rules, which are discussed in greater detail below, are temporary—much harsher rules are slated to return after 2012.

Background on EGTRRA Transfer Tax Changes

An understanding of the EGTRRA provisions is crucial to understanding the Act's changes. EGTRRA repealed the estate tax and the generation-skipping transfer (GST) tax for estates of individuals dying in 2010. However, to comply with budgetary rules, EGTRRA contained a so-called “sunset rule” under which the pre-EGTRRA rules were to return after 2010.

Under pre-EGTRRA law, there was no gift tax and no estate tax on the first $675,000 of combined transfers during life or at death for gifts made and individuals dying in 2001. These two taxes were tied together under a unified system having a top rate of 55%. However, there were differences between the gift tax and the estate tax. One difference potentially affected the income tax of donees (recipients) of gifts and heirs of estates. A donee generally gets the donor's basis (usually cost) for a gift. As a result of this carryover basis, if there is a gift of appreciated stock, for example, the donee will have a taxable gain if he sells at the gift value. Property acquired from a decedent, however, generally gets a basis equal to its value at his death. This means that, on a later sale by the heir, he won't have to pay income tax on the appreciation in the property that occurred while it was held by the decedent.

EGTRRA substantially increased the $675,000 exemption in stages after 2001. For individuals dying in 2006 through 2008, the exemption was $2 million. It rose to $3.5 million for individuals dying in 2009.

EGTRRA also changed the unified system so that the gift tax exemption amount remained at $1 million for all years after 2001. Under the “sunset rule,” the exemption was to be $1 million for both estate and gift tax purposes in 2011.

Under EGTRRA, the top estate and gift tax rate was reduced in stages. It was 45% for transfers in 2007 through 2009. In 2010, there was to be no estate tax and the top gift tax rate was to be 35%. The top estate and gift tax rate was to revert to 55% in 2011.

For 2010, the basis rules for inherited property were to be similar to the gift tax rules but with many opportunities for heirs to get increases in basis. For example, these so-called modified carryover basis rules would have permitted the basis of assets received from an individual dying in 2010 to be increased by $1.3 million and by an additional $3 million for assets going to a spouse. Under the sunset rule, the pre-EGTRRA step-up in basis rules were to return for 2011.

EGTRRA made other changes to the transfer tax rules that also were scheduled to sunset after 2010. For example, it repealed the State death tax credit and replaced it with a deduction. Under the sunset rules, the deduction was to end and the credit was to return in 2011.

EGTRRA also repealed the qualified family-owned business deduction, which was to return in 2011. It also made modifications to the rules regarding (1) qualified conservation easements, (2) installment payment of estate taxes, and (3) various technical aspects of the GST tax. These modifications were to terminate under the sunset rule.

Increased Exemption and Reduced Top Rate
The 2010 Tax Relief Act lowers estate and GST taxes for 2011 and 2012 by increasing the exemption amount (technically, the applicable exclusion amount) from $1 million to $5 million (as indexed after 2011) and reducing the top rate from 55% to 35%. ( Code Sec. 2010(c) , as amended by Act Sec. 302(a)) The $5 million exemption is per person. Thus, there is a $10 million exemption for a married couple. Plus, as explained below, there is a new portability feature for married couples.

Modified Carryover Basis Rules Generally Repealed

The 2010 Tax Relief Act generally repeals the modified carryover basis rules that, under EGTRRA, would apply only for purposes of determining basis in property acquired from a decedent who dies in 2010. Under the Act, a recipient of property acquired from a decedent who dies after Dec. 31, 2009 generally will receive fair market value (i.e., “stepped up”) basis under the rules applicable to assets acquired from decedents who died in 2009. (Act Sec. 301) However, if an executor chooses no estate tax for a decedent dying in 2010, the modified carryover basis rules apply, as discussed below.

Special Choice for 2010 Decedents

The 2010 Tax Relief Act allows estates of decedents dying in 2010 to choose between (1) estate tax (based on a $5 million exemption and 35% top rate) and a step-up in basis, or (2) no estate tax and modified carryover basis. (Act Sec. 301(c)) In technical terms, the Act achieves this choice by making the estate tax and basis changes effective retroactively for estates of decedents dying after 2009 (Act Sec. 301(a)), but allowing the opt-out choice for estates of decedents dying in 2010. (Act Sec. 301(c)) The executor should make whichever choice would produce the lowest combined estate and income taxes for the estate and its beneficiaries, as shown in the following simplified illustrations.

