Highlights of Recently Enacted Tax Laws for Law Firms, Clients, Lawyers, and Staff

This article addresses two significant changes made by the Small Business and Work Opportunity Tax Act of 2007 ('Small Business Act') ' the new preparer penalty provisions (up to 50% of the fee for preparing the tax return), which have broad implications for attorneys who offer tax advice to their clients and the revised kiddie tax provisions, which now reach a substantially larger group of children. This article also details pertinent changes made by the Tax Relief and Health Care Act of 2006 ('TRHCA'), which extend the time for several tax cuts that had expired at the end of 2005, make certain tax breaks more beneficial, and provide greater flexibility regarding health savings accounts. Noteworthy new TRHCA provisions are highlighted that can benefit law firms and their clients, as well as individual attorneys and staff members and their families.

Since Form 1040 paper forms had already been printed when TRHCA was enacted, a few special instructions are noted for those filing on paper versus electronically.

Revised Standards for Preparers

You May Be a Tax Return Preparer

The new law replaces the original Code definition of 'income tax preparer' with 'tax return preparer.' A tax return preparer now includes any person who prepares for compensation, or who employs one or more persons to prepare for compensation, all or a substantial portion of any tax return or any claim for refund. In other words, this standard no longer applies solely to those who prepare income tax returns ' it also now encompasses those who prepare estate and gift tax returns, employment tax returns, excise tax returns, and exempt organization returns.

You do not need, however, to actually prepare or sign a tax return in order to be a tax return preparer under the law. The regulations currently state that a preparer includes any person who gives a taxpayer or other preparer sufficient information and advice so that the completion of the return or claim for refund is largely a mechanical or clerical matter, even though that person does not actually place or review the placement of information on the return or claim for refund. A person who merely gives advice on specific issues of law is a preparer if: 1) the advice is given for events which have occurred at the time the advice is rendered and is not given with respect to the consequences of contemplated actions, and 2) the advice is directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim for refund.

In order to be a preparer, however, a person must 'prepare' all or a substantial portion of a return or claim for refund. The current regulations contain a safe harbor provision which states that a schedule, entry, or other portion of the return or claim for refund is not a substantial portion if the amounts of gross income, deduction, or amounts on the basis of which credits are determined are:

• less than $2000; or
• less than $100,000, and also less than 20% of the gross income (or adjusted gross income if the taxpayer is an individual) as shown on the return or claim for refund.

If this safe harbor is not met, the determination of whether a schedule, entry, or other portion of a return or claim for refund is a substantial portion is made by comparing the length and complexity of, and the tax liability or refund involved in, that portion to the return or claim for refund as a whole.

Revised Penalty Standards and Amounts

The two-tier preparer understatement penalty structure of the Code has been modified by the new law. For the first tier, a preparer who prepares any return or claim for refund with respect to which any part of an understatement of liability is due to an unreasonable position shall pay a penalty for each such return or claim equal to the greater of $1000 or 50% of the income derived or to be derived by the preparer with respect to the return or claim. This is quite a substantial increase from the prior penalty, which was only $250. A position is unreasonable if:

a) The preparer knew (or reasonably should have known) of the position;

b) There was not a reasonable belief that the position would more likely than not be sustained on its merits; and

c) The position was not disclosed or there was no reasonable basis for the position.

There will not, however, be any penalty imposed if it is shown that there is reasonable cause for the understatement and the preparer acted in good faith. This is a facts-and-circumstances analysis which should consider the nature of the error causing the understatement, the frequency of errors, the materiality of errors, the preparer's normal office practice, and whether the preparer relied on the advice of another preparer in good faith. Attorneys who send their clients written opinions that may or may not meet this 'more likely than not' standard may wish to state in each opinion that the client needs to disclose the position by attaching a completed Form 8275 Disclosure Statement or Form 8275-R Regulation Disclosure Statement to the tax return.

For the second, more serious penalty tier, a preparer who prepares any return or claim for refund with respect to which any part of an understatement of liability is due to willful or reckless conduct shall pay a penalty for each such return or claim equal to the greater of $5000 or 50% of the income derived or to be derived by the preparer with respect to the return or claim. Conduct is willful or reckless if it is:

a) A willful attempt in any manner to understate the liability for tax on the return or claim; or

b) A reckless or intentional disregard of rules or regulations.

The amount of any penalty due to willful or reckless conduct will be reduced by any unreasonable position penalty paid regarding that return or claim for refund.

