STONE V. COMMISSIONER–KEY POINTS OF A FAVORABLE FAMILY LIMITED PARTNERSHIP CASE

In Stone v. Commissioner, the Tax Court ruled in favor of the taxpayer when the IRS sought to attack the favorable estate tax consequences of a family partnership under Code §2036(a). Code §2036(a) will result in gross estate inclusion for transferred property when the decedent retains income rights or dominion and control over the property. However, Code §2036(a) will not apply if the transfer was a bona fide sale for adequate and full consideration.

This exception can be broken down into two elements – (a) a bona fide sale, and (b) adequate and full consideration. The short story on this case is that absent bad facts, the presence of a legitimate and significant nontax purpose for the partnership will allow both (a) an (b) to be satisfied, at least under this interpretation of Code §2036.

Key points of this case are:

     A. In context of FLP transfers, the requirement of a “bona fide” sale is met if there is a legitimate and significant nontax reason for the transfer.

          1. Use of a limited partnership to facilitate ease of gift giving may not be enough of a nontax reason for this requirement.

          2. A desire for joint management of assets by family members can be an adequate nontax reason.

          3. A desire to avoid partition of an asset can be an adequate nontax reason.

          4. Per the enumeration of six listed “bad” factors, good or bad facts may sway the decision on whether an otherwise adequate reason will be deemed a legitimate and significant nontax reason. These six factors are: (1) the taxpayer standing on both sides of the transaction; (2) the taxpayer's financial dependence on distributions from the partnership; (3) the partners' commingling of partnership funds with their own; (4) the taxpayer's actual failure to transfer the property to the partnership; (5) discounting the value of the partnership interests relative to the value of the property contributed; and (6) the taxpayer's old age or poor health when the partnership was formed. Importantly, the case confirmed that presence of some of these facts will not be determinative. In the Stone case, (1) was present since the transferors were the former owners and also general partners of the recipient partnership, and that was not fatal to the use of this Code §2036 exception. Interestingly, and perhaps importantly for the court, there were no gift tax discounts taken when the partnership interests were transferred by the funding parents to gift recipients.

     B. In context of FLP transfers, the Tax Court’s “recycling of value” theory continues to be applied, as to whether adequate and full consideration exists. However, in regard to this theory, the court determined that a legitimate nontax purpose for the transaction was enough to escape a mere “recycling of value” finding that would prevent a finding of adequate and full consideration. Note that this method of analysis is significantly different from that applied in Bongard and Kimbell.

Stone v. Commissioner, TC Memo 2012-48

SECTION 2704 TACKLES ESTATE FOR A CLAIMS COURT LOSS

EXECUTIVE SUMMARY: A company formed to operate an NFL franchise runs afoul of Section 2704 at the death of its principal stockholder. While the estate put forth some creative arguments to elude the grasp of Section 2704, the Claims Court sides with the IRS and applies Section 2704 to substantially increase the estate tax value of the decedent's shares of stock.

FACTS:  The Five Smith's, Inc. was formed in 1965 to own and operate an NFL franchise. The decedent owned Class A common stock. Pursuant to a 1986 recapitalization, that stock had 11.64 votes per share, while the Class B common stock only had 1 vote per share. In 1991, third parties purchased Class B shares of 6% each. At that time, the company amended its Articles of Incorporation to provide that upon the decedent's death, or his sale or transfer of any of his Class A shares, the Class A shares would convert to Class B shares. The effect of the conversion would be a lapse of the enhanced voting power of the Class A shares.

The decedent died in 1997. The IRS disputed the estate tax value of the decedent's Class A shares. The IRS argued that Section 2704 applied, so that the enhanced voting power of the Class A shares should be included in valuing the shares. If Section 2704 applied, the estate and the IRS agreed that the the shares were worth $30 million on the date of death. The estate argued that Section 2704 did not apply. If that was correct, since the enhanced voting power disappeared at death it should not be included in value. This resulted in an agreed valuation of only $22.5 million.

The estate asserted several arguments, both as to whether Section 2704 applied, or if it did, whether its effects could be overridden by creating an inter vivos gift instead of a testamentary transfer, or by creating an arms-length exception to the statute. The Court of Claims rejected all of the estate's arguments and applied Section 2704 to the valuation.

COMMENT: Section 2704 is a special valuation rule that favors the government, and one that planners seek to work around. It is rare to see a disputed case that fits so squarely within it. The case is interesting as a review of Section 2704 and its application, and for the creative arguments put forth by the taxpayer.

     General Application of the Statute. Section 2704(a) reads as follows:

(1)    In general.

            For purposes of this subtitle, if-

(A)    there is a lapse of any voting or liquidation right in a corporation or partnership, and

(B)    the individual holding such right immediately before the lapse and members of such individual's family hold, both before and after the lapse, control of the entity,

such lapse shall be treated as a transfer by such individual by gift, or a transfer which is includible in the gross estate of the decedent, whichever is applicable, in the amount determined under paragraph (2).

      (2) Amount of transfer.

For purposes of paragraph (1), the amount determined under this paragraph is the excess (if any) of-

(A) the value of all interests in the entity held by the individual described in paragraph (1) immediately before the lapse (determined as if the voting and liquidation rights were nonlapsing), over

(B) the value of such interests immediately after the lapse.

      (3) Similar rights.
   
The Secretary may by regulations apply this subsection to rights similar to voting and liquidation rights.

    Thus, on its face, under the above facts there was a lapse of a voting right. Both before and after the decedent's death, his family held more than 80% of the voting power of the company, and thus meets the requirement for family control. For this purpose, the definition of control under Section 2701(b)(2) applies. Under Section 2701(b)(2)(A), in the case of a corporation "the term 'control' means the holding of at least 50 percent (by vote or value) of the stock of the corporation." Thus, applying Section 2704(a)(2)(A), the loss of value relating to the lapse of the extra voting power is disregarded, and the $30 million valuation applies.

     Control Argument. Section 2704(a)(1)(B) requires that "such individual's family hold, both before and after the lapse, control of the entity." Section 2701(b)(2)A) defines control as "the holding of at least 50 percent (by vote or value) of the stock of the corporation."

     Despite this simple definition of control, the estate asserted that for the family to have control, it must be able to reverse the lapsing of the voting power that occurred, if it wanted to. Since the family apparently did not have the power to do this after the decedent's death, the estate argued Section 2704(a) did not apply. The estate crafted this argument from the legislative history of Section 2704, which explicitly reflected the intent to overcome the Tax Court's ruling in Estate of Harrison v. Commission, 52 TCM (CCH) 1306 (1987). In Harrison, a decedent's partnership interest was valued at a lower value because the decedent's estate did not have the liquidation or dissolution rights that the decedent had prior to death as a general partner. However, the decedent's successors in Harrison did have the requisite control after the decedent's death to restore the lapsed liquidation right. Since the successors here did not have the requisite control or rights to restore the decedent's enhanced voting power, the estate argued that they did not have the requisite control to trigger Section 2704(a).

     The Claims Court rejected this interpretation. It noted examples in the legislative history that applied Section 2704(a) while noting only that a power lapsed, without discussion whether the successors needed the power to reinstate the lapsed power. Further, it distinguished Harrison as dealing with a liquidation right, which is different from a voting right. Lastly, it found no hint of any additional requirements in the statute or the regulations that would authorize the additional 'control' requirement that the estate sought to read into the law.

     Timing of the Lapse. Alternatively, the estate sought to have Section 2704(a) apply in 1991, as a gift of the lapsed enhanced voting rights, instead of a testamentary transfer subject to estate tax. More particularly, the estate argued that the lapse occurred at the time the restriction was incorporated into the Articles of Incorporation, and not the later date (death) when the loss in voting power actually occurred.What did the estate have to gain by treating the transfer as a gift? No gift tax return was filed in 1991 to commence the statute of limitations on assessment of a gift tax for the year. Instead, the strategy of the estate was to assert that notwithstanding Section 2704(a) operating in 1991, no gift tax liability came into being because the changes in the Articles of Incorporation arose from an arm's length transaction. Thus, Treas. Regs. §25.2512-8 would void a taxable gift because the property transfer would have been for adequate and full consideration. The Claims Court did not need to address whether adequate and full consideration existed for this transfer and whether that would override Section 2704(a) and its special valuation rules, since it ruled that the transfer occurred at death.

     The estate's argument of an inter vivos gift was not totally without merit. Treas. Regs. §25.2704-1(b) provides that "[a] lapse of a voting right occurs at the time a presently exercisable voting right is restricted or eliminated." Arguably, the voting rights were "restricted" in 1991, even though they were not eliminated until the later death.