RIA illustration 1: Smith, a single individual, dies in 2010 with an estate worth $6 million and with a basis of $3.7 million. Under the Act, his heirs would face an estate tax of $350,000 ($2,080,800 tax on $6 million under the new rate schedule reduced by $1,730,800 tax offset by applicable exclusion amount), and they would get a step-up in basis. If the executor were to make the election, the estate would owe no estate tax and his heirs would face income tax on $1 million worth of assets when they sell them. This is the $6 million they inherit less a basis of $5 million (Smith's original $3.7 million basis as increased by $1.3 million under the modified carryover basis rules). Assuming the $1 million were taxed at 15%, the income tax cost would be $150,000. Thus, the election should be made as it would result in lower combined estate and income tax ($150,000 as opposed to $350,000).

RIA illustration 2: Assume the same facts as in the preceding example, except that Smith's basis immediately before death was $700,000. If the executor were to make the election, there would be no estate tax but the beneficiaries would face income tax on $4 million. At 15%, this would come to $600,000. This would be more than the $350,000 in estate tax that would be owed without the election. Thus, the election should not be made in this instance.

RIA observation: The illustrations assume that the beneficiaries would sell the inherited assets reasonably soon after the decedent's death. Obviously, the results would be different if the beneficiaries planned to retain the assets or sell them several years down the road. Also, the results in any case would be impacted by state death taxes, if any, plus estate administration costs and other estate expenses. For the sake of simplicity, these factors were ignored in the foregoing illustrations.

The election will have no effect on the continued applicability of the GST tax. In addition, in applying the definition of transferor in Code Sec. 2652(a)(1), the determination of whether any property is subject to the estate tax is made without regard to whether an election is made.

IRS is to determine the time and manner for making the election. Once made, the election is revocable only with IRS consent. (Act. Sec. 301(b), Committee Report))

Gift Tax Changes

Under the 2010 Tax Relief Act, for gifts made in 2010, the exemption is $1 million and the gift tax rate is 35%. For gifts made after Dec. 31, 2010, the gift tax is reunified with the estate tax, with an applicable exclusion amount of $5 million and a top estate and gift tax rate of 35%. (Act 301(b), Code Sec. 2505(a), as amended by Act Sec. 302(b))

The Act also makes clarifying changes to how gift taxes are taken into account in the mechanism for computing estate and gift taxes. Under pre-Act law, the gift tax on taxable transfers for a year is determined by computing a tentative tax on the cumulative value of current year transfers and all gifts made by a decedent after Dec. 31, '76, and subtracting from the tentative tax the amount of gift tax that would have been paid by the decedent on taxable gifts after Dec. 31, '76 if the tax rate schedule in effect in the current year had been in effect on the date of the prior-year gifts. Under the Act, for purposes of determining the amount of gift tax that would have been paid on one or more prior year gifts, the estate tax rates in effect under Code Sec. 2001(c) at the time of the decedent's death are used to compute both (1) the gift tax imposed with respect to such gifts, and (2) the unified credit allowed against such gifts. (Code Sec. 2001(b)(2), as amended by, and Code Sec. 2001(g), as added by, Act Sec. 302(d))

Generation-Skipping Transfer Tax Changes

Under the 2010 Tax Relief Act, the GST exemption for decedents dying or gifts made after Dec. 31, 2009 and before Jan. 1, 2011 is equal to the applicable exclusion amount for estate tax purposes (e.g., $5 million). Therefore, up to $5 million in GST tax exemption may be allocated to a trust created or funded during 2010. Although the GST tax is applicable in 2010, the GST tax rate for transfers made during 2010 is 0%. (Act Sec. 302(c)) The GST tax exemption for decedents dying or gifts made after Dec. 31, 2010 is equal to the basic exclusion amount (a new concept arising under the portability feature, discussed below) for estate tax purposes (e.g., $5 million, as indexed). (Code Sec. 2631(c), as amended by Act Sec. 303(b)(2)) The GST tax rate for transfers made in 2011 and 2012 is 35%. (Act Sec. 301, Act Sec. 302)

The Act extends the EGTRRA modifications to the rules regarding various technical aspects of the GST tax. (Act Secs. 101(a) and 301(a), Committee Report)

