Key developments during the second quarter of 2010

While the new law tax changes in the health reform legislation and the hiring legislation were the most significant developments in the first quarter of 2010, many other tax developments may affect you, your family, and your livelihood. These other key developments in the first quarter of 2010 are summarized below.

Estate planning uncertainty. As of now, there is no estate or generation-skipping transfer tax for individuals who die this year. Because of changes to the income tax basis rules for property acquired from a decedent in 2010, some heirs could actually face higher combined estate and income tax costs if their loved one dies in 2010 than would have been the case if death had occurred in 2009. Congress could still retroactively reinstate the estate and generation-skipping transfer taxes to the beginning of this year and restore the favorable prior basis rules that wipe out income tax on pre-death appreciation in asset values. But, so far, there is no clear indication of what lawmakers will do. Apart from tax uncertainty, the continuing inaction could also pose a problem for individuals with wills using formula clauses. These clauses work well when the estate tax is in force but they may produce unintended consequences when there is no estate tax. Action may need to be taken if it becomes clear that Congress will not be addressing the situation.

Like-kind exchange relief for those snared by QIs in bankruptcy or receivership. In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is held either for productive use in a trade or business or for investment. When a taxpayer uses a qualified intermediary (QI), generally he will transfer the relinquished property to the QI, who will sell the property to a buyer. The QI will then take the proceeds of the sale of the relinquished property, purchase the replacement property, and transfer the replacement property to the taxpayer. If the taxpayer receives the replacement property within a specified period and meets other requirements, he is considered to have engaged in a like-kind exchange of property with the QI and he won’t recognize gain on the exchange.

Unfortunately, many QIs went bankrupt in the last few years thus posing a problem for taxpayers who used them. However, the IRS has now granted relief for taxpayers who were unable to timely complete a like-kind exchange because their QI entered into bankruptcy or receivership. The IRS won’t treat taxpayers as being in actual or constructive receipt of exchange proceeds if they can’t complete an exchange because of a default of a QI in bankruptcy or receivership. Affected taxpayers may use a special safe harbor method to report gain or loss.

Reporting of uncertain tax positions. IRS has released a draft schedule and instructions under which, beginning with the 2010 tax year, certain business taxpayers with both uncertain tax positions and assets of $10 million or more will be required to file Schedule UTP if they or a related party issued audited financial statements. Currently, the reporting requirement applies to corporations required to file a Form 1120, insurance companies required to file a Form 1120L or a Form 1120 PC and foreign corporations required to file a Form 1120F. The schedule is filed together with the taxpayer’s annual tax return and includes a concise description of each uncertain tax position and information on the maximum amount of potential federal tax liability attributable to each uncertain tax position.

Chances of being audited. The IRS has issued its annual data book, which provides statistical data on its fiscal year 2009 activities, including how many tax returns it examines (audits), and what categories of returns it focuses its resources on. Of the 138,788,744 total individual income tax returns with a filing requirement (this excludes returns filed only to receive an economic stimulus payment) in calendar year 2008, 1,425,888 (1%) were audited. For business returns other than farm returns showing total gross receipts of $100,000 to $200,000, 4.2% of returns were audited. For business returns other than farm returns showing total gross receipts of $200,000 or more, 3.2% of returns were audited. For returns showing total positive income of $200,000 to $1 million, 2.3% of returns not showing business activity were audited, and 3.1% of returns showing business activity were audited.

IRS honoring medical resident FICA refund claims for pre-April 1, 2005 periods. The IRS made an administrative determination to accept the position that medical residents are excepted from FICA taxes based on the student exception for tax periods ending before April 1, 2005, when new IRS regulations went into effect. The IRS intends to contact hospitals, universities and medical residents who filed FICA (Social Security and Medicare tax) refund claims for these periods with more information and procedures. The period of limitations for filing a claim for tax periods before April 1, 2005 has expired. An individual who is or was a medical resident, and did not file an individual FICA refund claim, may be covered by a FICA refund claim filed by his employer for the period he was a medical resident. The individual should contact his employer (or former employer) to see if it filed a FICA refund claim. On April 1, 2005, new IRS regulations regarding the student FICA exception became effective. Under these regulations, an employee including a medical resident who works 40 hours or more for a school, college or university is not eligible for the student exception.

