From a tax perspective, 2009 got off to a fast start. Within two weeks of taking office, President Obama issued an Executive Order establishing the President’s Economic Recovery Advisory Board (“ERAB”) led by Paul Volker, former Federal Reserve Chair under Presidents Carter and Reagan. Modeled on the Foreign Intelligence Advisory Board created by President Dwight D. Eisenhower to provide an independent voice on intelligence issues, the ERAB was tasked with responsibility to, among other things, report directly to the President on the design, implementation, and evaluation of policies to promote the growth of the American economy, establish a stable and sound financial and banking system, create jobs, and improve the long-term prosperity of the American people. Many people also believed that the ERAB would recommend substantive tax law changes, including the possibility of a full rewriting of the Internal Revenue Code as last occurred in 1986.

As in the case of many other well intentioned efforts, the continuing rise in unemployment coupled with the steady decline in consumer optimism stood in the way of any major changes in tax law during 2009. Other than the changes tied to various health care proposals, most of the tax law changes were relatively low-key. In short, 2009 was not a year either Congress or the President chose to add to the uncertainty already being felt by both individuals and businesses. If anything, many of the enacted tax law changes were designed primarily to quickly move money into the hands of individuals and businesses in order to prime the economic pump.

While the federal government ran up a 2009 deficit exceeding $1 trillion, the fiscal pain was not without its other governmental victims. According to a report from the Nelson A. Rockefeller Institute of Government released in late November, preliminary tax collection data for the July-September quarter of 2009 show continued widespread and sharp declines for most states for all three major sources of tax revenue, as well as for overall taxes. In fact, the Rockefeller Institute study shows that tax revenues declined in at least 44 states during 2009. The biggest revenue declines were in corporate income tax revenues (-19.4%) and personal income tax revenues (-11.4%). State sales tax revenues declined 8.2%. The ten states with the biggest tax revenue declines are:

 

1. Alaska	-52.4%
2. Vermont	-31.6%
3. Oklahoma	-28.4%
4. Utah	-20.5%
5. Montana	-20.2%
6. North Dakota	-17.3%
7. Arizona	-16.3%
8. Delaware	-15.7%
9. Louisiana	-14.9%
10. Colorado	-14.1%

Clearly, 2010 will see tax increases across the board at the federal, state and local government levels. It is also likely that 2010 will bring a renewed focus on alternative revenue raisers from carbon taxes to (potentially) a value-added tax. Increasing reliance on property taxes, sales taxes and user fees are also likely as state and local governments dig out of 2009 deficits and look for ways to fund the ever increasing demand for services as well as their rapidly escalating pension costs. In Illinois alone, unfunded pension costs remain the “hidden” time bomb in the state’s ever growing budget deficit.

Heath Care Proposals in the Spotlight

As we approach year-end, the dominant tax law focus is on the revenue raisers required to support the various health care proposals. Both the House Ways and Means Committee and the Senate Finance Committee have voted out of committee proposals not only to radically change the way health care is provided, but also to raise the revenue needed to pay the costs of what is expected to be a $1 trillion program over ten years. The $1 trillion or so expected to be spent on health care over the next 10 years is in addition to the separate 2009 budget deficit, which alone exceeds $1 trillion. As such, the revenue raisers in both health care bills are targeted solely to recovery of health care related costs, and will not contribute in any way to the funding of the current or future federal budget deficits.

The key revenue provisions included in H.R. 3962, the “Affordable Health Care for America Act,” include:

Sec. 551. Surcharge on AGI in excess of $1 million. The bill would impose a 5.4% surcharge on adjusted gross income (AGI) above $1,000,000 (married filing a joint return) and $500,000 (single). This proposal has been estimated to raise $460.5 billion over ten years.

