Tax and Business Alert - 

July 2005

Overview of the 2005 Bankruptcy Act

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the 2005
Bankruptcy Act) was signed into law by the President on April 20, 2005. Most of its provisions become effective on October 17, 2005, so there is time to prepare for the sweeping changes contained in the new law.

The 2005 Bankruptcy Act has garnered significant attention in the media, primarily because fewer consumers will be able to use Chapter 7 (straight liquidation) as a quick fix for extinguishing credit card bills or other unsecured debts. The overriding purpose of the new law appears to be to reduce the attractiveness of bankruptcy and to restore its historic reputation as an option of last resort. This is accomplished in many ways, however, the two most noteworthy changes that will lessen the appeal of bankruptcy are:

1. Prior to filing for bankruptcy protection, debtors are required to submit to credit counseling and meet other obligations intended to dissuade them from seeking bankruptcy protection.

2. There is now a "means" test that limits access to a straight liquidation of debts under Chapter 7. Generally, if the combined gross income of the debtor's family is greater than the median family income in his or her state, he or she will be placed in a 36--60 month repayment plan under Chapter 13 rather than getting the coveted "fresh start" under Chapter 7 of the bankruptcy code.

The news is not all bad for debtors. The new law increases the exemption for retirement funds, exempts personal residences owned for at least 40 months, and protects funds properly transferred to asset protection trusts (e.g., Alaska or Delaware asset protection trusts). There is also a mild incentive for creditors to work out repayment plans outside of bankruptcy. A court may reduce an unsecured consumer debt claim by up to 20% if the claim was filed by a creditor who unreasonably refused a reasonable alternative repayment schedule proposed by an approved credit counseling agency on the debtor's behalf.

New Exemption Limit on IRAs. The new law places a limit of $1 million on the exemption for traditional and Roth IRAs. Qualified plans [e.g., 401(k) and 403(b) plans], SEPs and SIMPLE IRAs enjoy an unlimited exemption.

More Responsibility for Bankruptcy Attorneys. Under the new act, the person preparing a bankruptcy petition must give assurances about the accuracy of its contents. Attorneys must make "reasonable inquiry to verify that the information contained in such documents is well grounded in fact."

Tax Calendar

August 1

--For those with employees, a federal unemployment tax (FUTA) deposit is due if the FUTA liability through June 30 exceeds $500.

--The second quarter Form 941 (Employer's Quarterly Federal Tax Return) is also due today (except that you have until August 10 to file if you deposited all taxes for the quarter when they were due).

August 15

--Personal returns extended in April need to be filed or extended (to October 17) by today.

September 15

--Third quarter estimated tax payments are due for individuals, trusts, and calendar-year corporations.

If a six-month extension was obtained, calendar year corporations should also file their 2004 income tax returns by this date.

Lexus Certified for Clean Fuel Deduction

The IRS recently announced that it had certified the 2006 Lexus RX 400h as eligible for the clean fuel vehicle deduction. The RX 400h is the first luxury brand vehicle to qualify for this deduction. It joins five less-expensive vehicles from Ford, Honda, and Toyota which were previously certified as eligible for the deduction. Taxpayers can now choose a premium vehicle brand that gets increased gas mileage and is good for the environment.

The original owner of an RX 400h, or other qualified vehicle, can claim a tax deduction in the year the vehicle is originally used. For 2005, the deduction limit is $2,000. The deduction will be reduced to $500 in 2006. Currently, no deduction will be allowed after 2006. The benefit can be taken as an adjustment to income on your tax return and you don't need to itemize to claim this deduction.

Many Taxpayers Underreport Income

The tax gap--the difference between what taxpayers should pay and what they actually pay on time--is estimated to be from $312 billion to $353 billion, according to preliminary findings from a study of 2001 tax returns. The initial tax gap findings come from a three-year study called the National Research Program which audited 46,000 individual income tax returns from 2001. The IRS expects to recover about $55 billion of this gap from late payments and through enforcement activities. So, the final tax gap figure for 2001, expected to be released by the end of 2005, will likely exceed $250 billion.

The study showed that the tax gap results largely from three components: underreporting income, underpaying taxes, and failure to file returns. The findings indicate that underreporting accounts for more than 80% of the shortfall and is caused by individuals understating income, primarily from business activities, not wages and salaries. Underpaying and nonfiling each make up about 10% of the tax gap. Compliance is highest where third-party withholding or reporting is required with less than 1.5 percent of wages and salaries misreported.

The administration has requested an increase of almost 8% in the 2006 IRS budget to expand audits of corporations and high-income individuals as well as collection and criminal investigation activities.

