YEAR END TAX LAW CHANGES

A number of interesting year-end tax law changes were recently enacted. We will review a few of them in the coming postings. Let's start with two - AMT relief and mortgage discharge relief.

A. Alternative minimum tax exemptions have been increased for 2007, instead of being decreased as required under prior law. The exemption is increased to $66,250 (up from $62,550 in 2006) for married couples filing a joint return and surviving spouses, to $44,350 (up from $42,500 in 2006) for an individual who isn't married or a surviving spouse, and to $33,125 (up from $31,275 in 2006) for married individuals filing separate returns.

B. In recognition of the real estate debt problems many taxpayers are facing, a relief provision has been added for discharge of indebtedness of income relating to principal residences. Normally, if a lender relieves a borrower from having to pay off debt, the borrower incurs taxable income. Thus, for example, assume a taxpayer owns a house with a $300,000 mortgage. Due to increases under an adjustable mortgage, the taxpayer can no longer pay the mortgage. Due to decline in values, the house is only worth $250,000. The lender forecloses on the residence and acquires ownership to the residence, and does not pursue the borrower for the $50,000 loss it suffers due to the difference between the $300,000 loan amount and the $250,000 value of the house. Under normal circumstances, the taxpayer would incur $50,000 of ordinary income, unless the taxpayer was otherwise insolvent or other limited exceptions to discharge income applied under the Internal Revenue Code.

Under the new rules, if the discharge occurs before 2010, the indebtedness was incurred to acquire, construct, or substantially improve the individual's principal residence, and is secured by the residence, no discharge of indebtedness income will arise. The new rules are limited to $2 million of such "acquisition indebtedness." The exclusion rule will not apply to second homes, vacation homes, business property, or investment property, since these properties aren't the taxpayer's principal residence. It also will not apply to discharges of second mortgages or home equity loans, unless the loan proceeds were used to acquire, construct, or substantially improve the taxpayer's principal residence.

Note that a foreclosure is not required - a restructuring of a debt that involves a reduction in debt will also be covered, if the above requirements are met.

APPLICABLE FEDERAL RATES - JANUARY 2007

January 2008 Applicable Federal Rates Summary:

-Short Term AFR - Semi-annual Compounding - 3.16% (3.84%/December -- 4.07%/November -- 4.15%/October)

-Mid Term AFR - Semi-annual Compounding - 3.55% (4.09%/December -- (4.34%/November -- 4.3%/October)

-Long Term AFR - Semi-annual Compounding - 4.41% (4.67%/December -- (4.83%/November -- 4.82%/October)

DIRECTION OF RATES: Down

WASH SALE RULE LOOPHOLE CLOSED

Common year-end tax planning advice is to consider selling publicly traded securities that have lost value, so as to obtain a loss deduction to offset otherwise incurred gains. However, as a practical matter, a taxpayer may like a particular stock and want to keep it in his portfolio. Therefore, thoughts are given to selling the stock to incur the loss, and then quickly buying it back to put it in the portfolio.

Code Section 1091, also known as the "wash sale rule," limits the ability to do this. If a share of stock or securities are sold at a loss, and substantially identical stock or securities are acquired within 30 days (before or after) the sale, the loss is disallowed. Some taxpayers have sought to get around the loss sale rule by repurchasing the stock or securities in an IRA or Roth IRA account, on the theory that the repurchaser is not the taxpayer, but a different legal entity and taxpayer.

In Revenue Ruling 2008-5, the IRS has advised that it considers the IRA or Roth IRA as effectively the same person as the taxpayer, and will apply Section 1091 to these types of purchases and resales. It based its ruling on a 1930's case that held that a trust controlled by a taxpayer was considered a mere agent for the taxpayer, allowing the application of the predecessor to Section 1091 to a sale by the taxpayer and a repurchase by such a trust.

Interestingly, the Ruling also disallows the use of Section 1091(d), which preserves the built-in loss in the property repurchased that is subject to Section 1091 through an upward adjustment in basis equal to the disallowed loss. No explanation is given, but presumably this is done in light of the tax-exempt nature of the IRA or Roth IRA.

Rev.Rul. 2008-5, 2008-3 IRB

CAN A SLOTS PLAYER BE IN A TRADE OR BUSINESS?

Before we get to the main question, let's review why we care. Section 165(d) limits losses from wagering losses to the amount of wagering gains (regardless of trade or business status). However, if a gambler is in the trade or business of gambling, he or she can generally make the offset of losses against gains. If the gambler is not in the trade or business, the loss deduction is an itemized deduction and is subject to general limitations on itemized deductions.

One could argue that statistically speaking one cannot be in the trade or business of playing slot machines because there is no realistic expectation of profit when it comes to playing slot machines due to the built-in house edge. This is the tack taken by the IRS in a recent Tax Court case when it sought to deny trade or business status to a slot machine gambler.

