The summer months can be a stormy time of the year. Hurricane season is now under way, and high winds and tornadoes can accompany thunderstorms. Add flooding and the occasional earthquake and no area of the country is entirely safe from natural disasters.

From a tax standpoint, you should develop a disaster recovery plan for your business and personal affairs by taking a few simple steps:

1. Create a backup set of electronic records
Keep your backup records in a safe place, stored at a different location from the original records. Keeping a backup set of records is easier now that many financial institutions provide statements and documents electronically, and much financial information is available on the Internet. Even if the original records are provided only on paper, they can be scanned into an electronic format. With documents in electronic form, you can download them to a backup storage device, like an external hard drive, or burn them to a CD or DVD.

2. Document your valuables
Photograph or videotape the contents of your home and business, especially items of higher value. The IRS has a disaster loss workbook, Publication 584, which can help you compile a room-by-room list of belongings. A photographic record can help prove the market value of items for insurance and casualty loss claims. Photos can be stored electronically or given to a friend or family member who lives outside your area.

3. Update emergency plans
Emergency plans should be reviewed annually. Personal and business situations change over time, as do preparedness needs. When employers hire new employees or when a company or organization changes functions, plans should be updated accordingly and employees should be informed of the changes.

4. Check your insurance coverage
Make sure property insurance covers the full replacement cost of the asset insured. Meet with your insurance agent to review deductibles and determine whether additional riders are necessary. Be sure you understand what risks are covered and which are excluded. If you have a business, consider business interruption coverage.

A few simple steps now can prevent unpleasant surprises later

The federal Making Home Affordable modification program helps homeowners who have defaulted, or are at risk of default, on their mortgages.

A homeowner who makes timely payments on a modified loan is eligible to have incentive payments made to lenders/investors that reduce the principal balance on the loan. The IRS has determined that these Pay-for-Performance Success Payments are excludable from the homeowner's income under the general welfare exclusion of the income tax law.

For many businesses, summer traditionally brings an influx of part-time or seasonal workers into the work force. Employers are responsible for treating these workers properly for employment tax purposes.

Generally, workers are either employees or independent contractors, based upon the facts and circumstances of the relationship between the business and the worker. For federal income tax withholding, Social Security, Medicare, and federal unemployment tax purposes, neither the number of hours worked nor the amount earned determines the status of an individual as independent contractor or employee.

For example, an individual can be an employee even though the individual works one hour a week or one day a year. Part-time or seasonal workers who are employees are subject to the same tax withholding rules that apply to other employees.

Members of the Senate Finance Committee and House Ways and Means Committee have asked IRS Commissioner Douglas H. Shulman to suspend certain penalties assessed on small businesses while Congress works on legislation to address what they term an inequitable and unintended consequence in the tax code.

The members of Congress are concerned that small businesses with investments in listed tax shelter transactions have been assessed tax penalties significantly larger than the tax benefits received.

 In a letter dated June 12, 2009, the lawmakers requested that Shulman "use the discretion provided to the IRS with its effective tax administration authority to suspend efforts to collect IRC (Internal Revenue Code) Section 6707A liabilities ... while Congress acts to remedy this situation." Code Sec. 6707A was enacted in 2004 as part of a package of provisions intended to help the IRS detect, deter and shut down tax shelters.
 
Treasury regulations require taxpayers to tell the IRS if they invest in "listed" tax shelter transactions, and Code Section6707A imposes penalties on taxpayers who fail to disclose this information. For listed transactions, the penalties are $100,000 for natural persons and $200,000 for others.
 
The lawmakers pointed out that the inequitable consequences were unexpected at the time the penalty was enacted, and they plan to introduce legislation that would result in penalty amounts that are more reasonable in proportion to the tax benefits. No timetable was offered as to when new legislation might be introduced.
 
Read more in the Letter to the IRS

The IRS has clarified the income tax deduction authorized by Congress to stimulate new car sales.

The deduction for state and local sales or excise taxes on the purchase of new vehicles is available to purchasers in states without a sales tax. If you purchase a new motor vehicle in a state that does not have state sales taxes, you are entitled to deduct other fees or taxes imposed by the state or local government. The fees or taxes must be assessed on the purchase of the vehicle and must be based on the vehicle's sales price or as a per-unit fee.

To qualify for the deduction, you must purchase a new vehicle between Feb. 17 and Dec. 31, 2009. Importantly, the deduction is available even if you don't itemize. That means the deduction also reduces your adjusted gross income (AGI) for purposes of determining whether you qualify for other tax breaks.

If your new vehicle is very expensive, the deduction is limited to the portion of the tax attributable to the first $49,500 of the purchase price. To qualify for the full deduction, your modified AGI cannot exceed $125,000 for individuals or $250,000 for married couples. No deduction is available if your modified AGI is greater than $135,000 for individuals or $260,000 on a joint return.
 
The deduction is available for any qualified purchase of a new car, light truck, motor home or motorcycle.
 
Read Information Release 2009-60 here.

IRS clarifies rules for unemployed, formerly self-employed, workers

If you are living and working abroad, you may be entitled to the foreign earned income exclusion. But qualifying for the exclusion may be more complicated than it sounds.

The Tax Court ruled recently that a flight attendant could not treat income earned in international airspace as income earned in a foreign country because such airspace is not under the sovereignty of a foreign government. The court had previously denied the exclusion to a worker in Antarctica for the same reason.
 
Yen-Ling Rogers was a flight attendant for United Airlines based in Hong Kong. She regularly flew round-trip flights from Hong Kong to San Francisco or Chicago. Rogers contended that all of her income was earned for services performed outside the United States. However, the IRS contended, and the Tax Court agreed, that only services she provided in a foreign country or while flying over a foreign country qualified for the exclusion.

Generally, the earned income exclusion is available to United States citizens and resident aliens who live and work abroad. These individuals may be able to exclude all or part of their foreign salary or wages from their income when filing their U.S. federal tax return. They may also qualify to exclude compensation for their personal services or certain foreign housing costs.
 
To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must have a tax home in a foreign country and income received for working in a foreign country, otherwise known as foreign earned income. The taxpayer must also meet one of two tests: the bona fide residence test or the physical presence test.
 
The foreign earned income exclusion is adjusted annually for inflation. For 2009, the maximum exclusion is $91,400 per qualifying person. 
 
Read more in W.D. Rogers v. Commissioner, TC Memo. 2009-111, May 20, 2009.

June 30 is the deadline for filing the current year Report of Foreign Bank and Financial Accounts, Treasury Form TD F 90-22.1 (FBAR).

FBAR forms are deemed filed when received by the IRS, not when postmarked, so use certified mail with return receipt when filing these forms. There is no extension of time to file available. 
 
The IRS has announced that you can rely on the definition of a United States person as set forth in the prior instructions to the FBAR form when determining your filing requirement. The IRS took this action to reduce the burden after concerns and questions were raised regarding the new instructions issued last year on who must file the revised Form TD F 90-22.1.
 
For this year, you can rely on the definition of a United States person included in the prior instruction: "United States Person - The term "United States person" means (1) a citizen or resident of the United States, (2) a domestic partnership, (3) a domestic corporation, or (4) a domestic estate or trust."
 
All other requirements of the current version of the FBAR form and instructions (revised in October 2008) are still in effect. The current version of the form must be used when filing an FBAR.

This substitution affecting who must file the FBAR applies only to FBARs due on June 30, 2009. The IRS will follow up with additional guidance on the requirement to file for future years.
 
Read more in Announcement 2009-51.

Businesses planning to claim the newly expanded work opportunity tax credit (WOTC) for eligible unemployed veterans and unskilled younger workers hired during the first part of 2009 have until Aug. 17 to request the certification required for these workers, according to the IRS.

The American Recovery and Reinvestment Act, enacted in February, added unemployed veterans returning to civilian life and "disconnected youth" to the list of groups covered by the credit. Though eligible unemployed veterans and disconnected youth who begin work anytime during 2009 or 2010 may qualify a business for the credit, certification by the state work force agency is required.

In general, an unemployed veteran is a person discharged or released from the military during the five years preceding the hiring date, who received unemployment benefits for at least four weeks during the one-year period ending on the hiring date. A "disconnected youth" is a person age 16 to 24 on the hiring date who has not been regularly employed or attending school and who meets other requirements.

The WOTC offers tax savings to businesses that hire workers belonging to any of 12 targeted groups. The other 10 groups include people ages 18 to 39 living in designated communities in 43 states and the District of Columbia, Hurricane Katrina victims, recipients of various types of public assistance, and certain veterans, summer youth workers and ex-felons.
The certification requirement applies to all groups of workers except employees who were Hurricane Katrina victims.

Normally, a business must file Form 8850 with the state work force agency within 28 days after the eligible worker begins work. But under a special rule, businesses have until Aug. 17, 2009, to file this form for unemployed veterans and disconnected youth who begin work on or after Jan. 1, 2009, and before July 17, 2009.

The IRS has published proposed regulations allowing employers that incur a substantial business hardship an alternative to terminating their §401(k) safe harbor plans. Qualifying employers can reduce or suspend required safe harbor nonelective contributions without losing their plan's qualified status.

Prior to issuance of the proposed regulations, employers were required to maintain the safe harbor plan throughout the entire plan year, with two exceptions:

1. The employer could amend the plan to reduce or suspend safe harbor matching contributions on future employee elective contributions.
2. The employer could terminate the plan. 

The proposed regulations allow an employer that suffers a substantial business hardship to amend its plan to reduce or suspend the plan's safe harbor nonelective contributions if procedural requirements specified in the proposed regulations are followed. 

In determining whether the employer is suffering a substantial business hardship, the IRS will consider whether: 

• The employer is operating at an economic loss.
• There is substantial unemployment or underemployment in the trade or business and in the industry concerned.
• The sales and profits of the industry concerned are depressed or declining.
• It is reasonable to expect that the plan will be continued only if the waiver is granted. 

The Small Business Administration has announced a new loan program for debt-burdened small businesses. The program is called the American Recovery Capital (ARC) Loan Program.

Guaranteed by the SBA, the ARC Loan Program provides interest free loans to small businesses "for the purpose of making principal and interest payments on existing, qualifying small business loans for up to six months." These loans can include credit card loans, capital leases, Certified Development Company (504) loans, other loans made without an SBA guaranty, and loans made with or without an SBA guaranty since Feb. 17, 2009.

The ARC Loan provides up to $35,000 to qualified small businesses to make payments of principal and interest, on one or more existing qualifying small business loans for up to six months. The loan is interest free and 100 percent guaranteed by the SBA. No collateral is needed, and there are no fees associated with the loan.

Repayment of the ARC Loan principal is deferred for 12 months after the last disbursement of the proceeds. Repayment can extend up to five years.

The loan is available to viable, for-profit small businesses in the United States that are experiencing immediate financial hardship. To qualify, you must be able to prove the viability of your business by providing evidence that you can project sufficient cash flow to be able to meet the loan payments over a two-year period from the loan approval date.

ARC Loans are provided by commercial lenders. Your lender or bank can help determine your eligibility.

The Tax Court has agreed that the leasehold improvements made by a partnership to a hotel property owned by a city were substitutes for rent, and the cost of the leasehold improvements was allowed as a tax deduction. The partnership operated a Sheraton Hotel at the Cleveland Hopkins International Airport.

The property was owned by the city of Cleveland. The partnership was losing money, and the property was in need of repair. Through a series of negotiations, the partnership and the city reached an agreement whereby the cost of certain improvements approved by the city would be credited against rent otherwise payable by the partnership.

In allowing the deduction for the cost of the improvements, the Tax Court ruled that:

• The partnership's transfer of the improvements to the city was not illusory because the benefits and burdens of ownership shifted to the city in the year the improvements were credited against rent.
• The rent credit arrangement had a subjective business purpose and had objective economic substance.
• The negotiation of the lease agreements to include rent credits provided the partnership with a significant benefit independent of any tax considerations.
• The parties to the lease had valid business reasons for choosing the rent credit structure over other alternatives.
  Finally, the court ruled that the partnership's method of accounting for the improvements clearly reflected income and was not a change in accounting method.

The first-time home buyer tax credit is set to expire at the end of November. Now the Department of Housing and Urban Development (HUD) has announced a plan to allow borrowers who use Federal Housing Administration (FHA) financing to apply the first-time home buyer credit toward the purchase of a home. The new policy is the latest move by the Obama administration to spur demand in the housing market.

Through Nov. 30, 2009, qualified first-time home buyers are entitled to a tax credit equal to 10 percent of the purchase price of the dwelling, or $8,000, whichever is smaller. Normally, the tax credit can be claimed only by filing your federal income tax return once the home has been purchased. Several states -- including Colorado, Idaho, Missouri, New Jersey and Ohio -- allow people to "monetize" the tax credit by advancing money to qualified borrowers so that they can apply the funds from the tax credit toward the down payment on a home purchase.

HUD has announced that it will allow FHA borrowers to do something similar. However, amounts advanced by FHA lenders cannot be used to meet FHA's minimum 3.5 percent down payment. The law bars such lenders from assisting borrowers with their down payments. FHA borrowers may use the money to increase the size of their down payment above the 3.5 percent minimum or to pay closing costs, any upfront interest charges or FHA's upfront premium.

State and local housing finance agencies as well as certain nonprofits aren't barred from assisting FHA borrowers with their down payment. They will be allowed to provide short-term loans to borrowers for that purpose under FHA's new policy. To assure that lenders and borrowers don't abuse the program, HUD requires that any fees and costs charged by the lender to advance funds from the tax credit must be reasonable.

If you are thinking about buying one of those new electric vehicles designed to get you to the grocery store and run other neighborhood errands, both the Emergency Economic Act of 2008 and the American Recovery and Reinvestment Act of 2009 created tax credits that can help lower your out-of-pocket cost.

The credit for qualified plug-in electric drive motor vehicles placed in service between Jan. 1, 2009, and Dec. 31, 2014, is $2,500 plus an additional $417 for each kilowatt hour of traction battery capacity in excess of four kilowatt hours.

For purchases after Feb. 17, 2009, a separate credit is available for 10 percent of the cost of acquiring certain electrically powered two-wheeled vehicles, three-wheeled vehicles and low-speed vehicles. The credit is available in the tax year the vehicle is placed in service.

Qualifying vehicles, often called "neighborhood electric vehicles," must be manufactured primarily for use on public roadways. Some vehicles may qualify for either or both credits, but you can claim only one credit per vehicle.

The IRS has issued a new ruling clarifying the tax treatment when you sell or surrender a life insurance policy. The ruling describes three situations: a surrender of a cash-buildup policy to the insurance company, a sale of a cash-buildup policy to a third party, and a sale of a term policy to a third party.

The ruling describes how to calculate the tax basis in the insurance policy to determine the amount of gain on the sale. For a policy you own personally, as opposed to one owned by a business, gains are taxable but losses are nondeductible personal losses.

