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

What is Income?

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

“Income” in the tax sense does not always coincide with the definition of income for other purposes. Consider a $500 graduation gift. Though clearly one’s bank statement balance would be increased by receipt of this gift, the tax law does not consider it to be income. Conversely, consider the winner of a vacation to Hawaii who gives the vacation to his friend. The winner (but not the friend) must still report the entire value of the trip as income.

Internal Revenue Code § 61(a) is the linchpin to taxability of these, and all other items of income. That section succinctly declares “Except as otherwise provided…gross income means all income from whatever source derived…” Treasury Reg. § 1.61-1(a) embellishes the Code section by thoughtfully adding “income may be realized in any form, whether in money, property, or services.”

The gift does not constitute income because it falls within the exception “Except as otherwise provided.” Congress has determined that gifts should not be taxed as income. Code § 102 thus provides that “Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.” The vacation prize is taxable to the winner since it clearly constitutes an accession to wealth, taxable under Code § 61(a), and no exception applies. The fact that the winner immediately transferred the prize to a friend is immaterial. The friend, however, will not be taxed, since it constitutes a gift to him.

Generally no tax is imposed on appreciated property until it is sold, since
Congress probably considers it inappropriate to impose tax on “paper” gains. Thus, although Code § 61(a) imposes tax on “gains derived from dealings in property,” Code § 1001(a) provides that no gain is realized until property is sold. Realized gain is generally the difference between the purchase and sale price of the property. Code § 1001(c) provides that realized gain is subject to tax “except as otherwise provided.” One example of a realized gain not being subject to tax is where the proceeds from the sale of a home are reinvested in a new home. Code § 1034 permits the entire gain to be “rolled over,” or deferred. To be sure, the entire gain may eventually be taxed, since the purchase price of the new home is reduced by the amount of unrecognized gain for tax purposes. This mechanism sets the stage for a taxable event when the “new” home is sold. However, the deferral becomes permanent if the taxpayer dies owning the “new” home, since his heirs will inherit the property with a “stepped up” basis.

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Imposition of IRS Accuracy Related Penalties

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

The enactment of the Revenue Reconciliation Act of 1993 has made it significantly easier for the IRS to impose accuracy-related penalties against taxpayers. The penalty for substantial understatement of income tax is one of five accuracy-related penalties found in the Code.

The accuracy-related penalties are in turn one of three classes of penalties, the other two being the delinquency penalties (e.g., failure to timely file or failure to timely pay income tax liabilities shown on a return) and the penalty for fraud, which requires a willful attempt to deceive the government.

Having decided to assess an accuracy-related penalty, the IRS thereby forgoes any opportunity it might otherwise have to impose either a delinquency penalty or a fraud penalty. Similarly, the IRS may impose but one of the five accuracy-related penalties, even though more than one might apply.

Each of the five accuracy-related penalties imposes a penalty equal to 20 percent of the amount of the “underpayment” attributable to the specific penalty. An “underpayment” is the amount by which the tax owed exceeds the tax paid. The “understatement,” from which the “underpayment” derives, is reduced to the extent that the taxpayer’s position is (1) adequately disclosed on the face of the return or on an attached statement, or for which there is (2) “substantial authority.”

Treas. Reg. § 1.6662-4(d)(2) provides that “substantial authority” only exists if “the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary positions.” “Authoritative” sources include cases, rulings, regulations, treaties and Congressional Reports. Opinions of tax counsel or of tax experts writing in journals or law review articles are not, however, considered authoritative for purposes of determine whether there exists “substantial authority.”

The new tax law, enacted as the Revenue Reconciliation Act of 1993, redefines the element of adequate disclosure. Under prior law, if disclosure were not made, an asserted understatement could be defeated by a showing of reasonableness. Under prior law, if disclosure was made, a nonfrivolous position taken by the taxpayer was sufficient to defeat the imposition of the understatement penalty. Under the new law, the taxpayer’s position must be reasonable, even if disclosed, in order to avoid the understatement penalty.

Thus, under the new law, even a disclosed position must be “reasonable” in order to defeat the imposition of the substantial understatement of income penalty. Although the term “reasonable” is not defined in Code § 6662 (i.e., which enumerates the accuracy-related penalties), or anywhere else in the Code, the Conference Committee Report stipulates that “reasonable basis” comprehends a “relatively high standard of tax reporting, that is, significantly higher than ‘not patently improper’.” The Report continues, and states that the reasonableness standard is not satisfied by a return position that is “merely arguable or that is merely a colorable claim.”

Income Shifting

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

The effective rate of income tax imposed on certain individuals may reach 45 percent, or even higher, when the repeal of the Medicare wage-base cap, the limitation on itemized deductions, the phase-out of personal exemptions, and the liability for state and local taxes are taken into consideration. The tax rate for a child of 15, however, with only $10,000 of taxable income, is 15 percent.

If, in this situation, it were possible to shift $10,000 of income from the parent to child, immediate income tax savings of $3,000 (i.e., $4,500 – $1,500) could be achieved.

Assume the parent owns shares of GM, and receives quarterly dividend checks of $2,500. May the parent enter into a contractual arrangement with the child and assign to the child the right to collect those dividend checks? Yes, and that contract might be binding under New York law. However, that assignment of income would not effectively shift the federal income tax consequences of the dividend income to the child. This result is dictated by Horst, a Supreme Court case which stands for the proposition that the taxpayer who owns the income “tree” is taxed on all the income thrown off by that tree, which in our example is the GM stock. Gifts of “fruit” from the tree, which in our case was the right to receive dividends, are ineffective to shift the incidence of income taxation.

What if the parent actually gave the child 25 percent of his holdings in GM? In this case, since the gift was of a part of the “tree” itself, the child will be taxable on the dividend income produced by his shares of GM. This result accords with intuition. However, if the GM stock transferred were worth more than $10,000, (or $20,000 if the donor’s spouse agreed to split the gift) gift tax liability might be incurred on the transaction, although in most cases no gift taxes would be currently payable, owing to the $600,000 lifetime exemption from the transfer taxes to which every person is entitled.

Actually, by making this gift of GM stock, the parent has succeeded in accomplishing two important aspects of estate planning: First, as mentioned, the transfer enables the parent to utilize the $10,000 annual exclusion, and also permits use of a portion of the $600,000 lifetime exemption from transfer taxes.

Second, the gift removes future appreciation in the GM stock from the estate of the parent. Thus, if the stock were to double in price over the next 10 years, that appreciation would no longer constitute part of the parent’s taxable estate. This might be important if the total of lifetime and testamentary gifts, exclusive of the stock, were expected to exceed $600,000.

Suppose the parent wished to transfer the GM stock in trust, so that the child were not given outright control over the stock or dividend income? This could be accomplished without adverse tax consequences provided (1) the trust were irrevocable, and (2) the grantor (parent) did not retain prohibited “strings” over the trust, so that the gift were not deemed incomplete for income tax purposes. Code Sections 675 and 677 provide that where the grantor retains administrative powers (e.g., the power to purchase or exchange trust property for less than adequate consideration, or the power to borrow from the trust) or economic benefits (e.g., the right to have income distributed to the granter or his spouse, or the right to accumulate income for future distribution to the grantor or his spouse), the gift will be considered incomplete for income tax purposes, and the grantor will be taxed on the income of the trust.

Recall that the child in our example was 15 years of age. Suppose that his sister was 12 years old. Could the same tax treatment be obtained with respect to her? No, on account of the application of the “kiddie tax” provision in the Code. To prevent income shifting to children under 14, Congress imposes a tax on the child’s “net unearned income” in excess of $1,200, at the parents’ tax rate. “Net unearned income” includes interest and dividends, but does not include income which the child earns, for example, by acting or modeling.

Two other methods for shifting income to family members include the use of family partnerships and S corporations.

