Authors: George Mentz and Professor William Byrnes

The Internal Revenue Service announced late in June an increase in the optional standard mileage rates for the final six months of 2011.[1] Generally, taxpayers may use the optional standard rates to calculate the deductible costs of operating an automobile for trade or business and other purposes. The rate will increase to 55.5 cents a mile for all business miles driven from July 1, 2011, through Dec. 31, 2011. This is an increase of 4.5 cents from the 51 cent rate in effect for the first six months of 2011. [2]

The IRS states that “In recognition of recent gasoline price increases, it has made this special adjustment for the final months of 2011.” But the prices of gas hit a high in the first six months of 2011, as shown below.

The IRS normally updates the mileage rates once a year in the fall for the next calendar year. “This year’s increased gas prices are having a major impact on individual Americans. The IRS is adjusting the standard mileage rates to better reflect the recent increase in gas prices,” said IRS Commissioner Doug Shulman. “We are taking this step so the reimbursement rate will be fair to taxpayers.”

While gasoline is a significant factor in the mileage figure, other items enter into the calculation of mileage rates, such as depreciation and insurance and other fixed and variable costs.

The optional business standard mileage rate is used to compute the deductible costs of operating an automobile for business use in lieu of tracking actual costs. This rate is also used as a benchmark by the federal government and many businesses to reimburse their employees for mileage. The new six-month rate for computing deductible medical or moving expenses will also increase by 4.5 cents to 23.5 cents a mile, up from 19 cents for the first six months of 2011. The rate for providing services for charitable organizations is set by statute, not the IRS, and remains at 14 cents a mile.

Taxpayers under most circumstances will also still retain the option of calculating the actual costs of using their vehicle rather than using the standard mileage rates. The Market prices show however that the increased mileage rate may have come too late. As of June 24^th, August 2011 reformulated gasoline blendstock for oxygenate blending  (RBOB) contracts on the Chicago Mercantile Exchange have reached the lowest point since February of this year at 2.7394 a gallon. Prices hit a high in May reaching 3.30 a gallon.

Gasoline prices increased since the beginning of the year but rose sharply from March through the end of April into May but have now come back to pre-march levels. Increases in the crack spread (crude spot price minus conventional gasoline spot price) were seen over this time period. Commentators have attributed this result to downstream supply disruptions including unplanned refinery outages and concerns over flooding.

Does Washington know something the market doesn’t? Why have prices seemingly decreased but the Treasury is now increasing the mileage deduction? Or could this just be the Treasury’s way of compensating those who were negatively affected by high prices earlier in the year? Either way most taxpayers are not complaining.

Overall, the authors wonders how much more the public can handle in the form of energy taxation. Right now, energy is taxed at the state, federal and city levels.  If you don’t believe me, check out your electric bill, your natural gas bill, your gasoline bills, and even your heating oil bill.  [3] In January 2011, Federal Government  taxation on motor gasoline averaged 48.1 cents per gallon and diesel fuel taxes averaged 53.1 cents per gallon. [4]

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

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[1] See IR-2011-69.

[2] See Revenue Procedure 2010-51.

[3] Gas Taxes http://www.gaspricewatch.com/usgastaxes.asp

[4] Fueling America http://www.nacsonline.com/NACS/Resources/campaigns/GasPrices_2011/Pages/StatisticsDefinitions.aspx

Short-term gains carry an additional 20% tax cost over long-term gains, motivating the manufacturing of transactions designed to convert short-term to long-term gains. But as you’d expect, these transactions attract undue attention from the IRS and are often disregarded by the Service. The IRS recently considered the tax treatment of one of these gain-recharacterization schemes, a basket option contract, in a generic legal advice memorandum (AM 2010-005).

The IRS recharacterized the contract, viewing it as if the investor purchased the securities in a margin account, paying cash equal to 10% of the value of the securities and borrowing 90% of the value from the investment bank. Just as was the case with the “option,” the investor had almost total control over investment of the securities and would reap all appreciation and income from the securities, less interest and brokerage fees.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For in-depth analysis of options, see Advisor’s Main Library: G—Options and Futures.

Why is This Topic Important to Wealth Managers? This blogticle discusses the new PTIN which may apply to some wealth managers who also file client tax returns.

Prior to January 1, 2011, any individual generally was allowed to prepare a tax return or claim for refund in exchange for compensation. An individual who prepares and signs a taxpayer’s return or claim for refund as the preparer may also generally represent that taxpayer during an examination of the taxable period covered by that return or claim for refund.

