Tax Complexity

As Congress deals with various tax measures, the usual calls for tax simplication are made. So how complex is the federal tax system?

Complexity is a difficult concept to measure. One objective indicator is how words there are in the applicable tax laws. John Walker, of the site www.fourmilab.ch, has indexed the Internal Revenue Code and sets the number of words at 3.4 million. If Treasury Regulations are added in, add another 6 million words to the total, with the combined total approaching 10 million words. If you want to add in Treasury Department pronouncements, such as publications, revenue rulings, revenue procedures, private letter rulings, and other explanations of the law, the number becomes incalculable.

To put these numbers in context, there are 602,585 words in the Old Testament. In the New Testament, there are 180,552 words. So who has the more difficult job - bible scholars or tax attorneys? Even without the word differential, the Bible is static - the Internal Revenue Code and its interpretation is a moving target with the constant tinkering and revision of Congress and the Treasury Department.

As the Wall Street Journal noted in a November 1 article on the subject ("Taxing Words"), Ronald Reagan's 1986 tax reform cut the Internal Revenue Code in half, but it has since grown back like jungle brush, thicker than ever. Will this year's tax acts add or take away from the size of the Code? I think we can all predict the answer to that.

That $3 Checkbox

When you file your income tax return, there is a box that taxpayers can “check off” to send $3 of their taxes to the Presidential Election Campaign Fund. This Fund provides funds to candidates to help finance presidential campaigns. When initiated in 1981, 28.6% of taxpayers made the designation. In recent years, this has dropped to 9.1%.

There are various theories discussed for why the participation has dropped. One theory is that the computer/electronic tax preparation software discourages taxpayers from participating, based on default assumptions of “no participation” and inadequate descriptions. According to this theory, the explosion of use of this software has accelerated the decline.

Working with Commisioners of the Federal Election Commission, the Campaign Finance Institute has been able to bring the purported problem to the attention of the tax preparation software producers and tax preparers. In response, two of the major software producers have now agreed to modify their software.

H &R Block has agreed -- in all of its TaxCut boxed software and online products -- to:

--Change “I want to contribute $3” to “I want to designate $3” to the Presidential Fund (This is followed by the caution “Checking the box will not change your tax or reduce your refund,” a key Form 1040 phrase that the company added last year at CFI’s request); and

--Add to its explanation of the Fund the following Form 1040 language: “The fund reduces candidates’ dependence on large contributions from individuals and groups and places candidates on an equal footing in the general election.”

Intuit agreed -- for all versions of consumer TurboTax -- to:

--Eliminate the pre-filled in “No” check box;

--Change “Do you want $3 to be contributed” to substitute “designated” for the last word (The caution remains, “Note: Selecting Yes will not increase your tax due or reduce your refund”) ; and

--Amplify its current explanation of the Fund to include the missing 1040 phrase, “and places candidates on an equal footing in the general election.”

All of the changes will go into effect in consumer product and web updates for Tax Year 2005.

It will be interesting to see if this reverses the slide in taxpayer participation, or whether the decline arises for other reasons (including the reduction in the number of tax filers that actually owe tax and intentional decisions not to participate in public finance of elections).

Private Trust Companies

At times, families often seek to establish their own trust company to serve as fiduciaries of estates and trusts of family members. Such a trust company can reduce the costs involved with using third party trust companies, allows for continuity, management and control of the fiduciary function by a family, and avoids some of the drawbacks to both third party trust companies and individual fiduciaries. Indeed, several well-known trust companies got their start as private trust companies for a family.

Since the trust company is generally established and controlled by senior family members, tax issues arise regarding whether this “related” relationship gives rise to retained control by family members such that the grantor trust rules may be inadvertently brought into play, and that also may result in unintended estate tax inclusion in family members of the trust assets.

In a favorable ruling, the IRS has confirmed that when properly structured (including provisions that exclude family members from participating in discretionary decisions and having adequate trust company “firewall” provisions), the private trust company is not a “related or subordinate” party for purposes of these tax provisions and does not otherwise give rise to undesired grantor trust consequences. Private Letter Ruling 200546052, 11/18/2005.

Foreign Life Insurance Policy Reporting

U.S. taxpayers are generally required to report their ownership interests in non-U.S. bank accounts using Form 90-22.1. At first analysis, one wouldn't think that an interest in a foreign life insurance policy is a reportable account. However, some practitioners have been advised that the Department of Treasury believes that premium payments for insurance policies with cash surrender value or other investment features constitute "deposits" within the meaning of Form 90-22.1. Therefore, if a life insurance policy is a "whole life" or other type of policy with investment value, then it is an "other financial account" subject to reporting. Whether this is a correct interpretation is unknown, but conservative reporting would indicate that such policies should be reported.

