IRS Collections: Defensive Measures

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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A taxpayer facing IRS collection should initially determine whether the assessment was timely or whether the 10-year collection period will soon expire. Collections may not proceed if the statute of limitations on assessment was time-barred. Agreeing to extend the statute of limitations on assessment or collection, even if  immediate assessment or enforcement action will otherwise is threatened, is not always advantageous. One reason is that interest well above the prime rate will continue to accrue.

Pursuant to the Freedom of Information Act, 5 U.S.C. § 552, the taxpayer may request copies of (i) the entire transcripts of individual master files; (ii) records relating to filed notices of tax lients; (iii) all records used to conclude that there was a deficiency; and (iv) all records used as a basis to conclude that there was basis for imposing penalties. These records can be invaluable when facing collections.

A new audit may be requested if the taxpayer never had the opportunity to substantiate the tax information and may now do so.  IRM [4.13]1.3. The IRS may also agree to put collection action on “hold” at the taxpayer’s request. If IRS threatens to file a notice of tax lien, a collection due process hearing may be requested. Injunctive relief may be available in federal district court in certain situations, such as where the IRS attempts to levy when that action is statutorily proscribed.

IRC § 6159 authorizes the IRS to enter into an installment agreement if that will facilitate collection. Although financial disclosure is required, the requirement is somewhat perfunctory, in that the Service is without the resources to fully investigate all financial data provided. The IRS may not levy when an installment agreement request is either pending or is in effect.

IRC § 7122 permits IRS, acting as an ordinary creditor would, to accept an offer in compromise based on doubt as to (i) liability or (ii) collectibility. Under (i), the taxpayer sets forth the factual and legal arguments; the IRS may not request financial disclosure. The more common offer under (ii) requires full financial disclosure. Collection activity is normally suspended during the pendency of the offer. However, collection will resume if IRS determines that the offer was submitted to delay collection. Treas. Reg. § 301.7122-1(g)(6).

If the taxpayer’s deficiency was in whole or in part attributable to an unreasonable delay by the IRS in performing a ministerial or managerial act, a request for abatement of interest may be filed under IRC § 6404(e). If the IRS rejects the request, appeal may be taken to the Tax Court without prepayment of the interest. If payment of interest has been made, the 5th Circuit recently held that the taxpayer has the option of seeking an interest abatement in federal district court as well. (See Beall v. U.S, 5th Cir. No. 01-41471, 6/27/03).

If spouses filed a joint return, innocent spouse relief under IRC § 6015(e) may be available. The innocent spouse may be relieved from tax liability if (i) the understatement relates to erroneous items of the guilty spouse, (ii) the innocent spouse had no knowledge of the understatement and, (iii) it would be inequitable to hold the innocent spouse liable. Divorce or legal separation is not required for innocent spouse relief, although in those circumstances relief is somewhat more liberal.

If the IRS files a notice of federal tax lien (NFTL), the taxpayer may request a collection due process hearing (CDP) within 30 days following of the date when the taxpayer is notified of the filing of the lien. Under IRC § 6320, the taxpayer is entitled to judicial review of the Appeals determination.

If IRS collection activites have resulted in, or are about to result in significant hardship, the Taxpayer Advocate, a quasi-independent agency, has authority to issue a Taxpayer Assistance Order requiring the IRS to release filed tax liens, to suspend collection activities, to prevent an IRS levy, or to take any other action. Regs. § 301.6323(j)-1 provides for the withdrawal of a tax lien where the best interests of the taxpayer and the IRS would be served. Since a filed tax lien may impair the taxpayer’s ability to conduct business, and ultimately pay the IRS, the Taxpayer Advocate may order the IRS to release the filed lien.  Prop. Regs. § 301.6343-3 similarly provides for a return of property levied by the IRS in similar circumstances.

Although the IRS Appeals Office historically operated in the audit context, as a result of the 1998 IRS Reform Act, an Appeals Office conference during collection must now be provided (i) following the filing of a federal tax lien, (ii) when a levy is contemplated, (iii) when an installment agreement is to be terminated, (iv) when a request for penalty abatement is denied, or (v) when an offer in compromise is rejected.

Full tax payment will stop IRS collections. A refund claim may then be filed within 2 years from date of payment or 3 years from the due date of the tax return, if later. If the IRS denies or fails to timely respond to the refund claim, a refund action may be commenced in federal district court or the U.S. Claims Court, both taxpayer-friendly venues. The “full payment” rule does not apply to all tax liabilities: if the tax in question is a “divisable” tax, such as withholding tax, a payment of all taxes for a single employee for will confer refund jurisdiction on the federal court.

A bankruptcy petition generates an automatic stay that stops virtually all IRS collection action. An eventual discharge can provide the taxpayer “fresh” start. Non-trust fund taxes are dischargeable if they are due more than 3 years, filed more than 2 years, and assessed more than 240 days prior to the filing of a bankruptcy petition.

Certain real and personal property is exempt from creditors even in bankruptcy. Moreover, it is not improper, within reason, to convert nonexempt assets to exempt assets prior to filing a petition. However, this rule favors the IRS, since exempt property surviving bankruptcy will become subject to IRS collection if the taxes are nondischargeable, or if the taxes are  dischargeable but they are secured by a tax lien filed prior to the bankruptcy petition.

A debtor may not obtain a discharge of for any tax for which the related return is fraudulent (11 U.S.C. § 523(a)(1)(C)) or any tax for which the taxpayer willfully attempts to evade or defeat the tax. An automatic stay of any Tax Court proceedings issues upon the commencement of a bankruptcy case.  Thereafter, bankruptcy court has jurisdiction to determine the amount and dischargeabilty of the debtor’s tax liabilities.

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Northern District Finds Successive Tax Penalties Imposed by NYS-AG and NYS-DTF to be Unconstitutional

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Finding that Tax Law § 481(1)(b)(i) effectively operates as a criminal penalty, the Northern District  held that the assessment of a tax penalty by the Department of Taxation and Finance under § 481(1)(b)(i) following the taxpayer’s previous prosecution and conviction by the Attorney General for the same offense under Tax Law § 1814, violated the Double Jeopardy Clause of the Fifth Amendment. Abuziad v. N.Y.S. Department of Taxation & Finance, No.1:08-CV-1213, 2/19/10, (NDNY), motion to reconsider denied, 5/12/10; appeal docketed, No. 10-1210, 3/22/10 (2nd Circuit).

[Tax Law § 481 authorizes a cigarette tax of $15 per carton by means of tax stamps. Abuzaid was charged under Tax Law § 1814(e) with purchasing cigarettes for sale bearing counterfeit tax stamps, a class E felony. On November 13, 2006, approximately seven months after Abuzaid pled and was sentenced for the crime of possessing unlawfully stamped cigarettes, the N.Y.S.  Department of Taxation and Finance (“the Department”) assessed a penalty under Tax Law § 481(1)(b)(i) for the same conduct.

