View in PDF:  Tax News & Comment — February 2013

2012 Regulations, Rulings & Pronouncements of Note

I.   Taxpayer Advocate Report

National Taxpayer Advocate Nina E. Olson issued the agency’s annual report to Congress on January 9, 2013. The report cited the dire need for tax reform and simplification of the Code. Underfunding of the IRS, identity theft and return preparer fraud were also identified as chronic problem areas. The report found that the existing Code makes compliance difficult, and requires taxpayers to spend “excessive time” in preparing their returns. The Code also “obscures comprehension, leaving many taxpayers unaware of how their taxes are computed. . . it facilitates tax avoidance by enabling sophisticated taxpayers to reduce their tax liabilities and provides criminals with opportunities to commit tax fraud.”

The report found that the Internal Revenue Code imposes a “significant, even unconscionable burden on taxpayers” and noted that if tax compliance were an industry, it would be “one of the largest in the United States.” Simplification, according to the report, would occur if Congress reassessed and reduced the dizzying number of exclusions, deductions, exemptions and credits, generally known as “tax expenditures.” If Congress were to eliminate all such tax expenditures, the report concludes that individual income tax rates could be cut by 44 percent, and still generate the same amount of income. The suggestion is made that as a starting point all tax expenditures be eliminated and then reassessed, with the objective of determining whether the incentive would be best administered through the Code or as a direct spending program.

The report fails to comprehend the difference between the complexity of the Code and the purpose of a tax expenditure. Achieving simplification of the Code is not dependent on eliminating tax expenditures. To cite a case in point, Code Section 1031 provides a deferral of tax when exchanging property of like kind. There is no question but that Section 1031 is a tax expenditure or tax incentive. If Section 1031 were eliminated, there would be no feasible way for Congress to provide this incentive in a direct spending program.

Another example which illustrates the folly of suggesting that tax expenditures be eliminated would be Section 179, which provides a current deduction for business investments. Eliminating Section 179 would result in taxpayers being required to capitalize the cost of tangible personal property used in a business. Again, no comparable method of providing the benefit of Section 179 could be achieved by a “direct spending program.”

The confusion about the purported cause and effect relationship between the complexity of the Code and tax expenditures is surprising. Tax expenditures are not bad per se. Nor is the “complexity” of the Code bad per se. A flat tax with no deductions would likely “simplify” the Code, but it would come at the cost of eliminating progressivity in the tax system. The very problems which have plagued the Alternative Minimum Tax would visit an attempt to simplify the Code by eliminating appropriate deductions, credits and exclusions.

This is not to say that the Code is not complicated. There are undoubtedly many areas of the tax law that are complex. However, to cite another example, Congress has decided that losses incurred in “passive” activities should not be permitted to offset other deductions. This is a judgment that Congress has made, and Section 469 stands as a proper exercise of the legislative power of Congress to collect tax. The complexity of Section 469 is undeniable, but should the difficulty — or perhaps impossibility — of “simplifying” a provision designed to achieve a specific purpose necessarily result in an indictment of that statute?

There is arguably a need to simplify compliance procedures. However, the argument that it takes sophisticated tax software for the average taxpayer to complete a return is somewhat naïve. The world is more complex today than 50 years ago. The availability of sophisticated software makes compliance easier. Few taxpayers today sit down with a form 1040 and a pencil and calculate their tax liability. Congress has taken concrete steps to ease compliance difficulties. Withholding laws have been strengthened. Information reporting for securities transactions, as well as for other receipts of income from sources requiring 1099 reporting, have been expanded. The complexity of the Internal Revenue Code is not the problem. Part of the problem lay in the fact that the forms and instructions provided by the IRS are not always models of clarity.