     However, examples in the Regulations convinced the court that the lapse occurred at death. For example, Treas. Regs. §25.2704-1(f), ex. 1. reads:

Prior to D's death, D owned all of the preferred stock of Corporation Y and D's children owned all the common stock. At that time, the preferred stock had 60 percent of the total voting power and the common stock had 40 percent. Under the corporate by-laws, the voting rights of the preferred stock terminated on D's death. The value of D's interest immediately prior to D's death (determined as if the voting rights were nonlapsing) was $100X. The value of that interest immediately after death would have been $90X if the voting rights had been nonlapsing. The decrease in value reflects the loss in value resulting from the death of D (whose involvement in Y was a key factor in Y's profitability). Section 2704(a) applies to the lapse of voting rights on D's death. D's gross estate includes an amount equal to the excess, if any, of $90X over the fair market value of the preferred stock determined after the lapse of the voting rights.

    Thus, the example supports a reading that a lapse in voting rights at death occurs at death and not on the adoption of the provision providing for the lapse. The court noted that Treas. Regs. §25.2704-1(f), ex. 3 also supports such a reading, as do excerpts from the committee reports for Section 2704.

    Bona Fide Business Arrangement. The estate also argued that the 1991 limitations were a restriction on the sale of shares that invoked Section 2703. Since Section 2703(b)(1) excepts out from Section 2703 agreements, rights, and restrictions that are a bona fide business arrangement (if sections (b)(2) and (3) are also met), that exception should insulate the estate from Section 2704(a). The court was not convinced, finding that Section 2703 dealt with restrictions on the sale of shares. Instead, this case involved only the voting rights of the shares, and further Section 2704 specifically applies to lapses of voting rights.

    It is uncertain from the opinion whether the decedent's planners were cognizant of the Section 2704 issue before the decedent's death. If they were, perhaps there were no other viable planning alternatives, they had comfort in the arguments they put forth in the Court of Claims, or otherwise thought they could eek out some favorable settlement from the IRS that perhaps never was offered.

Estate of Rankin M. Smith, Jr. v. U.S., 109 AFTR 2d 2012-XXXX (Ct Fed Cl), 2/13/12

IRS DOES NOT RESPECT SPLIT ELIGIBLE ENTITY INTEREST TRANSACTIONS

An owner of an interest in a disregarded entity, such as a sole owner of a domestic LLC, is treated as incurring directly the income and expense items of the entity – hence the term “disregarded.” Some taxpayers have taken to creating multiple types of interests in disregarded entities, based on various preferences or types of income or properties held by the LLC. This is akin to a partnership being able to define different interests in property, income and expenses among its partners.

In the partnership scenario, different partners will obtain different outside basis in their interests over time, as different types of income and expense are allocated to them. Sole owners of LLC’s that create similar disparate interests assert that each such interest has its own separate adjusted basis computation. This can allow for tax manipulation of the basis of interests for sale, upon distributions, and other purposes. For example, if the owner sells part of his ownership interest in the LLC, he or she may assert that the adjusted basis (for gain/loss determination purposes) is not a pro rata portion of the underlying basis of the LLC assets, but perhaps is higher than that (and the proportionate adjusted basis of the interests not being sold) due to the above allocations.

No way, says the IRS in Associate Chief Counsel Legal Advice. A disregarded entity will not allow for the creation of interests with different tax attributes in the hands of its sole owner. This makes sense, but you have to admire the creativity of some of these tax planners.

Office of Chief Counsel Memorandum Number AM2012-001 (February 9, 20120

DO YOU REALIZE HOW MUCH FEDERAL TAXES ARE GOING UP NEXT YEAR?

Most Americans are generally aware that the Bush tax cuts will expire in 2013, and that the new healthcare law will also impose some new taxes. As we get closer to 2013, the scope of the increases will come into clearer focus for taxpayers. For those taxpayers who will be subject to them (generally, married couples with income over $250,000 and singles over $200,000), the new amounts of their income that will be sucked into the abyss of what is the federal budget deficit is eye-popping:

INCOME TYPE	OLD TOP RATE	NEW TOP RATE	% INCREASE
Ordinary income, in general	35%	39.6%	13.14%
Earned income hospital insurance (HI)	1.45%	2.35%	62.06%
Capital gains	15%	23.8%	58.66%
Dividends	15%	43.4%	289.33%
Interest, rents, royalties	35%	43.4%	24%
Estate, Gift & Generation Skipping Transfers	35%	55%	57.14%
Estate, Gift & GST Exemptions	$5.12 million exemption	$1 million exemption	80.46% reduction in exemption

The income tax increases arise from two principal components. First, the maximum rates are being rolled back to the pre-Bush tax cut maximums (i.e., 39.6%). Second, investment income for those over the thresholds are subject to an additional 3.8% tax under Obamacare (e.g., on interest, dividends, capital gains, net rental income, and royalties – but excluding tax-exempt municipal bond interest and withdrawals from qualified plans and IRAs). Lastly, the HI tax on earned income is increased by 0.9% on persons over the thresholds.

Note that further increases in taxes will arise in 2013 that are not reflected in the above table. These relate to the return of limits on itemized deductions for higher income taxpayers.

Note that the threshold for the additional 3.8% investment tax and the new 39.6% maximum tax rate is extremely low for estates and noncharitable trusts that do not distribute their investment income (i.e., it is at the same income level that the highest income tax bracket begins to apply). Thus, many of such entities are in for some unpleasant increased check writing to the U.S. Treasury Department come 2013.

Of course, the Bush tax cuts rollback was deferred in 2010 for 2 years, so perhaps this could happen again. Obamacare is also up for review by the U.S. Supreme Court, and there may be a new President or party alignment in Congress after the 2012 elections. So, while all of the above changes will come into law if no new laws are passed, the uncertainty of what will happen in the law that has existed for the last few years will likely persist for the foreseeable future.

ANOTHER REASON TO FILE A CORRECT RETURN

Filing a false income tax return can result in civil penalties, and also criminal fines and jail time. Now you can adddeportation from the U.S. (if you are not a U.S. citizen) to the list of penalties.

Mr. Kawashima and his wife are citizens of Japan, but are admitted in the U.S. as permanent residents (i.e., they have green cards).  Mr. Kawashima pleaded guilty to willfully making and subscribing a false tax return, and his wife pleaded guilty to aiding and assisting in the preparation of a false tax return.

The government sought to deport the Kawashimas under subparagraph (M) of 8 U.S.C. §1101(a)(43). That subparagraph classifies as a deportable aggravated felony an offense that involves fraud or deceit in which the loss to the victim or victims exceeds $10,000.

The offense of filing a false return does not require a showing of fraud or deceit. Thus, the Kawashimas argued that the above provision did not apply to them. The U.S. Supreme Court took on the case, and ruled that the Kawashimas could be deported. The court found that deceit is present when filing a false return, even though it is not an explicit element in the statute.

Note that this is not the situation of deportation of someone present in the U.S. only on a temporary visa. As green card holders, the Kawashimas would have been entitled to remain in the U.S. for the rest of their lives.

Kawashima v. Holder, (S Ct 2/21/2012) No. 10-577

THE OBAMA BUDGET TRANSFER TAX PROPOSALS–SOME OLD WINE AND SOME NEW WINE

Earlier this week, the Obama Administration released its 2013 revenue proposals. In the area of transfer taxes, the Administration’s wish list includes many items previously proposed, but also has at least one relatively new item. Given the current political situation in Washington D.C., the ability of the Administration to get all or most of these enacted is questionable. However, it is still useful to know what is in the scope of the Treasury Department’s rifle, even though they may not be able to take the shot this year. The proposed modifications are:

1. Restore the 2009 Credit and Exemption Levels. The 2009 unified credit and GST exemption levels will be reinstated and made permanent. These include a 45% maximum estate, gift and GST rate, an exclusion amount of $3.5 million for estate and GST taxes, and a $1 million exemption for gift taxes. However, portability of unused estate and gift tax exemption between spouses, which entered into the law after 2009, will be retained.

COMMENTS: No surprises here, although some would have expected the Administration to retain the 2001 levels which will be reinstated in 2013 if no new legislation is enacted, since they are substantially lower than the 2009 levels. The decoupling of estate and gift tax rates creates unneeded complexity, and the $1 million gift tax exemption is disappointingly low. That proposed gift tax exemption adds further urgency to taxpayers to make larger gifts in 2012 before the exemption shrinks up.

2. Consistency in Value for Transfer and Income Tax Purposes.  Taxpayers who receive property by reason of an individual’s death or by gift receive a basis step-up or carryover basis for future gain/loss computations, based on various rules. The proposal mandates that the recipient is bound by and must file returns with a basis consistent with information reported by the transferor, including values when relevant.

COMMENTS: Conceptually, there is nothing wrong with this idea. However, similar to the ability of a taxpayer in the income tax arena to report a tax item in a manner that differs from a Form K-1 entry so long as that different reporting is disclosed to the IRS, hopefully the same opportunity will be open to taxpayers in this area.