Abuzaid filed an administrative appeal with the Division of Tax Appeals (DTA) asserting that the assessment violated both the state and federal constitutions. On March 19, 2009, ALJ Timothy J. Alston issued a Determination which denied the petition of Abuzaid and sustained the Department’s Notice of Determination. ]

The ALJ Determination

Judge Alston first addressed the issue of whether the penalty under Tax Law § 481(1)(b)(i) was civil or criminal in nature. The ALJ determined that the penalty was civil in nature for two reasons:  First, the tribunal found that “the fact that authority to impose the subject penalty was conferred on an administrative agency is prima facie evidence that the Legislature intended to provide for a civil sanction.”  Second, the ALJ noted that the existence of a criminal sanction in Tax Law § 1814(e) for the same conduct “indicates that the Legislature intended a civil fine under Tax Law § 481(1)(b)(i).” Judge Alston concluded that since § 481(1)(b)(i) is “clearly a civil statute [] penalties imposed thereunder are not ‘punishment’ for purposes of the double jeopardy clause.”

[On August 21, 2009, Abuzaid joined an action which had been commenced by three other similarly situated persons who had been arrested in the same sting operation. Before the District Court were Plaintiff taxpayers’ and the Defendant Department’s cross-motions for summary judgment.]

The District Court Opinion

The District Court’s opinion first addressed the issue of whether the federal court had jurisdiction over the action. The Tax Injunction Act (“TIA”) precludes a district court from enjoining the collection of any tax under State law where an effective remedy exists in the courts of such State. The District Court concluded that TIA was inapplicable, since the Notices of Determination (NODs) themselves indicated that the assessments were penalties, and not taxes. The court then addressed the Fifth Amendment Claim.

The first issue involved a determination of whether the imposition of penalties under § 481(1)(b) following criminal conviction under § 1814(e) constituted multiple criminal punishments for the same offense, thereby violating the Double Jeopardy Clause. In resolving this inquiry, the court framed the issue before it as “whether the statutory scheme was so punitive either in purpose or effect, as to transfor[m] what was clearly intended as a civil remedy into a criminal penalty.”

The court concluded that in enacting § 481(1)(b)(i), the “Legislature did not intend to create a criminal sanction.” However, the court noted that “aspects of  481(1)(b)(i), however, indicate that that the Legislature did not clearly intend a purely civil penalty either,” since § 481 provides that “the commissioner may impose a penalty.”

The court also noted that the imposition of penalties under § 481(1)(b) is “dependent on the offender’s mental state, with more severe penalties resulting from when the violator ’knowingly’ possesses the unlawful cigarettes.” Therefore, the statute was intended to “punish and deter criminal activity.”

The court concluded that even if the Legislature had intended to adopt a civil sanction, since § 481(1)(b)(i) “operates as a criminal penalty [] the imposition of penalties subsequent to a prior criminal prosecution for the same conduct [violates] Plaintiffs’ rights under the Fifth Amendment.”

Analysis

Taxpayers contesting Department tax assessments must first petition the Division of Tax Appeals for a hearing. The Tax Law imposes a presumption of correctness in favor of the Department at hearing. Exceptions from an ALJ Determination may be taken to the Tax Appeals Tribunal. In  fiscal year 2008-09, the Department boasted a won-loss record of 31-2 in the Tribunal. (Cf. Koufax ’65, 26-8; Seaver ’69, 25-7).

Only after the Tribunal has ruled may the taxpayer seek review in the Appellate Division. Entry to the Appellate Division is guarded tenaciously by CPLR Article 78, which greets appellants with burdensome bonding requirements. Once the case has been docketed, the “arbitrary and capricious” standard of review of Tribunal decisions imposed by Article 78 is difficult to surmount.

Given the difficulty of prevailing in the administrative tribunal, taxpayers have sought judicial review elsewhere, either before or after exhausting administrative appeals. Although Tax Law §§ 690(b), 1090(b) and 1140 state that review by the Tax Tribunal is the “exclusive remedy available to any taxpayer for the judicial determination” of tax liability, New York courts routinely rule in declaratory judgment actions in matters involving the constitutionality or inapplicability of the Tax Law, or where the Department has exceeded its taxing jurisdiction.

As Abuzaid illustrates, federal courts may also assert jurisdiction in disputes involving constitutional issues. It would appear that where constitutional interests are implicated, an Article 78 proceeding might also be commenced in the Appellate Division, bypassing the Division of Taxation.

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APPEALING A DETERMINATION OF THE TAX APPEALS TRIBUNAL

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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The Tax Appeals tribunal sits as the final administrative tax tribunal. A CPLR Article 78 proceeding is the “dotted line” in the flowchart that brings the tax dispute out of administrative tribunal system and into the New York judicial court system. From a tax petitioner’s standpoint, Article 78 is far from perfect: it possesses treacherous statutes of limitations, it is inherently capable of providing only narrowly circumscribed relief, and it imposes onerous bonding requirements. Still, like the Spirit of St. Louis, Article 78  will at least take the taxpayer into the courtroom of the Appellate Division, where counsel may be able to convince the Court of reversible error below.

Article 78 review must be commenced within 4 months following an adverse decision or declaratory ruling by the Tax Appeals Tribunal. An Article 78 petition is returnable to the Appellate Division, 3rd Department, in Albany. If corporate sales tax is in issue, the taxpayer must deposit the tax or post an undertaking. No undertaking is required to seek  review of personal income and corporate tax determinations, including responsible person determinations; however, assessment and collection of these taxes may proceed during the pendency of  an Article 78 proceeding.

Article 78 review is commenced by personal service of a notice of petition and verified petition upon the Tax Appeals Tribunal, the Commissioner, and the Attorney General. The Commissioner must serve an answer at least 5 days before the petition is returnable. Judicial review is limited to the record before the agency — no new evidence may be submitted. The stipulated record and a brief must be filed within 9 months after the date of commencement of the proceeding.

The Appellate Division will affirm if it finds the decision was (i) supported by “substantial evidence” and was not (ii) erroneous, arbitrary or capricious. Following submission of the record and briefs, oral argument before five judges will be scheduled in the Appellate Division. Within 4 to 6 weeks, a decision will be handed down.

An appeal to the Court of Appeals from an adverse decision of the Appellate Division must be taken within 30 days after being served with a notice of entry. Failure to timely take an appeal is a fatal jurisdictional defect that will foreclose all further relief.

The Court of Appeals generally reviews only questions of law. However, it may also review the Appellate Division’s reversal of the administrative tribunal’s finding of fact or exercise of discretion.

Appeals to the Court of Appeals may be taken either by permission or as of right. In either case, no oral argument on the motion is permitted. Appeals as of right may be taken where (i) two justices dissented on a question of law in favor of the taxpayer; or (ii) the issues in dispute directly involve a constitutional question. With respect to (i), it is not enough that there have been two dissenting judges; each must have advocated judgment in favor of the taxpayer based on questions of law. With respect to (ii), even where a constitutional question is presented, the appeal will be dismissed if the decision could have been decided on other grounds. Thus, a constitutional question cannot be raised solely to obtain jurisdiction.

A motion seeking permission to appeal may be based upon three grounds: (i) the decision conflicts with a prior Court of Appeals decision; (ii) a novel question is presented; or (iii) a question of substantial public importance is presented. Permission is typically sought under (ii) or (iii). The motion must include (a) a concise statement of facts; (b) a statement of the procedural history and a showing that the motion is timely; (c) a showing that the Court has jurisdiction; (d) an argument as to why the case merits review; and (e) an identification of portions of the record where the questions sought to be reviewed were preserved for appellate review.

