Rubin on Tax

PURCHASE PRICE ALLOCATIONS ARE BINDING ON THE BUYER

2012-02-01T16:23:00.001-05:00

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

2012-01-28T18:58:00.001-05:00

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

2012-01-26T19:23:00.001-05:00

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

2012-01-21T08:53:00.001-05:00

FOREVER IS A LONG TIME

2012-01-17T21:02:00.001-05:00

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

2012-01-15T12:20:00.001-05:00

[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

2012-01-11T20:08:00.002-05:00

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

2012-01-11T19:29:00.001-05:00

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

2012-01-10T22:09:00.001-05:00

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

2012-01-07T17:45:00.001-05:00

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

2012-01-04T19:48:00.001-05:00

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

2011-12-31T12:25:00.001-05:00

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

2011-12-25T08:50:00.001-05:00

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

2011-12-22T15:01:00.001-05:00

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

2011-12-21T20:00:00.000-05:00

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

2011-12-20T18:00:00.001-05:00

TIME TO RENEW PTIN’S

2011-12-18T18:01:00.001-05:00

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]

2011-12-15T15:50:00.001-05:00

[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

2011-12-13T21:45:00.001-05:00

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

2011-12-12T10:45:00.000-05:00

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

2011-12-10T10:09:00.001-05:00

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

2011-12-06T16:14:00.001-05:00

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:

The grantor is not the trustee.
The trust terms prohibit the grantor from serving as trustee.
The grantor has no power to revoke, alter, amend, or terminate the trust.
The substitution power is exercisable in a nonfiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity.
The grantor must certify equivalent values when exercising the substitution power.
The trustee has a fiduciary obligation to confirm equivalent values on a substitution.
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.
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

2011-12-04T15:41:00.001-05:00

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

2011-12-03T17:19:00.001-05:00

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)

2011-12-03T16:43:00.001-05:00

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

2011-11-30T18:45:00.001-05:00

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

2011-11-27T11:28:00.001-05:00

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

2011-11-22T13:51:00.000-05:00

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

2011-11-20T11:28:00.001-05:00

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).

APPLICABLE FEDERAL RATES–December 2011

2011-11-17T18:55:00.001-05:00

IRS ADDS GST TAX AVOIDANCE TO TAX SHELTER REPORTING & DISCLOSURE – DO WE CARE?

2011-11-13T11:23:00.001-05:00

The IRS has issued final regulations that add generation-skipping tax avoidance as reportable under the tax shelter reporting and disclosure rules. Do we care?

The short answer is “not yet.”

Promoting, advising taxpayers about, or participating in a transaction that is the same as or substantially similar to a transactions determined by IRS to be a tax avoidance transaction and a “listed transaction” triggers numerous disclosure and penalty rules. Taxpayers may need to disclose their participation and material advisors may need to disclose these transactions. Material advisors also must maintain lists of advisees and other information with respect to these listed transactions. “Transactions of interest” are included in reportable transactions. These are transactions that IRS believes have potential for tax avoidance or evasion, but for which it lacks enough information to determine whether they should be identified specifically as tax avoidance transactions.

The final regulations finalize proposed regulations that include GST taxes as coming under this rules. It is the position of the Dept. of the Treasury that the changes were “corrective,” not “expansive.”

The reason we don’t care yet is that there are no transactions on the IRS “listed transaction” list or the “transactions of interest” list that involve generation-skipping taxes. Therefore, the rules will only be relevant if the lists are expanded to include transactions involving GST taxes in the future.

Objections to the expansion were raised by persons representing corporate fiduciaries – that they would be subject to reporting as a material advisor simply by being a trustee or a personal representative when a reportable transaction was undertaken by a trust or estate. In response to those comments, Treasury noted that a “fiduciary will not be treated as a material advisor merely by acting as an executor or trustee with respect to an estate or trust that is incidental to a transaction. A fiduciary will be treated as a material advisor only if the fiduciary provides material aid, assistance or advice as described in § 301.6111-3(b)(2), the fiduciary directly or indirectly derives gross income in excess of the threshold amount as described in § 301.6111-3(b)(3), and the transaction is entered into by the taxpayer.”

T.D. 9556, 11/10/2011; Reg. § 26.6011-4, Reg. § 301.6111-3, Reg. § 301.6112-2

POST-NUPTIAL AGREEMENT TRAP

2011-11-10T16:10:00.001-05:00

A recent Florida appellate court decision bears review by practitioners drafting post-nuptial agreements.

The case involved a husband who provided for assets to pass to his wife in his Last Will. After the Will was signed, the spouses entered into a post-nuptial agreement. The husband then died while the parties were still married. The probate court determined that the gift to the wife was waived by the wife under the agreement, and thus she could not inherit the gifted property. It appears that the husband had children from a prior marriage, and it was the husband’s prior wife who challenged the gift to the surviving spouse in favor of her minor children with the decedent.

Let’s assume that the terms of the agreement, in conjunction with Fla.Stats. §732.702(1), constituted a waiver of rights by the surviving spouse of her rights under the Will - this is what the probate court and the appellate court found. This is an interpretative issue.

The more interesting part of this case was the effect of the following common clause that was in the post-nuptial agreement:

Notwithstanding the terms of this Agreement, either party shall have the right to voluntarily transfer or convey to the other party any property or interest therein, whether Separate Property or other property, which may be lawfully conveyed or transferred during his or her lifetime, or by will or otherwise upon death. Neither party intends by this Agreement to limit or restrict in any way the right and power of the other to receive any such voluntary transfer or conveyance. Such gifts shall not constitute an amendment to or other change in this Agreement, regardless of the extent or frequency of such gifts. Any gifts given by one party to the other hereafter shall constitute the receiving party’s separate property.

The first two sentences of this clause clearly authorized the husband to make a valid and effective gift to the wife in his Last Will. However, the courts found that the term “hereafter” in the last sentence meant that only a Will signed AFTER the post-nuptial agreement would be given effect.

This is a strained reading of that clause. The purpose of such clauses is to establish the property rights of the spouses in various property, but to allow for the parties to make their own voluntary transfers to the other spouse if they want. Whether those transfers are set out in a Will that predated the agreement seems irrelevant, and a trap for unwary spouses (and their counsel). That the Will doesn’t take effect until the post-agreement death of the spouse further suggests that the date of the Will should not matter.

Further, all the last sentence appears to be doing here is characterizing gifts as “separate property” under the Agreement. This makes sense – if an inter vivos gift was made, it would be appropriate to treat that as the separate property of the recipient spouse that cannot be reached by the other spouse per the terms of the agreement relating to separate property. It does not appear to be designed to address any testamentary transfer issues – how would the label “separate property” in the hands of a surviving spouse have any relevance to anything?

How would this principle be applied to other testamentary transfers, such as a revocable trust or beneficiary designation made before the marital agreement? Would a post-agreement codicil addressing other dispositions or Will terms eliminate the pre-agreement character of the gift? Is this a narrow case that is dependent on the “hereafter” wording in the above clause, or is it of broader import that may have precedential value in all prenuptial and postnuptial situations?

Of course, in the future, agreements can be drafted with terms that specifically address pre-existing dispositions between the spouses. Alternatively, pre-existing dispositions can be redone post-agreement. However, such technical solutions are apt to be overlooked in many circumstances.

Steffens v. Evans, 4th DCA (Case No. 4D10-2467), October 5, 2011

TICK, TOCK, WILL CONGRESS SPEED UP THE GIFT TAX CLOCK?

2011-11-09T18:01:00.001-05:00

As part of the 2010 budget showdown, the unified credit equivalent for federal gift taxes was bumped up to $5 million for 2011 and 2012. In 2013, the amount will be reduced down to $1 million with the expiration of the Bush tax cuts, unless Congress and the President act to modify that amount. What this means is that high net worth taxpayers only have until the end of 2012 to take advantage of the $5 million exemption.

Or do they? About a month ago, rumors started that the Congressional budget “Super Committee” that is tasked with producing budget cuts to Congress by November 23 was considering a reduction in the exemption to $1 million. What was once a trickle is now becoming a torrent of newsletters and warnings regarding the possible reduction with an effective date of November 23.

So far, I have not seen anything from official sources on this. Personally, I find it hard to swallow that the Republicans on the Super Committee would accept this, but of course, anything is possible in Washington D.C. Even if a change is contemplated, there is no certainty that the effective date would be on November 23 – it could be before or after that.

AT THE INTERSECTION OF MEDICINE AND TAX LAW

2011-11-04T14:35:00.001-05:00

Medicine and tax law are two distinct fields. However, when tax law allows a deduction for expenditures relating to disease, tax lawyers and courts have to apply medical concepts.

Code §213 allows a deduction for medical expenses if paid for the diagnosis, cure, mitigation, treatment or prevention of disease. Cosmetic surgery doesn’t come under his unless related to a congenital abnormality, personal injury, or a disfiguring disease.

Do expenses for hormone therapy and sex reassignment surgery relate to a disease, so that they are deductible?

In O'Donnabhain, 134 TC 34 (2010), the Tax Court allowed the deduction for some of these items. It was able to do this by locating a disease – here, “sever gender identity disorder.” What likely tipped the scale was that such an order is listed in the Diagnostic and Statistical Manual of Mental Disorders. That is published by the American Psychiatric Association. In other words, it had enough scientific recognition to be a “disease.”

The Tax Court allowed deductions for expenses of hormone therapy and sex reassignment surgery. However, expenses relating to breast augmentation surgery were found to be cosmetic only and therefore nondeductible. For some reason, below the belt surgery was deemed noncosmetic and above the belt surgery was cosmetic. We won’t dwell on the legitimacy of that distinction, nor the applicable mental images – the opinion does have something of an involved discussion of this issue.

The IRS initially opposed the Tax Court’s determination. However, it has now acquiesced and says it will follow the decision.

AOD 2011-03, 11/2/11

DISREGARDED ENTITIES AND EMPLOYMENT TAXES–FURTHER REFINEMENTS

2011-11-01T15:35:00.001-05:00

A recent post noted that disregarded entities are not treated as disregarded for employment tax purposes, but are instead treated as corporations. This special treatment came into effect in 2009, and the treatment as a corporation was specifically provided for recently.

Some wage payments are exempt from FICA and FUTA taxes. For example, services performed by a child under the age of 18 in the employ of his father or mother is not considered employment for FICA purposes. Code §3121(b)(3)(A). Services performed by an individual under the age of 21 who is employed by his father or mother, or performed by an individual employed by his spouse or son or daughter (subject to certain conditions) for domestic service in a private home of the employer is not considered employment for FICA purposes. Code §3121(b)(3)(B). Services performed by an individual in the employ of his son, daughter, or spouse, and service performed by a child under the age of 21 in the employ of his father or mother, are not considered employment for FUTA purposes. Code §3306(c)(5).

If the employer is a disregarded entity owned by an employer described in one of the preceding exemptions, the treatment of the employer as a corporation and not a disregarded entity for employment tax purposes acts to convert exempt wages to taxable wages for FICA and FUTA taxes. In recognition of this problem, the IRS has issued temporary Treasury Regulations that will allow the exemptions to continue to apply in this circumstance. Essentially, they provide a partial exception to the nondisregarded entity treatment applied to otherwise disregarded entities for employment tax purposes – yes, quite a mouthful.

The new regulations also confirm that information reporting and backup withholding is applied to the owners of disregarded entities, and more specifically, that the disregarded entities themselves are relieved of such obligations.

Treas. Regs. §§31.3121(b)(3)-1T(e) , 31.3127-1T(d) , 31.3306(c)(5)-1T(e) , and 301.7701-2T(e)(5)

DISREGARDED ENTITIES ARE NOT ALWAYS DISREGARDED

2011-10-29T10:09:00.001-05:00

Under the check the box rules, entities owned by one person can often be disregarded for federal tax purposes. Such entities are referred to as "disregarded entities."

As time has progressed since the passage of the check the box rules, the IRS has created more and more exceptions to the disregarded treatment. For example, disregarded entity status is ignored or modified in regard to employment and withholding taxes of a disregarded entity.

The IRS has now issued final treasury regulations that provide that an entity whose disregarded status is ignored for employment tax purposes will be treated as a corporation. Treas. Regs. §301.7701-2(c)(2)((iv)(B).

It would be helpful to put in one place the several exceptions that now exist to disregarded entity status. The following is a summary of the principal exceptions, but is not intended to be exhaustive. If any readers think I have missed anything major, please feel free to comment to this posting and let us know what the item is.

A. Status is modified if the single owner of the entity is a bank. Treas. Regs. §301.7701-2(c)(2)(iii).

B. Status is modified for certain tax liabilities. Treas. Regs. §301.7701-2(c)(2)(iii). These include: (1) federal tax liabilities of the entity with respect to any taxable period for which the entity was not disregarded; (2) federal tax liabilities of any other entity for which the entity is liable; and (3) refunds or credits of federal tax.

C. Disregarded status ignored or modified for taxes imposed under Subtitle C—Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24, and 25 of the Internal Revenue Code) and taxes imposed under Subtitle A, including Chapter 2—Tax on Self-Employment Income. Treas. Regs. §301.7701-2(c)(2)(iv)(A).

D. Status is modified for certain excise taxes, as described in Treas.Regs. §301.7701-2(c)(2)(v). Although liability for excise taxes isn't dependent on an entity's classification, an entity's classification is relevant for certain tax administration purposes, such as determining the proper location for filing a notice of federal tax lien and the place for hand-carrying a return under Code §6091 .

E. Conduit financing proposed regulations will treat a disregarded entity as separate from its single member. Code §7701(l).

F. Special rules will apply in hybrid situations. Hybrid situations are circumstances where an entity is not disregarded in one jurisdiction but is disregarded in another.

(1) Hybrid payments made between a CFC and its hybrid branch, or between two hybrid branches of a CFC, would be recharacterized as subpart F income in the same amounts, if the conditions of the regulations are met. Those conditions are as follows: (1) the hybrid branch payment reduces the foreign tax liability of the payer; (2) the payment would have been FPHC income if paid between two CFCs; and (3) a disparity exists between the effective rate of tax on the payment in the hands of the payee and the hypothetical rate of tax that would have applied if the payment had been taxed to the payer. If no tax rate disparity exists, no recharacterization would occur. Proposed Regulations under TD 8827, 1999-30 IRB 120.

(2) In certain cases, payments made by domestic reverse hybrid entities to related foreign interest holders are recharacterized as a dividend. Such payments are recharacterized as dividends to the extent of the interest holder's proportionate share of payments by the domestic entity to the domestic reverse hybrid entity that are treated as dividends by either jurisdiction. The recharacterization as a dividend means that the payments cannot be deducted by the domestic reverse hybrid entity. This prevents the use of a domestic reverse hybrid entity to make deductible payments to the foreign interest holder that are taxed at lower withholding tax rates. Treas.Reg. §1.894-1(d)(2)(ii)(B).

(3) Special rules relating to allocation of foreign tax credits. Prop.Regs. §1.901-2(f)(3).

NO SURPRISE HERE

2011-10-23T16:45:00.002-05:00

There has been quite a bit of buzz about a recent bankruptcy case involving an Alaska asset protection trust. However, the case merely confirms a weakness in the use of domestic asset protection trusts that was obvious even before this case.

Domestic asset protection trusts (DAPTs) promise the holy grail of creditor protection – a trust where the settlor/grantor can transfer assets to, be a discretionary beneficiary of, but still have the assets of the trust be protected from the settlor’s/grantor’s creditors. Alaska, Delaware, and Nevada are three popular jurisdictions for these trusts.

There are open questions about the effectiveness of the trusts for creditor protection purpose, including enforceability across state lines under the U.S. Constitution. A major issue is the 10 year voidability provision of 11 U.S.C. §548(e) that entered the U.S. Bankruptcy Code in 2005. That provision provides that a trustee in bankruptcy can reach the assets a debtor transferred to a trust:

that was made on or within 10 years before the date of the filing of the petition, if –

(A) such transfer was made to a self- settled trust or similar device;
(B) such transfer was by the debtor;
(C) the debtor is a beneficiary of such trust or similar device; and
(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

A transfer to a DAPT will typically meet the requirements of (A)-(C) above. The big question is whether a transfer to a DAPT demonstrates the requisite “actual intent to hinder, delay or defraud” under (D). Since DAPTs were created to address creditor issues, and are marketed as providing that benefit, a reasonable person would suspect that the use of one demonstrates the actual intent to hinder, delay or defraud, even if the settlor was not rendered insolvent by reason of the transfer. Note, however, that Alaska law expressly provides that a settlor’s expressed intent to protect trust assets from a beneficiary’s potential creditors is not evidence of an intent to defraud.

In Battley v. Mortensen, a bankruptcy court in Alaska found that a transfer to a DAPT could run afoul of 11 U.S.C. §548(e), even though the debtor was solvent at the time of creation of the trust. The court noted:

when property is transferred to a self-settled trust with the intention of protecting it from creditors, and the trust’s express purpose is to protect that asset from creditors, both the trust and the transfer manifest the same intent. In this case, I found that the trust’s express purpose could provide evidence of fraudulent intent.

The court did not give any effect to the provision of Alaska law that indicated the trust language could not be used as evidence of an intent to defraud. There were other factors that the court found that evidenced intent to defraud, so it is uncertain how the court would have ruled absent those other factors.

