Domestic Production Activities Deduction: Evolving Rules

Transcription

1 7.1 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules This chapter explains the new Code Sec. 199 domestic production activities deduction (also known as the manufacturing deduction). This deduction first became available in 2005 and since then it has been the nonstop focus of issue spotting, IRS guidance, and planning advice. This chapter recaps the cutting-edge developments surrounding this significant business tax benefit. The provisions for determining the deduction are complex, but the benefits are significant. The deduction is one of the most important new business tax breaks to come about in the past five years. Code Sec. 199 introduces many concepts that are new to the Tax Code. Many businesses that are not ordinarily considered manufacturing, such as construction and engineering services, will qualify for the deduction, making it crucial to understand the scope of the new deduction. Small, midsize, and large businesses, whether operated as a proprietorship, a partnership, LLC, or corporation, can all qualify. LEARNING OBJECTIVES Upon completion of this chapter, you will be able to: Describe the scope of the manufacturing deduction; Determine qualified production activities income; Calculate domestic production gross receipts; Define qualified production property and other sources of domestic production gross receipts; Apply the W-2 wage limitation; Understand the availability of the deduction to pass-through entities and expanded affiliated groups; and Explain the impact of the Tax Increase Prevention and Reconciliation Act of These objectives will be met especially within the context of understanding the most recent IRS guidance, the 2006-enacted Tax Increase Prevention and Reconciliation Act (TIPRA), and practitioner-generated issue spotting that continues to develop within this dynamic area. Top_Fed_07_book.indb /15/2006 2:41:42 PM

2 7.2 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE INTRODUCTION The American Jobs Creation Act of 2004 added the Code Sec. 199 deduction to the Tax Code to replace tax code benefits that had been provided to U.S. corporations operating abroad. Code Sec. 199 is a wide-ranging benefit available to domestic businesses engaged in manufacturing activities, whether operated by a corporation, individual, or passthrough entity. The definition of manufacturing is broad and encompasses activities, such as construction, farming, and filmmaking, which would not ordinarily be considered manufacturing. Code Sec. 199 will benefit an estimated 17 million taxpayers. LOTS OF GUIDANCE AND MORE TO COME Code Sec. 199 is effective for tax years beginning on or after January 1, TIPRA and other legislation enacted in 2006 modified certain provisions. The Tax Code provisions were amended by the Gulf Opportunity Zone Act of 2005 and the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Changes in the GO Zone Act took effect January 1, 2005, whereas changes made by TIPRA apply to taxable years beginning after May 17, 2006, the date that TIPRA was signed into law. The IRS and Treasury issued Notice , IRB , followed by proposed regulations (REG , 70 FR 67220, Nov. 4, 2005) that incorporated the notice. In May 2006, the government issued final regulations (T.D. 9263, 71 FR 31275, May 24, 2006). Reg. Sections through of the final regulations apply to tax years beginning on or after June 1, For prior periods, the notice and proposed regulations apply. Reg. Section , concerning the W-2 wages of a passthrough entity, applies to tax years beginning on or before May 17, Taxpayers can apply the final regulations to the period before June 1, 2006, but they must follow the regulations in toto. COMMENT Code Sec. 199 is complex. The government noted in the final regulations that it was difficult to simplify many of the rules. In 2006, the government also issued guidance on the treatment of computer software (T.D. 9262, May 25, 2006) and the calculation of W-2 wages (Rev. Proc , IRB ). Treasury and the IRS intend to issue further guidance for the changes made by TIPRA. Other guidance anticipated in the near future will address the use of statistical sampling to calculate expenses, a revenue procedure on the method for deducting expenses under Code Sec. 861, and the treatment of disallowed losses. Top_Fed_07_book.indb /15/2006 2:41:42 PM

3 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.3 This chapter reviews the basics of the deduction and puts those basics within the framework of recent guidance and anticipated issues that still remain unaddressed. BASICS OF THE MANUFACTURING DEDUCTION The domestic production activities deduction allows qualified taxpayers to deduct an amount equal to the lesser of a phased-in percentage of taxable income (adjusted gross income for individual taxpayers) or qualified production activities income (QPAI). Only items that are attributable to the actual conduct of a trade or business are taken into account; investment property cannot generate any portion of the deduction. Further, to simultaneously serve the purpose of jobs creation, the deduction cannot exceed one-half of the W-2 wages paid by the taxpayer during the year. Special rules apply for purposes of net operating losses (NOLs) and the alternative minimum tax (AMT). Qualified Production Activities Income After all of the exceptions and limitations are whittled away (that is, the phased in percentage of taxable income; active trade or business, W-2 wages and the special NOL and AMT rules), what s left to the computation of the domestic production activities deduction and key to computing it is to determine qualified production activities income (QPAI). QPAI is the starting point and forms the framework for computing the deduction; all the exceptions and limitations fall into place as the QPAI computation moves step-by-step based on its statutory formula. QPAI equals a business s domestic production gross receipts (DPGR), reduced by: The cost of goods sold (COGS) allocable to those receipts; Other deductions, expenses and losses directly allocable to the receipts; and A ratable portion of deductions, expenses, and losses that would not be directly allocable to DPGR or other income. The deduction is calculated as a percentage of QPAI. However, if the business s overall taxable income (before the Code Sec. 199 deduction) is lower than its QPAI, the deduction must be taken as a percentage of taxable income. The amount of the percentage is phased in over several years, as shown in Table 1. Top_Fed_07_book.indb /15/2006 2:41:43 PM

4 7.4 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Table 1. Phase-in Percentage of QPAI Used in Calculating the Domestic Production Activities Deduction Year Percentage of QPAI and beyond 9 Wage Limitation The Code Sec. 199 deduction is a percentage of QPAI or taxable income. However, an additional limitation requires that the deduction not exceed 50 percent of a company s W-2 wages. This cap was inserted by Congress to carry out its intention to make the manufacturing deduction not only good for business but also good for job creation. And within that jobs focus was the intent to create stable employer employee relationships rather than independent contract work especially contract work done offshore. When Code Sec. 199 was enacted in 2004, the wage limit was based on all of the company s W-2 wages. Congress, in TIPRA, made a significant change to this requirement. TIPRA limits the deduction to 50 percent of the W-2 wages paid to generate the domestic production gross receipts (DPGR), the income component of QPAI. TIPRA applies to tax years beginning after May 17, For calendar year businesses, that starts in COMMENT The TIPRA change is a significant limitation placed on the size of the deduction for many businesses. What is more, it comes just when the general W-2 wage limit itself will become more of a hurdle as the 3 percent deduction increases to 6 and then 9 percent. W-2 wages include salary reduction contributions to a 401(k), 403(b), or 457 plan, a simplified employee pension (SEP) plan and a SIMPLE retirement account. The limit is based on wage expense, which may include items such as stock options. For tax years beginning after December 31, 2005, wages also include designated contributions to a Roth IRA. The wage limit includes amounts paid by another company, such as an employee leasing firm or professional employer organization, provided that the worker is an employee of the business generating the QPAI. A husband and wife filing a joint return are treated as one taxpayer and may use W-2 wages paid by the husband, for example, to QPAI generated by the wife. This treatment is not available if the husband and wife file separate returns. Compensation for household Top_Fed_07_book.indb /15/2006 2:41:43 PM

5 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.5 employees does not qualify as W-2 wages. Wages paid for services in the home do not qualify because they are not attributable to the conduct of a business. The determination of employment status must be made under common law rules that focus on the employer s control of the individual. Payments to officers also qualify as W-2 wages, but payments to independent contractors are not treated as W-2 wages. Employers must apply the employee classification rules on a consistent basis. Using Form W-2. There is no single box on Form W-2 that meets the definition of W-2 wages. As a response, the government in Rev. Proc prescribed three methods that could be used to calculate the wage limit from the information on Form W-2, the same methods that were provided in earlier guidance. The unmodified W-2 box method allows a simplified calculation, whereas the modified Box 1 method and the tracking wages method are more accurate. The government indicated that it put the calculation of W-2 wages in a revenue procedure, instead of regulations, so that it could update the requirements more promptly as Form W-2 changed. So expect regular revisions of Rev. Proc ! Already anticipating the next revision, the government has said that the methods for determining W-2 wages will be similar to those in the existing revenue procedure, but this could be difficult to achieve because W-2 wages incurred to produce QPAI may not correspond to the totals on the W-2. DOMESTIC PRODUCTION GROSS RECEIPTS How does one determine DPGR? One must keep the computation of QPAI in mind whenever working with any of the manufacturing deduction s components. To review: QPAI equals a business s DPGR reduced by: The cost of goods sold (COGS) allocable to those receipts; Other deductions, expenses, and losses directly allocable to the receipts; and A ratable portion of deductions, expenses, and losses that would not be directly allocable to DPGR or other income. DPGR includes gross receipts derived from the sale, exchange, lease, rental, license or other disposition of qualified production property (QPP). The property must have been manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part in the United States. DPGR does not include gross receipts from the sale or other disposition of land. The provision of services does not, in general, qualify for the deduction. See, however, the discussion on embedded services. Contracts to repair and refurbish property do not qualify for the deduction. However, any replacement parts or other tangible property used in the repair will qualify for the deduction. Top_Fed_07_book.indb /15/2006 2:41:43 PM

6 7.6 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE DPGR Calculation: Derived From Gross receipts considered derived from the sale, exchange, lease, rental, license or other disposition of qualified production property (QPP) are limited to the direct proceeds from the lease, rental, license, sale, exchange, or other disposition of QPP (collectively, a disposition). To determine whether a disposition has occurred, taxpayers should look to existing federal income tax law principles for guidance. For example, Rev states that a short-term rental is treated as a service. Thus, a short-term rental is generally not a qualifying activity. The regulations clarify that, in some cases, receipts from short-term rentals can be allocated between QPP and services. However, not every transaction involving the use of property with services will qualify as a rental. Whether the transaction is a rental is based on the facts and circumstances. All interest and finance charges received from a lease of property are considered derived from the lease, even if separately stated. The sale requirement is met if the taxpayer has direct proceeds from the sale of QPP, or self-constructed QPP, used in the taxpayer s business and manufactured in whole or in significant part within the United States. Additionally, business interruption insurance and payments not to produce to the extent the payments are substitutes for gross receipts are treated as qualifying gross receipts. Gains and losses from hedging transactions also are treated as DPGR. Determining DPGR on Item-By-Item Basis DPGR must be determined on an item-by-item basis. The proposed regulations required that QPAI be determined on an item-by-item basis. The final regulations modified the item requirement and moved it upstream so that it applies to the determination of DPGR. As a result, the requirement does not apply to the amounts deducted from DPGR. If the production of an item produces a loss, the company must aggregate gains and losses before applying the applicable percentage. Identifying the item can be difficult, and applying Code Sec. 199 on an item-by-item basis can be burdensome. Because of this difficulty, the regulations explain the concept through examples for shoes, toys, and cars. COMMENT Despite strong objections by taxpayers and practitioners, the final regulations retained the item-by-item requirement. The government declined to allow other methods, such as product-by-product or division-by-division. The final regulations do allow the use of any reasonable method to allocate receipts between DPGR and nonqualifying receipts. Top_Fed_07_book.indb /15/2006 2:41:43 PM

7 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.7 The final regulations define an item as the product offered for sale, lease, license, or other disposition in the normal course of the taxpayer s business that meets the requirements for DPGR. In the case of a wholesaler, the final regulations clarify that determining the item is based on the manner of sale by the wholesaler, not the manner of sale of a retailer who obtained the item from the wholesaler. Shrink-Back Method If the product does not qualify under this definition, the item is any component of the product that would qualify as DPGR. This determination is known as shrink-back. Each qualifying component is a separate item. EXAMPLE Corporation B manufactures and sells shoes in the United States. B manufactures the sole and imports the portion above the sole. If the shoes do not qualify as an item, B must treat the sole as the item. Corporation C manufactures windshields for cars, purchases cars, installs the windshields in the cars, and sells the cars to customers. If the cars do not qualify as the item, C must treat the windshield as the item. The shrink-back method may require a difficult allocation of receipts and expenses between DPGR and non-dpgr. Generally, a qualifying component cannot be combined with a nonqualifying component to be treated as an item. If there are two qualifying components, they cannot be combined into one item. If a taxpayer manufactures qualifying property, sells the property, and then acquires property that contains the qualifying property, the taxpayer can treat the receipts from the second sale as DPGR. However, under the first-sale rule, if the taxpayer cannot determine how much or what type of the original qualified property is in the acquired property, the taxpayer has the option of treating the receipts from the second sale as non-dpgr. EXAMPLE Corporation C manufactures leather uppers for shoes and sells them to another company that completes the manufacture of the shoe. If C reacquires the shoe and then sells it, the proceeds from the second sale will be DPGR for C, provided that the upper is at least 20 percent of the shoe. Companies constructing real property do not have to use the item approach and have more discretion when calculating their deduction. Top_Fed_07_book.indb /15/2006 2:41:43 PM

8 7.8 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE De Minimis Rule If less than 5 percent of the receipts from the disposition are not gross receipts, the taxpayer can treat all of the gross receipts as DPGR. The flip side of this rule is that all of a taxpayer s gross receipts from the disposition of an item may be treated as non-dpgr if less than 5 percent of the receipts qualify as DPGR. The final regulations also provide non-dpgr de minimis rules for construction, architecture, engineering, and embedded services. STUDY QUESTIONS 1. For 2006, the percentage of QPAI used for the manufacturing deduction is: a. 3 b. 6 c. 9 d. None of the above 2. Which of the following is not subtracted from a business s domestic production gross receipts to arrive at the qualified production activities income? a. Losses allocable to the receipts b. Payments to independent contractors c. Cost of the goods sold d. All of the above are subtracted to arrive at QPAI NOTE Answers to Study Questions, with feedback to both the correct and incorrect responses, are provided in a special section beginning on page TYPES OF QUALIFIED PRODUCTION PROPERTY As discussed, DPGR includes gross receipts derived from the sale, exchange, lease, rental, license or other disposition of qualified production property (QPP). QPP includes tangible personal property, computer software, and certain sound recordings. Code Sec. 199 borrows the definition of tangible personal property from Reg. Sec (c). Thus, for purposes of the manufacturing deduction, tangible personal property means any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures. Local law is not controlling for purposes of determining whether Top_Fed_07_book.indb /15/2006 2:41:44 PM

9 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.9 property is tangible personal property; definitions of property under federal tax law control. QPP can include business information reports created from a database. In addition, if property is classified as tangible personal property, it is automatically excluded from being deemed computer software, a sound recording, or qualified film. Brokerage fees and commissions for a lease or sale of property are not DPGR. The final regulations definition of tangible person property includes gas (other than extracted natural gas), chemicals, and similar substances, such as steam, hydrogen and nitrogen. Computer Software Types Considered QPP Qualified production property includes computer software sold on a disk or downloaded from the software company s website. The debate over what exactly constitutes computer software has been one of the hottest controversies arising for the manufacturing deduction to date. Computer software is essentially any program or any sequence of machinereadable code that is designed to cause a computer to perform a desired function or set of functions. QPP includes software that is affixed to a disk by another, unrelated person. However, computer software does not mean that the program must be designed to operate on a computer. For purposes of the manufacturing deduction, computer software also includes machine-reading coding for video games and similar programs. Online sale or service? Proposed regulations excluded software from the definition of QPP if the customer used the software online for a fee but did not take possession of the software. This exclusion applied to Internet access services, online services, telephone services, online access services, and games played online. The government said that the software company was providing a service rather than selling a product, and that the manufacturer had not sold, licensed, or disposed of the software. There was concern that a more lenient position could open the door to services being treated as qualifying property. The computer industry questioned the logic of this distinction and pushed for treatment of online software as DPGR. The Congressional tax committees asked that Treasury further consider the treatment of online software. The government stuck to its position in the final regulations. However, to address the concerns of the software community, the government issued temporary and proposed regulations (T.D. 9262, May 25, 2006) that provide two exceptions as a matter of administrative convenience for treating the online use of software as a lease, license, or other disposition of the software product. Top_Fed_07_book.indb /15/2006 2:41:44 PM

10 7.10 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Exceptions. The first exception applies to a company that provides computer software affixed to a disk or allows customers to download the same computer software from the Internet. The online software must have been manufactured in whole or significant part in the United States, and the customer cannot be a related party. The second exception allows favorable treatment if an unrelated company, as a regular part of its business, sells substantially identical software that is affixed to a disk or is downloaded from the Internet. Substantially identical software must provide the same function as the online software and must significantly overlap with the features or purpose of the online software. An example is payroll software. A safe harbor treats all computer games as substantially identical software. Maintenance agreements. The regulations provide an exception to the disallowance of the deduction for services for a computer software maintenance agreement provided with the sale of software. The price for the agreement cannot be separately stated and customers must not be able to purchase the software without the maintenance agreement. This includes software updates, releases, rewrites and customer support services. If the taxpayer provides other services as part of the transaction, the taxpayer must allocate receipts between DPGR and non-dpgr. Examples of services are the storage of customer data and the provision of telephone support. However, computer software updates can qualify as DPGR even if the updates are provided under a software maintenance agreement. The temporary regulations apply to tax years beginning on or after June 1, 2006, but taxpayers may apply them for tax years after December 31, 2004, the effective date of Code Sec Sound Recordings Considered QPP QPP also includes sound recordings, which are defined as any property described in Code Sec. 168(f)(4). Therefore, for purposes of the manufacturing deduction, a sound recording includes any work that results from the fixation of a series of sounds to a disk, tape, or other material. Sound recordings qualify if attached to the medium by another party. Sound recordings are treated in much the same way as computer software for purposes of allocating gross receipts. If the sound recording is recorded on a compact disk, the production of the sound recording and the compact disk are classified separately. Embedded Services Considered QPP Embedded services are services that are provided as part of the sale of a product, if their price is not separately stated. Receipts from services, including embedded services, generally do not qualify as DPGR, unless the services Top_Fed_07_book.indb /15/2006 2:41:44 PM

11 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.11 are from construction, architecture, and engineering. If qualified property, film, or utilities includes an embedded service, the taxpayer must allocate receipts between the product and services. An allocation based on relative fair market value is considered reasonable. There are six exceptions for embedded services to be considered DPGR, provided the services are not offered separately and their cost is not separately stated in the normal course of the taxpayer s business. Embedded services that are treated as part of the qualified property include warranties, product deliveries, instruction and operating manuals (not included with a training course), installation (including minor assembly), computer software maintenance agreements, and services that are less than 5 percent of the product s value. EXAMPLE 1 Corporation X sells a copier to Company Z and trains Z s employees how to use and operate the copier. In the normal course of business, the copier and the training services are separately stated in the sales contract. The training services are not treated as embedded services and do not give rise to DPGR. EXAMPLE 2 The facts are the same, except that the training provided by Corporation X to Company Z s employees are not separately stated and cannot be separately purchased. If the gross receipts from the training are less than 5 percent, the receipts can be included in DPGR under the de minimis exception. ACTIVITIES, TAXPAYERS, AND SITES CONSTITUTING QUALIFIED PRODUCTION PROPERTY As discussed, DPGR includes gross receipts derived from the sale, exchange, lease, rental, license, or other disposition of qualified production property (QPP). To be DPGR, however, the property also must have been: 1. Manufactured, produced, grown, or extracted (MPGE); 2. By the taxpayer; and 3. In whole or in significant part in the United States. Manufactured, Produced, Grown, or Extracted (MPGE) Requirement Congress intended the manufacturing deduction to be available to a broad range of taxpayers. Thus, in the determination of the type of qualified Top_Fed_07_book.indb /15/2006 2:41:44 PM

12 7.12 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE production property that gives rise to domestic production gross receipts, Treasury and the IRS took a liberal approach in defining the phrase manufactured, produced, grown, or extracted and made it quite broad. MPGE activities include not only the activities listed in Code Sec. 199 but also the activities listed in Code Sec. 263A(g)(1), which include constructing, building, installing, manufacturing, developing, or improving property. Producer treatment. To maintain consistency, a taxpayer that engages in MPGE activities should also treat itself as a producer under Code Sec. 263A with respect to QPP for the tax year, unless the taxpayer is not subject to Code Sec. 263A. If a taxpayer is not accounting for production activities, the IRS advises the taxpayer to change its method of accounting according to Revenue Procedure , , or However, a taxpayer whose MPGE activity is exempt from Code Sec. 263A does not have to change its method of accounting. Food and beverages. Receipts from food and beverages sold at retail are excluded from DPGR. A retail establishment is real property used in the trade or business of selling food or beverages to the public. A food cart or food stand is considered a retail establishment. If a taxpayer only uses a facility to prepare food or beverages for wholesale sale, the facility is not a retail establishment and the food or beverage satisfies the MPGE requirement. Even if a taxpayer s business is a retail establishment, taxable income derived from food or beverages prepared at the facility and sold at wholesale qualifies for the manufacturing deduction. An example would be bakery items that a grocery store sells to a restaurant. DPGR also includes receipts from the sale of alcohol at a vineyard or brewery. If both retail and wholesale sales occur at a taxpayer s facility, the taxpayer is allowed to allocate gross receipts between retail sales that do not qualify as DPGR and wholesale sales that do qualify as DPGR. Involvement of Taxpayer Requirement If a product is sold to another company that resells it, the latter company cannot take a deduction because it did not produce the product. Thus, a wholesaler who acquires property from a producer and then sells it to a retailer cannot take a deduction for the wholesale proceeds. The storage of agricultural products is treated as MPGE. The regulations require that the person storing the products retain the benefits and burdens of owning the product. Dispositions of land do not qualify because land is not MPGE. Receipts from the transmission or distribution operations of a utility also do not qualify. Top_Fed_07_book.indb /15/2006 2:41:44 PM

13 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.13 STUDY QUESTIONS 3. Engineering, construction, and architecture services qualify as DPGR. True or False? 4. Which of the following production activities satisfies the manufactured, produced, grown, or extracted (MPGE) requirement for QPP? a. Real estate developers selling excess property lots b. Wholesale distributions of steel products c. A company that transmits electricity to out-of-state utility companies experiencing supply shortages d. Storage of harvested corn in a co-op s silo By the Taxpayer MPGE activities must be performed by the taxpayer to qualify as DPGR. Only one taxpayer can claim DPGR for the same activity, even if two companies share ownership. Ordinarily the taxpayer must own the property before disposing of it. The party with the benefits and burdens of holding the property is treated as the owner. The benefits and burdens test will be applied based on case law. Examples in the regulations illustrate some of the important factors, such as holding title, bearing the risk of loss, and having an insurable interest. COMMENT The Treasury Department declined to provide an election that would allow companies to decide who gets the deduction. Situations involving contract manufacturers can be difficult. When one taxpayer performs MPGE activities under a contract, only the taxpayer that has the benefits and burdens of ownership of the property during the period that the MPGE activities occur is entitled to the DPGR. If the contractor does not have the benefits and burdens of ownership at the time of the MPGE activities, the contractor is merely considered to be performing a service for the customer of the contractor. Determining benefits and burdens depends on the facts and circumstances. An exception applies to property manufactured for the federal government by a contractor or subcontractor. Because government rules require that the government own the property, ownership will be attributed to the taxpayer manufacturing the property, who will then qualify for the deduction. Another exception is provided for joint ventures in the oil, gas, and petrochemical industries. Ownership is attributed to the partner, not the joint venture, provided the venture does not sell the product but distributes it entirely to the partners. Top_Fed_07_book.indb /15/2006 2:41:45 PM

