The start of a New Year is a traditional time to take stock of the events of the past year to better prepare for what's coming. Taking inventory as it relates to tax law can produce many dividends.2005 proved to be no exception in getting prepared for 2006. Looking forward to 2006, here is a "Top 10" list of 2005 tax events that will have an impact on what will happen to many taxpayers in 2006.
1: IRS enforcement/anti-tax shelter initiatives. The Internal Revenue Service's aggressive campaign against tax shelters continued to rage in 2005, with investors, promoters and advisors all put on the defensive. This campaign also has caused lots of collateral damage in the general tax enforcement/collection area. While collecting billions of dollars from tax shelters, the IRS is keenly aware that much more is at stake, namely the perception of fairness in the system held by the general taxpaying public.
The impact of IRS tax shelter activity in 2005 will be felt in 2006 particularly in three areas:
* Tougher disclosure requirements on 2005 returns filed in 2006;
* The closing of a global settlement offer on January 23 that invites many of those tax shelter participants not covered by previous settlement initiatives to come forward in exchange for reduced penalties; and,
* The litigation of cases in which participants have not accepted a settlement offer. In connection with anticipated litigation finally coming to trial, more than several tax shelter investors are hoping that the courts will turn back the IRS's aggressive positions on economic substance.
While tax shelters have been the showpiece of the IRS's "get-tough" attitude, the IRS commissioner, the chief counsel and other agency officials worked on the general enforcement theme throughout 2005. More audits, fewer no-change examinations, and an increasingly refined computer-driven return-selection process occured in 2005, and are in the IRS business plan again for 2006.
2: Tax reform debate. Since 2005 was supposed to have been the year for Social Security reform, many observers hold only guarded hope that tax reform will not succumb to the same political fate. The President's Advisory Panel on Federal Tax Reform in late 2005 recommended a somewhat conservative approach to tax reform that retains a good portion of the current income tax system. While this route perhaps holds more chance of acceptance than a radical approach, its evolution within the Bush administration and on Capitol Hill over the next few months will be key.
Taxpayers need to remain flexible to anticipate which way the winds of reform will blow. While transition rules and fairness are sure to be focal points in any final tax reform bill, change will bring about "winners" and "losers."
Although real estate and debt financing have been mentioned so far as possible losers, and investment in capital assets and those presently hit by the alternative minimum tax appear as winners, it is too early to make decisions. Watching what takes place over the next few months is critical.
3: Casualty loss/hurricane relief. Hurricane Katrina has changed the tax paradigm for victims of major disasters. A portion of the provisions in the Katrina Emergency Tax Relief Act of 2005 were based on refinements to the tax relief granted after 9/11. Still more legislative relief is planned in a business-directed bill now before Congress. Victims of Hurricanes Rita and Wilma share with Katrina victims postponed deadlines for filing and payment to Feb. 28, 2006.
Sen. Bill 2020, pending as we go to press, targets tax relief to businesses in the form of a Gulf Opportunity Zone; bonus depreciation; enhanced small business expensing; enhanced NOL carrybacks; and other relief. The bill also give victims of Hurricanes Rita and Wilma many of the same tax breaks that Katrina victims received in the Katrina Emergency Tax Relief Act of 2005, such as relaxation of the casualty loss rules and less restrictions on early distributions from retirement plans.
4: Continued rise of the LLC. Over the past several years, the use of limited liability companies in the United States has exploded. Many businesses that didn't give the LLC a second look years ago - when the law surrounding LLCs was developing - should reconsider their initial decision in 2006.
A 2005 Statistics of Income Bulletin reported that 2002 marked the first year in which limited liability companies became the most prevalent form of partnership entity. LLCs constituted 42.2 percent of all partnerships in existence during 2002. Estimates now are that LLCs have risen well above the 50 percent mark.
The proliferation of LLCs also created some problems. 2005 saw a number of clarifications and breaks given to LLCs. IRS officials reported in 2005 that disregarded entities are being used to shield the federal tax liabilities of the partnership from the partner; for example, by way of ownership of a general partnership interest through an LLC in order to be sheltered from liability. The Treasury has promised regulations on the subject.
5: Continued bolstering of HSAs. The Bush administration and Congress continue to promote health savings accounts as a partial way out of escalating health care and health insurance costs.
