BMY Professional Services – 2011 Tax Highlights

The following is a summary of the most important tax developments that have occurred in 2011 that may affect you, your family, your investments, and your livelihood. Please call us for more information about any of these developments and what steps you should implement to take advantage of favorable developments and to minimize the impact of those that are unfavorable.

Guidance on 100% bonus depreciation and other bonus depreciation issues. The IRS has issued detailed guidance on the 2010 Tax Relief Act’s 100% bonus depreciation rules for qualifying new property generally acquired and placed in service after Sept. 8, 2010 and before Jan. 1, 2012. Overall, the rules are quite generous. For example, they permit 100% bonus depreciation for components, even if work on a larger self-constructed property that includes the components began before Sept. 9, 2010, allow a taxpayer to elect to “step down” from 100% to 50% bonus depreciation for property placed in service in a tax year that includes Sept. 9, 2010, and provide an escape hatch for some business car owners who would otherwise be subject to a draconian depreciation result. The guidance also addresses other bonus depreciation issues. For example, the guidance permits 100% bonus depreciation for qualified restaurant property or qualified retail improvement property that also meets the definition of qualified leasehold improvement property.

New law creates a 100% write-off for heavy SUVs used entirely for business. Under the 2010 Tax Relief Act, a taxpayer that buys and places in service a new heavy SUV after Sept. 8, 2010 and before Jan. 1, 2012, and uses it 100% for business, may write off its entire cost in the placed-in-service year. A heavy SUV is one with a gross vehicle weight (GVW) rating of more than 6,000 pounds.

IRS further delays health insurance coverage information reporting for small employers. The new health reform legislation generally requires employers to report the cost of health insurance they provide to employees on their W-2 forms. Last fall, the IRS made this new reporting requirement optional for all employers for the 2011 Forms W-2. More recently, the IRS announced that the reporting requirement will continue to be voluntary for small employers (i.e., those filing fewer than 250 Forms W-2) at least through 2012, or until further guidance is issued by IRS.

New settlement offer for those voluntarily disclosing unreported offshore income. The IRS has announced a second voluntary disclosure initiative designed to bring offshore money back into the U.S. tax system and help people with undisclosed income from hidden offshore accounts get current with their taxes. It will be available through Aug. 31, 2011. The IRS released details of the new voluntary offer, called the 2011 Offshore Voluntary Disclosure Initiative (OVDI), in the form of 53 frequently asked questions (FAQs). As with the first offer, participants have to pay back taxes and penalties but will avoid criminal prosecution. The offshore penalty is different under the new offer. The general rule is that the penalty is 25% based on amounts in foreign bank accounts, but can be as low as 12.5% or 5% for some taxpayers.

IRS eases lien procedures. The IRS has announced new policies and programs to help taxpayers pay back taxes and avoid tax liens. Its goal is to help individuals and small businesses meet their tax obligations, without adding an unnecessary burden to taxpayers. Specifically, the IRS is:

Significantly increasing the dollar threshold when liens are generally issued, resulting in fewer tax liens.
Making it easier for taxpayers to obtain lien withdrawals after paying a tax bill.
Withdrawing liens in most cases where a taxpayer enters into a Direct Debit Installment Agreement.
Creating easier access to Installment Agreements for more struggling small businesses; and
Expanding a streamlined Offer in Compromise program to cover more taxpayers.

Lactation expenses now qualify as deductible medical expenses. Reversing its prior position, the IRS has announced that expenses paid for breast pumps and supplies that assist lactation qualify as deductible medical expenses. Amounts reimbursed for these expenses under FSAs (flexible spending accounts), Archer MSAs (medical savings accounts), HRAs (health reimbursement arrangements), or HSAs (health savings accounts) are accordingly not income to the taxpayer.

Tax consequences of governmental homeowner-assistance payments. The IRS has explained the income tax and information return consequences of payments made to or on behalf of homeowners under various government programs designed to prevent avoidable foreclosures of homeowners’ homes and stabilize housing markets. In general, homeowners may exclude the payments from income, and may deduct all payments they actually make during 2010–2012 to the mortgage servicer, HUD (the Department of Housing and Urban Development), or the State HFA (housing finance agency) on the home mortgage. The aid payments aren’t subject to information reporting, and there are transition rules for payments that are incorrectly reported.