IRA Taxable at Full Value for Estate Tax Purposes

When an individual dies, his assets are subject to federal estate taxes based on the value of those assets (subject to reduction for applicable deductions and credits). For this purpose, value is the price that the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

There is precedent that allows for the reduction in value for taxes that would have to be paid when the successor owner sells the subject property. There is also precedent for taking into consideration costs that would need to be expended to sell the subject property.

The Tax Court recently addressed the issue whether the value of IRA account for estate tax purposes should be reduced by the income taxes that will eventually be paid on distributions from the IRA. The logic of the estate's argument was that the IRAs that were involved were not transferable and therefore were unmarketable. According to the estate, the only way that the owner of the IRAs could create an asset that a willing seller could sell and a willing buyer could buy is to distribute the underlying assets in the IRAs and to pay the income tax liability resulting from the distribution. Upon distribution, the beneficiary must pay income tax. Therefore, according to the estate, the income tax liability the beneficiary must pay on distribution of the assets in the IRAs is a “cost” necessary to “render the assets marketable” and this cost must be taken into account in the valuation of the IRAs.

Unfortunately for the estate, the Tax Court did not buy into this argument, and held that the IRA was includible at the value of the securities held in the IRA, withour reduction for future income taxes. Kahn v. Comm., 125 T.C. No. 11 (2005).

More Year End Planning Ideas

Since for individuals income tax system is generally a calendar year system, the end of the year presents opportunities for tax planning. Here are some ideas for consideration (but please consult with your tax advisor before undertaking any to confirm it makes sense in your specific situation):

-Sale of capital gain and capital loss properties to (a) offset each other, and (b) avoid limitations on deductibility of capital loss property

-Defer income until 2006

-Avoid or reduce penalty for underpayment of estimated tax by increasing income tax withholding on wages and pension/IRA distributions

-Increase your basis in partnerships and Subchapter S corporations to allow deductibility of losses

-Set up a qualified tuition program (529 plan) – this allows for tax-free earnings accumulations and tax-free distributions if used for qualified higher education expenses

-Minimize Florida intangible taxes through conversion of assets to nontaxable assets or use of swing trusts

-Make annual exclusion gifts of $11,000 per recipient to reduce estate and gift taxes

-Set up a retirement plan

-Make expenditures that qualify for Section 179 $105,000 business property expensing option

-Accelerate deductions (e.g., pay union or professional dues, preparing professional subscriptions, etc.)

Applicable Federal Rates - Update for December 2005

December 2005 Applicable Federal Rates Summary (Rev.Rul. 2005-77):

-Short Term AFR - Semi-annual Compounding - 4.29% - (4%/Nov. -- 3.89%/Oct.)

-Mid Term AFR - Semi-annual Compounding - 4.47% - (4.19%/Nov. -- 4.08%/Oct.)

-Long Term AFR - Semi-annual Compounding - 4.73% - (4.52%/Nov. -- 4.40%/Oct.)

Tax Bill Expected Soon

Congress is hard at work on a new tax bill. Since different versions are out of committee and are before the House and Senate, the final look of the bill is not yet known. Items included in one or both bills include:

- numerous extensions of expiring tax provisions

- hurricane relief (relief similar to that in the Katrina Emergency Tax Relief Act of 2005 (KETRA) to victims of Hurricanes Rita and Wilma, and would also offer extra tax breaks for rebuilding in the Hurricane Katrina disaster area),

-charitable giving provisions (charitable contributions from IRAs),

-extension for existing favorable capital gain and dividend rates.

Given the substantial differences between the House and Senate versions, what finally makes it into the final bill is anyone’s guess.

Hybrid Cars - Better to Buy Now or Later?

WHY BUY IN 2005? As previously discussed, for buyers situated in states that charge sales tax, the ability to deduct sales taxes for federal income tax purposes is due to expire on December 31, 2005. Therefore, unless this deductibility is extended, it is advantageous for those persons to purchase large ticket items in 2005.

If the vehicle is a qualified hybrid vehicle, a deduction of up to $2,000 of the cost is also allowed if the vehicle is purchased in 2005. This is a useful deduction since it is "above the line" - it is deductible even if you do not itemize deductions, and is not subject to the phase-out of itemized deductions that applies to higher income taxpayers.

