Since this is our first column of the New Year, it may be particularly appropriate to look back into 2007 to try to predict some of what will happen in 2008. The history of important tax developments that took place in 2007 is rich and varied. Shakespeare's "What is past is prologue" was never so apt.In that spirit, we have selected 10 developments as standouts in terms of their impact on the future, and especially on 2008 tax strategies. We explain each of these top 10 below. And, of course, respecting the difficulty of prioritizing just 10 2007 tax developments as most significant, we conclude by listing several more as runners up!
No. 1: AMT. 2007 has set the stage for the eventual resolution of the exponentially growing grasp of the alternative minimum tax on taxpayers of many different categories, but especially an expanding upper middle class. Admitting there is a problem, however, is only the first step, with full reform or repeal likely awaiting resolution of the 2008 elections. In the meantime, then, 2008 promises to be another exercise in juggling income and assessing the true benefit of deductions and credits when the AMT, rather than the regular tax regime, is required to be applied.
No. 2: Preparer penalty rules. The Small Business and Work Opportunity Tax Act of 2007 significantly changed the preparer penalties under Code Section 6694. Before the new law, the standard for non-abusive, undisclosed items under Section 6694(a) was "a realistic possibility of success" (essentially a one-third likelihood of success). Under the new law, the standard is "more likely than not" (essentially a 51 percent chance of success).
While the Internal Revenue Service gave transitional relief for returns filed through 2007, the rules are in full force in 2008. Practitioners are bracing for possible conflicts with clients because of the disconnect in their disclosure standards. The new more-likely-than-not standard could motivate a preparer to disclose a return position that a taxpayer, under the substantial authority standard, might not be inclined to disclose.
No. 3: "Kiddie Tax" spoiler. Finally, a zero percent tax rate that until now was only the stuff of dreams has arrived in 2008. First promised in the Jobs and Growth Tax Relief Reconciliation Act of 2003 for 2008 and 2009, and lengthened by the Tax Increase Prevention and Reconciliation Act of 2005 through 2010, the zero percent rate was primarily seen to benefit those young adults over 18 but out of range of the "Kiddie Tax."
Unfortunately, Congress was plugged into that strategy, too, and blocked it before it took effect through expansion of the Kiddie Tax in the 2007 Small Business Tax Act. The Kiddie Tax now applies to any child who is 18 years old at the end of the tax year or who is a full-time student over the age of 18, but under 24 at the end of the year. This change is effective starting in 2008, not coincidentally the same year that the zero percent capital gains rate would otherwise apply to most in this older group. Young adults over 23 who remain in the 15 percent income tax bracket, however, may continue to benefit from the zero percent rate, as will some retirees with low taxable income.
No. 4: Small business tax cuts. Aside from causing angst over preparer penalties and the Kiddie Tax, the 2007 Small Business Tax Act actually included provisions to help small business. Two of these changes are especially relevant to tax planning in 2008. First, the new law increased the annual dollar limitation for small business expensing from $112,000 to $125,000 for tax years beginning in 2007 and through 2010; and similarly increased the investment limitation from $450,000 to $500,000, with annual inflation adjustment. Second, the Work Opportunity Tax Credit was expanded to cover more veterans, high-risk youth, and individuals needing vocational rehabilitation, applicable to individuals who begin work after Dec. 31, 2007, and before Sept. 1, 2011.
No. 5: Section 409A reg compliance. The Treasury and the IRS relented and in Notice 2007-86 pushed back until Dec. 31, 2008, the deadline for complying with the final nonqualified deferred compensation regulations under Code Sec. 409A. Practitioners and employers had insisted that compliance with the final regs, issued in April 2007, was a complex and time-consuming task that could not be achieved by the end of 2007.
Now, employers and their practitioners have an additional year to identify every deferred compensation arrangement, determine how to fix areas of noncompliance, educate participants and obtain elections, obtain necessary corporate approvals for plan amendments, and redraft plans. Doing all of this in 2008, with most of the work needing to be frontloaded into the first nine months, will make for a very busy year.
No. 6: Small business and tax exempts targeted. The tax gap, the difference between what is owed and what is reported and collected, is now over $350 billion, and growing concern over how to stop the hemorrhaging of revenues has produced what some fear is an overreaction by the IRS.
Two areas of abuse that were identified in 2007 were small business and tax-exempt organization compliance. While much underreporting takes place in the small business area (estimates are as high as 60 percent), the fear is that increased information reporting will create a quagmire of bureaucracy that could hamstring the success of small businesses that are compliant. The same argument is being presented by small tax-exempt organizations, which also were identified in several 2007 reports as areas in which abuse was prevalent. The IRS plans to increase examinations in both sectors in 2008, making tax planning in those areas generally subject to greater scrutiny.
