Claiming Expanded NOL Carrybacks for 2008 and 2009

Prior to the 2008 tax year, net operating losses (NOLs) could generally be carried back two years and forward 20 years. In February 2009, the American Recovery and Reinvestment Tax Act (the “February Act”) extended the carryback period to a maximum of five years—but only for “eligible small businesses” (ESBs) and in most cases only for the 2008 loss. ESBs are defined under a $15 million gross receipts test discussed below. As a further stimulus measure, in November 2009 Congress passed the Worker, Homeownership & Business Assistance Act of 2009 (the “November Act”), extending five-year carryback relief to most businesses including those that are not ESBs. Even after the November Act, however, ESBs still enjoy two important advantages—discussed below—over non-ESBs. On November 20, 2009, IRS issued Rev.Proc. 2009-52, 2009-49 IRB 744, which spells out the timing and procedure involved in claiming carrybacks under the November Act. This article refers to a taxpayer’s ability to elect a 3, 4 or 5 year carryback period under Code Section 172(b)(1)(H), whether under the February Act or the November Act, as “expanded carryback relief”.

Certain recipients of federal emergency assistance (TARP funds) and their affiliates are ineligible for expanded carryback relief under the November Act. Additionally, special rules—not covered here—apply to NOLs of life insurance companies and corporations filing consolidated returns.

An ESB is a corporation, partnership, or sole proprietorship that has $15,000,000 or less in average annual gross receipts over a three-year period, determined after aggregating gross receipts of certain related persons and applying other special rules adopted from the gross receipts test of Code Section 448(c)(1) (which relates to restrictions on use of the cash method of accounting). In the case of a partnership or S corporation, although the election to use expanded carryback relief is made at the partner or shareholder level, the gross receipts test itself is applied at the partnership or S corporation level. In Rev.Proc. 2009-26, 2009-19 IRB 935 (April 24, 2009), IRS ruled that for purposes of expanded carryback relief the three-year period for averaging gross receipts includes the year in which the NOL arises (the loss year). The gross receipts test is applied by aggregating gross receipts of all persons treated as a single employer under Code Sections 52(a) or (b) or 414(m) or (o), and by eliminating gross receipts from transactions between the persons being aggregated. “Gross receipts” are reduced by returns and allowances and, where capital or Section 1231 assets are sold, by the adjusted basis of the property sold (per Temp.Treas.Reg.Sec. 1.448-1T(f)(iv)). Special rules apply to short taxable years, entities with less than a three-year history, and predecessor businesses.

The most important difference in treatment between ESBs and non-ESBs is that “applicable net operating losses” from two tax years of an ESB—but only one tax year of a non-ESB—can qualify for expanded carryback relief. An “applicable net operating loss” is the NOL for a tax year that ends after December 31, 2007, and begins before January 1, 2010. Thus a calendar year taxpayer with 2008 and 2009 NOLs attributable to an ESB may carry back each NOL to a period of up to five years (subject to different filing deadlines as explained below). In contrast, a calendar year taxpayer with 2008 and 2009 NOLs from a non-ESB who elects expanded carryback relief must choose between the two years. Under the first example, a further difference is that the 2008 ESB NOL that is carried back to the fifth preceding tax year (under the February Act) is not subject to the limitation under the November Act that prevents an applicable NOL from offsetting more than 50% of taxable income in the fifth preceding year.

Not surprisingly, an election to use expanded carryback relief applies for purposes of both the regular tax and the alternative minimum tax (AMT). An important benefit of expanded carryback relief under the November Act, however, is that it is not subject to the rule that would otherwise prevent an AMT NOL from offsetting more than 90% of AMT income in a carryback year.

An election to use expanded carryback relief pursuant to the November Act is normally made by attaching to the taxpayer’s original or amended return for the loss year a statement that includes the following information:

That the taxpayer is electing to apply Section 172(b)(1)(H) of the Internal Revenue Code under Rev. Proc. 2009-52;

That the taxpayer is not a TARP recipient nor, in 2008 or 2009, an affiliate of a TARP recipient; and

The length of the NOL carryback period that the taxpayer elects (3, 4 or 5 years).

