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

INCENTIVE STOCK OPTIONS

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

Stock options may comprise a significant portion of compensation to key employees. Incentive stock options (ISOs) are subject to various nontax requirements, e.g., that the options be granted within 10 years of plan adoption, that they be exercised within 10 years of the grant date, and that the strike (exercise) price equal or exceed the stock’s FMV at the grant date. Stock options that do not qualify as ISOs are referred to as “nonqualified stock options” (NQSOs), and receive less favorable tax treatment.

Assume XYZ Corp. issues 100,000 ISOs with an exercise price of $12 to Executive when the stock is trading at $10. When the stock reaches $15, Executive exercises all 100,000 options. A year and a day later, when the stock is trading at $20, Executive sells the stock.

No tax occurs when the stock options are granted. Upon exercise, no regular tax event occurs, but an AMT tax preference of $300,000 is created on the difference between the FMV of the stock and the exercise price [($15 – $12) x 100,000]. If Executive is subject to AMT, the AMT tax cost would be $84,000. When the shares are sold, a long-term capital gains tax of $75,000 would result [($20 – $15) x 100,000 x 0.15]. When the shares are sold, a negative AMT preference would be available to offset AMT if Executive were subject to AMT in that taxable year.

If a year and a day after exercise the stock were instead trading at $11, which is lower than the exercise price, Executive could sell the stock and claim a $1 per share long-term capital loss for regular tax purposes ($12 – $11) or a $4 per share AMT loss ($15 – $11). If, alternatively, the trading price a year and a day after exercise were $14 — which is higher than the exercise price but lower than the trading price when option was exercised — a long-term capital gain of $2 per share would be reported for regular tax purposes ($14 – $12), but a capital loss of $1 per share for AMT purposes would result ($15 – $14).

The grant of a NQSO is also not a taxable event if there is no readily ascertainable FMV, which is usually the case. However, the exercise of nonqualified stock options results in ordinary income in the year of exercise (rather than merely an AMT tax preference as with ISOs) equal to the excess of the FMV of the stock at the time of exercise over the strike price. In the first example, upon exercise, a tax liability of $105,000 would result [($15 – $12) x 100,000 x 0.35]. Upon eventual sale of the stock (after a year) long-term capital gain treatment would be available.

To induce loyalty of employees, compensation may take the form of restricted stock subject to a substantial risk of forfeiture if the employee terminates service. Under IRC § 83(a), which governs property received for services, no taxable event occurs upon receipt of restricted stock. However, when the restrictions lapse (e.g., at IPO), employee must report ordinary income equal to the difference between the FMV of the stock and the price (if any) paid for the stock. Long-term capital gain treatment will be available for reporting subsequent stock appreciation.

Ordinary income tax liability upon lapse of the restrictions can be avoided by making an IRC § 83(b) election when the option is granted. With a § 83(b) election, the FMV of the restricted stock is reported as income when received. When the restrictions lapse, no taxable event occurs. A capital gains tax is imposed when stock is eventually sold. Two disadvantages with the election are first, that tax must be paid currently rather than when the restrictions lapse and second, that if the stock is forfeited, no tax loss will be available. [Note that a § 83(b) election is not available for stock options, because they are not considered “property” under the Code.]

Posted in Incentive Stock Options | Tagged incentive stock options, IRC § 83(a), nonqualified stock option | Leave a comment

Gain, Loss, Basis & Debt Issues in Like-Kind Exchanges

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

A. Gain or Loss in Exchange

Where a taxpayer “trades up” in a like-kind exchange by acquiring property more valuable than the property relinquished and no boot is received, Section 1031 operates to defer recognition of all realized gain. However, if the taxpayer “trades down” and acquires property less valuable than that relinquished — thereby receiving cash or other nonqualifying property in the exchange — like kind exchange status will not be imperiled, but the taxpayer will be forced to recognize some of the realized gain.

Nonqualifying property, or “boot” may consist of (i) cash; (ii) relief from liabilities; (iii) property that could be exchanged under Section 1031, but is not of “like kind” to the relinquished property (e.g., a truck for a horse); or (iv) property expressly excluded from exchange treatment under IRC §1031(a)(2) (e.g., partnership interests).

Realized gain equals the sum of money and the fair market value of property received in the exchange, less the adjusted basis of property transferred. IRC §1001(a); Regs. § 1.1001-1(a). Realized gain is recognized to the extent of the sum of money and the fair market value of nonqualifying property received in the exchange. IRC § 1031(b).

If liabilities associated with the relinquished property are assumed by the other party to the exchange, the taxpayer is deemed to receive cash. IRC §1031(d); Regs. §1.1031(b)-1(c); Coleman v. Com’r, 180 F2d 758. Whether another party to the exchange has assumed a liability of the taxpayer is determined under IRC §357(d).

Although realized gain is recognized to the extent nonqualifying property is received, realized loss with respect to like-kind property relinquished in the exchange is never recognized. IRC §1031(c). However, this does not mean that loss will never be recognized in a like kind exchange. Section 1031 takes a restrictive view of nonqualifying property received in an exchange, since it undermines the purpose of the statute. However, under IRC §1031(c), both gains and losses are recognized with respect to nonqualifying property transferred in a like-kind exchange. Thus, IRC §1031 has no effect on the income tax treatment of nonqualifying property transferred in the exchange.

To illustrate, assume taxpayer exchanges property in Florida which has declined in value, for an oil and gas lease in Montana, and cash. Realized loss with respect to the Florida property is not recognized because loss is not recognized with respect to the transfer of qualifying property. However, if as part of the consideration for the Montana property the taxpayer also transfers Ford stock which has declined in value, realized loss on the Ford stock will be recognized because both gains and losses with respect to the transfer of nonqualifying property in a like-kind exchange are recognized.

As noted, the receipt of cash or other nonqualifying property would normally produce taxable boot to the extent of realized gain. However, Revenue Ruling 72-456 provides that brokerage commissions and perhaps all transaction costs may offset boot. Blatt v. Com’r, T.C. Memo (1994-48) held that expenses incurred in connection with an exchange and not deducted elsewhere on the taxpayer’s return offset boot. Prop. Regs. §1.263(a)-1(c)(2) provide that transaction costs incurred in connection with the sale of property must be capitalized, but those expenses reduce the amount realized. The ABA also endorses this position.

B. Basis Rules

Unlike IRC §121, which excludes realized gain, IRC §1031 operates merely to defer recognition of realized gain. Basis rules under Section 1031 provide the mechanism by which deferred gain is preserved for future recognition the if the replacement property is later sold. (The deferral would, of course, become permanent if the taxpayer dies owning the replacement property, since the basis would then be stepped up to fair market value by virtue of IRC §1014(b).)

IRC §1031(d) and the Regs provide that the basis of property received in a like-kind exchange equals the aggregate basis of property transferred, decreased by (i) cash received; (ii) debt relief associated with the relinquished property; and (iii) loss recognized with respect to the transfer of nonqualifying property. Basis of property received in an exchange is increased by (i) cash or notes transferred; (ii) the adjusted basis of nonqualifying property transferred; (iii) gain recognized on the exchange; and (iv) liabilities associated with the replacement property which are assumed by the taxpayer.

Where non-cash boot is received, basis must be allocated between the replacement property and the boot. Basis is allocated first to nonqualifying property (boot) to the extent of its FMV. Remaining basis is then allocated to nonrecognition properties in proportion to their respective fair market values. The holding period of qualifying property transferred is “tacked” onto the holding period of qualifying like-kind property received in the exchange. However, the holding period of boot received in the exchange begins anew.

To illustrate, assume taxpayer exchanges a building, with an adjusted basis of $500,000, a FMV of $800,000, and subject to a mortgage of $150,000, for consideration consisting of (i) a vacant lot worth $600,000; (ii) $30,000 in cash; and (iii) a Picasso sketch worth $20,000. Realized gain (AR – AB) equals $300,000 [($600,000 + $150,000 + $30,000 + $20,000) – $500,000]. Since debt relief is considered as cash received, $200,000 of nonqualifying property (boot) has been received and will be subject to capital gains tax. The remaining $100,000 of realized gain is deferred. Basis calculations are as follows:

1.Basis of Relinquished Building $500,000

2. Basis Increase: Gain Recognized$200,000

3. Basis Decreases:

a. Money Received $30,000

b. Debt Relief $150,000

Total Basis Decreases $180,000

4. Basis of Relinquished Building $500,000

Plus: Basis Increase $200,000

Minus: Basis Decreases $180,000

Total Basis to be Allocated $520,000

5. Allocation of Basis Allocated Remaining

Total Basis

to be Allocated $520,000

First: To Picasso Sketch

to Extent of FMV $20,000 $500,000

Next: Remainder of

Basis to Land $500,000 -0-

Note: If one year following the exchange the vacant lot which is still worth $600,000 and the Picasso sketch which is still worth $20,000 are both sold, the Picasso sale will produce no gain, but the land sale will generate $100,000 in recognized gain, which corresponds to the deferred gain from the initial sale. (If the Picasso had increased in value and were sold after one year, the sale would produce short-term capital gain, since the holding period for boot begins anew on the date of the exchange. The gain would be short-term because the property was not held for more than one year.)

