Current developments: in the last year, many significant developments affected individual taxpayers. This article summarizes legislation, the principal residence exclusion, AMT, income recognition, deductions and other significant areas.

EXECUTIVE SUMMARY

* The ETIA and the SAFETEA provide a number of energy-based credits that individuals can use in 2006 and subsequent years.

* There were a myriad of developments on deductions, including Sec. 199 guidance, charitable contributions, contingent attorneys' fees and healthcare premiums.

* In 2005, the IRS continued its strategy of offering settlements to taxpayers involved in various tax shelters.

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Last year was certainly a busy tax year for individual tax developments. To aid those devastated by the hurricanes that swept through the southeastern U.S., Congress enacted two substantial tax bills with a speed that amazed many. (1) In addition, it also adopted the Energy Tax Incentives Act of 2005 (ETIA) (2) and the Safe, Accountable, Flexible, Efficient Transportation Equity Act. (SAFETEA), (3) which provided energy credits for individuals. The IRS, Treasury and the courts continued to provide guidance and to interpret the less-than-simple Code. They addressed the Sec. 199 deduction, the principal residence exclusion, alternative minimum tax (AMT), healthcare, tax shelters and a variety of other income recognition and deduction issues. These developments will be covered in this article.

Legislation

Congress introduced energy tax incentives in the ETIA and SAFETEA, both of which were passed after much partisan wrangling. The IRS also issued guidance on the new deduction for qualified production activities that was enacted by the American Jobs Creation Act of 2004 (AJCA).

ETIA

The ETIA provides multiple credits for individuals, which are based on energy-efficient purchases in 2006 and subsequent years. First, a credit of up to $500 can be claimed for non-business, energy property installed in a taxpayer's residence. Qualified property includes exterior doors, windows, insulation, heat pumps, furnaces, central air conditioners and water heaters. In addition to the overall credit limit, individuals have specific limits (i.e., a $200 limit on credits for windows). Also, the energy property must meet certain criteria and energy standards specified by the IRS and Department of Energy to qualify for a credit. Credits are nonrefundable and, of course, will not reduce the AMT.

A maximum credit of $2,000 applies to the cost of solar water heaters and solar electricity equipment installed in a personal residence. The credit is not available for expenditures that are allocable to a swimming pool, hot tub or other activity that has a function other than energy storage. As with the energy property credit, the credit cannot be used to offset AMT.

SAFETEA

Congress also passed the SAFETEA. That law has several credits that can be used by individuals in 2006 and thereafter. The credits apply to purchases of alternative fuel vehicles, depending on a vehicle's weight--the larger the vehicle, the larger the credit. To qualify, the motor vehicle must generally meet several requirements. First, its original use must begin with the taxpayer. Further, it must be acquired for use or lease by the taxpayer, and not for resale. However this requirement has a trap--the leasing company, not the lessee, gets the credit on leased vehicles. Obviously, this will become a negotiating point between the lessee and the leasing company. The vehicles must be made by a manufacturer and be certified as qualifying for the credits. Further, in many cases, a vehicle meeting increased fuel-efficiency standards will be entitled to additional credits based on the increased fuel efficiency. Finally, a qualifying alternative fuel must propel the vehicle. Qualifying alternative fuels include fuel cells and advanced lean burn technology. Qualifying vehicles include hybrid motor vehicles, qualified alternative fuel vehicles and mixed fuel vehicles. The credit for these vehicles can be as much as $3,400.

The IRS quickly issued some guidance on parts of this legislation. Notice 2006-9 (4) deals with advanced lean burn technology vehicles and qualified hybrid vehicles. It addresses the certification process and permits taxpayers to rely on a manufacturer's certification in claiming credits. It requires manufacturers to report sales of advanced lean burn technology and qualified hybrid vehicles on a quarterly basis, because the credits begin to phase out after the end of the first calendar quarter after the quarter in which the manufacturer sells 60,000 combined units.

Sec. 199 Guidance

One of the more complex provisions of the AJCA was the new deduction for qualified production activities. At only 3% for 2005, the deduction eventually becomes 9% in 2010 when fully phased in. It equals the phase-in percentage multiplied by the lesser of taxable income from qualifying activities, or 50% of W-2 wages. The latter limit will pose a major problem for many small businesses that rely on contractors rather then employees, became subcontractor payments do not qualify as W-2 wages. Contractors could be particularly hard hit by this limit.