No. 7: Overhaul of Form 990. The IRS released in June 2007 a redesigned draft Form 990, Return of Organization Exempt from Income Tax - the first major revision of the form since 1979. The form is "the primary compliance tool for tax-exempt organizations," the IRS explained in a background paper. "In addition, most states rely on the Form 990 to perform ... oversight and to satisfy state income tax filing requirements."
The new form consists of a summary page, a nine-page core form that all organizations must complete, and 15 schedules that must be completed if applicable. The IRS released a progress report in October and, as the result of over 600 comments, will be making changes. The new form and instructions are expected to be released by May 2008 for use beginning in 2009.
Advisors to tax-exempts should start reviewing the new form now, to prepare their organizations to be in compliance when asked to respond to questions on structure, whistle-blowers, compensation paid through related organizations, financial statements, and taxes owed by the organization.
No. 8: Economic substance doctrine. The Supreme Court declined in 2007 to review two major tax shelter cases won by the IRS using the economic substance doctrine - Dow Chemical Company, 435 F.3d 594 (6th Cir. 2006), and Coltec Industries, 454 F.3d 1340 (Fed. Cir. 2006). Some practitioners fear that an unbridled economic substance doctrine may be extended by the IRS to cover a greater number of tax strategies, putting not only transactions that are clearly tax shelters at risk, but also endangering cutting-edge financial, partnership, corporate and estate planning, even though the technical requirements of the Tax Code may be apparently satisfied.
Legislation has been introduced in Congress to codify the economic substance doctrine and is a tempting addition to any tax legislation, since it generates revenue to offset tax cuts. 2008 promises to be the year when more defined boundaries on the doctrine will be drawn.
No. 9: Tax accrual workpapers. In what was hailed by practitioners as a watershed victory for corporate taxpayers, Textron Inc., DC R.I., 2007-2 (USTC ¶50,605) denied the IRS access to tax accrual workpapers. The work product privilege applies to materials prepared by an attorney in anticipation of litigation. The court rejected the IRS's argument that the workpapers were not prepared for litigation but in the ordinary course of business and to satisfy requirements for financial statements filed with the Securities and Exchange Commission.
Despite the loss, IRS Chief Counsel Donald Korb has vowed to continue the agency's policy of asking for tax accrual workpapers: "The court's analysis is incorrect. We're not going to change anything because of this case." An appeal is expected in Textron, however, and resolution may be reached sometime in 2008. The IRS's general access to the underlying workpapers used to support FIN 48 disclosures is at stake.
No. 10: E-filing push. Those practitioners who operate with pen and paper need to "upgrade" to electronic data storage and filing. Most practitioners are finding computerization cost effective. The IRS is clearly finding it cost effective, and sees it as part of its rescue plan, under which it can eventually trim its processing budget for re-allocation to enforcement and taxpayer services.
Individual use of e-filing was well over 50 percent for the 2007 filing season. The IRS also reported that businesses of all sizes had electronically filed their returns in record numbers. Corporate e-filing, which was made mandatory for midsized businesses for the first time in 2007, was up 60 percent over 2006. Nearly 800,000 small businesses e-filed their returns in 2007, representing a 50 percent increase from 2006, even though e-filing is still not mandatory for small businesses.
Also having a significant impact on many tax strategies in 2008 are the following additional 2007 tax developments:
* A new IRS employment tax initiative in which it sees payroll tax abuses and misclassification of independent contractor status as significant revenue drains;
* The issuance of over 60 tax patents and applications for 100 more, the beginnings of patent-infringement litigation, and the campaign launched by the American Bar Association, the American Institute of CPAs and others to have Congress ban tax patents altogether;
* Reverse partnership allocation rules, anti-mixing-bowl regs, and the continuing complexity of partnership groups in the face of growing use of the partnership form of business;
* The IRS's new focus on international tax issues, including abuses in foreign tax credits and "Killer B" transactions;
* A changing landscape of rules issued or being developed by the IRS and the Treasury for accounting method changes; and,
* The issuance of reliance regs on automatic enrollment provisions under 401(k) plans, as well as final regs on phased retirement, including an age 62 safe harbor, and other incentives to increase the national level of retirement savings, now headed for a record low.
2008 promises to be a good year for tax strategies. Major legislation should be postponed until after the presidential elections, allowing some certainty in setting short-term strategies. At the same time, the lack of legislation will allow the Treasury and the IRS to dig themselves out from under the backlog of guidance required by the legislation of the past several years. That, in turn, will enable more certainty in planning "close to the line" but within the rules. Lastly, many of those 2007 developments that have spilled into 2008 also will work themselves out over the course of 2008.
Some, however, won't, and, together with a new Top 10 list in 2008, they will surely keep things interesting.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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