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Coordinated Issues Paper - Insurance

Margins and Other Unsubstantiated Additions to Insurance Company Reserves for Unpaid Losses and Claims – 11-18-2009.

LMSB4-1109-041
EFFECTIVE DATE: November 18, 2009

Coordinated Issue Paper
Non-life Insurance Industry
• Health Insurance Companies
• Property-Casualty Companies
• Blue Cross Blue Shield Entities

Margins and Other Unsubstantiated Additions to Insurance Company Reserves for Unpaid Losses and Claims

UILs: 832.06-00 Losses Incurred
832.06-02 Unpaid Losses

Note: This issue paper is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.

ISSUE:
May margins or other additions to reserves for unpaid losses shown on an insurance company's Annual Statement be included in the computation of "losses incurred" for federal income tax purposes where the taxpayer fails to establish that the additional amounts are based upon the company's actual loss experience and the total reserve is in excess of a fair and reasonable estimate within the meaning of Treas. Reg. § 1.832-4(b)?

CONCLUSION:
For federal income tax purposes, estimates of insurance company unpaid losses must be fair and reasonable in amount and must represent actual unpaid losses. Margins or other additions to unpaid losses that are not based upon the company's actual loss experience cannot be included in the deduction for losses incurred. If a taxpayer cannot establish that a margin or other addition to unpaid losses represents actual unpaid losses, the deduction will be disallowed to the extent it exceeds a fair and reasonable estimate.

BACKGROUND
1. The Internal Revenue Code and the NAIC Annual Statement. Beginning with the Revenue Act of 1921, the structure for the taxation of property and casualty insurance companies has been based upon the Annual Statement that insurers file with state regulators in accordance with the forms and procedures approved by the National Association of Insurance Commissioners ("NAIC"). See I.R.C. § 831(b) ("In the case of an insurance company subject to the tax imposed by section 831. . . [t]he term “gross income” means the sum of . . . the combined gross amount earned during the taxable year, from investment income and from underwriting income as provided in this subsection, computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners.")

Among other things, the Annual Statement includes a schedule for computing "losses incurred," which is shown as the sum of losses paid during the year less salvage, increased by reinsurance assumed and reduced by reinsurance recovered, plus net losses unpaid at the end of the current year, minus net losses unpaid at the end of the prior year. Liabilities for unpaid losses are often called "loss reserves." Insurance Accounting & Systems Association, Inc. ["IASA"], Property-Casualty Insurance Accounting page 3-5 (7th ed. 1998). For purposes of computing losses incurred, any increase in the reserve for unpaid losses increases the amount of losses incurred, while any decrease in the reserve decreases losses incurred.

For federal income tax purposes, I.R.C. section 832(b)(5) sets forth a similar formula:

(A) In General -- The term “losses incurred” means losses incurred during the taxable year on insurance contracts computed as follows:

(i) To losses paid during the taxable year, deduct salvage and reinsurance recovered during the taxable year.

(ii) To the result so obtained, add . . . all discounted unpaid losses (as defined in section 846) outstanding at the end of the taxable year and deduct . . . all discounted unpaid losses outstanding at the end of the preceding taxable year.

(iii) To the results so obtained, add estimated salvage and reinsurance recoverable as of the end of the preceding taxable year and deduct estimated salvage and reinsurance recoverable as of the end of the taxable year.

The amount of estimated salvage recoverable shall be determined on a discounted basis in accordance with procedures established by the Secretary.

2. Statutory Accounting. NAIC accounting is described as "Statutory Accounting," as opposed to generally accepted accounting principles (GAAP). IASA, supra at page 1-15. See also Physicians Insurance Company of Wisconsin, Inc. v. Commissioner, T.C. Memo. 2001-304 ("Insurance companies are required to prepare their annual statements using a system of accounting known as the statutory or annual statement method, which does not necessarily conform to generally accepted accounting principles that govern the preparation of an insurance company’s financial statements"). In the past, NAIC accounting practices were not set out in a single document. In many cases the only sources were the forms, exhibits, and schedules of the Annual Statement, and the instructions to the Annual Statement. Recently, the NAIC has “codified” various accounting practices in a series of separate documents under the general title “Statement of Statutory Accounting Principles” ("SSAP"), which are set forth in the NAIC's Accounting Practices and Procedures Manual. SSAP No. 55 establishes statutory accounting principles for “Unpaid Claims, Losses and Loss Adjustment Expenses.”

At some point in the process of estimating loss reserves an actuarial projection is made, either by an in-house actuary or by an outside consultant. However, the NAIC does not require that the amount shown on the Annual Statement must be determined by an actuary. Instead, SSAP No. 55 states that “[M]anagement shall record its best estimate of its liabilities for unpaid claims, unpaid losses, and loss/claim adjustment expenses.” Note that SSAP No. 55 refers to management’s best estimate, not the actuary’s best estimate.

The NAIC's instructions to the Annual Statement require that it include a Statement of Actuarial Opinion. The form of the actuarial opinion varies for different types of companies, but generally includes a declaration that the amounts stated are "in accordance with accepted actuarial standards" and "make a good and sufficient provision" for all unpaid obligations or make a "reasonable provision." See, e.g., Utah Medical Insurance Association v. Commissioner, T.C. Memo. 1998-458 ("computed in accordance with accepted loss reserving standards . . . and provided sufficiently for all of petitioner’s unpaid loss and loss expense obligations"); Minnesota Lawyers Mutual Insurance Company v. Commissioner, T.C. Memo. 2000-203, aff'd, 285 F.3d 1086 (8th Cir. 2002) ("were computed in accordance with the standards of practice issued by the Actuarial Standards Board . . . and made reasonable provision for all unpaid loss and loss expense obligations"). See also, Hospital Corporation of America v. Commissioner, T.C. Memo. 1997-482 (opinion letter to Commissioner of Insurance: "were computed in accordance with accepted loss reserving standards . . . and made good and sufficient provision for all . . . unpaid loss and loss expense obligations"); Physicians Insurance Company of Wisconsin, Inc. v. Commissioner, T.C. Memo. 2001-304, (opinion letter to Commissioner of Insurance: “Make a reasonable provision, in the aggregate, for all unpaid loss and loss adjustment expense obligations").

Again, note that the Statement of Actuarial Opinion does not state that the amount shown on the Annual Statement has been determined by an actuary, but only that such amount has been determined "in accordance with" accepted actuarial standards, and makes a "reasonable provision" for all unpaid obligations. See, e.g., Minnesota Lawyers Mutual Insurance Company v. Commissioner, T.C. Memo. 2000-203 ("Petitioner's actuaries did not assist in establishing petitioner's reserves in the first instance but were asked after the fact to review petitioner's carried reserves, for purposes of satisfying the statutory certification requirement").

3. Annual Statement conservatism. In general, state insurance regulators are concerned with the solvency of insurance companies, and accordingly state insurance regulatory accounting favors conservatism. Sears, Roebuck and Co. v. Commissioner, 96 T.C. 61, 72 (1991) ("State regulators are concerned with financial solvency and market conduct, including matters such as pricing and product content, and with regulation of the claims adjustment process. The primary goal of regulation is to preserve the financial assets and solvency of the company, thereby assuring that the insurer will satisfy loss claims").

The Preamble to the NAIC's Accounting Practices and Procedures Manual includes a "Statement of Concepts." The Preamble states that "The primary responsibility of each state insurance department is to regulate insurance companies in accordance with state laws with an emphasis on solvency for the protection of policyholders." Manual, p. P-5. The first "concept" described in the Preamble is the concept of conservatism: "In order to provide a margin of protection for policyholders, the concept of conservatism should be followed when developing estimates as well as establishing accounting principles for statutory reporting." Manual, p. P-6.

This preference for solvency and conservatism is reflected in the NAIC's Health Reserves Guidance Manual 9 (November 6, 2000):

F. Conservatism
1. General
Conservatism can be explicit or implicit depending on the method used. “Explicit conservatism” means that a preliminary reserve is determined using assumptions that represent expected experience; then, a separate provision for adverse deviations from expected -- the “load” or “margin” -- is added to provide conservatism. “Implicit conservatism” means that the reserve is determined using assumptions that are more conservative than what is actually expected. In some cases, reserves may be determined with some implicit conservatism, and then increased by an explicit load or margin to provide sufficient overall conservatism. [Emphasis added.]

* * *

The level of conservatism needed typically will vary by, among other factors, the size of the block of business and the type of coverage. . . . Note, however, that reserve adequacy ultimately is to be judged in the aggregate for a reporting entity. For example, a high degree of conservatism might be appropriate for small-group hospital claims on a stand-alone basis; when a reporting entity combines its reserves for hospital and physician claims, and small and large groups, the necessary degree of conservatism is likely to be substantially less than the sum of the margins developed on a stand-alone basis.

Several factors in the process of determining liabilities would impact the level of conservatism. As the process more precisely adjusts for large claims and for increases and decreases in inventory, the amount of additional margin needed would be decreased. Other factors that impact the margin level are the potential variance in the trend in claim costs at the valuation date and the rate of growth in the line of business.

The level of conservatism needed will also vary according to the sophistication of the reserving process. Less margin should be needed to the extent that the process explicitly and accurately reflects such items as atypically large claims; changes in the level of claim inventory or “backlog” (claims received but not yet processed); trend in claim costs; seasonality of claim costs; changes in provider reimbursement arrangements (e.g., switches between capitation and fee-for-service payments); and changes in the demographic characteristics of the covered lives (age/sex mix, etc.). This list is not exhaustive, and other techniques may also reduce the need for conservatism in the reserve. However, unless such techniques have been in use for a significant period of time, the acceptable reduction in conservatism will be largely a matter of judgment.

The NAIC has recognized a possible conflict between the discussion of "margins" in the Health Reserves Guidance Manual, and SSAP 55, which directs management to record its "best estimate" of its unpaid claim liability. The matter was referred to the NAIC's Emerging Accounting Issues Working Group, which adopted the following "interpretation" of SSAP 55:

The working group reached a consensus that the concept of conservatism is inherent to the estimation of reserves and as such should not be specifically prohibited in the consideration of management’s best estimate. On the other hand, the working group does not believe there should be a specific requirement to include a provision of adverse deviation in claims as the application of estimates varies greatly from company to company and requires the careful judgment of management.

INT 01-28 (October 16, 2001, Accounting Practices and Procedures Manual B-150 (2008). Note that while the working group endorsed the concept of conservatism, it did not believe there should be a specific requirement to include a provision for adverse deviation in claims. In other words, while the concept of a "best estimate" does not prohibit a consideration of conservatism, statutory accounting does not require the addition of a "margin" or other provision for adverse deviation in claims.

4. "Margins" and other "add-ons." As described in the Health Reserves Guidance Manual, an “explicit" margin is distinct and identifiable and is generally added on after an initial determination of the reserve amount necessary to discharge the company’s liability. The taxpayer or its actuary determines a preliminary reserve for unpaid losses based upon expected experience, and then a margin or other amount is added to the preliminary reserve above and beyond the amount needed to meet the expected experience. In contrast, the phrase "implicit conservatism" describes a situation where the taxpayer or its actuary determines the overall reserve using assumptions that are more conservative than what is actually expected, resulting in an overstatement of the overall reserve. In that case, there is only one figure, the final reserve number, rather than a preliminary figure with a separate figure for the explicit margin. In both cases the effect is the same: the overall reserve is overstated, but in the case of an explicit margin, the overstatement is a direct result of the explicit margin, while in the case of implicit conservatism the cause of the overstatement may not be immediately apparent.

