Law Offices of David L. Silverman, J.D., LL.M.

Recent Tax Developments — October 2003

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

The IRS announced on 9/15 that it had reached agreements with 40 states to trade information on unlawful tax shelters. Arthur Roth, Commissioner of the NYS-DTF, said the potential revenue loss was in the “tens of millions.”

The IRS is also exploring ways to share taxpayer information with law-enforcement agencies, including the Justice Department, the FBI, the INS and the SEC. Currently, the IRS must get a court order before it can share information with another governmental agency. However, any such action could violate IRC provisions enacted in the mid-1970s after the Nixon administration used IRS records to intimidate enemies.

The 7th Circuit affirmed the Tax Court’s holding that gifts of LLC membership interests do not qualify for the annual exclusion where the operating agreement contained restrictions preventing the donees from realizing any substantial economic benefit. Hackl v. Comr, 9/22, 92 AFTR 2003-5254.

The IRC § 179 expensing limitation will be $102,000 in 2004. The gift tax exclusion will remain at $11,000, but the GST tax exemption amount will rise to $1.5 million in 2004.

Effective in 2004, a person over age 70½ can make tax-free gifts from an IRS to any U.S. charity. Although no charitable deduction will be allowed, the donor will not be requried to the IRS distribution as taxable income. The charitable IRA rollover law would permit an individual to fund a charitable remainder trust to provide retirement income, without paying any income tax on the IRA distribution used to fund the CRT. Taxpayers who do not itemize, and who wish to make outright gifts to charities with IRA funds would also benefit under the new tax law.

Under a Senate bill marked up in Committee on 9/17 whose objective is protect employee pensions, publicly held companies would be required to allow workers to divest themselves of company stock attributable to employer contributions once they had completed 3 years of service.

Robert E McKenzie, Esq., of the ABA Tax Section, in a letter to the IRS Oversight Board Hearing, criticized the centralized administrative processing of offers in compromise in recent years. Noting that while “the aim of the OIC program is to collect the maximum, reasonably collectable amount from the taxpayer . . . the IRS in recent years has tended to process OICs restrictively with the result that taxpayers are not only left with tax debts they are not reasonably able to pay but also are strained to meet their current tax obligations.” To realize the objectives of the OIC program, he urged that (i) a local system of processing offers be reinstated and (ii) IRS employees be directed to follow statutory directives to consider individual facts and circumstances.

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Interest Abatement Denial Subject to Judicial Review

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

The 5th Circuit Court of Appeals has held that in amending IRC § 6404(e), which grants IRS the authority to abate an assessment of interest attributable in whole or in part to any error or delay by the IRS in performing a ministerial or managerial act, Congress clearly expressed its intent that the decision to abate interest was subject to judicial review. Beall v. U.S., No. 01-41471, (6/27/03).

[Following the IRS denial of their claim for refund and for abatement of interest under IRC § 6404(e), the taxpayers commenced suit in district court under IRC § 7422, which permits a claim for refund for “any sum . . . wrongfully collected.” The district court dismissed, citing a lack of subject matter jurisdiction. The instant appeal ensued.]

Finding that the phrases (i) “any sum” includes unabated interest on income taxes owed and (ii) “wrongfully collected” includes interest that the IRS has refused to abate under IRC § 6404(e), the court first determined that the claim was not barred by sovereign immunity and that the District Court had in fact possessed subject matter jurisdiction.

Although an IRS decision not to abate interest was not previously subject to judicial review, the addition by Congress of the word “unreasonable” to modify the words “error or delay” indicated that “Congress clearly expressed its intent that the decision to abate interest no longer rest entirely within the Secretary’s discretion.” The vesting of jurisdiction in the Tax Court to review interest abatement challenges authorized judicial review.

The final issue facing the court was whether the Tax Court had exclusive jurisdiction under IRC § 6404(h) to review an IRS decision not to abate interest. §6404(h) provides: “The Tax Court shall have jurisdiction over any action brought by a taxpayer . . . to determine whether the Secretary’s failure to abate interest . . . was an abuse of discretion.” In its brief, the government cited to the House Report accompanying the 1996 Taxpayer Bill of Rights, which stated that “[f]ederal courts generally do not have the jurisdiction to review the IRS’s failure to abate interest.”

Noting that the House Committee Report “clearly states” that “[n]o inference is intended as to whether under present law any court has jurisdiction to review IRS’s failure to abate interest,” the court rejected the government’s argument, which assumed that in vesting to the Tax Court jurisdiction to review, the statute “impliedly repealed” the district court’s existing jurisdiction.

The decision is significant for a two reasons: First, the taxpayer who has paid the entire tax liability plus interest will not be forced to litigate the interest abatement issue in Tax Court and the refund claim in federal District Court. Also, litigating an IRS abatement issue in federal district court is far more appealing from a strategic standpoint than litigating the issue in Tax Court, which is viewed as far less taxpayer-friendly than federal district courts.

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1999 Regs, IRS Rulings & Pronouncements

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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Life Insurance Trusts Mitigate Estate Tax Uncertainties

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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Irrevocable life insurance trusts (ILITs) enjoy vastly preferential status under the income and transfer tax laws. Properly structured, proceeds are not included in the insured’s gross estate. Even so, the ILIT trustee can loan cash to the estate (or purchase estate assets) to fund the insured’s estate tax liability. Therefore, the ILIT may also serve as a hedge against estate tax repeal not occurring. Funding an ILIT could produce a small taxable gift. However, since policy proceeds may exceed the premium by a multiple of 100 or more, the virtues of the ILIT are apparent.

The use of Crummey withdrawal powers permits policy premiums paid by the grantor to qualify for the $11,000 per donee annual gift tax exclusion. However, since the lapse of a withdrawal right in excess of $5,000 or 5% of trust assets constitutes a taxable release by the beneficiary holding the power, it may be necessary to use “hanging” Crummey powers, which lapse annually at the rate of “5-and-5.” PLR 8901004.

Life insurance proceeds are excluded from beneficiaries’ income under § 101. However, the transfer for consideration of a right to receive policy proceeds voids the exclusion. An exception to the “transfer for value” rule exists when the policy retains the same basis in the hands of the transferee. Both the transfer for value rule and the 3-year rule of § 2035, which requires inclusion in the grantor’s estate if the grantor dies within 3 years of making a gratuitous transfer to an ILIT, might be avoided if the grantor sells a policy to a spouse who then gifts the policy to an ILIT. Under § 1041, the spouse would take a transferred basis in the policy, rendering the transfer for value rule inapplicable. Section 2035, which applies only to transfers by the insured, would also be inapplicable in this case. (But see Brown v. U.S, pg. 1, col. 2, discussing applicability of step-transaction doctrine.)

The deleterious effect of the 3-year rule of § 2035 could also be avoided if the ILIT authorizes the trustee to pay the proceeds to the surviving spouse, since the Executor could then claim a marital deduction. However, in such a case if (i) the grantor had allocated GST exemption to the ILIT; and (ii) the Executor makes a reverse QTIP election with respect to the entire marital deduction trust, the Will of the surviving spouse should waive the right to recovery under § 2207A so that the tax is apportioned against the residue of the surviving spouse’s estate. Otherwise, the GST exemption will be wasted.

If the potential application of the 3-year rule cannot be avoided through planning (e.g., there is no spouse), the grantor must decide whether the policy beneficiaries should pay the estate taxes attributable to the proceeds, or whether the tax liability should be borne by the residuary estate. Under § 2206, the Executor is entitled to recover from beneficiaries estate taxes attributable to their bequests. However, even a general provision in the Will requiring that estate taxes be paid by the residuary is sufficient to opt out of the statutory right of recovery. Plainly, the language of the tax apportionment clause of the Will should be carefully considered.

The ILIT should also be drafted to avoid traps which might cause inclusion of insurance proceeds in the grantor’s estate, which would be disastrous. If the grantor is a beneficiary of the ILIT, § 2036 requires inclusion for any retained use or enjoyment of property. The use by the trustee of ILIT property to discharge a legal support obligation of the insured would be such a retained interest, as would a reserved power by the grantor to change a beneficiary or cancel a policy. This list is illustrative rather than exhaustive. IRC § 2038 taxes “revocable transfers” and is triggered when the grantor retains the right to replace the trustee, unless the new trustee is not “related or subordinate to the grantor” within the meaning of § 672(c). Rev. Rul. 95-58.