Payments for use of trademarks. A prestigious Federal Appellate Court has ruled that a corporation that manufactured kitchen knives and tools could currently deduct the royalties it paid under trademark licensing agreements. In so deciding the Appeals Court rejected the IRS’s position (which had been sustained in the lower court) that the payments had to be capitalized under complex statutory provisions. The immediate deduction produced a quicker tax break than would have been the case had the Appeals Court agreed with the IRS.

Boosted housing allowances for those working abroad in high-cost areas. Guidance from the IRS increases the maximum housing cost exclusion for some U.S. citizens and residents working abroad in specified high-cost locations in 2010. The increases are based on geographic differences in foreign housing costs relative to U.S. housing costs. For example, assume a U.S. taxpayer is posted to Tokyo, Japan for all of 2010. Under the new IRS guidance, his maximum housing cost exclusion is $93,260 ($107,900 full year limit on housing expense in Tokyo minus $14,640 base amount). Before the 2010 table was issued, the IRS had last issued a table for 2008, which is also used for 2009. However, the 2010 table can be used for 2009 if it produces a better result for the taxpayer. In some cases, the 2010 allowances are lower than the 2008 allowances.

Moratorium on enforcement of tax shelter penalty continues. Continuing a previously announced policy, the IRS has suspended through May 31, 2010 its efforts to collect penalties under IRC §6707A in some cases. This provision imposes a penalty of $100,000 per individual and $200,000 per entity for each failure to make special disclosures with respect to a transaction that the IRS characterizes as a “listed transaction” or “substantially similar” to a listed transaction. The suspension applies where the annual tax benefit from the transaction is less than $100,000 for individuals or $200,000 for other taxpayers. The IRS originally implemented the suspension after Congressional leaders complained that IRC §6707Aan result in disproportionate penalties for small businesses that thought they were investing in legitimate benefits plans, but unknowingly invested in listed tax shelter transactions. Legislation that would ease IRC §6707A’s application has passed the Senate and has been introduced in the House.

Government seeks input on annuitization of retirement plan payments. The Department of Labor and the Department of the Treasury are currently reviewing the law to determine whether (and, if so, how) they could or should enhance the retirement security of participants in employer-sponsored retirement plans and IRAs by facilitating access to, and use of, lifetime income or other arrangements designed to provide a lifetime stream of income after retirement. To that end, they are seeking input on this subject from plan participants, employers and other plan sponsors, plan service providers, and members of the financial community, as well as the general public. The concern is that many employers no longer provide fixed lifetime pensions but rather provide 401(k) plans. With these plans, employees bear investment risks and can choose lump sums. Accordingly, employees are not only increasingly responsible for the adequacy of their savings at the time of retirement, but also for ensuring that their savings last throughout their retirement years.

Post-2009 Roth IRA rollovers

As you have probably heard, in 2010, for the first time, you may roll over amounts in qualified employer-sponsored retirement plan accounts, such as 401(k)s and profit sharing plans, and regular IRAs, into Roth IRAs—regardless of your adjusted gross income (AGI).

What’s so attractive about a Roth IRA? Here’s a summary:

• Earnings within the account are tax-sheltered (as they are with a regular qualified employer plan or IRA).
• Unlike a regular qualified employer plan or IRA, withdrawals from a Roth IRA aren’t taxed if some relatively liberal conditions are satisfied.
• A Roth IRA owner does not have to commence lifetime required minimum distributions (RMDs) after he or she reaches age 70 1/2 as is generally the case with regular qualified employer plans or IRAs. (For 2009, there was a moratorium on RMDs.)
• Beneficiaries of Roth IRAs also enjoy tax-sheltered earnings (as with a regular qualified employer plan or IRA) and tax-free withdrawals (unlike with a regular qualified employer plan or IRA). They do, however, have to commence regular withdrawals from a Roth IRA after the account owner dies.

The catch, and it’s a big one, is that the rollover will be fully taxed, assuming the rollover is being made with pre-tax dollars (money that was deductible when contributed to an IRA, or money that wasn’t taxed to an employee when contributed to the qualified employer-sponsored retirement plan) and the earnings on those pre-tax dollars. For example, if you are in the 28% federal tax bracket and roll over $100,000 from a regular IRA funded entirely with deductible dollars to a Roth IRA, you’ll owe $28,000 of tax. So you’ll be paying tax now for the right to future tax-free withdrawals, and freedom from the RMD rules.

