Current developments: in the last year, many significant developments affected individual taxpayers. This article summarizes legislation, the principal residence exclusion, AMT, income recognition, deductions and other significant areas.

• Author: Mares, Michael E.

EXECUTIVE SUMMARY

* The ETIA and the SAFETEA provide a number of energy-based credits that individuals can use in 2006 and subsequent years.

* There were a myriad of developments on deductions, including Sec. 199 guidance, charitable contributions, contingent attorneys' fees and healthcare premiums.

* In 2005, the IRS continued its strategy of offering settlements to taxpayers involved in various tax shelters.

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Last year was certainly a busy tax year for individual tax developments. To aid those devastated by the hurricanes that swept through the southeastern U.S., Congress enacted two substantial tax bills with a speed that amazed many. (1) In addition, it also adopted the Energy Tax Incentives Act of 2005 (ETIA) (2) and the Safe, Accountable, Flexible, Efficient Transportation Equity Act. (SAFETEA), (3) which provided energy credits for individuals. The IRS, Treasury and the courts continued to provide guidance and to interpret the less-than-simple Code. They addressed the Sec. 199 deduction, the principal residence exclusion, alternative minimum tax (AMT), healthcare, tax shelters and a variety of other income recognition and deduction issues. These developments will be covered in this article.

Legislation

Congress introduced energy tax incentives in the ETIA and SAFETEA, both of which were passed after much partisan wrangling. The IRS also issued guidance on the new deduction for qualified production activities that was enacted by the American Jobs Creation Act of 2004 (AJCA).

ETIA

The ETIA provides multiple credits for individuals, which are based on energy-efficient purchases in 2006 and subsequent years. First, a credit of up to $500 can be claimed for non-business, energy property installed in a taxpayer's residence. Qualified property includes exterior doors, windows, insulation, heat pumps, furnaces, central air conditioners and water heaters. In addition to the overall credit limit, individuals have specific limits (i.e., a $200 limit on credits for windows). Also, the energy property must meet certain criteria and energy standards specified by the IRS and Department of Energy to qualify for a credit. Credits are nonrefundable and, of course, will not reduce the AMT.

A maximum credit of $2,000 applies to the cost of solar water heaters and solar electricity equipment installed in a personal residence. The credit is not available for expenditures that are allocable to a swimming pool, hot tub or other activity that has a function other than energy storage. As with the energy property credit, the credit cannot be used to offset AMT.

SAFETEA

Congress also passed the SAFETEA. That law has several credits that can be used by individuals in 2006 and thereafter. The credits apply to purchases of alternative fuel vehicles, depending on a vehicle's weight--the larger the vehicle, the larger the credit. To qualify, the motor vehicle must generally meet several requirements. First, its original use must begin with the taxpayer. Further, it must be acquired for use or lease by the taxpayer, and not for resale. However this requirement has a trap--the leasing company, not the lessee, gets the credit on leased vehicles. Obviously, this will become a negotiating point between the lessee and the leasing company. The vehicles must be made by a manufacturer and be certified as qualifying for the credits. Further, in many cases, a vehicle meeting increased fuel-efficiency standards will be entitled to additional credits based on the increased fuel efficiency. Finally, a qualifying alternative fuel must propel the vehicle. Qualifying alternative fuels include fuel cells and advanced lean burn technology. Qualifying vehicles include hybrid motor vehicles, qualified alternative fuel vehicles and mixed fuel vehicles. The credit for these vehicles can be as much as $3,400.

The IRS quickly issued some guidance on parts of this legislation. Notice 2006-9 (4) deals with advanced lean burn technology vehicles and qualified hybrid vehicles. It addresses the certification process and permits taxpayers to rely on a manufacturer's certification in claiming credits. It requires manufacturers to report sales of advanced lean burn technology and qualified hybrid vehicles on a quarterly basis, because the credits begin to phase out after the end of the first calendar quarter after the quarter in which the manufacturer sells 60,000 combined units.

Sec. 199 Guidance

One of the more complex provisions of the AJCA was the new deduction for qualified production activities. At only 3% for 2005, the deduction eventually becomes 9% in 2010 when fully phased in. It equals the phase-in percentage multiplied by the lesser of taxable income from qualifying activities, or 50% of W-2 wages. The latter limit will pose a major problem for many small businesses that rely on contractors rather then employees, became subcontractor payments do not qualify as W-2 wages. Contractors could be particularly hard hit by this limit.

Given the complexity of this provision, it is no surprise that both the IRS and Treasury got busy and released guidance in 2005. In Notice 2005-14, (5) the IRS offered initial guidance on this provision, outlining the activities eligible for the deduction, and providing some simplified formulas for computing taxable income and for determining what comprises W-2 wages. In addition, the notice also added some de minimis rules to help avoid revenue and expense allocations due to minor amounts of nonqualifying income.

This guidance was followed up later in the year by Prop. Kegs. Secs. 1.199-1 through -8. The proposed regulations generally follow Notice 2005-14, but introduce additional detail and refine some of the issues that raised questions in the initial guidance. As indicated by the proposed regulations, taxpayers can rely on either the notice or the proposed regulations until the regulations become final. If the proposed regulations and the notice differ on the same issue, a taxpayer may select whichever is more beneficial, although this will no longer be the case once the final regulations are issued.

Contingent Attorneys' Fees

In 2005, the Supreme Court rendered a decision that was definitely not taxpayer-friendly. After years of controversy and contradictory decisions from many Courts of Appeal, the Court ruled in Banks (6) that contingent fees paid to an attorney from the proceeds of a...