Since each partner in a partnership reports income based on his or her “distributive share” of the partnership’s income, it might be possible to create a partnership consisting of family members, and allocate income to members in lower tax brackets. Provided certain “safe harbor” rules are closely adhered to, this plan can achieve its purpose of redistributing income. In order to be considered “real” partners, family members must be the “true” owner of a “capital” interest. That interest must also be a “material income-producing factor in the partnership’s business activity.” A capital interest gives a partner a right to receive partnership assets upon liquidation of the partnership. Capital is a material income-producing factor if gross income of the partnership is, in substantial part, derived from the use of capital.

The I.R.S. will generally not litigate the issue of whether a family member is a true owner if that person’s interest was purchased at market price from another family member. If, however, the interest was gifted to the family member, and the donor retained effective control over the partnership interest, then the IRS may seek to tax the donor on that distributive share, irrespective of the transfer. The Treasury regulations list factors which weaken the contention of “true” ownership by a family member. They include the donor retaining excess control over (1) partnership assets, (2) partnership distributions or (3) partnership management; or (4) a limitation on the family member’s right to sell or liquidate his interest.

Family S corporations may also constitute an effective means of shifting income to other family members. For federal income tax purposes, S corporations are taxed similarly to partnerships. Profits and losses of the S corporation are “passed through” to S corporation shareholders, who then pay income tax on those passed-through earnings at their own individual income tax rates. As in the case of family partnerships, the IRS may challenge transfers of partnership interests to family members unless the stock is acquired in a bona fide transaction, and the family member is the “true owner” of the stock. Where the stock is purchased at market value, the family member is generally considered to be the true owner.

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Significance of IRS Rulings

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

The Internal Revenue Code, a body of federal law enacted by Congress, is controlling authority in any federal tax dispute. Treasury Regulations, which interpret and expound upon various Code provisions, are also controlling except in the rare circumstance where a court decides that the regulation conflicts with the Code provision.

Even the voluminous and authoritative Treasury regulations cannot, however, address every conceivable tax issue that might arise under the Code. Consequently, the IRS is empowered to issue rules, policy statements, and interpretations in order to clarify the revenue laws. Two such pronouncements are the Revenue and Letter Rulings.

Constituting nothing more than the official position of the IRS with respect to the interpretation of the revenue laws, these rulings do not have the force of law. Consequently, courts of law are free to reject positions of the Service expounded in these agency briefs. Still, courts regularly defer to the expertise of federal agencies entrusted to administer federal law, and deference to the IRS in the administration of the federal tax laws is no exception.

As a practical matter, these rulings assume great importance, since structuring a transaction so that it falls within the scope of the ruling minimizes the potential for future problems with the IRS, at least with respect to that transaction. Moreover, although courts are not bound by rulings articulated by the Service, the converse is not true: The Service is bound by its position taken in Revenue Rulings, provided the ruling has not been withdrawn or superseded by the Code.

Revenue Rulings and Letter Rulings are different in scope and effect. The former constitute official interpretations of the tax law with respect to a specific set of facts. Their purpose is to inform and advise taxpayers, as well as to promote the uniform application of the tax laws by the IRS. As noted, Revenue Rulings may be cited and relied upon by any taxpayer in structuring contemplated transactions. The issuance of a Revenue Ruling is determined exclusively by the IRS, rather than by a direct request by any taxpayer.

Letter rulings, unlike Revenue Rulings, are issued in response to taxpayer request, and opinions expressed therein may be relied upon by the taxpayer seeking the ruling. However, the IRS takes the position that these rulings may not be relied upon by other taxpayers. Still, other taxpayers may seek guidance and illumination from these rulings, especially where the factual circumstances are similar.

The Service will not issue letter rulings in certain circumstances, including those where the transaction (1) has no bona fide business purpose or has as its principal purpose tax avoidance, (2) involves alternate plans or a hypothetical situation, (3) involves income or gift tax after a return has been filed, (4) involves issues which are under the jurisdiction of a District or Appeals Office, (5) concerns the applicability of an estate tax to matters involving a living person is involved, (6) involves a question of fact or a determination of “reasonableness” under the Code, or (7) involves a transaction which is part of an larger, integrated transaction.

Although advantageous for the reasons articulated above, it is not always in the taxpayer’s best interest to seek a letter ruling. Before issuing a favorable ruling, the Service may recommend changes in a proposed transaction. If the taxpayer is unable or unwilling to make the changes, he may withdraw the request for a ruling. However, having alerted the I.R.S. to the proposed transaction, the likelihood of the taxpayer’s being questioned on subsequent audit is increased. Therefore, if the likelihood of a favorable ruling appears slim, and the contemplated transaction that has little room for flexibility, then it might be preferable not to seek a ruling.

Another less abstruse factor may also discourage the taxpayer from making a request for a letter ruling: The taxpayer must pay a fee, ranging from $500 for a request from an individual, trust, or estate with total income of less than $150,000, to $2,500 for most other rulings. Letter rulings are generally handled in the order in which they are received by the Service, although expedited handling of requests is possible if there is a “compelling need” for such priority.

Once a decision is made to request a ruling, the taxpayer must furnish the Service with a statement of facts, a statement of the ruling requested, supporting authorities, and a declaration stating that none of the issues pertaining to the ruling request is under current audit, or is in a return of a taxpayer with reference to which the statute of limitations for assessment has not expired.

Despite the cost and delay associated with seeking a letter ruling, and the circumscribed number of situations in which the Service will issue letter rulings, the issuance of a favorable ruling may well provide a level of certainty and freedom from future controversy that is unparalleled in the tax law. The possibility also exists that the Service will, during the process of ruling on the request, suggest changes in the proposed transaction that will permit the I.R.S. to give its blessing. If those recommended changes can be implemented without causing substantial hardship for the taxpayer, the ruling request may have accomplished the result of resolving a potential dispute at an early juncture, in an efficient and equitable manner.

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Taxpayer Rights During an IRS Audit

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

Pursuant to the “Taxpayer Bill of Rights,” enacted by Congress as part of the Internal Revenue Code, the IRS is required to disclose to taxpayers their rights, and the obligations of the IRS during the audit, appeals, refund, and collection processes. In the event that the taxpayer is audited, an awareness of the audit process, and rights accorded to the taxpayer during it will best enable him or her to meet the challenge.

Assume that a hypothetical taxpayer converts a personal residence to a rental unit in 1993, sells the unit shortly thereafter, and claims a $15,000 loss on his 1993 return.

What are the chances of this taxpayer being audited?

Normally, losses on the sale of a personal residence are not allowable, but losses from the sale of a rental unit are. Since the residence was sold shortly after its conversion to a rental unit, the likelihood of an audit is increased substantially. Despite the common belief that audits are a random process, the phrase “audit-lottery” is misleading. Since audits are designed to produce additional revenue, the probability of an audit depends in substantial part on the amount of additional revenue which the IRS believes it might collect were the return to be audited.

When will the taxpayer’s 1993 return no longer be subject to the threat of an audit?

Generally, 3 years after it is file. However, if the IRS suspects fraud, the taxpayer’s return may be examined and subject to an audit forever. If the IRS asserts negligence, the statute of limitations is 6 years.

What are the procedural aspects of an audit?

Some audits are conducted by means of correspondence between the IRS and the taxpayer. These audits usually involve matters such as substantiating medical deductions claimed on a return. In other audits, the IRS asks the taxpayer to meet with an IRS auditor at the office of the District Director. Complex returns may require an IRS revenue agent to visit the taxpayer at his place of business in order to conduct a “field examination.”

Must the taxpayer cooperate with the IRS during an audit?

Yes; the taxpayer must furnish various records and books to substantiate deductions or transactions reported on the return. Privileged workpapers of the accountant, however, are seldom requested. Nonetheless, the taxpayer is accorded many important rights during the examination and appeals process. First, he has the right to suspend an interview with any IRS employee in order to consult with a tax professional. The taxpayer also has the right to be absent from any meeting with the IRS if so represented. If the taxpayer has relied on erroneous written advice furnished by the IRS, any penalty or addition to tax attributable to that erroneous advice must be abated.