The retention of a general power of appointment could also result in estate tax inclusion under § 2041 to the grantor or anyone else holding that power. A beneficiary-trustee’s right to make discretionary distributions to himself would constitute a general power, unless limited by an ascertainable standard relating to the beneficiary’s support, maintenance and health. If such discretionary distributions are contemplated, the trust should provide for the appointment of a co-Trustee with a substantial adverse interest whose consent to every such distribution would be required.

The liberalization of GST rules in the 2001 Tax Act makes ILITs attractive as dynastic trust vehicles. Property held by the ILIT can be transmitted to succeeding generations without the imposition of estate or GST tax in the estates of spouses or other beneficiaries. The retroactive allocation of GST exemption for a non-skip beneficiary’s unnatural order of death while the grantor is alive maximizes use of the GST exemption. The Act also allows a “qualified” severance of a trust into multiple trusts, with favorable GST tax consequences, if permitted by state law or the governing instrument.

Posted in Estate Planning, Life Insurance Trusts, Trusts | Tagged 3-year rule, Crummey withdrawal, estate tax planning, ILIT, IRC § 2035, IRC § 2041, life insurange trust, revocable transfer | Leave a comment

2006 REGS, IRS RULINGS & PRONOUNCEMENTS

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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Since IRA accounts often reflect a lifetime of retirement savings, their inclusion in a QTIP trust is important. Rev. Rul. 2000-2 stated that IRA proceeds may qualify for a QTIP election if the surviving spouse may compel a trustee to make annual income distributions. Rev. Rul. 2006-26 added that (i) a separate QTIP election must be made for the IRA and the trust receiving the IRA payments; and (ii) income must be determined separately for the trust and the IRA.

Given the present estate tax uncertainty, few people will risk making gifts exceeding the $1 million gift tax exemption. Formula clauses could be employed as a “hedge” against the possibility of gift tax where the value of gift is uncertain, by imposing a $1 million “cap” on the gift. Historically, formula clauses have been viewed with disfavor. Com’r v. Procter, 142 F.2d 824 (4th Cir. 1944), cert. denied, 323 U.S. 756 (1944) held that such clauses tend to “discourage the collection of the tax . . . since the only effect of an attempt to enforce the tax would be to defeat the gift; and . . . the effect of enforcing the clause would be to obstruct the administration of justice by requiring courts to pass upon a moot case.” However, other savings clauses may be less objectionable, particularly if they do not return transferred property to the donor as in Procter, but rather reallocate property among transferees.

To illustrate, assume property of uncertain value is sold to a grantor trust. Such sales are intended to be free of gift tax. If the property has an ascertainable value, the note would reference that value. However, if the property has an uncertain value, immediate gift tax liability will result unless a savings clause is used to reallocate the value of the property in excess of the note. Shifting any gift in excess of $1 million back to the grantor is not an option, since that would clearly violate Procter. However, the governing instrument could provide that any excess value be allocated to a nontaxable donee. If trust beneficiaries include the grantor’s spouse, the excess could be shifted to the grantor’s spouse without gift tax, since the gift would qualify for the unlimited marital deduction.

Recent rulings demonstrate the determination of the IRS to assert the applicability of IRC § 2036 in transfers to family entities. In PLR 200626003, A transferred real property to a family LLC, retaining a 25 percent interest. Following A’s death, the IRS determined that A’s retained right to income resulted in inclusion under IRC § 2036. The estate’s request for 9100 relief to file a late IRC § 754 election was denied. However, since the property was includible under IRC § 2036, the LLC’s inside basis in the assets was increased pursuant to IRC §1014. Thus, the IRC § 754 basis increase sought was achieved under IRC § 1014.

IRC § 6324 provides for a special 10-year estate tax lien. FSA 20061702F addressed the issue of priorities among lienors. After inheriting property, Son defaulted on a loan in which the property had been pledged as collateral. Lender was reluctant to foreclose believing that the estate tax lien might have priority. The FSA concluded that the pledge of the real estate as collateral constituted a “transfer” under IRC § 6324(a)(2), which divested the government’s lien interest. However, the lien remained to the extent the value of the real estate exceeded the balance of loan. Son also remained personally liable for the portion of the unpaid estate tax equal to the value of the real property.

Whether to file an amended return often sparks a lively debate. Taxpayers may view them as a “cure all” for previous tax transgressions. Practitioners are less sanguine, sometimes concluding that their filing may do more harm than good. Generally, no duty exists to file an amended return. The Supreme Court, in Hillsboro National Bank v. Com’r., 460 U.S. 370 (1983), remarked that “the Internal Revenue Code does not explicitly provide either for a taxpayer’s filing, or for the Commissioner’s acceptance, of an amended return; instead, an amended return is a creature of administrative grace and origin.” Regs. § 25.2504-1(d) explicitly sanction an amended return if a gift was omitted from a previous return. It should be reported on Schedule B of Form 709 as part of gifts for previous years.

[Although the filing of a gift tax return is required only where a taxable gift has been made — and in the case of sales to grantor trusts that is usually not the case — filing a return (reporting the amount of the gift as zero) would start the running of the 3-year statute. If no gift tax return is filed, the IRS could many years later challenge the value of property sold to the trust.]

Circular 230 contains regulations governing the practice of Attorneys and CPAs before the IRS. Subpart B, §10.34(a), which addresses standards for preparing or signing returns, provides that a practitioner may not sign a return if the position taken does not have a “realistic possibility of being sustained on the merits.” That standard is met if “a person knowledgeable in the tax law would . . . conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits.” The possibility that a return will not be audited or that the issue would not be raised on audit may not be taken into account.

Authorities that may be taken into account in assessing the “realistic possibility” standard are those enumerated in the substantial understatement penalty regulations, §1.6662-4(d)(3)(iii). They include (i) Code provisions; (ii) Treasury Regulations; (iii) Rulings and Procedures; (iv) tax treaties; (v) case law (that has not been overruled); (vi) Committee Reports; (vii) Blue Book Explanations of Tax Legislation; and (viii) PLRs, TAMs, GCMs, Actions on Decision, Notices and Announcements. Conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax professionals are not substantial authority. However, authorities underlying such expressions of opinion where relevant may give rise to substantial authority for tax treatment of an item.

Creating wholly grantor trusts without risking estate inclusion is difficult. In PLR 200606006, the trust provided the grantor’s spouse with a limited withdrawal right, and the grantor with the right to reacquire trust principal by substituting property of equal value. The ruling concluded the substitution power would not cause inclusion under IRC §§ 2033, 2036 or 2039, and the trust would be a wholly grantor trust as to the grantor. Although a beneficiary spouse may be treated as owner of the portion of the trust over which she has a withdrawal power, the trust is a fully grantor trust with respect as to the grantor since IRC § 678(b) trumps IRC § 678(a).

PLR 200620025 stated that an IRA may be transferred to a Supplemental Needs Trust (SNT) that is a grantor trust without income tax consequences. The ruling relied on Rev. Rul. 85-13, which holds that if a grantor is treated as the the owner of a trust, the trust is ignored for income tax purposes, and any transactions between the grantor and the trust are also ignored. Rev. Rul. 85-13 is one of the foundations upon which the technique of sales to “defector” grantor trusts relies.

Controversial legislation passed in 2006 limited deductions for Americans working abroad. Notice 2007-25 increased the housing expense limits in approximately twenty foreign cities, and permits Americans working abroad to exclude up to $82,400 of their foreign-earned pay. However, income in excess of that amount is subject to higher tax rates than before.

Announcement 2006-63 clarified rules relating to private collection agencies. PCAs may access non-IRS computer databases to obtain financial information, but may not inquire with the taxpayer’s employer, bank, or neighbors concerning the taxpayer’s financial condition. PCAs must safeguard taxpayer information and may not access unnecessary tax information. PCAs may not telephone the taxpayer in unusual hours, and may not threaten to harm the taxpayer’s credit. Failure to respect taxpayer rights may subject the PCA to civil liability or criminal prosecution.