Nonetheless, the case confirms the exposure that the use of a DAPT leaves the door open to the reach of a trustee in bankruptcy within 10 years of the funding of the trust. Since a debtor can be placed in bankruptcy by his creditors on an involuntary basis, one cannot simply avoid this exposure by not filing for bankruptcy protection.

DAPTs are still useful for those that do not expect to have significant creditor issues within the next 10 years, but are in a high risk field and thus still desire its protections over an extended period beyond 10 years. Further, DAPTs can provide tax benefits via moving assets out of the taxable estate of a grantor while still allowing a discretionary beneficiary interest to the grantor. Nonetheless, in these circumstances, the constitutional issues regarding DAPTs still remain.

Battley v. Mortensen, Memorandum Decision & Memorandum on Defendant’s Motion for Reconsideration (Case No. A09-00565-DMD, United States Bankruptcy Court, D. Alaska)

DETAILED PROTECTIVE REFUND CLAIM GUIDANCE RELEASED

2011-10-22T08:14:00.001-05:00

The IRS has released detailed guidance to taxpayers on how to file and administer protective refund claims for amounts that are not currently deductible under Code Section 2053 when the Form 706 is filed (such as contested or uncertain claims and expenses that have not yet been paid). As part of its guidance, the IRS announced that it will create a Schedule PC to be attached to the Form 706 to assist taxpayers in filing these protective claims at the time of filing of the Form 706.

FACTS

Final regulations under Code Section 2053 were published on October 20, 2009 to provide guidance in determining the deductible amount of a claim against a decedent's estate, particularly in regard to contested or uncertain claims and expenses. The final regulations provide, with certain exceptions, that the amount deductible for a Code Section 2053 claim or expense is limited to the amount actually paid in settlement or satisfaction of that claim or expense. For amounts not paid or otherwise deductible by the time the Form 706 is filed, the Regulations allow a protective refund claim to be filed. This allows for a refund to be sought later if amounts are paid or become deductible after the expiration of the estate tax statute of limitations. Rev.Proc. 2011-48 provides details on how to file and administer protective refund claim.

TIMING. The protective refund claim must be filed before the expiration of the Code Section 6511(a) statute of limitations. This is 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid.

CONTENT OF PROTECTIVE CLAIM. The protective claim must be a written declaration that is executed under penalties of perjury, listing each ground upon which a refund is claimed and facts sufficient to apprise the Commissioner of the exact basis of the claim. Required information includes:

a. An explanation of the reasons and contingencies delaying the actual payment to be made in satisfaction of the claim or expense.

b. Information on whether other protective claims for refund are being filed or were previously filed and the approximate date on which each was filed.

c. If the claim is being contested, specified information about the contested matter and the potential liability of the estate.

EVIDENCE OF AUTHORITY. The protective claim must be accompanied by documentary evidence, including certified copies of the letters testamentary, letters of administration, or other similar evidence, to establish the legal authority of a fiduciary or other person to file and pursue a protective claim for refund on behalf of the estate of a decedent. However, if the protective claim is filed by same person that submitted the Form 706, the only thing needed is a statement affirming that the fiduciary or other person filing the protective claim for refund also filed the Form 706 and that such fiduciary or other person is still acting in a representative capacity.

WHICH FORM TO USE. For decedents dying after October 19, 2009, and before January 1, 2012, the claim is filed using Form 843. For decedents dying on or after January 1, 2012, the claim can be filed on a Form 843, or on a Schedule PC filed with Form 706. This Schedule does not yet exist, but should simplify the process for making a protective claim if made at the time of the Form 706 filing.

SEPARATE CLAIM REQUIREMENT. A separate claim filing is required for each claim or expense for which a deduction may be sought. Multiple Schedules PC should be used, if making the claims with the Form 706 filing.

Related and ancillary expenses relating to resolving, defending, or satisfying the identified claim or expense as well as certain expenses relating to pursuing the claim for refund for the identified claim or expense are not considered separate claims for this purpose, but are included in the separate claim to which they relate.

REJECTION PROCEDURES. If a protective claim filing is rejected by the IRS, a corrected (and signed) protective claim for refund can be refiled before the expiration of the period of limitation or within 45 days after the date of the Service's notice of the defect, whichever occurs later. Thus, a defective election filed shortly before the expiration of the statute of limitations should have an opportunity to cure even though the statute runs out before receiving the Service’s rejection.

FOLLOW-UP REQUIREMENTS. The IRS will generally accept or reject filed protective claims, and notify the taxpayer. The taxpayer should contact the IRS if no IRS acknowledgment of the protective claim filing is received within 180 days of filing a Schedule PC or 60 days of filing a Form 843. If such taxpayer contact is not made within 30 days of the applicable deadline, an estate will lose the ability to correct a defective claim if the statute of limitations has expired (even if the estate has proof of mailing the protective claim to the IRS).

NOTIFICATION OF RESOLUTION OF CONTINGENCIES. To obtain a refund, the taxpayer must notify the IRS when the claim is ready for consideration (that is, once deductibility is permitted by reason of payment or otherwise meets the regulatory requirements for deduction). The notification generally should describe the relevant facts that support, and provide evidence to substantiate, a deduction under Section 2053 and should claim a refund of the overpayment of tax based on the deduction under Section 2053 and the resulting recomputation of the estate tax liability.

This notification must be submitted within a "reasonable period" after the item becomes deductible. There is a 90 day safe harbor that will meet the “reasonable period” requirement. If filed later, a reasonable cause explanation must be submitted. Special rules apply for multiple or recurring payments.

The Revenue Procedure provides specific information on what must be included in the notification, and whether the notification must be made on a Supplemental Form 706 or a Form 843.

MISC. The existence of a protective claim will not affect Form 706 audits. The new rules are applicable with respect to protective claims for refund filed on behalf of estates of decedents dying on or after October 20, 2009.

COMMENT

The drafters of the Revenue Procedure should be commended for providing detailed and precise rules to address most of the basic protective claim filing issues.

The ability to make a protective claim on a Schedule PC on the Form 706 is especially welcomed. This will make it easier for taxpayers to comply with the requirements. Also, it will help taxpayers avoid inadvertently missing the statute of limitations deadline for submitting the protective claim. Presently, many estates will defer filing a protective refund claim, instead adopting a wait-and-see attitude to see if claim and expense issues resolve themselves before the statute of limitations expires and hopefully avoiding the bother of a Form 843 filing. By easing the process for filing the protective claim, more taxpayers should take advantage of the procedure at the time the estate tax return is filed and thus avoid missing the deadline later. Indeed, the existence of the Schedule PC will likely educate some preparers that might not be knowledgeable of the protective claim procedure of its availability.

Note that some claims are deductible, even if not paid when the Form 706 is filed. These include executor and attorney fees (Treas. Regs. §20.2053-1(d)(4)), claims against the estate relating to property or claims included in the gross estate (Treas. Regs. §20.2053-4(b)), and claims not totaling more than $500,000 (Treas. Regs. §20.2053-4(c)). Taxpayers may still want to file a protective claim for additional amounts not reported on the Form 706 or that do not meet the foregoing statutory requirements. There is a trap, here, since the Revenue Procedure requires that such protective claims, in addition to meeting the regular protective claim requirements, the taxpayer must also disclose the amount of the deduction already claimed on the Form 706 for the subject claim or expense and must reference the regulatory provision under which the deduction was claimed. See §4.05(4) of the Revenue Procedure.

For more information regarding when uncertain or contested claims and expenses can be deducted under the Code Section 2053 regulations, I refer readers to my article on the subject in the March 2010 Journal of Taxation.

Rev. Proc. 2011-48

[This article will also be published on Leimberg Information Services, Inc.]

APPLICABLE FEDERAL RATES–NOVEMBER 2011

2011-10-20T17:11:00.001-05:00

HERMAN CAIN’S 9-9-9 TAX PLAN IS REALLY JUST A FANCY 25.38% NATIONAL SALES TAX

2011-10-19T10:11:00.001-05:00

According to the Tax Policy Center, presidential candidate Herman Cain’s 9-9-9 tax plan is essentially three sales taxes.

Obviously, the 9% national sales tax component is just that – a retail sales tax.

The business tax component is effectively a subtraction method value-added tax, or a business transfer tax. It is a 9% tax on all sales minus purchases from other businesses. It is the same as a retail sales tax, but it is collected in pieces on the value added at each stage of production. In the aggregate, all retail sales are then taxed under this component.

The 9% individual flat tax is also a subtraction method value-added tax, except that businesses may deduct wages and workers are taxed on their wages. A charitable contribution deduction may be allowed.

The plan has the merits of a certain level of simplicity, the removal of various tax regimes (such as estate and gift taxes) and the spreading of the tax burden. It has the detriments of a lack of progressivity (if you consider that a detriment based on your political beliefs, although persons below the poverty line are exempted from the taxes), being a disincentive to consumer purchasing, and the introduction of a tax regime (the VAT) that many blame for the anemic economies of Europe.

Whatever its pros and cons, this is the first I have seen it characterized as being effectively a combined 25.38% national sales tax (which would be in additional to state and local sales taxes).

TAX POLICY CENTER ANALYSIS

SHAM PARTNERSHIP STRIPS PARTNER OF DESIRED LOSSES

2011-10-16T10:14:00.001-05:00

A recent case before the 5th Circuit Court of Appeals provides an instructive illustration of a sham partnership.

A condensed version of the facts are as follows (with some liberties taken to keep this simple):

1. LLC formed, with Chinese government-owned financial institution (Cinda) and a 1% third party. Cinda contributes $1.1 billion portfolio of nonperforming loans. A U.S. investor (Beal) contributes $180 million of GNMA securities to the LLC and buys 90% of Cinda’s interest from Cinda for $19.4 million. Lots of strings are tied to the LLC’s ability and economic benefits from the GNMA securities, all running to the benefit of Beal.

2. The loans are carried on the LLC books at a tax-loss, since Cinda invested much more into them than current value. Normally, when these losses are realized by the LLC, they would be allocated back to Cinda under Section 704(c). However, by buying most of Cinda’s interest, Beal now gets the benefit of most of the losses when they arise. Since he obtained a large basis in the LLC via his investment of the GNMA securities, he has a large basis against which to use the losses.

3. The LLC operates, and losses are generated and allocated to Beal. Cinda, who is responsible for servicing the loans, does a terrible job, and in fact threatens to bring the matter to the IRS if the LLC and Beal don’t stop bothering it about its failure to properly service the loans. The LLC and Beal back down, and indeed do another deal with Cinda.

The IRS sought to challenge the losses taken by Beal. The court affirmed the lower court that the acquisition of the loans had economic substance. Unfortunately for the taxpayer, the court also affirmed a finding that the LLC was a sham partnership. Beal was instead treated as having bought the loans directly and receiving a tax basis equal to what he paid – and thus lost the ability to deduct Cinda’s losses (as successor partner to Cinda) on the loan portfolio.

Under the Supreme Court’s decision in Culbertson, whether a partnership will be respected for tax purposes depends on whether “the parties in good faith and acting with a business purpose” genuinely “intended to join together for the purpose of carrying on the business and sharing in the profits and losses.” This determination is made in light of all the relevant facts and circumstances. The appellate court focused on three particular aspects of this test.

LACK OF AN INTENT TO JOIN TOGETHER. At first, it does appear that the partners intended to operate a joint venture to make a profit on collecting the nonperforming loans. However, when the partners failed to force Cinda to fulfill its functions as loan servicer (after Cinda threatened to disclose the transaction to the IRS), the court determined that the tax benefit was the real purpose of the transaction, not the potential profits from loan collections. It also did not help that Cinda obtained regulatory approval for the transaction by indicating that its retained 10% LLC interest was only “symbolic” and characterizing its transaction as a “package sale of bad debts.”

LACK OF INTENT TO SHARE PROFITS AND LOSSES. Again it first, such an intent appears – Beal did after all contribute $180 million of GNMA securities to the LLC which were at risk of loss. However, by retaining the rights to income, and controlling the use and disposition of funds and the securities themselves, the court found that Beal personally received all of the potential benefits from those securities and retained all of the risks. Even though Cinda could benefit from appreciation in those securities, Beal’s ability to control any sales of the securities substantially diminished any chance of Cinda benefitting in this manner. Thus, there was a lack of intent to share profits and losses.

LACK OF A BUSINESS PURPOSE. This question focused on whether there was a non-tax need to form the LLC to profit from the nonperforming loans investment – or whether it was all about tax benefits. The taxpayer raised six reasons why an LLC was needed, but the court did not buy into any of them.

Thus, the court found that Beal directly purchased the loans from Cinda. The LLC was ignored, and the loss benefits predicated on the partnership form, disappeared.

The court did not impose any penalties on the taxpayer based on tax opinions obtained from a law firm and an accounting firm that the taxpayer relied on.

SOUTHGATE MASTER FUND, L.L.C. v. U.S., 108 AFTR 2d 2011-XXXX, (CA5), 09/30/2011

MORTGAGE INTEREST DEDUCTION ALLOWED, EVEN WITHOUT A RESIDENCE

2011-10-10T18:13:00.001-05:00

Section 163(h) of the Code allows a deduction for qualified residence interest. This is interest paid or accrued on acquisition indebtedness with respect to any qualified residence of the taxpayer (or home equity indebtedness), subject to maximum debt limits.

A "qualified residence" is the principal residence of the taxpayer, and one other residence used by the taxpayer as a residence.

In a recent Tax Court case, a taxpayer purchased land, upon which he was going to build a residence. He took out a mortgage loan to buy the property. He then started the design and approval process to build the residence. Two years after, everything was set for construction to begin. However, because of the decline in the real estate market, the taxpayer could not obtain financing for additional funds needed for construction. The house was never built and the taxpayer eventually sold the land (for a large loss).

The taxpayer deducted the interest he paid on the mortgage loan for two years as qualified residence interest. The IRS disallowed the deductions, claiming that there was never a "qualified residence."

The Tax Court sided with the taxpayer and allowed the deduction, even though the residence was never built. The key provision allowing deductibility was Treas.Regs. Section 1.163-10T(p)(5) which allows a taxpayer to treat a residence that is UNDER CONSTRUCTION as a residence for up to 24 months after construction has begun. The Court did not care that the residence was never completed. In effect, it would be illogical for the deduction to be ultimately determined on whether a residence is built, since the deduction that is allowed for the 2 year construction period would have to be taken on a return oftentimes before it is known whether construction will be completed. This would violate the principle that each tax year stands on its own.

The court was also generous with the term "construction." It held that construction began even before the taxpayer acquired the land, since the taxpayer required the seller to demolish an old house on the lot and clear the land before closing. Further, taxpayer's permitting process was also considered to be construction.

Rose v. Commissioner, T.C. Summary Opinion, 2011-117

SETTLEMENT ALLOCATION PRINCIPLES, IN ACTION

2011-10-08T10:53:00.001-05:00

When amounts are paid in settlement of litigation, different tax consequences can apply based on what the payments are for. For example, punitive damages will typically generate ordinary income for the recipient, while payments for damage to goodwill can generate capital gain. Such differing tax consequences bring about taxpayer efforts to characterize payments in the manner most favorable to them.

Two principles are important in determining whether the IRS will respect an agreed-upon characterization of settlement proceeds.

The first is the origin of the claim doctrine, under which the tax treatment of the proceeds of a settlement or judgment will depend on the nature of the claims made and the actual basis of the recovery. The tax consequences of a settlement depend on the nature of the claim that was the basis for the settlement, rather than the validity of the claim.

The second is that the IRS will be more likely to respect a settlement allocation of the parties if they have adverse interests as to that characterization. If one party is indifferent to the allocation, or both parties obtain tax advantages from the same characterization, the risk of IRS challenge is heightened.

A recent Tax Court case demonstrates the real world application of these principles. The case involved the settlement of a lawsuit for false advertising, unfair competition, and trademark dilution, with damages relating to loss of goodwill and reputation, lost profits, and punitive damages.

ORIGIN OF THE CLAIM. The Tax Court determined that the character of the settlement proceeds paid was to be allocated among the various claims made, in accordance with the origin of the claim doctrine. The parties characterized only a relatively small portion of the settlement to lost profits (an item which would produce ordinary income and not capital gain to the recipient) and no portion to punitive damages (another ordinary income item). Under the origin of the claim doctrine, the settlement proceeds should have been allocated among all the claims made.

ALLOCATION AMONG CLAIMS – NO ADVERSE INTERESTS. The court determined that the parties’ allocation was suspect since the payor was generally indifferent to the characterization (and the payee would benefit from allocations away from ordinary income items). Thus, the parties did not have an adverse interest to each other and their allocation was subject to much higher scrutiny. As to the punitive damages question, the taxpayer pointed out that the payor was against paying punitive damages and was not indifferent, since it would put the payor in a bad light and implied wrongdoing. Thus, the implied argument was the allocation away from punitive damages was not collusive and done solely to avoid ordinary income for the recipient, but was a bargained for element by the payor and was perhaps sought but compromised away by the recipient. This was an interesting argument, but the Tax Court did not buy into it since the payor was agreeable to the amount to be paid for punitive damages but just didn’t like the label applied.

An important aspect of this case is that just because the settlement arises from a bona fide dispute involving unrelated and truly adverse parties, the parties cannot count on IRS acceptance of a damages allocation unless the parties have adverse interests over the allocation itself. The type of adversity that most impresses courts in these circumstances is where a given type of payment produces a tax negative for one party while producing a better tax result for the other – that was not the situation here.