Also, the proposal indicates there will be enhanced (i.e., new)  reporting on decedents and donors  as to value and basis information. Hopefully, this will not be as extensive as that required under the Form 8939 reporting that was required for many 2010 decedents. This raises a number of questions. Will estates that do not have to file a Form 706 still have to obtain values (including appraisals to determine value) for their assets? Will those estates have to report information to the IRS, thus creating a mandatory federal filing for ALL estates that does not currently exist? How will annual exclusion gifts be reported? Is there really such a large problem with inconsistent reporting that a new and burdensome (and costly) reporting obligation needs to be imposed on all decedents and donors? The proposal does note that special provisions may be applicable to nontaxable estates and annual exclusion gifts, but what that means is not discussed.

3. Reduction of Discounting Involving Family-Controlled Entities. In an attempt to reduce discounting of interests in family partnerships and other closely-held entities, valuation rules will be enacted under Section 2704 to disregard limits on an owner’s right to liquidate interests and limits on the ability to be admitted as a full partner or hold an equity interest.

4. Minimum Term for Grantor Retained Annuity Trusts. The proposal would require that a GRAT have a minimum of a ten year term. It would also require that the remainder interest be above zero in value, and that no decrease in the annuity would be allowed during the GRAT term.

COMMENTS: GRATs will still remain as a planning tool if this enacted, but the ten year term will make it more unlikely that a donor will survive the term - if the donor does not survive the term, the value shifting benefits will not arise. It will also eliminate quick-hit transfers through the use of short-term rolling GRATs that allow for transfers under a shorter term spike in values before that increase can be offset by later reductions in value. Also, it will make GRATs  less attractive in higher interest rate years, since it will increase the payouts back to the grantor for no less than 10 years.

5. Limit GST Exemption Benefits to 90 Years. After a trust has been in existence for 90 years, its generation-skipping tax exemption would be effectively eliminated.

COMMENTS: Yes, the idea of trusts that are exempted from further transfer taxes forever is a wonderful thing (or for 360  years in Florida). But considering that our country was founded only 236 years ago, is a longer time period really going to be missed by many? There are some families where trusts may actually continue beyond 90 years, but I’d venture to say there aren’t that many.

6. Create Estate Tax Inclusion for All Grantor Trusts. In a major rewrite of the estate tax provisions, any individual who is taxed as the owner of a trust for grantor trust purposes will have to include the trust assets in his or her gross estate for federal estate tax purposes (at least as I read the proposal). Also, any non-grantor who is deemed the owner of the trust and engages in a sales transaction with the trust will be subject to estate tax on the portion of the trust attributable to the transferred property. The Treasury Department has sales to defective grantor trusts in its sights on this one.

COMMENTS: Many grantor trusts are already subject to gross estate tax inclusion. However, piggybacking the grantor trust rules into the estate tax area jumbles the various tax policies involved, and will result in many trusts being subject to estate tax when it is wholly inappropriate. For example, in the grantor trust area one spouse is generally attributed the rights and powers of another spouse, which can create a grantor trust in a donor spouse even though he or she retains no rights, powers, or interests over an inter vivos irrevocable trust that is created for the other spouse and/or children. Is the donor now going to be subject to estate tax on that trust?

This provision is using an elephant gun to shoot a squirrel. If Treasury is concerned about sales to defective trusts, then it should limit inclusion only to the extent of sale transactions. Indeed, the proposal already addresses sale transactions for non-grantors, so that can simply be expanded to cover all grantors engaged in sale transactions, without an unneeded overexpansion of the gross estate inclusion rules.

7. Extension of Estate Tax Lien Period for Section 6166 Deferrals. Under this provision, the ten-year estate tax lien period will be extended to cover the extended estate tax deferral period of 15 years, 3 months, when a deferral of estate tax is involved.

COMMENT: This proposal avoids the need for estate beneficiaries to come up with security interests to secure the deferred estate tax beyond the ten-year period. As  such, this extension is a useful mechanism for both the government and taxpayers.

General Explanations of the Administration’s Fiscal year 2013 Revenue Proposals

ESTATE AND TRUST LITIGATION UPDATE [FLORIDA] by Norman Fleisher, Esq.*

A newly published opinion arising out of the Probate Division of the Broward Courts illustrates, yet again, how important it is to strictly adhere to the terms of estate planning documents.  In Jervis v. Tucker  the settlor of a trust was adjudicated incompetent and her brother was appointed to be her limited guardian.  After she was declared incompetent the settlor executed an amendment to her trust which adjusted the dispositive scheme.  By its terms, the trust was revocable and amendable, but it contained a provision which suspended the settlor's right to amend or revoke the trust if she was adjudicated to be incapacitated.  However, the trust provided that the right to amend or revoke could be reinstated if the settlor was restored by the court, or if the trustee received written opinions from two "licensed physicians" indicating that the settlor was competent.  In this case two letters were obtained, but only one letter came from a "licensed" physician.  The second letter came from "Dr. Strang, a nursing home administrator with expert experience and medical schooling - but without a physician's license."  After the settlor died there was a trust contest concerning the validity of the amendment.  The court ruled that the amendment was invalid because the letter from Dr. Strang failed to comply with the strict wording of the trust instrument.  The appellate court affirmed the lower court's decision.  The lessons are obvious but worth repeating: be careful about the manner in which rights and procedures are created and described in estate planning documents, and be sure that clients strictly follow the terms of the instruments.

Jervis v. Tucker, 4th DCA (2012)

*Norman is one of our trust and estate litigation partners at Gutter Chaves Josepher Rubin Forman Fleisher P.A.

ARTICLE ON WHY FOREIGN ASSET REPORTING MAY NOT BE ONEROUS AS EXPECTED

For those with an interest, an article of mine was published in the Miami Herald today entitled “New Offshore Asset Reporting Not as Taxing as Feared.” It can be read online here.

SAME SEX MARRIAGES AND COMMUNITY PROPERTY

Washington state is now the latest state to allow for same sex marriages. Importantly, for federal tax purposes the Defense of Marriage Act (DOMA) will not respect these marriages. Thus, the various provisions of the Internal Revenue Code that apply to married individuals (e.g., the ability to file joint income tax returns, the estate and gift tax marital deduction, etc.) cannot be used by a same sex couple married under state law.

However, it is often overlooked that this is not a blanket rule. Since federal tax consequences are applied to property ownership as determined  by state law, a state law marriage between two same sex individuals may still affect their income tax liabilities. Thus, for example, if a same sex couple owns community property under state law, each partner must report on his or her own income tax return 1/2 of the income from the community property. See CCA 201021050.

This treatment leaves open the currently unanswered question whether other community property rules will also apply. For example, will a double step-in basis in community property at the death of the first partner be allowed to occur as it would in non-same sex marriage?

Further adding to the tax difficulties in planning for same sex couples is that state laws may provide state tax benefits to same sex marriages even though they are not available at the federal level.

It is these subtleties and uncoordinated treatment that make planning in this area a challenge. For more on this subject, see Effect of Same-Sex Marriage Laws on Estate Planning, by Nicole Pearl and Carlyn McCaffrey in the January 2012 edition of Estate Planning Journal.

DO PRIVATE ANNUITY SALES MAKE SENSE?

In the past, a common estate planning technique to shift future appreciation on a sale of property would be to sell the property for a private annuity. This provided an income stream to the seller, and also allowed the seller to defer taxes on any gain until payments were received.

In 2006, the IRS  issued proposed regulations that disallow any deferral of tax on gains – instead, all gain on sale is taxed in the year of sale. For many, this is perceived as a death blow to the planning technique.

However, even with a current income tax bite, there are still advantages to the technique and justify its use in appropriate circumstances:

a. The benefit of shifting future appreciation out of the seller’s gross estate for estate tax purpose still fully applies (although this can backfire if a seller substantially outlives his or her life expectancy, since the total annuity payments may then exceed the value of the property plus appreciation).

b. Income taxes may not be a major issue. For example, there may not be much current appreciation (i.e., little or no gain) in the property. Or perhaps the seller has other losses they can use to offset the gain.

c. For 2012, recognizing long-term capital gain may be a good thing since maximum rates are only 15%, and are scheduled to increase next year.

d. In the past, a seller of property for an annuity could not secure the annuity obligation with a pledge or mortgage on property, because that would prevent income tax deferral. Thus, sellers had to take on increased risk of loss as to a default by the buyer. Now that deferral of tax is off the table, sellers can secure the payment obligation without giving up anything.

TEMPORARY VISA DID NOT BAR HOMESTEAD STATUS [FLORIDA]

Favio came to the U.S. in 2005 after a kidnapping attempt against his son in Venezuela. He rented an apartment, and lived there with his son (a U.S. citizen), and his wife. He then purchased an apartment in 2006 and lived there with his family until his death in 2009.