Where nonqualifying property is transferred in the exchange, the transaction will still constitute a good like-kind exchange, but the consideration received must be allocated between the qualifying property and the nonqualifying property transferred in proportion to their respective fair market values. As noted, consideration allocated to nonqualifying property transferred in the exchange will result in gain or loss recognition under IRC §1001(c); Reg. §1.1031(d)-1(e). No gain or loss is recognized with respect to the transfer of cash, since no “sale or exchange” occurs.

To illustrate basis rules where nonqualifying property is transferred by the taxpayer seeking exchange treatment in a like-kind exchange, consider the taxpayer who exchanges a building, with an adjusted basis of $1 million and a FMV of $1.1 million, plus GM stock with an adjusted basis of $400,000 and a FMV of $200,000, for a vacant lot with a FMV of $1.3 million.

The consideration of $1.3 million is allocated between the building and the GM stock in proportion to their respective fair market values. The taxpayer realizes gain of $100,000 in the building ($1.1 million – $1 million) and recognizes a loss (AB – AR) of $200,000 on the GM stock ($400,000 – $200,000) under IRC §1001(c). The gain realized from the exchange of the building for the vacant lot is not recognized because those properties are of like-kind. The basis of the vacant lot is calculated as follows:

1. Loss on transfer of GM stock

a. Adjusted Basis $400,000

b. Less: amount realized $200,000

c. Loss realized and recognized $200,000

2. Adjusted basis of

relinquished building $1,000,000

Plus: Adjusted basis

of GM stock $400,000

Aggregate basis of

property transferred $1,400,000

3. Aggregate basis of

property transferred $1,400,000

Less: Loss recognized

on GM stock $200,000

Basis of vacant lot $1,200,000

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. The receipt of an installment obligation will constitute boot, which may be eligible for installment reporting if the taxpayer otherwise qualifies to use the installment method.

Prop. Regs. §1.453-1(f) provide for the timing of gain upon receipt of an installment obligation received in an exchange. The Regs allocate basis in the transferred property entirely to like-kind property received in the exchange. This is disadvantageous, since a greater portion of each payment received under the installment obligation will be subject to current tax.

Relief from liabilities associated with relinquished property may trigger boot gain, or could require the taxpayer to pay cash. For example, if the replacement property is subject to a smaller mortgage than the relinquished property, the net relief from liability will be treated as cash being received in the amount of the net debt relief. This will result not only in boot gain, but will also necessitate payment by the taxpayer of cash to equalize the net disparity in debt among the properties relinquished and replaced. If the taxpayer could prevail upon the seller of the replacement property to increase the mortgage on the replacement property prior to closing, the taxpayer might be able to avoid boot gain. (However, the IRS might still argue that the taxpayer has received boot equal to the cash extracted by the seller of the replacement property, by arguing that in substance, the cash payment the taxpayer is no longer required to pay — and that could easily be extracted tax-free by refinancing after the exchange — is boot.)

Assume the converse situation: The relinquished and replacement properties are of equal value, but the replacement property is subject to a larger mortgage than the relinquished property. If nothing is done, the taxpayer will receive cash to offset the smaller liability associated with the relinquished property. This will result in boot gain. If the taxpayer refinanced the relinquished property prior to the exchange to “even out” the mortgages, the necessity of the taxpayer receiving cash — and therefore the necessity of the taxpayer reporting boot gain — might be avoided.

Fredericks v. Com’r, T.C. Memo 1994-27 posed the scenario described above. Fredericks approved of the pre-exchange financing where it was (i) independent of the exchange; (ii) not conditioned on closing; (iii) dependent on the creditworthiness of the taxpayer, rather than the cash buyer; and (iv) made sufficiently in advance (i.e. “old and cold”) of any contemplated exchange. If these requirements are not met, the IRS may argue that the mortgage was, in substance, obtained by the cash buyer and constitutes taxable boot. Ideally, the taxpayer’s reasons for refinancing should be unrelated to the exchange, and should be motivated, at least in part, by an independent business purpose.

Pre-exchange financing carries with it the risk that the IRS may attempt to recast the cash extracted in the refinancing as taxable boot. Post-exchange financing, in contrast, carries with it much less risk. The differing risk reflects the obligation of the taxpayer vis à vis the loan following the like-kind exchange.

After engaging in pre-exchange financing, the taxpayer will dispose of the property subject to the new mortgage. Since the loan is presumably secured by the real property, the taxpayer’s liability vanishes once the like-kind exchange is consummated. However, the situation with post-exchange financing is different: Here the taxpayer will remain “on the hook” with respect to the financing, since the replacement property will be encumbered. For this reason, little risk is thought to be associated with post-exchange financing.

Some practitioners adhere to the “millisecond” rule, which theorizes that post-exchange financing with respect to the replacement property may be undertaken a “millisecond” after the exchange. More cautious taxpayers will wait until the day following the exchange to complete the financing on the replacement property. In any case, the (i) a different lender should be used for the post-exchange financing; and (ii) no new financing proceeds should appear on the closing statement for the replacement property.

In addition, the taxpayer should not be economically compelled to engage in the post-exchange financing. If the taxpayer would be subject to monetary penalties were he not to proceed with the planned post-exchange financing, the IRS might argue that the cash received in the post-exchange financing actually constituted boot.

The deductibility of interest on refinanced indebtedness depends on the use to which the borrowed funds are placed. In general, interest expense on debt is allocated in the same manner as the debt to which the interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. Temp. Regs. §1.163-8T(a)(3). Property used to secure the debt is immaterial. Temp. Regs. §1.163-8T(c)(1); §1.163-8T(a)(3).

Expenditures are allocated into one of six categories: (i) passive activities; (ii) former passive activities; (iii) investment; (iv) personal; (v) portfolio; and (vi) trade or business. Temp. Regs. §1.163-8T(a)(4)(i)(A)-(E). Thus, the investment of refinancing proceeds in tax-exempt bonds would result in a denial of the interest deduction. Likewise, personal use of refinancing proceeds will result in a complete denial of the interest deduction. The deduction for investment interest is limited to “net investment income.” IRC §163(d)(1). Investment interest does not include interest taken into account under the passive activity loss rules. IRC §163(d)(3)(A), (B). Proceeds of refinanced indebtedness used in an active business are subject to no limitations on deductibility. IRC §163(a).

Posted in Federal Income Tax, Like Kind Exchanges | Tagged 1031, debt, like kind exchange, relief from liabilities, section 1031 | Leave a comment

PRESIDENT BUSH URGES CONGRESS TO MAKE TAX CUTS PERMANENT

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

President Bush has urged Congress to make permanent various tax relief provisions which include (i) the $1,000 per child tax credit; (ii) the 15% dividends and capital gains tax rates, expiring after 2008; (iii) “bonus” depreciation provisions applicable to qualifying property acquired after 5/5/03 and before 1/1/05; and (iv) the estate tax repeal, scheduled to expire on December 31, 2010, at which time the applicable exclusion amount credit would revert to the pre-estate tax repeal amount of $1 million.

The FY 2005 budget includes compliance and enforcement proposals intended to (i) add a new civil penalty for failure to disclose foreign financial accounts; (ii) curtail abusive corporate tax shelters by forcing promoters to register abusive transactions and disclose the identities of investors; (iii) curtail abusive leasing transactions involving tax-indifferent parties; (iv) resolve issues involving IRC § 529 plans relating to changing beneficiaries or account owners, and plan distributions; (v) permit the IRS to enter into installment agreements not guaranteeing full payment over the lifetime of the agreement; and (vi) permit the IRS to engage private collection agencies.

Other proposals would (i) simplify the earned income tax credit (EITC); (ii) simplify higher education tax benefits; (iii) simplify the standard deduction for dependents and eliminate the kiddie tax; and (iv) eliminate special capital gains rates for particular assets such as small business stock and collectibles by taxing 50% of the gain at ordinary income rates and the balance at the standard capital gain rates.