Report Cites IRS Underfunding 

 The Advocate’s report also cites extreme IRS underfunding as a major problem. The report postulates that it is “ironic and counterproductive” that deficit concerns result in less funding for the IRS. A statistic is cited in the report that the “return on investment” of the IRS is “214:1” and states that “no business would fail to fund a unit that . . . brought in [much more than] every dollar spent.” The report then finds that the decline in IRS services since 2004 has been the result of IRS underfunding. Fewer taxpayer telephone calls are answered by live agents, and more ominously, automated enforcement procedures are causing the issuance of liens and levies where an installment agreement or offer-in-compromise could be considered.

This argument seems strained. Computers do not issue liens and levies. Computers could be just as easily programmed to issue letters requesting that delinquent taxpayers consider an installment agreement or offer in compromise. There is no question but that IRS personnel have a daunting task in handling millions of taxpayer inquiries. Yet other large companies also face the same task and can seemingly deliver prompt customer service. No one would argue that the IRS should not be properly funded. However, “fencing off” the IRS and making it immune from spending ceilings imposed on other governmental agencies based on the argument that the IRS “is the de facto Accounts Receivable Department of the federal government” seems specious.  Not everyone would agree with the conclusion of the Taxpayer Advocate that “[t]he plain truth is that the IRS’s mission trumps all other agencies’ missions.”

Tax-Related Identity Theft

The report cites the spiraling incidence of taxpayer identity theft, which often results in a six month or longer delay in a taxpayer receiving a refund, since no refund will issue until a case is closed. The report cites the need for a “streamlined process” to resolve the cases and notes that taxpayers still face a “labyrinth of procedures and drawn-out timeframes for resolution.”  Among other “serious” problems encountered by taxpayers and identified by the IRS include the following:

(i) the failure by the IRS to provide tax refunds to victims of preparer fraud;

(ii) the “extraordinarily high audit rate” of taxpayers claiming the adoption tax credit (which results in only about 10 percent of the credits being denied);

(iii) the failure of the Offshore Voluntary Compliance Program to distinguish between “bad actors” and “benign actors” in enforcing Foreign Bank and Financial Accounts Reporting (FBAR) requirements. By requiring taxpayers to “opt out” of the voluntary program and submit to onerous audits to avoid the imposition of “draconian” penalties, the program has caused an “excessive burden” on taxpayers who had reasonable cause not to file FBAR returns; and

(iv)   the need to improve voluntary compliance by small businesses and sole proprietors, whose compliance is regarded as generally poor. The report found that low-compliance taxpayers were more suspicious of the tax system and were less likely to have trust in tax preparers and were less likely to use them.

II..    Treasury Proposals in 2012

¶ Treasury proposed expanding the category of “disregarded restrictions” under IRC §2704(b) to impair the ability to take discounts on intra-family transfers. Since courts have upheld the viability of discounts when compared to state law, the proposal would instead reference standards in Treasury regulations.

¶ Treasury raised the subject of requiring a minimum ten-year term for GRATs. However, no action was taken, and there was no mention of impairing the ability of taxpayers to “zero-out” GRATs.

¶ Treasury proposed limiting the duration of the GST tax exemption to 90 years. If adopted, this measure would be more stringent than the existing rule against perpetuities.

¶ In what would constitute a damaging blow to a popular estate planning technique, Treasury proposed including the date-of-death value of all grantor trusts in the grantor’s gross estate. Taxpayers who have relied on the ability to shift assets out of their estate while picking up the income tax would be “grandfathered,” as the proposed changes would not be retroactive. While this proposal if enacted would defeat the benefit of funding grantor trusts, the measure appears to be years away from enactment and, if one had to speculate, it appears that there is greater chance that the estate tax itself would be eliminated than that this measure would see the light of day.

¶  Treasury proposed regulations to implement the Supreme Court’s decision in Knight v. Com’r, 552 U.S. 181 (2008), which interpreted IRC §67(e)(1). Section 67 states that certain expenses incurred in administering a trust or estate are not subject to the 2 percent itemized deduction limitations. [Section 67(e)(1) provides an exception to nondeductibility for costs that “would not have been incurred if the property were not held in such trust or estate.” The Supreme Court interpreted that phrase to mean costs that were not “commonly or customarily” incurred by individuals. The decision effectively repudiated a decision of the 2nd Circuit (by then Justice Sotomayor) which limited the exception to costs individuals were “incapable of incurring.” Rudkin Testamentary Trust v. Com’r, 467 F.3d 149 (2006).]