The ruling also concluded that any gain attributable to the cash buildup in the policy is taxed as ordinary income. Only gain attributable to a payment from a third party in excess of the policy's cash buildup would qualify for capital gain treatment.

Read Revenue Ruling 2009-13 here.

The federal minimum wage rate will be increased to $7.25 per hour, effective July 24, 2009. The rate has been set at $6.55 per hour since July 24, 2008.

The federal minimum wage provisions are contained in the Fair Labor Standards Act (FLSA).   

Many states also have minimum wage laws. Some state laws provide greater employee protections, and employers must comply with both. If the state minimum wage is higher than the federal amount, employees are entitled to the greater amount.

Read more in FSLA Fact Sheet #14 here.

Do the abbreviations "i.e." and "e.g." confuse you? Are you unsure which one to use? A recent tax case required the court to deliver a grammar lesson.

First a little background on the tax issue involved in the case. Compensation received for physical injury is generally excluded from income. However, emotional trauma is not considered physical injury. So payments received for emotional distress are fully taxable.

In a settlement with her former employer, Laura Seidel received $157,000. The settlement agreement described the payment as being for "personal injury (i.e., emotional distress) damages only."

The case originally went before the Tax Court in 2007. All of the parties - the court, Seidel and the IRS - focused their attention on the "i.e." Seidel argued that emotional distress was an example of the types of injuries she received. The IRS argued that "i.e." is a limiting phrase that should be read to mean that emotional distress was the only type of personal injury being compensated by the payment.

The Tax Court observed that "i.e." is an abbreviation for the Latin phrase id est, which roughly means "that is" or "that is to say." Accordingly, the court agreed with the IRS.

Now the Court of Appeals for the 9th Circuit has upheld the Tax Court. Interestingly, the higher court did not comment on the Tax Court's grammar skills. The appellate court simply upheld the Tax Court's decision in an unpublished opinion.

Note that Seidel might have fared better if the settlement agreement had used "e.g." instead of "i.e." Both are abbreviations for Latin terms. However, "e.g." stands for exempli gratia, which means "for example."   

In the last issue of Washington Tax Update, we advised pensioners that new IRS withholding tables may, in some cases, cause too little to be withheld from pension payments, resulting in additional taxes owed when 2009 income tax returns are filed.

Now the IRS has advised payors of pension benefits, that they are not required to use new withholding tables that reflect lower withholding due to the Making Work Pay tax credit in effect for 2009. However, payors are given the choice of using the new withholding tables or the withholding tables that were issued before the new tax credit was enacted.

Pension recipients are now faced with an additional challenge. If you qualify for the Making Work Pay tax credit, and taxes are being withheld using the old withholding tables, you may be overwithheld. If you don't qualify for the credit and your payor uses the new withholding tables, your taxes may be underwithheld. You are going to have to check carefully to avoid a surprise next April 15. 

Read Information Release 2009-50 here.

You may have noticed a modest increase in your take-home pay recently.

To encourage you to spend more to stimulate economic activity, the government adjusted the income tax withholding tables so the tax savings from the new Making Work Pay Credit is immediately available. This credit is equal to 6.2 percent of earned income – from a job or from self-employment – up to a maximum of $400. A married couple can get up to $800, even if only one works.

Everyone is not eligible for the credit, however, including high income households, dependents and nonresident aliens. Because withholding tables cannot always distinguish those eligible for the credit, it is possible that you could have your withholding reduced inappropriately.

You are most likely to have this problem if you and your spouse are both working, you hold more than one job at the same time or you are someone else’s dependent. If you are self-employed, you will not benefit from the credit until you file your 2009 return unless you reduce your quarterly estimated tax payments to account for the credit.

If you want to check to see if the credit has been reflected in your take-home pay, compare a recent pay stub to one issued in February to see if your withholding has gone down. For most people, the amount will drop by $10 to $15 per week. If you don’t think you will qualify for the credit, consider filing a new Form W-4 with your employer to increase your withholding and avoid a tax surprise next April 15.

Here are some reasons you may not qualify for the Making Work Pay Credit:

• You make too much money. The credit phases out for single filers with adjusted gross income between $75,000 and $95,000 and for joint filers with adjusted gross income between $150,000 and $190,000. Adjusted gross income counts all of your income, not just the amount you earn from your job.
• You are a dependent. Young people can often be claimed as dependents by their parents, while elders can sometimes be claimed as dependents by their children.  Dependents are not eligible for the credit.

Here are some reasons you may qualify for the Making Work Pay Credit, but your employer may reduce your withholding too much.

• You work more than one job at the same time. Each employer may cut your withholding by up to $400, but you are entitled to only one credit.
• You and your spouse both work. The new withholding tables generally reduce withholding by $600 for married workers. That means it is possible that the combined withholding for you and your working spouse could be reduced by $1,200, although your maximum credit is $800.

The IRS has released three pieces of guidance regarding new energy credits available to both individuals and businesses.

In Information Release 2009-44, the IRS reminds taxpayers that new tax benefits were enacted as part of the American Recovery and Reinvestment Tax Act of 2009. These benefits are available to individuals and businesses that reduce energy use and to producers that create new energy sources.

For homeowners, tax credits have been increased for energy-efficient improvements or installation of alternative energy equipment. Homeowners seeking to claim these credits may rely temporarily on existing manufacturer certifications or Energy Star labels in determining which products are qualified until the IRS announces updated certification guidelines.

Under provisions relevant to energy producers, taxpayers who place in service facilities that produce electricity from wind or other renewable resources can choose among the following:

• The energy investment tax credit
• The renewable electricity production tax credit
• A grant from the Treasury Department

The IRS has also issued Fact Sheet 2009-10, which summarizes the provisions of the new law that provide new, extended or increased incentives for taxpayers' efforts to increase energy efficiency. The most in-depth discussion focuses on the residential energy property credit. This credit is available for improvements including the addition of insulation, energy-efficient exterior windows and energy-efficient heating and air conditioning systems.

Other credits discussed in the fact sheet include:

• The residential energy efficient property credit
• The plug-in electric drive vehicle credit
• The plug-in electric vehicle credit for smaller vehicles
• The credit for plug-in electric drive conversion kits
• The alternative motor vehicle credit
• The renewable energy production tax credit
• The energy investment credit
• The credit for alternative fuel vehicle refueling property

The fact sheet also discusses the opportunity for businesses to obtain renewable energy grants in place of the energy investment credit or the renewable energy production credit.

Finally, in Notice 2009-41, the IRS has provided interim guidance on the credit provided for residential energy-efficient property. This credit applies to expenditures on qualified solar electric property, qualified solar water-heating property; qualified fuel cell property; qualified small wind energy property and qualified geothermal heat pump property. The credit extends to labor costs for site preparation, assembly, original installation and piping or wiring to connect the property to the dwelling.

The IRS has issued a ruling describing the payroll tax consequences for employers who continue to pay employees who leave their job to go on active duty with the military.

According to the ruling, this differential pay is subject to income tax withholding but is not subject to either Federal Insurance Contributions Act (FICA) or Federal Unemployment Tax Act (FUTA) taxes. The payments must be reported to employees annually on Form W-2.

The Court of Appeals for the 10th Circuit has upheld a decision of the Tax Court that the lead defense attorney for Timothy McVeigh in the Oklahoma City bombing trial could not claim a charitable contribution deduction for the donation of discovery material he had accumulated during the trial.

The attorney's tax basis in the material was zero. Therefore, unless the property was a long-term capital asset, the amount of the deduction would also be zero because the charitable contribution deduction would be reduced by the amount that would be ordinary income in a hypothetical sale.

The Tax Court had previously held that the attorney did not own the property because, under Oklahoma law, discovery materials belong to the client. Alternatively, the material was not a capital asset because capital assets do not include "a letter or memorandum, or similar property, held by a taxpayer whose personal efforts created such property ... (or by) a taxpayer for whom such property was prepared or produced."

The appellate court ruled that copies of FBI memoranda, lab reports, computer discs and photographs containing information regarding McVeigh, as well as letters to McVeigh from the FBI and Department of Justice, were clearly letters, memoranda or similar property within the plain language of the statute.

Although the material was not originally created for the attorney's benefit, it was produced or prepared for the attorney. The material was copied, organized and categorized by the government for the benefit of the attorney and his client and then placed in boxes with a letter listing the contents. The material, which was of the type typically produced for use in a criminal trial, was then provided to the defense attorney. The appeals court never ruled on ownership.

Read more in Sherrel and Leslie Steven Jones v. Commissioner, CA-10, 2009-1 USTC ¶50,316, March 27, 2009.

The IRS recently provided a six-month grace period during which taxpayers with offshore financial interests can voluntarily reveal previously undisclosed foreign financial accounts and pay a reduced penalty.

U.S. citizens and residents are required to pay tax on worldwide income. They are also required to disclose to the IRS ownership interests in foreign accounts, often by filing form TD F 90-22.1, Report of Foreign Bank and Financial Accounts, commonly known as FBAR.

The IRS has indicated it will not pursue criminal penalties against those who voluntarily disclose during the grace period.

This opportunity to become compliant is available until Sept. 23, 2009. 

Read more in the IRS's FBAR Voluntary Disclosure Memo.

If you paid your taxes with a credit or debit card this year, keep track of any convenience fees charged by your card company. Convenience fees can be charged to offset the costs associated with the processing of credit card charges  The IRS had previously declined to allow a deduction for these fees but has reconsidered.

 If you itemize your deductions in 2009, you will be able to deduct the convenience fees as a miscellaneous itemized deduction. Miscellaneous itemized deductions are deductible only to the extent the total exceeds 2 percent of your adjusted gross income (AGI).

Read IRS Information Release 2009-37 here.

Will the tax code change in 2011?

President Obama has formed a task force, chaired by former Federal Reserve chairman Paul Volcker, to study ways to revise the federal tax laws. The task force is charged with closing loopholes, streamlining the law and generating revenue to pay for the stimulus/recovery program.

Consistent with promises made during the campaign, the president has directed the panel not to increase taxes on families earning less than $250,000 a year and not to increase taxes in 2009 or 2010. The timetable is to have recommendations ready for the 2011 budget.

Past attempts to simplify the tax code have met with mixed results. President Reagan managed to remove a plethora of loopholes and tax breaks to construct a two-tiered system of 28 percent and 15 percent tax rate, with a "bubble rate" of 33 percent, on all personal income. The system did not last long.

Both Presidents George H. W. Bush and Bill Clinton raised income taxes, expanding the number of tax brackets from two to eventually five. Currently, there are six tax brackets.

Congress regularly inserts tax breaks and loopholes to satisfy political objectives and lobbyists. The first President Bush appointed the most recent bipartisan commission to study tax revisions. The recommendations of the commission were largely ignored.

The tax law provides a couple of incentives to assist you in purchasing a new hybrid vehicle.

Depending on the type of vehicle you purchase and the date of purchase, you may be entitled to a tax credit. In addition, if you purchase the vehicle after Feb. 16, 2009, and before Jan. 1, 2010, you will be able to deduct some or all of any sales or use tax you pay on the purchase.

If you are planning to support the American auto industry by purchasing a new Ford hybrid, however, your tax benefits may be limited. For purchases made after March 31, 2009, the tax credit for hybrid passenger automobiles and light trucks manufactured by the Ford Motor Company has begun to phase out. The full credit ranges from $1,950 on some Ford Escapes and Mercury Mariners to $3,400 on the 2010 Ford Fusion and Mercury Milan.

The phaseout has already begun because, during the last quarter of 2008, Ford's total sales of credit-qualified vehicles reached 60,000 units. Those who purchased or leased Ford hybrids prior to April 1, 2009, will receive the full credit. From April 1 through Sept. 30, 2009, the credit level will be 50 percent of the full amount. The credit drops to 25 percent on Oct. 1, 2009, and is eliminated after March 31, 2010.

Compensation issues are an ongoing point of dispute between taxpayers and the IRS when a corporation pays compensation to a controlling shareholder who is also an employee of the corporation.

The portion of the compensation that reasonably rewards the services as an employee is fully deductible. However, any excess amount is considered a disguised dividend, paid to a shareholder. The corporation may not deduct dividend payments.

In a recent case, the Court of Appeals for the 7th Circuit reversed a decision of the Tax Court, which had disallowed a deduction for almost $10 million paid as a bonus to the CEO and controlling shareholder of a home improvement retailer. The appeals court chastised the Tax Court for gauging the reasonableness of the compensation by comparing the CEO's compensation to the cash salaries and stock options received by CEOs of two publicly traded competitors, while ignoring the value of severance packages, retirement plans and other perquisites available to the other executives.

The appellate court also questioned whether the Tax Court adequately compared the duties of this CEO, who took only seven days of vacation per year and micromanaged the business, with the duties of the CEOs of the public companies, who employed large staffs to whom they might delegate responsibilities.

The appeals court also was unimpressed by several arguments normally put forth by the IRS in reasonable compensation cases. First, the court disagreed that the payment of a year-end bonus is indicative of a disguised dividend.

The court observed that bonuses are normally paid at the end of the year and are based on profits. Dividends are seldom calculated based on the corporation's profits.

The court also rejected the Tax Court's view that a controlling shareholder would be willing to work without compensation because the shareholder would benefit from the retained profits of the business.

Read more in Menard v. Commissioner, CA-7, 2009-1 USTC ¶ 50,270, March 10, 2009.

In a recent article, TIME magazine quoted an auto dealer as saying that the average car in America is more than nine years old.

 In the same article, TIME quotes an industry economist as predicting that 35 million cars now on the road will be at least 10 years old in two years. TIME's conclusion: "There's not enough duct tape in America to hold that much junk together."

 If you are driving one of these limping lizzies and you're thinking it may be time for a replacement, consider the recently enacted tax deduction available for new passenger vehicles purchased this year. The vehicle must be purchased after Feb. 16, 2009, and before Jan. 1, 2010, to qualify for the deduction.

 The deduction is limited to the state and local sales and excise taxes paid on up to $49,500 of the purchase price of a qualified new car, light truck, motor home or motorcycle. The amount of the deduction is phased out for those with modified adjusted gross income between $125,000 and $135,000 for individual filers and between $250,000 and $260,000 for joint filers. The special deduction is available regardless of whether you itemize deductions.

Read more in Information Release 2009-030.

You can deduct as an itemized deduction the interest you pay on a mortgage used to acquire a home. However, the deduction is limited to the interest paid on the first $1 million of mortgage debt. A $100,000 limit applies for home-equity debt.

 The IRS Office of the Chief Counsel was recently asked to address the question of how the $1 million limitation applies to a home with multiple owners. Does each owner receive a $1 million limit, or is the $1 million limit shared among the owners? If each owner has a $1 million limit, then a married couple could deduct the interest paid on a $2 million mortgage.

