2011 Tax Considerations

Before the year end, Peter Shannon & Co. updates the Tax Considerations articles every year. The following articles are categorized in:

Individual Income Tax Provisions
Education
Estate, Gift, and Generation-Skipping Transfer Taxes
Pension and IRA Provisions
Business Provisions
Things to Consider before the End of 2011

Individual Income Tax Provisions

Individual Income Tax Brackets are Extended Through 2012
The 2010 Tax Relief Act provides that individuals’ taxable income for 2011 and 2012 will continue to be subject to six tax brackets, taxed at 10%, 15%, 25%, 31%, 33%, and 35% marginal tax rates.

Expansion of Marrieds-Filing-Jointly 15% Rate Bracket to Provide Marriage Penalty Relief is Extended Through 2012
A “marriage penalty” exists whenever the tax on a couple’s joint return is more than the combined taxes each spouse would pay if they were not married and if each filed a single or head of household return. The tax is more on a joint return if the couple’s taxable income is pushed into a higher marginal tax bracket than would apply if the couple were not married (so they pay at a higher tax rate on the same total income than they would pay if each were single). And that usually happens where both spouses work and have relatively equal incomes.

Prior law phased-in an increase in the size of the 15% regular income tax rate bracket for a married couple filing a joint return to equal twice the size (200%) of the corresponding rate bracket for an unmarried (single) individual. The Economic Growth and Tax Relief Act of 2001 (EGTRRA) also provided special inflation adjustments rules relating to this change.

The 2010 Tax Relief Act provides that the EGTRRA sunset will not take effect until after December 31, 2012. That is, for 2011 and 2012 the expanded 15% bracket for married joint filers, and the related special inflation adjustment rules, remain in effect.

Because the lowest tax rate bracket (the 10% bracket) for married joint filers for 2011 and 2012 is twice the size of the 10% bracket for single filers, for 2011 and 2012, the tax on a couple’s income reported on a joint return, up to the maximum income level under their 15% bracket, equals the tax two single filers-each reporting half that joint income-would pay.

Because all of the tax brackets for joint filers are not made equal to twice the corresponding single filer tax brackets, however, the marriage penalty effect under the income tax rate schedules is not completely eliminated by the above-described changes.

Kiddie Tax Rates are Extended Through 2012
The 2010 Tax Relief Act provides that the EGTRRA sunset will not take effect until after December 31, 2012 (instead of after December 31, 2010).

That is, as a result of the above extension, for tax years 2011 and 2012:

Kiddie tax – a parent who elected to report a child’s income on the parent’s return must also include 10% (instead of 15%) of the lesser of: (a) the inflation-adjusted standard deduction in effect for the tax year allowable to a child who can be claimed as a dependent on the parent’s return, or (b) the excess of the child’s gross income over that amount.
Backup withholding rate on reportable payments – the rate stays at 28% (instead of rising to 31%).
Minimum withholding rates on supplemental wages under flat rate method – the optional flat rate for payments totaling $1 million or less for a calendar year stays at 25% (instead of rising to 28%), and the mandatory flat rate for payments totaling more than $1 million stays at 35% (instead of rising to 39.6%).
Voluntary withholding rates on specified federal payments – the rates stay at 7%, 10%, 15%, or 25% (instead of rising to 7%, 15%, 28%, or 31%).
Voluntary withholding on unemployment benefits – the rate stays at 10% (instead of rising to 15%).
Withholding on gambling winnings – the rate stays at 25% (instead of rising to 31%).
Withholding on Indian casino profits distributed to tribal members – the rate stays at 31%.

0% and 15% Capital Gain Rates are Extended Through 2012
A noncorporate taxpayer’s adjusted net capital gain is taxed at a maximum rate of 15%, or, to the extent it would have been taxed at a 10% or 15% rate if it had been ordinary income, at a maximum rate of 0%. These rates apply for both regular income tax and alternative minimum tax (AMT).

“Adjusted net capital gain” is net capital gain plus qualified dividend income, minus specified types of long-term capital gain that are taxed at a maximum rate of 28% (gain on the sale of most collectibles and on the unexcluded part of Code Sec. 1202 small business stock) or 25% (unrecaptured section 1250 gain, i.e., gain attributable to real estate depreciation).

“Net capital gain” is the excess of net long-term capital gains over net short-term capital losses for a tax year.

Under section 303 of the 2003 Jobs and Growth Act (JGTRRA), as amended by section 102 of the 2005 Tax Increase Prevention Act:

The 0% and 15% maximum rates on adjusted net capital gain were scheduled to expire for tax years beginning after December 31, 2010.
The rates in effect before passage of JGTRRA, which ranged from 8% to 20%, were scheduled to come back into effect.

The 2010 Tax Relief Act extends the 0% and 15% rates on adjusted net capital gain for two additional years, so that they apply for tax years beginning before January 1, 2013.

This two-year extension dispels some of the uncertainty that surrounded year-end tax planning for capital gains in 2010. Before the sunset was extended, individuals with large gains and few available losses to offset them faced the difficult choice of whether to realize some gains in 2010 to lock in the 15% rate, given the possibility that capital gain rates could rise for 2011. The extension of the sunset eliminates the rate increase as a consideration in year-end planning.

0% and 15% Rates on Qualified Dividend Income of Noncorporate Taxpayers are Extended Through 2012
“Qualified dividend income” – generally, dividends received from domestic corporations and “qualified foreign corporations,” subject to holding period requirements and specified exceptions – is effectively treated as, and is taxed at the same 0% and 15% maximum rates that apply to, adjusted net capital gain.

For dividends on stock to qualify as qualified dividend income, the taxpayer must hold the stock for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date.

The amount of a taxpayer’s “unrecaptured section 1250 gain” – that portion of a noncorporate taxpayer’s long-term capital gain that is attributable to real estate depreciation – that is eligible to be taxed at a maximum 25% rate is limited to the taxpayer’s net capital gain determined without regard to the taxpayer’s qualified dividend income.

Under section 303 of the 2003 Jobs and Growth Act, as amended by section 102 of the 2005 Tax Increase Prevention Act.

The Taxation of qualified dividend income at 0% and 15% rates was scheduled to expire for tax years beginning after December 31, 2010;
Qualified dividend income was then to be taxed at ordinary income rates.

Similarly, the following rules were scheduled to expire for tax years beginning after December 31, 2010:

The holding period rule for determining when dividends on stock qualify as qualified dividend income, and
The exclusion of qualified dividend income from net capital gain for purposes of computing the limitation on the amount of unrecaptured section 1250 gain that is eligible to be taxed at a maximum 25% rate.

The 2010 Tax Relief Act extends the treatment of qualified dividend income as adjusted net capital gain, taxable at the same 0% and 15% maximum rates that otherwise apply to adjusted net capital gain, for two additional years, so that it applies for tax years beginning before January 1, 2013.

The 2010 Tax Relief Act also extends the following rules so that they apply for tax years beginning before January 1, 2013:

The holding period rule for determining when dividends on stock qualify as qualified dividend income.
The exclusion of qualified dividend income from net capital gain for purposes of computing the limitation on the amount of unrecaptured section 1250 gain that is eligible to be taxed at a maximum 25% rate.

100% Gain Exclusion for Qualified Small Business Stock (QSBS) is Extended Through December 31, 2011
Subject to a per taxpayer limit, noncorporate taxpayers exclude 100% of the gain realized on the sale of “qualified small business stock” held for more than five years and acquired in a temporary period. Additionally, the excluded portion of the gain from eligible QSBS is excepted from treatment as an alternative minimum tax (AMT) preference item.

The effect of the AMT exception is that, subject to the per taxpayer limit and the more-than-five-year holding requirement, no gain from QSBS acquired during the temporary period is taxed for either regular tax or AMT purposes.

Under pre-2010 Tax Relief Act law, the temporary period began on September 28, 2010 and ended on December 31, 2010.

For periods before and after the temporary period, the exclusion , instead of being a 100% exclusion, is a partial exclusion, allowed in varying amounts. Thus, for stock acquired before or after the temporary period, the excluded percentage is 50% (60% for certain stock issued by corporations in empowerment zones), but is 75% for any QSBS acquired after February 17, 2009 and before September 28, 2010.

For regular income tax purposes, the portion of the gain that is includible in taxable income is taxed at a maximum rate of 28%. Thus, for regular tax purposes, the gain from QSBS that is subject to the 50% exclusion is taxed at a maximum effective rate of 14%, and the gain from QSBS that is subject to the 75% exclusion is taxed at a maximum effective rate of 7%.

Also, for periods before and after the temporary period discussed above, a varying percentage of the excluded portion of gain from QSBS is treated as a preference item and, thus, is included in income. The percentage is equal to 7%, 28% or 42%, depending on when the stock was acquired and other facts.

Generally, QSBS must be acquired by the taxpayer at original issue and after August 10, 1993. Also, QSBS must be issued by a corporation that meets a gross assets limit and certain other requirements. Under the per taxpayer limit, the gain excludible by a taxpayer for the QSBS of any one corporation is the greater of:

ten times the taxpayer’s basis (excluding post-issuance basis increases) in that corporation’s QSBS disposed of by the taxpayer in the tax year, or
$10 million ($5 million if married filing separately), and the $10 million (or $5 million) amount is reduced by the total amount of eligible gain taken into account by the taxpayer on dispositions of that corporation’s QSBS in earlier tax years.

The 2010 Tax Relief Act extends the 100% exclusion and exception from minimum tax treatment for QSBS for one year by changing the date before which eligible QSBS must be acquired from January 1, 2011 to January 1, 2012.

Thus, subject to the per taxpayer limit (see above) and the more-than-five-year holding requirement (see above), no regular tax or AMT is imposed on the sale or exchange of QSBS acquired after September 27, 2010 and before January 1, 2012.

On October 1, 2011, T, and individual, acquires at original issuance 100 shares of QSBS at a total cost of $100,000. T sells all of the shares on October 2, 2016 for $1.1 million. Assuming that none of the possible income exclusion is barred by the per taxpayer limit (see above), T excludes from income all of the $1 million of gain for regular tax and AMT purposes.

Unless Congress extends beyond December 31, 2011 the deadline for acquiring QSBS eligible for the 100% gain exclusion, the 50% and 60% gain exclusion rules will again be in effect, and a percentage of the excluded portion of the gain will be treated as a preference item for AMT purposes.

15% Accumulated Earnings Tax Rate and 15% Personal Holding Company Tax Rate are Extended Through 2012
The 2003 Jobs and Growth Act (JGTRRA) reduced the maximum tax rate paid by noncorporate taxpayers on qualified corporate dividends to 15%. Because the purpose of the accumulated earnings tax and the personal holding company tax was to prevent corporations from accumulating their earnings and not distributing the earnings as taxable dividends, the 2003 Jobs and Growth Act also reduced the accumulated earnings tax rate and the undistributed personal holding company tax rate of 15%.

Under §303 of the 2003 Jobs and Growth Act as amended by §102 of the 2005 Tax Increase Prevention and Reconciliation Act, the rules that subject qualified dividend income to a maximum 15% tax rate and the rules reducing the accumulated earnings tax rate and the undistributed personal holding company tax rate to 15% were due to expire at the end of 2010.

The 2010 Tax Relief Act extends the 15% maximum tax rate that applies to qualified dividend income for two additional years. In connection with that extension, the 2010 Tax Relief Act also extends the 15% accumulated earnings tax rate and the 15% undistributed personal holding company tax rate for two additional years, so that they apply for tax years beginning before January 1, 2013.

Exclusion of Qualified Dividend Income from Investment Income is Extended Through 2012
A noncorporate taxpayer’s deduction for investment interest expense is limited to the amount of the taxpayer’s net investment income, i.e., the excess of investment income over investment expenses for the year. Any investment interest that is disallowed because it exceeds this limit is carried over to the next tax year and treated as investment interest paid or accrued in that year.

Qualified dividend income (dividends taxed at the 0% or 15% capital gain rates) is included in “investment income” for this purpose only to the extent the taxpayer so elects. Any amount that the taxpayer elects to treat as investment income is not treated as qualified dividend income and is not eligible to be taxed at the 0% or 15% rates.

This means that a taxpayer whose investment interest deduction is limited because the interest exceeds the amount of his net investment income can increase the deduction by electing to include all or part of qualified dividend income in investment income. The cost of making the election is that the dividends will be taxed as ordinary income rather than capital gain.

The 2010 Tax Relief Act extends the above rule regarding the treatment of qualified dividend income as investment income so that it applies for tax years beginning before January 1, 2013.

Employee’s Social Security Tax Rate for 2011 is Reduced from 6.2% to 4.2%

FICA Tax
The Federal Insurance Contributions Act (FICA) imposes two taxes on employers and employees, an old-age, survivors, and disability insurance (OASDI) tax, commonly referred to as social security tax, and a hospital insurance (HI) or Medicare tax.

For 2011, the OASDI tax is computed on the first $106,800 of the employee’s wages. The HI tax is computed on the employee’s total wages.

The HI tax rate is 1.45%. Under pre-2010 Tax Relief Act law, the OASDI tax was 6.2%, for a combined tax rate of 7.65% on both employers and employees.

Making Work Pay Credit
For tax years beginning in 2009 and 2010, eligible individuals were allowed a refundable income tax credit (the “making work pay credit”) equal to the lesser of:

6.2% of the taxpayer’s earned income, or
$400 ($800 for a joint return). The credit was phased out at a rate of 2% of the taxpayer’s modified adjusted gross income (MAGI) above $75,000 ($150,000 for joint returns).

Payroll Tax Holiday for Workers Hired in 2010
The employer OASDI tax was forgiven for wages paid from March 19, 2010 to December 31, 2010 to workers hired after February 3, 2010, who certified that they had not been employed for more than 40 hours during the 60-day period ending on the date they started employment.

The 2010 Tax Relief Act reduces the employee OASDI tax rate from 6.2% to 4.2% for 2011. The employer OASDI tax rate remains at 6.2% A similar rate reduction applies to the railroad retirement tax.

Under the 2010 Tax Relief Act, the employee OASDI tax rate is 4.2% for remuneration received during the “payroll tax holiday period,” defined as calendar year 2011.

The FICA tax rate for 2011 on employees’ wages up to $106,800 is 5.65% (4.2% OASDI tax +1.45% HI tax). On wages in excess of $106,800, the rate is 1.45%.

The maximum reduction in FICA tax for an individual employee is $2,136 ($106,800 x .02). For a married couple, each with wages of $106,800 or more, the maximum reduction would be $4,272.

The OASDI tax rate reduction differs from the payroll tax holiday that was in effect for 2010. The holiday was designed to encourage hiring of unemployed workers by forgiving the employer’s OASDI tax for those workers. The rate reduction cuts the employee’s OASDI tax for all employees, not just the newly-hired. It is designed to boost consumer spending by giving workers a de facto pay increase, in the hope that the increased demand will lead to new hiring.

Self-Employed Individual’s Social Security Tax Rate for 2011 is Reduced from 12.4% to 10.4%
The Self-Employment Contributions Act (SECA) imposes two taxes on self-employed individuals: an old-age, survivors, and disability insurance (OASDI) tax, commonly referred to as social security tax, and a hospital insurance (HI) or Medicare tax.

These SECA taxes apply to “net earnings from self-employment” above a $400 minimum for the tax year. There is an annually-adjusted ceiling limitation on the amount subject to OASDI tax ($106,800 for 2011), but no limit on the HI tax.

The HI tax rate is 2.9%. Under pre-2010 Tax Relief law, the OASDI tax rate was 12.4%.

AMT Relief in The 2010 Tax Relief Act

Brief Overview of the AMT
The AMT is a parallel tax system which does not permit several of the deductions permissible under the regular tax system, such as property tax. Taxpayers who may be subject to the AMT must calculate their tax liability under the regular federal tax system and under the AMT system taking into account certain “preferences” and “adjustments”. If their liability is found to be greater under the AMT system, that’s what they owe the federal government. Originally enacted to make sure that wealthy Americans did not escape paying taxes, the AMT has started to apply to more middle-income taxpayers, due in part to the fact that the AMT parameters are not indexed for inflation.

In recent years, Congress has provided a measure of relief from the AMT by raising the AMT “exemption amounts” – allowances that reduce the amount of alternative minimum taxable income (AMTI), reducing or eliminating AMT liability. (However, these exemption amounts are phased out for taxpayers whose AMTI exceeds specified amounts.) For 2009, the AMT exemption amounts were $70,950 for married couples filing jointly and surviving spouses; $46,700 for single taxpayers; and $35,475 for married filing separately. However, for 2010, those amounts were scheduled to fall back to the amounts that applied in 2000: $45,000, $33,750, and $22,500, respectively. This would have brought millions of additional middle-income Americans under the AMT system, resulting in higher federal tax bills for many of them, along with higher compliance costs associated with filling out and filing the complicated AMT tax form.

New Law Provides Two-Year Stopgap Fix
To prevent the unintended result of having millions of middle-income taxpayers fall prey to the AMT, Congress has once again relied on a temporary “patch” to the problem, this time a two-year extension of the 2009 exemption amounts, increased slightly. Under the new law, for tax years beginning in 2010, the AMT exemption amounts are increased to:

$72,450 in the case of married individuals filing a joint return and surviving spouses;
$47,450 in the case of unmarried individuals other than surviving spouses; and
$36,225 in the case of married individuals filing a separate return.

For tax years beginning in 2011, the AMT exemption amounts are increased to:

$74,450 in the case of married individuals filing a joint return and surviving spouses;
$48,450 in the case of unmarried individuals other than surviving spouses; and
$37,225 in the case of married individuals filing a separate return.

Personal Credits May Be Used to Offset AMT Through 2011
Another provision in the new law provides AMT relief for taxpayers claiming personal tax credits. The tax liability limitation rules generally provide that certain nonrefundable personal credits (including the dependent care credit and the elderly and disabled credit) are allowed only to the extent that a taxpayer has regular income tax liability in excess of the tentative minimum tax, which has the effect of disallowing these credits against the AMT. Temporary provisions had been enacted which permitted these credits to offset the entire regular and AMT liability through the end of 2009. The new law extends this temporary provision to 2010 and 2011.

2010/2011 AMT Exemption Amounts are Retroactively Increased to $47,450/$48,450 for Unmarrieds and $72,450/$74,450 for Joint Filers

In computing the alternative minimum tax (AMT) for individuals, the AMT tax rate is applied against the taxpayer’s alternative minimum taxable income (AMTI), as reduced by the taxpayer’s exemption amount (which phases out for AMTI above certain threshold levels).

Pre-2010 Tax Relief Act law provided the following statutory AMT exemption amounts for tax years beginning in 2010 (and later years):

$33,750 for unmarried individuals who are not surviving spouses;
$45,000 for married couples filing jointly and surviving spouses; and
$22,500 (technically, 50% of the joint return/surviving spouse amount) for married individuals filing separately.

AMT “patch” provisions (to reduce the number of individuals who otherwise would be subject to the AMT) began with the temporary increases to the AMT exemption amounts provided by the Economic Growth and Tax Relief Reconciliation Act of 2001. Additional increases for 2003 and 2004, and temporary increases for 2005, were provided by the Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Working Families Tax Relief Act of 2004, respectively.

Later legislation also provided similar one-year “patches” for 2006 through 2009. For example, the 2009 Recovery Act provided the following higher AMT exemption amounts for tax years beginning in 2009:

$46,700 for unmarried individuals who were not surviving spouses;
$70,950 for married couples filing jointly and surviving spouses; and
$35,475 for married individuals filing separately.

Under pre-2010 Tax Relief Act law, the temporary increases expired after 2009. This meant that the lower generally applicable statutory AMT exemption amounts were to apply for 2010 and 2011.

The 2010 Tax Relief Act increases the individual AMT exemption amounts for 2010 and 2011 (rather than allowing them to decrease to pre-“patch” statutory levels). Specifically, for tax years beginning in 2010, the AMT exemption amounts are:

$72,450 (up from $70,950 in 2009) for married couples filing a joint return and surviving spouses;
$47,450 (up from $46,700 in 2009) for an individual who is not married or a surviving spouse; and
$36,225 (up from $35,475 in 2009) for married individuals filing separate returns.

For tax years beginning in 2011, the AMT exemption amounts will be further increased as follows:

To $74,450 for married couples filing a joint return and surviving spouses;
To $48,450 for an individual who is not married or surviving spouse; and
To $37,225 for married individuals filing separate returns.

AMT Exemption Amount for Estate and Trusts
The 2010 Tax Relief Act does not change the $22,500 exemption amount for an estate or trust.

Phase-Out of AMT Exemption Amount
The 2010 Tax Relief Act does not change the phase-out rules for the AMT exemption amount. Under those rules, the AMT exemption amount is reduced by an amount equal to 25% of the amount by which the individual’s AMTI exceeds the following threshold amounts:

$112,500 for unmarried individuals,
$150,000 for married individuals filing a joint return and surviving spouses, and
$75,000 for married individuals filing separate returns.

0% and 15% AMT Capital Gain Rates are Extended Through 2012
The 2010 Tax Relief Act extends the 0% and 15% AMT rates on adjusted net capital gain for two additional years, so that they apply for tax years beginning before January 1, 2013.

Nonrefundable Personal Credits Can Offset AMT Through 2011 (Instead of 2009)
Individuals can qualify for a number of nonrefundable personal tax credits. These credits are subject to limitations based on tax liability. For tax years when Code Sec. 26(a)(2) applies, the credits can be used to offset alternative minimum tax (AMT) as well as regular income tax. For tax years when Code Sec. 26(a)(2) does not apply, most of the credits are subject to Code Sec. 26(a)(1), which does not allow the AMT offset. Certain “specified personal credits” are excepted from Code Sec. 26(a)(1) and have their own separate limitations that allow the AMT offset.

For tax years beginning before 2010 (tax years when Code Sec. 26(a)(2) applied), the nonrefundable personal credits were allowed to the extent of the full amount of the individual’s regular tax and AMT.

The 2010 Tax Relief Act (“the Act”) extends Code Sec. 26(a)(2) so that it applies to tax years beginning during 2010 and 2011. This allows an individual to offset the entire regular tax liability and AMT liability by the nonrefundable personal credits for 2010 and 2011.

$1,000 Per Child Amount and Expanded Refundability of Child Tax Credit are Extended Through 2012

An individual may claim a child tax credit (CTC) for each qualifying child under the age of 17.

Sec. 201 of the 2001 Economic Growth and Tax Relief Reconciliation Act as amended by the 2003 Jobs and Growth Tax Relief Reconciliation Act and the 2004 Working Families Tax Relief Act, modified the CTC as follows:

The per child amount of the CTC was gradually increased to $1,000 (from $500).
The CTC was made refundable for all taxpayers with qualifying children, regardless of the number of children, to the extent of 15% of the taxpayer’s earned income in excess of a threshold amount (the “earned income formula”). This statutory threshold amount of $10,000 was indexed for inflation from 2001. Families with three or more children were allowed to compute their refundable CTC using the earned income formula or by using the method available to them under pre-EGTRRA law (the excess, if any, of the taxpayer’s social security taxes over the EIC for the year).

