The IRS has provided guidance on two exceptions to the 10 percent additional tax under Code Sec. 72(t)(1) for emergency personal expense distributions and domestic abuse victim distributions. These exceptions were added by the SECURE 2.0 Act of 2022, P.L. 117-328, and became effective January 1, 2024. The Treasury Department and the IRS anticipate issuing regulations under Code Sec. 72(t) and request comments to be submitted on or before October 7, 2024.

The IRS has provided guidance on two exceptions to the 10 percent additional tax under Code Sec. 72(t)(1) for emergency personal expense distributions and domestic abuse victim distributions. These exceptions were added by the SECURE 2.0 Act of 2022, P.L. 117-328, and became effective January 1, 2024. The Treasury Department and the IRS anticipate issuing regulations under Code Sec. 72(t) and request comments to be submitted on or before October 7, 2024.

Distributions for Emergency Personal Expenses

Code Sec. 72(t)(2)(I) provides an exception to the 10 percent additional tax for a distribution from an applicable eligible retirement plan to an individual for emergency personal expenses. The term "emergency personal expense distribution" means any distribution made from an applicable eligible retirement plan to an individual for purposes of meeting unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses. The IRS specifically noted that emergency expenses could be related to: medical care; accident or loss of property due to casualty; imminent foreclosure or eviction from a primary residence; the need to pay for burial or funeral expenses; auto repairs; or any other necessary emergency personal expenses.

The IRS provides that a plan administrator or IRA custodian may rely on a written certification from the employee or IRA owner that they are eligible for an emergency personal expense distribution. Furthermore, the IRS provides that an emergency personal expense distribution is not treated as a rollover distribution and thus is not subject to mandatory 20% withholding. However, the distribution is subject to withholding, the IRS said. If the emergency personal expense distribution is repaid, it is treated as if the individual received the distribution and transferred it to an eligible retirement plan within 60 days of distribution.

If an otherwise eligible retirement plan does not offer emergency personal expense distributions, the IRS indicated that an individual may still take an otherwise permissible distribution and treat it as such on their federal income tax return. The individual claims on Form 5329 that the distribution is an emergency personal expense distribution, in accordance with the form’s instructions. The individual has the option to repay the distribution to an IRA within 3 years.

Distributions to Domestic Abuse Victims

Code Sec. 72(t)(2)(K) provides an exception to the 10 percent additional tax for an eligible distribution to a domestic abuse victim (domestic abuse victim distribution). The guidance defines a"domesticabusevictimdistribution" as any distribution from an applicable eligible retirement plan to a domestic abuse victim if made during the 1-year period beginning on any date on which the individual is a victim of domestic abuse by a spouse or domestic partner. "Domesticabuse" is defined as physical, psychological, sexual, emotional, or economic abuse, including efforts to control, isolate, humiliate, or intimidate the victim, or to undermine the victim’s ability to reason independently, including by means of abuse of the victim’s child or another family member living in the household.

As with distributions for emergency personal expenses, a retirement plan may rely on an employee’s written certification that they qualify for a domestic abuse victim distribution. Similarly, if an otherwise eligible retirement plan does not offer domestic abuse victim distributions, the IRS indicated that an individual may still take an otherwise permissible distribution and treat it as such on their federal income tax return. The individual claims on Form 5329 that the distribution is a domestic abuse victim distribution, in accordance with the form’s instructions. The individual has the option to repay the distribution to an IRA within 3 years.

Request for Comments

The Treasury Department and the IRS invite comments on the guidance, and specifically on whether the Secretary should adopt regulations providing exceptions to the rule that a plan administrator may rely on an employee’s certification relating to emergency personal expense distributions and procedures to address cases of employee misrepresentation. Comments should be submitted in writing on or before October 7, 2024, and should include a reference to Notice 2024-55.