Effective Date

These new preparer penalty provisions under the Small Business Act initially applied to all returns that were 'prepared' after May 25, 2007. The IRS, however, has announced that it was providing transitional relief while it considers potential revisions to regulations, forms, and other published guidance. The new broader penalty rules under the first tier (more likely than not) standard will now be applicable to all returns, amended returns, and refund claims due after Dec. 31, 2007, to all 2007 estimated tax returns due after Jan. 15, 2008, and to all 2007 employment and excise tax returns due after Jan. 31, 2008. No transitional relief is available for any return or refund claim that reflects willful or reckless conduct.

Expanded Reach of the Kiddie Tax

The kiddie tax is applied to certain children with net unearned income. When the tax applies, the portion of a child's unearned income that exceeds an inflation-adjusted threshold is taxed at his or her parents' tax rate, assuming that the parents' tax rate is higher. For 2006 and 2007, the tax applies to children with unearned income in excess of $1700 who have not turned 18 by the end of the year, who had at least one parent alive at the end of the year, and who will not be filing a joint tax return for the year. Under the Small Business Act, beginning in 2008, the kiddie tax will also apply to all children who are 18 as well as all full-time students over age 18 but under age 24 by the close of the year whose earned income does not exceed one-half of their support.

One criticism of the age expansion under the new law is that no consideration is given to the source of the assets that generate the investment income. An older child could invest his or her earned income and find the related investment income subject to the kiddie tax (assuming that the investment income threshold was surpassed). Also, should an older child have unearned income from a trust established by a grandparent, that child will still need to obtain his or her parents' tax return information in order to calculate the kiddie tax, even if the child and the parents are estranged.

There are several ways to avoid or minimize the impact of the kiddie tax. Since earned income is not subject to the kiddie tax, a child could work in the family business. Assets could be transferred to a child that will not yield more income than the inflation-adjusted threshold for the year. Alternatively, assets could be converted to those that do not currently generate taxable income, such as stocks that generate capital growth, tax-exempt municipal bonds, and undeveloped land.

Employment Credits for Hiring Low Income Workers

TRHCA extends the Welfare-to-Work credit and the Work Oppor-tunity credit as separate credits through 2006. For 2007, the credits are combined into one credit with enhanced features. These credits are designed to encourage law firms and their clients to hire individuals from targeted groups such as qualified summer youth employees and persons receiving certain Supplemental Security Income benefits. Depending on the number of hours that an eligible employee works during the first year, the maximum credit available is $2400. Also, starting in 2007:

• Employers have an extended
  period of time to file certification documents;
• The requirement that ex-felons be from an economically disadvantaged family is repealed; and
• The age limit for food stamp recipients increases to 40.

The Small Business Act has extended the hiring deadline for this credit to Aug. 31, 2011.

Accelerated Depreciation for Leasehold Improvements

TRHCA extends the 15-year recovery period (instead of the general 39-year period) for qualified leasehold improvements. Generally, a qualified leasehold improvement is any improvement to an interior portion of a nonresidential building that is placed in service more than three years after the building was constructed. The improvements may be made by the lessor, the lessee, or a sublessee.

Health Savings Account Enhancements

The new law also encourages attorneys and their staff to make use of Health Savings Accounts ('HSAs'). HSAs are designed for individuals with a high deductible health insurance plan. Contributions to these accounts can be made by employers on a pretax basis on behalf of employees. The funds and any related earnings may then be withdrawn tax-free to pay for qualified medical expenses. Starting in 2007, the contribution limit is $2850 for a policy with single-person coverage and $5650 for a family coverage policy. Individuals age 55 and older may also make limited 'catch-up' contributions.

TRHCA also made the following enhancements to HSAs:

• Attorneys and their staff who are eligible for coverage under an HSA during the last month of a taxable year are treated as having been eligible for the entire year. They may therefore make contributions to the HSA for the months before they are enrolled (up to the maximum contribution limit for the year);
• A one-time distribution may be made from every flexible spending account ('FSA') and health reimbursement account ('HRA') owned by attorneys and their staff. The maximum transfer for each account may not exceed the lesser of: a) the FSA or HRA balance on the day of the transfer, or b) the balance in the FSA or HRA on Sept. 21, 2006. Any distributions must be made before Jan. 1, 2012.

