Moore Colson :: News & Resource Center

Uncertainty principles
Accounting for income taxes under FIN 48

To anyone familiar with the Internal Revenue Code, it may seem that the gray areas outnumber the black and white ones. In many cases, you can’t be certain that a tax position you take on your company’s tax return will be accepted by the IRS or the courts.

Last year, the Financial Accounting Standards Board (FASB) issued controversial new guidelines on the treatment of uncertain tax positions for financial statement purposes. FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, applies for fiscal years beginning after Dec. 15, 2006. It applies to public and private companies that prepare financial statements in accordance with Generally Accepted Accounting Principles (GAAP).

Affected organizations will need to review their tax positions, evaluate the level of uncertainty and account for any uncertainty in their financial statements.

A two-step process

Evaluating a tax position under FIN 48 involves two steps. First, determine whether it’s more likely than not that the position would be sustained — based on its technical merits — by the IRS or a state taxing authority (including any appeals or litigation).

If a position fails this test, you can’t recognize any related tax benefits in your financial statements. When you evaluate a position on its merits, assume that it’ll be examined by the taxing authority with full knowledge of all relevant information.

The second step, for positions that meet the more-likely-than-not test, is to determine the portion of the tax benefit to recognize in your financial statements. Under FIN 48, that means “the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority.”

For example, let’s say XYZ Industries takes a position on its federal income tax return that generates a $100,000 benefit. Although there is limited information about how the IRS and the courts will view the position, XYZ management is confident the position meets the more-likely-than-not standard. At the same time, the company likely will settle for less than the full amount on examination.

XYZ estimates the possible outcomes:

Because $75,000 is the largest amount with a greater-than-50% chance of being realized on ultimate settlement, the company recognizes a $75,000 tax benefit in its financial statements.

It’s important to understand that, even though recognition is based strictly on a position’s technical merits, the measurement process takes into account more practical considerations, such as the amount a party would settle for to avoid going to court.

After your initial determination, monitor tax positions and revise your financial statements as needed to reflect changes in the law or your circumstances. You might derecognize a tax benefit in light of an unfavorable court ruling, for example, or identify a previously unrecognized benefit after the statute of limitations period for an audit expires.

A road map for the IRS?

Some taxpayers fear that FIN 48 will provide taxing authorities with a road map to questionable tax positions. FASB dismissed this concern, noting that the guidelines require disclosures of only aggregate amounts, without details about specific tax positions or jurisdictions. Still, even aggregate amounts can raise red flags that may invite further investigation.

Become familiar with FIN 48

FIN 48 is complex, but if your company — whether it’s public or private — prepares financial statements in accordance with GAAP, it’s advisable to consult your tax advisor to learn how it affects you.

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Tax tips

Production numbers

The IRS recently issued guidelines for using statistical sampling methods to calculate the Internal Revenue Code Section 199 “manufacturers’ deduction.” Sec. 199 generally allows qualifying companies to deduct a specified percentage (currently 6%) of their income from qualifying production activities.

Income eligible for the deduction generally includes a company’s domestic production gross receipts (DPGR) from qualifying production activities less the cost of goods sold allocable to those receipts. Under the new guidelines, a company may be able to use statistical sampling to allocate income and costs for purposes of Sec. 199 if other methods would be unduly expensive or time-consuming and certain other requirements are met.

When education costs may qualify as a medical expense

IRS letter ruling 200521003 may offer some tax relief to parents of physically or mentally disabled children. The ruling allowed a married couple to claim a medical expense deduction for their two learning-disabled children’s special education tuition.

Normally, educational costs aren’t considered medical expenses. In this case, the key to qualifying for the deduction was: 1) The education was designed to treat a medical condition, and 2) Medical care was the principal reason for attending the institution.

Keep in mind that a letter ruling applies only to the taxpayer who requests it and doesn’t serve as binding precedent in other cases. But it does reflect the IRS’s thinking on the issue.

Turning up the HEET

Families looking to transfer significant amounts of wealth at a minimal tax cost are increasingly turning to health and education exclusion trusts (HEETs). A HEET is a dynasty trust that benefits your children, grandchildren and future generations.

Contributions to the trust are taxable gifts, but Crummey trust provisions may enable you to use your annual gift tax exclusion (currently $12,000) to minimize or eliminate the tax without dipping into your $1 million lifetime gift tax exemption. Trust assets are removed from your estate and, best of all, a properly structured HEET avoids generation-skipping transfer (GST) taxes without using any of your $2 million GST exemption. The key is to grant a “significant” interest in the trust to a charitable beneficiary.

A HEET can make tax-free distributions only to pay tuition and unreimbursed medical expenses on behalf of your beneficiaries. Payments must be made directly to the educational institution or medical provider.