Democratic leaders, citing a dangerous fiscal path, urged that the FY 2005 budget (i) cover at least the 10-year period through FY 2014 to reflect fiscal realities; (ii) address long-term needs of Social Security and Medicare; (iii) clarify whether the budget includes funds for military actions; and (iv) provide for current soldiers, their families, and veterans. Democrats have also cited the need for expanding health care and balancing the budget.

Senator Kerry called on Congress to “restore public confidence in our federal tax system . . . by ensuring that . . . middle class Americans are not the only ones left holding the bill.” Mr. Kerry criticized the Administration’s proposal to eliminate the corporate Alternative Minimum Tax, and also urged Congress to (i) eliminate tax shelters which have “no real economic risk or business purpose — but which capitalize on technical ambiguities in the tax code” and (ii) enact legislation to curtail “offshore tax havens.” The Senator remarked that “[a] tax system which asks working families to pay their fair share, but gives large corporations such as Enron a free ride, is a national disgrace.”

In a report to Congress, the National Taxpayer Advocate concluded that the AMT will, absent a change in law, affect more than 30 million taxpayers by 2010, with more than 70% of its revenues attributable to personal and dependent exemptions, the standard deduction, state and local taxes, and miscellaneous itemized deductions. The NTA also proposed a legislative solution to the estimated $81 million tax gap attributable to unreported income of self-employed individuals: that self-employed taxpayers be subject to withholding at a rate of 5%.

The IRS announced that it intends to counteract transactions designed to avoid the statutory limits on contributions to Roth IRAs through the use of a business to disguise and shift value into a corporation whose shares are owned by the taxpayer’s Roth IRA. (Adv.Notice 2—4-8m 2004-4 IRB).

The IRS has issued final regs revising the definition of “income” in IRC § 643(b) to take into account changes in the definition of trust accounting income under state law. Under the regs, an allocation between income and principal pursuant to applicable local law is permissible if it provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary and tax-exempt income, capital gains, and appreciation. Thus, a state statute which provides that income is a unitrust amount of between 3% and 5% of the FMV of trust assets is a reasonable apportionment. So too, a state statute permitting the trustee to make adjustments between income and principal to achieve impartiality between the income and remainder beneficiaries is generally a reasonable apportionment of the total income of the trust. Reg. § 1.643(b)-1.

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

Estate Fails to Qualify for Innocent Spouse Relief

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

The 10th Circuit Court of Appeals has held that a decedent’s estate cannot initiate an innocent spouse claim for relief under IRC Sec. § 6015(c). Jonson, CA-10 (12/30/03).

[The spouses claimed deductions attributable to the husband’s interest in a limited partnership. IRS denied the deductions and the taxpayers sought a redetermination of the deficiency in Tax Court. After his wife’s death, husband, on behalf of the estate, filed a request for innocent spouse relief under IRC § 6015(c), which provides relief from joint or several liability if the “innocent” spouse is no longer married to, or is legally separated from, the culpable spouse.]

The estate argued that the wife became entitled to innocent spouse relief the day she died because death ended the marriage. While agreeing that the marriage terminated on the decedent’s death, the court denied relief because the IRC § 6015 applies to “individuals” — a term not defined in the Code — but which according to its “ordinary, everyday” meaning, could only include a living person. The court noted however that a decedent’s executor may continue an innocent spouse claim initiated while the taxpayer was still alive.

* * *

The Middle District Court of Pennsylvania has held that minimum pension benefits payable to a designated beneficiary are not “property” of the deceased taxpayer to which a federal tax lien could attach. Asbestos Workers v. U.S., (1:01-CV-2253; 1/12/04).

[The taxpayer participated in a pension benefit plan that offered several payment options. In 1996, the taxpayer selected the 10-year guaranteed payment option, payable in 120 monthly installments, and named his son as designated beneficiary (DB). After the IRS tax lien filed in 1997, the pension fund reduced the taxpayer’s payments by one-half and sent the balance to the IRS. Upon the death of the taxpayer, the IRS advised the pension fund that the tax lien still applied to the benefits payable to the son as DB. The pension fund placed the balance allegedly due the IRS in escrow and sued to resolve the conflicting claims.]

In determining the validity of the tax lien, the court considered (i) the asset which the IRS sought to attach; (ii) the interest of the taxpayer in the asset under state law; and (iii) whether the taxpayer derived sufficient benefits from the asset for it to constitute “property” of the taxpayer.

The court found that the “asset” was the right to receive minimum benefit payments under the pension plan. The taxpayer’s interest was limited to his right to collect those payments during his lifetime. The pension plan did not grant the taxpayer the power to obtain or reject funds during his lifetime, nor did it permit early payment or the option of surrendering the value of the annuity for a lump-sum payment.

Only the DB has the power to compel payment of minimum payments or of taking the payments as a lump sum. Therefore, payments to the DB did not constitute “property” of the taxpayer to which the lien could attach. The decision appears to make a perceptible inroad into the creditor rights of the IRS. In general, IRS may levy on pension benefits once they are in “pay status.” The decision appears to carve out an exception.

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

2007 Estate & Gift Tax Cases

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

The 11th Circuit, reversing the Tax Court, held that an estate properly reduced the value of the decedent’s interest in a company holding marketable securities by the company’s entire $51 million built-in capital gain tax liability. Estate of Jelke Est. v. Com’r, __ F.3d __, 2007 WL 3378539 (11th Cir. 11/16/07), rev’g, T.C. Memo 2005-131. The Tax Court had discounted the capital gains tax liability to reflect the likelihood that stocks owned by the company would not be liquidated for many years following the decedent’s death.

The court of appeals found that the Tax Court’s choice of a 16-year period to reflect when the corporation would sell all of its marketable securities at the present turnover rate was not “persuasive” since “[w]e are dealing with hypothetical, not strategic, willing buyers and willing sellers. As a threshold assumption, we are to proceed under the arbitrary assumption that a liquidation takes place on the date of death.
Assets and liabilities are deemed frozen in value on the date of death and a “snap shot” of value taken.” The appeals court upheld the Tax Court’s determination that the claimed minority discount of 25% and the claimed marketability discount of 35%, should be reduced to 10% and 15%, respectively.

An estate which owned a one-half interest in 19 valuable paintings claimed a 44% discount for lack of marketability and control, resulting in a reported value of $1.42 million. Stone v. U.S., 2007 WL 1544786, 99 AFTR2d 2007-2992 (N.D. Ca. 5/25/07) (slip opinion), final opinion 2007 WL 2318974, 2007 TNT 158-15 (N.D. Ca. 8/10/07) (slip opinion). The IRS valued the decedent’s interest at 50% of the value of the entire collection. The District Court agreed that a discount should be allowed, but that it should be substantially less than the 44% claimed.

The court found persuasive the testimony of the IRS Art Advisory Panel, comprised of a collection of unpaid art experts, which based its valuation on comparable sales of similar paintings near the date of valuation. Rejecting the estate’s analogy to discounts allowed for sales of undivided interests in real estate, the District Court agreed with the IRS contention that the only discount allowable was a 2% discount for partition. The court reasoned that a hypothetical willing seller of an undivided interest in art would likely seek to sell the entire work of art and divide the proceeds by partition, rather than sell its fractional interest at a discount.

The IRS was successful in 2007 in a number of cases involving valuation discounts in the context of transfers to family limited partnerships. The Service continued to rely on IRC §2036 to pull back into decedents’ estates assets nominally transferred to FLPs but in which the decedents continued to retain possession, enjoyment or the right to income from the transferred assets.

In Estate of Gore, the inter vivos transfer of assets to the FLP was never completed, since the formalities of transfer were not observed. While bank accounts and stock certificates were purportedly transferred to an FLP, names were not changed on any of the accounts, and Gore continued to collect income and dividends from the assets. T.C. Memo. 2007-169 (June 27, 2007).

In Estate of Erickson, the partnership agreement contemplated that assets would be transferred to the FLP when the operating agreement was executed. However, transfers were not made to the FLP until two days before the decedent’s death, suggesting that partnership formalities had not been observed. Finding that Erickson had retained the benefit of the assets during her lifetime, and that no independent non-tax purposes existed for creating the partnership, the assets were includible in her estate under IRC §2036(a)(1). The court found that the partnership’s purchase of assets from the estate to meet estate tax liabilities was also tantamount to the funds being available to the decedent. T.C. Memo. 2007-107 (April 30, 2007).

