This year-end tax update letter provides information on selected tax developments for businesses and individuals to consider. While annual tax payments can be the single largest cash expense for the year, tax planning decisions should not be isolated from other financial and business planning. When evaluating transactions, such as buying or selling a business or merging with another company, effective up-front tax planning can lead to significant tax savings.
The selected topics include - the recently enacted changes in the tax return preparer standards, the expanded "kiddie tax" rules, tax incentives for "green buildings" and our annual list of year-end tax planning reminders. We also discuss the prospects for future tax legislation.
In the spring, Congress passed the only legislation with tax provisions enacted so far in 2007, the Small Business and Work Opportunity Act of 2007 (‘the Act"). The main purpose of the Act was to increase the minimum wage. Congress also included a few tax incentives for businesses to defray the cost of the increase, as well as a few revenue raiser offsets. The tax provisions included an increase in the age of children, including full-time students up to 23, subject to the "kiddie tax," an increase in the Section 179 deduction, an extension of various tax credits and liberalization of some S corporation rules.
The changes to the tax return preparer standards in the 2007 legislation focus on the preparer's evaluation of the support for positions reported on tax returns and when disclosure will provide a defense if the IRS asserts penalties. We describe these changes and discuss our perspective on what it means in this letter.
If you have any questions, please don't hesitate to contact your Beers + Cutler advisor.
Prospects for Tax Legislation in 2007 and 2008
At the end of October, House Ways and Means Chairman Rangel introduced two tax bills: Part 1 - Alternative Minimum Tax (AMT) Relief for 2007 and Part 2 - a broad proposal described by Representative Rangel as "the mother of all tax reform."
AMT Relief for 2007
If the 2007 AMT relief is passed, the questions are whether there will be revenue raising items to pay for it or if Congress will waive the pay-go requirement. We have learned not to bet on the outcome of such questions. Trends are more predictable than the details. We predict that AMT relief for 2007 will pass, and same as 2006, the relief will not provide significant benefit to many of our clients.
Beyond 2007
The consensus of many is that there will be tax legislation that increases taxes. Whether it includes details from the "mother of all tax reform" proposal is to be determined. The reform bill puts a number of revenue raisers on the table in exchange for full repeal of the AMT and a lower corporate tax rate. Some of the significant items included in the Rangel reform proposal include the following.
A key point in the ongoing tax legislation debate is that the Bush tax rate cuts expire at the end of 2010. Unless changed by new legislation, the individual tax rate brackets of 15%, 28%, 35% and the 15% maximum tax rate on qualified dividends and long term capital gains all expire at that time. Absent legislation, the pre 2001 tax rates will then be effective, and, for example, the 35% bracket would be a 39.6% bracket and the capital gains rate would be 20%.
State Taxes
Maryland is holding a special legislative session to address budget shortfalls. Since we are going to press before the session concludes, we cannot describe the final impact. Working proposals in Maryland include a rate increase on high income individuals and an increase in the corporate income tax rate and sales tax rate. The detail will be covered in our next tax letter along with a description of whatever federal tax legislation passes before the end of 2007.
New Tax Return Preparer Standards Affect Taxpayers and Practitioners
The purpose of this article is to discuss recent changes in the factors and standards that apply to our role as tax advocates for our clients. The most recent changes are tax provisions included in the 2007 minimum wage increase law. These provisions included changes in the definitions of the preparer standards and changes in the possible penalties for tax positions that do not meet the "more likely than not" standard and are not adequately disclosed in the return.
Background
Taxpayers, both business and individual, hire tax return preparers and tax advisors with the expectation that the tax professional will apply their knowledge of the tax law to the information and facts provided by the taxpayer. The tax professional provides his or her services on behalf of the taxpayer and does so in accordance with professional standards of practice.
Professional standards of practice for CPAs are in the AICPA Code of Professional Conduct and AICPA Statements on Standards for Tax Services. Tax practice, with respect to the IRS and Federal tax matters, must comply with the rules of Circular 230 issued by the US Treasury Department. Circular 230 covers CPAs, attorneys and anyone else regarding federal tax practice. The Internal Revenue Code includes several code sections that define the standards for tax return positions. Under these standards, a tax position reported on the tax return must meet the applicable standard or be disclosed.