The IRS continued to bend over backwards to side in favor of HSAs in 2005. Transitional relief for health savings accounts announced in 2004 was extended to some non-calendaryear health plans that otherwise qualify as high-deductible health plans. New regulations favorably interpret circumstances under which employers are required to make comparable contributions.
The IRS also ruled that one spouse's qualification to use an HSA is not dependent on the other spouse's qualification, even though the couple may file joint returns and are otherwise considered the same "economic unit." Given these and previously announced rules, many more employers are expected to turn to HSA/HDHP as an alternative to rising health care costs.
6: Roth 401(k)s. A new retirement savings option, designated Roth contributions to 401(k) plans, started Jan. 1, 2006. Under this option, employees will be able to designate all or part of their contributions to their 401(k) plans on an after-tax basis, which will make most distributions tax-free. No plan sponsor is forced to amend its plan, but no employee may elect after-tax Roth contributions without that amendment. Final regulations are expected momentarily. Proposed regs issued early in 2005 set forth the ground rules, which are fairly liberal. Expect Roth 401(k)s to be a hot topic in 2006.
7: Manufacturing deduction. 2005 guidance from the Treasury and the IRS generally reflects Congress' intent to make the domestic production activities or "manufacturing" deduction available to as many U.S. businesses as possible, but "without giving away the store."
Manufacturers, construction contractors, farmers and many other types of businesses in all 50 states and the District of Columbia are able to claim this targeted new tax break for 2005 through 2010. Smaller manufacturers are especially helped by safe harbors and de minimis rules that avoid the application of otherwise complex cost allocations.
While the most recent guidance is in the form of proposed reliance regulations, lobbyists will continue to press for changes. While generally limited to 3 percent of the lesser of qualified production activities income or taxable income and half of paid-out W-2 wages for 2005 and 2006, the stakes will rise as the deduction grows to 6 percent in 2007 through 2009 and 9 percent in 2010.
Since the proposed regs are "reliance regs," amended returns may be filed for 2005 if more favorable final regulations, which are expected sometime in 2006, are released.
8: Revised Circular 230. After years of proposals, debates and controversy, final Circular 230 rules of practice became effective for all written tax advice rendered after June 20, 2005. Many practitioners are still struggling to understand the full scope and consequences of the new Circular 230. Most are not happy with the awkwardness with which they now must communicate with clients.
Under revised Circular 230, tax advice that is a "covered opinion" must include details that are considered far above the former standards for routine advice. For certain covered opinions, the practitioner is allowed to be held to a less rigorous standard only if the client is told that the advice carries no penalty protection.
Many practitioners see no safe alternative but to start including penalty disclaimer language in virtually every written client communication. 2006 will prove to be a watershed year, determining how aggressively the IRS Office of Professional Responsibility will enforce the existing rules, and whether it will persuaded to make revisions either by practitioners or the courts.
9: Nonqualified deferred-comp rules. The Treasury and the IRS have issued long-awaited guidance on the requirements for deferred-compensation plans under Code Sec. 409A. The regulations incorporate earlier guidance (Notice 2005-1) and address many additional issues. While they are still in proposed form, the IRS will allow taxpayers to opt to treat them as law until final regs are issued. At the same time, the regulations postpone until 2007 a documentary compliance deadline that had been fast approaching.
Practitioners should be cautioned that the rules also set forth a limited time during which a plan adopted before Dec. 31, 2005, may provide a participant a right to terminate participation or cancel an outstanding deferral election with regard to amounts subject to Code Sec. 409A. The new regs do not extend this period.
10: Energy Tax Act. After several years of contentious debate, the Energy Policy Act of 2005 was approved in 2005. Most provisions are effective Jan. 1, 2006. Topping the list of consumer incentives is the new $500 lifetime home improvement energy tax credit. Some costs, such as window replacements, are capped. Homeowners are also entitled to a $2,000 credit for solar water heater or solar electricity projects. A new "green vehicle" credit replaces the old hybrid vehicle deduction.
While Top 10 lists help set priorities, they clearly are subjective in the sense that a practitioner's client base, and what is important to her clients, can vary markedly. Nevertheless, the basic reason for such lists - that tax law changes enough each year from the prior year to warrant a re-evaluation of strategies and techniques used only a year ago - is a constant. In that light, customizing your own "top issues" list by reviewing news and trends from the immediately prior year is an excellent way to jump-start tax strategies for the coming year.
2006 is no exception.
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 WoltersKluwer company.
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