14 7.14 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE In Whole or in Significant Part Within the United States To qualify for the manufacturing deduction, MPGE activities must be performed in whole or in significant part by the taxpayer in the United States. The significant part test applies to both the by the taxpayer and the within the United States requirement, discussed in the following section. A taxpayer satisfies this requirement even if the taxpayer purchases partially manufactured QPP from another taxpayer that satisfies the in whole or in significant part requirement; imports QPP that is partially manufactured outside the United States; or manufactures QPP in significant part in the United States and exports the goods for further manufacturing outside the United States. For the MPGE activity to be performed in whole or in part by the taxpayer within the United States, the MPGE in the United States must be substantial in nature. The test for substantiality depends on all of the facts and circumstances surrounding the MPGE activity, including the relative value added by the MPGE activity in the United States; relative cost of the MPGE activity in the United States; nature of the property; and nature of the MPGE activity performed in the United States. This requirement can be satisfied by meeting a safe harbor. The safe harbor rule applies if the conversion costs, direct labor, and overhead to MPGE property incurred by the taxpayer in the United States are 20 percent or more of the total cost of goods sold attributable to the property. The 20 percent amount is based on the taxpayer s direct labor and overhead costs to MPGE the QPP domestically. For taxpayers subject to Code Sec. 263A, overhead includes all costs that must be capitalized. If an item was leased or licensed and does not have COGS, the 20 percent safe harbor is applied to the taxpayer s unadjusted basis in the property under Code Sec Amounts expensed under Code Sec. 179 do not reduce the basis for this determination. Research and experimental costs for creating software are included even if the costs arose in a prior year. Not every activity performed by a taxpayer in connection with bringing a product to market counts toward the substantial-in-nature test. Activities such as packaging, repackaging, labeling, and minor assembly operations are disregarded activities and should not be considered in applying the safe harbor. The MPGE activity must be meaningful. COMMENT The government rejected a key component standard. For example, if a company manufactures computer chips, purchases computers and then installs the chips, the manufacture of the chips would not by itself satisfy the substantial in nature test for the finished computers. Top_Fed_07_book.indb /15/2006 2:41:45 PM

15 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.15 Design and development activities may or may not be disregarded for purposes of the substantial in nature test. In general, if the design and development of certain tangible property occurs entirely in the United States, but the tangible property is manufactured entirely outside of the United States, the design and development activities are disregarded for both the substantial in nature test and the safe harbor rule. As a matter of administrative convenience, the final regulations allow taxpayers to take account of research and experimental costs. In the case of intangible property such as computer software and sound recordings, design and development compose a significant portion of the production process. Thus, the design and development activities relating to computer software and sound recordings are not disregarded for purposes of the substantial in nature test or the safe harbor rule. The costs to develop the software or recording include direct labor, overhead, and COGS, even if the costs were incurred in a prior year. These rules apply whether the item is the software or recording itself or the disk or record to which they are affixed. The costs for computer software must be allocated to the estimated number of units that the taxpayer expects to sell. A member of an expanded affiliated group (EAG) can take into account prior activities of other EAG members to produce an item, but cannot take into account current costs of other members. The United States includes the 50 states, the District of Columbia, and the territorial waters of the United States. It does not include U.S. possessions and territories. Legislation has been introduced to include Puerto Rico. COMMENT The inclusion of the territorial waters ensures that offshore oil and gas rigs will qualify. OTHER SOURCES OF DPGR DPGR also includes receipts from certain activities that do not involve a disposition of qualified production property: The sale or other disposition of a qualified film produced in the United States The sale of electricity, natural gas, or drinking water produced in the United States; Construction projects built or erected in the United States; and Engineering or architectural services provided for U.S. construction projects. Top_Fed_07_book.indb /15/2006 2:41:45 PM

16 7.16 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Although services generally do not qualify when determining DPGR from qualified production property, construction, engineering, and architecture by their nature involve the provision of services. Film A film is qualified if at least 50 percent of the compensation paid to produce the film is for services performed in the United States by actors, production personnel, directors and producers. The 50 percent requirement is applied to all compensation paid by the taxpayer and anyone else to produce the film. Film includes motion pictures, videotapes, and live or delayed television programming. Film is limited to either the master copy of the film or another copy from which a taxpayer makes and produces copies. Examples of production personnel include writers, choreographers, composers, casting agents, camera operators, set designers, lighting technicians, and make-up artists. Persons who do not qualify as production personnel include advertisers, promoters, distributors, studio administrators and managers, studio security personnel, and personal assistants to actors. The final regulations clarify that this list is not exclusive. Several related items are not considered qualified film, including: Tangible property such as DVDs and videocassettes used to hold the film; films, videotape, and other materials that depict actual sexually explicit conduct ; Ticket sales for viewing qualified film; Screenplays or other writings even if developed into a qualified film; Revenue from the sale of tangible personal property that is film-themed merchandise; and A license of the right to use the film characters. Compensation paid for services by production personnel must be allocated according to those who are directly involved and those who are ancillary to the production of the film. Only compensation paid to personnel directly involved in the production of the film qualifies for the 50 percent test. The proposed regulations clarify that compensation is not limited to Form W-2 wages. A live or delayed television broadcast of a qualified film is not treated as a lease or other disposition unless the program is licensed to an unrelated cable company. Advertising related to the license also would qualify. Advertising Income Receipts attributable to advertising in newspapers, magazines, directories, periodicals and similar publications are treated as DPGR if the sale of the print products qualifies as DPGR. Income from both display advertising and classifieds qualifies. Receipts from the disposition of a qualified film Top_Fed_07_book.indb /15/2006 2:41:45 PM

17 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.17 include advertising and product-placement income if the receipts from the film are DPGR. Receipts from movie advertising also qualify. The advertising receipts can qualify if there are no gross receipts from the film or print materials. Electricity, Gas, and Drinking Water Allocation of receipts. Although production of electricity, natural gas, and potable water in the United States may qualify for the manufacturing deduction, transmission or distribution of these items alone does not. Taxpayers that both produce and transmit or distribute electricity, natural gas, and potable water in the United States can still qualify for the deduction. An integrated producer of these items must allocate its gross receipts between qualifying production and nonqualifying distribution or transmission. A safe harbor rule applies if less than 5 percent of total gross receipts is attributable to the transmission or distribution activities. Activities constituting production. Natural gas generally means only natural gas extracted from a natural deposit. Natural gas production involves extracting natural gas from the ground and processing the gas into pipeline quality gas. Mineral royalties and net profits interests, other than operating or working interests, do not qualify as DPGR. The production of bottled water in the United States is classified as tangible personal property rather than the production of potable water. Fortunately, no allocation of gross receipts between tangible personal property and potable water production is needed. For actual production of potable water, only gross receipts derived from the acquisition, collection, and storage of raw or untreated water, transportation, and treatment of raw water to a water treatment facility are included in DPGR. Construction Gross receipts derived from the construction of real property qualify as DPGR. Real property includes buildings, structural components, inherently permanent structures other than machinery, inherently permanent land improvements, oil and gas wells, and infrastructure. Structural components and permanent structures include walls, partitions, doors, wiring, plumbing, central air conditioning and heating systems, pipes and ducts, and elevators and escalators. An entire utility plant is an inherently permanent structure. Top_Fed_07_book.indb /15/2006 2:41:45 PM

18 7.18 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE COMMENT W-2 wages earned as an employee are not treated as DPGR. The deduction is technically for the construction services, but the services must have been performed to construct or renovate real property in the United States. The taxpayer must be actively engaged in the construction trade or business the taxpayer s trade or business must be treated as construction under the North American Industry Classification System (NAICS) codes. A taxpayer active in multiple trades must engage in construction on a regular and ongoing basis. A joint venture to build a specific project may not meet the regular and ongoing standard but will qualify if the taxpayer sells the property within five years after completing construction. A new company will qualify if the taxpayer reasonably expects to engage in construction on a regular and ongoing basis. DPGR may include the proceeds of a sale, exchange, or other disposition of real property constructed in the United States if all the requirements for the manufacturing deduction are met. An individual who purchases a building and has another company perform all the construction services cannot claim receipts from the sale of the building as DPGR; the construction company can treat its receipts from working on the building as DPGR. Construction includes activities typically performed in connection with the erection or substantial renovation of real property. Substantial renovation of real property is the renovation of a major component or substantial structural part of real property that materially increases the value of the property, substantially prolongs the useful life of the property, or adapts the property to a new or different use. COMMENT Receipts from the sale of raw land or from activities related to the land, such as zoning, planning permit, or surveys, do not qualify as DPGR. Gross receipts derived from the construction of infrastructure in the United States also may qualify as DPGR. Infrastructure includes roads, power lines, water systems, railroad spurs, communication facilities, sewers, sidewalks, cable, wiring, and permanent oil and gas platforms. Mining, drilling an oil or gas well, intangible drilling costs, and development of a mine or natural deposit qualify as construction activities, even if performed on property owned by another person. A taxpayer that wants to claim income from real property must construct the property. A major issue was whether a company can claim the deduction Top_Fed_07_book.indb /15/2006 2:41:45 PM

19 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.19 if the majority of the work is performed by subcontractors or other parties. The final regulations make it clear that a company does not have to hammer nails and can qualify if it performed management functions such as oversight, inspection, and approval. Both the contractor and subcontractor can derive gross receipts from the same construction project. The builder does not have to be a general contractor. EXAMPLE A general contractor is hired to renovate a building. The general contractor hires a subcontractor to install heating and air conditioning. The general contractor and the subcontractor both derive DPGR from the renovation activity. COMMENT The subcontractor can treat receipts from the materials as DPGB, as well as the construction services, as long as the materials are consumed in the construction project. If a sale of real property includes land, the taxpayer must allocate a portion of the sales price to the land. A safe harbor allows taxpayers to value land using the taxpayer s cost of the land increased by a specified percentage, based on the number of years the taxpayer owned the land: 5 percent for up to 5 years, 10 percent for 6 to 10 years, and 15 percent for 11 to 15 years. The taxpayer cannot use the safe harbor for land held 16 or more years. Gross receipts from the sale of the land are excluded when determining DPGR. The value of the land is excluded when a de minimis rule applies. COMMENT The holding period will carry over from the previous owner of the land if required by another section of the Tax Code. An example would be a contribution of land to a partnership. The holding period does not include any period during which the builder held an option on the land, unless the price of the land will be adjusted to its fair market value at the time of purchase. Builders can claim the receipts from activities that transform the land, such as grading, hauling, and demolition, as long as the activities are performed as part of the construction or substantial renovation of real property. Painting also qualifies. Top_Fed_07_book.indb /15/2006 2:41:46 PM

20 7.20 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE COMMENT Zoning and planning costs do not qualify because they are not attributable to land. Gross receipts from leasing construction equipment used in construction as well as the sale of tangible personal property constructed by the taxpayer do not qualify as DPGR from construction. Tangible personal property includes items such as appliances or furniture sold as part of a construction project and is not considered real property. A safe harbor rule is allowed: If more than 95 percent of the total gross receipts derived from a construction project is attributable to real property, all of the total gross receipts qualify as DPGR. COMMENT DPGR includes a construction warranty if the warranty is embedded in the sale of the property. Engineering and Architectural Services Engineering and architectural services must be performed in the United States for a construction project in the United States to be considered QPAI. Proposed regulations impose a two-pronged test for what constitutes engineering and architectural services: the engineering or architectural services must relate to real property; and the services must be performed in the United States. In addition, to claim the deduction, the taxpayer must be engaged in the active conduct of an engineering or architectural services trade or business on a regular and ongoing basis. A safe harbor is allowed if less than 5 percent of total gross receipts is derived from architectural services performed outside the United States or related to property other than real property. In such a case, all the gross receipts will be treated as qualified DPGR. DPGR includes a project feasibility study. The fact that a construction project planned to occur in the United States falls through does not disqualify gross receipts derived from engineering or architectural services rendered for the failed construction project. Payments for secretarial and other support services will be treated as construction, engineering and architectural services. Payments for the post-construction inspection of real property do not qualify as DPGR. Top_Fed_07_book.indb /15/2006 2:41:46 PM

21 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.21 STUDY QUESTIONS 5. Which of the following are considered production personnel for the 50 percent compensation rule for films qualified as DPGR? a. Distributors b. Studio administrators c. Personal assistants to actors d. Casting agents 6. All of the following qualify as construction activities for DPGR except: a. Substantial renovation of real property b. General contracting activities c. Surveys of undeveloped land d. All of the above are construction activities qualifying as DPGR CALCULATING DPGR USING A REASONABLE METHOD Taxpayers may use any reasonable method to determine DPGR that identifies gross receipts based on the information available to the taxpayer. The final regulations provide a list of factors that can be used to determine whether the allocation method is reasonable: Whether the taxpayer is using the most accurate information available to the taxpayer; The relationship between the gross receipts and the base chosen; The accuracy of the method chosen as compared with other possible methods; Whether the method is used by the taxpayer for internal management or other business purposes; Whether the method is used for other federal, state, or foreign income tax purposes; The time, burden, and cost of using various methods; and Whether the taxpayer applies the method consistently from year to year. If a taxpayer already has a system in place to determine where an item was manufactured, produced, grown, or extracted for another purpose or has information available to use a specific identification method for another purpose, the taxpayer must use that method. Use of a different, less accurate system than one already in place would not be considered reasonable. However, if a taxpayer does not already have a system in place or available information for a specific identification method, the IRS would probably grant more leeway in determining the reasonableness of the taxpayer s selection of a method. Top_Fed_07_book.indb /15/2006 2:41:46 PM

22 7.22 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE A taxpayer that receives income from a long-term contract may use any reasonable method to determine the amount allocated each year to DPGR. APPORTIONING COST OF GOODS SOLD TO DPGR Any item or service brought into the United States is treated as a purchase at the item s value. A similar rule applies to leased and rented property. COGS must be allocated to DPGR using the taxpayer s tax accounting method. If the taxpayer s books and records do not allow the taxpayer to match up COGS and DPGR, any reasonable method may be employed by the taxpayer to do so. Taxpayers using the last-in, first-out (LIFO) inventory method also may use any reasonable method. The taxpayer must use the same method for allocating COGS as the taxpayer uses for allocating gross receipts between DPGR and non-dpgr, unless the taxpayer can specifically identify COGS allocable to DPGR. If gross receipts and the corresponding expenses are recognized in different tax years, taxpayers must take receipts and expenses in the tax year during which they are recognized under the taxpayer s method of accounting. However, if expenses relate to receipts earned before Code Sec. 199 took effect, the expenses must be allocated to non-dpgr. If a contract to sell property covers two or more years, the taxpayer can use historical data to allocate receipts between DPGR and non-dpgr (i.e., services). APPORTIONING DEDUCTIONS Deductions may or may not reduce DPGR or gross income attributable to DPGR. A loss generated by the sale of property will reduce DPGR if the proceeds from the property would have been included in DPGR. However, deductions attributable to net operating losses (NOLs) or personal deductions not attributable to a trade or business are not allocated to DPGR or gross income attributable to DPGR. Code Sec. 861 Method Three allowable methods may be used for allocating and apportioning deductions. Under the Code Sec. 861 method, which is available to all taxpayers, deductions are allocated and apportioned to DPGR by applying the allocation rules under the Code Sec. 861 regulations. Special rules exist for apportioning certain charitable deductions, interest expense, and research and experimentation deductions. Simplified Deduction Method The IRS created two alternative deduction allocation methods. Taxpayers with average annual gross receipts of $100 million or less or assets of $10 million or less at the end of the year may use the simplified deduction Top_Fed_07_book.indb /15/2006 2:41:46 PM

23 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.23 method. Under this method, deductions are generally apportioned between DPGR and other receipts based on the percentage of qualifying and nonqualifying gross receipts. The proposed regulations had an asset threshold of $25 million or less. COMMENT The simplified method cannot be used to allocate COGS. Simplified Overall Method for Small Businesses For a taxpayer with average annual gross receipts of $5 million or less and COGS and deductions of $5 million or less, the small business simplified overall method is available. This simplified method is also available to those taxpayers eligible to use the cash method outlined in Rev. Proc and to farmers who are not required to use the accrual method under Code Sec The final regulations limit the item-by-item calculation to the determination of gross receipts. The government has indicated that it may issue additional guidance allowing the use of statistical sampling. If DPGR is being claimed by an expanded affiliated group (EAG), these thresholds and requirements apply to the expanded affiliated group, not to individual EAG members. Members of an EAG may use any allocation method they qualify for; members of a consolidated group must all use the same method. For purposes of meeting the gross receipts threshold, the average of annual gross receipts of the taxpayer is based on average annual gross receipts of the taxpayer for the three tax years preceding the current tax year. Special rules apply for calculating the average annual gross receipts for members of an expanded affiliated group and for short years. Taxpayers may switch methods from one year to the next, provided the taxpayer meets the conditions for using the alternative method. ALLOCATION BETWEEN DOMESTIC AND FOREIGN PRODUCTION Taxpayers that manufacture QPP both inside and outside the United States must perform an additional calculation to determine DPGR. They must calculate the portion of gross receipts attributable to the QPP inside the United States that qualifies for the manufacturing deduction and the portion attributable to nonqualifying QPP manufactured outside the United States. Some taxpayers need not allocate gross receipts using this method if certain conditions are met. A safe harbor rule is provided for taxpayers with less than 5 percent of total gross receipts from items other than DPGR. In such a case, the taxpayer may treat all gross receipts as DPGR. Top_Fed_07_book.indb /15/2006 2:41:46 PM

24 7.24 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE STUDY QUESTIONS 7. The method for allocating and apportioning deductions is available to all taxpayers. a. Code Sec. 861 b. Simplified deduction c. Simplified overall d. All of the above are available alternatives for any taxpayer 8. The simplified deduction method can be used to allocate deductions if the taxpayer has average annual gross receipts of or less or assets of or less. a. $5 million; $5 million b. $50 million; $7 million c. $100 million; $10 million d. $200 million; $50 million APPLICATION TO PASSTHROUGH ENTITIES The final regulations on passthrough entities apply to taxable years beginning on or before May 17, TIPRA amended the rules for allocating QPAI to partners and shareholders effective after May 17, The government plans to issue regulations on the new allocation rule. In the case of a partnership or S corporation, Code Sec. 199 applies to the partner or shareholder ( owner ). Each owner is allocated his or her distributive or proportionate share of income items, COGS, and gross receipts included in the items. Generally, Code Sec 199 applies at the level of the shareholder or partner, trust or estate (the fiduciary ), and the beneficiary of a trust or estate. If disallowed losses or deductions of a partner or S corporation shareholder are allowed in a later year, the partner or shareholder must take into account a share of those losses or deductions in calculating QPAI or the wage limitation. This rule does not apply to pre-2005 losses and deductions. To compute QPAI, a partner cannot take into account the particular items of a partnership, for example, to determine whether a de minimis rule applies. The Code Sec. 199 deduction does not reduce the basis of shareholder stock or the partnership interest. However, the shareholder s or partner s share of items included in computing the deduction will affect basis. Current rules allow partnership activities to be attributed to partners in the case of in-kind partnerships and extended affiliated groups. The government intends to issue guidance on the treatment of disallowed losses in determining the Code Sec. 199 deduction for a passthrough entity. These disallowed losses stem from provisions such as Code Sec. 465 (at-risk amounts) or 469 (passive activity losses). Top_Fed_07_book.indb /15/2006 2:41:46 PM

25 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules 7.25 In-kind partnerships. An in-kind partnership is a joint venture established by two corporations to produce or extract a product. All of the product is distributed to the partners of the joint venture, who then sell or use the product in their business. The special rule attributes the production or extraction of oil to the partners of the joint venture. Without a special rule, no one would be able to claim the deduction for receipts from the oil, because the corporation would not have extracted (MPGE) the oil. The proposed regulations applied the rule to oil and gas. The final regulations apply the rule to partnerships engaged in the extraction, refining or processing of oil, natural gas, petrochemicals, and products derived from these substances. Producers of electricity also qualify for the rule. The regulations authorize the IRS to designate additional industries. The IRS considered the following factors for this treatment: The industry must have a historical practice of operating in this manner; The partnership must not sell any of the product; The partnership must transfer all of the product in-kind to its partners The property is sold and marketed separately by each partner as competitors; There is no marketing of the property by the partnership; and The deduction would be lost for activity that clearly should qualify for the deduction. Trusts and estates. Each beneficiary s share of W-2 wages must be computed as if the beneficiary were a partner in a partnership. If QPAI is not greater than zero, the beneficiary is not allocated any of the fiduciary s W-2 wages. However, the beneficiary must aggregate its share of QPAI from the trust or estate with QPAI from other sources. Agricultural cooperatives. QPAI and the Code Sec. 199 deduction are calculated by the cooperative. A co-op member that receives a patronage dividend is then allocated a portion of the deduction based on the portion of QPAI attributable to the dividend. Expanded Affiliated Groups and Consolidated Groups All members of an expanded affiliated group of corporations are treated as a single taxpayer. An EAG is an affiliated group with ownership of more than 50 percent of the affiliated corporations, rather than the 80 percent required for a consolidated group. If a member of an EAG disposes of a product produced by another member of the group, the group s activities are attributed to the corporation disposing of the product. The attribution of activities is made when the selling member disposes of the property. Top_Fed_07_book.indb /15/2006 2:41:47 PM

26 7.26 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE A single Code Sec. 199 deduction is computed for the EAG. The deduction is then allocated among members in proportion to their share of QPAI, regardless of whether the group member has separate taxable income and W-2 wages. If all the interests in a partnership are owned by members of a single expanded affiliated group, the group and its members will be treated as a single taxpayer. Transactions. If a member of an EAG disposes of property that was MPGE by the EAG partnership, the disposing member is treated as engaging in the activities of the EAG related to the property. The attribution of activities is tested at the time the property is disposed of. If an EAG partnership distributes property to a partner who disposes of the property in the same year, the EAG partnership is treated as having the gross receipts. The 5 percent de minimis rule and the reverse de minimis rule are applied to the individual members of an EAG, not at the group level. However, the de minimis rules apply to a consolidated group at the group level. The consolidated group rules under Code Sec ensure that the group s DPGR will not be reduced by an intercompany transaction. Losses. The Code Sec. 199 deduction cannot create or increase the amount of a net operating loss deduction. An exception is provided for an allocation to a member of an EAG. If a member of an EAG has a net operating loss that carries over, the amount that offsets taxable income cannot exceed the taxable income of the member. If, however, a consolidated group has an NOL, the amount that offsets taxable income cannot exceed the group s taxable income and cannot offset income of other EAG members. ALTERNATIVE MINIMUM TAX The manufacturing deduction is used when one calculates the alternative minimum tax (AMT). For purposes of calculating the AMT, the deduction is 9 percent of the lesser of QPAI or alternative minimum taxable income (AMTI). Instead of this AMTI limitation, an individual s limitation for AMT purposes is the individual s adjusted gross income (AGI). The deduction in computing AMTI is determined without regard to the deduction. STUDY QUESTIONS 9. The special attribution rule for the QPAI of in-kind partnerships applies to all of the following except: a. Natural gas extraction partnerships b. Electricity producing partnerships c. Oil and petrochemical processors d. All of the above are types for which the special rule applie Top_Fed_07_book.indb /15/2006 2:41:47 PM

27 MODULE 3 CHAPTER 7 Domestic Production Activities Deduction: Evolving Rules For an estate or trust, the fiduciary s W-2 wages: a. Are computed as though each beneficiary were a partner in a partnership b. Are disregarded for the wage limitation for the deduction c. Are separated from other QPAI of the beneficiaries d. None of the above CONCLUSION The manufacturing deduction becomes more valuable in 2007, increasing to 6 percent of qualified production activities income. The government sought to simplify its guidance, but there are many complicated concepts in the final regulations. This chapter should help you make the necessary calculations: identifying activities that give rise to domestic production gross receipts, calculating deductions, determining QPAI, and applying the W-2 wage limitation. This is an evolving area. You should stay alert for guidance on the application of Code Sec. 199 to computer software, the use of statistical sampling to calculate expenses, how to compute expenses under Code Sec. 861, and how to apply the new W-2 wage limitation. After working with the rules, businesses will have a better idea how they actually work. Top_Fed_07_book.indb /15/2006 2:41:47 PM

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29 8.1 MODULE 3 CHAPTER 8 IRS Enforcement Programs Ever since Mark Everson became the 46th commissioner of the IRS, he has worked toward revitalizing the IRS s enforcement programs. His motto of service plus enforcement equals compliance has been the defining tenet of his tenure at the IRS. As a result, the IRS has revamped its enforcement capabilities and programs and continues to do so. It may be irrelevant whether the IRS Commissioner is the designated front man for Administration and Congressional leaders, is acting on his own personal convictions, or is simply a reflection of the times during which a frustrated public is shouting enough about tax shelters, tax cheats, and others who force higher taxes on the rest of us. The result is the same: enforcement is being ratcheted up. LEARNING OBJECTIVES Upon completion of this chapter, you will be able to: Describe the IRS Large and Mid-Size Business Division s program against abusive tax shelters; Understand the IRS rules on political activity by tax-exempt organizations; Know about other compliance programs addressing abusive programs of tax-exempt organizations; Understand the self-correction program for employee plans and taxexempt bonds; and Identify the range of criminal tax fraud programs maintained by the IRS Criminal Investigation Division. INTRODUCTION This chapter provides an overview of recent IRS enforcement programs and highlights the plans of the IRS in the future. Taxpayers should keep informed about the enforcement trends in the IRS as specific sectors or industries may be targeted. For example, in recent years, there have been substantial efforts by the IRS to bring the tax-exempt sector into compliance with the tax laws. Although the overall audit rate is up, the IRS is more concerned about targeting taxpayers whose audits will bring in the most dollars and send out a clear message to others not to cheat. It is using advances in computer technology to identify those taxpayers who are most likely to cheat. There is a lot more science to auditing these days, both in identifying likely underpayers Top_Fed_07_book.indb /15/2006 2:41:47 PM