¶  Treasury proposed introducing “present value concepts” in relation to the timing of deductions claimed by an estate. In certain cases, deductions are taken on an estate tax return but the associated payment is not made until much later. This creates an opportunity for arbitrage with respect to which Treasury disapproves.

¶  Treasury proposed final regulations under IRC §2642(g) addressing extensions of time to make allocations of the GST tax exemption. Under the proposed regulations, the standard under which requests for extensions of time to make allocations will be measured is that “the transferor or the executor . . . acted reasonably and in good faith, and that the grant of relief will not prejudice the interests of the government.” In addition, the Proposed Reg. §26.2642-7(h)(3)(i)(D) would require affidavits from “tax professionals” who advised or were consulted by the taxpayer with respect to the GST tax.

¶  Trust decanting could create a taxable event for income, gift, estate, or generation-skipping tax (GST) purposes. For this reason, a trustee has an affirmative duty to consider tax implications before consummating a decanting transaction. Notice 2011-101 requested comments from the public regarding possible income, gift, estate and Generation Skipping tax issues arising from transfers by a trustee of all or a portion of the principal of a distributing trust.  Treasury identified  thirteen “facts and circumstances” potentially affecting one or more tax consequences.

Although the IRS encouraged the public to participate in formulating guidance, and stated that it would continue to publish PLRs addressing decanting, no further action was taken. Viewed in a favorable light, this may mean that the IRS has concluded that any tax issues arising in connection with decanting do not rise to a level serious enough to warrant further study.

III.   Rulings of Note

In PLR 201229005, the beneficiary of a trust was given a testamentary power to appoint trust assets to a class consisting of descendants of the beneficiary’s parents. Since the “class of appointees” did not include the beneficiary’s estate or his creditors, the power was not taxable as a Section 2041(a)(2) general power.

The trust in Rev. Rul. 2011-28, permitted the grantor to reacquire trust property, which consisted of a life insurance policy. The issue was whether the grantor’s right to reacquire the insurance policy constituted a retained “incident of ownership” over the policy which would result in estate inclusion. The ruling stated that since the grantor was constrained under local law from exercising the powers for his personal benefit, he had not retained any prohibited incidents of ownership.

Non-spouses may not enjoy the benefits of property they disclaim. In PLR 201243001 a joint revocable trust executed by both spouses provided that upon the death of last spouse to die, assets would pass outright to son. The trust was later amended to provide that son could disclaim into a trust with respect to which he and his descendants were beneficiaries. After the death of the last spouse, the attorney became aware that the requirements for a qualified disclaimer could not be satisfied, since son was a beneficiary of property he disclaimed.

An application made to the state court to amend the trust based on “ambiguity” or “scrivener’s error due to mistake of law” was granted by the state court. However, the IRS opined that it was not bound by the amendment, since it was not a contracting party to the agreement to amend. Furthermore, the IRS noted that under Estate of Bosch, 387 U.S. 456 (1967), federal courts, though bound by decisions of a state’s highest court, are not bound by state trial courts, to which they must only give “proper regard.”

In PLR 2012233011 the grantor created a lifetime QTIP trust for his spouse. Although a gift tax return was filed, the preparer failed to make the QTIP election on the return. Following the death of the grantor’s spouse, the grantor requested an extension of time in which to make the QTIP election. In general, extensions of time limitations that are not otherwise provided by statute will be granted if the taxpayer acted reasonably and in good faith, and the interests of the government are not prejudiced. Reg. §301.9100-3(b)(1(v) provides that a taxpayer has acted in good faith if he relied on a tax professional who failed to make or advice of the necessity of a required election.

The problem in this case was that the time period for making the lifetime QTIP election was statutory, and not regulatory. Therefore Section 9100 relief could not issue. However, the IRS had earlier ruled favorably, only to withdraw the ruling upon realizing its error.