Estate of Korby posed a different problem: distributions from the partnership were found to have been made under the pretext of “management fees,” since no written management agreement concerning those fees was ever executed. Moreover, no record of management fees paid was kept, no management income was ever reported, and the management fees paid were greatly in excess of the amounts distributed to the limited partners. Since Korby had retained practically nothing outside the partnership, the Tax Court found an implied agreement that the assets transferred to the partnership would continue to be made available to Korby and her spouse during their lifetime. Thus, the “management fees” constituted an income interest which caused the assets transferred to the FLP to be includible in Korby’s estate under IRC §2036(a)(1). 471 F.3d 848 (8th Cir. 2007).

Rounding out the significant partnership cases, Estate of Bigelow, decided by the 9th Circuit, held that Virginia Bigelow had retained an economic interest in residential real property transferred to an FLP, since the property secured a debt for which Bigelow was personally liable. Another problem was that the partnership continued to make monthly debt payments for Bigelow. Finding an implied agreement to retain both the economic benefits (loan security) and the right to income (loan payments), the real property was includible in Bigelow’s estate under IRC §2036. 503 F.3d 955 (2007).

Tax payment clauses are important, but often overlooked, provisions in testamentary trusts and wills. The decedent in Estate of Sowder bequeathed $600,000 to persons other than his spouse, and left the residue of his estate to his wife, Marie “if she survives me, and is she does not survive me, or dies before my estate is distributed to her. . . .” 2007 WL 3046287, 100 AFTR2d 2007-6379 (9th Cir. 10/18/07) (slip opinion), aff’g per curiam 407 F. Supp.2d 1230 (E.D. Wash. 2005).

The IRS disallowed the marital deduction, asserting that the condition of survivorship caused the residuary bequest to constitute a nondeductible terminable interest under IRC §2056(b)(3). However, the district court concluded that the decedent’s intent was for the residuary bequest to qualify for the marital deduction, citing as authority a Washington statute which requires construction of a marital bequest intended to qualify for the marital deduction in such a manner as to cause it to qualify. The 9th Circuit affirmed per curiam.

To assist a court in construing the will in a manner consistent with the decedent’s intent, the inclusion of the following language might be advisable: “I intend that the value for Federal estate tax purposes of property given, devised or bequeathed outright or in trust to my spouse shall qualify for the marital deduction allowed by Federal estate tax law applicable to my estate.”

The 2nd Circuit, in Estate of Thompson, 499 F.3d 129, 2007 WL 2404434 (8/23/09) vacated a decision of the Tax Court which held that the taxpayer had demonstrated reasonable cause for its understatement. The decedent’s estate valued the decedent’s block of stock at $1.75 million, based upon an appraisal prepared by an attorney and an accountant, which claimed a 40% minority interest discount and a 45% lack of marketability discount. The court noted that the understatement penalty applies automatically, unless it is shown that reliance was reasonable. In this case, the taxpayer had failed to demonstrate that the estate’s reliance on its experts was reasonable and in good faith, or whether the estate knew or should have known that the appraiser lacked the expertise to value the company. This case underscores the importance of ensuring that the appraiser selected is qualified by virtue of a designation from a professional appraisal organization, and has relevant experience in the subject matter of the valuation.

The Tax Court, in Estate of Roski, 128 T.C. 113 (4/12/07) held that the failure of the IRS to exercise discretion with respect to the necessity of requiring an estate to (i) furnish bond equal to twice the estate tax deferred under IRC §6166(a)(1), (ii) provide the IRS with a special lien against estate assets under IRC §6324A, warranted further proceedings. The Tax Court rejected the IRS contention that Section 6166 provided for no judicial review, noting that neither the Code nor the legislative history expressly precluded Tax Court review of IRS discretion in this matter. The estate had attempted without success to obtain a bond and argued that it was barred from pledging business assets because the lien would violate covenants in the partnership agreement.

The use of domestic asset protection trusts has continued to increase, as more states have enacted favorable statutes. Tennessee and Wyoming in 2007 became the eighth and ninth states to permit self-settled trusts. Nevada broke new ground with legislation making it difficult for creditors of persons who own interests in private corporations to satisfy judgments. On July 1st, 2007, Nevada enacted legislation limiting the exclusive remedy for judgment creditors of stockholders in certain corporations to a charging order with respect to the shares in the corporation. Creditors will therefore have no claim against corporate assets, and will be limited to making claims only against actual dividends paid from the corporation. Prior to this statute, this limitation of remedies was available only to LLCs and limited partnerships.

In In Re Eversoff, 2006 U.S. Dist. Lexis 69575 (E.D.N.Y. 9/27/07) the IRS claimed the taxpayer’s transfer of property to an irrevocable trust was fraudulent. Eversoff transferred $220,000 and a house into an irrevocable trust shortly after an IRS audit in which an assessment of $700,000 was issued. Following the transfer, the taxpayer still possessed more than $1 million in other assets, including several retirement accounts.

The IRS argued that the retirement accounts should not be considered in determining the taxpayer’s solvency, and that the transfers rendered the taxpayer insolvent. However, the Eastern District held that under federal law, the IRS could levy on the retirement accounts and seize distributions. Since the taxpayer had sufficient funds to pay the tax assessment even following the transfers in trust, the taxpayer committed no actual or constructive fraud. The court held that the trust assets could not be used to satisfy the tax judgment.

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MINIMIZING THE IMPACT OF THE ALTERNATIVE MINIMUM TAX (AMT)

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

Originally intended as a backstop to prevent tax-avoidance by high income taxpayers, the AMT now affects a soaring number of middle income taxpayers. The AMT applies if it is higher than the taxpayer’s regular tax liability.

Two factors may cause the AMT to be higher: First, many deductions allowed in calculating regular tax liability are not allowed when calculating AMT. For example, state and local income taxes, real estate taxes and miscellaneous itemized deductions are allowed as deductions in calculating regular tax liability. However, for AMT purposes, these deductions are not taken. Second, various income adjustments may propel a taxpayer into the AMT regime, or increase the AMT liability for a taxpayer already ensnared by it. For example, the exercise of Incentive Stock Options or the receipt of certain tax-exempt interest income may increase AMT, but not regular income tax, liability. Finally, depreciation of business assets is less favorable for AMT purposes than for regular income tax purposes.

One blessing to the AMT curse is that its marginal rates are lower: A 28% rate applies to AMT income above $175,000; a 26% rate to AMT income below this amount. An AMT exclusion amount of $58,000 applicable to married filing jointly is fully phased out when AMT income reaches $382,000. The AMT’s lower tax rates create some tax planning opportunities:

If it appears that a taxpayer will be subject to the AMT in 2004 but not 2005, it might be prudent to (i) defer to 2005 those deductions which are not allowable for AMT purposes since if paid or accrued in 2004 they will be wasted; (ii) accelerate ordinary income and short-term capital gains into 2004 to benefit from the lower AMT tax rate; and (iii) postpone until 2005 certain expenses (e.g., charitable contributions) which are deductible against both AMT and ordinary income, since a deduction against income taxed at the higher regular income tax rate is significantly more valuable.

Conversely, if it appears that the AMT will not apply in 2004 but will apply in 2005, it would be prudent to (i) take all deductions in 2004 which cannot be taken against AMT; and (ii) defer income to 2005 to benefit from the lower AMT tax rate.

Following a year in which the AMT applies, the taxpayer may be entitled to an AMT credit against regular income tax liability for “deferral” items, such as depreciation and passive activity adjustments. The credit ensures that the same amount of total deductions are ultimately allowed for both AMT and regular income tax liability purposes. “Bonus” depreciation will not result in a later credit since it applies to regular tax and AMT.

Long-term capital gains (LTCGs) are now taxed at 15% for both regular income tax and AMT purposes. Net LTCGs are not AMT preference items. Nonetheless, they may indirectly trigger the AMT since large net LTCGs will increase state and local taxes, which are not deductible for AMT purposes. Thus, a net LTCG could ultimately result in a denial of the deduction for state and local income taxes. Accordingly, it may be advisable to report LTCGs in a tax year in which the AMT will not be triggered by those gains.

Posted in Tax Decisions, Tax News & Comment | Tagged alternative minimum tax, AMT, AMT Patch, preference item | Leave a comment

2007 Estate and Gift Tax Decisions of Note

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

Printer-friendly PDF: 2007 Estate and Gift Tax Decisions of Note.wpd

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USE OF DISCLAIMERS IN POST-MORTEM ESTATE PLANNING

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

Many Wills have been drafted to eliminate the estate tax at the first spouse’s death by (i) funding a credit shelter trust with the maximum amount such that no estate taxes are due and then (ii) leaving the remaining share in a marital (QTIP) trust for the surviving spouse. As recently as 2001, the maximum credit shelter amount was $675,000. For decedents dying in 2004 and 2005, that amount is $1.5 million.