30 8.2 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE and nonfilers and creating the greatest psychological impact on the rest of us that cheating does not pay. IRS STRATEGIC PLAN According to the IRS five-year plan, with the tax gap the difference between taxes owed and taxes paid at close to $345 billion each year, the IRS has stepped up its enforcement programs. The IRS s enforcement funding for the current year is $442 million more than it was last year and the president s budget for FY 2007 requests another $137 million increase (Statement of Eileen J. O Connor, Assistant Attorney General, Tax Division Before the Committee on Finance, United States Senate, Concerning Corporate and Partnership Enforcement Issues, presented on June 13, 2006, page 2). IRS s enforcement activities in conjunction with late payments collect about $55 billion of the tax gap, leaving a net tax gap of $290 billion (IR, , IRS Updates Tax Gap Estimates, Feb. 14, 2006). Enhanced enforcement of the tax laws is one of the three goals laid out in the IRS s strategic plan for years 2005 to 2009 (available at (improving taxpayer service and modernizing systems and processes are the other two). In order to achieve the goal of enhanced enforcement within the IRS, its strategic plan outlines four basic objectives: To discourage and deter noncompliance by emphasizing abuses by individuals and corporations that contribute to the tax gap; To make sure that attorneys, accountants, and other tax professionals are following the law; To detect and deter domestic and off-shore-based tax criminal activity; and To stop abuses within tax-exempt and governmental organizations. Deterring Noncompliance To deter noncompliance, the strategic plan identifies several areas of special focus. First, the IRS intends to adjust audit processes so that it can identify the major players that are not complying with their reporting requirements (both those who earn the income and those who are obligated to withhold taxes). Second, the IRS plans on continuing to crack down on abusive tax shelters. The enforcement plan also includes strategic redeployment of resources and leveraging enforcement activities with other governmental agencies. Educating the Professional Tax Community The strategic plan includes a plan to ensure the professional tax community namely attorneys and accountants are kept informed of their obligations. The IRS recognizes that practitioners can serve as allies in improved adherence to the tax laws and can be useful gatekeepers. In order Top_Fed_07_book.indb /15/2006 2:41:47 PM

31 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.3 to do this, the IRS plans on strengthening partnerships with practitioners, establishing clear standards of conducts, maintaining an effective system of practitioner oversight, and administering a fair and effective way to impose sanctions on practitioner misconduct. In other words, if appealing to a tax professional s obligation to uphold the law as an adjunct to winning for the client doesn t produce the results that the IRS wants, it will lean on tax professionals through its role of gatekeeper of those who wish to practice before the IRS. Detecting Domestic and Off-Shore Tax Evasions The strategic plan recognizes that the criminal investigation function of the IRS is a critical component in enforcing the tax laws because the most severe penalties available are imposed for criminal misconduct. In order to fine-tune its criminal investigation function to better enforce the tax laws, the IRS will examine the criminal investigation process to better pursue criminal violations. In addition, the IRS will focus on in deterring criminal activity in certain target areas such as corporate fraud, high-income individuals participation in abusive schemes, malicious nonfilers, and international and terrorist related tax avoidance schemes. Starting with Congressional hearings at the end of July 2006 aimed specifically at offshore tax schemes, a bright spotlight has been placed on offshore deals. A large report accompanied the kickoff of these investigations. The conclusions are firm, recommending immediate action on offshore tax shelters that includes tougher IRS enforcement and a revision of the underlying laws by Congress. Remedying Abuses in the Tax-Exempt Community The IRS realizes that many abusive tax schemes are conducted by using tax-exempt organizations. The strategic plan declares the IRS s dedication to combating abuse in this area by increasing audits in certain targeted areas, such as the tax-exempt community. Abuses by tax-exempt organization cover a wide range, from serving as tax indifferent parties in multimillion-dollar tax shelters to being used as a front for profit-making purposes or to move forward a private political agenda. Informing the IRS about Tax Noncompliance The IRS relies in part on the general public to get information about tax noncompliance or violations of the tax laws. To that end, the public can report known or suspected violations of the tax laws by filling out Form 3949-A, Information Referral, and sending it to the Internal Revenue Service, Fresno, CA As an alternative to Form 3949-A, taxpayers may send a letter and include the name and address of the person being reported, the Top_Fed_07_book.indb /15/2006 2:41:48 PM

32 8.4 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE taxpayer identification number (social security number for an individual or employer identification number for a business), a brief description of the alleged violation, the years involved, the estimated dollar amount of any unreported income. Submissions may be anonymous, although the IRS encourages people reporting the violation to reveal their identities, which can be kept confidential. In addition, reporters of violations may qualify for rewards. Although encouraging watchful eyes to turn in tax cheats will overall help the IRS s campaign to put the nation s voluntary compliance system back on the right track, it readily admits that it is not the magic bullet. It is but one of many steps being taken by the IRS to ratchet up enforcement necessary to bring compliance back to acceptable norms. STUDY QUESTIONS 1. Which of the following is not one of the IRS five-year strategic plan objectives? a. To stop tax-exempt and governmental organization abuses b. To detect and deter domestic and off-shore based-tax criminal activity c. Discouraging abuses that contribute to the $345 billion tax gap d. All of the above are objectives in the IRS strategic plan 2. To inform the IRS about suspected tax law violations and tax cheats, individuals can submit to the Fresno, California, office of the IRS. a. Amended Form 1040 tax returns b. Form 945, Annual Record of Federal Tax Liability c. Schedule E of Form 1040, Supplemental Income and Loss d. Form 3949-A, Information Referral NOTE Answers to Study Questions, with feedback to both the correct and incorrect responses, are provided in a special section beginning on page EXAMINING IRS ENFORCEMENT EFFORTS Although the IRS ultimately is run by the National Office, with the IRS Commissioner as its chief enforcement policymaker, implementation falls on the new, decentralized IRS. That organization falls into three categories Top_Fed_07_book.indb /15/2006 2:41:48 PM

33 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.5 arranged better to serve its customers and, not incidentally, to keep closer to their activities. This chapter provides an overview of specific recent and upcoming IRS enforcement initiatives. With more than 100,000 employees at the IRS hearing the same message Effective enforcement of the tax laws is critical to our survival as an organization it is no wonder that enforcement initiatives will continue to predominate as the most frequent breaking news at the IRS for The chapter takes a snapshot of IRS enforcement. As with any enforcement effort within a large organization, there are those within the IRS who are overzealous as well as those who misinterpret the National Office s directives. The appeals processes, both within the IRS and in the judicial system, will be especially active during these years. They will produce more law on where the boundaries are both for the IRS and for taxpayers. Crusading against the IRS is respected in many circles and litigating taxpayer rights is basic to the U.S. system of laws, but most taxpayers want to avoid confrontation, if only because it often is expensive. Even the IRS, with its large staff, cannot be everywhere at the same time. The following list pinpoints those areas in which the IRS will be focused on during the next year. The IRS s budget is sufficiently flexible to accommodate a few new hot spots over the course of the year, so the following areas of enforcement are where the money is at present as to IRS enforcement of the tax laws: IRS Large and Mid-Size Business (LMSB) initiatives: Abusive tax shelter initiatives, appeals, and fast track settlement program; Tax-Exempt Organizations enforcement programs: A political activities compliance initiative (PACI), a credit counseling initiative (Credit Counseling Compliance Project, Frequently Asked Questions, May 15, 2006; Credit Counseling Compliance Project Report, May 15, 2006, available at an executive compensation practices initiative, and many other hot-button exempt-organization enforcement areas including down-payment assistance organizations, misuse of conservation and façade easements, and hospital questionnaire; Employee Plans enforcement initiatives; Tax-Exempt Bond enforcement initiatives; and IRS Criminal Investigation Division enforcement programs: Although the use of criminal statutes under the tax law to put away criminals is not new (Al Capone and colleagues as the classic example), the number of taxpayers targeted by IRS criminal investigations is unprecedented. The IRS is now using the criminal statutes to attack a long list of tax cheats. Whether this is saber rattling intended to scare other taxpayers into reporting income or whether it is part of a plan to recapture billions of dollars in unpaid taxes now outstanding or a little bit of both remains for history to tell. Top_Fed_07_book.indb /15/2006 2:41:48 PM

34 8.6 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Criminal Law The IRS and the Justice Department (the legal arm that prosecutes tax cheats) have inaugurated over the past year a long list of programs that make it clear that violation of the tax laws not only costs money in terms of penalties but may mean jail time for a growing number of tax cheats. The growing list of areas in which the IRS has pinpointed for criminal penalties has resulted in a long list of formal IRS programs. These include: An abusive return preparer program; An abusive tax schemes program; A bankruptcy fraud program, A corporate fraud program; An employment tax enforcement program; Focus on excise tax fraud; Financial institution fraud; Gaming; Healthcare fraud; Insurance fraud; Money laundering; Narcotics-related investigations; Nonfiler enforcement; Public corruption tax crimes; A questionable refund program; and Investigations into telemarketing fraud. All within the past year! Uptick in Collections Also Noticeable Enforcement not only includes determining who owes what but also making sure that those who definitely do owe, pay up. Of course, many taxpayers who haven t paid up do not immediately have the funds to do so. As a result, an entire section of the IRS is now devoted to collecting what is owed the IRS. This includes getting tough when needed by imposing levy and collection rules but also includes compromises and payment plans in which, basically, the IRS figures that something is better than nothing (although it will never admit to such a policy). Developments in the collection area include revised installment agreement rules as well as ways to take care of payment agreements online. Top_Fed_07_book.indb /15/2006 2:41:48 PM

35 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.7 STUDY QUESTIONS 3. All of the following are areas in which the IRS will focus increased funding and attention in 2007 except: a. Offers in compromise program b. LMSB initiatives c. Criminal Investigation Division enforcement programs d. Tax-Exempt Organizations Enforcement programs 4. Which of the following is not a type of fraud the IRS has pinpointed for criminal penalties? a. Healthcare fraud b. Insurance fraud c. Corporate fraud d. All of the above are types pinpointed by the IRS IRS LARGE AND MID-SIZE BUSINESS INITIATIVES The IRS s Large and Mid-Size Business (LMSB) Division is responsible for the tax matters of corporations, subchapter S corporations, and partnerships with assets exceeding $10 million. The LMSB Division handles many complex tax matters and has been responsible for initiating several recent enforcement programs ( IR , Announcement ). Abusive Tax Shelter Initiative In 2001, the IRS focused on cracking down on abusive tax shelters, and it does not look like the efforts will be halted anytime soon. This effort started around 2001 as a comprehensive strategy led by the LMSB Division and IRS Chief Counsel. The enforcement strategy (Abusive Tax Shelters and Transactions, available at consists of a multipronged approach that has included: Actively pursuing promoters of abusive transactions by conducting promoter examinations; Publishing legal guidance for transactions deemed to be abusive; Conducting a disclosure initiative that brought taxpayers into compliance and provided leads into new abusive transactions; Increasing audits of taxpayers to determine whether they participated in abusive transactions; and Conducting special settlement initiatives to offer alternatives to litigation (IR , April 15, 2003, Office of Tax Shelter Analysis, Top_Fed_07_book.indb /15/2006 2:41:48 PM

36 8.8 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Most recently, the IRS launched the global tax shelter settlement initiative in 2005 and opened the Office of Tax Shelter Analysis with its restructuring in What is an abusive tax shelter? An abusive tax shelter, according to the IRS, has one main characteristic no economic substance ( IR , Announcement ). In other words, if a transaction has a business purpose other than solely saving taxes, it is probably not a tax shelter. Tax planning is not considered to be an abusive tax shelter, i.e., a transaction that has a business-related purpose can be restructured to take advantage of the most tax savings. Tax shelter participants usually insulate themselves from risks by using hedges, circular tax flows, defeasements, and others. The IRS has been looking out for the following additional characteristics in transactions, and if found, will scrutinize these transactions closely: Transactions that earn no economic profit and merely give rise to tax benefits; Transactions that have inconsistent financial accounting and tax treatment, because tax shelters often reduce taxable income while leaving book income unaffected; The participation of a tax-indifferent party in a transaction, i.e., some type of entity involved in the transaction that can absorb the taxable income or deflect the tax liability, most often a foreign or charitable tax-exempt entity; The use of special entities, structures, and innovative financing instruments that are unnecessary to the transaction except to be more able to claim on a technicality a direct tax result or one facilitated by the use of a tax-indifferent party; and Taking unnecessary steps or novel investments. Disclosure initiative. The IRS conducted a disclosure initiative from December 2001 to April 2002 to bring taxpayers into compliance and learn more about abusive tax shelters (IR , Tax Shelter Disclosure Initiative Benefits the IRS in Fighting Abuse, available at gov/pub/irs-news/ir pdf). The initiative resulted in 1,664 disclosures from 1,206 taxpayers. The initiative was successful in alerting the IRS to a number of different tax shelters as well as helped it identify promoters of abusive tax shelters. From that information, the IRS has published guidance and developed other projects described in more detail here. It continues to mine that information to this day. Abusive tax shelter guidance. The IRS has made available public guidance (Notice ) to help taxpayers determine which transactions are abusive. Of particular importance is the reportable transactions guidance. Top_Fed_07_book.indb /15/2006 2:41:49 PM

37 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.9 Every taxpayer that has participated in a reportable transaction, and who is required to file a tax return, must make a disclosure of the transaction to the IRS on Form There are six categories of reportable transactions: Listed transactions. A listed transaction is a transaction that is the same or substantially the same as one of the types of transactions the IRS has determined to be a tax avoidance transaction in a notice, regulation, or other form of guidance. To date, 30 listed transactions have been identified. (Within those listed transactions are many variations; the IRS describes each in fairly broad terms in order not to be pinned down by factual variations); Confidential transactions. A confidential transaction is one that is offered to a taxpayer under conditions of confidentiality for which the taxpayer has paid a minimum fee to an advisor; Transactions with contractual protection. This is a transaction where the taxpayer (or a related party) has the right to a full or partial refund of fees if all or parts of the intended tax consequences of the transaction are not sustained. A transaction in which fees are contingent on realization of the tax benefits is a transaction with contractual protection. In determining whether a fee is refundable or contingent, all the facts and circumstances relating to the transaction are considered; Loss transactions. Any transaction that results in a taxpayer claiming a Code Sec. 165 loss above certain threshold amounts is a loss transaction; Transactions with a significant book-tax difference. Where the amount of certain transaction items for tax purposes differs from the amount for book purposes by more than $10 million on a gross basis in any tax year, the transaction is reportable (this is an especially hot button for public corporations that are worried about the interplay of this rule and the recent SEC and Sarbanes-Oxley restrictions placed on tax reporting); and Transactions involving a brief asset holding period. If a transaction results in a tax credit exceeding $250,000, the transaction is reportable if the asset holding period is brief. Abusive Transaction Settlement Initiative. On January 23, 2006, the IRS concluded the abusive transaction settlement initiative (FS , IRS Settlement Initiative, IR , IRS Launches Abusive Transaction Settlement Initiative). The initiative was designed for taxpayers to come forward and settle a number of transactions that were determined to be abusive by the IRS. Along with earlier settlement initiative, they covered virtually all organized tax shelter deals marketed on any significant scale from the late 1990s into The 2006 settlement initiative allowed taxpayers to settle 21 identified abusive transactions. Taxpayers who wanted to take part in the initiative had from October 27, 2005, to January 23, Top_Fed_07_book.indb /15/2006 2:41:49 PM

38 8.10 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 2006, to file Form with the IRS. In order to settle a transaction, the following terms had to be met: The participant must have conceded 100 percent of all tax benefits; Transaction costs were generally allowed as ordinary losses; and The IRS could assess specified amounts of accuracy-based penalties under the initiative. Son of Boss Shelter Initiative. The Son of Boss (IR , March 24, 2005, IRS Collects $3.2 Billion from Son of Boss; Final Figure Should Top $3.5 Billion) was a tax shelter heavily marketed to wealthy individuals in the late 1990s and More than 1,800 people participated in abusive Son of Boss tax shelters. To curtail involvement in the transaction, the IRS started the Son of Boss tax shelter settlement initiative requiring taxpayers to concede 100 percent of the claimed tax losses and pay a penalty of 10 to 20 percent unless the transaction was already disclosed to the IRS. The IRS collected more than $3.2 million from the settlements. A district court in Texas recently ruled that the Son of Boss shelter was not contrary to the literal reading of the Tax Code (Klamath, DC Texas, July 2006), but the IRS is pressing forward with what it believes is its trump card in all of these tax-shelter cases: that the transaction for which tax benefits were claimed lacked economic substance and, as such, no tax benefit should be allowed based on Congress s general intention. Executive Stock Options Settlement Initiative. In 2005 the IRS started an enforcement project (IR , Feb. 22, 2005, Settlement Offer Extended for Executive Stock Option Scheme) specifically targeting transactions whereby executives transferred stock options to family-controlled entities that were created for the sole purpose of receiving the options and avoiding taxes on compensation income. In general, up to 30 years of compensation would be deferred under most executive stock options tax shelters and in some cases resulted in the corporation deferring a legitimate deduction for the compensation. This would be accomplished by transferring the options to the family entity that would then sell the stock in the market. Then, the executive would claim that the tax was not owed until the date of the deferred payment, 15 to 30 years later, even though the executive had access to the partnership assets. Under the IRS program, executives were given a time period, ending on May 23, 2005, to come forward and accept an IRS settlement offer. Participants were required to disclose 100 percent of the compensation and pay interest and a 10 percent penalty, which is half of the maximum available penalty, and corporations and executives also had to pay employment taxes due. Promoter fees and other professional fees as well as transaction costs could be deducted. Top_Fed_07_book.indb /15/2006 2:41:49 PM

39 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.11 Promoters. Since the IRS launched the abusive tax shelter transaction initiative, it has targeted the promoters of abusive tax shelters as a way to get to the source of the tax shelters. In conjunction with the Department of Justice, the IRS referred numerous cases for civil injunctions (FS , IRS Obtains More Than 100 Injunctions Against Tax Scheme Promoters, April 2005, available at The IRS continues to conduct numerous promoter investigations, in which it examines whether promoters are complying with the regs that require them to identify potentially abusive tax avoidance transactions. Those rules require them to register with the IRS and maintain or make investor lists available to the IRS upon request. If the findings support a civil injunction, the promoter case is referred to the Department of Justice and if it agrees, then suits are filed in court. As of April 2005, the IRS had obtained more than 100 civil injunctions against promoters and fraudulent return preparers, including 81 permanent injunctions and 18 preliminary injunctions against promoters of abusive schemes. The IRS continues to investigate more than 1,000 promoters for possible referral to the DOJ. Joint International Tax Shelter Information. Australia, Canada, the United Kingdom, and the United States established a joint task force to collaborate and coordinate information regarding abusive tax shelters. The countries entered into a Memorandum of Understanding that was signed on April 23, 2004 (IR , May 3, 2004, Australia, Canada, UK, and US Agree to Establish Joint Task Force). Initially, the commission s priority was examining the use of financial products in abusive tax transactions. The goals of the commission include sharing of expertise and best practices to follow in handling abusive tax shelters, exchange information regarding specific abusive tax transactions, and carry out enforcement activities more effectively and efficiently. Office of Tax Shelter Analysis. The Office of Tax Shelter Analysis (OTSA) is part of the IRS s LMSB Division and was started with the purpose of identifying and responding to abusive tax shelter transactions (Office of Tax Shelter Analysis, available at html). OTSA coordinates a web-based application system that processes information related to tax shelters. Most of the information OTSA processes comes from the information reported on Form 8886, Reportable Transaction Disclosure Statement, which is filed by approximately 70,000 taxpayers annually. The battle being waged between tax shelter investors and their tax advisors and promoters is slowly being brought to court. Liability is intertwined with cases that currently are being put on the docket from taxpayers and the IRS. Both the IRS and its opponents recognize that cases are fact intensive, making each case a separate battle. Top_Fed_07_book.indb /15/2006 2:41:49 PM

40 8.12 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Appeals Fast Track Settlement Program Sometimes related to issues originating in a tax shelter strategy, but usually much broader in application, are those problem areas within an audit examination that are ripe for the Fast Track Settlement (FTS) program. The LMSB Division started an Appeals Fast Track Settlement Program (FTS) back in 2003 (LMSB/Appeals Fast Track Settlement Procedure, Rev. Proc ). It has been widely praised as a step in the right direction in resolving issues quickly. FTS was designed to help taxpayers undergoing examinations to resolve their tax disputes in an expedited manner. It is especially useful to put a reoccurring issue into the FTS so that positions taken in current and future years can be resolved before they develop into reoccurring deficiency determinations. To apply for the program, taxpayers must fill out a one-page application form, Application for Fast Track Settlement. Once the case is accepted for FTS, the case will be assigned to an Appeals officer who is in charge of the case and has authority to engage in a dispute resolution process. The goal is to reduce the amount of time that taxpayers spend dealing with the IRS and to come to a settlement that is mutually agreeable to all parties. The consensus is that fast track settlement is working well for large, global corporations. The challenge, everyone admits, is to drive this success down to the medium and even small size corporation so that audit issues are solved on the front end of the examination process, if not earlier. NOTE Taxpayers do not have to use FTS to resolve disputes; traditional dispute resolution alternatives are still available. In addition, taxpayers may withdraw from FTS at any time. STUDY QUESTIONS 5. Which of the following is not one of the six categories of reportable transactions? a. Transactions having tax credits of more than $250,000 involving a brief asset holding period b. Transactions with contractual protection c. Confidential transactions d. All of the above are categories of reportable transactions 6. The Fast Track Settlement program has proven effective for small and medium-sized corporations but not as well for large, global corporations. True or False? Top_Fed_07_book.indb /15/2006 2:41:50 PM

41 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.13 ENFORCEMENT PROGRAMS FOR TAX-EXEMPT ORGANIZATIONS Tax-exempt organizations are organizations that are exempt from federal income taxation under Code Sec. 501(c)(3). The Tax Code describes more than 30 types of tax-exempt organizations. An exempt organization (EO) may be created as a corporation, a trust, or an unincorporated association. An exempt organization must be organized and operated for an exempt purpose, such as charity or education, which is specifically described in the Tax Code. In addition, exempt organizations are subject to special rules and prohibitions, such as the prohibition on political activities. In recent years, the IRS has launched several initiatives to ensure tax-exempt organizations are in compliance with the tax laws. The problems being addressed by the IRS are varied, ranging from political activities, to serving as tax-indifferent parties in tax shelters, or serving as devices that benefit the donors more than the needy public. Political Activities Compliance Initiative Tax-exempt organizations under Code Sec. 501(c)(3) churches, charitable and educational organizations and others are prohibited from participating or intervening in any political campaign on behalf of or in opposition to any candidate for office. There are many rules related to the type of political activity in which tax-exempt organizations may engage. Tax-exempt organizations can lose their tax-exempt status if they participate in certain political activities. Under the rule, charities and churches that qualify for tax-exempt treatment cannot engage in political campaigns. The purpose behind the rule is to separate churches and charities from politics. Tax exemption is viewed by the courts as a privilege, not a right; therefore, no right is violated in requiring tax-exempt organizations to disengage from politics in order to receive the tax benefits. Based on information letters and other tips received, the IRS became aware of an increase in noncompliance with the political activities rules by tax-exempt organizations and initiated a project in June of 2004 to address these abuses. The project was approved and became known as PACI, or Project 302 the Political Activities Compliance Initiative. The goal of the project was twofold: Addressing noncompliance with the rules against political campaign intervention by expediting the review of allegations of prohibited political intervention by tax-exempt entities during the 2004 election cycle; and Educating tax-exempt organizations so they are on notice of the enforcement program and prevent violations (Final Report, Project 302, Political Activities Compliance Initiative). Top_Fed_07_book.indb /15/2006 2:41:50 PM

