Recent Federal Tax Developments

By William Grimsingery

Over the last year, the Internal Revenue Service has issued significant guidance on matters import-ant to both small and large businesses. With a constantly changing environment, businesses have opportunities for tax savings and risks of additional tax and penalties. This article describes some of the recent business provisions that are both favorable and unfavorable to business.

Manufacturing Deduction Final Regulations Issued
In response to the World Trade Organization’s ruling that the U.S. extraterritorial income exclusion was a forbidden export subsidy, Congress enacted a manufacturing deduction designed to make U.S. companies competitive both at home and abroad.1 The manufacturing deduction is based on a percentage of the lesser of Qualified Production Activities Income (“QPAI”) or Taxable Income. In general, Qualified Production Activities Income is determined by a taxpayer’s domestic production gross receipts less cost of goods sold, other expenses and losses directly allocable to such receipts; and a ratable portion of other deductions, expenses, and losses not directly allocable to those receipts.2
The manufacturing deduction is available for tax years beginning in 2005 and will be phased in through 2010. For 2005 and 2006, the deduction is limited to percent of QPAI; for 2007 to 2009, the deduction limitation doubles to 6 percent of QPAI, and in 2010 and later years, the deduction limitation rises to 9 percent of QPAI.3
The IRS issued guidance to taxpayers under Notice 2005-144 and at Proposed Regulations Sections 1.199-1 to 1.199-85 for details and questions in qualifying for and determining the amount of the manufacturing deduction available to businesses. The IRS has continued to issue regular guidance for particular industries and entities and has also issued Final Regulations that simplify some of the earlier rules, expand the deduction for the construction, software, and film industries, and extend the deduction to partnerships.6 The Final Regulations are generally effective June 1, 2006.7

Information Reporting Burden Eased for Corporate Transactions
On May 26, 2006, the IRS issued a comprehensive guidance designed to make it easier for large corporations and their shareholders to meet their disclosure obligations and to take advantage of electronic filing.8 Many of the provisions relate to report-ing required by corporations and shareholders in transactions such as transfers to a corporation, spin-offs, mergers, or liquidations.
For example, reporting on transfers of property to corporations under Section 351 previously required 18 items of information from shareholders and 20 items of information from corporations. Under the revised regulations, the Section 351 reporting requirements will be limited to only stockholders that own either a 5 percent or greater stake in a public company or a 1 percent or greater stake in a private company.9 Additionally, the only items of information required from shareholders will consist of 4 items: the name and employer identification of the corporation, the date of the asset transfer, the fair market value and basis of the assets transferred, and the date of any IRS private letter applicable to the transaction.10

Expansion of Merger in Tax Free Reorganization
The IRS recently finalized regulations under Section 368 defining the term “statutory merger” or “consolidation” for purposes of applying the tax free reorganization provisions under Section 368(a)(1)(A).11 Generally, the statutory merger (or type A reorganization) offers the most flexibility to businesses seeking to qualify for a tax free reorganization.
Under former rules, a statutory merger or consolidation was a transaction effected under U.S. law in which all of the assets and liabilities of the target are acquired by the acquiring corporation and in which the target ceases its separate legal existence for all purposes. The new regulations define a statutory merger or consolidation as a transaction in which all of the assets (other than those distributed in the transaction) and liabilities of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of the combining unit (the transferee unit), and the combining entity of each transferor unit ceases its separate legal existence for all purposes.12
Apart from changing the terminology involved, the new regulations offer more flexibility to business in using the statutory merger or consolidation with respect to transactions involving separate limited liability companies, a corporation that is a qualified real estate investment trust subsidiary, and a corporation that is a qualified subchapter subsidiary, as well as transactions effected under the laws of foreign jurisdictions.13
The Final Regulations detail 14 different examples that cover a wide variety of restructuring transactions that qualify or fail to qualify for type A tax free treatment. The Final Regulations apply to transactions occurring after January 22, 2006 and should be reviewed thoroughly before planning a transaction with a disregarded entity or a foreign entity.14

Corporate Estimated Tax Requirements
The IRS recently issued Proposed Regulations under Section 6655 to stem perceived abuses by corporate taxpayers that attempt to significantly reduce or eliminate quarterly tax payments.15 Section 6655 imposes a penalty for the underpayment of estimated taxes by a corporation. Corporations that do not make the required quarterly minimum payment when due are subject to a penalty consisting of the amount of the underpayment multiplied by an interest factor under Section 6621.
The Proposed Regulations revise how corporations may include items such as net operating losses, tax credits, depreciation, deferred compensation, prior year overpayments, and current liabilities in determining quarterly income for the purpose of determining the appropriate quarterly estimated tax payment.16

Federal Challenge to State Tax Incentive Dismissed
On May 15, 2006, the Supreme Court issued an opinion in DaimlerChrysler Corp. v. Cuno.17 The Supreme Court left unchanged an Ohio tax incentive that offered local and state tax benefits to DaimlerChrysler to expand its Jeep manufacturing operation. Technically, the Supreme Court ruled that the plaintiff-taxpayers lacked standing to challenge the Ohio tax incentive under federal law. Practically, however, the Court’s ruling means that future challenges to state tax incentives under federal law will be more difficult.