TRHCA allows HSA participants to make a one-time contribution of funds from an IRA into an HSA. This rollover, which must be made in a direct trustee-to-trustee transfer, is not taxable as an IRA distribution or subject to the 10% early withdrawal penalty. The rollover is also limited to the maximum deductible HSA contribution for the rollover year. This opportunity is not, however, available for simplified employee pension plans ('SEPs') or SIMPLE retirement accounts.

Research Tax Credit

For those law firms with clients taking advantage of the R&D credit, that credit has also been extended through 2007. Generally, the credit is equal to 20% of qualified research expenses that exceed a certain base amount for a given year. Law firm clients can opt to use an alternative incremental credit ('AIC') based on a stated percentage of qualified expenses that exceed the average expenses over a four-year period. For 2006, the credit's expiration date was simply extended to the end of 2006. For 2007, the R&D credit is modified by an increase in the stated percentage for the AIC. Additionally, the law creates an election for law firm clients to use the alternative simplified credit ('ASC'), which is equal to 12% of qualified research expenses that exceed 50% of the average qualified research expenses for the three prior tax years. The ASC rate is reduced to 6% if there were no qualified expenses in any of the three preceding tax years.

Corporate Donations of Computers and Scientific Equipment

Under TRHCA, the enhanced charitable deduction for corporate donations of scientific property used for research and for contributions of computer technology and equipment to educational organizations and public libraries is extended through 2007. Property that is 'assembled by' the taxpayer is now eligible for the charitable contribution deduction in addition to property 'constructed by' the taxpayer.

UBTI of Charitable Remainder Trusts

For law firms that suggest charitable remainder trusts to their clients, the law has changed regarding the taxability of the trusts. Normally, charitable remainder trusts are exempt from federal income tax unless they have any unrelated business taxable income ('UBTI') for the year. Under prior law, a charitable remainder trust that had any UBTI during a year lost its income tax exemption for that year and was taxed as a complex trust. Beginning in 2007, instead of removing the income tax exemption for the year, an excise tax that is equal to the amount of the trust's UBTI for the year (i.e., a 100% tax) is imposed.

State and Local Sales Tax Itemized Deduction

TRHCA extends the option to deduct state and local sales taxes instead of state and local income taxes for tax years through 2007. Attorneys and their staff may benefit from this deduction if they:

• Live in states that have no income tax;
• Make significant purchases; or
• Find themselves subject to the Alternative Minimum Tax ('AMT') because of the state income tax deduction.

The deduction may be calculated either by deducting the total of the sales taxes shown on a taxpayer's receipts or by using optional state sales tax tables provided by the IRS.

If filing on paper, claim the sales tax deduction on Schedule A, line 5, 'State and local income taxes.' On the dotted line to the left of the line 5 entry box, enter 'ST' to indicate that the general sales tax deduction is being claimed instead of the deduction for state and local income tax.

Deduction for College Tuition Payments

This deduction has been extended through 2007. It allows attorneys and their staff to deduct a portion of qualified tuition, fees, and other related expenses paid for higher education. Attorneys and their staff with an adjusted gross income ('AGI') that does not exceed $65,000 for singles and $130,000 for joint filers may take a maximum annual deduction of $4000. Attorneys and their staff with an AGI that does not exceed $80,000 for singles and $160,000 for joint filers may deduct up to $2000.

Note that no deduction is allowed for a married individual who does not file a joint return or for an individual who is claimed as another taxpayer's dependent. Additionally, attorneys and their staff who elect to use the Hope or Lifetime Learning credit for a student may not use this deduction for the same student. The ability to utilize those two credits, however, is subject to more stringent income requirements; the credits are completely phased out when AGI reaches $55,000 for singles and $110,000 for joint filers.

If filing on paper, claim the deduction on Form 1040, line 35, 'Domestic production activities deduction.' In the blank space to the left of that line entry, enter 'T' if claiming only the tuition deduction, or 'B' if claiming both a deduction for domestic production activities and the tuition deduction. Those entering 'B' must attach a breakdown showing the amounts claimed for each deduction.

Teachers' Deduction for Classroom Expenses

Spouses or children of attorneys and their staff who are elementary or high school teachers (or counselors, principals, or aides) and who work at least 900 hours during a school year may take an above-the-line deduction for up to $250 of the expenses they pay for books, supplies, computers (including related software and services), other equipment, and supplementary materials used by them in the classroom. This deduction is now available for amounts paid or incurred for the 2006 and 2007 tax years.