Favio had borrowed $500,000 from Eric and Carla. When Favio died, they filed a claim against Favio’s estate to be repaid. Favio’s estate claimed the apartment was homestead property, and thus could not be reached by Eric and Carla to repay the debt. Presumably, Favio did not have other assets to fully satisfy the debt.

The probate court reviewed numerous cases that provided that an individual in Florida on a temporary visa could not form the requisite intent to make a residence a “permanent residence” so as to qualify for homestead protection against creditors. The court found that since Favio did not have the right to stay here on a permanent basis (he did not have a green card admitting him as a lawful permanent residence nor was he a U.S. citizen), the property was not homestead property.

The 3rd DCA reversed, and held the property was protected homestead. In doing so, they made a number of interesting observations and statements:

     a. That the son was a U.S. citizen was an important fact. The court noted that the Florida Constitution does not require the owner to reside on the property – it is enough that the owner’s family reside on the property. Thus, the father could in effect piggyback on the son’s permanent status.

     b. The intent question is to be answered based on the intent of the homesteader and not that of the U.S. Citizenship and Immigration Services. Thus, while Favio did not have the right to remain in the U.S. permanently, that was not controlling.

     c. Precedent and rules in the ad valorem tax homestead exemption area do not control in regard to the exemption from forced sale. There is strong precedent in the tax area that temporary immigration status is not sufficient to obtain the ad valorem homestead exemption. That precedent is not controlling because for tax exemption purposes, the statute is to be strictly construed against the taxpayers. However, in the forced sale arena, the rules are to be liberally construed for the benefit of those that the rules are designed to protect.

     d. That Favio and has wife had applied for permanent residence status before Favio’s death was an important fact that supported homestead status.

In the end, the court noted that based on (a) continued residence at the property since its purchase, (b) possession of a visa that permitted residence here (albeit not on a permanent basis), and (c) the application that had been made for permanent resident status, homestead protection against forced sale was appropriate.

WHERE’S THE VALUE HERE? The court opens the door to homestead protection against forced sale, even when the owner does not have the right to permanently reside in Florida. However, the special facts discussed above in (a)-(c) were key – absent similar compelling facts in other situations, the lack of the ability to permanently reside is still likely to be a significant bar to forced sale homestead protection based on the other cases in this area.

Estate of Favio Jose Grisolia Sanchez v. Pfeffer, 36 Fla.L.Weekly D2554 (3rd DCA (November 23, 2011))

PURCHASE PRICE ALLOCATIONS ARE BINDING ON THE BUYER

Purchasers and sellers of businesses will often allocate the purchase price among the assets sold. Under Code §1060, the buyer and seller must make an allocation with their tax returns.

When the allocation is made in a written agreement, the parties are bound by it for tax purposes, except under the Danielson rule. Code §1060(a).  That rule allows a party to contradict an unambiguous contractual term by offering proof that would alter that construction or to show its unenforceability because of mistake, undue influence, fraud, or duress.

Peco Foods purchased two processing plants. Portions of the purchase price were allocated to “Processing Plant Building” and “Real Property: Improvements.” Instead of capitalizing the purchase price into real property only (Code §1250 property), Peco conducted a post-closing study that broke these allocations into component parts, including allocations to specialized mechanical systems and other personal property assets (Code §1245 property). By doing this, Peco was able to increase its depreciation deductions through the use of faster write-off methods that are allowable under Code §1245.

The IRS objected, and the matter ended up in the Tax Court. The Tax Court sided with the government, and determined that a subdivision of the allocations to real property assets between real property and nonreal tangible personal property rule was an impermissible modification of the allocation in the purchase agreement.

WHERE’S THE VALUE HERE? Buyers of businesses should conduct their cost segregation analysis before the closing and conduct any refinements in the allocation in the purchase agreement, instead of doing these things after the agreement is finalized.

Peco Foods Inc. et al., TC Memo 2012-18

RELIANCE ON COUNSEL DEFENSE WAIVES WORK PRODUCT AND ATTORNEY-CLIENT PRIVILEGE PROTECTION

In litigation, the work-product doctrine and the attorney-client privilege protect materials and communications from discovery by an adversary in litigation. The work-product doctrine excludes from discovery materials prepared in anticipation of litigation because discovery of such materials would hamper the orderly prosecution and defense of legal claims in adversary proceedings. The attorney-client privilege extends to communication between a taxpayer and a “federally authorized tax practitioner” with respect to tax advice, to the extent the communication would be privileged if it were between a taxpayer and an attorney.

Many tax penalties will not apply if the taxpayer had reasonable cause for its tax position. At times, reliance on the advice of counsel in adopting a tax position constitutes reasonable cause.

Reliance on counsel, the work-product doctrine, and the attorney-client privilege, do not play well together, as Salem Financial, Inc. learned in a recent Court of Claims case. Salem is a successor to Branch Investments LLC, a subsidiary of BB&T. In tax litigation, Salem raised reliance on counsel to defend itself against asserted penalties. The Government used that defense to claim access to documents and communications that would otherwise have been protected under the work-product doctrine and attorney-client privilege. The Claims Court sided with the Government, and authorized the release of the contested items since they related to the reliance on counsel defense.

The reliance on counsel defense has saved many a taxpayer from penalties. It is unknown if the taxpayer in this case knew that by using that defense it would be forfeiting the above evidence protections – perhaps the benefits of the defense outweighed the negatives relating to the disclosure of the subject items and thus was intentional.

WHERE’S THE VALUE HERE? A reminder to litigating taxpayers that a reliance on counsel “reasonable cause” defense may result in a waiver of protections otherwise available under the work-product doctrine and the attorney-client privilege.

SALEM FINANCIAL, INC v. U.S., 109 AFTR 2d 2012-XXXX, (Ct Fed Cl  01/18/2012)

REPORTING OF TAX INFORMATION WITH YOUR PASSPORT APPLICATION

Passports are not under the purview of the IRS, and generally do not involve tax administration issues. However, since 1986, U.S. passport applicants have to report certain information when they make their application. Code §6039E.

Proposed Regulations on what must be reported were issued in 1992, but never finalized. Treasury has now issued new proposed Regulations. Under these, the items to be reported are:

(1) the applicant's full name and, if applicable, previous name;

(2) address of regular or principal place of residence within the country of residence and, if different, mailing address;

(3) taxpayer identifying number (TIN); and

(4) date of birth.

Not a burdensome filing, but an additional filing for taxpayers to deal with, nonetheless. The changes from the 1992 proposed Regulations are minor.

Code §6039E also requires reporting for individuals applying for lawful permanent resident status (green card). The items to be reported are more broad. Haowever, while the 1992 proposed Regulations included these items, the new proposed Regulation does not address such applicants.

Most people think the income tax is all about tax. What often goes unrealized is that the income tax provides legal justification for the gathering of reams of data on taxpayers, including marital status, business and investment activities, and asset holding that might otherwise be beyond the interest of government.

Proposed Treas. Regs. §301.6039E-1

APPLICABLE FEDERAL RATES–FEBRUARY 2012

FOREVER IS A LONG TIME

Usually, a taxpayer cannot obtain a charitable income tax deduction for a contribution of property if the taxpayer transfers less than his or her entire interest in the property. However, Code §170(h) does allow for a charitable deduction for a conservation easement granted in property owned by a taxpayer. To qualify, the easement must be granted “in perpetuity” (among other requirements).

In a recent Tax Court case, the taxpayers conveyed a conservation easement in their Colorado property to a charitable organization. The deeds restricted the charity’s use of the gift to “preserve and protect in perpetuity the Conservation Values of the Property for the benefit of this generation and generations to come.” The deeds also provided for the extinguishment of the easement under certain circumstances:

“Extinguishment—If circumstances arise in the future such that render the purpose of this Conservation Easement impossible to accomplish, this Conservation Easement can be terminated or extinguished, whether in whole or in part, by judicial proceedings, or by mutual written agreement of both parties, provided no other parties will be impacted and no laws or regulations are violated by such termination.” (emphasis added)

The IRS sought to deny the deduction since the conservation could be terminated by mutual agreement of the parties, and thus violated the perpetuity requirement (even though the purposes of the easement first had to be rendered impossible to accomplish). The Tax Court agreed with the IRS. Forever means forever, so the retention of a mutual right to terminate violated the perpetuity requirement.

Treas. Regs. §1.170A-14(g)(3) provides that a charitable deduction will not be disallowed merely because the interest which passes to, or is vested in, the donee organization may be defeated by the performance of some act or the happening of some event, if on the date of the gift it appears that the possibility that such act or event will occur is so remote as to be negligible. The taxpayers argued that the likelihood of a mutual termination of the easement was so remote that this regulation should save the charitable deduction. The Court held that this “remoteness” exception was something separate and apart from the perpetuity/extinguishment requirements, and thus could not be applied to override the perpetuity/extinguishment requirements.