Within 10 days taking an appeal by right or by permission, the petitioner must “perfect” the appeal by filing a jurisdictional statement. The petitioner must then file and serve his brief, with the record and original exhibits. Oral argument is before the Chief Judge, now Judge Judith S. Kaye, and six Associate Judges.

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Defeating The Right of Election in EPTL § 5-1.1-A

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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Under Estates, Powers & Trusts Law (EPTL) § 5-1.1-A, a surviving spouse has a right to elect against the Will of a predeceasing spouse. The elective share is one-third of the net estate. The  net estate consists of the net probate assets as well as testamentary substitutes. [EPTL § 4-1.1 provides that if the decedent dies intestate and is survived by a spouse and issue, the spouse takes $50,000 plus one-half of the residue; if there are no surviving issue, the spouse takes the entire estate.]

Testamentary substitutes include those assets over which the decedent may have parted with legal title prior to his death, but are brought back into the estate solely for purposes of calculating the surviving spouse’s right of election. Testamentary substitutes include (i) gifts causa mortis [gifts that become revocable if the donor survives the contemplated event (e.g., voyage, operation, etc.)]; (ii) joint bank accounts; (iii) jointly owned property; (iv) pension plans; (v) date-of-death value of lifetime trusts over which the decedent retained the right to possession or enjoyment of the property; (vi) any property over which the decedent had a presently exercisable power of appointment; and (vii) any property transferred by the decedent for inadequate consideration, except $10,000 annual exclusion gifts.

When EPTL § 5-1.1 was revised in 1992, life insurance was not a included as a testamentary substitute. Former Nassau Surrogate Raymond Radigan recalls that the insurance industry was “absolutely opposed to having insurance included as a testamentary substitute.” (NYLJ, 3/31/03) As a result of this omission, one may validly reduce his net estate for the purpose of defeating his spouse’s right of election by purchasing life insurance.

In second marriage situations, a waiver of the right of election is often included in the prenuptial agreement. The spouse or soon-to-be spouse can waive her right of election by a signed, acknowledged writing. Such a waiver need not be supported by consideration. However, any person a seeking a waiver after marriage would be well advised to have his spouse represented by counsel prior to executing the waiver, since a waiver may be withdrawn if it was obtained by fraud, concealment or overreaching. See Matter of Sunshine, 369 N.Y.S.2d 304.

[Note that only a spouse can waive an interest in certain ERISA pension rights. Therefore, any waiver of these federally mandated rights would have to occur after marriage. The prenuptial agreement could contain a provision requiring the execution of documents necessary to effectuate this waiver. Note also that a separation agreement waiving rights in the other’s property that makes no mention of death of the parties is not a waiver of the right of election. See Matter of Curran, 80 N.Y.S.2d 421 (4th Dept. 1948).]

A surviving spouse may also be disqualified from exercising a right of election. Under EPTL § 5-1.2, a surviving spouse is disqualified if (i) a final decree of divorce or separation was entered; (ii) the surviving spouse procured a divorce not recognized in New York; or (iii) the surviving spouse abandoned the decedent, and the abandonment continued until the decedent’s death.

“Abandonment” means an unjustified departure without the consent of the other spouse. Matter of Riefberg, 58 N.Y.2d 134 (1983). It may be difficult to establish. Merely leaving the marital abode is not enough; it involves a “hardening of resolve” that culminates in a decision to sever the conjugal relationship. Matter of Baldo, 620 N.Y.S.2d 602 (3rd Dept. 1994). Even reprehensible behavior, such as cruelty or adultery, does not disqualify the surviving spouse.

Divorced spouses have few rights against their former spouse’s estate. Under EPTL § 5-1.4, not only may a divorced spouse named her former spouse’s Will not exercise the right of election, but she also no right to inherit any property or to act as a named Executor or Trustee under the Will. For purposes of effectuating the dispositive provisions of the Will, the former spouse is treated as though she immediately predeceased the testator. One logical exception to this rule exists: A former spouse may inherit or act as fiduciary if the Will expressly provides that the testator desires to override the statutory rule.

There can be no right of election if there is no Will. Still, one seeking to minimize the rights of the surviving spouse is not better off without a Will. The surviving spouse of a decedent who dies intestate is entitled to entire estate if no issue survive, and to $50,000 plus half the estate if issue survive. Compare these with the the right of election, which is one-third of the net estate, regardless of whether issue survive. Thus, a Will should be executed and entrusted to someone who can be depended upon (e.g., attorney or friend) to propound the Will to probate.

An agreement before marriage waiving the right of election is preferable, since some consideration flows from the non-waiving party’s agreement to marry. A spouse waiving the right of election after marriage should be represented by counsel, since consideration may be an issue. Divorce also cuts off the right of election, but only if decree of divorce has been awarded. Although abandonment also cuts off the right of election, abandonment may be difficult to establish. If no waiver is feasible, the purchase of insurance will reduce the size of one’s “net estate” against which the right of election operates. Executing a Will and ensuring that it will be propounded is essential.

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IRS Criminal Investigations

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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The IRS reserves the threat of incarceration for taxpayers it believes are guilty of tax evasion, failure to file, or making false statements. About 3,500 cases commenced by the Criminal Investigation Division (CID) each year result in prosecution. CID generally focuses on cases having a high deterrent value.

A criminal investigation often begins with a referral from a revenue agent. All civil investigations and audits immediately cease. The revenue agent should be accorded utmost respect, but rarely should any relevant information be voluntarily disclosed. Informants and states may also provide information leading to criminal investigations. Even if a criminal investigation concludes favorably — about half the time — the civil audit which resumes could make the taxpayer’s life miserable for years.

CID possesses an array of investigative tools, including the subpoena, which commands the taxpayer to testify and produce books and records. Any “relevant” information, a term broadly defined by the Supreme Court, may be discovered. The right against self-incrimination or the attorney-client privilege might be invoked to defeat a summons.

Special agents typically request the taxpayer to submit to an interview. Showing “good faith” by consenting is inadvisable, since candor and cooperation will doubtless not lessen the chance of prosecution. False statements could result in additional criminal penalties, and telling the truth might guarantee a conviction. Rather, an interview should be refused and the taxpayer should immediately consult with counsel. Engaging an attorney is important, since the privilege possessed by a return preparer is narrow, and could later be subject to collateral attack by the IRS.

If a special agent recommends prosecution, a “conference” occurs at the district level which in theory affords the taxpayer an opportunity to present his case. In practice, it is used to obtain more damaging information.The Justice Department prosecutes most criminal tax cases; most are disposed of by plea.

CID may prove tax fraud by direct evidence of unreported income or fictitious deductions. If books and records are unavailable or inadequate, circumstantial evidence, consisting perhaps of unexplained accretions to net worth, is also permitted. However, increases in net worth alone cannot support a conviction — a likely source of income must also be established.

Indirect evidence of bank deposits exceeding reported gross income could also be presumed to establish unreported income. The burden of proof would shift to the taxpayer to disprove IRS figures.

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Trust May Compliment Prenuptial Agreement

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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The prenuptial agreement effectively protects against the vagaries of marital dissolution. However, even a well-drafted prenuptial agreement will not always succeed in fully accomplishing this objective. For example, the agreement will likely not prevent separate property from becoming marital property if assets are commingled.

Nor is there any assurance that a prenuptial agreement will not be declared invalid in whole or in part if circumstances have changed during a long marriage, or if the equities of the case run against the party in whose favor enforcement of the prenuptial agreement would inure. Fortunately, the prenuptial agreement need not stand alone: Inherited family wealth and to a lesser extent assets acquired before marriage may be protected by a trust.

