A. Recent IRS Developments
Field audits of taxpayers with incomes exceeding $200,000 rose 34 percent in fiscal 2011 to 78,392. IRS Deputy Commissioner Steve Miller stated that “[w]e are looking more at taxpayers at these income levels because we find more issues there.” Much of the audit increase is attributable to IRS efforts to pursue revenue from undeclared offshore accounts. Audits of Sub S corporations also rose by 13 percent in 2011. In 2011, the IRS recommended 1,622 criminal prosecutions, up 7 percent from 2010. The conviction rate was 93 percent, and the average sentence was 25 months. The percentage of e-filed returns increased to 77 percent in 2011, up from 69 percent in 2010. The IRS recently announced renewal of the Offshore Voluntary Disclosure Initiative program. Begun in 2009, OVDI has now yielded $4.4 billion in tax collections. In contrast to the earlier programs, which imposes deadlines, the new initiative will continue until further notice.
National Taxpayer Advocate Nina Olsen in a report to Congress stated that IRS underfunding has resulted in harm to taxpayers and an inability of the IRS to raise tax revenue. The report cited the failure to classify most inquiries as audits, thus depriving taxpayers of audit rights. Another problem cited concerned IRS notices of mathematical errors on returns. The notices are often vague, making the assessment difficult to contest. The report called for the enactment of a new comprehensive taxpayer bill of rights.
B. New Regulations
Section 403 of the Energy Improvement and Extension Act of 2008 amended the Internal Revenue Code to mandate that every broker required to file a return with the IRS reporting gross proceeds from the sale of a covered security also report a customer’s adjusted basis in the security and whether any gain or loss on the sale is classified as short-term or long-term. The amendments direct brokers to follow customers’ instructions and elections when determining adjusted basis. Those cost basis rules, instituted on January 1, 2011, will be entirely phased in this year. The new reporting requirements apply with respect to stock bought in 2011. However, the cost basis of shares bought in 2011 but not sold will not be reported until the shares are sold. Additionally, the basis of stock sold in 2011 but purchased in earlier years will not be subject to the new reporting rules. Effective June 24, 2011, Regs. §1.6081-6 reduce the automatic extension of time to file a fiduciary income tax return Form 1041 to five months from six months. The rationale for this change is to allow tax preparers additional time to complete income tax returns for individuals who receive Forms K-1 from fiduciaries.
C. Proposed Regulations
The alternate valuation date election permits an executor to value the estate six months after the death of the decedent. Prop. Regs. §20.2032-1(c)(1)(i) ignore during alternate valuation date changes in value which occur by reason of deemed distributions or sales. In a related development, PLR 2011122009 allowed a late election pursuant to Regs. §301.9100 of the alternative valuation date, since the election was made within one year of the due date of the estate tax return, with extensions. Treasury in 2011 proposed regulations requiring that a new category of restrictions, “Disregarded Restrictions,” be applied in valuing an interest in a family owned entity for Alternate Valuation Date (AVD) purposes. In a significant departure from current law, disregarded restrictions would include those more restrictive than a standard found in the regulations. Previously, only those restrictions more restrictive than those found in state law would be disregarded. The proposed regulations followed the Tax Court decision in Kohler v. Com’r, T.C. Memo, 2006-152, nonacq., 2008-9 IRB 481. In Kohler, which the IRS lost, a tax-free reorganization under IRC §368(a)(1)(E) following death greatly reduced the value of the estate at the AVD.
IRC §67(a) provides that miscellaneous itemized deductions are allowed only to the extent that those deductions exceed 2 percent of AGI. IRC §67(e) provides that AGI of an estate or trust is computed like that of an individual, except that costs paid or incurred in connection with the administration of the estate or trust that would not have been incurred if the property were not held in such estate or trust are allowable in arriving at AGI. Consequently, those costs are not subject to the two percent floor. Although the statutory language appears benign, the Supreme Court in Knight v. Com’r, 552 U.S. 181 (2008) held that fees customarily or generally incurred by an estate or trust are not uncommonly incurred by individual investors. Therefore such expenses are subject to the two percent floor. The court acknowledged it was conceivable “that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper.”
