The Federal Government provides tax benefits to companies developing new products or methods to produce products.  One such benefit is a tax credit available to companies who are spending money on qualifying research expenses related to such innovation.  Section 41 of the Code provides a tax credit that is based on a taxpayer’s spending on “qualified research.”  This research must satisfy the §174 definition of “research and experimental” to be considered qualified research.  The research credit is more than “product” development costs in a traditional sense, and should be considered for other development costs (e.g., the costs of developing manufacturing processes).  However, §41(d) provides that qualified research includes research for the purpose of developing new or improved “business components” which includes products, processes, computer software, techniques, formulas, and inventions, whether held for sale or lease by the taxpayer or used in the taxpayer’s trade or business.  Successful development is not required. 

The credit is available for both in-house (wages and supplies) and contract costs – qualified research expenses (or “QREs”) incurred by the taxpayer in conducting qualified research.  The Code provides a detailed definition of qualified research; but, simply stated, it consists of research and development activities involving a process of experimentation designed to discover new information intended to develop a new or improved business component. Various exclusions are applicable as well. One of the most important aspects of claiming this credit is for the taxpayer to properly retain the documentation to support the qualified activities that occurred. This is a vital and extremely important step that must be done to sustain the credit. 

The research credit calculation is determined a couple of different ways with the current computational method being the taxpayer’s most beneficial choice, elected on a timely, originally filed tax return. The research credit is currently available only through to December 31, 2009. Some bills are in process to have the research credit extended a 14^th time in the past 28 years. The current thought is that this credit will be extended again.  Furthermore, President Obama proposed in the FY2011 budget to make the research credit permanent. 

It is important to work with the right professionals to guide you through the process of determining the appropriate amount of research tax credit to claim.  Much abuse of the credit has taken place over the recent years and has led to increased scrutiny by the IRS.  If calculated, documented, and claimed properly within the tax law, the research tax credit can be a very powerful tax tool for innovating companies.

On January 26, 2010, the Internal Revenue Service (“IRS”) released Announcement 2010-09. The announcement explains the content of a proposed schedule that certain business taxpayers will be required to file with their annual tax returns. The schedule will include disclosures regarding uncertain tax positions for which a tax reserve has been established under FIN 48 or other accounting standard.

According to the announcement, the required disclosures will include the following:

• The Internal Revenue Code sections potentially implicated by the position;
• A description of the taxable year or years to which the position relates;
• A statement that the position involves an item of income, gain, loss, deduction, or credit against tax;
• A statement that the position involves a permanent inclusion or exclusion of any item, the timing of that item, or both;
• A statement whether the position involves a determination of the value of any property or right;
• A statement whether the position involves a computation of basis;
• The entire amount of United States federal income tax that would be due if the position were disallowed in its entirety on audit. This amount is the maximum tax adjustment for the position reflecting all changes to items of income, gain, loss, deduction, or credit if the position is not sustained.

Uncertain tax positions will also include any position for which a taxpayer or related party has not recorded a tax reserve because:
1. the taxpayer expects to litigate the position, or
2. the taxpayer has determined that the Service has a general administrative practice not to examine the position.

The IRS intends that the new schedule will be filed by a business taxpayer with total assets in excess of $10 million if the taxpayer has one or more uncertain tax positions of the type required to be reported on the new schedule. This includes a taxpayer who prepares financial statements, or is included in the financial statements of a related entity that prepares financial statements, if that taxpayer or related entity determines its United States federal income tax reserves under FIN 48, or other accounting standards.

The IRS has invited the public to submit comments on the proposal described in this Announcement by March 29, 2010. The Service intends to mandate that the new schedule be filed for uncertain tax positions filed with returns filed after release of the schedule. There has been no indication as to when the schedule will be released.

The IRS recently released updated federal mileage rates that will apply to mileage incurred on or after January 1, 2010:

* 50 cents per mile for business miles
* 16.5 cents per mile for medical or moving purposes
* 14 cents per mile for service of charitable organizations

The standard mileage rate for business mileage actually went down, reflecting the fact that the cost of fuel overall has decreased. The charitable mileage rate is fixed by Congress and they just haven’t addressed changing it for years, so it stays the same as it has for quite some time now.