Typically, a trust designed to protect family wealth would be created by a parent for the benefit of the either spouse. Unlike a prenup, the trust could be implemented at any time, even after marriage, and could exist without the knowledge other spouse. Trust distributions could be within the unreviewable discretion of the trustee, who might be the parent implementing the trust. Generally, inherited property, even that acquired during marriage, remains separate property.

During the pendency of a divorce proceeding, the trustee could cease making distributions. Since the beneficiary could not force the trustee to make a distribution during the divorce, a fortiori the creditor-spouse could not. A creditor’s rights cannot exceed those of the debtor. (However, an exception might exist for court-ordered child support or alimony payments. A court might invade even a discretionary trust to satisfy these obligations.)

Where a spouse has herself accumulated significant wealth before marriage, asset protection need also not stop with the prenup. Although NY EPTL § 7-3.1 has long provided that trusts created by the grantor for her own benefit which purport to shield trust assets from creditors are unenforceable, not all domestic jurisdictions continue to adhere to this common law view.

A decade ago, one attempting to circumvent the EPTL prohibition against “self-settled” spendthrift trusts might have ventured to a remote venue with a tropical — or vaguely sinister — name. Today, one need venture no further than Delaware. This does not mean that a New York court would not look askance upon such a trust. Nonetheless, a New York court seeking to invade the trust might find it difficult to convince a Delaware court in whose jurisdiction the assets reside of the inapplicability of the Full Faith and Credit Clause.

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AVOIDING CHALLENGES TO TESTAMENTARY INSTRUMENTS

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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Protracted legal proceedings by disgruntled descendants and relatives asserting lack of testamentary capacity or undue influence deplete the estate and delay distribution. Therefore, steps taken by the testator before death which minimize the possibility of later challenge are essential. Although somewhat surprising, the mere choice of who witnesses the will execution may later determine the success of a will contest. Favorable testimony given by attesting witnesses at an SCPA § 1404 deposition may facilitate the admission of the instrument into probate, or at least force a favorable settlement.

The ideal witness recalls the ceremony and can testify that statutory procedures were followed. Friends and relatives make poor witnesses, as they are more likely to have competing loyalties to the litigants. Similarly, secretaries may be difficult to locate and may be unfriendly if their employment was terminated. Attorneys and law students, on the other hand, make excellent witnesses. They likely to accurately recall the ceremony and realize the significance of the affidavit made immediately thereafter attesting that “[t]he testator . . . was suffering from no defect of sight, hearing or speech or from any other physical or mental impairment which would affect his capacity to make a valid Will.”

The witnessing attorney should also be present during a portion of the meeting prior to the actual signing to facilitate their giving credible testimony concerning the testator’s capacity and awareness of his current circumstances. Witnessing attorneys might also draft short memoranda detailing their own observations and impressions of the testator.

If the testator’s condition is poor on the scheduled date for signing, consideration might be given to rescheduling the signing. Similarly, a regularly scheduled medical examination coinciding with will execution might help in establishing the testator’s mental capacity. If serious mental capacity concerns exist, an examination by an independent geriatric physician might be considered. Finally, a will signing might be coincident with a family function; this might enable friends or relatives to be in a position to offer favorable testimony.

Mental capacity required to execute a will is substantially less than that required to enter into a contract: The testator need only know the extent of his estate and the natural objects of his bounty. Horn v. Pullman, 72 NY 269 (1878). Nevertheless, may an attorney draft and participate in the execution of a will if the testator appears to be under diminished capacity? The American College of Trusts and Estates, Model Rules of Professional Conduct takes the position that “because of the importance of testamentary freedom, the lawyer may properly assist clients whose testamentary capacity appears to be borderline.”

If diminished mental capacity cannot be asserted, a disgruntled family member may claim undue influence, particularly where the testator left a large portion of his estate to one with whom he cohabited or married. A child might also make such an assertion where a sibling has received a larger portion of the inheritance. Yet it is not uncommon for a testator to leave a significant portion of his estate to one who was kind and attentive to him; nor is it unusual for one to leave unequal shares to various children for a myriad of reasons.

If the drafting attorney suspects undue influence, the testator should be interviewed alone by the attorney. Gifts that seem unusual should be discussed, so that the attorney understands the client’s motive in making the gift. Consideration might also be given to inserting a provision stating that the testator acknowledges that certain persons may not understand the reasons for the disposition chosen, but that the disposition was carefully considered and was not made out of any lack of love or affection by the testator.

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Attorney-Client Privilege in Tax Disputes

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

The attorney-client privilege protects confidential communications between attorneys and clients. The privilege extends to an accountant hired by an attorney to assist in understanding the client’s financial information. U.S. v. Adelman, 68 F.3d 1495 (2nd Cir. 1995). Privileged attorney-client communications include expressions conveyed through conversations, documents, records and internal memoranda. Even billing and travel records, and expense reports, may be protected if they relate to a privileged matter.

U.S. v. Frederick held that advice rendered in connection with tax return preparation — whether by an attorney or by an accountant — is not privileged. Moreover, protected client communications made during tax planning may lose privileged status if those communications are incorporated into tax return preparation. 182 F.3d 496 (7th Cir. 1999). However, documents prepared for a tax audit may be privileged if they relate to impending litigation rather than to the submission of revised tax returns. Id.

The disclosure of privileged documents to third parties may result in a waiver of the privilege. See U.S. v. Brown, 478 F.2d 1038 (7th Cir. 1973). However, documents provided by clients to their accountants to assist an attorney in rendering legal advice retains its privilege.  U.S. v. Schwimmer, 892 F.2d 237 (2nd Cir. 1989).

Documents prepared in anticipation of litigation are protected from disclosure under Rule 26(b)(3) of the Federal Rules of Civil Procedure. However, the “work product” doctrine was held inapplicable to an accountant’s memorandum which was prepared not in anticipation of litigation, but rather to enable the client to assess whether tax risks justified a decision to proceed with a transaction. Adelman, supra.

Section 7525, enacted in 1998, extended the attorney-client privilege to confidential communications between taxpayers and practitioners that would be privileged if the communication were between the taxpayer and an attorney. However, the scope of the privilege accorded by Section 7525 has been diminished by recent tax shelter legislation and case law. Cavallaro v. U.S. held that disclosures to accountants providing accounting services in a merger plan were not protected under tax practitioner privilege — despite the fact that the accountant had been engaged by an attorney — since the services did not facilitate the communication of legal advice. 284 F.3d 236 (1st Cir. 2002).

Appraisers may be engaged to assist in estate planning or in other tax-related matters. An appraisal made to assist an attorney in rendering legal advice may be privileged. However, if the privilege is held not to apply, all documents within the appraiser’s file, including drafts and correspondence, may be reviewable by an agent or discoverable in litigation. If a second appraiser is hired, conclusions reduced to writing by the first appraiser may be discoverable. Therefore, discussions with an appraiser concerning assumptions and methods should precede the preparation of drafts.

Code Sec. 7491 shifts the burden of proof in tax controversies to the IRS where “credible evidence” has been introduced. For this evidentiary rule to apply, the taxpayer must have complied with “reasonable” IRS requests for information and documents. The assertion of the attorney-client privilege would likely cause the IRS to argue that the taxpayer cannot shift the burden of proof.