Can the taxpayer “bargain” with a revenue agent conducting an audit?

Technically, no. Revenue agents have no formal settlement authority as such. However, factual disputes can be resolved, and areas of disagreement can be narrowed. Some factual differences may be amenable to solution by means of informal conferences with the revenue agent’s supervisor.

What occurs at the conclusion of an IRS audit?

If the IRS is satisfied with the accuracy and propriety of the taxpayer’s return, it will simply accept the return as filed. Alternatively, the Service 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 to the IRS within 30 days a “consent to assessment and collection.” The taxpayer need not affirmatively respond to this “30-day letter.” However, during the 30-day period, additional evidence may be submitted, or a conference with a senior examiner may be requested. The taxpayer may also request a conference with an appeals officer who, unlike the revenue agent, does have authority to settle issues of fact and law. Appeals officers will generally consider any offer made in good faith.

What happens if further conferences are unavailing, or if the taxpayer disregards the 30-day letter?

He will be issued a “90-day letter.” Also known as a “notice of deficiency,” the issuance of this letter puts the taxpayer at the crossroads of his dispute with the IRS. Upon receipt of this letter, the taxpayer may either pay the tax or not pay it. If, during the 90-day period the taxpayer files a petition in Tax Court for a “redetermination” of the deficiency, the IRS is not permitted to assess any taxes until after the conclusion of a Tax Court proceeding. Therefore, the taxpayer has the right to fully contest the merits of the dispute before paying any additional taxes. However, if the taxpayer ultimately loses, he will be assessed the tax, plus interest which accrues during the dispute. Despite the interest penalty, the vast majority of taxpayers prefer to litigate in Tax Court rather than prepaying the asserted tax deficiency, and then bringing a refund suit in U.S. District Court or Claims Court.

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Wash Sales

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

Under Internal Revenue Code Sec. 1001, gain or loss realized on the sale or exchange of property is the excess of the amount realized over the adjusted basis. If one purchased 100 shares of Exxon in August, 1993, and sold them on December 26, 1993, realizing a loss of $1,000, one would expect that this loss would be reported on Schedule D of the taxpayer’s 1993 tax return as a short term capital loss. In many cases, this is indeed the tax treatment of such a stock sale.

Suppose, however, the same individual repurchased 100 shares of Exxon during the period from December 26, 1993 until January 25, 1994. In this case, the loss would be disallowed in its entirety, since the repurchase, within 30 days of the sale, would have triggered the wash sale rule. Under Code Sec. 1091, no deduction is allowed for a loss incurred on the sale or exchange of a security where “substantially identical” securities are acquired within a 61-day period beginning 30 days before the date of the sale and ending 30 days after the sale.

“Substantially identical” is narrowly defined to mean stock of the same corporation. Therefore, the wash sale rule would be inapplicable if the individual in our example had, after selling Exxon, instead purchased Mobil stock within the 30-day period commencing on December 27. Mobil could then be sold after 30 days, and Exxon repurchased at that time, without triggering the wash sale rule.

Would the loss on the Exxon stock disappear if the individual instead repurchased Exxon within the prohibited time frame? No, Code Sec. 1091 does not permanently deny the loss on the stock involved in the wash sale; rather, the loss is postponed until the replacement stock is later sold. If Exxon were repurchased within 30 days of its sale, the $1,000 of unrecognized loss would be added to the basis of the repurchased stock. If the repurchased stock was itself sold the following day, the $1,000 loss would then be recognized, since the individual’s adjusted basis would exceed his amount realized by $1,000.

What can be done to reduce the impact of the rule? One tactic is to purchase stock of a similar corporation, as noted above. Another alternative entails waiting until 31 days after sale before repurchasing the identical stock. However, if the stock goes up within this period, the taxpayer would be unable to replace the stock at the initial sale price. In this case, the wash sale rule would have achieved its precise purpose.

Another method of finessing the rule entails the purchase of an additional 100 shares of Exxon on November 27, 1993, 30 days before selling the original 100 shares. The individual could now safely sell 100 shares of Exxon on December 26, recognize the loss, and still have an interest in Exxon. Of course, this method is not without its own risk, since the stock could decline in price from November 27 until December 26. In that case, the taxpayer would have avoided the wash sale rule only to incur an economic loss.

In closing, it should be noted that the wash sale rule may occasionally work to the taxpayer’s advantage: In cases of a poorly timed loss, the taxpayer can invoke the provision by repurchasing the stock within 30 days, thereby postponing the tax loss.

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Administrative Appeals Within the Internal Revenue Service

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

At the heart of the Internal Revenue Service procedural engine lies the internal appeal process, whose function is to resolve taxpayer disputes through the use of negotiation and settlement, without the necessity of litigation.

The Appeals office has “exclusive and final authority” to mediate tax disputes and to impartially determine tax liability. Appeals Office involvement, at the earliest, may not commence until after the taxpayer had filed a protest in response to receipt of a 30-day letter from the I.R.S. If Appeals fails to resolve the matter at this juncture, further Appeals Office involvement will be precluded after the taxpayer files a Tax Court petition. Still, the taxpayer may choose to bypass early Appeals involvement at the 30-day letter stage. In this case, Appeals may enter the dispute even after a Tax Court petition has been filed.

As suggested, although Appeals office involvement may begin after the taxpayer has received a 30-day letter, the taxpayer might decide to bypass early Appeals office involvement in favor of later involvement, or no involvement. This could be accomplished by simply ignoring the 30-day letter. If the taxpayers stands mute upon receipt of this letter, he will be issued a 90-day letter, also known as a statutory notice of deficiency, at the expiration of the 30-day period.

If the taxpayer fails to file a petition in Tax Court seeking a redetermination of the proposed deficiency after receipt of the 90-day letter, he will be assessed the entire amount of the deficiency at the expiration of the 90-day period. After assessment, the taxpayer can call the I.R.S.’s bet by paying the disputed tax and then bringing a refund suit in U.S. District or Claims court alleging that the I.R.S. had erroneously or illegally assessed taxes. Once the assessed tax is paid, however, the doors to the Tax Court are forever closed with respect to that assessment.

Whether to file a protest and seek early Appeals office involvement requires the careful analysis of several competing considerations. For example, filing a protest at the 30-day stage may be an effective dilatory tactic by the taxpayer, since the issuance of a 90-day letter may then be held in abeyance. It might be beneficial for the taxpayer to impede early resolution of the dispute if money that would otherwise be used to pay the disputed tax can earn interest at a rate in excess of that which the I.R.S. would impose on the deficiency if taxpayer ultimately lost the dispute.

In contrast, by ignoring the 30-day letter, and by waiting until actual receipt of the 90-day letter to seek Appeals involvement, the taxpayer will succeed in putting the dispute on a fast track. This may be desirable if the taxpayer seeks an expeditious resolution of the matter, and does not want the dispute to drag on while he is incurring what could be substantial interest penalties. Once the matter is docketed in Tax Court, but not before, the taxpayer may post bond to stop the running of interest on the disputed tax.

Other factors also militate against filing a protest and seeking early Appeals involvement. First, the taxpayer who files a protest requesting an Appeals office conference risks the possibility that Appeals will find new issues to be raised against the taxpayer on which the taxpayer will then bear the burden of proof if the dispute goes to trial. In contrast, the taxpayer who seeks Appeals office involvement only after he has filed a Tax Court petition minimizes that risk, since Tax Court rules expressly provide that the I.R.S. must bear the burden of persuasion with respect to issues raised after the case has been docketed. Normally, the burden of proof in tax disputes, a burden that may be quite difficult to overcome, is placed squarely on the taxpayer.

If the taxpayer does decide to file a protest seeking early Appeals office involvement, the protest must conform to certain I.R.S. requirements. Aside from purely formalistic requirements, the protest must (1) identify the adjustment being protested; (2) provide facts which support the taxpayer’s position; and (3) provide the legal foundation upon which the taxpayer’s position rests. The taxpayer may also attach documents and affidavits which support the statements made.