Typically, the credit shelter trust provides for discretionary income and principal distributions to the surviving spouse during her lifetime. At her death, an outright distribution to the children is made. Some credit shelter trusts were not drafted to provide for discretionary distributions to children.

Assume decedent dies in 2004 with an estate worth $5 million, his Will utilizing the pecuniary credit shelter funding mechanism described above, with no discretionary distributions to the children. He is survived by three adult children, ages 48, 50 and 52, and a spouse age 80 in good health. The credit shelter trust will be funded with $1.5 million, and the marital trust with $3.5 million.

The surviving spouse, whose average life expectancy is approximately 9.3 years, will be entitled to all of the income from the marital trust, and will also have a right to discretionary distributions of income and principal from the credit shelter trust. The children will inherit nothing until the death of the surviving spouse.

In this situation, the family may decide that the children should receive some of the decedent’s assets prior to the death of the surviving spouse. One option would be for the surviving spouse to take distributions from the trusts and then make gifts to the children. However, this option has drawbacks: First, the trustee is under a fiduciary obligation to make distributions only for the benefit of the surviving spouse; second, and perhaps more importantly, any gifts by the surviving spouse to her children will incur a gift tax. The gift tax has not been repealed. In fact, the maximum amount which can be gifted before incurring a gift tax liability is $1 million — an amount which is now frozen. Finally, should the surviving spouse die before 2010, her estate could incur a sizeable estate tax.

Another solution could be for the surviving spouse to disclaim all or a portion of what she would take under the credit shelter trust. Many Wills contain a provision allowing a beneficiary to disclaim; however, a valid disclaimer can be made even without such an explicit provision in the Will.

To be effective for state law purposes, EPTL § 2-1.11 provides that “any beneficiary may renounce all or part of his interest [provided] such renunciation shall be in writing . . . and shall be filed in the office of the clerk of the court having jurisdiction over the will . . . within nine months . . . accompanied by an affidavit of the renouncing party that he has not received . . . any consideration . . . for such renunciation.” To be effective for federal tax purposes, IRC § 2518 provides rules similar to EPTL § 2-1.11.

The nine-month period under EPTL § 2-1.11 is rigid but not jurisdictional: a court may extend the time to renounce for reasonable cause. However, the nine-month requirement under IRC § 2518 is jurisdictional. Therefore, if a New York court allows a disclaimer after nine months, it will constitute a gift for federal gift tax purposes. However, the later renunciation would nevertheless be effective as against creditors of the surviving spouse.

To return to the hypothetical, the effect of the renunciation is that the renouncing party is treated as though she predeceased the decedent. It is black letter law that a disclaimant must have no ability to designate who receives the disclaimed property. Thus, the children would each receive outright 1/3 of the cash (or property) which would, but for the renunciation, have funded the credit shelter trust. In this case, each child (or issue if the child predeceased) would receive $500,000.

The advantage of executing the disclaimer is that the children will receive cash at a time when their parent might have wanted them to receive it, and the surviving spouse will still have ample funds with which to maintain her accustomed standard of living. To the extent this money never enters the surviving spouse’s estate, her own estate planning task will be simplified. Both EPTL § 2-1.11 and IRC § 2518 allow the renouncing party to renounce all or part of the interest. The surviving spouse in the example might have renounced only half of the amount that would have funded the credit shelter trust.

A problem frequently encountered with disclaimers involves the requirement that the renouncing person receive no benefit from the renounced interest. A person may not renounce once he has accepted any part of the distributive property. Smith v. City of New York, 344 N.Y.S.2d 799. If the surviving spouse, who might also be the executor, during the time prior to engaging counsel, receives any distribution of property to be renounced, perhaps even of any property in the estate, a later disclaimer may be invalid. It is critical that the estate be left intact until a valid disclaimer is effected. A valid disclaimer may be made before a Will is admitted to probate, and before letters are issued.

Updating a Will drafted when the both the credit shelter amount and the size of one’s estate was more modest is preferable to relying on post-mortem estate planning involving disclaimers for two reasons: First, the potential disclaimant, typically the surviving spouse, may not wish to disclaim; and second, even if she were otherwise favorably disposed to executing a disclaimer, the Will may provide alternate dispositions which do not accord with her own desire as to who should receive the disclaimed property.

Disclaimers can accomplish a variety of objectives. At times, they can be used to fine-tune dispositive Will provisions. Their importance is elevated where they are utilized to make substantive changes to the dispositive scheme where the decedent failed through inadvertence during his lifetime to make those changes.

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IRS ISSUES GUIDANCE FOR HEALTH SAVINGS ACCOUNTS

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

Notice 2004-2 provides guidance for new Health Savings Accounts (HSAs) which, beginning in 2004, may be funded by an “eligible individual” with tax deductible cash contributions which grow tax-free. Tax-free distributions from the account may be made by the taxpayer to pay for “qualified medical expenses.” The confluence of tax deductible contributions, tax-free earnings and tax-free distributions make HSAs extremely attractive from a tax perspective. Nontax requirements, discussed below, are not as inviting. The taxation of HSAs, which resembles that of IRAs, is found in IRC § 223, enacted as part of the Medicare Modernization Act of 2003.

Any “eligible individual” may contribute to an HSA. Family members may also contribute on behalf of other family members. An HSA may pay qualified medical expenses only for a person covered under a high-deductible health plan (HDHP). An HDHP, in turn, must satisfy certain requirements with respect to deductibles and out-of-pocket expenses. For family coverage, an HDHP must have an annual deductible of at least $2,000 and annual out-of-pocket expenses required to be paid not exceeding $10,000. A person covered by an HDHP will be ineligible for an HSA if he is concurrently covered under another health plan. Even so, some types of health coverage, such as (i) worker’s compensation, (ii) insurance for a specific illness, and (iii) hospitalization insurance, will not result in ineligibility.

Any approved IRA custodian qualifies as an HSA custodian. The HSA need not be established at the institution providing the HDHP. In that case, the custodian may require proof of eligibility. However, neither an HSA custodian nor an employer making contributions to an employee’s HSA is required to determine whether HSA distributions are used for qualified medical expenses. The individual should maintain adequate records for this purpose.

The maximum annual contribution to an HSA is determined separately each month based on status, eligibility and health plan coverage as of the first day of the month. For 2004, the maximum monthly contribution for eligible individuals with self-coverage is 1/12 of the lesser of (i) 100% of the annual deductible under the HDHP (minimum of $1,000) and (ii) $2,600. (For eligible individuals with family coverage, the minimum in (i) equals $2,000; and (ii) equals $5,150.)

To illustrate, assume an individual begins self-coverage on June 1, 2004 and is covered under the HDHP for the remainder of the year. The contribution limit is computed each month. If the annual deductible is $5,000 for the HDHP, then the lesser of the annual deductible and $2,600 is $2,600. The monthly contribution limit is $216.67 ($2,600/12). An additional $500 “catch-up” contribution may be made by or on behalf of individuals between 55 and 65 for the calendar year 2004. The catch-up amount will increase in $100 increments, reaching $1,000 in 2009.

Contributions made by an eligible individual (or by a family member on behalf of the eligible individual) may be made any time prior to the time required by law (without extensions) for filing the eligible individual’s tax return. Contributions are deductible by the eligible individual in arriving AGI, thus providing a tax benefit regardless of whether the individual itemizes. Employer contributions are excludible from the employee’s income and are not subject to withholding. Excess contributions are included in gross income, are not deductible, and are subject to an excise tax of 6%. Inside buildup is exempt from tax, unless the account ceases to be an HSA. Rollover contributions from Archer MSAs and other HSAs are permitted, and need not be in cash.

Tax-free distributions may be made at any time to pay qualified medical expenses of the beneficiary, his spouse, or dependents. Distributions are excludible even if the individual would no longer be qualified to make HSA contributions. Qualified medical expenses consist of those paid for medical care as defined in IRC § 213(d) “for the diagnosis, cure, mitigation, treatment, or prevention of disease” to the extent not covered by insurance or otherwise. The expense must be incurred after the HSA has been established. Amounts not used exclusively for qualified medical expenses are includible in income and incur an additional 10% tax. However, distributions made after the account beneficiary’s death, disability, or his attaining age 65 are not subject to tax.