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INSTALLMENT SALES OF ASSETS TO GRANTOR TRUSTS

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Installment sales of assets to irrevocable grantor trusts is one of the most powerful estate planning techniques available today. Sales to “intentionally defective” irrevocable grantor trusts capitalize on different definitions of “transfer” for income and transfer tax purposes. Following such a sale, the grantor reports income tax on trust income. However, the grantor no longer owns the assets for gift and estate tax purposes. Therefore, the trust assets (and appreciation) will be removed from the grantor’s gross estate. Assets sold to the trust may consist of stock in a closely held business, real estate, marketable securities, or limited partnership interests. The trust may even hold S Corporation stock without jeopardizing the election.

(Although not discussed in this article, assets sales to trusts will also further asset protection objectives.)

Revenue Ruling 2004-64 states that a grantor’s payment of income tax attributable to the trust is not a gift to trust beneficiaries. Furthermore, an independent trustee’s discretionary power to reimburse the grantor for the payment of income taxes will not cause inclusion in the grantor’s estate. The grantor’s payment of income tax will result in accelerated growth of trust assets, since the trust will not be burdened with tax payments.

Rev. Rul. 85-13 and Madorin v. Com’r, 84 TC 667 (1985) held no gain or loss is recognized on a sale of assets to a grantor trust. Thus, appreciated assets can be sold to the trust without any gain. In exchange for assets sold, the grantor will receive cash or a promissory note. The note may provide for interest payments only, with a balloon payment of principal at the end. By so providing, the amount of assets “leaking” back into the estate is minimized. The note may also provide for refinancing. This will enable the trust to postpone seriatim the date the principal obligation becomes due.

The note must bear interest at a rate determined under §7872(f)(2)(A), which references the applicable federal rate (AFR) under §1274(d). The AFR for short-term obligations (less than 3 years) is 4.99% for June, 2006. In comparison, a GRAT, to its disadvantage, must bear interest at rate which is 120% of the AFR.

The grantor realizes no income upon receipt of interest payments — he is treated as paying interest to himself. To minimize the risk that the grantor will be treated as having retained possession or enjoyment of the transferred interest under §2036, the grantor should fund the trust with assets worth at least 10% of the note. This is referred to as “seed” money. PLR 9515039 stated that § 2036 can be avoided if beneficiaries guarantee the note’s payment. Whichever method is used, the grantor will be treated as owner of all trust assets for income tax purposes.

To avoid the risk of inclusion in the grantor’s estate, the grantor should not be trustee. If the grantor will require trust assets during his lifetime, another person could be given the power to make discretionary distributions to the grantor without unduly increasing the risk of inclusion. If the grantor insists on being named trustee, his powers should be limited to administrative powers, such as allocating receipts and disbursements, or distributing income or principal to beneficiaries, when limited by an ascertainable standard.

Trust assets will not receive a basis step-up under §1014(a), since the assets (having been sold to the trust) are not included in the grantor’s estate. This problem can be avoided by substituting higher basis assets for lower basis assets during the grantor’s life. The trust instrument must be drafted to allow this.

The retained right to substitute assets of equal value pursuant to § 675(4)(C) is actually the one of a few provisions that will ensure the trust is taxed as a grantor trust. Another is a provision allowing the grantor to borrow from the trust without being required to pay interest or provide adequate security. § 675(2). When drafting, one must carefully consider which provision will be used to achieve grantor trust status.

Since the initial asset sale is ignored for income tax purposes, the balance due on the note will not constitute income in respect of a decedent (IRD). However, the remaining discounted balance of the note will be included in the grantor’s estate, and will acquire a fair market value basis. Remaining principals to the grantor (if he is alive when the balloon payment becomes due) or to his estate (if he is not alive), should not result in income, since having been included in the grantor’s estate, the note’s basis will offset the principal payment.

By combining an asset sale with minority discounts available for closely held businesses and partnerships, estate tax savings can be enhanced. The value of discounted interests transferred to the trust is less than the value of a proportionate part of the entity’s underlying assets. Accordingly, the price the trust must pay for the assets is reduced. The smaller note will result in lower interest and principal payments, and more estate tax savings.

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Importance of Trusts in Estate Planning & Asset Protection

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

A trust beneficiary possesses an equitable interest, but not legal ownership, in trust property. Creditors of a trust beneficiary therefore cannot generally assert claims at law against the beneficiary’s equitable interest in trust assets. However, under common law, a settlor cannot establish a trust for his own benefit thereby protecting trust assets from claims of the his own creditors. Such a trust would be a “self-settled spendthrift trust.”

New York retains the common law rule. EPTL § 3.1 provides that “[a] disposition in trust for the use of the creator is void as against existing or subsequent creditors of the creator.” However, seven states do now permit self-settled spendthrift trusts, which have also come to be known as “asset protection trusts” (APTs). Delaware’s statute, 12 Del. C. § 3570 et seq., among the most liberal, notes that it “is intended to maintain Delaware’s role as the most favored jurisdiction for the establishment of trusts.”

A Delaware trust is established when the Settlor transfers assets to a Delaware person or entity authorized to act as Trustee. Although the trust must be irrevocable, the Settlor may retain the right to (i) veto distributions; (ii) exercise special powers of appointment; (iii) receive current income distributions; and (iv) receive principal distributions if limited to an ascertainable standard (e.g., health, maintenance, etc.)

Existing creditors must assert rights against a Delaware APT within a certain time period, or will later be barred from bringing any claim. Under 12 Del. C. § 3572(b), a creditor who knows of the transfer must commence an action within 4 years from the date of the transfer, or within 1 year after the transfer was or could reasonably have been discovered, if later. A creditor whose claim arises after the transfer to the APT must commence an action within 4 years of the date of transfer, irrespective of his knowledge of the transfer.

On June 30, 2005, the law was amended to permit a trust which is being redomiciled in Delaware to include for purposes of computing the period of limitations for creditor claims the time it was located in another state. Section  3572 also now provides that if another state’s court fails to apply Delaware law, the trustee’s authority is terminated by operation of law, and a new trustee is appointed.

It appears likely that a Delaware Court would apply Delaware’s statute in a manner consistent with the settlor’s intent, even if the settlor were a nonresident. In Wilmington Trust Co., 186 A. 903 (Del. Ch. 1936), the Delaware court remarked: “Suppose a person domiciled in New York should travel by train to Delaware, carrying with him a sum of cash, and in Delaware deposit his money with a Delaware resident under a specified trust to be there held and administered, and should then return to his state of  domicil, it would seem all out of reason to say that the law of New York rather than the law of Delaware should govern the validity of the trust.”

Although the Full Faith and Credit Clause requires every state to respect the statutes and judgments of sister states, the Supreme Court, in Franchise Board of California v. Hyatt, 538 U.S. 488 (2003) held that it “does not compel a state to substitute the statutes of other states for which its own statutes dealing with a subject matter concerning which it is competent to legislate.” In Hanson v. Denckla, 357 U.S. 235 (1958), a landmark case, the Supreme Court held that Delaware was not required to give full faith and credit to a judgment of a Florida court that lacked jurisdiction over the trustee and the trust property.