ALLOCATION AMONG CLAIMS – THE SEARCH FOR OBJECTIVE EVIDENCE. The origin of the claim doctrine does not provide any direct guidance on how to allocate settlement proceeds among various claims when there is more than one. In this situation, one can expect taxpayers, the IRS, and courts, to search for objective guidelines to use in the allocation. Such objective guidelines may not always exist – however, in the instant case they did. The lawsuit at issue was actually the second lawsuit arising from similar facts and claims. Since the original lawsuit was tried and a judgment was made by a jury that allocated the damages, the Tax Court used the percentage allocations from that case and applied them to the settlement.

ALLOCATION AMONG CLAIMS – OTHER HELPFUL ASPECTS. Taxpayers seeking to uphold an allocation that does not involve truly adverse issues should look long and hard for some methodology or expert opinion to help backstop their allocation. Such contemporaneous methodology and analysis will put the taxpayer in a better defensive position than the parties simply agreeing on an allocation with no methodology or analysis to justify it.

Healthpoint, Ltd, et al, TC Memo 2011-241

IRS TEMPTS EMPLOYERS WHO HAVE BEEN MISCLASSIFYING EMPLOYEES

2011-10-02T12:20:00.001-05:00

Employers have a strong withholding and employment tax incentives to classify their workers as independent contractors instead of employees. Such a course avoids income tax withholdings and FICA, FUTA, and Medicare taxes and withholdings, shifting responsibility of such items to the worker.

As such, employers may have aggressively or inappropriately classified employees as independent contractors. An IRS settlement program known as the “Voluntary Classification Settlement Program,” or VCSP, provides a semi-painless way for employers to correct their classifications and come into the fold of compliant taxpayers. A recent set of FAQs provides details on the new program. Below is a summary of the key provisions.

WHO CAN USE THE PROGRAM?

Businesses, tax-exempt organizations, and government entities.

BASIC ELIGIBILITY REQUIREMENTS

To be able to apply, the employer must:

(1) have consistently treated the subject workers as nonemployees,

(2) have filed all required Forms 1099 for the workers for the previous three years, and

(3) not be under audit by IRS, or currently under audit concerning the classification of the workers by the Department of Labor or a state government agency.

EFFECT OF PROGRAM

The employer will have to pay a relatively small sum to enter the program, but will then receive absolution for its mischaracterizations for past years. More particularly, the employer will:

(1) owe 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, applying the special reduced rates of Code Section 3509, and without interest or penalties being imposed on that liability,

(2) be safe from an employment tax audit for the worker classification of the subject workers for prior years, and

(3) have to agree to extend the period of limitations on assessment of employment taxes for three years for the first, second and third calendar years beginning after the date on which the taxpayer has agreed under the VCSP closing agreement to begin treating the workers as employees.

Of course, the employer will begin classifying the subject workers as employees and paying appropriate employment and withholding taxes.

Given the relatively small amount that is due, the program provides an excellent opportunity for taxpayers to put themselves into compliance. In an example provided in the FAQ, an employer who paid $1,500,000 to workers in the subject tax year owed only $16,020 for the required 10% payment.

Application for the program is made on Form 8952, Application for Voluntary Classification Settlement Program. More information on the VCSP is available in Announcement 2011-64.

Voluntary Classification Settlement Program (VCSP) Frequently Asked Questions

REPORTING OF INTERESTS IN MEXICO FEDEICOMISOS

2011-09-28T17:34:00.001-05:00

U.S. residents, and other nonresidents of Mexico, are restricted from owning certain real estate in Mexico. The Mexican Constitution prohibits foreigners from purchasing or owning real estate within 60 miles of an international border or within 30 miles of the Mexican Coast.

To facilitate foreign ownership, Mexico law allows for foreign persons to own property through a fideicomiso. A fideicomiso is a Mexico trust arrangement under which a Mexico bank acquires title to the real property, and foreigners own the beneficial interest.

A recently released letter from the Office Chief Counsel warns that such arrangements may constitute foreign trusts for U.S. tax purposes, and thus may trigger Form 3520 and 3520-A filing requirements for U.S. beneficiaries. Interestingly, the letter does not conclude one way or the other whether a fideicomiso will be treated as a trust, only that it may be. The taxpayer recipient of the letter was instructed to review Regs. Section 301.7701-4 for the definition of a trust for U.S. tax purposes, and Code Section 7701(a)(31)(B) and the Regulations thereunder for whether a trust is foreign.

There is a reasonable possibility that many fideicomisos will meet the regulatory definition of a trust (at least in the opinion of the IRS), even though common law trusts are not a regular feature of Mexico law. The Regulations define a trust as:

…an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.

Further, if a fideicomiso is considered a trust, it should then be considered a foreign trust, at least if a Mexico bank serving as trustee.

However, one may be able to argue that a fideicomiso is more akin to a “business trust” which is subject to taxation as a business entity under Regulations Section 301.7701-4(b).

Some facets of U.S. reporting of interests in foreign trusts only apply if distributions are made to U.S. beneficiaries. However, rent-free use of trust properly can be treated as a distribution to a beneficiary, so this is a reporting trap for many if the fideicomiso is characterized as a foreign trust since most beneficiaries will not be paying rent to use the Mexico property.

The actual income taxation of the U.S. beneficiaries will depend on whether the trust is a grantor trust or a nongrantor trust (or, of course, whether the fideicomiso is taxed as a trust or a business entity). Also, different reporting requirements are triggered based on grantor vs. nongrantor trust status or busines entity status.

Thus, the IRS’ letter is helpful in reminding taxpayers of potential reporting and income tax issues relating to a fideicomiso interests. However, each case will require its own analysis as to whether a foreign trust or other entity exists, if a trust whether it is a grantor or nongrantor trust, and what particular reporting is required. If worth the cost, a private letter ruling as to “trust” status could also be sought from the IRS.

INFO 2011-0052 dated 11/17/2010 (released 6/24/11)

APPLICABLE FEDERAL RATES–OCTOBER 2011

2011-09-20T15:30:00.001-05:00

TAX COURT GOES EASY ON LAX CRUMMEY PROTOCOLS

2011-09-18T11:23:00.001-05:00

Irrevocable life insurance trusts are a mainstay of transfer tax planning with the object of avoiding estate tax on life insurance policy payouts. Such trusts often provide a Crummey withdrawal feature to one or more trust beneficiaries, so that premium payments by the grantor are eligible for exclusion from taxable gifts as present interest annual exclusion gifts.

Clients are instructed that the grantor should transfer premium payments to the trust, and that the trust should remit the proceeds to the insurance company. Further, the trustee should provide notice to the beneficiaries of their withdrawal rights at or about the time of the contributions of premium amounts to the trust. These protocols are intended to minimize the risks of IRS challenge to present interest status of the contributions.

Oftentimes, clients disregard these instructions, and the grantor makes direct payments of premiums to the insurance company. This is what occurred in the recent Tax Court case of Estate of Turner v. Commissioner. As one might expect, the IRS challenged the present interest exclusion status of the premium payments. However, in a boon to other taxpayers who have similarly funded their premium payments, the Tax Court still allowed the present interest exclusion treatment.

The IRS first argued that the trust beneficiaries had no meaningful rights to withdraw the premium payments since they were not first paid to the trust. The Tax Court noted that the key factor in a present interest gift such as this is whether the beneficiary had the "legal right to demand" the withdrawal. Under the terms of the trust, the beneficiaries have the absolute right and power to demand withdrawals from the trust after each direct or indirect transferred to the trust. That the funding occurred indirectly was thus irrelevant to the right to demand.

The IRS also argued that there was no meaningful withdrawal rights because some, or even all, of the beneficiaries may not have known they had the right to demand withdrawals per the absence of notice to them. Again, the Tax Court indicated such lack of notice did not affect the "legal right to demand" withdrawals and thus lack of notice was not determined to be an impediment to present interest status. The court appropriately noted that lack of notice was not an impediment in the Crummey case, either.

Does this mean that taxpayers can now make direct premium payments that bypass the trusts, and avoid delivering withdrawal notices to beneficiaries? For taxpayers that end up in the Tax Court, and that are willing to front the litigation costs to get there, the answer is probably yes. However, since the IRS has not conceded this issue, and since other courts may not agree with this interpretation, proper contribution and withdrawal notice protocols should still be observed (but with the comfort that favorable Tax Court treatment will backstop the protocols if they are not fully observed). Also, practitioners should confirm that their life insurance trust forms allow for withdrawals for both direct and indirect contributions.

Estate of Turner v. Comm'r, T.C. Memo. 2011-209 (Aug. 30, 2011)

SAFELY DETERMINING PUBLIC CHARITY STATUS

2011-09-15T17:46:00.001-05:00

Grantors and contributors to charities often need to know if the charities qualify as "public" charities under Internal Revenue Code Section 170(b)(1)(A)(vi), so as to properly determine various tax consequences. Code Sections for which such status is relevant include Sections 170, 507, 545(b)(2), 642(c), 4942, 4945, 4966, 2055, 2106(a)(2), and 2522.

Grantors and contributors can request a copy of the charity’s exemption letter to determine if the IRS has recognized its status under Section 170(b)(1)(A)(vi). Alternatively, the status can be reviewed in IRS Publication 78, “Cumulative List of Organizations described in Section 170(c) of the Internal Revenue Code of 1986.” This publication is available in paper, or online through http://www.irs.gov.

But what if the charity has had its Section 170(b)(1)(A)(vi) revoked, but the grantor or contributor is not informed of this? For example, the charity may provide the contributor with a copy of the original exemption letter, even though it has been revoked. Alternatively, the grantor or contributor may check the status online and see the charity has the proper status, but perhaps the IRS had not yet updated its database to show a revocation.

Under recently issued Regulations, the IRS will allow a contributor or grantor to rely upon an IRS determination letter or ruling (notwithstanding its revocation) until the IRS publishes notice of a change of status. Reg. Section 1.170A-9(f)(5)(ii). This is both a good and a bad thing. It is good, in that it provides a clear methodology to determine status, without risk that the status may have been changed. It is bad, since it imposes a clear burden on the taxpayer to review Publication 78, as updated, to confirm that there has been no revocation.

Previously, newly formed charities had only a five year advance ruling period for their “public charity” status – at the expiration of the period the charity had to go back to the IRS and seek a permanent ruling. While this process has been changed, there are organizations out there with ruling letters that have a fixed advance ruling period expiration date, but that are no longer obligated to seek a permanent ruling. The Regulation provides that a taxpayer may rely on advance rulings that expired on or after June 9, 2008.

A taxpayer cannot use these reliance rules if it was responsible for, or aware of, an act or failure to act that resulted in the organization's loss of classification under Section 170(b)(1)(A)(vi) or acquired knowledge that the IRS had given notice to such organization that it would be deleted from such classification. At first glance, this would appear to be a problem for large contributors, since if a contributor makes a large enough contribution to an organization, this may mathematically remove it from “public charity” status. However, the Regulations anticipate this and provide that an outsider to the charity (that is, is not a founder, creator, or foundation manager) will not be considered responsible for, or aware of, a loss of public status if it received and relied upon a written statement by the charity that the grantor contribution will not result in the loss of public status. Reg. Section 1.170A-9(f)(5)(iii). Such written statement must meet specific criteria, including the provision of five years of financial data to allow for a computation of public charity status.

Note that the online Publication 78 describes various types of exempt organizations. Various codes are used to assist readers to determine the status of the organization. The code needed to confirm public charity status is actually the absence of a code, or “none.” Below is a table of the various codes.

LIMITED OBJECTION PERIOD UPHELD FOR NONQUALIFIED PERSONAL REPRESENTATIVES [FLORIDA]

2011-09-10T12:17:00.001-05:00

Individuals who were not domiciled in Florida are not eligible to serve as a Personal Representative of a Florida decedent, except under limited circumstances (e.g., if they are related within certain stated family relationships to the decedent). Fla. Stats. Section 733.304. Florida law also provides that persons who are served a copy of the Notice of Administration must file an objection to the appointment of a Personal Representative within three months of service. Fla.Stats. Section 733.212(3).

A recent Florida Supreme Court case took on the question whether the three-month objection period applies to a challenge of an individual to serve as Personal Representative when that person is not within the class of persons authorized to serve as a Personal Representative (in this case, because he was not domiciled within Florida and was not within the requisite family relationship). The Supreme Court took on the case due to a split between appellate courts on this question.

The Court determined that the three-month objection period does apply.

This is an important case because many times estate beneficiaries do not engage counsel to assist them until a dispute or problem arises, and that often occurs beyond the three-month objection. At that time, their counsel may note that the Personal Representative is not qualified to serve. Per this decision, in most cases it will now be too late to seek the removal of the Personal Representative as a disqualified person under the statute.

The door to objections is not completely closed, however. The opinion is clear that if there was fraud or misrepresentation relating to the petition for administration, a later action for removal should not be time-barred.

Hill v. Davis, Fla. Supreme Court case No. SC 10-823, September 2, 2011

CHECK THE BOX ELECTIONS BY INSOLVENT CORPORATIONS

2011-09-05T07:33:00.001-05:00

When a corporation makes a check the box election, it is treated as having liquidated and then being reestablished as a partnership. In context of an insolvent corporation, this raises questions about worthless stock treatment, bad debts, and other tax consequences. A recent Chief Counsel Memorandum provides the IRS' opinion on these issues.

WORTHLESS SECURITY DEDUCTION. In the deemed liquidation of a solvent corporation, the shareholders realize gain or loss based on the deemed distribution that occurs. However, an insolvent corporation has no net assets to distribute. Therefore, the shareholders do not receive anything and thus there is no sale or exchange to fix gain or loss. See Rev. Rul. 2003 – 125. In this circumstance, however, the shareholders will be entitled to a worthless security deduction in the amount of their basis in their stock pursuant to Code Section 165(g). Code Section 165(g) provides that if any security which is a capital asset (such as a share of stock in a corporation) becomes worthless, a loss from a seller or exchange of that security is deemed to occur.

Note that this result holds even if the shareholder is a corporation owning 80% or more of the stock of the insolvent subsidiary. That is, Code Section 332 (which applies to liquidations of corporate subsidiaries into a parent corporation) will not apply to disallow the loss. This result occurs because Code Section 332 will not generally apply to the liquidation of an insolvent subsidiary when the parent corporation receives no assets as shareholder.

TAXABLE SUBSTITUTION OF LIABILITIES. The substitution of a debt instrument that differs materially in kind or in extent from an existing debt instrument may constitute a sale or exchange of that debt instrument under Code Section 1001. Changes in obligor of the debt instrument can constitute such a taxable substitution.

Since an insolvent corporation will likely have liabilities to its shareholders or third parties, the issue arises whether such a substitution of debt occurs when the debt is deemed transferred and reestablished in the partnership, since at a minimum, there is a new obligor for federal tax purposes. Notwithstanding this new obligor, the Memorandum concludes that there is no such taxable substitution occurring under Code Section 1001.

BAD DEBT DEDUCTION. We noted above that the shareholders of the insolvent corporation are eligible to receive a worthless stock deduction upon the deemed liquidation of the corporation. This might lead you to believe that a creditor of the corporation should likewise receive a bad debt deduction under Code Section 166 since the corporation disappears. Code Section 166 allows as a deduction any debt which becomes worthless within a taxable year. However, you would be wrong in that conclusion (at least according to the Memorandum).

The Memorandum determines that Code Section 166 does not apply because the full amount of the liability is treated as surviving the liquidation and being assumed by the partnership. Thus, the debt was not rendered worthless by reason of the election.

BASIS IN PARTNERSHIP INTEREST AND PARTNERSHIP BASIS IN ASSETS. The Memorandum then addresses various basis issues arising from the deemed liquidation and deemed formation of the partnership. Interested persons should consult the Memorandum – we will not run through them here to avoid the risk of readers never wanting to read this blog again.

Office of Chief Counsel Memorandum AM2011-003, August 26, 2011

FLORIDA LEGISLATIVE UPDATE – PROBATE AND TRUST CHANGES [FLORIDA]

2011-08-31T10:16:00.002-05:00

Our last Florida update relates to changes to Florida’s probate and trust code. The following summary has been written by Sean Lebowitz of our office.

On April 14, 2011 and April 29, 2011, the Florida legislature enacted several significant changes to the probate and trust code (hereinafter referred to as “legislation”). The bill was signed by the Governor on June 21, 2011. Some of the key sections of the legislation became effective on July 1, 2011 and others will become effective on October 1, 2011. In essence, the legislation creates or substantially modifies the following subject matters: I) Intestate succession; II) Reformation of a will; III) Challenges to revocation of a will and trust; IV) Attorney-client privilege relating to fiduciaries; and V) Timing for requesting attorney’s fees in a trust matter. The author urges probate and trust litigators to review the entire legislation because it contains nuances not fully addressed in this article.

I. Intestate Succession

When a decedent dies without a will, the assets are distributed according to the laws of intestacy. Currently, the intestate share of a surviving spouse where all of the decedent’s descendants are also descendants of the surviving spouse is the first $60,000.00 and half of the remaining estate. Effective October 1, 2011, the legislation amends Florida Statute § 732.102(2) so that the intestate share of a surviving spouse of a decedent where all of the decedent’s descendants are also descendants of the surviving spouse (or if there are no descendants) is the entire estate. The legislation also creates Florida Statute § 732.102(4) to provide that if the surviving spouse has descendants that are also the decedent’s descendants and has descendants not related to the decedent, the surviving spouse’s intestate share is half of the estate.