IRS Retreats from Telephone Excise Tax
After suffering losses in five separate Courts of Appeal, the IRS recently announced on May 25, 2006 that it will concede that the telephone excise tax no longer applies to long distance telephone charges.18 Refunds will be available for affected services that were billed after February 28, 2003, and before August 1, 2006. The IRS estimates that refunds due for this period will total approximately $13 billion for fiscal years 2007 and 2008.19
Although the IRS’ concession does not apply to tax on local services, former Secretary of the Treasury, John Snow, made clear that the administration would support legislation to repeal the tax still remaining on local services. Further, the IRS also announced that its concession would extend to cellular and bundled services.20
Corporations and other entities must seek a refund of actual taxes paid, unlike individuals. The IRS is expected to issue further guidance for business entities, but as the procedures stand now, businesses should be prepared to claim the refund on their 2006 tax returns for any tax billed after February 28, 2003, even if previous claims for refund for these periods have been filed.21

Deferred Compensation
The IRS is in the process of issuing Final Regulations regarding deferred compensation under Section 409A. The Final Regulations are expected to be issued between June and December of 2006.22 The Final Regulations follow Proposed Regulations that were issued in September 2005. Since the Proposed Regulations were issued, more than 100 comment letters have been sent to the IRS with suggestions or criticisms.23
In general, the Final Regulations will be aimed primarily at executives and other highly compensated business employees, although they will also impact many ordinary employees. Among many issues, the Final Regulations will address the treatment of stock options, renewals or modifications of stock options, stock appreciation rights, equity valuation, aggregation of plans, non-qualified plans, and perhaps split-dollar life insurance. The Final Regulations are also expected to establish sanctions for violation of the terms of Section 409A, as well as describe the relief available to businesses and employees.24

Conclusion
The IRS 2005 to 2006 guidance year ended on June 30, 2006. Consequently, in the coming months, expect to see the IRS issue further guidance in the areas discussed above, and in many other areas as well. Staying abreast of these developments is key in finding opportunities and minimizing risks. Meanwhile, the wheel begins to turn again as the IRS is also setting priorities and goals for the 2006 to 2007 guidance year.

William Grimsinger is a shareholder at Chamberlain, Hrdlicka, White, Williams & Martin in Houston, Texas. Grimsinger’s practice focuses on both federal and state tax controversies.

Endnotes
1. I.R.C. § 199. 2. I.R.C. § 199(b). 3. I.R.C. §199(a). 4. I.R.S. Notice 2005-14, 2005-7 I.R.B. 498. 5. Prop. Treas. Reg. §§1.199-1 to 1.199-8, 70 Fed. Reg. 67220-67276 (Nov. 4, 2005). 6. T.D. 9263, 71 Fed. Reg. 31268-31333 (June 1, 2006). 7. T.D. 9263, 71 Fed. Reg. 31268-31333 (June 1, 2006). 8. Rev. Proc. 2006-21, 2006-24 I.R.B. 1. 9. T.D. 9264, 71 Fed. Reg. 30591-30608 (May 30, 2006). 10. T.D. 9264, 71 Fed. Reg. 30591-30608 (May 30, 2006). 11. T.D. 9259, 71 Fed. Reg. 23855 (April 25, 2006), corrected, T.D. 9243, 71 Fed. Reg. 28266-28267 (May, 16, 2006). 12. T.D. 9259, 71 Fed. Reg. 23855 (April 25, 2006), corrected, T.D. 9243, 71 Fed. Reg. 28266-28267 (May 16, 2006). 13. T.D. 9259, 71 Fed. Reg. 23855 (April 25, 2006), corrected, T.D. 9243, 71 Fed. Reg. 28266-28267 (May 16, 2006). 14. T.D. 9259, 71 Fed. Reg. 23855 (April 25, 2006), corrected, T.D. 9243, 71 Fed. Reg. 28266-28267 (May 16, 2006). 15. Prop. Treas. Reg. §1.6655-1, 70 Fed. Reg. 73393-73413 (Dec. 7, 2005). 16. Prop. Treas. Reg. §1.6655-1, 70 Fed. Reg. 73393-73413 (Dec. 7, 2005). 17. DaimlerChrysler Corp. v. Cuno, 574 U.S. _____, 126 S.Ct. 1854 (2006). 18. I.R.S. Notice 2006-50, 2006-25 I.R.B. 1. 19. Crystal Tandon and Dustin Stamper, Treasury to Issue $13Billion in Telephone Excise Tax Refunds, 2006 TNT 102-1 (Tax Analysts 2006). 20. Id. 21. Id. 22. Susan Simmonds, IRS Officials Discuss Coming Deferred Comp Guidance, 2006 TNT 107-9 (Tax Analysts 2006). 23. Id. 24. Prop. Treas. Reg. 1.409A-1, 70 Fed. Reg. 57930 (Sept. 29, 2005).

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