By transferring assets to a Delaware APT, the settlor may be able to retain enjoyment of the trust assets while at the same time rendering those assets impervious to those creditor claims which are not timely interposed within the applicable period of limitations for commencing an action. [A Delaware trust may also continue in perpetuity. By contrast, New York retains the common law Rule Against Perpetuities, which limits trust duration to 21 years after the death of any person living at the creation of the trust. NY EPTL § 9-1.1.]

However effective trusts are at protecting against creditor claims, once trust assets are distributed to beneficiaries, the beneficiary holds legal title to the property. At that point, creditor protection may be lost. Since one cannot predict in advance a particular beneficiary’s needs, “sprinkling” provisions accord the Trustee discretion to distribute income or principal among the settlor’s descendants as the Trustee deems appropriate for their needs, taking into consideration the likelihood that a creditor might attempt to seize distributed property.

Although many settlors choose to distribute trust assets outright to children once their children reach certain predetermined ages, holding the assets in trust for longer periods may be preferable, since creditor protection can then be continued indefinitely. If the Trustee has wide discretion to make distributions of income and principal, and may even distribute all of the principal — thereby terminating the trust — flexibility is not lost even if the trust instrument provides that it will continue indefinitely.

One example which illustrates the advantages to holding assets in trust for a longer period of time involves the possibility of divorce. Assets held in an APT set up either by the spouse or by the parent stand a greater chance of being protected in the event of a divorce than assets distributed outright to the spouse even if the beneficiary-spouse does not “commingle” these distributed assets with other marital assets.

If the settlor insists on providing for a distribution of all of the principal of the trust upon the beneficiary’s reaching a certain age, e.g., 35 or 40, a “hold-back” provision allowing the Trustee to withhold distributions in the event a beneficiary is threatened by a creditor claims, could prove invaluable. To provide maximum creditor protection, the “sprinkling” power should end when a creditor appears. If the trustee has discretion to distribute in the event a creditor appears, then a court might be more willing for order the trustee to exercise discretion to make a distribution.

The settlor should not be named as trustee of an irrevocable trust since a settlor’s power to determine beneficial enjoyment would cause estate tax inclusion under IRC §§ 2036 and 2038. However, the settlor will not be deemed to have retained control for estate tax purposes merely because the trustee is related to the settlor. Therefore, the settlor’s spouse or children be named as trustees. Also, the settlor may be named the trustee of certain nongrantor trusts provided the settlor’s powers are circumscribed to avoid estate tax inclusion. However, even here it is preferable not to name the settlor as trustee.

To avoid estate tax problems for the beneficiary herself, the powers granted to the beneficiary must be circumscribed. A beneficiary’s power to make discretionary distributions to herself without an ascertainable standard limitation would constitute a general power of appointment under Code Sec. 2041 and would result in inclusion of trust assets in the beneficiary’s estate. To avoid this problem, an independent trustee should be appointed to exercise the power to make decisions regarding distributions to that beneficiary.

Planning to divest New York of jurisdiction to impose fiduciary income tax on undistributed trust assets can produce large tax savings. NY Tax. Law. §605(b)(3) taxes trusts created by New York settlors. However, a resident trust is not subject to tax if (i) all trustees are domiciled in a state other than New York; (ii) all property, both real and intangible, is located outside of New York; and (iii) all income and gains of the trust are derived from sources outside of New York. Therefore, New York will not tax a trust that has no New York trustees and no New York assets or income.

To illustrate, a trust created by a New York resident and administered in New York must pay $76,992 of New York State tax on a capital gain of $1 million. However, if the trust were domiciled (or redomiciled) in Delaware, this tax would be avoided, as Delaware imposes no income tax on capital gains incurred on an irrevocable nongrantor trust provided that no remainder beneficiary lives in Delaware. Del. Code Ann., §§ 1101-1243.

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Validity, Interpretation & Effect of Wills Having Jurisdiction Outside of New York

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

PDF: Wills Having Jurisdiction Outside NYS

The burden of proof that a will was executed in accordance with formal requirements imposed by EPTL § 3-2.1 is on the will’s proponent, who may be the executor, a beneficiary, or an interested person. These requirements are intended to prevent revisions to the will after it has been executed. Even if there are no objections, SCPA § 1408 provides that the court must be satisfied that will has been properly executed.

EPTL § 3-5.1 sets forth rules governing wills having some relation to a jurisdiction outside of New York. For a will to be admitted to probate in New York, it must be executed either in accordance with local law formalities imposed by (i) EPTL § 3-2.1; (ii) the jurisdiction where the will was executed; or (iii) the jurisdiction where the decedent was domiciled, either at the time of execution, or at the time of the decedent’s death. If a will has been executed in accordance with local law, EPTL § 3-5.1(c)(3) further provides that “[a] will disposing of personal property, wherever situated, or real property situated in this state . . . is formally valid and admissible to probate in this state.”

Thus, the will of a California domiciliary, whose will was executed in accordance with the laws of France, where decedent was domiciled when the will was executed, may be offered for probate in New York, if the will disposes of (i) any personal property, regardless of where the personal property is situated, or (ii) real property situated in New York. However, a New York Surrogate may decline to probate a will under the doctrine of forum non conveniens if decedent had minimal contacts with New York.

The law of the forum state applies to issues of due execution. However, in the context of a will contest, Surrogate Holtzman, citing EPTL § 3-5.1(c), held that New York law exclusively governs issues of testamentary capacity, fraud and undue influence, regardless of the forum in which the will was executed. In re Gottfried, N.Y.L.J., May 20, 2002 (Surr. Ct. Bronx Cty).

Most states recognize the common law doctrine of “incorporation by reference,” which permits a will to reference extraneous documents. New York does not. Thus, a will consisting of a pre-printed form upon which the testator had written “see attached” was denied probate. However, EPTL § 3-3.7 creates a limited exception, permitting the testator to direct that probate assets “pour over” to an existing revocable or irrevocable trust. The rationale for this exception, which codified a decision by Judge Cardozo, is that the execution of trust instruments is customarily accompanied by ample safeguards. In re Rausch, 222 N.Y. 222 (1918).

Can a lost or destroyed will be admitted to probate? Yes. SCPA § 1407 provides that a lost or destroyed will may be admitted if it is established that (i) the testator had not revoked the will; (ii) due execution is proved in the manner required for an existing will; and (iii) all of the will provisions are clearly proved by at least two credible witnesses, or by a copy or draft of the will proved to be true and complete.

What if a will executed later in time has been intentionally destroyed by a beneficiary of an earlier will, who seeks to probate the earlier will? In such a case, the requirements of SCPA § 1407 with respect to proving the validity of a lost or destroyed will might be difficult to establish. Where the requirements of SCPA § 1407 could not be satisfied, the court admitted the earlier will to probate, but denied the right of the person who destroyed the later will to benefit under the earlier will. A constructive trust was imposed for the benefit of the testator’s son, who would have benefited under the destroyed will. In re Katz, 358 N.Y.2d 616 (Sur. Schoharie Cty, 1974).