The 2010 Tax Relief Act (the Act) extends the EGTRRA changes to the CTC for two years (through 2012) by postponing the EGTRRA sunset date to December 31, 2012. Specifically, the Act provides that the provisions of, and amendments made by, EGTRRA will not apply to tax years beginning after December 31, 2012 (instead of after December 31, 2010). In other words, the $1,000 per child amount of the CTC and the earned income formula for determining the refundable portion of the credit are extended for two years (through 2012).

EGTRRA-Expanded Dependent Care Credit is Extended Through 2012
Taxpayers who have one or more qualifying individuals (a dependent qualifying child under age 13, or a dependent or spouse who is incapable of self-care and has the same principal place of abode as the taxpayer for more than half the tax year) are allowed a dependent care credit equal to a percentage of the expenses paid for the care of the qualifying individual(s) that enable the taxpayer to be gainfully employed (“eligible expenses”).

Sunset
The EGTRRA enhancements to the dependent care credit are subject to the EGTRRA sunset provision. After the EGTRRA sunset date, the credit percentage, credit base, and maximum credit all revert to the lower pre-EGTRRA levels after. That is, the credit percentage drops to 30% and begins to phase out at AGI of $10,000. The maximum credit drops to $720 (30% of up to $2,400 of eligible expenses) for one qualifying individual, and to $1,440 (30% of up to $4,800 of eligible expenses) for two or more.

Under pre-2010 Tax Relief Act law, the EGTRRA enhancements to the dependent care credit were scheduled to sunset after December 31, 2010. This meant that the above-described reductions to the credit percentage, credit base, and maximum credit were to apply for tax years beginning after December 31, 2010. That is, the reduced amounts were to be in effect for 2011 and later years.

The 2010 Tax Relief Act (the Act) extends the dependent care credit EGTRRA expansion for two years (through 2012) by postponing the EGTRRA sunset date to December 31, 2012 (instead of December 31, 2010). Specifically, the Act provides that the provisions of, and amendments made by, EGTRRA will not apply to tax years beginning after December 31, 2012 (instead of after December 31, 2010).

In other words, the expanded dependent care credit rules provided under EGTRRA §204 apply for an additional two years. That is, for 2011 and 2012, qualifying taxpayers with AGI of $15,000 or less are allowed a dependent care credit equal to 35% of eligible expenses paid during the year. The percentage decreases by 1% for each $2,000 (or fraction thereof) of additional AGI, until it is reduced to 20% (at AGI of $43,000). The maximum amount of expenses that can be used to compute the credit is $3,000 for one qualifying individual and $6,000 for two or more qualifying individuals. Thus, the maximum credit is $1,050 (35% x $3,000) for one qualifying individual, and $2,100 (35% x $6,000) for two or more.

EIC Simplification is Extended Through 2012
Certain low- and moderate-income workers are allowed a refundable credit, the “earned income credit” (EIC). Eligibility for the EIC is based, in part, on earned income, adjusted gross income, filing status, and number of qualifying children. The amount of the EIC is based on the presence and number of qualifying children in the taxpayer’s family, as well as on adjusted gross income (AGI) and earned income. The EIC is computed (subject to a phaseout) by multiplying a credit percentage by the taxpayer’s earned income.

The EIC generally equals a specified percentage of earned income up to a maximum dollar amount. The maximum amount applies over a certain income range and then diminishes to zero over a specified phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the beginning of the phaseout range, the maximum EIC amount is reduced by the phaseout rate multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is allowed.

The 2010 Tax Relief Act provides that the EGTRRA sunset will not take effect until after December 31, 2012 (instead of after December 31, 2010). The EGTRRA changes to the EIC rules described above are extended for two years (through 2012). As discussed above, these include: (1) a simplified definition of earned income; (2) a simplified relationship test; (3) use of AGI instead of MAGI; (4) a simplified tie-breaking rule; and (5) the repeal of the prior-law provision that reduced an individual’s EIC by the amount of his AMT liability.

Expanded Adoption Credit Rules (But Not Refundability) are Extended Through 2012
Under Code Sec. 36C, individuals are allowed a credit for qualified adoption expenses paid or incurred for the adoption of an eligible child (the “adoption credit”). The credit is refundable, and is allowed against income tax and alternative minimum tax (AMT). The maximum credit is $13,360 per eligible child for 2011 ($12,650 for 2012), for both special needs and non-special needs adoptions. The credit begins to phase out for taxpayers with modified adjusted gross income (AGI) over $185,210 for 2011 ($189,710 for 2012) and is fully eliminated at modified AGI of $225,210 for 2011 ($229,710 for 2012). All these dollar amounts are adjusted annually for inflation.

The 2010 Tax Relief Act (the Act) extends the EGTRRA expansion of the adoption credit rules for one year (through 2012) by postponing the general EGTRRA sunset date to December 31, 2012 and removing the EGTRRA changes from the changes subject to the special sunset date.

The December 31, 2011 sunset date for the 2010 Patient Protection and Affordable Health Care Act (PPACA) changes means that the changes will not apply for tax years beginning after December 31, 2011. The adoption credit rules will revert to pre-PPACA law. This means that in 2012:

The maximum per-child credit will drop to $12,650 (indexed for inflation after 2010);
The credit will not be refundable, and will not be provided by Code Sec. 36C. Instead, it will be a nonrefundable credit provided by Code Sec. 23;
The credit will be subject to the tax liability limitations (under either Code Sec. 26(a)(2) or Code Sec. 23(b)(4), whichever applies), and carryover rules that applied before the PPACA changes were enacted; and
The references to Code Sec. 23 that were deleted from certain credit provisions will be restored.

The December 31, 2012 sunset date for the EGTRRA changes means that the changes will not apply for tax years beginning after December 31, 2012. The adoption credit rules will revert to pre-EGTRRA law. This means that starting in 2013:

The credit will be available only for special need adoptions;
The maximum per-child credit will drop to $6,000, and will depend on actual expenses;
The modified AGI starting point for the credit phase-out will be reduced to $75,000 – i.e., the credit will be eliminated at modified AGI of $115,000;
Absent a further extension of Code Sec. 26(a)(2), the credit will not be allowed against AMT because it will be subject to the general Code Sec. 26(a)(1) tax liability limitation.

Nonbusiness Energy Property Credit is Extended for 2011 under Pre-2009 Recovery Act Rules
Individuals are allowed a nonrefundable personal income tax credit, known as the nonbusiness energy property credit, for certain energy efficient property installed in a dwelling located in the U.S. and owned and used by the taxpayer as the taxpayer’s principal residence.

Under pre-2010 Tax Relief Act law, the credit was equal to 30% of the sum of:

The amount paid or incurred by the taxpayer during the tax year for qualified energy efficiency improvements (building envelop components meeting certain requirements) installed during the tax year, and
The amount of residential energy property expenditures paid or incurred by the taxpayer during the tax year for the purchase of (a) advance main air circulating fans, (b) qualified natural gas, propane, or oil furnace or hot water boilers, and (c) energy-efficient building property.

The aggregate amount of the credit allowed for a taxpayer for tax years beginning in 2009 and 2010 is $1,500. The credit was not available for property placed in service in 2008, but a credit of 10% of qualified energy efficiency improvements plus specified dollar amounts for residential energy property expenditures, subject to a $500 lifetime limit ($200 for windows), applied for 2006 and 2007.

Under pre-2010 Tax Relief Act law, the credit was not available for property placed in service after December 31, 2010.

The 2010 Tax Relief Act:

Extends the credits for one year;
Returns to the credit structure and rates in effect before the 2009 Recovery Act;
Allows the credit for windows, skylights, and doors that meet the Energy Star standards;
Restores to their previous levels certain efficiency standards that were weakened by the 2009 Recovery Act;
Reinstates the rule that denies the credit for expenditures made from subsidized energy financing.

Credit Extended for One Year
Under the 2010 Tax Relief Act, the nonbusiness energy property credit will not apply for property placed in service after December 31, 2011 (rather than after December 31, 2010).

Credit Rates and Limits Return to Pre-2009 Recovery Act Rules
Under the 2010 Tax Relief Act, the nonbusiness energy property credit is equal to the sum of:

10% of the amount paid or incurred by the taxpayer for qualified energy efficiency improvements installed during the tax year, and
The amount of the residential energy property expenditures paid or incurred by the taxpayer during the tax year.

Thus, the credit consists of a 10% credit for the purchase of energy-efficient building envelope components that meet certain requirements and specified credits for the purchase of specific energy efficient property placed in service by the taxpayer during the tax year.

Dollar Limits on Residential Energy Property Expenditures
The credit allowed for residential energy property expenditures cannot exceed:

$50 for each advanced main air circulating fan;
$150 for each qualified natural gas, propane, or oil furnace or hot water boiler; and
$300 for each item of energy-efficient building property.

Lifetime Limit is $500 ($200 for Windows)
Under the 2010 Tax Relief Act, a taxpayer’s maximum nonbusiness energy property credit for all tax years is $500, no more than $200 of which may be for expenditures on windows.

Thus, the nonbusiness energy property credit allowed to a taxpayer for a tax year cannot exceed the excess (if any) of $500 over the aggregate nonbusiness energy property credits allowed to that taxpayer for all earlier tax years ending after December 31, 2005.

The nonbusiness energy property credit allowed for amounts paid or incurred for exterior windows and skylights by a taxpayer for any tax year cannot exceed the excess (if any) of $200 over the aggregate nonbusiness energy property credits allowed for those amounts for all earlier tax years ending after December 31, 2005.

The above credit rates, dollar limits, and lifetime limits are the same as in effect for 2006 and 2007. The 2009 Recovery Act provided an enhanced nonbusiness energy property credit for 2009 and 2010, but the 2010 Tax Relief Act returns the credit to its earlier, less generous form for 2011.

To apply the $500 lifetime limit, the taxpayer must look back to all tax years for which the nonbusiness energy property credit was in effect. Those years include 2006 and 2007, when the credit was subject to a $500 lifetime limit, and 2009 and2010, when there was a $1,500 aggregate limit.

If the total of nonbusiness energy property credits for all earlier years is $500 or more, the taxpayer cannot claim a credit for 2011. If the total is less than $500, the taxpayer can claim up to $500 minus the total credits claimed in earlier years.

Personal Exemption Phaseout (PEP) Will Not Apply Until After 2012 (Instead of After 2010)
Taxpayers are allowed two types of personal exemptions: the exemption for the taxpayer and the taxpayer’s spouse, also referred to as the “personal exemptions” and the exemption for dependents. An individual is entitled to a deduction of a $3,650 for 2010 (as adjusted for inflation) for a personal exemption.

Under the personal exemption phaseout (PEP) rules in effect before the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), the exemption amount of a taxpayer whose adjusted gross income (AGI) for the tax year exceeded a specified threshold amount was reduced by an applicable percentage. The applicable percentage was two percentage points for every $2,500 (or fraction of $2,500) by which the taxpayer’s AGI for the tax year exceeded the threshold amount. The threshold amount varied, depending on the taxpayer’s filing status.

EGTRRA Changes

Reduced the PEP for tax years beginning after December 31, 2005, and before January 1, 2010; and
Eliminated the PEP for tax years beginning after December 31, 2009.

Under pre-2010 Tax Relief Act law, a sunset provision had provided that all changes made by EGTRRA would not apply to tax years beginning after December 31, 2010. In other words, the PEP rules would have reverted to pre-EGTRRA law for tax years beginning after 2010.

Reversion to pre-EGTRRA law would have meant that the PEP would have been in full effect after 2010.

The 2010 Tax Relief Act (Act) extends the sunset in Sec. 901 of EGTRRA from “tax years beginning after December 31, 2010” to “tax years beginning after December 31, 2012.”

So, under the Act, the PEP does not apply for two additional years (through 2012).

In other words, by extending the EGTRRA sunset provision as it applies to the EGTRRA changes in the PEP rules, the Act extends for two years the elimination of the PEP rules that otherwise would have expired after 2010. This means that there will be no PEP until after 2012.

Standard Deduction Marriage Penalty Relief is Extended Through 2012
Individuals who do not elect to itemize their deductions are allowed, instead, to deduct from their adjusted gross income (AGI) an inflation-adjusted basic standard deduction to determine their taxable income. The basic standard deduction in 2011 is $5,800 for unmarrieds, $11,600 for marrieds filing jointly and surviving spouses, $5,800 for marrieds filing separately, and $8,500 for heads of household.

Under the standard deduction rules in effect before the 2001 Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the basic standard deduction for married taxpayers filing jointly and qualified surviving spouses was the statutory amount of $5,000, as adjusted annually for inflation; for single taxpayers who were not surviving spouses or heads of household, it was the statutory amount of $3,000, as adjusted annually for inflation; for marrieds filing separately, it was the statutory amount of $2,500, as adjusted annually for inflation. So, the basic standard deduction amount for joint filers and surviving spouses under the pre-EGTRRA rules was 167% (1.6667 x $3,000 = $5,000) of the basic standard deduction amount for single taxpayers who were not surviving spouses or heads of household. And the standard deduction for marrieds filing separately was half the joint filer amount.

A “marriage penalty” exists when the combined tax liability of a married couple filing a joint return is greater than the sum of the tax liabilities of each individual computed as if they were not married.

EGTRRA, as amended by the Jobs Growth and Tax Relief Reconciliation Act of 2003, and the Working Families Tax Relief Act of 2004, increased the basic standard deduction for joint filers and surviving spouses to 200% of the dollar amount in effect for an unmarried individual or a married taxpayer filing a separate return for the tax year.

The EGTRRA increase in the basic standard deduction amount for joint filers was intended to mitigate the so-called “marriage penalty.”

EGTRRA also made the basic standard deduction for marrieds filing separately equal to the basic standard deduction for single filers.

The 2010 Tax Relief Act (Act) extends the sunset in Sec. 901 of EGTRRA from “tax years beginning after December 31, 2010” to “tax years beginning after December 31, 2012.” So, under the Act, the basic standard deduction for a married couple filing a joint return is increased to twice the basic standard deduction for an unmarried individual filing a single return, for two years (through 2012). And, for two years (through 2012), the basic standard deduction for marrieds filing separately is made equal to the basic standard deduction for single filers.

In other words, by extending the EGTRRA sunset provision as it applies to the EGTRRA/JGTRRA/WFTRA changes to the standard deduction rules, the Act extends for two years the standard deduction marriage penalty relief that otherwise would have expired at the end of 2010. The basic standard deduction for a married couple filing a joint return continues to be twice the basic standard deduction for an unmarried individual filing a single return. And the basic standard deduction for marrieds filing separately equals the basic standard deduction for single filers.

Overall Limitation on Itemized Deductions Will Not Apply Until After 2012 (Instead of After 2010)
Individuals who do not elect to itemize their deductions are allowed, instead, to deduct from their adjusted gross income (AGI) an inflation-adjusted basic standard deduction to determine their taxable income.

Under an overall limitation on itemized deductions in effect before the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), if an individual’s adjusted gross income (AGI) exceeded the “applicable amount,” the amount of the itemized deductions otherwise allowed for the tax year was reduced by the lesser of : (i) 3% of the excess of AGI over the applicable amount, or (ii) 80% of the amount of itemized deductions otherwise allowable for the tax year.

The above-described reduction in total itemized deductions is referred to as the “overall limitation on itemized deductions,” the “3%/80% rule,” or the “Pease limitation.”

EGTRRA Changes

Reduced the above reduction in itemized deductions for tax years beginning after December 31, 2005, and before January 1, 2010; and
Eliminated the above reduction for tax years beginning after December 31, 2009.

Sunset
Under pre-2010 Tax Relief Act law, a sunset provision in Sec. 901 of EGTRRA had provided that all changes made by EGTRRA would not apply to tax years beginning after December 31, 2010. In other words, the rules for the overall limitation on itemized deductions would have reverted to pre-EGTRRA law for tax years beginning after 2010.

New Law
The 2010 Tax Relief Act (Act) extends the sunset in Sec. 901 of EGTRRA from “tax years beginning after December 31, 2010” to “tax years beginning after December 31, 2012.” So under the Act, the overall limitation on itemized deductions does not apply for two additional years (through 2012).

In other words, by extending the EGTRRA sunset provision as it applies to the EGTRRA changes in the overall limitation on itemized deductions, the Act extends for two years the elimination of the overall limitation on itemized deductions that otherwise would have expired after 2010. This means that there will be no overall limitation on itemized deductions until after 2012.

Election to Claim Itemized Deduction for State/Local Sales Taxes is Retroactively Extended Through 2011
Sec. 501 of the 2004 Jobs Act as amended by Sec. 103 of the 2006 Tax Relief and Health Care Act and Sec. 201(a)DivC of the 2008 Extenders Act provided taxpayers with an election to take an itemized deduction for state and local general sales taxes instead of an itemized deduction for state and local income taxes. Under pre-2010 Tax Relief Act law, this election was available for only tax years beginning after December 31, 2003 and before January 1, 2010.

The 2010 Tax Relief Act (the Act) replaces “January 1, 2010” with “January 1, 2012.” In other words, the Act extends for two years (through December 31, 2011) the provision allowing taxpayers to elect to deduct state and local sales taxes in lieu of state and local income taxes.

Interest Deduction for Mortgage Insurance Premiums is Extended to Amounts Paid or Accrued Before 2012
Premiums a taxpayer paid or accrued during the tax year for qualified mortgage insurance in connection with acquisition indebtedness for the taxpayer’s qualified residence are treated as qualified residence interest, and so are deductible, subject to phaseout rules affecting taxpayers with adjusted gross income (AGI) over $100,000 for the tax year.

“Qualified mortgage insurance” means:

Mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration (FHA), or the Rural Housing Service, and
Private mortgage insurance.

To be deductible qualified residence interest, the amounts must be paid or accrued under a mortgage insurance contract issued after December 31, 2006.

Under the 2010 Tax Relief Act (the “Act”), the rules treating the deduction of qualified mortgage insurance premiums as deductible qualified residence interest do not apply with respect to amounts paid or accrued after December 31, 2011, or properly allocable to any period after that date. So, the Act extends the deduction for private mortgage insurance premiums for one year (only for contracts entered into after December 31, 2006). The Act provides that the deduction applies to amounts paid or accrued in 2011, which are not properly allocable to any period after 2011.

That is, the Act extends the itemized deduction for private mortgage insurance to amounts paid or accrued before January 1, 2012 that are not allocable to any period after December 31, 2011.

Up-to-$250 Above-The-Line Deduction for Teachers’ Out-of-Pocket Classroom-Related Expenses is Retroactively Extended Through 2011
“Eligible educators” – kindergarten through 12^th grade teachers, instructors, counselors, principals, or aides in any elementary or secondary school – are allowed an above-the-line deduction of up to $250 for out-of-pocket expenses they paid in connection with books, supplies (other than nonathletic supplies for courses of instruction in health or physical education), computer equipment (including related software and services), other equipment, and supplementary materials used in the classroom. Under pre-2010 Tax Relief Act law, this deduction for eligible educator expenses was available in tax years beginning during 2002, 2003, 2004, 2005, 2006, 2007, 2008, or 2009.

The 2010 Tax Relief Act (Act) replaces “or 2009” with “2009, 2010, or 2011.” In other words, the Act extends the deduction for eligible educator expenses for two years so that it is available for tax years beginning before January 1, 2012.

Without the deduction for eligible educator expenses, any unreimbursed expenses that elementary or secondary school teachers might be able to deduct in connection with their teaching activities would be deductible only as unreimbursed employee business expenses – i.e., as miscellaneous itemized deductions subject to the 2%-of-adjusted gross income (AGI) floor on miscellaneous itemized deductions.

Rule Allowing Tax-Free IRA Distributions of Up to $100,000 if Donated to Charity, is Retroactively Extended Through 2011
The Pension Protection Act of 2006 amended the IRA distribution rules to allow tax-free treatment of distributions from IRAs where the distributions are donated to charity. Specifically, a taxpayer may exclude from gross income so much of the aggregate amount of his “qualified charitable distributions” not exceeding $100,000 in a tax year.

A “qualified charitable distribution” is any otherwise taxable distribution from a traditional IRA or a Roth IRA that is:

Made directly by the IRA trustee to a Code Sec. 170(b)(1)(A) charitable organization (other than a Code Sec. 509(a)(3) private foundation or a Code Sec. 4966(d)(2) donor advised fund); and
Made on or after the date on which the individual for whose benefit the IRA is maintained (i.e., the IRA owner) has attained age 70½.

For purposes of the required minimum distribution (RMD) rules as they apply to individual retirement account and individual retirement annuities, qualified charitable distributions may be taken into account to the same extent that the distribution would have been taken into account under the RMD rules had the distribution not been directly distributed under the IRA qualified charitable distribution rules. Thus, an IRA owner who makes an IRA qualified charitable distribution in an amount equal to his RMD for the tax year is considered to have satisfied his minimum distribution requirement for that year, even though a charitable entity (and not the IRA owner) is the recipient of the distribution.

Under pre-2010 Tax Relief Act law, the tax-free qualified charitable distribution rules, above, only applied to distributions made in tax years beginning in 2006 through 2009.

The 2010 Tax Relief Act extends the exclusion for qualified charitable distributions to distributions made in tax years beginning after December 31, 2009 and before January 1, 2012.

Thus, under the Act, taxpayers age 70½ or older may exclude from gross income up to $100,000 of their qualified charitable distributions for each tax year beginning in 2010 and 2011 (in addition to any qualified charitable distributions they may have made in 2006 through 2009).

Special Election for January 2011 Distributions
Under a special rule, for purposes of both (i) the tax-free qualified charitable distribution rules, and (ii) the RMD rules as they apply to individual retirement accounts and individual retirement annuities, any qualified charitable distribution made after December 31, 2010, and before February 1, 2011, will be deemed to have been made on December 31, 2010, if the IRA owner so elects at such time and in such manner as IRS will prescribe.

Thus, a qualified charitable distribution made in January 2011 is permitted to be (a) treated as made in the taxpayer’s 2010 tax year, and thus permitted to count against the 2010 $100,000 limitation on the exclusion, and (b) treated as made in the 2010 calendar year, and thus permitted to be used to satisfy the taxpayer’s RMD for 2010.

John is an individual who is over age 70½, and the owner of a traditional IRA. During 2010, he does not take any distributions from the IRA, even though he is required to take a $100,000 minimum distribution for 2010. On January 18, 2011, John makes a $100,000 charitable transfer.

Under the special rule, John can elect to treat the $100,000 charitable transfer as having been made on December 31, 2010. If John makes the election (pursuant to rules that IRS is to prescribe), he will be (i) considered to have satisfied his minimum distribution requirement for 2010, and (ii) entitled to make another tax-free charitable transfer of up to $100,000 in 2011.

Additional 0.9% Medicare Tax Will be Imposed After 2012 on Wages and Self-Employment Income over Threshold Amounts

FICA Taxes
The Federal Insurance Contributions Act (FICA) imposes two taxes on employees on wages received with respect to employment. Similar taxes are imposed on wages paid by employers.

The Old Age, Survivors and Disability Insurance (OASDI) tax is imposed at a 6.2% rate, on wages up to an annually-adjusted “wage base” ($106,800 for 2010).

Under pre-2010 Health Care Act law, the Medicare Hospital Insurance (HI) tax was imposed at a 1.45% rate on all wages, regardless of amount.

Employers must collect the employee FICA tax by withholding it from the employee’s wages when paid.