 The chief counsel concluded that the $1 million limit is applied "per home," rather than "per taxpayer." For example, if three people pool their funds to purchase a home in which they all live, the $1 million limit is distributed proportionately to the share of the total interest payments each owner makes during the year.

Read more in CCA 200911007.

In addition to tax relief, the American Recovery and Reinvestment Act includes a number of additional provisions aimed at stimulating small businesses.

Last month, the White House, the United States Department of the Treasury and the Small Business Administration (SBA) all announced measures aimed at addressing the economic challenges faced by small businesses and entrepreneurs.

The SBA recently announced changes to its lending and investment programs that will make it easier and less expensive for more small businesses to get financing. These changes include:

• Temporarily eliminating fees on SBA-backed loans and raising SBA's guarantee percentage on some loans to 90 percent. The elimination of fees is retroactive to Feb. 17, 2009, and will remain in effect until the end of the calendar year or until the funding is exhausted.
• Introducing a new loan program to help small businesses meet existing debt payments.
• Expanding the Microloan program to finance new lending and technical assistance grants to microlenders.
• Streamlining lending and oversight processes. 
•  Expanding the Surety Bond Guarantee program.
• Adding staffing to meet demands for new programs.

Read more here. 

The IRS ruled that investors in the Ponzi scheme perpetrated by Bernard Madoff are entitled to a theft loss deduction. However, a recent Tax Court case highlights some of the challenges a taxpayer faces when trying to claim that deduction.

To support a deduction for a theft loss, you must be prepared to prove three claims: (1) the fact that a theft occurred; (2) the amount of the loss; and (3) the year of discovery of the loss.

For Madoff investors, the fact that a theft occurred and the year of discovery of the loss seem to be satisfied by Madoff's guilty plea and the IRS's own pronouncements.

Under the income tax regulations, however, if you have a reasonable prospect of recovery on a claim for reimbursement by insurance or otherwise, the loss deduction is postponed until it can be ascertained with reasonable certainty whether the recovery will be received. Many of Madoff's victims invested through other advisers and may have claims against those intermediaries.

In the Tax Court case, Dominick Vincentini had invested in a phony investment scheme. The operators of the scheme were convicted of numerous federal criminal charges including money laundering, tax fraud, mail fraud and wire fraud. Vincentini claimed a theft loss deduction, either in the year the operators were charged with fraud or in the year they were convicted.

The IRS objected and the Tax Court sided with the IRS, ruling that Vincentini was unable to prove that he had no reasonable possibility of recovering some or all of his investments because he had yet to fully pursue his recovery plans. Therefore the amount of the theft loss could not yet be determined.

Read more in Dominick J. Vincentini v. Commissioner, T.C. Memo 2008-271.

As economic conditions continue to tighten, more people are operating businesses out of their homes. If you use part of your home exclusively for business, you may be able to deduct expenses for the business use of your home.

 The home office deduction is available for homeowners and renters and applies to all types of homes, from apartments to mobile homes. Deductible expenses may include mortgage interest, insurance, utilities, repairs and depreciation.

 But be careful. The IRS is concerned that the Internet may provide a new medium for promoters to sponsor illegal tax avoidance schemes. Some of these schemes suggest the conversion of a hobby or recreational activity into a "business" to claim personal expenses improperly as business expenses.

 Many schemes involve the use of fictitious online businesses including online retail and services, online auction sales and bartering.

 You must carry on a bona fide business, as well as meet other specific requirements, to deduct expenses related to the business use of your home. Even then, your deduction may be limited.

 To qualify to claim a home office deduction for business expenses, your business use of that part of your home must be both exclusive and regular. In addition, the business part of your home must be one of the following:

• Your principal place of business
• A place where you meet and deal with customers in the normal course of your trade or business
• A separate structure you use in connection with your trade or business 

Read more in IRS Headline Volume 263. 

Eligible small businesses may carry back a 2008 net operating loss up to five years instead of the normal two-year limit, according to guidance recently issued by the IRS.

The guidance applies to the enhanced net operating loss (NOL) carryback provisions of the American Recovery and Reinvestment Act. Eligible small businesses are those with average gross receipts of $15 million or less for the three-year period ending in 2008.

 These provisions do not apply just to corporations. Individuals who experience an NOL as a result of losses from one or more eligible small businesses that operate as sole proprietorships, partnerships, LLCs or S corporations also qualify for the extended carryback period.

Fiscal year businesses may make the election for an NOL occurring in a tax year either beginning or ending in calendar 2008, but not both.

 Depending upon whether you have already filed a return for the NOL year, you may be required to take action as early as April 17, 2009, to perfect your right to a five-year carryback. In an accompanying news release, the IRS said it will work to issue NOL-related refunds within 45 days or sooner.

Read more in Revenue Procedure 2009-19.

The IRS has decided that an investor's loss resulting from a Ponzi-type scheme is a theft loss rather than a capital loss.

This guidance is for investors who lost money in the Ponzi scheme operated by Bernard Madoff. It also applies to losses in any similar frauds.

The loss is deductible as an ordinary loss from a transaction entered into for profit. As such, the loss is fully deductible and not subject to the limitations that apply to personal theft losses.

Also, to the extent the loss creates a net operating loss, the investor is eligible to carry the loss back to receive a refund of taxes paid in prior years.

As a theft loss, the loss is deductible in the year discovered rather than in the year it occurred. The amount deductible is the amount of the loss not covered by a claim for reimbursement. In some cases, the IRS will allow investors to claim the deduction before the person charged with the crime is actually convicted.

Read more in Revenue Ruling 2009-9 and
Revenue Procedure 2009-20.

 The federal government has reported a new scam involving fake economic stimulus grants for small businesses.

Undoubtedly, you have read a number of reports about scammers impersonating the IRS in an attempt to gain access to your personal information and steal your identity. Because of these reports, crooks know you are suspicious, so they set up Web sites that discuss government grants. The information sites then direct you to the scammers' other sites.

Here's how a typical scam works. For a fee of $30 to $50 you get a subscription to a grants database or a grant package with information on how to write a grant proposal, along with a list of government agencies that provide grants to businesses.

After you pay the fee, you may or may not receive the information promised. And if you pay by credit or debit card, you may receive continuing charges for your subscription.

Federal and state agencies do not provide small business grants to start a business, pay off debt or cover operating expenses. However, they do provide guarantees on low-interest loans that can be used for these purposes.

Government agencies publish free grant information on the Web. You do not need to pay anyone to gain access to this information.

Visit agency Web sites and use your favorite search engine to access a wealth of free information from the government.

With falling home prices and low interest rates, many people may be considering the purchase of their first home. The newly enhanced first-time home buyer credit is an added incentive.

As part of the American Recovery and Reinvestment Act signed into law by President Obama on Feb. 17, 2009, the first-time home buyer credit was increased to $8,000 for homes purchased during 2009.

The 2009 credit does not have to be repaid as long as the home remains the purchaser’s principal residence for 36 months following the purchase date.

Now the IRS has announced that those who qualify can claim the credit on either their 2008 or 2009 tax return. If you claim the credit on your 2009 return, you may not get the full benefit of the credit until you file your 2009 return and receive your refund in 2010.

If you are considering buying a new home that will qualify for the credit, you should also consider extending the filing date of your 2008 return.

By filing Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, before April 15, 2009, you will have until Oct. 15, 2009, to file your 2008 return. Then, if you later purchase a home that qualifies for the first time home buyer credit, you can claim the credit on your 2008 return and reap an immediate tax savings.

The credit is equal to 10 percent of the purchase price of the home. To qualify for the maximum credit, the purchase price of the home must be at least $80,000. For married individuals filing separate returns, the maximum credit is $4,000. If two or more unmarried individuals pool their resources to purchase a home, the credit is allocated among the purchasers. However, the total credit for the group cannot exceed $8,000.  Since the credit is refundable, you can claim the credit, even if you owe no income tax.

The credit begins to phase out for individuals with adjusted gross income (AGI) in excess of $75,000 ($150,000 for a joint return). No credit is available for those with AGI over $95,000 ($170,000 for a joint return). You are considered a first-time home buyer if neither you nor your spouse had an ownership interest in a principal residence during the three-year period before you purchase the new home.

Read IRS Information Release 2009-14.

The IRS is now requesting that business taxpayers, associations and other interested parties submit new issues involving a tax controversy to the Industry Issue Resolution Program, which addresses industry-specific tax issues.

Occasionally, methods of accounting and specific tax issues relating to income and deductions are treated differently, depending on the type of industry. It is important to know how those transactions will be handled from a tax perspective.

As industry-specific transactions are identified, IRS personnel are assigned to look at those tax issues that affect multiple taxpayers and come to conclusions about how to apply the tax law consistently. The ultimate goal is that taxpayers in similar situations and industries should be accounting for transactions and paying taxes in a similar manner.

Submissions may be made any time. However, issues submitted and received by March 31, 2009, will be considered for acceptance in April. The IRS reviews submissions semiannually.

After three years and a great deal of controversy, the IRS has announced that it is terminating the use of private contractors to collect back taxes.

The program has been under fire since its inception, drawing the ire of taxpayers, the union representing IRS employees, the IRS's own taxpayer advocate and members of Congress.

After conducting an extensive review of the private debt collection program, including the cost effectiveness of the effort, the IRS will not renew its contracts with the two private debt collection agencies. The IRS determined that the work is best done by IRS employees who have more flexibility in handling cases, which is particularly important with many taxpayers currently facing economic hardship.

The IRS anticipates hiring over 1,000 new collection personnel. These new employees would give the IRS the flexibility to make assignments based on the areas of greatest need rather than filtering which cases can be worked using contractor resources.

It seems that more than a few people don't file their federal income tax returns.

And this is not just tax evaders and other scofflaws. Apparently, some people realize that their withholding exceeds their tax liability and decide not to bother filing a tax return.

According to estimates provided by the IRS, it is holding approximately $1.3 billion in unclaimed refunds for calendar year 2005 alone. The IRS is waiting for more than 1 million people to file their 2005 federal income tax returns to claim their refunds.

Here's the rub. If taxpayers are owed a refund for 2005 and have yet to file a tax return, they have until April 15, 2009, to file or the refund is gone.

If a return is filed after that date, the IRS is not allowed to process the refund claim. That's because refunds must be claimed no later than three years after the original due date of the tax return.

Returns seeking a refund must be properly addressed, postmarked and mailed by April 15. No penalties are assessed for filing late returns that qualify for refunds.

Unfortunately, traffic flows only one way on this street. Although a refund for 2005 cannot be claimed after April 15, 2009, the IRS can still assess additional taxes owed. The three-year period the IRS has to assess additional taxes doesn't begin until a return is filed.

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If you find yourself temporarily out of work in these difficult economic times, you should be aware of some tax law provisions that could be of benefit to you.

 The American Recovery and Reinvestment Act of 2009 makes the first $2,400 of unemployment benefits received during 2009 nontaxable.

 In addition, if you itemize deductions, you may be able to deduct job-hunting expenses, as long as you are seeking a job in the same line of business. The expenses are nondeductible if you are seeking employment in a new line of business, seeking your first job or have experienced a long period of unemployment.

 While you are unemployed, or if you have additional time on your hands because of a temporary layoff or reduced work hours, consider the possibility of improving your marketability through education or training. The tax law provides a number of valuable benefits, most of which are available for any field of study, not just your current field. They include:

 American Opportunity Tax Credit -- Formerly known as the Hope credit, the maximum credit is $2,500 in 2009 and 2010. The credit amount is 100 percent of the first $2,000 of qualifying expenses, plus 25 percent of the next $2,000.

 The credit is available for four years of a full- or part-time degree or certificate program. Qualifying expenses include tuition and fees but not room and board. The credit is phased out for a single taxpayer with modified adjusted gross income over $80,000 ($160,000 for joint filers). The credit is allowed against both regular and alternative minimum tax. Up to 40 percent of the credit is refundable.

 Lifetime Learning credit -- The maximum credit is $2,000 per year for a post-secondary school degree program. It is available for courses taken to acquire or improve job skills. The credit amount is 20 percent of the first $10,000 in qualifying expenses.

 Higher education deduction -- This deduction is available to non-itemizers. It was extended through Dec. 31, 2009, by the Emergency Economic Stabilization Act of 2008. The maximum deductible amount is $4,000 for taxpayers with adjusted gross income not exceeding $65,000 ($130,000 for joint filers).

 Work-related expenses -- An employee can deduct work-related expenses, job-hunting expenses plus other miscellaneous expenses as a miscellaneous deduction, but only for amounts that exceed 2 percent of adjusted gross income. If you are self-employed, you can deduct the expenses directly from self-employment income.

 Note that you can't double-count the same expenditure. You should determine which characterization is most beneficial to you.

 Read more in IRS Publication 970, Tax Benefits for Education. Note: This publication has not yet been updated for changes made by the new act.

On Feb. 17, 2009, President Obama signed the American Recovery and Reinvestment Act of 2009. Approximately one-third of the total package is composed of tax incentives.

 While most of the tax changes are retroactive to Jan. 1, 2009, a few key provisions, such as the new car sales tax deduction and the enhanced exclusion of gain on the sale of small business stock are effective as of the date of signing.

Here to read some of the key provisions of the new law that affect individual taxpayers.

• In 2008, the government mailed out stimulus checks. For 2009 and 2010, it is going to try a tax credit -- the Making Work Pay credit. Workers will be entitled to a credit of up to $400 ($800 on a joint return). The IRS has released  new withholding tables that will increase your take-home pay by the amount of the credit. Don't expect to see a check in the mail. Not everyone will be entitled to the full amount of the credit. For individuals with earned income below $6,452 ($12,904 for married couples), the maximum credit is 6.2 percent of earned income. The credit begins to phase out for individuals with modified adjusted gross income over $75,000 or $150,000 for married couples. Depending on how the withholding tables are designed, if your income is higher than the phaseout threshold, it is possible that you will have to repay part of the credit when you file your tax return.
• For 2009, but not 2010, disabled veterans, Social Security recipients, government retirees and others without earned income will receive a one-time payment of $250. At this time, it is unclear how and when these payments will be distributed.
• To stimulate new car sales, Congress has authorized an income tax deduction for state and local sales or excise taxes. To qualify for the deduction, you must purchase a new vehicle between Feb. 17 and Dec. 31, 2009. Importantly, the deduction is available even if you don't itemize. If your new vehicle is very expensive, the deduction is limited to the portion of the tax attributable to the first $49,500 of the purchase price. The deduction phases out when modified adjusted gross income exceeds $125,000 for individuals or $250,000 for married couples.
• The first-time home buyer credit is increased from $7,500 to $8,000 for purchases between Dec. 31, 2008, and Nov. 30, 2009. Unlike last year's credit, the $8,000 credit does not have to be repaid if the buyer keeps the home for at least three years. The maximum credit is 10 percent of the purchase price of the home, and a phaseout begins when modified adjusted gross income exceeds $75,000 ($150,000 for married couples).
• For 2009 and 2010 installations, energy-efficient improvements qualify for a 30 percent credit (up from 10 percent) with an aggregate cap of $1,500. You are entitled to this credit even if you previously used your $500 lifetime cap, which has been repealed.  Eligible improvements include insulation materials; exterior windows and skylights; exterior doors; central air conditioners; natural gas, propane or oil water heaters or furnaces; hot water boilers; electric heat pump water heaters; certain metal roofs and stoves and advanced main air circulating fans.
• For 2009, the alternative minimum tax exemption is increased to $46,700, or $70,950 for joint filers.
• The earned income tax credit and the refundable aspect of the child tax credit have also been enhanced for lower income workers.