If filing on paper, claim the deduction on Form 1040, line 23, 'Archer MSA deduction.' On the dotted line to the left of that line entry, enter 'E' if claiming the teachers' deduction, or 'B' if claiming both an Archer MSA deduction and a teachers' deduction. Those entering 'B' must attach a breakdown showing the amounts claimed for each deduction.

Expanded AMT Credit

TRHCA allows for a refundable alternative minimum tax ('AMT') credit starting in 2007 and ending in 2012. A portion of the minimum tax credit can be applied against the regular tax liability of attorneys and their staff and is refundable. This modification was designed, in part, to help taxpayers who had exercised incentive stock options and were unable to utilize the related AMT credit that may have been generated.

The AMT refundable credit amount is the greater of: a) the lesser of $5000 or the long-term unused minimum tax credit, or b) 20% of the long-term unused minimum tax credit. The 'long-term unused minimum tax credit' for a year is the portion of the minimum tax credit attributable to a taxpayer's adjusted net minimum tax for years before the third year immediately preceding the tax year (i.e., for the 2007 year, utilize the portion of credit on Form 8801 that relates to tax years before and including 2003 on a first-in, first-out basis). Table 1 shows how this long-term credit translates into the taxpayer's AMT refundable credit.

In the case of an individual whose AGI for a taxable year exceeds the threshold amount for purposes of the dependency exemption, the AMT refundable credit amount is reduced.

Deduction for Mortgage Insurance Premiums

For 2007 only, qualified mortgage insurance premiums paid in connection with acquisition indebtedness that is related to a qualified residence may be deducted as qualified residence interest. Qualified mortgage insurance includes mortgage insurance provided by the Veterans Administration, the Federal Housing Authority, the Rural Housing Administration, or private mortgage insurance ('PMI'). The deduction begins to phase out once AGI exceeds $100,000 ($50,000 if
married filing separate) and is completely phased out once AGI exceeds $110,000 ($55,000 if married filing separate).

[IMGCAP(1)]

Richard H. Stieglitz is a tax partner, and Michael G. Freel is a tax manager in the New York accounting firm of Anchin, Block & Anchin, LLP, which specializes in providing accounting, tax, and consulting services to law firms. Stieglitz can be reached at 212-840-3456 or [email protected].

This article addresses two significant changes made by the Small Business and Work Opportunity Tax Act of 2007 ('Small Business Act') ' the new preparer penalty provisions (up to 50% of the fee for preparing the tax return), which have broad implications for attorneys who offer tax advice to their clients and the revised kiddie tax provisions, which now reach a substantially larger group of children. This article also details pertinent changes made by the Tax Relief and Health Care Act of 2006 ('TRHCA'), which extend the time for several tax cuts that had expired at the end of 2005, make certain tax breaks more beneficial, and provide greater flexibility regarding health savings accounts. Noteworthy new TRHCA provisions are highlighted that can benefit law firms and their clients, as well as individual attorneys and staff members and their families.

Since Form 1040 paper forms had already been printed when TRHCA was enacted, a few special instructions are noted for those filing on paper versus electronically.

Revised Standards for Preparers

You May Be a Tax Return Preparer

The new law replaces the original Code definition of 'income tax preparer' with 'tax return preparer.' A tax return preparer now includes any person who prepares for compensation, or who employs one or more persons to prepare for compensation, all or a substantial portion of any tax return or any claim for refund. In other words, this standard no longer applies solely to those who prepare income tax returns ' it also now encompasses those who prepare estate and gift tax returns, employment tax returns, excise tax returns, and exempt organization returns.

You do not need, however, to actually prepare or sign a tax return in order to be a tax return preparer under the law. The regulations currently state that a preparer includes any person who gives a taxpayer or other preparer sufficient information and advice so that the completion of the return or claim for refund is largely a mechanical or clerical matter, even though that person does not actually place or review the placement of information on the return or claim for refund. A person who merely gives advice on specific issues of law is a preparer if: 1) the advice is given for events which have occurred at the time the advice is rendered and is not given with respect to the consequences of contemplated actions, and 2) the advice is directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim for refund.

In order to be a preparer, however, a person must 'prepare' all or a substantial portion of a return or claim for refund. The current regulations contain a safe harbor provision which states that a schedule, entry, or other portion of the return or claim for refund is not a substantial portion if the amounts of gross income, deduction, or amounts on the basis of which credits are determined are:

• less than $2000; or
• less than $100,000, and also less than 20% of the gross income (or adjusted gross income if the taxpayer is an individual) as shown on the return or claim for refund.