So what happens if circumstances change so that the easement no longer makes sense? Does tax law nonetheless require the easement to still go on forever? Treas. Regs. §1.170A-14(g)(6)(i) provide an out:

“If a subsequent unexpected change in the conditions surrounding the property that is the subject of a donation under this paragraph can make impossible or impractical the continued use of the property for conservation purposes, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding and all of the donee's proceeds *** from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution…” (emphasis added)

Thus, a judicial termination under these conditions is allowed, without that violating the perpetuity requirements. Forever is a long time, but under the appropriate circumstances, it need not go on, well, forever.

Kayln M. Carpenter, et al., TC Memo 2012-1

REPORTING OF SPECIFIED FOREIGN FINANCIAL ASSETS – TRUSTS & ESTATES

[The following was also published on Leimberg Information Services on January 9, 2012]

EXECUTIVE SUMMARY. Taxpayers with non-U.S. financial assets are subject to new and extensive reporting, commencing with the 2011 tax year filings. The IRS has recently issued guidance, which includes specific rules relating to grantor trusts and interests in foreign trusts and estates. All return preparers should have some familiarity with these new rules.

FACTS. Code §6038D, enacted as part of the Hiring Incentives to Restore Employment (HIRE) Act, will result in the first foreign asset disclosure filings in 2012. Form 8938 will be used to report. In recent weeks, Treasury has released a final version of the Form 8938, Instructions under the form, and temporary and proposed regulations relating to this reporting. Before addressing the specific provisions relating to estates and trusts, a short overview of the filing requirements is helpful.

WHO MUST FILE? (a) A “specified person,” (b) with an “interest,” (c) in “specified foreign financial assets (SFFAs),” (d) that meet stated filing thresholds, and (e) that otherwise has to file an income tax return, is required to prepare the Form 8938. Generally, a “specified person” at this time is an individual that is a U.S. citizen or resident alien. An “interest” means ownership of a subject asset in such a manner that income, gain, loss, expense from that item would be reported on an annual return of the taxpayer (regardless of whether there is income, gain, loss or expense for the current year). The filing threshold for a U.S. resident is SFFAs in excess of $50,000 on the last day of the tax year or $75,000 at any time during the year. Higher thresholds exist for married persons, and persons residing abroad.

WHAT IS AN SFFA? There are two types of assets that are a “specified foreign financial asset.” The first is a financial account of the taxpayer maintained by a foreign financial institution. The second is an asset not held in such an account, if held for investment, and that is: (a) stock or securities issued by a non-U.S. person, (b) a financial instrument or contract with a non-U.S. issuer or counterparty, or (c) an interest in a non-U.S. entity.

VALUATION. Values of SFFAs must be determined, both to determine if the filing threshold has been met, and to report the value on the Form 8938. Reasonable estimates of value are (thankfully) allowed.

PENALTIES. Failure to fully disclose will result in monetary penalties of $10,000 (up to a maximum of $50,000), absent reasonable cause. Failure to report will also result in statute of limitations extensions on income, both relating to the unreported SFFAs and potentially to all income of the taxpayer.

DUPLICATIVE REPORTING. For FSSAs reported on other tax forms, reporting may not be necessary under the Form 8938. However, those filings must be referenced on the Form 8938.

TRUST AND ESTATE ISSUES. There are some specific rules and aspects that relate to trusts and estates.

1. At this point in time, domestic trusts are not reporting taxpayers – only individuals need to report. At some point in the future, domestic entities that are availed of to avoid reporting will also need to report.

2. In counting SFFAs to see if the filing threshold is exceeded, or in actually reporting SFFAs, a beneficiary is not treated as owning the assets of a trust or estate. However, owners of an interest in a grantor trust will report the SFFAs of the trust attributed to them, subject to some exceptions.

3. An interest of a beneficiary in a foreign trust or a foreign estate is itself an SFFA. However, the beneficiary needs to know or have reason to know about the foreign trust or estate based on readily accessible information before it will be considered an SFFA. A receipt of a distribution from the estate or trust constitutes knowledge for this purpose.

4. In determining the “maximum value” of a beneficial interest in a foreign trust, the maximum value is the sum of (a) the fair market value on the last day of the year of all cash and property distributed to the beneficiary, and (b) the actuarial value on the last day of the year of the beneficiary’s rights to receive mandatory distributions. If the beneficiary cannot obtain information to calculate (b), they can use only the value under (a).

5. In determining the value of a beneficial interest in an estate, the taxpayer can limit the computation to that described in 4.(a) above, if it cannot obtain the information needed to value the beneficial interest.

COMMENT. Tax preparers are now obligated to inquire about the foreign assets of their clients so that proper reporting can be made. This will require preparers to be familiar with the foregoing rules, including what constitutes an SFFA and the application of the rules to interests in trusts and estates. Note that the Form 8938 instructions and accompanying regulations provide additional detail and exceptions beyond the general overview provided above.

Importantly, reporting of foreign accounts on an FBAR does NOT relieve taxpayers of reporting SFFAs on the Form 8938.

As noted above, a mere beneficial interest in a foreign trust or a foreign estate is an SFFA that is subject to reporting if the filing thresholds are met. There is no guidance that limits this to current beneficiaries or vested remainder beneficiaries. Thus, contingent beneficiaries at this point should report to avoid a risk of penalty, although an argument can be made that such persons do not have the requisite “interest.”

The valuation aspects are interesting. As to interests in a foreign trust, a beneficiary is not generally required to obtain valuation of the trust assets, since he or she needs only to report the value of distributed property. However, if the beneficiary has a mandatory distribution right, an actuarial computation is required. To compute this, the value of the underlying trust assets in that situation will be needed. For foreign estates, some effort will need to be undertaken to obtain the value of the beneficiary’s interest. Helpfully for beneficiaries of foreign trusts and foreign estates, if readily accessible value information is not available, valuation can be limited to the value of distributed property that is received.

The question arises whether values reported on the Form 8938 can be used by the IRS to challenge asset values for other purposes, such as estate or gift tax transfer values for transfers occurring in the tax year or in the future. There is nothing that prohibits the IRS from using the reported values, although the probative value of such reporting is arguably limited since the form only requires “reasonable estimates” of value. Nonetheless, to avoid issues if there are somewhat contemporaneous transfers subject to estate or transfer taxes, some coordination of reporting is advisable to avoid creating inconsistent reporting problems to the extent workable within the confines of the Form 8938 reporting rules.

CITES: Code §6038D; Form 8938 and Instructions; TD 9567, Reporting of Specified Foreign Financial Assets (12/14/11); Treas.Regs. §1.6038D-1T, -2T, -3T, -4T, -5T, -7T, & -8T.

VALUE OF AN LL.M. DEGREE

I almost never link to other blogs, but I am making an exception today. I am often asked about the value of an LL.M. degree. This blog post suggests that the only worthwhile LL.M. degree in law is for tax, and then only if it is obtained from NYU, Georgetown, or the University of Florida. I would also add degrees from the University of Miami School of Law - perhaps there are others, but I don't know enough about them to comment.

The Value of the LL.M. Degree? Still Low, by Elie Mystal

SOME IMPORTANT 2012 DATES AND AMOUNTS

Most readers are aware of the $5 million exemption amounts for 2011 and 2012 for federal estate, gift and GST taxes. Keep in mind, however, that the exemption for 2012 is indexed for inflation, and thus is actually $5,120,000. Rev.Proc. 2011-52, §3.29.

Federal tax returns usually due on April 15 will be due on April 17 in 2012 (April 15 is a Sunday and April 16 is Emancipation Day, a Washington D.C. holiday).

IRS OPENS 3RD OFFSHORE VOLUNTARY DISCLOSURE PROGRAM

Taxpayers with unreported offshore accounts or entities now have a third bite at the apple. The IRS has reopened its offshore voluntary disclosure program to allow delinquent reporting with reduced penalty and criminal exposure.

The program is similar to the 2011 program, but there is presently no deadline to apply (unlike prior programs which had a fixed expiration date). However, taxpayers with an interest should not unduly delay, since the IRS has reserved the right to close the program or increase penalties at any time. The new program also has a penalty of 27.5% of the highest aggregate balance in the foreign bank account or entities or the value of the unreported assets during the eight full tax years prior to disclosure. This is up from the 25% that applied in the 2011 program.

Participants must file all original and amended tax returns and include payment for back taxes and interest, as well as paying accuracy-related and/or delinquency penalties. At times it may be beneficial to conduct reporting outside of the program. Consultation with a qualified tax professional is recommended.

IR-2012-5, Jan. 9, 2012

THAT’S A GOOD WAY TO AVOID INCOME ON DAMAGES

The starting point for most damages recovered by litigants is that the damages are gross income. The hunt then is on for some exception to gross income treatment. A recent private letter ruling illustrates one favorable path, if it fits the facts.