The NAIC's Health Reserves Guidance Manual refers to "explicit margins" and "implicit conservatism." The NAIC's Emerging Accounting Issues Working Group, in INT 01-28, refers to a "provision for adverse deviation." Insurers may make additions to Annual Statement loss reserves under other labels or descriptions, such as "reserve for adverse development," or "add-ons." See, e.g., Minnesota Lawyers Mutual Insurance Company v. Commissioner, T.C. Memo. 2000-203, ("bulk reserve for 'adverse loss development'"); Physicians Insurance Company of Wisconsin v. Commissioner, T.C. Memo. 2001-304 ("add-ons to [the actuary's] point estimates").

TAXPAYER'S POSITION
In preparing the Annual Statement that is filed with state insurance regulators, some taxpayers have increased the reserve for unpaid losses by adding explicit margins or other distinct and identifiable amounts that are not based upon the company's actual experience. Other taxpayers have determined the overall reserve using assumptions that are more conservative than what is actually expected. In both situations the taxpayer's Annual Statement includes a Statement of Actuarial Opinion. In both situations the taxpayer uses the Annual Statement reserve amount in preparing its federal income tax returns. In general, taxpayers argue that the Annual Statement numbers must be accepted for federal income tax purposes. Various specific arguments typically raised by taxpayers are addressed below.

DISCUSSION

While section 832 refers to the Annual Statement that insurance companies file with state regulators, for federal income tax purposes the Annual Statement is only a general guide. The Code contains numerous modifications to Annual Statement accounting. While the Annual Statement includes a provision for unpaid losses, for federal income tax purposes the requirements for the deduction are set forth in Treas. Reg. §§ 1.832-4(a)(14) [formerly § 1.832-4(a)(5)] and 1.832-4(b):

§ 1.832-4 Gross income

(a)(14) In computing “losses incurred” the determination of unpaid losses at the close of each year must represent actual unpaid losses as nearly as it is possible to ascertain them.

(b) Losses incurred. -- Every insurance company to which this section applies must be prepared to establish to the satisfaction of the district director that the part of the deduction for “losses incurred” which represents unpaid losses at the close of the taxable year comprises only actual unpaid losses. See section 846 for rules relating to the determination of discounted unpaid losses. These losses must be stated in amounts which, based upon the facts in each case and the company's experience with similar cases, represent a fair and reasonable estimate of the amount the company will be required to pay. Amounts included in, or added to, the estimates of unpaid losses which, in the opinion of the district director, are in excess of a fair and reasonable estimate will be disallowed as a deduction. The district director may require any insurance company to submit such detailed information with respect to its actual experience as is deemed necessary to establish the reasonableness of the deduction for “losses incurred.” [Emphasis added.]

In summary, for federal income tax purposes, the deduction for unpaid losses is limited to actual unpaid losses, and the deduction must be stated in amounts that represent a fair and reasonable estimate of the amount the company will be required to pay.

Several conclusions follow from these general principles:

1. Not all "reserves" shown on the Annual Statement or allowed by state insurance regulators are allowable as deductions for federal income tax purposes. The Internal Revenue Code specifies the items that are deductible for federal income tax purposes. To the extent that a state statute requires a reserve in addition to or in excess of those reserves necessary for the protection of policyholders, the reserve is merely a solvency reserve. Additions to solvency reserves have no bearing on what part of an insurance company’s gross income is treated as net income for tax purposes. United States v. Boston Insurance Co., 269 U.S. 197 (1925); McCoach v. Insurance Company of North America, 244 U.S. 585 (1909); Colonial Surety Co. v. United States, 178 F.Supp. 600, 602 (Ct. Cl. 1959) ("reserves to take care of the other contingencies, although they are proper to insure solvency, are not deductible for tax purposes"). See also, Rev. Rul. 83-174, 1983-2 C.B. 108; Rev. Rul. 76-56, 1976-1 C.B. 185.

2. The Service is not bound by the numbers shown on the Annual Statement. It has long been the position of the Internal Revenue Service that the NAIC Annual Statement is merely a "general guide" in computing insurance company taxable income. Rev. Rul. 61-167, 1961 C.B. 130; Rev. Rul. 60-306, 1960-2 C.B. 211. See Commissioner v. U.S. Guarantee Company, 190 F.2d 152 (2d Cir. 1951), rev’g and rem’g, 8 CCH Tax Ct. Mem. 510 (1949); Commissioner v. General Reinsurance Corp., 190 F.2d 148 (2d Cir. 1951), rev’g and rem’g, 9 CCH Tax Ct. Mem. 141 (1950); Pacific Insurance Co., Ltd. v. United States, 90 F. Supp. 328 (Hawaii D.C. 1950), aff’d, 188 F.2d 571 (9th Cir. 1951); and Pacific Employers Insurance Company v. Commissioner, 89 F.2d 186 (9th Cir. 1937), aff’g 33 B.T.A. 501 (1935). Contra New Hampshire Fire Insurance Co. v. Commissioner, 146 F.2d 697 (1st Cir. 1945), aff’g, 2 T.C. 708 (1943); and Columbia Casualty Co. v. Commissioner, 7 CCH Tax Ct. Mem. 282 (1948).

Annual Statement numbers for loss reserves are not determinative for federal income tax purposes. Hanover Insurance Company v. Commissioner, 598 F.2d 1211, 1217 (1st Cir. 1979), aff'g 65 T.C. 715 (1976). Physicians Insurance Company of Wisconsin v. Commissioner, T.C. Memo. 2001-304. The taxpayer must satisfy the Treasury Regulation's requirement that the part of the deduction for “losses incurred” which represents unpaid losses must comprise only actual unpaid losses, stated in amounts that represent a "fair and reasonable" estimate of the amount the company will be required to pay.

3. The Service is not bound by the Statement of Actuarial Opinion included in the Annual Statement, and the actuary's opinion is not entitled to any presumption or deference. First, under the procedures of SSAP No. 55, the unpaid loss reserve numbers reflected on the Annual Statement are selected by management. The Statement of Actuarial Opinion included in the Annual Statement merely confirms that the numbers selected by management are "in accordance with accepted actuarial standards" and "make a good and sufficient provision" for all unpaid obligations or make a "reasonable provision." In other words, the Statement of Actuarial Opinion does not determine the numbers that are shown on the Annual Statement.

Second, the Statement of Actuarial Opinion included in the Annual Statement -- or any related actuarial study -- is prepared for purposes of the Annual Statement, not for federal income tax purposes. Accordingly, it reflects the standards of Annual Statement accounting, such as conservatism, and not the standards of the Treasury Regulations. The fact that the Statement of Actuarial Opinion concludes that the numbers shown on the Annual Statement make a "reasonable provision" for unpaid losses does not establish that those numbers are "fair and reasonable" for federal income tax purposes. Hanover Insurance Company v. Commissioner, supra, 598 F.2d at 1217.

Third, the Service is not required to accord deference to the opinion of the taxpayer’s actuary. In Vinson & Elkins v. Commissioner, 99 T.C. 9, 16-17 (1992), aff’d, 7 F.3d 1235 (5th Cir. 1993), the Tax Court, explained that in the context of a defined benefit plan under I.R.C. § 412(c)(3) the Service was only permitted to retroactively challenge an actuary’s assumptions if the assumptions were “substantially unreasonable.” In the context of I.R.C. § 832, deference to the taxpayer's actuary is not applicable with respect to estimates of unpaid loss reserves for property and casualty insurers, where a different statutory scheme applies and where Treas. Reg. § 1.832-4 specifically authorizes the Service to adjust a taxpayer’s reserves if they are not fair and reasonable in amount. Treas. Reg. § 1.832-4 does not require that the Service must establish that a reserve is “substantially unreasonable” prior to making any adjustment.

4. For federal income tax purposes, the deduction for unpaid losses must be based on actual loss events. "Formula" reserves are not allowable. Treasury Reg. § 1.832-4(a)(14) (formerly Treas. Reg. § 1.832-4(a)(5)) requires that a taxpayers’ estimate of unpaid losses at the close of each year “represent actual unpaid losses as nearly as it is possible to ascertain them." The predecessor to Treas. Reg. § 1.832-4(a)(14) was promulgated in 1943. See T.D. 5236, 1943 C.B. 519. At that time, the NAIC required insurers to establish unpaid loss reserves equal to the greater of two separately-calculated reserves: (1) a case-based reserve representing the aggregate reserves for specific claims estimated by the insurer’s claims adjusters or; (2) a formula reserve representing a specified percentage of the insurer’s premium volume. See Charles W. Tye, The Convention Form and Insurance Company Tax Problems, 6 Tax Law Rev. 245, 245-246 (1951). Prior to the promulgation of T.D. 5236, the Service had successfully litigated its position that insurers were only entitled to deduct unpaid losses that were calculated on the case method, thereby preventing insurers from using the formula method for tax purposes. See, e.g., Pacific Employers Ins. Co. v. Commissioner, 33 B.T.A. 501 (1935), aff’d, 89 F.2d 186 (9th Cir. 1937); American Title Co. v. Commissioner, 29 B.T.A. 479 (1933), aff’d, 76 F.2d 332 (3d Cir. 1935). Accordingly, the language presently contained in Treas. Reg. § 1.832-4(a)(14) was initially included in the regulations in an attempt to emphasize the Service’s longstanding position that insurers were not entitled to use the formula method for tax purposes. See also Rev. Rul. 61-167, supra (percentage reserve for fidelity and surety business: "The reserve maintained by the taxpayer in this case does not comprise actual losses which, based on the facts of each case and the company's experience in similar cases, can be said to represent a fair and reasonable estimate of the amount the company will be required to pay but, in fact, constitutes a contingency reserve, computed on the basis of a percentage rate established by the Treasury Department, which the taxpayer is required to maintain as a condition of writing surety bonds on United States Government contracts.").

On the Annual Statement, unpaid losses include losses that are "incurred but not reported" ("IBNR"), and the Service allows IBNR losses to be included in the estimate of unpaid losses for federal income tax purposes. Rev. Rul. 70-643, 1970-2 C.B. 141. Although IBNR losses are, by definition, "unreported," the deduction for unpaid losses is limited to losses that have actually been incurred and cannot include estimates of potential future losses or mere contingency reserves. The Tax Court described this distinction in State of Maryland Deposit Insurance Fund Corp. v. Commissioner, 88 T.C. 1050, 1060 (1987):

Clearly, estimates are permissible in calculating IBNR insurance losses. By definition, an insurance company will not yet know the specific amount of such losses at the end of the taxable year (because they have not yet been reported). The authorities are clear, however, that the calculation of IBNR losses must be based on estimates of actually incurred losses as of the end of the year. This is to be distinguished from an impermissible calculation based on estimates of potential losses that might be incurred in future years. Maryland Savings-Share Ins. Corp. v. United States, 226 Ct. Cl. at 499-500, 507, 644 F.2d at 24, 28; Home Mutual Ins. Co. v. Commissioner], 70 T.C. 944, 951 (1978), affd. in part, revd. in part and remanded in part 639 F.2d 333 (7th Cir. 1980); Modern Home Life Ins. Co. v. Commissioner, 54 T.C. 935, 939 (1970).