42 8.14 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE PACI addresses all referrals alleging that a Code Sec. 501(c)(3) organization has participated in or intervened in a political campaign, or on behalf of (or opposition to) any candidate for public office. In 2004, the IRS investigated 132 tax-exempt organizations, with the following outcomes: 22 of the cases were closed after concluding the organizations were in compliance with the rules; 82 cases have been concluded; and 28 cases remain open. The completed investigations revealed that three-quarters of the 82 organizations examined had engaged in some sort of prohibited political activity. IRS Fact Sheet The IRS issued a fact sheet to be used as guidance under PACI as well as other guidance dealing with the political prohibition (Election Year Activities and the Prohibition on Political Campaign Intervention for 501(c)(3) Organizations, FS , February 2006). The fact sheet highlights some of the major political activity mishaps that took place during the 2004 election cycle and is meant to be used as guidance for tax-exempt organizations during the 2006 and later election cycles. Major topics include: What is political campaign intervention? Political campaign intervention refers to activities that favor or oppose one or more candidates for public office. Not all political activity is prohibited, but activities that show partiality towards one candidate are not allowed. In many circumstances, the areas are gray and require an evaluation of all the facts and circumstances to determine if the activity is a prohibited form of political campaign intervention. Blatant candidate endorsements are the most obvious form of prohibited political campaign intervention, but the prohibition on political activities also includes contributions to political campaigns, distributing statements supporting or opposing a candidate, allowing candidates to use an organization s facilities or assets without equal opportunity to other candidates, and others. Below is a more detailed description of what activities may constitute prohibited political activity and how to avoid them. Voter education and registration: The prohibition on political campaign intervention does not include voter education activities that encourage people to vote so long as they are nonpartisan. The IRS gave as an acceptable example a booth set up at a state fair with signs and banners that gave only the name of the organization, the date of the election, and voter registration information. Top_Fed_07_book.indb /15/2006 2:41:50 PM

43 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.15 Organization leaders: Organization leaders are not prevented by the rules to voice their opinions on political matters as long as they are speaking for themselves, but they cannot give their opinions in official organization publications or at official organization functions. The IRS suggests that these leaders give the disclaimer that their comments are personal opinions. Candidate appearances: The rules do not prohibit a candidate from appearing at an organization s function. If it invites a political candidate, the organization must provide opposing candidates an equal opportunity to speak. It must make sure not to take sides in favor or against any candidate and there may be no fundraising associated with the event. Organizations may also invite candidates to speak at a public forum as long as the forum is not operated to show bias for any candidate. Candidates may also appear at an organization s function in a noncandidate capacity, but the organization must ensure that the candidate is in fact speaking for reasons other than his or her candidacy, that the candidate speaks only in a noncandidate capacity, that there is no mention of the candidacy, that there is no campaign activity, and that a nonpartisan atmosphere is maintained. Public policy positions: Although an organization may take positions on public policy issues, the organization must ensure that any public policy statement maintains an unbiased position at all times. Examples of factors to consider in determining whether a statement is unbiased are what is the timing of the statement in relation to the election, whether the statement approves or disapproves of a candidate s position, and whether the statement identifies one or more candidates. Voter guides: An organization may distribute voter guides that narrow the candidates positions. However, this area is particularly sensitive, and the IRS warns against voter guides that focus on one issue or a narrow set of issues that may reflect bias. The IRS describes some factors to apply in deciding whether a voter guide may be appropriate and says that in assessing a voter guide, the guide s format, content, and distribution should be considered. Business activities: Leasing office space, selling mailing lists, or accepting paid political advertising may all give rise to prohibited political involvement despite being legitimate business activities. For organizations to decide whether a business activity will give rise to too much political involvement, the IRS suggests looking at whether the good, service, or facility is offered to all candidates, whether they are offered just to candidates or also to the public, whether the fee charged is customary, and whether the activity is ongoing or a one-time event to accommodate a candidate. Top_Fed_07_book.indb /15/2006 2:41:50 PM

44 8.16 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Websites: The IRS says the organizations will be responsible for the contents of websites that are linked to the organization s website, even though the contents of the linked pages change constantly and the organization has no control over the linked sites. Candidate-related material is not automatically prohibited, but the IRS will look at the context of the link, whether all candidates are represented, and other factors in deciding whether the material represents prohibited political activity. News release. On June 1, 2006, the IRS issued a news release (IR ) urging Code Sec. 501(c)(3) organizations to be aware of the prohibition on political campaign activities during this election season. The news release warns organizations that new procedures are in place to respond to possible instances of prohibited activities for the 2006 election cycle, and other enforcement programs such as PACI are still being used to combat the prohibited activities. PACI Procedures for 2006 election cycle. Under PACI, the program begins with an election period. An election period is deemed to begin no later than January 1 of even-numbered years and to end November 30 th of that year. The 2006 election cycle thereby ends on November 30, The program may begin earlier with approval of IRS officials if the IRS receives an increase of referrals alleging political activity (Political Activities Compliance Initiative, Procedures for 501(c)(3) Organizations, available at Case-processing procedures are expedited during an election cycle. A PACI classification committee screens all political intervention referrals on a regular basis. During an election cycle, the goal is to complete classification processing of referrals within 14 days. Expedited procedures will apply even if a return has not yet been filed or the tax year has not closed. Conclusions. The debate is far from over, both within the IRS and elsewhere, as to how far the IRS can push in denying church representatives from expressing moral views that correlate with the position of a particular political candidate or party. The specter of having IRS agents situated amid a congregation to monitor sermons, of course, is unacceptable. Yet having such politicized information called to its attention continues to have the IRS placed in a quandary. To date, it restates frequently the rule that religious organizations cannot engage in political activity while obviously limiting to virtually nil the occasions upon which it will enforce those principles. Top_Fed_07_book.indb /15/2006 2:41:50 PM

45 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.17 STUDY QUESTION 7. Organization leaders of Code Sec. 501(c)(3) organizations are prohibited under PACI from doing any of the following regarding political matters except: a. Writing their opinions about politics or candidates in organization publications b. Addressing partisan political issues at organization functions c. Endorsing one candidate over another because of the candidates positions on a public policy issue d. All of the above are prohibited for organization leaders Credit Counseling Initiative Credit counseling agencies are responsible for providing financial education, advice, and assistance. Under the Bankruptcy Reform Act of 2005, before a person files for bankruptcy, he or she must first visit a credit counseling agency for a consultation. The IRS became aware of many abuses associated with tax-exempt credit counseling agencies and began an initiative to bring these agencies into compliance (Credit Counseling Compliance Project, Frequently Asked Questions, May 15, 2006; Credit Counseling Compliance Project Report, May 15, 2006, available at Audit actions. The IRS has identified credit counseling agencies as especially prone to violating the private purpose prohibition for tax-exempt status. Starting in 2004, the IRS has an audit focus on tax-exempt credit counseling agencies because of widespread abuses that are associated with the industry. The IRS has completed 41 of the audits, out of 63 agencies (56 percent of the revenue in the industry) that were selected for the initial audits. All of the audits have resulted in either revocation, proposed revocation, or other termination of the agencies tax-exempt status. Most of the revocations have been undertaken because the agencies were providing little counseling on education and were mostly focused on their own bottom-line profits. The IRS found that many agencies were not providing the level of public benefit needed to qualify for tax-exempt status. Tax-exempt entities must operate for an exempt purpose, such as education or charity. The IRS explained that it expects a credit counseling agency s objective to be helping clients understand their financial problems and develop the skills to address them. Many agencies were not providing the desired level of education, based on all the facts and circumstances. Other problems with the organizations included operation as commercial businesses and unacceptable concern over the private interests of directors, officers, and related entities. Top_Fed_07_book.indb /15/2006 2:41:51 PM

46 8.18 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE On May 15, 2006, the IRS issued a report on the results of the Credit Counseling Initiative so far. The initiative has implemented a three-part strategy that includes: An educational, outreach component; An aggressive examination program; and A stricter determination process to disallow abusive organizations from getting tax-exempt status. What s next? The report also outlines the path that the initiative will take during the coming year, including: Revised Forms 1023 and 990. The IRS has revised Form 1023, Application for Recognition of Tax Exempt Status Under Section 501(c)(3) of the Internal Revenue Code, and Form 990, Return of Organization Exempt from Income Tax, in order to gather information and better identify abuses by credit counseling agencies. Follow through on Chief Counsel Advice Memorandum. Chief Counsel Advice Memorandum CA (May 9, 2006) contains the framework to determine whether a credit counseling agency provides the educational services necessary to qualify as a Code Sec. 501(c)(3) organization. Core Analysis Tool (CAT). The IRS is encouraging organizations, as well as requiring IRS agents, to use CAT as a tool in determining whether a credit counseling agency is in compliance with the tax-exempt rules. Compliance check questionnaire. The IRS has sent a compliance check questionnaire to the remaining 743 tax-exempt credit counseling agencies that were not subjected to the initial audits. Once an agency answers the questionnaire, the IRS will use that information to determine whether there are any problems with the agency; if it is compliant, the IRS will not take any further action. If the IRS determines there are problems, it will either issue a written advisory, offer a closing agreement, or refer the organization for examination. Closing agreements. The IRS will issue closing agreements to organizations if all the facts and circumstances indicate that it is likely that the agency can correct its problems. Follow-up program. The IRS has introduced a follow-up program to check on organizations that have entered into a closing agreement and received written advisory. A team of IRS specialists will research public records, the agency s website, IRS records, and other sources to determine whether the agency has in fact come into compliance. Public awareness. The IRS has posted its educational materials on its website, and plans to launch another site dealing exclusively with the area of credit counseling organizations. Top_Fed_07_book.indb /15/2006 2:41:51 PM

47 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.19 Fact Sheet IR The IRS has issued Fact Sheet IR describing the progress it has made on its initiatives to crackdown on abuses associated with tax-exempt credit counseling agencies. The fact sheet reveals that based on the findings from the audits, the IRS has decided that further action is needed to ensure credit counseling agencies truly merit their tax-exempt status. First, the IRS plans to issue further guidance explaining the legal standards for tax exemption. Second, the IRS will send compliance questionnaires to some agencies, and based on the information received, may select some more agencies for auditing. In addition, the IRS is closely scrutinizing new applications for tax-exempt status from credit counseling agencies. Out of 100 or so applications reviewed since 2003, only three have been approved for tax-exempt status. STUDY QUESTIONS 8. According to the May 15, 2006, report on the future strategy of the Credit Counseling Initiative, to minimize abusive credit counseling agency practices, the initiative will do all of the following except: a. Using a stricter process to prevent abusive organizations from getting tax-exempt status b. Implementing an educational component c. Implementing an aggressive examination program d. Audit new credit counseling agencies following their first year of operations 9. When does the IRS issue a closing agreement to a credit counseling agency? a. When the follow-up compliance audit indicates the agency has achieved compliance b. When facts and circumstances indicate the agency can correct its problems c. When audits indicate problems are so severe that the agency should cease operations d. None of the above triggers issuance of a closing agreement Executive Compensation Practices Initiative Tax-exempt organizations have to comply with reasonable compensation rules related to the compensation of their executives or risk losing their exempt status. The IRS became aware that some tax-exempt organizations were not complying with the reasonable compensation rules. As a result, in 2004, it announced an initiative to combat the trend of paying excessive compensa- Top_Fed_07_book.indb /15/2006 2:41:51 PM

48 8.20 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE tion to officers and other executives (Compensation Issues for Tax-Exempt Organizations, Karen Fitch, David Fish, IRS Phone Forum, May 17-18, 2006, available at So far, the initiative has consisted of compliance checks and examinations. An interim report is expected shortly. Reasonable compensation rules. During its May 2006 phone forum, IRS officials highlighted the results of the initiative so far and gave some recommendations about what organizations can do to comply with the executive compensation rules. The officials highlighted four key governance areas that organization boards should keep in mind: Legal protection: Boards should consider meeting the requirements for the rebuttable presumption of reasonableness. For the presumption to be met, compensation must be set in advance by disinterested board members on the basis of appropriate comparability data, and the decision must be appropriately and timely documented. Meeting the presumption is not required to be within the reasonable compensation rules, but doing so offers a sort of safe harbor and will make it less likely that the IRS will scrutinize the organization s compensation practices; Reporting and disclosure: All economic benefits provided to officers, directors, and other key employees should be timely and reported completely on Form 990. Form 990 was changed in 2005 and the IRS is in the process of completely redesigning the form, but organizations should try to keep up to date with the changes because Form 990 is the primary tool used by the IRS in evaluating tax-exempt organizations; NOTE Ways that Form 990 was changed in 2005 include a clarification to the total number of directors to be listed and payment of compensation. It also includes a table for former officers and directors that are receiving compensation. Schedule A to Form 990 includes an entry to include compensation to the five highest paid independent contractors for professional services. Avoid automatic excess benefit transaction: Every form of compensation needs to be reported on a timely basis as compensation; and Transparency: Compensation must be set by disinterested persons and compensation matters should be disclosed to the full board, even when boards delegate compensation matters to compensation committees. What s happened, and what s next. The results of the initiative to date, and the next steps planned include: Compliance checks: The first phase of the initiative consisted of compliance checks of 1,200 tax-exempt organizations. Those checks consisted Top_Fed_07_book.indb /15/2006 2:41:51 PM

49 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.21 mostly of exploring an organization s compliance with recordkeeping and information reporting requirements. The organizations were selected for compliance checks based on information provided on their Form 990, Return of Organization Exempt from Income Tax. The IRS made it clear that these compliance checks were not examinations because they do not relate directly to determining a tax liability (both to ease taxpayer s concerns over closer scrutiny and to avoid any double-audit prohibition). Based on the answers to the compliance check letters, the IRS conducted examinations of 200 organizations. Examinations: In addition, the IRS conducted about 600 single-issue examinations. During those examinations, the IRS investigated the compensation of disqualified persons to ensure their compensation was reasonable. The questions were much more detailed than the compliance checks and inquired into how organizations established compensation, how the board approved compensation, whether individuals use the organization s property for purposes unrelated to the organization, and other issues. NOTE Disqualified persons generally are high-level officers, such as CFOs and CEOs, but could be other employees. The definition refers to insiders of an organization who are in a position to exercise substantial influence over the affairs of an applicable tax-exempt organization. Next phase: IRS officials said in the phone forum held in May 2006 that they have launched another phase in the initiative. This one involves contacting another 250 tax-exempt organizations and is designed to teach the IRS more about compensation practices within exempt organizations. Other Tax-Exempt Organizations Enforcement Areas The IRS has targeted the tax-exempt organization area to be subject to many abusive practices. Additional noncompliance involving organizations for which investigations have been initiated include the following three areas: Down-payment assistance organizations. Organizations that provide down-payment assistance to homebuyers have recently come under close scrutiny by the IRS. In a recent news release (IRS Targets Down Payment Assistance Scams; Seller-Funded Programs Do Not Qualify As Tax-Exempt, IR , May 4, 2006, available at the IRS declared that organizations that provide seller-funded down-payment assistance would not qualify for tax-exempt status. Top_Fed_07_book.indb /15/2006 2:41:51 PM

50 8.22 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Most down-payment assistance programs provide cash assistance to homebuyers who cannot afford to make minimum down-payments or pay the closing costs to buy a home. The IRS started the initiative to examine organizations that provide down-payment assistance because it found that many organizations were providing seller-funded assistance programs that are self-serving, circular financial arrangements. In the typical seller-funded assistance program, the down-payment assistance provided by an organization to the buyer was the same amount provided by the seller to the organization. The seller s payment was contingent on the sale of property. The organization usually charged extra fees for its services. Finding that these types of arrangements are not charitable and are in place mostly for the noncharitable purpose of helping the sellers, the IRS issued a ruling (Rev. Rul ) holding that seller-funded assistance programs will not qualify as tax-exempt organizations. In addition, the IRS is in the process of examining 185 organizations that provide down-payment assistance. Misuse of conservation and façade easements. The IRS has also been examining abuses related to conservation easements and tax-exempt organizations since it issued a Notice in 2004 (Notice ). The transactions at issue mostly involve transfers of easements on real property to a charitable organization, for which a charitable deduction is claimed under Code Sec Because the donor can in most cases expect to receive economic benefits from the donation greater than expected to be received by the general public, the transactions are not properly deductible. The problem is also apparent with historic easements in particular, façade easements (Improper Conservation Easements, Notice ). The IRS may deny deductions, impose penalties on the donor, and challenge the organization s tax-exempt status. The IRS also may impose penalties on promoters and appraisers involved in the transactions. Hospital questionnaire. The IRS has started a hospital compliance initiative by sending compliance questionnaires to several hundred hospitals asking questions related to whether the hospital is in compliance with the community benefit standard and whether the hospital is providing excessive compensation to its employees. The IRS has not launched an official enforcement program for hospitals, but IRS officials have said they would decide on the next steps once they review the answers to the questionnaires. Top_Fed_07_book.indb /15/2006 2:41:52 PM

51 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.23 STUDY QUESTIONS 10. Because they lack a charitable purpose, the IRS has disqualified as a whole from tax-exempt organization status. a. Seller-funded down-payment assistance organizations b. Hospitals c. Credit counseling agencies d. All of the above 11. The reason that the IRS is examining donations of conservation easements for abuses is that: a. The property is not actually historical under preservation regulations b. The donation amounts deducted are excessive c. The donor receives more economic benefits than does the general public d. The IRS cannot properly follow up that the recipients maintain the property under conservation regulations EPCRS ENFORCEMENT INITIATIVE FOR EMPLOYEE RETIREMENT PLANS Retirement plans offered by employers to employees have to comply with a complex set of rules that change frequently. As a result of the intricate rules and the constant changes, plans often fall out of compliance with the tax law requirements. The IRS has enacted the Employee Plans Compliance Resolution System (EPCRS) (Rev. Proc ) to ensure plans are complying with the tax laws. This situation represents the IRS s approach to enforcement when the complexity of the rules themselves is an obvious reason for noncompliance. In these cases, the IRS sets up assistance programs to enable compliance and defers deadlines to make compliance more likely. In the domain of retirement plan compliance, the approach has been working. EPCRS is a self-correction program that allows plan sponsors of retirement plans under Code Sections 401, 403, and 408 to correct problems associated with their plans and bring their plans into compliance. New Developments The IRS has issued a new revenue procedure (Rev. Proc ) that supersedes Rev. Proc The procedure outlines several different programs that are part of EPCRS, each tailored to address different problems a plan sponsor may face. The programs are outlined here. Top_Fed_07_book.indb /15/2006 2:41:52 PM

52 8.24 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Self-correction program. This program addresses minor or insignificant failures and some significant ones. Under this program, insignificant failures can be corrected at any time, and significant failures can be corrected within a two-year period without incurring fees or penalties. This plan is available to plan sponsors that have established compliance procedures and requires a determination letter from the IRS. Voluntary correction program. This program allows employers to pay a limited fee and request IRS approval for correction at any time before an audit. Audit Closing Agreement program. This program allows plan sponsors to correct failures that do not fall within the other two programs and that are identified during an audit. A sanction must be paid for the correction whose amount is determined based on the nature, severity, and extent of the failure. EPCRS and Abusive Tax Avoidance Transactions The rules provide that if a plan or plan sponsor has been involved in an abusive tax avoidance transaction, the self-correction program may not be used to correct its related failures. In addition, plans and plan sponsors will be required to disclose participation or involvement in abusive tax avoidance transactions. If the IRS determines that an applicant to EPCRS has been involved in an abusive tax shelter transaction and the involvement is related to the failure for which the plan is seeking to participate in a voluntary compliance program, the plan may not use any of the voluntary compliance programs and the case will be referred to the Examinations Division of Employee Plans. If the failure is unrelated, the unrelated failure may be worked out through one of the voluntary compliance programs. Expanded Use of EPCRS Also expanding the availability of EPCRS, the new rules: Make the program available to plans that no longer have an employer maintaining them; Lower the fees to use the voluntary compliance programs from $500 to $250; and Allow relief for participants of plan loan failures who have been taxed under Code Sec. 72(p) when the participant was not at fault. Top_Fed_07_book.indb /15/2006 2:41:52 PM

53 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.25 ENFORCEMENT INITIATIVES FOR TAX-EXEMPT BOND COMMUNITY The Tax Exempt Bond Division of the IRS s Tax Exempt and Government Entities Division (TE/GE) is a separate office within TE/GE whose goal is to deal with matters related to tax-exempt bonds. As with the other divisions, the Tax-Exempt Bond Division has enacted its own enforcement program. Parallel Voluntary Closing Agreement Program The voluntary compliance initiative for tax-exempt bonds (TEB VCAP) was started in 2001 and provides a mechanism for issuers of tax-exempt bonds to voluntarily come forward and enter into closing arrangements with the IRS with regard to Code Sec Code Sec. 103 provides the requirements for interest from state and local bonds to be exempt from income. The Voluntary Closing Agreement Program (VCAP) provides bond issuers the opportunity to settle violations of Code Sec. 103 before the bond issue is under examination. Situations in which VCAP is unavailable. VCAP is unavailable if: The violation can be remedied under other existing remedial options; The bond issue is under examination; The tax-exempt status of the bonds is at issue in any court proceeding or is being considered by the IRS Office of Appeals; or The IRS determines the violation is due to willful neglect. Effect of closing agreement. A closing agreement will protect bondholders from including in their gross income any interest on the bonds during the period specified in the agreement for any violation specified in the agreement. Procedures for Requesting a VCAP Issuers requesting a closing agreement must follow these procedures: Submit a statement certifying under penalty of perjury a detailed description of the violation, the procedures instituted to ensure future compliance with the tax laws, that the bond issue is not under examination, that the tax-exempt status of the bond issue is not at issue in a court proceeding or being considered by IRS Appeals, that on the issue date the issuer expected to comply with Code Sec. 103, that the violation was not due to willful neglect, that the request for the closing agreement was prompt, that payment for the violation will not be made with bond proceeds; Submit a statement with proposed closing terms based on the model created by the IRS; and Include the contact information for someone to contact in case of additional information. Top_Fed_07_book.indb /15/2006 2:41:52 PM

54 8.26 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE STUDY QUESTIONS 12. If an employee retirement plan has been involved in an abusive tax avoidance transaction and the involvement is not related to the failure for which the plan is seeking to participate in the program, which of the following EPCRS programs is unavailable to it to correct related failures? a. Self-correction program b. Voluntary correction program c. Audit Closing Agreement program d. All of the above remain available to the plan to correct its failures 13. VCAP offers an opportunity for bond issuers to settle their Code Sec. 103 violations if: a. The bond issue is currently under examination b. The tax-exempt status of the bonds is at issue in court proceedings c. The cause of the violation was willful neglect by the issuer d. None of the above is an opportunity to use VCAP IRS CRIMINAL INVESTIGATION DIVISION ENFORCEMENT PROGRAMS The IRS s Criminal Investigation Division is the official enforcement arm of the IRS and employs special agents to conduct financial investigations that uncover tax-related crimes. The Criminal Investigation Division s Program Strategy (IRS Criminal Investigation Overview, available at consists of three enforcement programs: Legal Source Tax Crimes, Illegal Source Financial Crimes, and Narcotics-Related Financial Crimes. Legal Source Tax Crimes Program The purpose of this enforcement program is to investigate tax crimes that involve legal industries, occupations, and legally earned income. The majority of the work relating to this program deals with questionable refund cases, abusive return preparers, frivolous filers, nonfilers challenging the legality of the return requirement, and employment tax fraud cases. Illegal Source Financial Crimes Program The focus of the Illegal Source Financial Crimes Program is to find illegal source proceeds. The IRS believes the untaxed underground economy threatens the voluntary tax compliance system and public confidence in the tax system. Top_Fed_07_book.indb /15/2006 2:41:52 PM