The 2010 Health Care Act increases the employee portion of the HI tax after 2012 by an additional tax of 0.9% on wages received in excess of the applicable threshold amount (see below). Unlike the general 1.45% HI tax on wages, the additional tax on a joint return is on the combined wages of the employee and the employee’s spouse.

The same additional HI tax applies to the HI portion of SECA tax on self-employment income. Thus, an additional tax of 0.9% is imposed on every self-employed individual on self-employment income in excess of the applicable threshold amount. The threshold amount is reduced (but not below zero) by the amount of wages taken into account in determining the taxpayer’s FICA tax.

For tax years beginning after December 31, 2012, an additional 0.9% HI tax will be imposed on taxpayers (other than corporations, estates, or trusts) on wages received with respect to employment in excess of:

$250,000 for joint returns (Code Sec. 3101(b)(2)(A)),
$125,000 for married taxpayers filing a separate return, and
$200,000 in all other cases.

These threshold amounts are not indexed for inflation. Thus, as time goes on, more taxpayers will become subject to these taxes.

This tax will be in addition to the regular HI rate of 1.45% of wages received by employees with respect to employment.

Thus, the HI tax rate will be:

1.45% on the first $200,000 of wages ($125,000 on a separate return, $250,000 of combined wages on a joint return); and
2.35% (1.45% + 0.9%) on wages in excess of $200,000 ($125,000 on a separate return, $250,000 of combined wages on a joint return).

This change does not affect the HI tax imposed on employers.

A single taxpayer earns wages of $500,000 for 2013. Taxpayer pays HI tax of $2,900 on the first $200,000 of wages ($200,000 x 1.45%) and $7,050 on the excess of his wages over $200,000 ($300,000 x 2.35%), for a total HI tax of $9,950.

For 2013, H and W file a joint return. H earns wages of $125,000 and W earns wages of $175,000. H and W pay HI tax of $3,625 ($250,000 x 1.45%) on their first $250,000 of wages and $1,175 on the excess of their combined wages over $250,000 ($50,000 x 2.35%), for a total HI tax of $4,800.

Employer’s Obligation to Withhold
The employer is required to withhold the additional 0.9% HI tax on wages. The employer is liable for the tax that it fails to withhold from wages or to collect from the employee (where the employer fails to withhold).

However, an employer’s obligation to withhold the additional 0.9% HI tax applies only to wages in excess of $200,000 that the employee receives from the employer. The employer may disregard the amount of wages received by the employee’s spouse. The Committee Report adds that the employer must disregard the spouse’s wages.

Thus, the employer is only required to withhold the additional 0.9% HI tax on wages in excess of $200,000 for the year, even though the tax may apply to a portion of the employee’s wages at or below $200.000, if the employee’s spouse also has wages for the year, they are filing a joint return, and their total combined wages for the year exceed $250,000.

For 2013, H has wages of $250,000, and W has wages of $100,000. H’s employer must withhold the additional 0.9% HI tax on the $50,000 of H’s wages in excess of $200,000. W’s employer is not required to withhold any portion of the additional 0.9% HI tax, even though H and W’s combined wages are over the $250,000 threshold.

Couples in this situation may have to make estimated tax payments to cover the additional 0.9% HI tax, because the amounts withheld by their employers will not be sufficient.

The employer will not be liable for any additional 0.9% HI tax that it fails to withhold and that the employee later pays, but will be liable for any penalties resulting from its failure to withhold.

The employee will be liable for the additional 0.9% HI tax to the extent it is not deducted by the employer. In contrast, employees generally have no direct liability for the employee portion of the general 1.45% HI tax.

The amount of the additional 0.9% HI tax not withheld by an employer must be taken into account in determining a taxpayer’s estimated tax liability.

The above is effective for tax years beginning after December 31, 2012.

New 3.8% Medicare Contribution Tax Will be Imposed after 2012 on Net Investment Income of Individuals, Estates, and Trusts.
The 2010 Reconciliation Act imposes an unearned income Medicare contribution tax on individuals, estates, and trusts.

The tax is generally levied on income from interest, dividends, annuities, royalties, rents, and capital gains.

For individuals, the tax is 3.8% of the lesser of (a) net investment income or (b) the excess of modified adjusted gross income (MAGI) over the applicable threshold amount.

Net investment income is investment income reduced by the deductions properly allocable to such income.

MAGI is adjusted gross income (AGI) increased by the amount excluded from income as foreign earned income, net of the deductions and exclusions disallowed with respect to the foreign earned income.

The threshold amount is $250,000 for joint returns or surviving spouses, $125,000 for separate returns, and $200,000 in other cases.

Only individuals with MAGI above the applicable threshold amount will be subject to the tax.

1) For 2013, a single taxpayer has net investment income of $50,000 and MAGI of $180,000. The taxpayer will not be liable for the Medicare contribution tax, because his MAGI ($180,000) does not exceed his threshold amount ($200,000).

2) For 2013, a single taxpayer has net investment income of $100,000 and MAGI of $220,000. The taxpayer would pay a Medicare contribution tax only on the $20,000 amount by which his MAGI exceed his threshold amount of $200,000, because that is less than his net investment income of $100,000. Thus, taxpayer’s Medicare contribution tax would be $760 ($20,000 x 3.8%).

An individual will pay the 3.8% tax on the full amount of his net investment income if his MAGI exceeds his threshold amount by at least the amount of the net investment income.

3) Assume that the taxpayer in illustration (2) had MAGI of $300,000. Because taxpayer’s MAGI exceeds his threshold amount by $100,000, he would pay a Medicare contribution tax on his full $100,000 of net investment income. Thus, taxpayer’s Medicare contribution tax would be $3,800 ($100,000 x 3.8%).

The Medicare contribution tax is in addition to the 0.9% HI tax on wages and on self-employment income in excess of threshold amounts. Taxpayers who have both high wages or self-employment income and high investment income may be hit with both taxes.

4) For 2013, a single taxpayer has net investment income of $100,000, Wages of $300,000, and MAGI of $375,000. In addition to paying a Medicare contribution tax of $3,800, as explained in illustration (3), the taxpayer would also pay an additional HI (Medicare) tax of $900 ($100,000 x 0.9%) on his wages in excess of $200,000.

For estates and trusts, the tax is 3.8% of the lesser of (a) undistributed net investment income or (b) the excess of AGI over the dollar amount at which the highest estate and trust income tax bracket begins.

“Net Investment Income” Defined
For purposes of the Medicare contribution tax, “net investment income” means the excess, if any, of:

(1) The sum of:

gross income from interest, dividends, annuities, royalties, and rents, unless those items are derived in the ordinary course of a trade or business to which the Medicare contribution tax does not apply (see below),
other gross income derived from a trade or business to which the Medicare contribution tax applies (below),
net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the Medicare contribution tax does not apply, over

(2) The allowable deductions that are properly allocable to that gross income or net gain.

Gross income does not include items, such as tax-exempt bond interest, veterans’ benefits, and excluded gain from the sale of a principal residence, that are excluded from gross income for income tax purposes.

Trades and Businesses to Which Tax Applies
The Medicare contribution tax applies to a trade or business if it is:

a passive activity of the taxpayer, within the meaning of Code Sec. 469, or
a trade or business of trading in financial instruments or commodities as defined in Code Sec.475(e)(2).

The Medicare contribution tax does not apply to other trades or businesses conducted by a sole proprietor, partnership, or S corporation.

Thus, for a taxpayer that does not engage in a passive activity or a financial instrument or commodities trading business, “net investment income” will include non-business income from interest, dividends, annuities, royalties, rents, and capital gains, minus the allocable deductions. Business income will not be included.

For a taxpayer that does engage in a passive activity or a financial instrument or commodities trading business, “net investment income” will include the above items, plus the gross income (minus allocable deductions) from the passive activity or trading business.

Income on Investment of Working Capital Subject to Tax
For purposes of the definition of “net investment income,” a rule applies that is similar to the rule of Code Sec. 469(e)(1)(B), which treats income, gain, or loss attributable to an investment of working capital as not derived in the ordinary course of a trade or business.

Thus, income, gain, or loss on working capital is not treated as derived from a trade or business.

As a result, those items will be subject to the Medicare contribution tax.

Exception for Certain Active Interests in Partnerships and S Corporations
Gain from a disposition of an interest in a partnership or S corporation is taken into account as net investment income only to the extent of the net gain that the transferor would take into account if the partnership or S corporation had sold all its property for fair market value immediately before the disposition.

A similar rule applies to a loss from a disposition of an interest in a partnership or S corporation.

Thus, only net gain or loss attributable to property held by the entity that is not properly attributable to an active trade or business is taken into account. For this purpose, a business of trading financial instruments or commodities is not treated as an active trade or business.

Qualified Plan Distributions
Qualified retirement plan distributions are not included in investment income. Specifically, net investment income does not include any distribution from a plan or arrangement described in: (Code Sec. 1411 (c)(5))

Code Sec. 401(a) (qualified pension, profit-sharing, and stock bonus plans);
Code Sec. 403(a) (qualified annuity plans);
Code Sec. 403(b) (annuities for employees of tax-exempt organizations or public schools);
Code Sec. 408 (individual retirement accounts-IRAs);
Code Sec. 408A (Roth IRAs);
Code Sec. 457(b) (deferred compensation plans of state and local governments and tax exempt organizations).

Investment income does not include amounts subject to SECA taxes. Specifically, net investment income does not include any item taken into account in determining self-employment income for the tax year, if that item is subject to the HI portion of SECA taxes under Code Sec. 1401(b).

Estates and trusts are subject to a Medicare contribution tax for each tax year equal to 3.8% of the lesser of:

(1) The estate’s or trust’s undistributed net investment income for the tax year, or
(2) The excess (if any) of:

the estate’s or trust’s AGI for the tax year, over
the dollar amount at which the highest tax bracket in Code Sec. 1(e) begins for the tax year.

For 2010, the highest estate and trust income tax bracket begins at $11,200. These brackets are indexed for inflation. Presumably, by the time the Medicare contribution tax takes effect in 2013, the dollar amount will be higher.

The Medicare contribution tax does not apply to a trust all of the unexpired interests in which are devoted to one or more of the charitable purposes described in Code Sec. 170(c)(2)(B).

The tax also does not apply to a trust that is tax-exempt under Code Sec. 501 or a charitable remainder trust exempt from tax under Code Sec. 664.

In addition, the Medicare contribution tax probably will not apply to simple trusts and grantor trusts. A simple trust is a trust that makes no distribution other than of current income and whose terms require all of its income to be distributed currently and do not provide for charitable contributions. Thus, it would not have any undistributed net investment income that would be subject to the Medicare contribution tax.

Under the grantor trust rules, a grantor or other person, such as a beneficiary, may be treated as “owner” of all or part of the trust and taxed directly, to that extent, on the trust income. To the extent that the grantor trust rules apply, the regular rules for taxing trusts and their beneficiaries do not apply.

The Medicare contribution tax is subject to the individual estimated tax provisions. The Medicare contribution tax is treated as “tax” for purposes of computing the penalty for underpayment of estimated tax.

Limits on Deductions for Investment and Personal Interest
The deductibility of investment and personal interest is limited.

Investment Interest
Investment interest, generally defined as interest used to buy or carry investment property, is deductible by noncorporate taxpayers only to the extent of net investment income. Investment income includes income such as dividends, interest and certain gain on the sale of investment property but, for purposes of the investment interest deduction, generally does not include net capital gain from disposing of investment property (including capital gain distributions from mutual funds) or qualified dividend income. Net capital gain is the excess of net long-term capital gain for the year over the net short-term capital loss for the year. Qualified dividend income is income from dividends that qualify to be taxed at the net capital gain tax rates. However, the taxpayer can choose to include part or all of net capital gain and qualified dividend income in investment income. (Investment interest not allowed as a deduction for a tax year because of the investment interest limit is treated as interest paid or accrued in the following year and may eventually become deductible, either in the following tax year or in some later year).

Election to Include Net Capital Gain and Qualified Dividend Income in Investment Income
A taxpayer may elect to include all or part of his net capital gain and qualified dividend income in investment income. However, any amount that the taxpayer elects to include in investment income does not qualify for the favorable maximum tax rates that apply to net capital gain and qualified dividend income. Net capital gain and qualified dividend income is reduced (but not below zero) by the amount the taxpayer elects to take into account as investment income to permit investment interest deductions. (In deciding whether to make the special election, taxpayers whose marginal rate is 25% or higher should compare the relative tax benefits of:

postponing the interest deduction to a later year, or
giving up the benefit of the maximum capital gain and qualified dividend income rate ceilings.

Their calculations should take into account the time value of money, the length of the deferral and the taxpayer’s top tax brackets for 2010 and for the year that the investment interest is likely to be deducted).

Personal Interest
Personal interest is not deductible. This includes all interest except:

interest connected with a trade or business (but not interest paid on a tax deficiency arising from an unincorporated business),
investment interest,
passive activity interest,
qualified residence interest,
interest on qualifying higher-education loans, and
otherwise deductible interest on deferred estate tax payments.

Passive Activity Loss Rules
Interest may also be subject to passive activity loss rules. The passive activity loss and investment interest rules dovetail in such a way that any interest, other than personal interest, qualified residence interest, estate tax interest, or interest relating to a trade or business in which the taxpayer materially participates, is subject to one of the two rules. The application of the investment interest limitation is described above. Interest that relates to a passive activity is subject to the passive activity rules.

Qualified Residence Interest
One kind of interest that remains deductible is qualified residence interest. This term includes interest on debt secured by the taxpayer’s principal residence and one other qualified residence (including a trailer or houseboat). If the taxpayer has a principal residence and two or more other residences, he can choose each year which of the other homes qualifies as his second residence.

Qualified residence interest includes acquisition debt and home equity debt with respect to a taxpayer’s qualified residence. The maximum amount of acquisition debt is $1,000,000. Home equity debt cannot exceed $100,000 (or, if less, taxpayer’s equity in the home). Under a grandfather provision, pre-October 14, 1987 mortgage debt (regardless of amount) is treated as acquisition debt.

Acquisition debt is debt that is incurred in acquiring, constructing or substantially improving the principal or second qualified residence of the taxpayer and which is secured by the residence. If the debt to acquire, construct or substantially improve a principal and second residence exceeds $1,000,000, then only the interest on a total principal amount of $1,000,000 is deductible as interest on acquisition debt.

You cannot deduct the interest for acquisition debt greater than $1 million ($500,000 for married individuals filing separately). So, for example, if you were to buy a $2 million house with a $1.5 million mortgage, only the interest that you pay on the first $1 million in debt will be deductible. The rest will be considered personal interest and not deductible.

Note also that the $1 million ceiling on deductible home mortgage debt includes both your primary residence and your second home combined.

Acquisition indebtedness is defined by code section 163(h)(3) as any indebtedness which is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence. In other words if you borrowed $500,000 from the bank and secured this loan with your primary residence and further used the $500,000 to acquire a vacation home in Wisconsin, a literal reading of the code would conclude that the interest expense on this $500,000 loan would be non-deductible personal interest and this is because the Wisconsin residence does not secure such debt. The interest on this same loan would be fully deductible simply by securing the loan by the Wisconsin residence.

We have seen many clients borrowing on their principal residence in order to acquire a second home in the last few years. In order to be able to deduct this interest expense you must make sure that the debt is secured by the second home. While this may seem unnecessary, we have reached our conclusions after receiving second opinions on this issue from a law firm as well as directly from the IRS.

A residence under construction may be treated as a qualified residence for a period of up to 24 months, but only if it becomes a qualified residence as of the time it is ready for occupancy. The 24-month period referred to above may begin on or after the date construction began.

X owns a residential lot. On April 20 of year 1, X obtains a mortgage loan secured by the lot and any property to be constructed on the lot. He uses the proceeds of the loan to finance the construction of a vacation home on the lot. Construction commences on August 9 of year 1. The vacation home is ready for occupancy on November 9 of year 3, and qualified as X’s second residence at that time. Under these circumstances, X may treat the vacation home as a second residence for any 24-month period during which it was under construction. This 24-month period may commence on or after the date construction began (August 9 of year 1). If X chooses to begin this 24-month on August 9 of year 1, the period ends on August 8 of year 3. Whether the vacation home is a qualified residence for the period August 9 – November 8 of year 3 is determined without regard to the “under construction” rules.

If you are planning to refinance your mortgage, special rules apply. If the old mortgage that you are refinancing is home acquisition debt, your new mortgage will also be home acquisition debt, up to the principal balance of the old mortgage just before it was refinanced. The interest on this portion of the new mortgage will be deductible. Any debt in excess of this limit will not be home acquisition debt. In other words, a taxpayer who refinances cannot take down additional cash and have it count as acquisition indebtedness. Acquisition indebtedness may be refinanced to take advantage of lower rates or more favorable terms. As long as there is no additional amount of indebtedness the new debt is also treated as acquisition indebtedness. In general, points that you pay to refinance your home are not fully deductible in the year that you paid them. Instead, you can deduct a portion of these points each year over the life of the loan.

Home Equity Debt
Home equity debt is debt (other than acquisition debt) secured by the taxpayer’s principal or second residence. Interest on home equity debt is deductible even if the proceeds are used for personal purposes.

Tracing of Interest
Temporary regs on allocating interest expense for purposes of the limitations on passive activity losses, investment and personal interest employ a system of tracing disbursements of debt proceeds to specific expenditures. This generally means that the allocation of interest depends on how the debt proceeds are used. An exception to this rule applies to qualified residence interest, the allocation of which is governed by the security (i.e., the residence) given for the debt. Taxpayers can take advantage of these rules by using loan proceeds for deductible purposes, or by using home equity debt as the source of personal expenditures.

Health Savings Accounts

The rising cost of health care coverage has caused many individuals and employers to switch from traditional health insurance coverage to high-deductible health plans. Individuals or employees who were covered by a high-deductible health plan at any time during 2011 have a savings opportunity. They can contribute an amount equal to all or a part of their annual deductible to a Health Savings Account (HSA). Contributions by an individual to an HSA are deductible above-the-line in computing Adjusted Gross Income (AGI).

Any “eligible individual” can set up an HSA. An eligible individual is a person who:

is covered under a high-deductible health plan (HDHP) on the first day of the month,
is not covered by any other health plan that is not a HDHP (with certain exceptions for plans providing limited types of coverage),
is not entitled to Medicare benefits (generally, has not yet reached age 65), and
may not be claimed as a dependent on another person’s tax return.

For example, an individual may acquire high-deductible health coverage from an insurer and set up an HSA through the insurer or with a bank. Similarly, an employee who has qualifying high-deductible coverage through his employer can independently establish and fund an HSA.

For 2011, a high deductible health plan may be either an insured plan or an employer-sponsored self-insured medical reimbursement plan. In the case of individual self-only coverage, a plan must have an annual deductible of at least $1,200 and an annual cap on out-of-pocket expenses (counting deductibles, copayments, and other amounts, but not premiums) of no more than $5,950. For family coverage, the annual deductible must be at least $2,400 and the annual out-of-pocket expense cap cannot exceed $11,900. The plan must provide that no payments will be made until the family as a whole has incurred annual covered expenses in excess of the annual deductible.

The amount that can be contributed to an HSA depends on the type of coverage (i.e., self-only or family), the annual deductible, and the period of coverage during the year. The maximum annual contribution is the sum of limits determined separately for each month.

For 2011, the maximum monthly contribution for an individual with self-only coverage is 1/12 of the lesser of the annual deductible (minimum $1,200) or $3,050. For family coverage, the maximum annual contribution is 1/12 of the lesser of the annual deductible (minimum $2,400) or $6,150.

Individuals between ages 55 and 65 can make catch-up contributions in addition to their regular contributions for the year. For 2011, the catch-up contribution limit is $1,000. As with regular contributions, catch-up contributions are computed on a monthly basis.

Contributions, including catch-up contributions cannot be made to an individual’s HSA after age 65.

Although the contribution limits are determined monthly, annual HSA contributions can be made in one or more payments at any time before the contribution deadline. The contribution deadline is the due date (without extensions) for filing the individual’s return for the year of the contribution. Thus, for calendar year taxpayers, the deadline for making 2011 HSA contributions is April 15, 2012.

Distributions from an HSA are tax-free to the extent they are used to pay for qualified out-of-pocket medical expenses of the HSA account holder or the account holder’s spouse or dependents. However, distributions qualify for tax-free treatment only if they are used to pay qualified medical expenses that were incurred after the HSA was established. Consequently, taxpayers who have not yet established an HSA will not be able to use their 2011 contributions to cover medical expenses incurred earlier in the year.

HSA funds that are not needed for medical expenses can serve as a tax-deferred savings for retirement. A distribution that is not used to pay qualified medical expenses is includible in the gross income of the account holder. In addition, such a distribution generally is subject to an additional 10% tax. However, the 10% penalty tax does not apply to distributions made on account of death or disability or after the account holder reaches age 65.

Reduced Home Sale Exclusion for Some Sellers
Most homeowners are aware of the home sale exclusion, a provision of the tax laws which provides that homeowners who sell their principal residence typically do not need to pay taxes on as much as $500,000 of their gain if they meet certain conditions. (The $500,000 exemption is the maximum exclusion for a married couple filing jointly; taxpayers filing individually get an exemption of up to $250,000.) To be eligible for the full exclusion, a taxpayer must have owned the home – and lived in it as his or her principal residence – for at least two of the five years prior to the sale. Because of the “principal residence” requirement, vacation or second homes normally do not qualify for the exclusion. However, in what some saw as a loophole, the law permitted taxpayers to convert their second home to their principal residence, live in it for two years, sell it, and take the full $250,000/$500,000 exclusion available for principal residences, even though portions of their gains were attributable to periods when the property was used as a vacation or second home, not a principal residence.

The new law closes that “loophole” by requiring homeowners to pay taxes on gains made from the sale of a second home to reflect the portion of time the home was not used as a principal residence (e.g., vacation or rental property). The amount taxed will be based on the portion of the time during which the taxpayer owned the home that the house was used as a vacation home or rented out. The rest of the gain remains eligible for the up-to-$500,000 exclusion, as long as the two-out-of-five year usage and ownership tests are met. The new law in effect reduces the exclusion based on the ratio of years of use as a principal residence to the total time of ownership. For example, if a taxpayer owned a vacation home for ten years, but lived in it as a principal residence only for the final two years prior to sale, the maximum available exclusion would be reduced by four-fifths. Accordingly, a $400,000 gain on the sale that would be eligible for the full exclusion under pre-Act law would be reduced by four-fifths, to $80,000.

The good news for current owners of second homes is that the new law is not retroactive. The tightening applies only to sales after 2008. Plus, any periods of personal or rental use before 2009 are ignored for purposes of the provision. Also, the new law does not change the rule that allows homeowners to take advantage of the home sale exclusion every two years. Taxpayers can still “home hop” with full tax exclusion if they only own one home at a time. Moreover, the taxpayer still qualifies for capital gain treatment on the amount of gain that cannot be excluded.

For purposes of the allocation of gain to periods of nonqualified use, a “period of nonqualified use” is any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse.

Since the definition of a period of nonqualified use doesn’t include any period preceding January 1, 2009, a taxpayer can avoid the application of Code Sec. 121 (b)(4) if he moves into his vacation home (or any other residence owned by the taxpayer) and makes it his principal residence before January 1, 2009.