5. For federal income tax purposes, the deduction for unpaid losses must represent a fair and reasonable estimate of the amount the company expects to pay. No administrative "margin" or "tolerance" is required or allowable. Treasury Reg. § 1.832-4(b) requires that the part of a taxpayer’s deduction for “losses incurred” which represents unpaid losses at the close of the taxable year "must be stated in amounts which, based upon the facts in each case and the company's experience with similar cases, represent a fair and reasonable estimate of the amount the company will be required to pay." (Emphasis added.) The predecessor to Treas. Reg. § 1.832-4(b) was promulgated in 1944, in part to address concerns raised by the 1943 promulgation of T.D. 5236, which required that unpaid losses must represent "actual" unpaid losses, "as nearly as it is possible to ascertain them.” That language appeared to set forth an exact standard with respect to an estimated item that was inherently uncertain. Practitioners raised questions concerning the manner in which the Service would determine whether case-based reserves were overstated. See Charles W. Tye, Federal Taxation of Insurance Companies and Their Problems, 21 Taxes 594, 616 (November 1943) (“The [Service], if it is to try and treat the computation of ’unpaid losses’ as an exact science on a case basis should give the companies more of a guide to their intention in the matter than to merely state that ‘unpaid losses must represent actual unpaid losses as nearly as it is possible to ascertain them’”). The Service addressed these concerns by promulgating T.D. 5387, which authorized the Service to make adjustments to reserves that it deemed impermissibly excessive, i.e., not “fair and reasonable."

Along with T.D. 5387 the Service issued Comm. Mim. R.A. No. 1366, which set forth a rule of thumb for auditing agents to use in determining whether estimates of unpaid losses were reasonable. Specifically, it directed agents to make adjustments to loss reserves for certain lines of insurance only if the average of the preceding five years’ estimated losses exceeded 115 percent of the average one year development of those estimates.

While Comm. Mim. R.A. No. 1366 was not published by the Service its contents were widely circulated among practitioners and the insurance industry. Comm. Mim. R.A. No. 1366 did not represent a legal interpretation but merely provided administrative guidance for examining estimates of unpaid losses.

In 1975, the Service issued Rev. Proc. 75-56, 1975-2 C.B. 596, which effectively revoked Comm. Mim. R.A. No. 1366. Rev. Proc. 75-56 stated that "The long term administrative practice enunciated in Com. Mim. R.A. 1366 can no longer be justified in view of the technological advances made by the insurance industry in the area of statistical collection and analysis. Instead the standard of reasonableness in computing unpaid losses will be that set forth in sections 1.832-4(a)(5) [now section 1.832-4(a)(14)] and 1.832-4(b) of the regulations." Emphasis added.

Comm. Mim. R.A. No. 1366 is sometimes described as providing a 15% "tolerance" for estimates of unpaid loss reserves: that no adjustment should be made if the taxpayer's estimate is not more than 15% greater than the Service's estimate. That procedure no longer applies. Rev. Proc. 75-56 specifically supersedes Comm. Mim. R.A. No. 1366. No tolerance may be allowed.

6. For federal income tax purposes, the determination of a fair and reasonable estimate of unpaid losses is a factual determination to be made based on the standards set forth in Treas. Reg. §§ 1.832-4(a)(14) and 1.832-4(b), and not on the standards of the Annual Statement. The taxpayer must establish that the deduction for unpaid losses is comprised of only actual unpaid losses, and the taxpayer may be required to submit detailed information with respect to its actual experience as is deemed necessary to establish the reasonableness of the deduction. As a preliminary matter, it should first be emphasized that any adjustment to an insurance company's deduction for losses incurred for federal income tax purposes has no effect on the company's loss reserves for Annual Statement or state regulatory purposes. As the Court of Appeals stated in Hanover Insurance Company v. Commissioner, supra, 598 F.2d at 1218:

[The taxpayer] was free to maintain reserves in any amount for unpaid losses. I.R.C. § 832 and accompanying regulations do not limit an insurance company’s freedom to keep records in whatever manner it chooses for financial or state regulatory use. Any increased burden on the insurance company is no greater than that borne by other taxpayers who use different data for tax purposes as opposed to other purposes.

Second, it should also be emphasized that valuation standards for Annual Statement purposes are different from valuation standards for federal income tax purposes, and in any particular case the different standards may produce different results. For federal income tax purposes the question is not whether the amount shown on the Annual Statement makes a "reasonable provision" for unpaid losses. That is an issue for the state insurance regulators, applying their standards of conservatism. Nor is the question whether a "reasonable provision" for Annual Statement purposes should be considered a "fair and reasonable estimate" for federal income tax purposes. Annual Statement valuation standards do not apply for federal income tax purposes.

As indicated above, a taxpayer may overstate its Annual Statement reserve for unpaid losses either by adding an "explicit" margin or by applying "implicit conservatism" in determining the overall reserve. Two cases have dealt with what may be considered "explicit" margins: Minnesota Lawyers Mutual Insurance Company v. Commissioner, T.C. Memo. 2000-203, aff'd, 285 F.3d 1086 (8th Cir. 2002) ("bulk reserve for 'adverse loss development'") and Physicians Insurance Company of Wisconsin v. Commissioner, T.C. Memo. 2001-304 ("add-ons to [the actuary's] point estimates"). The taxpayer in the Minnesota Mutual case made arguments similar to those discussed above, which the Court of Appeals summarized as follows:

MLM contends the deductions claimed on its 1994 and 1995 tax returns should be presumed fair and reasonable because the estimates were selected by professional management and not tax-motivated; certified as reasonable by a qualified actuary; within a range of reasonable actuarial estimates; and reported in MLM's annual statement and accepted by the Minnesota Department of Commerce (MDC) without change. MLM invites us to adopt a test which conclusively establishes the fairness and reasonableness of unpaid loss estimates for tax purposes when the estimates meet these four criteria.

We decline MLM's invitation and affirm the tax court. The fairness and reasonableness of unpaid loss estimates is a factual issue determined by the tax court on a case-by-case basis. The four criteria outlined by MLM should be considered by the tax court in reaching its factual determination, but they are not conclusive. The tax court need not defer to estimates set forth in an annual statement and accepted by a state insurance regulator if the taxpayer cannot otherwise defend its estimates with detailed information related to its own experience. [285 F.3d at 1088.]

The tax court found MLM failed to demonstrate either the necessity or reasonableness of the ALD [adverse loss development] reserves. As a factual matter, the tax court found that MLM did not establish the ALD reserve to hedge against historically inadequate reserves because MLM's recent experience had proven its case reserves to be generous. . . .

The tax court further determined that MLM did not carry its burden of showing the ALD amounts were fair and reasonable -- even assuming MLM could demonstrate the need for an ALD reserve. The tax court noted MLM did not show what specific factors, if any, were taken into account in establishing the extra reserve or how such factors might have been weighed. Indeed, MLM produced no documentation of any kind to show what data it analyzed in determining the amount of the ALD reserve. . . . [285 F.3d at 1090, emphasis added.]

MLM relies principally upon Utah Med. Ins. Ass'n v. Comm'r, 76 T.C.M. (CCH) 1100, 1998 WL 906665 (1998). . . .

The tax court distinguished Utah Med. because, notwithstanding the fact that MLM's unpaid loss estimates fell within an actuary's range of reasonable estimates and were accepted by a state insurance regulator, MLM neglected to present “detailed information with respect to its actual experience,” Treas. Reg. § 1.832-4(b), to establish the reasonableness of its ALD reserve. [285 F.3d at 1091, emphasis added.]

Similarly, in Physicians Insurance Company of Wisconsin v. Commissioner, T.C. Memo. 2001-304 the Tax Court stated:

Petitioner contends that because it reported the same estimates of unpaid losses on its annual statements and tax returns, and because it estimated these unpaid losses in a reasonable manner, using sound business practices, these estimates should be accorded deference for Federal income tax purposes. . . .

Petitioner's contention is at bottom a rehashing of long-rejected arguments that the Code reflects a congressional expectation that the estimates of unpaid losses used for tax purposes should conform to the precise figures shown on the annual statement. [Citing Hanover Ins. Co. v. Commissioner, 598 F.2d 1211, 1217 (1st Cir. 1979).]

Summary and Conclusions:
For federal income tax purposes the standards for the deduction for unpaid losses are set forth in Treas. Reg. §§ 1.832-4(a)(14) and 1.832-4(b). With respect to "margins" or other additions to unpaid losses two elements must be considered:

Estimates of unpaid losses must be fair and reasonable in amount,
and the estimates must represent actual unpaid losses. Margins or other
additions to unpaid losses that are not based on the company's actual experience cannot be included in the deduction for losses incurred.

Estimates of unpaid losses must be fair and reasonable in amount.

For federal income tax purposes the first and principal criterion in the examination of unpaid losses is that amounts included in or added to the estimates of unpaid losses must represent a fair and reasonable estimate of the amount the company will be required to pay. Accordingly, the first step in the examination of unpaid losses is to make an independent evaluation of the amount claimed as a deduction, without regard to the manner in which the taxpayer's Annual Statement reserves were determined or the labels or descriptions which the taxpayer attaches to any additions to its Annual Statement reserves.

If, as a result of this independent evaluation, it appears that the amount claimed by the taxpayer as unpaid losses is in excess of a fair and reasonable estimate, the Service may require the taxpayer to submit detailed information to establish the reasonableness of its deduction for losses incurred as demonstrated by its actual experience. Depending on the specific facts of any particular case, any excess over a fair and reasonable amount may be disallowed on that basis alone.

Estimates of unpaid losses must represent actual unpaid losses.

In addition, depending on the specific facts of the case, where an overstatement of loss reserves is due to distinct and identifiable additions to unpaid losses, including “explicit” margins or other "add-ons," any excess over a fair and reasonable amount may be disallowed on the basis that it does not comprise actual unpaid losses. In those circumstances, the reserve addition fails the “fair and reasonable” standard and also constitutes an unallowable contingency reserve or solvency reserve.

No distinction shall be made or deference given based on who determined or recommended that the margin be added to reserves. While careful consideration should be given to full disallowance of the overstatement for each examination year, the margin or other unsubstantiated addition must, at a minimum, be disallowed. Under Rev. Proc. 75-56, no portion of these additions can be compromised unless the taxpayer provides compelling evidence that the margin or reserve addition meets the documentary requirements of the Regulations, which require that all reserve components be based on the actual historical experience of the taxpayer.





