The Top 10 Tax Developments of 2001—A List Based on Future Impact

By George G. Jones and George L. Yaksick Jr.

This article presents, albeit somewhat presumptively, the “Top 10” federal tax developments of 2001. In constructing our list, we quickly discovered that there were certainly more than 10 developments this year. However, working under the assumption that you do not want to be caught missing the significance of a major development, here’s our list.

1. EGTRRA: The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) is the biggest tax cut package in 20 years, and for a generation of tax practitioners who do not remember the 1986 Tax Reform Act, it is probably the most seminal event in their early careers. The new law brings significantly lower income tax rates over the long haul that will change the equation for tax-driven transactions. It also introduces new incentives—starting in 2002—for retirement plans, thus making evaluation of clients’ retirement plans a major area of practice next year. EGTRRA also continues the flux in phase-in and phase-out dates of deductions, exemptions and credits. Similarly, the gradual and temporary “repeal” of the estate tax can sow confusion among clients who mistakenly believe the estate tax is abolished. Like every other change in EGTRRA, the old estate tax reappears when EGTRRA expires in 2010.

2. Continuing IRS Reorganization: It has been four years since we saw taxpayers grimly testifying before Congress about Internal Revenue Service abuses and the agency is still “reforming and reorganizing.” The IRS seems to have placed its hopes to be more customer friendly on its new operating divisions and technology. Management has been drum beating that good customer service makes good business. Whether the agency’s message has really created a change in the culture of the IRS is debatable.

3. Minimum IRA Distribution Rules: In January 2001, the IRS issued new regulations governing minimum distributions from IRAs (NPRM REG-130477). Enthusiastically welcomed by practitioners, the new regs simplify and liberalize the old complex and sometimes contradictory rules. Formerly, an IRA owner had to make two irrevocable choices by his or her RBD: naming a beneficiary for purposes of calculating the period over which the account would be distributed, and deciding whether to recalculate life expectancies each year. The new rules delete these requirements as well as simplify the calculation process and expand beneficiary options.

4. Tax Shelters: It was defeat snapped from the jaws of victory when the IRS lost what could have been the largest deficiency judgment in the agency’s history. In UPS v. Commr, the Eleventh Circuit rejected the IRS’ use of the economic substance doctrine to characterize the taxpayer’s loss protection program as a sham. Extremely favorable tax consequences, even those bordering on abuse, may be protected if they are linked to a business purpose where any profit potential can be shown. This ruling, combined with the IRS’ jettison of the economic substance test from its anti-abuse regs, may signal a trend toward a liberal understanding of bona fide business purpose.

5. Annual Expenses: 2001 did not bring any clarification to the disputes over capitalization but a potentially far-reaching decision out of the Seventh Circuit was very taxpayer-friendly. In US Freightways v. Commr, the court found that the plaintiff’s annual fees for permits, licenses and insurance premiums could be deducted in the year they were incurred even though their usefulness extended over parts of two tax years. This decision should prove valuable when confronted with IRS stonewalling about “future benefit.”

6. Cancellation of Insolvent S Corp Debt: The Supreme Court handed S corp shareholders a major victory early in 2001. It held that the cancellation of indebtedness of an insolvent S corp passed through to increase shareholder basis for the purpose of deducting suspended losses. The high court’s ruling in Gitlitz v Commr was so controversial that legislation is pending in Congress to reverse it.

7. S Corp Shareholder Deemed Employee: Not all the news was good for S corp shareholders. The Tax Court surprised many practitioners when it found that the sole shareholder of an S corp was the corp’s employee for employment tax purposes. The court repeatedly emphasized that the form of payment is immaterial; if the payments were received as compensation for services they are subject to employment taxes. Shareholders need to watch if the Third Circuit takes the same view on appeal. Veterinary Surgical Consultants v. Commr, 117 TC No 14.

8. Back Wages Subject to FICA/FUTA: In a rare unanimous decision, the Supreme Court held that back wages are subject to federal employment taxes in the year they are paid and not in the year in which the employee rendered services. IRS regs requiring this treatment were reasonable and the court deferred to them in US v. Cleveland Indians Baseball Co.

11. Innocent Spouse Protections: Petitioners for innocent spouse relief got a break from the Tax Court when it held that actual knowledge is more than what a reasonably prudent person would be expected to know. In Culver v. Commr, 116 TC No 15, the court found that the IRS must prove actual knowledge by a preponderance of the evidence. The more liberal approach likely will continue to fuel the flood of innocent spouse cases.

12. Reasonable Compensation: Practitioners pinning their hopes on the “hypothetical independent investor test” as the sole measure of deductibility were disappointed when the Tenth Circuit flatly refused to use it in its analysis of reasonable compensation disputes. The sputtering economy may push this issue off center stage.

Honorable Mention. Post-Sept. 11th Relief: The IRS quickly announced relief for victims and taxpayers affected by the tragic events of Sept. 11. Even though many of the early announcements had to be “clarified,” the IRS was surprisingly proactive.