Taking its cue from Knight, Treasury has withdrawn earlier proposed regulations, and advanced new proposed regulations. Under new proposed regulations, in order to avoid the two-percent floor, the trust or estate must show that (i) the investment advisory fee exceeds that normally charged to individual investors; and (ii) the excess is attributable to an unusual investment objective of the trust or estate. In offering limited relief, the IRS has stated that taxpayers will not be required to determine the portion of a “Bundled Fiduciary Fee” that is subject to the two-percent floor under Section 67 for taxable years beginning before the date that the regulations become final.
Treasury in 2011 promulgated temporary regulations which updated mortality tables reflecting longer life expectancies. The result of the new mortality tables is to increase the value of lifetime interests and to decrease the value of future (remainder) interests. Under the new tables, QPRTs are less attractive since the grantor is less likely to die within the term of the QPRT. This in turn reduces the value of the reversionary interest, and increases the amount of the gift. On the other hand, Self-Cancelling Installment Notes, or SCINs, will be more attractive. The buyer of a SCIN must pay a premium which takes into account the actuarial probability that the seller will die before the term of the note. Since there is less of a probability that the seller will die, the premium is reduced, thus making the SCIN a more attractive estate planning vehicle. T.D. 9540, 76 Fed. Reg. 49570.
C. New Rulings and Procedures
The IRS in Notice 2012-4 estimated that taxpayers underpaid their taxes by $385 billion in the tax year 2006. Individuals and corporations paid 85.5 percent of their actual tax liability in 2006, compared with 86.3 percent in 2001. The amount underreported by individuals was more than three times that of all corporations; and among individuals, the largest element of noncompliance related to undeclared income by businesses on Schedule C, and by farms on Schedule F.
The IRS provided guidance for filing protective refund claims for an estate in Rev. Proc. 2011-42. Generally, only claims that are actually paid or ascertainable with reasonable certainty are allowed as an estate deduction. A protective claim would be made where these conditions are not met when the estate tax return is filed. Rev. Proc. 2011-42 articulates the manner in which the protective claim is made, the necessary contents of the claim, and the requirement that a clear identification of the claim be made. A protective claim must be filed within three years from the date the return was filed or within two years from the date when the tax was paid, whichever is later.
In PLR 201118014 the IRS permitted a QPRT to be modified to permit the grantor to continue to reside in the residence after the retained use period. The QPRT provided the grantor with a right to use the residence after the initial term. The grantor’s children possessed a remainder interest. As trustee, the grantor and her children executed a modification to the QPRT which granted the children the right to amend and restate the trust to allow the grantor to continue to use the residence for a term of years after the retained use period. The IRS stated that the modification did not violate IRC §2702(a)(1). However, the transfer of the term interest constituted a taxable gift by the children to the grantor, the value of which was the actuarial value of the term interest given to the grantor.
TAM 201126030 illustrates the need for clarity and precision in a Will. The Will in question stated “it is my desire” that certain assets pass to the testator’’s children. The IRS was asked whether the bequest to the children was mandatory or merely precatory. Consulting applicable state law, the IRS concluded that where an instruction to a beneficiary is stated as a desire, the direction is usually precatory; but where an instruction to an executor is stated as a desire, the direction is usually mandatory. Since the direction in question was made to the executor, the IRS concluded that the direction was mandatory. Since a mandatory direction resulted in the beneficiaries becoming entitled to specific bequests, the marital deduction was reduced.
D. Other Treasury Proposals
Treasury fiscal year 2012 proposed that there be a requirement that values reported for income tax purposes match values reported for transfer tax purposes. This “duty of consistency” would ameliorate the situation where, after estate tax audit, the IRS increases the value of an asset. Since the asset will have been reported to the beneficiary at a lower basis, the beneficiary would incur excessive capital gains tax when the asset is sold prior to the conclusion of estate litigation. Treasury believes that requiring that the value used for estate tax purposes match that used for capital gains purposes would encourage more realistic estate valuations as an initial matter.
Another Administration proposal that has been circulating for the last few years would impose a minimum 10-year term for GRATs. Treasury believes that taxpayers are avoiding gift tax by using short term (“zeroed out”) GRATs that impose little or no gift tax. However, Treasury does not object to the use of zeroed out GRATs for 10-year GRATs.