If this safe harbor is not met, the determination of whether a schedule, entry, or other portion of a return or claim for refund is a substantial portion is made by comparing the length and complexity of, and the tax liability or refund involved in, that portion to the return or claim for refund as a whole.

Revised Penalty Standards and Amounts

The two-tier preparer understatement penalty structure of the Code has been modified by the new law. For the first tier, a preparer who prepares any return or claim for refund with respect to which any part of an understatement of liability is due to an unreasonable position shall pay a penalty for each such return or claim equal to the greater of $1000 or 50% of the income derived or to be derived by the preparer with respect to the return or claim. This is quite a substantial increase from the prior penalty, which was only $250. A position is unreasonable if:

a) The preparer knew (or reasonably should have known) of the position;

b) There was not a reasonable belief that the position would more likely than not be sustained on its merits; and

c) The position was not disclosed or there was no reasonable basis for the position.

There will not, however, be any penalty imposed if it is shown that there is reasonable cause for the understatement and the preparer acted in good faith. This is a facts-and-circumstances analysis which should consider the nature of the error causing the understatement, the frequency of errors, the materiality of errors, the preparer's normal office practice, and whether the preparer relied on the advice of another preparer in good faith. Attorneys who send their clients written opinions that may or may not meet this 'more likely than not' standard may wish to state in each opinion that the client needs to disclose the position by attaching a completed Form 8275 Disclosure Statement or Form 8275-R Regulation Disclosure Statement to the tax return.

For the second, more serious penalty tier, a preparer who prepares any return or claim for refund with respect to which any part of an understatement of liability is due to willful or reckless conduct shall pay a penalty for each such return or claim equal to the greater of $5000 or 50% of the income derived or to be derived by the preparer with respect to the return or claim. Conduct is willful or reckless if it is:

a) A willful attempt in any manner to understate the liability for tax on the return or claim; or

b) A reckless or intentional disregard of rules or regulations.

The amount of any penalty due to willful or reckless conduct will be reduced by any unreasonable position penalty paid regarding that return or claim for refund.

Effective Date

These new preparer penalty provisions under the Small Business Act initially applied to all returns that were 'prepared' after May 25, 2007. The IRS, however, has announced that it was providing transitional relief while it considers potential revisions to regulations, forms, and other published guidance. The new broader penalty rules under the first tier (more likely than not) standard will now be applicable to all returns, amended returns, and refund claims due after Dec. 31, 2007, to all 2007 estimated tax returns due after Jan. 15, 2008, and to all 2007 employment and excise tax returns due after Jan. 31, 2008. No transitional relief is available for any return or refund claim that reflects willful or reckless conduct.

Expanded Reach of the Kiddie Tax

The kiddie tax is applied to certain children with net unearned income. When the tax applies, the portion of a child's unearned income that exceeds an inflation-adjusted threshold is taxed at his or her parents' tax rate, assuming that the parents' tax rate is higher. For 2006 and 2007, the tax applies to children with unearned income in excess of $1700 who have not turned 18 by the end of the year, who had at least one parent alive at the end of the year, and who will not be filing a joint tax return for the year. Under the Small Business Act, beginning in 2008, the kiddie tax will also apply to all children who are 18 as well as all full-time students over age 18 but under age 24 by the close of the year whose earned income does not exceed one-half of their support.

One criticism of the age expansion under the new law is that no consideration is given to the source of the assets that generate the investment income. An older child could invest his or her earned income and find the related investment income subject to the kiddie tax (assuming that the investment income threshold was surpassed). Also, should an older child have unearned income from a trust established by a grandparent, that child will still need to obtain his or her parents' tax return information in order to calculate the kiddie tax, even if the child and the parents are estranged.

There are several ways to avoid or minimize the impact of the kiddie tax. Since earned income is not subject to the kiddie tax, a child could work in the family business. Assets could be transferred to a child that will not yield more income than the inflation-adjusted threshold for the year. Alternatively, assets could be converted to those that do not currently generate taxable income, such as stocks that generate capital growth, tax-exempt municipal bonds, and undeveloped land.

