Tax strategies don't just come from nowhere. They arise out of necessity and typically are reactive, constructed as work-arounds to avoid certain tax pitfalls or to meet certain rules. Viewed from this perspective and appropriate to the start of a New Year, we offer our list of the Top 10 tax developments of 2006 that will shape tax strategies in 2007.* No. 1: The IRS's use of the economic substance doctrine. Under the economic substance doctrine as adroitly used by the Internal Revenue Service Chief Counsel's Office in the Coltec case, Black & Decker and other tax-shelter-related litigation, a tax strategy can conform to the letter of the Revenue Code, yet fail to win the desired result.
This happens because the underlying transaction is without economic substance. The courts lately have been reading into each grant of any business-related deduction, credit or other tax benefit the underlying intention of Congress that it is done for some market-driven purpose, rather than solely for tax savings.
Flushed with its recent court victories, the IRS is now reluctant to press for codification of the doctrine, which necessarily would be more narrowly defined. For the time being, the IRS appears to be using the uncertainty of how far the courts will extend economic substance to discourage aggressive tax strategies in general.
In managing its court calendar carefully, the IRS continues to keep this uncertainty alive. Under the economic substance doctrine, even following the code itself sometimes may not be good enough. Determining the boundaries of economic substance will be a challenge for many tax strategies this year.
* No. 2: IRS enforcement to close the "tax gap." With proof now in hand through its tax gap study that more than $300 billion each year is slipping through the federal government's fingers principally because of tax cheats and deadbeats, the IRS has a powerful justification to ratchet up audit and collection activities. Eventually, stricter and more pervasive information reporting enabled by significant strides in computer technologies, along with a more "simplified" tax system for the majority, likely will bring down the cost of "surveillance" and prove to be the long-range solution to closing the tax gap.
In the meantime, however, the IRS cannot audit nearly enough individuals and small businesses alone to make a statistical dent. Rather, it must increasingly rely on deterrence based on convincing taxpayers that noncompliance is not worth the risk. For taxpayers using legitimate tax strategies, the principal questions are whether certain strategies are now "audit triggers" that will put up red flags subjecting the entire business or family of taxpayers to scrutiny that will not be cost-effective; and whether the "audit lottery" still offers good enough odds that a tax strategy that should work should be "given a shot" because after the 97-3 audit odds that nothing will be questioned, there is a 60-40 chance that your client deserves to win.
* No. 3: 2006 legislation. For creating genuinely new opportunities for tax planning, there is nothing like new tax legislation. The big laws for 2006 were the Tax Increase Protection and Reconciliation Act of 2005, the Pension Protection Act of 2006 and - looking through a crystal ball yet at press time to reveal its "inevitable" result - the Tax Extenders Bill of 2006. Each law contains scores of provisions that will result in scores of regulations and guidance that will result in scores of tax strategies.
* No. 4: Expanded Schedules M-3. Enron and the Sarbanes-Oxley legislation started the ball rolling, but Schedule M-3, Book and Tax Differences, truly has brought tax accounting oversight into the mainstream. For tax compliance and Securities and Exchange Commission regulation purposes, Schedule M-3 has become the king gatekeeper. FIN 48 and its apparent preference for conservative tax strategies further complicate tax planning for public companies, and, in true "trickle-down" fashion, discourage earnings reports that in part depend on a tax strategy working against the IRS.
Schedule M-3 has extended its reach for 2006 returns to large partnerships and S corps; similar disclosures for smaller enterprises are not far behind. "Transparency" is unfamiliar turf for many tax strategies, but one which must be accommodated.
* No. 5: Regs on the domestic production activities deduction. The domestic production activities deduction, a.k.a. the manufacturing deduction, is the biggest deduction news for business since the expanded Section 179 expensing deduction. While the 179 deduction principally affects small businesses, however, the manufacturing deduction cuts across the board.