Portability of Unused Exemption between Spouses

Under the 2010 Tax Relief Act, any exemption that remains unused as of the death of a spouse who dies after Dec. 31, 2010 (the “deceased spousal unused exclusion amount”) is generally available for use by the surviving spouse, as an addition to the surviving spouse's exemption. A surviving spouse may use the predeceased spousal carryover amount in addition to his or her own $5 million exclusion for taxable transfers made during life or at death. (Code Sec. 2010(c), as amended by Act Sec. 303(a)) In technical terms, the Act achieves this result for decedents dying and gifts made after 2010 by defining the applicable exclusion amount as the basic exclusion amount ($5 million for 2011, as indexed) plus the deceased spousal unused exclusion amount. (Code Sec. 2010(c)(2), as amended by Act Sec. 303(a))

If a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion that is available for use by such surviving spouse is limited to the lesser of $5 million or the unused exclusion of the last such deceased spouse. (Code Sec. 2010(c)(4), as amended by Act Sec. 303(a))

A deceased spousal unused exclusion amount is available to a surviving spouse only if an election is made on a timely filed estate tax return (including extensions) of the predeceased spouse on which such amount is computed, regardless of whether the estate of the predeceased spouse otherwise must file an estate tax return. In addition, notwithstanding the statute of limitations for assessing estate or gift tax with respect to a predeceased spouse, IRS may examine the return of a predeceased spouse for purposes of determining the deceased spousal unused exclusion amount available for use by the surviving spouse. (Code Sec. 2010(c)(5), as amended by Act Sec. 303(a))

Illustration: Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made on his estate tax return to permit Wife to use his deceased spousal unused exclusion amount. As of his death, Wife has made no taxable gifts. Thereafter, Wife's applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death. (Committee Report)

Illustration: Assume the same facts as in the prior illustration, except that Wife subsequently marries Husband 2. He predeceases Wife, having made $4 million in taxable transfers and having no taxable estate. An election is made on his estate tax return to permit Wife to use his deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2's $1 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse of the surviving spouse. Thereafter, Wife's applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death. (Committee Report)

Extension of Filing Deadlines

Under the 2010 Tax Relief Act, for a decedent dying after Dec. 31, 2009 and before the enactment date, the due date for certain tax actions is not to be earlier than the date that's nine months after the enactment date. This extension applies for:

• filing an estate tax return required under Code Sec. 6018;
• paying the estate tax; and
• making any Code Sec. 2518(b) disclaimer of an interest in property passing by reason of the death of such a decedent. (Act. Sec. 301(d)(1))

For a generation skipping transfer made after Dec. 31, 2009 and before the enactment date, the due date for filing any return required under Code Sec. 2662 (including the making of any election required to be made on the return) is not to be earlier than the date that's nine months after the enactment date. (Act. Sec. 301(d)(2))

Other EGTRRA Changes Temporarily Continued

The 2010 Tax Relief Act temporarily continues other changes made by EGTRRA for decedents dying after Dec. 31, 2009 and before Jan. 1, 2013, including the deduction for certain death taxes paid to any State or the District of Columbia and modifications to the rules regarding qualified conservation easements and installment payment of estate taxes. (Act. Sec. 101(a), Committee Report))

New EGTRRA Sunset

Under the 2010 Tax Relief Act, the sunset of the EGTRRA estate, gift, and generation skipping transfer tax provisions, which was scheduled to apply to the estates of decedents dying, gifts made, or generation skipping transfers made after Dec. 31, 2010, is extended to apply to estates of decedents dying, gifts made, or generation skipping transfers made after Dec. 31, 2012. The EGTRRA sunset, as extended by the Act, applies to the amendments made by the Act. Therefore, neither the EGTRRA rules nor the new 2010 Tax Relief Act rules will apply to estates of decedents dying, gifts made, or generation skipping transfers made after Dec. 31, 2012.

Tax Season Starts on Time for Most Taxpayers — Those Affected by Late Tax Breaks Can File in Mid- to Late February

IRS Newswire – December 23, 2010

Following tax law changes enacted 12/17/10, the Internal Revenue Service announced that the upcoming tax season will start on time for most people, but taxpayers affected by three recently reinstated deductions need to wait until mid- to late February to file their individual tax returns. In addition, taxpayers who itemize deductions on Form 1040 Schedule A will need to wait until mid- to late February to file as well.

The start of the 2011 filing season will begin in January for the majority of taxpayers. However, last week’s changes in the law mean that the IRS will need to reprogram its processing systems for three provisions that were extended in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 that became law on Dec. 17, 2010.