Here, the taxpayer recovered damages from a defendant that had interfered with the taxpayer’s agreement to buy assets of a unit investment trust. The effect was the taxpayer had to pay more for the acquired property than if there had been no interference.

Instead of treating the damages as an item of gross income, the ruling allows the taxpayer to treat it as a nontaxable return of capital in the acquired assets. Thus, the effect is no income tax on the proceeds received, to the extent they do not exceed the adjusted basis of the taxpayer in the subject assets. Should the damages exceed the total basis, then income to that extent would occur. Also, the adjusted basis of the taxpayer in the assets would be reduced for the damages received. This will increase the likelihood of future gains from the property if and when sold.

The key here was an injury to property. If a recovery compensates a taxpayer for injury or loss to the taxpayer's property, it is considered a restoration of capital to the extent of the taxpayer's capital interest therein. Rev.Proc. 67-33, 1967-2 CB 659. Therefore, a review of the facts in recovery situations to determine if there is a property interest that was damaged and compensated is a worthwhile endeavor.

PLR 201152010, December 30, 2011

BEWARE THE INTERMEDIARY SALE CORPORATION

There are acquisition companies out there that promote a benefit to ‘C’ corporation shareholders that are looking to sell their business. If the corporation sells its assets, there will often be substantial corporate gains and income tax. The acquisition companies instead offers to buy the shares of the company from the shareholders. The acquisition companies represent that they have available tax losses that can be used to offset the corporate gains, and thus indicate they can avoid or minimize the corporate taxes on the sale of assets. The assets of the corporation are sold and the proceeds of the sale are used to pay off the purchase price for the share purchase of the shareholders. The benefit to the shareholders in doing a stock sale is that the acquisition company will pay them more for their stock than they would receive if the corporation sold its assets, paid its income taxes on the sale, and then liquidated and distributed the remaining sale proceeds to the shareholders. Of course, the acquisition corporation retains some of the sale proceeds as its pay for its role. The additional payment to the shareholders and the compensation retained by the acquisition corporation is funded by the purported corporate tax savings from the tax losses of the acquisition corporation.

This is what occurred in a recent Tax Court case. Unfortunately, the Tax Court made three findings that potentially leave the shareholders in a bad place.

First, the Tax Court held that the asset sale by the corporation, followed by the sale of shares by the shareholders to the acquisition corporation, was recast as an asset sale followed by a liquidation and not a stock sale. This recharacterization alone may have been enough to blow up the tax planning, since presumably the acquisition corporation’s losses could not be used to offset the selling corporation’s gains on the asset sale – thus the anticipated tax savings that lubricated the transaction would not exist. The Tax Court did not need to take this tack. Instead, the Tax Court determined that the tax losses that the acquisition corporation claimed to have were not valid. The result was the same – the selling corporation had no losses to offset its gains, and thus unexpected corporate level taxes were incurred.

The third finding was that since the transaction was characterized as a corporate liquidation, the shareholders as recipient of corporate assets under the deemed liquidation were personally responsible for the unpaid corporate tax  liabilities as transferees under Code Section 6901. Since the acquisition corporation was paid through the retention of some of the sale proceeds that effectively should have gone for payment of corporate taxes, it is likely that the shareholders will end up with less after they pay the corporate taxes than if they had just sold the assets and liquidated. Of course, perhaps the shareholders can recover their shortfall, including potential interest and penalties, from the acquisition corporation. But then again, perhaps not.

It is notable here that the corporation sold its assets and ceased its business prior to the sale of the shares to the acquisition company. Perhaps if the sale of shares preceded the sale of assets, the court may not have found a constructive liquidation. However, it is likely that some risk of a constructive liquidation will nonetheless remain since one doubts whether the acquisition corporation would purchase the shares of the company absent a binding contract by the company to sell its assets to a third party shortly after the stock purchase. Such a binding arrangement would still leave plenty of room for a court to still impose its recharacterization.

Feldman, TC Memo 2011-297

EMPLOYER PROTECTED FROM LIABILITY FOR IRS LEVY ON EMPLOYEE WAGES

The IRS issued a levy to US Airways in regard to the tax liability of an employee. US Airways garnished the wages of the employee and paid them over to the IRS.

The employee was not pleased, and sued US Airways, claiming it should not have complied with the levy. Two reasons were provided. The first was that US Airways failed to ensure the levy was valid. The second was that the employee had indicated on his W-4 that his wages were exempt, and thus should not have been subject to garnishment.

The District Court threw out the lawsuit. Code §6332(e) provides protection to persons satisfying an IRS levy. It reads:

Any person in possession of (or obligated with respect to) property or rights to property subject to levy upon which a levy has been made who, upon demand by the Secretary, surrenders such property or rights to property (or discharges such obligation) to the Secretary (or who pays a liability under subsection (d)(1) ) shall be discharged from any obligation or liability to the delinquent taxpayer and any other person with respect to such property or rights to property arising from such surrender or payment.

Valid or not, the employer had no responsibility for challenging the levy, and indeed had no standing to do so even if it wanted to. The fact that the employee’s wages were characterized on the W-4 as “exempt” did not change the employer’s obligation to comply with the IRS’ levy.

All this makes perfect sense from a policy standpoint. If property holders can contest levies they receive relating to property they hold of a taxpayer, collection by the IRS would be impaired by persons without a direct interest in the subject property. That being said, a grant of immunity to the party receiving the levy for complying with a levy that they have no ability to contest is both necessary and proper.

Gust v. US Airways, 108 AFTR 2d ¶2011-5603 (DC NC 12/16/2011)

PENALTIES ON UNREPORTED FOREIGN TRUSTS MUST BE PAID IN FULL TO OBTAIN DISTRICT COURT OR CLAIMS COURT JURISDICTION

Taxpayers that desire to contest an IRS assertion of tax liability in Federal district court or the Court of Federal Claims must first FULLY pay the asserted tax liability, and then sue for a refund. If the liability is high enough, a taxpayer may be unable to afford to do this.

However, under the “divisible tax” analysis, some tax penalties may be divisible from others – when that analysis applies, the taxpayer can only pay some and not all of them, and still get to court by suing for a refund. In a recent Chief Counsel Advice, the issue was raised whether Code §6048 penalties failures to report contributions to, ownership of, and distributions from foreign trusts are “divisible taxes” that would allow for less than all asserted penalties to be paid and still allow a refund suit.

At first, such penalties would appear to be divisible, since different penalties arise under Code §6048 for different types of failures to report, and because multiple tax years may be involved. Nonetheless, the IRS concluded that Code §6048 penalties are NOT divisible. Thus, taxpayers seeking to get to district court or the Claims Court will need to first prepay all asserted penalties in full.

The theory of the CCA was that if payment of only one portion of the penalty was sufficient for jurisdiction, the court nonetheless would have full jurisdiction of all the asserted penalties. Further, different reasonable cause defenses against different portions of the penalty could be argued by the taxpayer. The CCA concluded that this was inconsistent with the theory of a “divisible tax,” and thus partial payment would not give rise the sought after jurisdiction.

There are two important provisos to this determination. First, this is only the IRS’ position, and thus a taxpayer could contest that determination in court. Second, the CCA notes that if the taxpayer is willing to drop its opposition to the unpaid tax portion, it could proceed to obtain court jurisdiction over a portion of the penalties asserted by paying just those penalties first.

Chief Counsel Advice 201150029

SOUTH FLORIDA PRESENTATION – FORM 8939 FOREIGN FINANCIAL ASSET DISCLOSURES – THE WHO, WHAT & HOW, INCLUDING COMPLIANCE TRAPS AND TIPS

For those readers who are situated in South Florida, I am giving you first crack at seats to a complementary small group presentation I will be giving at our firm office on several Fridays in January on the above topic. As you may be aware, substantial new reporting requirements relating to foreign financial assets apply to income tax returns due for the 2011 tax year.

Click the link to download the full invite which will go out to a broader audience in the next few days. The invite has the dates and times and RSVP information. Since space is limited, please call or email (the instructions are on the invite) as soon as practicable to reserve a space if you are interested.

For any larger organizations within decent driving range (Palm Beach to Ft. Lauderdale) that have 5 or more interested persons, I would be happy to schedule a visit to your office to make the presentation (if my schedule permits) – feel free to contact me at crubin@floridatax.com in that regard.

Invitation

RETURN PREPARERS FACE STRICTER DUE DILIGENCE ON EARNED INCOME CREDIT RETURNS

The earned income credit (EIC) can provide tax refunds to qualified low income taxpayers. Due to faulty submissions (intentional or unintentional), efforts have escalated over the years to pressure preparers to limit filings to eligible cases only – that is, to get preparers to police this area. For example, in 1997 a penalty of $100 was added for preparers who fail to comply with due diligence requirements in determining eligibility for the EIC.