Any type of trust can be costly to establish and maintain, but the results can make it worthwhile.

A capital idea

For most investors, the 15% reduced tax rate on long-term capital gains and qualified dividends provides welcome relief from ordinary income tax rates as high as 35%. But in some cases, there may be an advantage to electing the higher tax rate.

Why would anyone in his or her right mind do that? The answer lies in the tax code provision that limits your deduction of investment interest to your investment income. Disallowed deductions can be carried forward to future years. But some investors have more investment interest than they’ll realistically be able to deduct in the future or will benefit by claiming the deduction sooner.

In these situations, you can elect to treat capital gains and dividends as investment income by forgoing the reduced tax rate. Then you can offset that income with unused investment interest deductions.

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Shopping for tax savings

As the holiday season approaches, your thoughts may naturally turn to giving. Without some planning, though, you could inadvertently add the IRS to your gift list. It’s easy to overlook year end tax planning, especially if you expect a refund next April. But, if you’re like most people, income taxes are one of your largest annual expenses, so it pays to review ways to reduce your bill. Let’s look at a few strategies, including shifting income, examining your stock portfolio and reviewing the alternative minimum tax (AMT).

Look at the big picture

To plan effectively, it’s important to look beyond this year and to consider your overall tax picture for multiple years. For example, begin by projecting your income, deductions and tax liabilities for 2007 and 2008 and beyond, if possible. You may have opportunities to shift income and deductions between tax years to minimize your overall tax burden for that period.

As you weigh your options, factor in the time value of money — the principle that a dollar you have today is worth more than a dollar you receive later. So, as you contemplate strategies that involve deferring income or accelerating expenses, be sure to weigh the tax savings against lost earnings on the money you’re forgoing.

Play the margins

The right strategy depends in large part on your projected marginal tax rate for each year. As a general rule, you should shift income, if possible, into a year when your marginal rate is lower. And, in most cases, deductible expenses are more valuable when your marginal rate is higher. If your marginal rate remains the same from year to year, it’s generally best to defer income or accelerate deductible expenses.

There are many ways to shift income and expenses between tax years. You can accelerate deductions, for example, by paying property taxes early. One of the best ways to defer income is to make a contribution to an IRA or employer-provided retirement plan. Many plans allow you to make a contribution for 2007 as late as the 2008 income tax filing deadline.

Keep in mind that most itemized deductions are reduced once your income reaches a certain level, and this can affect your marginal rate. If your income exceeds the threshold — currently $156,400 for single taxpayers, married taxpayers filing jointly, heads of households, and widows and widowers, and $78,200 for married taxpayers filing separately — you must subtract from your total itemized deductions the lesser of: 1) 3% of the adjusted gross income (AGI) exceeding the threshold, or 2) 80% of total allowable itemized deductions.

For 2007, the 3% limitation is reduced by one-third of the calculated amount; for 2008 and 2009, the 3% limitation is reduced by two-thirds.

The reduction doesn’t apply to deductions for:

• Investment interest,

• Medical expenses,

• Casualty and theft losses, or

• Gambling losses.

Another potential strategy is “bunching” certain deductions into one year. Medical expenses, for instance, are deductible only to the extent they exceed 7.5% of your AGI. And miscellaneous itemized deductions, such as unreimbursed employee business expenses, investment expenses and tax-preparation fees, are deductible only to the extent they exceed 2% of your AGI. By shifting expenses into one tax year — when feasible — you can maximize the deductions.

Take stock of your investments

Review your investment portfolio and consider selling some of the poorer-performing assets to offset capital gains you’ve recognized this year from asset sales or mutual fund distributions. Remember, you can use net capital losses to offset up to $3,000 of ordinary income, and you can carry over unused losses indefinitely to offset gains — and up to $3,000 of ordinary income annually — in future years.

If you sell publicly traded stocks at a gain, you may be able to avoid some or all of the capital gains taxes, which are subject to limitations, by rolling over the proceeds (within 60 days) into a specialized small business investment company (SSBIC). SBICs are private companies licensed by the U.S. Small Business Administration (SBA) to make loans to qualifying small businesses with SBA assistance. An SSBIC is an SBIC that makes loans to companies run by socially or economically disadvantaged people.

If you plan to contribute to charity this year, think about donating appreciated stock or other securities. Subject to certain limitations, you can take a charitable tax deduction for the stock’s full fair market value while avoiding capital gains taxes on the appreciation.

But if you’re thinking about donating stock that’s declined in value, you’re likely better off selling the stock and donating the proceeds to charity. That way you can take a deduction for both the capital loss and the charitable donation.