II. Reformation of a Will

Reformation of a testamentary document is an effective, yet often times overlooked, probate litigator’s technique to reform a document to conform to the settlor’s intent. Since 1998, Florida case law permitted reformation of a trust instrument to correct a mistake. See In re Estate of Robinson, 720 So. 2d 540 (Fla. 4th DCA 1998). In 2007, the Florida legislature codified and expanded common law to permit reformation to correct a trust to cure a mistake as well as reformation of a trust to achieve a settlor’s tax objectives. See Fla. Stats. §§ 736.0415 and 736.0416.

Effective July 1, 2011, the legislation created Florida Statutes §§ 732.615 and 732.616. These statutes mirror the above-referenced trust code statutes to permit reformation of a will to correct a mistake and to modify a will to achieve a testator’s tax objectives. The mistake statute, Florida Statute § 732.615, allows an interested person to seek reformation of the terms of a will to conform to the testator’s intent, and provides a burden of proof of clear and convincing evidence. The statute even permits reformation that is completely inconsistent with the apparent terms of the will.

The tax modification statute, Florida Statute § 732.616, permits an interested person to seek reformation of the terms of a will to achieve a testator’s tax objectives in a manner that is not contrary to the testator’s “probable intent.” These statutes are significant because reformation of an unambiguous will was previously never permitted by case law or statute. In addition, the legislation creates Florida Statute § 732.1061 which requires that in actions under reformation of a will to correct a mistake and modification of a will to achieve tax objectives, the court must award attorney’s fees and costs to the prevailing party. Nonetheless, the statute also gives the court discretion in awarding and allocating fees using the concept of equity.

III. Challenges to Revocation of a Will and Trust

Florida law provides that a will or trust is void if procured by fraud, duress, mistake or undue influence. A testator or settlor may revoke a will or trust by writing or act. Until the legislation, there was no mechanism to challenge a revocation of a will or trust by physical act based upon fraud, duress, mistake or undue influence. The legislation amends Florida Statutes §§ 732.5165 and 736.0406 to provide that revocation of a will or trust is void if procured by undue influence, fraud, duress or mistake. A challenge to the revocation of a testamentary document cannot take place until the instrument becomes irrevocable or at the settlor’s demise.

IV. Attorney-client Privilege relating to Fiduciaries

Florida law provides that communication between an attorney and the client is confidential if it is not intended to be disclosed to third parties. The legislation clarifies and expands existing law so that communication between a fiduciary client and the attorney is confidential and privileged. See Fla. Stat. § 90.5021. The legislation also amends Florida Statutes §§ 733.212(2)(b) and 736.0813 which create new reporting requirements for personal representatives and trustees. The reporting requirement compels personal representatives and trustees to provide notice to the beneficiaries that an attorney-client privilege exists between the fiduciary and the attorney employed by the fiduciary. See Fla. Stats. §§ 733.212(2)(b) and 736.0813.

V. Timing for Requesting Attorney’s Fees in a Trust Matter

The Florida Trust Code provides that trust proceedings are governed by the Florida Rules of Civil Procedure. In civil litigation, Florida Rule of Civil Procedure 1.525 is commonly used which requires a party to serve a motion seeking fees or costs within 30 days after the filing of a judgment. By amending Florida Statute § 736.0201(1), the legislation clarifies and confirms that Florida Rule of Civil Procedure 1.525 applies to all judicial proceedings concerning trusts.

The legislation also creates Florida Statute § 736.0201(6) which states that Florida Rule of Civil Procedure 1.525 applies to all judicial proceedings concerning trusts, but provides the following two exceptions: “A trustee’s payment of compensation or reimbursement of costs to persons employed by the trustee from assets of the trust [and] [a] determination by the court directing from what part of the trust fees or costs shall be paid, unless the determination is made under s. 736.1004 in an action for breach of fiduciary duty or challenging the exercise of, or failure to exercise, a trustee’s powers.”

FLORIDA LEGISLATIVE UPDATE–CREDITOR PROTECTION FOR IRA’S [FLORIDA]

2011-08-31T10:03:00.001-05:00

In likely response to earlier cases in various states questioning the creditor protection aspects of an inherited IRA, Fla.Stats. §222.21(2)(c) has been modified to expressly include such IRAs in Florida’s statutory protection scheme.

FLORIDA LEGISLATIVE UPDATE–LLC CHARGING LIENS [FLORIDA]

2011-08-31T10:01:00.001-05:00

Florida has modified Fla.Stats. §608.433 to both clarify and change the rights of creditors vis-à-vis LLC owner interests owned by debtors.

First, the statute has been modified to make clear that the charging lien is the sole and exclusive remedy of a creditor against a debtor’s LLC interest, if the LLC has more than one member. A creditor is expressly prohibited from seeking a foreclosure sale of the member’s LLC interest.

Second, if the debtor is the sole member of the LLC, a creditor’s remedies are not restricted to a charging lien. Thus, for example, the creditor can foreclose on the member’s LLC interest, and the purchaser at the foreclosure sale can obtain full voting and other powers over the interest (that is, the sold interest will not be limited to an “assignee” interest). However, before remedies other than a charging lien are allowed, the creditor must establish to the satisfaction of a court that distributions under a charging order will not satisfy the judgment within a reasonable time. The new statute should provide statutory certainty to the issues raised in the 2010 Olmstead decision.

Thus, the use of single-member LLC’s should not be relied upon as an asset protection mechanism. For planning, the addition of bona fide additional members may allow for a limitation of remedies to a charging lien if not subject to challenge on a sham, fraudulent conveyance, or other equitable theory.

OVDI DEADLINE EXTENSION NOW APPLIES TO FAQ 17 & 18 FILINGS

2011-08-29T17:26:00.001-05:00

Further to my last posting, the IRS acted today to also extend the offshore initiative filing deadline for FAQ 17 & 18 filings to September 9, due to Hurricane Irene. While the announcement only refers to FBAR filings, FAQ 17 & 18 themselves have the new deadline, and thus September 9 also applies to Form 5471 and Form 3520 filings.

For those not familiar with FAQ 17 & 18, these questions allow the late filing of FBARs and Forms 5471 and 3520 without risk of late filing penalties, if the taxpayer otherwise reported all income in the subject years.

It looks someone in Washington D.C. is reading this blog!

HURRICANE IRENE BLOWS BACK OVDI DEADLINE

2011-08-28T05:48:00.001-05:00

In recognition of the anticipated disruption to come from Hurricane Irene, the IRS has pushed back the compliance submission deadline for its 2011 offshore voluntary disclosure initiative from August 31, 2011 to September 9, 2011. This extension applies to all taxpayers – not just those affected directly by Hurricane Irene. The later date also extends the filing date for requesting a 90 day extension to submit the complete disclosure package.

It is unclear whether this extension also applies to taxpayers who have paid all of their tax but are filing late Forms 5471, 3520, and/or FBAR’s under FAQ’s 17 and 18, since those FAQ’s still reference the August 31, 2011 date.

IRS Announcement, August 26, 2011

NO FIFTH AMENDMENT PRIVILEGE FOR OFFSHORE BANKING RECORDS

2011-08-24T17:52:00.001-05:00

Under the Fifth Amendment to the U.S. Constitution, a taxpayer may refuse to answer specific questions or produce specific records if it would violate his or her privilege against self-incrimination. In a recent appellate case, the taxpayer was under a grand jury investigation as to whether he used undisclosed Swiss bank accounts to evade taxes. The taxpayer claimed that the Fifth Amendment protected him from having to provide his records relating to his foreign bank accounts. More specifically, a subpoena was issued for the taxpayer to produce “[a]ny and all records required to be maintained pursuant to 31 C.F.R. § 103.32 [subsequently relocated to 31 C.F.R. § 1010.420] relating to foreign financial accounts that you had/have a financial interest in, or signature authority over, including records reflecting the name in which each such account is maintained, the number or other designation of such account, the name and address of the foreign bank or other person with whom such account is maintained, the type of such account, and the maximum value of each such account during each specified year.”

The information identified in the subpoena mirrors the banking information that 31 C.F.R. § 1010.420 2 requires taxpayers using offshore bank accounts to keep and maintain for government inspection. The information the subpoena seeks is also identical to information that anyone subject to § 1010.420 already reports to the IRS annually through Form TD F 90-22.1, known as a “Report of Foreign Bank and Financial Accounts,” or “FBAR.”

The taxpayer argued that the information he provided could be used to prosecute him criminally if it conflicts with other information he provided to the IRS. He also argued that if he had to deny he had such information, he could be guilty of a felony of not meeting legal requirements to maintain such records.

Notwithstanding the risk of criminal prosecution relating to responding to the record requests, the Ninth Circuit Court of Appeals held that the Fifth Amendment privilege did not apply under the “Required Records Doctrine.” This exception to the privilege applies under Grosso v. U.S., 21 AFTR 2d 554 (S Ct 1968) if:

a. The purpose of the government’s inquiry is regulatory and not criminal prosecution. Here, the government’s purpose under the Bank Secrecy Act was essentially regulatory. It was important to the Court that the activity being regulated (participation in offshore banking) is not inherently unlawful, and thus information reporting in regard to it is not essentially related to criminal prosecution.

b. And, the information requested is contained in documents of a kind the regulated party customarily keeps. In this situation, bank customers would generally keep basic account information both to comply with required reporting of offshore bank information and to be able to access their accounts.

c. And, the records have public aspects which render them at least analogous to public documents. The records here had public aspects because individuals had to retain them for five years and provide them to the government upon request. Further, such records were required to be kept to aid in the enforcement of a valid regulatory scheme.

Thus, taxpayers under investigation in regard to offshore bank accounts will not be able to rely on the Fifth Amendment to deny access to their banking records.

In re: M.H., 108 AFTR 2d Para. 2011-5203

APPLICABLE FEDERAL RATES–SEPTEMBER 2011

2011-08-18T10:14:00.001-05:00

JTWRS TRUMPS HOMESTEAD [FLORIDA]

2011-08-14T16:24:00.001-05:00

Article X, section 4(c), of the Florida Constitution provides that “[t]he homestead shall not be subject to devise if the owner is survived by spouse or minor child.” What happens if a Florida resident acquires property while he has a minor child and lives in it as his primary residence – but instead of acquiring property in his own name he acquires it as joint tenant with rights of survivorship with a third party, and then dies?

Option One – the property is not the decedent’s homestead, and it passes entirely at his death to the other joint tenant.

Option Two – the property is the decedent’s homestead, and his interest in the property does not pass to the joint tenant as an invalid devise under the foregoing Constitution provision.

These were the facts in Marger v. De Rosa, wherein the administrator ad litem for the estate of Mr. Marger asserted Option Two – that is, the homestead nature of the property trumped the JTWRS status of ownership.

Both the trial court and the Second District Court of Appeals found for Option One. The appellate court noted:

“This language [in the Constitution] does not restrict the type of interests in real property a person may acquire or how a person may title his or her property. Instead, it restricts a person's attempt to devise property he or she owns when homestead status has attached to that property.”

Since the property was not homestead property at the time of the joint purchase, the homestead restriction was determined not to apply.

Marger v. De Rosa, 57 So.3d 866 (2nd DCA 2011)

MORE GUIDANCE ON ELECTING OUT OF ESTATE TAX FOR 2010 DECEDENTS

2011-08-11T17:44:00.001-05:00

The IRS has issued detailed guidance regarding estates of 2010 decedents that elect out of federal estate tax. The guidance has lots of details, and should be reviewed by any persons involved with the estates of decedents that died in 2010.

While not intended as a comprehensive analysis of the new guidance, some highlights and interesting points follow:

1. Form 8939 will be used to opt-out of estate tax (the Section 1022 election), and to allocate available basis step-up among eligible assets.

2. Form 8939 is due no later than November 15, 2011. Since the form is not out yet, estates should start gathering information now. The are only limited circumstances for an extension or a later amendment.

3. A conditional Form 8939 (one that is effective only if assets exceed the remaining unified credit amount of the decedent) is not allowed.

4. If the Section 1022 election is made, the decedent’s GST exemption is allocated by attaching Schedule R to the Form 8939. For decedents that made a 2010 inter vivos gift, the Form 8939 is not used to elect out of the automatic allocation of GST exemption. If the gift was made before December 17, 2010, the time for filing a Form 709 with the election out is extended to September 19, 2011. If the gift was on or after December 17, the regular 2010 Form 709 filing dates apply.

5. Note that the Form 8939 must report ALL of the decedent’s assets, not just those for which a basis step-up allocation applies (except for cash and IRD items, and noncitizens who are nonresidents only report U.S. assets). The form must also report property that was required to be included on another donor’s Form 709 if gifted to the decedent within 3 years of his or her death.

6. The executor must provide a statement to each recipient of property acquired from the decedent within 30 days of the filing of the Form 8939.

7. If the decedent creates separate interests in an item of property (such as a life estate and remainder), the basis interest must be allocated to all such separate interests if an allocation to any portion is desired.

If the opt-out election is not filed, the estate must file a Form 706, unless the assets of the decedent total less than the decedent’s available unified credit amount. Those estates that do not file a Form 706 because the value of its assets do not require one and for which an opt-out election does not make sense should NOT file a Form 8939 since this could act to reduce the available amount available to step-up the basis in the decedent’s assets.

Notice 2011-66 and Revenue Procedure 2011-41

ANOTHER ATTACK ON DEFINED VALUE CLAUSES FAILS

2011-08-06T16:55:00.002-05:00

In the previous posting on June 23, 2011, we discussed the use of charitable lid/defined value clause planning, and how it had recently been upheld in by the Tax Court in Hendrix. Such planning has now successfully weathered another attack – this time in the 9th Circuit Court of Appeals in Petter. This time, the IRS dropped its public policy objections and focused on denial of the gift tax charitable deduction for additional amounts passing to charity by reason of a revaluation of gifted or sold property under regulations prohibiting a condition precedent to a deductible charitable gift.

In Petter, the taxpayer transferred UPS stock to a family LLC. She then gifted LLC units to two trusts and a charitable organization. The gift was accomplished via a transfer of a fixed number of LLC units. A formula was employed to allocate the transferred units between the two trusts and the charitable organization. The amount allocable to the trusts was intended to equal the value of the taxpayer's unused unified tax exemption. More specifically, the allocation clause allocated to each trust a portion of the LLC units equal to "one-half the [maximum] dollar amount that can pass free of federal gift tax by reason of Transferor's applicable exclusion amount allowed by Code Section 2010(c). Transferor currently understands her unused applicable exclusion amount to be $907,820, so that the amount of this gift should be $453,910." To the extent the value of the transferred LLC units exceeded this allocation to the trusts, such remaining LLC units from the transfer were allocated to the charitable organization. The transfer documents also provided that if the value of the units was finally determined for federal gift tax purposes to be different than as originally computed, the trusts and charitable organization would reallocate those units amongst themselves in accordance with that final determination. Subsequent to the gift, a sale of additional LLC units to the two trusts was undertaken on an installment basis. The sold units were allocated to the two trusts and another charitable organization in a similar manner.

The LLC interests were eventually revalued higher than the value used on the Form 709. This triggered additional units passing to the charitable organizations.

Generally, gifts to charities are not subject to gift tax pursuant to the gift tax charitable deduction under Code Section 2522(a). However, no charitable deduction is allowed "[i]f, as of the date of the gift, a transfer for charitable purposes is dependent upon the performance of some act or of the happening of a precedent event in order that [the transfer] might become effective" (emphasis added). Treas. Reg. Section 25.2522(c)-3(b)(1). The IRS argued that the transfer of the additional LLC units to the charities is subject to a condition precedent within the meaning of that regulation. The condition precedent is the IRS audit that ultimately determines that the reported value of the LLC units is too low and triggers the additional transfer.

The IRS further bolstered its argument by citing Code Section 2001(f)(2). That provision provides that a value as finally determined for gift tax purposes means the value shown on the taxpayer's return unless the IRS audits and challenges the value. The IRS thus argued that under the taxpayer's formula, the value, and thus the amount passing to charity, was fixed by the value reported on the gift tax return. Any IRS action to change that value was a subsequent action, and thus a necessary precedent event, to increase what passes to the charity - thus that increase would be a prohibited precedent event to the transfer at the time of the gift.

The appellate court found that there was no condition precedent - the Taxpayer's transfers became effective immediately upon the execution of the transfer documents and delivery of the units. The only post-transfer open question was the value of the units transferred, not the transfers themselves. The court stated the "clauses merely enforce the foundations' rights to receive a pre-defined number of units...Thus, the IRS's determination...in no way grants the foundations rights to receive additional units." Similarly, the court noted "that value was a constant, which means that both before and after the IRS audit, the foundations were entitled to receive the same number of units. Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the Taxpayer's transfer was dependent upon an IRS audit." If the charities did not agree with the reported value, they could have brought suit to determine the proper value applying the gift tax definition and thus did not need an IRS audit to get all they needed (although the court notes this was unlikely to occur).

The appellate court overcame the IRS' argument that Code Section 2001(f)(2) set the value as finally determined for gift tax purposes at the returned value, by noting that Code Section 2001(f)(2) applies to set the value as finally determined for purposes of gift only for purposes of applying Code Section 2001(f)(1) which relates to determination of values only after the period for assessment of tax has expired. Code Section 2001(f)(2) does not apply to set that value for other Chapter 12 gift tax purposes.