In part, the PPA's tightening of the W-2 wage limitation to only wages connected directly with manufacturing represents a significant proportion of this year's challenge. So, too, however, do new regulations issued in 2006 to better control the benefits of this new deduction. In late May 2006, the Treasury and the IRS issued much-anticipated comprehensive final regs that expanded the activities that qualify for the deduction, made the rules more user-friendly, and simplified the required calculations. In mid-October, more temporary and proposed regs were issued, this time to explain how to compute the new, stricter W-2 wage limitation.
* No. 6: Circular 230 puts pressure on tax planners. In early February, the IRS issued proposed regs to make important changes to eligibility for enrollment, limited practice, sanctions and disciplinary proceedings, contingent fees, and confidentiality agreements as they relate to Circular 230 Rules of Practice. The IRS wants the disclosure and other rules to settle in a while before it will issue final and more black-letter rules. Those rules are expected soon. No one denies the "chilling effect" that the rules have on the implementation of aggressive tax strategies. This is a story that has yet to see a final resolution.
* No. 7: Complying with deferred-comp transition rules. In early October, the IRS announced that employers that maintained a nonqualified deferred-compensation plan would have more time to comply with regs under Code Sec. 409A. Final rules had been slated to take effect Jan. 1, 2007. Instead, the regs will not apply until Jan. 1, 2008. As an indication of how confusing the application of Code Sec. 409A is, the postponement basically was the result of the IRS's failure to come up in time with a decision of what the final rules should contain. Nevertheless, compensation planning is a bread-and-butter area of tax planning and, considering the pervasiveness of the new rules, everyone should continue to track compliance deadlines, as well as the development of final regs.
* No. 8: The march of inflation. While inflation has been relatively low in recent years, it has "marched on" and must be a factor in every tax strategy. 2006 saw inflation heat up a bit at the beginning, only to settle in to a hopeful lower level as the year ended. Nevertheless, the IRS again announced its inflation-adjusted tax brackets and other tax amounts for the coming year. Those figures increase in number each year as Congress recognizes that inflation can be an insidious tax increase.
Unfortunately, Congress is not protecting all incentives equally, and certain tax strategies, especially tax-deferred retirement savings and capital-gains-generating investments, usually fare better than most. Effective tax strategies require continued identification of those opportunities, as well as those situations in which inflation continues to eat into otherwise-attractive tax benefits.
* No. 9: Retirement savings. Social Security alone cannot guarantee the comfortable retirement that many Baby Boomers and their juniors expect. While theoretically each potential retiree is responsible for themselves, Congress continues to worry that these voters will not do what is in their long-term best interest. Incentives to help boost retirement savings are increasing (and likely will continue to increase). Higher contribution levels; easier rollover and emergency withdrawal rules so as not to discourage locking in assets; increased "automatic" 401(k); and other retirement options new for 2006 are expected to increase over the coming years. Tax strategies aimed toward other benefits, such as capital gains or tax-exempt investments, need to be reconsidered as Congress increases savings incentives in other areas.
* No. 10: What didn't happen. No tax reform, no permanent alternative minimum tax solution, and no resolution of the estate tax happened in 2006. All the while, the return of pre-2001 tax rates looms for post-2010, which is sooner than many taxpayers believed back in 2001.
Short-term tax strategies do pay off; they should not be denigrated to being "knee-jerk reactions" to the current year's laws. Yet, take a look at the tax laws in 1996, and what has changed is significant. We should expect more of the same over not only the next 10 years, but also in the next year. The tax law as it will exist in January 2008 remains an unknown, but one for which our "best shot" must be given in developing and executing tax strategies over the next year.
The big picture should not overshadow the little advances throughout any period that make for significant change.
Many notable developments took place in 2006 to fill that category. Our partial list includes a potentially faster TAM and letter-ruling process, abuse of tax-exempt status by charities and other "tax-neutral" organizations, developing rules on the capitalization of tangible as well as intangible property, the limited duration of energy credits, the "e-revolution" in compliance, common use of qualified intermediaries in like-kind exchanges of business assets, and nuances in determining S shareholder basis and loans. AT
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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