As part of its new oversight program of the nation’s tax return preparation industry, the Internal Revenue Service earlier this week announced it will send letters to approximately 100,000 tax return preparers who prepared returns in 2011 but failed to follow new requirements.

In 2010, the IRS launched an initiative to increase its oversight of the tax return preparation industry and regulate the conduct of tax return preparers. All paid tax return preparers must obtain a Preparer Tax Identification Number (PTIN) and, when required to do so, sign their names and include their PTINs on the returns and refund claims they prepare for compensation.

Starting July 7, 2011, the IRS began sending letters to about 100,000 tax return preparers who either used outdated PTINs or used social security numbers as identifying numbers on returns they prepared this filing season. The letters explain the new oversight program, inform preparers of how to register for a new PTIN, or renew an old PTIN, and where to get assistance.

“The vast majority of federal tax return preparers complied with the rules. Obviously, some preparers did not get the word, so these letters provide additional information so they can register as soon as possible,” said IRS Commissioner Doug Shulman. “We owe it to the compliant tax preparers to make sure that everyone is on a level playing field.”

The IRS launched its PTIN registration program last fall. Since then, about 712,000 tax preparers have registered and obtained PTINs. Paid preparers who are not Certified Public Accountants, attorneys or Enrolled Agents, have additional requirements to pass a competency exam and suitability check, which are expected to start this fall, and complete 15 hours of continuing education credits annually, which will start in 2012.

Some unscrupulous preparers may attempt to elude the new oversight program by not signing returns they prepare. Taxpayers should never use tax return preparers who refuse to sign returns and enter PTINs.

In an effort to identify these “ghost preparers,” the IRS later this year also will send letters to taxpayers who appear to have had assistance with their returns but lack tax return preparer signatures. The letter will inform taxpayers how to file a complaint against preparers who failed to sign returns and explain how to choose legitimate tax preparers. The goal of the letters is to protect taxpayers by ensuring that all paid federal tax return preparers are registered with the IRS, and sign tax returns they prepare and use an identifying number when required to do so.

Compliance is a central part of the new tax return preparer initiative and the letters are one step in an ongoing compliance effort to ensure tax return preparers are following the new regulations. The IRS also is working to identify tax return preparers who make repeated errors and IRS personnel have had face-to-face meetings with thousands of these tax return preparers over the past two.

Tomorrow’s blogticle will discuss issues related to wealth management techniques.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

Why is This Topic Important to Wealth Managers? This blogticle discusses the proper treatment of a partial exchange of an annuity contract for tax purposes. The information presented herein is useful for those wealth managers considering a tax-free exchange of annuities under Section 1035 for their clients.

The Internal Revenue Service recently released a revenue procedure addressing the tax treatment of certain tax-free exchanges of annuity contracts under Sections 72 and 1035 of the Internal Revenue Code. [1]

Generally, the Code provides that no gain or loss shall be recognized on the exchange of an annuity contract for another annuity contract. [2] The legislative history of IRC Section 1035 states that exchange treatment is appropriate for “individuals who have merely exchanged one insurance policy for another better suited to their needs.” [3]

The Income Tax Regulations provide that the exchange, without recognition of gain or loss, of an annuity contract for another annuity contract under IRC Section1035(a)(3) is limited to cases where the same person or persons are the obligee or obligees (beneficiary or beneficiaries) under the contract received in the exchange as under the original contract. [4]

If, in addition to an annuity contract, a taxpayer receives other property or money in exchange for a second annuity contract, then gain (if any) is recognized to the extent of the sum of money and the fair market value of other property received, but loss (if any) is not recognized to any extent. [5]

The Tax Court has held that the direct exchange by an insurance company of a portion of an existing annuity contract to an unrelated insurance company for a new annuity contract was a tax-free exchange under IRC Section 1035.  [6] Such a transaction is sometimes referred to as a “partial exchange.”