Given the complexity of this provision, it is no surprise that both the IRS and Treasury got busy and released guidance in 2005. In Notice 2005-14, (5) the IRS offered initial guidance on this provision, outlining the activities eligible for the deduction, and providing some simplified formulas for computing taxable income and for determining what comprises W-2 wages. In addition, the notice also added some de minimis rules to help avoid revenue and expense allocations due to minor amounts of nonqualifying income.

This guidance was followed up later in the year by Prop. Kegs. Secs. 1.199-1 through -8. The proposed regulations generally follow Notice 2005-14, but introduce additional detail and refine some of the issues that raised questions in the initial guidance. As indicated by the proposed regulations, taxpayers can rely on either the notice or the proposed regulations until the regulations become final. If the proposed regulations and the notice differ on the same issue, a taxpayer may select whichever is more beneficial, although this will no longer be the case once the final regulations are issued.

Contingent Attorneys' Fees

In 2005, the Supreme Court rendered a decision that was definitely not taxpayer-friendly. After years of controversy and contradictory decisions from many Courts of Appeal, the Court ruled in Banks (6) that contingent fees paid to an attorney from the proceeds of a lawsuit have to be included in the clients' income. The client can, when appropriate, deduct those fees as a miscellaneous itemized deduction under Sec. 212. Of course, because these deductions are not allowable when computing an individual's AMT, the net result is frequently a tax liability that is much higher than it would have been had the fees been deductible in computing adjustable gross income.

In Banks, the Supreme Court essentially told Congress that if Congress thought there was a problem, Congress needed to fix it. Fortunately, for some cases, most noticeably discrimination cases, Congress corrected the inequity in the AJCA. However, the change made by the AJCA does not cover all circumstance; thus the problem still remains.

Principal Residence Exclusion

There were some significant 2005 developments involving gain on principal residences. Since 1997, individuals selling their principal residence have been able to exclude $250,000 of gain ($500,000 on a joint return) when they used the residence as their principal residence for at least two of the preceding five years. To the extent that the two-of-five-year test is not met, gain has to be recognized. In 2005, Treasury issued final regulations providing a safe harbor when the two-of-five test is not met due to health reasons, a change of employment or unforeseen circumstances. Under Regs. Secs.1.121-3(b)-(f) and 1.121-5, if a safe harbor applies, a portion of the gain will be excludible, based on the number of months the property was used as a residence. However there are some restrictions. For example, the change-of-employment test requires the new place of employment to be at least 50 miles farther from the residence that is sold than was the former place of employment. Or if there was no former place of employment, the distance between the new place of employment and the residence sold must be at least 50 miles. Also, the test for unforeseen circumstances does not allow for an improvement in financial condition.

While many hailed the regulations as more taxpayer-friendly than anticipated, there was still some anxiety over how the IRS would apply them. Fortunately, many of those concerns were eased by a letter ruling. (7) In the ruling, a police officer purchased a townhouse. Afterward, he was assigned to a K-9 unit, which required the officer to care for his K-9 partner at home. Unfortunately, the homeowners' association rules prohibited maintaining a kennel. As a result, the officer and his wife sold their townhouse. They then requested a ruling on whether the facts constituted an unforeseen circumstance. The ruling concluded that the couple could exclude the gain, up to a reduced maximum, because the major reason for the sale was an unforeseen circumstance.

In another case, Rev. Rul. 2005-74 (8) dealt with the consequences of an employee selling his home to his employer through a relocation management company. According to the ruling, the transaction would be cast as either a sale from the employee to the employer followed by a sale by the employer to a third party, or as a single transaction if the sale were deemed to be made directly to the third party with the relocation management company acting as an intermediary. If treated as a sale made to the employer, the gain would not be treated as compensation. Likewise, if the transaction were viewed as the sale of a residence through an intermediary, the gain would still not be treated as compensation. However, in the latter case, any expenses paid by the employer (e.g. maintenance, taxes, insurance) will be taxable to the employee as compensation.

AMT

The AMT continues to be tremendously complex and inequitable to individuals. Unfortunately, relief has been denied thus far by the courts and IRS, which insist that only Congressional action can address the problem. However, despite these protests, the IRS did create some equity in Rev. Rul. 2005-11, (9) which concluded that home mortgage interest resulting from one or more refinancings is deductible for AMT purposes, as long as the mortgage amount is not increased and the interest is qualified housing interest under Sec. 163(h)(3).