Exceptions to the Definition of a Period of Nonqualified Use
A period of nonqualified use will not include any portion of the five-year testing period which is after the last date that the property is used as the principal residence of the taxpayer or the taxpayer’s spouse. Thus, any period after the last date the property was used as the principal residence of the taxpayer or his spouse (regardless of use during that period) is not taken into account in determining periods of nonqualified use.

Z, an individual, buys a principal residence on January 1, Year 9 (a year beginning after December 31, 2008), for $400,000, and moves out on January 1, Year 19. On December 1, Year 21 (more than two years after it was last used as Z’s principal residence), Z sells the property for $600,000. The entire $200,000 gain will be excluded from gross income, as under pre-2008 Housing Act law.

Since the period that Z did not use the residence as a principal residence occurred after the last date that Z had used the property as a principal residence during the five-year testing period, that period will not be considered to be a period of nonqualified use under the exception. Thus, even if Z had rented the residence (his former principal residence) during Years 19 and 20, that period will not be considered to be a period of nonqualified use.

Since the exception provided above will only apply to any portion of the five-year testing period which is after the last date that the property is used as the principal residence of the taxpayer or the taxpayer’s spouse, the exception will not apply to periods of nonqualified use that occurred before the five-year testing period. If a taxpayer uses the property as his principal residence in more than one period of time during the ownership period, the exception will only apply to the period after the last date that the property was used a principal residence by the taxpayer or his spouse. Any other periods that he did not use the property as his principal residence presumably will be considered to be periods of nonqualified use. Unless one of the other exceptions (such as the temporary absence exception or the exception for taxpayers serving on qualified official extended duty, both described below) apply, those periods of nonqualified use will be included in the numerator of the ratio (used to determine the amount of gain allocated to nonqualified use as part of the aggregate periods of nonqualified use during the period the taxpayer owned the property.

C, an individual, buys a principal residence on January 1, Year 1 (a year beginning after December 31, 2008), for $400,000, and lives in it as his principal residence for five years (i.e., until December 31, Year 5). Due to a change in his employment, C moves away and does not use the property as his principal residence for the next five years (January 1, Year 6 to December 31, Year 10). On January 1, Year 11, C moves back in the house and uses it as his principal residence. On December 31, Year 20, C sells the property for $800,000 and realizes a gain of $400,000.

The five-year period from January 1, Year 6 to December 31, Year 10 will not qualify for the exception and thus, is a period of nonqualified use. That period of nonqualified use was not a portion of the five-year testing period which was after the last date that the property was used as a principal residence.

Thus, 25% of the gain [5 years (the aggregate period of nonqualified use during the taxpayer’s ownership of the property) ¸ 20 years (the period of the taxpayer’s ownership of the property)] will be gain allocated to periods of nonqualified use and the Code Sec. 121 exclusion will not apply to $100,000 (25% of $400,000). Of the remaining $300,000 of gain, the maximum amount of gain that qualifies for the Code Sec. 121 exclusion will be $250,000.

In Summary, C’s taxable gain from the sale will include: $100,000 of gain allocated to periods of nonqualified use, and $50,000 of gain in excess of C’s Code Sec. 121 exclusion ($300,000 – $250,000).

C’s absence from the residence (January 1, Year 6 to December 31, Year 10) will not qualify for the temporary absence exception to the definition of a period of nonqualified use because the absence exceeded an aggregate period of two years.

Temporary Absence – Exception to the Definition of a Period of Nonqualified Use
A period of nonqualified use will not include any other period of temporary absence (not to exceed an aggregate period of two years) due to change of employment, health conditions, or any other unforeseen circumstances as may be specified by IRS.

Taxpayers Serving on Qualified Official Extended Duty – Exception to the Definition of a Period of Nonqualified Use
A period of nonqualified use will not include any period (not to exceed an aggregate period of ten years) during which the taxpayer or the taxpayer’s spouse is serving on qualified official extended duty as a member of the uniformed services , a member of the Foreign Service, or an employee of the intelligence community.

The suspension election for members of the uniformed services, members of the Foreign Service, and employees of the intelligence community is the same as it was under pre-2008 Housing Act law.

If any gain was attributable to post May 6, 1997 depreciation, the exclusion will not apply to that amount of gain as under pre-2008 Housing Act law.

The above is effective for sales and exchanges after December 31, 2008.

Two-Year Extension of Home Mortgage Debt Forgiveness Relief Provision
The new law provides assistance to homeowners who have been caught in the current mortgage crisis and are trying to save their homes. Under 2007 tax legislation, taxpayers are generally allowed to exclude up to $2 million of mortgage debt forgiveness on their principal residence. However, this relief provision was scheduled to expire at the end of 2008. Under the new law, this debt relief provision is extended through 2012. To understand the importance of this relief provision, one needs to know that for income tax purposes, a discharge of indebtedness – that is a forgiveness of debt – is generally treated as giving rise to income that’s includible in gross income. Under pre-2007 tax law, there were no special rules applicable to discharges of acquisition debt on the taxpayer’s principal residence. For example, assume a taxpayer who wasn’t in bankruptcy and wasn’t insolvent owned a principal residence subject to a $200,000 mortgage debt for which the taxpayer had personal liability. The creditor foreclosed and the home was sold for $180,000 in satisfaction of the debt. Under pre-2007 tax law, the debtor had $20,000 of debt discharge income. The result was the same if the creditor restructured the loan and reduced the principal amount to $180,000. In 2007 the tax laws were temporarily changed to allow taxpayers to exclude up to $2 million of mortgage debt forgiveness on their principal residence. For example, assume the same facts as in the foregoing example except that the discharge occurs in 2008. In that case the debtor has no debt discharge income when the creditor (1) restructures the loan and reduces the principal amount to $180,000 or (2) forecloses with the result that the $200,000 debt is satisfied for $180,000. However, this debt relief provision was scheduled to expire at the end of 2009. The new legislation extends the provision through 2012. The relief is not extended to home equity loans.

Converting a Residence to Rental Property
A taxpayer may decide to permanently convert a personal residence to rental property. This decision is often made as a result of the taxpayer’s inability to sell the property at a gain, or a desire to retain the property for future personal use.

The decision whether to convert a personal residence to rental property may be based on several non-tax factors. If selling a personal residence would result in a nondeductible loss, the taxpayer should consider converting the residence to rental property since any loss realized while the home is a personal residence is never deductible. While tax savings opportunities are generally limited for residential rental conversions primarily because of the passive activity loss rules, converting a personal residence into rental property may allow the taxpayer to eventually recognize a loss on the property’s subsequent sale if it continues to decline in value.

When a principal residence is converted to business use (or for use in the production of income), its starting point for basis for depreciation is the lower of (1) the adjusted basis on the date of conversion, or (2) the property’s fair market value at the time of conversion.

Taxpayer purchased a home in Chicago in 2004 for $250,000, of which $50,000 represented the cost of the land. Taxpayer lived in the home until 2008, when he moved to New York. Rather than sell the house, he converted it to a rental property. The property’s FMV, excluding the land, on its conversion to rental property was $185,000. Taxpayer’s basis for depreciation is $185,000, the FMV at the time of conversion, since it was less than the adjusted basis. (Adjusted basis is generally the cost of the property plus amounts paid for capital improvements less any depreciation claimed for tax purposes).

Property converted from residential to rental use must be depreciated using the method and recovery period in effect in the year of conversion.

If the taxpayer intends to incur major renovation or remodeling costs, the costs should be incurred after the property has been placed into service (offered for rent). This may allow for a higher depreciable basis of the property and turn repairs into deductions.

Taxpayers may need the equity in cash from their current residence for a down payment on a new residence. Yet, for non-economic reasons they may want to retain the old residence. In this situation, they should consider selling the home to a newly formed controlled entity (for example, a wholly owned S Corporation) at fair market value for a mortgage note. The residence can then be rented inside the S Corporation and depreciated at the stepped-up FMV basis. The residence is effectively retained with no current tax cost because the gain on the sale is excluded under Sec. 121 (provided the requirements of Sec. 121 are met).

The IRS has ruled that the sale of a residence to a taxpayer’s wholly owned corporation qualified for the former Sec. 1034 Gain Deferral. In that ruling, the IRS stated that there was no prohibition in the Sec. 1034 rules against selling the residence to a related party and excluding the gain. Many tax practitioners believe this same rationale can apply to the Sec. 121 Gain Exclusion rules.

Taxpayers own a house that they have lived in for 20 years. The house has a tax basis of $75,000 and a FMV of $275,000. They have decided to relocate in order to live closer to their family. They need the value in cash from their old residence for a down payment on their new residence. However, because they hope to move back in a few years, they would prefer not to sell the old residence. They like the idea of renting the old house in order to retain it and still provide some tax benefits and possibly some cash flow.

Taxpayers can form a wholly owned S Corporation and have the S Corporation buy the residence for its value ($275,000) on a third-party mortgage note. Taxpayers would receive cash of $275,000, and the $200,000 gain ($275,000-$75,000) is excluded under Sec. 121. Therefore, this is accomplished at no current tax cost.

The S Corporation can begin to rent the house and take depreciation deductions on the portion of the $275,000 cost allocated to the building. The rental activity inside the S Corporation will generate either passive activity gains or losses.

If gain from the sale of the residence to the controlled entity exceeds the maximum Sec. 121 exclusion, the excess is taxable as ordinary income (rather than capital gain) because the controlled entity (related-party) purchaser will depreciate the property (Sec. 1239 (a)).

If the S Corporation ultimately sells the residence, any gain would be taxed at capital gains rates (currently 15%), subject to a 25% rate for unrecaptured Sec. 1250 gain (i.e. gain attributable to depreciation allowed on the residence for periods after May 6, 1997).

If a residence converted to rental property is later sold at a gain, the basis in the converted property is the original cost or other basis plus amounts paid for capital improvements, less any depreciation taken. If the sale results in a loss, however, the starting point for basis is the lower of the property’s adjusted cost basis or FMV when it was converted from personal to rental property. This rule is designed to ensure that any decline in value occurring while the property was held as a personal residence does not later become deductible on the sale of the rental property.

Taxpayer converted their personal residence to income-producing property in 2000. The house had a $50,000 original cost, and the property’s FMV was $45,000 when it was converted to rental use. Over the eight year rental period, a total of $8,000 in depreciation was taken. In 2008, taxpayer sold the property for $40,000.

1)         Original Cost                                                                                          $     50,000
2)         Conversion Value                                                                                         45,000
3)         Depreciation Taken                                                                                        8,000
4)         Adjusted Basis for Determining Gain (1– 3)                                                  42,000
5)         Adjusted Basis for Determining Loss Lesser of (1) or (2 – 3)                        37,000
6)         Sales Price                                                                                                    40,000
7)         Recognize Gain (6 – 4) but not less than 0                                                     – 0 -
8)         Recognize Loss(6 – 5) but not more than 0                                                      – 0 -

No reportable gain or loss occurs because (1) no gain results when the original cost is used in the gain computation, and (2) no loss results when using the lower of cost or market basis for determining loss.

The fact that a residence is rented at the time of a sale does not automatically preclude gain attributable to such use from being excluded under Sec. 121. The taxpayer must still meet the ownership and use and the one-sale-in-two-years tests of Sec. 121 and gain cannot be excluded to the extent of depreciation adjustments to periods after May 6, 1997.

Safe Harbor for Exchanges of Vacation Homes
Until recently, taxpayers who own vacation and second homes have been in a quandary as to whether Section 1031 (Like-Kind Exchange) could apply to exchanges of those types of properties. In order to qualify for nonrecognition treatment under Section 1031 both the property relinquished and the property received must be deemed held for use in the taxpayer’s trade or business or for investment.

One consequence of the held for requirement is that homes used purely for personal use do not qualify for exchange treatment. Nevertheless, taxpayers often purchase and own second homes with the duel intention of personal use and future appreciation. These taxpayers have wondered whether this type of ownership could be considered as “held for investment” so as to qualify the property for exchange treatment on sale.

In 2007, the tax court for the first time considered the application of Section 1031 to vacation homes. In Moore, TCM 2007 – 134, the court denied Section 1031 treatment on an exchange of vacation properties, which it deemed were not held primarily for trade or business or for investment by the taxpayers. The facts in Moore illustrate a fairly common scenario associated with recreational vacation properties. In 1988 the Moore’s purchased two contiguous parcels of lakefront real property, along with a mobile home located on one of those parcels (the Clark Hill property). The Moore’s and their children used the Clark Hill property two or three weekends a month during the summers. They also made various improvements to the property. They never advertised the Clark Hill property for sale and never rented or attempted to rent the property to others. They did not claim deductions for investment interest or for maintenance and repair costs. Several years later, the Moore’s moved their principal residence and decided to sell the Clark Hill property and purchase another piece of improved lakefront property closer to their new residence (the Lake Lanier property). In 1999 they bought a 75% interest in the Lake Lanier property and an escrow agent bought a 25% interest, which the Moore’s later acquired after the sold the Clark Hill property, treating the 25% Investment in the Lake Lanier property as replacement property in a Section 1031 exchange for the Clark Hill property. They and their children used the Lake Lanier property similarly to the Clark Hill property. They never rented or attempted to rent the Lake Lanier property. The Moore’s asserted that one of their principal reasons for holding both the Clark Hill property and the Lake Lanier property was the investment potential of these assets. The tax court dismissed this rationale, holding that in order to qualify for Section 1031 treatment on the exchange the Moore’s had to prove that they held both properties primarily for investment. This conclusion is the critical holding in the case.

The court specifically held that it was not sufficient to show that expectation of appreciation in value was one of the motives for holding the property, but that investment must be the principal or primary intent. It further relied on a line of cases that rejected taxpayer attempts to convert primary residences to investment property be moving out prior to placing the property on the market for sale. The court concluded, based on the Moore’s use of the homes, the lack of rental activity, and their failure to hold the homes primarily for sale at a profit, that they did not hold the homes primarily for investment. Accordingly, Section 1031 treatment was denied.

A government report stated that there is a lack of IRS guidance as to whether vacation and second homes qualify under Section 1031. The report urged the IRS to issue clear guidance in this area.

In March 2008, the IRS issued Rev. Proc. 2008-16. The procedure provides a safe harbor under which the service will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031. The safe harbor is effective for exchanges occurring after March 9, 2008.

Under Rev. Proc. 2008-16, a dwelling unit passes the held for test with respect to its personal use as relinquished property in a like-kind exchange if it is owned by the taxpayer for at least 24 months immediately before the exchange and in each of the two 12-month periods immediately preceding the start of the exchange:

The taxpayer rents the property to another person at a fair rental for 14 days or more, and
The taxpayer’s personal property does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the property is rented at a fair rental.

Similarly, a dwelling unit passes the held for test with respect to its personal use as replacement property in an exchange if it is owned by the taxpayer for at least 24 months immediately after the exchange and in each of the two 12-month periods immediately after the exchange:

The taxpayer rents the property to another person at a fair rental for 14 days or more, and
The taxpayer’s personal use of the property does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.

Steve has a summer cottage in Fort Wayne that he purchased in 2006. Steve lives full time in Indianapolis. For the first several years of ownership, Steve used the cottage himself during the summer. Steve did not attempt to rent the cottage to third parties. In 2007 and 2008, Steve rented the cottage to a family at fair rental value for 175 days during the summer and fall. In each of those two years, Steve used the cottage himself for 16 days during the spring. In December 2008, Steve exchanges the cottage for a larger house in Pompano Beach, Florida. Steve rents that house to third-party tenants a total of 200 days during 2009 and just 14 days during 2010. Steve uses the home himself for 19 days during 2009 and for no days during 2010.

Steve meets the safe harbor described by Rev. Proc. 2008-16. As such, he may properly report his exchange of the Fort Wayne cottage for the Pompano Beach house as a valid Section 1031 exchange on his 2008 federal income tax return, provided that all other requirements of Section 1031 are met.

The post-exchange replacement property use requirements applicable to Steve extends well beyond the time he is required to file his tax return for the year of the exchange. What if planned rental usage does not materialize or a taxpayer’s personal use of the property exceeds the allowable limits? Rev. Proc. 2008-16 provides for this by stating that if a taxpayer reports a transaction as an exchange on the taxpayer’s federal return expecting that the replacement property will meet the Revenue Procedure’s qualifying use standards but this does not occur, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange.

Accordingly, if Steve ends up using the Pompano House primarily for his own personal use and does not rent it out for the two 12-month periods following its exchange, he may be required to amend his 2008 return and report a taxable sale of the Fort Wayne cottage unless he can establish that the personal use was not his primary purpose for ownership of the cottage.

Rev. Proc. 2008-16 offers a fairly clear, albeit limited, set of parameters for determining whether vacation property held for personal use as well as future appreciation qualifies under Section 1031. It is important to remember, however, that as a safe harbor it neither establishes substantive law nor affects any requirement of Section 1031 other than the question of whether personal use of a residence prevents it from being deemed to be held primarily for use in a trade or business or for investment.

To qualify for the safe harbor for property being sold, a taxpayer must rent out the property for the two years prior to an exchange, and during that period engage in limited personal use. To avoid potential IRS challenge on the held for issue with respect to vacation property being acquired in an exchange, the taxpayer must rent out that property and also limit personal use for the two years following the exchange. There is clearly no requirement that both sides of an exchange satisfy these requirements; because all real estate is generally considered like-kind, a taxpayer can exchange a vacation property for an office, commercial, or other type of rental property or vice versa.

While it clearly does not resolve the issue of when vacation homes may be the subject of like-kind exchanges, Rev. Proc. 2008-16 provides welcome guidance to taxpayers seeking to exchange vacation properties and second homes. The safe harbor will allow taxpayers that buy and hold such properties with true investment intent to structure valid Section 1031 exchanges despite limited amounts of personal use. It also should reduce the time to audit and review such transactions. Nevertheless, Rev. Proc. 2008-16 is just a safe harbor. Taxpayers can and should be able to structure exchanges of homes that fall outside its guidance.

Education

American Opportunity Tax Credit (AOTC) for Higher Education Expenses is extended Through 2012
For tax years beginning before 2009, individual taxpayers could claim a nonrefundable personal credit – the Hope credit (a component credit of the “higher education credit,” along with the Lifetime Learning Credit) – against income tax of up to $1,800 (for 2008) per eligible student for qualified tuition and related (QT&R, see below) expenses paid for the first two years of the student’s post-secondary education in a degree or certificate program. To claim the Hope credit, the student could not have completed the first two years of that post-secondary education before the beginning of the tax year for which the credit was claimed (i.e., the credit was allowed only for QT&R expenses paid for the first two years of the post-secondary education).

Generally, QT&R expenses for the pre-2009 Hope credit included, with specific exceptions, tuition and fees (excluding nonacademic fees) required for the enrollment or attendance of the taxpayer, his spouse, or tax dependent, at a post-secondary educational institution eligible to participate in the federal student loan program.

For 2009 and 2010
For tax years beginning in 2009 and 2010, the American Recovery and Reinvestment Act of 2009 added Code Sec. 25A(i), which increased and expanded the Hope credit and renamed that modified credit the “American Opportunity tax credit” (AOTC). Specifically, the 2009 Recovery Act:

Increased the maximum credit amount to $2,500 per eligible student per year for qualified QT&R expenses. The AOTC equals the sum of (a) 100% of so much of the QT&R expenses paid by the taxpayer during the tax year (for education furnished to the eligible student during any academic period beginning in the tax year) as does not exceed $2,000, plus (b) 25% of the QT&R expenses so paid as exceeds $2,000 but does not exceed $4,000;
Expanded the definition of QT&R expenses to include course materials;
Allowed the AOTC for the first four years of the student’s post-secondary education in a degree or certificate program, if the student has not completed the first four years of post-secondary education before the beginning of the fourth tax year. And, for each eligible student, the AOTC can be claimed for four tax years;
Increased the MAGI range at which the credit is phased-out to between $80,000 and $90,000 ($160,000 and $180,000 for married joint filers);
Applied a separate tax liability limitation permitting the AOTC credit to be claimed against alternative minimum tax (AMT) liability; and
Allowed 40% of the otherwise allowable AOTC to be refundable (unless the taxpayer claiming the credit was a child to whom the Code Sec. 1(g) “kiddie tax” rules apply for the tax year, i.e., generally, any child under age 18 or any child under age 24 who is a student providing less than one-half of his support, who has at least one living parent, and does not file a joint return).

The 2010 Tax Relief Act modifies Code Sec. 25A(i) to provide that they also apply for tax years beginning in 2011 and 2012. That is, the 2010 Tax Relief Act extends for two years (through 2012) the above-described 2009 and 2010 modifications to the Hope credit that are known as the AOTC, including the rules governing treatment of the U.S. possessions.

Specifically, as a result of the above extension of the AOTC, for tax years beginning in 2011 and 2012 (for most individuals who are calendar year taxpayers, 2011 and 2012):

the maximum AOTC credit amount is $2,500 per eligible student per year (computed as described above) for qualified QT&R expenses;
QT&R expenses include tuition, fees, and course materials;
The AOTC is allowed for each of the first four years of the student’s post-secondary education in a degree or certificate program. And, for each eligible student, the AOTC can be claimed for four tax years;
The AOTC is phased-out at MAGI between $80,000 and $90,000 (between $160,000 and $180,000 for joint filers);
The AOTC can be claimed against AMT liability;
40% of the otherwise allowable AOTC is refundable (unless the taxpayer claiming the credit is a child under age 18 or a child under age 24 who is a student providing less than one-half of his support, who has at least one living parent, and does not file a joint return); and
Bona fide residents of U.S. possessions cannot claim the refundable portion of the AOTC credit in the U.S. Instead, they claim the refundable portion in the possession in which they reside (subject to the limitations described above).

Neither the 2009 Recovery Act nor the 2010 Tax Relief Act modify the rules applicable to the Lifetime Learning credit, which, a taxpayer can claim in addition to a Hope credit (collectively, as a higher education credit) for a particular tax year. Thus, existing requirements for eligibility for the Lifetime Learning credit continue to control a taxpayer’s eligibility to claim that credit for 2011 and 2012.

The up-to-$2,000 per year Lifetime Learning credit is calculated on a per family (i.e., per tax return) basis – in contrast to the AOTC which is calculated on a per student basis. However, expenses paid with respect to a student for whom an AOTC is claimed are not eligible for the Lifetime Learning credit – i.e., both credits cannot be claimed for the same student in the same tax year.

Increased $2,000 Contribution Limit and Other EGTRRA Enhancements to Coverdell ESAs are Extended Through 2012
An individual can make a nondeductible cash contribution to a Coverdell education savings account (formerly called an “education IRA”) for qualified education expenses of a beneficiary under the age of 18. A specified aggregate amount can be contributed each year by all contributors for one beneficiary. The amount an individual contributor can contribute is phased out as the contributor’s modified adjusted gross income (MAGI) exceeds specified levels. A 6% excise tax applies to excess contributions.

Earnings on the contributions made to a CESA are subject to tax when withdrawn. But distributions from a CESA are excludible from the distributee’s (i.e., the student’s) gross income to the extent the distributions do not exceed the qualified education expenses incurred by the beneficiary during the tax year the distributions are made. The earnings portion of a CESA distribution not used to pay qualified education expense is includible in a distributee’s income, and that amount is subject to a 10% tax that applies in addition to the regular tax.