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The IRC § 2036 Trap in Planning With FLPs & Grantor Trusts

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Printer-friendly PDF Memorandum: The IRC § 2036 Trap in Planning With FLPs & Grantor Trusts.wpd

The IRS has advanced many theories to challenge the gift and estate tax savings occasioned by the use of family entities and grantor trusts in estate planning. Until recently, most IRS arguments had been rather unsuccessful. However, the IRS discovered a potent weapon in IRC § 2036(a), which provides that the value of the gross estate includes the value of all property to the extent the decedent has made a transfer but has retained (i) the possession or enjoyment of, or the right to income from, the property, or (ii) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

The IRS has been successful in arguing that IRC § 2036(a) requires the inclusion in the decedent’s estate of (i) partnership assets if the decedent continued to derive benefits from the partnership, or of (ii) trust assets, if the decedent continued to receive distributions, disguised in the form of a note, from assets sold to a “defective” grantor trust. The IRS has been most successful where the transactions with not imbued with a sufficient quantum of non-tax objectives, or the economics of the transaction were questionable, most often because the grantor had not left himself with sufficient assets to live according to his accustomed standard without receiving partnership (or trust) distributions.

Gifts of partnership interests shift wealth and future appreciation, and are effective in transferring management and control of family businesses to younger generations. Various discounts, which reflect the lack of control and the lack of transferability of the transferred interests, as well as built-in capital gains tax liability, have enabled the estate planners to leverage both the $1 million gift tax exemption and the $2 million lifetime exemption. The largest discounts, which may exceed 50 percent, arise with respect to family entities owning real estate.

Sales to “defective” grantor trusts are useful where the size of the estate exceeds the $2 million lifetime exemption. Assets (which could include partnership interests) are sold by the grantor to the trust in exchange for a promissory note. The sale accomplishes the following: (i) the asset, as well as future appreciation, is shifted out of the estate; (ii) “leakage” back into the estate is minimized by reason of the low interest rate of the note; (iii) the obligation to pay trust income tax remains that of the grantor, thereby enabling trust assets to grow without diminution for income taxes — accomplishing a gift-tax free payment of the trust’s income tax liability by the grantor (hence, the term “defective”); and (iv) asset protection against potential creditors of the grantor and trust beneficiaries.

If discounted partnership assets are sold to the trust, the sale price — and consequently the principal amount of the note as well as interest payments — can be reduced. The reduction in purchase price will further enhance the estate planning attributes of the transaction by stemming “leakage” back into the grantor’s estate.

To illustrate, assume FLP owns appreciating real estate worth $1 million. Father sells a 50 percent limited partnership interest to family trust in exchange for a 15-year interest only, balloon principal, promissory note. The note bears interest at the AFR of 6 percent, pursuant to IRC § 1274(b). Upon the advice of appraiser, father takes a 50 percent discount for the real estate within the FLP. Although 50 percent of the value of the real estate is $500,000, the discounted value is $250,000. Thus, the principal amount of the note is $250,000. The note requires interest in year one of $15,000, which is 6 percent of $250,000.

If the property produces annual income of 10 percent, the value of the underlying assets in the partnership interest purchased by the family trust would increase by $50,000 in year one. Since the trust is obligated to make only a $15,000 interest payment, $35,000 in growth is shifted out of the estate. Moreover, the income tax liability of the family trust — perhaps $20,000 — will be paid by father, since the trust is a wholly grantor trust with respect to father. (Although an early ruling viewed the payment by father of the income tax liability of the trust as a taxable gift to trust beneficiaries, that argument was abandoned.)

Trend of Recent Cases

In Estate of Stone, 86 T.C.M. (CCH) 551 (2003), the IRS argued that Stone had retained possession or enjoyment of the property that had been transferred to separate FLPs owned by Stone’s children. In rejecting the application of IRC § 2036, the Tax Court found the partnerships were the result of arm’s-length negotiations in which each child was represented by independent counsel. The transfers were motivated primarily by “investment and business concerns” and a desire to avoid litigation.

Similarly, in Estate of Kimbell, Mrs. Kimbell held most of her assets in a living trust, of which she and her son were trustees. In exchange for trust assets, the trust received a 99 percent limited partnership interest. The district court held the partnership should be ignored under IRC § 2036(a). The Fifth Circuit reversed, holding that a “bona fide sale for adequate and full consideration” precluded the application of IRC § 2036. 371 F.3d 257 (5th Cir. 2004), rev’g 244 F.Supp. 700 (N.D. Tex. 2003). “[O]bjective facts” supported the conclusion that the transfer to the partnership was a bona fide sale. Credible non-tax reasons for the partnership formation included (i) creditor protection, which could not have been accomplished with a trust; (ii) the preservation of property as separate property for descendants, and (iii) the availability of a dispute resolution mechanism for the children.

Section 2036 may apply even in cases where no abuse has occurred. In Estate of Abraham v. Com’r, 87 T.C.M. 975 (2004), a guardian ad litem, with court approval, established an estate plan for Mrs. Abraham. The partnership agreement created pursuant to the estate plan required the partnership to “share equally any and all costs and expenses [related to] . . . the support of Ida Abraham.” Since Mrs. Abraham had been been given the legal right to continue to benefit from partnership assets, inclusion in her estate was “required.” The First Circuit affirmed. 408 F.3d 26 (2005).

Some cases seemed destined to fall prey to IRC § 2036. The Eighth Circuit recently affirmed a Tax Court decision in Estate of Korby, 98 AFTR 2d ¶ 2006-5897, aff’g T.C. Memo, 2005-103. After attending an estate planning seminar in 1993, the Korbys created FLPs into which they transferred marketable securities. A gift tax return claimed a 43.61 percent discount. The Korbys died within five months of each other in 1998. The Tax Court, finding an implied agreement that the Korbys would continue to receive distributions “as long as they needed income,” held that partnership assets were includible under IRC § 2036. The lack of a written management contract and Korby’s failure to report self-employment income were cited by the court in rejecting the management-fee claim.

Estate of Bongard, 124 T.C. No. 8 (2005), reviewed by the entire court, demonstrated that significant non-tax reasons alone will not defeat the application of IRC § 2036. The court found “legitimate and significant non-tax reason[s]” for the creation of the FLP and acknowledged that “legitimate non-tax purposes are often inextricably interwoven with testamentary objectives.” Nevertheless, since Bongard retained the practical control over the entities formed as CEO, the entire value of the partnership holdings were includible in his estate under IRC § 2036(a)(1).

In Estate of Discrow, 91 TCM 794 (2006), the decedent transferred her New York residence to a general partnership of which she, her children and her spouse, were partners. Within 30 days, she gifted her entire interest in the partnership (which owned no other assets) to the children. Pursuant to an implied understanding, she continued to live in the residence pursuant to below-market lease agreements until her death. The residence was included in her estate under IRC § 2036(a)(1).

In Estate of Rosen, 91 TCM 1220 (2006), Rosen created an FLP to which he contributed liquid assets worth $2.4 million. The partnership was created after the decedent’s son-in-law attended an estate planning seminar. The court found the primary reason for creating the FLP was to avoid taxes and that no legitimate or significant non-tax reasons were present. There was an implied understanding that Rosen would receive partnership distributions. Since Rosen continued to “possess and enjoy the transferred assets until her death,” the entire value of the FLP was included pursuant to IRC § 2036(a)(1).

Tax Court’s holding in Rosen that partnership distributions constituted a retained interest, rather than loans (as the estate argued) makes the case relevant in the context of asset sales to grantor trusts. The IRS may attempt to recharacterize the note received from the trust as a retained equity interest in trust assets, resulting in inclusion in the grantor’s estate of all trust assets. It is therefore critical that the note be respected as debt.

Debt Versus Equity Distinction

The starting point for determining whether a note constitutes true debt or a disguised retained equity interest is Fidelity-Philadelphia Trust Co. v. Smith, 356 U.S. 274 (1958). The Supreme Court held that where a decedent transfers property in exchange for the transferee’s promise to make periodic payments to the transferor, those payments are not chargeable to the transferred property but rather constitute a personal obligation of the transferee. Accordingly, the property is not includible in the transferor’s estate under IRC § 2036(a)(1).