Courts differ over whether basis overstatement can trigger 6-year limitations period under new regulations. Late last year, the IRS issued final regulations under which an understated amount of gross income reported on a return resulting from an overstatement of unrecovered cost or other basis is an omission of gross income for purposes of the 6-year period for assessing tax and the minimum period for assessment of tax attributable to partnership items. The 6-year limitations period applies when a taxpayer omits from gross income an amount that’s greater than 25% of the amount of gross income stated in the return. Several courts had held that a basis overstatement is not an omission of gross income for this purpose. In response to these decisions, the IRS issued the new regulations to clarify that an omission can arise in that fashion. Now, some Courts have addressed the regulations. The Court of Appeals for the Fourth Circuit and the Tax Court have rejected the regulations. On the other hand, the Federal Circuit has upheld them and the Seventh Circuit has viewed them favorably. As a result, it looks like the Supreme Court will ultimately have to resolve the issue.

New deadline for electing modified carryover basis rules. Estates of decedents dying in 2010 can choose zero estate tax, but at the price of beneficiaries being limited to the decedents’ basis plus certain increases. The IRS has announced that Form 8939, Allocation of Increase in Basis for Property Acquired From a Decedent, is not due Apr. 18, 2011 and should not be filed with the final Form 1040 of persons who died in 2010. The IRS says the due date will be set in forthcoming guidance but does not indicate when that guidance may be issued. The forthcoming guidance will also explain the manner in which an executor of an estate may elect to have the estate tax not apply for a decedent dying in 2010.

Another Appeals Court upholds IRS’s time limit on spousal relief requests. Married joint return filers are jointly and severally liable for the tax arising from their returns. Innocent spouses may request relief from this liability in certain circumstances. An IRS regulation states that a request for equitable innocent spouse relief must be no later than two years from the first collection activity against the spouse. The Tax Court had found this regulation invalidly imposed a time limit. However, the Court of Appeals for the Third Circuit has reversed the Tax Court and upheld the regulation (so has the Court of Appeals for the Seventh Circuit).

Business expenses of professional gamblers not limited. Gambling losses may be deducted only to the extent of gambling winnings, even in the case of an individual engaged in the trade or business of gambling. Previously, the Tax Court had held that losses for purposes of the limitation included both the cost of wagers and business expenses. Earlier this year, the Court overruled its prior position and now says that a professional gambler’s business expenses are not subject to the loss limitation.

Physician statement alone doesn’t establish financial disability to toll limitations period. In general, a taxpayer must file a claim for credit or refund of tax within three years after filing the return or two years after paying the tax, whichever period expires later. (Code Sec. 6511(a)) However, the statute of limitations is suspended for certain taxpayers who are unable to manage their financial affairs because of a medically determinable mental or physical impairment. A physician’s statement must be submitted to claim this relief, but a Court has made clear that the statement alone doesn’t establish that the taxpayer was financially disabled. Thus, it allowed the IRS to seek additional proof of the taxpayer’s condition.

Standard mileage rates increase for last half of 2011. The IRS has announced that the optional mileage allowance for owned or leased autos (including vans, pickups or panel trucks) is increased 4.5¢ from 51¢ to 55.5¢ per mile for business travel from July 1, 2011 to Dec. 31, 2011 to better reflect the real cost of operating an auto in this period of rapidly rising gas prices. This rate can also be used by employers to reimburse tax-free under an accountable plan employees who supply their own autos for business use, and to value personal use of certain low-cost employer-provided vehicles. The rate for using a car to get medical care or in connection with a move that qualifies for the moving expense also increases 4.5¢ for the last half of 2011 from 19¢ to 23.5¢ per mile.

FUTA surtax is no longer in effect. Beginning July 1, 2011, the 0.2% federal unemployment tax (FUTA) surtax is no longer in effect. Thus, the FUTA tax rate, before consideration of state unemployment tax credits, is now 6.0%. Employers need to separately track FUTA taxable wages paid before July 1, 2011, and FUTA taxable wages paid after June 30, 2011, since the FUTA tax rates are different during those two periods. Employers whose FUTA tax is more than $500 for the calendar year need to make quarterly FUTA deposits. The next quarterly payment is due on Aug. 1, 2011, but that payment is based on taxable wages paid through June 30, 2011, so it will be computed using the 6.2% FUTA tax rate. However, the payment after that is due on Oct. 31, 2011, and it will be computed using the 6.0% FUTA tax rate if legislation is not enacted to retroactively reinstate the FUTA surtax beginning July 1, 2011.