Tax-free (including free of the 10% tax described above) transfers or rollovers of CESA account balances from a CESA benefiting one beneficiary to a CESA benefitting another beneficiary (and redesignations of named beneficiaries) are permitted if the new beneficiary is a family member of the previous beneficiary and is under age 30. Generally, a balance remaining in a CESA is deemed to be distributed within 30 days after the beneficiary turns 30.

Under the Economic Growth and Tax Relief Reconciliation Act of 2001, with a technical correction under the Working Families Tax Relief Act of 2004, the CESA rules were modified to:

increase the limit on CESA aggregate annual contributions (from $500) to $2,000 per beneficiary;
permit corporations and other entities (in addition to individuals) to make contributions to a CESA, regardless of the corporation’s or entity’s income;
increase the MAGI phaseout range for joint filers (from $150,000-$160,000) to $190,000-$220,000 to equal twice the range for single filers (i.e., $95,000-$110,000), and so eliminate any “marriage penalty;”
permit contributions to a CESA for a tax year to be made until April 15^th of the following year;
modify the definition of excess contribution to a CESA for purposes of the 6% excise tax on excess contributions to reflect various other EGTRRA changes;
extend the time (to before June 1^st of the following tax year) for taxpayers to withdraw excess contributions (and the earnings on them) to avoid imposition of the 6% excise tax;
expand the definition of education expenses that can be paid by CESAs to include elementary and secondary school expenses (in addition to qualified higher education expenses);
provide for coordination of the Hope and Lifetime Learning credits with the CESA rules to permit a Hope or Lifetime Learning credit to be taken in the same year as a tax-free distribution is taken from a CESA for a designated beneficiary (but for different expenses);
provide rules coordinating distributions from both a qualified tuition program (QTP, or “529 plan”) and a CESA for the same beneficiary for the same tax year (but for different expenses;)
eliminate the age limitations described above for acceptance of CESA contributions, deemed balance distributions, tax-free rollovers to other family-member-beneficiaries, and tax-free change of beneficiaries, for “special needs beneficiaries”;
provide that the 10% additional tax on taxable distributions from a CESA does not apply to distributions of contributions to a CESA made by June 1^st of the tax year following the tax year in which the contribution was made.

Under Sec. 901 of EGTRRA all of the EGTRRA/WFTRA changes described above were scheduled to expire for tax years beginning after December 31, 2010, and the CESA rules in effect before the passage of EGTRRA were scheduled to come back into effect.

The 2010 Tax Relief Act provides that the EGTRRA sunset will not take effect until after December 31, 2012 (instead of after December 31, 2010) i.e., the provision delays the EGTRRA sunset as it applies to CESAs for two years, and the education tax benefits described above continue to be available through 2012.

Specifically, as a result of the above extension, for tax years beginning in 2011 and 2012 (for most individuals who are calendar year taxpayers, 2011 and 2012):

the limit on CESA aggregate annual contributions is $2,000 per beneficiary (and is not decreased to $500 per beneficiary);
corporations and other entities (not just individuals) can make contributions to a CESA, and the corporations and other entities can do so regardless of their income;
the MAGI phaseout range for joint filers is $190,000 – $220,000 (and does not decrease to $150,000 – $160,000);
CESA contributions for a tax year can be made until April 15^th of the following year;
the definition of CESA excess contribution reflects the various other EGTRRA changes to the CESA rules;
taxpayers have until June 1^st of the following tax year to withdraw excess contributions (and the earnings on them) to avoid imposition of the 6% excise tax;
education expenses that can be paid by CESAs include elementary and secondary school expenses and qualified higher education expenses (rather than only qualified higher education expenses);
a Hope or Lifetime Learning credit can be taken in the same year as a tax-free distribution is taken from a CESA for a designated beneficiary (but for different expenses);
the rule coordinating distributions being made from both a QTP and a CESA for the same beneficiary for the same tax year (but for different expenses) applies;
special needs beneficiaries are exempted from the age limitations for a CESA’s acceptance of contributions, deemed balance distributions, tax-free rollovers to other family-member-beneficiaries, and tax-free change of beneficiaries; and
the 10% additional tax on taxable distributions from a CESA is inapplicable to distributions of contributions to a CESA made by June 1st of the tax year following the tax year in which the contribution was made.

Qualified Tuition Deduction is Retroactively Extended Through 2011
An individual is allowed an above-the-line deduction for “qualified tuition and related (QT&R) expenses” for higher education paid by the individual during the tax year. These expenses include tuition and fees for the enrollment or attendance of the taxpayer, the taxpayer’s spouse, or any dependent for whom the taxpayer can claim a personal exemption, at an eligible institution of higher education for courses of instruction at the institution. These expenses must be in connection with enrollment at an institution of higher education during the tax year, or with an academic term beginning during the tax year or during the first three months of the next tax year. The amount of these expenses must be reduced by tax-free educational assistance and certain exclusions from income under the rules for savings bond interest, Coverdell education savings accounts (ESAs), and qualified tuition programs (QTPs or 529 plans).

The maximum deduction is:

$4,000 for an individual whose adjusted gross income (AGI), with certain modifications, does not exceed $65,000 ($130,000 for a joint return),
$2,000 for an individual whose modified AGI exceeds $65,000 ($130,000 for a joint return), but does not exceed $80,000 ($160,000 for a joint return), or
zero for other taxpayers.

Under pre-2010 Tax Relief Act law, the higher-education expense deduction was not available for tax years beginning after December 31, 2009.

The 2010 Tax Relief Act (Act) replaces “ December 31, 2009” with “December 31, 2011.” Thus, the Act extends the qualified tuition deduction for two years so that it is generally available for tax years beginning before January 1, 2012.

Most individuals are on a calendar year. For these individuals, the qualified tuition expenses must be paid before 2012. But, as noted above, the deduction is for expenses in connection with enrollment at an institution of higher education during the tax year, or with an academic term beginning during the tax year or during the first three months of the next tax year. Thus, expenses for an academic term beginning as late as March 31, 2012 may qualify for the deduction, if the taxpayer pays these expenses before 2012.

A taxpayer who plans to go to college or graduate school for an academic term beginning January, February, or March 2012 (or whose spouse or dependent plans to do so) should consider paying some tuition for that term at the end of 2011-namely, the dollar amount equal to the maximum allowable deduction ($4,000 or $2,000, depending on the taxpayer’s modified AGI).

EGTRRA Changes to Student Loan Deduction Rules are Extended Through December 31, 2012
Individuals can deduct a maximum of $2,500 annually for interest paid on qualified higher education loans. The deduction is claimed as an adjustment to gross income to arrive at adjusted gross income (AGI). For 2011 and 2012, the deduction phases out ratably for taxpayers with modified AGI between $60,000 and $75,000 ($125,000 and $155,000 for joint returns). The phaseout amounts and ranges are indexed for inflation.

The 2010 Tax Relief Act amends 2001 EGTRRA §901 to provide that amendments to the student loan interest deduction rules provided in 2001 EGTRRA §412 do not apply to tax years beginning after December 31, 2012. In other words, the 2010 Tax Relief Act delays the 2001 EGTRRA sunset as it applies to the student loan interest deduction, and this tax benefit will continue to be available through December 31, 2012.

Thus, for tax years beginning after 2010 and before 2013, the 60-month limitation on the student loan interest deduction will not apply. Also, for tax years beginning after 2010 and before 2013, the AGI phaseout ranges will not revert to the AGI phaseout ranges that applied before 2001 EGTRRA. But, absent further legislation, for tax years beginning after 2012, the student loan interest deduction rules will revert to the rules with respect to the 60-month limit on the deduction, the phaseout ranges, and the inflation adjustments to the phaseout ranges that applied before 2001 EGTRRA.

Exclusion for Employer-Provided Educational Assistance, and Restoration of the Exclusion for Graduate-Level Courses, Extended Through 2012
Under Code Sec. 127, an employee’s gross income does not include amounts paid or expenses incurred (up to $5,250 annually) by the employer in providing educational assistance to employees under an educational assistance program. An educational assistance program is a separate written plan of the employer for the exclusive benefit of its employees, having the purpose of providing the employees with educational assistance. The courses taken need not be related to the employee’s job for the exclusion to apply. To be qualified, the program must not discriminate in favor of highly compensated employees, nor may more than 5% of the amounts paid or incurred by the employer for educational assistance during the year be provided for individuals (and their spouses and dependents) owning more than 5% of the employer. Further, the program cannot provide employees with a choice between educational assistance and other remuneration that would be includible in their gross income. Finally, reasonable notification of the program’s availability and terms must be provided to employees.

Under the 2010 Tax Relief Act, the EGTRRA sunset is extended from December 31, 2010 to December 31, 2012. Thus, the Code Sec. 127 exclusion, including the assistance for graduate courses, is available through 2012.

Illinois “Bright Start” College Savings Plan
The Illinois “Bright Start” college savings plan is being offered under provisions of Section 529 of the Internal Revenue code. Bright Start works by investing in mutual funds. Illinois has contracted with Oppenheimer Funds to manage the investment trust.

Illinois also has “College Illinois” which has been around for a few years. Prepaid tuition through the college Illinois plan is a less aggressive investment, a defined benefit plan that acts as a hedge against tuition inflation by allowing parents and grandparents to lock in current tuition rates for state schools.

Section 529 college savings plans offer contribution advantages over another option called Coverdell Education Savings Accounts with their low annual deposit limits of $2,000.

Contributions of up to $13,000 a year and $320,000 over the life of the account are permitted in Bright Start.

Provisions for lump sum contributions as large as $65,000 ($130,000 for married couples) without gift tax penalties are also included in the tax code, in case grandma and grandpa want some of their nest egg to go toward educating their grandchildren.

Private institutions may be sponsors of prepaid tuition programs. The definition of a “Qualified Tuition Program” will include certain prepaid tuition programs established and maintained by eligible educational institutions (including private institutions) that satisfy the requirements under code section 529.

Exclusion for qualifying payouts. Distributions will be excluded from gross income to the extent they are used to pay for qualified higher education expenses. The exclusion will apply to payouts from qualified state tuition programs, and to payouts from qualified tuition programs established and maintained by entities other than a state.

Qualified higher education expenses will include special needs services for special needs beneficiaries.

For the exclusion for distributions from qualified tuition plans to pay for qualified higher educational expenses, including room and board, the maximum room and board allowance will be the actual amount charged by the educational institution for room and board.

During the same tax year, taxpayers will be able to claim the American Opportunity Credit or Lifetime Learning Credit and exclude amounts distributed from a qualified tuition program for the same student as long as the distribution is not used for the same expenses as which a credit will be claimed.

The definition of a family member for purposes of beneficiary changes and rollovers will include first cousins of the original beneficiary.

Coverdell ESAs and Qualified Tuition Programs offer essentially the same income tax benefit, namely tax-free earnings if payouts are made for qualified educational purposes. However, each offers a unique combination of benefits and limitations. For example, a Coverdell ESA can be used for elementary and secondary school expenses or college costs, but annual contributions are limited $2,000 per beneficiary and an individual’s contributions are subject to AGI phase outs. The qualified tuition program, on the other hand, does not restrict contributions, but must be used for higher education. The best savings vehicle ultimately will depend on the needs of the donor and the beneficiary who will receive the education.

Unlike custodial mutual funds in his name that become his property at age 18, college savings plans like Bright Start remain in the name of the adult who opened the account. The beneficiary may be changed to another family member, including adults who may want to pursue an advanced degree.

The account is also not included as part of the owner’s taxable estate.

However, withdrawals for nonqualified education expenses incur a federally mandated 10% penalty on top of the income being taxed at the owner’s higher rate.

Most Section 529 savings plans offered by other states are open to out-of-state residents.

Bright Start applications and other information are available at 877-43-BRIGHT or online at www.brightstartsavings.com.

Trust, Estate and Decedent Income Tax

Top Four Reduced Trusts and Estates Income Tax Rates (25%, 28%, 33%, and 35%) are Extended Through 2012
The income tax liability of trusts and estates is computed using a tax rate schedule applicable only for trusts and estates. That tax rate schedule is divided into five income ranges (tax brackets), which are taxed at progressively higher marginal tax rates as the income brackets increase. Each year IRS adjusts each bracket (income range) for inflation (computed from 1992), and IRS’s inflation-adjusted rate schedule is the one used to compute tax (not the statutory rate schedule).

The 2010 Tax Relief Act provides that the EGTRRA sunset will not take effect until after December 31, 2012 (instead of after December 31, 2010). That is, the reduced 25%, 28%, 33%, and 35% rates for taxing trusts’ and estates’ taxable income are extended for an additional two years, through 2012.

That is, trusts’ and estates’ 2011 and 2012 taxable income will continue to be taxed at 15%, 25%, 28%, 33%, and 35% marginal tax rates.

The projected 2011 trusts and estates income tax rate schedule below (reflecting extension of the reduced rates, and applicable inflation adjustments)

2011 Rate Schedule for Trusts and Estates

If taxable income is:	The tax would be:
Not over $2,300	15% of taxable income
Over $2,300 but not over $5,450	$345.00 plus 25% of the excess over $2,300
Over $5,450 but not over $8,300	$1,132.50 plus 28% of the excess over $5,450
Over $8,300 but not over $11,350	$1,930.50 plus 33% of the excess over $8,300
Over $11,350	$2,937.00 plus 35% of the excess over $11,350

Inclusion of Qualified Dividend Income in Prohibition on IRD Double Benefit is Extended Through 2012
Under Code Sec. 691(c)(4), when “income in respect of a decedent” (IRD) includes net capital gain, including qualified dividend income, to prevent the estate of heirs from receiving the double benefit of both lower capital gains rates on the IRD and the ordinary income deduction allowed for estate tax attributable to that IRD, the amount subject to the lower capital gains rates is reduced by the amount of the IRD deduction.

Under section 303 of the 2003 Jobs and Growth Act, as amended by section 102 of the 2005 Tax Increase Prevention Act, the inclusion of qualified dividend income in this rule was scheduled to expire for tax years beginning after December 31, 2010.

The 2010 Tax Relief Act extends the inclusion of qualified dividend income in the Code Sec. 691(c)(4) prohibition on an IRD double benefit so that it applies for tax years beginning before January 1, 2013.

Passthrough of Qualified Dividend Income by Common Trust Funds is Extended Through 2012
A Code Sec. 584 common trust fund maintained by a bank is not subjected to tax. Instead, each trust participant includes in income its proportionate share of the common trust fund’s short term capital gain or loss, long-term capital gain or loss, and ordinary income, regardless of whether the trust distributes these amounts.

Under the 2003 Jobs and Growth Act, qualified dividend income received by noncorporate shareholders is taxed as a capital gain at a maximum 15% rate. As a conforming change, the 2003 Jobs and Growth Act also provided that each common trust fund participant’s proportionate share of the amount treated as qualified dividends received by the fund is treated as qualified dividend income.

Under the 2010 Tax Relief Act, the 2003 Jobs and Growth Act sunset is extended from December 31, 2010 to December 31, 2012. Thus, the existing rules applicable to qualified dividends, including the passthrough of qualified dividends from a common trust fund, are extended for two additional years.

Estate, Gift, and Generation Skipping Transfer Taxes

Estate and Gift Tax – Overview
The estates of wealthy individuals who died in 2010 did not pay any federal estate tax, but that situation is about to change. Under the recently enacted “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010,” the federal estate tax, which disappeared for 2010, springs back to life in 2011 and is imposed at the top rate of 35% of the estate’s value after the first $5 million.

Background
The modern estate tax dates back to 1916, when it was imposed at a rate of 10% on the portion of estates above $50,000. Over the following years, the rates and exemption amounts have varied, reaching a high of 77% from 1941 to 1976 with a $60,000 exemption amount.

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the first of the two large legislative packages that contain most of what are now commonly referred to as the “Bush tax cuts.” EGTRRA gradually lowered the maximum estate tax rate and substantially raised the applicable exclusion amount over the years 2002 through 2009. The maximum tax rate fell from 60% under the prior law in 2001 (a 55% marginal rate on taxable estate values over $3 million plus a 5% surtax from $10 million to $17 million) to 45% in 2007-2009. EGTRRA repealed the estate tax completely for decedents dying in 2010. That led to several well-publicized instances in which famous people died in 2010 leaving multibillion-dollar estates that will pass to their heirs without paying so much as a penny in federal estate tax. However, all of those provisions were scheduled to sunset on December 31, 2010, meaning that if Congress had not acted, starting January 1, 2011, the estate tax would have sprung back at a level that no one seemed to want. Where the exclusion was $3.5 million ($7 million for couples) in 2009 – a level at which it affected relatively few households – it would have been $1 million ($2 million for couples) in 2011. The tax rate would also have risen, from a top rate of 45% in 2009, to a top rate of 55% in 2011.

New Law
The new law brings back the estate tax, for 2011 and 2012 anyway. During 2011 and 2012, the top rate will be 35%. For 2011, the exemption amount will be $5 million per individual (indexed for inflation after 2011). At those levels, the vast majority of estates (all but an estimated 3,500 nationwide in 2011) will not be subjected to any federal estate tax, and the tax will raise about $11.4 billion for the government. By way of comparison, the 55% tax with a $1 million exemption would have resulted in about 43,540 taxable estates in 2011, and raised about $34.4 billion. Tax historians would also note that except for the temporary repeal of the estate tax in 2010, the estate tax rate has not been less than 45% since 1931.

The new law also gives heirs of decedents dying in 2010 a choice of which estate-tax rules to apply – 2010’s or 2011’s. That is important because although there is no estate tax in 2010, some inherited assets are subject to higher capital gains tax under the 2010 rules, a situation that actually raises the tax burden for some heirs. Inherited assets under the 2010 rules have a tax basis equal to the price when they were purchased (referred to in tax parlance as “carryover basis”) rather than the price at death. That could lead to a significant tax burden for heirs who sell assets such as stocks that had been held for many years and have greatly appreciated in value. Under the 2011 rules, by contrast, heirs will be allowed to inherit assets with a “stepped-up basis.” While most heirs would choose the 2011 regime ($5 million exemption from both estate and generation-skipping tax and an unlimited step-up in the basis of assets to their current market value), the heirs of superrich decedents could find it more advantageous to elect the 2010 law (limited step-up in the basis of assets and no estate tax). If the executor makes the election to have the 2010 rules apply, the estate tax return’s due date will not be earlier that the date that is nine months after the new law’s enactment date.

For gifts made after December 31, 2010, the gift tax will be reunified with the estate tax. Under the new law, the estate and gift tax exemptions will be reunified starting in 2011, which means what the $5 million estate tax exemption will also be available for gifts. The law in effect prior to 2010 provided a $3.5 million lifetime exemption for estates, but only $1 million for gifts. The gift tax rate, starting in 2011, will be 35%. The exemption from the generation-skipping tax (GST) – the additional tax on gifts and bequests to grandchildren when their parents are still alive – will also rise to $5 million from the $1 million it would have been without the new law. The GST tax rate for transfers made in 2011 and 2012 will be 35%.

From a planning standpoint, a nice feature of the new law is that it makes it easier to transfer the $5 million exemption to a surviving spouse, so married couples can shield $10 million of their assets from taxes. In the language of tax professionals, the estate tax exemption will be “portable.”

2010 Modified Carryover-Basis-at-Death Rules and Related Provisions are Repealed
Generally, for decedents dying before January 1, 2010, the basis of most property transferred by reason of the death of an individual had a basis, in the hands of the transferee, equal to the fair market value of that property on the date of death (or six months afterwards if the estate’s alternate valuation date was elected), i.e., the fair market value basis rules, also known as the step-up or step-down basis rules.

However, 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) repealed the fair market value basis rules for decedents dying in calendar year 2010, and EGTRRA replaced the fair market value basis rules with modified carryover basis rules, under which property acquired from a decedent was treated generally as property acquired by gift, with the basis of the property being the lesser of the property’s adjusted basis or fair market value on the date of death. EGTRRA also allowed an allocation of $1,300,000 ($60,000 for nonresident alien decedents) of basis increases among any properties that were owned (or treated as owned) by the decedent. For decedents other than nonresident aliens, the $1,300,000 was increased by unrealized losses and unused capital loss and net operating loss carryovers. An additional allocation of $3,000,000 of basis increases was allowed for properties deemed to be passing to a surviving spouse. The $1,300,000, $60,000 and $3,000,000 allocations were not permitted for certain types of property or in an amount that would cause the basis of any asset to exceed its date-of-death fair market value.

The termination of the fair market value basis rules and the application of the modified carryover basis rules, and related rules, were to be effective only for property acquired from a decedent dying in 2010 because of the interaction of the following provisions: (1) pre-2010 Tax Relief Act which provided that the fair market value basis rules were not to apply to decedents dying after December 31, 2009, which provided that the modified carryover basis rules, and related rules, were to be effective for estates of decedents dying after December 31, 2009, which provided that the termination of the fair market value basis rules and application of the modified carryover basis rules, and related rules, were to be no longer effective for estates of decedents dying after December 31, 2010 (the EGTRRA sunset rule).

Notwithstanding the rules discussed below, the modified carryover basis rules (and other rules discussed above) can apply to property acquired from a decedent dying during 2010 (the 2010 modified carryover basis rules) if the executor makes the election. Under the election, for estate property and other property acquired from a decedent dying during 2010, the estate tax does not apply and the 2010 modified carryover basis rules do apply.

The 2010 Tax Relief Act repeals the provisions that, under EGTRRA, applied for purposes of determining basis in property acquired from a decedent who dies in 2010.

Thus, a recipient of property acquired from a decedent who dies after December 31, 2009 generally will receive date-of-death fair market value basis under the basis rules in effect in calendar-year 2009.

Accordingly, subject to the election referred to above, whether a decedent dies before, during or after calendar-year 2010, the fair market value basis rules apply (and not the modified carryover basis rules, nor any of the other related rules discussed above).

Executor Can Elect out of the Estate Tax and into Modified Carryover Basis Rules for Death in 2010
The Economic Growth and Tax Relief Reconciliation Act of 2001 repealed the estate tax for estates of decedents dying after December 31, 2009, and repealed the generation-skipping transfer (GST) tax for generation-skipping transfers made after December 31, 2009.

EGTRRA included a sunset provision under which the estate and GST tax changes made by EGTRRA were scheduled to sunset for estates of decedents dying, and generation-skipping transfers made, after December 31, 2010.

Generally, for decedents dying before January 1, 2010, the basis of most property transferred by reason of the death of an individual had a basis, in the hands of the transferee, equal to the fair market value of that property on the date of death (or six months afterwards if the estate’s alternate valuation date was elected), i.e., the fair market value basis rules, also known as the step-up basis rules.

However, EGTRRA repealed the fair market value basis rules for decedents dying in calendar year 2010, and EGTRRA replaced the fair market value basis rules with modified carryover basis rules under Code Sec. 1022, under which property acquired from a decedent was treated generally as property acquired by gift, with the basis of the property being the lesser of the property’s adjusted basis or fair market value on the date of death. EGTRRA also allowed an allocation of $1,300,000 ($60,000 for nonresident alien decedents) of basis increases among any properties that were owned (or treated as owned) by the decedent. For decedents other than nonresident aliens, the $1,300,000 was increased by unrealized losses and unused capital loss and net operating loss carryovers. An additional allocation of $3,000,000 of basis increases was allowed for properties deemed to be passing to a surviving spouse. The $1,300,000, $60,000 and 3,000,000 allocations were not permitted for certain types of property or in an amount that would cause the basis of any asset to exceed its date-of death-fair market value.