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April 21, 2010 Tax Seminar in Lake Success, New York

Posted on March 25, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

To view April 21, 2010 Tax Seminar Invitation, or to Attend Seminar, press here: April 21 Tax Seminar Invitation

The lecture will first discuss researching and drafting the Petition to the DTA following the Conciliation Conference. Pre-hearing motion practice and discovery will then be addressed, including how to survive (or make) a summary judgment motion. The actual hearing, including the preparation of witnesses, experts, and exhibits, will be presented. The importance of the post-hearing brief, with proper citation to cases, exhibits and the hearing transcript will follow. The procedure for taking an Exception to the Tax Appeals Tribunal, and oral argument, will ensue. Finally, Article 78 appeals to the Appellate Division, with bonding requirements, will be addressed. Throughout the presentation, emphasis will be placed on strategies for successful litigation and jurisdictional time constraints.

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Installment Sale Reporting of Deferred Exchange Boot

Posted on March 24, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

IRC §453 provides that an “installment sale” is a disposition of property where at least one payment is to be received in the taxable year following the year of disposition. Income from an installment sale is taken into account under the “installment method,” whereby income recognized in any taxable year following a disposition equals a proportion of the payments received, that proportion being equal to the gross profit over the total contract price.

IRC §453(f)(6)(C) provides that for purposes of the installment method, the receipt of qualifying property in a like-kind exchange is not considered to be “payment.” However, a problem arises in connection with exchange funds held by a qualified intermediary (QI) in deferred exchanges. Although the eventual receipt of qualifying like kind property is not considered “payment,” the IRS has suggested that exchange funds held by a qualified intermediary at the beginning of the exchange period could be considered as “payment” under Temp. Regs. § 15A.453-1(b)(3)(i). If this were the case, funds held by the QI would render installment reporting of boot gain impossible, even though most of the exchange funds were actually used to purchase qualifying like kind property within the 180-day exchange period.

Fortunately, the final regulations under IRC § 453 provide that the deferred exchange safe harbor regulations under IRC §1031 themselves — rather than the rules proposed in Temp. Regs. §15A.453-1(b)(3)(i) — control in determining whether the taxpayer is in receipt of “payment” at the beginning of the exchange period. Since the raison d’être of the deferred exchange regulations under Section 1031 is to insulate the taxpayer from being considered in constructive receipt of exchange funds, this rule would appear to bless installment reporting of boot gain later attributable to exchange funds held by a qualified intermediary not used to purchase replacement property.

However, one important condition must be satisfied for this “override” rule to apply: The taxpayer must possess a “bona fide intent” to enter into a deferred exchange at the beginning of the exchange period. Regs. §1.1031(k)-1(k)(2)(iv) state that a taxpayer possesses a bona fide intent to engage in an exchange only if it reasonable to believe at the beginning of the exchange period that like kind replacement property will be acquired before the end of the exchange period. If the intent requirement is met, gain recognized from a deferred exchange structured under one or more of the safe harbors will qualify for installment method reporting (provided the other requirements of Sections 453 are met.) The rationale for this rule appears to be that without the bona fide intent requirement, a taxpayer without a true intention to consummate a like kind exchange could engage the services of a qualified intermediary, not acquire replacement property within the exchange period, yet defer gain recognition until the following year under the installment method.

To illustrate the operation of this rule:

On November 1st, 2008, QI, pursuant to an exchange agreement with New York taxpayer (who has a bona fide intent to enter into a like kind exchange) transfers the Golden Gate Bridge to cash buyer for $100 billion. The taxpayer’s adjusted basis in the bridge is $75 billion. The exchange agreement provides that taxpayer has no right to receive, pledge, borrow or otherwise obtain the benefits of the cash being held by QI until the earlier of the date the replacement property is delivered to the taxpayer or the end of the exchange period. On January 1st, 2009, QI transfers replacement property, the Throgs Neck Bridge, worth $50 billion, and $50 billion in cash to the taxpayer. The taxpayer recognizes gain to the extent of $25 billion.  However, the taxpayer is treated as having received payment on January 1st, 2009, rather than on November 1st, 2008. If the other requirements of Sections 453 and 453A are satisfied, the taxpayer may report the gain realized in 2008 under the installment method.

[Note: If the QI had failed to acquire replacement property by the end of the exchange period, and had distributed $100 billion in cash to taxpayer on May 1st, 2009, Regs. §1.1031(k)-1(j)(2)(iv) would still permit gain to be reported on the installment method, since the taxpayer had a bona fide intent at the beginning of the exchange period to effectuate a like kind exchange. Note also: Under its “clawback” rule, California will continue to track the deferred gain on the exchange involving the Golden Gate Bridge. If the taxpayer later disposes of Throgs Neck Bridge in a taxable sale, California will impose tax on the initial deferred exchange. This will result in the taxpayer paying both New York (6.85 percent) and California (9.3 percent) income tax, in addition to New York City (3.65 percent) and federal income tax (15-25 percent, depending on the extent of unrecaptured Section 1250 gain) on the later sale.]

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General Power of Appointment Can Neutralize Estate Tax

Posted on March 24, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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A general power of appointment is power of appointment that is exercisable in favor of the donee, the donee’s creditors, or the creditors of the donee’s estate. Under IRC § 2042, the value of property over which the donee possesses a general power of appointment at death is included in the donee’s estate.

In situations where spouses have vastly unequal estates, the prudent use of a general power of appointment can avoid wasting the $3.5 million applicable exclusion amount, and in so doing, save more than $1.5 million in estate taxes.

To illustrate, assume one spouse has an estate worth $7 million, and the other spouse has an estate worth only $0.05 million. If poorer spouse dies first, virtually the entire applicable exclusion amount of the poorer spouse will be wasted. Upon the death of richer spouse, that spouse’s estate may be subject to significant estate taxes, since only $3.5 can currently be shielded from estate tax.

The traditional solution to this problem has been to “equalize” estates before the death of either spouse. If richer spouse were to transfer $3.5 million to poorer spouse either by outright gift or by lifetime QTIP trust under IRC §2523(f),  the estate tax problem would be solved, since regardless of which spouse died first, the applicable exclusion amount would be sufficient to avoid the imposition of estate taxes. However, richer spouse may be reluctant or unwilling to make such a large lifetime transfer to poorer spouse. Thus, exposure to a large estate tax liability could be eventuate.

Another solution involves the use of a testamentary general power of appointment. Employing this technique, richer spouse grants to poorer spouse a testamentary general power of appointment over so much of richer spouse’s estate as is equal to poorer spouse’s unused applicable exclusion amount. In the example, richer spouse would grant to poorer spouse a testamentary general power of appointment equal to $3.45 million (i.e., $3.5 million applicable exclusion amount less $0.05 million estate of poorer spouse). The testamentary general power of appointment would be conferred upon poorer spouse by virtue of a revocable testamentary trust executed by richer spouse during his lifetime. Being revocable in nature, the power could be revoked by richer spouse at any time before the death of poorer spouse.

Note that if richer spouse were to die first, the problem requiring the use of the general power of appointment will not arise: Richer spouse could simply leave to poorer spouse an amount equal to $3.5 million — either outright or in a QTIP trust. Richer spouse would still have available his own $3.5 million exemption, and upon the eventual death of poorer spouse, that spouse’s estate will have been augmented so that it can utilize that spouse’s own $3.5 million exemption.

However, if poorer spouse dies first, the general power of appointment conferred upon her will result in her estate being increased by an amount equal to the difference between the applicable exclusion amount and her estate, so that the poorer spouse’s entire $3.5 million exemption amount would be utilized. The general power of appointment exercised by poorer spouse at death could even fund a credit shelter trust which would benefit richer spouse during his lifetime.