The decision is important for several reasons. It applies a well-reasoned and supported appellate court defeat to the IRS' condition precedent argument. Also, it may signal IRS surrender on the public policy arguments it has been asserting, per its withdrawal of those arguments from the appeal issues. Lastly, another Circuit Court of Appeal is voicing its approval of the formula clauses.

The appellate court invites the IRS to seek a change in the law if it is troubled by these clauses. One hopes that Capital Hill would resist such changes. While the clauses can be subject to abuse, for the majority of taxpayers they provide a mechanism to allow them to make full use of available transfer tax exemptions without being subject to the risk of taxes arising from challenges to a good faith valuation.

Petter v. Commissioner (9th Cir. 2011)

SECTION 197 AMORTIZATION APPLIED TO NONCOMPETE COVENANT IN SMALLER STOCK ACQUISITION

2011-08-02T15:34:00.001-05:00

Noncompetition covenants are common when interests in businesses are sold. The buyer typically would like to amortize (deduct) the cost of the covenant as quickly as possible, so as to get the tax savings from the deduction sooner rather than later. Absent any special statutory treatment, the cost of the covenant is usually written off over the number of years that the covenant applies.

However, if Code Section 197 applies to the covenant, the buyer must amortize it slowly, over a 15 year term. In a recent case, the First Circuit Court of Appeals held that Section 197 applies to a one-year covenant not to compete when it was issued in conjunction with a redemption of a 23% corporate shareholder.

The case turned on whether Code Section 197(d)(1)(E) characterizes such a covenant as a section 197 intangible. That section includes as a section 197 intangible “any covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a covenant not to compete) entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof.”

The taxpayer argued that the term "thereof" at the end of this provision requires that the interest sold any trade or business must be substantial, and that the 23% sold here is not substantial. Thus, the covenant would not be a section 197 intangible.

The IRS argued that the term "thereof" does not not modify the term "interest" but instead modifies the term "trade or business." Applying the IRS' interpretation, there are thus two circumstances that will treat the covenant as a section 197 intangible. The first is the purchase of an INTEREST in a trade or business, such as stock, no matter how small that interest is. The second is the purchase of assets of the trade or business (that is, the purchase of the trade or business itself), in which case the sale must be at least of a substantial portion of the total assets to trigger section 197 treatment.

At first, the IRS interpretation appears strange, if not outright ridiculous. However, if you look at it long enough, it does appear to be more reasonable, and if you keep looking at the clause, you soon have no idea what it really means.

The Tax Court accepted the IRS’ interpretation. It based this in part on the policy of Code Section 197 to discourage over allocation of purchase price to a covenant by a buyer. However, this is probably not a fair basis on which to base the interpretation, since in a stock sale there is a natural tension between the buyer and seller that limits the ability of the buyer to over allocate purchase price to a covenant not to compete. This is because the covenant not to compete will be ordinary income to the seller, while the allocation of sale proceeds to the asset being sold would generate only capital gain. The buyer will thus be bargaining for a lower allocation of proceeds to the covenant not to compete.

Nonetheless, with this case the IRS' interpretation of Code Section 197(d)(1)(E) must be given due consideration in regard to any sales of interests in business entities that are accompanied by a covenant not to compete, no matter how small the percentage interest that is being sold.

Recovery Group, Inc., 108 AFTR 2d ¶ 2011-5114 (CA 1 7/26/2011)

FOUNDATION THAT CORRECTS SECTION 4942 DISTRIBUTION DEFICIENCY ON ITS OWN ACCORD STILL IS SUBJECT TO PENALTY

2011-07-30T20:51:00.001-05:00

Section 4942 requires a private foundation to make minimum distributions to charitable recipients each year (generally, no less than 5% of its assets). If not made in a timely manner, a first tier penalty tax of 30% is imposed.

A private foundation filed its Forms 990-PF for several years, but neglected to make the required minimum distributions. When this was discovered by a new accountant, the foundation eventually made the missing distributions and filed a Form 4720 (Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code) requesting abatement of the penalty tax.

Under Code Section. 4962(a) , the IRS can abate the penalty if the private foundation establishes to the IRS's satisfaction that the violation (1) was due to reasonable cause; (2) wasn't due to willful neglect, and (3) has been corrected within the appropriate correction period. The foundation alleged reasonable cause due its accountant advising it that it qualified as a private operating foundation that did not have the minimum distribution requirement.

Since the foundation submitted returns that provided it was not a private operating foundation, the IRS did not accept that reasonable cause existed for missing the required distributions. The IRS also felt that changes by the foundations Board to increase returns and reduce expenditures evidenced knowledge that the foundation should have known that distribution shortfalls were occurring.

While not discussed in the ruling, apparently the foundation did not earn enough brownie points by reason of its voluntary disclosure of the issue so as persuade the IRS to abate the penalty.

PLR 201129050

INNOCENT SPOUSES GAIN MORE TIME TO SUBMIT CLAIMS FOR RELIEF

2011-07-27T14:37:00.001-05:00

In my December 1, 2010 posting, I included links to my summary of various routes available to innocent spouses relief from income tax liabilities. One of those routes is Code Section 6015(f) which allows a claim for equitable relief if certain requirements are met.

Regulations under that section limited this relief to spouses who apply for relief within two years after the date of the IRS' first collection activity. Various courts have disagreed whether that limited time period is authorized by law.

The IRS has now issued a Notice that it will do away with the two-year limitation. Instead, individuals may request equitable relief without regard to when the first collection activity was undertaken. However, requests must still be filed within the Code Section 6502 period of limitations on collection (generally, 10 years), or for any credit or refund of tax within the Code Section 6511 period of limitation (three years of filing or two years after payment of tax).

The notice also goes on to provide guidance as to pending request for relief, previously denied requests, and requests that are in court.

Notice 2011 – 70

NEW FLORIDA DURABLE POWER OF ATTORNEY STATUTE [FLORIDA]

2011-07-21T17:45:00.002-05:00

Below is a summary of the new law from Mitch Goldberg of our office:

Introduction. On May 4, 2011, the Florida legislature passed Senate Bill 670 which substantially revises the Florida power of attorney ("POA") statute, § 709. The new law is effective for POAs executed on or after October 1, 2011 albeit, for matters other than execution formalities (such as statutory interpretation and fiduciary duties), the new law applies to all POAs, regardless of when it was executed. § 709.2402. While this article discusses relevant changes to the statute in brief, the author urges practitioners who deal with the subject matter discussed herein to read the new statue in its entirety to better understand the scope of the substantive changes.

Creation and Termination. The formalities to execute a POA have not changed from prior Florida law, to wit: (1) signed by the principal; (2) with two subscribing witnesses; and (3) before a notary public. § 709.2105. Also consistent with prior law, a POA is not durable unless the instrument explicitly designates it as such. § 709.2104. However, a significant change is the elimination of springing POAs (unless executed prior to October 1, 2011 and contingent on the principal's incapacity), provided, however, that military deployment-contingent POAs are still valid. § 709.2108. To revoke a POA, the principal must do so by expressly stating the revocation in a subsequently executed POA or other writing signed by the principal; mere execution of a subsequent POA, without indicating revocation of prior instruments, is insufficient to revoke prior executed POAs. § 709.2110.

Agents, Co-Agents and Successor Agents. The new statute imposes certain mandatory fiduciary duties on agents that cannot be eliminated by contract as well as default duties that can be waived by written agreement. § 709.2114. If more than one agent is designated to act on behalf of the principal, unless the instrument provides otherwise, a co-agent may act independently of the other co-agent(s), departing from the prior requirement that two co-agents must act in concert, or if more than two, by a majority. Notwithstanding the fact an instrument requires co-agents to act together, a co-agent may delegate to another co-agent authority to conduct banking transactions. In addition, if a co-agent has actual knowledge of a fiduciary breach by another co-agent or predecessor agent, such co-agent has an affirmative duty to take reasonably appropriate action to safeguard the principal's best interests. Failure to take such action renders the agent liable to the principal for the principal's reasonably foreseeable damages that could have been avoided had the agent taken such action. § 709.2111.

Agent's Authority to Act. The new law imposes additional drafting and execution requirements when enumerating an agent's authority to act on behalf of the principal. Generally, an agent may only exercise authority specifically granted to the agent in the instrument and the new law explicitly states that global provisions, such as those attempting to grant the agent authority to do all acts the principal can do, are ineffective. § 709.2201. Even more specifically, the following powers require they be specifically granted in the instrument and the principal sign or initial next to each specific grant of authority:

-Create an intervivos trust;
-With respect to a trust created by or on behalf of the principal, amend, modify, revoke, or terminate the trust, but only if the trust instrument explicitly provides for amendment, modification, revocation, or termination by the settlor's agent;
-Make a gift (as further discussed below);
-Create or change rights of survivorship;
-Create or change a beneficiary designation;
-Waive the principal's right to be a beneficiary of a joint and survivor annuity, including a survivor benefit under a retirement plan; or
-Disclaim property and powers of appointment. § 709.2202.

Agents are specifically precluding from the following acts:

-Perform duties under contract that requires the exercise of personal services of the principal;
-Vote in any public election on behalf of the principal;
-Execute or revoke any will or codicil for the principal; or
-Exercise powers or authority granted to the principal as trustee or as court-appointed fiduciary. § 709.2201.

In addition, to the above limits, if an agent is not an ancestor, spouse, or descendant of the principal, such agent cannot exercise any authority to grant an interest in the principal's property to the agent or to an individual to whom the agent owes a legal obligation of support, unless the instrument states otherwise. Also an agent's authority to make gifts, described above, is limited in amount to the annual gift tax exclusion provided for in 26 U.S.C. § 2503(b), per donee, regardless of whether the annual exclusion applies, unless the instrument provides otherwise. § 709.2202.

Non-Exclusive. The new law is not the exclusive method of interpretation and enforcement. The new law is supplemented by the common law of agency and principles of equity. § 709.2301. The remedies provided in the new law are not exclusive and do not abrogate any other right or remedy under any other law. § 709.2303.

APPLICABLE FEDERAL RATES–AUGUST 2011

2011-07-20T17:12:00.001-05:00

FATCA IMPLEMENTATION SCHEDULE

2011-07-16T08:58:00.001-05:00

The implementation of FATCA is approaching. FATCA imposed a substantial withholding tax, due diligence, and reporting regime on non-U.S. entities to enlist their assistance in rooting out U.S. taxpayers who are using offshore entities and accounts to hide their assets and income. Unfortunately, the rules are lengthy, difficult to comprehend, expensive to implement, and will likely have the unfortunate result of keeping much needed capital from being invested in the U.S. at a time when that capital is needed for job creation.

The IRS has issued Notice 2011-53 which provides guidance and information on the phase-in of implementation. Covered in the Notice are the dates that participating foreign financial institutions must register with the U.S., the phase-in of such institutions’ due diligence requirements, the phase-in of reporting of foreign accounts, and the implementation in two stages of the new withholding rules.

For those that have an interest in these rules, and other masochists, I have prepared a map outline of the principal Notice provisions, available at http://goo.gl/4OwbZ. You will need a recent version of Adobe Reader or Adobe Acrobat to be able to view the file.

Notice 2011-53

ANOTHER DAY TRADER TAXED AS AN INVESTOR

2011-07-13T18:05:00.001-05:00

Successful stock market day-traders like to be characterized as mere investors for federal income tax purposes - this allows them to pay taxes on their trading gains at preferential capital gains rates. Unsuccessful stock market day traders want to avoid the "investor" label, and instead they want to be characterized as engaged in the trade or business of trading. This is because they don't want capital loss treatment for their trading losses - capital losses can only be used to offset capital gains (except as to $3,000 per year which can be used to offset ordinary income).

Traders that are engaged in the trade or business of trading securities may elect to have the Code Sec. 475(f) mark-to-market rules apply. Under these rules gain or loss is recognized on their securities held at the close of a tax year as if they were sold for their fair market value on the last business day of the tax year. Further, gain or loss is taken into account for the tax year as ordinary income or loss. Being engaged in a trade or business also avoids the expense limits on investors – investor trading expenses can only be deducted to the extent they and any other miscellaneous itemized expenses exceed 2% of adjusted gross income.

A recent Tax Court case involved a trader who engaged in substantial trading activities. The trader lost over $2 million in 2000, $400,000.oo in 2001, and $278,000.00 in 2002. With all those losses, the trader sought trade or business treatment so as to obtain ordinary loss treatment for the losses.

In 2000, the trader traded on 73 days with a total of 313 trades. In 2001, he traded on 18 days and had 72 trades, and in 2002 he traded on 21 days for 84 days.

A taxpayer's activities constitute a trade or business if (1) the taxpayer's trading is substantial, and (2) the taxpayer seeks to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holding.

In regard to the first test of “substantiality,” the courts will examine the number of trades, the amount involved in the trades, the number of days on which trading occurs, and whether trading is the taxpayer’s sole or primary source of income. Since the taxpayer only traded on 29%, 7% and 8% of the trading days in 2000-02, this was not substantial enough for the court (even though they acknowledged that the dollar volume of the trades was significant).

In regard to the second test, the courts will examine whether stocks were held for more than 30 days, and how often stocks were both purchased and sold on the same day. In the instant case, a majority of the stocks purchased were held for over 30 day, and very few stocks were sold on the same day they were purchased. Thus, the court ruled against the taxpayer on this element, too. The taxpayer was denied ordinary loss/trade or business treatment.

This case is factually similar to Holsinger v. Comm., which I wrote about here, and with a similar holding. Per these two cases, taxpayers with stock trades that number in the hundreds should not automatically assume they will achieve trade or business status. Of course, those traders at that level who are successful will not want trade or business status anyway so they can get preferential capital gains rates (for their long-term gains).

Richard Kay, Jr., TC Memo 2011-159

KILLER B REGULATIONS FINALIZED

2011-07-09T13:38:00.001-05:00

Triangular B reorganizations are often conducted whereby a subsidiary corporation will acquire a target corporation in exchange for stock of the subsidiary’s parent corporation. Throw a foreign corporation into the mix and the opportunity exists for tax avoidance, especially as to the acquisition of the subsidiary of stock of its parent for valuable consideration to use in the acquisition. For example, a foreign subsidiary may be able to repatriate earnings to a U.S. parent without a taxable dividend, or if the parent corporation is foreign then funds may be transferred to the parent without a U.S. withholding tax.

So-called ‘Killer B’ transactions were first addressed in Notices 2006-85 and 2007-48, and then further addressed in 2008 Temporary Regulations under Code Section 367(b). In May of this year, final Regulations were issued.

The final Regulations, when applicable, generally result in deemed distributions that are subject to tax under other Code sections, such as Section 301. They may also result in deemed contributions from the parent to its subsidiary. The deemed distributions may be characterized as ‘notional’ only, so as to avoid the potential application of Code Section 311(b) gains and losses.

Jeffrey Rubinger has published a recent article in the June 2011 Journal of Taxation that provides the history of the ‘Killer B’ transactions and an analysis of the new Regulations (“Final ‘Killer B’ Regulations Further Expand Likelihood of Gain Recognition by Taxpayers”). He points out that the deemed distributions can occur even if the target corporation is unrelated to the acquiring parent/sub group. He also notes that in circumstances when Code Section 367(b) does not apply due to a lack of earnings and profits, Code Section 367(a) may still be triggered.

Treasury Decision 9526, 5/19/11

DISCRETIONARY TRUST INTEREST HAS A GIFT TAX VALUE, BUT WHAT IS IT?

2011-07-06T17:27:00.001-05:00

In a recent Private Letter Ruling, a current trust beneficiary was entitled to income only in the discretion of the trustee, and was entitled to principal in the discretion of the trustee as needed for the beneficiary’s health, support or maintenance. The trust beneficiaries and trustee are seeking State court approval for an early distribution of a portion of principal to the remaindermen, since it appears they would not otherwise be entitled to any distributions until the death of the current trust beneficiary.

The current trust beneficiary has advised the IRS that her income and resources are sufficient to maintain her current standard of living for her lifetime and any forseeable emergencies, that she has received no trust distributions, and based on her financial condition she will not qualify for distributions from the trust. The trustee has represented that distributions would be made to the current trust beneficiary only in case of emergency.

Thus, the IRS was advised that the chances of a distribution being made to the current trust beneficiary during her lifetime are between slim and none. Based on that, the current beneficiary sought a ruling that her cooperation in allowing the early distribution of a portion of the principal to the remaindermen would not be a taxable gift.

The IRS ruled that a gift would occur with such a distribution. The gift arises by reason of the current beneficiary giving up the ability to receive income or principal from the principal amount that will be distributed, and that such transfer is a gratuitous and taxable transfer to the remaindermen. Regardless of the lack of likelihood of a distribution ever being made to the current beneficiary, the possibility remains.

This is a fair and appropriate legal analysis. The practical issue is how to value the gift? This is a fact question and not something the IRS wouldl rule on, although the ruling does concede that the value may be nominal. When dealing with gifts involving discretionary interests, and even ascertainable standards, this is a common valuation question, but one that begs a practical solution.

I would be interested to hear via the comment section from any readers how they deal with these valuation issues.

Private Letter Ruling 201122007

NEW FOREIGN FINANCIAL ACCOUNTING REPORTING ONE STEP CLOSER

2011-07-05T17:38:00.001-05:00

For tax years beginning after March 18, 2010, the Hiring Incentives to Restore Employment Act of 2010 (HIRE Act) provides that individuals with an interest in a “specified foreign financial asset” during the tax year must attach a disclosure statement to their income tax return for any year in which the aggregate value of all such assets is greater than $50,000. This reporting is in addition to similar reporting required on the annual FBAR form.