Please refer to our disclaimer

Recently enacted legislation allows all U.S. companies to carry back net operating losses incurred in either 2008 or 2009 to the previous five years. The carryback can offset 50% of the taxable income in the fifth carryback year, and 100% of taxable income in the first four carryback years.

The Colorado Office of State Planning and Budgeting recently proposed a number of revisions to Colorado tax exemptions and credits, in an attempt to close a projected fiscal shortfall. Among the proposals are elimination of exemptions or credits, either temporary or permanent, that would affect:

* direct mail advertising
* energy use in industrial and manufacturing sectors
* non-essential contaners for food services
* candy and soft drinks
* agricultural compounds
* pestisides
* enterprise zone investment tax credit
* alternative fuel vehicles
* gross conservation easement credit
* alternative minimum tax and alternative minimum tax credit
* software sales tax exemption
* sales taxes for online purchases
* net operating loss limitations

Regarding the software sales tax exemption, it is expected that the definition of software would be expanded. Currently, software is defined as taxable only if 1) it is packaged for repeated sale, 2) it is subject to a non-negotiable, tear open license agreement, and 3) it is delivered on a tangible medium. By definition, this would exclude software sold over the Internet or by “load and leave”. Presumably, these types of software purchases would be taxable under the proposed changes.

It is expected that the corporation net operating loss limitation provisions would be revised to limit the amount of net operating losses that could be utilized to offset income for the next three years, beginning January 1, 2010, to $250,000.

These changes, if enacted, would have a significant impact on how businesses operate in Colorado.

On November 5, 2009, an unemployment insurance extension bill was approved by the House of Representatives that allows businesses with net operating losses (NOLs) for 2008 or 2009 to carry those losses back for up to five years. The bill also extends and modifies the first-time homebuyer credit that was established by the American Recovery and Reinvestment Act of 2009. The Senate earlier this week approved The Worker, Homeownership, and Business Assistance Act of 2009, and the bill now heads to the White House; President Obama is expected to sign it into law. The bill includes revenue offsets including a delay in the effective date of the worldwide interest allocation election, an increase in the corporate estimated tax payments for certain large taxpayers, and an increase in the penalty for failure to file a partnership or S corporation return, among other provisions.

We usually defer the dissemination of proposed legislation until passed by Congress and signed by the President. We’re getting lots of questions about what Congress is considering in its proposed Health Reform Bill, so here are a few key highlights coming out of the Senate Finance Committee which passed earlier this week:

- Starting in July 2013, the bill would establish a requirement for U.S. legal residents to obtain insurance and would in many cases impose a financial penalty on people who don’t do so.
- A 40% nondeductible excise tax would be levied on health coverage in excess of $8,000/$21,000 (indexed for inflation), effective for tax years beginning after 2012. Increased thresholds would apply for over age 55 retirees and certain high-risk professions (e.g., firefighters, construction and mining workers), and a higher threshold would apply for health insurance plans maintained in the 17 states in which health care was least affordable for the year ended Dec. 31, 2012. For employees, the employer would aggregate the coverage subject to the limit and issue an information return for insurers indicating the amount subject to the excise tax. The excise tax would be levied at the insurer level.
- Employers would be required to report the value of health benefits on employees’ Form-W-2s, effective for tax years beginning after 2009. For purposes of employer provided health coverage (including health reimbursement accounts (HRAs) and health flexible savings accounts (FSAs), HSAs, and Archer medical savings accounts (MSAs)), the definition of medicine expenses deductible as a medical expense would generally be conformed to the definition for purposes of the itemized deduction for medical expenses. But this change would not apply to doctor prescribed over-the-counter medicine. Thus, the cost of over-the-counter medicine (other than doctor prescribed) could not be reimbursed through a health FSA or HRA. In addition, the cost of over-the-counter medicines (other than doctor prescribed) could not be reimbursed on a tax-free basis through an HSA or Archer MSA. These changes would be effective for tax years beginning after 2009.
- The penalty for nonqualified HSA distributions would be increased from 10% to 20%, effective for disbursements made during tax years beginning after 2010.
- Allowable contributions to health FSAs in cafeteria plans would be capped at $2,500, effective for tax years beginning after 2010.
- Effective for tax years beginning after the enactment date, Code Sec. 501(c)(3) hospitals would be subject to new requirements, e.g., a community health needs assessment, promulgation and dissemination of a written financial assistance policy, and new reporting and disclosure rules.
- Effective for payments made after 2011, the bill would modify the general information reporting requirement by eliminating the exception for payments to corporations. The class of payments with respect to which reporting is required would be clarified to include gross proceeds for both property and services.
- The floor beneath itemized medical expense deductions would be raised from 7.5% of adjusted gross income (AGI) to 10%, effective for effective for tax years beginning after 2012. The AGI floor for individuals age 65 and older (and their spouses) would remain unchanged at 7.5%.
- The deduction for expenses allocable to Medicare Part D subsidy would be eliminated, effective for tax years beginning after 2010. A $500,000 deduction limit would apply to the remuneration of officers, employees, directors, and service providers of covered health insurance providers. This limit would be effective for remuneration paid in tax years beginning after 2012 with respect to services performed after 2009.
- For tax years beginning after 2010, the bill would provide for a safe harbor from the nondiscrimination requirements for cafeteria plans for an eligible small employer. The safe harbor would also apply to the nondiscrimination requirements for specified qualified benefits offered under the cafeteria plan, including group term life insurance, coverage under a self insured group health plan, and benefits under a dependent care assistance program. The safe harbor would require that the cafeteria plan satisfy minimum eligibility and participation requirements and minimum flex-credit contribution requirements.
- The bill would create a temporary tax credit, subject to an overall cap of $1 billion, to encourage investments in new therapies to prevent, diagnose, and treat chronic diseases, effective for expenditures paid or incurred after 2008, in tax years beginning after 2008. The credit would sunset at the end of 2010.

Have you ever had income from a foreign bank account that wasn’t reported on your U.S. income tax return? That income is subject to U.S. tax and the Internal Revenue Service is stepping up enforcement by going directly to the source, foreign banks, to obtain names of U.S. citizens that hold these accounts to cross check the reporting of the income.

A settlement offer was recently announced by the IRS to encourage compliance, and the agency has just announced that it is postponing the deadline for taxpayers to act on its settlement offer to report previously unreported offshore income. This is a “one-time only” postponment from September 23, 2009 to October 15, 2009.

Earlier in the year, the IRS provided the following settlement for all taxpayers that make voluntary disclosure requests:
1) The taxpayer must file amended returns going back 6 years (2003 to 2008) and pay taxes and interest.
2) IRS will assess either a delinquency penalty or an accuracy penalty and no reasonable cause exception will apply.
3) A penalty equal to 20% of the amount in a foreign bank account in the year with the highest aggregate account or asset value will be assessed, in lieu of other penalties that may apply.

The IRS has indicated that no further extensions will be provided and that taxpayers who do not voluntarily disclose their hidden accounts by the new deadline face much harsher civil penalties and where applicable, criminal prosecution.

I had lunch with a colleague recently who is a partner at a national accounting firm. The conversation turned to staff and he communicated how frustrated he was with his. Apparently he had just returned from vacation, reviewed timesheets and was very disappointed in the level of effort that they put in while he was away. He commented on how he needed to be on his people all of the time in order to get any work out of them. When I mentioned that I never feel that way, that our people are very focused on producing results and are even more so when I’m not there, he responded that we have different people and that his firm doesn’t have “those people”. So who are “those people” and how did our firm get them?

We only recruit from the top firms. Firms like his. We recruit high achievers who have a history of success in academics, career, and other aspects of life such as athletics and community service. Successes that require personal responsibility and accountability, hard work, discipline, and devotion. But we don’t have an HR department or recruiting staff to post positions, screen resumes or interview candidates like the national firms do. That can’t be our advantage. As a matter of fact, I am sure that they recruit the same people that we do and have an easier time doing it.