On June 17, 2024, the U.S. Department of the Treasury and the Internal Revenue Service announced a new regulatory initiative focused on closing tax loopholes and stopping abusive partnership transactions used by wealthy taxpayers to avoid paying taxes.

On June 17, 2024, the U.S. Department of the Treasury and the Internal Revenue Service announced a new regulatory initiative focused on closing tax loopholes and stopping abusive partnership transactions used by wealthy taxpayers to avoid paying taxes.

Specifically targeted by this new tax compliance effort are partnership basis shifting transactions. In these transactions, a single business that operates through many different legal entities (related parties) enters into a set of transactions that manipulate partnership tax rules to maximize tax deductions and minimize tax liability. These basis shifting transactions allow closely related parties to avoid taxes.

The use of these abusive transactions grew during a period of severe underfunding for the IRS. As such, the audit rates for these increasingly complex structures fell significantly. It is estimated that these abusive transactions, which cut across a wide variety of industries and individuals, could potentially cost taxpayers more than $50 billion over a 10-year period, according to an IRS News Release.

"Using Inflation Reduction Act funding, we are working to reverse more than a decade of declining audits among the highest income taxpayers, as well as complex partnerships and corporations," IRS Commissioner Danny Werfel said during a press call discussing the new effort on June 14, 2024.

"This announcement signals the IRS is accelerating our work in the partnership arena, which has been overlooked for more than a decade and allowed tax abuse to go on for far too long," said IRS Commissioner Danny Werfel. "We are building teams and adding expertise inside the agency so we can reverse long-term compliance declines that have allowed high-income taxpayers and corporations to hide behind complexity to avoid paying taxes. Billions are at stake here".

This multi-stage regulatory effort announced by the Treasury and IRS includes the following guidance designed to stop the use of basis shifting transactions that use related-party partnerships to avoid taxes:

• proposed regulations under existing regulatory authority to stop related parties in complex partnership structures from shifting the tax basis of their assets amongst each other to take abusive deductions or reduce gains when the asset is sold;

• proposed regulation to require taxpayers and their material advisers to report if they and their clients are participating in abusive partnership basis shifting transactions; and

• a Revenue Rulingproviding that certain related-party partnership transactions involving basis shifting lack economic substance.

"Treasury and the IRS are focused on addressing high-end tax abuse from all angles, and the proposed rules released today will increase tax fairness and reduce the deficit," said U.S. Secretary of the Treasury Janet L. Yellen.

In the June 14, 2024, press call, Commissioner Danny Werfel also noted that there will be an increase in audits of large partnerships with average assets over $10 billion dollars and larger organizational changes taking place to support compliance efforts, including the creation of a new associate office that will focus exclusively on partnerships, S corporations, trusts, and estates.

By Catherine S. Agdeppa, Content Management Analyst

A savings account with the tax benefits of a health savings account or an educations savings account but without the singular restricted focus could be something that gains traction as Congress addresses the tax provision of the Tax Cuts and Jobs Act that expire in 2025.

A savings account with the tax benefits of a health savings account or an educations savings account but without the singular restricted focus could be something that gains traction as Congress addresses the tax provision of the Tax Cuts and Jobs Act that expire in 2025.

The concept was promoted by multiple witnesses testifying during a recent Senate Finance Committee hearing on the subject of child savings accounts and other tax advantaged accounts that would benefit children. It also is the subject of a recently released report from The Tax Foundation.

Rather than push new limited-use savings accounts, "policymakers may want to consider enacting a more comprehensive savings program such as a universalsavingsaccount," Veronique de Rugy, a research fellow at George Mason University, testified before the committee during the May 21, 2024, hearing. "Universalsavingsaccounts will allow workers to save in one simple account from which they would withdraw without penalty for any expected or unexpected events throughout their lifetime."

She noted that, like other more focused savings accounts, like health savings accounts, it would have "the benefit of sheltering some income from the punishing double taxation that our code imposes."

De Rugy added that universal savings accounts "have a benefit that they do not discourage savings for those who are concerned that the conditions for withdrawals would stop them from addressing an emergency in their family."