The IRS has now released a revised draft Form 8938, “Statement of Specified Foreign Financial Assets,” for public comment and review. This is the form that will be used for the HIRE Act reporting. Interestingly, the draft requires the taxpayer to list out the various income items from reported foreign financial assets and indicate where they are reported on the taxpayer’s income tax return (see excerpt below):

The actual reporting is not yet required. In Notice 2011-55the IRS suspended the reporting requirements until it releases a final Form 8938. Once the final form is released, taxpayers will still need to report for the period required by the new law, but not until they file their next income return that is due. The Notice also advises that the Code Section 6501(c)(8) limitations period for tax assessments for periods for which reporting is required will not expire before three years after the date on which the IRS receives Form 8938.

Link to Draft Form 8938

5 MONTH EXTENSIONS FOR PASS-THROUGH ENTITIES MADE PERMANENT

2011-06-30T18:23:00.001-05:00

In 2008, proposed and temporary Treasury Regulations reduced the six-month automatic extension of time to file income tax returns for most partnerships, estates, and certain trusts to five months. The IRS has now finalized the Regulations, retaining the shortened five month period. Such extension period will include extensions for the filing of Forms 1065, 8804 and 1041.

The purpose of the shortened period is to allow persons reporting income from such pass-through entities, which persons may be on a six month extension, a month to prepare their own returns. That is, the pass-through entity will have to get them the reporting information a month before their own extended return is due.

The final Regulations also provide rules as to some specific filing situations, such as:

--Even though individual bankruptcy estates file a Form 1041, they still will use the six month period (unless it is a pass-through entity that is in bankruptcy).

--Electing large partnerships also use the six month period.

T.D. 9531, 06/23/2011 ; Reg. §1.6081-2 , Reg. §1.6081-6 , Reg. §54.6081-1

NEW ARTICLE OUT–FBAR’S AND TRUSTS

2011-06-25T16:41:00.001-05:00

For those readers that have issues involving trusts and foreign accounts, I suggest they review my latest article entitled Final Regulations Expand on FBAR Reporting which is being published in the July 2011 edition of Estate Planning Journal (WG&L). To my knowledge, it is the only summary out there that brings together in one analysis the various disparate factual circumstances that may trigger an FBAR filing requirement for a trust or persons connected with trusts (including grantors, beneficiaries, and trustees). I hope to have a copy of the article up at my firm’s website in a few days (www.floridatax.com).

A special thanks to my co-author, a sharp, up-and-coming estates and trusts lawyer in Miami, Jenna Rubin…and yes, she is my daughter.

DON'T HOLD ANNUITIES IN TRUSTS - WELL, MAYBE IT'S OKAY

2011-06-25T12:43:00.001-05:00

Section 72 of the Internal Revenue Code generally provides favorable deferral of income tax for qualified annuities. However, Code Section 72(u) disallows such favorable treatment when the annuity is owned by someone other than a natural person, such as a trust. An exception to the exception allows a trust to hold the annuity as an agent for a natural person.

A recent private letter ruling has employed the "agent for a natural person” exception to allow use of the trusts. The subject ruling allowed the trust to purchase annuities with the remaindermen as the annuitants. Another individual was the current beneficiary of the trust. To the extent that distributions were made from the annuity prior to the death of the current beneficiary, those proceeds would be payable to the trust. After the death of the current beneficiary, the annuity policies will be distributed to the remaindermen (each receiving his or her annuity for which he or she is the annuitant).

The IRS examined the history of the Code Section 72(u) limit on non-individual ownership. It found that provision was largely intended to restrict an employer's use of annuity contracts to fund significant amounts of deferred compensation for employees. In the context of the subject trust, no such employment aspects were involved. Since all of the beneficiaries of the trust were natural persons, the IRS ruled that the Code Section 72(u) limits did not apply.

The IRS also ruled favorably in regard to Code Section 72(e)(4)(C). That provision holds that an assignment of an annuity contract without full and adequate consideration will be taxable as a sale of the contract based on the cash surrender value of the contract at that time. The IRS ruled that the later distribution of the annuity contracts to the individual remaindermen would not be subject to this deemed sale provision. Again, the IRS ruled favorably based on its reading of the legislative history. According to the ruling, the purpose of the restriction on gratuitous transfers of annuity contracts related to inhibiting taxpayers from continuing tax deferral beyond a life of an individual taxpayer. Since such deferrals were not involved in the subject transfers, the IRS ruled that Code Section 72(e)(4)(C) will not apply.

Clearly, these rulings are very favorable for the requesting taxpayers, and are not directly supported by language of the Internal Revenue Code. However, it is doubtful if anyone is going to be upset by this. Note that this is not the first time that the IRS has provided ruling similar to this.

Private Letter Ruling 201124008

‘CHARITABLE LID’ DEFINED VALUE CLAUSE UPHELD

2011-06-23T20:27:00.002-05:00

Federal transfer tax laws provide for various fixed exemptions and credits, such as the unified credit amount, the annual exclusion gift maximum amount, and the generation-skipping tax exemption. Taxpayers seeking to make inter vivos transfers of difficult-to-value assets that are at or under an exemption amount have a practical problem. To make the transfer they need to transfer property (such as shares of a closely-held business), but unless and until the IRS audits the transfer, there can be a large swing in potential transfer tax value between the estimate provided by the taxpayer’s appraiser, and what the IRS may assert or believe. Attempts to make transfers based on a formula such as “so many XYZ Corp. shares that are equal in value to $x” are vigorously opposed by the IRS. They can also be impractical because some number of shares would need to be transferred based on the initial valuation, with a later adjustment and transfer of shares one way or the other if the value is adjusted by the IRS. The IRS generally challenges such formula gifts as being invalid “savings clauses” under Procter, 142 F2d 824 (4th Cir. 1944). The precise scope of Procter has never been fully delineated by the courts, with King in the 1970’s, and Harwood and Ward in the 1980’s, helping somewhat to define its parameters.

In 2003, the 5th Circuit in McCord, 461 F2d 614, rev’g. 120 T.C. 358 (2003), reversed the Tax Court and gave tax effect to a defined value clause. Now, the Tax Court itself has ruled in a case that also gave effect to such a clause. The planning in the instant case was excellent – it included two elements presumably intended to defuse anticipated IRS arguments, and they appear to have functioned as designed.

The first such planning element was a the inclusion of small gift to a charitable recipient (here, a donor advised community fund), based on the donors’ valuation. The gift was structured that a fixed dollar amount of stock was to be transferred to family trusts, with any excess value passing to the charitable fund. This achieved two benefits, and since the charitable gift was relatively small as compared to the transfer to the trusts, it did not have a substantial economic cost to the donors.

First, it allowed the donors to defend against the IRS’ argument that a defined value clause was against public policy. That argument is that the IRS is discouraged from challenging valuations in these circumstances since it has no transfer tax “upside” to disputing value - any increase in value would only create a deductible charitable gift. The donors instead could, and did, argue that the clause furthered a public policy of encouraging charitable gifts. This charitable benefit was noted by the Tax Court.

Second, it avoided the problem of the possibility of shares being returned to the donors, or additional shares being transferred from the donor, based on changes in value. Instead, the donors were taken out of the picture in regard to transfers that were needed by such subject revaluations. Any adjustments in value resulted in the adjustment in shares occurring between the trusts and the charitable fund – the donors were not a participant. This distinguishes these transfers from facts similar to Procter.

The other interesting element was that the transfers to the trusts were a part sale/part gift transaction. Only the excess of the total defined transfer to the trusts over the consideration paid by the trusts constituted a gift. The IRS argued that the formula clauses were invalid because they were not reached at arm’s length. An important aspect of the court’s decision to nonetheless find an arm’s length transaction was the sale element. Pursuant to the sale, the trusts incurred economic and business risk – if the value of the stock used in the initial computation turned out to be too low, more shares would pass out of the trusts and go to the charitable fund.

It is important to note that the subject case is appealable to the 5th Circuit Court of Appeals – the same circuit as McCord. Thus, issues as to applicability of this case to cases arising in other circuits still remain. However, the case is still important because it was not a mere repeat of McCord. The Tax Court considered, and was not persuaded by, two arguments of the IRS that were not considered in McCord. Those two arguments were the public policy and lack of arms-length dealings discussed above. Further, the court also noted with approval the application of a similar clause in regard to a disclaimer in Estate of Christiansen, 586 F3d 1061 (8th Cir 2009), which should help bolster support for the use of such clauses outside of the 5th Circuit.

Hendrix, TC Memo 2011-133

APPLICABLE FEDERAL RATES–JULY 2011

2011-06-22T18:09:00.001-05:00

‘BLAME THE TAX PREPARER’ DEFENSE SHOT DOWN

2011-06-16T15:34:00.001-05:00

Taxpayers received a Form 1099-MISC reporting $3.4 million in income. This income item never made it to the income tax return. The IRS noted the missing item and assessed tax on it, and an accuracy-related penalty under Code §6662(a) of $104,295. That Code section imposes a 20% penalty on substantial understatements of income tax.

The taxpayers had engaged a specialty firm to prepare their income tax return. The return was over 115 pages long, and involved the integration of 160-plus information returns.

Code §6664(c)(1) overrides the above accuracy-related penalty if the taxpayer can show reasonable cause for the underpayment. In the instant case, the taxpayers claimed reasonable reliance on their tax preparer to show reasonable cause.

The Regulations allow reliance on “professional advice” to constitute reasonable cause if such reliance was reasonable and the taxpayer acted in good faith. Nonetheless, the Tax Court did not permit the IRS to use this reasonable cause exception.

The problem for the taxpayers was that “advice” is defined in the Regulation. To constitute “advice,” the advisor must reflect the adviser’s “analysis or conclusion.” No evidence was offered that the advisor conducted any analysis or provided any substantive advice on the item that was omitted. Instead, it just appeared to be a clerical omission. Thus, reliance on “professional advice” was not allowed to avoid the penalty.

The Regulations also note that an isolated computational or transcriptional error is not inconsistent with reasonable cause. There are cases that support the defense when an item is unintentionally left off the return by a third party preparer. However, a number of items conspired to disallow such a defense in this case, including a taxpayer’s duty to conduct a reasonable review of the return to assure all income items are reported. All of these were noted by the Tax Court, so it is uncertain what the result would be if some of them were absent:

a. It was assumed that the omission was a computational or transcriptional error, but no evidence was submitted to support that.

b. The large dollar amount of the omitted item raises questions whether the taxpayers conducted a reasonable review of the return. This amount was both large in amount and in the percentage of income omitted.

c. The omitted income item was specifically and intentionally triggered by one of the taxpayers during the tax year.

d. The taxpayers could not remember how much time and effort they put into reviewing the return.

e. One of the taxpayers had the knowledge and general sophistication to have been able to notice the missing item.

Stephen G. Woodsum, et ux. v. Commissioner, 136 T.C. No. 29, 06/13/2011

FLORIDA TAX LEGISLATION HIGHLIGHTS [FLORIDA]

2011-06-11T21:23:00.004-05:00

2011 BACK TO SCHOOL SALES TAX HOLIDAY. Continuing the annual tradition, Florida has enacted legislation that there will be no sales tax collected during the period from August 12, 2011, through August 14, 2011, on the sale of clothing, footwear, and certain accessories selling for $75 or less per item; or school supplies having a sales price of $15 or less per item. These tax exemptions do not apply to sales within a theme park or entertainment complex, a public lodging establishment, or an airport.

ABILITY TO APPORTION FLORIDA INCOME TAX TO FLORIDA BASED SOLELY ON SALES FACTOR INSTEAD OF NORMAL THREE-FACTOR APPORTIONMENT FORMULA. A taxpayer doing business within and without Florida, who demonstrates to the Office of Tourism, Trade, and Economic Development that, within a 2-year period beginning on or after July 1, 2011, it has made qualified capital expenditures of at least $250 million, may apportion its adjusted federal income solely by the sales factor beginning in the taxable year that the Office approves the application, but not before a taxable year that begins on or after January 1, 2013. Once approved, a taxpayer may elect to apportion its adjusted federal income for any taxable year using the sales factor method or the three-factor apportionment formula. This provision does not apply to taxpayers that are financial organizations, banks, savings associations, international banking facilities, or banking organizations

GOLFER RETIEF GOOSEN SCORES A BOGIE IN TAX COURT

2011-06-11T21:21:00.001-05:00

Golfer Retief Goosen, a nondomiciliary UK resident, entered into endorsement agreements with various corporate sponsors, and other agreements to provide services for those sponsors. The IRS challenged Goosen’s characterization of payments under those agreements, raising issues of personal services income, royalty income, source of income, and taxation under the U.S. – U.K. income tax treaty.

These issues arise often for athletes and international artists. Many of the characterization issues are factual and difficult to apply. The Tax Court ultimately disagreed with several of Goosen’s positions and increased his U.S. income taxes.

Given the variety of arrangements that Goosen entered into, the Tax Court’s discussion and conclusions should be helpful in assisting other athletes and artists in both structuring their arrangements and determining the proper U.S. income tax consequences. The following provides a brief summary of the what and why of the various arrangements. Taxpayers and advisors with these issues would be well served to review the opinion and conclusions.

Item: Prize money from U.S. golf tournaments and appearance fees in the U.S.

Character: Effectively connected income from a U.S. trade or business.

Item: Off-course endorsement agreement payments (that is, the ability of the sponsor to use Retief’s name and likeness in advertising and product promotions).

Character: Royalty income, per Retief’s ownership interests in his name and likeliness. As to royalty income relating to golf card and video game sales, these were sourced in the U.S. based on the percentage portion of U.S. sales of those items to worldwide sales. Allocating by the relative amount of advertising conducted for such items inside and outside the U.S. by the sponsors was rejected by the court. Royalty payments attributable to on-course and other endorsement agreements were treated as 50% U.S. source based only on a general analysis of various markets of the sponsors.

Item: On-course endorsement fees and bonuses, relating in large part to wear or use sponsor products while playing golf.

Character: Personal services income, which are sourced by where the services are performed. However, some of the contracts combined such on-course use of products with the ability of the sponsor to use Retief’s name and likeness. Such contract payments were thus considered to be partly personal services income and party income from royalties, with the court being forced to make some type of guestimate allocation between the two.

Item: U.S. source royalty income from endorsements – effectively connected with a U.S trade or business?

Character: As to on-course endorsements, which were tied to and required Retief to play in golf tournaments, Retief’s participation was material to his receiving such income and is treated as income effectively connected with a U.S. trade or business. As to off-course endorsements, these were not dependent on tournament play or Retief’s presence in the U.S. These were thus determined to be non-effectively connected income, subject to 30% tax as FDAP income.

Item: Applicability of U.S.-U.K. tax treaty.

Character: The opinion noted that the treaty will apply to income for a U.K. nondomiciliary resident only to the extent the income is remitted to or received in the U.K. Retief’s endorsement income was initially paid into Liechtenstein bank accounts of entities controlled by Retief’s manager. Amounts were ultimately transferred to a U.K. bank account, but often in the form of salary and other payments. While the Tax Court acknowledged funds being paid to the U.K. bank account, Retief could not provide enough proof that such payments were endorsement income. Thus, Retief was denied the use of the treaty, which might otherwise have provided reduced U.S. income taxation on Retief’s U.S. source income.

Because the various contracts often mixed on-course use of sponsor products, with ability to use name and likeness for advertising and promotion, the court had a difficult time allocating such combined items. Taxpayers seeking more certainty in this area should consider allocating a fixed portion of the compensation to the various items being paid for.

Retief Goosen v. Commissioner, 136 T.C. No. 27 (June 9, 2011)

TAX POLICY BLOGS

2011-06-08T10:07:00.002-05:00

I am pleased to announce that this blog has been included in a listing of the top 50 tax policy blogs at http://www.mastersinaccounting.org/2011/top-50-tax-policy-blogs. I didn't know there were 50 tax policy blogs out there! Thank you to that site for our inclusion.

DEBT FORGIVENESS IN AN INSOLVENT ESTATE [FLORIDA, BUT RELEVANT ELSEWHERE]

2011-06-07T15:37:00.002-05:00

A recent Florida case addresses an interesting question not previously decided in Florida. The facts are straightforward. A decedent’s son and daughter-in-law owed the decedent money under a promissory note. In the decedent’s last Will, he forgave the repayment of the note. However, if the decedent’s estate does not collect on the note, it will not have enough money to pay its administrative costs, debts and expenses. Thus, the question raised is whether the loan forgiveness is effective if the estate is rendered insolvent by it.

The probate court held the loan forgiveness was effective. On appeal, the probate court was reversed and the loan forgiveness was not given effect.

This makes sense. Florida law, as does the probate law of most states, gives a priority in payment to administrative costs, debts of the decedent, and expenses. Heirs of the probate estate are entitled to receive gifts and bequests only to the extent there are assets remaining after the payment of such items. One policy of such a system is to encourage the probate of insolvent estates to wind-up the affairs of the decedent, even though there may not be assets for the heirs. If costs and expenses of administration could not be paid from available assets first, it would be difficult to find persons willing to undertake such administration. Another policy served is that a decedent’s creditors should be paid before his heirs.