Miller v. Com’r, 71 T.C.M. 1674 (1996), aff’d, 113 F.3d 1241 (9th Cir. 1997) distinguished Fidelity-Philadelphia, and held that the “mere promise” to pay a sum of money in the future accompanied by an “implied understanding” that the promise would not be enforced is not evidence of a loan. Whether a “real expectation of repayment” exists depends upon factors such as whether (i) a promissory note existed; (ii) interest was charged; (iii) any security or collateral was advanced; (iv) a fixed maturity date was present; (v) a demand for repayment was made; (vi) any actual payment was made; and (vii) the transferee had the ability to repay.

The prominence of non-tax factors in transfers to family partnerships and “defective” grantor trusts appears to be a prerequisite to establishing the legitimacy of those transfers for gift and estate tax purposes. However, as Bongard clearly demonstrates, non-tax factors alone are insufficient to prevent the inclusion of partnership or trust assets pursuant to IRC § 2036, even if the general partner or trustee has respected fiduciary obligations.

Inclusion may be nearly unavoidable if (i) the decedent continued to control partnership property or could benefit from partnership or trust distributions pursuant to an express or even an implied agreement or (ii) the other partners’ or beneficiaries’ contributions were more imaginary than real. The situation is even more precarious since even where the decedent had been punctilious, IRC § 2036 has defeated many plans which seemed sound on their face.

Posted in Family Entities | Tagged applicable exclusion amount, estate planning, estate tax, gift tax, gross estate, IRC § 2036, irs | Leave a comment

LEAD TRUSTS THRIVE IN LOW INTEREST RATE ENVIRONMENT

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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The Charitable Lead Trust (CLT) is a trust in which the donor gives an income interest to a charity and, upon the donor’s death or after a term certain, a remainder interest passes to noncharitable beneficiaries. In essence, the donor is “lending” the assets to the charity for the term of the trust. Since the gift tax exemption is scheduled to remain at $1 million indefinitely, CLTs may enable charitably-inclined individuals to make substantial lifetime transfers without incurring a current gift or estate tax liability, thus preserving wealth for future generations.

Moreover, the current low interest rate environment is exceptionally hospitable to the CLT. As with a mortgage, the grantor of a CLT may “lock in” the favorable interest rate used to determine the gift and estate tax cost of the arrangement.

To fund a CLT, the donor gifts property into a trust which provides an income interest to a qualifying charity for a determinable period (e.g., a term of years or life of an individual) and a remainder interest to one or more noncharitable beneficiaries. The property may consist of cash, stock, income-producing real estate, or interests in a closely-held family business.

For gift tax purposes, a gift of (i) a present interest is made to the charity and (ii) a future interest is made to the noncharitable beneficiaries. A gift tax deduction is available only for the gift of the present interest to the charity. The larger the nontaxable gift to the charity, the smaller the taxable gift to the remainder beneficiaries.

For income tax purposes, since the CLT is a separate taxpayer, no income tax deduction will be available to the donor for gifts made to the CLT. However, an exception to this rule exists if the CLT is a grantor trust. In that case, an income tax deduction would be allowed since the grantor (donor) will pay income taxes associated with the trust. Grantor trust status may or may not be acceptable to the donor.

Congress requires annual payments to the charity of either (i) a fixed annuity or (ii) a payment consisting of a percentage of the fair market value of the trust assets. This rule prevents donors from investing trust assets in low-income investments which would diminish the present income interest of the charitable beneficiary. Increasing the size of the annuity reduces the size of the taxable gift to noncharitable beneficiaries.

For gift tax purposes, the present value of the annuity or unitrust interest depends on the IRC § 7520 rate (120% of the mid-term AFR) which is 3.6% for June 2003. Ultimately, what is removed from the donor’s estate is the growth of trust assets in excess of the Section 7520 rate. Therefore, like GRATs, CLTs work best in low-interest rate environments. Unlike GRATs, however, CLTs can be zeroed-out at inception with no initial taxable gift by providing for a sufficiently high annuity. Nevertheless, like a GRAT, if trust income is insufficient to pay the annuity, invasion of principal will be required. Selecting a high annuity amount to decrease the size of the taxable gift works if the property generates income sufficient to actually pay the annuity. Invasion of principal, if required to subsidize the annuity payment, would naturally reduce the amount ultimately passing to noncharitable beneficiaries.

To illustrate the mechanics, a CLT is funded with $500,000 in stock, providing for a 6% annuity to a named charity for 20 years, after which the trust will terminate and pay the remaining balance to the donor’s children. Assume (i) the assets will appreciate at a rate of 5%, and (ii) the donor has fully utilized his gift and estate tax exemption, meaning that any further gifts would result in a current tax liability or a future estate tax liability.

If the assets were simply invested, the donor’s taxable estate in the year 2023 would be $3.91 million, of which $1.79 million would be required to pay estate tax, leaving $2.11 million available for distribution. With a CLT, the taxable estate would be $1.43 million, of which $0.53 million would be required to pay estate tax. The lead trust assets, now worth $1.51 million, would pass to the children at no estate tax cost, having been removed from the estate in 2003. The net estate available for distribution would be $2.38 million, $270,000 more than what would have been available for distribution had the assets simply been invested.

Posted in Charitable Entities, Tax Decisions | Tagged charitable remainder trusts, CRTs, GRATS, lead trusts | Leave a comment

FAMILY DISCOUNT ENTITIES: INCOME TAX CONSIDERATIONS

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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FLPs (and LLCs) are ideal holding entities for family assets since fractional discounts yield substantial transfer tax savings. While the income tax treatment of asset transfers to and from these “flow thru” entities is generally placid, income tax planning should not be relegated to a mere afterthought.

IRC Secs. 721 and 731 generally confer nonrecognition status on most asset transfers to and distributions from FLPs. The operative word here is “generally.” Case in point: § 721(b) requires recognition when appreciated property is contributed to a partnership (i) 80% of the value of whose assets, immediately after the transfer, are held for investment, and consist of stock, securities and money, if (ii) “diversification” resulted from the transfer. (Rev. Rul. 87-9 opined that 5% diversification is de minimus, while 11% diversification produces a taxable event.) Note that the 80% test can be satisfied, and gain recognition can be required, if real estate is contributed to a partnership holding only securities, since the test measures the mix of property held by the partnership immediately after the transfer, without regard to the property contributed.

Distributions of appreciated property are tax-free to the distributee partner under §731(a), except to the extent money distributed exceeds the partner’s basis in his partnership interest. Many family entities hold title to marketable securities. A distribution of marketable securities by a family entity could trigger gain under § 731(a), since § 731(c) thoughtfully provides that the term “money” includes “marketable securities.” However, §731(c)(3)(A)(i) tempers this harsh rule by exempting from the definition of money appreciated securities which had been contributed to the partnership by the partner receiving the distribution. The declaration of § 731 defining marketable securities as money does not stand alone in its attempt to erode the general rule of nonrecognition: other Code provisions stand as sentinels attempting to deny tax-free treatment in a variety of distribution transactions.

One such provision narrowing the scope of nonrecognition is § 707(a)(2)(B), which recasts nominal § 721 tax-free contributions and § 731 tax-free distributions into constructive sales by the “contributing” partner if the transfers “viewed together” are “properly characterized” as a sale or exchange. Thus, a partner who receives cash immediately after contributing appreciated real estate could be treated as if he had sold the property to the partnership. Regs. § 1.707-3(c)(2) requires disclosure of such transfers within two years of one another. Regulations under § 707 do allow that if the contribution and distribution are more than two years apart, the transaction will be presumed not to be a sale of the property to the partnership.

Another provision which further attenuates the general rule of nonrecognition on property distributions is § 704(c)(1)(B), which provides that if a partner contributes appreciated property and, within 7 years, such property is distributed to another partner, the contributing partner is taxed on the contributed property’s built-in gain as if it had been sold by the partnership.

Closely related to § 704(c)(1)(B) is §737, which focuses its gaze not on the effect of distributions involving previously contributed appreciated property to another partner but rather, on the effect of distributions to the partner who himself contributed such property at an earlier time. IRC § 737 thus provides that a partner who contributes built-in gain property to a partnership must recognize the remaining net precontribution gain to the extent the value of other property distributed to him within 7 years exceeds the adjusted basis of his partnership interest immediately before the distribution.