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Provisions of HIRE Act effective 3..18..2010

RIA Special Study: Hiring and Business Stimulus Provisions in the HIRE Act of 2010
The Hiring Incentives to Restore Employment Act (HIRE Act, P.L. 111-147 ) was signed into law by the President on Mar. 18, 2010, one day after it passed Congress. This Special Study explains how the HIRE Act encourages companies to hire (and retain) unemployed workers by creating an employer “payroll tax holiday” of sorts for hiring unemployed workers in 2010 and an employer tax credit if these new hires are retained for at least one year. It also explains how the Act boosts expensing for 2010 and permits certain bond issuers to elect to receive a payment in lieu of providing a tax credit to the bondholders. For a Special Study on the Act's new anti-offshore tax abuse measures, and other revenue raising provisions, see ¶ 2 .
Payroll Tax Holiday in 2010 for Hiring Unemployed Workers
The Federal Insurance Contributions Act (FICA) imposes two taxes, the Old Age, Survivors and Disability Insurance (OASDI) tax and the Medicare Hospital Insurance (HI) tax. These taxes are imposed on employers for wages paid with respect to employment and on employees for wages received with respect to employment. The OASDI tax rate is 6.2% on wages up to an annually-adjusted “wage base” ($106,800 for 2010). The HI tax rate is 1.45% on all wages, regardless of amount. Under pre-Act law, the Social Security payroll tax wasn't forgiven for employers who hired the unemployed.
Employers who hire members of certain targeted groups before Sept. 2011 may claim a work opportunity credit (WOTC) equal to a percentage of up to $6,000 of first-year wages per employee, $12,000 for qualified veterans, and $3,000 for qualified summer youth employees. If the employee is a long-term family assistance recipient, the credit is a percentage of first- and second-year wages, up to $10,000 per employee.
New law. The Act provides relief from the employer share of OASDI taxes for employers that hire unemployed workers. The relief applies to wages paid beginning on Mar. 19, 2010 (the day after the enactment date) and ending on Dec. 31, 2010. ( Code Sec. 3111(d) , as amended by Act Sec. 101(a))
More specifically, the OASDI tax on employers doesn't apply to wages paid by a qualified employer with respect to employment during the period beginning on Mar. 19, 2010 and ending on Dec. 31, 2010, of any qualified individual for services performed:
... in a trade or business of the qualified employer; or
... for a qualified employer that is tax-exempt under Code Sec. 501(a) , in furtherance of the activities related to the purpose or function on which the employer's exemption is based. ( Code Sec. 3111(d)(1) , as amended by Act Sec. 101(a))
RIA observation: The payroll tax holiday applies only to the 6.2% OASDI portion of the employer's tax. It doesn't apply to the 1.45% Medicare (HI) portion of the employer's tax, nor to any part of the employee's tax. It also doesn't affect the self-employment tax paid by self-employed individuals.
RIA observation: The amount of tax forgiven per employee can't exceed $6,621.60, because the OASDI tax applies to only the first $106,800 of wages paid in 2010 ($106,800 × 6.2% = $6,621.60).
RIA observation: An employee need not work for a minimum number of hours in order for the employer to qualify for the payroll tax holiday.
Qualified employer defined. A qualified employer is any employer other than the U.S., a state, or a political subdivision of a state (i.e., a local government, or an instrumentality). ( Code Sec. 3111(d)(2)(A) ) However, a public institution of higher education is a qualified employer even though it is a government instrumentality. ( Code Sec. 3111(d)(2)(B) )
RIA observation: Thus, the payroll tax holiday applies to employers in the private and not-for-profit sectors. It doesn't apply to public-sector employers other than public institutions of higher education.
Qualified individuals defined. A qualified individual is anyone who:
(1) Begins employment with a qualified employer after Feb. 3, 2010, and before Jan. 1, 2011.
RIA observation: Although a qualified employee who begins work after Feb. 3, 2010 can be eligible for the payroll tax holiday, only the employer's portion of OASDI on his wages paid with respect to employment after Mar. 18, 2010 (the enactment date) will be forgiven.
(2) Certifies by signed affidavit, under penalties of perjury, that he hasn't been employed for more than 40 hours during the 60-day period ending on the date the individual begins employment with the qualified employer.
(3) Isn't employed to replace another employee of the qualified employer unless that other employee separated from employment voluntarily or for cause.
(4) Isn't related to the qualified employer in a way that would disqualify him for the WOTC under Code Sec. 51(i)(1) . ( Code Sec. 3111(d)(3) )
The Committee Report says an employer may qualify for the payroll tax holiday when it hires an otherwise qualified individual to replace one who was terminated for cause or due to other facts and circumstances, such as where a factory is closed due to lack of demand. When the factory reopens, the payroll tax holiday can be claimed both for rehiring old workers and hiring new workers. However, an employer who terminates an employee without cause in order to claim the payroll tax holiday for hiring the same or another employee doesn't qualify.
RIA observation: Under item (4), above, there's no payroll tax holiday for hiring a relative such as the qualified employer's child or descendant of a child; a stepchild; sibling, stepbrother, or stepsister; parent or stepparent; niece, nephew, uncle or aunt; or in-laws.
If the qualified employer is:
... a corporation, an individual standing in any of the above relationships to anyone who owns, directly or indirectly, more than 50% in value of its outstanding stock, after applying the Code Sec. 267(c) attribution rules, won't qualify.
... a noncorporate entity, an individual standing in any of the above relationships to anyone who owns, directly or indirectly, more than 50% of the capital and profits interests in the entity attribution rules, won't qualify.
... an estate or trust, a grantor, beneficiary, or fiduciary of the estate or trust, or an individual having any of the familial relationships described above to a grantor, beneficiary, or fiduciary of the estate or trust, won't qualify.
An individual unrelated to the qualified employer who is the employer's dependent because he has the same principal place of abode and is a member of the employer's household won't qualify. If the qualified employer is a corporation, an individual who is a dependent of anyone who owns, directly or indirectly, more than 50% in value of the outstanding stock, won't qualify. A dependent of a grantor, beneficiary, or fiduciary of an estate or trust that is a qualified employer won't qualify.
Special rule for first calendar quarter of 2010. The payroll tax holiday doesn't apply for wages paid during the first calendar quarter of 2010. Instead, the amount by which the qualified employer's OASDI tax for wages paid during the first calendar quarter of 2010 would have been reduced if the payroll tax holiday had been in effect for that quarter is treated as a payment against the qualified employer's OASDI tax for the second calendar quarter of 2010. ( Code Sec. 3111(d)(5)(B) ) The payment is treated as made on the date when the employer's second-quarter OASDI tax is due.
RIA observation: Most employers report employment taxes quarterly on Form 941 (Employer's Quarterly Federal Tax Return). The rule providing that the payroll tax holiday doesn't apply for wages paid during the first quarter will give IRS time to issue guidance about the payroll tax holiday and will give employers time to adjust their payroll systems accordingly. Employers won't lose out, because the amount of first-quarter wages that would have been forgiven will be allowed as a credit for the second quarter.
Election out; coordination of payroll holiday with WOTC. A qualified employer may elect, in the manner that IRS requires, not to have the payroll tax holiday apply. ( Code Sec. 3111(d)(4) ) Unless the employer elects out of the payroll holiday, wages paid or incurred to a qualified individual won't qualify for the WOTC during the one-year period beginning on the date that the qualified employer hired the individual. ( Code Sec. 51(c)(5) ) The Committee Report indicates that the election can be made on an employee-by-employee basis.
RIA observation: The WOTC is in many cases more valuable than the payroll tax holiday, especially for low-wage employees, because it is generally 40% of “qualified first-year wages” of up to $6,000, for maximum credit of $2,400 per worker. The payroll tax holiday is equal to 6.2% of wages, and applies only to wages paid through Dec. 31, 2010. However, the WOTC is harder to qualify for, because the employee must be certified by an agency as belonging to a targeted group. The main qualification for payroll tax holiday is that the employee have been unemployed for 60 days, and the employee's affidavit is sufficient for this purpose.
Railroad retirement tax holiday. Effective for compensation paid after Mar. 18, 2010, the Act provides a railroad retirement tax holiday that is similar in many respects to the OASDI tax holiday. ( Code Sec. 3221(c) , as amended by Act Sec. 101(d))
New Up-to-$1,000 Credit for Each “Retained Worker”
For any tax year ending after Mar. 18, 2010, the Act provides an up-to-$1,000 credit for “retained workers.” (Act Sec. 102) A retained worker is defined as any qualified individual, as defined for purposes of the payroll tax holiday (see above):
(1) who was employed by the taxpayer on any date during the tax year,
(2) who was so employed by the taxpayer for a period of not less than 52 consecutive weeks, and
(3) whose wages (as defined in Code Sec. 3401(a) ) for that employment during the last 26 weeks of the period (described in item (2) above) equaled at least 80% of the wages for the first 26 weeks of that period. (Act Sec. 102(b))
RIA observation: The definition of wages for withholding purposes in Code Sec. 3401(a) generally includes all remuneration (other than fees paid to a public official) for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash. Thus, compensation that isn't subject to withholding, such as certain fringe benefits, wouldn't be included as wages for purposes of the up-to-$1,000 credit for retained workers. Also, wages paid to certain types of employees that are exempt from income tax withholding under Code Sec. 3401(a) wouldn't qualify as wages for purposes of the up-to-$1,000 credit. The exemptions from withholding provided in Code Sec. 3401(a) include wages paid to certain agricultural labor, domestics working in private homes, certain employees working in foreign countries (if the employer is required to withhold on the wages under foreign law), etc.
Amount of the credit. Under Act Sec. 102(a), for any tax year ending after Mar. 18, 2010, the current year business credit determined under Code Sec. 38(b) for the tax year is increased, for each retained worker (as defined above) with respect to which the 52-consecutive-week requirement in (2), above, is first satisfied during the tax year, by the lesser of:
... $1,000; or
... 6.2% of the wages (as defined for income tax withholding in Code Sec. 3401(a) ) paid by the taxpayer to the retained worker during the 52-consecutive-week-period. (Act Sec. 102(a))
RIA observation: If a retained worker's wages during the 52-consecutive-week-period exceed $16,129.03, the increase to the current year business credit for that retained worker will be $1,000.
RIA observation: Since the increase to the current year business credit under the above rules applies in the tax year in which the 52-consecutive-week test is first satisfied, the increase to the current year business credit with respect to each retained employee only occurs in one tax year (i.e., the tax year in which the 52-consecutive-week test is first satisfied by a particular employee).
RIA observation: For an employer using the calendar year as its tax year, the increase to the current year business credit will be claimed on the employer's 2011 tax return.
RIA illustration 1: ABC Corp., a taxpayer using the calendar year as its tax year, hires Earl, a retained worker, on Feb. 15, 2010. The 52-consecutive-week requirement is first satisfied in the 2011 tax year if Earl works for ABC until Feb. 14, 2011. His wages for the 52-consecutive-week period are $30,000. In that case, on its 2011 tax return, ABC's current year business credit will be increased by $1,000 for Earl.
RIA observation: Certain fiscal year taxpayers may have to claim the increase to the current year business credit on tax returns for two tax years on an employee-by-employee basis.
RIA illustration 2: The facts are the same as in illustration (1) except that ABC Corp. uses a fiscal year beginning on Dec. 1 and ending on Nov. 30 as its tax year. ABC Corp. also hires Carol (a retained worker) on Dec. 31, 2010, and she is still working for ABC on Dec. 30, 2011. Carol's wages for the 52-consecutive-week-period are $52,000.
The 52-consecutive-week requirement is first satisfied with respect to Earl on Feb. 14, 2011, and with respect to Carol on Dec. 30, 2011. Thus, ABC can claim the $1,000 increase to the current year business credit for Earl on its tax return for the fiscal year ending on Nov. 30, 2011 and the $1,000 increase for Carol on its tax return for the fiscal year ending on Nov. 30, 2012.
RIA illustration 3: The facts are the same as in illustration (2) except that Earl quits working for ABC on Jan. 30, 2011. Since he only worked for ABC for 50 consecutive weeks, the 52-consecutive-week requirement isn't satisfied for Earl, and ABC can't claim the up-to-$1,000 credit for him.