Thus, if a probate estate has $100,000 in cash which is left to the decedent’s son, but has $100,000 of administrative costs, debts and expenses, the son would get nothing. What if the estate did not have $100,000 in cash, but instead has $100,000 due to it from the son under a promissory note which is forgiven in the Will? If the forgiveness is effective, the son is effectively $100,000 richer as if he received $100,000 from his father’s estate, and the estate has no money to pay its costs, debts and expenses. That is, if the promissory note forgiveness is given effect, the son receives the benefit of the write off and thus gets more than if he was entitled only to a $100,000 cash gift, and essentially jumps ahead of the creditors in receiving payment. This was rejected by the appellate court – it noted:

“[t]he ruling by the lower court elevates the gift of forgiveness of an obligation to a superior status over the rights of legitimate creditors of the decedent, contrary to the priorities established in the Probate Code.”

The appeals court distinguished these facts from those in Estate of Whitley, 508 So.2d 455 (Fla. 4th DCA 1987). In that case, loan forgiveness was effectuated by the provisions of the promissory note itself, thus keeping the note out of the probate estate and giving effect to the write-off. This is important in context of the judicial recognition of the effectiveness of the cancellation provisions of self-cancelling installment notes, and provides an avenue for a decedent to be able to assure loan forgiveness at death in all events.

The appeals court rejected arguments that the forgiveness mechanism was the equivalent of forms of ownership that allow for the transfer of assets at death outside of the probate estate. Again, this appears to be a correct analysis since it is the Will that effectuates the loan forgiveness.

The appellate court also noted that while this was a case of first impression in Florida, its decision is in accord with all other jurisdictions that have addressed the issue.

Bernadette Lauritsen, as Personal Representative v. Brian Wallace, 5th DCA, April 1, 2011

INTEREST IN TRANSFER TAX REVISIONS BEGINS TO WARM

2011-06-07T10:38:00.001-05:00

The last time there was a threat to return to pre-2001 transfer tax rules and levels, Congress sat on its hands for over 9 years. It waited until the last minute at the end of 2010 to avoid such a return, but the new legislation that was passed expires after 2012. If Congress does not act, in 2013 the unified credit will return to $1 million and the maximum transfer tax rates will rebound to 55% (from a $5 million unified credit and a 35% maximum rate, for 2011 and 2012).

According to a recent New York Post article, there is interest in Congress to act now to deal with 2013 and beyond. While there is still Republican interest for total repeal, there does some to be a fair amount of cross-party agreement to extend the $5 million unified credit amount, but perhaps bump up the maximum rates to 45%. The hope is that Congress will take up the matter if and when it gets past the current debt-ceiling matters.

Early action to deal with the post-2012 situation would be welcome by planners and taxpayers alike. I don’t think there are too many out there that would like a replay of the last-minute planning and forecasting that arose from Congress’ last minute activities in 2010. As to whether Congress could actually get something done this year? Your guess is as good as mine.

Senate Eyes Compromise on Estate Tax, June 5, 2011

TAX RETURN PREPARER AND ADVISOR STANDARDS REVISED

2011-06-04T11:48:00.001-05:00

The IRS recently issued new rules that tinker with the ethical standards for tax return preparers, and persons advising taxpayers in regard to positions taken on a return.

These provisions reside in §10.34 of the Circular 230 regulations that govern ethical standards and discipline for tax practitioners before the IRS. The provisions are separate and apart from similar (and overlapping) rules under Code §6694 which relate to penalties that may be imposed on return preparers under the Internal Revenue Code.

Essentially, there are 3 courses of conduct that may get a preparer in trouble under the new Circular 230 rules. The same items apply to persons signing a return or claim for refund and persons advising taxpayers on adopting a return position:

a. If the position lacks a reasonable basis;

b. If it is an unreasonable position under Code §6694(a)(2) (relating to the Code penalties on tax preparers); or

c. If the position is a willful attempt to understate liability or is a reckless or intentional disregard of rules and regulations.

Note that it is possible that the position have a reasonable basis, with a violation still occurring. This is because under Code §6694(a)(2), a reasonable basis will not protect a practitioner against penalties for certain tax shelter and listed transaction standards, nor for positions that lack “substantial authority” if required disclosure rules are not complied with.

However, the preamble to the new rules does provide that a violation of Code §6694(a)(2) is not a per se or automatic violation of Circular 230. An independent determination as to whether the practitioner engaged in willful, reckless or grossly incompetent conduct will be made before such a violation is found.

T.D. 9527, IRS Final Regs. Governing Practice Before the Internal Revenue Service ( May 31, 2011)

PURCHASE AND SALE OF MARITAL TRUST ASSETS DID NOT TRIGGER ANY TRANSFER TAX CONSEQUENCES

2011-06-01T18:00:00.001-05:00

Trust and estate litigation often involves issues regarding a QTIP marital trust for which a deduction was taken under Code §2057(b)(7) for estate tax purposes. This comes up often, since such litigation often arises between a surviving spouse who is beneficiary of the QTIP trust, and children of the decedent who are remaindermen and may not be children of the surviving spouse.

Care must be undertaken in dealing with such trusts and their assets in crafting settlements of such disputes. Transfers of interests in such trusts, terminations of such trusts, and other transactions can trigger gift tax consequences, including under Code §2519 (creating a gift tax upon disposition by a surviving spouse of all or part of such spouse’s mandatory income interest in the QTIP).

Not all settlement transactions give rise to adverse transfer tax consequences. In a recent private letter ruling, a QTIP trust purchased ownership interests in entities owned by the children/remaindermen and trusts for their benefit. The children/remaindermen also purchased interests in other entities that were owned by the QTIP trust. The taxpayers sought confirmation that such transfers did not trigger Code §2519 or other gift tax consequences.

Since there was no effective or deemed disposition of the spouse’s income interest in the QTIP trust, the IRS confirmed that Code §2519 was not triggered. Further, no other taxable gift was deemed to occur.

Central to the ruling was that the prices for the various purchases were determined by independent third party appraisals – thus, there were no underpayments or overpayments for the assets. If the remaindermen had been able to purchase QTIP trust assets at a discounted value, or if the QTIP trust overpayed for the assets it bought, this might otherwise have been construed as a disposition of the spouse’s income interest under Code §2519. Underpayments or overpayments for the assets may have also given rise to other gift tax consequences, although if undertaken in context of litigation settlement it probably could still be argued that other consideration was exchanged for the assets (such as releases of rights under the purported claims) as to avoid a gift element.

Private Letter Ruling 201119003, 05/13/2011

MANAGEMENT ENTITIES

2011-05-30T11:26:00.002-05:00

Taxpayers who own various business entities often establish a management entity to provide management services to the entities and/or to act as a common paymaster and employer of all the various entities. The operating businesses will pay a fee to the management entity for the services provided, which fee will usually include an element for reimbursement of the hard costs of the management entity such as for employee wages and withholding taxes.

A recent Tax Court case challenged the deductions claimed by the operating entity for its payments to the management entity. The case addressed a number of the tax issues involved in these arrangements, and provides many “lessons” in structuring them. Some of the key lessons are described below.

1. WHEN WILL THE IRS ATTACK? The IRS will generally be interested in attacking these arrangements only when it perceives taxes are being deferred or avoided. Oftentimes, there are no deferral or avoidance circumstances. For instances, if the operating entities and the management entity are commonly owned, and are pass-through entities such as LLC’s, partnerships or S corporations, the deduction on the operations side is offset by the income on the management entity side. Even with C corporations, if both the operations side and the management side are profitable, then there is little chance of tax avoidance. In the instant case, the operating entity and the management entity were both S corporations. However, the management entity was owned by an ESOP. Thus, there was not common ownership on both sides. Further, the ESOP allowed for deferral or avoidance of tax on the management fees earned by the management entity, while the payor operating entity received an operating deduction. Thus, the IRS was very interested in challenging the management fees.

2. WILL THE MANAGEMENT ENTITY BE DISREGARDED AS A SHAM ENTITY? Relying on Moline Props., Inc. v. Commissioner, 319 U.S. 436 [30 AFTR 1291] (1943), in the instant case the IRS argued that the management entity should be disregarded for Federal income tax purposes because it lacked a legitimate business purpose and economic substance and was formed for the sole purpose of obtaining tax benefits. Such an attack can be successfully defended if the taxpayer can show the management entity was formed for a valid business purpose or if it actually engaged in business activity. Some business purposes that often exist in these circumstances (and that should be of assistance in defending a Moline-type attack) include:

a. Centralization of employee management;

b. Provision of management and other actual services;

c. Creditor protection (including products liability protection) by placing management in an entity without significant business assets and separating business activities in multiple entities;

d. Establishment of incentive and retirement plans for employees; and

e. Business efficiencies via centralization of services and activities.

In the instant case, while the taxpayer had difficulty factually proving a valid business purpose for the arrangement, it did conduct enough actual business activities to avoid a sham finding. In particular, the Tax Court noted that the management entity provided personnel services, maintained an investment and bank account, paid employees by check, adopted a retirement plan, followed corporate formalities and filed income and employment tax returns.

3. WILL MANAGEMENT FEES BE DEDUCTIBLE? Code §162 requires that expenses be ordinary and necessary in carrying on a trade or business to be deductible. Presumably, if the management entities provide employees to the operating entities, fees paid for such employees will be ordinary and necessary and deductible – this is what occurred in the subject case and was approved by the Tax Court. However, in the subject case, the IRS successfully challenged the management fees paid for other services. To enhance the deduction for such services, the following items are helpful:

a. Have an agreement to establish what services will be performed and what will be paid for them; and

b. Make sure the services are in fact performed by the management entity, and be able to specifically prove what was done (this was a problem in the subject case).

Overcharging or undercharging for fees can be problematic, either under Code §162 requirements of a “reasonable” amount, or Code §482 which requires amounts paid between commonly controlled entities to meet arms-length standards.

4. LOANS. If loans exist between the entities, adequate interest should be charged – if not, the IRS will typically be able to impute interest under Code §§482 and/or 7872. Code §7872 was applied in the subject case. All loans should be documented and treated as such on the books and records – failure to do so could result in deemed distributions and dividends.

On the positive side, the Tax Court had no problem with the concept of a management entity or centralized employer – so long as the parties toe the line on the above issues.

Weekend Warriors Trailers, Inc. v. Comm., TC Memo 2011-105

HOMESTEAD WAIVER CASE WITHDRAWN [FLORIDA]

2011-05-27T18:36:00.004-05:00

On March 19, 2010, I commented on the Habeeb case. In that case, a Florida appellate court ruled that the entry of a spouse into a deed that transferred the spouse's ownership interest in a homestead to the other spouse was sufficient for that spouse to waive his remaining homestead rights in the property.

I commented that for various reasons, this appeared to be a questionable conclusion, due to Florida requirements for written waivers of homestead rights and fair disclosure of assets for a valid waiver.

The Habeeb opinion has now been withdrawn. Perhaps for the reasons I mentioned, perhaps for other reasons. Until a subsequent opinion is issued, or some other court addresses a similar issue, things are now back to where they were before the Habeeb case.

ARE YOU CHECKING FOR DOCUMENTARY STAMP TAXES ON TRANSFER OF ENTITY INTERESTS [FLORIDA]?

2011-05-24T12:47:00.001-05:00

Florida recently issued emergency rules relating to the imposition of documentary stamp taxes on the transfer of conduit entity interests. The rules do not greatly expand on the statutory rules, but are a useful reminder of the broad reach of the conduit rules. I would wager a significant sum that there are many transactional attorneys and business persons that are not routinely reviewing the potential application of Florida documentary stamp taxes on the transfer of interests in corporations, partnerships, LLC’s, and other entities.

Florida imposes documentary stamp taxes at the rate of $0.70 per $100 of consideration paid for Florida real property. Some counties impose an additional surtax. In recent years, Florida law has developed to allow or acknowledge that oftentimes real property can be transferred to an entity without incurring the tax. This has opened the door to planning whereby taxpayers would transfer real property free of tax to an entity, and then sell the entity to a third party buyer (instead of selling the real property directly) to avoid documentary stamp taxes on that sale.

In 2009, Florida sought to close the door on this type of planning. It revised Fla.Stats. §201.02 to impose tax on transfers of interests in “conduit entities.” Generally, a tax will be imposed if (a) real property is conveyed to a conduit entity, (b) within 3 years of the conveyance, and (c) all or a portion of the grantor's direct or indirect ownership interest in the conduit entity is subsequently transferred for consideration. If the entity owns assets other than real property, then the tax will be prorated. A “conduit entity” is a legal entity to which real property is conveyed without full consideration by a grantor who owns a direct or indirect interest in the entity, or a successor entity.

Exceptions exist. Transfers of interests in a conduit entity that are in the nature of a gift (that is, they are without consideration), are not taxable. Transfers of interests in publicly traded entities are also exempt. A transfer of an interest to an irrevocable grantor trust is exempt – this appears directed at exempting sales to defective grantor trusts. A transfer of an entity interest at death generally should not be subject to tax since there is usually an absence of consideration paid.

The new emergency rules clarify that if the transfer to the entity was subject to documentary stamp taxes, then the transfer of the interest in the entity is not taxable as to that real property. They also have an example that makes clear that the buyer of an interest in the conduit entity will not be subject to tax on a subsequent resale of that interest, since the buyer was not the original “grantor.” The rules also provide that that tax is due on the earliest of the 20th day of the month following the month the ownership interest is transferred or the date that an instrument evidencing the transfer is filed or recorded in Florida.

Thus, any time there is a transfer of an interest in any nonpubicly traded entity for consideration, the question needs to be asked if Florida real property was transferred to it within 3 years by the seller (including indirect transfers through entities). This is similar to another set of tax rules that can relate to transfers of entities that is often overlooked – Code §1445 withholding on dispositions by foreign persons of interests in entities that are U.S. real property interests by reason of ownership of U.S. real property.

Florida Administrative Code §12BER11-2 (May 13, 2011)

APPLICABLE FEDERAL RATES–JUNE 2010

2011-05-22T17:38:00.001-05:00

FUTA SURTAX EXPIRING SOON

2011-05-15T17:59:00.002-05:00

Employers pay federal unemployment taxes on employee wages at the rate of 6.2%. 6% is the permanent rate, and 0.2% is a "temporary" surtax. Perhaps the temporary tag is a misnomer - it has been in place since 1976.

The 0.2% portion is set to expire, effective July 1, 2011. In today's political environment, it would be sheer speculation whether Congress will act to extend that portion. The President's 2012 budget seeks to make the 0.2% permanent.

PUBLIC CHARITY STATUS DENIED

2011-05-14T06:47:00.001-05:00

Code §501(c)(3) organizations usually prefer to be classified as a public charity and not a private foundation. Private foundations are subject to excise taxes and limitations on donor charitable deductions that public charities do not have to deal with, among other disadvantages.

The usual route to public charity status is to meet certain numerical tests that show the foundation has broad funding. Organizations with a limited number of donors will not pass these tests. All is not lost for such organizations. If they can show they are operating for the benefit of one or more other specific public charities, they can qualify as Code §509(a)(3) “supporting organizations” which are treated as public charities.

One requirement (among others) under Code §509(a)(3) is the “organization test” that requires that the organization “is organized and, at all times thereafter, operated exclusively for the benefit of, to perform the functions of, or to carry out the purposes of one or more…specified organizations” that are public charities (other than by reason of being supporting organizations). Thus the question arises whether a given organization meets this specificity requirement. The Regulations generally require the articles of incorporation to designate each of the specified organizations. Treas.Regs. §1.509(a)-4(d)(2)(i). Further refinements to the requirements are based on the “type” of qualification sought. A Type II organization need not specify by name each publicly supported organization it intends to support if its articles of incorporation “require that it be operated to support or benefit one or more beneficiary organizations which are designated by class or purpose....” Treas.Regs. § 1.509(a)-4(d)(2)(i)(b).

A recent case tested the limits of these identification and specificity requirements. The organization at issue identified the organizations it intended to support as organizations “which support, promote and/or perform public health and/or Christian objectives, including but not limited to Christian evangelism, edification and stewardship.”

The IRS argued that this identification did not meet the Type II specificity requirements. It interpreted the “designation by class or purpose” allowance as still requiring that the identification be specific enough so that the class of beneficiary organizations is “readily identifiable.” The taxpayer challenged this gloss on the regulation, but the appellate court determined that the IRS’ interpretation of its regulation was not plainly erroneous or inconsistent and thus would be respected.

The organization’s description of the organizations it would support was found to be too broad to meet this “readily identifiable” standard. The appellate court noted that there were no geographic limits imposed, nor a limit to a certain type of organization such as a church or seminary.

Note that it is not the number of organizations that are specified that is important – instead, it is whether someone can use the description to actually identify the subject organizations. For example, the IRS and the court noted with approval the description used in Rev.Rul. 81-43. The organization in that ruling described the organizations it will support as “charitable organizations located in the Z area that are exempt under section 501(c)(3) of the Code and are public charities described in section 509(a)(1) or 509(a)(2).” Thus, this description passes muster because even though it may identify a large number of organizations, it is a precise enough standard that the organizations identified can be precisely determined.

Organizations that are not naming their supported public charities by name should take a clue from this case and undertake to include geographic limits and/or identification of the type of organization that will be supported.

Polm Family Foundation v. U.S., 107 AFTR2d Para. 2011-804 (CA DC 5/6/2011)

COMPENSATION VIA SHARE OF PROFITS DID NOT ESTABLISH A PARTNERSHIP

2011-05-07T06:54:00.001-05:00

Parties that jointly conduct a business or venture and share the profits and losses will typically meet the definition of a “partnership” for income tax purposes and be taxed accordingly. Such partnership treatment can arise, even though the parties did not intend to create a partnership and merely have some other type of contractual arrangement between them.