More recent changes to the law and regulations have ramped up the compliance burden. For example, earlier this year, the preparer penalty was increased to $500 (Code §6695(g)). Now, the IRS has issued proposed and final Regulations that affect this area.

Previously to avoid the penalty, a preparer had to prepare an Eligibility Checklist (Form 8867) and a Computation Worksheet, and retain them for three years. Under proposed Regulations that were issued on December 19, the Form 8867 would now be required to be submitted with the filed tax return. The three year retention period may also be extended in some circumstances under the proposed Regulations, and other changes have been made under both the proposed and final regulations.

Preparers that prepare EIC claims should review the new Regulations to minimize their exposure to the increased preparer penalty.

T.D. 9570, 12/19/2011, Reg. § 1.6695-2

APPLICABLE FEDERAL RATES–JANUARY 2012

TIME TO RENEW PTIN’S

In an effort to stake out its own piece of the regulatory State, the IRS now requires return preparers to register with them and obtain a Preparer Tax Identification Number (PTIN), for returns filed after 12/31/10. For preparers with PTINs, the first renewal date is now coming up.

PTIN holders will need to go online to http://www.irs.gov/ptin to renew before December 31, 2011. PTIN holders will have to pay $63 for the privilege of being regulated.

For more information on the PTIN requirements and how to renew, consult IRS News Release 2011-119.

IR 2011-119.

DRAFTING ATTORNEY WHO IS ALSO BENEFICIARY MAY CONTEST WILL [FLORIDA]

[This article was prepared by Sean Lebowitz of our office]

The Agee v. Brown* decision has been a highly talked about recent 4^th DCA opinion among Florida estate planners and probate litigators. In Agee, an attorney prepared a Will (“2007 Will”) for the Decedent naming himself and his wife as beneficiaries of real property. Two years later, the Decedent went to a different attorney and prepared a subsequent Will (“2009 Will”) that removed the attorney and his wife as beneficiaries.

When the Decedent passed away, the Personal Representative sought to have the 2009 Will admitted into probate. The drafting attorney of the 2007 Will filed a Petition to Revoke Probate which alleged the 2007 Will is the last valid Will of the Decedent.

In response, the Personal Representative filed a Motion to Dismiss which alleged that the drafting attorney lacked standing to contest the 2009 Will. The Motion to Dismiss asserted that the drafting attorney’s bequest in the 2007 Will is void since it is in violation of the Rules Regulating the Florida Bar. In particular, Rule 4-1.8(c) does not permit an attorney to prepare an instrument for a client which gives the attorney or a person related to the attorney a substantial gift unless the recipient of the gift is related to the client. In the instant case, the drafting attorney and his wife were not related to the Decedent. The Probate Court granted the Personal Representative’s Motion to Dismiss and determined that the drafting attorney lacked standing to contest the 2009 Will because his bequest in the 2007 Will was void due to public policy.

The Fourth District Court of Appeal reversed the Probate Court and found that notwithstanding his ethical violation, the drafting attorney did have standing to contest the 2009 Will. The Appellate Court determined that the Probate Code does not provide any exception to prohibit a drafting attorney who is also a substantial beneficiary from contesting a will. Instead, the Probate Code simply permits an “interested person” to file an action contesting a Will. “Interested person” is defined very broadly in the Probate Code, allowing any person reasonably affected by the proceeding to file an action. The Appellate Court conservatively analyzed the Probate Code and found that the Probate Court imputed ethical rules not found in the Probate Code.

*Disclaimer: Our firm represents the Appellee/Respondent, Mr. Brown, in his capacity as Personal Representative and Trustee in the probate and trust litigation.

CONSERVATION EASEMENTS–USING THE IRS AUDIT MANUAL TO AVOID ISSUES

An owner of real property that donates a conservation easement to a qualified organization may be able to deduct the value of the easement for income tax purposes. Such a deductible contribution requires the contribution of a qualified real property interest to a qualified organization exclusively for conservation purposes. A qualified real property interest is a restriction granted in perpetuity on the use, modification, and development of property such as parks, wetlands, farmland, forest land, scenic areas, historic land or historic structures.

The IRS has revised it Conservation Easement Audit Techniques Guide as of September 30, 2011. This lengthy guide should be reviewed by those structuring such contributions to assure compliance with all statutory and regulatory requirements.

Exhibit 12-1 is especially beneficial since it provides an all-inclusion list of potential issues. It includes general problems that may arise with charitable contributions, deficiencies in the appraisal process, deficiencies as to the perpetuity requirements, deficiencies as to the recipient organization, and deficiencies as to the requisite conservation purpose. The list is a gift for planners and return preparers – it should be used as a checklist for planning and compliance.

For those with an interest, I have reproduced the Exhibit 12-1 issue list below:

Conservation Easement Audit Techniques Guide

NO 15% RATE ON CONTROLLED FOREIGN CORPORATION INCOME INCLUSION

Under the Controlled Foreign Corporation (CFC) rules, U.S. shareholders of foreign corporations will have to include in their income their pro rata share of the CFC’s income on a pass-through basis under certain circumstances. Such inclusion can be required in the year the income is earned, or in a later year if and to the extent the CFC invests its untaxed earnings in U.S. property. Such income is included in the shareholder’s income at ordinary income rates, like a dividend.

Hmm, like a dividend. Does that mean the U.S. shareholder can pay tax on this income at the preferential 15% rates presently allowed for qualified dividend income under Code §1(h)(11) if the CFC is otherwise a qualified foreign corporation?

I think most international tax planners would tell you the answer is no. While the Code taxes these inclusions as ordinary dividend like a dividend, it does not actually characterize them as dividends. There are plenty of other situations in the Code when it will specifically characterize a deemed distribution or other amount as a deemed dividend, but that language is not present in the CFC rules.

This analysis didn’t stop at least one taxpayer from reporting this income relating to the reinvestment of CFC earnings in U.S. real property as a dividend to be taxed under the reduced rates, to the tune of about $3 million in income. The IRS challenged the treatment, and the taxpayer took the issue to the Tax Court. The Tax Court took the side of the IRS, and disallowed the application of the 15% maximum tax rate.

The Tax Court noted the items above, such as the lack of an explicit dividend label to the CFC income inclusion, and that Congress has given that label in other areas when it intends such treatment. The taxpayer did note that the 2004 instructions to Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, indicated that individual CFC shareholders should report section 951 inclusions as “ordinary dividend income.” Nonetheless, the Court noted that there were other instructions to the contrary that accompanied that Form, and further that “taxpayers cannot rely on Internal Revenue Service instructions to justify a reporting position otherwise inconsistent with controlling statutory provisions.”

Osvaldo Rodriguez, et ux. v. Commissioner, 137 T.C. No. 14,

ADD ANOTHER EXCEPTION TO DISREGARDED ENTITY TREATMENT

The Treasury Department greatly simplified tax planning and compliance with the check-the-box regulations. One aspect of those regulations is that certain single-owner entities (either by default or via the check-the-box election) are entirely disregarded for all federal tax purposes.

Or that is how it started. As time has progressed, so have the number of exceptions to disregarded status that have been promulgated. Making the job of tax professionals more difficult, there is no centralized list of the exceptions to disregarded entity treatment. Instead, they are scattered in various regulations, creating traps for unwary taxpayers and planners. Planners would be well-served by maintaining their own cheat sheet of exceptions to these rules to make sure that a particular transaction is not covered by an exception.

A new exception now has been added to the list. Under final regulations issued under Section 881, the IRS can treat a disregarded entity in a financing structure as a person separate from its owner (that is, as a non-disregarded entity), in determining whether a financing arrangement exists that should be recharacterized under the multiple-party financing rules of Code §7701(l) and Treas. Regs. §1.881-3. These rules allow the IRS to disregard the participation of one or more intermediate entities in a financing arrangement and recharacterize the financing arrangement as a transaction directly between other parties. It will often be applied where intermediate entities are employed by taxpayers to obtain treaty or other tax benefits that would not be available if a financing transaction was directly conducted between the ultimate lender and borrower.

T.D. 9562, 12/08/2011; Reg. § 1.881-3

GRANTOR’S ABILITY TO SUBSTITUTE ASSETS IN A LIFE INSURANCE TRUST NOT A PROBLEM

Planners often grant Code §675(4) power of substitution rights to a grantor of a trust to create a grantor trust (i.e., a trust whose income is taxable to the grantor). That provision creates a grantor trust if the grantor has the power in a nonfiduciary capacity, without the approval or consent of any person in a fiduciary capacity, to reacquire trust corpus by substituting other property of an equivalent value.

Such planning was given a boost in Rev.Rul. 2008-22 which provided that such a power, when properly structured, will not result in estate tax inclusion of the trust assets in the gross estate of the grantor. Thus, the advantages of grantor trust status can be obtained without the cost of estate tax inclusion.