In 2005, the Tax Court considered the AMT problem in Speltz. (10) In that case, it declined to overrule the IRS's rejection of the taxpayers' offer in compromise (OIC). In 2002, the taxpayers reported an AMT liability of over $200,000, arising from the exercise of incentive stock options (ISOs). Unfortunately, the value of the stock dropped dramatically. This caused the taxpayers to file an OIC based on the effects of the AMT on their finances. The offer was rejected. In supporting the IRS's rejection, the Tax Court concluded that there was no Congressional intent to provide authority for overriding the AMT's effect based on unfairness or inequity. Thus, to correct such an inequity, Congress must act.

Income Recognition

Income recognition is always a point of controversy between taxpayers and the IRS. Taxpayers try to delay recognizing income as long as possible, while the IRS wants to recognize it as quickly as possible. In 2005, the IRS won an interesting Ninth Circuit case in George. (11) In that case, a cash-basis individual was a court-appointed receiver, handling various receiverships for financially troubled radio stations, and receiving fees in exchange for his services. The fees were subject to possible repayment on a final accounting of the receivership, but the possibility was a contingency, not a certainty. The Ninth Circuit held that the receiver should have reported the fees as income when received, because a contingent obligation to repay income is not sufficient to preclude inclusion of that income until the contingency is removed.

Likewise, the IRS won in the Tax Court on the issue of whether an employer's insider trading policy constituted a substantial risk of forfeiture, thereby permitting deferral of income recognition until the risk of forfeiture was removed. In Robert Merlo, (12) the court concluded that an employee's rights to stock acquired by exercising ISOs was not subject to a substantial risk of forfeiture by virtue of the fact that the employer prohibited insider trading. The limit imposed by the employer did not give the employer the right to recover the stock from the employee or require the employee to return the stock. Rather, the prohibition really functioned as a disciplinary measure, imposing penalties up to termination of employment. Accordingly, there was no substantial risk of forfeiture, and the income was recognized on the exercise of the options.

Constructive receipt of income is often successfully argued by the IRS to accelerate the recognition of income. However, in Jombo, (13) the IRS was on the opposite side of constructive receipt, arguing that it did not exist in that case. It contended that the taxpayer should report lottery proceeds as the proceeds were paid, not in the year the taxpayer won the lottery. The taxpayer, a foreigner, had diplomatic status at the time he won the lottery. Thus, he would have no income for U.S. tax purposes if the proceeds were constructively received when he won. Naturally, the taxpayer argued that he did constructively receive all of the lottery proceeds in the year he won. On appeal the court disagreed, because a taxpayer's right to assign rights to a lottery prize does not affect the timing of the payments. Thus, there is no constructive receipt, and the proceeds were taxable as collected.

Classification of income as capital gain versus ordinary income also provided a case in 2005. In Jones, (14) an Alabama district court reaffirmed that termination payments made to a retiring insurance agent are taxable as ordinary income because the goodwill was really the insurance company's property under the terms of the agent-company agreement. The court, in effect, followed the Seventh Circuit's 1993 decision in Baker. (15)

Deductions

Deductions also played a role in 2005 individual tax developments. For example, the cost of operating an automobile created a significant hardship for many Americans as gas prices rose above $3.00 a gallon after Hurricane Katrina. In recognizing this, the IRS provided relief by increasing the standard mileage deduction, for the final few months of 2005. Initially, it set the business mileage rate at 40.5 cents per mile in Rev. Proc. 2004-64. (16) This procedure also set the medical/moving rate at 15 cents per mile, while keeping the charitable rate at 14 cents per mile. However, as a result of the sharp spike in gas prices, the IRS issued Ann. 2005-71, (17) which increased the business mileage rate to 48.5 cents per mile and the medical/moving rate to 22 cents per mile for transportation expenses incurred on or after Sept. 1, 2005. Of course, the Katrina Emergency Tax Relief Act created a special deduction equal to 70% of the business mileage rate for the use of an automobile in providing donated services to a charity for Hurricane Katrina relief, effective Aug. 25, 2005 through the end of 2005. Finally, in Rev. Proc. 2005-78, (18) the IRS set the 2006 business mileage rate at 44.5 cents per mile, the medical/moving rate at 18 cents per mile and again kept the charitable rate at 14 cents per mile.