WHY BUY IN 2006? In 2006, a qualified hybrid will qualify for a tax credit from $400 to $3,400, depending on the model. A tax credit (the 2006 and beyond incentive) is better than a tax deduction (the 2005 incentive) of the same amount, since it reduces taxes dollar-for-dollar. A tax deduction only reduces the amount of income subject to tax, and thus does not reduce the tax bill dollar-for-dollar.

SO WHICH YEAR TO BUY IN? A comparison needs to be made in regard to whether a tax deduction of up to $2,000 is better in 2005, or a tax credit for the particular model car for a 2006 purchase of hybrid. Other factors favoring a 2005 purchase are the more immediate tax benefit on a 2005 tax return (instead of a 2006 return), and the above sales tax deduction for 2005 if applicable. One last factor to consider is that the tax credit will only fully apply to 60,000 vehicles from each manufacturer - thereafter, the credit is reduced and eventually eliminated for such manufacturer. A 2006 purchase runs the risk that your desired hybrid model may not qualify for the full credit due to this limit.

Hong Kong Seeks to Abolish Its Estate Taxes

Hong Kong's Legislative Council has passed the Revenue (Abolition of Estate Duty) Bill 2005 which seeks to amend the Estate Duty Ordinance to implement the proposal announced in the 2005-06 Budget to abolish estate duty. The Ordinance will commence operation on Feb. 11, 2006.

The Secretary for Financial Services and the Treasury, Frederick Ma, said that apart from removing the unfairness and obstacles arising from the collection of estate duty, another key objective of the proposed abolition was to facilitate the further development of Hong Kong as an important asset management center. The government consulted the public last year on whether to abolish estate duty. By and large, the majority view tended to support abolition. Ma believed that by abolishing estate duty, Hong Kong can attract more local and overseas investors to hold assets here. More companies and professionals will come here, which will facilitate the further development of asset management services, create more employment opportunities, and in turn make Hong Kong more competitive as an international financial center. "The abolition of estate duty is not only a tax concession but also a long term strategic investment in Hong Kong's financial services industry and the overall development of the economy," he stressed. It is estimated that the proposal to abolish estate duty will cost the government annual revenue of around 1.5 billion HK dollars (193.55 million US dollars).

Tax Return Filing Obligations Imposed on Bankrupt Debtors

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) amends the U.S. Bankruptcy Code by adding new tax return responsibilities for debtors. Most BAPCPA provisions apply to cases filed on or after Oct. 17, 2005.

If debtors fail to file a return that becomes due after the date of their bankruptcy petition, or fail to file an extension, the IRS may request the Court to order a conversion (change from Chapter 7 to Chapter 11 or from Chapter 11 to Chapter 13, for example) or dismiss the case. To have their plan confirmed, Chapter 13 debtors must also file all tax returns with IRS for the four-year period before the bankruptcy petition. The debtor must establish filing by the first meeting of creditors.

Seven days before the first meeting of creditors, debtors must give trustees a copy of their most recently filed federal tax return or a transcript of the return. Similarly, copies of amendments to the returns, and any past due returns filed while the case is pending, must also be filed with the court if requested. The returns or transcripts must be provided to the court at the same time they are filed with IRS. If the returns or transcripts are not filed, a Chapter 7 discharge will not be granted, or a Chapter 11 or 13 plan will not be confirmed. In addition, debtors must also provide a copy of the tax return or transcript to requesting creditors.

Lottery Luck Runs Out in Recent Case

After the lottery winner checks to see how much he won, his or her next thoughts turn to what will be left after taxes. Since lottery payouts are taxed as ordinary income, a good piece of each payment goes to the IRS.

Some lottery winners sell their right to payments over many years to a third party buyer. The issue arises whether such sale can be taxed as a sale of a long term capital asset (if the original payout stream was held for long enough) so as qualify for the 15% maximum tax on individual capital gains. These rates can be less than 1/2 of the ordinary income rates.

In conformance to other recent rulings, the U.S. Tax Court has confirmed its reading of the law that long term capital gain treatment is not available. The Tax Court applied the "substitute for ordinary income doctrine" to disallow capital gain treatment. Under this doctrine, a court will narrowly construe the term "capital asset" when a taxpayer makes an attempt to transform ordinary income into capital gain. Prebola v. Commissioner, TC Memo 2005-261 , 2005 RIA TC Memo ¶2005-261

Bankruptcy Act is a Mixed Bag for Taxpayers

While some taxes are discharged in bankruptcy, not all are. For example, income taxes cannot be discharged if they are from tax returns due within three years of the bankruptcy petition filing date, or if they are assessed or assessable within 240 days of the petition. In the past, taxpayers have used offers in compromise and successive bankruptcy filings to get more taxes covered by the discharge. The new bankruptcy laws restrict these strategies by suspending the running of the time periods and adding additional days in these situations. The new law also resolves an existing uncertainty in the law by unequivocally providing that the "automatic stay" provisions that apply to tax issues do not apply to post-petition taxes.