Sec. 552. Excise tax on medical devices. The bill would impose an excise tax on the sale (other than for resale) or lease of medical devices equal to 2.5% of the sales price. The tax is deductible for income tax purposes. Retail sales of devices that are available to the general public, and are of a type (and purchased in a quantity) that is purchased by the general public, sales for export, and sales of devices for use in further manufacturing would be exempt from the excise tax. This proposal has been estimated to raise $20 billion over ten years.

Sec. 553. Expansion of information reporting requirements. Under present law, a taxpayer is required to file an information return if the taxpayer makes aggregate payments of $600 or more to a recipient for services or determinable gains in the course of a trade or business during the calendar year. Notwithstanding this general requirement, taxpayers are not required to file information returns for payments to corporations. The bill would require taxpayers to file an information return for aggregate payments of $600 or more in a calendar year to a corporation. This proposal has been estimated to raise $17.1 billion over ten years.

Sec. 554. Delay implementation of worldwide allocation of interest. In 2004, Congress provided taxpayers with an election to take advantage of a liberalized rule for allocating interest expense between United States sources and foreign sources for purposes of determining a taxpayer’s foreign tax credit limitation. Although enacted in 2004, this election was not available to taxpayers until taxable years beginning after 2008. Last year, the House of Representatives delayed the phase-in of this new liberalized rule for two years (for taxable years beginning after 2010) as part of the Housing and Economic Recovery Act of 2008 (P.L. 108-289). The bill would further delay the phase-in of this new rule for an additional nine years (for taxable years beginning after 2019). This proposal has been estimated to raise $26.1 billion over ten years.

Sec. 561. Limitation on treaty benefits for certain deductible payments. The bill would prevent foreign multinational corporations incorporated in tax haven countries from avoiding tax on income earned in the United States by routing their income through structures in which a United States subsidiary of the foreign multinational corporation makes a deductible payment to a country with which the United States has a tax treaty before ultimately sending these earnings to the tax haven country. This proposal has been estimated to raise $7.5 billion over ten years.

Secs. 562 and 563. Codification of the economic substance doctrine and tax penalties on understatements of income. The economic substance doctrine is a judicial doctrine that has been used by the courts to deny tax benefits when the transaction generating these tax benefits lacks economic substance. The courts have not applied the economic substance doctrine uniformly. The bill would clarify the manner in which the economic substance doctrine should be applied by the courts. However, the bill does not change current-law standards used by courts in determining when to utilize an economic substance analysis. Under the provision, in any case in which the economic substance doctrine is relevant to a transaction, the economic substance doctrine would be satisfied only if (1) the transaction changes in a meaningful way (apart from federal income tax consequences) the taxpayer’s economic position, and (2) the taxpayer has a substantial non-federal tax purpose for entering into such transaction. The provision also imposes a 20% penalty on understatements attributable to a transaction lacking economic substance (penalty increased to 40% in the case of transactions in which the relevant facts affecting the tax treatment of the transaction are not adequately disclosed). This proposal has been estimated to raise $5.7 billion over ten years.

Consistent with the House bill, the Senate bill includes a barrage of higher taxes to pay for the bill’s immense price tag. Also like the House bill, the revenue raisers in the Senate bill are not intended to fund either the 2009 or subsequent fiscal year budget deficits.

The Senate bill includes 17 tax increases designed to raise $370.2 billion in revenues over 10 years. These include:

1. 40% excise tax on health coverage in excess of $8,500/$23,000 ($149.1 billion);
2. Employer W-2 reporting of value of health (negligible revenue effect);
3. Conform definition of medical expenses ($5.0 billion);
4. Increase penalty for nonqualified health savings account distributions to 20% ($1.3 billion);
5. Limit health flexible spending arrangements in cafeteria plans to $2,500 ($14.6 billion);
6. Require information reporting on payments to corporations ($17.1 billion);
7. Additional requirements for section 501(c)(3) hospitals (negligible revenue effects);
8. Impose annual fee on manufacturers & importers of branded drugs ($22.2 billion);
9. Impose annual fee on manufacturers & importers of medical devices ($19.3 billion);
10. Impose annual fee on health insurance providers ($60.4 billion);
11. Study and report of effect on veterans health care (no revenue effect);
12. Eliminate deduction for expenses allocable to Medicare Part D subsidy ($5.4 billion);
13. Raise 7.5% AGI floor on medical expenses deduction to 10% ($15.2 billion);
14. $500,000 deduction limitation on taxable year remuneration to health insurance officials  ($0.6 billion);
15. Additional 0.5% hospital insurance tax on wages > $200,000 ($250,000 joint) ($53.8 billion);
16. Modification of section 833 treatment of certain health organizations ($0.4 billion); and,
17. Impose 5% excise tax on cosmetic surgery ($5.8 billion).

The Obama Administration has also proposed new taxes to finance its health care reform proposal. The potential new taxes in the Administration’s proposal include, among many other things:

1. an income surtax on taxpayers earning more than $500,000 a year;
2. a limit on itemized deductions for taxpayers with a top income tax rate greater than 28 percent;
3. a value-added tax;
4. an increase in the Medicare portion of the payroll tax to 3.4 percent for incomes great than $200,000 a year ($250,000 for married filers);
5. an excise tax on sugar-sweetened beverages including non-diet soda and sports drinks;
6. higher taxes on alcoholic beverages including beer, wine, and spirits;
7. an increase in the payroll taxes on students; and among many other potential revenue raisers; and
8. a $500,000 deduction limitation for the compensation paid by health insurance companies to their officers, employees, and directors.

To be sure, much remains to be done in both the House and Senate before any final health care proposal is passed. In fact, it is entirely possible that the final health care proposal will look very different from the current versions and will have a very different mix of revenue raisers from those already proposed. What is certain is that both individuals and businesses need to prepare for the coming barrage of new taxes directed solely at funding health care beginning in 2010.

Expiring Tax Breaks Waiting in the Wings

As year end approaches, there are a plethora of tax benefits that will expire on December 31, 2009 absent affirmative steps to extend their respective lives. In late November, House Ways and Means Committee Chairman Charles Rangel, D-N.Y., announced his intention to introduce legislation in December that would keep a variety of tax breaks from expiring. Importantly, rather than sending the bill through the Ways and Means Committee, Rangel announced that he will send the bill directly to the full House for consideration. There are approximately 73 tax provisions set to expire by year end, including the credit for research and experimentation expenses, deductions for tuition and state and local taxes, film and TV production expensing rules, a deduction for contributions of food inventory, tax breaks for certain expenses by school teachers, and a myriad of other tax benefits.

The Tax Extenders Act of 2009 would provide individuals and businesses with approximately $30 billion in tax relief in 2009. The $30 billion in tax relief includes more than $5 billion in individual tax relief and more than $17 billion in business tax relief, including, among many other items, the following:

Individual Provisions

1. Extension of the deduction of State and local general sales taxes;
2. Extension of the above-the-line deduction for qualified tuition and related expenses; and
3. Extension of the additional standard deduction for real property taxes.

Business Provisions

1. Extension of the R&D credit;
2. Extension of 15-year straight-line cost recovery for qualified leasehold, restaurant and retail improvements;
3. Extension of expensing of “brownfields” environmental remediation costs; and
4. Extension of employer wage credit for activated military reservists.

Charitable Provisions

1. Extension of provision encouraging contributions of capital gain real property for conversation purposes;
2. Extension of enhanced deduction for corporate contributions of computer equipment for educational purposes;
3. Extension of tax-free distributions from individual retirement account plans of up to $100,000 per taxpayer, per taxable year for charitable purposes; and
4. Extension of special rule for S corporations making charitable contributions of property.

Expiring Community Assistance Programs

1. Extension of tax incentives for Empowerment Zones;
2. Extension of New Markets tax credit for one year; and
3. Extension of tax incentives for Renewal Communities.