Two bonus depreciation deductions for one expenditure. Under IRS regulations, businesses that trade in machinery or equipment for which they claimed bonus depreciation may qualify for another bonus depreciation deduction on the remaining depreciable basis if they swap for like-kind property that also is eligible for bonus depreciation. In effect, the business gets two bonus depreciation deductions for its expenditure on the traded-in property.

Real estate professionals allowed late election to aggregate rental real estate interests. The IRS has provided guidance that allows certain real estate professionals to make a late election under the regulations to treat all interests in rental real estate as a single rental real estate activity for purposes of the passive activity loss (PAL) rules. This election can make it easier to currently deduct losses from real estate activities. As a general rule, the election is made by filing a statement with the taxpayer’s original income tax return for the tax year. However, under new guidance, a taxpayer meeting certain conditions can make a late election on an amended return.

More courts treating basis overstatements as triggering 6-year limitations period. Late last year, the IRS issued final regulations under which an understated amount of gross income reported on a return resulting from an overstatement of unrecovered cost or other basis is an omission of gross income for purposes of the 6-year period for assessing tax and the minimum period for assessment of tax attributable to partnership items. The 6-year limitations period applies when a taxpayer omits from gross income an amount that’s greater than 25% of the amount of gross income stated in the return. Several courts had held that a basis overstatement is not an omission of gross income for this purpose. In response to these decisions, the IRS issued the new regulations to clarify that an omission can arise in that fashion. Recently, two Courts of Appeals (the Tenth Circuit and the District of Columbia Circuit) have upheld the regulations. While the momentum clearly is in favor of the IRS on this issue, others courts have rejected the regulations. Ultimately, the Supreme Court will have to resolve the dispute.

Regulations would toughen tax rules for owners of bankrupt disregarded entities. A taxpayer whose debts are forgiven generally has cancellation of debt (COD) income subject to exceptions including one for bankruptcy and one for insolvency. Some taxpayers have taken the position that the bankruptcy exception is available if a grantor trust (trust used in family or business planning) or disregarded entity (e.g., a single-member limited liability company taxed directly to owner) is under the jurisdiction of a bankruptcy court, even if its owner is not. Similarly, some taxpayers have contended that the insolvency exception is available to the extent a grantor trust or disregarded entity is insolvent, even if its owner is not. The IRS has issued proposed regulations that would clarify that the bankruptcy exception is available only if the owner of the grantor trust or disregarded entity is subject to the bankruptcy court’s jurisdiction, and the insolvency exception is available only to the extent the owner is insolvent. They would apply to COD income occurring on or after the date they are published as final regulations.

Trust’s investment advice fees. The Supreme Court has held that investment advisory fees paid by a trust were deductible only to the extent that they exceeded 2% of the trust’s adjusted gross income (AGI), where the investment advisor didn’t charge the trustee anything extra, or treat the trust any differently than it would have treated an individual. Thus, such expenses didn’t qualify for the exception to the 2% of AGI limit in the tax law for costs paid or incurred in connection with the administration of a trust or estate that wouldn’t have been incurred if the property weren’t held in the trust or estate. However, for the sake of administrative convenience, the IRS has provided that, until final regulations are issued, nongrantor trusts and estates will not have to “unbundle” a fiduciary fee (i.e., separate the fee into components that are subject to the deduction limit and those that aren’t). As a result, until the regulations are issued, affected taxpayers can deduct the full amount of a bundled fiduciary fee without regard to the 2% floor.