Transfers of property subject to debt can also cloud transfers to family entities. A gift of property whose debt exceeds basis results in gain recognition under Regs. § 1.1001-2 to the extent of the difference. Thus, a gift of real estate worth $1 million, with basis of $250,000, and which is subject to a nonrecourse mortgage of $500,000, would result in $250,000 of realized gain to the transferring partner.

To vanquish the gain problem in this situation, the transferor might consider a “freeze” partnership instead of a discounted gift transaction. Thus, with respect to the property in the preceding paragraph, the parent could contribute the real estate worth $1 million to an LLC in exchange for membership interest with a liquidation preference equal to the equity in the property, or $500,000, and also retain the right to (i) an annual return of 8% on the liquidation preference and (ii) 10% of any profit and gain in excess of the liquidation preference. The transferor’s children could contribute a small amount of capital in exchange for an interest providing them with 90% of the profit and gain in excess of the transferor’s priority return.

Assuming the transaction were not to run afoul of the rules in IRC § 2701 et seq. (Chapter 14) which require the priority return to constitute a “qualified payment” — and there is no reason why it should — the real estate could be contributed to the partnership without a deemed relief of liabilities and its attendant gain recognition. Note that in this transaction, no gift will have been made; thus, the technique could be ideal for a person who has already depleted his or her entire gift tax exemption amount. If the transferor holds the “frozen” membership interest until his or her death, the heirs would receive a step-up in basis, and 90% of the appreciation in the real estate would have been transferred out of the parent’s estate.

The “preferred” limited partnership (PLP) “freezes” the value of preferred interests held by the transferor. Generally, the preferred interests must have a value immediately following their issuance equal to the property contributed. In contrast, a typical FLP is entitled to a large discount upon formation at the cost of a current gift tax liability. Often, this gift tax liability can be shielded from current tax by the applicable exclusion amount.

From a discounting perspective, the FLP is superior to the PLP upon formation. Thereafter, to the extent the FLP assets appreciate, the value sought to be removed from the transferor’s estate may “leak” back into the transferor’s estate. Accordingly, while the FLP may hold an initial advantage, if the expected total return of the asset substantially exceeds the cash-flow preference of the preferred partners, the PLP may ultimately be superior to the FLP.

Posted in Family Entities | Tagged estate planning, income tax considerations, LLC, marketability discount, minority discount, valuation discount | Leave a comment

Real Estate Title Issues in Estate Planning

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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Estate planning and administration frequently involve the transfer of real estate to family members. The choice of deed to convey title is important, as the rights of the grantee may be significantly affected. The use of an incorrect deed might cause title insurance to lapse. It is also important to ensure that title protection afforded by the policy remains effective following intrafamily transfers.

Transferring title without considering title insurance coverage could have the unintended effect of terminating policy coverage. Although most title insurance policies extend coverage to grantees who succeed in interest by operation of law, coverage may not be effective where voluntary transfers are made to entities created when planning the estate.

The deed conveying the greatest number of rights to the grantee is the warranty deed. The grantor of a warranty deed guarantees that he owns the property and has a right to convey it. The warranty deed, which purports to convey property free and clear of all encumbrances, creates liability in the grantor if the title transferred is defective. The guarantee extends to prior owners as well, so that the grantor is guaranteeing title against all claimants beginning from the first owner’s period of ownership.

Bargain and sale deeds also guarantee that the grantor is the owner and has the right to convey. However, the warranty against defects in title is limited to defects arising through the grantor, and does not extend to defects in title attributable to predecessors in interest. At the other end of the spectrum lies the quitclaim deed, which carries with it no implied warranties, and makes no representations concerning the condition of title. The quitclaim deed conveys only those rights the grantor possesses, but no more. Consequently, the quitclaim deed does not give rise to damages in the event title is defective.

Since liability arising from defects in title would not likely be a concern in most intra-family or post-mortem transfers, it might seem logical to choose a quitclaim deed. Although that deed protects the grantor, it might also extinguish the grantee’s right to pursue claims against the grantor’s predecessors for defects in title. Rights provided under the grantor’s title insurance policy could also be lost. A quitclaim deed would be a poor choice in an intrafamily transfer.

Choosing a bargain and sale deed might also be unwise, since remedies against the grantor’s predecessors in interest arising from earlier title defects could be extinguished. The best choice might be the warranty deed. Concerns about potential liability of the grantor can be addressed by drafting the deed so that it limits the grantee’s right to recover to claims against the grantor’s predecessors in interest.

The trend in title policy language is to expand the definition of the “insured” to include entities commonly succeeding to interests owned by family members. Nevertheless, inquiry should be made to confirm that coverage will be effective following the proposed transfer.

Posted in Estate Planning, Real Estate Title Issues | Tagged bargain & sale deed, grantee, grantor, quitclaim deed, real estate, title, title issues, warranty deed | Leave a comment

Reverse Exchanges

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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Although the deferred exchange regulations apply to simultaneous as well as deferred exchanges, they do not apply to reverse exchanges. See Preamble to final Regulations, 56 Red. Reg. 19933 (5/1/91). Reverse exchanges occur where the taxpayer acquires replacement property before transferring relinquished property. Perhaps because they are intuitively difficult to reconcile with the literal words of the statute, reverse exchanges were slow to gain juridical acceptance.

An early case, Rutherford v. Com’r, TC Memo (1978) held that purchases followed by sales could not qualify under Section 1031. However, Bezdijian v. Com’r, 845 F.2d 217 (9^th Cir. 1988) held that a good exchange occurred where the taxpayer received heifers in exchange for his promise to deliver calves in the future. Following Bezdijian, taxpayers began engaging in reverse exchanges in which either relinquished or replacement property was “parked” with an accommodator. Just as deferred exchanges were recognized by courts, so too, reverse exchanges soon received a judicial imprimatur.

Rev. Proc. 2000-37 Safe Harbor

Rev. Proc. 2000-37 was borne of an attempt by the IRS to provide a safe harbor that allows taxpayers intending to complete a like-kind exchange after acquiring replacement property to accomplish that result in a predictable fashion. Although the deferred exchange regulations do not govern reverse exchanges, many of its rules and time periods have been “borrowed” by Rev. Proc. 2000-37. Thus, the familiar 45-day identification and 180-day exchange periods which govern deferred exchanges also appear in Rev. Proc. 2000-37, albeit in a different context.

The 45-day period limits the time in which the taxpayer may identify up to three properties to be relinquished in an “Exchange Last” reverse exchange. The 180-day period limits the time in which the taxpayer must relinquish one of those three identified properties. The 180-day period also applies with respect to the accommodator. The 180-day period limits the time in which an accommodator may hold and improve replacement property in an Exchange Last reverse exchange. The 180-day period also limits the time in which an accommodator may hold relinquished property for sale in an “Exchange First” reverse exchange.

Reverse exchanges under Rev. Proc. 2000-37 are effective with respect to an “Exchange Accommodation Titleholder” (EAT) that acquires beneficial title in either the relinquished or the replacement property. The IRS will not challenge the qualification of either replacement property or relinquished property, or the status of the EAT as owner for federal income tax purposes of such property, if the property is held in a “qualified exchange accommodation arrangement” (QEAA). The EAT in a QEAA may hold the exchange property for no more than 180 days.

To be the tax owner, the EAT must possess “qualified indicia of ownership” (QIO) from the acquisition date until the date the property is transferred. While the taxpayer will want to profit while the property is held in a QEAA, if the EAT has actually acquired an ownership interest — which it must to engage in the exchange — the EAT must also profit from property appreciation during its period of ownership. The IRS states the EAT must have between three and seven percent of its equity at risk. The taxpayer may continue to lease or manage the property while it is parked with the EAT.

The EAT cannot be either the taxpayer or a “disqualified person.” Disqualification is determined under rules similar to those found in deferred exchange Regs. § 1.1031(k)-1(g). The QEAA must explicitly provide that the EAT is not the taxpayer’s agent for federal tax purposes since only the property owner can engage in a like-kind exchange. To avoid exposure to state and local taxes, the QEAA should also provide that the EAT is not taxpayer’s agent for state or local tax purposes.