For taxpayers using the actual-expense method for transportation expenses, Rev. Proc. 2005-13, (19) established the 2005 depreciation limits for passenger automobiles at $2,960 for the first tax year, $4,700 for the second tax year, $2,850 for the third tax year and $1,675 for each succeeding year. For trucks and vans, the 2005 limits are $3,260 for the first tax year, $5,200 for the second tax year, $3,150 for the third tax year and $1,875 for each succeeding year. For electric autos, the 2005 limits are $8,880 for the first tax year, $14,200 for the second tax year, $8,450 for the third tax year and $5,125 for each succeeding year.

Business Expenses

Business expense issues also continue to create controversy. For example, accountable expense plans were developed to permit employees to be reimbursed by their employers for their business expenses without having to include the reimbursements in income. This tax advantage has a trade-off. Certain requirements on advancing reimbursements, reporting requirements and repaying any reimbursement excess have to be met. This was demonstrated in Rev. Rul. 2005-52. (20) An employer provided employees a tool allowance because each employee had to provide his or her own tools as a job condition. Each employee's allowance was based on hours worked along with some national averages. No substantiation of the use of the allowance was required and nonrepayment of any excess allowance was necessary. Because the accountable plan requirements were not met, the allowance was taxable income to the employees, who could then deduct the cost of purchasing and maintaining their tools as an employee business expense. At first blush, that seems fair, because income is offset by a corresponding deduction. Unfortunately, however, an employee's deduction will be subject to the 2%-of-AGI limit, as well as the overall phaseout of itemized deductions for high-income taxpayers. Of course, employee business expenses are clearly not deductible in determining whether AMT applies. Thus, the net result of this rifling, or of the denial of any accountable plan status, is an increase in an employee's income.

Per diems have long been a popular way to reimburse employees on business travel. Updated per-diem rates were provided in Rev. Proc. 2005-10. (21) The procedure increased the high-low rates for the high-low substantiation method. The rates were increased from $199 to $204 and from $127 to $129. The procedure also revised the localities qualifying as high-cost localities. It also revised the definition of incidental expenses, to match those in the Federal Travel Regulations.

Charitable Contributions

A provision of the AJCA slammed the door on what the IRS considered an abusive practice--contributing vehicles to charity, then chiming an inflated value as a charitable contribution. Starting in 2005, new limits were imposed on an individual's ability to claim a charitable deduction for contributed autos. The deduction is generally limited to the amount the charity sells the vehicle for at auction. However, an exception exists for vehicles the charity actually uses in its exempt activity (significant intervening use), or vehicles to which the charity makes substantial improvements. Guidance is provided in Notice 2005-44. (22) The notice defines "significant intervening use," as well as what constitutes substantial improvement. Finally, it offers some very helpful guidance on the format, contents and deadlines a charity must meet to fulfill the reporting requirements of the new law.

Sec. 170(f)(8) requires specific substantiation requirements for charitable contributions of $250 or more. For example in Kendrix, (23) the Tax Court reinforced the fact that failure to comply with the requirements means the deduction is disallowed. The taxpayer made cash contributions to a church. While the church receipt was signed by the appropriate church officials and broke down the contributions between monthly amounts paid and special contributions, it failed to state whether any goods or services were provided in consideration for the contributions. Likewise, non-cash contribution receipts also failed to acknowledge that no consideration was received in exchange for the contribution. To add insult to injury, the Tax Court affirmed the imposition of the accuracy-related penalty because of the taxpayer's negligence. The Tax Court pointed out that the taxpayer was an IRS Revenue Officer, and was a "self-professed" frequent contributor to charitable organizations and, thus, should have known the rules relating to charitable contribution substantiation. However, the court did permit a charitable deduction for substantiated contributions not subject to the special substantiation rules.

Healthcare

Healthcare costs and fringe benefits continue to create tax-planning opportunities for taxpayers. One opportunity involves an entity hiring an owner's spouse, and then paying the healthcare premiums for the spouse. Some guidance in this area was provided by the Tax Court when it addressed the issue in Hurst. (24) In that case, the taxpayer's spouse was treated as a 2% owner, even though she was not a shareholder, because of her husband's or son's ownership of the stock. Thus, she was not considered an employee for fringe benefit, and could not exclude the premium payment as a fringe benefit. However, she could claim the self-employed health insurance deduction.