The taxpayer must also file a copy of the election statement with the return that applies the NOL to the carryback year (e.g., the Form 1045, Application for a Tentative Refund, for the carryback year). The election must be made by the due date (including extensions) for filing the return for the taxpayer’s last tax year that begins in 2009; the same deadline applies to the applicable Form 1045. Once made, the election is irrevocable. If the election amends a previous carryback claim or application (e.g., the taxpayer carried back the applicable NOL on a previously-filed Form 1045), the election must so state. Note, however, that the prior carryback of an ESB NOL pursuant to the February Act cannot be amended. Section 4.01(4) of Rev.Proc. 2009-52 provides an alternate procedure for making the Section 172(b)(1)(H) election, which is similar to the primary procedure but does not require that the election statement be filed with the return for the loss year.

If a taxpayer has previously waived carrybacks from the loss year under Code Section 172(b)(3) and is now revoking that waiver, the taxpayer must also file a statement indicating that it is revoking the NOL carryback waiver and is electing to apply Section 172(b)(1)(H). The November Act permits such a revocation for a tax year that ended before the November 6, 2009, date of enactment. Filing of the revocation election involves much the same procedure, information, and time limits as those that apply to the election of expanded carryback relief. The revocation applies for both regular tax and AMT purposes.

A carryback election under the February Act may be made by filing Form 1045, Application for a Tentative Refund (or other applicable form applying the extended carryback), within six months of the extended due date for filing the taxpayer’s return for the year of the “applicable 2008 net operating loss”. Under the February Act, a fiscal year taxpayer may elect to treat as its “applicable 2008 net operating loss” the NOL for its tax year that begins in 2008 (rather than its tax year that ends in 2008). In this regard, see Rev.Proc. 2009-26, 2009-19 IRB 935 (April 25, 2009), which continues to provide procedures for electing carrybacks under the February Act. Making a timely election under the February Act for an ESB NOL preserves the possibility of claiming expanded carryback relief for two loss years—one under the February Act and one under the November Act.

Contributed by Glenn Madere, Esq. Glenn Madere is the Editor of The Readable Code and Regs: Partnerships (Blue Bell, PA: Readable Press, 2009) Readable Press Website

Prepare Now For Next April 15th?

I know 2009 has not ended. Obviously you have not received your W-2, 1099s or mortgage interest and real estate tax statement. Over the holidays, though, there some things you can do beyond the normal gathering and organizing to make your 2009 tax return preparation a little easier. If you are one of the few and brave who prepare their own tax return, now is the time to line up your tax return preparation software. There are plenty of efficient, cost effective options available. All you need to do is find the right one for you. Whether you self prepare or use a paid preparer, consider whether any of the following issues should be addressed now rather than later.

Having receipts to prove your tax deductions is obviously very important. Certain expenses such as charitable contributions greater than $250 and meals and lodging greater than $25 must be supported by receipts in order to be deductible. Now may be a good time to gather these receipts and if not available, request duplicates. You can also use this time to determine and finalize capital gains and losses for the year. You may want to call your broker before the end of 2009. Once an employee receives their final pay stub, he or she should review it first of all to make sure it is understood. In case there are any errors, your employer will have time before form W-2 is issued to correct these errors.

Inevitably, for some people there are certain issues that must be addressed before they can file their tax returns. It may be possible to reduce the April 15th stress by attempting to resolve these issues now.. Your filing status may be one of these issues. Married taxpayers may have to decide whether they want to file a joint return with their spouse or use the status of married filing separately. This involves many issues and April 15th is no time to make this decision. Similarly, if the dependency exemption between spouses and ex spouses has not been determined there is no advantage in delaying this discussion.

Another way to reduce stress is to decide now whether to make an IRA contribution. While the contribution does not have to be made until April 15th, you can avoid last minute potential problems by making the deposit now. If you employ at home domestic help, depending on the amount, you may be required to withhold and pay federal income and employment taxes. If you have not done so already, you need to discuss this with your employee now rather than later.

Finally, if your withholding and estimates for 2009 are not enough you can catch up somewhat with a January 15th estimate. State taxes paid by December 31, 2009 are deductible for 2009 even if due when filing your state return.