There are some rule changes that benefit taxpayers. One change is that the IRS needs to file a timely claim for nondischarged taxes in Chapter 7 bankruptcies. This was not the case in the past. Another benefit of the new law is that which allows tax authorities to set off pre-petition tax refunds due to a debtor against pre-petition taxes owed by the debtor. This benefits debtors because it stops interest from accumulating on pre-petition taxes due by the debtor and set-offs of other debts are not normally allowed by the bankruptcy court.

Source: New Law Toughens Rules for Avoiding Taxes Through Bankruptcy, Practical Tax Strategies, Nov 2005 by Randall K. Hanson and James K. Smith

Homestead Property and Florida Probate

Florida law regarding homestead is quite complex, with Florida appellate courts constantly addressing homestead issues. A recent appellate court decision summarized various principles of Florida law when a decedent's homestead was left under his Last Will to his three children:

the homestead property passed free of claims of the decedent's creditors since all of the devisees were heirs of the decedent, that is, they were within the class of persons who could be a beneficiary of the decedent under the laws of intestacy;

the homestead was not part of the probate estate as there was no explicit direction to sell the homestead;

even though not part of the probate estate, the personal representative nonetheless could take control over the homestead to protect it;

however, this power of control did not give the personal representative the power to sell the homestead.

Harrell v. Snyder et al, 5th District Court of Appeals Case No. 5D04-1961 (November 4, 2005)

Florida Intangible Tax Planning Deadline Approaching

Florida persons owning intangible property are subject to an intangibles tax. The tax rate has been reduced for 2006 from $1,000 per $1,000,000 of taxable intangible assets (e.g., stocks and bonds) to $500 per $1,000,000 of taxable intangible assets.

The tax is imposed based on assets owned on January 1. Since assets owned before and after that date do not enter into the computation, the tax is essentially avoidable with proper planning. This planning includes:

–transferring intangible assets to a special type of trust before January 1, under which neither the trust nor any beneficiary is subject to intangibles tax (note that while trusts are exempt from the tax, Florida beneficiaries can be taxed on their trust interests depending on the terms of the trust). After January 1 (subject to a reasonable waiting period) assets are typically then returned to the original owner(s);

–converting assets to intangible assets that are not subject to the tax before January 1, such as into Florida municipal bonds and funds owning exclusively such bonds; and

–owning assets in non-Florida limited partnerships that are not managed or controlled in Florida.

A single individual is not taxed on the first $250,000 of his or her taxable intangible assets, and a married couple has a $500,000 exclusion.

The end of the year comes upon us quicker than you would expect. For those who need year end planning, now is the time to get started.

IRS Automatic 6 Month Extensions for Income Tax and other Returns Now Allowed

Old Rules. Currently, most taxpayers other than corporations can receive a full six-month extension of time to file their income tax returns, but to obtain the full six-month extension they must file one application for an initial extension of time and then a second one. For example, individual income taxpayers request an initial four-month automatic extension on one form and then use a second one to request a two-month discretionary extension. Similarly, trusts and partnerships request an initial three-month automatic extension on one form and then use a second one to request a three-month discretionary extension.

The Change. To reduce the complexity of the pre-existing extension process, and to provide cost savings and other benefits to taxpayers and IRS, new regulations simplify the extension process by allowing most taxpayers to file a single request for an automatic six-month extension of time to file.

New Rules - Individuals. An individual may obtain an automatic six-month extension to file an income tax return by submitting a timely, completed application for extension on Form 4868. There is no need to sign the request or explain why an extension is sought. As under the pre-existing process, taxpayers must make a proper estimate of any tax due and failure to pay any tax as of the original due date of the return may subject the taxpayer to penalties and interest. (Reg. § 1.6081-4T )

New Rules - Corporations. The regulations don't change the rules on filing extensions for corporate income tax returns. Currently, corporations may obtain an automatic six-month extension of time to file their income tax returns by submitting Form 7004, Application for Automatic Extension of Time To File Corporation Income Tax Return. Corporations don't have to sign the extension request or give a reason for the request. Form 7004 does not extend the time for payment of tax—corporations filing Form 7004 must compute the total amount of their tentative tax and make a remittance of any balance due.