Businesses also benefit from the new act. Here are some examples: 

• The bonus depreciation and small business expensing provisions of the tax law that were enhanced for 2008 have been extended by one year. Now allowed for 2009 purchases is 50 percent bonus depreciation on new equipment. The increased Code Sec. 179 expensing amount remains at $250,000 (phaseout amount of $800,000) for tax years beginning in 2009.
• Qualified small businesses with average gross receipts of $15 million or less can carry back a 2008 net operating loss for a maximum of five years. If your business has been suffering losses recently, this provision could allow an immediate refund of taxes paid in prior years.
• For qualified small business stock issued after Feb. 17, 2009, and before Jan. 1, 2011, sellers can exclude 75 percent of the gain on the sale of such stock, provided the stock is held for more than five years. To qualify, the shares must be originally issued in exchange for money, property or services by a C corporation with assets of less than $50 million that engages in an active trade or business.
• Certain businesses that have the opportunity to reacquire their debt at a discount may be eligible to defer recognition of the related income from the discharge of indebtedness. For a reacquisition during 2009 or 2010, no income is recognized for the first four or five years, and the income is spread evenly over the next five years.
• The 10-year recognition period for built-in gains tax for S corporations is reduced to seven years.

The length of time you should keep a document depends on the action, expense or event the document records. Generally, you must keep records that support an item of income or deductions on a tax return until the period of limitations for that return runs out.

 The period of limitations is the period of time in which you can amend your tax return to claim a credit or refund or that the IRS can assess additional tax. The information below contains the periods of limitations that apply to income tax returns. Unless otherwise stated, the years refer to the period after the return was filed. Returns filed before the due date are treated as filed on the due date.

• Normally, the IRS has three years to initiate an examination, and you have three years to request a refund. Keep records for at least three years.
• If you do not report income that you should report, and it is more than 25 percent of the gross income shown on your return, the IRS has six years to initiate an examination.
• If you do not file a return or you file a fraudulent return, the limitations period is indefinite.

The following guidelines should guide your record-retention policies: 

1. Keep copies of your filed tax returns. They help in preparing future tax returns and making computations if you file an amended return.
2. If you file a claim for credit or refund after you file your return, keep records for three years from the date you filed your original return or two years from the date you paid the tax, whichever is later.
3. If you file a claim for a loss from worthless securities or bad debt deduction, keep records for seven years.
4. Keep all employment tax records for at least four years after the date that the tax becomes due or is paid, whichever is later.
5. Keep records relating to property until the period of limitations expires for the year in which you dispose of the property in a taxable disposition. You must keep these records to figure any depreciation, amortization or depletion deduction and to figure the gain or loss when you sell or otherwise dispose of the property.
6. Generally, if you received property in a nontaxable exchange, your basis in that property is the same as the basis of the property you gave up, increased by any money you paid. You must keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in which you dispose of the new property in a taxable disposition.

When your records are no longer needed for tax purposes, do not discard them until you check to see if you have to keep them longer for other purposes. For example, your insurance company or creditors may require you to keep them longer than the IRS does.

If you need any incentive not to overpay your taxes, consider what is happening in California.

When California taxpayers file their state income tax returns asking for a refund, State Controller John Chiang has said he will delay the refunds for at least 30 days. The delay results from a $15 billion budget shortfall the state is facing. With most states dealing with a fiscal crisis, taxpayers in other states may encounter similar refund delays.

It may not be a good idea for cash-strapped taxpayers to consider a refund anticipation loan, or RAL. According to the Center for Responsible Lending, the effective interest rates, or APR, on some RALs range from 40 percent to more than 700 percent.

A better alternative might be to apply your overpayment to your 2009 taxes. You make this election when you file your state income tax return. With this extra amount credited to your 2009 taxes, you can afford to reduce your 2009 withholding by providing your employer with a new state W-4 form. It's true that you won't get your refund in one lump sum, but at least your take-home pay will be increased as a result of the lower withholding.

For victims of federally declared disasters in 2008 and 2009, recent legislation offers relief -- tax relief.

Major provisions of the National Disaster Relief Act of 2008 affect both individuals and businesses and include:

For individual taxpayers

• All taxpayers, including those who do not itemize deductions, can claim a casualty loss, regardless of adjusted gross income.
• For 2009 only, the amount by which taxpayers must reduce their casualty loss from each loss is increased from $100 to $500.
• The requirement that the net loss must exceed 10 percent of the taxpayer's adjusted gross income before a deduction is allowed is removed.
• A special five-year net operating loss carryback period for qualified disaster losses is created.

For business taxpayers

• An election to deduct, rather than capitalize, qualified disaster cleanup expenses is added.
• A deduction for 50 percent of the cost of qualifying property in addition to the regular depreciation allowance that is normally available is added.
• Taxpayers may expense, rather than depreciate, an additional $100,000 in property.

Certain provisions of the National Disaster Relief Act do not apply to the midwestern disaster area, i.e., disasters affecting the midwest that were declared from May 20, 2008, through July 31, 2008. That's because the Heartland and Hurricane Ike Disaster Relief Act provides other tax benefits. Read more in IRS Fact Sheet 2009-8.

The chief counsel of the Internal Revenue Service recently clarified an issue raised during IRS audits of businesses claiming the deduction for domestic production activities, particularly in the area of deferred compensation or stock options.

Domestic production activities include:

• Manufacturing based in the United States
• Selling, leasing or licensing items that have been manufactured in the United States
• Selling, leasing or licensing motion pictures that have been produced in the United States
• Construction services in the United States, including building and renovation of residential and commercial properties
• Engineering and architectural services relating to a U.S.-based construction project
• Software development in the United States, including the development of video games

Qualifying businesses could take a 3 percent tax deduction in 2005 and 2006. The deduction then increased to 6 percent in 2007 and will increase again to 9 percent in 2010. The calculations for claiming the deduction are complex.

The chief counsel ruled that, when calculating the amount of the deduction, compensation earned in a prior year but paid in a later year will reduce the amount of the deduction in the later year. The chief counsel's memorandum is the first legal advice on the issue.

The issue primarily involves compensation expenses (such as deferred compensation or stock options) earned in one year but paid in a later year. The calculation is particularly detrimental when the services were performed prior to the Jan. 1, 2005, effective date of the deduction and the compensation was paid after that date.

In today's job market, many people find themselves on short-term, out-of-town assignments.

The importance of the terms "home" and "temporary" was highlighted in a series of recent Tax Court decisions involving airline mechanics caught in a shrinking job market.

Generally, the tax law allows a deduction for travel expenses incurred while you are temporarily away from home on business. For this purpose, your home is considered to be your regular or principal place of business or, if you have no regular or principal place of business, your regular place of abode.

If you have no regular place of business or abode, you are considered to be itinerant. In that case, you have no home to be away from.

The IRS considers your assignment to be temporary if it is expected to last, and in fact lasts, for less than one year. If the assignment period is indefinite, the assignment is not temporary, even if it lasts for less than one year.

Read the case of David A. Wilbert v. Commissioner, 2009-1 USTC ¶50,171, CA-7, Jan. 21, 2009, here.

What are your chances of being selected for an audit? Not high, based on statistics released by the IRS.

IRS agents examined 1.01 percent of all individual income-tax returns last year, down slightly from 1.03 percent the prior year. This decline followed five consecutive annual increases, as Congress pressured the IRS to crack down on tax cheats.

If you stratify the statistics by income, it is pretty clear that making more increases your chances of an audit. Looking only at people reporting income over $200,000, the number of returns audited increased 16 percent last year and was up 49 percent from 2006.

Another group that attracts more than its fair share of attention from IRS auditors is the self-employed – those whose tax return includes a Schedule C, Profit and Loss from Business (Sole Proprietorship). And the interest really piques if your business is a type that deals in large amounts of cash transactions. To prepare for the inevitable audit, self-employed business owners must be compulsive record keepers.

The IRS uses a classified computer system called DIF, short for Discriminant Function. Every tax return processed by the IRS is given a DIF score. The higher the DIF score, the greater the likelihood an audit of the return will result in additional taxes. The IRS strives to audit the higher-scored returns first.

DIF scores are developed from an analysis of a sampling of prior tax returns, from which the IRS determines such statistics as the range of charitable contributions expected at a given level of income. So, for example, if you claim deductions that are greater than the amount the IRS expects for your income level, your DIF score will be higher.

Naturally, the IRS does not make DIF scoring information public.

Other events that can trigger an audit include filing a return with numbers that don't match what the IRS received separately from your employer or a financial institution. Or the IRS may get a tip from an ex-business partner, ex-spouse or neighbor claiming you're cheating. If you have invested in what the IRS considers an abusive tax shelter, you are almost guaranteed to be audited.

Another item that attracts the attention of the IRS is a large loss, particularly if you seem to have another source of income. The IRS will investigate whether your side activity is really a hobby or a so-called passive activity. Either characterization could disallow the loss deduction.

Now is a good time to review your withholding for 2009.

With many people experiencing dramatic shifts in their economic situations, your previously filed W-4 form may no longer reflect current reality. Having excessive amounts of federal and state income taxes withheld from your paycheck may not be your best alternative. Instead your W-4 form should reflect your current economic situation. Lowering your withholdings increases your take-home pay and avoids making interest-free loans to the government.

You can change your withholding at any time by providing your employer with a new W-4 form. View the current version of Form W-4, Employee's Withholding Allowance Certificate.

Click here to see if any of these circumstances that would warrant a change to your W-4 apply to you. If so, it may be time to adjust your withholding.

The IRS has recently provided guidance for unmarried co-purchasers of a home, showing potential ways they can share the new 10 percent credit for first-time homebuyers.

The Housing and Economic Recovery Act of 2008 authorized the credit for first-time home buyers who purchased a residence after April 8, 2008, and before July 1, 2009. The maximum credit is $7,500 or $3,750 for a married taxpayer filing a separate return.

Unmarried taxpayers who jointly purchased a home during the credit period may qualify to share the credit. The total credit cannot exceed $7,500. This provision benefits any unmarried home buyers, including domestic partners.

According to the new guidance, the home buyer credit may be allocated between the taxpayers using any reasonable method. Reasonable methods include allocating the credit between taxpayers who are eligible to claim the credit based on the relative contributions toward the purchase price of the residence or the relative ownership interests in the residence.

The guidance provides several examples illustrating how the credit may be allocated.  In one of the examples, one of the unmarried co-owners contributed $45,000 and the other contributed $15,000 toward the $60,000 purchase price of a residence. Each co-owner owns a one-half interest in the residence. In this example, the co-owners may allocate the allowable $6,000 credit using one of the following methods:

• Three-fourths to the $45,000 contributor and one-fourth to the $15,000 contributor, based on their contributions

• One-half to each, based on their ownership interests in the residence

• Any other reasonable method

Read more details in Notice 2009-12

The Treasury has issued proposed regulations alerting businesses subject to the heavy vehicle highway use tax to prepare for electronic filing of the required tax returns. Highway vehicles with a taxable gross weight of 55,000 pounds or more are subject to the tax. Businesses operating such vehicles must file Form 2290, Heavy Highway Vehicle Use Tax Return.

The IRS then returns Schedule 1 of Form 2290 to the taxpayer as proof of payment of the tax. State governments are required to receive proof of payment as a condition of registering a vehicle for highway use.

Changes added by the American Jobs Creation Act of 2004 provide that any taxpayer who files a highway use tax return for 25 or more vehicles for any taxable period must file the return electronically. The proposed regulations provide that submission of a Form 2290 for 25 or more vehicles on paper rather than electronically constitutes a failure to file the return.

Moreover, the IRS will not return the Schedule 1, which is necessary to register the vehicle with the state. And the company may be assessed a penalty for failure to file a return.

The IRS has requested comments on the proposed regulations, which will be effective when they are finalized. You can read more in Prop. Regs. 41.4481-1, 41.4481-2, 41.6001-2, 41.6011(a)-1 and 41.6071(a)-1 here.  

When should losses be claimed for a deduction? A recent case says the sooner, the better.

In 1993, Alan Bilthouse purchased for $500,000 approximately 25 percent of the shares of S&E Contractors, Inc., an S corporation primarily engaged in public works construction projects. By 1997, Bilthouse’s share of the losses from S&E Contractors had accumulated to more than $5 million. Bilthouse had not been able to deduct these losses because of a combination of his limited tax basis in his S corporation shares and the passive activity loss limitation.

In 1995, S&E had ceased to bid on new contracts because its bonding companies had stopped issuing performance bonds. Also in 1995, the company filed a lawsuit against the City of Jacksonville, Fla., seeking $27 million in damages in connection with an unfinished city contract. The suit was settled in 1997, with no cash paid to S&E or the bonding companies.

In 1997, S&E realized income from cancellation of indebtedness, which increased the adjusted tax basis in Bilthouse’s shares by more than $5 million. Although the increase in the tax basis of his shares allowed Bilthouse to claim an additional $5 million loss deduction on his personal return, the passive activity rules still prevented him from deducting the losses.

Bilthouse argued that his S&E shares became worthless in 1997, when the Jacksonville lawsuit was settled and S&E had no future business prospects. Since a worthless stock loss is treated as a loss from the sale or exchange of the stock, Bilthouse argued that the passive activity loss restrictions were removed because he had effectively disposed of the property that produced the passive activity losses.

Without disputing Bilthouse’s technical analysis, the IRS contended that the S&E shares became worthless in 1995 and that his refund was barred by the statute of limitations. In 2007, the U.S. District Court in Illinois agreed with the IRS that S&E had no liquidation value in 1995 and the Jacksonville lawsuit did not create any potential value.

Read the case summary here.

Congress suspended the required minimum distributions from IRAs and other qualified retirement plans for 2009 in the Worker, Retiree, and Employer Recovery Act of 2008.

The suspension applies to 2009 distributions only. Those who reached age 70½ during 2008 must take a 2008 minimum distribution no later than April 1, 2009.