With that general background, let's look at the change made by the 2007 tax legislation. Under the legislation, the realistic possibility standard for undisclosed positions under prior law is replaced with a requirement that the preparer have a reasonable belief that a position reported on a tax return will more likely than not ("MLTN") be sustained on its merits. The legislation made this change effective immediately, but the IRS postponed the effective date and it will be effective for tax returns due after December 31, 2007 (due after January 31, 2008 for certain estimated payment, excise and employment tax returns).
Prior to the Act, a tax practitioner who signed a return or a non-signing practitioner who gave advice about a return-related position, could be sanctioned if the position taken on a return did not have a realistic possibility of succeeding based on the merits ("realistic possibility standard") unless the position was disclosed on the tax return. A position is considered to have a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis of the law and the facts by a person knowledgeable in the tax law would lead that person to conclude the position has approximately a one in three, or greater, likelihood of being sustained on its merits.
Under the Act, the standards are elevated to the MLTN standard. For returns due after December 31, 2007, penalties and possible sanctions may be imposed if a tax return position does not meet the MLTN standard - greater than 50% likelihood of being sustained on its merits, unless it is disclosed on the return.
The MLTN standard change may be seen as part of a series of changes, all of which increase disclosure related rules for taxpayers. The first was the new IRS Schedule M-3 requirement. The tax return Schedule M-3 requires more detailed reporting of book vs. tax differences on the corporate and partnership tax returns of entities with assets of $10 million or more. At about the same time, the Financial Accounting Standards Board ("FASB") adopted what is referred to as FIN 48. This FASB interpretation established MLTN as the threshold for financial statement recognition of any tax benefit from a tax position. FIN 48 was effective for GAAP financial statements of publicly held companies first, and its implementation to privately held companies was recently delayed for one year and will apply to financial statements of years beginning after December 15, 2007. The May 2007 Tax Act change of the tax return preparer standard to MLTN seems to fit into a pattern when considered in this context.
What Does it Mean in Our Practice
Because the MLTN standard is a tougher standard to meet, more tax return positions will require closer attention.
As part of the tax return preparation process, the tax professional identifies issues and evaluates the support for tax return positions that deserve attention. With a thorough understanding of the facts, the tax professional researches tax law and other precedent, such as IRS rulings and tax court cases, to determine the support and makes a qualitative judgment about the standard the support meets.
Tax return reporting issues can be complex because the taxpayer and the IRS may interpret the facts differently in the context of the tax law and court cases each considers most relevant. As an example, consider the significant difference in tax liability dependent on whether gain on sale of an asset is taxed as a long term capital gain (15% Federal tax rate) or taxed as ordinary income (35% Federal tax rate). The determination of whether the asset is considered a capital asset is dependent upon whether the asset is considered held for sale in the ordinary course of business or held for investment. This issue has been an often litigated matter. The Courts generally look to the intent of the taxpayer when deciding such cases. Under prior law, a practitioner simply needed to make certain that with respect to a factual issue, such as whether the asset was held for investment, there was a realistic possibility of success on the merits. Since many factual issues reasonably may be viewed in more than one way, in many cases it will be much more difficult to conclude that the intent of the taxpayer meets the higher standards of certainty now being imposed.
If the research conclusion is that the position does not meet the MLTN standard, but does meet the reasonable probability standard, then disclosure on the return may be the appropriate decision. In this situation, the preparer will explain the situation to the client and review the alternatives available. Before the decision to include disclosure of the position in the return is made, we may recommend that a tax attorney be contacted and in some instances a tax opinion letter be obtained. When the issue is a close one, the opinion is a good alternative.
Before the change we also researched and evaluated the support for tax return positions. You may have discussed with your tax advisor whether or not a tax position rose to a level of "substantial authority." This is the level of authority a return position must obtain for the taxpayer not to incur the 20% substantial understatement penalty if the position is not disclosed on the tax return. Substantial authority is not defined under the Code or IRS Regulations, but a majority of tax advisors consider a 40% likelihood of succeeding on the merits to constitute substantial authority.
In some ways this was an objective standard. The tax professional identified the relevant facts, researched the law and referenced meaningful support that was considered to sustain a 40% chance of successful conclusion. The MLTN standard involves a more thorough and necessarily more subjective evaluation. The analysis also starts with the relevant facts. The research requires a more complete and thorough weighing of law and precedent for and against the position in order to conclude whether it meets the MLTN standard.