Notwithstanding, the IRS has determined that the receipt of a check under a nonqualified annuity contract and endorsement of the check to a second company as consideration for a second annuity contract treated as a taxable distribution rather than as a tax-free exchange under IRC Section 1035. [7]

Generally, Rev. Proc. 2008-24 set forth circumstances under which a direct transfer of a portion of the cash surrender value of an existing annuity contract for a second annuity contract would be treated as a tax-free exchange under IRC Section 1035. Under the revenue procedure, a transfer was treated as a tax-free exchange if no amount was withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 12 months beginning on the date of the transfer, or if the taxpayer demonstrated that one of the conditions described by IRC Sections 72(q)(2)(A)-(J) or any similar life event “occurred between” the date of the transfer and the date of the withdrawal or surrender.

Revenue Procedure 2011-38, in sum amends Revenue Procedure 2008-24, and recognizes that generally a partial exchange (usually of cash value) of an annuity contract for another annuity contract is treated as a tax-free exchange under section 1035 if no amount is withdrawn from, or received in surrender of, either of the contracts involved in the exchange during the 180 days beginning on the date of the transfer.

Tomorrow’s blogticle will discuss additional tax issues relating to life insurance and annuities.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

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[1] See Revenue Procedure 2011-38.

[2] IRC Section 1035(a)(3).

[3] H.R. Rep. No. 1337, 83d Cong., 2d Sess. 81 (1954).

[4] Treas. Regs. Section 1.1035-1 of the Income Tax Regulations

[5] Section 1035(d)(1) (cross referencing § 1031(b) and (c)); § 1.1031(b)-1(a); § 1031(c)-1.

[6] Conway v. Commissioner, 111 T.C. 350 (1998), acq., 1999-2 C.B. xvi.

[7] See Rev. Rul. 2007-24, 2007-21 I.R.B. 1282.

In a merciful move, the Treasury has again extended the FBAR filing deadline for persons with only signature authority over a foreign financial account to November 1, 2011. [Notice 2011-54]. Two previous extensions had pushed the FBAR due date to June 30, 2011, but the Financial Crimes Enforcement Network (FinCEN) and the IRS recognized the difficulty signatories were having locating the information they needed to complete the form.

Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), must be filed annually by all U.S. citizens, residents, business entities, trusts, and estates with a financial interest in or signature authority over one or more foreign financial accounts (FFA) with an aggregate value greater than $10,000.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of the FBAR in Advisor’s Journal, see Do Your Clients’ International Assets Create Criminal Tax Exposure? (CC 11-73) & IRS Provides FBAR Answers (CC 11-119).

Why is This Topic Important to Wealth Managers? Today we discuss one issue that is a concern to most taxpayers. The Tax Gap—The difference between the amount of taxes due and those actually paid. The blogticle provides information and facts which makes for interesting discussion among wealth managers and clients.

The Government Accountability Office (GAO) recently released a report on the tax gap and taxpayer compliance and complexity. The report summarizes that the tax code compliance issues caused by complexity resulted in an increase to the overall tax gap.

It is no surprise that the federal tax system contains complex rules. These rules may be necessary, for example, to ensure proper measurement of income, target benefits to specific taxpayers, and address areas of noncompliance. However, these complex rules also impose a wide range of recordkeeping, planning, computational, and filing requirements upon businesses and individuals.

It has been shown in the past and is also no secret that complying with these requirements costs taxpayers time and money. In 2005 GAO reported that even using the lowest available compliance cost estimates for the personal and corporate income tax, combined compliance costs would total $107 billion (roughly 1 percent of gross domestic product) per year; other studies estimate costs 1.5 times as large. In addition, economic efficiency costs, which are reductions in economic well-being caused by changes in behavior due to taxes, are estimated to be even larger.

Although many taxpayers have simple forms of income, others do not—especially those who receive income from capital gains, rents, self-employment, international and other sources—and they may be required to do complicated calculations and keep detailed records.

Tax expenditures add to tax code complexity in part because they require taxpayers to learn about, determine their eligibility for, and choose between tax expenditures that have similar purposes. Tax expenditures also complicate tax planning because taxpayers must “predict” their own future circumstances as well as future tax rules to make the best choice among provisions.

Taxpayer errors also contribute to the tax gap. For example, in 2001 taxpayers underreported $6.3 billion in net income due to misreported Individual Retirement Arrangement (IRA) distributions. In addition, taxpayers may underclaim benefits to which they are entitled. According to GAO’s past  analysis, of tax filers who appeared to be eligible for a higher-education tax  credit or tuition deduction in tax year 2005, about 19 percent, representing  about 412,000 returns, failed to claim any of them.

The Internal Revenue Service (IRS) has estimated that the gross tax gap—the difference between taxes owed and taxes paid on time—was $345 billion in 2001.