55 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.27 Narcotics Related Financial Crimes Program The Narcotics Related Financial Crimes Program investigates crimes related to illegal source income derived specifically from the underground narcotics market. The three basic enforcement programs are interrelated and mutually supportive. In addition, there are several specific programs within the broader enforcement initiatives, such as the abusive return preparer program and others. These are discussed in more detail here. Concurrent Civil and Criminal Investigations One of the most discussed developments in the past year with regard to criminal tax investigations is the procedural tip-off to when the IRS is starting to consider criminal penalties as well as civil. In the past, a taxpayer had a red flag that could not be missed: Once a criminal investigation started, the civil side of an audit stopped immediately and was not to begin until the criminal aspect of the case was settled. In a change in policy, the civil side of an examination can and usually does continue while the Criminal Investigation Division investigates criminal prosecution. In recent years, there has been an increase in parallel proceedings, in which the government carries on a civil and a criminal investigation of the same matter simultaneously. Historically, it had been the government s practice to give precedence to criminal investigations and to hold off on civil investigations once a criminal investigation had started. That policy eroded over the years with the increase of abusive schemes involving return preparers and promoters. General Fraud Program The General Fraud Program is the largest enforcement program of the Criminal Investigation Division. This program focuses on taxpayers who willfully and intentionally violate their known legal duty of filing income tax returns and/or paying the right amount of income, employment, or excise taxes. The IRS regularly posts tax fraud alerts on its website. Abusive Return Preparer Program IRS Criminal Investigation launched the Return Preparer Program in 1996 (Tax Return Preparer Fraud, FS , February 2006, Overview-Abusive Return Preparer, available at The program enacted new procedures to identify, investigate, and prosecute abusive return preparers. Return preparers are persons who prepare tax returns or claims for refund. This program is a big concern for both taxpayers and the IRS because taxpayers may need to pay additional taxes and penalties. Common examples Top_Fed_07_book.indb /15/2006 2:41:53 PM

56 8.28 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE of abusive tax preparer schemes include filing a false return that claims inflated personal or business expenses, false deductions, or unallowable credits or exemptions. Program success rate. Since the program started in 1996, the IRS has investigated and prosecuted many cases of abusive return preparers. In 2005, the IRS investigated 248 cases of which 140 were recommended for prosecution. A large number of the cases 118 in total resulted in sentencing. IRS tips. The IRS has published a number of tips to use in choosing a return preparer. Because the taxpayer is ultimately responsible for accurate reporting, it is important for taxpayers to ensure their returns are accurate. The following are suggestions by the IRS for choosing a preparer and safeguarding proper preparation: Be careful of return preparers who promise a higher refund than other preparers; Do not enter into a fee arrangement that requests a percentage of the refund; Ensure the preparer signs the tax return and provides you with copies; Review the return and ask for clarification on unclear items; Never sign a blank return; Research a preparer s credentials and background. Abusive Tax Schemes Program The IRS Abusive Tax Schemes program focuses on violations of the tax laws using multiple flow-though entities to concoct tax evasion schemes. The Abusive Tax Scheme Program is designed to combat abuses in circumstances where flow-through entities such as trusts, limited liability companies, limited liability partnerships, international business companies, foreign financial accounts, and offshore credit/debit cards are used in a tax evasion scheme. Bankruptcy Fraud Program The Bankruptcy Fraud Program is designed to protect the interests of the IRS as a creditor in bankruptcy cases. The amount of bankruptcies filed each year is on the rise, and the IRS is a major creditor in about 40 percent of all bankruptcy proceedings. Corporate Fraud Program The corporate fraud program is in charge of investigating violations of the tax laws committed by large corporations or their senior executives. This Top_Fed_07_book.indb /15/2006 2:41:53 PM

57 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.29 program is a multiagency effort that includes the Presidential Corporate Fraud Task Force, established by President Bush in The cases generally also involve securities and accounting fraud, mail and wire fraud, and money laundering in addition to tax fraud. Employment Tax Enforcement Program This program is designed to address violations of the employment tax laws. Employers are required by law to withhold employment taxes from their employees wages. Employment taxes include federal income tax withholding, Social Security tax, and Medicare tax. The most common employment tax schemes involve pyramiding, employment leasing, paying employees in cash, filing false payroll tax returns, and failing to file payroll tax returns. Excise Tax Fraud This program addresses violations related to the state and federal motor fuel excise tax. The main violators are organized criminal groups. Many problems result from excise tax fraud, including revenue loss as well as placing legitimate dealers in the motor fuel industry at a competitive disadvantage. This program has been influential in dismantling organized crime groups. Financial Institution Fraud This program combats fraud and money laundering perpetrated against banks, savings and loans associations, credit unions, check cashers, and stock brokers. In recent years, the program has seen a rise in the use of sight drafts, or bills of exchange, that resemble cashier s checks and have been used frequently by radical militia groups to fraudulently withdraw large amounts of money. Gaming With the surge in legalized gambling and some form of gambling now being legal in 47 states (all but Utah, Hawaii, and Tennessee), the IRS started the gaming program to combat money laundering, tax violations and other financial crimes related to the gaming industry. The gaming program consists of a two-faceted proactive approach. The first facet is the investigation of entities suspected of violating tax or money laundering laws. The second is liaison activities with federal, state, and tribal gaming boards, licensing commissions, industry regulators, gaming operators, gaming industry suppliers, and law enforcement. Top_Fed_07_book.indb /15/2006 2:41:53 PM

58 8.30 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Healthcare Fraud This project consists of investigating false billings, mental health, nursing home fraud, chiropractic fraud, durable medical equipment fraud, staged accidents, pharmaceuticals diversion, and patient referral schemes for money laundering and tax violations. The Criminal Investigation Division is cooperating with other government agencies to investigate income tax evasion and other fraudulent activities. Insurance Fraud This project involves investigating agent/broker premium diversion, phony insurance companies, offshore/unlicensed Internet insurance companies, staged auto accidents, senior settlement for money laundering, and tax violations. Money Laundering This broad enforcement program consists of investigating transactions and schemes devised to hide the original source of income that was most likely derived from criminal activities. Narcotics-Related Investigations The IRS narcotics-related investigations are designed to uncover illegalsource income derived exclusively from narcotics trafficking. Nonfiler Enforcement This project involves investigations to uncover nonfilers or filers who make frivolous arguments to support their claims that they do not have to file tax returns. Public Corruption Tax Crimes This project is designed to curtail crimes that erode the public trust. Such crimes include criminal offenses: bribery, extortion, embezzlement, illegal kickbacks, entitlement and subsidy fraud, bank fraud, tax fraud, and money laundering. The Criminal Investigation Division cooperates with other federal, state, and local government agencies to investigate tax crimes and money laundering. Questionable Refund Program The Questionable Refund Program (QRP) is a longstanding, nationwide program that was established in January The QRP was designed to identify fraudulent returns, stop the payment of fraudulent refunds, and refer identified fraudulent refund schemes to Criminal Investigation Division (CID) field offices. Top_Fed_07_book.indb /15/2006 2:41:53 PM

59 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.31 Telemarketing Fraud This project conducts investigations of fraudulent telemarketing schemes in conjunction with multiagency task forces. The IRS pursues illegal telemarketers by recommending prosecution for violations. INCREASED AUDITS Fiscal year 2005, which ended on September 30, 2005 (and the year for which the latest statistics are available), was a record year for audits. IRS Commissioner Mark Everson reported that audits of high income taxpayers, corporations and small businesses reached the highest level in years for individuals and corporations. The following statistics illustrate the success of the IRS s audit efforts: Individual audits have risen 97 percent since 2000; Audits of high-income taxpayers have risen 122 percent since 2000; The IRS collected over $43 billion in revenues in fiscal year 2005; Corporate audits, which had decreased in 2003, were recovered by 50 percent in 2005; and The IRS increased audits by 20 percent over COMMENT Experts say that the increase in audits was due in part to the IRS s efforts to address low-hanging fruit, that is, problems that can be solved most easily. Experts claim that because most of these types of problems are now solved, it will prove more difficult for the IRS to continue its record high collections. Everson even warned that the results for FY 2006 may not be as dramatic. Top_Fed_07_book.indb /15/2006 2:41:53 PM

60 8.32 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE IRS Enforcement Revenue $47.3 $43.1 $ $ $ $ $ $33.8 $ $ F Y96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY0 5 C ollection D ocument Matchin g Examinatio n $ Billions Top_Fed_07_book.indb /15/2006 2:41:53 PM

61 MODULE 3 CHAPTER 8 IRS Enforcement Programs ,000 1,600 1, ,000 50,000 40,000 30,000 20,000 10,000 0 FY96 FY96 IRS Enforcement Activities Total Individual Audits (in thousands) FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 Audits of Small (Assets under Businesses $10 million) FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 Continue To Recover High Income Audits (over (in thousands) $100,000) FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 Audits of Corporations ( (Assets over $10 million) 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY04 FY05 FY05 Top_Fed_07_book.indb /15/2006 2:41:54 PM

62 8.34 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 60% 40% 20% 0% 100% 80% 60% 40% 20% E nhanced Enforcement Has Not Percent Percent of Individuals of Individuals Filing Electronically Filing Electronically 51% 47% 40% 36% 31% FY01 FY02 FY03 FY04 FY05 Toll-Free Telephone Level of of Service 87% 80% 83% 69% 62% FY01 FY02 FY03 FY04 FY05 Com e At 95% 90% 85% 80% 75% 70% 100% 80% 60% 40% 20% The Expense Of Service Toll-Free Tax Law Accuracy 89% 84% 82% 80% 80% FY01 FY02 FY03 FY04 FY05 Customer Satisfaction with IRS Toll-Free Service 9 4% 94% 95 % 67% FY02 FY03 FY04 FY05 To Date Top_Fed_07_book.indb /15/2006 2:41:54 PM

63 MODULE 3 CHAPTER 8 IRS Enforcement Programs 8.35 STUDY QUESTIONS 14. The Abusive Tax Schemes Program focuses on tax evasion by which type of entities? a. Flow-through entities b. C corporations c. Controlled foreign corporations d. All of the above 15. The Criminal Investigation Division program aimed at employers who fail to withhold income taxes, Social Security tax, and Medicare tax is the: a. Corporate Fraud Program b. Excise Tax Fraud program c. Employment Tax Enforcement Program d. Illegal Source Tax Crimes Program CONCLUSION The growing concerns regarding the tax gap will ensure that the IRS s enforcement initiatives will remain strong for a while. In fact, the president s fiscal year 2007 budget proposal contains five legislative changes aimed at narrowing the tax gap. These proposals will surely lead to the development of more IRS enforcement programs. The proposals may shed light on what future enforcement programs will target, and they include: Expanding third-party information reporting to include certain government payments for property and services; Expanding third-party information reporting on debt and credit card reimbursements paid to certain merchants; Clarifying liability for employment taxes for employee leasing companies and their clients; Expanding beyond income taxes the requirement that paid return preparers sign returns, and imposing a penalty when they fail to do so; and Authorizing the IRS to issue levies to collect employment tax debts prior to collection due process proceedings. Top_Fed_07_book.indb /15/2006 2:41:55 PM

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65 9.1 MODULE 3 CHAPTER 9 Tax News and Headlines This chapter explores some of the top tax news developments in As in past years, tax news was dominated by the passage of legislation. Two tax bills passed Congress in 2006: the Pension Protection Act (PPA) and the Tax Increase Prevention and Reconciliation Act (TIPRA). They affect taxpayers across the board: individuals, businesses, self-employed individuals, taxexempt organizations, and many others. Besides the new tax laws, the IRS issued some important and far-reaching rulings and decisions. Most were not controversial, but one partial outsourcing of tax collections created a lightening rod of criticism. LEARNING OBJECTIVES Upon completion of this chapter, you will be able to: Describe important tax incentives made permanent by the Pension Protection Act of 2006; Understand new rules for deducting contributions to charity; Identify tax cuts in the Tax Increase Prevention and Reconciliation Act; Understand the new rules for offers-in-compromise; Describe the IRS s initiative to partially privatize tax collection; Understand why the IRS is no longer collecting the federal telephone excise tax; Identify the dangers of scam artists phishing for taxpayer information; and Describe some other developments making news. INTRODUCTION When Congress passed the first big tax cut of the Bush presidency the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) it not only lowered the individual marginal tax rates but also closed the socalled marriage penalty, increased many tax credits and deductions, and enacted a host of retirement tax incentives. However, unlike previous tax cuts, Congress imposed an important limitation in EGTRRA. All of the tax cuts would expire after December 31, Congresspeople took the unusual step of enacting temporary tax cuts because of their huge cost. Supporters of the tax cuts were able to win enough votes in the House and Senate to enact them but only if they were temporary and not permanent. Many lawmakers and the White House believed that between 2001 Top_Fed_07_book.indb /15/2006 2:41:56 PM

66 9.2 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE and 2010, they could find enough votes in the House and Senate to make the tax cuts permanent. PENSION PROTECTION ACT MAKES RETIREMENT TAX INCENTIVES PERMANENT In 2006, five years after its original enactment, Congress made part of EGTRRA permanent. It didn t make the lower marginal tax rates or marriage penalty relief permanent. Rather, as part of the Pension Protection Act of 2006 (PPA), Congress made all of the retirement tax incentives in EGTRRA permanent. COMMENT Including EGTRRA s retirement tax incentives in PPA was a huge victory for the White House, which had lobbied hard since 2001 for making all of EGTTRA permanent. It also set in motion renewed momentum in Congress (especially in the Senate) to make permanent all of the other tax cuts in EGTRRA. Since 2001, EGTRRA s retirement tax incentives have become very popular. That s one reason why Congress members made them permanent. Individuals and businesses like the higher IRA and 401(k) contribution limits, catch-up contributions, and other taxpayer-friendly provisions. This section explores some of the many retirement tax incentives made permanent by PPA. COMMENT One year after Congress passed EGTRRA, it enacted the Job Creation and Worker Assistance Act of 2002 (JCWA). This law made some technical corrections and modifications to the retirement tax incentives in EGTRRA, so when looking back at the original language in EGTRRA, it s important to remember that it may have been modified by JCWA. The retirement tax incentives as they operate today reflect both EGTRRA and JCWA. IRA Contributions EGTRRA raised the maximum individual retirement account (IRA) contribution for traditional and Roth IRAs from $2,000 in 2001 to $4,000 in Under EGTRRA, the maximum contribution was scheduled to rise to $5,000 in 2008 before falling back to $2,000 in PPA makes the $5,000 amount permanent for 2008 and thereafter. Moreover, after 2008, the $5,000 amount is indexed for inflation. Top_Fed_07_book.indb /15/2006 2:41:56 PM

67 MODULE 3 CHAPTER 9 Tax News and Headlines 9.3 PLANNING POINTER The contribution limits on deductible and nondeductible IRAs are coordinated. The maximum total yearly contribution that can be made by an individual who will be at least age 50 by the end of the year to all IRAs (traditional IRAs and Roth IRAs) is $5,000 for 2006 ($4,000 plus the $1,000 catch-up contribution (described next)) and $6,000 for 2008 and later years ($5,000 plus the $1,000 catch-up contribution), not including rollover contributions. Catch-up Contributions One of EGTRRA s more popular tax incentives was allowing individuals age 50 and older to make catch-up contributions to IRAs, 401(k)s, and other savings arrangements. However, because of EGTRRA s sunset rule, catch-up contributions were temporary and would have expired after December 31, PPA makes catch-up contributions permanent. IRAs. For 2006 and thereafter, the IRA catch-up contribution limit is $1,000. However, it is not adjusted for inflation (see Table 1). 401(k)s and other arrangements. The catch-up amounts for 401(k)s, 403(b)s, 457s, and SEPs also increased rose under EGTRRA. For 2006, the catch-up amount for these plans is $5,000. PPA makes the $5,000 catch-up limit permanent and also adjusts it annually for inflation beginning in 2007 in $500 increments. SIMPLE plans. EGTRRA also increased the catch-up amount for SIMPLE plans. PPA makes the current $2,500 catch-up limit for SIMPLE plans permanent. Table 1. Catch-up Contributions Year IRAs 401(k), 403(b), 457, SEPs SIMPLE plans 2002 $500 $1,000 $ $500 $2,000 $1, $500 $3,000 $1, $500 $4,000 $2, $1,000 $5,000 $2, $1,000* $5,000* $2,500* *Adjusted annually for inflation in $500 increments. Contribution Limits Under EGTRRA, retirement plan contribution limits steadily increased between 2001 and PPA permanently keeps those limits at 2006 levels (shown in Table 2). The limits are also adjusted annually for inflation. Without PPA, the pre-egtrra limits would have been reinstated in Top_Fed_07_book.indb /15/2006 2:41:56 PM

68 9.4 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Table 2. Contribution Limits Plan Type Limit Defined contribution plans The lesser of 100 percent of compensation or $44,000 Elective deferrals $15,000 to a 401(k), 403(b) annuity or SEP plan $10,000 to a SIMPLE plan 457 deferrals $15,000 EGTRRA also raised the compensation limit that may be taken into account in applying the employer deduction rules and for nondiscrimination testing purposes for simplified employee plans (SEPs), voluntary employees beneficiary association (VEBAs), and supplemental unemployment benefit plans (SUBs). Since 2001, the compensation limit has been indexed for inflation. In 2006, it is $220,000. PPA continues this treatment. Otherwise, after 2010, the compensation limit would have reverted to its 2001 level of $170,000. Roth 401(k)s and 403(b)s Congress authorized Roth 401(k)s and Roth 403(b)s as part of EGTRRA but delayed their start until Roth 401(k)s share many similarities with Roth IRAs. Contributions are made with after-tax funds. Earnings in, and qualified distributions from, a Roth 401(k) are tax-free. They are available to everyone who is a participant in a 401(k) or 403(b) plan that allows the contributions. Just like all the other incentives in EGTRRA, Roth 401(k)s and 403(b)s would have expired after PPA makes them permanent. COMMENT In this arrangement, only employee-share contributions get Roth treatment. Designated Roth contributions are limited to a participant s elective deferrals. Experts expect a flood of Roth 401(k) plan amendments to be made in late 2006 and throughout 2007 as the result of making this benefit permanent and, therefore, cost effective for employers to administer. Rollovers A rollover is a direct or indirect transfer of assets from one retirement plan to another resulting in no tax to the participant or other person entitled to those assets. A direct transfer occurs when the trustee or other custodian who holds the assets comprising a participant s accrued benefit transfers some or all of those assets to the trustee or custodian of another retirement plan. An indirect transfer occurs when the trustee or custodian distributes the assets to the participant who, within a statutory time limit, transfers those assets to another retirement plan. PPA makes permanent many of the taxpayer-friendly rollover provisions in EGTRRA, whose highlights are discussed here. Top_Fed_07_book.indb /15/2006 2:41:56 PM

69 MODULE 3 CHAPTER 9 Tax News and Headlines 9.5 Rollovers of after-tax contributions. Under EGTRRA, employees may roll over the entire amount of any qualified distribution received from a qualified plan into another qualified plan or IRA, including the portion of the distribution representing after-tax contributions. Qualified plans must separately track the contribution and any related earnings. IRAs are not subject to tracking but rather a pro-rata distribution rule. PPA continues EGTRRA s rollover options. Rollovers from IRAs to employer plans. EGTRRA eliminated the need for so-called conduit IRAs to facilitate rollover from a contributory IRA to a qualified employer retirement plan, a 403(b) annuity, or a 457 deferred compensation plan. PPA makes this treatment permanent. Rollovers of governmental 457 plan benefits. Before EGTRRA, governmental employees could not roll over their savings in a 457 plan tax-free into an IRA, a 403(b) tax-sheltered annuity, or a traditional qualified plan. Distributions from an IRA, a 403(b) annuity, or a qualified plan could not be rolled over tax-free into a 457 plan. The direct trustee-to-trustee rollover option was also not available. EGTRRA abolished this treatment; PPA makes it permanent. Rollovers of 403(b) plan benefits. EGTRRA also expanded the rollover options of taxpayers enrolled in 403(b) plans. Before EGTRRA, a distribution from a 403(b) plan could not be rolled over into a qualified plan. Distributions from an IRA or a 457 plan could not be rolled over into a 403(b) plan. EGTRRA temporarily lifted these restrictions, and PPA removes them permanently. Rollovers on cashouts. EGTRRA made a direct rollover the default option for mandatory qualified plan distributions exceeding $1,000. The distribution must be rolled over automatically to an IRA unless the participant elects otherwise. PPA makes this change permanent. Waivers of the 60-day Rollover Period Generally, a rollover generally must be completed by the 60 th day following the date on which the taxpayer receives the distribution. Before EGTRRA, the IRS could only waive the 60-day rollover period for distributions from an IRA or a qualified plan in two circumstances: The taxpayer was performing military service in a combat zone; or The taxpayer was affected by a presidentially declared disaster. EGTRRA greatly expanded the IRS s power to waive the 60-day rollover period for distributions from an IRA or qualified plan. EGTRRA allowed the IRS to waive the 60-day rollover rule when failure to waive the requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the taxpayer s reasonable control. PPA makes the taxpayer-friendly rollover changes in EGTRRA permanent. Top_Fed_07_book.indb /15/2006 2:41:56 PM

70 9.6 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE COMMENT In Rev. Proc , the IRS described when a taxpayer may request a waiver of the 60-day rule through the private letter ruling process. The IRS will consider: Errors by financial institutions; Death; Disability; Hospitalization; Incarceration; Use of the amount distributed; Length of time since distribution; and Other factors. Automatic approval is available if failure to satisfy the 60-day rule was because of error on the part of the financial institution. COMMENT The Katrina Emergency Tax Relief Act of 2005 enacted non-code provisions that eased restrictions on loans and early distributions from IRAs or qualified retirement plans in the wake of Hurricane Katrina. The Gulf Opportunity Zone Act of 2005 repealed the Katrina provisions and replaced them with similar codified language that applies more broadly to those affected by Hurricanes Katrina, Rita, and Wilma. Nonspouse Beneficiaries Traditionally, an individual may roll over his or her deceased spouse s interest in a qualified retirement plan, government plan, or tax sheltered annuity into an IRA. The taxpayer will not be taxed except as normal distributions are taken. PPA extends this special treatment to nonspouse beneficiaries. Nonspouse beneficiaries may roll over another person s interest in a retirement plan, government plan, or tax sheltered annuity into an IRA and be treated as a spouse would be treated for tax purposes. In addition, nonspouse beneficiaries will be able to apply for waivers of the 60-day rollover period. COMMENT The federal government, unlike some states, does not recognize same-sex marriage or same-sex unions distinct from marriage. Same-sex spouses do not enjoy the same privileges under the Tax Code, such as the ability to file joint returns, as do couples of the opposite sex. Extension of the spousal beneficiary rules to nonspouse beneficiaries expressly benefits same-sex couples. Surprisingly, the provision attracted little opposition when Congress debated PPA. Top_Fed_07_book.indb /15/2006 2:41:56 PM

71 MODULE 3 CHAPTER 9 Tax News and Headlines 9.7 Vesting of Employer-match Contributions An individual is generally entitled to retirement benefits that are the result of employer contributions only after a certain period of employment. Defined contribution plans must satisfy a minimum vesting schedule for employer matching contributions. Before EGTRRA, one schedule used a five-year period. After five years, a participant became vested. Another schedule, the graduated method, required a participant to be 20 percent vested after three years and then 20 percent more each year until he or she became 100 percent vested after seven years on the job. EGTRRA reduced the five-year schedule to three years. EGTRRA also accelerated 20 percent vesting to two years instead of three. Instead of being fully vested after seven years of service, a participant would be fully vested after six years. PPA makes this change permanent. COMMENT The vesting rules in EGTRRA did not apply to some collective bargaining agreements. Automatic Enrollment Some employers have set up automatic enrollment in 401(k)s and similar arrangements for new employees. Under these arrangements, employees are automatically enrolled in a 401(k) or similar plan unless they affirmatively opt-out. Employers make default contribution decisions. In some cases, an employee s contribution automatically increases when he or she receives a raise. Even though employers have been able to offer this treatment, there has been some hesitation because of fear of lawsuits from employees whose accounts decline in value instead of growing in value. PPA gives employers some insulation from lawsuits as long as the investment choices are prudent. Saver s Credit Starting in 2002 EGTRRA provided that lower- and middle-income taxpayers could claim a nonrefundable tax credit for their contributions or deferrals to retirement savings plans, including traditional and Roth IRAs, qualified plans, qualified cash or deferred arrangements, tax sheltered annuities, SIMPLE plans, simplified employee pensions, and eligible deferred compensation plans of governmental employers. The saver s credit, like the other incentives in EGTRRA, was temporary. However, instead of expiring after 2010, it was scheduled to sunset after PPA makes the saver s credit permanent. The amount of the credit for a tax year is equal to the credit rate (50, 20, or 10 percent) times the amount of qualified retirement savings contributions (not to exceed $2,000) made by an eligible individual in the tax year to certain Top_Fed_07_book.indb /15/2006 2:41:57 PM