Health insurance premiums are generally not qualified medical expenses; however, qualified long-term care insurance and COBRA insurance are not considered health insurance premiums. In addition, individuals over 65 may pay premiums for Medicare Part A or B and Medicare HMO from an HSA.

Upon death, an account beneficiary’s HSA becomes the property of the named beneficiary. A surviving spouse named as beneficiary is taxed only if distributions are not used to pay her own qualified medical expenses.

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Partnership Assessment Extends Collection Statute Against Partners

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

Reversing the 9th Circuit Court of Appeals, the Supreme Court has held that a timely assessment against a California partnership extends the statute of limitations for collection of tax against the general partners. U.S. v. Galletti et al, 541 U.S. ___, (2004).

[Taxpayers were general partners of a partnership that failed to pay federal employment taxes from 1992 to 1995. The IRS timely assessed the partnership, but collected no tax. IRS attempted to collect the tax from the general partners, asserting a 10-year collection period under IRC § 6502(a). The partners argued that a timely assessment of the partnership did not extend the 3-year limitations period against the partners, since they had not been separately assessed within 3 years. The District Court held for the partners, stating that under IRC §§ 7701, 6203 and 6501, separate assessments against the partners were required. § 7701 defines “taxpayer” to mean “any person subject to . . . tax.” §6501 provides that “tax imposed shall be assessed within 3 years after the return was filed.” §6203 provides that within 60 days of the assessment, the Secretary shall “give notice to each person liable for the unpaid tax.

The 9th Circuit Affirmed. On appeal to Supreme Court, the partners argued that a valid assessment must name them individually because they were the “relevant taxpayers” under § 6203 and because they were jointly and severally liable for the tax debts of the partnership.]

Writing for a unanimous court, Justice Thomas found that although an individual partner can be a ‘taxpayer,’ § 6203 speaks of “the liability of the taxpayer.” This requires the identification of the “relevant” taxpayer. Since the liability arose from the partnership’s failure to deduct and withhold employment taxes pursuant to IRC §3402, the liability was clearly that of the partnership.

The partners argued that they were primarily liable for the partnership’s tax debt under California law. The Court found, however, that since under California’s partnership principles a partnership and a partner are separate entities, the partners “cannot argue that . . . imposing a tax directly on the Partnership is equivalent to imposing a tax directly on the general partners.”

The Court then rejected the argument that a separate assessment of a single tax debt was required against persons secondarily liable for that debt, remarking that “throughout the Code, it is clear that the term ‘assessment’ refers to little more than the calculation or recording of a tax liability.” The Court added that “nothing in the Code requires the IRS to duplicate its efforts by separately assessing the same tax on individuals . . . who are not the actual taxpayers but are, by reason of state law, liable for payment of the taxpayer’s debt.”

Understanding the decision requires one to forego an intuitive reading of the statutes involved: The general partners were not the “actual taxpayers” and were not “primarily liable” for the federal tax under federal law, yet they became liable under state law partnership principles. Further, the extension of the statute of limitations applied not to the taxpayers themselves but to the “collection of the debt.”

The Code grants the IRS greatly enhanced collection powers for “trust fund” taxes such as employment taxes. Although the sentiment was not betrayed in the opinion, the Court may have been concerned that an affirmance might result in an erosion of the government’s ability to recoup these taxes if taxpayer were to employ multiple entities.

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2007 IRS REGS., RULINGS AND PRONOUNCEMENTS

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

Printer-friendly PDF: 2007 Regs., Rulings & Pronouncements.wpd

A. New Regs Govern Estate Deductions

All federal circuits, except the Eighth, have long adhered to the view that post-mortem events must be ignored in valuing claims against an estate. Ithaca Trust Co. v. U.S., 279 U.S. 151 (1929) held that “[t]empting as it is to correct uncertain probabilities by the now certain fact, we are of the opinion that it cannot be done, but that the value of the wife’s life interest must be established by the mortality tables.” Proposed Regs. §20.2053-1(a)(1) state that post mortem events must be considered in determining amounts deductible as expenses, claims, or debts against the estate.

The proposed regs. limit the deduction for contingent claims against an estate by providing that an estate may deduct a claim or debt, or a funeral or administration expense, only if the amount is actually paid. An expenditure contested by the estate which cannot not be resolved during the period of limitations for claiming a refund will not be deductible. However, the executor may file a “protective claim” for refund, which would preserve the estate’s ultimate right to claim a deduction under IRC §2053(a). A timely filed protective claim would thus preserve the estate’s right to a refund if the amount of the liability is later determined and paid.

Although a protective claim would not be required to specify a dollar amount, it would be required to identify the outstanding claim that would be deductible if paid, and describe the contingencies delaying the determination of the liability or its actual payment. Attorney’s fees or executor’s commissions that have not been paid could be identified in a protective claim. Prop. Regs. §20.2053-1(a)(4).

A second limitation on deductible expenses also applies: Estate expenses would be deductible by the executor only if approved by the state court whose decision follows state law, or established by a bona fide settlement agreement or a consent decree resulting from an arm’s length agreement. This requirement is apparently intended to prevent a deduction where a claim of doubtful merit was paid by the estate.

The proposed regs suffer from some problems. To illustrate one, assume the will of the decedent dying in 2008, whose estate is worth $10 million, designates that $2 million should fund the credit shelter trust, with the remainder funding the marital trust. Assume also the existence of a $3 million contested claim against the estate. If the executor sets apart $3 million for the contested claim and files a protective claim for refund, the marital trust would be funded with only $5 million, instead of $8 million. If the claim is later defeated, the $3 million held in reserve could no longer be used to fund the marital trust, and would be subject to estate tax.

Alternatively, the executor could simply fund the marital trust with $8 million, not set aside the $3 million, and not file a protective claim. If the claim is later determined to be valid, payment could be made from assets held in the marital trust. However, by proceeding in this manner, would the deduction for the marital trust be preserved if the IRS determined that the regulations were not followed?

The existence of a large protective claim might also tempt the IRS to look more closely at other valuation issues involving other expenses claimed by the estate as a hedge against the possibility of a large future deduction by the estate.

B. Preparer Penalties Under IRC §6694

Under revised IRC §6694, a return preparer (or a person who furnishes advice in connection with the preparation of the return) is subject to substantial penalties if the preparer (or advisor) does not have a reasonable basis for concluding that the position taken was more likely than not. If the position taken is not more likely than not, penalties can be avoided by adequate disclosure, provided there is a reasonable basis for the position taken. Under prior law, a reasonable basis for a position taken means that the position has a one-in-three chance of success. P.L. 110-28, §8246(a)(2), 110th Cong., 1st Sess. (5/25/07).

This penalty rule applies to all tax returns, including gift and estate tax returns. The penalty imposed is $1,000 or, if greater, one-half of the fee derived (or to be derived) by the tax return preparer with respect to the return. An attorney who gives a legal opinion is deemed to be a non-signing preparer. The fees upon which the penalty is based for a non-signing preparer could reference the larger transaction of which the tax return is only a small part.

Notice 2008-13 contains new guidance concerning the imposition of return preparer penalties. It provides that until the revised regs (expected to be issued before the end of 2008) are issued, a preparer can generally continue to rely on taxpayer and third party representations in preparing a return, unless he has reason to know they are wrong. In addition, preparers of many information returns will not be subject to the new penalty provisions unless they willfully understate tax or act in reckless or intentional disregard of the law.

Revised IRC §6694 joins Circular 230, now two years old (which Roy M. Adams observed effectively “deputizes” attorneys, accountants, financial planners, trust professionals and insurance professionals) in “extend[ing] the government’s reach and help[ing to] fulfill a perceived need to patch up the crumbling voluntary reporting tax system.” The Changing Face of Compliance, Trusts & Estates, Vol. 147 No. 1, January 2008. The perilous regulatory environment in which attorneys and accountants now find themselves counsels caution when advising clients concerning tax positions. Although a taxpayer’s right to manage his affairs so as to minimize tax liabilities is well-settled, Congress has signified its intention to hold tax advisers to a higher standard when rendering tax advice.

C. Other Developments

Final Regs. §301.6111-3(b)(1) under IRC §6011 impose substantial reporting and record-keeping requirements upon professionals who furnish advice relating to the filing of estate and gift tax returns. 72 Fed. Reg. 43146, 43154, 43157 (8/3/07). The final regs create a new category of reportable transactions, termed “transactions of interest,” for which the taxpayer or advisor must file a disclosure form and maintain records. Transactions of interest identify those transactions which the IRS believes have the potential for tax avoidance. The final regs also impose disclosure and record keeping requirements upon “material advisors,” who are persons providing any “material aid, assistance or advice regarding the organization, management, promotion, sale, implementation, insurance, or conduct of any reportable transaction, and derives substantial income from that aid, assistance, or advice.”