Deducting Fraudulent Investment Losses

If you did not know what a Ponzi scheme was prior to last year, you probably know by now thanks to Bernie Madoff. While Ponzi and Ponzi-like schemes have been going on for years, last year's economic downturn has brought the losses suffered by investors into focus.

There is no question that innocent investors have lost money in these schemes. For tax purposes though, it is sometimes unclear how and when to deduct these losses. Fortunately, in March 2009, the IRS issued Revenue Ruling 2009-9 which attempts to guide individual taxpayer victims of fraudulent investment schemes.

This ruling addressed a situation where the investor/taxpayer invested money with an investment advisor who perpetrated a criminal Ponzi scheme fraud on the investor. When the fraud was discovered, there was no money left in the fictitious account.

The first question that needed to be answered is whether the loss is capital in nature or a theft deduction. Taxpayers generally do not want capital loss treatment because such losses are limited to capital gains plus $3,000. IRS answered that if the loss resulted from illegal activity, then it is not a capital but a theft loss.

The next question is whether the theft loss was the result of a transaction entered into for profit. If not, the loss is deductible only to the extent it exceeds 10% of Adjusted Gross Income. Fortunately, the IRS decided that such fraudulent investment losses are the result of transactions entered into for profit and thus not so limited.

In this Revenue Ruling, the IRS concluded that the theft loss deduction for fraudulent investment schemes is a miscellaneous itemized deduction not limited by the 2% of Adjusted Gross Income or any other rule, therefore reported in full without limitation.

The IRS also addressed the timing of the theft loss. This is an issue because the loss was incurred in part in years that were closed by the Statue of Limitations. The IRS concluded that since a theft loss is deductible in full in the year the theft is discovered, losses incurred in previous years are not closed by the Statute of Limitations.

The amount of a deductible loss is the taxpayer's basis (contributions plus income reported as taxable less distributions). The deductible loss should be reduced by any amount for which in the year of discovery there is a reasonable prospect for recovery. Finally the IRS concluded that such a theft loss can create a net operating loss which can be carried back 3 years and carried forward 15 years.

This Revenue Ruling assumed certain important facts which helped the IRS reach its favorable opinion. It assumed the taxpayer's loss was from a theft discovered in the year a deduction was claimed. The amount was easy to determine because it was assumed that there was no reasonable prospect for recovery. These clear cut facts are not always the case, so the IRS went one step further and provided a safe harbor for taxpayers. If the provisions of Revenue Procedure 2009-20 are followed the IRS will not contest the taxpayer's treatment as a theft loss.

For this Revenue Procedure to apply, the loss must be connected with the commission of a crime which the investor had no knowledge of until it became public. If so, in the year in which the criminal indictment or complaint is filed the investor can deduct 95% of the loss if he or she does not pursue any avenue of recovery or 75% if the investor intends to pursue potential third party recovery. Please consult this Revenue Procedure (Rev. Proc. 2009-20, 2009-14 I.R.B. 749) for further details.

When To Take Social Security Retirement

Baby boomers are fast approaching their entitlement to Social Security retirement benefits. Many face an important decision as to whether to begin receiving these benefits at age 62, normal retirement age or to delay receipt until after normal retirement age.

Normal retirement age depends upon the year you were born. If you were born between 1943 and 1954, normal retirement age is 66. If you were born in or after 1960, normal retirement age is 67. Those born between these years have a graduated normal retirement age between ages 66 and 67.

Regardless of your normal retirement age, you may elect to receive your Social Security retirement benefits as early as age 62. For those facing this decision in the next 10 years, monthly benefits are permanently reduced by 5/9 of 1% for the first 36 months and 5/12 of 1% for any remaining months of benefits taken before normal retirement age. You can also decide to defer receiving your benefits past normal retirement age. If so, your monthly benefit will be permanently increased by 2/3 of 1% for each month you wait (up to age 70).

Social Security is designed, considering the population as a whole, to provide the same lifetime benefit whether received early, late or at normal retirement age. Your personal decision will depend upon a number of factors. The initial question is whether you have the flexibility to choose when to receive your benefits or because of economics, you need the cash as soon as possible. You may also want to consider your health and life expectancy.

