Tax Outlook for 2007

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Although Democrats significantly outnumber Republicans on the House Ways and Means Committee, and hold a 31 member majority in the full House, legislation raising marginal, capital gains or dividend rates in 2007 is not likely to be enacted this year. The Tax Reconcilation Act of 2005 extended through December 31, 2010, the dividend and capital gains tax reductions enacted in 2003, which hda been set to expire on December 31, 2008. AMT legislation appears likely in 2007.

Support for tax rate increases also appears weak in the Senate Finance Committee, which Democrats control by a single vote, and in the Senate itself. Senate Budget Chairman Conrad (D-ND) has ruled out raising tax rates. Democrats appear reluctant to risk new found political capital by voting to increase taxes even on a relatively small percentage of taxpayers.

The House voted 360-45 on February 16 to pass the Small Business Tax Relief Bill of 2007. Expected to cost $1.3 billion over 10 years, H.R. 976 would (i) increase the hourly minimum wage to $7.25 over two years; (ii) provide a one-year extension (through 2010) of IRC § 179 expensing limits, increase the annual limit to $125,000, and boost the phaseout threshold from $450,000 to $500,000, effective for the 2007 tax year and beyond; (iii) extend the work opportunity tax credit (WOTC) for one year, expand it to include disabled veterans, and increase the age limit from 25 to 40; and (iv) allow an unincorporated business that is jointly owned by a married couple in a non-community property state to file as a sole proprietorship without penalty.

Funding for H.R. 976 would be accomplished by (i) denying the lowest capital gains and divdend rate (5% for 2007; 0% for 2008) to dependent children of high-income txpayers (to prevent income-shifting); (ii) providing the IRS with four additional months (22 from 18) to give notice to taxpayers that they failed to comply with their tax obligations before being required to suspend the imposition of interest and penalties on underpayments; and (iii) increasing estimated taxes in 2012 for corporations with assets of at least $1 billion.

The Senate overwhelmingly approved an increase in the hourly minimum wage to $7.25, as well as an $8.3 billion package of small business tax incentives favorably reported out of the Senate Finance Committee. Although a House-Senate conference has not been scheduled, Senate Finance Committee Chairman Baucus (D-Mont.) believes differences among the House and Senate versions will be resolved. President Bush favors an increase in the minimum wage, but believes that it should be coupled with tax relief for small businesses which employ low-wage earners.

House Majority Leader Steny Hoyer (D-MD) indicated that the House will include, as part of its supplemental appropriations bill, funding for Katrina victims. Representative Charles Rangel (D-NY), Chairman of the House Ways and Means Committee, stated the Katrina tax package will extend various tax provisions enacted in 2005 to provide hurricane relief. Mr. Hoyer has indicated that he will reintroduce an energy bill called the “Progress Act” that will include tax-exempt bonds to promote high-speed rail travel.

The Alternative Minimum Tax, which is essentially a flat tax of 28 percent imposed on income without the allowance of many deductions to which taxpayers are accustomed, has become immensely unpopular, presumably because for the first time, tax computed under the AMT exceeds many taxpayer’s tax liability computed without regard to the AMT.

The Tax Increase Prevention and Reconciliation Act of 2005 increased the AMT exemption amount through December 31, 2006 to $62,550 for mraried persons filing jointly. However, the AMT exemption level for 2007 reverts to $45,000 for joint filers, and to $33,750 for single taxpayers. Thus, unless Congress acts, the AMT tax liability for 23.4 million taxpayers in 2007. Although the estimated cost of full repeal of the AMT is $1.2 trillion through 2015, the cost could be reduced to $529 billion through 2015 if AMT “preferences” were changed to allow a deduction for state and local taxes.

Since AMT may be triggered by a large capital gain, an installment sale might minimize AMT exposure. If AMT tax liability will exceed regular tax liability for a given year, depending upon timing considerations, itmight be prudent to accelerate income into that year to benefit from the lower marginal AMT rate of 28 percent. Similarly, in years in which the AMT will apply, the taxpayer might consider deferring expenses (including the payment of state income taxes) not deductible for AMT purposes until another year in which the AMT will not apply.