IRA trustees weren’t liable for Madoff losses. A district court has dismissed all claims brought by holders of self-directed individual retirement accounts (IRAs) against the IRA trustees for losses incurred by the IRAs for investments with Bernard Madoff’s firm. A number of individuals owned self-directed IRAs with IRA agreements that clearly stated that they were solely responsible for making investment decisions in connection with the funds in their IRAs, and that the IRA trustees would not provide any investment advice. Pursuant to instructions given by these IRA owners, the IRA trustees sent IRA funds to Bernard Madoff’s brokerage firm, Bernard L. Madoff Investment Securities LLC, for investment in securities. These funds were ultimately lost in Madoff’s ponzi scheme. The IRA owners sought to hold the IRA trustees responsible for their role in the losses that the IRAs sustained. The action asserted claims under federal common law based on Internal Revenue Code sections governing IRAs, and state law negligence, contract, and unjust enrichment claims. However, the court rejected all such claims.

Another Appeals Court upholds IRS’s time limit on innocent spouse relief requests. Married joint return filers are jointly and severally liable for the tax arising from their returns. Innocent spouses may request relief from this liability in certain circumstances. An IRS regulation states that a request for equitable innocent spouse relief must be made no later than two years from the first collection activity against the spouse. The Tax Court had found this regulation invalidly imposed a time limit. However, the Court of Appeals for the Fourth Circuit has reversed the Tax Court and upheld the regulation (as have the Courts of Appeals for the Third and Seventh Circuits).

Nonspouse real estate transfers under scrutiny. A recent court case reveals that the IRS has discovered a pattern of taxpayers failing to file gift tax returns for real property transfers between nonspouse related parties. As a result, it launched a compliance initiative to capture data from states and counties regarding real property transfers taking place between nonspouse family members for little or no consideration during the period of Jan. 1, 2005, through Dec. 31, 2010. While the IRS has faced hurdles in attempting to force California to release the data, a number of states have voluntarily done so. These include Connecticut, Florida, Hawaii, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Texas, Virginia, Washington, and Wisconsin. Thus, individuals who transferred real property to nonspouse family members should make sure that required gift tax returns were filed and file amended returns if they weren’t.

New settlement offer for misclassified workers. The IRS has launched a new Voluntary Classification Settlement Program (VCSP) for employees that have been misclassified as independent contractors (or as other nonemployees). The VCSP is available to taxpayers who are currently treating their workers (or a class or group of workers) as independent contractors or other nonemployees and want to prospectively treat the workers as employees. To be eligible, a taxpayer: (a) must have consistently treated the workers as nonemployees; (b) must have filed all required Forms 1099 for the workers for the previous three years; and (c) cannot currently be under audit by the IRS, or currently under audit concerning the classification of the workers by the Department of Labor or by a state government agency. A taxpayer who applies for and is accepted into the VCSP will agree to prospectively treat the class of workers as employees for future tax periods and in exchange:

(A) Will pay 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under reduced rates;

(B) Will not be liable for any interest and penalties on the liability;

(D) Will agree to extend the period of limitations on assessment of employment taxes for three years for the first, second and third calendar years beginning after the date on which the taxpayer has agreed under the VCSP closing agreement to begin treating the workers as employees.

Personal use of employer-provided cell phones generally nontaxable under new guidance. Close to one year after cell phones were removed from the “listed property” category of Code Sec. 280F, the IRS has explained the practical consequences of the change. In sum, where an employer provides employees with cell phones primarily for noncompensatory business reasons, neither the business nor personal use of the phone results in income to the employee, and no recordkeeping of usage is required. And, in most instances, an employer’s reimbursement to employees for their providing a cell phone for bona fide employment-related business use won’t be taxable. The guidance applies for all tax years after Dec. 31, 2009.

Simplified per-diem rates increase slightly for post-Sept. 30 business travel. An employer may pay a per-diem amount to an employee on business-travel status instead of reimbursing actual substantiated expenses for away-from-home lodging, meal and incidental expenses (M&IE). If the rate paid doesn’t exceed IRS-approved maximums, and the employee provides simplified substantiation, the reimbursement isn’t subject to income- or payroll-tax withholding and isn’t reported on the employee’s Form W-2. In general, the IRS-approved per-diem maximum is the GSA per-diem rate paid by the federal government to its workers on travel status. This rate varies from locality to locality. Instead of using actual per-diems, employers may use a simplified “high-low” per-diem, under which there is one uniform per-diem rate for all “high-cost” areas within the continental U.S. (CONUS), and another per-diem rate for all other areas within CONUS. The IRS has issued a new notice carrying the “high-low” simplified per-diem rates for post-Sept. 30, 2011 travel. The high-cost area per-diem increases by $9 to $242, and the low-cost area per-diem increases by $3 to $163. The IRS also has issued a revenue procedure providing rules for using per diem rates to substantiate the amount of ordinary and necessary business expenses paid or incurred while traveling away from home.