The Tax Court took seriously the gambler's claims that she ran her slots activities like a business. The Court applied nine factors to the analysis, taken from the Section 183 regulations, to determine if the taxpayer had the requisite intent to profit. These factors are(1) the manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his or her advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that the assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or loss with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved.

In applying these factors, the Court noted that the taxpayer played slots regularly (every day), she was an "expert" on slot play, she expended substantial time and effort, she expected to make a profit, and also had success in her other business ventures. She also had a specific system to her play, and adjusted her play when the system did not produce profits. On the negative side, the Court noted that she never produced profits on an annual basis (even though she did hit some big jackpots).

In the end, the Court sided with the taxpayer and found a trade or business. However, don't bother reading the opinion for a description of successful slots playing techniques - as noted above, the taxpayer never did have a winning year.

Linda M. Myers v. Commissioner, T.C. Summ. Op. 2007-194

CAN RELIANCE ON AN ATTORNEY AVOID PENALTIES FOR LATE FILING OF ESTATE TAX RETURN?

Code Section 6651(a)(1) provides for an addition to tax in the event a taxpayer fails to file a timely return (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect. What happens if an executor relies on his or her attorney to prepare the estate tax return, and the attorney doesn't prepare the return before the due date? Is the executor's reliance on the attorney reasonable cause?

No, says the Tax Court, in a case earlier this year. The Court quoted a Supreme Court case that provided:

Congress has placed the burden of prompt filing [of an estate tax return] on the executor, not on some agent or employee of the executor. *** Congress intended to place upon the taxpayer an obligation to ascertain the statutory deadline and then to meet that deadline, except in a very narrow range of situations.

However, the Court did provide some limited circumstances where reliance on an attorney could be a valid excuse. One of these is if the attorney specifically advised the executor of the due date of the return, but gave an erroneous date, and the return was filed late due to that erroneous advice.  Another is when the attorney erroneous advises that no return is due, causing the executor to file the return late.

Estate of Gertrude Zlotowski, et al., TC Memo 2007-203,

STRETCHING THE ENVELOPE TOO FAR

Insurance professionals have an incentive to find creative tax planning opportunities that involve insurance since their compensation is based on sales of policies. Such tax planning usually makes good sense, at least in appropriate circumstances, but sometimes that planning goes too far.

A recent Tax Court decision illustrates a planning arrangement that was marketed to many professionals as a method of generating income tax deductions for life insurance premiums, but which the IRS has successfully challenged in court. The case involved a partnership of 'S' corporations, whose shareholders were employed by the corporations and engaged to provide medical services to the partnership. Under the the Severance Trust Executive Program Multiple Employer Supplemental Benefit Plan and Trust (STEP) arrangement, a purported welfare benefit fund was established to pay severance payments to doctors that ceased to be employed. To fund those payments, the fund purchase life insurance on the lives the participants, which policies had significant cash values. Their 'S' corporations sought to deduct the premium payments as Section 162 business expenses to fund termination compensation.

An excerpt from the case best summarizes the Tax Court's dim view of the arrangement:

While the STEP plan may have been cleverly designed to appear to be a welfare benefits fund and marketed as such, the facts of these cases establish that the plan was nothing more than a subterfuge through which the participating doctors, through [the partnership], used surplus cash of the PCs to purchase cash-laden whole life insurance policies primarily for the benefit of the participating doctors personally. While employers are not generally prohibited from funding term life insurance for their employees and deducting the premiums on that insurance as a business expense under section 162(a), employees are not allowed to disguise their investments in life insurance as deductible benefit-plan expenses when those investments accumulate cash value for the employees personally.

Based on this view, the Court's disallowance of deductions for the premium payments should come as no surprise.

V.R. Deangelis M.D.P.C. & R.T. Domingo M.D.P.C., V.R. Deangelis M.D.P.C., Tax Matters Partner, ET AL. v. Commissioner, TC Memo 2007-360

IRS CAN ACT INCONSISTENT WITH FIELD SERVICE ADVICE

Auditors can ask for legal advice from the IRS's Office of the Chief Counsel. Such written advise is referred to as Field Service Advice, or an FSA.

In a recent tax case, the IRS had issued an FSA in regard to another taxpayer and acted consistently with it as to that other taxpayer. Later, in dealing with the taxpayer (who was a competitor of the prior taxpayer) under similar facts, the IRS disregarded the FSA and in effect treated the taxpayer different from its similarly situated competitor. The taxpayer sought to bind the IRS to the treatment it provided to the competitor, claiming that the IRS could not provide disparate treatment for itself, which treatment was further inconsistent with the previously issued FSA.