RIA observation: Presumably, IRS will soon issue a form for claiming the $1,000 increase to the current year business credit for the retention of certain newly hired employees as it has for other employee retention credits such as the Midwestern Disaster Area employee retention credit that is claimed on Form 5884-A and on Form 3800.
RIA caution: An employer will need to keep careful records with respect to each employee hired after Feb. 3, 2010 and before Jan. 1, 2011 so that it can prove that each employee for which it claims the up-to-$1,000 increase to the current year business credit meets the definition of a retained worker.
RIA observation: Presumably, the increase to the current year business credit under Act Sec. 102 occurs before the application of any of the limitations under Code Sec. 38(c) that apply to the general business credit as determined under Code Sec. 38(a)(2) . Thus, the up to $1,000 increase to the current year business credit is subject to the rules that, under Code Sec. 38 , can prevent some taxpayers from enjoying full use of the credit to reduce their tax liabilities in the tax year that the credit is claimed. For example, the increase to the current year business credit under Act Sec. 102 won't be allowed to offset any of a taxpayer's alternative minimum tax (AMT), and will be limited in its offset of a taxpayer's regular income tax.
Carryback limit on the $1,000 increase per retained worker. No portion of the unused business credit under Code Sec. 38 for any tax year that is attributable to the up-to-$1,000 increase in the current year business credit under Act Sec. 102 can be carried to a tax year beginning before Mar. 18, 2010. (Act Sec. 102(c))
RIA observation: A one-year carryback generally applies to unused business credits under Code Sec. 39(a)(1) . However, Act Sec. 102(c) prevents a taxpayer from carrying back any portion of an unused business credit that is attributable to the up-to-$1,000 increase of the current year business credit to a tax year beginning before Mar. 18, 2010. Since a taxpayer using the calendar year as its tax year is only entitled to the up-to-$1,000 increase to the current year business credit in 2011 (see above), the effect of the rule in Act Sec. 102(c) is that a calendar year taxpayer can't carry back any portion of the unused business credit that is attributable to the up-to-$1,000 increase to 2010 (a tax year that began before Mar. 18, 2010). Thus, a calendar year taxpayer isn't allowed the one-year carryback (that would be allowed under Code Sec. 39(a)(1)(A) but for the rule in Act Sec. 102(c)) of any portion of any unused business credit that is attributable to the up-to-$1,000 increase to the current year business credit under Act Sec. 102.
RIA observation: The transitional rule in Act Sec. 102(c) was necessary because the transitional rule in Code Sec. 39(d) (generally providing that no part of any unused current business credit attributable to a component credit can be carried back to any tax year before the first tax year that the component credit was allowable) is limited to the credits listed under Code Sec. 38(b) ), and the increase to the current year business credit under Act Sec. 102 isn't listed in Code Sec. 38(b) .
RIA observation: There are no special carryforward provisions that apply to the up-to-$1,000 increase to the current year business credit for retained workers. Thus, presumably, any portion of the general business credit that is attributable to the increase to the current year business credit will be subject to the 20-year carryforward limitations applicable to current year unused business credits.
U.S. possessions. The Act provides comparable rules relating to the application of the up to $1,000 increase to the current year business credit to employers in U.S. possessions. For this purpose, a U.S. possession includes Puerto Rico and the Northern Mariana Islands. (Act Sec. 102(d)(3)(A))
Expensing Limits Boosted For 2010
Generally, taxpayers can elect to treat the cost of any Code Sec. 179 property placed in service during the tax year as an expense which is not chargeable to capital account, and any cost so treated is allowed as a deduction for the tax year in which the section 179 property is placed in service.
For tax years beginning in 2008 and 2009, the maximum amount that could be expensed under Code Sec. 179 was $250,000, and the maximum deductible expense was reduced (i.e., phased out, but not below zero) by the amount by which the cost of Code Sec. 179 property placed in service during tax year 2008 or 2009 exceeded $800,000. The $250,000 and $800,000 amounts were not adjusted for inflation.
Under pre-Act law, for tax years beginning in 2010, the maximum amount that could be expensed under Code Sec. 179 , was $134,000, and the maximum deductible expense had to be reduced (i.e., phased out, but not below zero) by the amount by which the cost of Code Sec. 179 property placed in service during the 2010 tax year exceeded $530,000 (i.e., the beginning-of-phaseout amount). The 2010 amounts reflected statutory inflation adjustments.
For tax years beginning after 2010, the maximum expensing amount under Code Sec. 179 is $25,000, the beginning-of-phaseout amount is $200,000, and neither amount is adjusted for inflation.
Qualifying property for purposes of the Code Sec. 179 expensing election is depreciable tangible personal property purchased for use in the active conduct of a trade or business, including “off-the-shelf” computer software placed in service in tax years beginning before 2011.
New law. For tax years beginning after 2007 and before 2011, the Act provides that:
... the dollar limitation on the Code Sec. 179 expensing deduction is $250,000,
... the reduction in the dollar limitation (beginning-of-phaseout amount) starts to take effect when property placed in service in a tax year exceeds $800,000, and
... neither the dollar limitation nor the beginning-of-phaseout amount is adjusted for inflation. ( Code Sec. 179(b) , as amended by Act Sec. 201(a)).
Additionally, the increase in dollar limitation amounts and no-inflation-adjustment rule for 2008 and 2009 are removed. (Act Sec. 201(a)(3))
Thus, the Act increases for one year (2010) the amount a taxpayer can expense under Code Sec. 179 . The maximum amount a taxpayer can expense for a tax year beginning in 2010 is $250,000 of the cost of qualifying property placed in service for that tax year. The $250,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during 2010 exceeds $800,000.
RIA observation: Since the $250,000 and $800,000 limitation amounts and no-inflation-adjustment rule applied under pre-Act law for tax years beginning in 2008 and 2009, the Act both extends those limitation and phaseout amounts to tax years beginning in 2010 and eliminates the inflation-adjustment rule which applied for tax years beginning in 2010 under pre-Act law.
RIA illustration : In 2010, Midcorp, a calendar-year taxpayer, places into service Code Sec. 179 property with a cost of $660,000. It can elect to expense $250,000 of the cost (there's no phaseout because the cost of Code Sec. 179 property placed in service during the year does not exceed $800,000, the beginning-of-phaseout amount for 2010).
RIA observation: For property placed in service in tax years beginning in 2010, the Code Sec. 179 expensing deduction phases out completely only when the cost of the property exceeds $1,050,000 ($800,000 (beginning-of-phaseout amount) + $250,000 (dollar limitation)). This is the same limit that applied under pre-Act law for property placed in service in 2008 or 2009.
Issuers of Certain Tax Credit Bonds Can Elect to Receive Direct Payment In Lieu of a Tax Credit to the Bondholder
As an alternative to traditional tax-exempt bonds, state and local governments may issue qualified tax credit bonds. Qualified tax credit bonds allow the bondholder (i.e., investor) to claim a nonrefundable tax credit in lieu of receiving interest. Qualified tax credit bonds include:
... new clean renewable energy bonds (New CREBs)—i.e., certain bonds issued to finance capital expenditures for qualified renewable energy facilities;
... qualified energy conservation bonds (QECBs)—i.e., certain bonds issued for a “qualified energy conservation purpose” such as initiatives for reducing greenhouse emissions;
... qualified zone academy bonds (QZABs)—i.e., certain bonds issued to finance certain academic programs operated by public schools in cooperation with businesses in economically disadvantaged areas; and
... qualified school construction bonds (QSCBs)—i.e., certain bonds issued to finance the construction, rehabilitation, or repair of, or the acquisition of land for, public school facilities.
Build America Bonds (BABs), which are otherwise tax-exempt bonds issued to finance capital projects for which the issuer (i.e., a state or local government) irrevocably elects to treat as taxable bonds, entitle the holder to a nonrefundable tax credit. For BABs that are “qualified bonds”—certain BABs issued before 2011 for which the issuer irrevocably elects, on or before the issue date of the bonds, to have the refundable tax credit rules of Code Sec. 6431 apply—the issuer may elect to claim a refundable tax credit (the so-called “direct payment” option) in lieu of the tax credit to the bondholder.
New law. For bonds originally issued after Mar. 18, 2010, the Act allows an issuer of New CREBS, QECs, QZABs, or QSCBs to make an irrevocable election on or before the issue date of the bonds to receive a payment in lieu of providing a tax credit to the holder of the bonds. Thus, these “specified tax credit bonds” are treated as “qualified bonds” under Code Sec. 6431 , and the issuer is entitled to receive a direct payment from IRS. ( Code Sec. 6431(f) , as amended by Act Sec. 301(a))
RIA observation: Qualified forestry conservation bonds (another type of tax credit bond) aren't “specified tax credit bonds,” qualifying for the direct payment option.
Interest paid to the holder of the bond is includible in the holder's gross income. ( Code Sec. 6431(f)(1)(D) ) The issuer's direct payment option for qualified tax credit bonds is in lieu of the credit for the holder, and the bondholder can't claim the tax credit that otherwise would be available under the qualified tax credit bond rules. ( Code Sec. 6431(f)(1)(E) )
For specified tax credit bonds, the amount that IRS will pay to the issuer (or to any person making interest payments on the issuer's behalf) for any interest payment due under the bond is equal to the lesser of:
(1) the amount of interest payable under the bond on that date ( Code Sec. 6431(f)(1)(C)(i) ), or
(2) the amount of interest that would have been payable under the bond on that date if the interest were determined at the applicable credit rate determined under Code Sec. 54A(b)(3) . ( Code Sec. 6431(f)(1)(C)(ii) )
Thus, the amount of the payment to the issuer of a specified tax credit bond that is a New CREB, QECB, QZAB, or QSCB is a function of the market-determined interest rate on the bond and not a rate set by IRS. (Committee Report)
Under a special rule, for any New CREB or QECB, the amount of the credit determined under Code Sec. 6431(f)(1)(C)(ii) is 70% of the amount otherwise determined, without regard to this rule, Code Sec. 54C(b) (new CREB annual credit is 70% of the amount otherwise allowed), and Code Sec. 54D(b) (QECB annual credit is 70% of the amount otherwise allowed). ( Code Sec. 6431(f)(2) )
The income tax deduction otherwise allowed to the issuer of a qualified bond that is a New CREB, QECB, QZAB, or QSCB for interest paid on the bond is reduced by the amount of the payment made under Code Sec. 6431 for the interest. ( Code Sec. 6431(f)(1)(G) )
RIA observation: The issuer of a New CREB, QECB, QZAB, or QSCB that elects the direct payment option for the bond must make regular interest payments to the bond holders. The deduction otherwise allowed to the issuer for these interest payments must be reduced by the amounts the issuer receives from IRS.
New CREBs, QECBs, QZABs, and QSCBs for which the election is made count against the national limitation for such bonds in the same way that they would if no election were made. (Committee Report)
An issuer can elect the direct payment option for qualified bonds that are New CREBs, QECBs, QZABs, or QSCBs even if the bonds aren't issued before 2011. ( Code Sec. 6431(f)(1)(B) )
RIA observation: However, due to a “zero” national bond volume limitation that is prescribed for both QZABs and QSCBs for years after 2010, they can be issued after 2010 only if unused national bond volume limitations for pre-2011 years can be carried forward. For carryforward for QSCBs, see below.
In a technical correction, the Act also provides that for bonds issued after Feb. 17, 2009—i.e., as if it were originally included in American Recovery and Reinvestment Act §1521—the Code Sec. 54F(e) rule allowing the carryover of unused QSCB limitation by a State or Indian tribal government applies to the 40% of QSCB limitation that is allocated among the largest school districts. It also provides that the limitation amount allocated to a State is to be allocated to QSCBs issuers within the State by the State education agency (or such other agency as is authorized under State law to make the allocation). ( Code Sec. 54F , as amended by Act Sec. 301(b))

Red Flag audit issues - IRS dirty dozen

IR-2010-32,Internal Revenue Service, (Mar. 17, 2010)
2010FED ¶46,304
Code Sec. 6701, Code Sec. 7206, Code Sec. 7623, Code Sec. 7804

IRS dirty dozen: Tax scams: Tax fraud


Beware of IRS' 2010 “Dirty Dozen” Tax Scams
Videos:

Dirty Dozen : English

Message for Tax Preparers : English

Choosing a Return Preparer : English/Spanish/ASL

For this and other videos: YouTube/IRSVideos

IR-2010-32, March 16, 2010
WASHINGTON—The Internal Revenue Service today issued its 2010 “dirty dozen” list of tax scams, including schemes involving return preparer fraud, hiding income offshore and phishing.