Deferred Compensation Plans after 2004

Qualified retirement plans such as 401(k) plans provide a basic incentive or fringe benefit for the employees of numerous companies. However, many firms (particularly relatively small and privately held companies) use nonqualified deferred compensation arrangements (e.g., deferred bonus arrangements, stock options, or stock appreciation rights plans) to attract and retain a talented workforce.

The American Jobs Creation Act of 2004 (the 2004 Jobs Act) added new Section 409A to the Internal Revenue Code in an effort to reduce what Congress considered to be abusive company practices in the area of compensation at companies like Enron, WorldCom, etc. Through this statute, Congress hoped to curb abuses such as moving funds offshore to minimize creditor risk and stop distributions to executives triggered by a firm's financial deterioration. Unfortunately, and as is often the case, many innocent taxpayers will be caught in this net designed to help curb fraud and abuse by a few.

The premise of Section 409A is fairly simple and a little hard to swallow. Starting in 2005, during any year that certain requirements are not met, any previously deferred compensation that is not subject to a substantial risk of forfeiture (see the example below) will be treated as received that year In addition to income tax, a 20% penalty (calculated on the deferred income now recognizable) and interest (calculated on the tax underpayment from not recognizing the income in the year it was first deferred) will be imposed on the amount included in income. Talk about adding insult to injury!

Example: Substantial risk of forfeiture. In 2005, Taylor's employer (a calendar-year corporation) agrees to pay her a $50,000 bonus for past services at the end of five years, provided she is still employed at that time. Taylor has a legally binding right to the $50,000 in 2005, but the $50,000 bonus amount is subject to a substantial risk of forfeiture, i.e., she must work there for five years to actually receive it. Assume that on 6/30/10 Taylor completes the fifth year of service. If Taylor subsequently receives the $50,000 on 8/31/10, this arrangement will not result in constructive receipt of the income before it is received since Taylor was subject to a substantial risk of forfeiture during the five-year waiting period.

Section 409A does not apply to several types of compensation plans including, but not limited to, qualified plans [e.g., 401(k) and profit sharing plans], tax deferred annuities, simplified employee pension (SEP) and savings incentive match plan for employees (SIMPLE) plans, and compensation received 2½ months after the year any substantial risk of forfeiture lapses. Section 409A does apply to any plan or arrangement (other than those specifically excepted) under which compensation is payable in a year after the year the employee has a "legally binding right" to it. When a plan is subject to Section 409A, any previously deferred compensation that is not subject to a substantial risk of forfeiture is currently includable in gross income (to the extent not previously included) and is subject to interest and penalty unless the plan meets certain requirements as specified in IRC Sec. 409A.

Obviously, the new Section 409A requirements are complex and failure to comply could be costly. Needless to say, a review of any existing deferred compensation arrangements is warranted. Please call us if assistance is necessary to review an existing plan or to establish a new deferred compensation plan.

Dividing IRAs Tax-free in Divorce

Transferring an individual's interest in an IRA to a spouse or former spouse pursuant to a divorce decree is not taxable to either spouse. And, unlike a qualified plan [e.g., 401(k)], there is no requirement that a qualified domestic relations order (QDRO) be in place. This exception to the general rule that IRA amounts may not be paid or transferred to anyone other than the owner (before death) applies only to a spouse or former spouse. A distribution or transfer to anyone other than a spouse or former spouse, even if pursuant to a divorce, generally is taxable to the IRA owner.

The IRA transfer is tax-free only if it is specifically required by a decree of divorce or separate maintenance (or a written instrument incident to such a decree). Thus, the couple must eventually divorce or legally separate. Transferring an IRA under a written separation agreement or other court order (e.g., temporary support order) is not tax-free.

An IRA interest transferred under a decree of divorce or separate maintenance is treated as the recipient's IRA for all purposes. For example, if the transferee is over age 70½, minimum distributions must begin (unless the IRA is a Roth IRA). After the transferee's death, the IRA would be subject to the minimum distribution rules applied to any IRA owner. An IRA distribution to the receiving spouse after the transfer is subject to the 10% early distribution penalty if the recipient is under age 59½.

The safest way to accomplish a divorce-related IRA transfer is through a trustee-to-trustee transfer. Under this type of arrangement, the trustee of the paying spouse's IRA transfers the required amount to the trustee of the receiving spouse's IRA. Withholding does not apply to a trustee-to-trustee transfer, and the IRA owner does not risk being taxed on the distribution. If the paying spouse's trustee will not make a payment to another person's IRA, the trustee should be requested to make the payment to another IRA in the paying spouse's name followed by an assignment of ownership (and change of name) of the new IRA to the receiving spouse.

Taxpayers can transfer both traditional and Roth IRAs incident to divorce and they presumably retain their character as a traditional or Roth IRA.