In Rev. Rul. 2005-24, (25) the IRS ruled that a medical reimbursement plan that pays any excess amounts in cash (or any other benefits) was not a qualified plan. Accordingly, any payments under the plan would not be excludible by the employee. This ruling applies to plans covering both active employees and retired employees, as well as plans that just cover retired employees. Also, in Rev. Rul. 2005-25, (26) the IRS confirmed that contributions to a health savings account can be made by a taxpayer if his or her spouse has nonqualifying family coverage, as long as the spouse's health coverage does not include the individual. In addition, the ruling provides guidance on the amount such a spouse can contribute.

Other

Over the years, divorce and alimony have long been the source of many cases, and 2005 was no different. In Dunkin, (27) the Tax Court dealt with the question of whether monthly payments to an ex-spouse, based on retirement benefits the payor would have been entitled to if he had retired when initially eligible, qualified as alimony payments. In ruling that those payments were deductible, the court considered the fact that the payments were designed to prevent the payor from depriving his ex-spouse of her interest in his benefits. Accordingly, the assignment-of-income rules did not apply. In another Tax Court decision, Lofstrom, (28) a taxpayer was not permitted to deduct the value of a contract for a deed transferred to his ex-spouse in satisfaction of past and future alimony payments. Because the contract for the deed represented a third-party obligation, it was not a cash payment and, thus, not deductible as alimony.

The classification of activities as active or passive and the ability to deduct passive losses remains a hot topic, particularly on examination. For example, in Misko, (29) an attorney leased office equipment and state of the art video equipment to his 100%-owned C corporation law firm that ran a class action practice. The court concluded that the attorney was entitled to deduct the losses from the leasing activity because he engaged in the leasing activity as a bona-fide trade or business, not as a hobby, and the leasing activity was incidental to a nonrental activity--the operation of his law firm. Even though the law firm had no income (class action lawsuits frequently take years, providing no income to an attorney until the case is settled or tried) and thus did not pay the rents, the losses were still deductible business losses. The attorney proved that the losses were not hobby losses under Sec. 183 and that he operated the leasing business in a business-like manner. Further, an exception to the application of the passive-loss rules applies when a rental activity is incidental to a nonrental activity. For the exception to apply, Temp. Kegs. Sec. 1.469-1T(e)(ii)(D) requires (1) the taxpayer to own an interest in the trade or business to which the rental activity was incidental, (2) the property to be used in that business and (3) gross rental income to be less than 2% of the lesser of the unadjusted basis of the property and the property's fair market value. Because the attorney met all three requirements, the rental losses were incidental to the practice of law and deductible.

Tax Shelters

Tax shelters continue to be the target of IRS enforcement initiatives. In 2005, the IRS continued its strategy of offering settlements to taxpayers involved in various tax shelters. The 2005 settlement initiative (30) was offered to investors in 21 abusive tax shelters. It followed the basic terms of prior settlement initiatives including the son-of-boss transactions and the transfer by executives of stock options to family-controlled entities. The 2005 initiative, which closed on Jan. 23, 2006, required involved taxpayers to pay the tax owed on the transaction, interest and a penalty. Depending on the type of transaction, the penalty would be one-half or one-quarter of the maximum applicable penalty However, in opting to use the settlement strategy, taxpayers avoided litigation and criminal investigation. In exchange, the IRS would generally permit an ordinary deduction for the out-of-pocket expenses and costs of the shelter.

Pushing taxpayers to consider the settlement opportunity was a provision of the Gulf Opportunity Zone Act of 2005 (GO Zone Act), a post-Katrina tax act. The GO Zone Act now permits interest to be continuously assessed on any additional taxes arising from an abusive tax shelter transaction. Under prior law, the interest was generally suspended for an 18-month period beginning after filing and continuing until Oct. 3, 2004. However, the GO Zone Act excludes interest on any transaction disclosed as part of the settlement initiative.