[In contrast to the EAT in a QEAA, the QI in a safe harbor deferred exchange never has an equity stake in the transaction. The role of the QI is also distinguishable from that of the EAT in that the QI never acquires beneficial title in either the relinquished or the transferred property (and not even legal title if property is direct-deeded to the taxpayer) while the EAT must be the beneficial owner for tax purposes. Neither the QI nor the EAT is the taxpayer’s agent for income tax purposes. However, the QI is the taxpayer’s escrow agent for legal purposes. Since an escrow agent is bound by a fiduciary obligation, Regs. § 1.1031(k)-1(g)(3) provides that the taxpayer is not in constructive receipt of exchange funds held by the QI.]

“Exchange Last” and “Exchange First”

Rev. Proc. 2000-37 sanctions two types of reverse exchanges. The first is “Exchange Last.” Here, an accommodator acquires and “parks” replacement property until the taxpayer arranges to dispose of the relinquished property through a QI. Financing for the acquisition may be arranged by the taxpayer. The QI transfers proceeds from the relinquished property sale to the EAT in exchange for the parked replacement property. The EAT then transfers the replacement property directly to the taxpayer, completing the exchange. The EAT uses the cash received from the QI to retire the debt. While parked with the EAT, the replacement property may be net-leased or managed by the taxpayer.

Since the parked property will have been initially acquired by the accommodator and will not have been previously owned by the taxpayer, there is little risk the accommodator will be disregarded for tax purposes. Another advantage of Exchange Last is that following acquisition by the accommodator of the replacement property, the taxpayer can consider several potential properties to be relinquished, and ultimately choose that which generates the least gain. However, if the taxpayer elects to proceed under the safe harbor provided by Rev. Proc. 2000-37, flexibility will be limited, since the taxpayer must identify three potential properties to be relinquished within the 45-day identification period.

In Exchange Last, although the taxpayer eventually acquires title to the replacement property, while the replacement property is parked with the EAT, the EAT is title owner of that property. Therefore, the EAT will be the borrower on a loan associated with the acquisition of the replacement property until the loan is satisfied by proceeds from the sale of the relinquished property. To avoid loan application problems, the taxpayer should apprise the lender at an early stage of the planned reverse exchange and the presence of the EAT. A build-to-suit exchange would typically employ the Exchange Last format, since the replacement property may be improved while parked with the accommodator.

Many “build-to-suit” arrangements will not be suitable for the Rev. Proc. 2000-37 safe harbor, since completion of improvements may not be possible within the 180-day period in which the property is held by the EAT. If it is necessary to go beyond 180 days (or if the EAT is a “disqualified person”) the taxpayer can still a pursue “non-safe-harbor” or “pure” reverse exchange. Rev. Proc. 2000-37 states that “the Service recognizes that parking transactions can be accomplished outside of the safe harbor.” PLR 200111025 explicitly recognized that non-safe-harbor reverse exchanges survive Rev. Proc. 2000-37. Pure reverse exchanges free the taxpayer of constraints imposed by the 45-day identification period and the 180-day period during which the accommodator may improve the replacement property. However, pure reverse exchanges pose more tax risk, as they are burdened with issues of agency, constructive receipt and beneficial ownership.

Therefore, if more than 180 days are required, and a planned safe harbor Exchange Last reverse exchange is converted into a non-safe-harbor reverse exchange, liberties taken when planning under the safe harbor may have doomed a non-safe-harbor reverse exchange unless these troublesome issues are considered from the start.

The second type of reverse exchange is “Exchange First.” Here, the taxpayer sells relinquished property to an EAT through a QI. Shortly thereafter, the QI uses the sale proceeds to purchase replacement property, which is transferred directly to the taxpayer, completing the exchange. Although the exchange is complete, the EAT may continue to retain the relinquished property for up to 180 days, until the taxpayer arranges for a buyer. Since the replacement property is transferred directly to the taxpayer, the EAT never acquires ownership. This eliminates the requirement that the EAT be involved in the loan process. It also eliminates the necessity of the EAT taking legal title, which may be advantageous from a transfer tax standpoint. Since the taxpayer is taking title to the replacement property immediately, it may be pledged as collateral for a loan. If management problems exist, it may also be preferable for the taxpayer to take immediate ownership in the replacement property.

An Exchange First reverse exchange might be desirable if the purchaser of the property to be relinquished has defaulted, leaving the taxpayer obligated to close on the replacement property or risk losing his downpayment. The taxpayer could acquire the replacement property before finding a new buyer for the relinquished property.

By structuring an Exchange First reverse exchange under the Rev. Proc. 2000-37 safe harbor, the taxpayer sacrifices the luxury of time, since he may no longer wait 45 days to identify potential properties to be relinquished, nor wait 180 days to choose among those properties that property to be relinquished. Instead, the taxpayer must choose the property to be relinquished when the replacement property is acquired, and must actually relinquish it, since the QI must have the sales proceeds in hand to acquire the replacement property. The only applicable time constraint in a safe harbor Exchange First reverse exchange is the 180-period during which the EAT must dispose of parked relinquished property.

The requirement that the EAT obtain legal title to the parked property makes reverse exchanges relatively costly. Accordingly, their use should be reserved to situations where a deferred exchange is impossible, such as where the relinquished property buyer has defaulted, or where improvements must be commenced prior to disposition of the relinquished property. If improvements can be completed within the 180-day period in which the property may be parked with the EAT, Rev. Proc. 2000-37 provides a degree of certainty. However, if more time is required for construction, a non-safe-harbor reverse exchange may be the only option.

The validity of a pure reverse exchange will depend upon whether the accommodator is respected as tax owner, or is merely deemed the taxpayer’s agent. Just as pre-regulation case law remains relevant in resolving deferred exchange disputes, decisions predating Rev. Proc. 2000-37 are presumably still relevant in resolving disputes arising in reverse exchanges.

Posted in Federal Income Tax, Like Kind Exchanges, Reverse Exchanges | Tagged build-to-suit, deferred exchange, EAT, exchange accommodation titleholder, exchange first, exchange last, Rev. Proc. 2000-37, reverse exchange | Leave a comment

Tax Outlook for 2007

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

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Although Democrats significantly outnumber Republicans on the House Ways and Means Committee, and hold a 31 member majority in the full House, legislation raising marginal, capital gains or dividend rates in 2007 is not likely to be enacted this year. The Tax Reconcilation Act of 2005 extended through December 31, 2010, the dividend and capital gains tax reductions enacted in 2003, which hda been set to expire on December 31, 2008. AMT legislation appears likely in 2007.

Support for tax rate increases also appears weak in the Senate Finance Committee, which Democrats control by a single vote, and in the Senate itself. Senate Budget Chairman Conrad (D-ND) has ruled out raising tax rates. Democrats appear reluctant to risk new found political capital by voting to increase taxes even on a relatively small percentage of taxpayers.

The House voted 360-45 on February 16 to pass the Small Business Tax Relief Bill of 2007. Expected to cost $1.3 billion over 10 years, H.R. 976 would (i) increase the hourly minimum wage to $7.25 over two years; (ii) provide a one-year extension (through 2010) of IRC § 179 expensing limits, increase the annual limit to $125,000, and boost the phaseout threshold from $450,000 to $500,000, effective for the 2007 tax year and beyond; (iii) extend the work opportunity tax credit (WOTC) for one year, expand it to include disabled veterans, and increase the age limit from 25 to 40; and (iv) allow an unincorporated business that is jointly owned by a married couple in a non-community property state to file as a sole proprietorship without penalty.

Funding for H.R. 976 would be accomplished by (i) denying the lowest capital gains and divdend rate (5% for 2007; 0% for 2008) to dependent children of high-income txpayers (to prevent income-shifting); (ii) providing the IRS with four additional months (22 from 18) to give notice to taxpayers that they failed to comply with their tax obligations before being required to suspend the imposition of interest and penalties on underpayments; and (iii) increasing estimated taxes in 2012 for corporations with assets of at least $1 billion.