Conclusion
As tax return preparers and tax advisers, we have always worked within the tension and element of controversy of our Federal tax system. The MLTN standard will mean that significant issues get more attention. As tax professionals, we remain committed to delivering quality client service in our role as your advocates.
The "Kiddie Tax" and Planning Opportunities
What is the Kiddie Tax?
The phrase "kiddie tax" refers to a child's net investment income being taxed at the parents' highest marginal tax rate. The kiddie tax was intended to reduce the benefit of intra-family transfers of income producing property that ultimately shift income from the parents' highest marginal tax rate to the child's presumed lower tax rate. The net effect is to reduce the family's overall income tax liability.
The kiddie tax has seen two recent law changes. The Tax Increase Prevention and Reconciliation Act of 2005 increased the age limit to children under the age of 18 for tax years beginning after 2005. This is the law effective for 2007. Under the pre-2006 rules, the kiddie tax applied to children who were under the age of 14 at the end of the year. This article discusses the recent law changes as well as the use of college savings plans to obtain similar tax savings and avoid the kiddie tax.
The Small Business and Work Opportunity Tax Act of 2007 expanded the kiddie tax to apply to a child who is 18 years-old at the end of the tax year, or who is a full-time student over the age of 18, but under 24 at the end of the tax year.
Beginning in 2008, the net investment income of a child will be subject to the kiddie tax in any of the situations below, assuming that the child has a living parent and the child does not file a joint return.
Earned income includes wages, tips, salaries, professional fees or other amounts received as pay for work actually done. Interest, dividends, capital gains and rental income are considered unearned income. If you own a business, the family may obtain some tax savings if the business hires the child to perform actual work for the business since the kiddie tax only applies to unearned income.
What Planning Opportunities Exist?
There is a window of opportunity available in 2007 for some to consider because the expansion of who the kiddie tax applies to is effective for 2008. The group that will be affected beginning in 2008, 18 year-olds or students who are 19 to 23, should consider selling appreciated assets before the end of 2007, if they expect to be paying tax on those gains in 2008 or later at higher tax rates.
There are also investment options to consider for children subject to the kiddie tax. There will be tax savings when income is deferred until the young adult child is no longer subject to the kiddie tax and the tax rate is then lower than the rate would have been during the year the kiddie tax applies. For instance, the child could invest in U.S. government EE savings bonds that will mature after the child is no longer subject to the kiddie tax. The income taxes on the accrued interest income can be deferred if the child reports the interest on the redemption or maturity of the bonds, rather than electing to report it annually.
How Can Section 529 Plans Help Avoid the Kiddie Tax?
A college savings plan qualifying as a Section 529 plan is not a cure for the kiddie tax, but it can help the family accumulate tax free investment earnings. As a result, the recent kiddie tax expansion may increase the attractiveness of tax favored college savings accounts. In the past, when the kiddie tax only applied to children 13 and under, parents typically had three to four years before their child started college to liquidate investments held in the child's name to take advantage of the child's lower tax rates. This is no longer the case.
Although contributions to a Section 529 Plan are not deductible for federal purposes, the account is exempt from federal income taxation. This means that any appreciation in the account will never be taxed if the funds are spent on tuition, room & board, fees, books, supplies and equipment required by an institution for enrollment.
In order to encourage saving for college, the Internal Revenue Service allows the amount of the annual gift exclusion for up to 5 years to be contributed to a Section 529 Plan in a given year. For 2007, this means each parent or grandparent can contribute up to $60,000 [($12,000 annual gift exclusion) x 5] per child to a Section 529 account without incurring any gift tax consequences. Note that the contributor will have used his or her annual gift tax exclusions for the 5 year period.
Maryland, DC and Virginia each allow a subtraction from income on individual returns for contributions to their respective college savings plans or prepaid tuition plans (MD and VA only). For contributions to the respective state college savings plans, the subtraction is currently limited to $2,000 per beneficiary account per taxpayer per year for Virginia taxpayers, $2,500 for MD and $3,000 for DC. The MD and VA prepaid tuition plans allow a deduction of $2,500 and $2,000 respectively per contract per year. Contributions subject to limitations carry forward and may be subtracted from state taxable income in future years.