The IRS stated that it may impose a gross valuation misstatement penalty against an appraiser for post-May 25, 2007, estate and gift tax appraisals under new IRC §6695A, as adopted by the Pension Protection Act of 2006. The penalty is the greater of $1,000 or 10% of the amount of the underpayment attributable to the misstatement (but not more than 125% of the gross income received by the appraiser for preparing the appraisal). TAM 2007-0017.

The IRS re-issued proposed regulations under IRC §6159 describing how installment payment arrangements are requested, accepted and administered. The regs clarify when the IRS can terminate an installment payment agreement and recommence collection action. REG-10084172 Fed. Reg. 9712 (3/5/07). The IRS may reject an installment agreement by notifying the taxpayer or the taxpayer’s representative in writing of the reasons for the rejection and the taxpayer’s right to appeal to the IRS Office of Appeals within 30 days.

The IRS may cancel an installment agreement for reasons which include (i) nonpayment of any required installment payment when due; (ii) inaccurate or incomplete information; (iii) a determination that the collection of tax is in jeopardy; (iv) a significant change in the taxpayer’s financial condition; or (v) the failure of the taxpayer to pay any other federal tax liability when due. Prop. Regs. §301.6159-1(e)(4).

Notice 2007-90 provides guidance for estates seeking to defer payment of estate tax attributable to a closely held business under IRC §6166. The IRS will determine on a case-by-case basis whether security is required to protect the government’s interest in obtaining full payment of the estate tax. A primary factor will be the nature of the business generating the income on which estate taxes are owed.

Proposed regs articulate expenses of a trust or estate that are subject to the 2% floor on miscellaneous itemized deductions. The regs state that those costs which could not have been incurred by an individual in connection with property not held in a trust or estate are exempt from the 2% floor. Examples of costs excluded from the 2% floor include costs associated with fiduciary accountings, judicial or quasi judicial filings required in trust or estate administration, or fiduciary income tax returns, since those costs could not have been incurred by an individual. Expenses subject to the 2% floor include costs associated with the custody or management of property, advice on investing for total return, the defense of claims by creditors of the decedent or grantor, or the purchase, sale and management of business property. Reg.-128224-06, 72 Fed. Reg. 41243 (7/27/07).

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Tax Aspects of Incorporating

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

Deciding whether to incorporate a business requires careful analysis. Often the taxpayer will be faced with competing choices of operating the business as a sole proprietorship, or as an S corporation. Simply because nontax factors favor incorporating, do not assume that tax considerations will also yield the same conclusion.

Tax consequences vary greatly depending upon the business form which the taxpayer chooses. Moreover, there will often be a tension between business and tax objectives. For this reason, the taxpayer should be alert to the tax rules that will govern a newly formed corporation.

If There Were No Taxes

If the taxpayer could decide whether to incorporate based upon the unrealistic assumption that taxes were not a consideration, he or she might consider the following advantages to operating the business as a sole proprietorship (i.e., not incorporating): First, the business would be simple to operate and would be burdened by a minimum of legal restrictions. Second, the owner would receive all of the profits and would have the power to make business decisions easily. Third, the business would be easy to terminate, should that eventuality ever transpire. Finally, operating the business as a sole proprietorship would avoid incorporation costs, among which include legal fees.

Arrayed against these impressive advantages come, naturally, disadvantages to operating the business as a sole proprietorship. Foremost among those disadvantages would be the exposure of the sole proprietor: with no corporation to “shield” the sole proprietor from creditors, the owner would be legally liable for all debts of the business; creditors could reach even personal assets having no connection to the business.

Superimpose Taxes

Now, assume business objectives favor incorporation. What tax consequences will attach to that decision? (Note well that if the decision based upon nontax factors had been not to incorporate, only once in a blue moon would tax factors exert a pull strong enough to warrant reconsideration of the business decision not to incorporate. Put another way, only rarely will tax considerations alone justify incorporating.)

The first and most important tax consequence of incorporation is that a new taxpaying entity has been created, which must file returns and pay tax. The new corporation, like an individual, must pay tax on its income. Shareholders of the new corporation do not pay tax when the corporation earns income, but instead pay tax on distributed earnings of the corporation, which occur, inter alia, in the form of dividends.

That shareholders are ultimately taxed on the same income that the corporation had been previously taxed illustrates the corporate phenomenon of double taxation. To make matters worse, the corporation is not entitled to a deduction for dividends paid to shareholders. On the other hand, paying reasonable salaries to shareholders of closely held C corporations (which payments are deductible as a business expense to the corporation) may be an effective way to bleed a closely held C corporation of earned income while at the same time preserving a deduction at the corporate level.

Another unfavorable tax consequence of operating the business as a corporation versus a sole proprietorship lies in the former’s inability to offset its losses against other nonrelated business income of the taxpayer. In contrast, losses of a sole proprietor will offset other income, provided the sole proprietor materially participates in the business.

Although some of the painful tax consequences (double taxation, requirement that interests be freely transferable) of choosing the corporate form can be lessened by organizing the business as a sole proprietorship or partnership, the corporate form is often indispensable, since only it affords limited liability to the equity holders. Similarly, although the formation of an S corporation can mitigate the harsh sting of double taxation, it too has limitations, both in availability, as an initial matter, and also in the requirement that S corporation shareholders be taxed every year (regardless of whether there has been a corporate distribution or dividend) on their “distributive shares” of the S corporation’s income. Thus, for tax purposes, S corporations in many ways resemble partnerships.

Corporate Income Tax Rate

As a direct result of their independent tax status, C corporations must compute their own income and deductions, file their own returns (i.e., Form 1120), and pay their own taxes. Like individuals, gross income of a corporation is expansively defined to include most items that increase net worth. Unlike individuals (but like sole proprietors) corporations will be entitled to deduct various business expenses. Some corporations will also be entitled to take what is termed a “dividends received” deduction. The Tax Reform Act of 1986 lowered the tax rate for corporations with income over $75,000 to 34%. Lower rates apply to corporations with income under $75,000.

In summary, the act of incorporating should not be taken lightly: although legal dissolution will terminate a corporation’s tax liability, the tax cost of such a legal dissolution may be prohibitive, due to the largely unavoidable taxes associated with liquidating a corporation. [Internal Revenue Code, Sections 301 et seq.]

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Tax Aspects of Partnerships

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

A partnership, for tax purposes, is defined by negative implication. It is a “joint venture” or similar organization engaged in business that is not classified as a trust, corporation or estate. Partnerships, unlike corporations, generally pay no income taxes. Taxes are instead paid by the partners, who are taxed on their share of partnership income, deductions and losses.

A partner’s “share” of partnership income, deductions and losses is defined as the partner’s “distributive share” of those partnership items. This distributive share is in turn determined by reference to the partnership agreement. Thus, one of the attractive aspects of the partnership form becomes immediately apparent: The partners, themselves, can determine to a large extent what taxes will be paid by whom, since they themselves draft the partnership agreement with its provisions allocating distributive shares.

One sizeable constraint upon the partners’ liberty to themselves determine their tax fate through the partnership agreement lies in the requirement that allocations comport with economic reality. Thus, two partners could not, consistent with this rule, each contribute $10,000 to an oil venture and allocate all of the losses to one partner and all of the income (if any) to the other.

Another attractive feature of the partnership form is the ability of the partnership to generate losses which can be currently utilized by its partners. (In contrast, shareholders of a C corporation cannot deduct the corporation’s losses for the year. Before they can realize any of the corporation’s losses, such shareholders must actually sell their interest in the corporation.) This characteristic often makes the partnership form a good vehicle for the traditional tax shelter, where large losses are expected in the early years. If the venture later turns profitable, the entity can be changed to a corporation. At that point, the partners would no longer be taxed on their distributive share of income; of course, the corporation would itself be required to pay income tax at that point.

Note well: A partner’s allowable “distributive share” of partnership losses cannot exceed his “basis” in the partnership interest. Basis, however, is defined as the partner’s capital contributions to the partnership plus his share of the partnership’s liabilities. In contrast, a shareholder’s basis in a corporation includes capital contributions, but not loans incurred by the corporation.

Other Attributes

Deciding whether to operate a business as a partnership requires that the taxpayer also consider the nontax consequences attendant upon his or her choice of business form.