Internal appeals procedure differs from court procedure in that evidence which might be held inadmissible in court is not inadmissible in an Appeals forum. Nevertheless, the taxpayer may not
“surprise” the Appeals officer with new evidence at conference since the latter may, in his discretion, remit the new evidence to the district office for verification.

Offers made by the taxpayer in Appeals conferences must be made in good faith. The taxpayer may request terms of settlement which the Appeals officer might consider if his good-faith offer is rejected. While Appeals officers are required to consider litigation hazards, they are prohibited from settling cases based on their “nuisance” value. This rule is self-enforcing since Appeals officers must justify any settlement with written memoranda.

The I.R.S. is reluctant to enter into “closing” agreements with taxpayers, although by statute it may do so. Instead, the I.R.S. relies on Forms 870 and 870-AD to effectuate settlement agreements. Form 870-AD accords a measure of finality to the dispute, since neither the Service nor the taxpayer may generally reopen a dispute so concluded. Settlements concluded via Form 870 are less final. The I.R.S. may make further assessments, and the taxpayer may file a claim for refund as a prelude to a refund suit. Note that if the dispute has been docketed in Tax Court, neither of these forms may be used. Instead, a stipulated decision drafted by the parties becomes the decision of the Tax Court when signed by the presiding judge.

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Itemized Deductions

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

Deductible expenses may be classified as either above-the-line or below-the-line deductions. While above-the-line deductions reduce gross income, below-the-line or itemized deductions reduce adjusted gross income (AGI). For a taxpayer in the 39.6 percent tax bracket, each dollar of above-the-line deduction is worth $0.396 in tax savings. However, the same is not true for itemized deductions — they may produce far fewer tax savings.

Common above-the-line deductions include trade or business expenses, losses from the sale or exchange of trade, business or investment property, amounts paid for alimony, one-half of self-employment taxes, amounts contributed to an IRA, 25 percent of health insurance premiums for self-employed individuals, interest expenses related to business, and certain moving expenses.

Itemized deductions include allowable medical and dental expenses, state and local taxes, real estate taxes, investment interest expenses, qualified residence interest expense, charitable contributions and gifts, and other “miscellaneous” itemized deductions. As a class, itemized deductions are subject to two important limitations, discussed below. Specific itemized deductions may be subject to either, both, or neither these limitations.

The first limitation imposed on some itemized deductions is known as the “floor” limitation. Many itemized deductions are allowable only to the extent they exceed a particular percentage of the taxpayer’s AGI. For example, medical and dental expenses may only be deducted to the extent that they exceed 7.5 percent of AGI. Similarly, “miscellaneous” itemized deductions may be deducted, but only to the extent that their sum exceeds 2 percent of AGI. It may be possible to finesse this limitation by “bunching” itemized deductions into certain tax years. Alternatively, married taxpayers may derive more benefit from itemized deductions if they file separate returns.

The second limitation involves a phase-out for taxpayers whose AGI exceeds a threshold amount. The phaseout operates by reducing the total of itemized deductions by 3 percent of the excess of AGI over the threshold amount. In no case, however, may more than 80 percent of itemized deductions be phased-out. Medical and dental expenses, investment interest expenses, casualty losses, and wagering losses are expressly exempt from the operation of the phaseout limitation.

In sum, the viability of itemized deductions often depends upon AGI. Lower AGI will more easily permit the taxpayer to navigate both the floor and the phaseout limitations imposed on itemized deductions. Since AGI is itself defined as gross income less above-the-line deductions, one can minimize AGI by maximizing above-the-line deductions. Above-the-line deductions are most often credited with reducing ordinary income that would otherwise be subject to high tax rates. Their dual role as an inhibitor of floor and phaseout limitations might well justify their characterization as bona fide members of the increasingly rare species tax shelter.

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Home Office Deductions

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

Revenue Ruling 94-24 interpreted the Supreme Court’s 1993 Soliman decision regarding home office deductions. Soliman v. Commissioner, 93-1 USTC ¶50,014 (1993). Largely reinstating an earlier position of the Tax Court, the Court held that home office deductions are statutorily permissible only in circumstances where the taxpayer spends a substantial amount of time in the home office, and then only if the “relative importance” of activities there exceeds that of other business locations.

The decision primarily reflects the interplay of two Code provisions: First, IRC Section 280A(a), which excludes from the universe of otherwise allowable business deductions those deductions which relate to the use of a home or “dwelling unit;” and second, IRC Section 280A(c)(1), which carves out a limited exception to the Section 280A(a) deduction prohibition, by allowing the taxpayer to deduct business expenses with respect to the portion of a dwelling unit which is exclusively used on a regular basis “as the principal place of business for any trade or business of the taxpayer…”

In reaching its determination, the Court reviewed the statute’s legislative history, and found that its purpose had been to “provide a narrower scope for the [home office] deduction.” The Court noted, however, that Congress had failed to define “principal place of business.” In looking at the “ordinary, everyday sense” of the phrase “principal place of business,” it concluded that such a determination could not be made without a “comparison of locations.” While ascribing some importance to “necessary” or “essential” functions performed at the home office, the Court expressly found they were not controlling in a comparison of the relative importance of business locations. While the “comparative analysis” formula as articulated seemed to resemble the “focal point” test (which had been enunciated by the Tax Court but which was later abandoned after being criticized by several Courts of Appeals), the Supreme Court also faulted that test for having a “metaphorical quality” that was “misleading.” The Court concluded that “no one test is determinative.”

If a comparison of the relative importance of each business location (taking into account the characteristics of the particular trade or business) does not identify a principal place of business (PPB), then Soliman directed that an inquiry be made into the relative amount of time spent at each location. While the Court steadfastly declined to articulate an “objective standard” as to exactly how much time must be spent in the home office, it allowed that Soliman’s “10 to 15 hours per week spent in the home office measured against the 30 to 35 hours per week at the three hospitals [w]ere insufficient” to justify the conclusion that the home office was a PPB.

Implicit in the decision seemed to be the revelation that few taxpayers who do not spend at least half their time devoted to business activities at the home office could ever qualify for the deduction. The Court’s narrow view of the deduction also manifests itself in guidance provided to the “decisionmaker” where a comparison of locations fails to identify a PPB: The courts and the IRS are admonished from “strain[ing]” to conclude that the home office is the PPB by “default.” Unlike the concept of “tax home,” a taxpayer may well be engaged in business activities at multiple locations including the home office, yet have no principal place of business.

Revenue Ruling 94-24 (1994 I.R.B. 1994-5) offers guidance in determining the taxpayer’s PPB. Taking its cue from the Supreme Court, the Ruling stipulates that the determination of the taxpayer’s PPB requires one, and possibly two, separate inquiries. The separation of these inquiries appears more pronounced in the Ruling than it does in Soliman. The first inquiry again involves a comparison of the “relative importance” of activities performed at each business location. The result of this inquiry will result in one of three determinations: First, the home office is the PPB; second, the home is office is not the taxpayer’s PPB; or third, a comparison of the relative importance of activities fails to identify the location of the taxpayer’s PPB.

A definitive finding with respect to whether the home office is (or is not) the PPB conclusively determines the propriety of the deduction. If a comparison of the relative importance of the activities performed at each location fails to identify a PPB (as may occur, according to the Ruling, where the taxpayer performs income-generating activities at both the office in the taxpayer’s home and at some other location), then the wheel spins again and the second inquiry, i.e., the “time” test, becomes dispositive. As in Soliman, this directs that a time comparison be made among all business locations

The taxpayer loses if the “time” test yields the determination that there is no PPB, or that there is a PPB — but it is not his home, and wins with a finding that the home office is the taxpayer’s PPB. The ruling, however — presumably following the high Court’s lead — fails to provide a “safe harbor,” or offer any other practical guidance, with respect to what fraction of hours the taxpayer must devote to business activities at the home office in order to satisfy the “time” test.