If you have already begun to receive 2009 distributions, it is not too late to undo the situation. You have 60 days after receiving the distribution to roll it over to an IRA. If tax was withheld from the distribution, you will have to roll over the gross amount of the distribution to avoid income tax for 2009.

To read more, click Notice 2009-09.

If you have set up a tax-favored plan to save for college costs, generally known as a "529 plan," and have been disappointed by the recent investment performance, you should be aware of a new rule from the IRS.
 
The IRS has announced that during 2009 it will allow two changes in investment strategy rather than the normal one change per year.
 
State-sponsored and privately sponsored 529 plans allow contributors to prepay the beneficiary's education expenses. A state plan can also allow contributors to contribute to a tax-favored investment account for paying the expenses. The IRS's action impacts the latter type of 529 plan, a tax-favored investment account.
 
Contributions to 529 plans are not tax-deductible. However, both the plan's earnings and all distributions used to pay the beneficiary's qualified education expenses are tax-free.
 
Generally, you must select only from among broad-based investment strategies designed exclusively by the program. Until now, the IRS has permitted a change in investment strategy only once a year or upon a change in the designated beneficiary of the account.
 
Check with the plan sponsor to see whether it will permit the additional change for 2009.
 
When final regulations are issued, it is possible that the new rule may be applied beyond the end of 2009.
 
To read more, click Notice 2009-01.

Not all expenditures paid to medical providers are tax-deductible medical expenses.
 
For example, cosmetic surgery or similar procedures are nondeductible personal expenses, unless the surgery or procedure is necessary to ameliorate one of the following conditions:

• A deformity arising from, or directly related to, a congenital abnormality
• A personal injury resulting from an accident or trauma
• A disfiguring disease

In a recent IRS case, William Magdalin claimed a medical expense deduction for in vitro fertilization expenses incurred in fathering two children. The IRS disallowed the deduction, and the Tax Court has agreed with the IRS.

The court reasoned that Magdalin was a fertile man who used the procedure for nonmedical reasons. He had no physical or mental condition that prevented him from procreating without the use of in vitro fertilization technologies. The expenses were not, therefore, incurred for the treatment of a medical condition or for the purpose of affecting any structure or function of the body.

This case should not affect the deductibility of in vitro fertilization expenses for individuals who are infertile.

The IRS has twice denied charitable contribution deductions to Michael and Marla Sklar. The Tax Court has twice upheld the IRS disallowance.

Now the U.S. Court of Appeals for the 9th Circuit has twice agreed with the Tax Court that the Sklars may not deduct as a charitable contribution any portion of their tuition payments to a parochial school attended by their children.

The Sklars argued that, in return for the tuition payments, their children received two types of education: a general education and a religious education. They contended that the portion of the tuition attributable to the religious education should be deductible as a charitable contribution in the same manner as other contributions to a religious organization are deductible, even though the contributor receives religious benefits in return. Both courts rejected this argument.

If you haven't made your IRA or other retirement account contribution for 2008, doing so before April 15 is definitely a good idea. But another good idea is to make your 2009 contribution as early as possible after the first of the year.

The IRS is testing two new mediation and arbitration programs in an attempt to settle more disputes involving offers in compromise and penalties relating to employment taxes.

On Dec. 1, 2008, the IRS appeals offices in Atlanta, Chicago, Cincinnati, Houston, Indianapolis, Louisville, Phoenix and San Francisco began offering post-appeals mediation and arbitration for offer in compromise (OIC) and trust fund recovery penalty (TFRP) cases. The IRS hopes these programs will allow both taxpayers and the government to avoid the time and cost of litigation.

The mediation process is available for both legal and factual issues. The mediator's role is to facilitate settlement negotiations so the parties can reach their own agreement. The mediator does not have settlement authority over any issue.

The arbitration procedure is available for factual issues only. The arbitrator's role is to hear both sides of a disputed issue and then render a decision on the specific factual issue being arbitrated. This decision is binding on both parties.

Ira and Sheldon Nathel were shareholders in several S corporations. They had personally loaned a substantial amount of money to the corporations.

As a result of losses incurred over the years, their basis in the stock of the S corporations had been reduced to zero, and their basis in the loans had been substantially reduced. As part of a transaction that involved the buyout of a third shareholder, the Nathel brothers made capital contributions to the S corporations in excess of $1.4 million. During the same year, they also received loan payments in excess of $1.6 million.

The brothers argued that the capital contributions increased the basis in their loans so that the $1.6 million loan payments did not represent income to them. The Tax Court agreed with the IRS that the capital contributions increased the Nathel brothers' basis in their S corporation stock, not the loans. As such, since the loan payments exceeded their basis in the loans, the brothers were required to report the excess as taxable income.

The IRS has announced an expedited process that will make it easier for financially distressed homeowners to avoid having a federal tax lien block refinancing of mortgages or the sale of a home.

Those looking to refinance may request that the IRS make the tax lien secondary to the lien by the lending institution that is refinancing or restructuring the loan. Sellers may request that the IRS discharge its claim if the home is being sold for less than the amount of the mortgage lien under certain circumstances.

The process to request a discharge or a subordination of a tax lien takes approximately 30 days after the submission of the completed application, but the IRS will work to speed those requests in wake of the economic downturn.

The IRS urges people to contact the agency’s Collection Advisory Group early in the home sale or refinancing process so that it can begin work on their requests.

To apply for a certificate of lien subordination, you must follow directions in Publication 784, How to Prepare an Application for a Certificate of Subordination of a Federal Tax Lien. There is no form, but there must be a typed letter of request and certain documentation. The request should be mailed to one of 40 Collection Advisory Groups nationwide. See Publication 4235, Collection Advisory Group Addresses, for address information.

You may apply for a certificate of discharge of a tax lien if you are giving up ownership of the property, such as selling the property, at an amount less than the mortgage lien if the mortgage lien is senior to the tax lien. The IRS may also issue a certificate of discharge in other circumstances if you have sufficient equity in other assets, can substitute other assets or are able to pay the IRS its equity in the property.

Without a tax lien discharge, you may be unable to complete the home ownership change and the ownership title will remain clouded.

To apply for a tax lien discharge, applicants must follow directions in Publication 783, Instructions on How to Apply for a Certificate of Discharge of a Federal Tax Lien.

There is no form, but there must be a typed letter of request and certain documentation.

The request should be mailed to one of the Collection Advisory Groups.

Read Publication 784, How to Prepare an Application for a Certificate of Subordination of a Federal Tax Lien, here.

Read Publication 783, Instructions on How to Apply for a Certificate of Discharge of a Federal Tax Lien, here.

If you are nearing your adjusted gross income (AGI) limit on charitable deductions for the year, which is generally 50 percent, the IRS has issued a reminder of a year-end tax strategy to increase your contribution deduction.

Under the Emergency Economic Stabilization Act of 2008, cash contributions made before Dec. 31, 2008, to public charities that engage in disaster relief efforts in federally declared disaster areas of the Midwest are exempt from any AGI limit.

Contributions to relief efforts in Arkansas, Illinois, Indiana, Iowa, Missouri, Nebraska or Wisconsin count for this tax break. The must be made for areas that have been declared federal disaster areas and are designated for individual assistance as a result of tornadoes, severe storms or flooding between May 1 and Aug. 1 of 2008.

Congress passed the Worker, Retiree, and Employer Recovery Act of 2008 on Dec. 11, 2008,  and President Bush is expected to sign it. Although the new act suspends required minimum distributions (RMDs) from IRAs and other qualified retirement plans, the suspension takes effect in 2009. While the RMD rules remain in place for 2008, it is still possible that the government will take some action to suspend the rules for 2008 also.

If you have reached age 70½ by Dec. 31, 2008, you are required to take a minimum distribution from your IRA or other qualified retirement plan. You are permitted to distribute more than the minimum; however, failure to distribute at least the RMD amount results in the imposition of income tax plus a 50 percent excise tax. If you reached age 70½ during 2008, the RMD must occur by April 15, 2009. If you reached age 70½ in an earlier year, the RMD must occur by Dec. 31, 2008.

With many retailers in financial difficulty, there has been much news coverage lately about the advisability of purchasing gift cards. Gift card holders are unsecured creditors when a retailer seeks bankruptcy protection. However, retailers seeking to reorganize will usually request a court order allowing them to honor the gift cards so they will not alienate their customers.

In a recent technical advice memorandum (TAM), the IRS ruled that an issuer of gift cards must recognize taxable income for the amount of cash it received. The company covered by the TAM argued that sales of gift cards should be treated as nontaxable deposits because customers could obtain full cash refunds.

The IRS rejected this argument and also concluded that the amounts received for gift cards, under the facts presented, were not advance payments for future delivery of products or services. The company for whom the TAM was issued provided no products or services to the purchasers of the gift cards. Those products and services were provided by other businesses.

A retailer with facts similar to those described in the TAM could find its already precarious financial position exacerbated if the IRS attempts to accelerate tax collections related to the sale of gift cards.

Beginning in 2008, emergency responders get a federal tax break. They are not required to report as income: 

• Rebates or reductions of property or income taxes provided by a state or local government for providing services as a member of a qualified emergency response organization. Any such rebate or reduction normally reduces the amount of the income tax deduction for such taxes.
• Qualified payments made by a state or local government for providing services as a member of a qualified emergency response organization. The exclusion is limited to $30 multiplied by the number of months the member performs such services. A charitable deduction for expenses paid by the member in connection with performing such services must be reduced by any payment excluded from income.

On occasion, providing assistance to other family members comes with a few tax benefits.

Oralia Pavia lived with her sister and her sister's two daughters. Pavia paid a significant portion of her nieces' expenses along with the general household expenses. Her sister did not have sufficient income to require her to file a tax return.

The Tax Court ruled that Pavia was entitled to various tax benefits due primarily to her relationship with her nieces:

• She was entitled to a dependency exemption because her nieces were her sister's daughters. The nieces lived with Pavia for more than half the year, they were under 19 and they did not provide more than one-half of their own support.
• She could claim a child credit for her nieces because the girls were qualifying children under age 17.
• She could claim the earned income tax credit because her nieces were qualifying children with respect to Pavia under the specific tests provided in the tax law.
• She qualified as a head of household for filing purposes because she was not married, she had qualifying dependent children and she provided over half of the funds necessary to maintain her household.

If you sell your home during 2008, you may be entitled to a $500,000 exclusion if the sale occurs no later than two years after the death of your spouse, even if you no longer file a joint return.

However, this rule applies only if the requirements for joint filers relating to ownership and use were met immediately before the death of your spouse. Also, during the two-year period prior to the date of death, neither you nor your spouse may have sold a main home that qualified for the exclusion.

Normally, individuals may be able to exclude up to $250,000 of capital gain, and married taxpayers filing joint returns may be able to exclude up to $500,000 of gain each time you sell your primary residence, but generally no more frequently than once every two years.

 To qualify for this exclusion of gain, you must meet ownership and use tests.

• Ownership Test: During the five-year period ending on the date of the sale, you must have owned the home for at least two years.
• Use Test: During the five-year period ending on the date of the sale, you must have lived in the home as your main home at least two years.
  If you and your spouse file a joint return for the year of the sale, you can exclude the gain if either of you qualify for the exclusion. But both of you must meet the use test to claim the $500,000 maximum exclusion amount.

If you do not meet the ownership and use tests, you may be allowed to exclude a reduced maximum amount of the gain realized on the sale of your home if you sold your home because of health reasons, a change in place of employment or other certain unforeseen circumstances.

Examples of unforeseen circumstances include divorce or legal separation, natural or manmade disasters resulting in a casualty to your home or an involuntary conversion of your home. 

Read IRS Publication 523, Selling Your Home, here.

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Congress considers many tax proposals that never become law.

Washington Tax Update normally targets its coverage to new laws, court cases and rulings that actually apply to readers. In this issue, we depart from the norm to apprise readers of tax changes they might expect when the new administration takes office in January 2009.

This report includes a summary of the various tax proposals that President-elect Barack Obama has mentioned during his campaign.

The reader is cautioned, however, that only Congress has the authority to change the tax law. Many of the proposals mentioned during the campaign occurred months before the present credit freeze and financial uncertainty had seized the U.S. economy.

Historically, it is quite common for a new president to modify programs proposed during a campaign to meet the economic reality the new administration faces by the time it takes office. In fact, some announced members of the new Obama administration have already begun to suggest that a tax increase in 2009 would not be appropriate.

With those words of caution, below is a summary of the major tax proposals articulated by President-elect Obama during the campaign.

Two of the more memorable phrases from the campaign debates related to the Obama tax proposals:

• A tax cut for 95 percent of working families
• No tax increase for individuals making less than $200,000 and families making less than $250,000

 Individual tax rates
 
There are currently six tax rate brackets for individuals: 10, 15, 25, 28, 33 and 35 percent.

These rate brackets have been in place since Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). But after 2010, these provisions sunset, and the pre-EGTRRA rate brackets re-emerge.

The 10 percent rate bracket disappears, and the other bracket amounts become 15, 28, 31, 36 and 39.6 percent.

Other EGTRRA changes, such as the increase in the child tax credit and the increase in the costs eligible for the child and dependent care credit, are also scheduled to sunset after 2010.

As president, if Obama is going to stand by his campaign pledge not to raise taxes on families making less than $250,000, he will likely seek to retain the lowest four individual tax brackets after 2010. He will probably also seek to extend the current rules for the child tax credit and the child and dependent care credit beyond 2010.

It seems likely, however, that he will intend to allow the highest two brackets to return to their pre-EGTRRA levels. It is also possible that he will ask Congress to raise the top two brackets as early as 2009 or 2010.

Beginning in 1991, Congress passed a law restricting the amount of itemized deductions and personal exemptions available to high-income individuals.

Beginning in 2006, this restriction was being gradually eliminated, until it was scheduled to disappear after 2010. The effect of this restriction has been similar to a 1 percentage point decrease in the higher tax bracket amounts.

Obama has proposed restoring the restriction for individuals making over $200,000 and families with incomes above $250,000.
 
'Make Work Pay' tax credit
 
The centerpiece of Obama's tax cut for 95 percent of working families is a new refundable tax credit to offset the first $8,100 of payroll taxes for lower- and middle-income workers. Apparently, the maximum credit would be $500 per wage earner.
 
Planning opportunities
 
Higher-income taxpayers are unsure of exactly who will be targeted for a tax increase.

So far, Obama has been unclear whether the $200,000/$250,000 amounts refer to wages, gross income, adjusted gross income or taxable income. However, if you expect your marginal tax rate to rise in the future, it is sometimes advisable to accelerate income into lower-tax-rate years and defer tax deductions until higher rates take effect.

Of course, these actions also accelerate the tax payment and defer the tax savings. So you should discuss any tax planning opportunities with your tax adviser. Once the new president takes office in January, it is possible that he could ask Congress to make any tax changes retroactive to Jan. 1, 2009.
 