The gross tax gap is an estimate of the difference between the taxes—including individual income, corporate income, employment, estate, and excise taxes—that should have been paid voluntarily and on time and what was actually paid for a specific year.

Of the estimated $345 billion tax gap for tax year 2001, IRS estimated that it would eventually recover about $55 billion of that through late payments and enforcement actions, for a net tax gap of $290 billion.

The estimate is an aggregate of estimates for the three primary types of noncompliance: (1) underreporting of tax liabilities on tax returns; (2) underpayment of taxes due from filed returns; and (3) nonfiling, which refers to the failure to file a required tax return altogether or on time.

Tomorrow’s blogticle will discuss issues related to life insurance.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

The Foreign Account Tax Compliance Act (FATCA) was enacted as a comprehensive measure to combat offshore tax evasion—a noble enough goal. But FATCA’s comprehensiveness is also a sore point for many in the financial services industry, especially insurance carriers and producers. In comments to regulators, one foreign life insurance trade organization, the Association of International Life Offices (AILO), recently called FATCA’s requirements “onerous and disproportionate to the risk involved.”

Passed as part of H.R. 2847, the Hiring Incentives to Restore Employment Act (HIRE Act) on March 18, 2010, FATCA combats tax evasion by requiring disclosure from foreign institutions about accounts held by individuals, including U.S. citizens, and institutions that may be subject to U.S. tax. Many life insurance and annuity contracts are considered “accounts” under the Act, although FATCA doesn’t generally apply to property, casualty, and term life insurance contracts.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of FATCA in Advisor’s Journal, see IRS Proposed FATCA Guidance Expands Offshore Compliance Initiatives (CC 10-52) & Offshore’s Limited Shelf Life (CC 10-47).

Why is This Topic Important to Wealth Managers? This blogticle discusses one area that is well known to many wealth managers. However, this reexamination of a topic is designed to provide a refresher to wealth managers. Here we discuss the three year bring-back rule.

With certain exceptions, there is a general rule with respect to estates which requires that any property transferred by gift within three years prior to the transferor’s death has to be included in the gross estate of the deceased transferor, at its date-of-death value (even though the transferor may have had no ownership interest or retained rights of any kind when she died). [1] This rule is sometimes referred to as the “three year rule” or the “bring-back rule”.

The 3-year “bring-back” rule is applicable with respect to dispositions of retained interests in property which otherwise would have been includable in the gross estate.[2] All of these sections involve transfers of property as to which the transferor retained some form of continuing interest or right, which, if still retained when the transferor dies, is deemed sufficient to require the inclusion of the property in the gross estate of the transferor:

• §2036 -  Transfers with certain life interests retained
• §2037 -  Transfers with a reversionary interest retained
• §2038 -  Transfers with a right retained to alter, amend or revoke the transferee’s beneficial interest
• §2042 -  Transfers of life insurance policies with an incident of ownership retained

Under I.R.C §2035, if an insured individual transfers an insurance policy to a trust or another individual, even though the insured may no longer retain any incidents of ownership, if he dies within the 3-year period following the transfer, the entire policy proceeds will be includable in the insured’s gross estate, effectively defeating the major objective of the having the death benefits payable outside the estate.

For the most part, this problem can be eliminated by establishing a trust with a new policy (i.e., never owned by the insured). This, of course, may not be a viable alternative when an existing policy is involved. While consideration might be given to cancellation of an existing policy and replacement with a new one, such a course of action should be based more upon the non-tax aspects of a policy change (e.g., premium costs, contractual terms, quality of carrier, etc.) than purely the tax risk of §2035, the 3-year bring back rule.

In situations where a decision is made to establish an irrevocable life insurance trust with a policy to be newly issued, the §2035 problem (the 3-year rule) can usually be avoided by simply having the policy applied for by, and initially issued to, the trust as owner. If this is properly accomplished, the insurance proceeds will not be includable in the insured’s gross estate even if he should have the misfortune of living less than three years thereafter.

The critical factor in assuring the inapplicability of I.R.C. §2035 (the 3-year rule) is that the grantor/insured not have possessed at any time anything that might be deemed an incident of ownership with respect to the policy.