Adam Michel, director of tax policy studies at the Cato Institute, who also promoted the idea of universal savings accounts. He said these accounts "would allow families to save for their kids or any of life’s other priorities. The flexibility of these accounts make them best suited for lower and middle income Americans."

He also noted that they are promoting savings in countries that have implemented them, including Canada and United Kingdom.

"For example, almost 60 percent of Canadians own tax-free savingsaccounts," Michel said. "And more than half of those account holders earned the equivalent of about $37,000 a year. These accounts have helped increase savings and support the rest of the Canadian savings ecosystem."

De Rugy noted that in countries that have implemented it, they function like a Roth account in that money that has already been taxed can be put into it and not penalized or taxed upon withdrawal.

Michel also noted that the if the tax benefits extend to corporations as they do with deposits to employee health savings accounts, "to the extent that you lower the corporate income tax, you’re going to encourage a different additional investment into savings by those entities."

Simulating The Universal Savings Account Impact

The Tax Foundation in its report simulated how a universal savings account could work, based on how they are implemented in Canada. The simulation assumed the accounts could go active in 2025 for adults aged 18 years or older.

On a post-tax basis, individuals would be allowed to contribute up to $9,100 on a post-tax basis annually, with that cap indexed for inflation. Any unused "contribution room" would be allowed to be carried forward. Earnings would be allowed to grow tax-free and withdrawals would be allowed for any purpose without penalty or further taxation. Any withdrawal would be added back to that year’s contribution room and that would be eligible for carryover as well.

"The fiscal cost of this USA policy would be offset by ending the tax advantage of contributions to HSAs beginning in 2025," the report states. "As such, future contributions to HSAs would be given normal tax treatment, i.e. included in taxable income and subject to payroll tax with subsequent returns on contributions also included in taxable income."

In this scenario, the Tax Foundation report estimates that "this policy change would on net raise tax revenue by about $110 billion over the 10-year budget window."

As for the impact on taxpayers, the "after-tax income would fall by about 0.1 percent in 2025 and by a smaller amount in 2034, reflecting the net tax increase in those years," the report states. "Over the long run, and accounting for economic impacts, taxpayers across every quintile would see a small increase in after-tax income on average, but the top 5 percent of earners would continue to see a small decrease in after-tax income on average."

By Gregory Twachtman, Washington News Editor

The Internal Revenue Service’s use of artificial intelligence in selecting tax returns for National Research Program audits that areused to estimate the tax gap needs more documentation and transparency, the U.S. Government Accountability Office stated.

The Internal Revenue Service’s use of artificial intelligence in selecting tax returns for National Research Program audits that areused to estimate the tax gap needs more documentation and transparency, the U.S. Government Accountability Office stated.

In a report issued June 5, 2024, the federal government watchdog noted that while the agency uses AI to improve the efficiency and selection of audit cases to help identify noncompliance, "IRS has not completed its documentation of several elements of its AI sample selection models, such as key components and technical specifications."

GAO noted that the IRS began using AI in a pilot in tax year 2019 for sampling tax returns for NRP audits. The current plan is to use AI to create a sample size of 4,000 returns to measure compliance and help inform tax gap estimates, although GAO expressed concerns about the accuracy of the estimates with that sample size.

"For example, NRP historically included more than 2,500 returns that claimed the Earned Income Tax Credit, but the redesigned sample has included less than 500 of these returns annually," the report stated.

IRS told GAO that it "is exploring ways to combine operational audit data with NRP audit data when developing its taxgapestimates. IRS officials also told us that if IRS can reliably combine these data for taxgap analysis, IRS might be better positioned to identify emerging trends in noncompliance and reduce the uncertainty of the estimates due to the small sample size."

The report also highlighted the fact that the agency "has multiple documents that collectively provide technical details and justifications for the design of the AI models. However, no set of documents contains complete information and IRS analyst could use to run or update the models, and several key documents are in draft form."