Dividends/capital gains
 
Obama has proposed a 20 percent tax rate for dividends and capital gains that would apply to taxpayers above his $200,000/$250,000 threshold. This proposal compares to a 15 percent tax rate for everyone under current law and a zero tax rate in 2008-2010 for taxpayers in the 10- and 15-percent rate brackets. Most people are pleased to see that Obama recognizes the advantage of a lower tax rate for this type of income.

The president-elect has indicated support for eliminating all capital gains taxes on investments in small and startup firms, but he has not provided any details. Under current law, only one-half of the gain on the sale of "qualified small business stock" is taxed, provided the stock is held more than five years.
 
Payroll taxes
 
Obama has discussed eliminating the present cap on wages subject to Social Security tax. For 2007, employers and employees each pay 6.45 percent of the first $97,500 of compensation as Social Security taxes. They also each pay 2.9 percent of all compensation as Medicare taxes. Self-employed individuals pay double the employee amount but receive an income tax deduction for one-half of the amount paid.

For 2008, the Social Security wage base is scheduled to rise to $102,000. Obama has proposed to eliminate the wage cap for wages above an unspecified level.

For example, assume that Congress eliminates the cap for wages above $250,000. Persons earning $350,000 would see their Social Security tax rise by $6,450. And the employer's tax would increase by the same amount.

Obama has also proposed an increase to the Social Security and Medicare tax rate of between 2 and 4 percent on earnings above $250,000. This tax increase would take effect 10 or more years in the future. 

 
Retirement plans
 
Without providing details, Obama has proposed relaxing the rules that penalize early distributions from IRAs and other qualified retirement accounts.

He has also proposed relaxing the minimum distribution requirements so that seniors over age 70½ do not have to withdraw funds from their account while their investments are severely depressed. Since most required minimum distributions must be made by Dec. 31, it seems unlikely that Congress will act to suspend the rules for 2008.
 
Estate tax
 
Under rules enacted as part of EGTRRA, the estate tax exclusion is $2 million for 2008 and rises to $3.5 million for 2009. The maximum estate tax rate is 45 percent. EGTRRA repeals the estate tax in 2010 and reinstates it in 2011 with a $1 million exemption and a maximum tax rate of 55 percent.

Obama has proposed making the 2009 exemption and tax rates permanent. The sooner Congress acts to deal with the estate tax, the easier it will be for affected individuals to finalize their estate plans.

Other tax proposals the president-elect mentioned during the campaign include:

• Eliminating income taxes for seniors age 65 and over who earn less than $50,000
• Creating a refundable 10 percent universal mortgage credit for non-itemizers, up to $800
• Replacing the Hope credit with a refundable American Opportunity Tax Credit, providing up to $4,000 per year for qualifiying education expenses
• Expanding the earned income tax credit program
• Expanding the Saver's credit and making it refundable
• Expanding the credit for child and dependent care expenses and increasing the maximum credit to 50 percent of eligible expenses

 
Obama's business tax proposals are far less clear than his tax ideas for individuals. He appears to support lowering the corporate tax rate, provided unspecified "business tax loopholes" are closed.

The president-elect has proposed a $3,000 refundable business tax credit for 2009 and 2010 for each full-time employee added to the work force of an existing business.

The credit would be reduced or eliminated, in an unspecified fashion, for businesses that move jobs outside the United States.

Obama has also expressed support for extending the $250,000 limit on the expensing election beyond 2008 and for making the R&D tax credit permanent.

With U.S. corporate tax rates currently the second highest in the industrialized world, there may be some support in Congress for lowering the rates. But when it comes to closing "loopholes" to pay for the rate reduction, remember that what one person views as a "loophole" is often seen as a "tax incentive" by the person receiving the benefit.

Also keep in mind that many small and medium-sized businesses do not operate as tax-paying corporations. If corporate tax rates come down and individual tax rates go up, many businesses currently operating as partnerships, LLCs and S corporations may elect to change to tax-paying corporations.

Also, businesses that employ large numbers of knowledge workers or other highly paid employees may be adversely affected by a removal of the wage cap on Social Security taxes.

Tax savvy business owners will stay in contact with their tax advisers during the coming weeks and months.

Tax Planning Idea of the Week

You can expect an increased effort from charities this holiday season.

According to the Giving USA Foundation, in the five recessions since 1973, charitable giving fell an average of 1.3 percent adjusted for inflation. This compares to an average increase of 4.6 percent during non-recession years.

The IRS has warned charities not to get too aggressive in their fund-raising and valuation efforts.

If you are planning a charitable contribution and want to claim an itemized deduction in 2008, you must make the contribution before Dec. 31. Contributions can be made in cash, by check or with a credit card. Even though you won't receive your credit card statement until next year, the contribution is considered made on the date you provide the charity with your credit card information.

For contributions of cash, checks or other monetary gifts -- regardless of amount -- you must maintain either a bank record, a receipt or other communication from the charity indicating the name of the charity and the amount and date of the contribution. For contributions of $250 or more, you must obtain a contemporaneous written acknowledgment from the charity.

Additional record-keeping rules apply to non-cash contributions.

The IRS has published the 2008 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes.

Use of the standard mileage rates is optional. If your actual cost of operating your motor vehicle, including depreciation if the vehicle is used for business, is higher than the standard rate, you should keep records to substantiate your actual cost and deduct the higher amount.

Beginning Jan. 1, 2009, the standard mileage rates for the use of a car, van, pickup or panel truck will be:

• 55 cents per mile for business miles driven
• 24 cents per mile driven for medical or moving purposes
• 14 cents per mile driven in service of charitable organizations

The new rate for business miles compares to a rate of 50.5 cents per mile for the first half of 2008 and 58.5 cents per mile for the second half. The medical and moving rate was 19 cents for the first half and 27 cents for the second half of 2008. The rate for miles driven in service of charitable organizations has remained the same.

You can deduct the cost of parking and tolls in addition to the standard mileage rate.

The standard mileage rate for business, medical and moving purposes is based on an annual study of the fixed and variable costs of operating an automobile, performed for the  IRS by Runzheimer International. The mileage rate for charitable miles is set by law.

Read more in Revenue Procedure 2008-72.
 

If you are an owner of a single member limited liability company (LLC) and have at least one employee, you may have to change the way you report and pay federal employment taxes beginning next year.

This new requirement is the result of changes made to regulations issued by the Treasury Department in 2007 that become effective for the first time next year. The new rules apply to single owner LLCs that have not elected to be treated as corporations.  Beginning Jan. 1, 2009, the LLC, not its owner, will be responsible for filing and paying employment taxes.

For federal tax purposes, an LLC with one owner is referred to as an entity disregarded as separate from its owner, or a “disregarded entity,” unless the owner makes an election to treat the company as a corporation. A single member LLC is treated as a sole proprietorship for federal income tax purposes, and the owner is subject to taxes under the Self-Employment Contributions Act (SECA).

For wages paid before Jan. 1, 2009, disregarded entities could choose whether to file and pay their employment taxes using either the name and employer identification number (EIN) assigned to the LLC or the name and Social Security number of the single member owner. For wages paid after Jan. 1, 2009, employment taxes must be reported and paid in the name and EIN of the LLC.

If you don’t have an EIN for your LLC, you may apply online at www.irs.gov or file Form SS-4, Application for Employer Identification Number.

Click here to read the regulations.

The Tax Court ruled recently that a former law student, now an employee of the U.S. House of Representatives, had to pay tax on a portion of his student loan that was forgiven by his lender.

The principles in this case apply to any type of loan forgiveness, not just student loans.

From 1997 to 2000, David Plotinsky financed a portion of his education with federal loans. In 2001, Plotinsky consolidated his student loans through his lender's incentive program. The program provided that, if Plotinsky took out a loan from the lender to consolidate all his student loans and made 36 consecutive timely payments on the loan each month, the lender would discharge a portion of the consolidated loan.

In 2004, under the incentive program, the lender discharged $3,000 of Plotinsky's loan. Plotinsky argued that the forgiveness was a gift from the lender.

The IRS disagreed.

Small and medium-sized businesses are allowed to immediately deduct, rather than depreciate, up to $250,000 of qualified property purchased and placed in service during 2008.

Businesses eligible for the maximum deduction are those that acquire no more than $800,000 of qualified assets during 2008. Businesses that acquire up to $1,050,000 of qualified assets will be allowed a reduced expense amount.

Property that does not qualify for an immediate tax write-off under the expensing election may qualify for an increased first-year depreciation deduction under new bonus depreciation rules enacted as part of the economic stimulus package. This deduction is equal to 50 percent of the cost of qualifying property purchased and placed in service during 2008.

To qualify for bonus depreciation, the property must be new. Used property does not qualify. In addition, the property must either:

• Have an applicable modified accelerated cost recovery system (MACRS) recovery period of 20 years or less
• Be water utility property or computer software not covered by the Section 197 amortization rules
• Be qualified leasehold improvement property

Businesses that use a fiscal year as their tax accounting year should note that the new bonus depreciation rules apply to property purchased and placed in service during calendar year 2008.

For example, a business that files its tax returns using a fiscal year ending June 30 would be able to claim bonus depreciation in its return for the year ending June 30, 2008,but only for eligible property purchased and placed in service between Jan. 1 and June 30, 2008. Similarly, in its return for the year ending June 30, 2009, the company will be able to claim bonus depreciation for eligible property purchased and placed in service between July 1 and Dec. 31, 2008.

Retirement plans are not just for big businesses. If you are self-employed -- or a small business owner -- you can set up a retirement plan for yourself and your employees.

The tax law provides significant tax incentives for employers that establish and maintain qualified retirement plans. If you are a sole proprietor, you can even deduct contributions you make to the plan for yourself.

Smaller businesses often favor Simplified Employee Pension (SEP) plans and Savings Incentive Match Plan for Employees Individual Retirement Account (SIMPLE IRA) plans.

With all qualified retirement plans, contributions that are set aside for retirement may be currently deductible by the employer but are not taxable to the employee until distributed from the plan.

Generally, you may claim a tax deduction for contributions you make to a qualified retirement plan.

Depending upon the type of plan you set up, limits apply to the amount deductible. Also, some types of retirement plans must be established before the end of the year, while others can be set up as late as the due date of your tax return.

If you are thinking about setting up a retirement plan for 2008, you should speak with your tax adviser as soon as possible.

Read IRS Publication 560, Retirement Plans for Small Business here.

A planning technique that has been used to fund a new business venture by employees who have been downsized or who decide to pursue a new career has drawn the attention of the IRS.

In an internal memorandum, the IRS director of employee benefit plans has advised IRS examiners to take a close look at a transaction known as “Rollovers as Business Start-ups,” or ROBS.

In a typical transaction, an individual creates a corporation that establishes a qualified plan, generally a profit-sharing plan. The plan provides that all participants may invest all of their account balances in employer stock. Often, the business owner is the only employee and only plan participant.

The business owner subsequently rolls over a distribution from his or her 401(k) or IRA account to the new qualified plan. The owner directs that the account balance be invested by purchasing employer stock. The corporation uses the funds obtained by selling the stock to buy a franchise or begin some other business.

Although the IRS has alerted its agents about this situation, it has not designated it as “a transaction of interest,” so a Form 8886, Disclosure Statement, is not yet required.

One issue that concerns the IRS is whether proper appraisals are being performed to assure that the employer stock purchased by the qualified plan is really worth the purchase price being paid.

Tapping into accumulated retirement funds to start a new business without triggering tax on the distribution is an attractive opportunity. But before executing a ROBS transaction, be sure to get competent professional advice. And expect a close look by the IRS.

Click here to read the IRS memorandum on ROBS.

Businesses should not assume that payments made to settle lawsuits will be deductible as business expenses.

The Tax Court has ruled that the IRS properly denied a deduction to a commercial health insurance company for legal fees and settlement payments.

The company had merged with several licensees of Blue Cross and Blue Shield, which at the time were required to be nonprofit organizations. The attorneys general in three states where the mergers took place brought lawsuits claiming that the licensees had a charitable purpose and received benefits under state and federal law because of that purpose.

As a result of the mergers, however, the charitable purposes were no longer being met. Under charitable trust principles, according to the lawsuits, the charitable assets that had accumulated by the licensees should be taken away from the insurance company and redirected to the same or similar charitable purpose.

To settle the claims, the company paid more than $113 million to the three states, an amount it then deducted as a business expense. The company also deducted over $825,000 in legal and professional fees incurred defending itself in the lawsuit. The company argued that it only made the settlement payments to avoid interruption of its business or loss of goodwill.

Both the company and the IRS agreed that the origin of claim doctrine applied. Under this test, the substance of the underlying claim or transaction out of which the expenditure in controversy arose governs whether the item is a deductible expense or a capital expenditure, regardless of the motives of the payor making the payment or the consequences that may result from the failure to defeat the claim.

The court ruled that the origin of the litigation claims was a dispute over ownership of the alleged charitable assets. The settlement payments made to resolve the claims, as well as the accompanying legal and professional fees, had to be capitalized as an expense incurred to defend or perfect title to the property.

A business should consult its tax adviser before agreeing to the settlement and ask a tax adviser to review the proposed language being used in the settlement agreement.

Click here to read the case, Wellpoint, Inc., v. Commissioner.

 

As another group of unfortunate business owners and a CPA recently discovered, the IRS takes seriously the responsibility to timely deposit payroll taxes.

The IRS views these taxes as coming from both the employer and the employees since part of the tax payment comes out of each employee’s paycheck. If a business fails to make a payroll tax payment on time, the IRS views it – more or less – as a theft of the taxes the business took from the employees. The IRS reaction can be aggressive and punitive.

The IRS will likely pursue a payroll tax lien. The lien carries with it something known as the 100 percent penalty. Essentially, the IRS will double the amount it seeks to collect. The IRS may even seize business assets in an effort to satisfy the amount due.

In the latest case, S.P. Davis, Sr., Willie J. Singleton, Phillip Pennywell, Jr., and James C. Williams were equal owners, officers, and members of the board of Winward Institute, Inc. The four owners had check-signing authority, could hire and fire employees, could exercise control over the company’s finances, including the payment of payroll taxes, and were intimately involved in running the business. Samuel W. Stevens, a CPA, was employed as the vice president of finance. Although Stevens had no checksigning authority, he supervised the accounting department, oversaw the preparation of checks, including payroll and federal tax deposit checks, and had the authority to direct the accounting department to draft checks to the IRS instead of to other creditors.

The court held each of the five defendants jointly and severally liable for more than $3 million in unpaid payroll taxes.

Click here to read the case of S.P. Davis, Sr. v. United States of America. 

Many people start their year-end tax planning late in December. By that time, there may be few steps you can take to significantly affect your 2008 tax liability. But starting now may give you some time to put a few significant tax strategies into effect.