The Senate overwhelmingly approved an increase in the hourly minimum wage to $7.25, as well as an $8.3 billion package of small business tax incentives favorably reported out of the Senate Finance Committee. Although a House-Senate conference has not been scheduled, Senate Finance Committee Chairman Baucus (D-Mont.) believes differences among the House and Senate versions will be resolved. President Bush favors an increase in the minimum wage, but believes that it should be coupled with tax relief for small businesses which employ low-wage earners.

House Majority Leader Steny Hoyer (D-MD) indicated that the House will include, as part of its supplemental appropriations bill, funding for Katrina victims. Representative Charles Rangel (D-NY), Chairman of the House Ways and Means Committee, stated the Katrina tax package will extend various tax provisions enacted in 2005 to provide hurricane relief. Mr. Hoyer has indicated that he will reintroduce an energy bill called the “Progress Act” that will include tax-exempt bonds to promote high-speed rail travel.

The Alternative Minimum Tax, which is essentially a flat tax of 28 percent imposed on income without the allowance of many deductions to which taxpayers are accustomed, has become immensely unpopular, presumably because for the first time, tax computed under the AMT exceeds many taxpayer’s tax liability computed without regard to the AMT.

The Tax Increase Prevention and Reconciliation Act of 2005 increased the AMT exemption amount through December 31, 2006 to $62,550 for mraried persons filing jointly. However, the AMT exemption level for 2007 reverts to $45,000 for joint filers, and to $33,750 for single taxpayers. Thus, unless Congress acts, the AMT tax liability for 23.4 million taxpayers in 2007. Although the estimated cost of full repeal of the AMT is $1.2 trillion through 2015, the cost could be reduced to $529 billion through 2015 if AMT “preferences” were changed to allow a deduction for state and local taxes.

Since AMT may be triggered by a large capital gain, an installment sale might minimize AMT exposure. If AMT tax liability will exceed regular tax liability for a given year, depending upon timing considerations, itmight be prudent to accelerate income into that year to benefit from the lower marginal AMT rate of 28 percent. Similarly, in years in which the AMT will apply, the taxpayer might consider deferring expenses (including the payment of state income taxes) not deductible for AMT purposes until another year in which the AMT will not apply.

Spousal beneficiaries may roll over inherited IRAs into their own plans. However, nonspouse beneficiarlies may never roll over inherited benefits to their own plan. The nonspouse beneficiary has been required to withdraw all inherited money from a retirement plan, either as a lump-sum distribution or within five years. By not qualifying for an extended payout, the nonspouse beneficiary has been forced to forego yeras of tax-free growth. Until 2007, only one exception existed: a non-spouse beneficiary could transfer an inherited IRA owned by one participant to another inherited IRA owned by the same participant. The Pension Protection Act of 2006 (PPA) added a new exception. Beneficiaries of retirement plans, such as 401(k)s, 403(b)s and Section 457 plans, may transfer those assets into an “inherited IRA” established for the purpose of receiving the distribution and making payments to the beneficiary. Beneficiaries may then make withdrawals over their own life expectancies.

However, the IRS recently stated that retirement plans are not required to allow nonspouse beneficiaries to make direct transfers to inherited IRAs. To avoid the uncertainty of company plan rules when the participant is certain of a desire to leave a retirement plan to a nonspouse, the participant might consider rolling funds into an individual IRA immediately.

President Bush proposed a plan intended to make private health insurance more affordable. A standard inflation-adjusted tax deduction of $15,000 would be provided for every family and individual covered by a private policy purchased individually or through an employer. No income or payroll taxes would be due on the first $15,000 of income. However, employer-provided health insurance, now excluded from income, would become taxable. Employers would continue to be allowed a deduction for premiums paid. Federal grants would be made to states providing poor and difficult to insure citizens with low-cost private insurance. A top aide to House speaker Pelosi stated that Mr. Bush’s proposal will be pushed aside for at least two years, and “is dead for now.”

Florida’s Intangible Personal Property Tax (IPPT), an annual tax based on the value of intangible personal property owned or controlled by Florida residents, or by persons doing business in Florida, was abolished on January 1, 2007. Florida legislators are also considering a constitutional amendment that would abolish all property taxes on homesteads in exchange for increasing sales tax from 6 to 8.5 percent, (which would be the nation’s highest). Property taxes for non-homestead properties such as second or vacation homes, or to rental or business property, would decline but would not be eliminated.

Taxpayers whose AGI exceeds $100,000 have been prevented from converting a traditional IRA to a Roth IRA. Beginning in 2010, this rule will no longer apply. Rules governing Roth IRAs do not require annual minimum distributions after reaching age 70½. Therefore, the Roth IRA could make possible many years of tax-free growth.

The IRS has found significant reporting errors and omissions by tax-exempt organizations in the areas of excess benefit transactions, transactions with disqualified persons, and loans to officers. A compliance check, begun in 2004, has resulted in more than $21 million in excise taxes.

The deduction for investment interest is limited to “net investment income.” IRC § 163(d)(1). Any interest that is not deductible may be carried forward to future tax years, subject to the same limitation. An election made under IRC § 1(h)(2) to include capital gains and dividends in investment income would raise the net investment income ceiling. Although the election will cause capital gains and dividends to be taxed at ordinary income rates, taxpayers anticipating little investment income in future years might consider the election.

Hospital Corporation of America, 109 T.C. 21 (1997) held that tangible personal property includes many items permanetly affixed to a building. The decision made viable the use of cost analysis studies to allocate building costs to structural components and other tangible property. By reclassifying property, shorter costs recovery periods can be used. A successful cost segregation study would convert Section 1250 property to Section 1245 property with depreciation periods of five or seven years, using the double-declining balance method in Section 168(c) and (e)(1).

The IRS Cost Segregation Audit Techniquest Guide states the study should be prepared by a person with knowledge of both the construction process and the tax law involving property classifications for depreciation purposes. Cost segregation professionals must verify the accuracy of blueprints and specifications, and take measurements to calculate the cost of assets and then to segregate them. The average cost segregation study may identify 25 to 30 percent of a property’s basis thatis eligible for faster depreciation.

To illustrate the tax savings possible with component depreciation, assume a Manhattan office building worth $3 million with an adjusted basis of $1 million being depreciated using the straight-line method over 39 years. A cost segregation study determines that 25 percent of the value of the building is personal property qualifying for a 7-year recovery period using the 200 percent declining balance method of depreciation. Cost segregation could increase depreciation deductions from $25,641 ($1,000,000/39) to $90,659 [($750,000/39) + (2/7) x $250,000)].

Posted in From Washington, Tax News & Comment | Leave a comment

PRESIDENT BUSH SIGNS $350+ BILLION TAX CUT

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

After lengthy deliberations between feuding House and Senate Republicans, a tax bill has emerged which provides $350 billion in temporary tax cuts, and more than $700 billion in permanent cuts if key provisions, scheduled to expire, are reenacted. President Bush hailed the bill as good for American workers, families and investors. Senate Minority Leader Daschle, however, warned that Congress was “destroying the fiscal policy of this country, tax cut by tax cut.” Following passage of the bill, the Senate voted 53-44 to increase the debt limit by nearly $1 trillion.

The bill’s provisions would

¶ Cut the top tax rate on dividends and long-term capital gains to 15% through December 31, 2008. Dividend tax reductions will be retroactive to 1/1/03, while capital gains tax reductions will be effective with respect to sales or exchanges made on or after 5/6/03. To be eligible for the new 15% dividend tax rate, the underlying stock must be held for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date.

¶ Accelerate retroactively to 1/1/03 marginal tax rate cuts of 2% (3.6% for the 38.6% bracket) formerly scheduled to take effect in 2004 through 2006. The new rate brackets (above 15%) would be 25%, 28%, 33% and 35%. After 2010, rates above 15% would revert to pre-2001 EGTRRA levels. After July 1, 2003, paychecks will rise as companies adjust for taxes overpaid in the first half of 2003. For example, an employee formerly in the 27% bracket and now in the 25% bracket will be withheld at a rate of 23% for the remainder of 2003. A married couple earning $126,000 with 2 children will pay $3,028 fewer taxes each year in 2003 and 2004 under the new law.