Employment Credits for Hiring Low Income Workers

TRHCA extends the Welfare-to-Work credit and the Work Oppor-tunity credit as separate credits through 2006. For 2007, the credits are combined into one credit with enhanced features. These credits are designed to encourage law firms and their clients to hire individuals from targeted groups such as qualified summer youth employees and persons receiving certain Supplemental Security Income benefits. Depending on the number of hours that an eligible employee works during the first year, the maximum credit available is $2400. Also, starting in 2007:

• Employers have an extended
  period of time to file certification documents;
• The requirement that ex-felons be from an economically disadvantaged family is repealed; and
• The age limit for food stamp recipients increases to 40.

The Small Business Act has extended the hiring deadline for this credit to Aug. 31, 2011.

Accelerated Depreciation for Leasehold Improvements

TRHCA extends the 15-year recovery period (instead of the general 39-year period) for qualified leasehold improvements. Generally, a qualified leasehold improvement is any improvement to an interior portion of a nonresidential building that is placed in service more than three years after the building was constructed. The improvements may be made by the lessor, the lessee, or a sublessee.

Health Savings Account Enhancements

The new law also encourages attorneys and their staff to make use of Health Savings Accounts ('HSAs'). HSAs are designed for individuals with a high deductible health insurance plan. Contributions to these accounts can be made by employers on a pretax basis on behalf of employees. The funds and any related earnings may then be withdrawn tax-free to pay for qualified medical expenses. Starting in 2007, the contribution limit is $2850 for a policy with single-person coverage and $5650 for a family coverage policy. Individuals age 55 and older may also make limited 'catch-up' contributions.

TRHCA also made the following enhancements to HSAs:

• Attorneys and their staff who are eligible for coverage under an HSA during the last month of a taxable year are treated as having been eligible for the entire year. They may therefore make contributions to the HSA for the months before they are enrolled (up to the maximum contribution limit for the year);
• A one-time distribution may be made from every flexible spending account ('FSA') and health reimbursement account ('HRA') owned by attorneys and their staff. The maximum transfer for each account may not exceed the lesser of: a) the FSA or HRA balance on the day of the transfer, or b) the balance in the FSA or HRA on Sept. 21, 2006. Any distributions must be made before Jan. 1, 2012.

TRHCA allows HSA participants to make a one-time contribution of funds from an IRA into an HSA. This rollover, which must be made in a direct trustee-to-trustee transfer, is not taxable as an IRA distribution or subject to the 10% early withdrawal penalty. The rollover is also limited to the maximum deductible HSA contribution for the rollover year. This opportunity is not, however, available for simplified employee pension plans ('SEPs') or SIMPLE retirement accounts.

Research Tax Credit

For those law firms with clients taking advantage of the R&D credit, that credit has also been extended through 2007. Generally, the credit is equal to 20% of qualified research expenses that exceed a certain base amount for a given year. Law firm clients can opt to use an alternative incremental credit ('AIC') based on a stated percentage of qualified expenses that exceed the average expenses over a four-year period. For 2006, the credit's expiration date was simply extended to the end of 2006. For 2007, the R&D credit is modified by an increase in the stated percentage for the AIC. Additionally, the law creates an election for law firm clients to use the alternative simplified credit ('ASC'), which is equal to 12% of qualified research expenses that exceed 50% of the average qualified research expenses for the three prior tax years. The ASC rate is reduced to 6% if there were no qualified expenses in any of the three preceding tax years.

Corporate Donations of Computers and Scientific Equipment

Under TRHCA, the enhanced charitable deduction for corporate donations of scientific property used for research and for contributions of computer technology and equipment to educational organizations and public libraries is extended through 2007. Property that is 'assembled by' the taxpayer is now eligible for the charitable contribution deduction in addition to property 'constructed by' the taxpayer.

UBTI of Charitable Remainder Trusts

For law firms that suggest charitable remainder trusts to their clients, the law has changed regarding the taxability of the trusts. Normally, charitable remainder trusts are exempt from federal income tax unless they have any unrelated business taxable income ('UBTI') for the year. Under prior law, a charitable remainder trust that had any UBTI during a year lost its income tax exemption for that year and was taxed as a complex trust. Beginning in 2007, instead of removing the income tax exemption for the year, an excise tax that is equal to the amount of the trust's UBTI for the year (i.e., a 100% tax) is imposed.

State and Local Sales Tax Itemized Deduction

TRHCA extends the option to deduct state and local sales taxes instead of state and local income taxes for tax years through 2007. Attorneys and their staff may benefit from this deduction if they:

• Live in states that have no income tax;
• Make significant purchases; or
• Find themselves subject to the Alternative Minimum Tax ('AMT') because of the state income tax deduction.