The Ruling contains four examples which illustrate its principles. A synopsis of those four examples:

The home office of a self-employed plumber who talks to customers, orders supplies, reviews books and even employs an administrator there fails to qualify as his PPB since the relative importance of activities performed on service calls exceeds that of the activities performed at home. Similarly, a teacher who grades test papers at home cannot claim the deduction even though the amount of time spent at that office actually exceeds the amount of time spent teaching, since the “essence” of his trade or business requires the teacher to meet with students at school. However, the relative importance scales are tipped in favor of a self-employed author who writes at home but who meets with publishers and conducts research away from the home office, since the “essence” of his trade or business is writing, and that is done exclusively at home.

In the case of a self-employed retailer of costume jewelry selling both at craft shows and through mail orders at home, the relative importance test is inconclusive, and resort to the time test is required. Since the taxpayers spends 25 hours at the home office and only 15 hours away from the home office, the example concludes that the home office is indeed the PPB.

Interestingly, mention is made in the analysis of the time spent at various locations even where the determination of a PPB is made without resort to the time test. This phenomenon reveals that the inherent overlap between the two tests may undermine in practice the application of the of the Ruling’s hierarchical and bifurcated approach. In the only example where actual resort to the time test is required, the home office is determined to be the PPB where 62.5% of the total work time is spent there. Although from this one might be tempted to infer the existence of a “safe harbor,” caution might counsel otherwise: First, it is doubtful (though not impossible) that the Ruling would, as a practical matter, relegate an item of such importance to an example; and second, express language in Soliman appears to deny the existence of a safe harbor.

In the end, it will be the IRS and the courts, and not the Supreme Court, which will be charged with implementing the Soliman decision. For practical reasons, as well as for reasons grounded in principles of equity in the administration of the tax laws, the IRS may find it necessary to tacitly observe informal guidelines, which, though not rising to the level of a true “safe harbor,” might nevertheless provide needed guidance in the area of home office deductions. For the moment, such guidelines could most plausibly be inferred from Revenue Ruling 94-24 and its examples.

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Inter Vivos Trusts

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

As a testamentary instrument, the living trust possesses attractive attributes, especially for elderly testators. For younger persons, the will is generally preferable as a testamentary device.

Property placed in a will passes automatically into the probate estate, where it may become the subject of an unpleasant will contest However, property placed in a living trust cannot become the subject of a will contest since it does not constitute part of the probate estate. Moreover, having begun operating before death, questions concerning the trust instrument, or the competence or mental capacity of the grantor are likely to have been resolved during the grantor’s lifetime.

A living trust, like other trusts, affords the grantor great flexibility in disposing of property and in making use of tax-favored planning techniques. A “revocable” living trust, as its name implies, may be modified or revoked before the death of the grantor, while an “irrevocable” living trust may not. Whether to make the living trust irrevocable depends entirely upon the tax and planning objectives of the grantor. Obviously, the grantor’s “comfort level” will be greater when a revocable trust is used.

Many of the legal tasks necessary to create a living trust in effect serve as a proxy for, and merely accelerate into the grantor’s lifetime, tasks that would otherwise have awaited probate administration. Although it may involve a significant present cost (when compared to merely drafting a will), the grantor of a living trust will be able to assist in many facets of its creation, and thus ensure that the task proceeds efficiently.

Despite its attractive features, the living trust has not supplanted the will as the first choice among most estate planning practitioners and testators in effecting testamentary dispositions. Many attorneys prefer the simplicity and versatility of the will. Nearly all of the flexibility of the trust can also be accomplished using trust provisions within the will. Nearly every tax benefit which can be achieved using a living trust can also be attained using a will. Probate is, in most cases, efficient and relatively quick.

Ministering to the needs of a living trust also requires a constant vigilance which testators who are not elderly are likely to find burdensome. In addition, any property not properly placed in the living trust during the testator’s lifetime will pass by will or intestacy anyway. For this reason, even when a living trust is used, a will is usually required to dispose of any property which the testator neglected to place in the trust. For these reasons, the will remains a superior testamentary vehicle for many persons.

Posted in Estate Planning, Inter Vivos Trusts, Trusts | Leave a comment

Amortization of Good Will Under IRC Sec. 197

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

Under new IRC Sec. 197, certain intangible property (defined as “IRC Sec. 197 intangibles”) are amortizable ratably over a 15-year period. The new law represents a substantial change from the prior law, under which neither good will nor going-concern value, two examples of IRC Sec. 197 intangibles, were amortizable.

Either as a legislative judgment, or as a rule of administrative convenience, the 15-year amortization period applies regardless of the actual useful life of the IRC Sec. 197 intangible. Moreover, Sec. 197 occupies the amortization field entirely: no other amortization or depreciation rules can apply to intangible property amortizable under IRC Sec. 197.

The amortization deduction provided by IRC Sec. 197 is allowable with respect to the capitalized costs of certain intangible property that is acquired and held by the taxpayer in connection with the conduct of a trade or business or an activity engaged in for the production of income. Although the intangible must be held in connection with a trade or business, it need not constitute part of a trade or business when acquired. The amount of the deduction is calculated by amortizing the adjusted (e.g., cost) basis of the IRC Sec. 197 intangible ratably over the 14-year period, beginning in the month in which the intangible was acquired.

The following IRC Sec. 197 intangibles are defined in the Conference Committee Report which accompanied the legislation:

• Goodwill is defined as “the value of a trade or business that is attributable to the expectancy of continued customer patronage, whether due to the name of a trade or business, the reputation of a trade or business, or any other factor.”

• Going concern value is defined as “the additional element of value of a trade or business that attaches to property by reason of its existence as an integral part of a going concern”;

• Workforce in place is defined as “the composition of a workforce (e.g., the experience, education, or training of a workforce), the terms and conditions of employment whether contractual or otherwise, and any value placed on employees or any of their attributes.”

• Information base is defined to include “business books and records, operating systems, and any other information base including lists or other information with respect to current or prospective customers.”

• Know-how is defined as “any patent, copyright, formula, process, design, pattern, know-how, format, or similar item.”

IRC Sec. 197 intangibles also include these items:

(1) any “customer-based intangible”, such as market share; (2) any “supplier-based intangible”; defined as the value resulting from future acquisition of goods or services, (3) licenses, permits, and other rights granted by governmental units; (4) covenants not to compete; and (5) any franchise, trademark or trade name.

The following items are expressly excepted from IRC Sec. 197 intangible status:

• Certain financial interests, including “any interest in a corporation, partnership, trust, estate, existing futures contract and other enumerated contracts.”

• Land, specifically “the cost of acquiring an interest in land.”

• Computer software, defined to include (i) any computer software which is readily available for purchase by the general public, and (ii) certain acquisitions of computer software not involving the acquisition of a trade or business.

Other items similarly excepted from IRC Sec. 197 status include:

(1) certain interests or rights acquired separately; (2) interests under leases and debt instruments; (3) sports franchises; (4) mortgage servicing; and (5) certain transaction costs.

Posted in Amortization of Good Will, Depreciation & Amortization | Leave a comment

Limited Liability Companies

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

The Limited Liability Company (LLC) is a popular form of business entity. A creature of state law, virtually all states, including New York, have enacted LLC statutes. The principal allure of the LLC is the liability protection it affords its members. LLCs are also endowed with favorable federal tax attributes.

Why then does not every business convert to an LLC? In fact, many have. Many that have not are concerned that the personal liability protection offered in-state may not be recognized out-of-state. In addition, potential conflict of laws questions may arise with respect to how and whether courts of one state will interpret another state’s LLC statute.

Another difficulty in LLC status is getting there: while a start-up venture can easily choose LLC status, converting a C or S corporation to LLC form may entail prohibitive tax cost, since a corporation liquidation is required. A welter of administrative requirements must also be complied with in order to elect LLC status for a new or an existing entity. Of all existing entities, partnerships can most easily make the transition to LLC form. Favorable basis rules make the LLC a particularly attractive form for real estate investments.