“Taxpayers should be wary of anyone peddling scams that seem too good to be true,” IRS Commissioner Doug Shulman said. “The IRS fights fraud by pursuing taxpayers who hide income abroad and by ensuring taxpayers get competent, ethical service from qualified professionals at home in the U.S.”

Tax schemes are illegal and can lead to imprisonment and fines for both scam artists and taxpayers. Taxpayers pulled into these schemes must repay unpaid taxes plus interest and penalties. The IRS pursues and shuts down promoters of these and numerous other scams.

The IRS urges taxpayers to avoid these common schemes:

Return Preparer Fraud
Dishonest return preparers can cause trouble for taxpayers who fall victim to their ploys. Such preparers derive financial gain by skimming a portion of their clients' refunds, charging inflated fees for return preparation services and attracting new clients by promising refunds that are too good to be true. Taxpayers should choose carefully when hiring a tax preparer. Federal courts have issued injunctions ordering hundreds of individuals to cease preparing returns and promoting fraud, and the Department of Justice has filed complaints against dozens of others, which are pending in court.

To increase confidence in the tax system and improve compliance with the tax law, the IRS is implementing a number of steps for future filing seasons. These include a requirement that all paid tax return preparers register with the IRS and obtain a preparer tax identification number (PTIN), as well as both competency tests and ongoing continuing professional education for all paid tax return preparers except attorneys, certified public accountants (CPAs) and enrolled agents.
Setting higher standards for the tax preparer community will significantly enhance protections and services for taxpayers, increase confidence in the tax system and result in greater compliance with tax laws over the long term. Other measures the IRS anticipates taking are highlighted in the IRS Return Preparer Review issued in December 2009.

Hiding Income Offshore
The IRS aggressively pursues taxpayers involved in abusive offshore transactions as well as the promoters, professionals and others who facilitate or enable these schemes. Taxpayers have tried to avoid or evade U.S. income tax by hiding income in offshore banks, brokerage accounts or through the use of nominee entities. Taxpayers also evade taxes by using offshore debit cards, credit cards, wire transfers, foreign trusts, employee-leasing schemes, private annuities or insurance plans.

IRS agents continue to develop their investigations of these offshore tax avoidance transactions using information gained from over 14,700 voluntary disclosures received last year. While special civil-penalty provisions for those with undisclosed offshore accounts expired in 2009, the IRS continues to urge taxpayers with offshore accounts or entities to voluntarily come forward and resolve their tax matters. By making a voluntary disclosure, taxpayers may mitigate their risk of criminal prosecution.

Phishing
Phishing is a tactic used by scam artists to trick unsuspecting victims into revealing personal or financial information online. IRS impersonation schemes flourish during the filing season and can take the form of e-mails, tweets or phony Web sites. Scammers may also use phones and faxes to reach their victims.

Scam artists will try to mislead consumers by telling them they are entitled to a tax refund from the IRS and that they must reveal personal information to claim it. Criminals use the information they get to steal the victim's identity, access bank accounts, run up credit card charges or apply for loans in the victim's name.

Taxpayers who receive suspicious e-mails claiming to come from the IRS should not open any attachments or click on any of the links in the e-mail. Suspicious e-mails claiming to be from the IRS or Web addresses that do not begin with http://www.irs.gov should be forwarded to the IRS mailbox: phishing@irs.gov.

Filing False or Misleading Forms
The IRS is seeing various instances where scam artists file false or misleading returns to claim refunds that they are not entitled to. Under the scheme, taxpayers fabricate an information return and falsely claim the corresponding amount as withholding as a way to seek a tax refund. Phony information returns, such as a Form 1099-Original Issue Discount (OID), claiming false withholding credits usually are used to legitimize erroneous refund claims. One version of the scheme is based on a false theory that the federal government maintains secret accounts for its citizens, and that taxpayers can gain access to funds in those accounts by issuing 1099-OID forms to their creditors, including the IRS.

Nontaxable Social Security Benefits with Exaggerated Withholding Credit
The IRS has identified returns where taxpayers report nontaxable Social Security Benefits with excessive withholding. This tactic results in no income reported to the IRS on the tax return. Often both the withholding amount and the reported income are incorrect. Taxpayers should avoid making these mistakes. Filings of this type of return may result in a $5,000 penalty.

Abuse of Charitable Organizations and Deductions
The IRS continues to observe the misuse of tax-exempt organizations. Abuse includes arrangements to improperly shield income or assets from taxation and attempts by donors to maintain control over donated assets or income from donated property. The IRS also continues to investigate various schemes involving the donation of non-cash assets including situations where several organizations claim the full value for both the receipt and distribution of the same non-cash contribution. Often these donations are highly overvalued or the organization receiving the donation promises that the donor can repurchase the items later at a price set by the donor. The Pension Protection Act of 2006 imposed increased penalties for inaccurate appraisals and set new definitions of qualified appraisals and qualified appraisers for taxpayers claiming charitable contributions.

Frivolous Arguments
Promoters of frivolous schemes encourage people to make unreasonable and outlandish claims to avoid paying the taxes they owe. If a scheme seems too good to be true, it probably is. The IRS has a list of frivolous legal positions that taxpayers should avoid. These arguments are false and have been thrown out of court. While taxpayers have the right to contest their tax liabilities in court, no one has the right to disobey the law or IRS guidance.

Abusive Retirement Plans
The IRS continues to find abuses in retirement plan arrangements, including Roth Individual Retirement Arrangements (IRAs). The IRS is looking for transactions that taxpayers use to avoid the limits on contributions to IRAs, as well as transactions that are not properly reported as early distributions. Taxpayers should be wary of advisers who encourage them to shift appreciated assets at less than fair market value into IRAs or companies owned by their IRAs to circumvent annual contribution limits. Other variations have included the use of limited liability companies to engage in activity that is considered prohibited.

Disguised Corporate Ownership
Corporations and other entities are formed and operated in certain states for the purpose of disguising the ownership of the business or financial activity by means such as improperly using a third party to request an employer identification number.

Such entities can be used to facilitate underreporting of income, fictitious deductions, non-filing of tax returns, participating in listed transactions, money laundering, financial crimes and even terrorist financing. The IRS is working with state authorities to identify these entities and to bring the owners of these entities into compliance with the law.

Zero Wages
Filing a phony wage- or income-related information return to replace a legitimate information return has been used as an illegal method to lower the amount of taxes owed. Typically, a Form 4852 (Substitute Form W-2) or a “corrected” Form 1099 is used as a way to improperly reduce taxable income to zero. The taxpayer also may submit a statement rebutting wages and taxes reported by a payer to the IRS. Sometimes fraudsters even include an explanation on their Form 4852 that cites statutory language on the definition of wages or may include some reference to a paying company that refuses to issue a corrected Form W-2 for fear of IRS retaliation. Taxpayers should resist any temptation to participate in any of the variations of this scheme. Filings of this type of return may result in a $5,000 penalty.

Misuse of Trusts
For years, unscrupulous promoters have urged taxpayers to transfer assets into trusts. While there are many legitimate, valid uses of trusts in tax and estate planning, some promoted transactions promise reduction of income subject to tax, deductions for personal expenses and reduced estate or gift taxes. Such trusts rarely deliver the tax benefits promised and are used primarily as a means to avoid income tax liability and to hide assets from creditors, including the IRS.

The IRS has recently seen an increase in the improper use of private annuity trusts and foreign trusts to shift income and deduct personal expenses. As with other arrangements, taxpayers should seek the advice of a trusted professional before entering into a trust arrangement.

Fuel Tax Credit Scams
The IRS receives claims for the fuel tax credit that are excessive. Some taxpayers, such as farmers who use fuel for off-highway business purposes, may be eligible for the fuel tax credit. But other individuals are claiming the tax credit for nontaxable uses of fuel when their occupation or income level makes the claim unreasonable. Fraud involving the fuel tax credit is considered a frivolous tax claim and potentially subjects those who improperly claim the credit to a $5,000 penalty.

How to Report Suspected Tax Fraud Activity
Suspected tax fraud can be reported to the IRS using Form 3949-A, Information Referral. Form 3949-A is available for download from the IRS Web site at IRS.gov. The completed form or a letter detailing the alleged fraudulent activity should be addressed to the Internal Revenue Service, Fresno, CA 93888. The mailing should include specific information about who is being reported, the activity being reported, how the activity became known, when the alleged violation took place, the amount of money involved and any other information that might be helpful in an investigation. The person filing the report is not required to self-identify, although it is helpful to do so. The identity of the person filing the report can be kept confidential.