The taxpayer sought to rely upon the case of International Business Machines Corp. v. United States, 343 F.2d 914  (Ct. Cl. 1965), cert denied 382 U.S. 1028 (1966). That case involved the failure of the IRS to issue similar private letter rulings on a similar issue at about the same time to two different taxpayers, which case held such disparate treatment was improper.

The U.S. District Court was not swayed by this argument, and found no obligation on the IRS to either treat the similarly situated taxpayers in the same manner nor to apply the FSA to the taxpayer.  The IBM case was rejected as precedent, in large part because an FSA is not the same as a private letter ruling. The Court noted the following differences between FSA's and private letter rulings:

-an FSA is issued to IRS field personnel whereas a taxpayer requests a PLR;

-a taxpayer requesting a PLR can rely on it because the ruling is binding on IRS with respect to that taxpayer, but FSAs cannot be relied on by taxpayers because they are not binding on IRS; and

-when taxpayers ask for PLRs they submit information to IRS and they are entitled to have a conference with it, while FSAs are issued without notice to the taxpayer and the taxpayer has no right to a conference with the IRS.

Thus, attempting to bind the IRS to a FSA may be difficult, if not impossible. Nonetheless, FSA's may still be useful in negotiating with the IRS, even if they have no binding effect.

Schering-Plough Corporation v U.S., 100 AFTR2d 2007-5522 (DC NY 12/03/2007).

TREASURY CONCERNS IN THE INTERNATIONAL AREA

The Treasury Department often publishes reports on areas of tax law, addressing issues that are of current concern. Such reports are useful as an indication as to what legislation may be coming. Of course, just because the Treasury Department has a concern in an area does not mean that legislation will always follow, or that Congress will enact that legislation.

A recent report highlights three areas of concern in the international tax arena. These are:

EARNINGS STRIPPING. Treasury is concerned that U.S. corporations owned by foreign persons, that undergo "inversion transactions" to insert a foreign holding company in a low or no tax jurisdiction, may be engaged in excess stripping of earnings from the U.S. through excessive interest payments. The study recommends that tax forms be modified to require more information about earnings stripping.

TRANSFER PRICING. Treasury believes certain areas of its transfer pricing rules require modernization or revision. More particularly, it is interested in addressing contributions for which arm's length consideration must be provided as a condition to entering into a cost sharing arrangement, and completing revisions to the related-party services regulations, as well as some additional other areas.

TAX TREATIES. Treasury is concerned that persons who are not residents of treaty jurisdictions continue to improperly gain benefits from the U.S. treaty network as to those treaties that do not have adequate limitations of benefits provisions (provisions that limit treaty benefits to residents of the treaty countries).

Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties, Nov. 28, 2007

CLAIM OF RIGHT DOCTRINE

A recent tax case reminds of us an often overlooked income tax Code Section that can provide significant benefits to taxpayers - Code Section 1341. This Code Section is tied into the claim of right doctrine.

The claim of right doctrine typically applies where a taxpayer receives an income item in one year and reports it as income, even though there is a chance that the taxpayer will have to repay the amount in a future year. If the amount is repaid in a future tax year, the doctrine allows the taxpayer an income tax deduction in the year of REPAYMENT.

Oftentimes, the deduction in a later year is worth less in overall tax savings than the extra taxes imposed in the earlier year from the income. For example, tax rates may have been higher in the earlier year of income inclusion, so more taxes were paid in the earlier year than are saved from the deduction in the later year of repayment. Code Section 1341 provides relief, when it applies, by allowing further tax savings in the year of repayment to cover the shortfall in recovered income tax.

In Alcoa, Inc., and Affiliated Corporations, F/K/A Aluminum Company of America v. IRS, 100 AFTR 2d ¶ 2007-5506 (CA 3, 11/28/2007), the taxpayer tried a novel approach to Code Section 1341. Essentially, Alcoa claimed that it could have deducted environmental remediation costs in earlier tax years as it produced product, but it didn't. Later, under new environmental protection laws, Alcoa was forced to expend many millions of dollars on remediation costs relating to sites used for production in the earlier tax years. Since, due to a reduction in corporate tax rates, those deductions were not worth as much in tax savings in the years they were expended as the deductions would have been worth in the prior tax years if they had been deducted in those earlier years, it sought a $12+ million refund under Section 1341.

The appeals court found that Section 1341 did not apply, in large part because it could not equate Section 1341's requirement for an inclusion of an item in gross income in the earlier tax year as being the same thing as not taking a deduction against gross income in the prior tax year.  To rule otherwise would have opened the door to Section 1341 to taxpayers almost any time that it a taxpayer is faced with an expense it pays in a later year that can be related in any way to the fact that the taxpayer did not pay that expense in a prior year.