Most year-end tax strategies involve one of three objectives: 

1. Defer income from 2008 to later years
2. Accelerate deductions from 2009 into 2008
3. Take advantage of tax credits available in 2008

The IRS has issued final regulations that require open-account indebtedness between a shareholder and an S corporation to be treated as a separate indebtedness if the debt exceeds $25,000. These regulations affect shareholders who have deducted losses from their S corporation supported by the open-account debt. The regulations make it more difficult to continue to defer income that would result from repayment of the open-account debt by re-loaning funds to the S corporation. The final regulations became effective Oct. 20, 2008.

Read more here. 

Charles E. Jefferson is a member of the Illinois House of Representatives. He also served in an unpaid capacity as the volunteer president of the board of directors of a taxexempt day-care center. When the day-care center experienced financial difficulties and failed to deposit its payroll taxes, the IRS required Jefferson to pay the obligation using more than $40,000 of his personal funds.

Jefferson requested first a federal district court and then the Court of Appeals for the 7th Circuit to direct the IRS to give him his money back. The tax law does not apply the personal liability for delinquent payroll taxes to an unpaid volunteer board member or trustee of a tax-exempt organization, provided three tests are met:

1. The person serves solely in an honorary capacity.
2. The person does not participate in the day-to-day or financial operations of the organization.
3. The person does not have actual knowledge of the failure to deposit the payroll taxes.

The court agreed that Jefferson’s position was voluntary and uncompensated. It also agreed that he was not involved in the day-to-day operations of the day-care center.

However, the court found that Jefferson was involved in the financial operations, since he had check-signing authority, assisted the organization in obtaining a loan and caused the organization to hire an accounting firm to review its financial affairs.

In addition, Jefferson had knowledge of a previous instance in which the organization failed to deposit payroll taxes, he had instructed a director to timely remit withheld taxes to the IRS and he did not ensure that the payments were actually made. Finally, he had access to the accounting firm’s reports, which were available at the organization’s office, that the payroll taxes were not being deposited.

Jefferson had to personally pay the payroll taxes.

Click here to read the case of Charles E. Jefferson v U.S.

The Financial Accounting Standards Board (FASB) has approved an additional one-year deferral of FASB Interpretation No. 48 (Accounting for Uncertainty in Income Taxes) for private enterprises. The deferral gives private companies one more year to analyze and document their tax exposures.

FIN 48 already applies to public companies. When it goes into effect for private companies, FIN 48 will require disclosure of areas in which federal state and foreign tax authorities may assert additional taxes against the company.

Could you use a little extra money this holiday season? Have you moved recently? Could the IRS have lost contact with you?

The IRS is holding more than 279,000 economic stimulus checks worth about $163 million and more than 104,000 regular refund checks worth about $103 million. These checks were all returned by the U.S. Postal Service due to mailing address errors.

If you think one of these checks could be yours, all you have to do is update your address once. The IRS will then send out all checks due.

You can update your address using the "Where's My Refund?" tool on the IRS Web site at www.irs.gov. Or you can call the IRS at (800) 829-1954 to receive instructions for updating your address.

Read more in Information Release 2008-123

Whether you are motivated by the high price of gasoline or a desire to "go green," the purchase of a hybrid or lean-burn technology vehicle can entitle you to a tax credit.

Hybrid vehicles have drive trains powered by both an internal combustion engine and a rechargeable battery. Advanced lean-burn technology vehicles are passenger cars or light trucks with internal combustion engines that generally run on diesel fuels but use more air than is necessary for complete combustion of the fuel. Qualified lean-burn technology vehicles must also incorporate direct fuel injection technology and achieve at least 125 percent of the 2002 model-year city economy fuel rating. Credit amounts vary, based on the vehicle's city fuel economy rating and lifetime fuel savings.

The credit is available only to the original user of a new qualifying vehicle. If 60,000 hybrid or advanced lean-burn technology vehicles of a particular manufacturer are sold, the tax credit is reduced and eventually eliminated. The full credit can be claimed up to the end of the third month after the quarter in which the manufacturer sells its 60,000th qualified vehicle.

To find out whether a car qualifies for the tax credit -- and the maximum amount of that credit -- go to the IRS Web site at www.irs.gov and search for "qualified hybrid vehicles."

Many aspects of the income tax law, including tax rates, deductions, exemptions and credits have built-in inflation adjustments. Each fall, the IRS announces the new inflation-adjusted figures for the upcoming calendar year.

The IRS has released the following inflation-adjusted tax items for 2009:

• Each personal and dependency exemption will increase by $150 to $3,650.
• The standard deduction for married couples filing a joint return increases by $500 to $11,400. For singles, the standard deduction goes up by $250 to $5,700 and for heads of household the new amount is $8,350, up $350.
• Each tax bracket threshold for every filing status increases. For example, a married couple filing a joint return will pass from the 15 percent rate bracket to the 25 percent bracket at taxable income of $67,900, $2,800 higher than in 2008.
• The maximum earned income credit for low- and moderate-income workers and working families with at least two children increases by $204 to $5,028. The income limit for joint filers with at least two children is $43,415, up $1,769.
• The annual gift tax exclusion increases by $1,000 to $13,000 per donee.
• The limitation on the exclusion for elective deferrals to Section 401(k) plans is $16,500, up $1,000.

Read more about these changes in Information Release 2008-117, Information Release 2008-118 and Revenue Procedure 2008-66.

The popular press has devoted the bulk of its coverage of the Emergency Economic Stabilization Act of 2008 to the federal government's efforts to restart the frozen credit apparatus that has seized the U.S. economy - and rightly so.

But passing almost unnoticed as part of this massive legislation are a number of significant tax law changes that will become increasingly important to investors and businesses as the economy begins to regain its financial footing.

The tax changes fall into the following categories:

1. Tax provisions directly related to the government rescue plan
2. Tax provisions primarily affecting businesses
3. Tax changes primarily affecting individuals
4. Other provisions  

Limitation on executive compensation for financial institutions.  In response to public outrage of the government bailing out ailing financial institutions -- only to see taxpayer dollars used to fund extravagant compensation packages for company executives -- Congress prescribed restrictions on executive compensation for companies that sell more than $300 million in assets under the government's new asset recovery program.

The deductibility of compensation paid to the CEO, the CFO and three other highest paid officers will be limited to $500,000.

In some cases in which the government receives a meaningful equity or debt position in the company, the Secretary of the Treasury will require a limit on executive compensation and forfeiture of compensation by executives who provide financial information later determined to be materially inaccurate.

The treasury secretary may also require the companies to eliminate future golden parachute payments.

Charitable contributions.  Generally the deduction for a charitable contribution of ordinary income property is limited to the property's fair market value, reduced by the amount that would have been reported as ordinary income had the property been sold at its fair market value.

There are a number of exceptions:

• C corporations may claim an enhanced deduction for a property's basis plus one-half its unrealized appreciation - up to twice the amount of the basis - provided the gift is made to a qualified public charity or private operating foundation and the donee will use the property for the care of infants, the ill or needy.
• Corporations and noncorporate taxpayers may claim the enhanced deduction for donations of food inventory, provided the food was fit for human consumption and the donee used the food for the care of infants, the ill or needy. This provision expired at the end of 2007 but has now been extended for contributions made through the end of 2009.
• C corporations may also claim the enhanced deduction for donations of book inventory to public schools. This provision expired at the end of 2007 but has now been extended for contributions made through the end of 2009.
• C corporations, other than a personal holding company or a service organization, are also entitled to the enhanced deduction for a qualified research contribution of certain ordinary income property to an institution of higher education or to an exempt scientific research organization for research purposes.
• For tax years beginning before Jan. 1, 2008, corporations were entitled to the enhanced deduction for charitable contributions of computer technology equipment to an elementary school, secondary school or public library. The equipment must not have been used and the contribution must occur within three years of acquisition, construction or assembly. The new law extends this provision through the end of 2009.

Congress also extended the unlimited deduction for charitable contributions in the case of a qualified farmer or rancher contributing food before Jan. 1, 2009.

Finally, the new law extends through Dec. 31, 2009, the rule allowing S corporation shareholders to receive pass-through charitable deductions of appreciated property equal to fair market value, even if the deductions would exceed the shareholder's adjusted basis in the S corporation.

Higher investment limit for new markets tax credit.  The new markets tax credit encourages taxpayers to invest in or make loans to businesses in economically distressed areas. The total credit available is equal to 39 percent of the investment over seven years.

Active involvement of the low-income communities is required with strict penalties if the investment is terminated before seven years.

The national limitation for the new markets credit has been $3.5 billion annually through Dec. 31, 2008. The new law extends the temporary higher investment limit through Dec. 31, 2009. 

Extended deduction for energy-efficient buildings.  From Jan. 1, 2006, though Dec. 31, 2009, a deduction is available for the cost of certain energy-efficiency improvements installed in a depreciable building in the United States. The new law extends the deduction period to improvements placed in service before Jan. 1, 2014.

The deduction applies to "energy-efficient commercial building property," which is defined as depreciable property installed as part of a building's interior lighting system, heating, cooling, ventilation and hot water systems; or envelope as part of a certified plan to reduce the total energy and power costs of these systems by at least 50 percent in comparison to a reference building that meets certain minimum standards.
 

Renewable energy credits extended.  The new law extends the following credits:

• Credit for producing electricity from qualified wind facilities is extended through Dec. 31, 2009.
• Credits for producing electricity through biomass and other renewable sources are extended through Sept. 30, 2011.
• Credits for solar energy, fuel cell and micro-turbine property are extended through Dec. 31, 2016.

Transportation fringe extended to bicycles.  Employees can exclude from income certain transportation fringe benefits, such as transit passes and van pooling. The new law extends the exclusion to employees who commute by bicycle. The exclusion amount is $20 per month and is effective for years beginning after Dec. 31, 2008.

FUTA surtax extended.  The law extends the 0.2 percent surtax on FUTA (unemployment) taxes for one year, through 2009. The tax is paid by employers on the first $7,000 of compensation paid to each employee.

 Tax changes primarily affecting individuals

The law also abates all unpaid AMT liabilities, including penalties and interest, associated with the exercise of incentive stock options (ISOs) before 2008.

For those who exercised ISOs in prior years and paid an AMT liability, the law accelerates the minimum tax credit to allow the unused credit to be refunded over two years rather than five.

Residential energy credits.  The new law reinstates, for property placed in service in 2009, the tax credit for the installation of nonbusiness energy property, such as residential exterior doors and windows, insulation, heat pumps, furnaces, central air conditioners and water heaters. The credit is limited to a lifetime maximum of $500.

The new law also extends through Dec. 31, 2016, the credit for residential alternative energy equipment. The credit applies to certain solar water heaters, solar electricity equipment, fuel cell plants, residential small wind investment and geothermal heat pumps.

Enhanced refundable child tax credit.  For 2008, the refund threshold for the child tax credit is decreased from $12,050 to $8,500, making the child tax credit refundable for more low-income workers.

Charitable contributions from IRAs.  During 2006 and 2007, individuals age 70½ or older could distribute up to $100,000 annually from their IRAs to qualified charitable organizations without taking a charitable deduction or including the distribution in gross income. The new law extends this rule to 2008 and 2009.

State and local sales tax deduction.  For 2008 and 2009, the new law allows individuals who itemize their deductions to claim a deduction for state and local sales taxes paid, rather than state and local income taxes paid. This deduction primarily benefits residents of those states that do not have a state income tax.

Higher education tuition deduction.  The new law extends through Dec. 31, 2009, the above-the-line deduction for qualifying tuition and related expenses paid for enrollment or attendance by an eligible taxpayer, the taxpayer's spouse or dependent at any accredited post-secondary institution.

The deduction is not available to married taxpayers filing separately or if another person can claim the taxpayer as a dependent. The maximum deduction remains at $4,000 and is phased out at higher income levels.

Additional standard deduction for real property taxes.  In the Housing Assistance Tax Act of 2008, Congress authorized an additional $500 ($1,000 on a joint return) standard deduction for non-itemizers who pay at least that amount of real property taxes. This provision primarily benefits older homeowners who have paid off their mortgages.

The additional standard deduction was originally made available for 2008 only. The new law extends the provision to 2008 and 2009.

Teachers' classroom expense deduction.  For 2008 and 2009, teachers and other educators can deduct above-the-line up to $250 of certain out-of-pocket classroom expenses. For those who itemized their deductions, amounts in excess of $250 may qualify as a miscellaneous itemized deduction, subject to the 2 percent of adjusted gross income limitation.

Increased FDIC insurance limits.  The federal insurance of bank deposits is temporarily increased from $100,000 to $250,000 through Dec. 31, 2009. 

Broker basis reporting.  Brokers will be required to report the adjusted basis of publicly traded securities when reporting the sale of the security and indicate whether the gain or loss is long- or short-term. 

Reporting will begin for stocks acquired in 2011, mutual funds acquired in 2012 and other securities acquired in 2013.

Whether the Wall Street meltdown has ravaged your retirement savings, or you're a baby boomer who likes working, you may be joining the growing ranks of older workers who remain gainfully employed past their planned retirement date.

Whether by choice or out of necessity, like most life events, this decision presents an opportunity for efficient tax planning.

Working just a few extra years gives you the opportunity to build up your retirement account and receive an even larger benefit from Social Security. If you are planning to work a bit longer, consider some of the advantages that a Roth IRA has over a traditional IRA.

Both types of IRAs allow workers over the age of 50 to contribute up to $6,000. A Roth IRA differs from a traditional IRA in that contributions are never tax-deductible, but qualified distributions are also not taxable. There is no age restriction for a Roth IRA. Unlike traditional IRAs, Roth IRAs can accept contributions past age 70½, and there are no minimum distribution requirements.

There is an overall gross income limitation. You cannot contribute to a Roth IRA for 2008 if your modified adjusted gross income is greater than $116,000 for singles or $169,000 for joint filers.
 

The Emergency Economic Stabilization Act of 2008, passed by both houses of Congress and signed by the president last week, increases the federal insurance of bank deposits to $250,000. In addition, the act contains a handful of tax provisions that primarily affect financial institutions directly involved in the rescue plan.

The act treats any losses on sales of Fannie Mae and Freddie Mac preferred stock by financial institutions or financial institution holding companies as ordinary losses. This rule applies to any preferred stock that was owned on Sept. 6, 2008, or sold between Jan. 1 and Sept. 6, 2008.

Two sets of proposals are designed to prevent the government from subsidizing excessive payments to executives under the legislation.

1. If the government purchases distressed assets with no bidding process and the government receives a meaningful equity or debt position in the financial institution, the Secretary of the Treasury will require the financial institution to limit executive compensation, require executives to forfeit compensation if the executive provides financial information that is later determined to be materially inaccurate and prohibit the financial institution from making golden parachute payments.
2. For participants in auctions who sell $300 million in assets, or whose combined assistance from direct purchases and auctions reaches $300 million, executive compensation in excess of $500,000 is not deductible, the current golden parachute tax regime continues to apply to existing employee contracts and golden parachutes will be prohibited prospectively for the top five executives.