Should you consider making the rollover to a Roth IRA? The answer may be “yes” if:

• You can pay the tax on the rollover with non-retirement-plan funds. Keep in mind that if you use retirement plan funds to pay the tax on the rollover, you’ll have less money building up tax-free within the account.
• You anticipate paying taxes at a higher tax rate in the future than you are paying now. Many observers believe that tax rates for upper middle income and high income individuals will trend higher in future years. (See discussion below regarding Medicare tax on investment income beginning in 2013.)
• You have a number of years to go before you might have to tap into the Roth IRA. This will give you a chance to recoup (via tax-deferred earnings and tax-deferred payouts) the tax hit you absorb on the rollover.
• You are willing to pay a tax price now for the opportunity to pass on a source of tax-free income to your beneficiaries.

Roth rollovers made in 2010 represent a novel tax deferral opportunity and a novel choice. If you make a rollover to a Roth IRA in 2010, the tax that you’ll owe as a result of the rollover will be payable half in 2011 and half in 2012, unless you elect to pay the entire tax bill in 2010.

Why on earth would you choose to pay a tax bill in 2010 instead of deferring it to 2011 and 2012? Keep in mind that absent Congressional action, after 2010, the tax brackets above the 15% bracket will revert to their higher pre-2001 levels. That means the top four brackets will be 39.6%, 36%, 31%, and 28%, instead of the current top four brackets of 35%, 33%, 28%, and 25%.

What’s more, beginning in 2013, a Medicare tax will, for the first time, be applied to investment income. A new 3.8% tax will be imposed on net investment income of single taxpayers with AGI above $200,000 and joint filers over $250,000 (unindexed).

Net investment income is interest, dividends, royalties, rents, gross income from a trade or business involving passive activities, and net gain from disposition of property (other than property held in a trade or business). Net investment income is reduced by the deductions that are allocable to that income. Although the new tax won’t apply to income in tax-deferred retirement accounts such as 401(k) plans, taxable distributions from these plans can push your income over the limit subjecting your investment income to the higher rates.

Because the new tax on investment income won’t take effect for three years, that leaves more time for Congress and the IRS to tinker with it. So we can expect lots of refinements and “clarifications” between now and when the tax actually takes hold in 2013.

So if you believe there’s a strong chance your tax rates will go up after 2010, you may want to consider paying the tax on the Roth rollover in 2010.

Individuals ineligible to make deductible contributions to a traditional IRA, or to make any regular contributions to a Roth IRA, due to limitations based on adjusted gross income, may contribute to a traditional IRA and then convert this amount to a Roth IRA. So individuals who have never opened a traditional IRA because they weren’t able to make deductible contributions (and who have never rolled over pre-tax dollars to a regular IRA) should consider opening such an IRA and making the biggest allowable nondeductible contribution they can afford. If they convert the traditional IRA to a Roth IRA they will have to include in gross income only that part of the amount converted that is attributable to income earned after the IRA was opened, presumably a small amount. They could continue to make nondeductible contributions to a traditional IRA in later years, and roll the contributed amount over into a Roth IRA. However, note that if an individual previously made deductible IRA contributions, or rolled over qualified plan funds to an IRA, complex rules determine the taxable amount.

You need to consider your family’s entire financial situation before you plan for a large rollover to a Roth IRA. There also are many details that you should go over, such as whether the amounts you are thinking of switching to a Roth IRA are eligible for the rollover (technically, they are called “eligible rollover distributions”), whether you can make rollovers from your employer sponsored plan (for example, there are restrictions on rollovers from 401(k) plans), and the tax impact of rolling over amounts that represent nondeductible as well as deductible contributions. 

Finally, there are investment strategies you should consider such as setting up “segregated” Roth accounts where you put bonds, stocks and other assets in different Roth IRA accounts. Because you can’t recharacterize (undo) portions of a Roth IRA, if you are concerned about specific assets or asset classes losing value later, you can segregate those, at conversion, into several different accounts.  So if they did in fact lose value, you could recharacterize selected individual accounts.