Assuming you have the flexibility, most if not all actuarial studies show that in most cases, you would be better off electing to receive your benefits at age 62. There are several scenarios though where you may want to delay receiving your benefits.

If you intend to work after age 62. Social Security retirement benefits are reduced by $1 for every $2 of earnings greater than $14,160 in 2009 ($1 for every $3 of earnings greater than $37,680 if 2009 is the year you reach normal retirement age).

If you have not maximized your Social Security retirement benefit If you work after attaining age 62, you may increase your benefit to the extent your earnings in these years are greater than previous year earnings.

You should visit http://www.ssa.gov/. to see how these rules affect you personally. The retirement planning option will give dollars and cents options applicable to you.. Regardless of when you decide to receive retirement benefits, be sure to apply for Medicare benefits at age 65 since there is no advantage in delaying this benefit.

Want to Reduce Your 2009 Taxes?

Every Thanksgiving many people look for ways to reduce their taxes by year end. Reducing your taxes is accomplished by minimizing taxable income (deferring income and/or accelerating deductions) and maximizing tax credits. Taxpayers who believe an increase in rates for 2010 is inevitable may want to maximize 2009 income and minimize 2010 income to the extent possible. Assuming though you wish to employ traditional tax planning techniques and reduce your 2009 taxes, there are some options you may want to consider before year end.

Legally deferring income to 2010 can result in a double benefit. Not only do you delay paying tax on the deferred income, a lesser Adjusted Gross Income (AGI) means exclusions like IRA contributions, deductions limited by AGI, like medical expenses and credits, like education credits also limited by AGI can be greater. One cannot simply tell their employer to delay salary until 2010, nor can self employed individuals unilaterally wait until 2010 to deposit receipts. There are though legal ways to reduce AGI.

Self employed individuals can legally reduce their AGI by doing such things as accelerating purchases necessary to their business. They should seek to time the purchase of equipment such as computers in order to maximize the section 179 deduction which allows immediate expensing of otherwise depreciable assets. The self employed should also consider maximizing retirement plan contributions, which may require adopting a profit sharing, 401 (k) or SEP plan by year end. Wage earners should also plan to maximize their 401 (k) contributions by year end.

All taxpayers potentially can reduce AGI by making sure they recognize realized capital losses. Capital losses can offset capital gains in full. In addition, losses greater than gains up to $3,000 can offset any other type of income. Retired taxpayers over age 70 ½ do not have to take (and pay tax on) required minimum distributions in 2009. Despite the publicity concerning this issue, it is surprising many taxpayers are unaware of this opportunity.

This may also be the time to revisit your flexible spending account, especially if your employer requires you to spend your account by year end. You may also want to consider increasing your contribution for next year at this time. You may also want to examine your medical expenses at this time in order to maximize the 7.5% of AGI threshold either in 2009 or 2010.

The timing of charitable contributions can result in a tax planning opportunity. You may be able to satisfy a pledge early, or prepay contributions you would normally make in 2010 before year end. As always, consider donating appreciated stock to your charity and avoid the capital gains tax. To the extent you have a significant state tax liability for 2009, but due on 4/15/2010, consider paying by year end to get a 2009 tax deduction. Be careful to consider the alternative minimum tax implications.

At this point in the year, the first time home buyers tax credit is probably not available. However, if you were planning to buy a car soon, you still have time to purchase a new car before year end and perhaps deduct the sales tax. Finally, make sure you tax advantage of tax credits before year end, especially credits available to make your home more energy efficient.

Social Security Retirement

The Social Security Program was initially enacted to benefit senior citizens impoverished by the Great Depression. While many people think of Social Security in terms of retirement, today’s Social Security provides much more than benefits to retired workers. It also provides retirement benefits to spouses, ex spouses and minor children of retired workers as well as disability benefits to the worker, and his or her spouse and children.

