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News Notes

Supreme Court Holds Investment Advisory Fees Are Subject to 2% Floor • IRS Issues Rules on New Preparer Penalties • IRS Develops New Form for Misclassified Workers • Final Regs. Govern Release of Taxpayer Information by Preparers • IRS to Perform Mandatory Audits of Foreign Earnings Repatriation (box) • Revisions to 2007 Form 1120-F (box)

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Alistair M. Nevius, J.D.

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In the Courts

Supreme Court Holds Investment Advisory Fees Are Subject to 2% Floor

Under Sec. 67(a), miscellaneous itemized deductions are allowed only to the extent that they exceed 2% of a taxpayer’s adjusted gross income (AGI). The AGI of an estate or trust is computed in the same manner as for an individual for these purposes, except that, under Sec. 67(e)(1), administrative costs that “would not” have been incurred if the property were not held in an estate or trust are allowed in full as deductions in arriving at AGI (i.e., they are not subject to the 2% floor).

Courts have split over what trust administrative costs fall under this exception. For example, the Sixth Circuit has held that investment advisory fees are not subject to the 2% floor and are fully deductible (O’Neill, 994 F2d 302 (6th Cir. 1993)). In contrast, the Second, Fourth, and Federal Circuits have all held that investment advisory fees are subject to the 2% floor (Rudkin Testamentary Trust, 467 F3d 149 (2d Cir. 2006), aff’d sub nom. Knight, S. Ct. Dkt. 06-1286 (U.S. 1/16/08); Scott, 328 F3d 132 (4th Cir. 2003); Mellon Bank, N.A.,265 F3d 1275 (Fed. Cir. 2001)).

In October 2006, in Rudkin, the Second Circuit held that “would not” means “could not” in Sec. 67(e). The court held that Sec. 67(e) grants an estate or trust an exception from the 2% floor for itemized deductions only for “costs of a type” that “individuals are incapable of incurring.”

By contrast, the Fourth and Federal Circuits, while still subjecting trust investment advisory fees to the 2% floor, held that trust administrative costs of a type that would not “commonly” or “customarily” be incurred by individuals are not subject to the 2% floor.

The Supreme Court granted certiorari in the Rudkin case in June 2007 and has now issued a decision (Knight, S. Ct. Dkt. 06-1286 (U.S. 1/16/08)). The Court held that investment advisory fees are generally subject to the 2% floor (overruling O’Neill) but refused to go as far as the Second Circuit in saying that the exclusivity test requires that the fees could not have been incurred by an individual. Chief Justice Roberts, writing for a unanimous Court, said, “[t]his approach flies in the face of the statutory language.” The Court also noted that such an interpretation would make redundant the language “paid or incurred in connection with the administration of the . . . trust” in Sec. 67(e)(1).

Instead, the Court emphasized that Sec. 67(e)(1) says “would not,” which, according to the Court, “is best read to express concepts such as custom, habit, natural disposition, or probability.” The Court agreed with the test adopted by the Fourth and Federal Circuits that trust administrative costs not subject to the 2% floor are those that would not “commonly” or “customarily” be incurred by individuals.

The Court specified that this test “turns on a prediction of what would happen if . . . the property were held by an individual rather than by a trust.” The Court did not spell out how to make this prediction, but acknowledged it “may not be . . . easy.”

The Court noted that there might be investment advisory fees that would be fully deductible “if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts” or that a trust might have an unusual investment objective or require special balancing of the beneficiaries’ interests, in which case the incremental advisory fee, beyond what would have been charged to an individual, might be fully deductible. However, in the case before it, the Court found no such special circumstances and held that the trust’s investment advisory fees were subject to the 2% floor.

From the IRS

IRS Issues Rules on New Preparer Penalties

On the last day of 2007, the IRS issued Notice 2008-13, which implements the expanded tax return preparer penalties and increased standards of return preparer conduct enacted by the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA). The Service also announced that it intends to revise the regulatory scheme governing tax return preparer penalties by the end of 2008, and Notice 2008-13 asks for tax return preparer feedback on that planned overhaul.

The notice’s interim rules emphasize the importance of understanding the legal basis for positions taken on tax returns, the requirement for taxpayers to disclose certain positions, and the need for preparers to advise taxpayers on the various penalties that can apply when a position is taken on a return that may not be supported by existing law.

For undisclosed positions on a tax return, SBWOTA replaced the “realistic possibility” standard with a requirement that there be a reasonable belief that the position’s tax treatment would more likely than not be sustained on its merits (Sec. 6694(a)). Under Notice 2008-13, a return preparer is considered to reasonably believe that the tax treatment of an item is more likely than not the proper tax treatment if the tax return preparer analyzes the pertinent facts and authorities in the manner described in Regs. Sec. 1.6662-4(d)(3)(ii) and, relying on that analysis, reasonably concludes in good faith that there is a greater than 50% likelihood that the tax treatment of the item will be upheld if challenged by the IRS.