NOL Carrybacks For Businesses Large and Small - A Narrow Window of Opportunity

The Worker, Homeownership, and Business Assistance Act of 2009 (the “Act”), as signed into law by President Obama on November 6, 2009, creates a narrow window of opportunity for taxpayers of all sizes with net operating losses to obtain immediate tax refunds. Pursuant to the Act, a taxpayer with a net operating loss (“NOL”) arising in taxable years ending after December 31, 2007 and beginning before January 1, 2010 (generally referred to as an “applicable NOL”), may elect to carry back the NOL for up to five, instead of the usual two, prior taxable years. This temporary expansion of the NOL carry back rules could mean significant tax refunds for taxpayers who have suffered substantial losses in 2008 or 2009.

On November 23, 2009, the Internal Revenue Service released Rev. Proc. 2009-52 prescribing when and how to elect under IRC section 172(b)(1)(H) to carry back an applicable NOL for a period of 3, 4, or 5 years for (1) taxpayers that have not claimed a deduction for an applicable NOL; (2) taxpayers that previously claimed a deduction for an applicable NOL; and (3) taxpayers that previously filed an election under IRC section 172(b)(3) or 810(b)(3) (concerning life insurance companies) to forgo the NOL carry back period.

Taxpayers should consult their tax advisors regarding year-end planning opportunities that optimize their 2009 NOL so they can recoup the optimal amount of taxes paid over the past five taxable years. Taxpayers may need to conduct a multi-year analysis to determine whether the election should be made with respect to an applicable NOL generated in 2008 or 2009, and whether the election should be for a three-, four- or five-year carry back period.

To Roth Or Not To Roth - That Is The Question

One tax topic for which almost every U.S. citizen seems to be aware concerns the issue of Roth IRA conversions. Whether they have heard it from their accountant, lawyer, investment advisor, banker, insurance agent, or even their dentist, everyone seems to know that a traditional IRA can be converted into a Roth IRA beginning January 1, 2010 without a limitation based on modified adjusted gross income.

Traditional IRAs have contained a conversion opportunity since Roth IRAs were initially introduced. However, many people were generally precluded from making the conversion to a Roth IRA if their modified adjusted gross income exceeded $100,000. Beginning January 1, 2010, that ceiling is repealed. As a result, virtually every owner of a traditional IRA will be allowed to convert that account to a Roth IRA.

In general, traditional IRAs provide a current deduction with a delayed tax cost at the time of withdrawal. Roth IRAs, sometimes referred to as tax-prepaid IRAs, do not provide a current deduction, but also do not attract tax at the time of withdrawal. As a result, funds contributed to a Roth IRA are not deducted from the taxpayer’s income as they are contributed. Instead, those funds are excluded from income upon withdrawal from the account, thereby allowing appreciating assets to grow tax-free (in a manner very similar to the tax effect of a Grantor Retained Annuity Trust or GRAT).

Under the new rules, taxpayers will now have an opportunity to move funds from a tax-deferred platform (the general model for traditional IRAs) to a tax-free platform at a comparatively reasonable current tax cost.

There are numerous reasons for making current contributions to a Roth IRA, as well as converting an existing traditional IRA to a Roth IRA. These include, among other things, the suspension of the required mandatory distribution requirement under traditional IRAs at age 70 ½, and the income-tax free status of future Roth IRA distributions to beneficiaries.

Of course, nothing good ever comes without a price, Roth IRA conversions included. Generally, the conversion of a traditional IRA to a Roth IRA is similar in effect to the current withdrawal of funds from the traditional IRA account sans the 10% penalty. A current distribution from a traditional IRA is taxable in full at current rates (although the resulting tax can be paid over two tax years).

In short, a Roth IRA conversion involves trading today’s income tax rates for tomorrow’s tax rates. Moreover, there is no escaping the fact that a Roth IRA conversion accelerates an income tax liability to the year of conversion, which may be too bitter a pill to swallow for too many people.