This discussion though is limited to Social Security retirement benefits. While Social Security was never designed to be one’s sole source of retirement income, law changes through 1981 and automatic cost of living adjustments through 2009 have grown Social Security retirement benefits to a significant sum. The Social Security Administration though has recently announced that for the first time, there will be no cost of living adjustment for 2010 because there was no increase in the Consumer Price Index for the relevant period.

For 2009, the average Social Security benefit paid to a retired worker is $1,153 per month or $13,836 annually. The average monthly payment to a retired married couple is $1,876 or $22,512 annually. The maximum Social Security benefit in 2009 is $2,323 per month or $27,876 annually. To qualify for the maximum benefit, one must have worked for 35 years, earning at or above the maximum wage base applicable to each of the 35 years.

Your Social Security benefits are financed by payroll taxes paid equally by you and by your employer. Self employed workers pay the entire tax. The tax rate and taxable wage base have grown significantly. For 2009 (and 2010) the rate is 7.65% each on the first $106,800 of taxable wages. In 1937, the rate was 1% of the first $3,000 of taxable wages. In 1974, the rate was 4.95% each on the first $13,200 of wages.

This dramatic increase in payroll tax has caused many, especially higher earners, to ask whether these payroll taxes could have provided them a larger retirement benefit if invested privately. Social Security provides a monthly annuity for life. For the sake of comparison, let us see how much of a commercial monthly annuity could be purchased with these payroll taxes.

Assume an individual retiring in 2009 at full retirement age has worked for 35 years earning exactly one half of the maximum social security wage base in each of those 35 years. This person’s social security benefit would be $1652 per month increased each year for cost of living adjustments measured by the increase (if any) in the consumer price index. Over his or her earnings years, they would have paid $56,834 in payroll taxes. Invested at 3%, these taxes would buy a comparable annuity of $437.45 per month. Invested at 6%, the comparable annuity would be $695.05 per month. Considering that the employer contributes an equal amount, even doubling these commercial annuities would not beat Social Security.

Social Security benefits are weighted more for the first dollars of earnings than the last dollars of earnings. One would then expect a higher earning worker to receive a lesser return on their “investment”. An individual retiring in 2009 again at full retirement age but earning (and paying tax on) the maximum social security wage base for 35 years would receive the maximum retirement benefit of $2,323 per month. This individual would have paid $ 113,668 in payroll taxes. Invested at 3%, a comparable commercial annuity would pay $875.43 per month, $1390.74 per month if the payroll taxes were invested at 6%. Counting the equal employer contribution, if the total employer and employee payroll taxes were invested at 3%, the equivalent commercial annuity would be $1751.39 per month, far less than the monthly social security retirement benefit of $2323.

If both employer and employee taxes were invested at 6% a commercial annuity could be purchased paying $2782.01 per month. While this is slightly greater than the Social Security benefit, the Social Security program offers additional benefits to workers. For example, the Social Security retirement benefit is more like a 100% joint and survivor annuity in certain cases. The spouse of a deceased worker would receive the deceased worker’s benefit if greater than the surviving spouse’s own benefit. A worker retiring in 2009, having paid the maximum payroll tax for 35 years and invested both the employer and employee contributions at 6% could purchase a 100% joint and survivor annuity paying $2163.72 per month with the funds, less than the Social Security benefit of $2323.

Social Security taxes also fund a disability program for workers suffering total disability prior to attaining retirement age. This is a potential cost that would have to be added to the cost of the commercial annuity for comparison purposes.

Workers close to retirement should also consider whether they are better off receiving their Social Security benefits either before or after normal retirement age. This will be the subject of the next posting.

Charitable Trusts

The wealthy have long utilized charitable trusts to meet their philanthropic goals. In 1969, Congress provided tax benefits in the form of income tax deductions and income and estate tax exclusions for the transfer of assets to charitable trusts. Since then, these trusts have steadily gained popularity.

You can use one of several types of charitable trusts depending upon your goals. These trusts can be formed during your lifetime or after death, but all trusts must be irrevocable. Assuming you want to take advantage of these tax benefits during your lifetime, once you are comfortable with not being able to take back the assets, you must decide which type of trust meets your goals.