"Completing documentation would help IRS retain organizational knowledge, ensure the models are implemented consistently, and make the process more transparent to future users," the report stated.

By Gregory Twachtman, Washington News Editor

Starting in 2010, the $100,000 adjusted gross income cap for converting a traditional IRA into a Roth IRA is eliminated. All other rules continue to apply, which means that the amount converted to a Roth IRA still will be taxed as income at the individual's marginal tax rate. One exception for 2010 only: you will have a choice of recognizing the conversion income in 2010 or averaging it over 2011 and 2012.

The Tax Increase Prevention and Reconciliation Act of 2005 eliminated the $100,000 adjusted gross income (AGI) ceiling for converting a traditional IRA into a Roth IRA. While this provision does not apply until 2010, now may be a good time to make plans to maximize this opportunity.

The Roth IRA has benefits that are especially useful to high-income taxpayers, yet as a group they have been denied those advantages up until now. Currently, you are allowed to convert a traditional IRA to a Roth IRA only if your AGI does not exceed $100,000. A married taxpayer filing a separate return is prohibited from making a conversion. The amount converted is treated as distributed from the traditional IRA and, as a consequence, is included in the taxpayer's income, but the 10-percent additional tax for early withdrawals does not apply.

Significant benefits

While recognizing income sooner rather than later is usually not smart tax planning, in the case of this new opportunity to convert a traditional IRA to a Roth IRA, the math encourages it. The difference is twofold:

1. All future earnings on the account are tax free; and
2. The account can continue to grow tax free longer than a traditional IRA without being forced to be distributed gradually after reaching age 70 ½.

These can work out to be huge advantages, especially valuable to individuals with a degree of accumulated wealth who probably won't need the money in the Roth IRA account to live on during retirement.

Example. Mary's AGI in 2010 is $200,000 and she has traditional IRA balances that will have grown to $300,000. Assuming a marginal federal and local income tax of about 40 percent on the $300,000 balance, the $180,000 remaining in the account can grow tax free thereafter, with distributions tax free. Further assume that Mary is 45 years of age with a 90 year life expectancy and money conservatively doubles every 15 years. She will die with an account of $1.44 million, income tax free to her heirs. If the Roth IRA is bequeathed to someone in a younger generation with a long life expectancy, even factoring in eventual required minimum distributions, the amount that can continue to accumulate tax free in the Roth IRA can be staggering, eventually likely to reach over $10 million.

Planning strategies

Now is not too early to start planning to take advantage of the Roth IRA conversion opportunity starting in 2010. While planning to maximize the conversion will become more detailed as 2010 approaches and your assets and income for that year are more measurable, there are certain steps you can start taking now to maximize your savings.

Start a nondeductible IRA

The income limits on both kinds of IRAs have prevented higher income taxpayers from making deductible contributions to traditional IRAs or any contributions to Roth IRAs. They could always make nondeductible contributions to a traditional IRA, but such contributions have a limited pay-off (no current deduction, tax on account income is deferred rather than eliminated, required minimum distributions).

While a taxpayer could avoid these problems by making nondeductible contributions to a traditional IRA and then converting it to a Roth IRA, this option was not available for upper income taxpayers who would have the most to benefit from such a conversion. With the elimination of the income limit for tax years after December 31, 2009, higher income taxpayers can begin now to make nondeductible contributions to a traditional IRA and then convert them to a Roth IRA in 2010. In all likelihood, there will be little to tax on the converted amount.

What's more, taxpayers with $100,000-plus AGIs should consider continue making nondeductible IRA contributions in the future and roll them over into a Roth IRA periodically. As a result, the elimination of the income limit for converting to a Roth IRA also effectively eliminates the income limit for contributing to a Roth IRA.

