INTEREST RATES FOR TAX OVERPAYMENTS AND UNDERPAYMENTS (JANUARY 2010 QUARTER)

The IRS has announced the interest rates for tax overpayments and underpayments for the calendar quarter beginning January 1, 2010.

For noncorporate taxpayers, the rate for both underpayments and overpayments will be 4% (unchanged).

For corporations, the overpayment rate will be 3% (unchanged). Corporations will receive 1.5% (unchanged) for overpayments exceeding $10,000. The underpayment rate for corporations will be 4% (unchanged), but will be 6% (unchanged) for large corporate underpayments.

Rev. Rul. 2009-37

IRS ALLOWS TAXPAYER TO COMBINE ACQUISITION INDEBTEDNESS AND HOME EQUITY INDEBTEDNESS

The Internal Revenue Code does not allow deductions for “personal interest.” Nonetheless, qualified residence interest, which includes interest on acquisition indebtedness and home equity indebtedness on a qualified residence, is deductible. Generally, acquisition indebtedness is deductible only on the first $1 million of acquisition indebtedness. Home equity indebtedness is generally deductible on $100,000 of home equity indebtedness.

What happens if a taxpayer borrows $1.1 million to buy a qualified residence? Can the taxpayer get interest deductions on $1 million of acquisition indebtedness, AND interest deductions on another $100,000 of the acquisition debt? Or is the full $1.1 million clearly acquisition indebtedness only, thus qualifying only $1 million of the debt for deductible interest?

In Pau,  TC Memo 1997-43  and Catalano,  TC Memo 2000-82 , the Tax Court limited interest deductions in this context to the acquisition indebtedness amount only of $1 million. Interestingly, the IRS has now reversed course and in a Chief Counsel Advice is now allowing interest deductions on $1.1 million - $1 million for acquisition indebtedness and another $100,000 as home equity indebtedness. Its a rare day that the IRS goes against court precedent to provide a favorable interpretation for taxpayers, instead of the IRS.

Chief Counsel Advice 200940030

APPLICABLE FEDERAL RATES – DECEMBER 2009

ORDINARY INCOME ON SURRENDER OF LIFE INSURANCE POLICY

Borrowing from a life insurance policy is a tax-advantaged method of obtaining funds. Generally, a policy owner can borrow against the cash surrender value of non-term life insurance policies. The receipt of the loan proceeds is not a taxable event to the owner, even though part of the cash surrender value was created by untaxed earnings that accumulated in the life insurance policy. If the owner dies while the loan is outstanding, the owner does not typically have to repay the loan, although the beneficiary of the life insurance will have its policy proceeds reduced by the outstanding loans. Note that loans do not always come from direct loans from a policy – sometimes loan balances arise when premiums are not paid on the policy and the life insurance company charges the cash surrender value as a loan to pay the premiums.

The policy owner will often incur tax consequences relating to the loan if the policy is surrendered back to the company. At that time, the loan balance is treated as having been distributed to the policy owner. If the amount of the deemed loan distribution, plus any cash paid out to the owner by the insurance company, exceeds the total premiums paid by the owner (his or her “investment in the contract”), gain results.

This is what happened to the taxpayer in a recent Tax Court case. The taxpayer did not object to this gain treatment, but the taxpayer was not too pleased to learn that the gain was taxed as ordinary income and not capital gain (which would have received the benefit of lower capital gains rates).

The Tax Court schooled the taxpayer in the surrender of life insurance contracts. While such contracts may be capital assets, the surrender of a contract is not considered a “sale or exchange,” so no capital gains treatment is allowed (although there are exceptions for terminally ill or chronically ill individuals).

The taxpayer might have done better by selling the policy to a third party, instead of surrendering it back to the insurance company. This would allow for capital gains treatment. However, two important limitations apply for such sales, at least in the IRS’ opinion. First, the taxpayer’s basis in computing gain would not be all premium payments made, but only premium payments made that were not paid for the cost of insurance (that is, premium payments made in excess of cost of insurance that were used to build-up cash surrender value). Therefore, there would be more gain in this scenario than in the surrender scenario. Second, the IRS would still tax the owner at ordinary income rates on the portion of the cash surrender value attributable to earnings that had built up in the policy that were not previously subject to income tax. Therefore, numbers would have to be crunched to see if a sale of the policy would yield better tax results for the owner.