For homeowners facing foreclosure or loan modification, the provision of the Mortgage Forgiveness Debt Relief Act of 2007, which excludes from taxable income debt forgiven before the end of 2009, is extended for three years, through 2012. The extension does not apply to home equity loans.

Click here to read the new act.

To get congressional support for the financial rescue package, Congress sweetened the pie with a group of tax incentives. Those that tend to get the most press coverage include rapid depreciation for NASCAR racetracks and an excise tax exemption for children’s wooden arrows. But buried in the hundreds of pages of new law are many tax provisions that will affect a wide range of individual taxpayers, including:

• For 2008, the act provides a patch to the alternative minimum tax (AMT) that is designed to prevent as many as 25 million Americans from being subject to the AMT in 2008. The act raises the AMT exemption amount to $69,950 for joint returns and $46,200 for single filers. The patch removes several limitations in the current law on the ability to use personal tax credits.
• The alternative itemized deduction for sales taxes, the increased standard deduction for real property taxes, the increased education tuition deduction, the teachers’ classroom expense deduction and the tax-free IRA distribution for charitable purposes are extended through 2009.
• The child tax credit is enhanced by making the credit refundable for lower-income workers.
• A credit of up to $500 for energy-saving residential improvements like insulation, windows and doors will be reinstated for 2009.

Click here to read the Emergency Economic Stabilization Act of 2008.

As the Oct. 15 deadline for filing a 2007 income tax return rapidly approaches, the IRS is reminding individuals who are eligible for an economic stimulus payment to file a return in time to receive the stimulus check before the end of the year. The IRS will not distribute any payments after Dec. 31, 2008. If you don't act now, you will have to wait until you file a 2008 return to claim a refundable credit amount.

According to the IRS, there are an estimated 4.3 million retirees and disabled veterans who may be eligible for a stimulus payment and who have not yet filed a 2007 return.

Read Information Release 2008-109 here.

First-time home buyers should begin planning now to take advantage of a new tax credit included in the recently enacted Housing and Economic Recovery Act of 2008.

Available for a limited time only, the credit applies to home purchases after April 8, 2008, and before July 1, 2009. The credit reduces your tax bill or increases your refund, dollar for dollar, up to a maximum of $7,500. It is fully refundable, meaning you will receive the credit as a cash refund, even if you owe no tax.

However, the credit operates much like an interest-free loan, because it must be repaid over a 15-year period. So, for example, if you buy a home today and properly claim the maximum available credit of $7,500 on your 2008 federal income tax return, you must begin repaying the credit by including one-fifteenth of this amount, or $500, as an additional tax on your 2010 return.

If you bought a home recently, or are considering buying one, here are some highlights to help you determine whether you qualify for the credit:

• Only the purchase of a primary residence located in the United States qualifies and only for a limited time. Vacation homes and rental property are not eligible.  For a home that you construct, the purchase date is the first date you occupy the home.
• The credit is 10 percent of the purchase price of the home, with a maximum available credit of $7,500 for either a single taxpayer or a married couple filing jointly. The limit is $3,750 for a married person filing a separate return. In most cases, the full credit will be available for homes costing $75,000 or more.
• The credit is reduced or eliminated for higher-income taxpayers. The credit is phased out based on your modified adjusted gross income. For a married couple filing a joint return, the phase-out range is $150,000 to $170,000. For other taxpayers, the phase-out range is $75,000 to $95,000.

Read Information Release 2008-106 here.

Many people choose to have a professional prepare their income tax returns to assure accuracy and avoid penalties. In a recent case, the Tax Court imposed the 20 percent accuracy-related penalty on Jingyun Qi, who used an experienced certified public accountant to prepare her federal income tax return. The court imposed the penalty because Qi failed to demonstrate that she acted with reasonable care and in good faith.

The court identified a three-part test for a taxpayer to claim reliance on a tax professional as a defense to negligence:

1. The tax adviser must have been a competent professional with sufficient expertise to justify reliance.
2. The taxpayer must have provided necessary and accurate information to the adviser.
3. The taxpayer must have actually relied in good faith on the adviser's judgment.

The court accepted that the CPA was a competent professional who had sufficient expertise to justify reliance. However, Qi provided no evidence that she supplied the CPA with necessary and accurate information. Qi also failed to demonstrate that her reliance on the CPA was in good faith. While she did not have a good grasp of English, the CPA spoke Chinese.

She had a duty to examine her return to ensure that all income items were included. She conceded that she failed to do so. Although the form itself was in English, Qi read Arabic numerals and did not look at the details on the return before she signed it. She also failed to ask the CPA about the return.

Click here to read the summary of the case.

President Bush recently signed into law the Hubbard Act (H.R. 6580). While basically a nontax law, one provision of the Hubbard Act repeals the contribution limit that applies to qualified funeral trusts.

A qualified funeral trust is taxed as a separate entity, rather than as a grantor trust. As a separate entity, income taxes are paid out of trust assets. The income of a grantor trust is taxed to the grantor, who must fund the tax obligation.

Prior to the new law, which takes effect for trust years beginning after Aug. 29, 2008, a qualified funeral trust could not accept contributions from an individual in excess of $9,000. According to the National Funeral Directors Association, the average cost of a funeral, including cemetery expenses, marker and burial services, is almost $10,000.

Repeal of the contribution cap, which will first apply in 2009 for calendar year trusts, will allow senior citizens to set up funeral trusts without having to report income earned by the trust on their personal income tax returns. 

The IRS announced that it is not too late to obtain an economic stimulus check but that analysis of submissions to date has indicated several common questions and errors that delay receipt of the check.

The most frequent errors are:

• Filing more than one return Failing to properly report qualifying income
• Filing amended returns that increase the economic stimulus amount
• Failing to use your most current address  

The IRS will be issuing checks through December 2008 for returns filed by Oct. 15, 2008. Anyone who failed to file a 2007 return to receive a stimulus check can claim the economic stimulus payment on their 2008 income tax return.
 
If you are still waiting for your rebate, you can check the status of the payment on the IRS Web site, www.irs.gov, by using the "Where's My Economic Stimulus Payment?" tool.
 
Read Information Release 2008-103 here.
 

With the new school year now under way, it's a good time to remind teachers about saving receipts for money spent on supplies used in the classroom. In prior years, eligible educators were able to deduct up to $250 for amounts spent on books, supplies, equipment and software used in the classroom, whether or not they itemized their deductions.

If you have received stock in an insurance company that converted from a mutual insurance company to a stock insurance company, you should be alert to a recent decision of the U. S. Court of Federal Claims. In recent years, many mutual insurance companies decided to convert to stock companies and, in the process, granted existing policyholders shares of stock representing the relative ownership interests they were giving up.

The IRS took the position that there would be no gain from receiving the stock. However, the basis of the stock in the hands of the policyholders would be zero, because the basis was undeterminable. 

It remains to be seen whether the IRS will appeal this decision. However, if you reported a sale of stock received in a demutualization of an insurance company and reported a gain on the sale due to the zero-basis concept, you should consider filing an amended return. Generally, you have three years after filing the original return to file an amended return.

The Tax Court decided that former IRS agent Ralph Thomas Whitecavage was liable for the accuracy-related penalty after the IRS disallowed his losses attributable to his greyhound racing activities. The court determined that the IRS agent did not display a profit-seeking motive in the way he conducted his activities.

Click here to read more. Click here to read the case of Whitecavage v. Commissioner.

Contemporaneous acknowledgment required for charitable contributions

The tax law imposes strict record-keeping requirements to support your charitable contribution deductions. It requires a contemporaneous written acknowledgment for contributions of $250 or more. A written acknowledgment is contemporaneous only if you obtain it on or before the earlier of (1) the date on which you file your return for the year in which the contribution is made or (2) the due date (including extensions) for filing such return.

The acknowledgment must include both the amount contributed and whether the charity provided any goods or services in consideration for the contribution. If the charity provided goods or services, the acknowledgement must also contain a good-faith estimate of their value.

September is a good month to check your withholding. Look at your income and deductions since January, and make a projection of what is going to happen for the rest of the year. Then calculate an estimate of your 2008 tax bill. Compare that to your expected withholding -- the actual amount through the end of August plus your expected withholding for September through December.

If it looks as if you will owe more tax at the end of the year, you won't have to pay the bill until April 15, 2009. But be sure you won't be slapped with an underpayment penalty. The IRS charges a penalty if the amount you owe with your return is more than 10 percent of the total tax for the year. There is no penalty, however, if your total payments during 2008 are greater than your total tax shown on last year's return. If your 2007 adjusted gross income was greater than $150,000, your total payments during 2008 must be at least 110 percent of your 2007 tax.

Your tax adviser can help with all these calculations.

If you need to have more taxes withheld to avoid an underpayment penalty, you can file a new form W-4, Employee's Withholding Allowance Certificate, with your employer.

If your calculation shows that you will be expecting a refund when you file your 2008 return, why wait until 2009 to get your money back? Give your employer a new form W-4 to reduce your withholding and you can have your money sooner. Remember, the IRS doesn't pay interest on overpayment refunds.

The IRS has provided guidance that will allow a child of divorced or separated parents to be treated as a dependent of both parents, for certain tax provisions.

For purposes of the dependency exemption, $3,500 per dependent in 2008, a child of divorced or separated parents is generally treated as a dependent of the parent having custody of the child. The noncustodial parent can claim the exemption only if the custodial parent provides a written declaration that he or she will not claim the child as a dependent for the tax year and the noncustodial parent attaches the declaration to his or her return.

Many other provisions of the tax law that provide for benefits and exclusions attributable to dependents refer to the rules governing the dependency exemption.

Now the IRS has announced that it will treat a child as a dependent of both parents for purposes of several provisions relating to medical expenses, medical coverage and employee benefits, regardless of whether the custodial parent released the claim of the exemption.

Specifically, the IRS will treat a child as a dependent of both parents, without a declaration of the custodial parent, under the following circumstances:

• The exclusion from gross income of certain employer reimbursements of expenses incurred for the medical care of an employee's child.
• The exclusion from gross income of employer contributions to an accident or health plan on behalf of an employee's children.
• The exclusion from gross income of fringe benefits qualifying as no-additional cost services or qualified employee discounts that are treated as used by the employee due to use by an employee's child.
• The deduction of a child’s medical expenses paid by the parent.
• The exclusions for distributions from Archer Medical Savings Accounts and Health Savings Accounts, if the distributions are used to pay qualified medical expenses of the account beneficiary's child.

You may use this guidance to file an amended return to claim a refund of taxes paid in 2005, 2006 or 2007.

Click here to read Revenue Procedure 2008-48.

Investors who experience losses in the stock market are tempted to try to find a way around the $3,000 annual capital loss deduction.

One way around the limitation is to argue that your trading activities have risen to the level of a trade or business. As a trade or business activity, all gains and losses are considered ordinary, rather than capital. This characterization is beneficial for those who incur net losses, but those who experience net long-term gains lose the benefit of the lower tax rate on long-term capital gains.

Generally, you are considered engaged in the trade or business of trading stock if: 

• Your trading activity is substantial.
• You seek to profit from short-term swings in daily market movements.

The IRS has issued guidelines for determining whether an activity is engaged in for profit, such as a business or investment activity, or as a hobby.

Internal Revenue Code Section 183, Activities Not Engaged in for Profit, is sometimes referred to as the “hobby loss rule.”

In general, you may deduct ordinary and necessary expenses for conducting a trade or business or for the production of income. Trade or business activities and activities engaged in for the production of income are activities engaged in for profit.

The following factors, although not all-inclusive, may help you to determine whether your activity is considered an activity engaged in for profit or as a hobby:

If an activity is not engaged in for profit, you may not use losses from that activity to offset other income, and allowable deductions cannot exceed the gross receipts for the activity.

Click here to read IRS Fact Sheet 2008-23.

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If you are healthy and make few trips to the doctor's office, consider funding a tax-deductible health savings account, or HSA. Account earnings and distributions are tax free.

And unused balances may accumulate without limit for future years. Maximum tax-deductible contributions this year are $2,900 for single taxpayer health plans and $5,800 for family plans. An additional $900 contribution is allowed for taxpayers age 55 or older. Unlike other medical costs, contributions to HSAs are deductible even if you do not itemize.

An HSA is an alternative to traditional health insurance. It is a savings product that offers a different way to pay for health care. HSAs enable you to pay for current health expenses and save for future qualified medical and retiree health expenses on a tax-free basis.

In the Housing and Economic Recovery Act of 2008, Congress has offered a new tax break to first-time home buyers. Although it is described as a refundable tax credit, the new provision really amounts to an interest-free loan from the government.

Since the credit is refundable, you can claim the credit even if you owe no income tax. But unlike other tax credits, the first-time home buyer's credit must be paid back. Two years after you claim the credit, you must begin paying it back in equal annual installments over 15 years. If you sell the home before you repay the credit, the entire unpaid balance may become due.

Click here to read more.

The Housing and Economic Recovery Act of 2008 adds a new tax provision that will benefit some homeowners who have low or no mortgage debt.

Normally, only individuals who itemize can deduct real property taxes on their homes. For 2008 only, Congress has authorized an increase in the standard deduction for real property taxes. The maximum increase is $500 ($1,000 on a joint return).

Click here to read more. Click here to read the new amendments to Internal Revenue Code Section 63.

Carl H. Jones III, an electrical engineer, was laid off in 2002. A savvy investor with 35 years experience in the stock market, Jones began day trading in 2002. He spent approximately 6.5 hours a day Monday through Friday reviewing, studying, and executing trades. In order to improve his day trading abilities, Jones signed up for a fiveday one-on-one course that he had read about online. The course was held in Cartersville, Ga., approximately 750 miles from Jones’ home in Florida.

Jones claimed as an itemized deduction $6,053.06 for the course and related expenses, including lodging, travel, food and a course book. The IRS disallowed the deduction.

Jones argued that the course was necessary for him to become a better day trader and to maximize profits and minimize losses on his trading activity. In Jones’ opinion, the cost was an ordinary and necessary expense paid or incurred for the production or collection of income.

The IRS argued that the tax law specifically disallows as a deduction related to the production of income expenses allocable to a convention, seminar or similar meeting.  Jones countered that the course was not a convention, seminar or similar meeting as contemplated by the tax law.

The Tax Court sided with the IRS and denied Jones his deduction, noting that Congress specifically wanted to disallow tax deductions for individuals who attended financial planning seminars at resort locations. The fact that Jones did not engage in any recreational activity while attending the course did not convince the court to allow the deduction.

 Read more about the case of Carl H. Jones III and Rubiela Serrato v. Commissioner, 131 TC --, No. 3, July 28, 2008, here.

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