Mere compliance with state law does not assure that the LLC will attract favorable partnership tax rules under the Code. If the LLC has too many corporate characteristics, the IRS may seek to tax the entity as a C corporation. To be taxed as a partnership under federal tax law, Treasury Regulations provide that the LLC must lack two of the following four corporate attributes: (1) limited liability; (2) continuity of life; (3) free transferability of interests; and (4) centralized management.

By definition an LLC will not lack limited liability. It must therefore lack two of the three remaining corporate attributes in order to be taxed as a partnership under federal tax law. In order to obviate the possibility of failing this test, many states have enacted so-called “bulletproof” statutes. In these states, qualifying for partnership taxation is merely a matter of the LLC agreement being in compliance with the state’s LLC statute.

Other states, recognizing that the LLC need only lack two of the three remaining corporate characteristics (recall that the LLC will by definition fail to lack the corporate attribute of limited liability), permit the LLC to modify the “default” operating agreement so as to choose which corporate characteristics it will lack. New York is such a state. The danger posed in “flexible” states is that arrangements thought adequate to comply with the regulations may not suffice. This could result in the LLC losing its right to be taxed as a partnership under the Code.

It is important to remember that the determination of whether an LLC is eligible to be taxed as a partnership under the Code has little bearing on the status of the LLC under state law. That is, even if the entity fails to achieve favorable partnership tax status under the Code, it may nevertheless be a completely viable LLC under state law. In this case, only the entity’s right to be taxed as a partnership — and not the liability protection afforded its members — will have been lost.

What are the drawbacks to operating in the LLC form? To enjoy the favorable partnership tax rules, the LLC must lack at least two corporate characteristics. For some business ventures, this limitation may prove significant. Another problem with the LLC form is that although most states have enacted LLC statutes, it remains unclear how an out-of-state LLC will fare in courts of another state. Taxation of LLCs by states also varies widely, with some states taxing LLCs as C corporations, some as S corporations, and some as neither.

Most often, if an LLC is taxed as a partnership under federal tax law, the state in which the LLC operates will also accord flow-through status to the entity for state tax purposes. Not always, however: Florida, for example, taxes LLCs as C corporations, even though Florida accords flow-through status to S corporations.

New York imposes no entity level tax on LLCs similar to the one imposed on S corporations. Instead, New York imposes an “annual fee,” which is the greater of $325 or 50 times the number of employees, but not to exceed $10,000. New York City may also impose annual fees on LLCs with NYC source income.

In order to validly form or convert to LLC status in New York, compliance with various legal requirements must also be achieved:

¶ An operating agreement must be drafted, and it must contain allocations of income, gain, loss, deduction and credit. It must also define the rights and obligations of each LLC member. The operating agreement must also be consistent with the Articles of Organization required to be filed with the Secretary of State.

¶ Notice must be made by publication of the LLC’s existence. This requirement, unique to New York, may involve significant cost.

¶ Contracts, leases, insurance policies, and other legal documents must be reviewed in order to determine whether converting to LLC form would violate preexisting legal obligations.

¶ Bank accounts must be closed, and then reopened in the name of the LLC. The word “LLC” must also appear in the entity’s name, as well as on its letterhead.

Seventeen states, including New York have now enacted Limited Liability Partnership (LLP) statues. LLPs, strongly resemble LLCs. LLPs improve on the LLC form in a few important respects, most having to do with ease of converting existing entities. However, while an LLC may be composed of any members, only licensed professionals may operate in LLP form. Notably, a professional partnership wishing to convert to LLP form need not even draft a new operating agreement in New York, since the LLP statutes permits use of the firm’s existing partnership agreement.

While the professional in his individual capacity will still be subject to suit for torts committed by himself or his agent, the LLP member will not be held personally liable for the debts, obligations, or liabilities of the LLP. This treatment is considerably more favorable than that accorded to members under many other states’ LLP statutes in that the New York statute does not stop at negligent or wrongful acts, but extends coverage to contractual obligations of the LLP.

Posted in Limited Liability Companies, Tax News & Comment | Leave a comment

IRS Ruling Blesses New York RLLPs (January 1996)

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

New York Partnership Law Sec. 121-1500 provides that a professional partnership without limited partners may register as a limited liability partnership (RLLP) by registering with the NYS Department of State. The IRS has ruled that this registration results in seamless transformation into an entity classified as a partnership for federal tax purposes, and without termination under IRC Sec. 708(b). Rev. Rul. 95-55, IRB 1995-35.

In order to be classified as a partnership rather than as a corporation, Treasury Regulations require that the entity in question not “resemble” a corporation. There are four corporate “characteristics” which must be examined in this inquiry. If the entity in question has more than two corporate characteristics, it is deemed to resemble a corporation and will be taxed as such.

Those corporate characteristics are (1) continuity of life (a corporation continues indefinitely); (2) centralization of management (corporate powers are vested in a board of directors); (3) limited liability (shareholders are not normally liable for the debts of the corporation); and (4) free transferability of interests (shares of stock may be freely bought or sold).

The Ruling proceeds to analyze the resulting New York RLLP and concludes:

Since (1) every partner of the RLLP may bind the partnership, the RLLP lacks the corporate characteristic of centralization of management; (2) no person may become a partner in the RLLP without the consent of all of the partners, the RLLP lacks the corporate characteristic of free transferability; (3) no partner is personally liable for the debts or obligations of the partnership, the RLLP possesses (rather than lacks) the corporate characteristic of limited liability; and (4) the RLLP is dissolved by operation of law by the express will of any partner, the RLLP lacks the corporate characteristic of continuity of life. Therefore, since the RLLP possesses only one of four corporate characteristics (i.e., limited liability), the Ruling concludes that the RLLP is classified as a partnership for federal tax purposes.

The second part of the Ruling addressed the issue of whether registration of the general partnership as an RLLP would result in a termination of the partnership under IRC Sec. 708(b).

The Ruling states that registration of an RLLP results in an exchange under IRC Sec. 721, similar to where a general partnership converts to a limited partnership. The Ruling concludes that since no new tax entity is formed, the RLLP must secure the consent of the Secretary before changing its accounting method, pursuant to IRC Sec. 446(e).

Since New York’s Limited Liability Company (LLC) statute is “flexible,” the operating agreement may deviate from the default provisions provided in the statute. Rev. Proc. 95-10 provides guidance as to when it will issue a letter ruling requesting classification of an LLC as a partnership for tax purposes. IRB 95-3, 20. [Note: this ruling would also apply to RLLPs.]

Generally, the IRS will rule that the LLC lacks the corporate characteristic of free transferability of interests if majority approval is required for a transfer of a member’s interest. Centralized management will be lacking even if the members designate members as managers, provided the member-managers own at least 20% of the total interests in the LLC. Continuity of life will be absent only if the LLC terminates upon the death, retirement, or resignation of a member. [However, if a majority vote of the remaining members is required to keep the LLC alive, then a favorable ruling seems possible.]

The upshot of these rulings is that significant latitude exists when drafting the operating agreement. This latitude assures that the business objectives of the members can be achieved while preserving partnership tax treatment for the entity.

Posted in IRS Rulings & Regulations, Tax News & Comment | Leave a comment

Asset Protection; Avoiding Fraudulent Transfers

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

One of the simplest methods of protecting assets from potential creditors is transferring title to the marital home to one’s spouse. Creditors of the transferring spouse will thereby be precluded from making claims against the house. When making large transfers of assets between spouses, however, one must be vigilant in not squandering the $3.5 million estate tax credit, since this could ultimately result in an estate tax nightmare.

One must also consider the potential for divorce among spouses or discord among family members. Both could beset an otherwise effective asset protection plan with a host of its own intractable problems. When one transfers title one transfers ownership. Unfortunate as it may be, it is nevertheless true that transferring assets to family members in order to protect assets from future claims potential creditors or litigants is often a decision that the transferor may later regret.