72 9.8 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE retirement plans. The applicable credit rate depends upon the taxpayer s filing status and adjusted gross income. The amount of the credit for contributions to retirement savings plans varies with the taxpayer s filing status and adjusted gross income. The credit is completely phased out at an adjusted gross income of $50,000 for joint return filers, $37,500 for head of household filers, and at $25,000 for single and married filing separately filers. The maximum credit rate, for the lowest income taxpayers, is 50 percent; as the taxpayer s adjusted gross income increases, the credit rate is reduced, as shown in Table 3. Table 3. Maximum Credit Rate for Saver s Credit Adjusted Gross Income Joint Return Head of Household All Others Over Not Over Over Not Over Not Over $0 $30,000 $0 $22, $0 $15, $30,000 $32,500 $22,500 $24,375 $15,000 $16, $32,500 $50,000 $24,375 $37,500 $16,250 $25, $50,000+ $37,500+ $25, Applicable Percentage STUDY QUESTIONS 1. PPA made which set of EGTRRA tax cuts permanent? a. Retirement tax incentives b. Elimination of the marriage penalty c. Lower marginal tax rates d. All of the above were made permanent by PPA 2. Catch-up contributions to traditional and Roth IRAs have a maximum of for a. $500 b. $1,000 c. $2,500 d. $5,00 3. The Roth 401(k) and 403(b) plans implemented in 2006 are available to: a. Any employed taxpayer b. Participants in 401(k) or 403(b) plans allowing the contributions c. Rollover accounts from IRAs d. All of the above Top_Fed_07_book.indb /15/2006 2:41:57 PM

73 MODULE 3 CHAPTER 9 Tax News and Headlines 9.9 NOTE Answers to Study Questions, with feedback to both the correct and incorrect responses, are provided in a special section beginning on page PENSION PROTECTION ACT REFORMS CHARITABLE GIVING RULES Every year, Americans donate billions of dollars to charitable organizations. Taxpayers donate money, clothing, and many other items. The vast majority claim a tax deduction for their contributions. During the past 10 years, Congress has progressively tightened the rules for deducting gifts to charity. It imposed substantiation requirements for monetary donations. The rules for vehicle donations were overhauled a few years ago to prevent abuse. PPA tightens the rules even more. This section looks at three significant changes: New substantiation rules for cash contributions; New rules for deducting contributions of clothing and household items; and Tax-free IRA distributions to charities. Cash Contributions Under PPA, no deduction is allowed for any contribution of cash, check, or other monetary gift unless the donor can show a bank record or a written communication from the charity indicating the amount of the contribution, the date the contribution was made, and the name of the charity. Essentially, no bank record or no receipt means no deduction. Self-created records, such as a log book of donations, which had been permitted in the past to a limited extent, no longer suffice. It does not matter if the cash donation is $10, $250, or $1,000. A monetary donation must be substantiated by a bank record or written communication from the charity. (For contributions of more than $250, additional rules already in place apply, like having the charity attest in writing to the value of any goods or services received in exchange.) The new treatment is effective for tax years beginning after August 17, For calendar-year taxpayers, this means the start of Top_Fed_07_book.indb /15/2006 2:41:57 PM

74 9.10 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE COMMENT Unchanged by PPA is the rule that the deduction for an individual donor s aggregate charitable contributions in a single tax year is limited to 50 percent of the donor s contribution base (adjusted gross income computed without regard to the charitable deduction and without regard to any NOL carryback). Excess contributions may be carried forward and deducted over the five following years. In 2005, the 50 percent limit was temporarily suspended by the Katrina Emergency Tax Relief Act for contributions made between August 28, 2005, and December 31, Clothing and Household Items Just like the rules for cash gifts, the rules for deducting donations of clothing and household items have also been tightened. No deduction is allowed for used clothing unless the clothing is in at least good condition. The amount of the charitable contribution is based, as before, on the fair market value of the clothing or household item. The new rules for clothing and household items have a different effective date from the new rules for cash contributions. The new rules for clothing and household items are effective for contributions made after August 17, PPA does not define good condition. Good condition can, and often does, vary from person to person. As a guide, taxpayers can look to the criteria established by charities. Furniture, pots and pans, dinnerware, sheets and blankets, home furnishings, electronics, appliances, and similar items cannot be broken or in disrepair. COMMENT Under PPA, food, paintings, antiques, objects of art, jewelry, gems, and collectibles are not household items. Minimal Value Items The Joint Committee on Taxation s analysis of the new law states: The (Treasury) Secretary is authorized to deny a deduction for any contribution of clothing or household item that has minimal monetary value, such as used socks and used undergarments. It is expected that the Secretary of the Treasury, in consultation with affected charities, will exercise assiduously the authority to allow disallow a deduction for some items of low value, consistent with the goals of improving tax administration and to ensure that donated clothing and household items are of meaningful use to charitable organizations. Top_Fed_07_book.indb /15/2006 2:41:57 PM

75 MODULE 3 CHAPTER 9 Tax News and Headlines 9.11 Substantiation Requirements Acknowledgment. PPA does not change the substantiation requirements for gifts of clothing and household items. Donors must obtain a receipt from the charity, showing the name of the charitable organization, the date and location of the gift, and a detailed description of the property contributed. If obtaining a receipt is impractical, the donor must maintain reliable written information about the contribution. Gifts of $250 or more must be substantiated by: Acontemporaneous written acknowledgment from the charity containing a description of the contribution; A statement whether the donor received any goods or services in consideration for the contribution; and A good faith estimate of the value of any goods or services. If the claimed deduction exceeds $500, donors must include Form 8283, Noncash Charitable Contributions, with their return. Special rules apply for deductions of $5,000 or more. Exception. The new law does make one important exception. The rule about good or better condition does not apply if a single piece of clothing or household item is valued at $500 or more and the taxpayer includes an appraisal with his or her return substantiating the value of the donation. Tax-Free IRA Distributions to Charities Seniors qualified to make tax-free distributions. The new law opens a previously untapped source of funds to help charitable organizations. For two years only, PPA provides a temporary exclusion from gross income for qualified charitable distributions from IRAs. Taxpayers age 70½ and older and only those taxpayers may distribute up to $100,000 in 2006 and again in 2007 from their IRAs tax-free to charitable organizations. The distribution is not reported as income to the taxpayer, but it does count for purposes of satisfying any required minimum distribution (RMD) amount. Of course, with the income exclusion, qualified distributions are not also allowed as an itemized charitable deduction. COMMENT Distributions may be from a traditional or a Roth IRA. Donors with both types of IRAs will need to weigh the advantages and disadvantages of making a charitable contribution from either a traditional IRA or a Roth IRA. Generally, the new treatment will be considerably more valuable to owners of traditional IRAs rather than owners of Roth IRAs. Qualified distributions from Roth IRAs are not taxed but distributions from both types of IRAs may avoid the adjusted gross income limits imposed on charitable deductions. Top_Fed_07_book.indb /15/2006 2:41:57 PM

76 9.12 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Qualifying charity. The recipient of the IRA funds must be a qualifying charity: a 50 percent organization described in Code Sec. 170(b)(1)(A) (so named because the contribution can be deducted up to 50 percent of the taxpayer s contributions base in the contribution year). Distributions to supporting organizations described in Code Sec. 509(a)(3), however organizations that support churches, educational institutions, hospitals, medical research organizations, and others are not qualified distributions. Similarly, distributions to donor advised funds also do not qualify. Distributions of nondeductible contributions from a traditional IRA are not includible in income and are not eligible for qualified charitable distribution treatment. This special treatment tax treatment for IRA distributions to charitable organizations is temporary. It applies to distributions made in tax years beginning after December 31, 2005, and sunsets for distributions in tax years beginning after December 31, STUDY QUESTION 4. All of the following are required under PPA to substantiate gifts of $250 or more except: a. A good faith estimate of the value of goods or services b. Written acknowledgment from the charity describing the contribution c. A statement of whether the donor received any goods or services in exchange for the donation d. All of the above are required TAX INCREASE PREVENTION AND RECONCILIATION ACT EXTENDS DIVIDEND AND CAPITAL GAINS TAX CUTS In addition to PPA, the other big tax bill of 2006 was the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Even though it was enacted in 2006, the law carries a 2005 designation. That s because it was first proposed in 2005 and languished in a House-Senate conference, mostly because lawmakers could not decide whether to extend the temporary dividend and capital gains tax cuts. Dividend and Capital Gains Tax Rate Cuts In 2003, Congress lowered the tax rates on certain dividends and capital gains. At that time, the tax cut was popular and passed Congress without much opposition. Tempering opposition was the temporary nature of the tax cuts. As originally enacted, the dividend and capital gains tax rate cuts were scheduled to expire after Top_Fed_07_book.indb /15/2006 2:41:57 PM

77 MODULE 3 CHAPTER 9 Tax News and Headlines 9.13 The 2003 legislation lowered the maximum dividend and capital gains tax rates for most dividends and capital gains to 15 percent for qualifying taxpayers. Taxpayers in the 10 and 15 percent tax brackets were eligible for an even lower rate of 5 percent. In 2008, the rate for taxpayers in the 10 and 15 percent tax brackets were to fall to zero. In 2009, the rates were to go back up to 20 percent for most taxpayers and back up for the rest in the 10 or 15 percent brackets. In 2005, the White House and many Republicans in Congress started debating whether to extend the dividend and capital gains tax rate cuts or make them permanent. Democrats and others opposed the extension, questioning why Congress needed to act in 2005 when the tax cuts would not expire until Congress came close to making the dividend and capital gains tax cuts permanent in 2005, but Hurricane Katrina derailed those plans as lawmakers turned their attention to disaster relief. In early 2006, Congress passed TIPRA. TIPRA extends the dividend and capital gains tax rate cuts through December 31, 2010 (see Table 4). The extension through December 31, 2010, now aligns the dividend and capital gains tax rate cuts with the tax cuts in EGTRRA. All the tax cuts in EGTRRA except for the retirement savings tax incentives will sunset after December 31, Table 4. Dividend and Capital Gains Tax Rates Year 10 and 15% Income Tax Brackets 25, 28, 33, and 35% Income Tax Brackets COMMENT The dividend and capital gains tax rate cut was so controversial that Republicans knew they could only get it through Congress as part of a tax reconciliation bill, which requires only a simple majority in the House and Senate to pass. Otherwise, a standalone bill would require at least 60 votes in the Senate to prevent a filibuster, and Republicans did not have 60 votes in the Senate. Excluded Dividends Certain dividends are excluded from the tax cut. Dividend income is not qualified if paid by a corporation that is tax-exempt. A dividend received from a mutual savings bank (or similar savings institution) is not qualified dividend income if the bank claims a dividends-paid deduction. A dividend paid on employer securities in connection with certain retirement/savings plans is not qualified dividend income. Top_Fed_07_book.indb /15/2006 2:41:58 PM

78 9.14 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE A foreign corporation is qualified if it meets certain requirements. Generally, it must be a corporation that has stock that is readily tradable on an established U.S. securities market, is subject to an acceptable treaty or is incorporated in a U.S. possession. Dividend income that a taxpayer chooses to use in connection with the investment interest deduction is not eligible for the tax cut. If an investor borrows money to purchase investments (for example, stocks and bonds), the investor pays so-called investment interest to the lender. For a noncorporate investor, the deduction for investment interest is limited to the investor s net investment income. A noncorporate investor may elect to include qualified dividends in the computation of investment income for purposes of the investment interest limitation. If the investor so elects, the dividends are not qualified, so they are not eligible for the reduced rates. Alternative Minimum Tax Relief Despite many proposals to reform or abolish the alternative minimum tax (AMT) over the past few years, Congress hasn t come close to making any significant changes. The AMT generates billions of dollars in revenue every year for the federal government, and repealing it could cost more than $1 trillion over 10 years. The loss of revenue has made many lawmakers reluctant to jettison the AMT even though more middle-income taxpayers, especially two-income families, are paying the tax. TIPRA extends and increases for 2006 only the AMT exemption amount for individuals. Through December 31, 2006, taxpayers will be able to take advantage of higher AMT exemption amounts. The AMT exemption amount for married couples filing jointly is $62,550 and for single taxpayers, $42,500. TIPRA also extends through 2006 the provision allowing taxpayers to use nonrefundable personal credits to offset AMT liability. Nonrefundable personal credits include the dependent care credit, the credit for the elderly and disabled, the credit for interest on certain home mortgages, the Hope credit for certain college expenses, and the Lifetime Learning credit. COMMENT Without this relief, the government has estimated that an additional 15 million taxpayers would be subject to the AMT. However, because the relief is temporary, Congress will have to again tackle the AMT question in Top_Fed_07_book.indb /15/2006 2:41:58 PM

79 MODULE 3 CHAPTER 9 Tax News and Headlines 9.15 Small Business Expensing Small business expensing under Code Sec. 179 has been enhanced several times since Each time, the enhancements have been temporary. TIPRA continues the enhanced small business regime and as in the previous tax bills, the benefits are temporary. Under TIPRA, the maximum amount a taxpayer may expense is $100,000 of the cost of qualifying property, reduced by the amount by which the cost of qualifying property exceeds $400,000. Both amounts are indexed for inflation for tax years beginning after 2003 and before For 2006, the regular amounts are $108,000 and $430,000, respectively. For 2007, they are projected to rise to $112,000 and $450,000, respectively. COMMENT There are increased dollar limitations for enterprise zone businesses, renewal zones, New York Liberty Zone property, and Gulf Opportunity Zone property. Roth IRAs TIPRA also made a major although not immediate change to Roth IRAs. TIPRA eliminated the $100,000 adjusted gross income ceiling for converting a traditional individual retirement arrangement (IRA) to a Roth IRA. This special treatment applies to tax years beginning after December 31, For conversions in 2010, taxpayers can recognize conversion income (the amount transferred from a traditional IRA to a Roth IRA) ratably in 2011 and For conversions after 2010, all of the conversion income has to be recognized in the year of conversion. EXAMPLE Juan has a traditional IRA with a value of $10,000 consisting of deductible contributions and earnings. He does not have a Roth IRA. Juan converts the traditional IRA to a Roth IRA in As a result of the conversion, he has $10,000 in additional gross income. Unless he elects to recognize the $10,000 in 2010, $5,000 of the income is included in income in 2011 and $5,000 is included in income in If Juan converts his traditional IRA to a Roth IRA in 2011, all of the $10,000 conversion income would be recognized in Top_Fed_07_book.indb /15/2006 2:41:58 PM

80 9.16 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE COMMENT Taxpayers will need to decide whether the conversion can be funded outside the converted account or whether the individual must dip into the proceeds to pay the tax. Such withdrawals will be subject to both income tax and early withdrawal penalties. COMMENT In order to maximize conversions into Roth accounts in 2010, some taxpayers whose income exceeds the present Roth contribution income ceiling now are making annual contributions to nondeductible IRAs. When 2010 rolls around and the $100,000 income cap for rollovers is no longer applicable, these taxpayers will have more to roll over, because they can use the four additional years of extra IRA contributions to fund their new rollover Roth IRAs. As these are nondeductible IRAs, the taxpayers will recognize income only to the extent of earnings within the IRA. After conversion to a Roth IRA, even the earnings will be tax free when ultimately withdrawn. Kiddie Tax The kiddie tax rules require that a child s unearned income, such as dividends and interest, be taxed at the parents tax rate, which is usually a higher rate. Before TIPRA, the kiddie tax applied if the child was younger than age 14 at the end of the tax year, the child had net unearned income of more than $1,700, and the parent could claim the child as a dependent. TIPRA raised the age limit to 18. This treatment is effective immediately, for the entire 2006 tax year. Consequently, parents and others who had planned to sell a child s college stock portfolio after the child reached age 13 and before entering college have no opportunity to accelerate that planning technique if the child is older than 13. Unless the parent elects to include the child s income on the parent s return, the child must file a separate return to report his or her income. The child must attach Form 8615, Tax for Children under Age 18 Who Have Investment Income of More Than $1,700 (which the IRS has to revise to reflect TIPRA and annual inflation adjustments) to his or her return. Form 8814, Parent s Election to Report Child s Interest and Dividends, has to be filed if the parent elects to report the child s unearned income on the parent s return. If the election is made, the child is treated as having no income and the child does not have to file a return. Top_Fed_07_book.indb /15/2006 2:41:58 PM

81 MODULE 3 CHAPTER 9 Tax News and Headlines 9.17 COMMENT The kiddie tax rules do not apply to a child who, although not yet age 18, is married and files a joint return for the tax year, effective for tax years beginning after December 31, The child s eligibility to file a joint return is not enough to avoid application of the kiddie tax. The child must actually file a joint return for the tax year. More Changes Here is a selection of some of the many other provisions in TIPRA. Subpart F. The American Jobs Creation Act of 2004 carved a temporary exception from Subpart F taxation for active financing and insurance income. However, the exception was temporary and would have expired at the end of TIPRA extends it through December 31, TIPRA also created another temporary exception from Subpart F by providing a look-through exception for dividends, interest, rents, and royalties received by one controlled foreign corporation (CFC) from a related CFC to the extent attributable to non-subpart F income of the payor. This exception is effective for tax years beginning after December 31, 2005, and before January 1, Corporate estimated tax payments. Estimated tax payments for corporations with assets of at least $1 billion that are due in 2006, 2012, and 2013 are increased under TIPRA. Payments due in July, August, and September 2006 are increased to 105 percent; payments due in July, August, and September 2012 to percent; and payments due in July, August, and September 2013 to percent. However, 20.5 percent of the corporate estimated tax payment due on September 15, 2010, will not be due until October 1, percent of the corporate estimated tax payment due on September 15, 2011, will not be due until October 1, Code Sec. 911 housing exclusion. Code Sec. 911 provides an exclusion from gross income for certain foreign housing costs in an amount equal to the excess of a taxpayer s housing costs over a base housing amount. TIPRA sets a new base housing amount at 16 percent (computed on a daily basis) of the foreign earned income exclusion limitation, multiplied by the number of days of foreign residence or presence in that year. TIPRA also sets the tax brackets for any income in excess of the exclusion amount. Any income over the exclusion will be subject to the tax rate applicable had the taxpayer not elected the exclusion. Withholding on government payments. Effective in 2011, federal, state, and local government agencies must withhold 3 percent on payments for services or property provided by a taxpayer. Agencies must report the payments and Top_Fed_07_book.indb /15/2006 2:41:58 PM

82 9.18 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE the amount withheld to the IRS. However, the new withholding requirement will not apply to payments determined by a needs or income test, such as food stamps or welfare payments. New Rules for Offers-in-Compromise On July 16, 2006, the IRS s offer-in-compromise program underwent major changes because of TIPRA. The new tax law increases the amounts that must be paid by taxpayers submitting an offer-in-compromise and requires up-front and nonrefundable payments. TIPRA made the following changes to offers-in-compromise: Taxpayers filing a lump-sum offer must pay 20 percent of the offer amount with the application. A lump-sum offer is any offer of payments made in five or fewer installments; and Taxpayers filing a periodic-payment offer must pay the first proposed installment payment with the application and pay additional installments while the IRS evaluates the offer. A periodic payment is any offer of payments made in six or more installments. COMMENT The IRS will return as not processable any application for an offer-incompromise that does not include the 20 percent payment on a lump-sum offer or the first installment payment on a periodic-payment offer. Nonrefundable payments of tax. The IRS is treating the 20 percent payment for a lump-sum offer as a payment of tax. It is not refundable. The same treatment applies to the first proposed installment payment when filing a periodic-payment offer. However, undesignated voluntary payments, which are submitted in connection with an offer, to the extent that they exceed any required payment, will be refundable as tax deposits. Taxpayers also have to pay a $150 application fee. Special exceptions for some taxpayers. Lower-income taxpayers are exempt from the new payment requirements under TIPRA. Taxpayers must certify that they qualify for the lower-income exception on the Form 656-A, Income Certification for Offer-in-Compromise Application Fee, worksheet. Additionally, TIPRA s payment requirements do apply to taxpayers who submit offers based on doubt-as-to-liability. Both groups of taxpayers are also exempt from the $150 application fee. Offers deemed accepted. TIPRA did make one taxpayer-friendly change to the offer-in-compromise rules. If the IRS does not reject an offer within 24 months after having been submitted, the offer will be deemed accepted. However, the 24-month period will not apply if the IRS returns the offer to the taxpayer as not processable. The 24-month period also does not apply if the taxpayer fails to make timely payments. Top_Fed_07_book.indb /15/2006 2:41:59 PM

83 MODULE 3 CHAPTER 9 Tax News and Headlines 9.19 STUDY QUESTIONS 5. Under TIPRA, a business taxpayer may expense a maximum of of the cost of qualifying property, reduced by the amount by which the cost of the property exceeds (unadjusted for inflation). a. $100,000; $400,000 b. $125,000; $450,000 c. $150,000; $600,000 d. $50,000; $450, The kiddie tax applies to children whose net unearned income exceeds: a. $700 b. $1,000 c. $1,500 d. $1, All of the tax cuts in EGTRRA except the retirement savings tax incentives are scheduled to sunset after: a. December 31, 2006 b. December 31, 2007 c. December 31, 2010 d. All of the tax cuts have been extended without sunset IRS OUTSOURCES SOME TAX COLLECTION WORK In 2004, Congress authorized the IRS to outsource some tax collection work. The IRS invited private collection agencies to bid for the work and in early 2006 announced that three firms had been selected. The announcement immediately set off a firestorm of controversy. Consumer and labor groups protested that third-party tax collectors would be overzealous in their pursuit of debt collection and ignore taxpayer rights. The IRS has stressed that it will not tolerate any misconduct on the part of private debt collectors. COMMENT If all this sounds familiar, it should. The IRS tried to outsource some tax collection work in 1996 and the program was quickly abandoned after taxpayers howled in protest at the methods private debt collectors used. This time, the IRS promises that the mistakes of 1996 will not be repeated. Top_Fed_07_book.indb /15/2006 2:41:59 PM

84 9.20 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Commission Payment Much of the controversy focuses on how third-party debt collectors will be paid. Private debt collectors will be paid a commission of 21 to 24 percent of the taxes they collect. Opponents argue that this bounty will encourage abuses, such as repeat and annoying calling and contacting taxpayers outside the home. The IRS insists that these practices will not be tolerated. Private firms will be trained by the IRS and will be subject to the same taxpayer protection and privacy rules that apply to IRS employees. The IRS will conduct background checks on all employees of the private debt collector and will monitor all debt collection activities. Up to 40,000 Accounts Outsourced The IRS initially assigned 12,500 taxpayer accounts to private collection agencies in September Ultimately, a total of 40,000 accounts were to be turned over to third-party debt collectors by the end of The accounts will only be amounts for which the taxpayer has admitted liability. Taxpayers whose accounts are turned over to a private debt collector receive a letter from the IRS. The letter informs them of their rights and also provides telephone numbers for IRS employees overseeing the program as well as the Taxpayer Advocate Service. The IRS is also distributing a new publication, What You Can Expect When the IRS Assigns Your Account to a Private Collection Agency. Limited Collection Work Private debt collectors have only limited responsibilities. They cannot: Take enforcement actions involving liens, levies, or property seizures; Work cases in which the taxpayer qualifies for an installment agreement longer than five years; or Be involved in offers-in-compromise, bankruptcies, hardship issues, or litigation. Under law, taxpayers can have their accounts returned to the IRS. The taxpayer must write a letter to the private debt collector and instruct the collection agency to return his or her account to the IRS. A copy of the letter (see the sample in Figure 1) should be sent to the IRS. Top_Fed_07_book.indb /15/2006 2:41:59 PM