All types of charitable trusts have two classes of beneficiaries, one class entitled to periodic payments from the trust and the second class receiving the principal. The Charitable Remainder Trust (CRT) is designed to provide you or your designated beneficiaries (for example your children) with income from the trust either for your lifetime or a fixed period of time after which your designated charity receives the remaining principal. A Charitable Lead Trust (CLT) operates in reverse of the CRT in that your beneficiaries receive the remaining principal at your death, while your designated charity receives periodic payments from the trust.

Charitable trusts are further defined by how the periodic payments are determined. You can require the trust to distribute a fixed amount each year (a Charitable Remainder Annuity Trust or a Charitable Lead Annuity Trust). You can also require that the Trust distribute each year a fixed percentage of the trust principal (a Charitable Remainder Unitrust or Charitable Lead Unitrust).

Since Charitable Remainder Trusts (CRT) provide income to the donor or the donor’s beneficiaries, they are much more popular than Charitable Lead Trusts. The following is an example of how a typical CRT might work. Assume you are age 65 and have assets such as marketable securities or real estate worth $500,000 with a tax basis of $200,000. Once you decide which charity to receive the remaining principal, you must decide how much income you or your beneficiaries would like to receive and for what period of time. The unitrust, which pays a percentage of trust assets each year, is usually preferred by relatively young (age 65) donors because of its flexibility.

Assume you decide to receive 5% of the trust’s assets each year. (5% is the minimum). At age 65, you would receive $25,000 (5% of the fair market value of the trust or $500,000). For the rest of your life, you will receive 5% of the value of the trust. Your charitable tax deduction is $225460. If you cannot use all of it in the year you contribute the asset to the trust, you can carry forward the unused deduction for 5 years. Remember, you do not have to pay tax on the $300,000 appreciation in the donated asset and the asset is not included in your taxable estate.

The amount of your charitable tax deduction is directly related to the income you choose to receive. For example, if you chose to receive 8% of the trust’s assets ($40000) in year one, the charitable deduction is only $150,490. The amount of your charitable deduction is also a function of your age. If you wait until age 70 to make the contribution, assuming the minimum 5% payout is selected, your deduction would be $262,565.

Charitable Trusts are by no means for everyone. If you are otherwise charitable minded though,this may be a way to meet your goals with the help of the IRS. As always an attorney familiar with Charitable Trusts should be consulted.

Saving Estate Tax with a Family Limited Partnership

In order to reduce your potential estate tax you must reduce your taxable estate. One customary way to reduce your estate is to make gifts to your ultimate beneficiaries such as your children and grandchildren. Removing an asset from your taxable estate by gift though, will generally require you to part with all dominion and control of the gifted asset. Gifting interests in a Family Limited Partnership which owns the assets that you wish to transfer to your beneficiaries when, properly structured, will remove the assets including appreciation (at a discounted value) from your taxable estate while allowing you to retain control of the assets.

A Family Limited Partnership (FLP) is nothing more than a traditional limited partnership with the donor and the donor’s family members as the general and limited partners. A Limited Liability Company (LLC) is synonymous with a partnership for this purpose since an LLC can be taxed as if it were a partnership. Limited partners by law have no say in the operation and management of any limited partnership which accounts for the discount in value of their partnership interest. General partners control the operation of a limited partnership regardless of their percentage of ownership.

A typical FLP might be organized and operated in the following manner. Donor transfers an asset worth $1,000,000 to a newly created FLP in exchange for a 1% general partnership interest and a 99% limited partnership interest. Donor immediately gifts the 99% limited partnership interest to his children, retaining the 1% general partnership interest. Donor dies 10 years later when the asset is worth $2,000,000. Had Donor gifted 99% of the asset directly to his children, the value of the gift would have been $999,000. Since the children have no control over the asset, the value of the gifted limited partnership interest can be discounted for gift tax purposes. Properly structured and operated it is reasonable to assume the IRS would accept a discount for lack of control and marketability of at least 35%. The value for gift tax purposes of the limited partnership interest assuming a 35% discount would be $643,500. Assuming Donor retains control of the asset until death by retaining the 1% general partnership interest, he or she has removed $1,980,000 from his or her estate at a gift tax cost of only $643,500.