So how did his people, who are such high achievers, become so lazy and unmotivated that they won’t do any work unless someone is standing over them? I doubt that the people changed. I am positive that they are still out there achieving tremendous things in life and in the office. Maybe they are just being measured on, and held accountable to the wrong thing. Maybe when no one is looking, they feel like they can stop the charade and actually get something done. Maybe they should be held accountable for their results instead of activity and time. Maybe then, they would be viewed as one of “those people”.

Summary

On August 13, 2009, the U.S. Court of Appeals for the First Circuit (“Court of Appeals”) ruled 3-2 to overturn the U.S. District Court for the District of Rhode Island’s (“District Court”) decision in United States of America vs. Textron, Inc. and Subsidiaries. As a result, Textron’s income tax accrual workpapers are subject to an IRS summons.

Background

• In 2005, the Internal Revenue Service (“IRS”) issued an administrative summons for “all of the tax accrual workpapers” for Textron’s tax year ending in 2001. Textron refused to produce its tax accrual workpapers, asserting they were privileged and that the summons was issued for improper purposes. Textron’s tax accrual workpapers included:
   1. A spreadsheet that contained:
     a. Lists of items on Textron’s tax returns, which, in the opinion of Textron’s counsel, involved issues on which the tax laws are unclear and, therefore, may be challenged by the IRS;
     b. Estimates by Textron’s counsel expressing, in percentage terms, their judgments regarding Textron’s chances of prevailing in any litigation over those issues; and
     c. The dollar amounts reserved to reflect the possibility that Textron might not prevail in such litigation.
   2. Backup workpapers consisting of the previous year’s spreadsheet and earlier drafts of the spreadsheet together with notes and memoranda written by Textron’s in-house tax attorneys reflecting their opinions as to which items should be included on the spreadsheet and the percentage that should apply to each item.

• Textron is a publicly-traded company and is required by federal securities law to have public financial statements are certified by an independent auditor. Ernst & Young (“E&Y”) are Textron’s independent auditors. E&Y accessed and reviewed Textron’s tax accrual workpapers in conjunction with Textron’s financial statement audit for the year ending in 2001. The workpapers provided E&Y with evidence supporting Textron’s assertion that they had recorded an adequate reserve for uncertain tax positions in their financial statements.

District Court Ruling

In 2007, the District Court ruled that Textron did not have to comply with the IRS’ summons. The District Court found that the tax accrual workpapers were covered by work-product privilege. Work-product privilege applies to materials prepared or gathered by an attorney in anticipation of litigation.
The District Court agreed with Textron that the tax accrual workpapers would not have been prepared at all but for the fact that Textron anticipated the possibility of litigation with the IRS. If Textron had not anticipated a dispute with the IRS, they would have had no reason to record a reserve for potential tax liabilities and would not have had to prepare tax accrual workpapers for E&Y to audit.

Court of Appeals Ruling

On August 13, 2009, the Court of Appeals overturned the District Court ruling. The Court of Appeals agreed with the IRS that Textron did not prepare the tax accrual workpapers in anticipation of litigation, but to support their financial filings and gain auditor approval. As such, the tax accrual workpapers did not qualify for work-product privilege and are subject to the IRS summons.
Textron has until October 12, 2009 to file a petition for a writ of certiorari seeking review by the Supreme Court.

Planning

In light of the Court of Appeals’ decision, it may be difficult to withhold tax accrual workpapers from taxing authorities. However, implementing the following procedures may add some protection and/or limit the scope of what the IRS requests.
   1. Create a separate set of workpapers for each uncertain tax position.
   2. Within each set of workpapers, create multiple folders – separate the attorney’s analysis from the accountant’s analysis; separate all analysis from the determination of potential reserves.
   3. Do not allow financial statement auditors to keep copies of tax accrual workpapers.
   4. Require a signed confidentiality statement from financial statement auditors that specifically references the tax accrual workpapers.

Full Text

U.S. District Court for the District of Rhode Island http://www.rid.uscourts.gov/opinions/torres/08282007_1-06CV0198T_USA_V_TEXTRON_INC_P.pdf
U.S. Court of Appeals for the First Circuit
http://www.ca1.uscourts.gov/ (Click on Opinions, Search using keyword, “Textron”)