New Law
Notwithstanding 2010 Tax Relief Act (which reinstituted the estate tax and the step-up basis rules for estates of decedents dying in 2010, in the case of a decedent dying after December 31, 2009 and before January 1, 2011, the executor is allowed to elect to apply the Code as though the amendments made by 2010 Tax Relief Act do not apply with respect to the estate tax and with respect to property acquired or passing from the decedent within the meaning of Code Sec. 1014(b).

Thus, in the case of a decedent who dies during 2010, the election allows the executor of the decedent’s estate to elect to apply the Code as if the estate tax as provided by the 2010 Tax Relief Act and the basis step-up rules described above had not been enacted. In other words, instead of applying the estate tax as provided by the 2010 Tax Relief Act and the basis step-up rules, the executor can elect to have the rules for 2010 law, as enacted under EGTRRA apply. Therefore, in general, if the election is made, the estate is not subject to estate tax, and the basis of assets acquired from the decedent is determined under the modified carryover basis rules under Code Sec. 1022.

This election has no effect on the continued applicability of the generation-skipping transfer (GST) tax.

The election is made at the time and in the manner as IRS provides. An election, once made, is revocable only with the consent of IRS.

Extensions of Time Allowed for Filing Most 2010 Estate and GST Tax Returns, Paying Estate Tax, and Making Disclaimers
For a disclaimer of property passing by reason of a decedent’s death to meet the requirements for a “qualified disclaimer,” the disclaimer must be made within nine months of the decedent’s death.

The 2010 Tax Relief Act provides that, for estates of decedents dying after December 31, 2009, and before date of enactment of the 2010 Tax Relief Act, the due date for (1) filing an estate tax return, (2) paying the estate tax, and (3) making a disclaimer of an interest in property passing by reason of the decedent’s death, is not earlier than the date which is nine months after date of enactment of the 2010 Tax Relief Act.

Likewise, the 2010 Tax Relief Act provides that, for generation-skipping transfers made after December 31, 2009, and before date of enactment of the 2010 Tax Relief Act, the due date filing any GST tax return (including any election required to be made on the return) is not earlier than the date which is nine months after date of enactment of the 2010 Tax Relief Act.

Amount of Estate Tax Exemption and GST Exemption is $5 million in 2010, 2011, and 2012, subject to an Inflation Adjustment in 2012
The Economic Growth and Tax Relief Reconciliation Act of 2001 increased the “applicable exclusion amount” (the amount exempted from estate tax by the “applicable credit amount,” also known as the unified credit) on a phased-in schedule. Under the phased-in schedule provided by EGTRRA, the applicable exclusion amount was $3.5 million for estates of decedents dying in 2007, 2008, or 2009.

Every individual is allowed an exemption from the generation-skipping transfer (GST) tax. Under pre-2010 Tax Relief Act law, the GST exemption amount was equal to the applicable exclusion amount for estate tax purposes.

The 2010 Tax Relief Act provides that, for estates of decedents dying after 2009, the applicable exclusion amount is the sum of (1) the “basic exclusion amount” (defined below) and (2) in the case of a surviving spouse, the “deceased spousal unused exclusion amount.”

For estates of decedents dying after December 31, 2010, the basic exclusion amount is $5 million.

For estates of decedents dying after 2011, the $5 million basic exclusion amount will be increased by an amount equal to:

$5 million, multiplied by
the cost-of-living adjustment determined under Code Sec. 1(f)(3) for the year of the decedent’s death by substituting “calendar year 2010” for “calendar year 1992” in Code Sec. 1(f)(3)(B).

If any amount as adjusted under the above formula is not a multiple of $10,000, the amount will be rounded to the nearest multiple of $10,000.

The 2010 Tax Relief Act equates the amount of the GST tax exemption to the “basic exclusion amount” (i.e., $5 million, indexed for inflation after 2011, without regard to the “deceased spousal unused exclusion amount”), instead of the applicable exclusion amount.” Thus, up to $5 million in GST exemption may be allocated to a trust created of funded during 2010, depending on the amount of the exemption used by the taxpayer before 2010. The $5 million GST exemption is available in 2010 regardless of whether the executor of the estate of a decedent dying in 2010 makes the election to be subject to the estate tax and the carryover basis rules.

Under the 2010 Tax Relief Act, the sunset of the EGTRRA estate and GST tax provisions-which had been scheduled to apply to estates of decedents dying, and transfers, after December 31, 2010-will apply to estates of decedents dying, and transfers, after December 31, 2012.

Thus, absent further legislation, the applicable exclusion amount for estates of decedents dying after 2012, and the GST exemption for transfers after 2012, will be $1 million (the applicable exclusion amount that, under pre-EGTRRA law, had been scheduled to apply in 2006 and later years.)

Effective for estates of decedents dying, and transfers, after December 31, 2009.

Top Estate and Gift Tax Rate is 35% in 2010, 2011, and 2012
For estates of decedents dying, and gifts made, before 2010, the gift tax rates and the estate tax rates were set forth in a single graduated rate schedule. For estates of decedents dying, and gifts made, in 2007, 2008, or 2009, the maximum estate and gift tax rate was 45%.

The 2010 Tax Relief Act provides that, for estates of decedents dying after December 31, 2009, the maximum estate tax rate is 35%. This rate applies to transfers exceeding $500,000.

The estate tax exemption for estates of decedents dying in 2010, 2011, or 2012 is $5 million (subject to an inflation adjustment in 2012). Thus, the estate tax rate for estates of decedents dying in 2010, 2011, or 2012 is a flat 35% on transfers in excess of the $5 million applicable exclusion amount.

The gift tax exemption is the same as the estate tax exemption after 2010. Thus, the gift tax rate for gifts made after 2010 is a flat 35% on transfers in excess of the applicable exclusion amount. This is also the top rate that applied to gifts made in 2010, under the separate gift tax rate schedule provided by EGTRRA.

Thus, absent further legislation, the maximum estate and gift tax rate for estates of decedents dying, and gifts made, after 2012 will be 55%, and the benefits of the graduated estate and gift tax rate schedule will be phased out for taxable transfers exceeding $10 million.

Estate Tax Exclusion is Made Portable Between Spouses for Decedents Dying after 2010, but GST Exemption is not Portable
A credit (the “unified credit”) is allowed against the estate tax imposed on U.S. citizens and residents. The credit is equal to the tentative tax on the “applicable exclusion amount,” determined under the estate tax rate schedule.

Pre-2010 Tax Relief Act law did not allow for any unused portion of a decedent’s applicable exclusion amount to be used by the estate of the decedent’s surviving spouse.

Under the 2010 Tax Relief Act, any applicable exclusion amount that remains unused as of the death of a spouse who dies after December 31, 2010 (the “deceased spousal unused exclusion amount”) generally is available for use by the surviving spouse, as an addition to the surviving spouse’s applicable exclusion amount.

Specifically, the 2010 Tax Relief Act provides that the “applicable exclusion amount” is the sum of (1) the “basic exclusion amount” ($5 million, subject to an adjustment for inflation for estates of decedents dying after 2011), and (2) the “deceased spousal unused exclusion amount.”

For the surviving spouse of a deceased spouse dying after December 31, 2010, the term “deceased spousal unused exclusion amount” means the lesser of:

the basic exclusion amount ($5 million, subject to an adjustment for inflation for estates of decedents dying after 2011), or
the excess of: the basic exclusion amount of the last deceased spouse dying after December 31, 2010, of the surviving spouse, over the amount of the tentative tax on the estate of the deceased spouse, determined under the estate tax rate schedule.

A surviving spouse may use the deceased spousal unused exclusion amount in addition to the surviving spouse’s own $5 million exclusion for taxable transfers made during life or at death.

Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election (see below) is made on Husband 1’s estate tax return to permit Wife to use Husband 1’s deceased spousal unused exclusion amount. As of Husband 1’s death, Wife has made no taxable gifts. Thereafter, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.

If a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion that is available for use by the surviving spouse is limited to the lesser of $5 million or the unused exclusion of the last deceased spouse. This so-called “last deceased spouse” limitation applies whether or not the last deceased spouse has any unused exclusion, and whether or not his estate makes a timely election to allow the surviving spouse to use the deceased spousal unused exclusion amount.

Assume the same facts as above, except the Wife later marries Husband 2. Husband 2 also predeceases Wife (thus becoming the “last deceased spouse”), having made $4 million in taxable transfers and having no taxable estate. An election is made on Husband 2’s estate tax return to permit Wife to use Husband 2’s deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2’s $1 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse (Husband 2) of the surviving spouse (Wife). Thus, Wife can only use Husband 2’s $1 million unused exclusion. Thereafter, Wife’s applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.

The Committee Report also provides the following example of how the deceased spousal unused exclusion amount works when the surviving spouse remarries, and then predeceases her second spouse.

Assume the same facts as above, except that Wife predeceases Husband 2. Following Husband 1’s death, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1). Wife made no taxable transfers and has a taxable estate of $3 million. An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion amount, which is $4 million (Wife’s $7 million applicable exclusion amount less her $3 million taxable estate). Under the provision, Husband 2’s applicable exclusion amount is increased by $4 million, i.e., the amount of Wife’s deceased spousal unused exclusion amount.

Election by deceased spouse’s estate to allow surviving spouse’s estate to use deceased spousal unused exclusion amount.

A deceased spousal unused exclusion amount may not be taken into account by a surviving spouse unless the executor of the estate of the deceased spouse files an estate tax return on which the amount is computed, and makes an election on the return that the amount may be taken into account by the surviving spouse. The election, once made, is irrevocable. No election may be made if the estate tax return of the deceased spouse is filed after the due date (including extensions) for filing the return.

The election must be made on an estate tax return of the deceased spouse, regardless of whether the estate of the deceased spouse is otherwise required to file an estate tax return.

IRS May Examine Prior Returns After Expiration of Period of Limitations
In spite of any Code Sec. 6501 period of limitation for assessing estate or gift tax with respect to a predeceased spouse, IRS may examine a return of the deceased spouse after the period of limitation has expired, in order to determine the deceased spousal unused exclusion amount available for use by the surviving spouse.

IRS to Issue Regs
The 2010 Tax Relief Act directs IRS to issue regs that may be necessary or appropriate to carry out the rules on the deceased spousal unused exclusion amount.

GST Exemption is not Portable
The 2010 Tax Relief Act re-defines the amount of the generation-skipping transfer (GST) tax exemption from the “applicable exclusion amount” to the “basic exclusion amount” ($5 million, indexed for inflation after 2011). Thus, the 2010 Tax Relief Act provision allowing portability of the estate tax applicable exclusion amount does not allow a surviving spouse to use the unused GST exemption of a predeceased spouse.

Estate Tax Return Filing Threshold is Tied to Basic Exclusion Amount ($5 Million)
The Tax Relief Act provides that the estate of a U. S. citizen or resident must file an estate tax return if the gross estate exceeds the “basic exclusion amount” (i.e., $5 million, subject to an adjustment for inflation after 2011).

Thus, the estate of a U. S. citizen or resident dying after December 31, 2010, must file an estate tax return if the gross estate exceeds $5 million (as indexed for inflation after 2011), even if the decedent’s applicable exclusion amount is greater than $5 million as a result of the deceased spousal unused exclusion amount.

Portability Rules Will Sunset After 2012
Thus, absent further legislation, the rules allowing the portability of the applicable exclusion amount between spouses will not apply to estates of decedents dying after December 31, 2012.

Gift Tax Exemption Will be Reunified With Estate Tax Exemption for Gifts Made After 2010, but Stays Unchanged at $1 Million for Gifts Made in 2010
Before 2004, the estate and gift taxes were unified, so that a single exemption amount (the amount excluded from tax by the unified credit) applied for purposes of determining the tax on cumulative taxable transfers made by a taxpayer during his lifetime and at death. As a result of the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001, the estate and gift taxes were no longer unified after 2003.

For 2004 through 2009, the exemption amount allowed for estate tax purposes was higher than the exemption amount for gift tax purposes. In 2009, the exemption amount was $3.5 million for estate tax purposes, and $1 million for gift tax purposes.

For gifts made after December 31, 2010, the gift tax is reunified with the estate tax, with an applicable exclusion amount of $5 million.

Because this change applies to gifts made after December 31, 2010, the gift tax exclusion amount for gifts made in 2010 remains at $1 million.

Estate and GST Tax Changes Made by EGTRRA That Had Been Scheduled to Sunset After 2010 are Now Scheduled to Sunset After 2012
Under the 2010 Tax Relief Act, the sunset of the EGTRRA estate and GST tax provisions-which had been scheduled to apply to estates of decedents dying, and generation-skipping transfers made, after December 31, 2010 – is extended to apply to estates of decedents dying, and generation-skipping transfers made, after December 31, 2012.

Absent further legislation, the above-described rules will sunset for estates of decedents dying, and generation-skipping transfers made, after 2012.

Date-Of-Death Rates are Used in Determining Gift Tax On, and Unified Credit Allowable for, Decedent’s Post-1976 Gifts
In computing a decedent’s estate tax, the tentative estate tax is reduced by the total amount of gift tax that would have been payable with respect to gifts made by the decedent after 1976, if the Code Sec. 2001(c) estate and gift tax rate schedule in effect on the date of the decedent’s death had been applicable at the time of the gifts.

A credit (the “unified credit”) is allowed against the gift tax imposed on gifts made by a U.S. citizen or resident. The amount of the unified credit allowable against the gift tax on gifts made in a calendar year is reduced by the sum of all amounts allowable as a credit to the donor in preceding calendar periods.

The 2010 Tax Relief Act clarifies the rules on the computation of estate and gift taxes, to reflect differences in the unified credit resulting from different tax rates.

The 2010 Tax Relief Act provides that, for purposes of computing the amount by which a decedent’s tentative estate tax is reduced for the gift tax on the decedent’s post-1976 gifts, the Code Sec. 2001(c) tax rates in effect at the decedent’s death (instead of the tax rates in effect at the time of the gifts) are used to compute both:

the gift tax imposed on the gifts (as under pre-2010 Tax Relief Act law), and
the gift tax unified credit. For this purpose, the date-of-death tax rates are used in computing (a) the amount of the unified credit allowable against the post-1976 gifts, and (b) the sum of the amounts allowed as a credit for all preceding periods (which reduces the allowable unified credit).

The 2010 Tax Relief Act also provides that, for purposes of applying the rule that the amount of the unified credit allowable against the gift tax on gifts made in a calendar year is reduced by the sum of all amounts allowable as a credit to the donor in preceding calendar periods, the gift tax rates that are in effect for the calendar year of the gift (instead of the rates in effect for the preceding calendar periods) are used in determining the amounts allowable as a credit for all preceding calendar periods.

Effective for estates of decedents dying, and gifts made, after December 31, 2009.

Reporting Requirements Relating to the Carryover Basis Rules are Repealed
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) repealed the estate tax for estates of decedents dying after 2009, but the 2010 Tax Relief Act retroactively reinstates the estate tax for 2010, 2011, and 2012.

Property acquired from decedents dying after 2009, EGTRRA would have provided a modified carryover basis regime in place of the step-up (or step-down) in basis rules that apply to property acquired from decedents dying before 2010. Under the modified carryover basis rules provided by EGTRRA, an executor would have been permitted to allocate a $1.3 million “aggregate basis increase” among the decedent’s assets. The 2010 Tax Relief Act repeals the modified carryover basis rules that would have been provided by EGTRRA, and reinstates the step-up in basis rules for property acquired from decedents dying in 2010 and later years.

In conjunction with the repeal of the estate tax and the addition of the modified carryover basis rules, EGTRRA would have imposed certain reporting requirements. Specifically:

EGTRRA would have replaced the pre-2010 estate tax return filing requirements with a requirement that an executor file an information return with IRS if the value of property (other than cash) acquired from a decedent exceeded $1.3 million. For each asset acquired from the decedent, the information required to be reported on the return would have included the identity of the recipient, a description of the property, the decedent’s adjusted basis in the property, the decedent’s holding period, sufficient information to determine whether any gain on the sale of the property would be treated as ordinary income, and any basis increase allocated to the property. The information return would have had to be filed with the income tax return for the decedent’s tax year or a later date to be specified in regs; and
EGTRRA would have required every person who was required to file a gift tax return after 2009 to furnish, to each person whose name was required to be set forth in the return (other than the person required to file the return), a written statement showing (a) the name, address, and phone number of the person required to make the return, and (b) the information specified in the return with respect to property received by the person required to receive the statement.

The 2010 Tax Relief Act repeals the reporting requirements (and penalties for failure to comply with the reporting requirements) that would have applied to estates of decedents dying in 2010, under EGTRRA, do not apply. Instead, the Code Sec. 6018 estate tax return filing requirements that applied to estates of decedents dying before 2010 continue to apply to estates of decedents dying after 2009.

For an election which may be made by the executor of the estate of a decedent dying in 2010 to apply the Code as if the estate tax were not reinstated and as if the carryover basis rules were not repealed, the reporting requirements (and penalties) that would have applied under EGTRRA continue to apply to that estate.

Gift Tax Annual Exclusion
For gifts made in 2012, the gift tax annual exclusion will be $13,000 (for 2011 the annual exclusion was $13,000 as well).

Pension and IRA Provisions

Plan Benefit and Contribution Limits Increased

Defined Benefit Plans
The maximum annual benefit payable at retirement under a defined benefit plan is generally the lesser of 100% of average compensation or a statutory amount, $195,000 for 2011 and $200,000 for 2012.

Defined Contribution Plans
The qualification rules for defined contribution plans limits the annual additions for each plan participant to the lesser of 25% of compensation or a statutory amount ($49,000 for 2011 and $50,000 for 2012).

Compensation Limit
The annual compensation of each participant that can be taken into account for purposes of determining contributions and benefits under a plan is limited to a statutory amount, $245,000 for 2011 and $250,000 for 2012.

Elective Deferral Limitations
The limit on the deductible amount of elective deferrals to 401(k) plans and 403(b) annuities may not exceed the “applicable dollar amount.” The applicable dollar amount for these plans will be $16,500 for 2011 and $17,000 for 2012.

The deductible amount of elective deferrals to SIMPLE plans will be limited to another “applicable dollar amount.” The applicable dollar amount for SIMPLE plans will be $11,500 for 2011 and $11,500 for 2012.

Section 457 Plans
The limit on the deductible amount of elective deferrals to a Section 457 plan is also an applicable dollar amount. The maximum annual deferral will be $16,500 for 2011 and $17,000 for 2012.

Under the special catch‑up rule, the limit is twice the otherwise applicable dollar amount in the three years before retirement.

For Individuals Over Age 50, Additional Elective Deferrals in Excess of Otherwise Applicable Limits
The otherwise applicable dollar limit on elective deferrals under a Section 401(k) plan, Section 403(b) annuity, Simplified Employee Pension (SEP), or SIMPLE, or deferrals under a government Section 457 plan is increased for individuals who have attained age 50 by the end of the year. The additional amount of contributions that may be made is the lesser of (1) a specified dollar amount or (2) the participant’s compensation for the year reduced by his or her other elective deferrals for the year. The dollar amount under a Section 401(k) plan, Section 403(b) annuity, SEP, or Section 457 plan is $5,500 for 2011 and $5,500 for 2012.

The dollar amount under a SIMPLE plan is $2,500 for 2009 and later years.

Higher IRA Contribution Limits
An individual may make annual deductible contributions to a traditional IRA if neither the individual nor his spouse is an active participant in an employer‑sponsored retirement plan. For a married couple, deductible IRA contributions can be made for each spouse (including, for example, a homemaker who does not work outside the home) if the combined compensation of both spouses is at least equal to the contributed amount. If the individual is an active participant in an employer‑sponsored retirement plan, the deduction limit is phased – out if Adjusted Gross Income exceeds certain levels for the tax year. For example, for 2012, the IRA deduction for single taxpayers phased out over $58,000 to $68,000 of Adjusted Gross Income ($92,000 to $112,000 for married taxpayers filing jointly). For a nonactive participant who had an active‑participant spouse, the IRA deduction phase-out begins at $167,000 of Adjusted Gross Income.

Contributions to Roth IRAs are subject to income limits. The maximum yearly contribution that can be made to a Roth IRA is phased out for a single individual with an Adjusted Gross Income between $110,000 and $125,000 and for joint filers with Adjusted Gross Income between $173,000 and $183,000 in 2012.

The maximum annual dollar contribution limit for IRA contributions will increase to the following levels:

Tax Years Beginning in	Maximum Deductible IRA Amount
2008 and later	$5,000

Individuals who attain age 50 before the close of the tax year will be able to make additional catch‑up IRA contributions. The otherwise allowable maximum contribution limit (before applying the Adjusted Gross Income phase‑out limits) for these individuals will be $1,000 for 2006 and later years.

401(k) and 403(b) Plans May Treat Post-2005 Elective Deferrals as After-Tax Roth IRA Type Contributions
For tax years beginning after 2005, a 401(k) plan or 403(b) annuity will be allowed to include a “qualified Roth contribution program” that allows participants to elect to have all or part of their elective deferrals treated as Roth contributions. These deferrals will not be excludable from gross income. The annual dollar limit on a participant’s Roth contribution will be the then‑applicable Code Section 402(g) limitation on elective deferrals (e.g., $16,500 in 2011). This new option for elective deferrals will allow taxpayers to make larger annual Roth IRA contributions than they can make with regular Roth IRAs.

Tax Credit to Help Lower‑Income Taxpayers Save for Retirement
Eligible lower‑income taxpayers can claim a nonrefundable tax credit for contributions to certain qualified plans. The maximum annual contribution eligible for the credit is $2,000.

The credit will be in addition to any deduction or exclusion that would otherwise apply for a contribution. Only an individual who is 18 or over (other than a full‑time student or an individual allowed as a dependent on another taxpayer’s return) will be eligible for the credit.

The credit will be available for elective contributions to 401(k) plans, 403(b) annuities, Section 457 plans, SIMPLE or SEP plans, traditional or Roth IRAs, and voluntary after‑tax employee contributions to a qualified retirement plan. The amount of any credit‑eligible contribution will be reduced by taxable distributions received by the taxpayer.

The credit rate (50%, 20%, or 10%) depends on the taxpayer’s filing status and modified Adjusted Gross Income. For 2012, the rates are as follows:

Modified Adjusted Gross Income						Applicable Percentage
*Joint Return*		*Head of Household*		*All Other Cases*
Over	Not Over	Over	Not Over	Over	Not Over
$ – 0 -	$34,500	$ – 0 -	$25,875	$ – 0 -	$17,250	50%
$34,500	$37,500	$25,875	$28,125	$17,250	$18,750	20%
$37,500	$57,500	$28,125	$43,125	$18,750	$28,750	10%
$57,500		$43,125		$28,750		0%

The maximum credit allowed to an individual will be $1,000 ($2,000 x 50%) on joint returns with modified Adjusted Gross Income not over $34,500.