People claiming any of these three items — involving the state and local sales tax deduction, higher education tuition and fees deduction and educator expenses deduction as well as those taxpayers who itemize deductions on Form 1040 Schedule A — will need to wait to file their tax returns until tax processing systems are ready, which the IRS estimates will be in mid- to late February.

“The majority of taxpayers will be able to fill out their tax returns and file them as they normally do,” said IRS Commissioner Doug Shulman. “We will do everything we can to minimize the impact of recent tax law changes on other taxpayers. The IRS will work through the holidays and into the New Year to get our systems reprogrammed and ensure taxpayers have a smooth tax season.”

The IRS will announce a specific date in the near future when it can start processing tax returns impacted by the late tax law changes. In the interim, people in the affected categories can start working on their tax returns, but they should not submit their returns until IRS systems are ready to process the new tax law changes.

The IRS urged taxpayers to use e-file instead of paper tax forms to minimize confusion over the recent tax changes and ensure accurate tax returns.
Taxpayers will need to wait to file if they are within any of the following three categories:

Taxpayers claiming itemized deductions on Schedule A. Itemized deductions include mortgage interest, charitable deductions, medical and dental expenses as well as state and local taxes. In addition, itemized deductions include the state and local general sales tax deduction extended in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 enacted Dec. 17, which primarily benefits people living in areas without state and local income taxes and is claimed on Schedule A, Line 5. Because of late Congressional action to enact tax law changes, anyone who itemizes and files a Schedule A will need to wait to file until mid- to late February.

Taxpayers claiming the Higher Education Tuition and Fees Deduction. This deduction for parents and students — covering up to $4,000 of tuition and fees paid to a post-secondary institution — is claimed on Form 8917. However, the IRS emphasized that there will be no delays for millions of parents and students who claim other education credits, including the American Opportunity Tax Credit and Lifetime Learning Credit.

Taxpayers claiming the Educator Expense Deduction. This deduction is for kindergarten through grade 12 educators with out-of-pocket classroom expenses of up to $250. The educator expense deduction is claimed on Form 1040, Line 23, and Form 1040A, Line 16.

For those falling into any of these three categories, the delay affects both paper filers and electronic filers.

The IRS emphasized that e-file is the fastest, best way for those affected by the delay to get their refunds. Those who use tax-preparation software can easily download updates from their software provider. The IRS Free File program also will be updated.

As part of this effort, the IRS will be working closely with the tax software industry and tax professional community to minimize delays and ensure a smooth tax season.

Updated information will be posted on IRS.gov. This will include an updated copy of Schedule A as well as updated state and local sales tax tables. Several other forms used by relatively few taxpayers are also affected by the recent changes, and more details are available on IRS.gov.

In addition, the IRS reminds employers about the new withholding tables released Friday 12/17/10 for 2011. Employers should implement the 2011 withholding tables as soon as possible, but not later than Jan. 31, 2011. The IRS also reminds employers that Publication 15, (Circular E), Employer’s Tax Guide, containing the extensive wage bracket tables that some employers use, will be available on IRS.gov before year’s end.

Forms Affected By the Extender Provisions
Taxpayers will need to wait to file if they are impacted by any of the tax credits or deductions that expired at the end of 2009 and were renewed by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 enacted Dec. 17, 2010. The delays impact taxpayers claiming:

• Schedule A (Form 1040), Itemized Deductions
• Form 8917, Tuition and Fees Deduction
• Educator Expense Deduction claimed on Form 1040, Line 23, and Form 1040A, Line 16
• Form 4684, Casualties and Thefts
• Form 8859, District of Columbia First-Time Homebuyer Credit

A few other taxpayers will also need to wait to file, due to the impact of other recent changes, primarily some of those included in the Small Business Jobs Act of 2010. Affected forms include:

• Form 3800, General Business Credit
• Form 5405, First-Time Homebuyer Credit and Repayment of the Credit
• Form 6478, Alcohol and Cellulosic Biofuel Fuels Credit
• Form 8834, Qualified Plug-In Electric and Electric Vehicle Credit
• Form 8910, Alternative Motor Vehicle Credit
• Form 8936, Qualified Plug-In Electric DriveMotor Vehicle Credit

The delay affects both paper and electronic filers. All tax returns claiming these credits or deductions should not be filed until the IRS is ready to start processing these returns in mid- to late February. IRS e-file is the fastest, best way for those impacted by the delay to get their refunds.