Guidance on electing zero estate tax for 2010 decedents. Under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, estates of decedents who died in 2010 can choose zero estate tax, but at the price of beneficiaries being limited to the decedents’ basis plus certain increases under Code Sec. 1022. In early August, the IRS issued detailed guidance on how this election is made. The guidance revealed that the election is made by filing a Form 8939, Allocation of Increase in Basis for Property Acquired From a Decedent. Specifically, Form 8939 is an information return used by the executor of a decedent who died in 2010: (1) to make the Section 1022 Election; (2) to report information about property acquired from a decedent; and (3) to allocate Basis Increase to certain property acquired from a decedent. In general, Form 8939 is due by Jan. 17, 2012.

Time for executors to make portability election for 2011 decedents. In a new notice and accompanying news release, the IRS reminded executors of the estates of married decedents dying after 2010 that they must file an estate tax return in order to pass along the unused estate and gift tax exclusion amount, available for the first time this year, to their surviving spouse. The first estate tax returns for estates eligible to make the portability election started becoming due on Oct. 3, 2011 (i.e., nine months after a post-2010 date of death). Because the IRS believes that most married couples will want the surviving spouse to be able to take advantage of the unused exclusion amount of the first spouse to die, the election is deemed made if a Form 706 (estate tax return) is properly and timely filed. No affirmative statement or other indication is necessary. Even if the estate isn’t required to file a Form 706 (e.g., because the value of the gross estate is less than the exclusion amount), the Form 706 must be filed in ordered to make the election. For estates that choose not to make a portability election, if that estate is otherwise required to file a Form 706, the executor must follow the instructions for Form 706 describing the necessary steps to avoid making the election. For estates that aren’t required to file a Form 706, simply not filing the form will effectively prevent the making of the election.

Foreign financial assets disclosure. For tax years beginning after Mar. 18, 2010, the Hiring Incentives to Restore Employment Act of 2010 provides that individuals with an interest in a “specified foreign financial asset” during the tax year must attach a disclosure statement to their income tax return for any year in which the aggregate value of all such assets is greater than $50,000 (or a dollar amount higher than $50,000 as the IRS may prescribe). “Specified foreign financial assets” are: (1) depository or custodial accounts at foreign financial institutions, and (2) to the extent not held in an account at a financial institution, (a) stocks or securities issued by foreign persons, (b) any other financial instrument or contract held for investment that is issued by or has a counterparty that is not a U.S. person, and (c) any interest in a foreign entity. Disclosure is made by filing Form 8938 (Statement of Specified Foreign Financial Assets) with the taxpayer’s appropriate return (e.g., with Form 1040 in the case of an individual). In September, the IRS released a draft version of the 2011 Instructions to Form 8938. The instructions indicate that under a transitional rule, most taxpayers won’t have to file the form until 2012.

Equitable innocent spouse relief eased. Married joint return filers are jointly and severally liable for the tax arising from their returns. Innocent spouses may request relief from this liability in certain circumstances. Previously, the IRS took the position that a request for equitable innocent spouse relief had to be made no later than two years from the first collection activity against the spouse. After being pressured by legislators and the National Taxpayer Advocate, the IRS has now eliminated the two-year period for equitable relief. Elimination of the two-year period is reflected on Form 8857, which is used to request innocent spouse relief.

Supreme Court to decide whether basis overstatements can trigger six-year limitations period. Late last year, the IRS issued final regulations under which an understated amount of gross income reported on a return resulting from an overstatement of unrecovered cost or other basis is an omission of gross income for purposes of the six-year period for assessing tax and the minimum period for assessment of tax attributable to partnership items. The six-year limitations period applies when a taxpayer omits from gross income an amount that’s greater than 25% of the amount of gross income stated in the return. Several courts had held that a basis overstatement is not an omission of gross income for this purpose. In response to these decisions, the IRS issued the new regulations to clarify that an omission can arise in that fashion. However, some courts have upheld the regulations and others have rejected them. As a result, the Supreme Court has now decided to resolve the dispute.