Generally it is the IRS’ position that reapplication by third party owner after decedent initially applied for the insurance within three years of death does not present a three year rule problem. Central to the position is the notion that an application for insurance (as long as money is not submitted with the application) is only an offer to contract. There being no contract between the parties, decedent never held any incidents of ownership.[3]

Tomorrow’s blogticle will continue to discuss issues surrounding wealth management.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

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[1] I.R.C. §2035.

[2] For example, under I.R.C. §§ 2036, 2037, 2038, or 2042.

[3] See Technical Advice Memorandum (TAM) 9323002.

Why is This Topic Important to Wealth Managers? Today’s blogticle is presented as part of our casual Friday series. Here we present interesting topics that may or may not be directly related to wealth management but have some interesting element worth discussing with this audience. Our discussion in this blogticle focuses on the patentability of tax motivated transactions and strategies.

On Thursday, Congress passed by a vote of 304-117, the America Invests Act (H.R. 1249). One particular provision of the law addresses concerns relating to patenting tax transactions. The proposed law states under Section 14 that for purposes of evaluating an invention for patent issuance purposes, any strategy for reducing, avoiding, or deferring tax liability, shall be deemed insufficient to differentiate a claimed invention from the prior art.  In other words, the score may finally be settled as to whether or not tax motivated transaction can be patented under U.S. law.  As one commentator notes, it “looks as though the time has come for comprehensive patent reform, which includes the banning of tax strategy patents.” [1]

For purposes of the new law the term ‘‘tax liability’’ generally refers to any liability for a tax under any Federal, State, or local law, or the law of any foreign jurisdiction, including any statute, rule, regulation, or ordinance that levies, imposes, or assesses such tax liability.

The patenting of tax motivated transactions as type of business method has been the topic of discussion “ever since the Federal Circuit Court of Appeals determined that business methods could be patented in State St. Bank & Trust v. Signature Fin. Group.” [2] Since then, the Journal of Accountancy Reports “the U.S. Patent and Trademark Office has granted approximately 140 patents on tax strategies.” [3]

Some professional trade associations such as the AICPA have opposed the issuance of tax motivated transaction patents. The AICPA has in the past noted is discontent with the issuing of such patents. Reasons for some of the concerns are that these patents:

• Limit taxpayers’ ability to use fully tax law interpretations intended by Congress;
• May cause some taxpayers to pay more tax than Congress intended or more than others similarly situated;
• Complicates the provision of tax advice by professionals;
• Hinder compliance by taxpayers;
• Mislead taxpayers into believing that a patented strategy is valid under the tax law; and
• Preclude tax professionals from challenging the validity of a patented strategy. [4]

A similar version of the bill with the same name has already been passed in the Senate in March. [5] Now the two houses will work together to reconcile the provisions so that an acceptable version could be signed into law by the White House.

Next week’s bloticles will discuss tools being used by professionals this year related to wealth management.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

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[1] Rodger Russell. Accounting Today. “AICPA Opposes Grandfathering of Pending Tax Strategy Patents”. June 24, 2011. http://www.accountingtoday.com/news/AICPA-Opposes-Grandfathering-Pending-Tax-Strategy-Patents-58943-1.html. Last Accessed 6/24/2011.

[2] Id.; State St. Bank & Trust v. Signature Fin. Group 149 F.3d 1368 (Fed. Cir. 1998).

[3] See Journal of Accountancy. “House Passes Bill With Tax Patent Provision, Sends Back to Senate.” June 23, 2011. http://www.journalofaccountancy.com/Web/20114248.htm. Last Accessed 6/24/2011.

[4] Id.

[5] See generally, Tax Analysts. “House Approves Bill Banning Tax Strategy Patents”. 2011 TNT 122-3. June 24, 2011, Citing S. 23.

Life insurance policy loans can generally be taken without income tax consequences, but there are circumstances where a “loan” is immediately taxable. We’ve covered situations where a policy is surrendered with a loan outstanding, resulting in taxable income. This article discusses another case where a policy “loan” will be treated as taxable income.

In Frederick D. Todd II et ux. v. Commissioner (T.C. Memo. 2011-123), the Tax Court considered whether a distribution from a welfare benefit fund to a fund participant was a policy loan or a taxable distribution.

For previous coverage of life insurance policies held by welfare benefit funds in Advisor’s Journal, see Deductions for Life Insurance Premium Payments to Welfare Benefit Plan Denied (CC 10-29).

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For in-depth analysis of welfare benefit funds, see Advisor’s Main Library: B—Welfare Benefit Funds.