Minimum Distribution Regulations
On April 16, 2002, the IRS released final minimum distribution regulations for profit sharing, stock bonus, 401(k), and other defined contribution plans and IRAs. The regulations are effective beginning January 1, 2003 but may be used in determining minimum distributions for 2002.

The required distribution beginning date has not changed. Minimum distributions are first required for the year the plan participant reaches age 70½ but may be deferred until April 1^st of the following year. If the employee is not a 5% owner of a company that maintains a qualified plan, the first year a distribution from the qualified plan is required is the year in which the employee retires, if this is later than the year he or she reaches 70½.

The amount to be taken as a minimum distribution is the balance on December 31^st of the prior year divided by a divisor, which generally appears in a uniform lifetime table. The table is based on the joint life expectancy of the IRA owner and a hypothetical person ten years younger.

The tables in the final regulations recognize improvements in mortality and allow distributions over a longer period of time than under tables previously used.

Distributions are required after an owner’s death when an individual other than the spouse is beneficiary. When an individual who is not the owner’s spouse is beneficiary, distributions must begin by December 31^st of the year following the owner’s death. If the owner dies before the required beginning date of his or her distributions, the amount to be distributed is determined by dividing the account balance at the beginning of the year following death by the beneficiary’s remaining life expectancy. If the owner dies after the required beginning date of his or her distributions, the divisor is the longer of the owner’s or beneficiary’s remaining life expectancy.

Uniform Table for Lifetime Distributions
Age	Applicable Divisor	Age	Applicable Divisor	Age	Applicable Divisor
70	27.4	80	18.7	90	11.4
71	26.5	81	17.9	91	10.8
72	25.6	82	17.1	92	10.2
73	24.7	83	16.3	93	9.6
74	23.8	84	15.5	94	9.1
75	22.9	85	14.8	95	8.6
76	22.0	86	14.1	96	8.1
77	21.2	87	13.4	97	7.6
78	20.3	88	12.7	98	7.1
79	19.5	89	12.0	99	6.7

Roth IRA Conversion
The Tax Increase Prevention and Reconciliation Act of 2005 included the following:

The $100,000 modified Adjusted Gross Income limit on conversions of traditional IRA’s to Roth IRA’s will be eliminated for tax years beginning after December 31, 2009. For conversions occurring in 2010, unless a taxpayer elected otherwise the amount includible in gross income as a result of the conversion will be included ratably in 2011 and 2012.

This year, for the first time ever, all taxpayers, regardless of their modified adjusted gross income (AGI), may convert amounts in a traditional IRA to amounts in a Roth IRA. Marrieds filing separately also are eligible. Before 2010, only taxpayers with modified AGI of $100,000 or less could make such conversion, and marrieds filing separately were not eligible regardless of modified AGI.

Amounts from a SEP-IRA or a SIMPLE IRA also may be converted to a Roth IRA, but a conversion from a SIMPLE IRA may be made only after the 2-year period beginning on the date on which the taxpayer first participated in any SIMPLE IRA maintained by the taxpayer’s employer.

A conversion from a regular IRA to a Roth IRA generally is subject to tax as if it were distributed from the traditional IRA and not recontributed to another IRA, but isn’t subject to the 10% premature distribution tax.

Roth IRAs have two major advantages over regular IRAs:

Distributions from regular IRAs are taxed as ordinary income (except to the extent they represent nondeductible contributions). By contrast, Roth IRA distributions are tax-free if they are “qualified distributions,” that is, if they are made after the 5-tax-year period that begins with the first tax year for which the taxpayer made a contribution to a Roth IRA, and when the account owner is 59 ½ years of age or older, or on account of death, disability, or the purchase of a home by a qualified first-time homebuyer (limited to $10,000).
Regular IRAs are subject to the lifetime required minimum distribution (RMD) rules that generally require minimum annual distributions to be made commencing in the year following the year in which the IRA owner attains age 70 ½. By contrast, Roth IRAs aren’t subject to the lifetime RMD rules that apply to regular IRAs (as well as individual account qualified plans).

The consensus view is that the conversion route should be considered by taxpayers who:

Have a number of years to go before retirement (and are therefore able to recoup the dollars that are lost to taxes on account of the conversion),
Anticipate being taxed in a higher bracket in the future than they are now, and
Can pay the tax on the conversion from non-retirement-account assets (otherwise, there will be a smaller buildup of tax-free earnings in the depleted retirement account.

A unique income inclusion rule applies for IRA-to-Roth-IRA conversions occurring in 2010. Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012. Taxpayers who elect to include all of the 2010 rollover income on their 2010 return cannot change the election after the due date of that return.

Roth IRA Contributions
Individuals may make nondeductible contributions to a Roth IRA, subject to the overall limit on IRA contributions. The maximum annual contribution that can be made to a Roth IRA is phased out for taxpayers with MAGI over certain levels for the tax year. For taxpayers filing joint returns, the otherwise allowable contributions to a Roth IRA will be phased out ratably in 2012 for MAGI between $173,000 and $183,000 (up from between $169,000 and $179,000 in 2011). For single taxpayers and heads of household it will be phased out ratably for MAGI between $110,000 and $125,000 (up from $107,000 and $122,000 for 2011). For married taxpayers filing separate returns, the otherwise allowable contribution will continue to be phased out ratably for MAGI between $0 and $10,000 (same as for 2010).

Distributions From Elective Deferral Plans May be Rolled Over to Designated Roth Accounts.
The new law allows 401(k), 403(b), and governmental 457(b) plans to permit participants to roll over their pre-tax account balances into a designated Roth account. The amount of the rollover will be includible in taxable income except to the extent it is the return of after-tax contributions. If the rollover is made in 2010, the participant can elect to pay the tax in 2011 and 2012. Plans will be able to allow these rollovers immediately upon the Act’s enactment.

To be eligible for rollover to a designated Roth account, a distribution must be (i) an eligible rollover distribution, (ii) otherwise allowed under the plan, and (iii) allowable in the amount and form elected. For example, an amount in a 401(k) plan account that is subject to distribution restrictions (e.g., because the participant has not reached age 59 ½) cannot be rolled over to a designated Roth account under the new rollover rules. However, an employer may expand its distribution options beyond those currently allowed by the plan (e.g., by adding in-service distributions before normal retirement age) in order to allow employees to make rollover contributions to a designated Roth account through a direct rollover to the designated Roth account within that plan.

If a plan allows rollover contributions to a designated Roth account, the plan must be amended to reflect this plan feature.

Although there are many similarities between the treatment of Roth IRAs and designated Roth accounts, one difference is that, in determining the taxation of Roth IRA distributions that are not qualified distributions, after-tax contributions are considered recovered before income. This basis-first recovery rule for Roth IRAs does not apply to distributions from designated Roth accounts. Another difference is that a first-time homebuyer expense can be a qualified distribution from a Roth IRA (even without the occurrence of another event, such as the individual reaching age 59 ½), but cannot by itself be qualified distribution from a designated Roth account.

A taxpayer who can rollover an amount from an applicable employer plan to either a Roth IRA or a designated Roth account, might consider whether taking withdrawals from the Roth account or Roth IRA within the five-tax-year holding period for qualified distributions would result in additional tax on a distribution from a designated Roth account (because for the unavailability of the basis-first recovery rule). Also, a taxpayer who is contemplating a withdrawal from the Roth account or Roth IRA to purchase a home as a first-time homebuyer, but who has not yet reached age 59 ½, should consider that such a withdrawal can be qualified distribution from a Roth IRA, but not from a designated Roth account, if the taxpayer has not reached age 59 ½.

Under the 2010 Small Business Act, the tax-free treatment of rollovers that ordinarily applies (under Code Sec. 402(c) for qualified plans, under Code Sec. 403(b)(8) for 403(b) annuities and under Code Sec. 457(e)(16) for governmental section 457 plans) does not apply for distributions rolled over from an applicable retirement plan to a designated Roth account (as described above). Rather, the amount that an individual receives in a distribution from an applicable retirement plan that would be includible in gross income if it were not part of qualified rollover distribution, must be included in his gross income.

If a direct rollover is made by a transfer of property to a designated Roth account, then the amount of the distribution is the fair market value of the property on the date of the transfer.

Any amount that is includible in a taxpayer’s gross income for any tax year beginning in 2010 by reason of a distribution from an applicable retirement plan that is rolled over to a designated Roth account (as described above) is included in gross income ratably over the two-year period beginning in the first tax year beginning in 2011. However, the taxpayer may elect to not have this two-year deferral apply (and thus, to include the taxable portion in gross income in the 2010 tax year). Any such election for any distributions made during a tax year may not be changed “after the due date for such taxable year.”

Presumably, the “due date for such taxable year” refers to the due date for 2010, i.e., for most individuals, April 15, 2011. Neither the Act nor the Committee Reports indicate that the “due date” includes extensions.

Business Provisions

Expensing and Additional First-Year Depreciation in The 2010 Tax Relief Act – Overview
The recently enacted 2010 Tax Relief Act includes a wide-ranging assortment of tax changes affecting both individuals and business. On the business side, two of the most significant changes provide incentives for businesses to invest in machinery and equipment by allowing for faster cost recovery of business property. Here are the details.

Expansion and Extension of Additional First-Year Depreciation
Businesses are allowed to deduct the cost of capital expenditures over time according to depreciation schedules. In previous legislation, Congress allowed businesses to more rapidly deduct capital expenditures of most new tangible personal property, and certain other new property, placed in service in 2008, 2009, or 2010 (2011 for certain property), by permitting the first-year write-off of 50% of the cost. The new law extends and temporarily increases this additional first-year depreciation provision for investment in new business equipment. For investments placed in service after September 8, 2010 and through December 31, 2011 (through December 31, 2012 for certain longer-lived and transportation property), the new law provides for 100% additional first-year depreciation. In other words, the entire cost of qualifying property placed in service during that time frame can be written off, without limit. Note that even though the legislation did not take shape in Congress until mid-December of 2010, the effective date of this provision was made retroactive, to include qualifying property placed in service after September 8, 2010.

Fifty percent additional first-year depreciation will apply again in 2012.

The Act extends through 2012 the election to accelerate the AMT credit instead of claiming additional first-year depreciation.

The new law leaves in place the existing rules as to what kinds of property qualify for additional first-year depreciation. Generally, the property must be depreciable property with a recovery period of 20 years or less; water utility property; computer software; or qualified leasehold improvements. Also the original use of the property must commence with the taxpayer – used machinery does not qualify.

Enhanced Small Business Expensing (Section 179 Expensing)
Generally, the cost of property placed in service in a trade or business cannot be deducted in the year it is placed in service if the property will be useful beyond the year. Instead, the cost is “capitalized” and depreciation deductions are allowed for most property (other than land), but are spread out over a period of years. However, to help small businesses quickly recover the cost of capital outlays for qualifying personal property, small business taxpayers can elect to write off these expenditures in the year of acquisition instead of recovering the costs over time through depreciation. The expense election is made available, on a tax year by tax year basis, under Section 179 of the Internal Revenue Code, and is often referred to as the “Section 179 election” or the “Code Section 179 election.” The new law makes three important changes to the Code Section 179 expense election.

First, the new law provides that for tax years beginning in 2012, a small business taxpayer will be allowed to write off up to $139,000 (indexed for inflation) of capital expenditures subject to a phaseout (i.e., gradual reduction) once capital expenditures exceed $560,000 (indexed for inflation). The new maximum expensing amount and phaseout level for tax years beginning in 2012 is actually lower than the levels in effect for tax years beginning in 2010 and 2011 (maximum expensing amount of $500,000, and a phaseout level of $2,000,000). For tax years beginning after 2012, the maximum expensing amount will drop to $25,000 and the phaseout level will drop to $200,000.

Second, the rule which treats off-the-shelf computer software as qualifying property is extended through 2012.

Finally, the new law extends, through 2012, the provision permitting a taxpayer to amend or irrevocably revoke a Code Sec. 179 expense election for a tax year without IRS’s consent.

100% Bonus Depreciation is Allowed After September 8, 2010 and Before January 1, 2012
Under Code Sec. 168(k), “qualifying property” is allowed additional depreciation (bonus depreciation) in the year that the property is placed in service (with corresponding reductions in basis and, thus, reductions of the regular depreciation deductions otherwise allowed in the placed-in-service year and in later years).

The rule discussed above for qualified property does not apply to classes of property for which, under Code Sec. 168(k)(2)(D)(iii), the taxpayer elects not to apply Code Sec. 168(k) (an “election-out”).

Under pre 2010 Tax Relief Act law, the percentage of depreciable basis allowed as bonus depreciation was 50% for all qualified property.

The following are the requirements for qualified property under Code Sec. 168(k)(2):

the property must be of a qualifying type; i.e., generally, most machinery, equipment or other tangible personal property; most computer software; and certain leasehold improvements;
the property must not be either property that must be depreciated under the alternative depreciation system of “qualified New York Liberty Zone leasehold improvement property”);
the property must not be the subject of certain disqualifying transactions involving users other than the taxpayer or persons related to the taxpayer or the other users;
the property’s original use must generally begin with the taxpayer after December 31, 2007;
the property must meet a timely-placed-in-service requirement (see below); and
the property must meet a timely acquisition requirement (see below).

Under pre-2010 Tax Relief Act law, the timely-placed-in-service requirement was that the property had to be placed in service by the taxpayer before January 1, 2011, except for certain aircraft and certain long-production-period property that had to be placed in service before January 1, 2012. However, long-production-period property could qualify for the December 31, 2011 placed-in-service deadline only to the extent of adjusted basis attributable to manufacture, construction or production before January 1, 2011.

Under pre-2010 Tax Relief Act law, the timely acquisition requirement was satisfied if the property was acquired by the taxpayer either (1) after December 31, 2007 and before January 1, 2011, but only if no written binding contract for the acquisition was in effect before January 1, 2008, or (2) under a written binding contract entered into after December 31, 2007 and before January 1, 2011. For a taxpayer manufacturing, constructing or producing property for its own use, the timely acquisition requirement was treated as met if the taxpayer began the manufacture, construction or production after December 31, 2007 and before January 1, 2011 (the “self-constructed” property rule).

New Law
The 2010 Tax Relief Act provides that the bonus depreciation percentage is 100% (instead of 50%, see above) for “qualified property” (see the observations below) that is (1) placed in service after September 8, 2010 and before January 1, 2012 (before January 1, 2013 for the aircraft and long-production-period property discussed above) and (2) acquired by the taxpayer, under rules similar to the rules in Code Sec. 168(k)(2)(A)(ii) and Code Sec. 168(k)(2)(A)(iii) (see the Committee Report excerpt below), after September 8, 2010 and before January 1, 2012. (Code Sec. 168(k)(5) as amended by 2010 Tax Relief Act §401(b)).

The 2010 Tax Relief Act changed the general “before January 1, 2011” deadline in the timely-placed-in-service requirement for “qualified property” (above) to “before January 1, 2013” and the “before January 1, 2012” deadline in the timely-placed-in-service requirement for certain aircraft and long-production-period property (above) to “before January 1, 2014.” Also, the “before January 1, 2011” deadline in the progress expenditure rule (above) was changed to “before January 1, 2013.” In contrast, under Code Sec. 168(k)(5) (above) the general deadline for placing qualified property eligible for 100% bonus depreciation is “before January 1, 2012” but, for the aircraft and long-production-period property, “before January 1, 2013.” However, there is no separate progress expenditure rule for property eligible for 100% bonus depreciation. Thus, for the aircraft and long-production-period property, the entire adjusted basis of the property is eligible for the 100% bonus depreciation if the “before January 1, 2013” deadline is met.

The 2010 Tax Relief Act changed the “before January 1, 2011” deadline in the timely acquisition requirement for “qualified property,” including the deadline in the self-constructed property rule, to “before January 1, 2013.” In contrast, under Code Sec. 168(k)(5) (above) the deadline for acquiring property eligible for 100% bonus depreciation is “before January 1, 2012.”

According to Congress, a consequence of the requirement that property eligible for the 100% bonus depreciation be acquired under rules similar to the rules in Code Sec. 168(k)(2)(A)(ii) and Code Sec. 168(k)(2)(A)(iii) is that property acquired under a written binding contract entered into after December 31, 2007 is qualified property for purpose of the 100% bonus depreciation assuming all other requirements are met.

Code Sec. 179 Expensing Limit Will Increase to $125,000 and Phaseout Threshold to $500,000, Indexed for Tax Years Beginning in 2012
Subject to certain limitations, taxpayers can elect to treat the cost of any section 179 property placed in service during the tax year as an expense which is not chargeable to capital account, and, thus, allowed as a deduction for the tax year in which the section 179 property is placed in service.

Under pre-2010 Tax Relief Act law, the deductible Code Sec. 179 expense could not exceed $250,000 in the case of a tax year beginning in 2008 or 2009, and $500,000 (dollar limitation) in the case of a tax year beginning in 2010 or 2011. The maximum deductible expense had to be reduced (i.e., phased out, but not below zero) by the amount by which the cost of section 179 property placed in service during a tax year beginning in 2008 or 2009 exceeded $800,000, and during a tax year beginning in 2010 or 2011, exceeded $2,000,000 (beginning-of-phaseout amount). The dollar limitation and phaseout amount were not adjusted for inflation.

Under pre-2010 Tax Relief Act law, for a tax year beginning in 2010 or 2011, subject to a dollar limitation and a carryover limitation, “section 179 property” included up to $250,000 of the cost of “qualified real property.”

Under pre-2010 Tax Relief Act law, for tax years beginning after 2011, the dollar limitation (discussed above) was to be $25,000 and the phaseout amount (discussed above) was to be $200,000. The $25,000 and $200,000 amounts were not to be adjusted for inflation.

In 2012, T, a calendar-year taxpayer, places into service section 179 property with a cost of $215,000. Under pre-2010 Tax Relief Act law, the maximum amount T could elect to expense for 2012 was $10,000: $25,000 (maximum expense for 2012) – $15,000 (the amount by which the cost of section 179 property placed in service, $215,000, exceeds the phaseout amount for 2012, $200,000).

The 2010 Tax Relief Act provides that, for tax years beginning in 2012:

the dollar limitation on the Code Sec. 179 expense deduction will be $139,000 (Code Sec. 179 (b)(1)(C) as amended by 2010 Tax Relief Act §402(a)), and
the reduction in the dollar limitation will start to take effect when property placed in service in a tax year exceeds $560,000 (beginning-of-phaseout amount).

Thus, for tax years beginning in 2012, the maximum amount a taxpayer will be able to expense will be $139,000 of the cost of qualifying property placed in service for the tax year. The $139,000 amount will be reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the tax year exceeds $560,000.

Thus, for tax years beginning in 2012, the 2010 Tax Relief Act temporarily increases the maximum amount a taxpayer will be able to deduct under Code Sec. 179 to $139,000 of the cost of qualifying property placed in service for the tax year.

Thus $139,000 amount (discussed above) of qualified property that can be expensed will be reduced (but not below zero) by the amount by which the cost of qualifying property placed in service in tax years beginning in 2012 exceeds $560,000.

While the 2010 Tax Relief Act increases the dollar limitation and phaseout amount (to $139,000 and $560,000, respectively) for tax years beginning in 2012 from what they otherwise would have been under pre-2010 Tax Relief Act law ($25,000 and $200,000, as discussed above), those amounts will actually decrease from their 2010 and 2011 levels ($500,000 and $2,000,000, respectively).

The 2010 Tax Relief Act did not extend the temporary extension of the definition of qualifying property to include qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property (that applied for tax years beginning in 2010 or 2011).

Under the 2010 Tax Relief Act, the $139,000 and $560,000 amounts (discussed above) will be indexed for inflation.

For tax years beginning after 2012, the 2010 Tax Relief Act provides for a $25,000 dollar limitation on the Code Sec. 179 expense deduction, and a $200,000 beginning-of-phaseout amount.

Thus, for tax years beginning in 2013, and thereafter, the maximum amount a taxpayer will be able to expense will be $25,000 of the cost of qualifying property placed in service for the tax year. The $25,000 amount will be reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the tax year exceeds $200,000.

Thus, the reversion to the $25,000 dollar limitation and $200,000 beginning-of-phaseout amount will take effect for tax years beginning in 2013 and later, one year later than under pre-2010 Tax Relief Act law.

15-Year MACRS Depreciation for Certain Building Improvements and Restaurants is Extended to Apply to Property Placed in Service Before January 1, 2012
The rules that in most situations assign a recovery period (i.e., depreciation period) to the various types of MACRS property are known as the General Depreciation System (GDS).

Assets that are nonresidential real property-generally, nonresidential buildings and their structural components-are depreciated on the straight-line method, over a 39-year GDS recovery period.

However, under pre-2010 Tax Relief Act law, a building improvement that was “qualified leasehold improvement property” placed in service before January 1, 2010 was depreciated on the straight-line method, over a 15-year GDS recovery period.

Similarly, a building improvement that was “qualified retail improvement property” placed in service before January 1, 2010 was depreciated on the straight-line method, over a 15-year GDS recovery period.

Also, a building improvement or a building (see below) that was “qualified restaurant property” placed in service before January 1, 2010 was depreciated on the straight-line method, over a 15-year GDS recovery period.

Taxpayers are sometimes required to, or may elect to, depreciate MACRS property under the alternative depreciation system (ADS) instead of under the GDS. Nonresidential real property is depreciated over a 40-year recovery period for ADS purposes.

However, under pre-2010 Tax Relief Act law, qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property placed in service before January 1, 2010 were depreciated over a 39-year recovery period for ADS purposes.

The 2010 Tax Relief Act extends the rules discussed above for qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property for two years by changing the date before which the three types of property must be placed in service from January 1, 2010 to January 1, 2012.

Thus, the 15-year GDS recovery period and 39-year ADS recovery period continue in effect for qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property placed in service before January 1, 2012, but a 39-year GDS recovery period and 40-year ADS recovery period will apply to qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property in service after December 31, 2011.

Increase in First-Year Depreciation Cap for Cars That are “Qualified Property” is Extended Through 2012
Code Sec. 280F(a) imposes dollar limits on the depreciation deductions (including deductions under the Code Sec. 179 expensing election) that can be claimed with respect to “passenger automobiles.” The dollar limits are adjusted annually from a base amount to reflect changes in the automobile component of the Consumer Price Index (CPI). Generally, for passenger automobiles placed in service in 2010, the adjusted first-year limit is $3,060. For passenger automobiles built on a truck chassis (“qualifying trucks and vans”) a different CPI component is used, and for 2010 the adjusted first-year limit is $3,160.

For any passenger automobile that is “qualified property” and which is not subject to a taxpayer election to decline the bonus depreciation and AMT depreciation relief otherwise available for “qualified property” under Code Sec. 168(k), the above rules apply, except that the applicable first-year depreciation limit is increased by $8,000 (not indexed for inflation).

Under pre-2010 Tax Relief Act law, qualified property did not include property placed in service after December 31, 2010, except for certain aircraft and certain long-production-period property that had, instead, a December 31, 2011 paced-in-service deadline.

The 2010 Tax Relief Act provides that the placed-in-service deadline for “qualified property” is December 31, 2012 (December 31, 2013 for the aircraft and long-production-period property discussed above).