85 MODULE 3 CHAPTER 9 Tax News and Headlines 9.21 Figure 1. Sample Opt-Out Letter (Insert Date) Re: (Insert Your Name) Name of Private Debt Collection Company Street Address City, State, Zip Code To Whom It May Concern: I have received notification from the Internal Revenue Service that it has turned over to you my tax return information so that you may seek to collect a claimed tax debt from me. At the same time, I received information from the IRS telling me that I can, by writing to you, decline to permit you to proceed with my case. This letter shall serve as notice to you that I decline to give my permission for you to proceed. Accordingly, kindly return any and all information relating to me and my tax situation to the Internal Revenue Service, per instructions to you from that agency. In accordance with my notification from the IRS, I am providing a copy of this letter to the IRS. Sincerely, Name Address Any file identification number used by IRS on its notification letter to you Source: National Treasury Employees Union. Legislation Would Stop Initiative Although Congress gave the IRS a green light to proceed with privatization in 2004, the mood appears to be changing on Capitol Hill. In June 2005, the House voted to prohibit the IRS from using any of its fiscal year 2007 appropriated funds to outsource tax collection. This would effectively end the program after The Senate has not approved a similar prohibition. In September, an antiprivatization bill was introduced in the Senate. The Senate bill would immediately suspend outsourcing of tax collection. Top_Fed_07_book.indb /15/2006 2:41:59 PM

86 9.22 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE COMMENT In testimony before Congress, IRS Commissioner Mark Everson has said that using IRS employees would be a cost-effective means for collecting tax debt, but the agency s budget as passed by the House does not provide sufficient resources. STUDY QUESTIONS 8. Which of the following is a type of case that private debt collectors can handle? a. Bankruptcies b. Cases in which the taxpayer qualifies for an installment agreement lasting two years c. Liens and levies d. Offers-in-compromise 9. To elect to have his or her collections case handled exclusively by the IRS once the account has been outsourced to a third-party collector, the taxpayer: a. Must contact the Taxpayer Advocate Service b. Initiates the appeals process c. Sends a letter to the private debt collector instructing the firm to return the account files to the IRS d. The taxpayer is not permitted to choose between IRS and thirdparty collections personnel IRS OVERHAULS CAPITALIZATION REGULATIONS FOR TANGIBLE ASSETS In September 2006 the IRS released long-awaited comprehensive proposed regulations on the capitalization of tangible assets (NPRM REG , IR ). The proposed regulations attempt to simplify and clarify rules that touch virtually every business activity. COMMENT The IRS is predicting that the proposed regulations will help to reduce some of the conflict between taxpayers and the government over the capitalization of tangible assets an area that has been problematic for a long time. Top_Fed_07_book.indb /15/2006 2:41:59 PM

87 MODULE 3 CHAPTER 9 Tax News and Headlines 9.23 PLANNING POINTER As proposed, the regulations would not officially apply until tax years beginning on or after final regulations are issued. The IRS emphasized that taxpayers may not change a method of accounting in reliance upon the rules contained in the proposed regulations until the rules are published as final regulations. Because the IRS reports that portions of the regulations clarify existing law, rather than change it, parts of the new regulations may be applied immediately. Businesses are also advised to prepare for the new rules as early as possible, with the likelihood that they will go into effect sometime in early The same types of costs that must be capitalized to produced property or improvements under the uniform capitalization rules apply to produced property under the new regulations. Thus, all direct materials and direct labor, and all indirect costs that directly benefit or are incurred by reason of production/improvement activities, are capitalized to the property being produced or acquired. Unless an election out is made, an amount paid for the acquisition or production of a unit of property with an economic useful life of 12 months or less may not be treated as a capital expenditure. Property to which the 12-month rule is applied is not treated as a capital asset and may not be depreciated. All amounts realized upon disposition are treated as ordinary income (see Twelve-month Bright-line Rule later in the chapter). The regulations introduce exclusive-factors tests, rules on economic useful life, safe harbors, and simplified assumptions. They do so within the context of recent cases some of which the IRS has won and others it has lost to provide an overall framework that expands the standards for capitalization or expensing found in the current regulations. To add to the drive toward even further simplification, the IRS also is throwing open to discussion a de minimis rule under which small cost items would be exempt from capitalization. Twelve-month Bright-line Rule The proposed regulations provide a straightforward 12-month bright-line rule: A taxpayer cannot capitalize amounts paid to acquire or produce a unit of property that has a useful life of less than 12 months. A similar rule was adopted in the regulations governing capitalization of intangible assets. Previous regulations required capitalization of expenses of property having a useful life substantially beyond the year. Taxpayers will be required to capitalize expenses of repairing or restoring property with a useful life longer than one year. Taxpayers will also be required to capitalize inventory costs, including amounts paid to acquire real property for resale or to produce personal property for sale. Top_Fed_07_book.indb /15/2006 2:41:59 PM

88 9.24 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Election Out Taxpayers can elect not to apply the 12-month rule. This election is irrevocable. The election can be made for each unit of property acquired or produced by the taxpayer. However, the IRS does not believe that it would be appropriate to apply the 12-month rule to certain types of property. Thus, the 12-month rule does not apply to property that is or will be included in property produced for sale or property acquired for resale, improvements to a unit of property, land, or a component of a unit of property. So, for example, all indirect costs including otherwise deductible costs for equipment with a life of 12-months or less that directly benefit or are incurred by reason of a taxpayer s manufacturing activities must be capitalized to the property produced for sale. Safe Harbor and de Minimis Rules The proposed regulations also provide an elective safe harbor for repairs. There is a separate allowance for each class of property under the MACRS system. Amounts up to the safe harbor are deductible; excess amounts must be capitalized. The proposed regulations do not include a de minimis rule allowing a taxpayer to deduct an amount paid below a certain dollar threshold for the acquisition of tangible personal property. However, the IRS is considering including such a rule in the final regulations and specifically requests practitioner comments on this issue. COMMENT The preamble to the proposed regulations acknowledges that taxpayers often have an established policy of deducting amounts paid below a certain dollar threshold and that IRS examining agents usually do not challenge such an expensing practice so long as it does not have a material effect on tax liability. The preamble indicates that the absence of a de minimis rule in the proposals is not intended to change this practice. Repairs Amounts paid to improve tangible property must be capitalized. This includes amounts paid to repair, improve, or rehabilitate tangible property. Amounts must be capitalized if they materially increase the value of property or restore a unit of property. There are five tests for determining whether an amount materially increases value: Amounts paid prior to the initial date of service to put property into operating condition; Improvements in the condition of the property; Top_Fed_07_book.indb /15/2006 2:42:00 PM

89 MODULE 3 CHAPTER 9 Tax News and Headlines 9.25 Amounts that fix a defect; Adding a new or different use; and An increase in capacity. The proposed regulations retain current principles for the concepts of value, useful life, and new or different use. The IRS rejected adopting a recurring expense approach or an obligation to regularly carry out repair or maintenance. The economic useful life can be determined by looking at a company s financial statements. The proposed regulations also include four rules for determining when an amount substantially prolongs useful life: If it extends useful life more than one year; Replaces a major component: Restores to a like-new condition; or Represents a casualty loss deduction. STUDY QUESTION 10. The 12-month bright-line rule for capitalizing property proposed in new regulations requires capitalization of: a. The cost of property only if it has a useful life substantially beyond one year b. All direct material costs, but not labor costs, applied to a property required to be capitalized c. Otherwise permitted amounts only if elected by the taxpayer on an item by item basis d. Amounts paid for the acquisition or the production of a unit of property with an economic life of more than 12 months IRS TO REFUND FEDERAL TELEPHONE TAX After a string of court losses, the IRS announced in May that it will no longer collect the long-distance portion of the 3 percent federal telephone excise tax. Individuals and businesses will be able to request refunds of the long distance portion of the telephone tax. Taxes paid from March 1, 2003, through July 31, 2006, are eligible for the refund. COMMENT As of press time, only the portion of the federal telephone excise tax that applies to long-distance service has been discontinued. The excise tax still applies to local service. Several bills have been introduced in Congress to repeal the tax on local telephone service. Top_Fed_07_book.indb /15/2006 2:42:00 PM

90 9.26 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Long History The federal telephone excise tax was first imposed to pay for the Spanish- American War in Congress repealed it in 1902 but reinstated it during World War I. It was repealed again in 1924 but once again resurrected in 1932, this time on long-distance toll calls only. At that time, long-distance charges were based on the distance of the call. In 1941, Congress extended the tax to local telephone service. From time to time since then, there have been proposals in Congress to repeal the tax but ultimately the tax disappeared because of changes in telephone service. IRS Court Losses The definition of long-distance toll service has been widely litigated in the past several years. The taxpayers in those cases purchased long-distance telephone and were charged on a flat per-minute rate for every long distance call. The distance of the call was not a factor in the amount billed. The taxpayers argued that they should not be liable for the federal telephone excise tax because the charge does not vary with both time and distance. Pivotal in all of those cases was how to interpret the language in Code Sec defining taxable toll telephone service as a communication for which there is a toll charge which varies in amount with the distance and elapsed transmission time of each individual communication [emphasis added]. Specifically, did that language mean to include charges that vary with either distance or time, thus reading and disjunctively as the government argued? Or, did it contemplate charges that vary with both distance and time, as urged by taxpayers? All but one court that considered this question determined that and must be read conjunctively. After five federal appeals courts ruled against the government, the IRS conceded defeat. The appellate cases universally held that toll telephone service must be charged based on both elapsed transmission time of the call and distance of the call in order to be taxable. COMMENT In conceding that these services were not taxable, the IRS went one step further than the court decisions and stated that it would no longer tax any long-distance telephone services, even those billed based on transmission time and distance. In addition, the IRS will not tax bundled services, which are services provided under a plan that does not list the local telephone service charge separately. Bundled service includes Voice over Internet Protocol service, prepaid telephone cards, and plans that provide both local and long-distance service for either a flat monthly fee or a charge that varies with elapsed transmission time. Telecommunications companies provide bundled service for both landline and wireless (cellular) service. Both longdistance service and bundled service are no longer taxed. Top_Fed_07_book.indb /15/2006 2:42:00 PM

91 MODULE 3 CHAPTER 9 Tax News and Headlines 9.27 The IRS has instructed service providers to cease collecting and paying over the tax after July 31, However, service providers will continue, for now, to collect the tax for local-only service. Standard Safe Harbor Amounts Standard safe harbor amounts reaching $60 are available to individual taxpayers who claim refunds of the federal telephone tax based on actual amounts of tax paid. The refunds are the result of the government s decision to no longer collect the long distance portion of the federal telephone excise tax and will be issued in However, businesses and nonprofits cannot use the safe harbor amounts. Individuals can apply for refunds on their 2006 returns, or on special Form 1040EZ-T for taxpayers who do not file a Form Refunds reflect the amount of tax paid or the standard safe harbor amounts. Individuals can take a standard safe harbor amount from $30 to $60 based on the number of exemptions claimed on their return. Table 5. Standard Telephone Tax Safe Harbor Amounts Number of Exemptions Safe Harbor Amount 1 $30 2 $40 3 $50 4 $60 The standard amounts are based on actual telephone usage data, the IRS explained. Given a 3 percent tax, the safe harbor covers from $1,000 to $2,000 in long distance phone bills during the 41-month period. The IRS s announcement implies that the number of exemptions for purposes of the safe harbor is counted only based on the 2006 tax year, even though 2006 covers only 7 of the 41 months during which the excise tax was improperly charged. Individuals electing not to use the safe harbor amounts will calculate their refunds by using the actual amount of tax paid. Taxpayers must show and substantiate the actual amount of tax charged and the amount of tax paid. PLANNING POINTER The safe harbor amounts are most helpful to individuals who did not save their telephone bills or receipts, such as checks and credit card statements, showing tax paid. Practitioners need to tell individual clients not to expect a separate refund check. Refunds will be treated as a one-time payment on the taxpayer s 2006 return. The refund will reduce the income tax amount owed or increase the amount of the taxpayer s total refund. Top_Fed_07_book.indb /15/2006 2:42:00 PM

92 9.28 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Individuals who receive a credit or refund from their telephone service provider cannot double-dip and claim the federal refund. Taxpayers who paid the federal excise tax on their long-distance Internet plan can also request a refund, the IRS reported. Businesses and Nonprofits Businesses and nonprofit organizations cannot use the standard safe harbor amounts. Their refunds will be calculated on the actual amount of tax paid. They must submit Form The IRS is requesting comments on ways to simplify the refund process for business and nonprofit organizations, including the possibility of a standard amount table. PHISHING SCAMS SPIKE IN 2006 Coaxing Information from the Unwary Identity thieves are using bogus IRS s and fake IRS correspondence to lure unsuspecting taxpayers into revealing personal information, such as bank and credit card account numbers. In June 2006, the IRS reported a sharp rise in phishing scams and intensified its campaign to warn taxpayers about the dangers lurking in cyberspace. Types of Bogus Claims The most common type of scam tells recipients that they are owed a federal tax refund. Taxpayers are instructed to jump to a website to claim their refund. The website appears to be the genuine IRS site but is actually a fake site created by scam artists. On the fake website, taxpayers are asked to submit personal and financial information, especially PIN numbers and passwords for credit card and bank account numbers, so the IRS can process their refund. Thieves use this information to steal the taxpayer s identity, run up charges on credit cards, empty bank accounts, and even file fraudulent tax returns. The IRS never asks taxpayers for PIN numbers, passwords, or other confidential account information. Any suspicious claiming to be from the IRS and requesting this information should be forwarded to the IRS at phishing@irs. gov. In one month alone (June 2006), taxpayers forwarded more than 1,300 bogus s to the IRS. The IRS and the Treasury Inspector General for Tax Administration have discovered that many phishing schemes originate outside the United States. Federal investigators have tracked these scam websites to Asia, Europe, Oceania, and South America. Some scams are even targeting nonresidents who live abroad but own property or do business in the United States. Top_Fed_07_book.indb /15/2006 2:42:00 PM

93 MODULE 3 CHAPTER 9 Tax News and Headlines 9.29 COMMENT Taxpayers with addresses ending in.edu appear to be heavily targeted by phishers..edu suffixes are used by individuals having accounts through educational organizations, such as colleges and universities. STUDY QUESTIONS 11. A communication for which there is a toll charge which varies in amount with the distance and elapsed transmission time of each individual communication is a: a. Taxable combined local and long-distance service b. Taxable toll telephone service c. Traditional toll telephone service d. None of the above 12. Phishing scams trick computer users by: a. Offering low-cost accounting services guaranteed to increase individuals refunds by using official IRS tax preparers b. Offering phony Taxpayer Advocate services to individuals having trouble completing tax returns c. Luring them to fake sites that request personal or financial information used for identify theft d. Attaching virus or Trojan horse files to s that resemble official IRS communications MORE DEVELOPMENTS First Guidance on New Green Vehicle Tax Credit With gasoline prices reaching all-time records, more taxpayers are purchasing green vehicles: hybrid vehicles that are not only environmentally friendly in their discharges but also get better gas mileage. In 2005, Congress replaced the tax deduction for hybrid vehicles with a tax credit: the alternative motor vehicle credit. The IRS issued the first guidance on the new credit in January 2006 (Notice , IR ). The credit can reach as high as $3,400, but manufacturers first must go through a certification process. In related news, the IRS reminded taxpayers in July 2006 that employer-provided cash incentives to purchase hybrid vehicles are taxable compensation (IR ). Final Roth 401(k) Regulations Also in January 2006, the IRS issued final Roth 401(k) regulations on designating elective contributions. The final regulations clarified proposed regulations issued in March Top_Fed_07_book.indb /15/2006 2:42:01 PM

94 9.30 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Circular 230 The IRS made more revisions to Circular 230 in 2006 after beefing-up the rules for tax shelter opinions in Proposed regulations revoked the authority of an unenrolled return preparer to represent taxpayers during an exam if he or she prepared the return. The IRS also proposed making all disciplinary proceedings including reports, evidence, and decisions public. Strong Growth in e-filing Electronic filing of income tax returns showed strong growth in 2006, especially at the end of the filing season. As of April 21, 2006, more than 70 million returns had been filed electronically. Tax professionals e-filed 40 million returns. Roughly 20 million taxpayers e-filed using a home computer. Collection Due Process PPA of 2006 provides that all appeals of collection due process (CDP) determinations shall be made to the Tax Court. Taxpayers may no longer seek review of adverse CDP determinations in federal district court. Congress made the change so taxpayers would not risk filing an appeal in the wrong court. The change applies to CDP determinations made after October 16, IRS Streamlines TAM Process In May 2006, IRS Chief Counsel Donald Korb announced a new, streamlined process for technical advice memoranda (TAMs) with accelerated deadlines. Chief Counsel has a 120-day deadline, which represents a decrease from 180 days. Taxpayers must respond to government requests for information within 10 instead of 20 days. In addition, Chief Counsel has started issuing case specific and industry generic advice internally to field agents and industry directors in a process that is separate from the TAM process. Tax Shelter Win The Court of Appeals for the Federal Circuit handed the IRS a victory in a tax shelter case in July 2006 (Coltec Industries, Inc., USTC 50,389) and approved the IRS s use of the economic substance doctrine alone as sufficient grounds to deny tax shelter benefits. A tax shelter strategy can be 100 percent correct in following the language of the Tax Code but will lose in court if it lacks economic substance. The decision was a reversal of the lower court s ruling. Tax Shelter Loss Not all the news about tax shelter litigation was good for the IRS. Also in July 2006, the IRS lost a major tax shelter case (Klamath Strategic Investment Fund, LLC, USTC 50,408). A federal district court in Texas Top_Fed_07_book.indb /15/2006 2:42:01 PM

95 MODULE 3 CHAPTER 9 Tax News and Headlines 9.31 rejected the IRS s attempt to deny bond-linked investment premium structure (BLIPS) benefits by applying a regulation issued in 2003 to a transaction that took place in The court held that the regulation could not be given retroactive effect. Political Activities of Tax-Exempts The IRS continued to closely watch the activities of churches and other tax-exempt organizations for signs of impermissible political activity in All 501(c)(3) organizations are prohibited from engaging in any political activity. The IRS published a fact sheet (FS ) to help Code Sec. 501(c)(3) organizations to stay in compliance with prohibitions. In a closely watched case, the IRS announced in August that it was dropping its investigation of the NAACP for alleged political intervention in the 2004 presidential election. Billion-Dollar Transfer Pricing Settlement In September 2006, the IRS announced that an agreement between it and GlaxoSmithKline Holdings (Americas) Inc. & Subsidiaries (GSK) settled the largest tax dispute in the history of the IRS. The IRS announced on September 11 that the international pharmaceutical giant will make a $3.4 billion payment to settle a multiyear transfer pricing dispute. Glaxo has also agreed to abandon its $1.8 billion refund claim. Top IRS officials reiterated that transfer pricing remains a key issue for the IRS. STUDY QUESTIONS 13. Employer-provided cash incentives to purchase hybrid vehicles: a. Have been replaced with the green vehicle tax credit b. Are taxable compensation for employees c. Are given tax credits for employers on their business tax returns d. None of the above 14. Under PPA taxpayers may no longer request a review of adverse collections due process (CDP) determinations: a. In Tax Court b. Through the IRS appeals process c. In Federal district court d. All of the above are no longer available Top_Fed_07_book.indb /15/2006 2:42:01 PM

96 9.32 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 15. The outcome of the GlaxoSmithKline Holdings (GSK) transfer pricing case: a. Remains unsettled b. Was in favor of the pharmaceutical conglomerate, which will receive its refund of $1.8 billion c. Was settled in favor of the IRS as the conglomerate agreed to abandon its refund claim d. None of the above was the outcome CONCLUSION The crescendo of tax news that began to develop in 2006 promises to get even louder in Aside from the change to be dealt with because many of the provisions in both the Tax Increase Prevention and Reconciliation Act and the Pension Protection Act are not triggered until 2007, tax practitioners must prepare to deal with an IRS poised to release some much-needed guidance on ongoing projects. The IRS intends to flesh out rules promulgated in legislation as far back as 2001 and as fresh as a several months ago partnership allocations, deferred compensation, valuation, alternative minimum tax, like-kind exchanges, manufacturing deduction limitations, expanded expensing, and practitioner rules of conduct, among others. The IRS also will make news through continuing to step up audit activity to close the tax gap. Investors in tax shelters and those operating small businesses will especially feel the heat. Congress also will play an active role in tax law for Midterm elections will be over and a period of long-term planning is expected to begin in Washington during Core tax reform and alternative minimum tax relief are being promised. Stay tuned! CPE NOTE: When you have completed your study and review of chapters 7, 8 and 9 which comprise this Module, you may wish to take the Quizzer for this Module. CPE instructions can be found on page The Module 3 Quizzer Questions begin on page The Module 3 Answer Sheet can be found on pages and For your convenience, you can also take this Quizzer online at Top_Fed_07_book.indb /15/2006 2:42:01 PM

97 10.18 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE b. Incorrect. The trustee is not responsible for verifying such information. d. Incorrect. One of the parties bears these responsibilities. 13.b. Correct. The withdrawal is not treated as a taxable distribution. a. Incorrect. Withdrawing administration fees from the accountholder s balance does not mean he or she may contribute that much more for the year. c. Incorrect. Fees taken directly from the HSA count toward the maximum contribution, whereas fees paid by the employer or the beneficiary directly to the custodian do not count toward the maximum contribution. d. Incorrect. The fees are not replaceable by raising the maximum contribution the following year. 14.d. Correct. All of the choices summarize disadvantages of Archer MSAs compared with HSAs. a. Incorrect. Small employers (having 50 or fewer employees) covering employees with an HDHP or self-employed individuals are the only eligible accountholders for MSAs. b. Incorrect. These are the differences in required minimum deductibles between MSAs and HSAs. c. Incorrect. Excise tax penalties for nonqualified withdrawals are 15 percent for MSAs but only 10 percent for HSAs. 15. c. Correct. Unlike the safety of principal coupled with low returns that are characteristic of most bank accounts, HSAs offer both the risks and rewards of securities investments. a. Incorrect. Withdrawals for nonqualified expenses subject the accountholder to taxes and penalties. b. Incorrect. Withdrawals for nonqualified expenses are always subject to penalties and taxes. d. Incorrect. One of the choices is a good reason to consider HSAs as savings accounts offering more flexibility. MODULE 3 CHAPTER 7 1. a. Correct. For both 2005 and 2006 tax years, the amount of the percentage of QPAI used to calculate the manufacturing deduction is 3. b. Incorrect. This is the percentage used for calculating the deduction in 2007 through 2009, not c. Incorrect. This is the percentage for 2010 and beyond, not d. Incorrect. One of the choices is the correct percentage of QPAI used in the calculation for Top_Fed_07_book.indb /15/2006 2:42:06 PM

98 ANSWERS TO STUDY QUESTIONS CHAPTER b. Correct. Payments to independent contractors are not considered W-2 wages. The W-2 wage limitation is a ceiling on the amount of the deduction but is not part of the QPAI calculation. a. Incorrect. Losses directly allocable to the receipts are subtracted from DPGR to arrive at the QPAI of a business. c. Incorrect. COGS is subtracted from DPGR in calculating the qualified production activities income. d. Incorrect. One of the choices is not subtracted from DPGR in calculating the QPAI of a business. 3. True. Correct. These are some of the only services considered to be QPP. False. Incorrect. These services are embedded services excepted from the general exclusion of services from QPP. 4. d. Correct. As long as the co-op retains the benefits and burdens of owning the grain, the storage is treated as MPGE. a. Incorrect. Dispositions of land do not qualify as MPGE; land is not manufactured, produced, grown, or extracted. b. Incorrect. Resellers cannot take the deduction because they did not produce the products. c. Incorrect. Receipts from the transmission of a utility do not qualify as MPGE. 5. d. Correct. Casting agents qualify as production personnel for the 50 percent compensation requirement of qualified films. a. Incorrect. Distributors are not considered to be production personnel for qualified films. b. Incorrect. Studio administrators are not considered to be production personnel for the 50 percent compensation rule. c. Incorrect. Actors personal assistants are not considered to be production personnel for this requirement. 6. c. Correct. Activities related to the land such as zoning and surveying do not qualify as DPGR. a. Incorrect. Renovation of major components or substantial structural parts of real property qualifies as construction. b. Incorrect. Contractors and subcontractors can both derive gross receipts from the same construction project. d. Incorrect. One of the choices does not qualify as construction for the DPGR calculations. Top_Fed_07_book.indb /15/2006 2:42:06 PM