However, if the trust involved is an irrevocable trust holding a life insurance policy, the use of a power of substitution has raised the issue whether gross estate exclusion will apply as to the life insurance policy or proceeds. More particularly, the issue has been whether such a power of substitution constitutes an “incident of ownership” by the grantor in the insurance policy that results in gross estate inclusion at death under Code §2042.

The IRS has now ruled that such a power of substitution will NOT create an incident of ownership in the grantor. Thus, such grantor trust planning will not be problematic for trusts owning life insurance.

Note that Crummey withdrawal rights in a beneficiary, which are often used in life insurance trusts, will not defeat grantor trust status as to the grantor.

In relying on the ruling, planners should attempt to come as close as possible to the facts of the ruling as practicable, including:

1. The grantor is not the trustee.
2. The trust terms prohibit the grantor from serving as trustee.
3. The grantor has no power to revoke, alter, amend, or terminate the trust.
4. The substitution power is exercisable in a nonfiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity.
5. The grantor must certify equivalent values when exercising the substitution power.
6. The trustee has a fiduciary obligation to confirm equivalent values on a substitution.
7. The trustee has a duty under local law to act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries, if there is more than one beneficiary.
8. The trustee has discretionary power to acquire, invest, reinvest, exchange, sell, convey, control, divide, partition, and manage the trust property in accordance with the standards provided by law.

Code §677(a)(3) provides that income of a trust that may be applied to premiums on a policy insuring the grantor’s life creates a grantor trust. That being the case, an argument can be made that another grantor trust power, such as a substitution power, is not needed to create a grantor trust. However, the benefit of this ruling is that there is some uncertainty regarding whether Code §677(a)(3) creates a fully grantor trust, or only a partial grantor trust equal to the amount of the insurance premiums.

Many life insurance trusts do not earn income, so grantor trust status may not be needed. However, at other times, grantor trust is desired. For example, the trust may be funded with other income earnings assets, to help pay premiums or to be used for other purposes. Also, grantor trust status may be desirable so as to allow the trust to be funded with noncash assets via a sale to a defective installment trust.

Rev. Rul. 2011-28, 2011-49 IRB 830, 12/01/2011

SPECIAL OFFSHORE COMPLIANCE RELIEF MAY BE COMING FOR CANADIAN ACCOUNTS

IRS compliance initiatives in 2010 and 2011 have focused attention on the U.S. requirements for disclosure of non-U.S. accounts, and the penalties that apply for nondisclosure. For the past 2 years, the IRS has provided special initiative mechanisms for late reporting that involve reduced penalties, or no penalties under some circumstances.

It looks as if there may be country-specific relief coming, with the first relief to come to U.S. persons with accounts in Canada, at least according to this article.

STATE TAX BURDENS

Bloomberg just published an article that does a state-by-state analysis of state tax burdens.

The 5 states with the highest state tax burdens are Connecticut, New Jersey, New York, Massachusetts, and Maryland (interestingly, all in the Northeast).

The 5 with the lowest burdens are Mississippi, South Carolina, Tennessee, Alabama, and Alaska. Many of these states nonetheless have both an income and sales tax.

Florida (my state) is considered a tax haven because it lacks an income tax and an inheritance tax. It apparently did not make the lowest 5 due to the significant real property taxes collected. The article noted the following about Florida:

Retirees have good financial reasons to flock to Florida. It has no state tax on Social Security, no tax on capital gains, and no inheritance tax. Revenue must come from somewhere, though, so property taxes per capita rank in the nation's top 10. Florida Governor Rick Scott pushed for major cuts to the corporate income tax rate and to state fees during the last fiscal year. The legislature passed more than $300 million of the cuts, including lower fees for a driver's license and car registration.

You can read the full report here.

THE FUTURE OF TRANSFER TAXES (WITH A DEMOCRAT CONTROLLED CONGRESS AND WHITE HOUSE)

For a view on what may happen to federal estate and gift taxes should President Obama be reelected and the Democrats win enough seats in Congress, tax a look at the recently introduced “Sensible Estate Tax Act of 2011.” A wish list of tax increases, the Act proposes:

• raising the maximum estate and gift tax rate, and the GST rate to 55%;
• lowering the applicable exclusion amount to $1 million. This would include indexing for inflation after 2012, but with adjustments going back to 2000;
• restricting valuation discounts on investment assets;
• restoring the state death tax credit;
• eliminating GST exemption benefits after 90 years;
• requiring a minimum 10 year term for GRAT’s.

Of course, the first of these items will occur automatically in 2013 under current law even without the passage of a new law.

EXPIRING 2011 TAX PROVISIONS–ON THE BUBBLE

There are a number of favorable business and individual tax provisions that will expire or be substantially reduced after 2011. Perhaps Congress may extend some or all of them, or perhaps not.

There is still one month left to make use of these items, so relevant taxpayers may want to get moving on these items, if they are of interest or relevance.

I have created an abbreviated list, in both map and list format, that highlights the most important of these items. Click here or go to http://db.tt/4MKpQQj8 to access it in your browser.

WHAT SPOUSES ARE GOOD FOR IN 2011 AND 2012

Lots of things, obviously! In context of tax and business, a number of specific items (not exhaustive), including:

a. Creditor protection via the special protections afforded by property held jointly as tenants by the entireties (in those states recognizing such tenancies and protections, such as Florida);

b. Use of gift splitting to double annual exclusion gift amounts to a specific beneficiary;

c. Use of two unified credit amounts to make larger gifts; and

d. Decontrolling entities for valuation reduction purposes.

But there is nothing special about those items for 2011 and 2012. What is special for these two years is the $5 million unified credit amount for gift and estate tax purposes. This is the highest amount by far ever permitted, and it is scheduled to revert to $1 million on January 1, 2013.

Many high net worth families will want to take advantage of all or a part of this high amount to make gifts free of estate tax before 2013. If such amounts are used to establish long-term trusts for family members and are properly structured for generation-skipping tax exemptions, dynasty trusts that can pass assets through several generations without incurring estate, gift or generation-skipping tax can established.

Many parents are not eager to establish trusts for children or grandchildren. It may be because they want to hold on to the subject assets in case needed for their own future living expenses if their circumstances change, or perhaps they don’t want to “spoil” their lineal descendants with a large trust for them while they are young.

The benefit of being married is that each spouse can create a gift trust, naming the other as the current beneficiary, instead of (or in addition to) a younger generation beneficiary. This trust need not require current distributions, so it can grow over time and eventually pass to the children or younger generations when the parents die. Importantly, the parents will have access to the funds if needed during lifetime, as beneficiary of each other’s trust.

The trusts can be grantor trusts, so that the spouses will be directly taxed on the income of each trust and allowing the trusts to grow in an income-tax free environment. The trusts can also use a formula funding clause and variable dispositive provisions based on QTIP treatment, to allow partial QTIP treatment and division, if funded with difficult-to-value assets. This avoids the risk of the IRS successfully challenging the values to create a taxable gift over the remaining unified credit if that credit amount is exceeded. It may also allow for more aggressive valuation planning on in-kind funding of the trust.

Care must be taken, however, to avoid the application of the reciprocal trust doctrine. This is not difficult to accomplish, as long as one is conscious of the need for such planning.

This type of planning is not without its drawbacks, but all-in-all it provides significant benefits. It should be considered by those families with spouses in the older generation that are planning to use all or a portion of the enhanced unified credit in 2011 and 2012.

GIFT CARDS AND CELL PHONES MAY HAVE TO BE DECLARED AT THE BORDER

Travelers entering or leaving the U.S. with more than $10,000 in “monetary instruments” have to file a Currency and Monetary Instrument Report (CMIR) with U.S. custom officials.

Due to concerns that prepaid cards are being used for money laundering and other criminal uses, new proposed rules will extend the definition of “monetary instruments” to include prepaid cards and gift cards, gift cards, and potentially even cell phones to the list of “monetary instruments” whose value must be declared upon entering or leaving the country. When the total exceeds $10,000, the individual would have to file a special report with customs officials.

Interestingly, the rules may be extended to cell phones that can be used to accomplish digital fund transfers.

Credit cards and debit cards, which are considered more visible to law enforcement, are exempt from the rule.

NEW ALTERNATE VALUATION DATE PROPOSED REGULATIONS

Taxpayers are permitted to use a value for estate tax return purposes that is six months after the date of death, instead of the date of death value (or at times, at dates after death but before six months). Code §2032. In 2008, the IRS published proposed regulations. Due to numerous issues raised with the proposed regulations, the IRS went back to the drawing board and has now issued new proposed regulations.

For those of you that would rather not read through them, a shortened summary can be downloaded here (click the link and then download from the box.net page that opens).