The IRS and Congress have been increasingly concerned with this estate tax saving opportunity. IRS has repeatedly challenged what it believes to be the abusive use of Family Limited Partnerships. The kind of asset transferred to the FLP can be an issue. If marketable securities are the only asset, one can expect IRS scrutiny. At this point though, funding the FLP with something like a rental property appears to be safe.An IRS challenge can also be expected if the FLP fails to operate as such. For example, if the 1% general partner in our example receives distributions in excess of his or her ownership percentage, IRS can be expected to object.

The amount of minority or lack of marketability discounts continues to be an issue. A review of the case law and my personal experience leads me to feel comfortable with a combined discount of 35% when indicated by a sufficient appraisal. The courts have delineated the factors which constitute a sufficient appraisal. A potential donor would be well advised to engage an appraiser conversant with these factors.

Certain members of Congress are interested in legislating away this tax saving opportunity. The “Certain Estate Tax Relief Act of 2009” would eliminate discounts to Family Limited Partnerships as a matter of course. Nevertheless, unless this bill is passed and made retroactive, properly formed and operated, transfers to and gifts of FLP interests are an effective way to reduce estate tax while retaining control of the transferred assets. As always, an attorney well versed in these provisions should be consulted.

Roth Conversions

The advantages of a Roth IRA over a Traditional IRA or 401(k) plan have been well documented. Withdrawals from Roth IRAs (including untaxed earnings) are generally not taxable. Furthermore, unlike other tax deferred arrangements, mandatory distributions upon attaining age 70 ½ are not required from a Roth IRA.

Unfortunately, many people have not been able to take advantage of this tax saving opportunity. If your income exceeds certain levels ($176,000 for joint filers, $10,000 for married filing separately filers and $120,000 for all others) you cannot make a direct contribution to a Roth IRA. You cannot convert a Traditional IRA or 401(k) to a Roth IRA before 2010 if your income exceeds $100,000 or you are married but file separately.

Beginning in 2010 though, you will be able to convert a traditional IRA or in some circumstances your balance in a 401(k) plan to a Roth IRA regardless of your income or filing status. Income tax will be due on the conversion of pre tax contributions and earnings, but for 2010 conversions only, one half of tax will be due on your 2011 return and one half on your 2012 return. Taxable income will be accelerated though to the extent you make distributions from the Roth IRA before 2012.

There are several planning opportunities available in 2009 for those who plan to convert in 2010 or later. As previously mentioned, higher income taxpayers are not eligible to make direct contributions to a Roth IRA. Such taxpayers can make non deductible contributions to a traditional IRA before converting this account to a Roth effectively avoiding the Roth income limitation. Please be advised though that you cannot roll over just after tax contributions. A partial rollover is deemed to be a proportionate amount of pre tax and after tax dollars. All traditional IRAs are considered one for this purpose regardless of which IRA is to be converted.

Another planning opportunity exists for participants in a 401(k) plan. Since 2008, otherwise eligible participants can directly roll 401(k) balances into a Roth IRA if the plan so allows. This opportunity also effectively avoids the Roth income limitation.

If you are planning to convert in 2010, you may also want to consider accelerating 2010 income to 2009 and deferring 2009 tax deductions to 2010 where possible in order to even tax brackets as much as possible.

Whether a Roth conversion is beneficial depends upon a number of factors such as your post retirement income tax rate, your state income tax rules and the length of time your money will remain in the Roth IRA. While these considerations are complex, within certain time limits you may be able to reverse a Roth conversion. As always, you should consult your CPA, attorney or financial advisor to help you plan for this potential retirement savings opportunity.