99 10.20 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 7. a. Correct. Applying the allocation rules under the Code Sec. 861 regulations is permitted for all taxpayers. b. Incorrect. The simplified deduction method has ceilings on the taxpayer s annual gross receipts and assets. c. Incorrect. The simplified overall method is intended for small businesses and may be applied only if the taxpayer s annual gross receipts are $5 million or less and the taxpayer s COGS and deductions do not exceed $5 million. d. Incorrect. Only one method may be used by all taxpayers. 8. c. Correct. These taxpayers apportion deductions between DPGR and other receipts based on the percentage of qualifying and nonqualifying gross receipts. a. Incorrect. These amounts pertain to the simplified overall method for small businesses, not the simplified deduction method. b. Incorrect. None of the three permissible apportionment methods uses these amounts for maximum receipts and assets. d. Incorrect. The simplified deduction method has lower maximum gross receipts and assets. 9. d. Correct. All three types of partnerships may claim the deduction under the special in-kind partnership rule. a. Incorrect. Partners whose joint ventures are engaged in extracting natural gas can claim the deduction. b. Incorrect. The special attribution rule applies to producers of electricity. c. Incorrect. Oil and petrochemical processing partnerships may claim the deduction 10. a. Correct. The beneficiaries divide the fiduciary s W-2 wages if the QPAI is greater than zero. b. Incorrect. The fiduciary s wages are not disregarded for the deduction. c. Incorrect. A beneficiary must aggregate its share of QPAI from the estate or trust with QPAI from other sources. d. Incorrect. One of the choices is the treatment of the trust or estate fiduciary s W-2 wages. MODULE 3 CHAPTER 8 1. d. Correct. All three choices reflect the objectives of the five-year plan for the IRS. a. Incorrect. Stopping abuses in tax-exempt and governmental organizations is one of the plan objectives for the IRS for years b. Incorrect. Reducing such criminal activity denotes one of the five-year plan s objectives. Top_Fed_07_book.indb /15/2006 2:42:06 PM

100 ANSWERS TO STUDY QUESTIONS CHAPTER c. Incorrect. One of the five-year plan objectives for the IRS is discouraging and deterring noncompliance caused by abuses that contribute to the tax gap. 2. d. Correct. Form 3949-A is submitted along with the name and address of the person being reported, the taxpayer identification number (social security number for an individual or employer identification number for a business), a brief description of the alleged violation, the years involved, the estimated dollar amount of any unreported income. a. Incorrect. The amended return simply corrects an individual s own submitted return for the past tax year; it does not report tax cheats. b. Incorrect. This form is not submitted by a whistleblower reporting tax cheats. c. Incorrect. Schedule E is submitted by individuals and businesses to report rent and royalty income as well as pension, annuity, estate or trust, and small business income. 3. a. Correct. Although the IRS has noted increased collections, recent developments in collections are revised installment agreement rules and online payment agreements. Offers-in-compromise are not one of the hot spots now receiving substantially increased funding. b. Incorrect. Initiatives of the Large and Mid-Size Business Division are increasing money and time on abusive tax shelters, appeals, and the fast track settlement program. c. Incorrect. Criminal investigations are unprecedented in number, and criminal statues are in the IRS repertoire for attacking tax cheats. d. Incorrect. The PACI program, Credit Counseling Compliance Project, and executive compensation practices initiative are just some of the hotbutton enforcement areas for tax-exempt organizations. 4. d. Correct. All three choices are varieties of fraud for which the IRS and Justice Department are devising criminal as well as monetary penalties. a. Incorrect. Healthcare fraud is a program of the Criminal Investigation Division. b. Incorrect. The Criminal Investigation Division of the IRS and the Department of Justice are developing criminal penalties for insurance fraud. c. Incorrect. A corporate fraud program is being implemented by the IRS and Department of Justice. 5. d. Correct. All three of these types of transactions are reportable transaction categories. a. Incorrect. If the tax credits exceed $250,000 from the transaction, it is reportable if the asset is held for a period the IRS considers to be brief. Top_Fed_07_book.indb /15/2006 2:42:06 PM

101 10.22 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE b. Incorrect. If the taxpayer or related party has the right to receive refunded fees if the tax consequences of a transaction are not sustained, the transaction has contractual protection. c. Incorrect. If a taxpayer pays a minimum fee to an advisor to participate in a transaction offered under conditions of confidentiality, the confidential transaction is a type of reportable transaction. 6. False. Correct. Just the opposite is true. The FTS program has worked well for large corporations but as yet has not been applied as successfully to medium or small companies undergoing audit examinations. True. Incorrect. The FTS program has been much more successful for large, global corporations than for audits of small or even medium-sized corporations. 7.d. Correct. Leaders may express their opinions on political matters as individuals, but not in publications or at functions sponsored by the organization. They are forbidden to endorse candidates in public policy statements issued by the organization. a. Incorrect. Code Sec. 501(c)(3) leaders are prohibited from expressing political opinions in official organization publications. b. Incorrect. Leaders cannot express biased political views at organization functions. c. Incorrect. Leaders cannot favor one candidate compared to another in any positions the organization takes on a public policy issue. The organization may, however, take positions on such issues as long as their statements maintain unbiased positions. 8. d. Correct. Auditing new agencies soon after they launch operations is not one of the initiative s plans. a. Incorrect. As a preventive measure, the IRS will impose a stricter determination process for agencies to achieve tax-exempt status. b. Incorrect. As an educational outreach, the IRS is posting its educational materials on its website and plans to launch another site dedicated to the area of credit counseling organizations. c. Incorrect. The IRS compliance check questionnaires are completed by agencies to determine whether the agencies have compliance problems and if the IRS determines there are problems it will issue written advisories, enter into closing agreements, or refer the agencies for examination. 9. b. Correct. The closing agreement is issued when the IRS believes it likely that the agency can correct its problems. a. Incorrect. This is not the point at which the IRS issues the closing agreement. Top_Fed_07_book.indb /15/2006 2:42:06 PM

102 ANSWERS TO STUDY QUESTIONS CHAPTER c. Incorrect. The closing agreement is not a dictate to cease operations. d. Incorrect. One of the choices is the circumstance in which the IRS issues the closing agreement. 10. a. Correct. The IRS ruled that seller-funded down-payment assistance programs exist more to benefit the sellers than assist buyers in making down payments. b. Incorrect. Although hospitals are receiving questionnaires regarding compliance with their community benefit standard and excessive compensation of hospital employees, hospitals as a type of charitable organization remain tax-exempt. c. Incorrect. Credit counseling agency practices are being scrutinized and some agencies are losing tax-exempt status, but others remain qualified as tax-exempt organizations. d. Incorrect. Only one of the choices reflects a type of organization disqualified for tax-exempt status. 11. c. Correct. Donors in most cases receive economic benefits from the donation that are greater than those received by the general public for the easement. a. Incorrect. The IRS does not rule on whether the easements have been properly placed on historical property. b. Incorrect. Whether the deduction amounts match the property s value is not the central issue questioned by the IRS. d. Incorrect. The IRS is not involved in the eventual use of the easement or façade. 12. a. Correct. If a plan or plan sponsor has been involved in such a transaction, the self-correction program may not be used to correct the related failures. b. Incorrect. The plan may still use the voluntary correction program. c. Incorrect. The Audit Closing Agreement program remains available to such plans and sponsors despite the participation in the abusive transaction. d. Incorrect. One of the programs becomes unavailable to the plan if it or its sponsor has been involved in an abusive tax avoidance transaction. 13. d. Correct. All three choices reflect situations in which the VCAP program is unavailable to bond issuers. a. Incorrect. The bond issue may not be under examination if issuers wish to use VCAP to settle their violation. b. Incorrect. VCAP is unavailable for bonds whose tax-exempt status is in question. Top_Fed_07_book.indb /15/2006 2:42:07 PM

103 10.24 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE c. Incorrect. The program may not be used if the violation is determined by the IRS to be due to willful neglect. 14. a. Correct. Tax evasion by trusts, LLCs, LLPs, international business companies, foreign financial account, and offshore credit/debit cards is the focus of the Abusive Tax Schemes Program. b. Incorrect. C corporations are not the focus of this program. Rather, the Presidential Corporate Fraud Task Force of President Bush addresses violations by corporations or their officers. c. Incorrect. CFCs are not the focus of the Abusive Tax Schemes Program. d. Incorrect. Only one type of entity is the focus of this program. 15. c. Correct. This program is designed to address violations by employers of the employment tax laws, such as paying employees in cash and filing false payroll tax returns. a. Incorrect. The Corporate Fraud Program is a multiagency effort including the Presidential Corporate Fraud Task Force, so it is not a strictly a CID program nor does it focus on employment taxes. b. Incorrect. The Excise Tax Fraud program focuses on violations of the motor fuel excise tax, not withholding of payroll taxes. d. Incorrect. This program s focus is on illegal gambling operations, money laundering, and currency violations. MODULE 3 CHAPTER 9 1. a. Correct. PPA made permanent the higher annual maximum IRA contribution, catch-up IRA contributions, and accelerated vesting of employer-match retirement contributions. b. Incorrect. PPA did not repeal the sunset of the marriage penalty relief. c. Incorrect. Lower marginal tax rates were not made permanent under PPA. d. Incorrect. Only one choice reflects tax cuts made permanent by PPA. 2. b. Correct. Individuals age 50 or older by the end of 2006 may contribute up to $1,000 in addition to the $4,000 maximum contribution. a. Incorrect. Previously the catch-up contribution limit for IRAs was $500, but it is higher for c. Incorrect. The maximum catch-up contribution for IRAs is a different amount. SIMPLE plans have a maximum catch-up limit of $2,500. d. Incorrect. The maximum catch-up contribution for 401(k), 403(b), 457, and SEP plans is $5,000, but IRAs have a lower catch-up ceiling. 3. b. Correct. The new Roth accounts are available to everyone who is a participant in a 401(k) or 403(b) plan that allows the after-tax contributions. a. Incorrect. The plans are not offered to all employed taxpayers. Top_Fed_07_book.indb /15/2006 2:42:07 PM

104 ANSWERS TO STUDY QUESTIONS CHAPTER c. Incorrect. The Roth accounts do not apply to rollovers from traditional or Roth IRAs. d. Incorrect. Only one choice is the type of taxpayer for whom the Roth 401(k) and 403(b) plans are available. 4. d. Correct. Required substantiation for donations of any gift of $250 or more includes a good faith value estimate, written acknowledgment, and statement of any goods or services received in exchange. a. Incorrect. The good faith estimate is a required form of substantiation for gifts of this amount. b. Incorrect. The charity must provide a written acknowledgment that contains a description of the contribution. c. Incorrect. Tax rules require not only to state a quid pro quo exchange for the contribution but that the taxpayer subtract the value of the goods or services received in the exchange for his or her donation. 5. a. Correct. The maximum allowed to be expensed (unadjusted for inflation) is $100,000 reduced by any amount exceeding $400,000. b. Incorrect. The amount allowed to be expensed (unadjusted for inflation) has a different maximum reduced by any amount exceeding a different threshold. c. Incorrect. Both amounts for expensing are lower. d. Incorrect. The maximum allowed to be expensed (unadjusted for inflation) is a higher amount reduced by any amount exceeding a different threshold. 6. d. Correct. Children younger than age 18 who have net unearned income exceeding $1,700 are subject to the kiddie tax. Prior to TIPRA, the kiddie tax applied if the child was younger than age 14. a. Incorrect. The net unearned income amount is higher than $700. b. Incorrect. The kiddie tax applies to net unearned income exceeding a different amount. c. Incorrect. This is not the threshold for applying the kiddie tax. 7. c. Correct. The TIPRA extensions align the dividend and capital gains rate cuts with other EGTRRA tax cuts so that they all extend through 2010 only. a. Incorrect. TIPRA extended many existing temporary tax cuts and incentives beyond b. Incorrect. Only the AMT offsets will be reconsidered in d. Incorrect. Tax incentives were made permanent by TIPRA but the other EGTRRA incentives will sunset. Top_Fed_07_book.indb /15/2006 2:42:07 PM

105 10.26 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 8. b. Correct. Third-party collectors cannot work cases in which the taxpayer qualified for an installment agreement longer than five years, not two. a. Incorrect. Third-party collectors cannot pursue bankruptcy cases. c. Incorrect. The third-party debt collectors cannot take enforcement actions involving liens, levies, or property seizures. d. Incorrect. Third-party debt collectors cannot be involved in offers-incompromise. 9. c. Correct. An opt-out letter to the private debt collection firm should instruct the account to be returned to the IRS. a. Incorrect. Although the Taxpayer Advocate may be contacted if the taxpayer questions the conduct of the third-party debt collector, that office is not the proper channel for rejecting the move to the private debt collections firm. b. Incorrect. The outsourcing is unconnected to the appeals process for collections efforts. d. Incorrect. By law the taxpayer can have his or her account returned to the IRS collections personnel. 10. d. Correct. Under the rule, only an amount paid for the acquisition or production of a unit of property with an economic useful life of 12 months or less is not a capital expenditure. a. Incorrect. While the general rules remains that capitalization is required when useful life is substantially beyond one year, the new regs provide a safe-harbor that reduces the cutoff to a more measurable (and shorter) more-than-one-year. b. Incorrect. All direct materials and direct labor, and all indirect costs that directly benefit or are incurred by reason of production/improvement activities are capitalized to the property being produced or acquired. c. Incorrect. The 12-month rule generally applies unless the taxpayer elects not to apply the 12-month rule, which election may be made with regard to each unit of property that the taxpayer acquires or produces. 11. b. Correct. This is the definition under Code Sec a. Incorrect. Local service is not part of the term s definition. c. Incorrect. This is not the name of the term as defined under Code Sec d. Incorrect. One of the choices is the correct name of the term as defined under Code Sec Top_Fed_07_book.indb /15/2006 2:42:07 PM

106 ANSWERS TO STUDY QUESTIONS CHAPTER c. Correct. Phishing scams solicit credit card and bank account information on sites that promise refunds from the IRS. a. Incorrect. Accounting services are not part of the phishing scams. b. Incorrect. Phishing scams do not pretend to offer services such as tax preparation or help for taxpayers under examination. d. Incorrect. Infecting computer systems with viruses or Trojan horse files is not phishing. 13. b. Correct. Such incentives are subject to regular tax for employees. a. Incorrect. The tax credit is available in addition to any employer-provided incentives for the purchases. c. Incorrect. Employers receive no credit for offering the incentives. d. Incorrect. One of the choices is a tax consequence of the incentives. 14. c. Correct. PPA provides that all appeals of adverse CDP determinations shall be made to the Tax Court. a. Incorrect. Another venue was prohibited for review requests under PPA. b. Incorrect. The appeals process within the IRS that must be used prior to being able to bring the matter to court, is not affected by PPA mandate for reviews of CDP determinations. d. Incorrect. One of the choices was eliminated as a source for requesting review of an adverse collections decision. 15. c. Correct. GSK agreed to make a $3.4 billion payment to settle the dispute and to abandon its $1.8 billion refund claim. a. Incorrect. The case reached settlement during b. Incorrect. GSK was not upheld in its refund bid. d. Incorrect. One of the choices reflects the outcome. Top_Fed_07_book.indb /15/2006 2:42:08 PM

107 12.19 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Quizzer Questions: Module 3 Answer the True/False questions by marking a T or F on the Quizzer Answer Sheet. Answer Multiple Choice questions by indicating the appropriate letter on the Answer Sheet. 81. The Tax Increase Prevention and Reconciliation Act of 2005 limits the manufacturing deduction to no more than percent of the W-2 wages paid to generate DPGR. a. 25 b. 50 c. 75 d. None of the above 82. All of a taxpayer s gross receipts from an item s disposition may be treated as non-dpgr if less than percent of the receipts qualify as domestic production gross receipts. a. 1 b. 2 c. 5 d Which of the following computer products is not an example of qualified production property? a. Software downloaded from the developer s website b. A maintenance agreement bundled with the price of purchased software c. Telephone support for the program d. Substantially identical software Top_Fed_07_book.indb /15/2006 2:42:16 PM

108 12.20 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 84. A taxpayer satisfies the in whole or significant part safe harbor for MPGE activities if conversion costs, direct labor, and overhead to MPGE property incurred by the taxpayer domestically are percent or more of the total COGS attributable to the property. a. 10 b. 20 c. 25 d Which of the following is not a permitted method for allocating and apportioning deductions? a. Simplified overall method b. Simplified deduction method c. Code Sec. 861 method d. Cost of goods sold method 86. TIPRA amended the rules for allocating QPAI of passthrough entities effective: a. On or before May 17, 2006 b. After May 17, 2006 c. After September 30, 2006 d. Beginning January 1, For members of an expanded affiliated group of corporations, the 5 percent of gross receipts de minimis rule: a. Is applicable to the individual members b. Is applicable at the group level c. Is applicable selectively d. Is not applicable 88. In calculating alternative minimum tax, the manufacturing deduction is percent of the lesser of QPAI or AMTI. a. 9 b. 10 c. 15 d Installation charges are one of the embedded services considered to be qualified production property. True or False? Top_Fed_07_book.indb /15/2006 2:42:16 PM

109 QUIZZER QUESTIONS Module A taxpayer satisfies the in whole or significant part requirement for MPGE activities if it manufactures goods in significant part in the United States and exports the goods for further manufacturing outside the United States. True or False? 91. According to the IRS five-year plan, IRS enforcement programs and late payments help close of the annual tax gap. a. Less than one-fifth b. About one-third c. Approximately half d. Three-fourths 92. Serving as tax-indifferent parties in tax shelters, being used as a front for profit-making purposes, and working for a private political agenda are types of abuses perpetrated by: a. Fraudsters b. Tax-exempt organizations c. Off-shore tax haven representatives d. Tax advisers and preparers 93. What is the single main characteristic of an abusive tax shelter according to the IRS? a. A tax shelter has multiple business purposes b. A tax shelter uses aggressive tax-planning techniques c. A tax shelter hides proceeds in off-shore tax havens d. A tax shelter lacks economic substance 94. The Office of Tax Shelter Analysis was opened by the the IRS. a. Department of Justice jointly with b. Criminal Investigation Division of c. Large and Mid-Size Business Division of d. None of the above 95. Transactions having a significant book-tax difference are a type of: a. Confidential transaction b. Loss transaction c. Listed transaction d. Reportable transaction Top_Fed_07_book.indb /15/2006 2:42:16 PM

110 12.22 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 96. To fight the tax shelter scheme in which people transferred stock options to family-controlled entities created just to receive the options and avoid taxes on compensation income, the IRS launched the: a. Executive Stock Options Settlement Initiative b. Son of Boss Shelter Initiative c. Abusive Transaction Settlement Initiative d. None of the above 97. The Political Activities Compliance Initiative (PACI) seeks to curb political campaign intervention by: a. Third-party candidates and their supporters b. Tax-exempt organizations under Code Sec. 501(c)(3) c. Government appointees under patronage obligations d. None of the above 98. The penalty for violating the political activity prohibition of PACI is: a. Payment of back taxes for years in which the violations occurred b. Enforced dissolution of the organization c. Large monetary penalties d. Loss of tax-exempt status 99. The primary tool the IRS uses to evaluate whether the reasonable compensation reporting and disclosure requirements are met for taxexempt organizations is: a. Form 3949-A b. Form 990 c. Form 945 d. Form All of the following are results of new rules for the Employee Plans Compliance Resolution System (ECPRS) except: a. Relief for participants of plan loan failures taxed under Code Sec. 72(p) b. Availability of the program to plans that have no employer maintaining them c. Lower fees for the voluntary compliance programs d. All three choices are results of the expanded rules of the system Top_Fed_07_book.indb /15/2006 2:42:16 PM

111 QUIZZER QUESTIONS Module The Criminal Investigation Division s enforcement program targeted at the untaxed underground economy to find illegal source proceeds on which individuals have not paid tax is the: a. Legal Source Tax Crimes Program b. Illegal Source Financial Crimes Program c. Financial Institution Fraud Program d. Nonfiler Enforcement project 102. The international task force established to share tax shelter information includes the countries of Australia, United Kingdom, United States, and Canada. True or False? 103. Under the PACI rules, political candidates are not allowed to appear at functions of Code Sec. 501(c)(3) organizations. True or False? 104. Under PACI, Code Sec. 501(c)(3) organizations are responsible for biased content in other websites linked to their sites, even though the organizations have no control over the content of the other sites. True or False? 105. In parallel proceedings, the IRS now continues a civil examination of the taxpayer s tax investigation while the Criminal Investigation Division determines whether to press criminal charges against the same taxpayer. True or False? 106. For 2006, the maximum traditional or Roth IRA contribution without a catch-up contribution is: a. $2,000 b. $4,000 c. $5,000 d. $5,000 plus an inflation adjustment 107. Which type of retirement plan has the highest maximum catch-up contribution for 2006? a. SIMPLE plans b. Roth IRAs c. 401(k) and similar plans d. Traditional IRAs Top_Fed_07_book.indb /15/2006 2:42:16 PM

112 12.24 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 108. Under the Pension Protection Act, a charitable deduction for the donation of ordinary clothing and household goods was: a. Eliminated b. Restricted to items worth more than $100 c. Restricted to items in good-or-better condition d. Restricted to items that are valued by a professional appraiser 109. The saver s credit for low- and middle-income taxpayers is calculated by multiplying the amount of qualified retirement savings contributions times the credit rate, which is based on. a. The taxpayer s marginal tax bracket b. Half of the taxpayer s age c. The number of exemptions the taxpayer claims d. The taxpayer s filing status and adjusted gross income 110. Under the tightened PPA rules for deducting charitable donations of clothing, no deduction is allowed unless: a. The clothing is used for charitable causes by the recipient organization and not resold b. The clothing is in good condition c. The clothing is given to domestic charitable organizations and not shipped overseas d. None of the above 111. TIPRA extended for 2006-only an offset to the alternative minimum tax of: a. Nonrefundable personal credits b. General business credit c. State, local, and foreign tax payments d. Miscellaneous itemized deductions 112. Special treatment for conversions of traditional to Roth IRAs allowing income recognition over two years instead of one will apply only to the year: a b c d Top_Fed_07_book.indb /15/2006 2:42:17 PM

113 QUIZZER QUESTIONS Module TIPRA raised the age for applying the kiddie tax to children s unearned income from age 14 to: a. 15 b. 16 c. 17 d Under TIPRA, taxpayers (except lower-income taxpayers) filing a lump-sum offer for an offer-in-compromise must pay of the offer amount with the application as a nonrefundable tax payment. a. 20 percent b. 25 percent c. 35 percent d. 50 percent 115. Under the bright-line rule for capitalizing tangible assets, taxpayers cannot capitalize amounts paid to acquire or produce property that has a useful life equal to or less than: a. 12 months b. 18 months c. 24 months d. 36 months 116. Taking into account the latest extension of the reduction of the net capital gain rates introduced in the Economic Growth and Tax Relief Reconciliation Act of 2001, as well as prior extensions, the rates for 2007 are: a. 0 percent for 10 and 15 percent income tax bracket taxpayers and 15 percent for taxpayers in higher brackets, for both long-term capital gain and qualified dividends b. 5 percent for 10 and 15 percent income tax bracket taxpayers and 15 percent for taxpayers in higher brackets, for both long-term capital gain and qualified dividends c. 10 percent for 10 and 15 percent income tax bracket taxpayers and 20 percent for taxpayers in higher brackets, for both long-term capital gain and qualified dividends d. 5 percent for 10 and 15 percent income tax bracket taxpayers and 15 percent for taxpayers in higher brackets, for long term capital gain but no longer available for qualified dividends Top_Fed_07_book.indb /15/2006 2:42:17 PM

114 12.26 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 117. The standard safe harbor amount for individual taxpayers having four exemptions who claim refunds of the federal telephone tax based on actual tax paid is: a. $50 b. $60 c. $75 d. $ To encourage consumers to purchase green (hybrid) vehicles, Congress: a. Issued a tax credit for the vehicles purchased from certified manufacturers b. Mandated a new, larger itemized deduction for the vehicles starting in 2006 c. Exempted employer-provided cash incentives to purchase the vehicles from tax d. None of the above 119. Under Circular 230 revisions made in 2006, tax return preparers may represent taxpayers during an examination: a. Only if they did not prepare the taxpayers returns b. Only if they are enrolled c. If they are unenrolled, only if they prepared the returns d. None of the above 120. The new process for technical advice memoranda (TAM) deadlines: a. Allows Chief Counsel 120 fewer days to prepare b. Shortens the taxpayer s response time for government requests to 5 days maximum c. Grants Chief Counsel 60 days longer but taxpayers 15 fewer days to streamline the process d. None of the above Top_Fed_07_book.indb /15/2006 2:42:17 PM