For those who can afford the upfront tax cost, and for those who believe that future tax rates at the time of withdrawal will be less than current rates, the Roth IRA can be a good investment. In general, for every pre-tax dollar in an existing traditional IRA, its owner, assuming a 30% tax rate, can effectively add $.30 of after-tax funds held outside a tax preferred account to her tax sheltered account. Not a bad investment assuming one has the funds to pay the up-front cost (and those funds should never be derived from the balance in the traditional IRA).

Whether to make a Roth conversion or not is a difficult financial question requiring an analysis of current and expected future tax rates, expected appreciation within the account, and your investment profile, among other things. A discussion with your accountant, attorney, investment advisor, insurance broker, and, yes, perhaps even your dentist, is absolutely required before making the final decision to convert a traditional IRA to a Roth IRA.

The Latest On Home-Buyer Tax Credits

At the end of the week before Thanksgiving, President Obama signed a law that extends through next spring a temporary tax credit of up to $8,000 for some first-time home buyers. The law also adds a new tax credit of up to $6,500 for certain repeat home buyers.

Under the new law, first-time home buyers continue to receive a tax credit of as much as 10% of the purchase price, up to a maximum of $8,000. To qualify as a “first-time” home buyer, the purchaser (including both partners of a married couple) must not have owned a principal residence for the three years prior to the current purchase. The new home must also be the taxpayer’s principal residence for the next three consecutive years.

Unlike many tax credits, the first-time home buyer credit is refundable, which means that taxpayers will receive a refund for each dollar that exceeds the total amount of tax due. In other words, if a taxpayer only owes $5,000 in tax, the taxpayer could potentially receive a $3,000 cash refund (assuming all of the applicable requirements are satisfied). As under the original program, credits do not apply with respect to purchases from a lineal ancestor or descendant, which means a parent can still sell her home to her daughter, but her daughter will not qualify for the $8,000 credit.

There are some differences between the old law and the new law that are worth noting. Under the new law, a sales contract must be signed before May 1, 2010 and the sale must close prior to July 1, 2010. Unlike the earlier program, there is now a sales price ceiling. Specifically, for all purchases made after November 6, 2009, no credit is available for a home selling for more than $800,000.

As mentioned above, the new law encourages repeat home buyers to participate in the program, but limits the credit to a maximum of $6,500. For repeat home buyers to qualify, they must have lived in one residence for five consecutive years out of the past eight. There is also no requirement that the new home price exceed the cost of the old home.

As most people expected, the former home buyer credit was riddled with fraud. To combat those who would abuse the new program, the new law contains various anti-abuse measures. For example, buyers must generally be 18 or older, and no taxpayer may take a credit if he or she is claimed as a dependent on someone else’s return. Taxpayers taking the credit will also have to furnish proof of purchase, which will likely be a HUD-1 form.

Late Breaking Illinois Development of Interest Regarding Pass-Through Entities

It is our understanding that the Illinois General Assembly, by vote late in the Fall Session, has passed a bill restoring the ability of a partnership or LLC (taxed as a partnership) to deduct reasonable compensation paid to partners for services in determining Personal Property Replacement Tax.

We generally understand that the Governor is prepared to sign the Act, which essentially repeals the earlier law eliminating the subtraction modification. However, as of the date this newsletter goes to press, there is no word on whether the change will become effective for 2009. Considering the large number of taxpayers affected by both the earlier change in law and its repeal, we suggest that you contact your BWMS tax advisor as soon as possible for guidance.

Richard L. Lieberman may be reached at 312/840-7011 or rlieberman@burkelaw.com.

Circular 230 Disclosure:  Any tax advice contained in this newsletter was not intended or written to be used, and cannot be used (i) by any taxpayer for the purpose of avoiding any penalties that may be imposed on the taxpayer, or (ii) to promote, market or recommend to another party any transaction or matter addressed herein.