For purposes of determining whether a preparer has a “reasonable basis” for a position, the notice says a tax return preparer may rely in good faith—without verification—on information furnished by the taxpayer or by another tax return preparer or other third party and need not independently verify the information. (However, the return preparer cannot ignore the implications of information he or she actually knows or information furnished to him or her, and the preparer must make reasonable inquiries if the information furnished by another return preparer or a third party appears to be incorrect or incomplete.)

SBWOTA also expanded the return preparer penalty to cover all tax return preparers, not just income tax return preparers (SBWOTA Section 8246(a)). The notice states that the definitions of “tax return preparer” in Regs. Secs. 1.6694-1, 1.6694-3, and 301.7701-15 will be modified to eliminate the word “income” to conform to the changes made by SBWOTA.

The notice also provides interim guidance on penalty compliance rules for both signing and nonsigning return preparers. The interim rules will remain in effect until the overhaul of the current return preparer penalty regulations is complete.

Under the notice, preparers of many information returns will not be subject to the new penalty provision unless they willfully understate tax or act in reckless or intentional disregard of the law. The exempted information returns listed in the notice include the W-2 and 1099 series of forms, Forms 990, 990-EZ, and 990-N for exempt organizations, Form 1040-ES, Estimated Tax for Individuals, Form 1120-W, Estimated Tax for Corporations, and Form 2350, Application for Extension of Time to File U.S. Income Tax Return, as well as several others. The notice includes examples illustrating how the new standards would apply.

The notice also clarifies that the date a return or claim for refund is prepared is deemed to be the date shown on the preparer’s signature line on the return. For nonsigning preparers, the relevant date will be the date the person provided the advice, which will be determined by looking at all the facts and circumstances. (The rules in the notice supersede the rules of Regs. Sec.1.6694-2(b)(5), which establish when a realistic possibility is determined.)

IRS Develops New Form for Misclassified Workers

The IRS announced on December 20, 2007, that it has developed a new form for employees who have been misclassified as independent contractors to report their share of uncollected Social Security and Medicare taxes: Form 8919, Uncollected Social Security and Medicare Tax on Wages.

Misclassifying employees as independent contractors is a constant temptation to employers, who then avoid having to collect and pay income, Social Security, Medicare, and unemployment taxes on the employees’ income.

Use of Form 8919 will ensure that a worker’s Social Security and Medicare taxes will be credited to his or her Social Security record. The form should be attached to the taxpayer’s Form 1040, U.S. Individual Income Tax Return. Form 8919 requires the employee to indicate why he or she is filing the form. The reasons include that the employee filed Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, and received a determination letter that he or she is an employee (or has not yet received a reply from the Service) or that he or she received other correspondence from the IRS determining that he or she is an employee. In general, the IRS wants an employee who is filing Form 8919 to also file a Form SS-8.

In the past, misclassified workers sometimes used Form 4137, Social Security and Medicare Tax on Unreported Tip Income, to report their share of Social Security and Medicare taxes, but the Service says they should no longer use that form.

Regulations

Final Regs. Govern Release of Taxpayer Information by Preparers

On January 3, 2008, the IRS released final regulations that govern the handling and release of taxpayer information by return preparers (TD 9375). The final regulations are the first update to the rules governing preparer disclosure and privacy requirements since 1974. Return preparers will have until January 1, 2009, to implement the new requirements.

The new rules affect only return preparers; they do not affect the strict rules governing how the IRS handles taxpayer information.

Under the new rules, preparers generally must obtain taxpayer consent, either by paper or electronically depending on how the return is being filed, before tax return information can be disclosed to any third party or used for any purpose other than filing the return. Such consent must identify the intended purpose of the disclosure, identify the recipients, and describe the particular authorized disclosure or use of the information.

The regulations include mandatory language that must be included in the consent informing individual taxpayers that (1) they are not required to sign the consent; (2) if they sign the consent, federal law may not protect their information from further disclosure; and (3) if they sign the consent, they can set a time period for the duration of that consent. If taxpayers fail to set a time period, the consent is valid for a maximum of one year. Consent requests on paper must be in 12-point type on 8½ × 11-inch paper. Elec-tronic consent requests on a website must be in the same type as the website’s standard text.

To protect taxpayers from being pressured with repeated consent re-quests regarding the same issue, if a taxpayer declines to provide consent for an unrelated tax preparation disclosure or use request, the preparer cannot make another similar consent request.

Finally, preparers must obtain consent from taxpayers before sending tax information to a preparer outside the United States. This is to ensure that taxpayers know when their returns are being sent offshore for preparation. In such cases, the regulations require that the taxpayer’s Social Security number be redacted.

 

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© 2008 AICPA