Example. John and Mary are a married couple with $300,000 in income. They are not eligible to contribute to a Roth IRA because their AGI exceeds the $160,000 Roth IRA eligibility limit. Beginning in 2006, the couple makes the maximum allowed nondeductible IRA contribution ($8,000 in 2006 and 2007, and $10,000 in 2008, 2009, and 2010). In 2010, their account is worth $60,000, with $46,000 of that amount representing nondeductible contributions that are not taxed upon conversion. The couple rolls over the $60,000 in their traditional IRA into a Roth IRA. They must include $14,000 in income (the amount representing their deductible contributions), which they can recognize either in 2010, or ratably in 2011 and 2012.

Assuming they have sufficient earned income each year thereafter (until reaching age 70 1/2), John and Mary can continue to make the maximum nondeductible contributions to a traditional IRA and quickly roll over these funds into their Roth IRA, thereby avoiding significant taxable growth in the assets that would have to be recognized upon distribution from a traditional IRA.

Rollover 401(k) accounts

Contributions to a Section 401(k) plans cannot be rolled over directly into a Roth IRA. The lifting of the $100,000 AGI limit does not change this rule. However, they often can be rolled over into a traditional IRA and then, after 2009, converted into a Roth IRA.

Not everyone can just pull his or her balance out of a 401(k) plan. A plan amendment must permit it or, more likely, those who are changing jobs or are otherwise leaving employment can choose to roll over the balance into an IRA rather than elect to continue to have it managed in the 401(k) plan.

For money now being contributed to 401(k) plans by employees, an even better option would be for those contributions to be made to a Roth 401(k) plan. Starting in 2006, as long as the employer plan allows for it, Roth 401(k) accounts may receive employee contributions.

Gather those old IRA accounts

Many taxpayers opened IRA accounts when they were first starting out in the work world and their incomes were low enough to contribute. Over the years, many have seen those account balances grow. These accounts now may be converted into Roth IRAs starting in 2010, regardless of income.

Paying the tax

In spite of all the advantages of a Roth IRA, a conversion is advisable only if the taxpayer can readily pay the tax generated in the year of the conversion. If the tax is paid out of a distribution from the converted IRA, that amount is also taxed; and if the distribution counts as an early withdrawal, it is also subject to an additional 10-percent penalty. For those planning to convert who may not already have the funds available, saving now in a regular bank or brokerage account to cover the amount of the tax in 2010 can return an unusually high yield if it enables a Roth IRA conversion in 2010 that might not otherwise take place.

Careful planning is key

Transferring funds between retirement accounts can carry a high price tag if it is done incorrectly. For those who plan carefully, however, converting from a traditional IRA to a Roth IRA can yield very substantial after-tax rates of return. Please feel free to call our offices if you have any questions about how the 2010 conversion opportunity should fit into your overall tax and wealth-building strategy.

The AMT is difficult to apply and the exact computation is very complex. If you owed AMT last year and no unusual deduction or windfall had come your way that year, you're sufficiently at risk this year to apply a detailed set of computations to any AMT assessment. Ballpark estimates just won't work.

If you did not owe AMT last year, you still may be at risk. The IRS estimates that half million more individuals will be subject to the AMT in 2006 because of rising deductions and exemptions. If Congress doesn't extend the same AMT exclusion amount given in 2005, an estimated 3 million more taxpayers will pay AMT.

For a system that was intended originally to target only the very rich, the AMT now hits many middle to upper-middle class taxpayers as well. Obviously something has to be done, and will be, eventually, through proposed tax reform measures. In the meantime, expect AMT to be around for at least another year.

Basic calculations. Whether you will be liable for the AMT depends on your combination of income, adjustments and preferences. After all the computations, if your AMT liability exceeds your income tax liability, you will be liable for the AMT. Here are the basic steps to take to determine in evaluating whether you will owe the AMT:

• Step #1: Calculate your regular taxable income. If your regular tax were to be determined by reference to an amount other than taxable income, that amount would need to be determined and used in the next steps.
  