Barr, TC Memo 2009-250

SUMMARYOF NEW TAX ACT PROVISIONS

Congress passed last week the Worker, Homeownership, and Business Assistance Act of 2009. President Obama is expected to sign the new Act. Below is a summary of key provisions:

A. Expansion of 5 Year NOL Carrybacks. The ability to carry back NOL’s for 5 years (instead of the normal 2 years) has been expanded to include 2009 losses  (previously the 5 year rule only applied to 2008).  The rule has been expanded to include most taxpayers, not just the small businesses it applied to before. Other than taxpayers who have already carried back 2008 NOLs, only one extended carryback is allowed. There is also a 50% of taxable income limit to the use of the carryback to the 5th carryback year.

B. Suspension of 90% NOL Limitation for Alternative Minimum Tax Purposes. For tax years ending after 2002, the Act suspends the 90% limitation on the use of any alternative tax NOL deduction attributable to the carryback of an applicable NOL for which the extended carryback period is elected.

C. Extension of Extra .2% FUTA Surtax. The 6.2% FUTA tax rate continues to apply through June of 2011, and the 6.0% rate applies for the remainder of calendar year 2011 and for later years.

D. Increased Late Filing Penalties for S Corporations and Partnerships. Once upon a time, there typically was no penalty for late filing of an S corporation or partnership income tax return. Now it is $89 per owner per month. Under the new law, it will now be $195 per owner per month. This is irksome. Clearly, the current increase is not being made due to a compliance problem that is sought to be reduced. Instead, it is only a hidden tax – increasing revenues through penalties instead of an outright tax increase.

E. First Time Homeowner Credit Extended and Expanded. This credit is now extended to principal residence purchases purchased before May 1, 2010 (or a purchase closed before July 1, 2010 if a contract is entered into before May 1, 2010). The credit phases out for higher income taxpayers. Taxpayers who have stayed in their residence for a 5 year consecutive period will be deemed “first time homeowners” if they acquire a new residence. A residence cannot exceed $800,000.

TAX INCREASES IN HEALTH BILL NOT INDEXED FOR INFLATION, AND WILL ALSO REACH CAPITAL GAINS AND DIVIDENDS

In 1960, only 3% of tax filers paid a 30% or higher marginal tax rate. By 1980, after the inflation of the 1970s, the share was closer to 33%. In 1981, Congress realized the inequity in these "stealth" tax increases by requiring tax brackets be indexed for inflation. Without such indexing, lower income persons are eventually subjected to higher marginal rates of tax as their income rises with inflation, even though they have not really increased their income on after-tax basis. Similar "bracket creep" has occurred in the context of the alternative minimum tax, which once-upon-a-time only applied to 1% of U.S. taxpayers.

The current House health bill has not indexed two main tax features for inflation: the $500,000 threshold for the 5.4-percentage-point income tax surcharge, and the payroll level at which small businesses must pay a new 8% tax penalty for not offering health insurance. Therefore, as time (and inflation) march on, more and more taxpayers will be subject to these new taxes without any real increase in income level.

Also worthy of note is that the surcharge will apply to capital gains and dividends. Thus, the capital gains tax rate that is now 15% would increase in 2011 to 25.4% with the surcharge and repeal of the Bush tax rates. The tax rate on dividends would rise to 45% from 15% (5.4% plus the pre-Bush rate of 39.6%).

The increase in taxes on capital gains and dividends is what it is, and is being discussed here only because this point is not widely known. The lack of indexing for the new taxes and penalties, however, is a dishonest method of raising taxes, since it effectively raises taxes each year without a new Congressional vote or presidential approval.

WILLFUL FAILURE TO PAY OVER WITHHOLDING TAXES APPLIES, EVEN THOUGH EMPLOYER DID NOT HAVE THE MONEY TO PAY IT OVER

A nursing home operator collected payroll taxes from his employees. Instead of paying the collected taxes over to the IRS, the operator spent them on other expenses. The IRS obtained criminal tax convictions under Code Section 7202.

The nursing home operator appealed the conviction, claiming he could not have “willfully” failed to pay over the taxes since he did not have the money to pay them even if he wanted to.  The taxpayer argued that willfullness required “bad faith or evil intent” - which had to be absent if he didn't have the funds to pay over the taxes.

The 9th Circuit Court of Appeals rejected his appeal in 2008. It did so by noting that prior precedent which had opened the door to this type of argument had been subsequently changed. It further noted that the taxpayer's argument was  "inconsistent with common sense, for we think it unlikely that even under [the prior case law], a defendant could succeed in arguing that he did not willfully fail to pay because he spent the money on something else."

Earlier this week, the U.S. Supreme Court refused to review the case. Consequently, it seems highly unlikely that criminal defendants can avoid convictions for failure to pay over withheld taxes simply because they spent the money elsewhere.

U.S. v. Easterday, 102 AFTR 2d 2008-5847 (2008, CA 9) , cert denied 11/02/2009