This issue often arises when an individual or an entity provides services to another that is conducting a venture or business, and is paid for its efforts in whole or in part with a percentage of the profits of the venture. Since there is a sharing of “profits,” there is a reasonable risk that the IRS may find the arrangement to be a partnership, and not a non-partnership contractual arrangement.

The tax status of the relationship can have significant consequences for the parties, including whether the service provider is taxed immediately on a pass-through basis on the ventures profits, whether the provider can deduct venture losses, whether Section 1446 withholding on foreign participants may apply, and whether the service provider will be taxed on its receipts as ordinary income (nonpartner) vs. capital gain income (partner) if the shared profits are in the nature of capital gains.

It was whether such profits paid to a service provider were capital gains or ordinary income that was the issue in recent tax case. Interestingly, the court found that the service provider was NOT a partner even though it was paid with a 20% profits interest in the venture. While the court’s examination was very fact specific, the factors looked at by the court and its view whether those facts supported a partnership or nonpartnership relationship can be useful when crafting contractual relationships when no partnership relationship is (or is not) desired. These factors included:

-the contract specifically declared that the relationship was not a partnership (this obviously was a factor against a partnership);

-the contract provider expended its own funds in performing its functions (this was considered by the court as a capital contribution and was a factor in favor of a partnership);

-the contract provider did not have authority to withdraw funds from the business, it could not increase the business owner’s capital commitment to assets, it could not enter into binding agreements in the name of the business, and it could not dispose of an asset without the owner's prior written approval. The court held that the service provider’s responsibilities, while numerous, did not extend into the key areas of acquiring and disposing of assets or drawing upon the business’ bank accounts that would indicate a partnership relationship (factor against partnership);

-the contract provider did not own title to any of the assets in the business, and apart from depositing checks did not share control with the business over the bank accounts that corresponded with the companies in the business portfolio and could only make business recommendations (factor against partnership); and

-the parties did not file partnership tax returns, and the contract provider did not hold itself out as a partner to third parties (factor against partnership).

Compensating employees or independent contractors with a profits share often makes good business sense to owners, as compared to actually making them part owners. Benefits to business owners include avoiding creating statutory rights in the recipients (such as voting rights and rights to examine books and records), and the ability to terminate the relationship without an obligation to repurchase shares or ownership interests, while gaining the incentive benefits of a profit participation. Sometimes, these interests are established as a share of gross profit instead of net profit, to avoid the partnership tax risk -with a gross profit interest, there is no sharing of expenses or losses, thus eliminating an important factor in the establishment of a partnership relationship for tax purposes. Thus, in addition to providing helpful factors to avoid partnership status, the case also provides some comfort that compensation via a net profit share will not, in and of itself, necessarily create a partnership relationship.

Rigas v U.S., 107 AFTR 2d ¶2011-788 (CD TX 5/2/7/2011)

FLORIDA ACTS TO RESOLVE OLMSTEAD ISSUES [FLORIDA]

2011-05-02T14:49:00.002-05:00

I previously discussed the Olmstead case – that discussion can be read here. This case created a stir both inside and outside of Florida, when it provided that at least in the situation of a single member LLC, a creditor’s rights are not limited to a charging order but could include a right to foreclose on the debtor’s LLC interest. The potential application of the decision to multimember LLC’s became a much-discussed issue. My partner, Jordan Klingsberg, has written the following summary relating to new LLC legislation that seeks to resolve these issues:

On Friday April 29, 2010 the Florida Senate passed CS/HB 253, Limited Liability Companies, to address some of the uncertainty surrounding Florida LLCs created by the recent Florida Supreme Court case, Olmstead v. Federal Trade Commission, 44 So.3d 76 (Fla. 2010). The bill provides that, except in one situation, a charging order is the "sole and exclusive remedy" to satisfy a judgment from a judgment debtor's interest in an LLC. The exception concerns an LLC with one member where distributions under a charging order will not satisfy the judgment in a reasonable time. In such a situation, a court may order the sale of the single member's interest in the LLC. CS/HB 253 passed both the Florida House and Senate and has been sent to the Governor to be signed into law.

In June of 2010, the Florida Supreme Court in Olmstead held that a charging order is not the exclusive remedy available to a creditor holding a judgment against the sole member of a Florida single member LLC. The court ruled that the judgment debtor had to surrender all right, title, and interest in the member's single member LLC interest in order to satisfy the outstanding judgment. The dissent in Olmstead, however, stated that the majority's holding was not limited to single member LLCs and expressed a desire that the Florida legislature clarify the law in this area.

Many practitioners believed that the Supreme Court's reasoning in Olmstead would apply to all limited liability companies. This lead many businesses to change their situs and organize in states other than Florida where a charging order is the exclusive remedy available to judgment creditors of multimember LLCs. This bill amends Fla. Stat. §608.433 to clarify that the Olmstead decision does not extend to multimember LLCs and provides procedures for applying the Olmstead decision to single member Florida LLCs.

The bill specifically states that a judgment creditor has only the rights of an assignee of the LLC interest to receive distributions to which the judgment debtor would have otherwise been entitled from the LLC. The only situation in which a court may order the sale of a member's interest is where the judgment creditor of a member's interest in a single member LLC establishes "that distributions under a charging order will not satisfy the judgment within a reasonable time." Upon such a showing, the court may order the sale of the single member's interest pursuant to a foreclosure sale and the purchaser becomes a member of the LLC and obtains the prior member's entire interest in the LLC. The foreclosure remedy is not available to a judgment creditor of a multimember LLC and cannot be ordered by a court.

Section 9 of the Bill does provide that nothing in the statute shall (i) limit the rights of a secured creditor, (ii) change the impact of a fraudulent conveyance; or (iii) change the court's right to use equitable principals such as ruling that an LLC was sham or using equitable liens or constructive trusts. These provisions, however, were likely already law in Florida.

The Bill does not contain any provisions for treating a multi-member LLC as a single member LLC and disregarding nominal interests held by minority members such as family members and grantor trusts.

This Act and the amendment to Fla. Stat. §608.433 will hopefully clarify the judgment remedies available against Florida LLCs and remove some of the ambiguity surrounding the treatment and operations of LLCs in Florida.

Special thanks to Richard Josepher of Gutter Chaves Josepher Rubin Forman Fleisher PA and other members of the special committee of the Florida Bar Tax Section who worked extremely hard and supported this legislation.

BUNDLED FIDUCIARY FEES REMAIN DEDUCTIBLE (FOR NOW)

2011-05-02T14:31:00.001-05:00

In 2008, the U.S. Supreme Court held that costs paid to an investment advisor by a nongrantor trust or estate generally are subject to the Code §67(a) 2% floor for miscellaneous itemized deductions. Michael J. Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner, 552 U.S. 181 (2008). What happens when the estate or trust pays a bundled fiduciary fee – that is one that does not provide a breakout on the total fee paid between investment advisory fees subject to the 2% limit and other fees that are not subject to the 2% floor? How is the taxpayer supposed to know how much is subject to the 2% floor?

After the Knight case, the IRS has issued Notices on an annual basis that relieved taxpayers of having to determine the portion of a bundled fiduciary fee that is subject to the 2% floor.

The IRS has now issued a Notice that indefinitely extends this relief, until the date that final regulations on the subject are published. Prior to that date, taxpayers may deduct the full fee without regard to the 2% floor. The Notice warns that payments by the fiduciary to third party for investment expenses are deemed to be readily identifiable and must be treated separately from the otherwise bundled fee.

Notice 2011-37, 2011-20 IRB (4/13/11)

"’UNIFIED BUSINESS ENTERPRISE” THEORY

2011-04-30T09:11:00.001-05:00

Under Code §183, individuals and S corporations desiring deductions for their business activities must be engaged in the activity “for profit.” Activities which consistently generate losses may be presumed to be not for profit.

A recent case illustrates a seldom-discussed theory or concept, known as the “unified business enterprise” theory. Under this theory, a taxpayer conducting activities in isolation which generate losses and thus may be considered not to be “for profit” under Code §183, may be able to aggregate that activity with other activities conducted either individually or through other commonly controlled entities to come up with a profit motive for an aggregate, or “unified business” enterprise that will avoid the limits of Code §183.

The cases tend to arise where property, such as an airplane or land, is owned and leased to a related business venture, with losses arising in the owning entity. In the current case, the taxpayer was a principal in the Hard Rock Café chain. The taxpayer owned several aircraft in one or more entities, which aircraft were used by the taxpayer and/or other entities. The IRS asserted that deductions relating to the aircraft should be disallowed because the owning entities were not operated for profit. The taxpayer countered with the unified business enterprise theory.

The Court of Claims sustained the application of the unified business enterprise theory to the taxpayer’s situation, and ruled against the IRS (although IRS issues of substantiation of expenses were allowed to go forward). The IRS raised the cases of Deputy v. du Pont, 308 U.S. 488 (1940) and Moline Properties, Inc. v. Comm., 319 U.S. 436 (1943) to show that corporations and their shareholders should be treated as separate and distinct for tax purposes. However, the court noted that in those older cases, S corporations were not involved, and did not involve overlapping businesses that essentially treated the S corporations as alter-egos for the taxpayer owner.

Thus, the unified business enterprise theory is alive and well, at least for pass-through entity situations such as S corporation and partnerships. Situations involving C corporations should expect greater resistance, if not outright rejection, of the theory by the IRS and courts.

Morton v. U.S., 107 AFTGR 2d 2011-xxxx (Ct Fed Cl), April 27, 2011

WHERE IS MY REFUND?

2011-04-25T14:54:00.001-05:00

If you have an iPhone or an iPad, there is a new way to check on when to expect your income tax refund. By using the IRS2Go app, you can get this information on i-device. The app is available at the Apple app store.

Haven’t tried it myself, so I can’t vouch for its accuracy or effectiveness.

SECTION 332 LIQUIDATION OF INSOLVENT SUBSIDIARY VIA CONVERSION TO DISREGARDED ENTITY

2011-04-23T10:16:00.001-05:00

A corporation converted its wholly owned subsidiary to a disregarded entity via a check-the-box election. At the time, the subsidiary was insolvent. The parent corporation sought a worthless stock loss under Code §165(g)(1).

At issue is Code §332 which will not allow a parent corporation shareholder to recognize gain or loss on liquidating distributions of an 80%-or-more owned subsidiary. The corporation sought a private letter ruling to the effect that Code §332 did not apply.

A necessary requirement for Code §332 to apply is that the parent must receive at least partial payment for the stock it owns. Since a check-the-box election to be treated as a disregarded entity treats the electing corporation as liquidating, at least in normal circumstances it would appear that this constructive liquidation would result in the requisite partial payment for the stock and Code §332 would apply to disallow the loss.

However, in this case the subsidiary was insolvent. The taxpayer sought to apply Rev.Rul. 2003-125 in context of this constructive liquidation. In that Ruling, the IRS concluded that when the fair market value of the subsidiary's assets, including intangible assets such as goodwill and going concern value, is less than the sum of the subsidiary's liabilities, including bona fide liabilities owed to the parent, no part of the transfer is attributable to the parent's stock ownership and the above payment -for-stock requirement isn't satisfied. Accordingly, the Code Sec. 332 nonrecognition rules didn’t apply.

On a constructive liquidation of an insolvent subsidiary, the same effect should occur, even though no physical movement of assets occurs. Thus, in theory, Rev.Rul. 2003-125 should apply.

Theory does not always apply when dealing with the IRS. However, in this situation, it did, and the IRS acknowledged that Rev.Rul. 3002-125 could apply to a constructive liquidation under a check-the-box election. Thus, the parent corporation obtained the worthless stock deduction.

As an aside, note that the parent corporation was able to receive an ordinary loss instead of a capital loss, by reason of the application of the affiliation exception under Code §165(g)(3).

PLR 201115001

APPLICABLE FEDERAL RATES–MAY 2011

2011-04-20T17:04:00.001-05:00

DING, DONG, THE WITCH IS DEAD

2011-04-17T10:19:00.001-05:00

President Obama on Thursday signed into law a bill repealing the health care reform law's 1099 tax reporting requirement. Demands for repeal surfaced soon after the health care law was enacted, as the costly and time-consuming new reporting requirement was understood. Given the politics of Washington D.C., it took quite a while to kill off the reporting, even though the repeal was widely supported by Democrats and Republicans. The reporting requirement would have required business and real estate owners to file a 1099 form with the IRS for every vendor to whom they paid more than $600 in a year.

SUSPECT EXPERT APPRAISAL RISKS TOTAL TAXPAYER LOSS

2011-04-13T15:30:00.001-05:00

Numerous tax consequences flow from the value of property. Principal examples include charitable contribution deductions, estate taxes, and gift taxes. Absent a contemporaneous sale of the subject property to unrelated persons, an appraisal will usually be needed to compute the relevant tax. If the IRS disputes the value and the matter ends up in court, an expert will be needed to sustain the taxpayer’s valuation. The government will often offer up its own competing appraisal, although it may instead be content with only attacking the taxpayer’s expert and report.

A recent Tax Court case demonstrates the hazards of relying on a suspect expert or appraisal in tax litigation. In Boltar LLC et al v. Comm., the issue was the valuation of a conservation easement for charitable deduction purposes. During trial, the Tax Court noted a host of problems with the valuation opinion of the taxpayer’s expert. The government moved to exclude the expert’s report and testimony as neither reliable nor relevant, under the authority of the Federal Rules of Evidence and Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579 (1993). The expert’s report and opinion was so problematic that the Court granted the motion.

A typical result in a case such as this will be a finding of value at or close to the value presented by the government, since there will be little or no admissible evidence to the contrary. Opportunities to shift the burden of proof on value to the government may also be lost. Thus, a taxpayer relying on a weak appraisal report or expert risks a total loss on the valuation issue.

Results such as this demonstrate that relying on an aggressive value during litigation enhances the risk of total loss. It also demonstrates the importance of properly vetting the expert and his appraisal to determine its credibility and correctness. Lastly, it suggests that using more than one expert or report may be an appropriate litigation strategy in the proper circumstances (although having differing values under those reports may create other litigation issues, and will also include litigation costs).

The taxpayer argued that the Daubert analysis should only apply in a jury trial (Boltar involved a non-jury trial). The Tax Court did not buy into that, holding that a Daubert-type exclusion can apply in a bench trial.

Boltar, LLC et al v. Comm., 136 TC No. 14 (4/5/2011)

RECOVERING ATTORNEY FEES FROM THE IRS WHEN SOMEONE ELSE PAYS YOUR FEES

2011-04-10T10:27:00.001-05:00

Under Code §7430 , a taxpayer who prevails against the IRS in court (or at the administrative level) can recover his fees and costs. Restrictions on recovery exist, however. The taxpayer must have exhausted administrative remedies before going to court, the taxpayer must not unreasonably protract the proceedings, and the taxpayer must meet financial eligibility requirements. Further, no fees will be allowed when the IRS proves its position in the proceeding was substantially justified. Thus, taxpayers can only recover fees if the IRS was acting unreasonably in seeking to impose taxes.

Oftentimes, a taxpayer’s employer or a related person or entity may pay his attorneys fees. The procedural history of a recent case has established that recovery of fees by the taxpayer are still available in this circumstance, but only under two limited circumstances.

Under the first of these, the taxpayer must have an absolute obligation to repay the fees to the person or entity that paid them initially, regardless of whether he successfully recovers an award of fees from the IRS. Under the second, the taxpayer must have a contingent obligation to pay the fees if he recovers an award of fees from the IRS.

This new law established in the taxpayer’s case unfortunately did not help the taxpayer. The Tax Court, on remand from the appellate court to apply these rules, did not find either of the two limited circumstances to apply. While the taxpayer did assert that he had a contingent obligation to repay any fees he recovered by the IRS, there was no written evidence of such an obligation – essentially, the Court did not find sufficient evidence to find that there really was such an agreement.

The taxpayer also argued that he was obligated to pay the attorneys if the corporation that undertook to pay them could not. However, the court indicated that this does not meet the first circumstance – the test there is only whether the taxpayer had on obligation to repay the entity paying his fees.

“In other words, the relevant inquiry is whether petitioner is indebted to Caspian for the amounts Caspian paid to counsel on his behalf. Petitioner's argument focuses incorrectly on his supposed obligation to pay the fees to counsel directly ‘if Caspian failed to pay for such services’, rather than on an obligation to repay Caspian.”

Taxpayers seeking to be able to recover fees from the IRS in these circumstances would be well served to establish in a contemporaneous writing an agreement to repay the paying entity or person, either in all circumstances or in the event of recovery from the IRS (assuming that to be the actual agreement of the parties).

Morrison, TC Memo 2011-76

FORM 8939 AND ELECTION OUT OF ESTATE TAX FOR 2010–CONTINUING EXTENSION

2011-04-05T15:12:00.001-05:00

As April 18 approaches, there have been continuing concerns whether the election out of estate tax for those estates that desire to do so for 2010 decedents, and the filing of Form 8939 to report basis adjustments for those decedents, will be required to be filed by that date. This is because previously the Form 8939 reporting was to have been completed and submitted by the due date of the decedent’s 2010 income tax return.

We have previously discussed earlier guidance on when those items will be due here. On March 31, the IRS issued further unambiguous guidance that such items will not be due on April 18.

The due dates (and applicable forms) will be released by the IRS in the future.

IR-2011-33, March 31, 2011