Whistleblowers also may provide allegations of fraud to the IRS and may be eligible for a reward by filing Form 211, Application for Award for Original Information, and following the procedures outlined in Notice 2008-4 , Claims Submitted to the IRS Whistleblower Office under Section 7623 .

new liberal rules on computing future income

IRS Small Business/Self-Employed Interim Guidance for Calculation of Future Income in Offer in Compromise Cases, SBSE 05-0310-012, (Mar. 16, 2010)
2010ARD 052-5
Internal Revenue Service: Compromises: Future income
DEPARTMENT OF THE TREASURY INTERNAL REVENUE SERVICE Washington, DC 20224
March 10, 2010
SMALL BUSINESS / SELF-EMPLOYED DIVISION
SB/SE Control No: SBSE 05-0310-012
Expires: 3/10/2011
Impacted IRM 5.8.5
MEMORANDUM FOR DIRECTORS, COLLECTION AREA OPERATIONS DIRECTORS, CAMPUS COMPLIANCE OPERATIONS AND CHIEF, APPEALS
FROM: Frederick W. Schindler /s/ Frederick W. Schindler Director, Collection Policy
SUBJECT: Interim Guidance for Calculation of Future Income in Offer in Compromise Cases
The purpose of this memorandum is to provide revised guidance in the computation of the taxpayer's future income value during the evaluation of an offer in compromise.
Internal Revenue Manual (IRM) 5.8.5 defines future income as an estimate of the taxpayer's ability to pay based on an analysis of gross income, less necessary living expenses, for a specific number of months into the future. The number of months used depends on the payment terms of the offer. In general, a taxpayer's current income will be used in the analysis of future ability to pay.
Attached to this memorandum is a revision to sections of IRM 5.8.5, Financial Analysis which discuss the calculation of future income and the use of collateral agreements.
The revisions include specific examples of when the use of income averaging and/or a collateral agreement is appropriate.
These procedures are effective upon the date of issuance and should be applied to any offer currently under consideration. Additionally, these procedures may be applied to offers previously rejected which are currently in their appeal period or where the taxpayer has requested appeals consideration. These procedures will be incorporated into the next revision of IRM 5.8 Offers in Compromise.
If you have any questions, you may contact me, or a member of your staff may contact Thomas B. Moore, OIC Senior Program Analyst. Territory or Campus personnel should direct any questions, through their management staff, to the appropriate Area or Campus contact.
Attachment
cc: Commissioner, Small Business/Self-Employed Division
National Chief, Appeals
Chief Counsel
National Taxpayer Advocate
5.8.5.6 Future Income
(1) Future income is defined as an estimate of the taxpayer's ability to pay based on an analysis of gross income, less necessary living expenses, for a specific number of months into the future.
(2) As a general rule, the taxpayer's current income will be used in the analysis of future ability to pay. This includes situations where the taxpayer's income is recently reduced based on a change in occupation or employment status.
(3) Consideration should be given to the taxpayer's overall general situation including such facts as age, health, marital status, number and age of dependents, level of education or occupational training, and work experience.
(4) Situations that may warrant placing a different value on future income than current or past income indicates are discussed in the table below. Additionally, securing a future income collateral agreement based on the taxpayer's earnings potential may be appropriate and are discussed in more detail in IRM 5.8.5.19 and IRM 5.8.6, Collateral Agreements.

If… Then…

Income will increase or decrease or current necessary expenses will increase or decrease Adjust the amount or number of payments to what is expected during the appropriate number of months.

A taxpayer is temporarily or recently unemployed or underemployed Use the level of income expected if the taxpayer were fully employed and if the potential for employment is apparent. Each case should be judged on its own merit, including consideration of special circumstances or ETA issues.
Example: Unemployed - The taxpayer is a construction worker and between jobs. A review of the taxpayer's previous annual income and/or income averaging may be the appropriate method to determine taxpayer's income for calculation purposes.
Example: Underemployed - If a taxpayer is a teacher but recently moved and is currently at a lesser paying job until a teaching position becomes available, or has been hired and does not begin work until the school season begins, the taxpayer is considered to be currently underemployed. Use the anticipated income once the taxpayer is fully employed.

A taxpayer is unemployed and is not expected to return to their previous occupation or previous level of earnings Contact the taxpayer to discuss the expected future level of income. When considering future income, also allow anticipated increases in necessary living expenses and/or applicable taxes.
Each case should be judged on its own merit, including consideration of special circumstances or ETA issues.

A taxpayer is long-term unemployed Use of income averaging is not required; the taxpayer's current income may be used in the future income calculation.
Example: Taxpayer has been unemployed for over one year. There are currently no employment opportunities for the taxpayer and the household is living on one income. Use of the taxpayer's current income with a future income collateral agreement is appropriate.

A taxpayer is long-term underemployed Do not income average; use the taxpayer's current income.
Example: The taxpayer was previously employed in a manufacturing plant making $75,000 per year. There are currently no opportunities for the taxpayer to secure employment making the same rate of pay as their prior job. Their income is now $25,000 per year with no anticipated increase. Use the current income only.

A taxpayer has an irregular employment history or fluctuating income Average earnings over the three prior years. The use of a time period other than three years should be the exception and only when specific circumstances are present.
Example: The taxpayer is a stock broker whose income in 2007 was $150,000 and income in 2008 was $25,000. In this case, you should consider income averaging the prior three years or secure a future income collateral agreement if the offer is accepted.
Note: This practice does not apply to wage earners. Wage earners should be based on current income unless the taxpayer has unique circumstances.

A taxpayer is in poor health and their ability to continue working is questionable Reduce the number of payments to the appropriate number of months it is anticipated the taxpayer will continue working. Consider special circumstance situations when making any adjustments.
Example: Taxpayer has a serious health issue and it is anticipated they will be unable to work after six months. Use the taxpayer's current income for six months then reduce their income to the anticipated amount they will be receiving after they are unable to work.

A taxpayer is close to retirement and has indicated they will be retiring If the taxpayer can substantiate retirement is imminent, adjust the taxpayer's future earnings and expenses accordingly. If it cannot be substantiated, base the calculation on current earnings. At this point, it may be appropriate to discuss other options available to the taxpayer, for example an installment agreement.
Example: The taxpayer is 65 years of age and has indicated they will retire at the age of 66. They provide copies of documents that have been submitted to their employer discussing their retirement date. Use the taxpayer's current income until the taxpayer's anticipated retirement date, then adjust the taxpayer's income to reflect the amount expected in retirement.
Example: The taxpayer is 62 years of age, the taxpayer is in good health, and their income has remained stable for the past three years. The taxpayer states they would like to retire at age 65. Use the taxpayer's current income and if the RCP exceeds the offer amount, discuss the option of securing an installment agreement until the taxpayer actually retires, at which time an offer may be appropriate.

A taxpayer will file a petition for liquidating bankruptcy Consider reducing the value of future income. The total value of future income should not be reduced to an amount less than what could be paid toward non-dischargeable periods, or what would be recoverable through a bankruptcy proceeding. When considering a reduction in future income also consider the intangible value to the taxpayer of avoiding bankruptcy. Refer to IRM 5.8.10.2.

(5) Judgment should be used in determining the appropriate time to apply income averaging on a case by case basis. All circumstances of the taxpayer should be considered when determining the appropriate application of income averaging, including special circumstances and ETA considerations. Below are some examples of when income averaging may or may not be appropriate.
Example: Taxpayer's spouse has not worked for over two and one-half years and has no expectations of returning to work. Do not average income for the spouse's past employment.
Example: Taxpayer has been unemployed for over one year and provided proof that Social Security Disability is the sole source of income. Do not apply income averaging in this case but use current income to determine the taxpayer's future ability to pay.
Example: The taxpayer was incarcerated and unable to work for the past four years and provided proof that a relative is paying for all expenses, including child support payments. The taxpayer has no skills or promise of work in the near future but is planning on attending trade school to improve his chances of getting a job. Do not include income prior to the incarceration. In this case, since the taxpayer has no skills or promise of employment, their future income value may be determined to be zero. Consideration should be given whether it would be in the best interest of the government to accept the offer or reject the offer in favor of other case resolutions.
Example: The taxpayer recently began working after several months of unemployment. Use the most recent three months pay statements to determine future income. Since the taxpayer is a wage earner, the use of income averaging over the prior three years of income is not appropriate.
(6) In situations where the taxpayer's income does not appear to meet their stated living expenses the difference should not be included as additional income to the taxpayer, unless there are clear indications additional income not included on the collection information statement is being received and will continue to be received by the taxpayer. Discussion with the taxpayer/representative and a review of documents submitted by the taxpayer must take place to determine the appropriateness of including an additional amount in the calculation of future income. Verification of the source of unexplained bank deposits or statements from the source of gifts may be required to correctly determine the taxpayer's current income. Telephone contact is recommended to expedite case processing.
Example: The taxpayer has been receiving gifts from their parents to meet current living expenses for the past six months. The taxpayer has no guaranteed right to the funds in the future and the amount does not appear to be based on the transfer of assets to the parents. The gift amount should not be included as income.
Example: The taxpayer has been receiving an amount each month that only began recently, which they state is a gift from a friend. Further research has determined the taxpayer is in business with the friend and the amount is from their business. This amount should be included as income to the taxpayer. Additionally, consideration should be given to referring the taxpayer and the business income tax return to Examination.
Example: The taxpayer had gambling winnings over a period of time, but is not consistent. Do not include those winnings as additional income on the IET. This does not apply to professional gamblers.
Example: The collection information statement (CIS) submitted by the taxpayer included $ 3.000.00 of monthly income, which is verified by paystubs. The CIS submitted by the taxpayer includes $ 4,000.00 of expenses. An additional $ 1,000.00 should not be added to the taxpayer's income based solely on the fact it appears the taxpayer has been meeting the living expenses included on the CIS. Discussion with the taxpayer or representative is necessary to clarify the discrepancy prior to including the amount as additional income.
(7) Employees need to exercise good judgment when determining future income. The history must be clearly documented and support the known facts and circumstances of the case and include analysis of the supporting documents. Each case needs to be evaluated on its own particular set of facts and circumstances. The history must clearly explain the reasoning behind our actions.
Currently 5.8.5.6(7) Future Income Collateral Agreements
(1) In some instances, it may be difficult to calculate the taxpayer's anticipated income. While the use of income averaging is one method available and should be used when averaging the taxpayer's income provides a reasonable calculation of the taxpayer's future earnings potential, it may also be appropriate to use the taxpayer's current income and secure a future income collateral agreement. The use of a future income collateral agreement will protect the government's interest in any substantial increase in the taxpayer's earnings.
(2) A future income collateral agreement is most appropriate in situations where the taxpayer's future income is uncertain, but it is reasonably expected that the taxpayer will be receiving a substantial increase in income.
(3) A future income collateral agreement should not be used to accept an offer for a lesser amount than the calculated RCP. See IRM 5.8.6.3.1, Future Income, for instructions on completing collateral agreements.
Example: A taxpayer is currently in medical school; upon graduation income should increase dramatically. Consider securing a future income collateral agreement.
Example: A taxpayer recently secured a job as an attorney with a starting salary of $80,000 per year, with potential for significant increases in salary. Consider securing a future income collateral agreement.
Example: A taxpayer is a real estate agent who has had two years of high income and the current income is significantly diminished. Based on the current real estate market, it may be appropriate to use the taxpayer's current income and secure a future income collateral agreement in lieu of income averaging.
Example: A taxpayer's RCP is $12,000 but has offered $10,000 plus a future income collateral agreement. A future income collateral agreement is not appropriate in lieu of the taxpayer increasing their offer to the RCP amount. If the taxpayer is not willing to increase their offer to the RCP amount, the offer should be rejected.