Spousal beneficiaries may roll over inherited IRAs into their own plans. However, nonspouse beneficiarlies may never roll over inherited benefits to their own plan. The nonspouse beneficiary has been required to withdraw all inherited money from a retirement plan, either as a lump-sum distribution or within five years. By not qualifying for an extended payout, the nonspouse beneficiary has been forced to forego yeras of tax-free growth. Until 2007, only one exception existed: a non-spouse beneficiary could transfer an inherited IRA owned by one participant to another inherited IRA owned by the same participant. The Pension Protection Act of 2006 (PPA) added a new exception. Beneficiaries of retirement plans, such as 401(k)s, 403(b)s and Section 457 plans, may transfer those assets into an “inherited IRA” established for the purpose of receiving the distribution and making payments to the beneficiary. Beneficiaries may then make withdrawals over their own life expectancies.

However, the IRS recently stated that retirement plans are not required to allow nonspouse beneficiaries to make direct transfers to inherited IRAs. To avoid the uncertainty of company plan rules when the participant is certain of a desire to leave a retirement plan to a nonspouse, the participant might consider rolling funds into an individual IRA immediately.

President Bush proposed a plan intended to make private health insurance more affordable. A standard inflation-adjusted tax deduction of $15,000 would be provided for every family and individual covered by a private policy purchased individually or through an employer. No income or payroll taxes would be due on the first $15,000 of income. However, employer-provided health insurance, now excluded from income, would become taxable. Employers would continue to be allowed a deduction for premiums paid. Federal grants would be made to states providing poor and difficult to insure citizens with low-cost private insurance. A top aide to House speaker Pelosi stated that Mr. Bush’s proposal will be pushed aside for at least two years, and “is dead for now.”

Florida’s Intangible Personal Property Tax (IPPT), an annual tax based on the value of intangible personal property owned or controlled by Florida residents, or by persons doing business in Florida, was abolished on January 1, 2007. Florida legislators are also considering a constitutional amendment that would abolish all property taxes on homesteads in exchange for increasing sales tax from 6 to 8.5 percent, (which would be the nation’s highest). Property taxes for non-homestead properties such as second or vacation homes, or to rental or business property, would decline but would not be eliminated.

Taxpayers whose AGI exceeds $100,000 have been prevented from converting a traditional IRA to a Roth IRA. Beginning in 2010, this rule will no longer apply. Rules governing Roth IRAs do not require annual minimum distributions after reaching age 70½. Therefore, the Roth IRA could make possible many years of tax-free growth.

The IRS has found significant reporting errors and omissions by tax-exempt organizations in the areas of excess benefit transactions, transactions with disqualified persons, and loans to officers. A compliance check, begun in 2004, has resulted in more than $21 million in excise taxes.

The deduction for investment interest is limited to “net investment income.” IRC § 163(d)(1). Any interest that is not deductible may be carried forward to future tax years, subject to the same limitation. An election made under IRC § 1(h)(2) to include capital gains and dividends in investment income would raise the net investment income ceiling. Although the election will cause capital gains and dividends to be taxed at ordinary income rates, taxpayers anticipating little investment income in future years might consider the election.

Hospital Corporation of America, 109 T.C. 21 (1997) held that tangible personal property includes many items permanetly affixed to a building. The decision made viable the use of cost analysis studies to allocate building costs to structural components and other tangible property. By reclassifying property, shorter costs recovery periods can be used. A successful cost segregation study would convert Section 1250 property to Section 1245 property with depreciation periods of five or seven years, using the double-declining balance method in Section 168(c) and (e)(1).

The IRS Cost Segregation Audit Techniquest Guide states the study should be prepared by a person with knowledge of both the construction process and the tax law involving property classifications for depreciation purposes. Cost segregation professionals must verify the accuracy of blueprints and specifications, and take measurements to calculate the cost of assets and then to segregate them. The average cost segregation study may identify 25 to 30 percent of a property’s basis thatis eligible for faster depreciation.

To illustrate the tax savings possible with component depreciation, assume a Manhattan office building worth $3 million with an adjusted basis of $1 million being depreciated using the straight-line method over 39 years. A cost segregation study determines that 25 percent of the value of the building is personal property qualifying for a 7-year recovery period using the 200 percent declining balance method of depreciation. Cost segregation could increase depreciation deductions from $25,641 ($1,000,000/39) to $90,659 [($750,000/39) + (2/7) x $250,000)].

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