New Rules - Gift Tax Returns. Under Code Sec. 6075(b)(2) , an individual who makes a gift and who requests an automatic extension of time to file his income tax return is deemed to have an extension of time to file the return required by Code Sec. 6019 . Donors who do not request an extension of time to file an income tax return to request an automatic six-month extension of time to file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, by filing a new version of Form 8892, Payment of Gift/GST Tax and/or Application for Extension of Time to File Form 709. ( Reg. § 25.6081-1T ) Under the regs, Form 8892 no longer requires an explanation of the need for the extension of time to file or a signature.

Warning! An extension to file a tax return is NOT an extension to pay the taxes due under the return. If a sufficient tax payment is not made by the original due date of the return, penalties will likely apply for the late payment.

IRS Extends Withholding Program Amensty

Under Section 1441 of the Internal Revenue Code, U.S. payors of certain types of income to nonresidents (e.g., U.S. source interest, dividends, and rents) are obligated to withhold tax at 30% (or lower treaty rates) when such income is paid to a nonresident. This assists the IRS in collecting these taxes that might not otherwise be paid by foreign persons by shifting the payment obligation to the U.S. payors.

Since September 29, 2004, the IRS has had a program for U.S. payors that have withholding obligation issues. Under the program, the U.S. withholding agent agrees to identify to the IRS areas in which it isn't in compliance with obligations on payments to foreign persons, pays tax, interest, and any penalties, and implements corrective procedures to ensure future compliance. In turn, the IRS agrees not to impose penalties on underpayments that are due to reasonable cause, and will provide the withholding agent with written acknowledgement that its compliance procedures and policies are acceptable.This program was set to expire on December 31, 2005. However, due to the heavy volume of use, the IRS has now extended the deadline of the program to March 31, 2006. Revenue Procedure 2005-71.

Buy-Out Insurance Owned by Corporation Does Not Increase Estate Tax Values

To provide liquidity to a decedent's estate, or to provide for succession of ownership, buy-sell agreements are often entered into obligating a corporation to buy the stock of a major stockholder at the death of that stockholder. This purchase obligation is often funded by the corporation purchasing a life insurance policy on the life of the shareholder. That way, when the shareholder dies, the corporation receives the life insurance proceeds and thus has the cash to purchase the stock.

Since the estate of the decedent shareholder is subject to estate tax based on the value of the stock, the question arises whether the value of the stock (which is based on the value of the assets of the corporation) should be increased to account for the life insurance proceeds payable to the corporation. There has been case law to the effect that such insurance is NOT included in the valuation computation, but in a recent case the Tax Court ruled that the insurance proceeds should be counted in determining the value of the corporation (and the stock of the decedent stockholder).

In a ruling favorable to taxpayers, the U.S. Eleventh Circuit Court of Appeals reversed the Tax Court and held that the insurance proceeds should not be taken into account. The Court noted that the value of the insurance payout was offset by the obligation of the corporation to purchase the shares, and thus should not impact valuation of the company or the shares. Estate of Blount v. Comm., 96 AFTR 2d 2005-XXXX, (10/31/2005 CA11).

Nonresident Wage Earners May Not Need to File a U.S. Income Tax Return

Generally, nonresident individuals of the U.S. who perform services in the U.S. are required to file a U.S. income tax return (Form 1040NR), regardless of the level of income arising from those services. The IRS has now announced it will amend its Regulations to eliminate the filing requirement for nonresident alien individuals who have U.S. source effectively connected wages in amount below amount of one Code Sec. 151 personal exemption (which is presently $3,200). This amendment will be effective for tax years beginning on or after 1/1/2006 and will apply even if the nonresident alien also has U.S. source fixed or determinable income if that tax liability thereon is fully satisfied by withholding by the payor of such fixed or determinable income (e.g., dividends and interest). Notice 2005-77.

Florida Filing Extensions for Hurricane Victims

Corporate Tax Returns: The Florida Department of Revenue has indicated that it will follow the special tax relief granted by the IRS for filing of corporate income tax returns. The Department will extend the due date for filing the Florida corporate income tax return and tax payments to March 15, 2006. The extended due date applies to taxpayers affected by Hurricane Katrina with original or extended due dates on or after August 29, 2005, taxpayers affected by Hurricane Rita with original or extended due dates on or after September 23, 2005, and taxpayers affected by Hurricane Wilma with original or extended due dates on or after October 23, 2005.

Intangible Tax Returns: The Florida Department of Revenue has extended the filing deadline for intangible taxes until January 18, 2006 for taxpayers with valid extensions in those counties in Florida designated disaster areas, which include: Broward, Miami-Dade, and Monroe Counties and any counties or parishes in Mississippi, Louisiana, Texas and/or Alabama.