Irrevocable trusts, if properly structured, offer the potential for greater protection, and also permit the grantor (i.e., the person transferring the assets) to retain greater control over the trust property. In comparison, a properly devised by Will offers no asset protection during the testator’s life, for the simple reason that a Will (like a revocable “living trust”) can always be revoked. An irrevocable trust, on the other hand, even if it grants the creator certain desirable powers, cannot be revoked. One formidable estate planning advantage of transferring property into an irrevocable trust is that future appreciation may be taken out of the grantor’s estate. This could result in significant estate tax savings.

One interesting tax phenomenon of an irrevocable trust is illustrated where the transferor of property to the trust retains too few strings to imperil the transfer for gift tax purposes, but too many strings to result in a complete transfer for income tax purposes. Generally speaking, a transfer complete for transfer tax purposes will serve to insulate the property from claims of creditors. Therefore, asset protection is consistent with income tax planning in this regard, since an incomplete transfer for income tax purposes can be beneficial.

An incomplete transfer for income tax purposes will result in the creation of a “grantor” trust. The income tax rules governing grantor trusts provide that income is taxable to the grantor. This may result in tax savings, since if the trust were not a grantor trust, the payment of the tax liability of the trust by the grantor would itself result in a taxable gift to the trust. In the grantor trust context, no such taxable gift results. [One trust provision that would cause trust income to be taxed to the grantor but would not pull the trust back into his estate for estate tax purposes would be the retention of an administrative power, exercisable in a nonfiduciary capacity, to replace trust property with other property of equal value.]

Asset protection can also be facilitated by the use of family limited partnerships. This entity may enable the business owner to protect business assets from the claims of potential creditors. Since the owner would be named the general partner, he would still be entitled to make all business decisions. However, since as a general partner his interest in the partnership could be as little as 1%, the asset protection virtues of the family limited partnership become clear. The general partner can even take a salary for managing the assets of the partnership. If the general partner is sued, only his stake in the general partnership is subject to the claims of creditors.

Combining the virtues of the family limited partnership and the offshore trust can be especially attractive in asset protection.

Offshore Trusts

The concept of trusts dates back to the 11th Century, at the time of the Norman invasion of England. The trust has thus evolved for many centuries in common law countries around the world. Offshore trusts can assist U.S. residents in estate planning, asset protection, preservation of wealth, continuity of a family business, and avoidance of probate.

The basic underpinnings of an offshore trust track those of the domestic trust: a settlor (either an individual or a corporation), who establishes the trust agreement; the trustee, who takes legal title to and administers the assets transferred into the trust; and the beneficiaries, who receive distributions from the trust. Beneficiaries need not be named at the time of the creation of the trust; in that case the trust is termed a “discretionary” trust, i.e., the trustee has the power to determine the timing and identity of beneficiaries.

Under New York law, trust assets can be placed beyond the effective reach of beneficiaries’ creditors by use of a “spendthrift” provision. Typically, the spendthrift clause provides simply that the trust estate shall not be subject to any debt or judgment of the beneficiary. A settlor cannot, however, create a trust containing a spendthrift provision for his own benefit, since EPTL § 7-3.1 expressly provides that “a disposition in trust for the use of the creator is void as against the existing or subsequent creditors of the creator.”

Since offshore trusts are governed by the law of the jurisdiction in which the trust is created, one could in theory establish an offshore trust which contained a spendthrift provision protecting the settlor, provided the foreign jurisdiction permitted it. In fact, many foreign jurisdictions do permit the settlor to establish a spendthrift trust for the benefit of the settlor. This will place the trust assets farther from the practical (if not also legal) reach of potential creditors, while at the same time granting the settlor powers over and benefits from the trust that could not be achieved using a domestic trust.

One tax problem which arises when transferring assets to a foreign situs trust is that IRC Sec. 1491 imposes a “toll”charge of 35% on the unrealized gain attributable to the property transferred. There are, however, a two mitigating factors:

First, the taxpayer may instead elect to be taxed on the unrealized appreciation, in which case the normal capital gains rates (which are likely to become quite favorable in the near-term) would apply. Second, if the trust is governed by the grantor trust provisions of the Code, as discussed previously, the income of the trust would remain taxable to the grantor. In this case, there would be no “transfer” to the trust for income tax purposes, and Sec. 1491 would, by its own terms, be inapplicable.

Income tax planning and asset protection serve distinct, but equally important, functions. Income tax planning has as its primary objective the reduction in federal income taxes. Asset protection is a method of arranging one’s assets so as to make them impervious to creditor attack. Asset protection is becoming ever more essential as the litigiousness of U.S. society increases.

The family limited partnership (FLP) can be extremely useful in accomplishing tax and asset protection objectives. The FLP is a financial and legal partnership among family members established for their benefit. The FLP is especially attractive from the practical standpoint since an individual can transfer ownership of assets to family members, yet retain effective control over investment and business decisions by naming himself as the managing partner.

Since partnerships are imbued with extremely favorable income tax attributes, they are now a preferred entity for holding family wealth. FLPs can be used to shift income to family members, such as children and grandparents, who may be in much lower tax brackets. This reduces the incidence of overall taxation.

FLPs also accomplish important asset protection themes, since partnership assets can be placed virtually beyond the reach of creditors. Creditors attempting to reach partnership assets will be stymied since creditors cannot actually levy upon partnership assets. Instead, they must obtain a “charging order.”

A charging order is an interest in the partnership. Since a partnership is a pass-thru entity for tax purposes, a creditor possessing a charging order would be liable for tax if the partnership earned income but made no distributions. Thus, a charging order is extremely undesirable from a creditor’s tax standpoint, and a creditor may be repelled from seeking to attack partnership assets.

Even if a charging order would not deter a creditor (i.e., if the partnership has little or no current income), the FLP can enable family members to protect their assets by reason of the fact that the value of partnership interests held by family members is less — perhaps much less — than the corresponding value of the partnership interests held by the partnership. This reduces the value of the assets for both estate and gift tax purposes, as well as for creditor purposes.

As effective and desirable as FLPs are, they are not without limitations. For example, a court may reach partnership assets by asserting that the partnership’s principal purpose was to avoid creditors (see Avoiding Fraudulent Transfers, May Comment). It may therefore be advisable to implement a mechanism whereby the transfer of FLP interests to an offshore trust can be effectuated.

Under the plan being considered, assets transferred to a FLP would in most instances stay in the United States until the threat of a creditor appears. Once a creditor appears on the horizon, the partnership interests could be transferred to the trustee of a foreign trust. Once so transferred, the assets of the trust would in all likelihood no longer be subject to the United States legal system. Trusts so created are entirely legal; asset protection trusts have been recognized by the IRS as legitimate asset protection devices.

Foreign trusts also accord a measure of privacy to the grantor, and may convery the impression that the creator of the trust is judgment-proof, even if that is not the case. In any event, one seeking to enforce a judgment in a foreign jurisdiction would likely be required to retain foreign counsel, and litigate in a jurisdiction which might be generally hostile to his claim.

Of all offshore jurisdictions, the Cook Islands are generally recognized as a preferred location for an asset protection trust, for these reasons:

¶ There are few currency restrictions in the Cook Islands;

¶ The statute of limitations for fraudulent transfers is short;

¶ Self-settled spendthrift trusts are recognized under Cook Islands law. (Assets placed in a spendthrift trust are protected from creditor’s claims. However, all states in the U.S. prohibit one from creating a spendthrift trust in favor of oneself.)

¶ Rules of local taxation are favorable;

¶ Modern banking and trust facilities exist; and

¶ Judgments of U.S. courts of law or bankruptcy are not enforceable. (Of all offshore jurisdictions, only the Cook Islands appears not to enforce both law and bankruptcy court judgments.)