A partnership will usually have a closer nexus to its partners than does a corporation to its shareholders. Consequently, just as the income and losses of the general partnership flow out to the partners, so too do the obligations and debts. Unlike shareholders of a corporation, general partners are in a very real sense personally liable for the partnership’s obligations, if the partnership cannot meet those obligations. Another characteristic feature of the general partnership is that each of its partners, unlike shareholders of corporations, has the authority to legally bind the partnership.

Partnerships will not automatically continue in existence following the death, bankruptcy, retirement or resignation of a partner. Moreover, because of their close legal ties, partners are given a right to choose their associates. Partners may also have the right to dissolve the partnership at will and withdraw their capital, thus declining to participate further in the risks and ventures of the partnership. In contrast, shareholders of a corporation must continue their investment unless the corporation is liquidated or purchasers for their stock can be found.

Another characteristic that distinguishes partnerships from corporations is the usual lack of free transferability of interests in the former. Specifically, partners can transfer their entire partnership interest — including status as a partner — only if all other partners consent. No such constraint exists with respect to the transfer of corporate stock.

Posted in Partnership Taxation | Leave a comment

IRS Audit Procedures

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

PDF format: IRS Audit Procedures.wpd

The process used to select returns for audit is not a random one. The oft-repeated phrase “audit lottery” is in many ways misleading since certain items, such as claiming a loss on the sale of rental property which was recently converted from a personal residence, will greatly increase the probability of being subjected to a tax audit. The IRS may not, however, examine returns which are more than 3 years old, unless the taxpayer has committed fraud, in which case the statute of limitations never runs.

One type of examination, the “office examination,” involves an interview with the taxpayer at the office of the District Director. The other type of examination, which usually involves more complex issues, is the “field examination,” in which a revenue agent actually visits the taxpayer at his business or residence.

In any examination, the taxpayer may be called upon to furnish various records and books to substantiate deductions or transactions reported on the return. The IRS will seldom, however, request audit workpapers prepared by the taxpayer’s accountant. Although revenue agents have no formal settlement authority, factual disputes can be resolved, and areas of disagreement can be narrowed during the examination process. In the event closure cannot be reached, the taxpayer may wish to avail himself of informal conferences with supervisors.

At the conclusion of the examination, the IRS may be satisfied with the accuracy and propriety of the taxpayer’s return, and accept it as filed. Alternatively, the IRS may propose a “deficiency,” and in so doing issue an “examination report,” along with a letter requesting that the taxpayer accept its findings by executing, and returning within 30 days, a consent to assessment and collection.

The taxpayer has two options after receipt of this “30 day letter”: First, he may simply ignore the 30 day letter (thereby bypassing the Appeals Office process) and, at the expiration of 30 days, expect to be issued a formal “notice of deficiency” (see below). Second, the taxpayer may, in combination, seek to (a) submit additional evidence, (b) request a conference with a senior examiner, or (c) request a conference with an appeals officer.

An appeals office conference request often must be accompanied by a written protest containing a statement of facts, a statement of challenged adjustments, and a statement of pertinent law. Appeals officers, who, unlike revenue agents, have authority to settle issues of fact and law, will generally consider any settlement offer made in good faith. Although they will not settle a case to avoid the nuisance of litigation, appellate officers are permitted to consider litigation hazards. If negotiations produce no settlement the taxpayer will be issued a “notice of deficiency,” also known as a “90 day letter”.

A 90 day letter issued in response to a written protest will preclude further Appeals Office involvement, but only after taxpayer has actually filed a petition in Tax Court (see below). On the other hand, a 90 day letter issued in response to taxpayer inaction upon receipt of a 30 day letter will not preclude Appeals Office attemps to settle the matter until 4 months have elapsed from the time when a Tax Court petition was filed.

A taxpayer in receipt of a 90 day letter has two choices: He must either (1) pay the tax (and file a claim for refund) or (2) not pay the tax and petition the Tax Court for a redetermination of the proposed deficiency. Tax Court jurisdiction is predicated upon a “deficiency.” Therefore, if the taxpayer pays the tax, there is no deficiency, and no further recourse to the Tax Court may be had.

If, after having paid the deficiency, the taxpayer files a claim for refund which is rejected by the IRS, the taxpayer may then sue the IRS in the U.S. District or Claims Court for refund. However, these courts are without jurisdiction unless the deficiency has been paid. Thus, the taxpayer who chooses to “pays first” will go to District (or Claims) Court, while the taxpayer who prefers to “litigate first” will go to Tax Court. Choosing the appropriate forum in which to litigate requires a careful analysis of all facts.

Posted in IRS, IRS Audits | Tagged 90 day letter, Appeals Office, audit, claim for refund, deficiency, IRS Audit, notice of deficiency, statute of limitations | Leave a comment

Timing of Income and Deductions

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

The timing of income and deductions is of paramount importance in taxation. Just as a dollar today is worth more than a dollar a year from now, so too is a current deduction worth more than a future one, and a deferral of income preferable to an obligation to report income in the current tax year.

Deferral of income accomplishes two objectives: First, it leaves the taxpayer with more money at year-end, thereby increasing the effective yield of investments. Second, since dispositions of property often necessitate new investments, income (and, consequently, tax) deferral has the salient effect of easing cash-flow problems that might otherwise be associated with such a disposition.

Accelerating deductions is also a worthy tax objective. For example, accelerating deductions associated with depreciable property will lower the cost of capital investment by shortening the time period which is required for the taxpayer to recover, tax free, the total cost of a wasting asset. The object of prudent tax planning is therefore to accelerate deductions and at the same time defer recognition of income. Two income- deferral techniques will be explored below; further discussion of accelerating deductions is reserved for a later date.

____________________________ * * *

Installment sales can be an effective method of dispersing taxable gain associated with the disposition of appreciated property over a period of years. A taxpayer wishing to sell property that is not dealer property or publicly traded property (i.e., stock) may defer reporting gain by structuring the transaction as an installment sale (perhaps requiring a standby letter of credit to insure future payments.)

Assume that the taxpayer owns a piece of realty purchased for $50,000 which is now worth $500,000. A sale for cash would trigger a taxable gain of $450,000, which, taxed at 28% (assuming capital gain) would result in a tax payable of $126,000.

If the transaction were instead structured as an installment sale, with the taxpayer-seller taking $100,000 in cash, and a $400,000 note and mortgage for the balance, with $100,000 being payable in each of the four succeeding years, the tax consequences might be more palatable: The taxpayer would currently be required to report only $90,000 of taxable gain, and would owe only $25,200 in taxes in the current tax year. The same tax treatment would obtain in each of the four succeeding years.

The taxpayer should be aware of certain dangers lurking in this area: Installment sales (1) may not be used to report profit on the sale of depreciable property to a “related person”; and (2) should not be used to when the property being sold has been greatly depreciated. Furthermore, an added measure of caution must be observed when structuring any deferred-payment sale, since even inadvertent compliance with the installment sales provisions will trigger their application, unless the taxpayer affirmatively “elects out” of the statute.

* * *

If property held for productive use in a trade or business is exchanged for other property of a like kind to be used in such trade or business, no gain or loss will be recognized on that exchange, if all statutory requirements are met. Normally an exchange of property will trigger realization and recognition of gain or loss. If its technical requirements (of which there are many) are met, this provision achieves its end by causing a temporary break in the chain of taxation.

Through a series of complex provisions, the statute insures that untaxed gain will only rarely escape future taxation. To illustrate, assume that the taxpayer owned investment property in Manhattan purchased many years ago for $50,000 but was now worth $1,000,000. If the taxpayer acquired in a qualifying like-kind exchange Florida property also worth $1,000,000, the taxpayer’s old basis, $50,000 would “carry over” to the new property, but the taxpayer would recognize no gain currently. A later sale of the Florida property would, however, trigger large taxable gains.

Structuring a like-kind exchange requires careful attention to details in the tax law. The inclusion of cash, the presence of a related party, or the failure to timely designate replacement property are but a few of the many complicating factors which can imperil nonrecognition, or at least cause partial gain recognition. Unlike the installment sales provisions, the like-kind exchange provisions are not elective, and one may not “elect out” of this statute. Inadvertent compliance or, at the other extreme, a failure to comply, despite one’s best efforts to do so, are irrelevant in determining the applicability of the statute. Therefore, a taxpayer wishing to recognize losses should be particularly careful to avoid unintentional statutory compliance.

Posted in Property Transactions, Timing of Income and Deductions | Leave a comment

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

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