Keep the AMT to a minimum

Every year, the AMT ensnares more middle-income taxpayers, which requires them to pay regular tax or the AMT, whichever is higher.
For years, lawmakers have been considering legislation that would soften the effects of AMT on middle-income taxpayers. But Congress has favored short-term patches over permanent reform. Last year, for example, the AMT exemption was increased to $62,550 for joint filers, $42,500 for individuals and $31,275 for married individuals filing separately. This year, absent new legislation, the exemptions will drop back to their previous levels of $45,000, $33,750 and $22,500, respectively.

Stay tuned

These strategies are just a few examples of the many moves you can make before year end to cut your tax bill. Talk with your tax advisor to develop a strategy that’s right for you, and keep an eye on Congress to monitor tax legislation that may affect your strategies.

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Limited partnerships?
Estate planning opportunities for unmarried couples

Estate planning is important for all families, but for unmarried couples it’s an absolute necessity. If you’re married and you die without a will or living trust, your state’s succession laws will provide for your wealth to be divided among your surviving spouse, children or other family members. But if you’re unmarried and wish to leave assets to a life partner, you must have a plan.

Marital benefits

Marriage offers several estate planning advantages. One of the most important is the marital deduction, which allows spouses to make unlimited tax-free gifts to each other. Therefore, many estate planning strategies for married couples focus on leveraging this deduction.

To overcome this disadvantage, unmarried couples should begin planning early to take advantage of their annual gift tax exclusions and $1 million lifetime gift tax exemptions. Keep in mind that one partner’s payment of the couple’s living expenses may be considered a taxable gift.

Another advantage of marriage is the ability, in many states, to own property as tenants by the entirety. This form of ownership is similar to a joint tenancy, but offers additional asset protection benefits. For example, the property is protected against claims by an individual spouse’s creditors.

Unmarried partners can hold property as joint tenants with survivorship rights. This ensures that, when one partner dies, ownership automatically passes to the survivor. The disadvantage is that, once you transfer title, it can’t be undone. For this reason, a will or living trust is a more effective estate planning vehicle.

In some states, registered domestic partners can obtain certain benefits, but the laws typically provide little or no assistance when it comes to federal estate and gift tax rules.

In sickness and in health

Spouses generally can make health care decisions for each other without a medical directive or health care power of attorney, though it’s still a good idea to have one to make your wishes clear.

However, an unmarried person without such documentation typically has no right to participate in the health care of a partner who becomes incapacitated because of an injury or illness. In most states, an unmarried life partner has the same legal status as a complete stranger.

Unmarried couples should also have a durable power of attorney, which allows one partner to manage the other’s assets in the event he or she becomes incapacitated due to an injury or illness.

Building trust

A trust is one of the most effective and flexible tools available for passing your wealth to your loved ones. And in the case of one type of trust — the grantor retained income trust (GRIT) — unmarried couples actually have an advantage over married couples.

In the late 1980s, lawmakers were concerned about potential abuses of GRITS and other estate planning vehicles. So Congress eliminated their tax benefits when used to transfer assets to family members. But a GRIT remains a powerful tool for transferring property to nonfamily members.

To take advantage of a GRIT, transfer real estate, investments or other assets to an irrevocable trust. You retain the right to receive the trust’s income during its term, after which the assets are transferred to your partner or other nonfamily beneficiaries. You also reserve a “contingent reversionary interest,” which means that the assets will be pulled back into your estate if you die before the end of the trust term. For this strategy to work, you must outlive the trust term.

Transferring wealth

When you create a GRIT, you make a taxable gift to your beneficiary, but by retaining income and reversionary interests in the trust, you can minimize its value for gift tax purposes. The gift tax value is the initial value of the trust assets minus the value of your retained interests. And because the value of those interests is discounted to present value using a conservative applicable federal rate (AFR), a GRIT may allow you to transfer substantial amounts of wealth at a minimal tax cost.

For example, Stanley, age 50, transfers real estate worth $1 million to a 20-year GRIT for the benefit of his partner, Stella. At the time of the transfer, the AFR is 5%, which means that the trust is assumed to earn $50,000 per year, regardless of whether it actually produces any income.

Using IRS tables, the present value of Stanley’s retained income interest is about $579,000 and the present value of his contingent reversionary interest is approximately $129,000. So the GRIT’s value for gift tax purposes is roughly $292,000 ($1 million – $579,000 – $129,000).

Suppose that, at the end of the trust term, the property has appreciated in value to $3 million. Assuming that Stanley survives the term, Stella will receive $3 million in wealth at a gift tax value of only $292,000.

Overcoming the obstacles

When it comes to estate planning, unmarried couples have some disadvantages over married couples. But by planning carefully and taking advantage of GRITs and other tools, they can overcome the obstacles and ensure that their wishes are carried out — and in a tax-efficient manner.

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