The law of the trust’s situs controls whether the trust was properly executed. The situs of personal property is the domicile of the owner which, in the case of a foreign trust, would be the foreign trustee. To maximize the asset protecting effectiveness of the trust, the trust should (1) designate the law of the foreign jurisdiction as controlling with respect to all aspects of the trust, (2) be funded with personal or intangible property located in the foreign jurisdiction, and (3) be administered in the foreign jurisdiction by a trustee with no U.S. contacts.

The situs of real property is the location of the property itself. To protect real estate located in the U.S., the real property would therefore have to be converted to personal property by transferring the property to a corporation or partnership in exchange for a partnership interest or stock. Both of these would constitute intangible personal property. The stock or partnership interest could then be transferred to a foreign trust.

Movables, i.e., personal and intangible property, are generally governed by the law of their situs. A court has jurisdiction over intangibles embodied in a document within its boundaries. Intangibles not embodied in a document are subject to the jurisdiction of the state with the most significant relationship. Under the Uniform Commercial Code, in order to attach “certificated securities,” the security must be physically seized. Physically moving stock certificates to a foreign situs can thus be clearly beneficial. Even if the the foreign trust were disregarded, creditors would be unable to realize the value of the stock certificates without physically seizing them.

In general, foreign asset protection trusts are not endowed with special tax attributes which by their nature can legitimately reduce the incidence of U.S. income taxes. Legitimate tax savings which may result occur by reason of the type of entity which is chosen, and the avoidance of transfer taxes through carefully structured transactions, in which the grantor may retain limited control over trust assets.

Because of the secrecy often associated with foreign trusts, the IRS, despite strict reporting requirements, may be unaware of the assets placed in a foreign trust. Some taxpayers may seek to avoid paying taxes on foreign trust income. Foreign trusts are subject to strict reporting requirements by the IRS with harsh penalties for failure to comply. Taxpayers would be ill-advised to seek tax savings by deceiving the IRS, since this could result in criminal or civil liability.

An asset protection trust will be liable for U.S. income taxes. It is advantageous from a tax standpoint also to be recognized as a trust (rather than a corporation) for tax purposes. To be recognized, the entity must lack the corporate characteristics of having associates and an objective to carry on a business, and divide profits.

While it is possible to create a trust in a foreign jurisdiction which has a U.S. situs for income tax purposes and a foreign situs for debtor-creditor (i.e., asset protection) purposes, this may be risky from a tax standpoint, since the IRS will not rule in advance on this issue. It is therefore prudent to comply with reporting requirements as if the trust were foreign for U.S. income tax purposes.

President Clinton’s 1996 proposed tax legislation seeks to tighten the rules for taxing foreign trusts. To ensure that the U.S. collects tax on income earned by foreign trusts, the proposal would implement enhanced reporting requirements by foreign trusts.

Avoiding Fraudulent Transfers

In implementing an asset protection plan, attention must be paid to avoiding fraudulent transfers which could render a transfer ineffective, and subject both attorney and client to sanctions. Warning signs that a transfer may be fraudulent include insolvency of the transferor, lack of consideration for the transfer, and secrecy of the transaction.

Insolvency, for this purpose, means that the transfer is made when the debtor was insolvent or would be rendered insolvent, or is about to incur debts he will not be able to pay.

New York Debtor & Creditor Law, Sec. 275 provides that “[e]very conveyance and every obligation incurred without fair consideration [with an intent to] incur debts beyond ability to pay…is fraudulent.” Fortunately, however, once the determination has been made that the transfer is not fraudulent, later events which might have rendered the transaction fraudulent (if known earlier) would be of no legal moment.

The transfer of assets by a person against whom a meritorious court claim has been made — even if it the claim has not been reduced to judgment — would likely render the transfer voidable. If the claim were not meritorious, then the transfer would probably not be fraudulent, irrespective of the eventual disposition of the claim. For example, transferring title in the marital home to one’s spouse is an excellent asset protection tool, but attempting it when the IRS has just issued a notice of deficiency would probably fail. If the Tax Court had just upheld the deficiency the transfer would almost certainly be set aside, if challenged.

Transfers made without full consideration are especially prone to being characterized as fraudulent, since such a transfer suggests that the property is being held for the same beneficial interests. Therefore, transfers between family members (or even to a partnership) for little or no consideration in the presence of lurking creditors may establish a prima facie case of fraudulent intent.

Aside from avoiding any interest in the transferred property and receiving full consideration, the transferor should also adhere to the usual legal formalities associated with the transfer. Even a legitimate sale, if evidenced only by a flimsy, hastily prepared document, could suggest an element of immediacy, which could in turn support a finding of fraud.

Posted in Asset Protection | Tagged asset protection, charging order, fraudulent transfers, offshore trusts | Leave a comment

Clinton’s Tax Agenda for 2nd Term (May 1996)

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

President Clinton’s 1996 tax proposal draws significantly from Congress’ 1995 legislation which he vetoed, especially with respect to individuals and pension reform. Mr. Clinton will likely resist long-standing Republicans efforts to enact a capital gains tax cut to 14%, citing concern that such a cut would primarily benefit the affluent, and would sharply reduce tax revenues.

In a second term, Mr. Clinton, together with a Republican-controlled Congress, would likely press for immediate pension reform:

Both the President and Congress propose to (1) eliminate the rule which prevents one spouse from making a deductible IRA contribution if the other participates in an employer-sponsored plan, (2) raise the AGI threshold for phasing out deductible IRA contributions occurs, and (3) permit penalty-free distributions to (a) purchase or remodel a first home, (b) pay for certain medical or educational expenses, or (c) supplement unemployment compensation.

Mr. Clinton and Congress have both proposed “back loaded” IRAs. Nondeducitble contributions would be in lieu of amounts contributed to a traditional IRA. Earnings and principal could be withdrawn tax-free for one of the purposes listed in item (3)(c) at any time under Mr. Clinton’s plan and after 5 years under the Republican plan. Both proposals contain measures to:

¶ Require recognition of gain on the sale of a residence if depreciation deductions were previously taken for business or home office use. Neither a rollover nor an exclusion would defeat the imposition of this new tax.

¶ Allow a $500 tax credit for dependent children.

¶ Increase the deductible portion of self-employed health insurance payments from 30% to 50%.

¶ Require the registration of corporate tax shelters.

¶ Increase the Sec. 179 deduction to $25,000 by 2000.

¶ Deter tax-motivated expatriation by imposing objective (i.e., non-motive based) taxes and penalties.

¶ Extend the current rule allowing a full FMV deduction for charitable contributions of appreciated stock.

¶ Reinstate the exclusion for employer-provided educational assistance.

¶ Strengthen taxpayer rights vis-á-vis the IRS through a “Taxpayer Bill of Rights 2.”

Mr. Clinton alone champions tax proposals which would:

¶ Allow a $10,000 deduction ($5,000 until 1999) for post-secondary education and training for the taxpayer and family members.

¶ Prevent investors from selling high basis stock first (where multiple purchases were made) by requiring an average-cost basis.

¶ Require recognition of gain on short sales “against the box” by imposing a constructive sale.

¶ Reduce the corporate dividends received deduction to 50% from 80%.

¶ Shorten the NOL carryback period to 1 year, but extend the carryforward period to 20 years.

¶ Repeal tax-free conversions of large C to S corporations.

¶ Restrict like-kind exchanges involving personal property situated abroad.

¶ Increase penalties for failing to report business payments over $600.

¶ Permanently extend luxury excise tax on automobiles.

¶ Tighten rules for taxing foreign trusts.

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

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

What is Income?

Income Shifting

Significance of IRS Rulings

Taxpayer Rights During an IRS Audit

Wash Sales

Administrative Appeals Within the Internal Revenue Service

Itemized Deductions

Home Office Deductions

Inter Vivos Trusts

Amortization of Good Will Under IRC Sec. 197

Limited Liability Companies

IRS Ruling Blesses New York RLLPs (January 1996)

Asset Protection; Avoiding Fraudulent Transfers

Clinton’s Tax Agenda for 2nd Term (May 1996)

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