Business Plan

The IRS issued its 2005 business plan, incorporating several items affecting individuals. One of the more interesting parts of the business plan was the impact of the "tax gap" on enforcement. The IRS, using the results of the National Research Program (designed to help determine how to better audit taxpayers), concluded that the "tax gap "was approximately $257 billion--$298 billion. (31)

The major areas of noncompliance are income reporting from flow-through entities and sole proprietor's income and expenses. For individuals, the top IRS enforcement priorities are to discourage and deter noncompliance, focusing on individuals with incomes over $100,000, and to detect and deter domestic and offshore-based tax and financial criminal activity. In addition, individuals will benefit from IRS modernization. Beginning in January 2005, the IRS implemented the first module of the Customer Account Data Engine, which now permits the IRS to process Form 1040EZ on the new system.

The small business/self-employment division, in its plan, will retool the audit process to reduce cycle time and identify noncompliant taxpayers. It will focus on high-income taxpayers with income above $200,000, especially those with income above $1 million, and small businesses with assets under $10 million, particularly pass-through entities. Under the retooled audit process, agents are expected to clearly communicate their expectations concerning specific examination issues, required documentation and an agreed-on completion date to taxpayers. Further, they will meet with their managers at the beginning of an examination to discuss the audit approach. Further, they will employ standardized templates for each issue. Finally, there will be greater flexibility in scheduling exams to reduce cycle time.

The Wage and Investment Division will continue to work on reducing the earned income credit audit cycle, redesigning notices to be more taxpayer-friendly and continuing to promote and simplify E-Services for taxpayers.

Automatic Extension

The IRS gave some great news to CPAs and their clients. Effective for 2005 individual tax returns filed in 2006, an automatic six-month extension will replace the four-month extension. Thus, extensions requested for 2005 tax returns due on April 17, 2006 (April 15 falls on a Saturday; the next business day is April 17) will now automatically be extended until Oct. 15, 2006 (actually, the extension will be until Oct. 16, 2006 because the 15th falls on a Sunday). As a result, requests for a second extension are no longer necessary.

For more information about this article, contact Mr. Mares at [e-mail].

(1) See Tax Clinic, 37 The Tax Adviser 6 (January 2006).

(2) P.L. No. 109-58 (8/8/05).

(3) P.L. No. 109-59 (8/10/05).

(4) Notice 2006-9, IRB 2006-6, 413.

(5) Notice 2005-14, IRB 2005-7, 498.

(6) John Banks, 125 S.Ct. 826 (2005).

(7) IRS Letter Ruling 200504012 (1/28/05).

(8) Rev. Rul. 2005-74, IRB 2005-51, 1153.

(9) Rev. Rul. 2005-11, IRB 2005-14, 816.

(10) Ronald J. Speltz, 124 TC 165 (2005).

(11) Randolph George, 420 F3d 991 (9th Cir. 2005).

(12) Robert J. Merlo, TC Memo 2005-178.

(13) Augustin B. Jombo, 398 F3d 661 (DC Cir. 2005).

(14) David E. Jones, 355 FSupp2d 1292 (DC AL 2005).

(15) Warren L. Baker, 338 F3d 789 (7th Cir. 2003).

(16) Rev. Proc. 2004-64, 2004 IRB-49, 898.

(17) Ann. 2005-71, IRB 2005-41, 714.

(18) Rev. Proc. 2005-78, IRB 2005-51, 1177.

(19) Rev. Proc. 2005-13, IRB 2005-12, 759.

(20) Rev. Rul. 2005-52, IRB 2005-35, 423; see "Tool Allowances Based on Actual Costs," Tax Trends, 36 The Tax Adviser 713 (November 2005).

(21) Rev. Proc. 2005-10, IRB 2005-3, 341.

(22) Notice 2005-44, IRB 2005-25, 1287.

(23) Betty Kendrix, TC Memo 2006-9.

(24) Richard Hurst, 124 TC 16 (2005).

(25) Rev. Rul. 2005-24, IRB 2005-16, 892.

(26) Rev. Rul. 2005-25, IRB 2005-18, 971.

(27) John M. Dunkin, 124 TC No. 10 (2005).

(28) Dennis Lofstrom, 125 TC No. 13 (11/22/05).

(29) Fred Misko, TC Memo 2005-166.

(30) Ann. 2005-80, IRB 2005-46, 967.

(31) IR-2005-38.

Michael E. Mares, CPA/ABV, J.D.

Witt Mares, PLC

Newport News, VA