¶ Increase the standard deduction for married filers to twice that of single filers for 2003 and 2004. After 2004, the standard deduction for joint filers would revert to levels enacted by EGRRA (e.g., in 2005, to 174% of a single filer’s basic standard deduction).

¶ Raise the AMT exemption for married couples to $58,000 for joint filers and surviving spouses for the years 2003 and 2004. In 2004, the AMT exemption for those filers would revert to $45,000. Treasury predicts that the AMT will affect 40 million Americans by 2013 unless the law is overhauled.

¶ Increase the “bonus” depreciation rate established by the 2002 Tax Act to 50% from 30% through 12/31/04. Taxpayers may elect, on a class-by-class basis, to claim 30% depreciation instead of 50%. This election might be made where net operating losses are about to expire, or where the taxpayer expects to be in a higher rate bracket in the following year.

¶ Increase the IRC § 179 maximum annual expensing amount for small businesses to $100,000 from the current $25,000. The bill would also (i) increase the maximum capital expenditure permitted before the $100,000 expensing amount is reduced dollar-for-dollar — to $400,000 from the present $200,000; (ii) permit off-the-shelf computer software to be expensed; (iii) allow taxpayers to make or revoke expensing elections on amended returns without IRS approval; and (iv) index the increased amounts for inflation after 2003.

¶ Increase the child tax credit to $1,000 from $600 for tax years 2003 and 2004 only. Many families will receive rebate checks of $400 as early as this summer.

The bill will also provide $20 billion in short-term aid to state governments in 2003 and 2004. However, that amount is only a fraction of the deficit predicted for most states in fiscal 2004.

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9th Circuit Holds Actuarial “Bet” Voided by Step-Transaction Doctrine

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

The 9th Circuit, in Brown v. U.S., 91 AFTR 2d 2003-2085 (5/1/03) upheld the IRS interposition of the step-transaction doctrine to derail an estate plan involving the creation of a life insurance trust to fund a future estate tax liability. The eternal bane of the taxpayer, the doctrine is asserted when the formalities of a transaction are consistent with the tax treatment sought by the taxpayer, but the end result, in the Service’s view, could have been achieved in manner resulting in a tax liability.

Brown intended that his entire estate of $180 million pass into a marital deduction trust, thus avoiding payment of any estate tax at his death. A life insurance policy was also purchased on the life of his spouse; policy proceeds were intended to fund estate taxes due at her death.

Since the spouse was without the means to herself purchase the policy, Brown gave her $3.1 million to accomplish this. All agreed that this gift qualified for the unlimited gift tax marital deduction. However, Brown also gave his wife $1.4 million to pay the gift tax associated with the purchase of the insurance policy by the trust. At issue was whether Brown or his spouse paid this gift tax.

Brown died within 3 years after payment of the gift tax. The IRS asserted that in substance if not in form, Brown paid the gift tax liability of $1.4 million. Under § 2035, gift taxes paid on transfers made within 3 years of death are included in a decedent’s estate. The IRS therefore asserted that Brown’s gross estate should be increased by $1.4 million. To make matters worse, the IRS further argued that the $1.4 million included in Brown’s estate failed to qualify for the estate tax marital deduction.

Taking a “realistic view of the entire transaction,” while acknowledging that “anyone may so arrange his affairs that his taxes should be as low as possible,” the 9th Circuit nevertheless found the spouse to be a “mere conduit” of funds. Despite the lack of a legally enforceable obligation to purchase the policy, the step-transaction doctrine was apposite since “family members colluded to accomplish a prearranged plan.”

Brown had made an actuarial “bet” seeking to hedge against the possibility that he, but not his spouse, would die within 3 years after the gift tax payment. The hedge seemed to work: Brown in fact died within 3 years. However, the § 2035 inclusion risk did not track the “economics” of the tax payment. The “bet” would have been respected had the spouse paid the gift taxes with her own funds. However, her “transient ownership” for one day “had no independent purpose or effect beyond the attempt to alter tax liabilities.”

Interestingly, IRS Counsel allowed during oral argument that had the spouse died first, the Service would not have acquiesced in favor of relieving her of estate tax liability, even though she would have been forced to include the $1.4 million in her own estate under § 2035. This “asymmetry” in the application of the step-transaction doctrine, while giving the court “pause,” did not affect its holding, since it did not “reach” this issue.

After finding that the $1.4 million should be included in Brown’s gross estate, the court determined that since trust beneficiaries, rather than the surviving spouse, would benefit from the life insurance proceeds, the estate could not take a corresponding $1.4 million estate tax marital deduction. While the case does not, as counsel argued, “vitiate the entire estate planning profession,” it does illustrate its limits. Had the risk been foreseen, Brown, if insurable, could have purchased a 3-year term policy on his own life for the appropriate amount.

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2006 REGS, RULINGS & IRS PRONOUNCEMENTS

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Posted in News, Tax Decisions, Tax News & Comment | Leave a comment

Reporting Like Kind Exchanges

Posted on March 15, 2010 by David L. Silverman, J.D., LL.M. (Taxation)

Form 8824, used to report like kind exchanges, requires (i) a description of the relinquished and replacement properties; (ii) identification of related parties to the exchange; and (iii) calculation of realized gain, recognized gain, and the basis of replacement property received. Form 8824 now requires detailed information to ensure compliance with the 45-day identification and 180-day exchange periods, which are jurisdictional (i.e., cannot be extended). Sales or exchanges of business property must also be reported on either Schedule D or Form 4797 (“Sales of Business Property”).

Form 8824 requires the taxpayer to state whether the replacement property was acquired directly or indirectly from a related party. The instructions state that indirect related party exchanges include (i) an exchange made with a related party through an intermediary (such as a QI or EAT) or (ii) an exchange made by a disregarded entity (i.e., a single-member LLC) if the taxpayer owns the entity. Form 8824 must be filed for two years following the taxable year of the related party exchange.

The issue of whether or not an exchange qualifies under Section 1031 is often not clear. If “substantial authority” exists for a position taken on a return, neither the return nor the preparer will be subject to accuracy-related penalties for under reporting under IRC §6662, even if the IRS successfully challenges the position taken. By contrast, if a position is not supported by “substantial authority,” penalties may be imposed unless the position has been adequately disclosed and a “reasonable basis” supports the position. Substantial authority exists if the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.

Whether to make disclosure is often a question of judgment. A tax opinion letter may state that a transaction “should” result in the tax consequences predicted if it possesses at least an eighty percent chance of success. Disclosure would not be required in this instance. However, if the tax treatment has only a “reasonable possibility of success,” disclosure should be made. Some tax advisors consider a forty percent chance of success the threshold below which disclosure should occur. Some transactions, although generating clear and favorable conclusions from a tax standpoint, will not have substantial authority solely because IRS never issued guidance. Those transactions would presumably not require disclosure.

New York imposes few special reporting requirements for like kind exchanges involving New York residents. New York imposes no withholding tax on exchange proceeds. Nonresidents, who must generally make estimated payments, are required to check a box on Form IT-2663 and state that the transaction is a Section 1031 exchange.

A single-member LLC (SMLLC) that is ignored for federal income tax purposes is also ignored for New York income tax purposes. However, since an LLC is a “person” as defined in Tax Law §1101(b)(4), it may have an obligation to pay sales tax if it engages in a like-kind exchange. New York imposes no special licensing, bonding or registration requirements on “qualified intermediaries” or “exchange accommodation titleholders” providing exchange services in New York. Finally, the acquisition of replacement property outside of New York should not affect the tax-deferred nature of the exchange for New York tax purposes.

Non-California residents should be be aware of California’s “clawback” rule, which encourages only “one way” investments in California realty. Although California does allow exchange treatment to nonresidents, deferred gain must continue to be reported indefinitely if out-of-state replacement property is acquired. If that out-of-state property is ever sold in a taxable sale, California will “claw” its way back, and impose tax on the initial deferred gain, which may have occurred many years earlier. New York and other states are said to be considering such a rule. The “clawback” rule may not be unconstitutional, since no state is required to provide like-kind exchange treatment as an initial matter.

Posted in Federal Income Tax, Like Kind Exchanges | Leave a comment

Law Offices of David L. Silverman, J.D., LL.M.

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