The IRS and Treasury Department have provided revised guidance to Small Business/Self-Employed Division directors and the IRS Appeals chief on the computation of a taxpayer's future income value during the evaluation of an offer in compromise. The guidance revises sections of IRM 5.8.5, Financial Analysis, which discuss the calculation of future income and the use of collateral agreements. The revisions include specific examples of when the use of income averaging or a collateral agreement is appropriate.
The procedures apply to future offers and any offer currently under consideration. In addition, the procedures may be applied to offers previously rejected that are currently in their appeal period or where the taxpayer has requested appeals


IRS Small Business/Self-Employed Interim Guidance for Calculation of Future Income in Offer in Compromise Cases, SBSE 05-0310-012, (Mar. 16, 2010)
2010ARD 052-5
Internal Revenue Service: Compromises: Future income
DEPARTMENT OF THE TREASURY INTERNAL REVENUE SERVICE Washington, DC 20224
March 10, 2010
SMALL BUSINESS / SELF-EMPLOYED DIVISION
SB/SE Control No: SBSE 05-0310-012
Expires: 3/10/2011
Impacted IRM 5.8.5
MEMORANDUM FOR DIRECTORS, COLLECTION AREA OPERATIONS DIRECTORS, CAMPUS COMPLIANCE OPERATIONS AND CHIEF, APPEALS
FROM: Frederick W. Schindler /s/ Frederick W. Schindler Director, Collection Policy
SUBJECT: Interim Guidance for Calculation of Future Income in Offer in Compromise Cases
The purpose of this memorandum is to provide revised guidance in the computation of the taxpayer's future income value during the evaluation of an offer in compromise.
Internal Revenue Manual (IRM) 5.8.5 defines future income as an estimate of the taxpayer's ability to pay based on an analysis of gross income, less necessary living expenses, for a specific number of months into the future. The number of months used depends on the payment terms of the offer. In general, a taxpayer's current income will be used in the analysis of future ability to pay.
Attached to this memorandum is a revision to sections of IRM 5.8.5, Financial Analysis which discuss the calculation of future income and the use of collateral agreements.
The revisions include specific examples of when the use of income averaging and/or a collateral agreement is appropriate.
These procedures are effective upon the date of issuance and should be applied to any offer currently under consideration. Additionally, these procedures may be applied to offers previously rejected which are currently in their appeal period or where the taxpayer has requested appeals consideration. These procedures will be incorporated into the next revision of IRM 5.8 Offers in Compromise.
If you have any questions, you may contact me, or a member of your staff may contact Thomas B. Moore, OIC Senior Program Analyst. Territory or Campus personnel should direct any questions, through their management staff, to the appropriate Area or Campus contact.
Attachment
cc: Commissioner, Small Business/Self-Employed Division
National Chief, Appeals
Chief Counsel
National Taxpayer Advocate
5.8.5.6 Future Income
(1) Future income is defined as an estimate of the taxpayer's ability to pay based on an analysis of gross income, less necessary living expenses, for a specific number of months into the future.
(2) As a general rule, the taxpayer's current income will be used in the analysis of future ability to pay. This includes situations where the taxpayer's income is recently reduced based on a change in occupation or employment status.
(3) Consideration should be given to the taxpayer's overall general situation including such facts as age, health, marital status, number and age of dependents, level of education or occupational training, and work experience.
(4) Situations that may warrant placing a different value on future income than current or past income indicates are discussed in the table below. Additionally, securing a future income collateral agreement based on the taxpayer's earnings potential may be appropriate and are discussed in more detail in IRM 5.8.5.19 and IRM 5.8.6, Collateral Agreements.

If… Then…

Income will increase or decrease or current necessary expenses will increase or decrease Adjust the amount or number of payments to what is expected during the appropriate number of months.

A taxpayer is temporarily or recently unemployed or underemployed Use the level of income expected if the taxpayer were fully employed and if the potential for employment is apparent. Each case should be judged on its own merit, including consideration of special circumstances or ETA issues.
Example: Unemployed - The taxpayer is a construction worker and between jobs. A review of the taxpayer's previous annual income and/or income averaging may be the appropriate method to determine taxpayer's income for calculation purposes.
Example: Underemployed - If a taxpayer is a teacher but recently moved and is currently at a lesser paying job until a teaching position becomes available, or has been hired and does not begin work until the school season begins, the taxpayer is considered to be currently underemployed. Use the anticipated income once the taxpayer is fully employed.

A taxpayer is unemployed and is not expected to return to their previous occupation or previous level of earnings Contact the taxpayer to discuss the expected future level of income. When considering future income, also allow anticipated increases in necessary living expenses and/or applicable taxes.
Each case should be judged on its own merit, including consideration of special circumstances or ETA issues.

A taxpayer is long-term unemployed Use of income averaging is not required; the taxpayer's current income may be used in the future income calculation.
Example: Taxpayer has been unemployed for over one year. There are currently no employment opportunities for the taxpayer and the household is living on one income. Use of the taxpayer's current income with a future income collateral agreement is appropriate.

A taxpayer is long-term underemployed Do not income average; use the taxpayer's current income.
Example: The taxpayer was previously employed in a manufacturing plant making $75,000 per year. There are currently no opportunities for the taxpayer to secure employment making the same rate of pay as their prior job. Their income is now $25,000 per year with no anticipated increase. Use the current income only.

A taxpayer has an irregular employment history or fluctuating income Average earnings over the three prior years. The use of a time period other than three years should be the exception and only when specific circumstances are present.
Example: The taxpayer is a stock broker whose income in 2007 was $150,000 and income in 2008 was $25,000. In this case, you should consider income averaging the prior three years or secure a future income collateral agreement if the offer is accepted.
Note: This practice does not apply to wage earners. Wage earners should be based on current income unless the taxpayer has unique circumstances.

A taxpayer is in poor health and their ability to continue working is questionable Reduce the number of payments to the appropriate number of months it is anticipated the taxpayer will continue working. Consider special circumstance situations when making any adjustments.
Example: Taxpayer has a serious health issue and it is anticipated they will be unable to work after six months. Use the taxpayer's current income for six months then reduce their income to the anticipated amount they will be receiving after they are unable to work.

A taxpayer is close to retirement and has indicated they will be retiring If the taxpayer can substantiate retirement is imminent, adjust the taxpayer's future earnings and expenses accordingly. If it cannot be substantiated, base the calculation on current earnings. At this point, it may be appropriate to discuss other options available to the taxpayer, for example an installment agreement.
Example: The taxpayer is 65 years of age and has indicated they will retire at the age of 66. They provide copies of documents that have been submitted to their employer discussing their retirement date. Use the taxpayer's current income until the taxpayer's anticipated retirement date, then adjust the taxpayer's income to reflect the amount expected in retirement.
Example: The taxpayer is 62 years of age, the taxpayer is in good health, and their income has remained stable for the past three years. The taxpayer states they would like to retire at age 65. Use the taxpayer's current income and if the RCP exceeds the offer amount, discuss the option of securing an installment agreement until the taxpayer actually retires, at which time an offer may be appropriate.

A taxpayer will file a petition for liquidating bankruptcy Consider reducing the value of future income. The total value of future income should not be reduced to an amount less than what could be paid toward non-dischargeable periods, or what would be recoverable through a bankruptcy proceeding. When considering a reduction in future income also consider the intangible value to the taxpayer of avoiding bankruptcy. Refer to IRM 5.8.10.2.

(5) Judgment should be used in determining the appropriate time to apply income averaging on a case by case basis. All circumstances of the taxpayer should be considered when determining the appropriate application of income averaging, including special circumstances and ETA considerations. Below are some examples of when income averaging may or may not be appropriate.
Example: Taxpayer's spouse has not worked for over two and one-half years and has no expectations of returning to work. Do not average income for the spouse's past employment.
Example: Taxpayer has been unemployed for over one year and provided proof that Social Security Disability is the sole source of income. Do not apply income averaging in this case but use current income to determine the taxpayer's future ability to pay.
Example: The taxpayer was incarcerated and unable to work for the past four years and provided proof that a relative is paying for all expenses, including child support payments. The taxpayer has no skills or promise of work in the near future but is planning on attending trade school to improve his chances of getting a job. Do not include income prior to the incarceration. In this case, since the taxpayer has no skills or promise of employment, their future income value may be determined to be zero. Consideration should be given whether it would be in the best interest of the government to accept the offer or reject the offer in favor of other case resolutions.
Example: The taxpayer recently began working after several months of unemployment. Use the most recent three months pay statements to determine future income. Since the taxpayer is a wage earner, the use of income averaging over the prior three years of income is not appropriate.
(6) In situations where the taxpayer's income does not appear to meet their stated living expenses the difference should not be included as additional income to the taxpayer, unless there are clear indications additional income not included on the collection information statement is being received and will continue to be received by the taxpayer. Discussion with the taxpayer/representative and a review of documents submitted by the taxpayer must take place to determine the appropriateness of including an additional amount in the calculation of future income. Verification of the source of unexplained bank deposits or statements from the source of gifts may be required to correctly determine the taxpayer's current income. Telephone contact is recommended to expedite case processing.
Example: The taxpayer has been receiving gifts from their parents to meet current living expenses for the past six months. The taxpayer has no guaranteed right to the funds in the future and the amount does not appear to be based on the transfer of assets to the parents. The gift amount should not be included as income.
Example: The taxpayer has been receiving an amount each month that only began recently, which they state is a gift from a friend. Further research has determined the taxpayer is in business with the friend and the amount is from their business. This amount should be included as income to the taxpayer. Additionally, consideration should be given to referring the taxpayer and the business income tax return to Examination.
Example: The taxpayer had gambling winnings over a period of time, but is not consistent. Do not include those winnings as additional income on the IET. This does not apply to professional gamblers.
Example: The collection information statement (CIS) submitted by the taxpayer included $ 3.000.00 of monthly income, which is verified by paystubs. The CIS submitted by the taxpayer includes $ 4,000.00 of expenses. An additional $ 1,000.00 should not be added to the taxpayer's income based solely on the fact it appears the taxpayer has been meeting the living expenses included on the CIS. Discussion with the taxpayer or representative is necessary to clarify the discrepancy prior to including the amount as additional income.
(7) Employees need to exercise good judgment when determining future income. The history must be clearly documented and support the known facts and circumstances of the case and include analysis of the supporting documents. Each case needs to be evaluated on its own particular set of facts and circumstances. The history must clearly explain the reasoning behind our actions.
Currently 5.8.5.6(7) Future Income Collateral Agreements
(1) In some instances, it may be difficult to calculate the taxpayer's anticipated income. While the use of income averaging is one method available and should be used when averaging the taxpayer's income provides a reasonable calculation of the taxpayer's future earnings potential, it may also be appropriate to use the taxpayer's current income and secure a future income collateral agreement. The use of a future income collateral agreement will protect the government's interest in any substantial increase in the taxpayer's earnings.
(2) A future income collateral agreement is most appropriate in situations where the taxpayer's future income is uncertain, but it is reasonably expected that the taxpayer will be receiving a substantial increase in income.
(3) A future income collateral agreement should not be used to accept an offer for a lesser amount than the calculated RCP. See IRM 5.8.6.3.1, Future Income, for instructions on completing collateral agreements.
Example: A taxpayer is currently in medical school; upon graduation income should increase dramatically. Consider securing a future income collateral agreement.
Example: A taxpayer recently secured a job as an attorney with a starting salary of $80,000 per year, with potential for significant increases in salary. Consider securing a future income collateral agreement.
Example: A taxpayer is a real estate agent who has had two years of high income and the current income is significantly diminished. Based on the current real estate market, it may be appropriate to use the taxpayer's current income and secure a future income collateral agreement in lieu of income averaging.
Example: A taxpayer's RCP is $12,000 but has offered $10,000 plus a future income collateral agreement. A future income collateral agreement is not appropriate in lieu of the taxpayer increasing their offer to the RCP amount. If the taxpayer is not willing to increase their offer to the RCP amount, the offer should be rejected.