Key tax developments in the first quarter of 2001

Legislative developments dominated the tax news in the first quarter, as the President and Congress sparred over which taxes should be cut, by how much, and when. However, there were other important tax developments that may affect you, your family, your investments, and your livelihood. Some of these developments may be favorable for you while others may not be. Take a few minutes to skim through the important changes summarized below, and call me for more information about any of them and any steps you should take to capitalize on favorable developments and to minimize the impact of of unfavorable ones.

IRS revises split-dollar insurance rules and replaces key valuation table-immediate review in order. The IRS has issued new rules on "split-dollar" life insurance plans and replaced a key valuation table with a new one based on more current mortality assumptions. In a typical plan, the employer pays part of the premiums, to the extent of the annual increase in the policy's cash surrender value, and the employee pays the rest. The employer generally is entitled to receive (out of the policy proceeds) an amount equal to the policy's cash surrender value, and the employee can designate the beneficiary of the balance. The employee pays a substantial part of the premiums in the early years but relatively little, or nothing, later on as dividends payable on the policy's cash value are used to pay the premium cost. The prior rules taxed the employee on the value of the insurance protection he received under the arrangement, and on cash dividends or other benefits received, reduced by any premiums he paid. The "value" of the insurance protection included in income annually was the one-year term insurance premium cost for the coverage, determined by using an IRS table (P.S. 58 rates) or (under certain circumstances) the insurer's published premium rates, if lower. Under the IRS's revised rules, any payment made by an employer under a split-dollar arrangement must be accounted for either as a loan, an investment in the contract by the employer, or a compensation payment. Additionally, the IRS also revoked the "P.S. 58 table" and replaced it with a valuation table based on more current mortality assumptions.

In the opinion of many experts, all split-dollar plans must be reviewed immediately to determine how economic benefits should be reported, and whether existing plans should be retained or scrapped in favor of new arrangements.

IRS explains how accrual method sellers can capitalize on retroactive installment-method change. A controversial '99 tax law change which applied for sales after December 16, '99 provided that the installment method could no longer be used by most accrual method taxpayers (there were exceptions for certain farm property, residential timeshares and lots). Fortunately, this change was retroactively repealed by a law passed late last year. The problem was that some accrual-method taxpayers affected by the original ban had filed returns reporting an amount realized equal to the full selling price of property that would have been eligible for installment reporting. And under long-established rules, this is treated as an election out of the installment method, which can be revoked only with IRS's consent. To fix this problem, the IRS said that accrual method taxpayers that entered into an installment sale after Dec. 16, '99, and filed a federal income tax return by April 16, 2001, reporting the sale on an accrual method (and, thus, an amount realized equal to the selling price) had its permission to revoke their effective election out of the installment method. This relief applies only if timely amended returns are filed for the tax year in which the installment sale occurred, and for any other affected tax year, reporting the gain on the installment method.

IRS stops challenging contractors' use of cash method. The IRS has announced that it won't challenge the use of the cash method of accounting by small construction contractors. In the past couple of years, a number of courts have rejected the IRS position that these businesses must use inventory accounts and an accrual method of accounting. These cases involved a flooring installer, a paving contractor, and a cement contractor. Now the IRS says that until further guidance is issued, it will not argue that taxpayers in similar businesses must use inventory accounts and an accrual method of accounting. In particular, the IRS says this covers construction contractors involved in paving, painting, roofing, drywall, and landscaping. However, the interim policy does not apply to resellers, manufacturers, or certain other businesses otherwise required to use an accrual method, such as a C corporation (or partnership with a C corporation partner) with gross receipts of $5 million or more that is not a farming business or personal service corporation.

"Final" research credit regs put on ice. Late last year, the IRS issued final regs on how businesses can qualify for the 20% research credit. The regs were attacked for springing new requirements on businesses, and for taking an excessively restrictive posture on credit qualification. Responding to these criticisms, the IRS announced that it was putting the "final" research credit regs on hold. Pending review of the regs, which were supposed to go into effect for post-Jan. 2, 2001 expenses, the IRS said that businesses may continue to rely on them.

Company's deduction when nonqualified stock option is exercised reduces exposure to corporate AMT. When a nonqualified stock option is exercised, the employee generally has income equal to the difference between the exercise price and the option stock's fair market value at exercise. At that time, the corporation gets a compensation deduction equal to the amount the employee takes into income. The IRS has ruled that this compensation deduction also is allowed for purposes of computing corporate adjusted current earnings for alternative minimum tax (AMT) purposes. This has the effect of reducing the company's exposure to the AMT, and also may affect the shareholder tax treatment of corporate distributions.

W-2s can be sent electronically. Under recently issued regulations, employers/payers required to furnish a copy of a Form W-2, "Wage and Tax Statement," to an employee may furnish the form electronically on a Web site instead of on paper if certain conditions are met. This also applies to those required to furnish Forms 1098-T, Tuition Payments Statement, or Forms 1098-E, Education Loan Statement, to students and borrowers. However, the regs allow employees, students, and borrowers who want paper statements to choose to continue to receive them. The new regs will be effective for statements that have to be filed by January 31, 2002 for the 2001 year.