Even though the erroneous ruling and its withdrawal were two years before the requested ruling in the instant PLR, the IRS granted relief and ruled favorably. Under IRC §7805(b)(8), Treasury may determine the extent to which any revenue ruling will be applied without retroactive effect. Here, the IRS determined that the earlier ruling had been issued for a proposed transaction, the taxpayer in the instant case had relied on the ruling in good faith and had released the law firm involved from a malpractice action.

The ruling is interesting first because of the generosity of the IRS in deciding not to apply retroactively a PLR that had been available for two years. Also interesting is that the PLR seems to dispel the notion that PLRs cannot be relied upon by taxpayers, because in this very case the IRS spoke of the taxpayer’s justifiable reliance on the PLR.

PLR 201245004 blessed the disclaimer by a surviving spouse of an IRA account in which she was the designated beneficiary, despite her having received two distributions from the account that were in excess of her required minimum distribution (RMD). The RMD and the excess actually received could be disclaimed.

In PLR 201235006 the taxpayer created two trusts, Trust A and Trust B. Trust B was a grantor trust under IRC §675(4)(C), since the grantor had retained the power to reacquire trust assets by transferring other property of equal value. The ruling requested advice as to whether the purchase by Trust B of a life insurance policy owned by Trust A would cause Trust B to lose its grantor trust status by reason of the application of IRC §2042.

Section 2042 requires in inclusion the decedent’s estate if the decedent retains “incidents of ownership” over the policy. The IRS noted that in the facts of the ruling (i) the sale to the grantor trust is not a transfer for value for income tax purposes and (ii) local law requires that the trustee of Trust B ensure that the property which the grantor seeks to substitute is of equal value to the property that the grantor seeks to reacquire. Accordingly, Trust B would remain a grantor trust. [The IRS also stated that the existence of Crummey powers in Trust B would not affect its grantor trust status.]

                                                 *      *      *

In Rev. Proc. 2013-13 the IRS announced a simplified option for claiming a home office deduction in 2013. The new deduction would be capped at $1,500 per year based on $5 per square foot up to 300 square feet. The rule is intended to ease administrative and compliance burdens imposed on taxpayers. Currently, taxpayers must file Form 8829, which requires complex calculations of expenses, deductions and depreciation.

Though homeowners who use the new options cannot depreciate the portion of the home used for a trade or business, they may claim allowable mortgage interest, real estate taxes, and casualty losses as itemized deductions on Schedule A. These deductions would not need to be allocated between personal and business use, as currently required using Form 8829. The current requirement that the home office be used “regularly and exclusively” for business would still apply under the simplified option.

IV.    Proposed Changes to Circular 230

 The IRS has proposed changes to Circular 230, which governs ethical considerations relating to taxpayer representation. The first major change proposed by the IRS is to eliminate the disclaimer that must now appear on nearly every communication between an attorney and his client. According to the IRS, such disclaimers cause confusion and their requirement on nearly every communications likely causes clients to disregard the disclaimer entirely. The IRS concludes that the disclaimer is “irrelevant.”

Instead, the IRS proposes that ethical rules requiring a practitioner to (i) use reasonable factual and legal assumptions in providing advice; (ii) reasonably consider all facts the practitioner knows or should know; (iii) not rely on statements of the client that are unreasonable; and (iv) not take into account when rendering advice that the return will not be audited.

V.   Chief Counsel Memoranda

Persons maintaining foreign trusts are now under a heightened duty to file annual information returns. CCM 201208028 expressed the view of the IRS that the failure of the decedent to file informational returns during his life resulted in the imposition of significant failure to file penalties under IRC §6677(a). Since the decedent was a “responsible party” prior to his death, and his estate assumed the “rights, duties, and privileges” of the decedent, the estate became liable for the penalties. The returns in question were (i) Form 3250 “Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) and (ii) Form 3250-A (“Annual Information Return of Foreign Trust with U.S. Owner”).