Tax Incentives for Energy Efficient (Green) Commercial Buildings
A recent Beers + Cutler Real Estate CFO Roundtable presentation featured speakers with experience dealing with the Green Building LEED certification requirements as a developer/owner, a consultant and an architect and we discussed the practical issues and benefits of green buildings. There are several tax incentives available to encourage energy conservation expenditures. These tax incentives are available for renovations to existing buildings as well as new construction.
The Federal tax incentives allow a current year write-off for all or part of the cost of energy efficient commercial building property placed in service after December 31, 2005 and before January 1, 2009. The property must be depreciable and installed as part of one of the following subsystems:
The property expenditures must be certified by a qualified professional to reduce total annual energy and power costs of the building's heating, cooling, ventilation, hot water and interior lighting systems by 50 percent or more in comparison to a similar reference building that meets the minimum requirements of Standard 90.1-2001 of the American Society of Heating, Refrigerating and Air Conditioning Engineers (ASHRAE), which can be found at http://xp20.ashrae.org/frame.asp?standards/std90.html.
The maximum deduction for any tax year is limited to the square footage of the building multiplied by $1.80 for property placed in service after December 31, 2005 and before January 1, 2009, less deductions related to the building taken under this provision (Section 179D) in prior years. There is proposed legislation (S.1207 and H.R. 539) that increases the limit to $2.25 per square foot.
If the 50 percent reduction standard is not met for the systems in total but improvements to one of the subsystems reduces energy use by 16 2/3 percent related to that subsystem, a write-off for the cost of the subsystem may be taken, limited to $0.60 multiplied by the square footage of the building for property placed in service after December 31, 2005 and before January 1, 2009, less deductions claimed in prior years.
For example, if a 400,000 square foot (sf) energy efficient commercial building property qualifies as reducing energy usage by 50 percent, the deduction is the lesser of $720,000 (400,000 sf x $1.80) or the total cost of energy efficient commercial building property placed in service during the year. If the 50 percent reduction is not met and a subsystem reduces energy usage by 16 2/3 percent, the deduction is the lesser of $240,000 (400,000 sf x $0.60) or the cost for each qualifying subsystem placed in service during the year.
How to Document and Claim the Deduction
Many states also offer tax incentives for energy efficient building improvements.
Maryland Tax Incentives for Energy Efficient Buildings
A tax credit is available in Maryland for the years 2003 to 2011 for a portion of costs paid or incurred after July 1, 2001 to construct or rehabilitate a building to meet the energy efficiency and environmental standards established by the Maryland Energy Administration (MEA). These costs can include interest, architectural, engineering and other professional fees, closing costs, recording taxes and filing fees, finishes and furnishings, lighting, plumbing, electrical wiring and ventilation. Certain costs are specifically excluded from the credit amount, including the cost of telephone systems and computers, legal fees, site costs, non-qualifying finishes and furnishings and the cost of installing fuel cells, wind turbines or photovoltaic cells. Available credits for the tax period 2003 through 2011 in aggregate are limited to $25 million.
Owners and tenants of Maryland properties are eligible to claim tax credits for the cost of qualifying improvements. MEA has established certification standards. The Maryland tax credit for improvements to building common areas is generally the lesser of 6 percent of qualifying costs or the square footage of the building multiplied by $120.
For tenant space, the tax credit is generally the lesser of 6 percent of qualifying costs incurred by the owner or the square footage of the building multiplied by $60. For qualifying improvements to a building in which all common area and tenant space meets the standard, an owner may claim a credit equal to the lesser of 8 percent of costs paid or incurred by the owner, $120 per square foot limit, and a tenant may claim a credit equal to 8 percent of costs paid or incurred by the tenant, $60 per square foot limit.
Virginia Tax Incentives for Energy Efficient Buildings
For buildings in Virginia, the Federal deduction discussed above is also allowed for Virginia income tax purposes. The same certification and maximum deduction limitation standards apply.
Virginia also allows localities to tax energy efficient buildings at lower tax rates for real property tax purposes. In Virginia, an energy efficient building is defined as one that exceeds the energy efficiency standards defined in the Virginia Uniform Statewide Building Code by 30 percent. Taxpayers should check with their respective locality to determine if lower property tax rates are available for energy efficient buildings.
List of Year-End Tax Planning Reminders
For additional information on these topics, or to discuss your individual or business tax issues, please contact:
To ensure compliance with requirements imposed by the IRS, any written tax advice contained in this communication (including any attachments) was not written or intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.