• Step #2: Calculate your alternative minimum taxable income (AMTI) by increasing or reducing your regular taxable income (or other relevant amount) by applying the AMT adjustments or preferences. These include business depreciation adjustments and preferences, loss, timing and personal itemized deductions adjustments, and tax-exempt or excluded income preferences. This is the step with potentially many sub-computations in determining increases and reductions in tax liability.
  
• Step #3:  If your AMTI exceeds the applicable AMT exemption amount, pay AMT on the excess.

While no single factor will automatically trigger the AMT, the cumulative result of several targeted tax benefits considered in Step #2, above, can be fatal. Common items that can cause an "ordinary" taxpayer to be subject to AMT are:

• All personal exemptions (especially of concern to large families);
• Itemized deductions for state and local income taxes and real estate taxes;
• Itemized deductions on home equity loan interest (except on loans used for improvements);
• Miscellaneous Itemized Deductions;
• Accelerated depreciation;
• Income from incentive stock options; and
• Changes in some passive activity loss deductions.

Starting for tax year 2005, businesses have been able to take a new deduction based on income from manufacturing and certain services. Congress defined manufacturing broadly, so many businesses -just not those with brick and mortar manufacturing plants-- will be able to claim the deduction. The deduction is 3 percent of net income from domestic production for 2005 and 2006. This percentage rises to 6 percent and then 9 percent in subsequent years.

Domestic production includes the manufacture of tangible personal property and computer software in the U.S. It also includes construction activities and services from engineering and architecture. Income from these activities must be calculated on an item-by-item basis and cannot be determined by division, product line or transaction. Direct and indirect costs are subtracted to determine "qualified production income." Land does not qualify as domestic production property.

The 3 percent rate is applied to the lower of net income from domestic production and overall net income. That amount is then capped at 50 percent of wages paid out by the employer for all its business activities.

Example. In 2005, Company X has $300,000 of income from domestic production activities. The company's overall net income was $500,000.  The 3 percent rate is applied to $300,000, yielding a potential deduction of $9,000.

Company X paid its employees $50,000 in wages and reported this amount on Forms W-2 for 2005.  Since the deduction is limited to 50 percent of wages paid and reported, Company X's deduction for 2005 is capped at $25,000 (50 percent of $50,000 in wages).  X is entitled to a $9,000 deduction.

W-2 wage limitation

In some cases, the W-2 wage limit can easily trip up taxpayers. A successful sole proprietor who earns income but has no employees would not have any W-2 wages and, therefore, could not take the deduction.  Self-employment income is not treated as wages. Neither are payments made to independent contractors. A small business that is incorporated but has no employees would have the same problem. Because payments to partners are not W-2 wages, a partnership with two partners and no employees also would be unable to take the deduction. Sole proprietors and other small businesses may want to consider putting a family member on the payroll, so that they have W-2 wages to satisfy this requirement.

An incorporated business, such as an S corporation, could put an owner on the payroll and apply the W-2 limit to reasonable wages paid to the owner. Employees include officers of the corporation and common law employees, as defined in the Tax Code.  The more labor-intensive the manufacturing process, the more likely that a deduction will not be reduced by the W-2 wage limitation. The more automated the manufacturing process, the more likely it is that the manufacturer will find itself restricted by the wage limitation and not be able to take the full manufacturing deduction.

Code Sec. 199 defines W-2 wages as the sum of the total W-2 wages reported on Forms W-2, "Wage and Tax Statement," for the calendar year ending during the employer's taxable year. W-2 wages are defined as wages and deferred salary that is included on Form W-2.  Deferred salary includes elective deferrals for a 401(k) plan or tax-sheltered annuity; contributions to a plan of a state and local government or tax-exempt entity; and designated Roth IRA contributions. IRS guidance provides three methods for calculating W-2 wages.

Our office can help you determine your eligibility for the manufacturing deduction and the amount of the deduction. Give us a call today.