Garnett Decision Rejects Treatment of Losses from LLC and LLP Interests as Presumptively Passive

The passive activity loss rules in general prevent individuals and certain other taxpayers from deducting passive activity losses against non-passive income. In most cases whether an activity is passive depends on whether the taxpayer materially participates in it. In the case of limited partnerships, Code Section 469(h)(2) treats a taxpayer with a limited partner interest as not materially participating in the partnership’s activity except as provided in regulations (the “per se rule”). Those regulations in turn allow a limited partner to establish material participation, but only by using one of three tests—the 500 hours-per-year test, the test that requires material participation during five of the preceding ten years, or the test that requires three prior years of material participation in the case of a personal service activity. Temp.Reg.Sec. 1.469-5T(e). Were it not for the per se rule, the taxpayer could establish material participation under any of those tests or any of four additional tests—one of which allows aggregation of “significant participation activities” to achieve 500 hours of participation. Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009) holds, based on an analysis of state law governing the limited liability companies (“LLCs”) and limited liability partnerships (“LLPs”) at issue in the case, that interests in those entities are not subject to the per se rule. As a result, the taxpayers in the case are allowed to use any of the seven regulatory tests for material participation. The court reached the same conclusion with respect to certain interests of the taxpayers as tenants-in-common in rental properties.

The taxpayers in Garnett owned direct or indirect interests in seven LLPs and two LLCs engaged in various agricultural businesses. Under applicable state law, they had no personal liability for obligations of the entities. The IRS argued that such limited liability made the taxpayers’ interests limited partner interests for purposes of the per se rule. The Tax Court, however, pointed to the “general partner exception” of Section 1.469-5T(e)(3)(ii) under which an individual’s partnership interest is not treated as a limited partner interest if the individual is a general partner at all times during the relevant tax year. While that provision is aimed primarily at situations where the individual is both a general and a limited partner in the same partnership, the court found that the exception by its own terms is not limited to such dual-status cases. Noting the lack of a statutory or regulatory definition of “general partner”, the court looked to the legislative history of Section 469, which justifies the per se rule on the basis of state law principles that preclude a limited partner from participating in a partnership’s business while retaining limited liability protection. The court therefore concluded that the state law prohibition against limited partner participation in the partnership’s business—rather than limited liability—is the defining characteristic of a limited partner interest for purposes of the per se rule. Turning to the law of the state of formation of the entities (Iowa), the court noted that—in contrast to restrictions on the activities of limited partners—members of LLCs and LLPs can participate in management. Accordingly, the court concluded that taxpayers held their interests in the LLPs and LLCs as general partners for purposes of the per se rule. While the court acknowledged that a factual inquiry into the authority of taxpayers to act on behalf of their LLCs and LLPs may be appropriate in the context of determining material participation, it found such an inquiry unnecessary to determine the application of Section 469(h)(2).

Less than a month after the Garnett decision, the U.S. Court of Federal Claims decided Thompson v. U.S., 2009 TNT 138-4 (July 20, 2009), which also holds that an interest in an LLC is not an interest as a limited partner for purposes of the per se rule. While the court acknowledged certain legislative history suggesting that Treasury may have regulatory authority to treat “substantially equivalent entities” as limited partnerships for purposes of the per se rule, it found that an LLC is not such an entity. Whereas the Thompson decision is a final judgment while the Garnett decision is for partial summary judgment, should the government decide to appeal both cases it is likely the Thompson case would be decided first on appeal.

The Garnett and Thompson decisions may also benefit a real estate professional who qualifies for the “real property business” exception to the general rule that treats rental activities as automatically passive (Code Section 469(c)(2) and (c)(7)). This is because a real estate professional who holds an interest as a limited partner must still apply the per se rule before determining material participation (subject to a narrow de minimis exception contained in Treas.Reg.Sec. 1.469-9(f)(2)).

It is unclear what effect, if any, Garnett and Thompson may have on application of the self-employment tax to members of LLCs and LLPs. In this regard Code Section 1402(a)(13) excludes from self-employment earnings the distributive share of income of a limited partner, subject to an exception for certain guaranteed payments. Complicating any inquiry into this area are longstanding proposed regulations that create a separate series of tests for determining whether a taxpayer is a limited partner for self-employment tax purposes—tests relied upon today by some practitioners despite their status as proposed regulations. See Prop.Treas.Reg.Sec. 1.1402(a)-2(h).

Contributed by Glenn Madere, Esq. Glenn Madere is the Editor of The Readable Code and Regs: Partnerships (Blue Bell, PA: Readable Press, 2009)   Readable Press Website