The deduction may be calculated either by deducting the total of the sales taxes shown on a taxpayer's receipts or by using optional state sales tax tables provided by the IRS.

If filing on paper, claim the sales tax deduction on Schedule A, line 5, 'State and local income taxes.' On the dotted line to the left of the line 5 entry box, enter 'ST' to indicate that the general sales tax deduction is being claimed instead of the deduction for state and local income tax.

Deduction for College Tuition Payments

This deduction has been extended through 2007. It allows attorneys and their staff to deduct a portion of qualified tuition, fees, and other related expenses paid for higher education. Attorneys and their staff with an adjusted gross income ('AGI') that does not exceed $65,000 for singles and $130,000 for joint filers may take a maximum annual deduction of $4000. Attorneys and their staff with an AGI that does not exceed $80,000 for singles and $160,000 for joint filers may deduct up to $2000.

Note that no deduction is allowed for a married individual who does not file a joint return or for an individual who is claimed as another taxpayer's dependent. Additionally, attorneys and their staff who elect to use the Hope or Lifetime Learning credit for a student may not use this deduction for the same student. The ability to utilize those two credits, however, is subject to more stringent income requirements; the credits are completely phased out when AGI reaches $55,000 for singles and $110,000 for joint filers.

If filing on paper, claim the deduction on Form 1040, line 35, 'Domestic production activities deduction.' In the blank space to the left of that line entry, enter 'T' if claiming only the tuition deduction, or 'B' if claiming both a deduction for domestic production activities and the tuition deduction. Those entering 'B' must attach a breakdown showing the amounts claimed for each deduction.

Teachers' Deduction for Classroom Expenses

Spouses or children of attorneys and their staff who are elementary or high school teachers (or counselors, principals, or aides) and who work at least 900 hours during a school year may take an above-the-line deduction for up to $250 of the expenses they pay for books, supplies, computers (including related software and services), other equipment, and supplementary materials used by them in the classroom. This deduction is now available for amounts paid or incurred for the 2006 and 2007 tax years.

If filing on paper, claim the deduction on Form 1040, line 23, 'Archer MSA deduction.' On the dotted line to the left of that line entry, enter 'E' if claiming the teachers' deduction, or 'B' if claiming both an Archer MSA deduction and a teachers' deduction. Those entering 'B' must attach a breakdown showing the amounts claimed for each deduction.

Expanded AMT Credit

TRHCA allows for a refundable alternative minimum tax ('AMT') credit starting in 2007 and ending in 2012. A portion of the minimum tax credit can be applied against the regular tax liability of attorneys and their staff and is refundable. This modification was designed, in part, to help taxpayers who had exercised incentive stock options and were unable to utilize the related AMT credit that may have been generated.

The AMT refundable credit amount is the greater of: a) the lesser of $5000 or the long-term unused minimum tax credit, or b) 20% of the long-term unused minimum tax credit. The 'long-term unused minimum tax credit' for a year is the portion of the minimum tax credit attributable to a taxpayer's adjusted net minimum tax for years before the third year immediately preceding the tax year (i.e., for the 2007 year, utilize the portion of credit on Form 8801 that relates to tax years before and including 2003 on a first-in, first-out basis). Table 1 shows how this long-term credit translates into the taxpayer's AMT refundable credit.

In the case of an individual whose AGI for a taxable year exceeds the threshold amount for purposes of the dependency exemption, the AMT refundable credit amount is reduced.

Deduction for Mortgage Insurance Premiums

For 2007 only, qualified mortgage insurance premiums paid in connection with acquisition indebtedness that is related to a qualified residence may be deducted as qualified residence interest. Qualified mortgage insurance includes mortgage insurance provided by the Veterans Administration, the Federal Housing Authority, the Rural Housing Administration, or private mortgage insurance ('PMI'). The deduction begins to phase out once AGI exceeds $100,000 ($50,000 if
married filing separate) and is completely phased out once AGI exceeds $110,000 ($55,000 if married filing separate).

[IMGCAP(1)]

Richard H. Stieglitz is a tax partner, and Michael G. Freel is a tax manager in the New York accounting firm of Anchin, Block & Anchin, LLP, which specializes in providing accounting, tax, and consulting services to law firms. Stieglitz can be reached at 212-840-3456 or [email protected].