By utilizing this technique, the estates of both spouses have been equalized, and richer spouse has not been required to part with dominion or control over any assets until the death of poorer spouse. Moreover, even at the death of poorer spouse, at which time richer spouse will be divested of dominion and control by reason of the testamentary exercise of the power of appointment by poorer spouse, richer spouse may still continue to benefit from the assets, since those assets could fund a credit shelter trust benefiting richer spouse during his lifetime.

[Note: Although the credit shelter trust may be drafted to liberally provide distributions to richer spouse during his lifetime, it may not go so far as to give richer spouse an unrestricted right to appoint trust assets to himself or others (i.e., an general power of appointment), as this could cause the trust assets to be included in the estate of richer spouse upon his death by virtue of IRC § 2036.]

If properly structured, this technique would thus achieve the following favorable tax results:

¶   No taxable event would occur during the lifetime of either spouse, since the inter vivos revocable trust granting the testamentary general power of appointment is not a completed gift, since it is revocable;

¶  At poorer spouse’s death, richer spouse makes a completed gift to poorer spouse (qualifying for the unlimited marital deduction) of that portion of richer spouse’s property which is subject to the general power of appointment;

¶  The extent of richer spouse’s property that is subject to the general power of appointment is included in the poorer spouse’s gross estate;

¶   Poorer spouse is treated as the transferor of all assets which fund the credit shelter trust, established for the benefit of richer spouse during his lifetime;

¶    Richer spouse (i) may be named both the beneficiary and trustee of the credit shelter trust, provided the power to make distributions to himself is limited by an ascertainable standard and (ii) may even possess a special power of appointment over the trust property, without the property being included in his estate at his death;

¶  The credit shelter trust may be exempt from generation skipping tax through allocation of poorer spouse’s GST exemption; and

¶  Assets transferred to the credit shelter trust will be asset protected, despite the fact that richer spouse will continue to benefit from the trust.

The IRS, in four published rulings, has approved the technique and tax result outlined herein. See PLRs 200604028, 200403094, 200210051, and 200101021.

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Marital Deduction Planning

Posted on March 23, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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By making a QTIP election, the Executor will enable the decedent’s estate to claim a full marital deduction. To qualify, the trust must provide that the surviving spouse be entitled to all income, paid at least annually, and that no person may have the power, exercisable during the surviving spouse’s life, to appoint the property to anyone other than the surviving spouse. Since the Executor may request a 6 month extension for filing the estate tax return, the Executor in effect has 15 months in which to determine whether to make the QTIP election.

Nevertheless, electing QTIP treatment is not always advantageous. Inclusion of trust assets in the estate of the first spouse to die may “equalize” the estates. Equalization may have the effect of (i) utilizing the full exemption amount of the first spouse and (ii) avoiding higher rate brackets that apply to large estates. Still, the savings in estate taxes occasioned by reason of avoiding the highest tax brackets may itself be diminished by the time value of the money used to pay the estate tax at the first spouse’s death. On the other hand, if the second spouse dies soon after the first, a credit under IRC §2013 may reduce the estate tax payable at the death of the surviving spouse.

Although the IRS had at one time litigated the issue, it now appears that the Executor may elect QTIP treatment for only a portion of the trust, with the nonelected portion passing to a credit shelter trust. If a partial QTIP election is anticipated, separating the trusts into one which is totally elected, and second which is totally nonelected, may be desirable. In this way, future spousal distributions could be made entirely from the elected trust, which would reduce the size of the surviving spouse’s estate.

When the surviving spouse dies, QTIP property is included in her estate at the value at the date of her death. Her estate is entitled to be reimbursed for estate taxes paid by recipients of the trust property. The amount of reimbursement is calculated using the highest marginal estate tax brackets of the surviving spouse. The failure to seek reimbursement of estate taxes is treated as gift made to those persons who would have benefited from reimbursement. However, the failure by the estate of the surviving spouse to seek reimbursement will not be treated as a gift if the decedent’s will provides that reimbursement will not be sought from QTIP property.

Care must be taken when making the QTIP election, since the IRS takes the position that if the election taken on the initial federal and state estate tax returns was defective — but the IRS did not notice the defect and allowed the marital deduction — the assets will nevertheless be includible in the estate of the surviving spouse under IRC §2044. Thus, the IRS takes the position that the assets are includible even if the estate of the first spouse would have incurred no estate tax had the QTIP election not been made. See PLR 9446001.

On the other hand, an unnecessary QTIP election will occasion of fewer harsh results. Under Rev. Proc. 2001-38, an unnecessary QTIP election for a credit shelter trust will be disregarded to the extent that it is not needed to eliminate estate tax at the death of the first spouse. Similarly, a mistaken overfunding of the QTIP trust will not cause inclusion of the overfunded amount in the estate of the surviving spouse.  TAM 200223020.

Since the estate tax is a “tax inclusive,” as opposed to the gift tax, which is “tax exclusive,” there is a distinct tax benefit to making lifetime, as opposed to testamentary, gratuitous transfers. A QTIP trust can assist in accomplishing this objective. Assume at a time when the applicable exclusion amount (AEA) is $3.5 million, father has an estate of $6 million, and mother has an estate of $2.5 million. Father (who has made no lifetime gifts other than annual exclusion gifts) wishes to give his children $4.5 million. If $4.5 million were left to the children outright, the $1 million excess over $3.5 million would attract a federal estate tax of $450,000, and a New York estate tax of $160,000, for a total tax of $610,000. This would leave only $390,000 of the $1 million bequest to the children. If instead of leaving $4.5 million to his children outright, father were to leave only $3.5 million to them, and place $1 million in a trust qualifying for a QTIP election, many estate taxes could potentially be saved.

IRC §2519 provides that “any disposition of all or part of a qualifying income interest for life in any property to which this section applies is treated as a transfer of all interests in the property other than the qualifying income interest.” Therefore, were wife to gift one-half of her qualifying income interest, she would be deemed to have made a gift of the entire remainder interest in trust, in addition to the gift of the income interest. Under IRC §2207A(a), she would have a right to recover gift tax attributable to the deemed transfer of the remainder interest under IRC §2519.

Proposed regs provide for “net gift” treatment of the deemed gift of a remainder interest under IRC §2519. (A net gift occurs if the donee is required, as a condition to receiving the gift, that he pay any gift taxes associated with the gift.) The gift taxes so paid by the donee may be deducted from the value of the transferred property to determine the donor’s gift tax. Thus, assume the value of each of the income interest and the remainder interest in the QTIP trust are $500,000. If wife makes a gift of one-half of her income interest, or $250,000, she would be deemed to have made a net gift of the entire $500,000 remainder interest. If the gift tax rate were 50%, wife would have made a net deemed gift of the remainder interest constituting $333,333, resulting in a gift tax of $167,667.

Although there must be no prearranged agreement that wife will make the contemplated transfer of her lifetime income interest, it is evident that the gift of a qualifying income interest in a QTIP trust can be an effective means of leveraging the $3.5 million lifetime exemption amount by leaving assets to the surviving spouse, who is then expected — but not required — to make substantial gifts to the children. Note that in the example the intended result would not be accomplished if wife simply disclaimed her interest in the QTIP. In that case she would be treated as having predeceased her husband, and the $1 million would again be paid to the children and subject to $610,000 in combined federal and NYS tax.

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