Thus, for a passenger automobile that satisfies the other requirements (see below) for qualified property (and is not subject to the election to decline bonus depreciation and AMT depreciation relief), the 2010 Tax Relief Act extends the placed-in-service deadline for the $8,000 increase in the first-year depreciation limit from December 31, 2010 to December 31, 2012. The December 31, 2013 deadline that applies to the aircraft and long-production-period property discussed above is not available for passenger automobiles for the reasons discussed above concerning the December 31, 2011 deadline under pre-2010 Tax Relief Act law.

Property is “qualified property” if it satisfies the definitional requirements and is not subject to certain ineligibility rules. As applied to passenger automobiles, the effect of these requirements are ineligibility rules is that in most instances a passenger automobile that satisfies the December 31, 2012 placed-in-service deadline will be eligible for the $8,000 increase in the first-year depreciation limit if (1) the automobile’s original use begins with the taxpayers after December 31, 2007, (2) the automobile is predominantly used by the taxpayer in his business and (3) the automobile is acquired by the taxpayer after December 31, 2007.

On October 15, 2011, T, a calendar year taxpayer, places a new passenger automobile into service in his business. Assume that the vehicle is “qualified property” (and an election to decline bonus depreciation and AMT depreciation relief does not apply to the vehicle. T is allowed first-year depreciation for 2010 of no more than $11, 060 (the $3,060 amount discussed above-assuming, just for illustration purposes, that it remains the same for 2011-plus $8,000).

The facts are the same as above, except that in 2010 T uses the passenger automobile 80% for business and 20% for personal activities. Because the passenger auto depreciation limits are proportionally reduced to the extent that a vehicle is not exclusively used in business, T is allowed first-year depreciation for 2011 of no more than $8,848 (80% x $11,060).

Election to Expense Qualified Environmental Remediation Expenditures is Extended to Include Expenditures Paid or Incurred Before January 1, 2012
Taxpayers may elect to expense qualified environmental remediation expenditures, i.e., expenditures that would otherwise be chargeable to capital account and were incurred in connection with the abatement or control of “hazardous substances” at a “qualified contaminated site.” Under pre-2010 Tax Relief Act law, the election to deduct qualified expenditures in the year paid or incurred applied for eligible expenditures paid or incurred before January 1, 2010. That is, under Code Sec. 198, the election to expense qualified environmental remediation costs did not apply expenditures paid or incurred after December 31, 2009.

The 2010 Tax Relief Act extends the pre-2010 Tax Relief Act provision permitting the expensing of qualified environmental remediation expenditures for two years to include expenditures paid or incurred before January 1, 2012. Specifically, The 2010 Tax Relief Act does this by striking the December 31, 2009 termination date for the expensing election for environmental remediation expenditures and replacing it with a December 31, 2011 termination date. Thus, under the 2010 Tax Relief Act, Code Sec. 198 will not apply to expenditures paid or incurred after December 31, 2011.

Research Credit is Retroactively Extended to Apply to Amounts Paid or Incurred Before January 1, 2012
Under pre-2010 Tax Relief Act law, a taxpayer was entitled to a research credit for qualifying amounts paid or incurred before January 1, 2010.

The credit was generally equal to 20% of the amount by which the taxpayer’s qualified research expenses exceeded a specific base amount unless the taxpayer elected the alternative simplified credit. Additional components of the research credit included the separately computed “university basic research credit”, equal to 20% of the basic research payments to qualified research organizations less the “qualified organization base period amount,” and a separately computed “energy research consortium credit” based on amounts paid or incurred to an energy research consortium. Unlike the other components of the research credit, the energy research consortium credit applied for all qualified expenditures, not just those in excess of a base amount.

The 2010 Tax Relief Act extends the research credit for two years by striking the December 31, 2009 expiration date of the research credit (including the university basic research credit and the energy research consortium credit) and replacing that date with December 31, 2011.

Because the extension of the research credit is retroactive to include amounts paid or incurred after December 31, 2009, taxpayers, such as fiscal year corporations that paid or incurred amounts for research credits in 2010 and already filed returns for a fiscal year that includes part of 2010, should consider filing an amended return to claim a refund for the amount of the additional tax paid because of not claiming amounts now eligible for the credit.

Unless the research credit is extended further by future legislation, the credit will not apply to amounts paid or incurred after December 31, 2011.

Work Opportunity Credit is Extended for Individuals from Most Targeted Groups Who Begin Work for an Employer Through December 31, 2011
A work opportunity tax credit (WOTC) is available on an elective basis to an employer for a percentage of limited amounts of wages paid or incurred by the employer to individuals who belong to a “targeted group.”

Code Sec. 51(c)(4)(B), as in effect before the enactment of the 2010 Tax Relief Act, stated that the WOTC was not available for wages paid or incurred by an employer to an individual who began work for the employer after August 31, 2011.

Code Sec. 51(c)(4)(B) does not apply to the two classes of employees that are included in the target group consisting of “Hurricane Katrina employees.” Instead, an employer could claim a credit for an individual in one class of Hurricane Katrina employees only if the individual was hired on or before August 27, 2009 and for an individual in the other class only if the individual was hired on or before December 31, 2005.

The WOTC is also available for wages paid or incurred by an employer to unemployed veterans and disconnected youth who begin work for an employer in 2009 and 2010.

The 2010 Tax Relief Act extends the WOTC for four months (for individuals who began work for an employer after August 31, 2011 and before January 1, 2012, by providing that the term “wages” (for purposes of determining the amount of the WOTC) does not include any amount paid or incurred to an individual who begins work for the employer after December 31, 2011.

The last day a taxpayer can employ a qualifying individual and be eligible to get a credit for wages paid or incurred to that individual is December 31, 2011. However, subject to applicable percentage and dollar-amount limitations, the credit is, for most targeted groups, available for any eligible wages paid or incurred to that individual for service rendered during the period ending one year after the date that the individual was first employed, even though, for employees hired after December 31, 2010, the last day of the one-year period is after December 31, 2011.

One-Year Rule for Prepaid Expenses
The final regulations under Sec. 263(a) issued in January 2004 included a 12-month rule (Regs. Sec. 1.263(a)-4(f)), whereby taxpayers are not required to capitalize an expense if it is paid or incurred (see Regs. Sec. 1.263(a)-4(j)) to create a right or benefit that does not extend beyond the earlier of (1) 12 months after the first date of the right or benefit or (2) the end of the tax year following the tax year in which the expense was paid or incurred.

Regs. Sec. 1.263(a)-4(f)(6) makes it clear that, for an accrual-method taxpayer, the 12-month rule does not eliminate the other requirements for deduction – all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

Corporation X, an accrual-method taxpayer with a calendar tax year, made two prepayments in June 2005. One payment was for a fire and casualty insurance policy; the other was for equipment rental. Both payments covered the period July 1, 2005 to June 30, 2006. X is not required to capitalize the portion of the insurance payment attributable to 2006 because of the 12-month rule, and the portion can be deducted in 2005 because the all-events test is met, the amount is determinable with reasonable accuracy, and economic performance was satisfied on payment. The portion of the rental payment attributable to 2006 does not have to be capitalized because of the 12-month rule and, with the all-events and determinable-with-reasonable-accuracy requirements met, it can be deducted in 2005 if the payment satisfies the requirements for the economic performance recurring-item exception under Regs. Sec. 1.461-5.

The Sec. 263(a) regulations provided that for the first tax year ending on or after December 31, 2003, taxpayers wishing to change their accounting method to a method consistent with the regulations can make the change using the automatic consent procedure described in Rev. Proc. 2002-9. Accordingly, for example, a calendar-year taxpayer could make a change to apply the 12-month rule beginning with its tax year ended December 31, 2003, by filing Form 3115, Application for Change in Accounting Method, by the due date (including extensions) of its 2003 return.

Rev. Proc. 2004-23 was issued later. It provided additional guidance for completing Form 3115 under the automatic consent procedure to change to an accounting method to conform to the Sec. 263(a) regulations for the first tax year ending on or after December 31, 2003. Taxpayers could also use the procedure to correspondingly change their accounting methods to use the economic performance 3½-month rule or recurring-item exception in conjunction with the items changed under the 12-month rule, by including this information on the same Form 3115. The availability of the automatic consent procedure to change to the 12-month rule and to use the 3½-month rule or recurring-item exception was later extended by Rev. Proc. 2005-9 for taxpayers’ second tax year ending on or after December 31, 2003.

Rev. Proc. 2006-12 was issued on December 21, 2005. It allows taxpayers to change, under the automatic consent procedure, to an accounting method provided under the Sec. 263(a) regulations beginning with tax years ending on or after December 31, 2005. However, a major departure form Rev. Proc. 2004-23 and 2005-9 was made. Rev. Proc. 2006-12 only applies to taxpayers changing to an accounting method provided under the Sec. 263(a) regulations; it does not apply to taxpayers changing their method using the economic performance 3½-month rule or recurring-item exception. Rev. Proc. 2006-12 states:

Thus, for a change in method of accounting utilizing the 3½-month rule or the recurring-item exception in conjunction with a change to a method provided by the final regulations, a taxpayer must file two separate applications for a change in method of accounting – an application for a change in method of accounting under this revenue procedure to change to the method of accounting provided in the final regulations, and a separate application for a change in method of accounting under Rev. Proc. 97-27 for a change in method of accounting utilizing the 3½-month rule or the recurring-item exception.

Accordingly, in the example above, to change to an accounting method under which X could deduct in 2005 the insurance premium and equipment rental payments attributable to 2006, X would have to file two Forms 3115 – one under the automatic consent procedure by the due date of the 2005 return to change to the 12-month rule for both payments, and the other under the advance consent procedure, which would have to be filed by December 31, 2005 to permit X to use the recurring-item exception to deduct its equipment rental payment.

It appears the IRS made this significant change due to its findings that change to the use of the 3½-month rule or recurring-item exception when it is necessary to comply with the economic performance requirement in conjunction with a change to the 12-month rule was often not being made, and when made the exception may not have been applied correctly. It also appears that the IRS is proposing to modify Rev. Proc. 2006-12 to allow taxpayers in this situation to file one Form 3115 for both changes (instead of two) under the advance consent procedure. Rev. Proc. 2006-12 was modified by Rev. Proc. 2006-37 to allow taxpayers to file one Form 3115 for both changes.

Deduction for Manufacturing/Production Activities
For tax years beginning after 2004, the Act provides a deduction that is equal to a percentage of the income earned from manufacturing (and certain other production activities) undertaken in the U.S. The deduction equals the lesser of:

A percentage of the lesser of the qualified production activities income of the taxpayer for the tax year or taxable income without regard to this deduction, for the tax year. The percentage is 3% for tax years beginning in 2005 and 2006, 6% for tax years beginning in 2007-2009, and 9% thereafter.
50% of the sum of wages paid by the taxpayer and the elective deferrals, that are made by the taxpayer during the calendar year that ends in the tax year. (W-2 wages only include amounts that are properly allocable to domestic production gross receipts).

Qualified production activities income is equal to domestic production gross receipts reduced by the sum of:

the costs of goods sold that are allocable to such receipts, other deductions, expenses, or losses that are directly allocable to such receipts, and
a ratable portion of other deductions, expenses, and losses that are not directly allocable to such receipts or to another class of income.

Domestic production gross receipts are gross receipts of a taxpayer that are derived from:

any sale, exchange or other disposition, or any lease, rental or license, of qualifying production property that was manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the U.S.,
any sale, exchange or other disposition, or any lease, rental or license, of qualified films produced by the taxpayer,
any sale, exchange or other disposition of electricity, natural gas, or potable water produced by the taxpayer in the U.S.,
construction activities performed in the U.S., or
engineering or architectural services performed in the U.S. for construction projects located in the U.S.

Domestic production gross receipts do not include any gross receipts derived from the sale of food or beverages prepared by the taxpayer at a retail establishment, or the transmission or distribution of electricity, natural gas, or potable water.

Qualifying production property includes any tangible personal property, computer software and sound recordings. In order to be a qualified film, 50% of the total compensation relating to the production of the film must be for services performed in the U.S. by actors, production personnel, directors and producers.

The deduction is available to C corporations, S corporations, partnerships, sole proprietorships, co-operatives, and estates and trusts, and subject to an adjustment, is allowed for AMT purposes.

Who Must Use Accrual Method
C corporations, partnerships having a C corporation as a partner and tax shelters cannot use the cash method and must instead use the accrual method. However, this rule does not apply to a corporation or partnership (assuming it is not a tax shelter) if a not-more-than-$5 million average annual gross receipts test is met. “Tax shelter” means, among other things, a partnership or S corporation, interests in which are sold through an offering registered with a state or federal agency, or more than 35% of whose losses are allocable to limited partners and certain other non-active participants.

Small Business Exceptions to Required Accrual Accounting
The accrual method generally is also mandatory for purchases and sales where inventories must be used. However, qualifying small businesses with 3-year average annual gross receipts of more than $1,000,000 but not more than $10,000,000 that are not prohibited from using the cash method under Code Sec. 448 (such as tax shelters, and C corporations with more than $5 million average gross receipts, as discussed above) and otherwise would have to keep inventories and use accrual accounting may, instead, use the cash method for an eligible trade or business. Under this IRS relief, the following types of qualifying small businesses may use the cash method for all of their trades and businesses:

One whose principal business activity for its immediately preceding tax year is other than mining, manufacturing, wholesale trade, retail trade, or information industries.
Service providers, including those providing property incident to those services.
Fabricators or modifiers of tangible personal property upon demand in accordance with customer design or specifications.

Qualifying small businesses that come within any of these categories may use the cash method even for parts of their businesses, such as retailing or wholesaling, which otherwise would not qualify for the cash method.

IRS also allows taxpayers with average annual gross receipts of $1 million or less to use the cash method, with fewer restrictions than under the $10 million exception discussed above. For instance, retailers and wholesalers with gross receipts up to $1 million may use the cash method, but those with gross receipts between $1 million and $10 million generally may not.

Businesses that use the cash method under the exceptions generally include amounts in income attributable to open accounts receivable (i.e., receivables due in 120 days or less) as amounts are actually or constructively received. Businesses permitted to use the cash method under these exceptions that do not want to account for inventories must treat all inventoriable items (e.g., items purchased for resale and raw materials purchased for use in producing finished goods) in the same manner as nonincidental materials and supplies under Reg § 1.162-3 (i.e., deductible only in the year in which they are actually consumed and used in the taxpayer’s business).

Qualifying small business taxpayers that want to use the cash method and/or not account for inventories as described above must follow the automatic-change-in-accounting-method provisions of Rev. Proc. 2008-36, 2008-33 IRB 340, as modified by Rev. Proc. 2009-39, 2009-38 IRB, with certain modifications.

“S” Corporation Shareholder Compensation
The IRS is on the lookout for S Corporations that fail to pay reasonable salaries to shareholders who perform services for the corporation. The failure to pay adequate salaries to shareholder-employees is a red flag for an audit.

The IRS can reclassify as salaries any distributions to the shareholders. Determining what a reasonable salary is may be more art than science, but the attempt must be made.

Because the IRS’s goal is to collect FICA tax on the salaries, one solution is to pay the maximum amount of wages subject to FICA tax, assuming, of course this is a reasonable salary, based on the shareholder-employee’s services actually rendered. A smaller salary may be justified for an executive in a startup or a relatively small corporation. The salary should also consider the shareholder-employee’s experience and skill, the geographical region, customer base, number of employees, and time committed to the corporation. What is a reasonable salary depends on the facts of each case. No test is conclusive. It often becomes a judgment call by the IRS. Comparable salaries from industry data are usually appropriate.

The tax court in several instances allowed statistical data from an industry and region to be used as guidance for reasonable compensation. There is no IRS rule that insolates the S Corporation from an audit on this issue. A reasonable salary depends on all the facts and circumstances in each individual case. If the S Corporation is a personal service corporation with one employee, the shareholder-employee, then a case can be made that the entire net earnings of the corporation should be salary. At the other extreme, if the S Corporation is a construction company with large amounts of capital equipment, then a good deal of the corporate earnings are a return on this capital and a reasonable salary may be just a small percentage of corporate earnings.

The reclassification of a distribution to salary results in increased taxes to you in the form of payroll taxes.

The lost revenue is of great concern to the IRS. In May, 2005, the office of the Treasury Inspector General for the administration reported that in 2000 alone, more than 36,000 single-shareholder S Corporations with profits excess $100,000 paid no salaries or payroll taxes. Another 40,000 with profits between $50,000 and $100,000 did not pay any salaries.

We have seen an extreme increase in audits related to this issue. The IRS compares the officer compensation line item on the S Corporation return to the profit of the S Corporation and will typically audit those returns that show little if any officer compensation.

Shareholder Loans to “S” Corporations
On October 17, 2008 the IRS finalized regulations on the treatment of open account debt between S Corporations and their shareholders. If a shareholder’s basis in S Corporation shareholder debt has been reduced by his or her share of the S Corporation losses and the S Corporation makes a distribution or pays off the debt with an amount in excess of the remaining basis, gain must be recognized.

A capital gain will result if the debt is evidenced by a written note. If the S Corporation repays the debt and the shareholder lends more money later in the year for purposes of avoiding the gain, each payment is treated as an individual transaction, and the two payments are not netted for purposes of determining basis in debt at the end of the year. When the debt of the S Corporation to the shareholder is paid off in installments, each installment is allocated between return of capital and gain based on the proportion of the shareholder’s basis in the debt to its face amount. Under the final regulations, open account debt would be defined as shareholder advances not evidenced by separate written instruments for which the principal amount of the aggregate advances does not exceed $25,000 at the close of any day during the S Corporation’s tax year. If the running balance exceeds $25,000, the entire principal amount of that debt would no longer be open account debt. The principal amount would be treated as debt evidenced by a written instrument.

Regulation 1.1367-2(a) states that generally, if shareholder advances are not evidenced be separate written instruments for which the principal amount of the aggregate advances does not exceed $25,000 and repayments on the advances, the debt is called open account debt and treated as a single debt. However, ordinary income results on the S Corporation’s repayment of the open account debt.

Although ordinary income is a disadvantage of not evidencing loans, an advantage is that multiple loans and repayments made throughout the year are considered open account debt and are netted at the end of the year rather than gain occurring on repayment of each individual debt. The final regulations generally are proposed to apply to shareholder advances to S Corporations made on or after October 20, 2008.

If the indebtedness is evidenced by a note, the repayment is treated as a sale or exchange. Accordingly, if the note is a capital asset in the shareholder’s hands the excess of the amount repaid over basis is taxed as capital gain. (Rev. Rul. 64-162, 1964-1 C.B. 304).

However, if the debt is not evidenced by a note, there is no sale or exchange when the debt is paid. Thus, a payment by an S Corporation of a debt to a shareholder that is carried on an open account, will be ordinary income to the extent of the amount paid over the applied basis (Rev. Rul. 68-537, 1968-2 C.B. 372).

If a shareholder’s advances are not evidenced by a separate written instrument, net of repayments, exceed an aggregate outstanding principal amount of $25,000 at the close of the S Corporation’s tax year, for any later tax year, the aggregate principal amount is treated as indebtedness evidenced by a separate written instrument, with the result that the indebtedness is not open account debt and is subject to all basis adjustment rules applicable to basis of indebtedness of an S Corporation to a shareholder. However, in this case the gain would be ordinary as there is no written note it is merely deemed a written note for purposes of the timing of taxability. Should you find yourself in this situation, you should draw up actual notes so that the gain would be capital gain.

Economic Substance Doctrine Clarified
Under pre-2010 Reconciliation Act law, courts denied claimed tax benefits under two closely related nonstatutory doctrines that evolved in judicial decisions. Under the “economic substance” doctrine, courts generally denied claimed tax benefits if the transaction that gave rise to those benefits lacked economic substance independent of tax considerations – even though the purported activity actually occurred. A common law doctrine that often was considered together with the economic substance doctrine was the business purpose doctrine. The business purpose doctrine involved a subjective inquiry into the taxpayer’s motives, i.e., whether the taxpayer intended the transaction to serve some useful non-tax purpose.

There was a lack of uniformity as to the proper application of the economic substance doctrine. Some courts applied a conjunctive test that required a taxpayer to establish the presence of both economic substance (i.e. the objective component) and business purpose (i.e. the subjective component) for the transaction to be given effect. Under a narrower approach used by some courts either a business purpose or economic substance was sufficient to have the transaction respected. Under a third approach economic substance and business purpose were viewed as simply more precise factors to consider in determining if a transaction had any practical economic effects other than the creation of tax benefits. In 2006, the Federal Circuit Court stated that while the economic substance doctrine could well apply if the taxpayer’s sole subjective motivation was tax avoidance, even if the transaction had economic substance, a lack of economic substance was sufficient to disqualify the transaction without proof that the taxpayer’s sole motive was tax avoidance. In 2009, the 5^th Circuit also adopted the view that a lack of economic substance alone was sufficient to disqualify the transaction without regard to the taxpayer’s motive.

The 2010 Reconciliation Act provides statutory rules for applying the economic substance doctrine.

The 2010 Reconciliation Act also defines the economic substance doctrine as the common law doctrine under which the Federal income tax benefits of a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.

Testing a Transaction Under the Codified Economic Substance Doctrine
Under the 2010 Reconciliation Act, a transaction to which the economic substance doctrine is relevant (see below) has economic substance only if:

The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction. (This list is referred to as the economic substance test list.)

The determination of whether the economic substance doctrine is relevant to a transaction is made as if this provision was never enacted. Thus, the provision does not change current law standards in determining when to utilize an economic substance analysis.

Information Reporting Added for a Trade or Business Payor of $600 or More in Gross Proceeds to a Payee After 2011
Every person engaged in a trade or business has to file with IRS an information return for “payments” (described below) made to another person in the course of the payor’s trade or business that constitute fixed or determinable income aggregating $600 or more in any tax year. The “payments” subject to this information-return requirement are those for:

rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income, and commissions, fees, interest (including original issue discount), royalties, and pensions

Some payments are not required to be reported on Form 1099-MISC, although they may be taxable to the recipient. Payments for which a Form 1099-MISC is not required include payments to a Corporation. However, payments made to a Corporation for attorney fees must be reported on Form 1099-MISC.

The 2010 Health Care Act added amounts in consideration for property to the existing categories of payments for which an information return to the IRS will be required. In addition, the 2010 Health Care Act added payments made to Corporations for which an information return to the IRS will be required. The above additions to information reporting added by the 2010 Health Care Act were repealed before they took effect on April 14, 2011.

Things to Consider before the End of 2011

Use up expiring loss and credit carryovers.
Arrange with employer to defer bonus until 2012.
Increase basis in Partnership or S-corporation to make possible 2011 loss deduction.
Buy equipment by December 31st to get 100% bonus depreciation deductions in 2011.
Apply bunching strategy to “miscellaneous” itemized deductions, medical expenses, and other itemized deductions in order to increase deductible amounts.
Increase withholding to eliminate estimated tax penalty.
Set up self-employed retirement plan.
Make gifts taking advantage of $13,000 gift tax exclusion.
Avoid personal-holding company tax by making dividend payments.
Minimize income tax on social security benefits.
Dispose of passive activity in order to free-up suspended losses.
Make IRA contributions as early as possible.
Delay late year mutual fund investments until after the fund’s dividend date.
Maximize your contribution to a tax‑deferred retirement plan