Tax Watch: In wake of new tax law, time for planning

It’s number crunching time! Tax planning will be driven by projections of the impact of changes in the tax law over the next 10 years – even without the complications of additional tax legislation that is bound to follow.

And that’s the good news from the recently passed Tax Relief Reconciliation Act of 2001. Its centerpiece is a $958 billion consolidation and reduction of the marginal tax rates for individuals.

Most taxpayers should come out ahead under the rate cuts, which start with the creation of a new 10% rate bracket that will result in “advance refund” checks being issued to most taxpayers. All other individual income tax rates (except the 15% rate) also are cut for 2001, effectively by 0.5% across the board.

Figuring out winners and losers by running through the new tax rate schedules is the easy part. Far more complicated is assessing the relative importance that lower rates will have in driving future tax strategies. For example:

* Capital gains – Even before the ink has dried on the law, an effort is being made to bring net gains from the sale of long-term capital assets into the tax cut arena.

As it stands, beginning in 2006, the difference between long-term capital gains for the average investor and ordinary income tax rates will be 5, 8, 13 or 17 percentage points, depending on the bracket – hardly enough for many taxpayers to seriously consider planning.

* Family income shifting – Use of the lower tax brackets is one mainstay of family income shifting.

As long as the family member is not subject to the “kiddie tax” (for those under 14 years of age), shifting as much as $6,000 in dividend or interest income to a child or other family member can save 25% in taxes (the difference between the new 10% and 35% brackets) even when the new rates are fully phased in.

* Retirement planning – Although reduced tax rates will leave some taxpayers with more money to put into individual retirement accounts or 401(k) plans, they will also make savings for retirement on a tax-deferred basis less of a priority. One clear exception is that lower tax rates should make Roth IRAs more attractive, especially with many experts predicting that rates will likely increase by the time IRA assets are withdrawn.

* Choice of entity – Personal-service corporations are currently taxed at a flat 35%, while regular corporations are taxed at between 15% and 38%.

With personal income tax rates moving substantially lower than the average corporate rate, more financial planners and small-business owners may consider organizing and operating sole proprietorships, partnerships and S corporations rather than C corporations.

* Tax-free investments – A rate cut makes tax-exempt investments less competitive unless they are able to match the change with higher yields. Similarly, the benefits of operating as a tax-exempt organization are devalued.

* The AMT – Everyone subject to the alternative minimum tax will receive no reduction in taxes. Rates are still 26% for the first $175,000 of AMT income after applying a $45,000 exemption (unadjusted for inflation since 1986) and at 28% for the balance.

According to many projections, under the new tax law, the number of taxpayers subject to the AMT is expected to increase sixfold.

The law does, however, begin to address a part of the AMT problem. It makes permanent the use of the child credit to offset AMT and repeals the AMT offsets of refundable credits. It also increases the AMT exemption for joint filers by $4,000 and single taxpayers by $2,000, but only for the 2001-2004 period.

The IRS is asking

about burdens

As part of a continuing effort to improve service, the Internal Revenue Service is conducting a survey to measure the time and cost burdens placed on business taxpayers in complying with tax laws.

The survey, sponsored by the IRS’ large- and-midsize-business division, includes a version for business taxpayers and one for practitioners. About 2,500 taxpayers and 2,000 practitioners have been randomly selected and are being mailed a request to participate in the anonymous survey.

Two weeks later, they will be mailed the survey itself. The survey seeks to gather information on businesses’ costs for outside preparation of tax forms and documents, as well as on the time and money businesses spend on compliance within the company.

The costs may be associated with record keeping, purchase of tax software, internal preparation of tax forms and documents, or any other income tax-related activity or product.

The survey also asks participants to identify provisions of the tax code that they have the most difficulty in complying with, and areas in which time and cost burdens could be reduced.

The University of Michigan helped design and will independently conduct the survey to ensure impartiality, confidentiality and anonymity of the taxpayers and practitioners.

The university will analyze the survey results and submit a report to the IRS.

The report will quantify the burden and identify the most- and least-burdensome aspects of compliance, as well as areas of potential burden reduction.

Cite: IRS News Release No. IR-2001-55

IRS chief counsel:

No compromise

The IRS should not bend when it comes to a taxpayer’s tax shelter-related liabilities, even if such a compromise is based on the promotion of effective tax administration, according to the office of the IRS chief counsel.

The taxpayer invested as a limited partner in a partnership that produced significant investment tax credits. When the taxpayer learned that the IRS considered the entity a tax shelter and would disallow the credits, he filed amended returns to remove partnership-related items. The IRS did not process the new returns.

The taxpayer settled with the IRS on adjustments to partnership items, but not on related penalties. He then offered to compromise, arguing that holding him liable for full payment would be unfair and therefore detrimental to voluntary compliance.

The chief counsel’s office advised that the tax shelter-related liabilities should not be compromised based on the promotion of effective tax administration.

The chief counsel said the taxpayer’s personal profit motive was not relevant to determining the tax-motivated transaction interest he sought to avoid, regardless of whether the scheme was fair.

When Congress enacts a comprehensive scheme that dictates a certain result, a decision to categorically disregard that scheme is beyond the IRS’ authority, the chief counsel concluded.

Cite: Chief Counsel Advice: CCA 200121012

You win some

and lose some

The U.S. Tax Court recently ruled that one individual’s mining activities were for profit under the tax laws. Unfortunately, despite the favorable ruling, the taxpayer was subject to accuracy-related penalties for negligence.

James Tinnell, a doctor, practiced medicine at all relevant times, according to the court transcript. In 1973, Dr. Tinnell and his father bought Delta Roofing Mills. Dr. Tinnell participated in the management of Delta and helped triple its gross sales before its sale five years later.

In 1974, Dr. Tinnell moved to Nevada and invented an ointment, Herpaway. In 1980, He and his partner, Dr. Edwin McKay, formed Zila Pharmaceuticals to manufacture and distribute the ointment, and the business was very successful.

In 1978, Dr. Tinnell became interested in mining and began reading about it and searching for gold.

In 1994 and 1995, Dr. Tinnell expanded his business to include the sale of decorative rock. Those sales grew steadily, and he generated substantial income from them. Most of the mining was financed with royalties from Zila, sales of Zila stock and the exercise of stock options.

Tax Court Judge L. Paige Marvel considered whether Dr. Tinnell had a good-faith objective to realize a profit, so that his deductions wouldn’t be limited by Section 183, “Not-for-Profit Activities.”

Judge Marvel concluded that the mining was for profit. But the court also concluded that Dr. Tinnell was liable for accuracy-related penalties for the additional income from the stock options.

On his tax return, he took a discount for marketability when reporting the value of certain stock options received, but he did not disclose that on his return.

The court found that disclosure was required and allowed the imposition of the penalty.

Cite: James Tinnell v. Commissioner, T.C. Memo 2001-106